secondsealAfter the U.S. Supreme Court issued its opinion in Morrison v. National Australia Bank, the plaintiffs’ lawyers developed a number of theories to try to circumvent Morrison to assert claims under the U.S. securities laws on behalf of investors who purchased their shares in the defendant foreign company on a foreign exchange. These theories – including the so-called “listing theory” and the “f-squared” theory– have been largely rejected in the district courts, but the appellate courts had not yet weighed in. That is, until now.

 

In a May 6, 2014 opinion in the UBS credit crisis-related securities suit (here), the Second Circuit affirmed the district court and rejected the theories on which the plaintiffs had tried to assert the claims of UBS investors who had purchased their shares on foreign exchanges. Specifically, the appellate court rejected the plaintiff’s argument that because the company’s shares are cross-listed on the U.S., the U.S. securities laws apply even to transactions on the company’s securities on foreign exchanges. The appellate court also rejected the plaintiff’s argument that the U.S. securities laws applied to purchases on  foreign exchanges that originated with a buy order in the U.S. Finally, the appellate court affirmed the district court’s dismissal of the remainder of the plaintiffs’ claims on substantive grounds.

 

Background 

As discussed at length here, the case on appeal involved a consolidated securities class action filed against UBS and certain of its directors and officers. The action was filed on behalf of shareholders who purchased ordinary shares of UBS between August 13, 2003 and February 23, 2009. The shares were listed both on foreign exchanges and on the NYSE exchange. The plaintiffs argued that the defendants had made fraudulent statements concerning UBS’s mortgage-related assets portfolio and about UBS’s purported compliance with U.S. tax and securities laws by its Swiss-based global cross-border private banking business.

 

In a September 13, 2011 order (here), Southern District of New York Judge Richard Sullivan, in reliance on the U.S. Supreme Court’s holding in Morrison, dismissed the claims of foreign and domestic plaintiffs who purchased UBS shares on foreign exchanges. Judge Sullivan expressly rejected the plaintiffs’ argument that because UBS’s ordinary shares were cross-listed on a U.S. securities exchange, the U.S securities laws applied to all transaction in those securities, even those purchased on foreign exchange (the plaintiffs’ so-called “listing theory”).  Judge Sullivan also rejected the plaintiffs’ arguments that the U.S. securities laws applied to purchases of UBS shares on a foreign exchange where the buy order had been placed in the U.S.

 

On September 28, 2012, the district court dismissed the plaintiff’s remaining claims. The plaintiff appealed.

 

For purposes of the appeal it is important to note that in its 2010 opinion, the U.S. Supreme Court held that the U.S. securities laws apply to “[1] transactions in securities listed on domestic exchanges; and [2] domestic transactions in other securities.” These two phrases from the U.S. Supreme Court’s opinion often are referred to as Morrison’s first and second prongs.

 

The May 6 Opinion 

On May 6, 2014, in an opinion written by Judge José A. Cabranes for a unanimous three-judge panel, the Second Circuit affirmed the district court’s dismissal of this case.

 

With respect to the district court’s dismissal of the claims of the UBS shareholders who had purchased their shares on foreign exchanges, the plaintiff argued that because these foreign-purchasers shares were cross-listed on the NYSE, their acquisition of these shares satisfied Morrison’s first prong, because they involved “transactions in securities listed on domestic exchanges.”

 

The appellate court said that “while this language, which appears in Morrison and its progeny, taken in isolation, supports’ plaintiffs’ view, the ‘listing theory’ is irreconcilable with Morrison read as a whole.”  The court noted that in Morrison the Supreme Court had emphasized that “the focus” of the Exchange Act is “upon purchases and sales of securities in the United States,” with the concern upon “ the location of the securities transaction.” The focus of both of Morrison’s prongs “was domestic transactions of any kind, with the domestic listing acting as a proxy for a domestic transaction.”

 

The Second Circuit also noted in the Morrison case itself the securities at issue, while purchased on a foreign exchange, were cross-listed in the U.S., yet this “did not affect the Court’s analysis of the shares that were purchased on foreign exchanges.” Accordingly the Court concluded that Morrison does not support the application of the Exchange Act to claims by a foreign purchaser simply because those shares were also listed on a domestic exchange.

 

The appellate court also rejected the plaintiff’s so-called “f-squared” argument (so-called because it involved a foreign company defendant and shares purchased on a foreign exchange by a U.S. purchaser or based on a U.S. purchase order). The plaintiff had argued that the U.S. securities laws applied to purchases of UBS shares on a foreign exchange based on a “buy order” originated in the U.S. The plaintiff had contended that a purchase of this type satisfies Morrison’s second prong because it constitutes a “domestic transaction in other securities.”

 

The appellate court noted that in its own March 2012 Absolute Activist decision interpreting Morrison’s second prong (about which refer here), it had held that he purchaser’s citizenship or residency does not affect the determination of where a transaction occurs. The court had also said in the Absolute Activist case that a transaction takes place where “irrevocable liability” attaches. The court said that the allegation that a shareholder placed a buy order in the United States that was then executed outside the U.S. does not “standing alone” establish that the shareholder “incurred irrevocable liability in the United States.”

 

Finally, the appellate court affirmed the district court’s dismissal of the plaintiff’s remaining claims, holding that UBS”s statements about its compliance on which the plaintiff sought to rely were mere puffery and therefore immaterial; and holding further that the statements about UBS’s positions in mortgage-related assets were properly dismissed for failure to adequately plead a material misrepresentation or scienter.

 

Discussion 

The “listing theory” on which the plaintiff sought to rely here has not fared well in the district courts. For example, in a September 14, 2010 ruling in the Alstom securities class action lawsuit (about which refer here), Southern District of New York Judge Victor Marrero described the theory as dependent on a “selective an overly-technical reading of Morrison that ignores the larger point of the decision.”

 

Similarly, as discussed here, in a January 11, 2011 ruling in the RBS credit crisis-related securities class action lawsuit, Judge Deborah Batts also rejected the “listing theory,” saying that it is “simply contrary to the spirit of Morrison,” noting that Supreme Court had made clear that the concern of the securities laws is on “the true territorial location where the purchase or sale was executed.”

 

The appellate did court that the language of Morrison’s first prong on which the plaintiff’ relied in support of the “listing theory” – when “taken in isolation” – “supports plaintiffs’ view.” Nevertheless the theory did not fare any better in the appellate court than it has fared in the district court. Like the distict court’s the appellate court that the “listing theory” is “irreconcilable with Morrison read as a whole.”

 

Similarly the district courts have held that the mere fact that the purchaser is a U.S. citizen or that that the purchase order was placed in the U.S. was not enough to bring a transaction on a foreign securities exchange within the requirements of Morrison’s second prong. (Refer here, for example, with respect to Judge Marrero’s July 27, 2010 dismissal of the Credit Suisse credit crisis securities lawsuit.)

 

While the Second Circuit’s holdings on these issues are consistent with the district courts’ holdings, the appellate courts rulings were, as the court itself noted,  each a “matter of first impression” –meaning of first impression for an appellate court. The Second Circuit’s rulings, while entirely consistent with rulings of the lower courts, are important because they are the first by an appellate court on these issues. The rulings make it clear that the plaintiffs will not be able to use these theories to try to circumvent Morrison in order to present the claims of shareholders who purchased their shares in the defendant company on a foreign exchange.

 

ochThere is no private right of action under the Foreign Corrupt Practices Act (FCPA), but as I have frequently noted in prior posts, news of an anti-bribery investigation frequently is followed by a shareholder lawsuit based on allegations relating to the investigation. The latest example of this type of follow-on civil action involves the investment management firm, Och-Ziff Capital Management Group, which, according to media accounts, is the target of alleged corruption investigations.

 

In February 2014, the company’s name was linked to ongoing investigations involving the Libyan government in the years leading up to the 2011 overthrow of the Qaddafi regime. According to a February 3, 2014 Wall Street Journal article (here), Och-Ziff was one of several financial companies under investigation by the DoJ and the SEC for allegedly improper payments to government officials affiliated with investment funds of the Libyan government, including the Libyan Investment Authority.

 

As discussed here, on March 18, 2014, the company itself disclosed that it was the subject of an ongoing civil and criminal investigation into whether the company violated the FCPA in its dealings with Libya. The company also disclosed that it began receiving subpoenas from the Securities and Exchange Commission and requests for information from the Justice Department in 2011.

 

Then in late April 2014, news stories involving the possibility of a separate set of circumstances involving the company started circulating. As discussed here, the news reports suggested that the government authorities were investigating loans totaling $234 million the company allegedly had made to companies associated with a wealthy Israeli, in connection with two projects in the Democratic Republic of Congo. The company’s share price declined nearly 10 percent on this news. (Interestingly, and perhaps significantly, the Wall Street Journal article that first reported this news last week is no longer available on line, nor is the collection of documents the Journal had posted relating to the allegations.)

 

According to plaintiffs’ lawyers’ press release (here), on May 5, 2014, shareholders initiated a securities class action lawsuit in the Southern District of New York against Och-Ziff and certain of its directors and officers relating to these investigations. According to the press release, the complaint alleges that

 

defendants made false and/or misleading statements and/or failed to disclose that: (i) the Company violated relevant anti-bribery laws by accepting an investment from the Libyan Investment Authority, a sovereign wealth fund; (ii) the Company loaned $234 million to help finance two ventures in the Democratic Republic of Congo in violation of the Foreign Corrupt Practices Act (“FCPA”); (iii) beginning in 2011, the Company received subpoenas from the Securities and Exchange Commission (“SEC”) and the United States Department of Justice (“DOJ”) in connection with the transactions mentioned above; and (iv) as a result of the above, the Company’s financial statements were materially false and misleading at all relevant times.

 

While a civil action following an FCPA investigation is nothing new, this case may be somewhat unusual in that the investigation related to the Libyan investigation has not yet even resulted in an enforcement action against the company and the information relating to the Congo projects has so far been the subject only of various media reports.

 

In any event, the new securities class action lawsuit involving Och-Ziff is the latest example of a phenomenon  on which I have commented frequently in recent months , which is the filing of a shareholder lawsuit in the wake of the announcement of the a regulatory or governmental investigation.

 

There have in fact been a number of securities class action lawsuits filed already this year after the announcement of an investigation of possible violations of anti-bribery laws. As I discussed in a recent post, here, in March 2014, shareholders of Hyperdynamics Corporation filed a securities class action lawsuit against the company and certain of its directors and officers in connection with an FCPA investigation in which the company has become involved. In addition, as discussed here, in January 2014, NuSkin was hit with securities suit as a follow-on to the company’s announcement of an anticorruption investigation in China.  In addition, as discussed in the same blog post about NuSkin, Archer Daniels Midland was hit in January 2014 with a shareholders’ derivative suit after the company announced that it had settled a pending FCPA investigation.

 

The phenomenon of the civil action following after the announcement of an anti-bribery investigation is already a significant factor in the filing of securities class action lawsuits so far this year.  

 

chinaFor a brief period in the 2010-2012 time frame, U.S. securities lawsuits filings against U.S.-listed Chinese companies surged as investors filed a wave of lawsuits against Chinese companies that obtained U.S.-listings by way of a merging with a publicly traded shell. The Chinese reverse merger lawsuit filing wave eventually subsided – yet filings against U.S.-listed Chinese companies have continued even if in somewhat diminished numbers. For the last four years, U.S. securities suit filings against Chinese companies have represented the predominant part of all securities lawsuit filings against non-U.S. companies.

 

The latest securities class action lawsuit against a U.S.-listed Chinese company was filed on May 2, 2012 against Lihua International, Inc. a vertically integrated Chinese copper products manufacturing company. As described in the plaintiffs’ law firms’ May 2, 2014 press releases (here and here), shareholders have filed actions in the Central District of California against the company and certain of its directors and officers seeking damages for alleged violations of the U.S. securities laws.

 

The lawsuits followed quickly after NASDAQ halted trading in the company’s shares on April 30, 2014 after the company’s share price had dropped more than 50 percent from $4.35 a share to $2.08 a share following media reports that the company’s warehouses had been seized by a local court and that the company’s Chairman and CEO had attempted to hide inventory from creditors and was being investigated by local police allegedly for larceny. The same day the company issued a press release stating that

 

The Board of Directors of Lihua International is aware of a decline in the Company’s stock price and published allegations that Mr. Zhu Jianhua, the Company’s CEO and Chairman of the Company’s Board, may have diverted or attempted to divert Company assets and as a result may have been the subject of an action by local law enforcement. Although they have not yet been able to verify this information, the Board’s Audit Committee is taking steps to determine the facts and will take appropriate action. If the allegations prove true, the Company’s financial statements may contain material misstatements.

 

The new securities lawsuits involving Lihua may involve some potentially sensational allegations but in at least one respect they are consistent with many U.S. securities lawsuit filings in recent years, in that they involve a non-U.S. company defendant – and in particular, they involve a U.S.-listed Chinese company. For the last several years, lawsuit filings against U.S.-listed Chinese companies have represented the largest number of all U.S. securities lawsuit filings against non-U.S. companies.

 

According to NERA Economic Consulting (refer here, page 9), lawsuits against U.S.-listed Chinese companies have represented the largest segment of all U.S. securities lawsuits against non-U.S. companies in each of the last four years:

  • ·         in 2010, securities suits against Chinese companies represented 46.8%% of all U.S. securities suit filed against non-U.S. companies (15 suits against Chinese companies out of 32 lawsuits filed against non-U.S. companies that year);

 

  • ·         in 2011, the peak year for lawsuit filings against Chinese reverse merger companies, securities suits against Chinese companies represented 59.6% of securities suits against non-U.S. companies (37 out of 62);

 

  • ·          in 2012, securities  suits against Chinese companies represented 47% of all securities suits against non-U.S. companies (16 out of 34);

 

  • ·         in 2013, the securities suits against Chinese companies represented 45.7% of all securities suits filed against non-U.S. companies (16 out of 35).

 

In each of these four years, the suits filed against Chinese companies represented a larger percentage of the total number of suits filed against non-U.S. companies than did the lawsuits filed against companies from any other country outside the U.S.

 

It is interesting to note, however, that while lawsuit filings against Chinese companies have surged in recent years, overall lawsuit filings against non-U.S. companies have remained roughly proportionate to the percentage of U.S listings that the non-U.S. companies represent. The one exception to this generalization was during 2011, the peak year for Chinese reverse merger lawsuit fillings, when suits against non-U.S. companies represented 27.7% of all U.S. securities lawsuit filings, while at the same time non-U.S. companies represented only about 16.4% of all U.S. listings.

 

Other than that one exceptional year however, the filings against non-U.S. companies have been roughly proportionate to the percentage of non-U.S companies among all U.S.-listed companies; that it, both the percentage of lawsuits against non-U.S companies and the percentage of non-U.S. companies among U.S-listed companies have been around 15-16%.

 

Some readers may be interested to know how the U.S. Supreme Court’s 2010 decision in Morrison v. National Bank of Australia figures into all of this. Readers will recall that in Morrison, the U.S. Supreme Court held that the U.S. securities laws apply only to transactions in company shares listed on U.S. securities exchanges and to domestic transactions in other securities. The presumption at the time was that Morrison would result in fewer U.S. securities lawsuit filings against non-U.S. companies. Morrison may well have had some impact on securities lawsuit filings against non-U.S. companies whose shares are not listed on U.S. exchanges. However, the discussion above is focused on non-U.S. companies whose securities are listed on U.S. exchanges; with respect to transactions of those companies’ securities on U.S. exchanges, Morrison has no impact. The U.S. exchange transactions in those non-U.S. companies’ securities remain subject to the U.S. securities laws even after Morrison.

 

It is interesting to note that so far this year, there have been relatively fewer U.S. securities class action lawsuit filings against non-U.S. companies, even counting the recent lawsuit against Lihua. By my count, only about 10.9% of the securities lawsuit filings in 2014 (6 out of 55) have involved non-U.S. companies. (I am including the recent High Frequency Trading securities lawsuit in this tally as many – but not all – of the defendants in the lawsuit are domiciled outside the U.S.).  Of course we are only a third of the way through the year so far. Much could change before year end.

 

A Note of Gratitude for an Unexpected Anniversary Present: Almost exactly eight years ago, I launched The D&O Diary with no real plan and with absolutely no notion that it would take on the life that it has.  The great thing is that even after thousands of blog posts, I am still having fun with the site. Though I continue to do this for fun, it is always nice to find out every now and then that someone is actually reading my blog. For that reason, I was quite surprised and delighted to read Law 360’s May 1, 2014 article entitled “5 Law Blogs to Add to Your Daily Routine” (here, subscription required) and to see that The D&O Diary was listed among the five law blogs that the article describes as “must-read legal blogs.” 

 

The article specifically said “Corporate lawyers who are unfamiliar with the D&O Diary should consider bookmarking this site, as it contains in-depth analysis about legal issues involving directors and officers’ liability.”

 

In all honesty, I am astonished to find my blog included on this short list, particularly given the august company in which my site has been included. The other four blogs listed are truly indispensable legal websites – the other four are: How Appealing (here); the SCOTUSblog (here); the Harvard Law School Forum on Corporate Governance and Financial Regulation (here); and Instapundit (here). I am not indulging in false humility when I say I truly to not feel worthy of my blog’s inclusion among these other four. But while I do not feel worthy of the honor, it is nonetheless a terrific anniversary present for my blog to be recognized this way.

 

There is one other reason that I am grateful, and that is that the extent of the support I get from my readers. I could never keep this site going if it were not for the many helpful suggestions, questions and comments I get from the site’s readers on a daily basis. As the Law 360 article itself notes, The D&O Diary “benefits from an active readership that often sends LaCroix tips on litigation, memos and releases.” To all of you who have helped me over the past eight years, thank you. I could never keep this thing going without your contributions and suggestions.

 

Long time readers know that I have been fortunate to have had the opportunity over the last few years to travel to some very interesting places. One of the great things I have discovered on my many travels is how many readers this site has in many far-flung places. It never ceases to amaze me that my site has attracted readers from Beijing to Barcelona and from Singapore to Stockholm. It is truly remarkable that I sit here at my desk in Beachwood, Ohio and hit “Publish” and out my messages go to the whole wide world.  And through the miracle of the Internet, people around the world actually see and read what I have written.

 

I never imagined any of this when I started out eight years ago. It has been great, though. To all of my readers near and far, Cheers, It has been a great eight years. I look forward to many more.

 

 

capitol4The Jumpstart our Business Startups (JOBS) Act is only just two years old but there are already apparently Congressional initiatives to revise one of the centerpieces of the legislation, the much-vaunted crowdfunding provisions that have not yet in fact even gone into effect. According to a May 1, 2014 Wall Street Journal article entitled “Frustration Rises Over Crowdfunding Rules” (here), “several House Republicans are now pushing forth ‘JOBS Act 2’ proposals, arguing that legislation Congress passed in 2012 is too restrictive for small firms.”

 

 

The JOBS Act’s crowdfunding provisions were intended to allow small businesses to raise capital by selling equity or debt securities to non-accredited investors via the Internet. The provisions were not self-implementing but rather required the SEC to issue implementing regulations. As discussed in detail here, the SEC issued proposed regulations for review and comment in October 2013. The final regulations have not been issued. The proposed rules, which run to some 585 pages, have been criticized for their intricacy and burdensomeness. 

 

As discussed in the Journal article, the JOBS Act’s crowdfunding provisions contain a number of restrictions that are reflected in the SEC’s proposed rules. Among other things, the provisions limit the amount issuers can raise in a year and specify a number of disclosures that the issuers must make. As the Journal article notes, many entrepreneurs “find some of the provisions too burdensome,” while others say that the changes for which House Republicans are now pushing “could weaken investor protections.”  There is, as the article notes, in both camps, a “sense of frustration with how the JOBS Act is playing out.”

 

Among the revisions that the change advocates propose are alterations that would increase the annual amount that a private company could raise through equity crowdfunding from $1 million to $5 million, and increase the amount the companies could raise without providing financial statements to $3 million from $500,000. Other revisions that are under discussion would ease the requirements on crowdfunding websites by allowing them to select which offerings to list without being liable for fraud by the listing companies.

 

The JOBS Act’s provisions allowing equity crowdfunding are not the only parts of the legislation under scrutiny. In addition, the provisions in Title II of the JOBS Act allowing general solicitation and advertising of private placement securities offerings to accredited investors has also raised concerns. The Journal article cites data from a market data firm stating that 2,384 private issuers are currently trying to use the new advertising provisions to raise money online, but just 394 of them have reported receiving investor commitments and only 64 have secured commitments totaling more than $500,000.

 

According to the article, in addition to proposals to revise the JOBS Act’s crowdfunding provisions, there are also proposals circulating that would ease the burdens on private companies that are conducting private placements to accredited investors, to allow them to take greater advantage of the general solicitation rules. Among other things, at least one House member is looking at ways to make it tougher for the SEC to cancel an offering in instances where the SEC believes the company didn’t take reasonable steps to verify that investors meet the qualification requirements to be considered an accredited investor.

 

While there is a widespread concern that many of the JOBS Act’s innovations are not living up to expectations, there is still at the same time a view that it is still far too early to start tinkering with the legislation’s provisions. As noted above, the crowdfunding provisions still have not yet even gone into effect. The article quotes Columbia Law School professor John Coffee as saying “We need to have some experience with [equity crowdfunding] before we take away the safety net. This is a new and dramatically different procedure with a high potential for fraud.”

 

Discussion

 

As noted here, almost from the very outset, the JOBS Act’s provisions have been criticized on the one hand for being too burdensome to prospective issuer companies, while on the other hand allowing too great of an opportunity for possible fraud.

 

The burdensomeness of the crowdfunding requirements in the JOBS Act itself, which is carried over into the SEC’s proposed rules, reflects a fundamental Congressional ambivalence in the Act’s provisions. On the one hand, the Act’s Congressional sponsors wanted to make it easier for small companies to raise capital. On the other hand they didn’t want to open things up for fraudsters or leave small investors vulnerable. The resulting compromise is unlikely to satisfy either set of concerns.

 

The JOBS Act itself is a sort of a mishmash of seemingly unrelated capital-raising novelties, collectively reflecting nothing so much the haste with which the legislative package was put together and enacted into law. For that reason, it is not really all that surprising that there is, as the Journal notes, a “sense of disappointment and frustration with how the JOBS Act is playing out.”

 

But despite the concerns and the sense of disappointment, it seems unlikely that the prospective revisions will get through the current Congress. As the Journal article notes, the proposals are “a long shot” as “there is little appetite to further roll back securities laws in the Democratic-controlled Senate.”

 

So while there may be a sense of frustration with how the JOBS Act’s initiatives are playing out, at this point, it seems probable that the legislation’s various initiatives will be implemented according to the statutory provisions original design. The crowdfunding provisions will likely go into effect in some form at some point this year.

 

The JOBS Act presents at least two challenges for those of us concerned with the liability exposures of directors and officers. The first is that the JOBS Act’s provisions create a number of potential liability exposures for companies seeking to take advantage of the JOBS Act’s capital raising provisions, as well as for their directors and officers. The second is that many of the Act’s provisions seem to blur the previously sharp distinction between companies that are publicly traded and private companies.

 

Both of these sets of concerns are explored in an interesting series of three blog posts written by my good friend Randy Hein of Chubb and published on the Risk Conversation blog. The first of the three posts, dated April 7, 2014, discusses Title II of the JOBS Act, which allows public advertising of private placement securities offerings directed at accredited investors. The second, dated April 22, 2014, and which can be found here, discusses Title III of the Act, which allows, subject to limitations, issuers to raise capital from non-accredited investors via the Internet. Finally, the third, dated April 23, 2014, and which can be found here, discussed Title IV of the Act, which allows companies to conduct  “mini-IPOs” of up to $50 million per year without having to register the securities with the SEC, subject to limits on individual investment and subject to period SEC reporting requirements.

 

Readers interesting in knowing more about “mini-IPOs” pursuant Regulation A+ offerings under Title IV of the JOBS Act may want to take a look at the January 15, 2014 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation about the SEC’s proposed rules for Reg. A+ offerings (here).

 

aabdBanking industry commentators have long contended that aggressive efforts by the FDIC and others to hold bank developers liable is having a chilling effect on the willingness of existing and potential directors to serve on bank boards. An April 2014 American Association of Bank Directors report of a recent survey of banks and savings institutions and entitled “Measuring Bank Director Fear of Personal Liability” (here) provides statistical support for this contention. The report shows that nearly a quarter of the survey respondents have had a director or potential director shun or shy away from board service based on personal liability concerns. 

 

The AABD survey report is based on eighty survey responses from banking and savings institutions. According to the report, 24.5% of the survey respondents reported that within the past give years, they either had at least one director resign from office out of fear of personal liability; had at least one person offered a position as a director refuse to serve out of fear of personal liability; or had a director  refuse to serve on the Board Loan Committee out of personal liability.  

 

Fear of personal liability was the first most common reason given for refusing in to accept board director positions. Of those who declined an offer to serve as a bank director, almost half (47.3%) gave personal liability concerns as a reason.  

 

The report suggests that the fear of personal liability is based on a number of factors, “largely driven by federal banking agency suits, enforcement actions, threat of enforcement actions in reports of examinations, and responsibilities placed on bank directors by laws, regulations, and guidance” that single out bank directors.  The report also notes that “the inability of a bank to obtain sufficient director and officer insurance may also be a factor that exacerbates the fear.”  

 

The report goes on to identify thirteen separate factors that the AABD believes “contribute to the fear of personal liability that motivates bank directors resignations and others to reject offers to serve as bank directors.”  Among these thirteen factors are such considerations as the “numerous suits filed by the FDIC against directors of failed banks.” The report notes that many of these suits are grounded in simple, not gross negligence. The report objects that “the FDIC is treating directors as if they are experienced loan or credit officers and not unprofessional outside bank directors,” and argues that “Directors who acted in good faith should not be sued.” 

 

The report also notes that the directors are “always being blamed for banks failures” while at the same time the FDIC’s assessment of board fulfillment of their responsibilities is “based an old and outdated policy statement that ignores the right of bank directors to rely reasonably on the work and opinions of bank management and advisors.”  The report also objects that recent legislative and regulatory changes have overburdened banks and bank directors with regulatory excesses within an enforcement environment that increasingly seeks to impose liability without culpability.  

 

The report also notes a number of concerns related to D&O insurance. These include the FDIC’s prohibition of insurance for civil money penalties and the FDIC’s efforts to bar insurance that would cover the costs of defending directors against agency administrative actions if the director ultimately loses the case or if the case is settled. The report also notes that the FDIC aggressive pursuit against the former directors and officers of failed banks has led to difficulty obtaining D&O insurance to cover regulatory risks.  

 

From my perspective, it is a serious concern if qualified persons are unwilling to serve on bank boards for fear of personal liability. Everyone has an interest in banks being able to attract the most qualified individual to serve on the boards. If qualified existing and potential board member are deterred from board service, the oversight expected of bank boards may suffer. The report’s comments about the impact D&O insurance concerns on bank boards is also significant and underscores how important it is for bank boards to obtain and to be able to obtain D&O insurance that provides appropriate levels of director protection.

 

cornerThough the number of securities class action lawsuit containing accounting allegations remained essentially the same in 2013 compared to 2012, the market capitalization losses associated with the 2013 suits were more than double the losses associated with the 2012 suits, according to a new report from Cornerstone Research. The report contains a brief analysis of the ways SEC enforcement practices and priorities could lead to an increase in the number of accounting cases in the future  The report, entitled “Accounting Class Action Filings and Settlements: 2013 Review and Analysis,” can be found here. Cornerstone Research’s April 29, 2014 press release about the report can be found here.  

 

The report examines filing and settlements during 2013 in securities class action lawsuits containing accounting allegations. Securities suits are considered “accounting cases” if they include allegations related to Generally Accepted Accounting Principles (GAAP), auditing violations or internal control weaknesses.

 

According to the report,  47 of the 166 securities class action lawsuits filed in 2013 contained accounting allegations, compared to 46 (out of 152) filed in 2012. The 28 percent of all securities class action lawsuits filed in 2013 that involved accounting allegations represents a ten year low. By way of comparison, in 2011 43% of all class securities lawsuit filings contained accounting allegations, and in 2012, 30% of all filings had accounting allegations. No single industry sector accounted for a significant proportion of 2013 accounting cases; rather, the filings were evenly distributed across the seven industry sectors the report tracked.

 

At 40 percent of all accounting cases, the proportion of filings in 2012 involving restatements is higher proportion than any of the prior five years. However, in absolute numbers there were more restatement cases filed in 2011, when there 27 restatement cases representing 34% of all accounting cases, compared to the 19 restatement cases filed in 2013.  

 

In addition, the proportion of accounting cases involving allegations of internal control weaknesses was also higher in 2013 than in any of the prior five years. There were allegations of internal control weaknesses in 28 percent of all accounting cases in 2013, compared with only 6 to 8 percent between 2008-2010.

 

The market capitalization losses associated with the 2013 accounting cases increased significantly compared to the accounting cases filed in 2012. In reaching this conclusion, the report examines what it calls the “disclosure dollar losses’’, or DDL, which the report describes at the dollar value change in the defendant company’s market capitalization between the trading day immediately proceeding the end of the class period and the trading day immediately following the end of the class period. Based on this analysis, the market capitalization losses associated with the 2013 cases are $44.8 billion, compared to only $17.6 billion in 2013, representing a 155 percent in market capitalization losses.

 

Even though the number of accounting case filings in 2013 was essentially the same as in 2012, the number of accounting case settlements increased in 2013 compared to 2012. In 2013, there were 44 settlements in securities class action lawsuits involving accounting allegations, representing about 66% of all securities suit settlements during the year, compared to 38 representing about 67% of all securities lawsuit settlements. 14 of the 2013 settlements of accounting cases involved Chinese companies that had obtained their U.S. listing through a reverse merger with a publicly traded shell.

 

Historically, accounting cases have represented the vast majority of the annual aggregate dollar value of securities class action lawsuit settlements. However, in 2013, in contrast to prior years, accounting cases represented only 25 percent of the total value of cases settled. However, this unusual result is largely due to the presence of one very larger non-accounting case settlement in 2013 that by itself represented fifty percent of the total value of all securities lawsuit settlements. Excluding this one enormous settlement, accounting cases represented just over 50 percent of the value of all securities lawsuit settlement during the year.

 

Another reason that accounting settlements were lower than for non-accounting cases in 2013 was the large number of Chinese reverse merger lawsuit settlements, which tend to be smaller in size.

 

In part due to the presence of the Chinese reverse merger lawsuit settlements, the median and average accounting case settlements were lower than for non-accounting case settlements in 2013. During, 2013, the median accounting case settlement was $4.2 million and the average was $26.6 million, compared to a median of $15.3 million and an average of $156.7 million for non-accounting cases. However the majority of the total value of non-accounting cases during 2013 was attributable to that one large settlement. Without that case, the median and average of non-accounting case settlements in 2013 were $14.4 million and $53.6 million, respectively.

 

The report notes that overall accounting cases tend to involve substantially higher median “estimated damages” than cases without accounting-related allegations, a factor that is generally associated with higher settlement amounts.  In addition, cases involving accounting issues tend to be associated with accompanying SEC actions and accompanying derivative actions, both of which are also associated with higher median settlement values.

 

The proportion of cases involving auditor defendants has recently been lower than in the immediately after the PSLRA was passed, largely due to the changes in the case law making it more difficult to pursue securities claims against a company’s outside auditor. In 2013, 12 (or 27%) of the accounting case settlements involved auditor defendants, compared to only 8 (representing 21% of all accounting settlements) in 2012. The increase in the number of settlements involving auditor defendants in 2013 is largely a reflection of the number of settlements in Chinese reverse merger cases, which have tended to have auditors named as defendants more frequently than in other accounting cases. Cases involving auditors as named defendants tend to settle for higher amounts.

 

Though the report notes that the annual number of securities class action lawsuit filings containing accounting allegations was basically level between 2012 and 2013, the report notes a number of factors involving SEC enforcement practices and priorities that could lead to an increase in the number of accounting case filings in the future. The report notes that the SEC’s July 2013 formation of the Financial Reporting and Audit Task Force and the agency’s use of analytic tools such as the Accounting Quality Model, together with the agency’s efforts to facilitate whistleblower tips are “generally expected to increase SEC enforcement actions.”

 

These efforts could also “have significant potential consequences for private securities litigation involving accounting issues.” The report states that “it is conceivable that the SEC”s current focus could provide an opportunity for plaintiff counsel to make accounting-related cases a future wave in securities class action litigation.”

barclaysWhile claimants continue to fie private civil actions seeking to recover  damages they claim to have sustained as a result of the Libor manipulation scandal, the fact is that at least up to this point, the plaintiffs have not fared particularly well in the Libor-related civil litigation.

 

As noted here, on March 29, 2013, Southern District of New York Judge Naomi Reice Buchwald substantially granted the motion to dismiss in the consolidated Libor-scandal antitrust litigation, and as discussed here, on May 13, 2013, Southern District of New York Judge Shira Scheindlin granted the motion to dismiss in the Libor-related securities class action lawsuit filed against Barclays. And as reported here, on March 27, 2014, New York Supreme Court Judge Shirley Werner Kornreich dismissed the shareholder derivative suit filed against JP Morgan’s board in connection with the Libor scandal.

 

However, as a result of an April 25, 2014 decision of the Second Circuit in the Barclays Libor scandal securities class action litigation, at least part of the dismissed claims of at least one of these sets of claimants has been revived. While affirming the dismissal of the plaintiffs’ allegations based on statements concerning the bank’s internal controls, 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.”

 

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 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. The price of the company’s ADRs fell approximately 12 percent on the news of the settlements.

 

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. 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 and several of its officers 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 presented a misleading picture of the bank’s financial condition and artificially inflated the bank’s share price. The plaintiffs also allege that the defendants misleadingly stated that the company had established “minimum control requirements for all key areas of identified risks.” (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 shareholders’ complaint.

 

 

In a May 13, 2013 opinion (discussed here), Judge Shira Scheindlin granted the defendants’ motion to dismiss. With respect to the plaintiffs’ allegations that the bank had underreported its interest rates, Judge Scheindlin concluded that the plaintiffs had failed to present a plausible theory of loss causation. She reasoned that even if the defendants had misrepresented the bank’s interest rates between 2007 and 2009 and therefore inflated the bank’s share price, any share inflation would have been rectified prior to the June 27, 2012 announcement in which the company admitted it had underreported its interest rates. She also dismissed the plaintiffs’ claims based on the alleged internal control misrepresentations, on the grounds that the statements were mere “puffery” and were not materially false or misleading. The plaintiffs’ appealed the dismissal.

 

The April 25, 2014 Opinion         

In an April 25, 2014 opinion written by Southern District of New York Judge Richard Berman (sitting by designation) for a three-judge panel, the Second Circuit affirmed Judge Scheindlin’s dismissal of plaintiffs’ allegations based on the statements about the bank’s internal controls, but vacated Judge Scheindlin’s decision with respect to the alleged underreporting of the bank’s borrowing costs, holding that the plaintiffs had sufficiently pled loss causation.

 

With respect to the loss causation issue, appellate court said that “While expressing no view on the ultimate merits of plaintiffs’ theory of loss causation, we hold that the court below reached these conclusions prematurely.” Basically the Court could not agree with Judge Scheindlin’s assumption that Barclay’s false 2007-2009 submission rates were somehow corrected after January 2009 (but before June 27, 2012). The Court said that “while Barclay’s 2009-2012 submission rates may have provided accurate information about the company’s borrowing costs and financial condition for the period 2009-2012, that did not correct the prior years’ misstatements.”

 

The Court added “We cannot conclude, as a matter of law and without discovery, that any artificial inflation of Barclay’s stock price after January 2009 was resolved by an efficient market prior to June 27, 2012.” Whether the effects of Barclay’s ‘willfully false LIBOR representations dissipated before June 2012 is a question of fact that can be answered only upon a more developed record.”

 

With respect to the alleged misrepresentations concerning the company’s internal controls, the appellate court agreed with the district court that the alleged statements were not materially false because they were not specifically tied to Barclay’s LIBOR practices.

 

Discussion

 

The case will now go back to the district court for further proceedings, and presumably for discovery. The appellate court’s reinstatement of the plaintiffs’ claims is a reminder that a trial court’s action is granting a dismissal is only one procedural stages, and that there is always the possibility for further developments in subsequent proceedings.

 

Though the appellate court’s reinstatement of a portion of these plaintiffs’ securities claims is a significant development in this case, it may have relatively little significance for most of the other financial institutions caught up in the Libor scandal. Most of the Libor benchmark rate-setting banks d not have securities that trade on the U.S. securities exchanges, and so the U.S. securities laws do not apply to trading in those banks’ securities. Indeed, even among the Libor rate-setting banks that do have securities trading on the U.S. securities exchanges, Barclays is the only one to have been hit with a federal court securities class action. (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.)

 

But while the significance of the appellate court developments in the Barclays Libor-related securities suit mostly is limited to the immediate parties to the case, the Second Circuit’s actions are a reminder that we may still have a long way to go in the Libor-scandal related litigation and it may be some time yet before a comprehensive assessment of how the plaintiffs have fared in the cases is possible.

 

It is worth noting that earlier this month Barclays settled two separate U.K. court proceedings in which claimants alleged that Barclays had missold financial products that were linked to the Libor benchmark interest rates.

 

The Second Circuit’s action setting aside the district court’s dismissal of the Libor-scandal securities suit is not the only unwelcome litigation development for Barclays in recent days. As noted here, Barclays was among the many banks named as a defendant in the recently filed high frequency trading securities class action lawsuit. Barclays’ legal woes continue.

 

Special thanks to a loyal reader for alerting me to the Second Circuit’s decision.

 

 

virginiaIn a detailed April 23, 2014 opinion (here), Eastern District of Virginia Judge Liam O’Grady, applying Virginia law, held that the guilty pleas of executives of Protection Strategies, Inc. triggered four separate exclusions in the D&O coverage section of PSI’s management liability policy and that the management liability insurer was entitled to recoup the defense fees that it had advanced.

 

 

Background

PSI is a global security management and consulting company. On January 30 and 31, 2012, PSI received a subpoena from the NASA Office of Inspector General and a search and seizure warrant issued by the United States District Court for the District of Virginia. The warrant stated that the government was seeking evidence of violation of violations of various false statement and fraud provisions in the U.S. Criminal Code. On February 1, 2012, the NASA OIG executed a search of PSI’s headquarters. In June 2012, PSI received a letter from the U.S. Attorney for the Eastern District of Virginia stating that the U.S. Attorney and the DoJ were investigating PSI’s participation in a Small Business Administration program.

 

In March 2013, four PSI executives entered into plea agreements in the Eastern District of Virginia. PSI’s former CEO Keith Hedman pleaded guilty to a criminal information charging him with major fraud against the United States and conspiracy to commit bribery. Three additional PSI officials pled guilty to conspiracy to commit fraud and major fraud against the United States. Criminal judgments were subsequently entered against each of the four individuals and the four were sentenced to terms of incarceration.

 

In his plea agreement, Hedman stipulated that he and others had engaged in a scheme between approximately 2003 through February 2012 to defraud the Small Business Administration and several other U.S. government agencies by creating a sham company under the control of Hedman and PSI and by falsely representing that the sham company was eligible for SBA contracting preferences. Hedman admitted that the sham company received over $31 million in U.S. government contracts as a result of the scheme, with over $5 million of those funds flowing to PSI. Hedman agreed that he was aware of the illegal activities, including the activities of the three others. He also stipulated that his actions were done “willfully, knowingly and not because of accident, mistake or innocent reasons.”

 

The D&O coverage section of PSI’s private company  management liability insurance policy contained several exclusions, including the following, referred to in the opinion, respectively, as the personal profit, fraud and prior knowledge exclusions:

 

This policy shall not cover any Loss in connection with any Claim …

(a) arising out of, based upon, or attributable to the gaining of any profit or advantage or improper or illegal remuneration if a final judgment or adjudication establishes that such Insured was not legally entitled to such profit or advantage or that such remuneration was improper or illegal;

(b) arising out of, based upon or attributable to any deliberate fraudulent act or any willful violation f law by an Insured if a final judgment or adjudication establishes that such act or violation occurred;

….

(d) alleging, arising out of, based on or attributable to any facts or circumstances of which an Insured Person had actual knowledge or information of, as of the Pending or Prior Date set forth in Item 6 of the Declarations as respects this coverage section, and that he or she reasonably believed may give rise to a Claim under this policy.

 

The policy also states that in determination the applicability of Exclusions (a) and (b), “the knowledge possessed by, or any Wrongful Act committee by, an Insured Person who is a past or current [chief executive officer] …shall be imputed to the Company.

 

In connection with its purchase of the management liability insurance policy, PSI had provided the carrier with a February 15, 2011 Warranty Letter signed by Hedman which represented that “no person or entity proposed for insurance under the policy referenced above has knowledge of information of any act …which might give rise to a claim(s), suit(s), action(s) under such proposed policy.” The warranty letter further stated that if any such “knowledge or information exists, then … any claim(s), suit(s) or action(s) arising from or related to such knowledge or information is excluded from coverage.”

 

Section 6 of the Management Liability Insurance Policy’s general terms and conditions states that the Insurer “shall pay defense costs prior to the final disposition of any claim,” but that “in the event and to the extent that the Insureds shall not be entitled to payment of such Loss under the terms and conditions of this policy, such payments by the Insurer shall be repaid to the Insurer by the Insureds.”

 

In a separate coverage lawsuit, PSI and the insurer cross-moved for summary judgment. The insurer contended that the guilty pleas triggered each of the three exclusions quoted above as well as the exclusion in the warranty letter. The insurer also argued that it was entitled to recoup the amounts that it had advanced for the company’s and the individual defendants’ attorneys’ fees.

 

The April 23 Opinion

In his April 23, 2014 opinion, Judge O’Grady granted the insurer’s summary judgment motion and denied that of PSI, stating that “the Court finds that the policy’s exclusions apply and are a complete bar to coverage for the investigation of PSI and its Officers. Because the entirety of the defense costs advanced … fall under the exclusions in the policy,” the insurer “is entitled to recoupment.”

 

First, Judge O’Grady found that both the personal profit and fraud exclusions “unambiguously apply to the Claims in this case.” He went on to say that

 

Mr. Hedman’s plea agreement clearly establishes that PSI and its executives knowingly, intentionally and improperly gained an advantage and an illegal remuneration of at least $31 million by fraudulently creating Company B and representing that it was eligible for the SBA Section 8(a) program. It also establishes that PSI’s officers …willfully violated the law by committing fraud against the U.S. government. Neither party contests that each plea agreement is a “final judgment or adjudication,” nor is it disputed that under the terms of the policy, Mr. Hedman’s knowledge and wrongful acts are imputed to PSI itself. Because the Claims against PSI and its executives involve precisely the type of loss contemplated by the Profit and Fraud Exclusions, the Court finds that the Claims are not covered by the 2011 Policy.

 

PSI had tried to argue that the exclusions, even if triggered, only applied to the losses going forward – that is, that the insurer could not recoup any of the amounts it had advanced. However, Judge Grady found that the policy specifically excluded ‘any Loss” in connection with an excluded claim, adding that “while the policy language requires a final judgment or adjudication to trigger the Profit or Fraud exclusions, it nowhere suggests that the timing of the final adjudication affects the insurer’s obligation to pay.”

 

Judge O’Grady also concluded that the guilty pleas triggered the prior knowledge exclusion, as the pleas showed that each of the four officers had knowledge in February 2011 when the policy incepted of an ongoing scheme to defraud the government. He concluded that the preclusive effect of this exclusion applied even to PSI’s own defense expenses because they were “based upon or attributable to” facts of which an Insured Person had knowledge at the inception of the policy. He emphasized that the exclusion provides that “any Claim” is excluded when it arises from facts of which an Insured Person was aware; the exclusion is not limited to the specific Claim made against that particular Insured Person.

 

Judge O’Grady also concluded that the exclusion in the warranty letter had been triggered based on Mr. Hedman’s “material misrepresentation” that no person had knowledge of facts that might give rise to a claim.

 

Finally, Judge O’Grady concluded that “under the clear terms of the insurance policy and under recent Fourth Circuit precedent,” the insurer is entitled to recoupment of al defense costs it advanced to PIS related to this investigation,” adding that “because PSI was not entitled to coverage for any losses arising out of these Claims for the reasons described above, the recoupment provision applies.” (The Fourth Circuit precedent to which Judge O’Grady was referring is the appellate court’s 2013 opinion in the Farkas case, discussed here.)

 

Discussion

This case presents the rare instance where a D&O policy’s “after adjudication” provisions appear to have been unambiguously triggered. (Indeed, as Judge O’Grady’s opinion noted, PSI itself did not even attempt to argue that the plea agreements had not triggered the conduct exclusions.) Similarly, because of the express recoupment language in the policy, it was going to be very difficult for PSI to persuade the court that, once the exclusions were triggered, the insurer was not entitled to recoupment.

 

As I have noted before (here), it is relatively rare for D&O insurers to seek recoupment, primarily because it is relatively rare that there are case determinations that unambiguously establish that the conduct exclusions have been triggered. Another reason it is relatively rare for D&O insurers to seek recoupment is that usually by the time that things have progressed to the point that the insurer can seek recoupment, there often are no longer any assets from which a recoupment might be obtained. Yet another reason why D&O insurers often hesitate to seek recoupment is that it can be a poor public relations move to seek to reclaim amounts that have been paid – however, it could be argued that these constraints may be less compelling where as here the insureds’ senior executives have pled guilty to a massive multiyear effort to defraud the government.

 

The courts are relatively uniform in affirming the insurer’s right to seek recoupment where express policy language specifies the insurer’s recoupment right. The courts are more divided on the carrier’s right to recoupment where the sole basis on which the carrier asserts its right to do so is its own reservation of the right at the outset of the claim. Some courts have even taken the position that recoupment or reimbursement is prohibited in the absence of an express policy provision in the insurance contract preserving those rights.

 

baconYesterday on her Facebook page, my younger sister posted an item suggesting that her friends should post the name of a movie but substitute the word “Bacon” for one of the words in the movie’s name. I don’t know what got into me, but once I got started, I couldn’t stop. Here’s a very small sample:  

 

 

A Connecticut Yankee in King Arthur’s Bacon

Crouching Tiger, Hidden Bacon

Arsenic and Old Bacon

An Inconvenient Bacon

Gone with the Bacon

The Day the Bacon Stood Still

Desperately Seeking Bacon

Frost/Bacon

Zero Dark Bacon

Bacon of Frankenstein

The Invasion of the Bacon Snatchers

The Empire Strikes Bacon (see also: Indiana Jones and the Temple of Bacon)

Four Weddings and a Bacon

How Green Was My Bacon

All the President’s Bacon (see also: The King’s Bacon)

The Bacon of Sierra Madre (see also: The Bacon of Navarone)

The Bacon of the Condor (see also: The Bacon of the Jedi; The Bacon of the Yankees)

A Long Day’s Journey into Bacon

Brokeback Bacon

Legally Bacon

A Funny Thing Happened on the Way to the Bacon

La Cage aux Bacon (see also: Hiroshima mon Bacon; La Dolce Bacon)

The Good, the Bad and the Bacon (see also: A Fistful of Bacon; The Magnificent Bacon; How the Bacon was Won; The Man Who Shot Liberty Bacon; High Bacon)

From Bacon to Eternity

Bacon of Arabia

Night of the Living Bacon

The Agony and the Bacon

I Am Curious (Bacon)

Who’s Afraid of Virginia Bacon?

To Have and to Have Bacon

Chariots of Bacon

Saving Private Bacon

Four Weddings and a Bacon

Dead Bacon Society

You’ve Got Bacon!

Dances with Bacon

No Country for Old Bacon

On a Clear Day,You Can See Bacon

Hamlet

idahoAs those involved in D&O Insurance claims well know, a recurring D&O insurance problem is the question of whether or not the D&O insurer for a bankrupt company can pay the costs of the bankrupt company’s former directors and officers incurred in defending claims against them. Disputes arise when the individuals seek to have the stay in bankruptcy lifted to allow the insurer to pay their defense expenses. Oftentimes creditors or the bankruptcy trustee will oppose lifting the stay, arguing that the D&O policy proceeds are assets of the bankrupt estate and should be preserved for the benefit of the estate or the creditors rather than expended paying the individuals’ defense costs.

 

These issues were discussed in a recent case in the Bankruptcy Court for the District of Idaho. In a succinct March 25, 2014 opinion (here), Bankruptcy Court Judge Jim D. Pappas rejected the arguments of the bankruptcy trustee and ruled that the stay should be lifted to allow the D&O insurer to pay the fees that certain former officers of Hoku Corporation incurred in defending claims against them. Hat tip to the Jones, Lemon & Graham’s D&O Digest Blog (here) for the link to the opinion. The D&O Digest’s April 21, 2014 blog post about the opinion can be found here.

 

Background 

Hoku Corporation was a subsidiary of Tianwei New Energy Corporation. On July 2, 2013, Hoku filed a Chapter 7 bankruptcy petition. On August 20, 2013, JH Kelly LLC, the prime contractor for Hoku in the construction of a polysilicon plant in Pocatello Idaho, sued Tianwei and several former directors and officers of Hoku, alleging fraud, racketeering and other misconduct while JH Kelly was constructing the plant.

 

The individual directors and officers filed a motion in the bankruptcy proceeding requesting the bankruptcy court to determine that the proceeds of Hoky’s D&O insurance policy were not property of Hoku’s bankrupt estate, or in the alternative, granting relief from the automatic stay in bankruptcy to allow the D&O insurer to pay the individuals’ costs of defending themselves in the JH Kelly lawsuit. The bankruptcy trustee filed an objection to the motion, arguing that the proceeds of the policy are assets of Hoku’s bankruptcy estate, and arguing further that payment of the individual’s defense fees would diminish the bankruptcy estate’s potential recovery of its own claims under the Policy.

 

Hoku’s D&O insurance policy, which had limits of liability of $10 million, included a so-called order of payments provision, specifying that

 

In the event of Loss arising from a covered Claim for which payment is due under the provisions of this policy, then the Insurer shall in all events:

(a) first, pay Loss for which coverage is provided under Coverage A and Coverage C of this policy; then

(b) only after payment of Loss has been made pursuant to Clause 22(a) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverage B(ii) of this policy; and then

(c) only after payment of Loss has been made pursuant to Clause 22(a) and Clause 22(b) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverages B(i) and D of this policy.

The bankruptcy or insolvency of any Organization or Insured Person shall not relieve the Insurer of any of its obligations to prioritize payment of covered Loss under this policy pursuant to this Clause 22. 

 

 The March 25 Ruling 

In his March 25, 2014 order, the Bankruptcy Judge granted the directors’ and officers’ motion based on his determination that the individuals had shown cause for relief from the automatic stay under Section 362(d)(1) of the Bankruptcy Code.

 

After first noting that the question of whether or not the proceeds of a D&O Insurance policy are assets of a bankrupt insured company’s bankruptcy estate is “an unsettled question,” the Bankruptcy Judge turned to the question of whether or not the stay should be lifted, saying that “assuming without deciding, the proceeds of the Policy are property of the bankruptcy estate, the Court concludes that good cause has been shown by the Movants under Section 362(d) for relief [from] the automatic stay.”

 

The Bankruptcy Judge determined that in considering whether or not the individuals had shown cause for lifting the stay that the Court should “balance the harm to the debtor if the stay is modified with the harm to the directors and officers if they are preventing for executing their rights to the defense costs.” The Bankruptcy Judge noted further that “clear, immediate and ongoing losses to the directors and officers in incurring defense costs trumps only ‘hypothetical or speculative’ claims by the trustee.”

 

The Bankruptcy Judge found that the individuals “are experiencing clear immediate and ongoing defense costs expenses,” adding that under the priority of payments provision in the policy, payments under other coverage provisions of the policy were “subordinate” to payment under the Side A coverage provision under which the individuals sought to have their defense fees paid.

 

By contrast, the Bankruptcy Judge found that the “potential harm to the estate suggested by the Trustee consist of hypothetical, indeed perhaps speculative claims he might pursue against the Movants.” The Bankruptcy Judge noted that other courts had criticized other bankruptcy trustees for seeking to prevent the payment of individual directors and officers defense fees under Side A.

 

“All things considered,” the Bankruptcy Court said, “the potential harm to the bankruptcy estate inherent in granting the Movants relief is negligible.” After noting that the policy’s $10 million limit of liability provided “ample coverage,” he concluded that the fees the individuals were incurring in defending the JH Kelly matter represented “a clear, immediate and actual harm that greatly outweighs any speculative and hypothetical harm to the bankruptcy estate.”

 

Discussion 

The kinds of issues discussed here have been a feature of the D&O insurance claims environment for many years, since coverage for the corporate entity became a regular part of the typical D&O policy. When the corporate entity files for bankruptcy, the question that arises is whether as a result of the D&O policy’s entity coverage the policy and its proceeds are assets of the estate. The practical solution that has evolved is that now when individuals want to have their defense fees paid, they will approach the bankruptcy court to obtain what has become known as a “comfort order” to allow the D&O insurer to pay the individuals’ defense fees (as discussed in greater detail here).

 

As I noted in a prior post (here), the granting of these types of comfort orders is now something of a “standard” procedure. However, even though these practices are now well established, and have been employed in such high profile proceedings as the Lehman Brothers bankruptcy (refer here) and the MF Global bankruptcy (refer here), trustees like the one here will continue to agitate on these issues.  (Admittedly, other problems arose in those high profile cases but not with respect to the question of whether or not a comfort order was appropriate.)

 

Nevertheless we still have situations like this one where Trustees try to throw up roadblocks to the payment of individuals’ defense fees based on the speculative notion that the policy proceeds need to be preserved for rights of recovery the Trustee not only has not established yet but even has not yet asserted. In that respect, I think there is something to the suggestion of the Bankruptcy Court here that bankruptcy trustees may warrant criticism for putting up these kinds of obstructions to the enforcement of contractual rights based on such speculative grounds.

 

I have always thought that these recurring problems are the result of a fundamental misconception of the D&O insurance policy. For obvious reasons, claimants and creditors want to establish that the D&O insurance policy exists for their protection and benefit. For less obvious reasons, some courts fall for this, which I have always found frustrating.

 

The fact is that insurance buyers purchase D&O insurance to protect the insured persons from liability. No one pays insurance premium as a charitable act for the benefit of prospective third party claimants. Liability insurance exists to protect insured persons from liability, not to create a pool of money to compensate would-be claimants. The very idea that claimants who have not even established their right of recovery from the insureds should be able to deprive the insureds of their right to use their insurance to protect themselves stands the entire insurance proposition on its head.

 

All of that said, there are recurring issues involved with the administration of these kinds of comfort orders, particularly, as discussed here, when court insist on asserting so-called “soft caps” on the amount of defense fees that can be paid or otherwise requiring ongoing Court supervision.