brazilAfter investors recently launched a securities class action lawsuit against Petrobras and certain of its directors and officers on behalf of those who purchased the company’s ADSs on U.S. exchanges, I speculated on whether or not investors who purchased their Petrobras shares in Brazil and are therefore precluded from participating in the U.S. lawsuit might try to file their own separate action in Brazil, subject to whatever procedural limitations might apply there.

 

This speculation in turn triggered an email exchange with Brazilian readers who alerted me about the press coverage in Brazil following the filing of the U.S. lawsuit. Among other things, the Braziian press coverage has raised the question whether the ADS investors have avenues to seek redress under U.S. law that are simply not available to those who purchased their Petrobras shares on the Brazilian exchange.

 

According to a December 14, 2014 post on the CLS Blue Sky blog (here), this discrepancy in the remedies available to investors for the same essential alleged wrongdoing and harm depending on where they bought their shares has arisen in Brazil before.

 

The blog post, by Érica Gorga, a Professor at Fundação Getulio Vargas São Paulo Law School and a research scholar at Yale Law School, takes a look at two prior situations in which Brazilian companies with securities listed on U.S. securities exchanges were sued in U.S. securities class action lawsuits, while Brazilian investors were left out with respect to their personal investment losses. (The blog post presents a summary of the author’s longer scholarly paper, which can be found here.)

 

According to Gorga’s analysis, not only did the U.S. investors in those two prior cases recover compensation for their losses while the Brazilian investors did not, but the company’s settlement payments to the U.S. investors left Brazilian investors even worse off in a sort of double-whammy Gorga calls a “double circularity.”

 

The two prior situations that the author examined involved Sadia S.A. and Aracruz Celulose S.A. Both of these companies and certain of their directors and officers were sued in securities class action lawsuits in the U.S. on behalf of investors who purchased the companies’ American Depositary Receipts on U.S. exchanges. The Sadia U.S. lawsuit, which is described here, settled for $27 million. The Aracruz U.S. lawsuit, which is described here, settled for $37 million.

 

Shareholders of these two companies who purchased their shares on Brazilian exchanges also tried to initiate litigation in Brazil, relying on the same alleged wrongdoing alleged in the U.S. lawsuits. However, the author notes, “because of the lack of private class actions” in Brazil, the Brazilian investors “had to rely on derivative suits, which provided only a small recovery to one of the companies, rather than to harmed investors.”

 

The author says that the Sadia and Aracruz cases “provide concrete examples of the financial value distribution that characterizes the current system of transnational securities litigation.” The current state of affairs where investors who purchase their shares on U.S. exchanges can attempt to seek redress of their investment losses for alleged financial misrepresentations while investors who purchased their shares elsewhere cannot underscores the “costs borne by foreign investors” when non-U.S. companies cross-list in the U.S. As she puts it, the non-U.S. investors “who usually don’t enjoy the same antifraud protections overseas – due to the lack of appropriate law or enforcement mechanisms – are compelled to accept wealth transfers to U.S. investors.” These phenomena, the author suggests, are “aggravated” by the U.S. Supreme Court’s decision in Morrison v. National Australia Bank,

 

In commenting on this “wealth transfer,” the author suggests that the investors who purchased their shares in cross-listed companies on non-U.S. exchanges are hit with a sort of double whammy. This phenomenon is due in part to the so-called “circularity problem” in securities litigation, which refers to the fact that innocent shareholders who did not participate in the securities fraud bear the cost of compensating investors who lost value.

 

When a cross-listed company is involved, there is an extra layer of costs imposed on foreign shareholders, beyond those associated with the circularity problem. In what the author calls a “double circularity” problem, the shareholders who purchased their shares of the company on a non-U.S. exchange “bear twice the costs of failures in a company’s corporate governance practices: first, when their shares lost value due to the wrongdoing per se; second, when they bear the costs of indemnification paid exclusively to U.S. security holders.”

 

While the author’s analysis of these issues is focused particularly on the two Brazilian examples, these “foreign-bearer” costs are “likely to be generalized to foreign investors in all jurisdictions.” And while some jurisdictions have developed forms of aggregate litigation to provide avenues for redress for harmed investors, “there remain serious doubts whether these actions will provide an effective institutional framework that fully supports collective litigation and financial recovery.”

 

The general direction of the author’s analysis would seem to be a prelude to a call for other jurisdictions to provide investors who purchase shares on the jurisdiction’s exchanges with remedies equivalent to those available in the U.S. Indeed, she does note that there has been speculation in the wake of Morrison that the restriction on the availability of remedies in U.S courts for non-U.S. investors might lead to the expansion of investor remedies elsewhere. However, she also notes there are a host of structural restrictions – the absence of contingency fees, the loser pays model — that cut against the adoption of these kinds of reforms in many jurisdictions. Indeed, she notes, if there were a jurisdiction where the need for development of new remedies would seem to be apparent, it would be Brazil in the wake of the Sadia and Aracruz cases — but nothing along those lines has developed there, at least so far.

 

After reviewing a number of academic reform proposals, the author comes out in favor of a “system of adjudication of transnational securities litigation providing equal treatment for securities holders subject to the same wrongdoing regardless of the national of the purchasers or the location of the purchase/sale,” which could be achieved “through issuer or investor choice of applicable legal regime.”

 

Discussion

Before the U.S. Supreme Court’s Morrison decision, it was a frequent topic of discussion whether so called f-cubed lawsuits – involving claims by foreign investors who bought their shares in foreign companies on foreign exchanges – were appropriately being heard in the U.S. However, when the U.S. Supreme Court made it clear in the Morrison case that the U.S securities laws do not apply to f-cubed cases, the practical impact arguably may have been – at least from the perspective of this academic’s article – to substitute one problem for another.

 

The author’s paper describes what she calls the transnational securities litigation problem, in which different investors have different remedies (or some investors have no remedies) for similar wrongdoing based solely on where the investors bought their shares. Her paper emphasizes not just that the different investors have different remedies, but that the availability of remedies to one group of investors arguably comes at the expense of the other investors. This is an interesting and valuable insight.

 

While I appreciate the value of the authors’ observations, I nonetheless believe certain additional considerations need to be taken in to account

 

 

First, the presence of D&O insurance may ameliorate the concern the author describes. As the author acknowledges in her longer academic paper, most of the cost of one the U.S. securities suit against the two Brazilian companies (Aracruz) was paid for by the company’s D&O Insurers, and thus was not borne by non-U.S. investors. (The author notes that the costs of the D&O insurance was borne by all investors, but inured to the benefit only of the investors who purchased shares on U.S. exchanges)

 

Because in many cases U.S. class action securities litigation settlements are funded in whole or in part by D&O insurance, the magnitude of the adverse financial impact on non-U.S. investors from the settlement of U.S. securities litigation often arguably will be significantly less than the author suggests. The frequent role of D&O insurance in these kinds of settlements is a factor that adds a layer of complexity to the analysis of these issues and arguably reduces the magnitude of the “double circularity” issue the author describes.

 

Second, the “transnational securities litigation problem” the author describes arguably is at least in part a side-effect of advantages that the U.S. securities markets have in the global financial marketplace. To be sure, the availability of securities litigation remedies to investors who purchase securities on the U.S. exchanges means that companies with securities listed on the U.S. exchanges face a heightened risk of litigation. This litigation risk is well known and often decried, both within and outside the U.S. Yet despite these well- recognized litigation risks, non-U.S. companies continue to list their shares on U.S. exchanges. Indeed, as I noted in a recent post on 2014 IPOs, 23% of all IPOs on U.S. exchanges during 2014 involved non-U.S. companies, and these non-U.S. company IPOs represented 52% of all cross-border IPO deals globally during the year.

 

There are of course a host of reasons why non-U.S. companies seek to list their shares on U.S. exchanges. I would argue that among other reasons companies seek U.S listings is that because of the requirements for transparency and accountability, a U.S. listing  communicates a willingness to be subject to a certain level of scrutiny. One of the elements of the increased scrutiny prevailing in U.S. securities markets is the ability of investors who purchase their shares to collectively seek damages for financial misrepresentations. The increased level of accountability supports transparency, which in turn supports overall market confidence.

 

 

 

The absence of remedies to investors who purchase shares elsewhere is of course a detriment to those investors, but the availability of remedies is a clear advantage to investors who purchase shares on the U.S. exchanges. The availability of these remedies in turn helps support the U.S. markets’ reputation for transparency that makes the U.S. exchanges an attractive place for companies to list their shares. From that perspective, then, the circumstances of which the author complains are part of the features that make the U.S. exchanges attractive to issuers and to investors.

 

Third, I have long thought that the absence of equivalent investor remedies in other countries sooner or later would motivate investors to agitate for reform in their home countries. Change has been slow in coming. But despite the lack of progress to date on these issues, the prospect for the development of mechanisms for redress within individual countries seems likelier to occur than the development of complex mechanisms of the kind the author supports that would require cross-border collaboration of securities regulators.

 

Finally, there is the possibility that certain existing mechanisms could also provide investors with avenues for redress. It is beyond the scope of this blog post, but there have been developments in the Netherlands that suggest means by which global investors could seek to recover investment losses.  In addition, there have been class action developments in other countries (including in particular Canada and Australia) that could also allow for global class actions where jurisdictional requirements in those countries are otherwise met. In other words, there may be other forces at work that could help ameliorate the transnational securities litigation problem that the author describes.

 

A final note. It may be that the two prior cases to which the author refers may not have been sufficient to provoke a chance in the remedies available to Brazilian investors. I wonder whether the scope and scale of the new Petrobras scandal might be enough to bring about change. Brazil only recently adopted strong antibribery laws yet authorities have moved quickly to move against corruption. Could the same kind of thing develop with respect to allegations of securities fraud?  

 

riA recurring D&O insurance question is whether or not a policy’s contract exclusion precludes coverage for claims that the insured induced the claimant into entering a contract through negligent or intentional misrepresentations. In a interesting December 22, 2014 opinion (here), District of Rhode Island Judge John J. McConnell, Jr., applying Rhode Island law, held that even a contract exclusion with the broad “based upon” or “arising out of” preamble language did not preclude coverage for a portion of a jury verdict holding that the insured’s intentional misrepresentations had induced the claimant to enter into the disputed contract. As discussed below, Judge McConnell’s opinion provides a useful and interesting perspective on this recurring question about the scope of the contract exclusion’s preclusive effect.

 

In 2004, TranSched Systems undertook negotiations to acquire certain software assets from Versys Transit Sollutions. During the course of these discussions, Versys was represented by Versys’ Vice President Sheryl Miller and its Vice President of Product Development and Chief Technology Officer, Lorin Miller. In February 2005, the two companies entered an Asset Purchase Agreement (APA) and related documents transferring ownership of the software assets from Versys to TranSched.

 

The software assets were not delivered as provided in the APA. TranSched initiated litigation in Delaware alleging that prior to the parties’ entry into the APA the two Versys representatives had made material misrepresentations about the software assets and also that Versys had breached the APA. After Versys received the complaint, it submitted the lawsuit as a claim under its D&O insurance policy.

 

The Delaware lawsuit went to trial and the jury found against Versys on three grounds: (1) intentional misrepresentation; (2) breach of contract regarding misrepresentations and warranties under the APA; and breach of the covenant of good faith and fair dealing. The jury awarded damages of $500,000. The trial judge awarded TranSched costs and prejudgment interest of over $170,000.

 

TranSched was unable to collect the judgment from Versys, which is no longer in business. TranSched attempted to collect the judgment from Versys’s D&O insurance carrier. The insurer denied coverage for the judgment and the TranSched filed an action in the District of Rhode Island seeking to establish that the insurer’s policy provided coverage for the amount of the judgment.

 

The insurer contended that coverage for the judgment was precluded from coverage by two policy exclusions, the Limited Contract Exclusion and the Fraud Exclusion.

 

The Limited Contract Exclusion provides that there is no coverage under the policy for any Claim “based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement, provided that this Exclusion …shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract agreement.”

 

The Fraud Exclusion precludes coverage for Claims “based upon, arising from, or in consequence of any deliberately fraudulent act or omission or any willful violation of any statute or regulation by such Insured, if a final and non-appealable judgment or adjudication adverse to such Insured establishes such a deliberately fraudulent act or omission or willful violation.” The Severability of Exclusions clause provides further that with respect to the Fraud Exclusion, “only facts pertaining to and knowledge possessed by any past, present or future Chief Financial Officer, President, Chief Executive Officer or Chairperson of any Insured Organization shall be imputed to any Insured Organization to determine if coverage is available.”

 

The December 22 Opinion

 

In his December 22, 2014 memorandum opinion, District of Rhode Island Judge McConnell, applying Rhode Island law, held that while the breach of contract exclusion precluded coverage for the breach of contract and breach of the implied covenant of good faith portions of the jury’s verdict, neither of the two exclusions on which the insurer sought to rely precluded coverage for the intentional misrepresentation portion of the jury’s verdict.

 

In concluding that the Limited Contract Conclusion did not preclude coverage for the intentional misrepresentation portion of the jury’s verdict, Judge McConnell cited several prior decisions in which courts had concluded that intentional misrepresentations are not precluded from coverage under a contract exclusion “where the misrepresentations were made before the transaction and the transaction was generated by and was a consequence of a misrepresentation.” (Emphasis in original, citations omitted). Judge McConnell said he found “the reasoning in these cases to be persuasive and applicable to the facts of this coverage dispute.”

 

Judge McConnell went on to say that the contract exclusion is “limited to actual liability arising under the contract.” He added that the “evidence at trial sufficiently supports TranSched’s assertion that the intentional misrepresentation claim did not arise out of the contract, but concerned only pre-transaction conduct,” noting further that “the APA was not a cause of the intentional misrepresentation claim, it was the result of it, and any tortious conduct is not covered under the exclusion because it preceded the APA and was independent of the contract itself.”

 

With respect to the Fraud Exclusion, Judge McConnell rejected the insurer’s attempt to circumvent the Severability Exclusion by arguing that it was not attempting to impute any conduct to Versys but rather was focusing on the conduct of Versys itself. Judge McConnell said that to support this interpretation, he would have to “ignore the Severability of Exclusions clause” and would have to find that “any misleading statement representation or omission by any employee … would trigger the fraud exclusion.” He added that “the fraud exclusion, without the severability clause, could work an inequitable result when one considers how many employees a company has and the fact that the exclusion as written makes the company responsible for all of its employees’ misconduct without providing any coverage.”

 

Based on his review of the evidentiary material presented Judge McConnell said that “it is clear that the case mainly focused on the vice presidents’ roles in driving the transaction,” and that because “their conduct does not bind Versys on the terms of the exclusion, the fraud exclusion does not apply in this case.”

 

As a result of the Judge McConnell’s conclusion that the jury verdict was awarded on both covered and uncovered claims, he determined that there would have to be an allocation. He ordered the parties to submit the allocation to mediation using either the services of the Magistrate Judge assigned to the case or of a mediator of their own choosing.

 

Discussion

This case represents the relatively unusual circumstance that the insurance coverage questions are being considered after the entry of a jury verdict in the underlying claim. It is much more frequently the case that these kinds of issues are being disputed after the underlying case has been settled. Though the jury verdict does make this case distinct from many other situations in which these kinds of questions arise, Judge McConnell’s ruling may nevertheless be useful and even instructive in other cases in which the extent of the preclusive effect of the policy’s contract exclusion is in dispute.

 

In that regard, it is important to note that though there were breach of contract allegations, and though all of the allegations in the underlying lawsuit related to the transaction in connection with which the relevant contract had been entered, Judge McConnell did not simply conclude that the broad preamble of the exclusion meant that the exclusion’s preclusive effect applied to all of the transaction-related allegations.

 

As I have noted in prior posts (for example, here), I have been concerned by a number of recent court decisions in which courts have interpreted D&O insurance policy contract exclusions with a broad preamble to sweep so broadly as to preclude coverage not only for breach of contract claims but also for misrepresentation claims relating to the same transaction in which the contract arose.

 

Here, even though the contract in question followed the alleged misrepresentations, and even though the contract in question arose from and was induced by the alleged misrepresentations, Judge McConnell concluded that the contract exclusion did not preclude coverage for the misrepresentation claims. As he put it, the misrepresentations “did not arise out of the contract, but concerned only pre-transaction conduct,” adding that the APA contract “was not a cause of the intentional misrepresentation claim, it was the result of it, and any tortious conduct is not covered under the exclusion because it preceded the APA and was not independent of the terms of the contract itself.”

 

Judge McConnell’s conclusion in this regard (and the conclusions of the courts on whose opinions he relied) stands in contrast to the cases in which courts have interpreted contract exclusions with a broad preamble so broadly as to preclude coverage even for claims alleging that the contract resulted from pre-contract inducements.

 

While circumstances will vary and while there may be factual issues that affect the analysis in specific situations, there is an element of convincing logic to Judge McConnell’s analysis that the contract exclusion – even an exclusion with a broad “based upon” or “arising out of” preamble – does not apply to preclude coverage for claims involving conduct that preceded the entry of the contract. This logic applies even if the allegation is that the pre-contract conduct was an inducement for the parties to enter the contract. As Judge McConnell said, liability for these types of inducement claims does not arise out of the contract, it is the other way around; the contract arose out of the inducements.

 

As I have noted in prior posts, the prior cases in which courts have applied contract exclusions to preclude coverage even for negligent or fraudulent inducement claims arguably are applying the contract exclusions so broadly as to preclude coverage for the very types of claims for which the policy’s coverage was intended.

 

I have long thought that the cure for this overly broad application of the contract exclusion would be to amend the exclusion’s preamble to provide that the exclusion’s preclusive affect applies only to claims “for” breach of contract.

 

However, Judge McConnell’s opinion makes clear that even if a contract exclusion uses the broader “based upon or arising out of” language, the policy exclusion does not apply to all claims asserted merely because there is a transaction involved. His conclusion that the exclusion does not apply to pre-transaction conduct provides an important distinction on which policyholders can seek to rely in contending that even a contract exclusion with a broad preamble does not preclude coverage merely because a transaction is involved.

 

On a final note, it is worth observing that Judge McConnell concluded that the policy’s fraud exclusion did not preclude coverage even though this case involved the rather unusual situation in which there had actually been a final adjudication of an intentional misrepresentation. His ruling in that regards was reliance on the severability clause that limited the persons whose conduct could be imputed to the company. Judge McConnell’s ruling on the fraud exclusion not only underscores the critical importance of the inclusion of these types of severability provisions, but the analysis in his opinion highlights the unfairness that would be involved if the policy did not include a severability provision of this type. His analysis also highlights how important it is to limit the number of persons whose knowledge or conduct will be imputed to the entity for purposes of determining the applicability of the conduct exclusions.

prokauerIn numerous posts (most recently here), I have noted the ongoing controversy in Delaware on this issue whether or not companies organized under the laws of that state should be able to adopt so-called fee-shifting bylaws. In the following guest post, Tanya Dmitronow, Rachel Wolkinson, and Stacey Eilbaum, all of whom are litigation lawyers at Proskauer Rose LLP and authors of the Firm’s Corporate Defense and Disputes blog, discuss the debate in Delaware regarding the use of bylaws to impose limits on shareholder litigation in light of the Delaware Supreme Court decision in ATP Tour, Inc. v. Deutscher Tennis Bund. Brad Ruskin, a Proskauer partner, represented ATP Tour, Inc. in that case. A version of this post previously appeared on Proskauer’s Corporate Defense and Disputes blog. 

I woud like to thank the attorneys from Proskauer for their willingness to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of itnerest to readers of this blog. Please contact me directly if you are interested in publishing a guest post. Here is the Proskauer attorneys’ guest post.

**************************************  

The ability of corporations to impose liability on shareholders through bylaws and charter provisions has been the subject of much debate recently. On May 8, 2014, the Supreme Court of Delaware held in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 555 (Del. 2014), that “a fee-shifting provision in a non-stock corporation’s bylaws can be valid and enforceable under Delaware law.” This decision (in favor of ATP, represented by Proskauer’s own Brad Ruskin) prompted a proposed amendment to the Delaware General Corporation Law (DGCL) that would eliminate the ability of Delaware stock corporations to impose liability on shareholders through bylaw and charter provisions, including fee-shifting liability, and a debate about the use of bylaws to define the bounds of shareholder litigation. Act to Amend Title 8 of the Delaware Code Relating to the General Corporation Law, S.B. 236, 147th Gen. Assemb. (Del. 2014). Senator Bryan Townsend, D-Newark, was able to delay the debate on the proposed legislation until the Delaware legislature reconvenes in January 2015.

While the Supreme Court’s decision in ATP was the catalyst for the legislative development, ATP was not the first time that a court in Delaware had validated bylaws defining the bounds of shareholder litigation. Last year, the Delaware Court of Chancery upheld the validity of board-adopted forum selection bylaws in Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013). In that case, cited by the Delaware Supreme Court in ATP, the Delaware Court of Chancery held that a board of directors has the statutory authority to unilaterally adopt forum selection bylaws if the corporation’s certificate of incorporation permits the board to amend its bylaws. The Court of Chancery noted that board-adopted forum selection bylaws were statutorily valid because they were process-oriented, in that they concerned when a shareholder may sue a corporation. The Chancery Court contrasted forum selection bylaws with substance-oriented bylaws, which would involve whether a shareholder is barred from suing or the type of remedy a shareholder may recover, and could not be unilaterally adopted by a board of directors. The Chancery Court held that process-oriented bylaws were matters concerning the rights of shareholders that bylaws properly may address under 8 Del. C. Section 109(b). Id. at 952.

Moreover, the Chancery Court in Boilermakers found that the forum selection bylaws were contractually valid and enforceable, rejecting plaintiffs’ argument that the board-adopted bylaws could not be a contractual forum selection clause because the stockholders had not approved such provisions. Title 8 Del. C. Section 109(a) permits a corporation, through its certificate of incorporation, to grant its directors the unilateral power to adopt and amend the bylaws, and the boards in Boilermakers had the power to amend their corporations’ bylaws under their certificates of incorporation. Therefore, the Court of Chancery reasoned, when investors purchased stock in these corporations, they agreed to be bound by any board-adopted bylaws as “part of a binding broader contract among the directors, officers, and stockholders formed within the statutory framework of the DGCL.” Id. at 939. In addition, the Chancery Court noted that because of this “flexible contract” between the shareholders and the corporations, shareholders who object to forum selection bylaws have the option to amend or repeal the bylaws and the opportunity to elect directors on an annual basis. For more on the ATP and Boilermakers decisions, see Ralph Ferrara and Rachel Wolkinson, “When the Camel’s Nose Gets Under the Tent: Fee-Shifting and Forum Selection in Delaware,” Corporate Governance Advisor.

Interestingly, between the date of the Boilermakers decision and late September 2013, approximately 70 companies, including 21st Century Fox, DuPont, JCPenney, Electronic Arts, and Air Product & Chemicals adopted exclusive forum-selection provisions. See Glass Lewis on Exclusive Forum Provisions, Sept. 25, 2013.

A recent decision by the Court of Chancery provides further support for the validity of board-adopted forum section bylaws. In City of Providence v. First Citizens BancShares, Inc., 99 A.3d 229, 234 (Del. Ch. 2014), issued on September 8, 2014, the Court of Chancery again upheld the validity of a forum selection bylaw, addressing for the first time the question of “whether the board of a Delaware corporation may adopt a bylaw that designates an exclusive forum other than Delaware for intra-corporate disputes.” The forum selection bylaw at issue in City of Providence was “virtually identical” to the bylaw adopted in Boilermakers with the exception that, unlike the bylaws in Boilermakers, which designated Delaware as the exclusive forum, the bylaw designated “as the forum the United States District Court for the Eastern District of North Carolina, or, if that court lacks jurisdiction, any North Carolina state court with jurisdiction, instead of the state or federal courts of Delaware.” Id. at 230. Relying on Boilermakers, the Chancery Court dismissed the plaintiffs’ facial validity challenge, citing Sections 109(a) and (b) of the DGCL and explaining that First Citizen’s charter granted the board the power to amend the bylaws, therefore putting stockholders on notice that the board “may act unilaterally to adopt bylaws addressing” topics subject to regulation by bylaw under section 109(b). Id. at 234.

As to the question of whether the board of a Delaware corporation may adopt a bylaw designating an exclusive forum other than Delaware for intra-corporate disputes, the Chancery Court held that the analysis of Delaware law outlined in Boilermakers compelled the same conclusion in this matter. Although Delaware may be the most reasonable forum for disputes regarding the internal affairs of corporations, the Chancery Court explained that “nothing in the text or reasoning of [Boilermakers] can be said to prohibit directors of a Delaware corporation from designating an exclusive forum other than Delaware in its bylaws.” Id. 

The Chancery Court declined to address City of Providence’s argument that the forum selection bylaw improperly stripped the court of the “‘exclusive jurisdiction’ vested upon it by the General Assembly” as a “hypothetical as-applied challenge,” noting that “Vice Chancellor Laster recently . . . concluded that a grant by the General Assembly of ‘exclusive’ jurisdiction to this Court for claims arising under a particular statute does not preclude a party from asserting a claim arising under that statute in a different jurisdiction” and that “any attempt by the General Assembly to bestow . . . a ‘substantive right’ to bring a claim only in this Court would conflict with the Supremacy Clause of the United States Constitution and federal diversity jurisdiction.” Id. at 236.

City of Providence should provide some confidence in the numerous forum selection bylaws boards have adopted post-Boilermakers. Meanwhile, debate over the proposed DGCL amendment when the legislature reconvenes next month will no doubt add to the evolving discussion over the use of bylaws to define the bounds of shareholder litigation.

We will keep you apprised of developments on this issue in the upcoming year. 

minnOn December 16, 2014, in an interesting ruling that undoubtedly will stir up a great deal of debate, District of Minnesota Judge Paul Magnuson, applying Delaware law, granted U.S. Bancorp’s motion for summary judgment, holding that the bank’s professional liability insurers must pay $30 million of the $55 million the bank agreed to pay in settlement of overdraft fee overcharge class action lawsuits, plus related defense fees. A copy of Judge Maguson’s memorandum opinion can be found here.

 

Judge Magnuson rejected the insurers’ argument that coverage for the settlement was precluded as a matter of public policy because the underlying claims for repayment of the overcharges were restitutionary in nature. Judge Magnuson ruled that the “after adjudication” requirement of the policy’s ill-gotten gains exclusion implies coverage for the settlement of disputed claims for restitutionary amounts, where there has been no adjudication that the amounts involved were wrongfully taken.

 

Insurers contend (and indeed assume) that professional liability policies and management liability policies do not cover restitution. Indeed, Judge Magnuson was willing to assume for purposes of his opinion that restitutionary amounts are not covered. The question Judge Magnuson addressed was whether the policies at issue provided coverage for the settlement of claims for restitutionary amounts, where there had been no determination that the amount to be paid constituted a restitution. In a ruling that undoubtedly will prove controversial in claims departments everywhere, Judge Magnuson held that under policies with an adjudication requirement, coverage is available for settlements of restitutionary claims in the absence of an adjudication.

 

Background

In 2009, U.S. Bank was sued in a series of class action lawsuits in which the claimants alleged that the bank had improperly charged overdraft fees to its customers and that it had misrepresented its overdraft fee policy. The claimants asserted a variety of common law and statutory claims and sought the return of the excess overdraft fees.

 

U.S. Bank submitted the overdraft fee class action lawsuits as claims under its professional liability insurance policies.  U.S. Bank maintained a program of professional liability insurance with total limits of $35 million, consisting of a primary policy of $20 million and an excess policy of $15 million. The primary policy was subject to a $25 million deductible. The insurers denied coverage on the ground that the amounts claimed in the overdraft fee overcharge class actions were restitutionary in nature and that restitution is uninsurable as a matter of law.

 

U.S. Bank reached an agreement to settle the underlying lawsuit for a total payment of $55 million. The insurers provided consents to the settlement subject to a reservation of their rights under the policies to later contest coverage. In connection with the settlement, U.S. Bank did not admit liability, nor did the settlement characterize the settlement payment as restitution.

 

U.S. Bank filed an action against its insurers in the District of Minnesota alleging breach of contract and seeking a judicial declaration that the settlement and defense costs are covered. The insurers filed a motion for judgment on the pleadings.

 

The primary policy’s definition of the term “Loss” contained a provision (which the Court called the Uninsurable Provision) that “Loss” does not included “matters which are uninsurable under the law pursuant to which the Policy is construed.” The definition of “Loss” also specified (in a provision that the Court called the Extension-of-Credit Provision) that “Loss” does not include “principal, interest or other monies either paid, accrued or due as a result of any loan, lease or extension of credit” by the bank.

 

In addition, in an exclusion the Court called the Ill-Gotten Gains Provision, the primary policy precluded from coverage claims “brought about or contributed to in fact by any … profit or remuneration gained by [U.S. Bank] or to which [U.S. Bank] is not legally entitled … as determined by a final adjudication in the underlying claim.”

 

As discussed here, on July 3, 2014, Judge Magnuson denied the insurers’ motion for judgment on the pleadings. Judge Magnuson rejected the insurers’ arguments that the settlement was precluded from coverage as a matter of law. Judge Magnuson, reading the Uninsurable Provision in light of the Ill-Gotten Gains Provision, reasoned that “the policies exclude from coverage restitution resulting from a final adjudication and by implication include within coverage restitution stemming from a settlement.” He said that “to interpret the Uninsurable Provision to always preclude coverage for restitution would nullify the Ill-Gotten Gains Provision, which plainly says that only a final adjudication precludes coverage for restitution. The provision must have effect.”

 

Judge Maguson rejected the insurers’ motions for reconsideration and motion to have questions of law certified to the Delaware Supreme Court. U.S. Bank then moved for summary judgment on the question of coverage for the amount of the settlement in excess of the deductible as well as for the related defense costs.

 

The December 16 Summary Judgment Ruling

In his December 16, 2014 opinion, Judge Magnuson granted U.S. Bank’s motion for summary judgment, holding that the policy language at issue was “unambiguous” and that there were no disputed issues of material fact. He held that the bank is entitled to recover from the insurers of $30 million of the settlement in excess of the applicable deductible amount as well as related attorneys’ fees.

 

Although the insurers could not identify case law holding restitution to be uninsurable as a matter of Delaware law, Judge Maguson nevertheless was willing to assume without deciding for purposes of his ruling that restitution is uninsurable as a matter of law in Delaware. However, the “crux of the dispute,” he said, is not really whether or not restitution is uninsurable bur rather “whether the settlement constitutes restitution.”  Judge Magnuson ruled that it does not.

 

Based on the presence of the adjudication requirement in the Ill-Gotten Gains Exclusion, Judge Magnuson said that “the policies unambiguously require that a final adjudication in the underlying action determine that a payment is restitution before the payment is barred from coverage as restitution.” He reasoned that “the settlement is not a payment that a final adjudication in the underlying action determined is restitution” because there has been “no final adjudication in [the underlying litigation] determining that the gains were ill-gotten and ordering the return of those gains.”

 

He added that the court “will not automatically presume – as the Insurers do – that the settlement constitutes restitution because it resolved claims alleging ill-gotten gains and seeking disgorgement of those gains,” noting that “if a settlement resolves claims alleging unlawful activity but excludes an admission of liability for the activity, it does not establish that the underlying allegations are true or false.”

 

He noted further that “under a policy with an after adjudication requirement, mere allegations are insufficient. If allegations of unlawful activity are never determined to be true, a payment to dispose of those allegations is not restitution because restitution can only occur if that which is being returned was wrongfully taken.”

 

Judge Magnuson rejected the insurers’ attempt to rely on the “no loss” line of cases, such as the Seventh Circuit’s opinion in the Level 3 case, which hold that a policyholder that returns amounts to which it was never entitled suffered no loss. Judge Magnuson rejected the relevance of these cases based on his determination that those cases are distinguishable because they did not involve Ill-Gotten Gain Exclusions with an after adjudication requirement. Judge Magnuson even rejected the relevance of cases applying the “no loss” principles where the applicable policies’ exclusions had “after adjudication” provisions because the courts in those cases had “failed to otherwise analyze the impact of the final-adjudication requirement.”

 

Judge Magnuson also rejected the insurers’ argument that to allow coverage for the settlement of restitutionary claims would “incentivize banks to settle rather than to litigate these types of lawsuits to obtain coverage for restitution.” He said that if the insurers were concerned that the settlement constituted restitution, they “could have refused consent or conditioned consent on an admission of liability for wrongdoing or a stipulation that that the payment was restitution.”

 

Finally, Judge Magnuson rejected the insurers’ argument that the Extension-of-Credit Provision precluded coverage for the settlement amounts because the underlying claim was based on the bank’s improper overdraft fee practices and not on an extension of credit.

 

Discussion

In light of Judge Magnuson’s July ruling on the insurers’ motion for judgment on the pleadings, his ruling on the bank’s summary judgment motion arguably comes as no surprise. In many ways, his summary judgment opinion is simply a recapitulation of his earlier opinion on the insurers’ prior motion. However, while the outcome of the summary judgment motion arguably was preordained by his prior ruling, that does not mean the outcome of this case is not a surprise, at least for those in the claims departments of professional liability insurers and management liability insurers.

 

It has been a basic operating assumption for some time within these insurance claims departments that their companies’ policies do not cover restitutionary amounts. Within this assumption was the further assumption that this coverage prohibition extended not only to judgments requiring restitution (or disgorgement), but also to settlements of claims for restitution (or disgorgement).

 

The insurers in this case undoubtedly will seek to appeal Judge Magnuson’s ruling in this case, so there could be more of this story to be told before the outcome is certain. But even though this case may have further to go, Judge Maguson’s rulings so far have important implications that the insurers will have to consider.

 

The fact is that most professional liability and management liability claims settle without an adjudication. Up until now, insurers may have been secure in their belief that their policies do not cover even settlements of claims for restitutionary amounts. Judge Maguson’s rulings in this case clearly suggests that even if we can all agree that these kinds of policies do not cover restitutionary amounts, the policies – or at least those with after adjudication clause in their ill-gotten gains exclusions – may well cover settlements of claims for restitutionary amounts where there has been no adjudication of wrongdoing.

 

The significance of the after adjudication requirement in the ill-gotten gains exclusion is magnified by the fact that these days the equivalent exclusions in most professional liability policies and management liability policies have adjudication requirements. Insurers who up to this point may have felt secure in their belief that their policies did not cover settlement of claims seeking restitution will now have to consider whether their policy language will need to be changed. However, in light of Judge Magnuson’s analysis, it would not be sufficient for the insurers simply to modify their policy’s definition of loss to provide that “Loss” shall not include restitutionary amounts or disgorgement. Even if the insurers were to make this change to the policy definition, the presence of the after adjudication requirement would still arguably require the insureres’ payment under their policies of the settlement of claims for restitution in the absence of an adjudication of wrongdoing.

 

Nor is it an easy option for the insurers simply to remove the adjudication requirement from the ill-gotten gains provision, at least in the current marketplace environment. The fixture of the adjudication requirement in the conduct exclusions in these kinds of policies is the result of a hard-won, multiyear battle between policyholder representatives, on the one hand, and insurers’ representatives, on the other hand. Having won this battle over the course of many years, to the point that the adjudication requirement is now a basic provision in most insurers’ base policies, policyholders and their representatives are not going to simply sit back and take it if the insurers’ were to now try to remove the adjudication requirements. The restriction of coverage that the removal of the adjudication requirement might represent would be an unacceptable development and in a highly competitive marketplace any insurer trying to make this change would quickly find its premium revenue going elsewhere.

 

Focusing solely at the issues involved in this case, it seems to me that there is a relatively straightforward way for insurers determined not to provide coverage for amounts paid in settlement of claims for fee overcharges to avoid coverage for those amounts. That is, the insurers could specify that the policy does not provide coverage for any loss based on or arising out of claims that the insured improperly charged or over charged fees or other amounts. (Although in this marketplace even this tailored type of exclusion might prove competitively impractical.)

 

Even if the insurers could manage some kind of fee-dispute exclusion, that would not address the larger concern that the carriers don’t want to find themselves on the hook for amounts policyholders agree to pay in settlement of restitutionary claims. Insurers quite simply will not want to have their policies called upon to fund the resolution of claims that their insureds’ wrongfully obtained or withheld amounts from third-parties. But unless and until the carriers can figure out a way around the logical conundrum that the presence of the adjudication requirement in the ill-gotten gains exclusion creates, they may well find themselves called upon to contribute toward settlement of restitutionary claims.

 

It will in any event be interesting to see what happens on appeal in this case. One place the insurers may want to start as they think about the arguments to raise on appeal is Judge Maguson’s rejection of the insurers’ argument that the ruling in this case will incentivize defendants to settle rather than litigate restitionary lawsuits in order to secure insurance coverage for the restitution. In the Level 3 case, the Seventh Circuit had said that “it can’t be right” that coverage for restitution could pivot on whether the case was resolved by settlement or adjudication because the insured, “seeing the handwriting on the wall,” could simply agree “to pay the plaintiffs in the fraud suit all they were asking for” and “retain the profit it had made from the fraud.”

 

Judge Magnuson said that insurers could avoid this problem by refusing consent to the settlement or conditioning consent on an admission of liability for wrongdoing or a stipulation that the payment was restitution. With all due respect, these suggestions are impractical. Insurers that throw roadblocks into settlement discussion or that try to condition settlement consent on such unlikely things as admissions of wrongdoing or stipulations of restitution would very quickly find themselves embroiled in bad faith litigation and facing arguments that they should be held liable for the entire amounts of settlements in excess of the policy limits for their refusal to consent to settle. No insurance claims department could consider conducting itself the way Judge Magnuson suggests. On appeal, the insurers can seek to cite the concerns the Seventh Circuit noted while also seeking to undercut the sufficiency of the basis on which Judge Magnuson rejected these concerns. (Of course, this argument really does not avoid the analytical problem relating to the policy’s adjudication requirement.)

 

I suspect that this case will stir up some strong responses for many of this blog’s readers. I urge readers who have opinions to add their thoughts to this post using the blog’s comment feature.

 

Many thanks to a loyal reader for calling my attention to this ruling and for providing me with a copy of Judge Magnuson’s opinion.

 

oneworldOver the past several days there have been a number of items that will be of interest to readers of this blog, which I note briefly here.

 

First, an article in the December 20, 2014 Wall Street Journal entitled “Sony Made It Easy, But Any of Us Could Get Hacked” (here), contends that if you are aware of the current state of information-technology security, “you’re aware that this could happen to any company (though it is still amazing that Sony made it so easy).” Experts aware of hackers’ methods, the author contends, know that “against a sufficiently skilled, funded and motivated attacker, all networks are vulnerable.” The experts know that when this type of expert hacker is involved, the hacker “always gets in.” However, against the kind of lower-skilled hacker that hit Target and Home Depot, “good security may protect you completely.” To avoid winding up like Sony, the first thing to do is “for organizations to take this stuff seriously.” The second thing to do is for those of us who entrust companies with our information (that is, all of us), we have to be smart, understand the risks and “know that your data are vulnerable.”

 

Second, in a December 19, 2014 New York Times article entitled “Delving Into the Morass of Insider Trading” (here), James B. Stewart takes a look at the state of the law in light of the Second Circuit’s recent blockbuster ruling overturning the insider trading convictions of two Wall Street traders (about which refer here).  Stewart contends that we have reached the point where “we need an insider trading statute.” The root of the confusion over what trading is prohibited is that “insider trading is a crime entirely defined by common law.” As a result, it has been open to interpretation as prosecutors and enforcement officials come and go, which has led to “tortured attempts to fit new insider trading cases into earlier precedents.” The article quotes UCLA Law Professor Stephen Bainbridge as saying that the best way to organize some limiting principles would be for Congress to adopt an insider trading statute. A statute would also be simpler to enforce and prosecute. The article quotes one commentator as suggesting that the uproar following the recent Second Circuit decision may “finally spur Congress to act.”

 

Third,  an article in the December 13, 2014 issue of The Economist entitled “Accounting Scandals: The Dozy Watchdogs” (here) reviews the long list of accounting scandals starting with Enron and WorldCom, going through the later scandals at Olympus,  Autonomy, and Satyam, and running up to the recent Tesco scandal,  in which the scandals emerged after auditors had given each of the companies a clean bill of heath. The article suggests that “such frequent scandals call into question whether this is the best the Big Four can do – and if so, whether their efforts are worth the $50 billion a year they collect in audit fees.” In recent years, the “expectations gap” between what investors expect and the standards auditors set for themselves has led to a pattern in which “investors disregard auditors and make little effort to learn about their work, value securities as if audited financial statements were the gospel truth, and then erupt in righteous fury when the inevitable downward revisions cost them their shirts.” The stakes are high, the article note, and “only substantial reforms of the auditors’ perverse business model can end the cycle of disappointment.” The article urges a number of remedies, including an expansion of the audit report to include, for example, a more detailed summary of the auditors’ activities and areas of focus and greater competition. A more challenging remedy might include taking the selection of auditors away from the client companies.

 

One final note about the Economist article. Readers of this blog would be hard pressed to distinguish what the article calls the “most elegant solution”  to the accounting scandal conundrum — which involves a proposal for companies to adopt  “financial statements insurance” — from the entity liability coverage now available under most public companies D&O Insurance policies.

 

And Finally: In the Playlist column in the Saturday Wall Street Journal (here), actor Cary Elwes describes his lifetime love for the 1965 song by The Who entitled “I Can’t Explain.” He explains that over time she “had a deeper feeling for the song because I finally understood the lyrics and connected with their point: ‘I’m gettin’ funny dreams again and again / I know what it means, but / Can’t explain / I think it’s love / Try to say it to you / When I feel blue.’ The song is one of the most brilliant expressions of not being able to express yourself.”

 

This video includes an impossibly youthful version of The Who performing the song on the old Shindig! television show. Roger Daltrey is up front and singing, but the late lamented drummer Keith Moon is the one to watch in this video.  

 
http://youtu.be/rT6X8mns3VU

seal delA question that frequently recurs is whether or not directors of insolvent companies have fiduciary duties to creditors. Creditors often attempt to argue that as companies move into the “zone of insolvency,” directors’ duties move from the company’s shareholders to the company’s creditors. While courts have discredited this theory, creditors nevertheless seek to raise this issue.

 

In a November 3, 2014 post on his M&A Law Prof Blog entitled “Director Fiduciary Duties and the Insolvent Corporation” (here), Boston College Law Professor Brian J.M. Quinn reviews a recent Delaware Chancery Court decision that addressed these issues. (Hat Tip to UCLA Law Professor Stephen Bainbridge for his December 3, 2014 post on his blog linking to Quinn’s post.)

 

Professor Quinn’s blog post discusses the October 1, 2014 opinion in Quadrant Structured Products Ltd. v. Vertin (here) in which Vice Chancellor Travis Laster clarified the duties of directors of insolvent companies, particularly with respect to creditors.

 

In the Quadrant case, the directors of an insolvent company authorized the company’s participation in a transaction that, if it had succeeded, would have been very beneficial for the company’s controlling shareholder. If it were unsuccessful, it would have left the company as an empty shell. The company’s creditors sought to hold the directors liable for making risky decisions that would have benefited the controlling shareholder at their expense.

 

Vice Chancellor Laster said that “I do not believe it is accurate any longer to say that the directors of an insolvent corporation owe fiduciary duties to creditors.” He added that while it remains true that insolvency “marks a shift in Delaware law,” that shift “does not refer to an actual shift of duties to creditors (duties do not shift to creditors).” Instead, the shift refers primarily to creditors’ standing to bring derivative actions for breach of fiduciary duty, something they may not do if the corporation is solvent, even if it is in the zone of insolvency.

 

Laster concludes by saying that “the fiduciary duties that creditors gain standing to enforce are not special duties to creditors, but rather the fiduciary duties that directors owe to the corporation to maximize its value for the benefit of all residual claimants.”

 

Laster’s language stresses the directors’ obligations to maximize the value of the corporation for the benefit of all residual claimants. As Professor Quinn notes, “even in insolvency, stockholders remain residual claimants,” adding that “at no point do we see some sort of magical shifting of duties from the corporation to the creditors.”

 

What happens is that “once a corporation is insolvent, creditors may gain standing, but the duties of the board do not change.” That means that “boards of insolvent corporations are under no fiduciary duties to preserve capital and resources for the benefit of creditors.”

 

Apropos of Nothing: Beatles marionettes perform to the song “Help.” I recommend watching Ringo in particular.

 
http://youtu.be/fJjmC51FvbI?list=RDfJjmC51FvbI

mugshot4-300x224On several occasions I have published what I thought would be the last of the D&O Diary mug shots, only to find afterwards that still more mug shots were arriving in my email mailbox. That has happened yet again, and this time some of the late arriving mug shots are appropriate to the holiday season.

 

Readers will recall that early last year, I offered to send out a D&O Diary coffee mug to anyone who requested one – for free – but only if the recipient agreed to send me back a picture of the mug and a description of the circumstances in which the picture was taken. In prior posts (here, here, here, here, here, here, here, here , here, here, here, here, here, here, here, here,here, here, here and here), I published prior rounds of readers’ pictures. I have posted the latest round of readers’ pictures below.

 

The first of this round of mug shots comes to us from Jarrett Jeppesen at the Chubb office in Sydney. Jarrett reports that every year the different departments in the Chubb Sydney office decorate their office areas for Christmas. I am pleased to report that among the decorations under the tree in his department was a D&O Diary mug, as depicted in the picture below.

 

chubb mug

 

The next picture in this collection is again appropriate to the season. This picture, which sent in by Bill Boeck of Lockton Financial Services in Kansas City, Missouri. This picture shows Bill’s D&O Diary mug along with his family’s Christmas tree. I know a lot of readers enjoy the D&O Diary, but not everyone would include a D&O Diary mug in the household Christmas decorations.

 

christmas tree

 

I am grateful for all of the pictures that readers have sent in and I am glad to have this opportunity to publish a few festive pictures here to help celebrate this holiday season. I would like to wish everyone a very happy holiday season. I look forward to publishing very many new blog posts in the New Year. Happy Holidays to all. 

 

eleventh cuircuit sealGoing all the way back to the S&L crisis, a recurring insurance coverage issue that has arisen in the failed bank context has been the question of whether or not coverage for a claim brought by the FDIC in its capacity as receiver of a failed bank against the failed bank’s former directors and officers is precluded under the Insured v. Insured exclusion typically found in most D&O insurance policies. This issue has arisen yet again in connection with the failed bank litigation the FDIC has filed during the current bank failure wave.  

 

A number of district courts have found the question of the Insured v. Insured exclusion applicability to lawsuits brought by the FDIC in its capacity as receiver for a failed bank to be ambiguous, as reflected for example here. However, as discussed here, in September 2013, Northern District of Georgia Judge Richard W. Story, ruling in insurance coverage litigation relating to the failed Community Bank & Trust of Cornelia, Georgia, held that the exclusion’s applicability to claims brought by the FDIC in its capacity as receiver for the failed bank was not ambiguous and precluded coverage under the policy for the FDIC’s claims. 

 

Since it was entered in the Community Bank & Trust case, Judge Story’s ruling has represented arguably the strongest authority supporting  the D&O insurer’s arguments in other  cases that the Insured v. Insured exclusion unambiguously precludes coverage for claims brought by the FDIC in it s capacity as receiver for a failed bank. 

 

However, in a December 17, 2014 decision (here), the Eleventh Circuit, applying Georgia law and relying on the fact of the split authority on this issue, found the exclusion’s applicability to claims brought by the FDIC as receiver to be ambiguous and remanded the case for further evidentiary proceedings to determine the parties’ intent with respect to the exclusion. The Eleventh Circuit’s ruling will have a significant impact not only because it is the first appellate decision on this issue but also because it applies to district courts in Georgia and Florida (among several other states) where so many of the bank closures during the current bank failure wave took place. 

 

Background 

Community Bank & Trust failed on January 29, 2010. As noted here (second item), on February 24, 2012, the FDIC filed an action against two former officers of the bank. The complaint alleges that Charles Miller, the bank’s senior head of retail lending, violated his legal duties in approving loans in violation of the bank’s loan policies. Trent Fricks, the bank’s CEO, is alleged to have breached his duties in failing to supervise the loan officer and in failing to take corrective measures. The FDIC alleges that the defendants’ misconduct cost the bank $15 million in damages.  

 

The bank’s D&O insurer agreed to defend the individual defendants under a reservation of rights and initiated a separate lawsuit seeking a judicial declaration that it had no duty to defend or indemnify the individuals. The insurer moved for summary judgment in the coverage lawsuit seeking a ruling that as a matter of law coverage for the FDIC lawsuit was precluded under the Insured v. Insured exclusion.  The FDIC argued that the policy provisions on which the insurer sought to rely were ambiguous and that it was entitled to further discovery of the insurer’s internal communications about insurer’s own interpretation of the policy provisions. 

 

In moving for summary judgment, the insurer relied on its policy’s Insured vs. Insured exclusion, which, in pertinent part precludes coverage for loss “on account of any Claim made against any Insured … brought or maintained by or on behalf of any Insured or Company in any Capacity.”

 

In his August 19, 2013 opinion, Judge Story held that the FDIC was not entitled to further discovery because the policy’s insured vs. insured exclusion unambiguously precluded coverage. Judge Story noted that under FIRREA, the FDIC as receiver succeeds to “all rights, titles, powers and privileges of the insured depositary institution,” which means, in the language of the U.S. Supreme Court in its 1994 decision in O’Melveny & Myers v. FDIC, that the FDIC, as a failed bank’s receiver, “steps into the shoes” of the failed bank and any defenses that could have been raised against the bank can be raised against the FDIC. The FDIC and the individuals appealed Judge Story’s ruling to the Eleventh Circuit. 
The December 17, 2014 Opinion           

On December 17, 2014, in an opinion written by Judge Harvey Schlesinger (a federal district court judge sitting by designation) for a three-judge panel, the Eleventh Circuit reversed Judge Story’s ruling, holding that the question of the applicability of the Insured v. Insured exclusion to claims brought by the FDIC as receiver for a failed bank is ambiguous and therefore that it may be necessary to consider extrinsic evidence to determine the parties’ intent. Accordingly the Eleventh Circuit remanded the case to the district court for further proceedings. 

 

In connection with the question of whether or not the exclusion was ambiguous, the parties had raised a number of legal arguments based on the specifics of the FDIC’s role when it acts as receiver of a failed bank. However, rather than rely on these various legal arguments or on the nature of the FDIC”s role as receiver, the Eleventh Circuit said that “it seems to us that the most compelling argument is that courts who have addressed similarly worded insured vs. insured exclusions have reached different results.” In a footnote, the appellate court added that “the fact remains that there are two schools of thought on how to interpret insured v. insured exclusions, and that seems to make FDIC-R’s point.” 

 

The appellate court referenced, by way of illustration, a separate decision out of the Northern District of Georgia, also applying Georgia law to a nearly identical exclusion, in which the court held, contrary to Judge Story’s ruling in this case, that the exclusion is ambiguous. The Eleventh Circuit said that the fact that Judge Story in this case and that another judge in the same court “reached opposite conclusions about the effect of a nearly identically worded insured v. insured exclusion appears to us to plainly support a finding of ambiguity under Georgia law.”

 

In conclusion, the Court said, “since we conclude that the insured v. insured exclusion is ambiguous, it may be necessary to consider extrinsic evidence to determine the parties’ intent.” The Court remanded the case to the district court “for further consideration in accordance with this opinion.” 

 

Discussion 

The Eleventh Circuit’s ruling in this case is not the first instance in which a court has found the existence of the conflicting case law to be determinative of the question with the insured vs. insured exclusion is ambiguous. For example, in October 2014, a judge in the Central District of California found the exclusion to be ambiguous based on a similar reason (among other considerations). 

 

The various court decisions have indeed gone both ways on this exclusion. As long as there were strong decisions –like Judge Story’s in this case – finding the exclusion to unambiguously preclude coverage for claims asserted by the FDIC in its capacity as receiver, the D&O insurers have been emboldened to continue to try to contest coverage on this basis. However, now that the courts are finding ambiguity based on nothing more than the split in the case law (rather than on whether one side or the other was correctly decided), the game may be up for the D&O insurers. The insurers may still think they can argue on the merits that the exclusion is unambiguous, but if the existence of the case law split alone and without any reference to the merits is enough to establish ambiguity, then there really is not much left on which the insurers can base their argument. They can’t deny that there is a split in the authority on this issue. 

 

The fact that it was a federal appellate court that reached this decision will make this a very difficult decision for the insurers to avoid. To be sure, the court was applying Georgia law, so the carriers can try to argue that the ruling does not apply where the laws of other jurisdictions govern. The carriers can also try to argue against the ruling outside of the Eleventh Circuit. 

 

The carriers will face a number of obstacles in making these arguments. The first is that more banks failed in Georgia than any other state, so the Eleventh’s Circuit’s ruling will be determinative in connection with the largest state grouping of cases. Because Florida is also in the Eleventh Circuit, the ruling in this case will like be determinative, and whether or not determinative, nonetheless followed in cases to which Florida law applies.  Since there were almost as many failed banks in Florida as in Georgia, this case will likely foreclose matters in another of the largest state groupings of cases. And even outside of the Eleventh Circuit, other district courts will be that much less likely to reached a ruling contrary to this appellate court. 

 

It will be interesting to see what happens to this case when it goes back to the district court. I strongly suspect that the evidentiary inquiry to determine the parties’ intent with respect to this exclusion will not be an edifying spectacle. I have in my life lived through the kinds of discovery proceedings that are now going to take place in this case, with various underwriters and brokers having their depositions taken and their emails scrutinized. It is not the sort of thing that anyone who wasn’t getting paid for the exercise would actually want to sit through. I will say this, if the carriers know that they have to go through this sort of discovery exercise in order to try to assert the exclusion against an FDIC claim, they are very quickly going to try to find a different basis on which to try to contest coverage. 

 

In an earlier post, I had said that as long as the carriers think they can persuade a court to reach the same conclusion as Judge Story reached in the district court in this case, they will continue to argue that the insured vs. insured exclusion precludes coverage for claims brought by the FDIC in its capacity as receiver for a failed bank. Now the carriers can no longer rely on Judge Story’s opinion and they have an appellate court decision going against them. We may be approaching the point where the carriers’ position on this coverage question is unsustainable. 

 

Special thanks to a loyal reader for providing me with a copy of the Eleventh Circuit’s opinion.   

 

pwIn the following guest post, Susanna Buergel, Charles Davidow, Andrew Ehrlich, Brad Karp, Daniel Kramer, Richard Rosen and Audra Soloway, all of whom are litigation partners at Paul, Weiss, Rifkind, Wharton & Garrison LLP who are members of the Firm’s Securities Litigation Practice group explain the significance of the Second Circuit’s decision United States v. Newman. A version of this article previously appeared as a Paul, Weiss client alert. Mark Pomerantz, a retired Paul, Weiss partner, argued the appeal for co-defendant Anthony Chiasson.   

I would like to thank Richard Rosen of the Paul Weiss law firm for submitting this article as a guest post. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post. Here is the guest post from the Paul Weiss law firm. 

*****************************************  

Last week, the United States Court of Appeals for the Second Circuit issued a long-anticipated ruling dismissing with prejudice indictments against two insider trading defendants in United States v. Newman.  Two aspects of the decision are particularly important.  First, the Court ruled that the government must prove that a remote tippee knows of the personal benefit received by a tipper in exchange for disclosing nonpublic information.  Second, the Court held that the government must prove that the personal benefit is “of some consequence,” and determined that the benefits alleged by the government in United States v. Newman were not sufficient to support a conviction.  The ruling likely will have major ramifications for the future prosecutions of insider trading cases in the Second Circuit. 

The Newman and Chiasson Case

In United States v. Newman, the Second Circuit considered appeals from the insider trading convictions of Todd Newman, a former portfolio manager at Diamondback Capital Management, LLC, and Anthony Chiasson, a former portfolio manager at Level Global Investors, LP.[i]  Newman and Chiasson were accused of trading Dell and NVIDIA securities based upon material, nonpublic information they received from their respective analysts.  According to the testimony elicited during trial, the allegedly material, nonpublic information originated within Dell and NVIDIA, but it passed through numerous intermediaries before it was received by Newman and Chiasson, who contended that there was insufficient evidence that the tipper received any personal benefit in exchange for the tip, and, in any event, that they certainly did not know of any such benefit.  Newman and Chiasson were each convicted after a five-week trial.  They appealed to the Second Circuit, arguing, among other points, that they were convicted based on an improper jury instruction and that the evidence was insufficient to support their convictions.

The Supreme Court’s Decision in Dirks v. SEC

The Second Circuit agreed with Newman and Chiasson, concluding that the jury instructions were improper and that the evidence was insufficient to sustain a conviction.  The opinion turned on the Court’s reading of Dirks v. SEC, a thirty-one-year old Supreme Court decision.  463 U.S. 646 (1983). 

In Dirks, the Supreme Court held that, under the “classical theory” of insider trading liability,[ii] tippers are liable—and, by extension, tippees are liable—only when tippers breach a duty to the shareholders of a publicly traded company.  Dirks, 463 U.S. at 660.  Before deciding Dirks, the Supreme Court had held in Chiarella v. United States that, without more, trading on material, nonpublic information is not illegal, as there is no “general duty between all participants in market transactions to forgo actions based on material, nonpublic information.”  445 U.S. 222, 233 (1980).  Dirks built on Chiarella by setting forth when a tippee has a duty to disclose or abstain from trading on material, nonpublic information: a duty arises “only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know there has been a breach.”  Dirks, 463 U.S. at 660.  Put another way, the tippee’s duty derives from the tipper’s duty, and the tipper’s duty is created because of a fiduciary relationship with shareholders.

Further, according to Dirks, courts will look to whether the tipper received a personal benefit to determine if the tipper breached a duty by disclosing nonpublic information.  Id. at 662.  Courts have defined “personal benefit” quite broadly.  

The Second Circuit’s Opinion

In directing that the indictment be dismissed, the Court’s opinion clarified the standard set out in Dirks.  The Court— Circuit Judges Ralph K. Winter, Jr., Peter W. Hall, and Barrington D. Parker—held that a tippee must know of the personal benefit received by the tipper.  The Court explained that it was not sufficient for the government to show that the tippee received information that was material and nonpublic, or that the tipper was an insider, or even that the tipper breached a duty to the source of the information.  “[W]hile we have not yet been presented with the question of whether the tippee’s knowledge of a tipper’s breach requires knowledge of the tipper’s personal benefit,” the Court wrote, “the answer follows naturally from Dirks.”  Based on Dirks’s explanation of the nature of an insider’s fiduciary breach, “we conclude that a tippee’s knowledge of the insider’s breach necessarily requires that the insider disclosed confidential information in exchange for personal benefit.” 

In so holding, the Court once again rejected the notion that the federal securities laws require parity of information among investors.  The opinion quoted some of the most important language from Dirks and Chiarella: that there is no “general duty between all participants in market transactions to forgo actions based on material, nonpublic information”; that the law does not require symmetry of information among all participants in the marketplace; that not every instance of “financial unfairness” is punishable under Section 10(b); and that insider trading liability exists only when a duty of confidentiality was breached in exchange for a personal benefit.  As such, the Court held that the district court’s instruction, which did not require the jury to find knowledge of a personal benefit, was erroneous, and, moreover, that the error was not harmless.

Further, the Court concluded that the evidence was insufficient to support the government’s theory that the tipper received any personal benefit in exchange for providing inside information.  Although the government contended that the evidence showed that the Dell tipper had sought career advice from the friend who was the initial tippee and that the NVIDIA tipper was a “family friend” of the initial tippee, the Court held that the “circumstantial evidence in this case was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips.”  If the evidence of personal benefit proffered by the government was enough, the Court explained, “practically anything would qualify.”  For evidence of a personal benefit to be sufficient, the Court wrote, there must be “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”

The Court also rejected the government’s argument that the “specificity, timing, and frequency” of the information received by the defendants were so “overwhelmingly suspicious” that it provided support for the government’s theory that the defendants must have known, or consciously avoided knowing, that the information they were receiving was coming from an insider in breach of his duties and that the tipper must have received a personal benefit.  The Court reasoned that the financial estimates received by the defendants could also be obtained through “legitimate financial modeling using publicly available information and educated assumptions about industry and company trends.”  It noted trial testimony to the effect that companies’ investor relations departments would routinely provide guidance to investment professionals about the accuracy of their models, and evidence showing that companies would routinely “leak” estimates of their earnings data in advance of earnings announcements.  While explaining that there could be cases where a defendant receives information that is so “detailed and proprietary” to support an inference that the information must have come from an insider source, the Court concluded that the inference is “unwarranted” with respect to Newman and Chiasson, as they were several layers removed from the source of information and the information they received was similar to information they regularly received through legitimate means.

Conclusion

After Newman, it will be considerably more difficult for both the Justice Department and the SEC to win cases involving tips.  In particular, the government will likely find it more challenging to prosecute remote tippees for insider trading, especially when the tippees are several levels removed from the source of the information.  The opinion focused specifically on recent prosecutions fitting this description: “The Government’s overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.”[iii]  Additionally, it will be more difficult for the government to prove cases where the tipper does not receive money or other material consideration, but instead receives only an intangible benefit or the hope of a future benefit.  In future decisions, courts will be forced to grapple with when such benefits support a finding that a trader has engaged in insider trading.

Because of its holdings regarding remote tippees and the personal benefit standard, the opinion has also clarified the rules for investment professionals who regularly trade on information obtained through the marketplace.  It is now clear that the tipper must receive a personal benefit “of some consequence” to support a finding of insider trading liability.  Additionally, the opinion provides that tippee liability exists only when the tippee knows or should know that the information was confidential and divulged for personal benefit.  It is now evident that, going forward, the fact that a remote tippee receives improperly disclosed information, without more, will not be enough to support an insider trading case. 

 

[i][i] Paul, Weiss was counsel for Anthony Chiasson on this appeal and was lead counsel at the Second Circuit argument.

[ii] Two theories of insider trading liability are available to prosecutors: the “classical theory” and the “misappropriation theory.”  The prosecutions of Newman and Chiasson were brought under the “classical theory” of insider trading liability, which applies when a “corporate insider trades in the securities of his corporation on the basis of material, nonpublic information.”  United States v. O’Hagan, 521 U.S. 642, 651-52 (1997).  The “misappropriation theory,” by contrast, applies when an investor “misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”  Id. at 652.

[iii] In the passage in the opinion before this sentence, the Court discussed how, in an attempt to demonstrate that it need not prove that tippees know of the personal benefit received by the tipper, the government’s brief had parsed dicta from previous decisions.

cyber2As I noted in a post last week, in a speech earlier this month in which she outlined the steps bank boards can take to address cybersecurity issues, Sarah Raskin, the second-ranking official at the U.S. Department of Treasury, laid out the reasons why banking institutions should be investing in cyber insurance. This speech is only one of several recent developments raising the possibility that federal banking regulators may be moving toward requiring banks to carry cyber insurance, according to Tracey Kitten’s December 12, 2014 blog post on the Bank Iinfo Security blog entitled “Will Banks Be Required to Have Cyber-Insurance?” (here).

 

For example, on December 10, 2014, the New York State Department of Insurance Superintendent Benjamin M. Lawsky issued an industry guidance letter to all New York State Department of Financial Services (DFS)-regulated banks outlining the specific issues and factors on which those institutions will be examined as part of the agency’s new targeted cyber security preparedness assessments. The guidance letter expressly states that the department’s cyber security examinations will include “cyber security insurance coverage and other third-party protections.”  The Department’s December 10, 2014 press release about the new industry guidance can be found here. The December 10, 2014 letter sent to banks can be found here.

 

In her blog post, the author suggests that this move “by one of the nation’s largest states” could “foreshadow” cyber insurance requirements to be included in the anticipated cybersecurity guidance of the Federal Financial Institutions Examination Council. (As discussed here, the FFIEC is an organization of federal banking regulators and other institutions to prescribe principles for the uniform supervision of banking institutions.) On November 3, 2014, the FFIEC released the observations from the cybersecurity assessment that a number of its members participated in during the summer of 2014. Among other things, the organization’s observations included a statement that “as a result of the cybersecurity assessment, FFIEC members are reviewing and updating current guidance to align with changing cybersecurity risk.” (For more about the anticipated updated FFIEC cybersecurity guidance, refer here.)

 

Among other things, the blog post quotes one observer as saying, in light of the new concerns following the recent JP Morgan Chase data breach, ‘there’s little doubt that cyber-insurance will be a requirement that the FFIEC includes in its forthcoming cyber guidance.” The observer, a senior official at the Gartner consulting firm, adds the comment that “Cyber-insurance helped Target and Home Depot lower their breach-related costs substantially and, thus, converted market participants from former skeptics to current believers in the cyber-insurance policies.”

 

Whether or not federal regulators implement an express requirement that banking institutions have cyber insurance, it does seem increasingly likely that banking examiners will be reviewing is banking institutions’ cyber insurance program. Even if there is no express requirement, the inclusion of the item on the examination program could create a strong incentive for banking institutions to purchase the insurance.