barclaysThe Libor-scandal based securities suit filed against Barclays and certain of its directors and offices will now be going forward. The case was initially dismissed, but on appeal the Second Circuit vacated a part of the dismissal ruling and returned the case to the district court for further proceedings. The defendants filed a renewed motion to dismiss. In an October 21, 2014 order (here), Judge Shira Schindlin denied the defendants’ motion, holding that the plaintiffs’ allegations of scienter were sufficient to meet the pleading requirements. The lawsuit, filed on behalf of investors who purchased Barclays American Depositary Receipts (ADR) in the United States, will now proceed.

 

Background

On June 27, 2012, Barclays announced that it had entered settlements with regulators in the United States and the United Kingdom relating to the Libor-manipulation scandal. Barclays agreed to pay fines totaling more than $450 million and admitted for the first time that between August 2007 and January 2009 the bank had in its Libor submissions underreported the interest rates it was paying.

 

As discussed in greater detail here, on July 10, 2012, Barclays shareholders filed a securities class action lawsuit in the Southern District of New York, against Barclays PLC and two related Barclays entities, as well as the company’s former CEO, Robert Diamond; and its former Chairman Marcus Agius. (Former Group Chief Executive John S. Varley was added as a defendant later). The complaint, which can be found here, was filed on behalf of class of persons who purchased Barclays ADRs between July 10, 2007 and June 27, 2012.

 

The plaintiffs’ complaint alleges that the bank willfully misrepresented the bank’s borrowing costs between 2007 and 2009 and knowingly submitted false information for purposes of calculating Libor. The plaintiffs allege that by underreporting the bank’s interest rates, the bank misrepresented the bank’s financial condition. The plaintiffs also allege that the defendants misleadingly stated that the company had established adequate internal controls. (For a detailed background regarding the Libor rate setting process and the allegations regarding Libor’s alleged manipulation refer here.) The defendants moved to dismiss the complaint.

 

In a May 13, 2013 opinion (discussed here), Judge Scheindlin granted the defendants’ motion to dismiss.  The plaintiffs appealed. As discussed here, in an April 25, 2014 decision, the Second Circuit affirmed the dismissal ruling in connection with the allegedly misleading statements regarding the bank’s internal controls. However, with respect to the remaining allegations concerning  the alleged underreporting of the bank’s borrowing costs,, the appellate court vacated the district court’s dismissal based on her finding that the plaintiffs had not adequately pled loss causation. The appellate court said “While expressing no view on the ultimate merits of plaintiffs’ theory of loss causation, we hold that the court below reached these conclusions prematurely.” On remand to the district court, the defendants filed a renewed motion to dismiss.

 

The October 21 Order

In her October 21 order, Judge Scheindlin denied the defendant’s motion to dismiss, holding that the plaintiffs had adequately pled scienter as to Barclays and as to Diamond, and had adequately pled control person liability allegations as to Agius and Varley.

 

In concluding that the plaintiffs had adequately pled scienter as to the Barclays entities, Judge Scheindlin examined the plaintiffs’ allegations that Barclays submitted inaccurate Dollar Libor figures that underreported the bank’s borrowing costs. The plaintiffs also allege these inaccurate submissions were made at the direction of senior management. The plaintiffs’ allegations regarding the Libor submissions drew heavily on the factual recitals in the documents prepared in connection with the regulatory settlements.

 

Judge Scheindlin said that “Barclays’s repeated, long-term and knowing submission of false rates suggest far more than an intent to violate [British Banking Authority] rules. Rather the conduct constitutes strong circumstantial evidence of conscious misbehavior or recklessness.”(Citations omitted). The complaint’s allegations “are sufficient to give rise to a strong inference that the danger was either known to Barclays or so obvious that Barclays must have been aware of it.” (Citations omitted). She added that the complaint “also plausibly alleges Barclays’s motive – to counter negative perceptions about its borrowing costs and, more generally, its financial condition.”

 

Taken together, Judge Scheindlin said, the allegations, “give rise to a cogent and compelling inference that Barclays falsified the LIBOR submissions because it understood their likely effect on the market.” She rejected the innocent motive that the defendants sought to suggest – that is, that Barclays was merely attempting to correct a misrepresentation in the market about Barclays’s financial health. She said that the inference of scienter is “cogent and at least as compelling as the competing inference of innocent intent suggested by Defendants.”

 

Judge Scheindlin also found that the plaintiffs’ scienter allegations against Diamond were sufficient. The plaintiffs alleged that in October 2008, following a conversation with a Bank of England official, Diamond had ordered another executive to understate LIBOR submissions so that Barclays would not be an outlier on its reported interest rates among the rate setting banks. The plaintiffs also sought to rely on statements Diamond had made in an October 31, 2008 conference call with analysts about Barclays borrowing rates.

 

In concluding that the allegations regarding the instructions to the other executive to understate the bank’s LIBOR submissions met the Second Circuit’s “motive and opportunity” test for pleading scienter, Judge Scheidlin said that “the complaint’s allegations, including its historical context, provide a clear motive; the fact that Barclays made false LIBOR submissions following Diamond’s instructions evince opportunity.”  With respect to the statements in the analyst conference call, Judge Scheindlin noted that Diamond’s conversation with the Bank of England and instructions to the bank executive took place just two days before the conference call and his instructions to the bank executive, which she said is “inconsistent with the truth of either of the statements” Diamond allegedly made in the conference call on which the plaintiffs seek to rely.” The “inconsistency, together with the conduct alleged, creates a cogent and compelling inference that – at the very least – Diamond acted recklessly.”

 

With respect to the control person liability allegations against Agius and Varley, Judge Scheindlin noted that “while merely identifying the title of a corporate officer is insufficient to state a claim,” the Complaint “describes sustained and long-running misconduct that was known to management, including high-ranking corporate officers.” These allegations, Judge Scheindlin were sufficient to state a claim against Agius and Varley for control person liability.

 

Discussion

Of the many different financial institutions caught up in the Libor scandal, Barclays is the only one that is involved in a Libor-scandal related securities class action lawsuit – most of the other banks involved in the scandal do not have securities that trade on the U.S. exchanges, and of the banks that have securities trading in the U.S, Barclays is the only one to be hit with a securities suit. (As noted here, one Libor-scandal claimant, the Charles Schwab Corporation, has filed an individual action in California state court seeking to recover damages from the Libor rate-setting banks on a number of theories, including under Section 11 of the ’33 Act.)

 

When this case was dismissed at the outset, it looked as if Barclays was going to be able to avoid any potential liability under the U.S. securities laws for alleged misrepresentations concerning its Libor submissions. However, when the Second Circuit reversed a portion of the dismissal ruling, it meant that the case was returning to the district court for further proceedings. In light of Judge Scheindlin’s latest order, the case will now be going forward as to all of the defendants.

 

The Libor-related litigation generally, including the consolidated Antitrust litigation pending in the Southern District of New York, has had many twists and turns, and this case is no exception. Discovery in this case will now go forward.  For securities litigation plaintiffs, the name of the game is to get past the dismissal motions stage with at least some portion of the case intact, which the plaintiffs here have accomplished. While the next procedural stage is discovery, the likely direction of the case undoubtedly reflect the fact that securities cases almost always settle, a fact on which the plaintiffs undoubtedly will be pushing as the case goes forward.

 

This case is not the only securities suit that Barclays is facing in the Southern District of New York. As discussed here, in July, Barclays was also named as a defendant in a securities class action lawsuit arising out of the bank’s “dark pool” private securities trading venue. Barclays is also one of the many defendants named in the “Flash Boys” high frequency trading securities class action lawsuit, as discussed here.

 

Russian Drivers: I am sure many readers saw the terrible story about the plane crash in Russia in which Total SA’s Chief Executive Officer Christophe de Margerie was killed, along with three of the plane’s crew members. According to news reports, the crash occurred after the business jet in which de Margerie was traveling struck a snow plow on a runway. The driver of the snow plow reportedly was drunk  — apparently along with the airport’s dispatchers, according to a detailed account on Fortune magazine’s website.

 

According to Wikipedia (here), Russians consume about 18 liters 4.8 US gal) of spirits a year, more than double the 8 liters (2.1 US gal) that the World Health Organization considers dangerous. All of that alcohol consumption has its consequences. In June 2009, the Public Chamber of Russia reported over 500,000 alcohol-related deaths annually.

 

As the tragic death of de Margerie shows, all too often the consumption of alcohol results in vehicle- related deaths. It is one thing to recite these statistics. It is another thing altogether to see what is actually happening on Russia’s roads. There is no way to know how many of the drivers shown in the following  video are under the influence of alcohol, but watch it and see if you think I am jumping to conclusions is suggesting that an awful lot of these drivers have been drinking . By the way, these videos exist because pretty much everybody in Russia has a dash camera as way of substantiating what has happened in the event of an accident (as you can tell from the video, accidents happen frequently). 

 
http://youtu.be/E-l4w-DIiXk

wyndham Along with the separate derivative lawsuit filed against Target Corporation’s board, the cyber breach-related derivate action filed against Wyndham Worldwide Corporation’s board has been closely watched as representative of a potential new area  liability exposure for corporate directors and officers.  However, in an October 20, 2014 opinion, District of New Jersey Judge Stanley Chesler, applying Delaware law, granted the defendants’ motion to dismiss the plaintiff’s complaint. A copy of Judge Chesler’s opinion can be found here.

 

Background 

As discussed here, the derivative lawsuit filed against the Wyndham officials relates to the three data breaches the company the company and its operating units sustained during the period April 2008 to January 2010. As discussed here, the company is already the target of a Federal Trade Commission enforcement action in connection with the breaches. A prior ruling that the FTC action can proceed is currently on appeal; to the Third Circuit.

 

Judge Chesler’s opinion recites that after the breaches occurred, the board and its audit committee met multiple times to discuss the company’s cyber security. The company hired a technology company to investigate the breaches and to make recommendations. Between the time of the second and third breach the company began implementing the recommendations.

 

In November 2012, the plaintiff sent the Wyndham board a letter demanding that it bring a lawsuit based on the breaches. The board hired the law firm of Kirkland & Ellis to investigate the plaintiff’s demand. The law firm found after investigation that the demand was not well grounded. In March 2013, the board voted not to pursue the demanded lawsuit.  In June 2013 the plaintiff presented a second demand letter, which the board rejected in August 2013 for the same reasons it had rejected the initial demand. The plaintiff filed his lawsuit in February 2014.

 

In the derivative lawsuit complaint, the plaintiff alleges that “in violation of their express promise to do so, and contrary to reasonable expectations,” the company and its subsidiaries “failed to take reasonable steps to maintain their customers’ personal and financial information in a secure manner.” The complaint goes on to allege that the individual defendants “aggravated” the damage to the company by “failing to timely disclose the breaches in the Company’s financial filings.” The complaint notes that the company did not first disclose the breaches until July 25, 2012, over two-and-a-half years after the third breach occurred.

 

The complaint alleges that the defendants’ failure to implement appropriate internal controls designed to detect and protect repetitive data breaches “severely damaged” the company and resulted in the FTC enforcement action. The FTC action, the complaint notes, “poses the risk of tens of millions of dollars in further damages.” The company’s failure to protect its customers’ personal information “has damaged its reputation with its customer base.”

 

The complaint asserts substantive claims against the individual defendants for breach of fiduciary duty; corporate waste; and unjust enrichment. The defendants moved to dismiss the plaintiff’s complaint.

 

The October 20 Opinion

In his October 20 Opinion, Judge Chesler granted the defendants’ motion to dismiss with prejudice. The defendants had argued that the board’s refusal to pursue the plaintiff’s demand was a good-faith exercise of business judgment, made after a reasonable investigation. Judge Chesler agreed.

 

The plaintiff had tried to argue that the board’s decision to reject the demand was not in good faith because it was based on the advice of the Kirkland & Ellis law firm, the same firm that represents the company in the FTC action. Judge Chesler rejected the plaintiff’s argument that the law firm’s representation of the company in the FTC action put them in a conflict of interest since the firm’s obligation in the two matters were identical. Judge Chesler also rejected the plaintiff’s argument that the demand put the company’s general counsel in a conflict of interest, finding that there was nothing in the demand to suggest that it exposed the general counsel to liability, and indeed did not even mention the general counsel. Judge Chesler also found that the plaintiff had failed to allege any facts to support the allegations that the general counsel’s role included responsibility for the company’s cyber security program.

 

Judge Chesler also rejected the plaintiff’s argument that the board’s decision to reject the shareholder demand was based on inadequate investigation. The Court said that “in light of the ample information the Board had at its disposal when it rejected Plaintiff’s demand, and considering the numerous steps the Board took to familiarize itself with the subject matter of the demand, Plaintiff has also failed to make this showing.” Based on their various actions after the breaches occurred, the board’s members were “well versed on the allegations,” but they did not merely reject the allegations in the plaintiff’s demand. Instead, the board and audit committee hired outside counsel to investigate and they met separately to discuss the results of the investigation.

 

Judge Chesler concluded by observing that “given the business judgment’s rule’s strong presumption, court uphold even cursory investigations by boards refusing shareholder demands.” Here, Judge Chesler said, “the Court finds that the WWC’s Board had a firm grasp on Plaintiff’s demand when it determined that pursuing it was not in the corporation’s best interest.”

 

Discussion

When this lawsuit and the derivative lawsuits against the Target board were filed, there was a great deal of speculation about whether cyber risk represented an emerging area of exposure for the directors and offices of companies that experience cyber breaches. Cyber risk may yet emerge as a significant area of D&O liability exposure. But Judge Chesler’s opinion is a reminder of just how difficult it is for plaintiffs to survive the initial pleading hurdles in derivative lawsuits like the one the plaintiff filed here.

 

With the demand requirement and with the protections of the business judgment rule, plaintiffs face some difficult obstacles in just trying to overcome the preliminary motions. The outcome of this case may or may not discourage plaintiffs in other cases from trying to pursue claims against the boards of companies that experience cyber breaches, but this case hardly suggests that the potential liability of boards of cyber breach companies is a promising new area for plaintiffs’ lawyers.

 

It is probably worth noting that the derivative lawsuit that was filed several years ago against Heartland Payment Systems following that company’s cyber breach was also dismissed. Unless and until the plaintiffs’ lawyers score some successes in these kinds of cases, the outlook would have to be — based on the evidence so far – that this does not appear to be a particularly promising area for plaintiffs’ lawyers.

 

This case does provide some interesting insight into steps that companies that experience a cyber breach can take to try to protect their boards from potential liability related to the breach. Judge Chesler appeared to consider it significant that the board and the audit committee had met multiple times to discuss the breaches, to try to find out what had happened and to try to take remedial steps. By the time the demand latter arrived, the board could argue that its decision making about the demand was well-informed. Obviously, the board’s reliance on the investigation of outside counsel also helped them make the argument that their decision not to pursue the lawsuit was made in good faith.

 

There will much more to be told on the question of whether or not cyber liability represents a significant exposure for the boards of companies that experience a data breach. The lawsuit here does indeed suggest that boards can get sued following a cyber breach. Judge Chesler’s opinion highlights the fact that boards that are sued in these kinds of cases have substantial defenses that will difficult for plaintiffs to overcome.

 

graphicA single case may involve a host of interesting issues but sometimes the important lessons can only be discerned when many cases are considered collectively. This past week saw the release of some interesting analyses of aggregate litigation and enforcement statistics, each set of which told some interesting tales to tell and identified some important trends.

 

The SEC’s FY 2014 Enforcement Statistics

The first of these sets of statistics was presented in the SEC’s October 16, 2014 announcement of its Fiscal Year 2014 enforcement statistics. (The 2014 fiscal year ended on September 30, 2014.) The SEC reported that it filed a “record” number of enforcement actions in 2014 involving a “wide range of misconduct” and including a “number of first-ever cases.”

 

During FY 2014, the SEC filed 755 enforcement actions, which represented a 10% increase over the 686 enforcement actions filed in FY 2013. In FY 2014, the agency also obtained orders totaling $4.16 billion, compared to $3.4 billion in 2013. By way of comparison to the statistics for FY 2013 and FY 2014, in FY 2012 the agency filed 734 enforcement actions and obtained orders totaling $3.1 billion in disgorgement and penalties.

 

The agency identified at least two significant factors driving the increase in enforcement actions. The first was the agency’s use of “new investigative approaches and the innovative use of data and analytic tools” and the second was the agency’s expansion into a number of new areas based on “first time cases.”

 

With respect to the use of data and analysis, the press release quotes SEC Chair Mary Jo White as saying that “the innovative use of technology – enhanced use of data and quantitative analysis – was instrumental in detecting misconduct and contributed to the Enforcement Division’s success in bringing quality actions.”

 

The kinds of “first-ever cases” identified in the press release included “actions involving the market access rule, the ‘pay-to-play’ rule for investment advisers, an emergency action to halt a  municipal bond offering, and an action for whistleblower retaliation.”

 

The press release also quotes SEC Chair White as saying that “aggressive enforcement” will remain a “top priority” and quotes the head of the SEC Enforcement Division as saying that he expects “another year filled with high-impact enforcement actions.” Going forward, the SEC Enforcement head said, the agency will “continue to bring its resources to bear across the entire spectrum of the financial industry.” Ominously, for the clients of the readers of this blog, he noted that among other things the agency will focus on bringing “cases against gatekeepers.”

 

The SEC’s press release includes a detailed recitation of various enforcement initiatives and accomplishments during the year. Among other things, the press release notes that during FY 2014 the agency’s whistleblower program awarded nine whistleblowers with total awards of approximately $35 million (the bulk of which was a single $30 million award, the largest ever, as discussed here).

 

Among other accomplishments, the press release cites the agency’s success during the fiscal year in “holding gatekeepers accountable,” noting that during the year it “held attorneys, accountants and compliance professionals accountable for the important roles they play in the securities industry.” The report also highlights the fact that during the year the agency “obtained the highest-ever FCPA penalties against individuals.”

 

With respect to the agency’s new policy of requiring individual admissions of wrongdoing as a condition of settlement of cases involving “particularly egregious conduct,” the press release notes that during the fiscal year that it had “demanded and obtained acknowledgements of wrongdoing under the admissions policy announced in the previous fiscal year.”

 

Alix Partners 2014 Litigation and Corporate Compliance Survey

On October 16, 2014, the business advisory firm Alix Partners released the report of its 2014 Litigation and Compliance Survey. The report is the result of a June 2014 survey of general counsel and compliance officers at companies in the United States and Europe with annual revenues of $250 million or more. The report underscores the fact that companies of this size in both the US and Europe are experiencing increased levels of litigation activity and incurring increased litigation costs. The firm’s October 16, 2014 press release can be found here and the Survey Report itself can be found here.

 

According to the report, 32 percent of respondents reported an increase in the number of legal disputes in which their companies were involved in the 12 months preceding the survey. The five most frequent types of commercial disputes in which the respondents said their companies were involved in the preceding twelve months were: contract (58%); employment (50%); intellectual property or patent infringement (33%); accounting/financial reporting/disclosure (19%); and insurance (19%). (The results totaled greater than 100% because the survey allowed respondents to select multiple categories.)

 

A particularly interesting observation from the survey responses of the European respondents is that many companies are seeing increases in cross-border disputes, with 35% of European respondents reporting that the number of cross-border disputes had risen during the preceding 12 months.

 

Interestingly, 8% of all respondent and eleven percent of European respondents reported that their companies were involved in bet-the-company disputes during the preceding 12 months. The top five types of bet the company disputes in which the respondents reported that their companies were involved were: contract disputes (50%); intellectual property (38%); class action (38%); antitrust (31%); and securities (13%). (Results totaled greater than 100% because of the selection of multiple categories.) Among the European respondents reporting that their companies were involved in bet-the-company litigation, the most frequently reported categories were contracts (71%) and class actions (57%).

 

All of this litigation activity has led to an increase in litigation spending. 47% of all respondents reported that spending at their companies for litigation had increased in the past year and 38% reported that their litigation departments had grown in the past year. Among the European respondents, half said that their companies had increased spending and 37% reported an increase in the size of their companies’ litigation departments.

 

As a resulting of the growing litigation threats and the mounting litigation spending, many companies are implementing measures to try to detect potential problems. In particular, increased regulatory oversight has encouraged many companies to increase their focus on preventive measures.

 

Academics’ Review of Plaintiffs’ Firms Effectiveness in Merger Objection Litigation

Based on their review of M&A-related litigation over a ten year period, a trio of academics has concluded that the top plaintiffs firms obtain the best results for shareholders, because they aggressively litigate their cases. In their October 2014 paper entitled “Zealous Advocates or Self-Interested Actors?: Assessing the Value of Plaintiffs’ Law Firms in Merger Litigation” (here), Case Western Reserve University Professor C.N.V. Krishnan, U.Cal Berkley Law Professor Steven Davidoff Solomon, and Vanderbilt Law Professor Randall Thomas reviewed a sample of 1,739 merger objection class action lawsuits filed between 2003 and 2012, in order to assess the effectiveness of the plaintiffs’ law firms. The results of their analysis, summarized in an October 15, 2014 article on the Vanderbilt University Web Site entitled “Top Class-Action Law Firms Are Worth Hiring, Study Says” (here), showed, according to one of the study’s authors, that “the presence of one of the top plaintiffs’ law firms is significantly and positively associated with a higher probability of lawsuits success.”

 

The paper’s authors divided the plaintiffs law firms into groups they denominated “top-10” and “non-top-10” using “various reputation measures” The authors then further divided to top firms into “top-5 firms” based on their “popularity with informed plaintiffs and proven ability to obtain large attorneys’ fees awards” The authors then analyzed the results in the various lawsuits in their litigation database, from which they concluded that the involvement of one of the top five firms was very strongly correlated with what the authors described as lawsuit success. The authors said that these results hold even after controlling for selection bias – that is, the likelihood that the top law firms get to pick the better cases that have higher chances of success.

 

The authors concluded that the top plaintiffs’ law firms achieve the best results because the top firms are significantly more active in prosecuting cases than other plaintiffs firms, which adopt more passive strategies. The top firms’ more active prosecution of the cases is evidenced by the fact that they file more documents in their cases and the fact that they “have fewer cases dismissed, win more procedural motions and obtain more substantive settlements.”  The lower tier firms, by contrast, appear to file lawsuits “in hopes of generating a quick settlement and avoiding the expense of trial,” with the settlements of the type that “many times are believed to profit the law firms more than their clients.”

 

As one of the authors quoted in the Vanderbilt web site article puts it, “not all plaintiffs’ law firms are alike and lawmakers, judges and regulators should act accordingly.” The authors’ research, they state, should give courts “guidance about the appropriate method for selecting lead counsel in shareholder class action litigation.”

 

Special thanks to a loyal reader for sending me a link to the Vanderbilt web site.

 

Discussion

The SEC’s statement that its filing of a record number of enforcement actions during the past fiscal year was attributable in part to the agency’s “innovative use of data and statistical tools” is interesting. Since the agency announced the initiation of financial reporting task forces and implementation of data analytic tools to detect indicia of potential accounting fraud (dubbed in the media as “Robocop,”  about which refer here), there has been speculation that these initiatives could lead to an upsurge in enforcement activity. Although the agency’s fiscal year report does not directly link the increase in the number of enforcement actions to these initiatives, the SEC”s press release certainly does suggest that these initiatives represent a significant part of the agency’s enforcement actions during the past year. It seems likely that there will be more of this in the months and years ahead.

 

The SEC report’s emphasis on its actions targeting individuals and gatekeepers is certainly ominous for the interests of this blog’s readers. The agency’s focus on individuals and gatekeepers could, among other things, represent a real threat to the public company officers and directors.

 

The Alix Partners survey report is interesting not just because it documents that many companies are experiencing increased litigation activity and litigation spending, but also because it shows that these developments are not limited just to the more litigious United States. The fact that an even greater percentage of the European respondents to the survey than U.S. respondents reported that their companies were involved in bet-the-company litigation is surprising, and the fact that the European reported that their companies are experiencing increased litigation activity and litigation spending at about exactly the same levels as the U.S. respondents strongly suggests that the forces shaping the litigation environment in the two arenas may be similar — and even perhaps that the natures of the two environments may be converging. If nothing else, it may become harder over time to contend that litigiousness is a curse unique to the U.S. business environment.

 

Finally the academics’ analysis of the plaintiffs’ law firms’ results in merger objection litigation may not be surprising – it is hardly unexpected that top law firms produce better results – but their analysis is nonetheless interesting. If nothing else, their analysis substantiates a point that many of the more prominent plaintiffs’ firms frequently make about how many of the litigation ills of which the business community so frequently complains are the results of the actions of the bottom feeder law firms. The academics’ analysis provides support for the argument that the frivolous lawsuits filed only to try to extract a quick fee are the handiwork of the lower tier law firms. The academics report also provides some support for the arguments that some of the top firms often make, which is that their efforts produce real shareholder value and provide real protection for shareholders. The problem of course is to eliminate the frivolous unproductive litigation without eliminating the lawsuit that produce real benefits for shareholders.

PrintContinuing an recent downward trend, corporate and securities litigation filings during the third quarter declined, both compared to the prior quarter and compared to the third quarter last year, according a new report from Advisen, the insurance information firm. In its report, entitled “D&O Claims Trends: Q3 2014” (available here), Advisen reports that corporate and securities litigation declined 18 percent compared to the second quarter and 48 percent compared to the third quarter of 2013. This year’s filings are on pace for the third consecutive year of declining filing activity, as the wave of litigation that followed the financial crisis recedes into the past. However, the report does note that securities class action filing activity rose during the third quarter compared to the second quarter.

 

Unlike other published litigation reports, the Advisen claims update attempts to track not just securities class action litigation activity, but all corporate and securities litigation filing activity. So, in addition to securities class action filings, Advisen seeks to track, for example, shareholder derivative litigation and securities enforcement litigation, among other things. The Advisen report also tracks securities litigation brought on behalf of individuals (rather than on behalf of a class) and also attempts to track corporate and securities litigation outside the U.S. as well. Because the Advisen report tracks litigation activity other than just securities class action litigation activity, the data reporting  and conclusions in the Advisen report will differ from other published reports.

 

The Advisen report states that during the third quarter all corporate and securities litigation filings declined for the second consecutive quarter, putting 2014 on pace for its third straight year of annual aggregate declines. Third quarter filings not only declined by almost one-fifth (18%) from the second quarter, but third quarter filing activity is nearly half of what it was during the third quarter of 2013. The 48% year over year quarterly decline is the largest since before the financial crisis.

 

Nearly all classes of litigation that Advisen tracks declined in the third quarter compared to the second quarter. One exception is securities class action litigation, which increased to 52 filings in the third quarter from 43 in the second quarter. Because securities class action litigation activity picked up while other types of litigation declined, the percentage of all corporate and securities litigation filings represented by securities class action litigation increased. Securities class action litigation represented 21 percent of all corporate and securities litigation during the quarter, which is the highest quarterly percentage of total cases since 2009 and which exceeds the annual average of 15 percent since 2004.

 

Companies in the financial services industry were the most frequent targets for corporate and securities lawsuits in the third quarter. Fully one third of all third quarter filings were against companies in the financial services sector. Other industries that were active in the third quarter were: information technology (15%); industrials (14%) and consumer discretionary (13%).

 

The absolute number of merger objection lawsuit continued to decline in the third quarter, continuing a trend that began in 2011. At the current pace, it appears that the number of merger objection lawsuits will decline for the third year in a row in 2014. But while the Advisen report tracks the number of merger lawsuits, it does not track the number of mergers, leaving open the possibility that the number of merger of lawsuits has declined because the number of mergers has declined. Another factor may also be at work; in the past, mergers often attracted multiple lawsuits. It is possible that the aggregate number of merger objection lawsuits is declining because the number of separate lawsuit filed with respect to each merger deal is declining. The more interesting statistic is the percentage of all merger deals that attract at least one lawsuit. In recent years, the percentage of deals attracting at least one lawsuit has approached 100%. Because the Advisen report discusses only the absolute number of merger lawsuits, it does not shed any light on the more important question of the percentage of all merger deals attracting at least one lawsuit.

 

The general message of the Advisen report is that overall corporate and securities litigation filing levels are declining. Certainly relative to the high water mark of financial crisis-related litigation in 2011, filing activity is down. But evaluating the relative levels of filing activity arguably is a matter of your point of reference. Exhibit 1 in the Advisen report, a bar graph showing annual filing activity, makes the point. The exhibit shows that while filing activity is down relative to the financial crisis-related peak it also has returned to pre credit crisis-related levels. So another way of looking at the filing activity levels is that –rather than saying that the filing activity levels are declining — the filing activity has returned to more normal levels after the huge surge of litigation that followed the financial crisis.

 

Advisen Quarterly Claims Trends Webinar: On Thursday October 16, 2014, I will be participating in Advisen’s Quarterly Claims Trend Webinar. This free event will take place at 11 am EDT. Also participating in the seminar, in which the panelists will discuss the important trends in corporate and securities litigation, will be Jed Melnick, a leading corporate and securities litigation mediator and Managing Partner, Weinstein Melnick LLC, and Joseph E. White III, Co-Founder & Attorney at the Saxena White law firm. The event will be moderated by Jim Blinn of Advisen. Information about the seminar, including registration, can be found here.

 

stockmarketticker2One of the more interesting recent developments in the D&O liability arena has been the emergence of issues surrounding fee-shifting bylaws. As readers will recall, in May 2014, the Delaware Supreme Court in the ATP Tours case upheld the validity of a non-stock corporation’s bylaw imposing attorneys’ fees on an unsuccessful claimant in an intra-corporate lawsuit. Legislation to limit the Court’s decision’s effect to non-stock corporations was quickly introduced in the Delaware legislature, but the proposed legislation has been tabled until the legislative session resumes in 2015. While the question of the validity of these kinds of bylaws under Delaware remains on hold, some companies have continued to press ahead. Among the companies adopting fee shifting bylaws is none other than Alibaba, the IPO superstory of 2014.

 

As discussed in a September 30, 2014 post by Denver Law School Professor J.Robert Brown on the Race to the Bottom blog (here), Alibaba’s Amended and Restated Memorandum and Articles of Association (which can be found here) provide in Article 173:

 

Unless otherwise determined by a majority of the Board, in the event that (i) any Shareholder (the “Claiming Party”) initiates or asserts any claim or counterclaim (“Claim”) or joins, offers substantial assistance to or has a direct financial interest in any Claim against the Company and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits in which the Claiming Party prevails, then each Claiming Party shall, to the fullest extent permissible by law, be obligated jointly and severally to reimburse the Company for all fees, costs and expenses (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the Company may incur in connection with such Claim.

 

As Professor Brown points out, Alibaba is a Grand Cayman corporation, so the pending legislative developments in Delaware are irrelevant to the validity of Alibaba’s fee-shifting bylaw. In addition, as a Grand Cayman corporation, the company and its directors and officers are not subject to the same kind of state court litigation as domestic U.S. companies and their directors and officers. So it would seem that this bylaw is targeted at securities lawsuits. However, it should also be noted that the bylaw applies by its terms to claims against the company itself  (as opposed to its directors and officers) and that it requires only reimbursement of fees to the company by unsuccessful litigants.

 

Shareholders of Alibaba might well have reason to be concerned about this bylaw provision, because of the practical barriers it creates for any shareholder who might want to allege that the company misled investors and thereby violated the federal securities laws. However, for the shareholders to be concerned about the bylaw, they would have to know about it. As Professor Brown notes, the company’s IPO prospectus apparently neglected to mention the existence of this bylaw provision.

 

Nor is Alibaba the only recent IPO company to include a fee-shifting provision in its bylaw. As Alison Frankel discusses in her October 9, 2014 post on her On the Case blog (here), Smart & Final, a grocery store chain that went public last month, and ATD Corp, a tire distributor that in August filed to go public, have also adopted charter provisions that “shift the cost of defending shareholders’ claims to investors who sue and lose.” Interestingly, both Smart & Final and ATD Corp. are Delaware corporations, so the validity of their bylaw provisions will depend on the outcome of the pending legislative processes in Delaware. These companies join a number of other smaller public companies that have amended their bylaws to include fee-shifting provisions (as discussed here).

 

According to a Professor Brown’s September 28, 2014 post on the Race to the Bottom blog (here), the Smart & Final fee-shifting provision appears in the company’s articles of incorporation and expressly refers to actions against the company’s officers, directors and employees, so presumably it would apply to shareholders’ derivative lawsuits as well as other state court shareholder litigation.

 

As Frankel points out, the questions of the validity of these kinds of bylaw provisions may be different for IPO companies than for other publicly traded companies that amend their bylaws to include these kinds of provisions. For the publicly traded companies, shareholders may try to object that the bylaws were amended without their consent. For IPO companies, the defendants “will argue that their founding corporate documents told shareholders what to expect.” (Although that argument may carry less sway if, as seems to be the case with Alibaba, shareholders were not in fact informed about the existence of the provisions).

 

The more interesting question in all of this may be where the SEC was on these issues. In the past, the SEC seemingly at least, had been quite attentive to these kinds of initiatives. For example, as discussed here, when The Carlyle Group sought to go public in 2012 with, as was disclosed in its preliminary registration statement, a bylaw requiring the arbitration of shareholder disputes, the company ultimately was forced to revise its bylaw to remove the provision under pressure from the SEC. These prior events raise the question of how the various companies recently were able to complete their public offerings with fee-shifting bylaws, which in Alibaba’s case apparently were not even disclosed in the Prospectus

 

As Frankel notes in her blog post, even if the SEC has been quiet on these issues in the past, that may be about to change. The SEC’s Investor Advisory Committee apparently is taking up these issues. Among other things it may be expected that at least the agency will require companies to do a better job disclosing the existence of these kinds of bylaws.

 

In any event, it seems clear that these issues are going to continue to percolate, regardless of what the Delaware legislature ultimately does on the pending legislation. For starters, regardless of what the Delaware legislature does, these issues will continue to arise in connection with other companies – like Alibaba for example — to which Delaware’s laws do not apply. In addition, legislative and judicial developments in other jurisdictions could have their own impact; as I noted in a recent post, Oklahoma’s legislature recently adopted a provision authorizing Oklahoma corporations to extend loser-pays to all shareholder suits involving board members.

 

It remains to be seen where all of this well lead. I suspect that going forward there will be increased scrutiny on these issues for IPO companies and that companies with fee-shifting bylaws that are attempting to go public will likely be called out on the issue, assuming that is that the SEC continues to allow the IPOs of companies that have these kinds of bylaws to proceed.

 

The larger issue is whether or not the developments portend a significant revision of what is known as the American Rule, whereby it has been the practice in this country that each litigation party will bear its own costs. As companies increasingly seek to introduce their own form of litigation reform through revision of their own bylaws, and as courts and legislatures evolve their response to these kinds of bylaw provisions, there is a possibility that these developments could work a major change to the traditional American Rule on attorneys’ fees.  Which in turn could have a significant impact on the corporate litigation environment.

global directors 2The increasing globalization of business and commerce presents significant opportunities and major complications. The complications run across a wide variety of issues. Among other things, the complications arising from an increasingly global economy include concerns relating to the liabilities of companies’ directors and officers across jurisdictions. These concerns can vary widely depending on the countries in which the companies are involved.

 

Assessing and allowing for the legal differences between different jurisdictions can be challenging. Among other things, the laws regarding indemnification vary widely in different countries. The availability and procedures for class action litigation are also very different in different countries. The types, availability and applicability of D&O insurance also varies as well.

 

Fortunately, a new resource is available to help those struggling to identify the important issues affecting the liability of directors and officers in different jurisdictions. The resource is a American Bar Association publication entitled “The Global Directors and Officers Deskbook,” (here) which was edited by my good friend Perry Granof, director of Granof International,  and Henry Nicholls, who is senor counsel at the Cohon & Pollack law firm. The book provides an overview of the directors and officer liability landscape in 28 countries, including the United States, Canada and 26 other countries

 

Each of the chapters in this timely and helpful book addresses a different country. Each chapter follows a common format; the topics addressed in each chapter are: Statutory and Regulatory Framework: Indemnification; Regulatory Proceedings and Shareholder Representative Actions; Insolvencies, Arbitration and Alternative Dispute Resolution; and Insurance Issues.

 

The 28 countries addressed in the book are arranged regionally, with five countries from Africa and the Middle East (including Egypt, Israel, Nigeria, Saudi Arabia, and South Africa); seven countries from Asia/Pacific (including Australia, China; Hong Kong; India; Japan; Singapore; and South Korea); eight countries in Europe (including France, Germany, Italy, Netherlands, Russia, Spain and the United Kingdom); six countries in Latin America (including Argentina, Chile, Brazil, Colombia, Mexico, and Peru), as well as Canada and the United States.

 

I know from reviewing several of the chapters that the overview provided by each of the chapters is very useful. For example, the chapter on India provides a helpful discussion of the new Companies Act of 2013, which recently replaced the Companies Act of 1956.Among other things, the new Companies Act has introduced the concept of shareholder class actions. These and similar kinds of important observations are provided in each of the various chapters.

 

I was very pleased to note in reviewing the book how many of the chapters were written by friends and professional acquaintances. The India chapter was written by Burzin Somandy, whom readers may recall was my host and tour guide during my recent visit to Mumbai. The book’s regional coordinator for Europe and co-author of the U.K. chapter is my good friend Nilam Sharma of the Ince & Co. law firm. The Israel chapter was co-authored by Rachel Levitan with whom I have had much professional contact over the years. The China chapter was co-authored by Arthur Xiao Dong, whom I met for the first time during my 2012 visit to China. Other chapters were written by industry colleagues whom I have been fortunate to meet through PLUS. From my perspective, the book is clearly the work of knowledgeable and experienced industry veterans.

 

I would like to thank Perry Granof for the opportunity to review this book. I know that just about everyone in the D&O liability insurance industry will find this book to be indispensable.

 

caliAs I have previously noted on this blog, one of the recurring D&O insurance coverage issues arising during the latest bank failure wave has been the question whether the Insured  vs. Insured Exclusion precludes coverage for claims brought by the FDIC in its capacity as receiver for a failed bank against the failed bank’s former directors and officers. In denying coverage for these kinds of claims, the D&O carriers argue that because the only basis on which the FDIC has the right to assert these claims is that it “stands in the shoes” of the failed bank, the Insured vs. Insured (IvI) Exclusion precludes coverage. The FDIC and the individual directors and officers argue that the question whether exclusion precludes coverage for the FDIC claims is ambiguous, and therefore the exclusion cannot be applied as the carriers contend.

 

As these cases have unfolded in various courts across the country, the rulings have gone both ways – some courts have found that the exclusion applies, while others have found that it is ambiguous and does not apply.

 

In an October 8, 2014 Opinion (here), in the latest ruling on these issues, Central District of California Judge Andrew Guilford, addressing these issues in the coverage litigation filed in connection with the FDIC’s lawsuit against the former directors and officers of Pacific Coast National Bank, held that the question of whether the IvI Exclusion precludes coverage for claims brought by the FDIC in its capacity as receiver of the failed bank is ambiguous.

 

Background

Pacifica Coast National Bank of San Clemente, California failed on November 13, 2009. In November 2012, the FDIC, as the failed bank’s receiver filed a civil action against five of the bank’s former directors and officers, alleging negligence, gross negligence and breaches of fiduciary duty in relation to various loans the bank had made ad that allegedly resulted in millions of dollars of losses to the bank. The individual defendants sought coverage for the claims under the bank’s D&O insurance policy. The D&O insurance carrier, in turn, filed an action seeking a judicial declaration that there was no coverage under the policy for the FDIC’s claims. The FDIC moved for summary judgment in the coverage litigation and the individual defendants jointed in the FDIC’s motion. The insurer filed a cross-motion for summary judgment.

 

In denying coverage, the insurer relied on two policy provisions, the IvI Exclusion and the Unpaid Loan Carve-Out. The IvI Exclusion provided in pertinent part that the policy does not provide coverage for any claim against an Insured “brought by or on behalf of any Insured or Company [including the Bank] in any capacity.” The exclusion had a carve-back that preserved coverage for “a Claim that is a derivative action brought or maintained on behalf of the Company by one or more persons who are not Directors or Officers and who bring and maintain such Claim without the solicitation, assistance or active participation of any Director or Officer.”

 

The Unpaid Loan Carve-Out provides that the Loss as defined in the policy does not include “any unrepaid, unrecoverable or outstanding loan, lease or extension of any credit to any Affiliated Person or Borrower.”

 

The October 8 Opinion

In his October 8, 2014 Opinion, Judge Guilford denied the insurer’s motion for summary judgment and granted the motion for summary judgment of the FDIC and of the individual directors and officers. Judge Guilford held that the two policy provisions on which the insurer relied are ambiguous and therefore cannot serve as a basis to deny coverage.

 

With respect to the IvI Exclusion, Judge Guilford said that the fact that the exclusion is ambiguous when applied to the FDIC in its capacity as receiver of a failed bank “is evidenced by the fact that courts considering this exclusion have reached varying conclusions.” Noting the many decisions that have similarly concluded that the exclusion is ambiguous, Judge Guilford said that “there can be little doubt that repeated disputes over the IvI Exclusion have placed insurers on notice that it is ambiguous.”

 

Judge Guilford went on to note that “the insurance company has the ability, as a repeat party to these contracts, to ensure that ambiguities are eliminated over time.” The insurer “had the opportunity to make clear in the Policy that the IvI Exclusion applied to the FDIC-R, and it could have done so with a simple statement.” Judge Guilford noted that, in fact, the carrier “provides an optional regulatory exclusion – not included on the policy here – that explicitly names the FDIC.”

 

Judge Guilford expressly rejected the insurer’s argument that the IvI Exclusion applies because the FDIC “stands in the shoes” of the failed bank for which it is acting as receiver.” Though the U.S. Supreme Court had said in the O’Melveny & Myers v. FDIC decision that the FDIC as receiver “stands in the shoes” of the failed bank, the question to be answered under the IvI exclusion is whether or not the FDIC acting as the receiver of a failed bank is acting “on behalf of” the failed bank; the Supreme Court’s decision “doesn’t tell us whether ‘on behalf of’ means the same thing as ‘stands in the shoes.’”

 

Judge Guilford also found an ambiguity on the question of whether or not coverage for this claim was in any event preserved by the derivative claim coverage carve-back to the IvI Exclusion. Judge Guilford noted that the FDIC as receiver also succeeds to the rights of the failed bank’s shareholders. Even if, as the insurer argued, the FDIC’s lawsuit technically is not a derivative action, the question remains of on whose behalf the FDIC brings the claims. Judge Guilford said that “even if the procedure by which the FDIC-R asserts the claims differs from the derivative action available to shareholders,” the policy should cover the claims “if the FDIC-pursues them under its authority to recover losses on behalf of shareholders.”

 

Finally, Judge Guilford rejected the insurer’s argument that the Unpaid Loan Carve-Out precluded coverage for these claims because the damages the FDIC sought in the underlying action were in the amount of unpaid loans. Judge Guilford said that Carve-Out does not unambiguously apply to cases where tortious conduct results in damages that might happen to be in the amount of unpaid loans.

 

Discussion

Judge Guilford’s opinion in this case stands in interesting contrast with the August 19, 2013 decision of Northern District of Georgia Judge Richard W. Story in the Community Bank & Trust coverage action, in which Judge Story held that the Insured vs. Insured exclusion in the D&O insurance policy at issue in that case unambiguously precluded coverage for the FDIC’s lawsuit against the bank’s former directors and officers. Judge Story’s decision is discussed in greater detail here.

 

On the other hand, Judge Guilford’s opinion is consistent with an earlier ruling from a different judge in the same judicial district. On January 4, 2014, Northern District of Georgia Robert L. Vining, Jr. held in the Omni National Bank coverage action that because of the “multiple roles” in which the FDIC acts in pursuing claims against the former directors and officers of a failed bank, there is “ambiguity” on the question whether the FDIC’s lawsuit as the failed bank’s receiver triggers the insured vs. insured exclusion. For further background on Judge Vining’s decision, refer here.

 

Similarly to Judge Vining, in October 2012, District of Puerto Rico Judge Gustavo Gelpi declined to dismiss a direct action the FDIC had brought under the Puerto Rico direct action statute against the D&O insurer of the failed Westernbank, noting that the FDIC has authority under FIRREA to act on behalf of a number of different constituencies and therefore that “the FDIC”s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under [the Insured vs. Insured] Exclusion.” (For more about Judge Gelpi’s decision, refer here.)

 

Judge Guilford not only acknowledged the existence of this split in the case authority but he expressly relied on  it in concluding that the exclusion’s application to claims asserted by the FDIC-R is ambiguous, observing that the fact that the exclusion is ambiguous “is evidenced by the fact that courts considering this exclusion have reached varying conclusions.” This argument, taken together with the increasing weight of the cases that have concluded that the exclusion’s applicability to the FDIC-R is ambiguous, may increasingly make it more difficult for insurers to argue that the exclusion is not ambiguous.

 

Judge Guilford’s observation that the carrier could have easily precluded coverage for claims asserted by the FDIC by the inclusion of a regulatory exclusion is interesting. It is true that in the process of policy placement, the question of whether or not there is “regulatory coverage” tends to focus on whether or not the policy has some form of regulatory exclusion. Policies that do not have regulatory exclusions are preferred over policies that do. This marketplace distinction between policies that have the regulatory exclusion and that do not would be meaningless if coverage for FDIC claims is nevertheless precluded by the IvI Exclusion, whether or not the policy has a regulatory exclusion. Given this practical dynamic in the day-to-day insurance marketplace, there is some merit to the argument that the carrier ought not to be able to preclude coverage indirectly for a claim it could have but did not exclude expressly.

 

I will say I am less persuaded by Judge Guilford’s conclusion that even if the IvI Exclusion operates to preclude coverage for the FDIC’s claims coverage is nevertheless preserved by the application of the exclusion’s carve-back for derivative claims. The carve-back clearly was meant to apply to derivative claims. The FDIC’s lawsuit is not asserted as a derivative claim; it is a direct action. Judge Guilford’s analysis of this issue seems forced to me and unnecessarily fuzzies up the issue.

 

As long as the D&O insurance carriers hold out the hope that they might be able to persuade a court to reach the same conclusion that Northern District of Georgia Judge Richard Story reached in his August 2013 decision in the Community Bank & Trust case – that is, that the IvI exclusion unambiguously precludes coverage for the FDIC’s claims as receiver of a failed bank against the bank’s former directors and officers – they will continue to try to contest coverage in reliance of the exclusion. However, with each decision that the exclusion’s applicability to the FDIC’s claims is ambiguous, the argument will get harder and harder for the carriers to sustain. At some point, the cumulative weight of the case decisions could reach the point where the argument simply becomes unsustainable – that is, of course, unless the insurers can notch up some victories for the contrary position.

 

bbbWhat Warren Buffett has accomplished at the head of Berkshire Hathaway is nothing short of astonishing. Not only has he built a massive company, but he has done it while maintaining an unparalleled reputation for business integrity. The man is an American business icon. He is also mortal. Buffett is now 84 years old. The question of what happens to Berkshire after Buffett moves on has weighed on the company for years – indeed, the rating agency Fitch has long highlighted as a risk of the company that so much depends on Buffett, whose departure, they aver, can only diminish the company’s value. These kinds of questions will only grow in coming years as Buffett ages further. (In the interests of full disclosure, I should add that I am a Berkshire shareholder, so these questions are not mere idle concerns for me.)

 

Will all of magic really disappear once the Sage of Omaha is no longer at the helm? In his new book, “Berkshire Beyond Buffett: The Enduring Value of Values” (here), George Washington University Law Professor Lawrence Cunningham takes up this question with admirable enthusiasm. Based on his comprehensive overview of the incredible company that Buffett has built, Cunningham concludes that what makes Berkshire unique is not Buffett himself; rather, it is the culture of the company. Berkshire, according to Cunningham “has distinct features and a strong corporate culture that will endure beyond Buffett.’

 

Cunningham reaches this conclusion based on a wide-ranging inspection of the company’s many wholly owned subsidiaries. Based on this review, Cunningham concludes that the seemingly diverse collection of subsidiaries share a set of common traits that are “distinctive, durable – and unique to Berkshire” and that “will allow Berkshire to endure beyond Buffett’s departure.”

 

For “mnemonic power,” and with only a little strain to make it work, Cunningham has reduced the list of common traits to a nine-letter acrostic that just happens to spell out the word “Berkshire.” The traits are: Budget Conscious; Earnest; Reputation; Kinship; Self-Starters; Hands off; Investor Savvy; Rudimentary; Eternal. That is, Buffett has assembled a group of companies led by managers that share his commitment to thrift; that value the autonomy and long-term commitment involved in Berkshire’s ownership; and that share his commitment to maintaining a reputation for integrity.

 

Over several interesting and readable chapters, Cunningham examines various Berkshire subsidiaries to show how they exemplify these characteristic traits. Cunningham presents the subsidiaries’ stories as a series of case studies. The stories include the histories of many familiar Berkshire companies, such as See’s Candies and GEICO. The stories also include interesting descriptions of some companies that may not be as familiar, such as FlightSafety International, MiTek, and Forest River. The companies’ stories are presented as a series of short vignettes that read like parables – each one coming as it does with its own moral lesson.

 

Not that Cunningham’s review is simply a panegyric. Cunningham is careful to consider several notable stumbles that have occurred along the way. Cunningham closely examines problems that arose at Gen Re after the company was acquired by Berkshire. He is also critical of both Buffett’s and Berkshire’s handling of the unusual circumstances that led to the departure of David Sokol, after Sokol had made a massive investment in the shares of Lubrizol before recommending to Buffett that Berkshire consider buying the company. In Cunningham’s view, the stumbles represent circumstances where Berkshire or Buffett uncharacteristically strayed from the company’s fundamental principles – in the end, reinforcing how critical the fundamental principles are to the company’s value and success. 

 

Cunningham also optimistically suggests that some of the measures that Buffett has recently put in place have laid the groundwork for a smoother transition. For example, he notes that in recent  years Buffett has brought in Todd Coombs and Ted Wechsler as sub-portfolio managers, as one of several steps that Cunningham suggests provide “the promise of durability” that will ensure that Berkshire continues to thrive after Buffett is gone.

 

One particularly interesting part of Cunningham’s analysis is his consideration of the Marmon Group, which is a large industrial conglomerate that was founded by the Pritzker family. Berkshire took over ownership of the company in anticipation of the passing of the company’s long-standing leaders. As Cunningham notes, Marmon was not only a perfect fit for Berkshire, but the two companies were built in very similar ways. Both had grown by acquisitions, undertaken in a careful and controlled way. Both were founded and developed by powerful leaders who left an indelible mark on their companies.

 

While there are also important differences between the two companies, Marmon, Cunningham suggests, provides one potential model for the post-Buffett Berkshire Hathaway. Cunningham notes one particular step the Pritzkers took as they prepared their companies for their departure.They organized the company into sectors supervised by divisional Presidents, who could create and implement strategy across the business segments. Based on the Marmon example, there is, Cunningham asserts, “good precedent for believing that even such a vast and decentralized enterprise can endure well beyond its founders.”

 

Cunningham also makes an interesting point about the business activities of a number of the subsidiaries. While Buffett has many praiseworthy talents, his true genius is capital allocation. He has made an astonishing number of successful acquisitions. As a result, Berkshire represents a great collection of companies that will continue to produce revenue and profits long after Buffett is gone. My concern has always been that after Buffett is gone, his successors may be unable to repeat his incredible deal making acumen. Cunningham points out that a number of companies in Berkshire’s portfolio – companies as diverse as MiTek, Forest River and Lubrizol – have been very acquisitive since their own acquisition by Berkshire. The managers of these and several other companies in the Berkshire group have proven to be very successful dealmakers in their own right. Maybe there will never be anyone with quite the touch that Buffett has, but the company will still continue to be able to deploy its capital in ways that grow the company’s value and contribute to the company’s success, even after Buffett is no longer on the job.

 

The bottom line for Cunningham is that in Berkshire Buffett has assembled a set of businesses and business managers that will give the enterprise enduring value; as he puts it, you can take Buffett out of Berkshire, but you can’t take Berkshire out of the subsidiaries.

 

In the book’s Epilogue, Cunningham does sound notes of caution. He allows that after Buffett, we must accept that there will be “slippage.” He observes that: “Deals may not come Berkshire’s way. Offers Berkshire makes may not be on terms as agreeable as they have been. Negotiations may be less favorable.” But returns will not be disappointing, and there will be no justification for dismembering the company or taking other radical steps. In the end, Cunningham concludes, Berkshire transcends Buffett and the company will be his enduring legacy.

 

I have to say I found Cunningham’s analysis interesting and reassuring Just the same, I do worry what the future may hold for the company, both in the near and longer term. In the near term, I worry about the company as Buffett remains at the helm. My household happens to include an aging relative who is exactly the same age as Buffett. She could not be relied upon to organize a bowl of Wheaties even if you spotted her the bowl, the cereal box, the milk and the spoon. Buffett by contrast is aging well, but the years have their own weight and cannot be gainsaid. The transition to the post-Buffett era could prove difficult not because the change will take place abruptly; it could prove difficult because the pre-departure era could prove to be far longer than is good for the company.

 

I also worry about the ownership base. One of the keys to Buffett’s great success is that he managed to build a shareholder base for his company that shares his business philosophy, that is willing to take a long-term view, and that knows better than to insist that the company’s management meet various short term goals. The shareholders have been amply rewarded for acquiescing in these views. Will the shareholders be as patient with new managers who lack Buffett’s track record and credibility – particularly if the new managers feel compelled to go in new or different directions? Will the new managers feels constrained in the making the changes that different times may require?

 

For all of the company’s great past success, a period of uncertainty lies somewhere ahead for the company in the not too distant future. In reading Cunningham’s book, I was reminded of something that one of the Berkshire subsidiary Presidents once said to me. The individual said that when Buffett dies, the company’s share price could plunge, perhaps dramatically. When that happens, the individual said, raise all the cash you can and buy as many shares as you can, because once the dust has settled and some time has passed, the world will figure out that Berkshire will still be a great company, even after Buffett is long gone. I happen to believe that assessment is true. Cunningham’s interesting book provides the explanation why that is so.  

 

Readers who lilke me are particularly interested in Warren Buffett will want to note that Professor Cunningham is the author of the excellent topically indexed anthology of Buffett’s annual letters to Berkshire shareholders, “The Essays of Warren Buffett,” which I reviewed in an earllier post, here.

 

 

medtronicOne of the more distinctive business trends in recent months has been the surge of so-called corporate inversion transactions, in which a domestic U.S. company merges with a non-U.S. company, with the the successor company to be based in the foreign country in order to take advantage of a more favorable corporate tax regime. These transactions have drawn a great deal of criticism from Washington, and on September 22, 2014, the U.S. Treasury department issued regulations to deter companies from entering into these kinds of transactions.  But at least according to some press reports, while the new regulations may remove some of the benefits the transactions have offered in the past, may not end the transactions altogether.

 

While it might be expected that these transactions would be unpopular in Washington, you would think that shareholders would welcome these transactions, given the tax advantages that the transactions afforded. However, as I noted in a prior post, in some cases, the shareholders of some of these companies have filed lawsuits against the companies and senior management, complaining, for example about the immediate tax consequences for the individual shareholders that the transactions trigger.

 

Now a shareholder of Medtronic has filed another of these lawsuits, in connection with the company’s planned $42.9 billion merger with the Irish-based company, Covidien. As discussed in an October 6, 2014 St. Paul Pioneer Press article (here), on October 3, 2014, a Medtronic shareholder filed a derivative lawsuits against the company, as nominal defendant,  and certain of its directors and officers in connection with Medtronic’s planned “inversion” merger with Covidien.

 

In her complaint (here), the plaintiff asserts claims for breach of fiduciary duties, waste of corporate assets, and unjust enrichment. The crux of the plaintiff’s complaint is that the company’s board has agreed to make “gross-up” payments to certain officers and board members, in order to offset certain excise taxes these individuals will owe under the Internal Revenue Code as a result of the company’s inversion transaction. (The excise taxes are due under a revision to the Tax Code Congress enacted in 2004 to try to discourage inversion transactions.) The purpose of the gross up payments is to put the same position after tax that the individuals would have been in if the excise tax had not applied.

 

The plaintiff’s complaint alleges that the total cost to the company of these payments will total approximately $63 million, including $25 million to the company’s Chairman and CEO. Because the gross-up payments themselves represent taxable income to the individuals, and because the payments to the individuals includes further amounts to offset the additional  income tax expense, the cost to the company to provide the gross-up payments is far greater than the $32.7 million owed for the excise taxes.

 

The plaintiff alleges that the company has justified these payments on the ground that the affected individuals should not be discouraged from taking actions they believe to be in the best interests of the company because of their own personal tax situation. The plaintiff alleged that this justification showed that the Board was “incapable of acting in Medtronic’s best interests when their personal interests are at stake,” and therefore that a demand on the “self-serving” board would be futile.

 

The complaint seeks restitution from the individual defendants for all illicit and improper tax reimbursements, as well as corporate governance reforms to address what the plaintiff calls “self-dealing” by the board.

 

Lawmakers in Washington undoubtedly will continue to try to find ways to address concerns relating to these kinds of corporate inversion transactions. It remains to be seen whether other companies press ahead with these kinds of transactions after the latest round of regulatory changes out of the Treasury department. But if there are other transactions, companies engaging in inversion transactions not only risk attracting the ire of Washington lawmakers, but also may face the possibility of shareholder litigation, as this latest lawsuit shows.

 

Special thanks to a loyal reader for sending me a link to the news article about the lawsuit.

 

judgmentI have frequently noted in prior posts that a frequent development after a company announces the existence of an FCPA investigation is the filing of a follow on civil action (refer, for example, here). But while plaintiffs’ lawyers often are eager to file these lawsuits, in many instances they prove to be unsuccessful (as discussed here). A recent ruling in the FCPA follow-on securities class action lawsuit involving Avon Products illustrates the hurdles companies face in trying to pursue these kinds of claim. At the same time, however, recent dismissal motion denial in the FCPA follow-on securities class action lawsuit involving Wal-Mart Stores illustrates what may be sufficient for these kinds of cases to survive the initial pleading hurdles.

 

Avon Products  

Avon, a beauty products company that earns much of its revenue from direct sales operations, derived significant sales revenue from direct sales operations in China. The Chinese direct sales operations were made possible by licenses granted by the Chinese government. On October 20, 2008, Avon disclosed in a SEC filing on Form 8-K that in June 2008 the company’s CEO had received a whistleblower letter suggesting that certain travel and entertainment expenses associated with the company’s operations in China may have violated the FCPA. The company also announced that it had launched an internal investigation.

 

Between October 2008 and October 2011, the company reported generally increasing sales through its Chinese operations. In October 2011, the company announced that the SEC had launched a formal investigation of the company. Later in 2011, the company announced that its CEO would step down from that role but would remain as Executive Chairwomen for two years. In early 2013, the company announced that its Chief Financial Strategy Officer had been terminated in connection with the ongoing bribery investigation.

 

In July 2011, plaintiff shareholders filed the first of several securities class action lawsuits against the company and certain of its directors and officers. The plaintiffs alleged that the company had failed to disclose prior to the October 2008 8-K filing that it allegedly had obtained its licenses for direct sales operations in China through bribery of Chinese officials and that in subsequent communications reporting the company’s growing revenues in China the company failed to disclose that the revenue was possible as a result of the allegedly improperly obtained licenses. The defendants moved to dismiss.

 

In a detailed September 29, 2014 opinion (here), Southern District of New York Judge Paul G. Gardephe granted the defendants’ motion to dismiss the plaintiffs’ consolidated complaint. He did grant the plaintiffs leave to file an amended complaint.

 

With respect to Avon’s disclosures prior to the October 2008 8-K filing, he found that the plaintiffs had failed to show that any of the misleading statements had been made with the knowledge or awareness of the existence of the allegedly improper payments. In particular, he found that the allegations that the company’s executives “must have known” or “had to have known” about the improper payments because of their senior positions and direct involvement in the negotiation of the Chinese licenses were insufficient to satisfy the state of mind pleading requirements. He found with respect to the statements after the October 2008 8-K filing that the plaintiffs had failed to show that the statements were materially false or misleading.

 

Wal-Mart

On December 8, 2011, Wal-Mart disclosed in an SEC filing that as a result of information disclosed in an internal review, the company had begun an internal investigation whether certain matters were in compliance with the FCPA, and that the company had engaged outside counsel in the investigation and had voluntarily disclosed the matter to the SEC and the DoJ. In the subsequent securities class action lawsuit, the shareholder plaintiffs alleged that the company had learned of suspected corruption in its Mexican operations as early as 2005 and had conducted an internal investigation in 2006. The plaintiffs alleged that the December 2011 filing was misleading because it left investors with the impression that Defendants had first learned of the suspected corruption at that time. In June 2012, when Wal-Mart disclosed the events in 2005 and 2006, its share price declined significantly.

 

The defendants moved to dismiss the plaintiffs’ consolidated complaint. In a September 26, 2014 order (here), Western District of Arkansas Susan O. Hickey entered an order adopting the report and recommendation of the Magistrate Judge in the case denying the defendants’ motion to dismiss. Judge Hickey expressly agreed with the Magistrate Judge’s conclusion that the plaintiff had sufficiently alleged that the omission from the 2011 statement of 2005-2006 events rendered the 2011 statement materially misleading. She further affirmed the Magistrate Judge’s finding that omission of the information concerning the 2005-2006 events could have left a reasonable investor with the impression that the defendants first learned of suspected corruption at the time of the December 2011 statement – “an impression that would be untrue.”

 

The defendants had argued that Magistrate Judge’s conclusion that the plaintiffs had satisfied the requirement to plead scienter were incorrect. Judge Hickey concluded that the plaintiff had sufficiently alleged that defendants knew or had access to information suggesting that the December 2011 statement was not entirely accurate. She noted that the plaintiff had alleged that in October 2005, a Wal-Mart attorney had had given the Vice Chairman of the company’s international operations a detailed report of the suspected corruption allegations and that the Vice Chairman had rejected calls in 2006 for an independent investigation and instead assigned the investigation to the very office implicated in the corruption scheme. The complaint alleges that the company only disclosed the 2005-2006 events after an article appeared in the New York Times discussing the circumstances. Judge Hickey said that “the inference that the Defendants intentionally omitted certain information is just as strong, of not stronger, than any competing plausible inference.”

 

Discussion

The different outcomes of the two dismissal motions are obviously attributable to critical differences between the allegations in the two cases. Largely as a result of disclosures in the New York Times articles (and elsewhere) the plaintiff in the Wal-Mart case had a basis on which to allege that senior officials at Wal-Mart allegedly were aware of the alleged improper payments in Mexico prior to the SEC filing in December 2011, whereas the plaintiffs in the Avon case were able to allege only that the senior officials at the company must have known or should have known of the improper payments prior to the company’s October 2008 SEC filing.

 

The outcome of the dismissal motion in the Avon case shows that It will not be enough for securities class action plaintiffs to succeed for them to allege that the company was involved in significant bribery activities, and that even the existence of significant bribery allegations may not be enough to support a securities class action lawsuit, even where the revelation of the existence of bribery allegations results in a significant share price decline. To be sure, the plaintiffs in the Avon case have been given leave to amend their complaint, and their amended complaint may succeed in overcoming the initial pleading hurdles. But the ruling the case discussed above underscored how difficult it can be for plaintiffs to overcome the pleading hurdles.

 

The Wal-Mart case shows how significant and serious an FCPA follow-on lawsuit can be where the plaintiffs are able to present factual allegations sufficient to overcome the initial pleading hurdles. Of course, whether the plaintiff in the case ultimately will succeed remains to be seen. However, because surviving the initial pleading hurdles often is the name of the game for securities class action plaintiffs, the shareholder plaintiff in that case already has made it to a critical litigation milestone.

 

These cases are interesting in and of themselves. They are also interesting in the context of a changing global environment where a number of countries are becoming increasingly active in enforcing their own anti-bribery laws. Among other countries, Canada, China, Brazil, Italy and the UK have recently become more active in this area. For many years, anti-bribery enforcement had been an activity almost exclusively limited to U.S. authorities. As an increasing number of countries become active in this area, overall levels of anti-bribery activity will increase — a prospective development that could have a number of important implications.

 

Among these implications it the possibility that increase anti-bribery enforcement activity could lead to more of the kind of follow-on civil litigation these two cases exemplify – both here in the U.S. and perhaps even outside the U.S. as well. As the Avon case shows, it may be challenging for the plaintiffs in these follow-in civil lawsuits to succeed, but as the Wal-Mart case shows, with sufficient factual ammunition, the plaintiffs in these kinds of cases can raise sufficient allegations at least to survive initial pleading hurdles.