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. 

 

PrintOverall Filings of corporate and securities lawsuits during the first quarter of 2014 were at their lowest levels since before the financial crisis, according to the latest report from Advisen, the insurance information firm. The April 2014 report, which is entitled “D&O Claims Trends: 2014,” can be found here. As discussed below, the report will also be the subject of an Advisen webinar at 11:00 am EDT on Thursday, April 24, 2014.

 

It is important to note that unlike other regularly published reports in this area, the Advisen report analyses filings patterns for more than just securities class action lawsuits. The information in the report encompasses a broad range of corporate and securities lawsuits, including securities class action lawsuits but also including other types of lawsuits as well, including regulatory and enforcement actions; breach of fiduciary duty lawsuits; and securities lawsuits not filed as class actions. In addition, the Advisen reports includes litigation activity both inside the outside the United States. The Advisen report also uses its own “counting” protocols. These important characteristics of the Advisen report account for the signficiant differences between the statistics and information discussed in the Adivsen report and the information found in other published reports.

 

The first quarter traditionally is a busier period during the calendar year for the filing of corporate and securities lawsuits. However, according to the report, there was a 35 percent decline in the number of new corporate and securities lawsuits filed during the first quarter of 2014 compared to the same quarter a year ago and a 17 percent decline from the final quarter of 2013. The 238 first quarter filing “events” noted in the Adivsen report “represent the lowest quarterly total since prior to the financial crisis.”

 

Lawsuit filings were generally down across all categories of cases that Advisen follows during the first quarter. However, securities class action lawsuit filings were basically flat on a year-over-year quarterly basis, as there were 39 securities lawsuit filings in the first quarter of 2014, compared to 38 in the first quarter of 2013.  

 

With the decline of other types of suits and with securities class action lawsuit filings remaining flat, the proportion that securities class action lawsuit filings represent of all corporate and securities filings increased in the first quarter. During the first quarter of 2014, securities class action lawsuits represented 17 of all corporate and securities lawsuit filings, which is the highest quarterly percentage since the third quarter of 2009.  The report notes with respect to this percentage that “coming on the heels of two consecutive years of growth as a percentage of total events, this is a trend that is certainly worth following.”

 

Consistent with the overall downward trend, the report notes that M&A litigation, which had surged in recent years, was down in the first quarter of 2014 at least on an absolute basis. Indeed, the total number of M&A lawsuits peaked in 2011 and have decreased materially over the two years following. The report does not consider whether or not the decline in the absolute numbers of M&A lawsuits is due to a decline in overall M&A activity or how the numbers of M&A lawsuits filed compared to the varying levels of M&A activity over the time period under consideration.

 

The financial services sector “continues to be a lightening rod for D&O related litigation.” As has been the case in recent quarter, the financial services sector is the “leading target of new filings.” Companies in the financial services sector were the target of new filings in 29 percent of the total. Other active sectors included consumer discretionary at 17 percent and health care at 13 percent.

 

Discussion

 

Long time observers of corporate and securities claims activity know that lawsuit filings in this arena ebb and flow over time, and that the filings trends play out across multiyear periods, not on a quarterly basis. The fact that filings in any given quarterly period are “up” or “down” compared to a prior quarter or a year prior quarter may or may not tell you what you need to know to identify filing trends.

 

There are obviously a number of factors involved here. We are still coming out of the very active litigation period following the credit crisis, and while there may be many fewer credit crisis related lawsuit filings, many of the credit crisis cases are still playing out. If you talk to plaintiffs lawyers, they will tell you they are as busy as they have ever been. The relative number of quarterly filings may not mean the plaintiffs are inactive, it may only mean they are busy with other things.

 

One thing to keep in mind about apparently lower filing levels is that there have been short periods of apparently decreased filing activity in the past. For example, during the period from mid-2005 to mid-2007, there was a so-called “lull” in new securities lawsuit filings. However, the lull ended abruptly when the early fallout from the credit crisis started to hit, and we then moved into a period of very active litigation activity that lasted for several years. The point is that during the first quarter 2014, there were no events driving litigation activity, but if an event were to occure, there would likely soon be a swift upswing in new filings activity. In other words, it would be dangerous for anyone to presume that the apparently quiet first quarter of 2014 represents some kind of permanent downshift in the corporate and securities litigation arena. You can be sure that as soon as the next bandwagon appears, the plaintiffs’ lawyers will be among the first to jump on.

 

The report itself supplies a number of possible explanations for the quarterly downturn, some of which that are consistent with my remarks here. For example, the report speculates that the quarterly decline is “likely due to a combination of factors” including the “continued wind down of credit crisis litigation, fewer U.S. public company targets, and a limited number ability to settle due to fewer mediators.” For sure, the wind down of the credit crisis litigation is a factor as is the historical decline in the number of publicly traded companies (there are 40 percent fewer public companies than in 1997).

 

There are a number of current factors that could point to an upswing in the future or that at least seem likely to drive future litigation activity. The first is the new Financial Fraud Task force that the new SEC commissioner has formed. The activities of this task force seem likely to drive not only increased enforcement activity, but also follow-on civil litigation as well. Another factor is the Dodd Frank whistleblower program, which also seems likely to produce increased enforcement activity and follow-on civil litigation. In addition, the upswing in IPO activity, which picked up steam in 2013 and has continued so far in 2014, is likely to lead to increased activity due to the heightened susceptibility of IPO companies to litigation activity.

 

A wild card in all of this is the Halliburton case now pending before the U.S. Supreme Court. Although based on the tenor of the oral argument it seems unlikely, it is still at least theoretically possible that the Supreme Court will throw out the “fraud on the market’ theory. If that were to happen, it could be much harder for plaintiffs to pursue their claims. But while that might result in fewer class action filings, it could actually result in an increase in the number of filings, as more claimants pursue their claims as individual lawsuits. However, if, as seems likelier at this point, the Court adopts some middle course and doesn’t throw out but instead modifies the way the fraud on the market presumption operates, that could have yet a different impact on securities class action lawsuit filings. Until we know for sure what the outcome of the pending case is, it is premature to speculate on what will change. It is possible that while are waiting, the plaintiffs are holding back – although there have been plenty of case filings while the Halliburton case has been pending and in fact securities class action filings during the first quarter of 2014 were level with the first quarter of 2013.

 

Quarterly Advisen Claims Seminar: At 11:00 am EDT on Thursday April 24, 2014, I will be participating in a webinar entitled “Quarterly D&O Claims Trends: Q1” to discuss the findings in the Advisen report and other important D&O claims trends. The panel will also include my good friends Steve Shappell of AON and Will Fahey from Zurich. Jim Blinn of Advisen will moderate the panel. For further information about the webinar and to register, please refer here.

cali2In an interesting April 7, 2014 opinion (here), Magistrate Judge Stanley A. Boone of the Eastern District of California, applying California law, held that a D&O insurance policy’s insured vs. insured exclusion precludes coverage for claims brought against former officers of the failed County Bank of Merced, California by the FDIC in its capacity as the failed bank’s receiver. Because the magistrate judge’s ruling depended on an unusual wording not generally found in the typical insured vs. insured exclusion, the ruling may be of limited relevance to similar coverage disputes in other cases. However, the magistrate judge’s analysis may still be of interest notwithstanding the unusual wording because of the issues the magistrate judge considered in reaching his conclusion.

 

Background

County Bank of Merced, California failed on February 6, 2009 and the FDIC was appointed as receiver. The FDIC asserted potential claims against the bank’s officers on February 5, 2009. The FDIC made a formal claim against the officers on November 16, 2009. The claim was submitted to the bank’s insurer, which had issued a policy calling itself an Extended Professional Liability insurance policy (confusingly referred to in the magistrate judge’s opinion as an “EPL policy.” Readers of this blog well know that an EPL Policy is something entirely different, so for clarity’s sake and because the relevant coverage sections of the policy at issue provide D&O insurance, I will refer to the policy in this blog post as a D&O policy.)

 

The insurer denied coverage for the claim in reliance on the D&O policy’s insured vs. insured exclusion. The relevant exclusion, Exclusion 21 to the Policy, provides in pertinent part that the policy does not cover loss arising from “a claim by, or on behalf of, or at the behest of, and other insured person, the company, or any successor, trustee, assignee or receiver of the company.” (The exclusion also contains several carve backs preserving coverage for certain kinds of claims otherwise precluded from coverage by the exclusion, but none of these carve-backs are relevant here.) The D&O insurance carrier took the position that the FDIC’s claims against the former officers were precluded from coverage under Exclusion 21 because the FDIC brought the claims in its capacity as receiver of County Bank.

 

On February 27, 2012, the FDIC filed a civil action against five former officers of the failed bank, alleging that the defendants had been negligent and had breached their fiduciary duties. On November 12, 2012, the FDIC and the former officers reached a settlement in the civil action in which the officers assigned their rights under the D&O insurance policy to the FDIC and consented to the entry of a default judgment. A default judgment in the amount of $48.5 million was entered.

 

In the separate coverage lawsuit, the insurer and the FDIC (proceeding as the individuals’ assignee) cross-moved for summary judgment on the question of whether or not the insured vs. insured exclusion precluded coverage for the FDIC’s lawsuit against the former officers.

 

The April 7 Opinion 

In an April 7, 2014 Opinion, the magistrate judge granted the D&O insurer’s motion for summary judgment and denied the FDIC’s cross-motion. The magistrate judge concluded that Exclusion 21 precluded coverage for the FDIC’s claim because the FDIC brought the claims against the former officers in its capacity as “receiver.” He rejected the FDIC’s argument that the exclusion’s reference to “receiver” referred only to a court-appointed receiver, saying that “while the FDIC attempts to differentiate itself from other types of receivers, it fails to identify any significant distinction that would justify an interpretation of Exclusion 21 that would treat the FDIC differently from any other type of receiver.”

 

The FDIC also sought to fashion an argument for coverage based on the fact that the insurer offered a separate “Regulatory Exclusion” – not included on County Bank’s policy – that expressly excludes coverage for claims brought by any federal or state regulatory agency. The FDIC argued that the existence of the two different exclusions demonstrates that the regulatory exclusion was intended to exclude FDIC claims and the insured vs. insured exclusion was not intended to exclude FDIC claims.

 

The magistrate judge rejected this argument in light of the FDIC’s dual capacity as federal insurer of deposits and as liquidating agent for the bank. The FDIC, he noted, stands in the shoes of the bank only in the latter capacity. Thus, “the existence of a regulatory exclusion is not superfluous in light of the insured versus insured exclusion; the regulatory exclusion would bar suits brought by the FDIC in its capacity as federal insurer, also known as its ‘corporate capacity,’ whereas the insured versus insured exclusion would only bar claims by the FDIC in its capacity as receiver.”

 

The FDIC also tried to argue that the “reasonable expectation” regarding the insured vs. insured exclusion is that it was in the policy to prevent collusive lawsuits, and therefore should not preclude coverage for claims by the FDIC as receiver because they are not collusive. The magistrate judge rejected this argument on two grounds: first, he found that the argument was flawed because it would apply to any type of receiver in any context, yet the FDIC did not explain why the exclusion would not apply to the FDIC and not to other type of receivers.

 

The second ground on which the magistrate judge rejected the FDIC’s “reasonable expectation” argument is interesting. He said that a suit by the FDIC against a failed bank’s directors and officers “has the potential for collusion just as a suit by a corporation against its own directors and officers.” While he was “not accusing the FDIC of collusion,” he noted that the interests of the FDIC as receiver “could be aligned with the interests of the directors and officers of a failed bank when an insurer is involved.” Accordingly, he said, “it is not too difficult to imagine a scenario of collusion between the FDIC and the directors and officers.” For that reason, he rejected the FDIC’s argument that excluding the FDIC’s claims would be inconsistent with the parties’ reasonable expectations.

 

Discussion 

It is important to note that that Exclusion 21’s express reference to a company’s “receivers” is unusual. Indeed, the magistrate judge expressly rejected the relevance of various cases on which the FDIC sought to rely in which courts had concluded that the insured vs. insured exclusion does not preclude coverage for the FDIC’s claims as receiver. Exclusion 21, he noted, “is materially different from the insured versus insured exclusion interpreted in the cases cited by the FDIC,” because Exclusion 21 specifically excludes claims brought be “receivers,” while the cases the FDIC cited did not include language expressly excluding claims brought by “receivers.”

 

Because of this policy wording difference, the holding in this case will be of limited value in the many other coverage disputes arising in connection with FDIC failed bank litigation and involving the question of whether more conventional insured vs. insured exclusions preclude coverage for the FDIC’s claims as receiver.  Just the same, though the insurance question here involved unusual policy wording, the magistrate judge’s analysis is nevertheless interesting and potentially even relevant to other cases.

 

His analysis of why the existence of the regulatory exclusion does not negate the argument that the insured vs. insured exclusion applies to the FDIC is interesting. The FDIC will often seek to argue that the absence of a regulatory exclusion means that a D&O insurance policy should cover claims brought by the FDIC notwithstanding the existence of the insured vs. insured exclusion. By reasoning that two exclusions apply to the FDIC in different ways – with the regulatory exclusion precluding coverage for FDIC claims in either of its dual capacities, and the insured vs. insured exclusion precluding coverage only for FDIC claims in its capacity a receiver of a failed bank – the magistrate judge showed how the absence of a regulatory exclusion does not mean that FDIC as receiver claims are covered or that the insured vs. insured exclusion was not intended to exclude FDIC claims.

 

The magistrate judge’s “reasonable expectations” analysis is also interesting, for its recognition that an FDIC’s claims as receiver presents at least the theoretical possibility of “collusion” and so represents the kind of dispute the exclusion was designed to address.

 

I will say that the FDIC’s dual capacity represents a confusing strain in many of these cases, both in the underlying liability lawsuits and in the coverage actions. In many of the FDIC’s failed lawsuits, the defendant directors and officers attempt to assert affirmative defenses against the FDIC for actions it took in its capacity as the bank’s regulator prior to its collapse. Whether or not these kinds of defenses can be asserted in an action the FDIC is bringing in its capacity as receiver is a hotly contested issue. As this case shows (and other cases have also shown) the question of the capacity in which the FDIC is acting can become a factor in coverage litigation as well.

 

As interesting as this case is, the question of the applicability of the insured vs. insured exclusion to claims asserted in its capacity as the receiver of a failed bank will continue to be litigated. The carriers, for their part, will try to rely on the rulings, such as the Northern District of Georgia Judge Richard W. Story’s August 2013 opinion (discussed here) that the insured vs. insured exclusion does preclude coverage for an FDIC lawsuit against a failed bank’s directors and officers, while the directors and officers will try to rely on rulings such as Northern District of Georgia Judge Robert Vining’s January 2013 ruling, discussed here, that the insured vs. insured exclusion doesn’t preclude coverage.

 

Special thanks to Joe Montelone, now of the Rivkin Radler law firm, for sending me a copy of the magistrate judge’s opinion.  

 

flash boysThe topic of high frequency trading has dominated the business headlines since the late March publication of Michael Lewis’s new book, “Flash Boys: A Wall Street Revolt.”  The SEC, the U.S. Department of Justice and the Federal Bureau of Investigation have confirmed that they are investigating high frequency trading, as has the New York Attorney General.  With all this media attention and regulatory scrutiny, it was perhaps inevitable that the one of the consequences of these events would include a securities suit.

 

On April 18, 2014, plaintiffs lawyers’ filed a securities class action lawsuit in the Southern District of New York against 42 defendants including fourteen brokerages, sixteen securities exchanges and twelve high-speed traders. The roster of defendants includes the major exchanges, such as the NYSE and NASDAQ, as well as trading platforms such as the BATS Global Markets; major banks, such as BofA, UBS and Barclays; and a long list of trading firms large and small. The complaint does not name any individuals as defendants.

 

The lawsuit, filed by the City of Providence, Rhode Island, is brought on behalf of an ambitious putative class; the action purports to be brought on behalf of all public investors “who purchased and/or sold shares of stock in the United States between April 18, 2009 and the present (the “Class Period”) on a registered public stock exchange (the “Exchange Defendants”) or a United States-based alternate trading venue and were injured as a result of the misconduct.” And yes, the complaint (which can be found here) contains multiple references to Michael Lewis’s book.

 

Interestingly, the complaint not only purports to be filed on behalf of a plaintiff class, but it also purports to be filed against a defendant class as well. The Brokerage Firm Defendants and High Frequency Trader defendants named in the complaint purportedly are sued both individually and as representatives of a defendant class consisting of all (1) financial firms whose brokerage divisions placed bids or offers and/or transacted for members of the Plaintiff Class on stock exchanges or alternative trading venues during the class period: (2)  financial firms that operated alternative trading venues for the anonymous trading of bids and offers and trading by brokers to members of the Plaintiff Class during the class period; and (3) financial firms that engaged in high frequency trading during the class period.

 

The complaint traces the history of securities trading in the United States since the early 70’s to try to explain the “bold new world” that characterizes current securities trading, a world that now includes “high frequency trading,” which the complaint defines as “a type of algorithmic trading” involving “the use of sophisticated technological tools and algorithms to rapidly trade securities.”

 

According to the plaintiff’s lawyers’ April 18, 2014 press release (here), the complaint alleges that defendants  “engaged in a scheme and wrongful course of business whereby the Exchange Defendants, together with a defendant class of the brokerage firms entrusted to fairly and honestly transact the purchase and sale of securities on behalf of their clients … and a defendant class of sophisticated high frequency trading firms … engaged in conduct that was designed to and did manipulate the U.S. securities markets and the trading of equities on those markets, diverting billions of dollars annually from buyers and sellers of securities to the defendants.”

 

The complaint alleges that certain market participants received material, non-public information so that they could use the informational advantage obtained to manipulate the U.S. securities market. The Exchange Defendants and those defendants that controlled alternate trading venues allegedly demanded and received substantial kickback payments in exchange for providing the High Frequency Trader defendants access to material trading data via preferred access to exchange floors and/or through proprietary trading products.

 

In exchange ‘hundreds of millions of dollars” in payments, the Brokerage Firm Defendants allegedly provided access to their customers’ bids and offers, and directed their customers’ trades to stock exchanges and alternate trading venues that the Brokerage Firm Defendants knew had been rigged and were subject to informational asymmetries as a result of defendants’ scheme and wrongful course of business. The Brokerage Firm Defendants allegedly sold “special access” to material data, including orders made by the investing public so that the high frequency trader defendants could then trade against them using the informational asymmetries and other market manipulation.

 

The complaint alleges that the defendants’ alleged conduct deprived investors of the “market integrity” on which all securities buyers and sellers rely, as a result of which the plaintiff and the plaintiff class have been “victimized by what can fairly be characterized as a crooked crap game.” (Citations omitted).

 

The complaint alleges three substantive claims. The first, asserted against all defendants, alleges violation of Section 10(b) of the Exchange Act and Rue 10b-5 thereunder. The second, filed only against the Exchange Defendants, alleges violation of Section 6(b) of the Exchange Act. (Section 6 of the Exchange Act provides for the existence of National Securities Exchanges and specifies certain requirements for the existence, including in particular a requirement that the exchanges operate in a fair and equitable manner). Count III, filed against the Brokerage Firm Defendants and the High Frequency Trading, alleges violations of Section 20A of the Exchange Act. (Section 20A specifies the liabilities to contemporaneous traders for insider trading.) The complaint seeks compensatory damages, equitable restitution, forfeiture and other injunctive or equitable relief.

 

Discussion

This massive, sprawling lawsuit is nothing if not ambitious. Between the purported plaintiff class that includes everyone that traded in the U.S. securities marketplace during the last five years and an encyclopedia of defendants (including a purported defendant class) that includes just about every one of the financial firms that makes up the U.S. securities marketplace, this lawsuit basically tries to encompass the entire private U.S. securities arena and everything and everyone in it.

 

The plaintiffs’ lawyers’ ambition includes not only the size of their undertaking, but also the novelty of some of their approaches. I am very curious to know whether or not there is any history of private civil litigation under Section 6 of the Exchange Act and whether or not any other litigants have successfully pursued claims against the securities exchanges based on this statutory provision.

 

The plaintiff’s purported use here of a defendant class action is also interesting. The attempt to name a defendant class is not a new concept. Claimants have attempted to use this kind of procedural vehicle in a number of other kinds of lawsuits, ranging from patent litigation to product liability litigation against fire arms manufacturers. Still, as noted on the Class Action Countermeasures blog (here), defendant class actions are “rare beasts” because of definitional and procedural problems surrounding their use. Here, the plaintiffs will struggle to overcome some obvious problems with the seeming shapelessness of the defendant class and the problems associated with having class representatives that did not volunteer for the role.

 

Another challenge the plaintiffs may face has to do with the very subject of their lawsuit. For all of the adverse publicity surrounding high frequency trading, it is not (in and of itself) illegal – though of course, front-running, insider trading and other practices are or can be. However, it is a tall order to try to contend that everyone engaged in high frequency trading employed prohibited practices. Moreover, high frequency trading has its defenders. According to some, the presence of high frequency trading helps to narrow the gaps between bid and ask prices, which helps to reduce trading costs – a possibility that may highlight the kind of challenges the plaintiffs will face in pursuing these claims and in trying to show that all of the members of the purported plaintiff class were in fact damaged. As one author put it, high frequency trading may be “mysterious and secretive, but not at all evil.” 

 

And of course the plaintiff will face the hurdles that any private securities plaintiff faces – overcoming the heightened pleading standard under the PSLRA, presenting sufficient allegations of scienter as to each of the defendants – except that here all of those hurdles are magnified by the sheer number and diversity of the defendants involved.

 

If nothing else, this lawsuit looks like a full employment act for the securities defense bar. The dozens of defense law firms that will be involved undoubtedly will count on riding this baby for years. (Which of course underscores another aspect of the plaintiff’s lawyers’ audacity in brining this suit; that is, they are going to have to carry this massive lawsuit, which will be fiercely litigated for years, before they will realize any possibility of a recovery.)

 

Whenever there is massive new event-driven litigation like this I am asked what the litigation means for the D&O insurance industry. Here, I think this event means a variety of things. Many of the larger financial institution defendants are either self-insured, carry large self-insured retentions or only carry so-called Side A only insurance programs (which would not be triggered here). The involvement of these larger financial institution defendants in this lawsuit will have only a limited impact on the D&O marketplace.

 

Many of the other defendants, especially the smaller brokerage and trading firms, are likely to carry more traditional D&O insurance programs (although an interesting question is whether these claims would trigger their D&O insurance programs or the E&O insurance programs – or even perhaps both). The carriers insuring these other defendants are at a minimum going to be looking at some huge defense fee bills. Maybe not enough to change the overall marketplace, but maybe enough to substantially affect the D&O (and E&O) marketplace for these kinds of financial firms.

 

The real wild-card here, for the insurance carriers as well as for everyone else involved, is whether this case will get through to the point where there is a settlement or settlements, and importantly for insurance purposes, whether by that point there have been developments in the ongoing governmental investigations that might affect the availability of coverage (e.g., whether or not there have been any criminal guilty pleas or other admissions that might trigger coverage exclusions). In other words, at this early stage, it is far too early to try to conjecture how it might all play out. However, for better or worse, we will get to have the experience of watching this case unfold in the months ahead.

 

Many readers will recall that Michael Lewis spoke at the PLUS International Conference in Orlando last November. He was an engaging and entertaining speaker and he left the impression that he is an interesting, likeable person. Although it seems likely that this lawsuit will be referred to as the “high frequency trading securities lawsuit,” I kind of hope in an acknowledgement of Lewis that the lawsuit is known as the “Flash Boys lawsuit.” (I recognize that the defendants probably wouldn’t like that very much.)

 

Dinner at Edwin’s: On Saturday night, my wife and I joined another couple for dinner at a new and unusual restaurant in Shaker Square in Cleveland called Edwin’s. It is a high-end, white table cloth restaurant serving fine French food. The food was excellent, and the service was well-intentioned and enthusiastic, if not always perfect. But what made the meal interesting is Edwin’s mission:

 

Edwin’s Leadership & Restaurant Institute is a unique approach at giving formerly-incarcerated adults a foundation in the hospitality industry while providing a support network necessary for a successful reentry. Edwin’s goal is to enhance the community of Cleveland’s vulnerable neighborhoods by providing its future leaders. Our mission is to teach a skilled trade in the culinary arts, empower willing minds through passion for the hospitality industry and prepare students for a successful transition into the world of business professionals.

 

In recent years, there have been a string of restaurants in Shaker Square that have tried valiantly but failed. In fact, one of our favorite after-theater restaurants, the Wine Grotto, used to be located in the space now occupied by Edwin’s. For many reasons, it could be a tough road for Edwin’s, too.  But you just really want to see a project like this succeed. It was great to see that the restaurant was crowded and the large staff was busy. It makes such a difference to meet the staff members and to get a glimpse of the challenges they face – and of how hard they are willing to work to overcome the challenges.

 

The True Story of the Koy Panyee Southern Thailand Youth Soccer Club: A friend sent me a link to the video embedded below. The video tells the true story of how a group of boys figured out how they could find a place to play soccer in their water-surrounded floating fishing village in Thailand. The video is entertaining, heart-warming and inspiring. Do yourself a favor and take a couple of minutes to watch this video.

 

mugshotBecause the latest round of mug shots is long overdue, quite a backlog of pictures has built up. The latest round of readers’ photos may be a bit late but it may also be one of the best collections yet.

 

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

 

The first pictures come to us from our friend Mark Gebhardt, the risk manager for the Southern Ute Indian Tribe Growth Fund. Mark took these pictures last summer but only recently sent them in. These pictures were taken above 10,000 feet in a remote part of the San Juan Mountains, near Durango, Colorado, where Mark lives. The second of the two pictures features Mark’s “friend and intrepid camper” Charlie holding a D&O Diary mug; about Charlie, Mark said “if I know Charlie, it ain’t filled with coffee.”

 

southernute[1]

 

 

 

 

 

 

 

southern_ute_2[1]

 

 

 

 

 

 

 

The next picture, sent in by Rebecca Dutton of March, depicts the centerpieces of the FINPRO team’s Pi Day celebration. The picture does not quite include 3.1415 pies. (It does occur to me that a D&O Diary coffee mug might be a useful thing to have around on Pi Day.)

 

piday[1]

 

 

 

 

 

 

 

 

 

Our next picture, from Kent Paisley, the head of specialty lines for Darwin National in Canada, depicts Allied World’s new Toronto offices as the company prepares to launch its professional lines products in Canada.

 

alliedworldsmall[1]

 

 

 

 

 

 

 

 

 

This next picture was taken at Loyola Law School in downtown Los Angeles, where Phillip Reed of Willis (pictured) was asked to  “deliver a guest lecture on what lawyers should know about of liability insurance and its role in civil litigation.”   

 

  losangles[1]

 

 

 

 

 

 

 

 

 

And while we are on the West Coast, we should take a look at these pictures sent to us by Megge Van Valkenburg of the Bullivant Houser Bailey law firm in Portland, Oregon. The first picture was taken in front of the Voodoo Donut shot, which Megge reports is a local landmark. The next picture, a tribute to true Portlandia, depicts Megge in front of the sign showing the city’s unofficial motto – Keep Portland Weird.

 

portland1small[1]

 

 

 

 

 

 

 

 

 

 

portland2[1]

 

 

 

 

 

 

 

One of the most astonishing things I have learned over the years while maintaining this blog is just how far-flung this site’s readership is. As proof of this point, I am happy to publish this picture of the Moscow skyline, sent in to us by Alma Malysheva, the head of the Corporate Clients Liability division for Rosgosstrakh, which Alma reports is one of the three largest insurers in Russia.

 

moscowsmall[1]

 

 

 

 

 

 

 

 

 

And finally, we have these absolutely outstanding pictures taken in South Africa and sent in by our good friend Tracy Baughman, of Beazley in London. Seriously, if you are going to be hanging out with elephants and zebras in Africa, it is always a good idea to have a D&O Diary mug at the ready.

 

tracyelephancesmall[1]

 

 

 

 

 

 

 

 

tracyzebrasmall[1]

 

 

 

 

 

 

 

 

 

I never cease to be amazed at the breadth and diversity of pictures that readers send in. I find it incredibly amusing that readers are carrying their mugs onto mountain tops and on safari, as well as to donut shops and office parties.  Thanks to everyone who has sent in pictures of their D&O Diary mugs. This has been such a great experiment. It may just look like a coffee mug, but it turns out to be a tool for self-expression.

 

Because I have shipped out the last of the mugs, I am afraid I can’t fulfill any more mugrequests. However, if other readers would like to send in pictures taken with their own firm’s mugs, I would be happy to publish the pictures. Of course, if there are D&O Diary mug recipients out there who still have not sent in mug shots, I would be happy to post those pictures as well.

 

secOne frequently asked question is whether members of a corporate board’s audit committee face heightened liability exposures. Two recent SEC enforcement actions seem to underscore that audit committee chairs do face liability exposures. Though both cases involve somewhat unusual circumstances, they seem to suggest that the “gatekeepers” on which SEC has said it will be concentrating increased enforcement focus may include audit committee members.

 

Hat tip to Daniel Goelzer at the Baker & McKensie firm for his April 2014 memo entitled “Audit Committee and Auditor Oversight Update” (here) that brought these cases to my attention.

 

The Ag Feed Case: On March 11, 2014, the SEC filed an enforcement action in the Middle District of Tennessee against Agfeed Industries and certain of its current and former directors and officers. including K. Ivan Gothner, who served as chair of the company’s audit committee, and Edward Pazdro, who served for a time as the company’s CFO.

 

The SEC’s complaint, which can be found here, alleges that from 2008 through June 30, 2011, AgFeed, an animal nutrition and hog production company, overstated its revenue by $239 million. The fraud allegedly was orchestrated by the company’s Chinese management. The complaint alleges that in May 2011, Gothner and Pazdro learned that the hog production division had maintained two sets of books in China – a real set and a fake set. In June 2011, Gothner and Pazdro received a report from Chinese counsel at AgFeed which concluded based on witness statements and documents that AgFeed had maintained the two sets of books for the purpose of inflating revenue and profits, that the company’s former CEO and CEO had directed the fraud, and that the former CFO had ordered the destruction of the second set of books.

 

The complaint alleges that between June 2011 and September 2011, a period during which the company was engaged in an effort to raise capital, Gothner and Pazdro “engaged in a scheme to avoid or to delay disclosure of the fraud,” including failing to disclose the fraud to auditors and to key company personnel. With respect to Gothner, the audit committee chair, the SEC further alleges that he misrepresented to counsel that a third-party expert had been hired to analyze the USB stick on which the two sets of books were maintained when no expert had been hired. Both Gothner and Pazdro are alleged to have failed to “conduct further meaningful inquiries into the fraud even as additional red flags arose.” The complaint further alleges that their failure to act on the fraud allowed the company to file a false and misleading Form 10-Q in August 2011.

 

L&L Energy: On March 27, 2014, the SEC filed an administrative cease and desist order against Shirley Kiang, the firmer audit committee chair of L&L Energy, a Seattle-headquartered coal company with all of its operations in China. The order alleges that the company misrepresented in public filings that a person was serving as the company’s Acting Chief Financial officer when in fact that person never did.

 

The order alleges that  in May 2009 while Kiang was audit committee chair, the purported Acting Chief Financial Office became aware that she had been falsely represented as the company’s Acting CFO, and that the purported Acting CFO asked Kiang to investigate. Kiang advised the company’s chairman of the information; the chairman told Kiang that the person had never actually served as the Acting CFO and that Kiang should not share this information with anyone, including the company’s Board of Directors or the public.

 

In August 2009, the company filed its 10-K for the 2009 fiscal year. The 10-K contained the required certifications that any fraud involving management had been disclosed to the company’s auditors and audit committee. The SEC cease and desist order alleges that when Kiang signed this certification, she knew or should have know it was false.

 

The SEC’s cease and desist order charges that by withholding the information that the purported Acting CFO had not served as the actual Acting CFO and allowing the false certifications to be filed, Kiang “caused” L&L Energy to violate the reporting requirements of the securities laws. Kiang agreed to settle with the SEC without admitting or denying allegations (because the cease and desist order was filed in an administrative proceeding, no judicial approval was required). Kiang consented to the entry of an order directing her to cease and desist from any future violations.

 

Discussion 

As the Baker McKenzie memo notes, enforcement actions against audit committee chairs are rare, and these two cases involving as they do somewhat unusual fact patterns “may seem of limited significance.” However, these two enforcement actions come at a time when the SEC has already announced its intention to pursue “gatekeepers” and to hold them accountable.

 

It is noteworthy in that regard  that a March 11, 2014 Reuters article discussing the action against the AgFeed audit committee chair quotes SEC Enforcement Director Andrew Ceresney as saying that “today’s enforcement action is a cautionary tale about what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags.”

 

As the law firm memo puts it, “these cases seem to illustrate how the Commission intends to apply its gatekeepers program to audit committee members.” The Reuters article linked above quotes a leading defense attorney as saying that the AgFeed enforcement action represents “a warning shot across the bow” for public company audit committees,” and that the case is a reminder that “audit committees must follow up on red flags and seek outside counsel for assistance.”

 

At a minimum the cases should affect the way that audit committee members – particularly audit committee chairs – think about the liability exposure associated with their activities in those roles. These individuals will not only want to understand their exposures but also will want to inquire about the indemnification and insurance available to protect and defend them in the event they are hit with an action based on their service in those roles.

 

Special thanks to a loyal reader for sending me a copy of the Baker & McKenzie law firm memo.

 

The Beautiful Game: For many years, my wife and I have joked that when the Wall Street Journal or the New York Times decide to try to do some trend-spotting, they peek inside our house and then write about what we are doing. So it was this morning, when my wife handed me the Thursday Styles section of today’s Times, said, “They’re following us around again,” and pointed to an article entitled “Their Game, Now Ours,” (here), which in the print edition has the subtitle “Soccer emerges as the sport of the thinking class in the U.S.”

 

Regular readers undoubtedly are aware that I am an energetic fan of European soccer (sorry, to avoid confusion, I can’t call it football in this context), particularly English Premier League soccer. Some may even recall the short item in my post this past Monday about Liverpool’s dramatic 3-2 win over Manchester City on Sunday – a game that the Times article in fact references in its very first sentence. Among other things, the article states that soccer is a topic you can no longer ignore, which is “particularly evident in New York creative circles, where the game’s aesthetic, Europhilic allure and fashionable otherness have made soccer the new baseball – the go-to sport for the thinking class.”

 

I commend the Times article to anyone interesting in thinking about whether there actually is a trend here.  For myself, I think the current enthusiasm for the sport has less to do with Europhilic sensibilities and more to do with the sheer pleasure of watching the matches. It is, as is often said, a beautiful game – in fact, the beautiful game.

 

If you have any doubts about the game’s beauty, I recommend you watch the video below of the welsh soccer star Gareth Bale of Real Madrid scoring what proved to be the winning goal in Wednesday’s championship match in the annual  Copa del Rey soccer tournament, between Real Madrid and perennial rival Barcelona. It is one thing to watch the replay aware that you are about to see something special; at the time Bale scored the goal, the moment was absolutely electric. You will note in the video that when Bale’s breakaway run ended with his spectacular goal, Barcelona players collapsed onto the pitch as if they were literally thunderstruck. Watch this video, and you will see what the excitement is about. (When  the video begins, hit Skip Ad, and don’t worry when the video freeses momentarily about 49 seconds in, it starts up again).
http://youtu.be/vWUEmw4daew