dandbThe indictment last week of the top officials from the collapsed Dewey &  LeBouef law firm is merely the latest development in the long-running sequence of events following the law firm’s demise. The indictment (and the accompanying SEC enforcement action) paints a vivid picture of the desperate efforts of the law firm’s top officials to avert financial disaster, which in turn allegedly led them to mislead the law firm’s partners, creditors and investors. As I have previously noted in connection with the legal proceedings following the firm’s collapse, these latest developments raise important issues surrounding management liability insurance for law firms.

 

In many respects, the Manhattan District Attorney’s indictment is not a complete surprise. As detailed in James B. Stewart’s fascinating (yet deeply disconcerting) October 14, 2013 New Yorker article about the events leading up to the law firm’s demise entitled “The Collapse” (here), the criminal investigation had commenced even before the law firm filed for bankruptcy in May 2012.

 

Dewey & LeBoeuf was the product of the ill-fated 2007 merger between the storied Dewey Ballantine law firm and the LeBouef Lamb Greene & McRae law firm. At the time, the wisecrack was that “Dewey married money, LeBoeuf married up,” but the New Yorker article shows that turmoil and fear at LeBoef and declining firm fortunes  at Dewey had driven the firms to the alter. A potent mix of outsized partner compensation guarantees, infighting and the economic downturn led to serious financial problems in the first full year after the merger.

 

According to the indictment (here), as a result of the revenue downturn in 2008 and the pressure of the guaranteed partner payments, the company was out of compliance with certain covenants in its bank line of credit. In order to create the false impression that it was in compliance, the firm’s managers initiated a series of steps that one internal email cited in the indictment described as “accounting tricks.” The firm’s CFO described the process in another email as “cooking the books.”  The indictment describes a variety of different accounting ruses the top firm managers orchestrated to falsify the firm’s apparent financial condition.

 

These efforts were compounded in 2010, when the firm completed a $150 million private placement bond offering. The offering documents relied on financial statements that overstated the firm’s 2008 and 2009 revenues by tens of millions of dollars. According to the allegations, following the offering, the firm’s senior managers provided the bond investors with fraudulent quarterly certifications.

 

The criminal indictment names as defendants the firm’s former Chairman Steven Davis, former executive director Stephen DiCarmine and former Chief Financial Officer Joel Sanders. (A fourth individual is also named as a defendant in one count of the indictment for falsifying entries). A parallel SEC enforcement action (about which refer here) asserts securities fraud charges against Davis, DiCarmine and Sanders, as well as two members of the firm’s accounting staff. For readers that are interested, the New Yorker article linked above provides a lurid  picture of involvement of Davis and DiCarmine in the events that led up to the merger and then to the combined firm’s eventual collapse.

 

As discussed in Alison Frankel’s detailed March 6, 2014 post on her On the Case blog about the regulatory and criminal charges against the former Dewey firm managers (here), both the indictment and the SEC action are unprecedented. While there have previously been law firm managers that have been indicted before, those charges have mostly involved brazen self-enrichment through embezzlement or the like. Here, the criminal charges were the result of the actions the firm’s senior managers took in the course of their duties as leaders of the firm to try to stave off disaster after the global financial crisis.

 

But as Frankel also points out, the allegations may be unprecedented, but the precedent has now been set. The circle of potential claimants against law managers has just been widened, and the kinds of allegations that might be asserted against law firm managers have just expanded.

 

As I pointed out in a prior post about the settlement of various civil charges asserted in the law firm’s bankruptcy proceeding (here), among the many implications from the events surrounding the Dewey & LeBoeuf collapse are important implications in connection with management liability insurance for law firms.

 

First and foremost, the events following the law firm’s collapse underscore the importance for law firms of a separate program of management liability insurance. Every attorney is well aware of the need to have errors and omissions insurance in place (what they would typically think of as malpractice insurance). But while attorneys know they need insurance to protect them against claims that they erred in the delivery of client services, they may be less aware of (or persuaded of) the need for management liability insurance to protect their firm’s managers from claims for alleged wrongful acts committed in the  management of the firm.

 

As the latest regulatory and criminal proceedings arising out of the Dewey & LeBoeuf collapse demonstrate, law firm managers face the possibility of potential claims from a broad variety of potential claimants. Indeed, as the most recent developments underscore, the range of potential claimants includes creditors, vendors, suppliers, and even, as happened here, regulators and prosecutors. Indeed, at this point, the various claims that have arisen against the former Dewey & LeBoeuf provides something of a catalog of the kinds of claims law firm managers may face, which if nothing else will help law firm managers to understand why they need management liability insurance in place.

 

The events following the Dewey & LeBoeuf collapse also have important implications for law firms when they consider how much management liability insurance to buy.  Most law firms do not need to be persuaded that they need to carry significant limits of liability on their E&O insurance program, but they may underestimate their needs when it comes to management liability insurance. The cascade of claims that have been asserted against the former Dewey & LeBoeuf managers underscores the fact that in catastrophic circumstances the insurance requirements could prove to be extensive. In my prior post, I detailed how the settlements of the various claims in bankruptcy threatened to exhaust the limits of liability of the firm’s management liability insurance program. The new regulatory and criminal charges represent even more significant demands on the insurance program (or what may be left of it). This situation shows the importance of thinking about what might be required to ensure that the law firm’s managers do not run out of insurance protection before all of the claims against them have been resolved.  At a minimum, the sequence of events here ought to encourage some law firms to take a look at the possibility of increasing the limits of liability for their management liability insurance program.

 

The filing of regulatory and criminal charges against the law firm’s former management also raises important considerations with respect to the terms and conditions in a  law firm’s management liability insurance program. For starters, the criminal indictment has important implications for the program’s definition of a “Claim” under the policy. The typical definition of “Claim” in a management liability insurance policy will include as a covered claim a criminal proceeding after indictment or the return of criminal information. In the past, the wording of this particular provision in the law firm management liability policy may not have seemed as of high as a priority. But now the possibility of criminal indictment of law firm managers has emerged, this provision should take on added importance and receive greater attention.

 

The SEC’s filing of securities fraud charges may represent a particular concern. On the one hand, it is unusual for a law firm to conduct the type of offering that Dewey & LeBoeuf completed (and in light of how it played out, both law firms and investors may shy away from any future offerings of that type). On the other hand, it may make just as much sense for a law firm to try to raise capital through an offering as it does for any privately held enterprise (indeed, in Australia, there is at least one law firm that is publicly traded). The possibility of this type of offering raises a question about the availability of converge under the policy for claims arising from an offering of this type.

 

Most management liability policies for privately held organizations contain an exclusion precluding coverage for claims related to securities offerings. The sequence of events at the Dewey & LeBeouf highlights the fact that law firms might attempt to raise capital through a securities offering and that claims might arise in connection with such an offering. Again, given what happened with Dewey & LeBeouf, I don’t expect that there are going to be a lot of law firms rushing to try to raise capital through an offering of this type nor would I expect there to be much investor demand. Nevertheless, the possibilities for an offering and of claims related to the offering are there. These events suggest that the securities offering exclusion in the law firm management policy, which in the past may not have been the subject of a great deal of attention, may need to be reexamined. Of course, in light of what happened at Dewey & LeBeouf, the carriers providing law firm management liability insurance may now be particularly wary of adjusting the securities exclusion.

 

Many observers have chosen to interpret the demise of the Dewey & LeBoeuf law firm as a sort of a morality tale about the wages of supposed greed and excess. While some may find enough from the law firm’s demise to support that kind of an interpretation, it would be unfortunate if those lessons were the only ones drawn from these events. Even if the law firm’s collapse is the result of the firm’s own peculiar set of circumstances, there are still important lessons for other law firms, even those that consider their circumstances to be different from those of the late lamented Dewey & LeBoeuf firm. Among the lessons that every firm would do well to heed is the message about the importance of management liability insurance for law firm managers.

 

Start Spreading the News: For many years, since I spent a few months a very long time ago as a summer associate at one of the prestigious New York law firms, I have thought that one of the great curses on people who have been drawn to New York to seek their fortunes can be found in the lyrics of Frank Sinatra’s song “New York, New York.”

 

During my summer in New York, I often found myself in East Side watering holes full of crowds of young professionals. Inevitably, at some point (usually very late in the evening) somebody would cue up the Sinatra song and everyone in the crowd would sing along, with particular emphasis on the line that goes “If I can make it there, I’ll make it any where.” 

 

The song obviously is something of an anthem – as well as a battle hymn. Many do not succumb, but for some the compulsion to “make it there” turns the ordinary challenges of professional life into an existential struggle for self-validation. As the New Yorker’s account of this law firm’s demise demonstrates, the struggle to prove that you are “king of the hill, top of the heap” can, when things go wrong, lead to desperate behavior. Even in less extreme cases,   those who have discovered the steep downside to living “in a city that doesn’t sleep,” find themselves unable to make a tactical retreat for self-preservation, for fear that leaving town represents defeat and humiliation.

 

The amount of human misery accumulated out of a desperate effort to “make it there” and to get to and to stay “on top of the heap” is beyond calculation. It is a song for the winners, but even in New York, not everyone can win, and even in New York, not everyone can win all of the time. 

ScotussealOn Wednesday March 5, 2014, the U.S. Supreme Court heard oral argument in the closely watched Halliburton case, which, as discussed at length here, potentially could change the face of securities litigation. At issue is whether or not the Court will set aside the “fraud on the market” presumption of reliance at the class certification stage in Section 10 misrepresentation cases that the Court first recognized in its 1988 decision in Basic v. Levinson.

 

Unfortunately, I was not able to attend the oral argument. Fortunately, Alison Frankel was able to attend, and she has a detailed rundown of the argument on her On the Case blog, here. In addition the transcript of the oral argument in the case can be found here. A Bloomberg summary of the argument can be found here.

 

To the extent that the outcome of a Supreme Court case can be discerned from the oral argument, it does not appear that the Court will be setting aside the fraud on the market theory. Of course, the oral argument may not be a true indicator of the ultimate outcome.  But at least at oral argument it appears that the Justices were drawn more to the second of the two questions on which the Court granted cert: that is, whether or not the defendants ought to be able to rebut the fraud on the market presumption at the class certification stage.

 

Justice Kennedy, looking for a “midpoint” between dumping the fraud on the market theory and simply keeping it unchanged, wanted to discuss the position advocated in the amicus brief submitted on behalf of two law professors – U. Chicago Law Professor Todd Henderson and Michigan Law Professor Adam Pritchard – contending that there should be an event study to establish that the allegedly misleading statement distorted the company’s share price, in order for there to be a presumption of reliance at the class certification stage.  

 

Under this “price impact” approach, the plaintiff’s entitlement to a presumption of reliance based on the fraud on the market theory would depend on the question of whether an event study showed that the misrepresentation had distorted the share price. Several Justices, including Justice Breyer asked questions about the costs and value of an event study at the class certification stage, while Justice Sotomayor questioned whether there would be any need to perpetuate the efficient market hypothesis with the fraud on the market theory if an event study were to be required.

 

Counsel for Halliburton showed a clear willingness to accept an outcome for a requirement of an event study at the class certification stage to show that the misrepresentation had distorted the share price and argued that it would be a proper burden to place on the plaintiffs that sought to rely on the presumption of reliance.

 

When asked about the possibility of looking at price impact, counsel for the plaintiffs sought to argue that the price impact ought to be a merits question that would be very difficult and expensive to discern, because there are “confounding factors” that may complicate the question of what affected the share price.

 

Even though much of the argument was given over to the “price impact” discussion and even though there was a lot of discussion of the possibility of requiring an event study, there is nothing that says that either of those features ultimately will be reflected in the court’s decision.

 

The one thing that is interesting is that none of the Justices – even those that had in the Amgen case shown an interest in revisiting the Basic presumption and the fraud on the market theory – seemed particularly primed during oral argument to try to completely overturn Basic. Counsel for Halliburton didn’t seem to get support on that point from any of the Justices you would have expected to be supporting him there.  In addition, several of the Justices – particularly Chief Justice Roberts – seemed very reluctant to wade into the economic debate surrounding the question of whether or not the markets are efficient.

 

As I said above, it remains to be seen how this case ultimately will turn out. The Court’s decision is due before the end of the Court’s current term in June. 

omnicareAs if it were not enough that the Court is already considering a case that could change the face of securities class actions (that is, the Halliburton case, which will be argued this week), the U.S. Supreme Court has now agreed to take up yet another securities case.

 

In a March 3, 2014 order (here), the Court granted the defendant’s petition for writ of certiorari in Indiana State District Council of Laborers v. Omnicare, to determine whether or not to survive a dismissal motion it is sufficient for a plaintiff in a Section 11 case to allege that a statement of opinion was objectively false, or whether the plaintiff must also allege that the statement was subjectively false – that is, that the defendant did not believe the opinion at the time the statement was made.

 

The Supreme Court’s consideration of the Omnicare case will resolve a split in the circuits between those (such as the Second and Ninth Circuits) holding that in a Section 11 case allegations of knowledge of falsity are required; and those (such as the Sixth Circuit, in the Omnicare case) holding that they are not required. The case is potentially important because the absence of allegations of knowledge of falsity is a frequent basis for dismissals of Section 11 suits in the Second and Ninth Circuits, where the vast preponderance of securities suits are filed. As it is, the current split would allow cases to go forward in the Sixth Circuit that would not survive in the Second and Ninth Circuits.

 

Background

 

Omnicare provides pharmaceutical care services to long-term care facilities. The plaintiffs allege that Omnicare was engaged in various illegal activities including kickback arrangements with pharmaceutical companies and the submission of false Medicare and Medicaid claims. The plaintiffs allege that in connection with its December 15, 2005 stock offering, the company’s offering documents falsely stated that its arrangements with the drug companies were “legally and economically valid.”

 

As detailed here, the case, which was first filed in February 2006, has a long procedural history, and has made two separate trips to the Sixth Circuit. The most recent trip followed after the district court had dismissed the case, holding that the plaintiffs were required to but had failed to plead knowledge of falsity on the defendants’ part. The plaintiffs appealed.

 

In a May 23, 2013 opinion (here), a three-judge panel of the Sixth Circuit, in an opinion by Judge R. Guy Cole, Jr. reversed the district court (in relevant part), holding that “Under Section 11, if the defendant discloses information that includes a material misstatement, that is sufficient and a complaint may survive a motion to dismiss without pleading fraud.” The Sixth Circuit reasoned that a showing of knowledge of falsity was not necessary for claims under Section 11, which imposes strict liability for material misrepresentations in offering documents. The court said that “no matter the framing, once a false statement has been made, a defendant’s knowledge is not relevant to a strict liability claim.” 

 

The Sixth Circuit expressly declined to follow the Ninth Circuit’s 2009 ruling in Rubke v. Capitol Bankcorp and the Second Circuit’s 2011 decision in Fait v. Regions Financial, which had held that in order to survive a motion to dismiss, a Section 11 plaintiff must allege that the allegedly misleading statement was both objectively false and subjectively false – that is, that the statement was untrue and that the defendant disbelieved the statement at the time it was made.

 

In the Sixth Circuit’s view, the Second and Ninth Circuit decisions were based a faulty reading of the U.S. Supreme Court’s 1991 decision in Virginia Bankshares v. Sandberg. The Sixth Circuit said that in its reading the Virginia Bankshares case did not require the outcome that the Second and Ninth Circuit had reached. The Sixth Circuit said that “The Virginia Bankshares court was not faced with and did not address whether a plaintiff must plead knowledge of falsity in order to state a claim. It therefore does not impact our decision today.”

 

The defendants filed a petition for a writ of certiorari, seeking to have the U.S. Supreme Court determine whether for purposes of a Section 11 claim it is sufficient for a plaintiff to plead that that a statement of opinion was objectively wrong (as the Sixth Circuit held) or whether the plaintiff must also allege that the statement was subjectively false—requiring allegations that the speaker’s actual opinion was different from the one expressed – as the Second and Ninth Circuits require.

 

In their cert petition, the defendants argued that the Sixth Circuit both misread and failed to follow the Virginia Bankshares decision. The defendants also argued that the Sixth Circuit’s approach “threatens dangerous and far-reaching consequences” because it “would expose corporations, auditors, underwriters, and other professionals to a sharp increase in the cost of litigation, as certain types of federal securities claims – particularly those under Section 11 – would become far more difficult to resolve at the pleading stage.”

 

In their brief in opposition to the cert petition, the plaintiffs argued that the Supreme Court’s prior case law holds that Section 11 imposes strict liability in issuers for misrepresentations in offering documents, without regard to fault or knowledge. The plaintiffs also argue that Virginia Bankshares was a Section 14 case, not a Section 11 case and therefore is not controlling, and that in any event its principles should not be extended to the Section 11 strict liability context.

 

Discussion

 

At one level, it is not surprising that the Supreme Court granted cert in this case, in light of the circuit split on the question whether a plaintiff must plead subjective falsity in a Section 11 case. As things stand, a case that would be dismissed in the Second or Ninth Circuit could proceed if it were filed in the Sixth Circuit, allowing inconsistent outcomes based on nothing other than where a case was filed. In addition, the fact that the split is attributable to differing interpretations of a Supreme Court case precedent underscores the need for the Supreme Court to step in and sort out this circuit split.

 

Nevertheless, while I understand why the Supreme Court might take up this case, the Supreme Court’s recent fascination with securities law issues remains inexplicable to me. As I have said before, when the time comes for future academics to write the history of the Roberts Court, one of the things they will have to explain is why in beginning in the middle of the first decade of the 21st Century, the Supreme Court suddenly became so keen to take up securities cases. Until recemtly, years would pass between securities cases at the Supreme Court. Now there are one or two securities cases every term.

 

The Supreme Court just issued its opinion in the Amgen case a year ago. Last week, it issued its opinion in the Chadbourne & Parke case (about which refer here). On Wednesday, the Court will hear oral argument in the Halliburton case. And now the Court has agreed to take up the Omnicare case.

 

Indeed, the Omnicare case may take on heightened significance depending on how the Halliburton case turns out. Many commentators have suggested that even if the Supreme Court’s decision in the Halliburton case throws out the fraud on the market theory, plaintiffs will still be able to file securities class actions under Section 11, as the fraud on the market theory only applies to Section 10 misrepresentation cases.

 

If the lower pleading bar to Section 11 cases that the Sixth Circuit described in its Omnicare opinion is the standard to be applied the dismissal motion stage, Section 11 cases will indeed likely be an attractive alternative for prospective securities plaintiffs (or at least those that purchased their share in a securities offering). On the other hand, if the Supreme Court rules in the Onnicare case that the higher pleading bar described by the Second and Ninth Circuit applies, it will be more difficult for Section 11 complaints to survive the dismissal motion, and so Section 11 will be a less attractive alternative.

 

It is always hard to predict what the Supreme Court will do, even given the current Court lineup with a majority of Justices having a conservative inclination. Though the Supreme Court has often taken a business friendly and conservative approach to securities cases, it does not always do so – as may be seen for example in the Amgen case or the recent Chadbourn & Parke case. There is no way to know what the Court will do here.

 

The plaintiffs’ bar likely will criticize the position urged by Omnicare for in effect trying to import a scienter requirement into Section 11 claims. The defense bar has been sharply critical of the Sixth Circuit’s Omnicare opinion for overlooking the fact that as a matter of common sense a statement of opinion cannot be “false” unless the speaker truly did not hold the opinion. For a particularly good discussion of the defense perspective on the Sixth Circuit’s Omnicare decision and the issues it raises, please see Claire Loebs Davis’s August 12, 2013 post on the D&O Discourse blog (here) (the Omnicare Court’s misreading of the Virginia Bankshares decision “an abrupt wrong turn”).

 

Whatever the outcome, the Omnicare case will be important. The precedent in Second and Ninth Circuit’s holding that a Section 11 plaintiff must allege knowledge of falsity has been the basis of numerous dismissals in district courts in those circuits. If the Supreme Court were to hold that that a Section 11 plaintiffs does not need to plead knowledge of falsity, many cases in those jurisdictions that are now dismissed would survive. However, it remains to be seen which view of Section 11 pleading will prevail.

 

The Supreme Court will consider the Omnicare case in the court term beginning in October 2014.

buffOne of the most highly anticipated events in the annual business cycle is the March release of Warren Buffett’s letter to the shareholders of Berkshire Hathaway. Many investors and observers look forward to the letter for the business and investment insights that Berkshire’s Chairman provides, as well as for his plain-spoken style and homespun humor. This past Saturday morning, Berkshire released this year’s shareholder letter along with the company’s 2013 annual report. Though there is much in this year’s letter that will be familiar to long time Buffett fans, the letter contains a number of interesting new observations as well – about Berkshire, about the U.S. economy, and about investing. (Full disclosure: I own BRK B shares, although not as many as I wish I did.)

 

Much of the attention on Buffett’s letter and the Berkshire annual report will be on the company’s financial performance during 2013 – and rightfully so, as the company’s diverse operations performed well. As Buffett himself says in his shareholder letter, “just about everything turned out well for us last year – in certain cases very well.” Full-year profit rose 31 percent to $19.48 billion, or $11,850 per Class A share, while operating profit rose 20 percent to $15.14 billion, or $9,211 per share.

 

Notwithstanding these results, it would be a mistake just to focus on the company’s relative performance during a single 12-month reporting period. Obviously, it is inherent in the nature of annual reports that the company in question will be considered in an annual snapshot perspective. But if Berkshire is only considered on this annual reporting period basis, a much more meaningful message might be overlooked. Simply put, Berkshire Hathaway is an astonishing company, and it is becoming even more so all the time.

 

Let’s start with the company’s balance sheet. The company reported year end assets of $484.4 billion (representing an increase of about 12% from the end of 2012.). It is not just that the company now has assets of nearly a half a trillion dollars; the company’s assets have grown by an astounding 63% in the five year period ending in 2013. With the acquisition of a 50% interest in Heinz, the company now owns 8 ½ companies that if they were stand alone businesses would be in the Fortune 500.

 

The company ended the year with cash and cash equivalents of $42.6 billion, which at first glimpse might seem to be unchanged from $42.3 billion with which the company ended 2012. The thing is, the company ended 2013 with $42.6 billion in cash, even after spending almost $18 billion acquiring NV Energy and a 50% interest in Heinz; after spending $3 billion on what Buffett called “bolt-on” additions to existing businesses; after significantly increasing the company’s stock holdings in what Buffett called the company’s “big four” investments (Wells Fargo), American Express, IBM and Coca-Cola). After these and many other investments and expenditures, that the company ended the year with what might appear to be an unchanged cash position is remarkable.

 

The company’s  BNSF railroad operation (which is by far Berkshire’s largest acquisition ever) carries about 15% of all U.S. inter-city freight (whether transported by rail, truck, water air or pipeline) and is according to Buffett “the most important artery in our economy’s circulatory system.” The company now has 330,745 employees. On the one hand, that is not nearly as many employees as Wal-Mart has, on the other hand, Berkshire does now own 1.8% of Wal-Mart.

 

Buffett is himself famously self-effacing, but he feigns no modesty when he talks about his company. He refers to what he calls the company’s “supreme financial strength” – which, he adds, “we will always maintain.” He illustrates the importance of the company’s financial strength by examining what would happen if the insurance industry were to experience a $250 billion catastrophe loss, a loss that would be “triple anything it has ever experienced.” Were that to happen, Berkshire “as a whole would likely record a significant profit for the year because of its many streams of earnings,” while “all the other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency.” 

 

Berkshire’s promises, Buffett states, “have no equal,” a fact that has been “affirmed in recent years by the actions of some of the world’s largest and most sophisticated insurers,” who have sought to “cede” liabilities, particularly those involving asbestos claims. When insurers seek to shed themselves of long-lived liabilities, “almost without exception, the largest insurers seeking aid come to Berkshire.” To illustrate this point Buffett details the largest transaction of this type, the company’s 2007 transaction with Lloyd’s.

 

Another thing that is clear about Berkshire from this year’s report is how substantially its operations have changed and expanded. For many years, Berkshire was a sophisticated investment company operating in the guise of an insurance holding company. Berkshire’s insurance operations are massive. But the company is now much more diversified. It is now a manufacturing, utilities and industrial holding company as much as it is an insurance company. Indeed, just the company’s railroad, utilities and energy business produced almost as much revenue in 2013 ($32.7 billion) as the insurance operations ($36.6 billion in annual earned premium). BNSF alone produced more in net earnings ($3.79 billion) as the entire insurance operations produced in terms of underwriting gains, even though the insurance operations produced a remarkable $3.09 billion in underwriting profit – the eleventh consecutive year the insurance operations have produced an underwriting profit. (The insurance operations does also produce “float” which creates an opportunity to produce investment gains on top of underwriting profit, which has to potential – particularly for Buffett – to produce even greater overall profits over time.)

 

Among the more interesting features of this year’s letter is Buffett’s lavish praise of the U.S. economy. Buffett is clear that Berkshire’s prosperity derives from its opportunity to invest in the economy of the United States. After recalling that at the time of Berkshire’s acquisition of BNSF in 2009 – in the midst of “the gloom of the Great Recession” – he called the transaction an “all-in wager on the economic future of the United States,” Buffett said that he and the Berkshire co-Chair Charlie Munger “have always considered a ‘bet’ on ever-rising U.S. prosperity to be very close to a sure thing.” Buffett asks rhetorically, “who has ever benefitted during the past 237 years by betting against America?” Buffett says that “the dynamism embedded in our market economy will continue to work its magic.” Even more encouragingly, he adds, “America’s best days are ahead.”

 

Indeed, in a short discourse about investing (which was previously published as an excerpt on the Fortune magazine website), Buffett recommends that unsophisticated investors make regular investments over time in a low-cost S&P 500 index fund, in order to own a cross-section of  businesses. Even though some businesses might disappoint, as a group they are certain to do well, particularly over the long haul.  As Buffett asks, with respect to the possibility that financial turmoil might cause some investors to sell valuable assets as some investor did during the recent financial crisis, “Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?”

 

Buffett does, however, sound one cautionary note about the U.S. financial environment. Local and state governments face daunting financial challenges, largely because the various entities made pension promises they cannot afford. Buffett includes within Berkshire’s annual report a letter he wrote to the Washington Post’s Katherine Graham in 1975 about the pitfalls of pension promises. (“Rule number one regarding pension costs has to be to know what you are getting into before signing up.”) As Buffett puts it in the shareholder letter, “During the next decade, you will read a lot of news – bad news – about public pension plans.” He stresses “the necessity for prompt remedial action where problems exist.”

 

 

Berkshire naysayers may seize upon Berkshire’s “underperformance” according to Buffett’s own measure comparing the change in the company’s per share book value relative to the change in the value of the S&P 500. The S&P 500 has beaten Berkshire four out of the last five years according to this measure, and in 2013, because of the S&P 500’s strong performance, the stock index (which increased 32.4%) outperformed the Berkshire per share value change by a difference of 14.2 percentage points.

 

Buffett points out that “both Berkshire’s book value and intrinsic value will outperform the S&P in years when the market is down or moderately up,” adding that “we expect to fall short, though, in years when the market is strong – as we did in 2013.” Buffett adds that “we have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%.” (Indeed, in the four of the last five years when the S&P 500 outperformed, the index’s gain exceeded 15%).

 

Anyone who thinks Berkshire shareholders are getting shortchanged will want to examine what happened in the years where the S&P 500 underperformed Berkshire. In those years, Berkshire’s results far outperformed the S&P 500. In the financial crisis year of 2008 for example, both the S&P 500 and the per share value of Berkshire declined, but while Berkshire declined by 9.6 percent, the S&P 500 declined by 37%, meaning that Berkshire outperformed by a difference of 27.4 percentage points. In 2002, when the S&P 500 declined 22.1%, Berkshire’s per share value increased 10 percent, a difference of 32.1 percentage points.

 

The fact is, Berkshire will have a hard time matching in the future its compounded annual gain of 19.9% for the period 1965-2013. Indeed, during the period 1999-2013, the company exceeded the 19.9% compounded annual gain only twice (2003 and 2009) – and in both of those years, the company’s change in per share value underperformed the S&P. The company has reached a size where it will be very difficult to achieve significant annual increases in per share value or even for the change in per share value to outperform the S&P 500 — except in years where the S&P 500 declines in value. Just the same, because Berkshire’s per share value is unlikely to decline as much as the S&P 500 in down years, the company will still outperform over the long run – just not as dramatically as it did in the years between 1965 and 1999.

 

 

There are many other interesting details in Buffett’s letter. For example, the list of Berkshire’s fifteen common stock investments with the largest market value has changed slightly from 2012. Two companies have dropped off the list and two have been added. The two that dropped off the list are POSCO (market value at the end of 2012 of $1.2 billion) and ConocoPhillips ($1.399 billion). The companies that joined the list are ExxonMobil (market value at the end of 2013 of $4.1 billion) and Goldman Sachs ($2.3 billion). It is interesting to note in light of Berkshire’s ownership of General Re that among Berkshire’s top fifteen common stock investments is an 11.2 percent ownership share of Gen Re’s big European rival, Munich Re (market value $4.4 billion). It is also interesting that of the top fifteen common stock investments, only one carries a market valued below cost – Tesco, with a cost of $1.699 billion and a market value of $1.666 billion. Overall, Berkshire’s fifteen investment holdings have an aggregate cost of $56.5 billion and an aggregate market value of $117.5 billion.

 

Buffett also has some interesting comments in his letter about Gen Re, which still remains Berkshire’s second largest acquisition. He is full of praise for the reinsurance unit’s recent performance. However, he adds that “It can be remembered that soon after we purchased General Re, the company was beset by problems that caused commentators – and me as well, briefly – to believe I had made a huge mistake. That day is long gone. General Re is now a gem.” While flattering of the company now, this statement also conveys Buffett’s lingering ill feelings about the unit’s former management, who had to contend with the fallout from 9/11 and who then resigned amidst a variety of legal proceedings and investigations. I am sure my former colleagues at Gen Re are glad to receive Buffett’s current praise, but I suspect that his implicit rebuke of former management gives many of them a chill. Those of us who can remember will recall that there was a time when Buffett lavished praise on the now former-management as well.

 

As fascinating as both the shareholder letter is in many ways, it does have a certain repetitive quality. Once again, Buffett blasts the rest of the insurance marketplace for its lack of discipline, even repeating for the third year in a row his criticism of GEICO-competitor State Farm, which incurred an underwriting loss in nine out of the last twelve years through 2012 (the last year for which State Farm’s results are available). Like a talkative dinner guest, Buffett trots out the well-worn story about Rose Blumkin and the Nebraska Furniture Mart, and how as an immigrant she built up a very successful business. Not only that, but parts of his letter are nothing more than advertisements for Berkshire businesses. He not only announces the opening of a new Nebraska Furniture Mart store in Texas and broadcasts the formation of the new Berkshire Hathaway Specialty Insurance unit, but he even includes the phone number to obtain a GEICO insurance quote.

 

But while Buffett is sometimes repetitive and though his tone can sometimes edge toward hucksterism, he exhibits other traits that no other CEO displays. Buffett is brutally honest and self-critical about his 2007 decision to invest in Energy Future Holdings (a decision he admits he made without consulting his sidekick, Charlie Munger), which resulted in a $873 million before-tax loss. In the context of a company with revenues of over $180 billion and profits of $19.4 billion, there is no reason for Buffett to call attention to this one investment loss, even at $873 million. Many CEOs made dreadful mistakes in the run up to the financial crisis. How many other CEO’s would call themselves out on a misstep like this, where there was no need to do so?

 

Buffett’s track record is unparalleled and he has earned the high regard that he enjoys. But the question everyone will ask is – how much longer can he keep it up? Buffett does take pains in his shareholder letter to lavish praise on his two investment protégés, Todd Combs and Ted Wechsler, both of whom we are told not only outperformed Buffett in 2013, but outperformed the S&P as well. They each now run portfolios exceeding $7 billion. But are they ready to manage Berkshire’s entire investment portfolio and future investment strategy?  And even if they can manage the investments, who will run the company? The shareholder letter is full of the names of various Berkshire unit Presidents, many of whom may are highly successful. Just the same, the question of management succession at the top will only grow louder and more insistent. My household happens to include someone exactly Buffett’s age, and all I can say is that I sure hope Berkshire’s board is keeping a very, very close eye on Buffett.

 

For now, Buffett and his company remain virtually synonymous. But the day is coming when Berkshire shareholders will have to confront the reality of Berkshire without Buffett. When that day comes it will mean many changes — not the least for many of us, it will mean the end of the invaluable annual letter to shareholders. For now, then, let us celebrate the letters while Buffett is still producing them.  Buffett closes this year’s letter noting that next year’s letter will be the fiftieth and that he intends to use the letter to review the company’s prior 50 years and “to speculate a bit about the next 50.” That sure sounds like a perfect opportunity for a valedictory production to me.

 

 

043aNext Monday, March 3, 2014, the Hong Kong New Companies Ordinance will go into effect. The Hong Kong Legislative Council enacted this overhaul of the existing companies laws provisions in July 2012, and on October 25, 2013, the Secretary for Financial Services and the Treasury published the requisite notice to implement the upcoming March 3 effective date.

 

According to a January 24, 2014 Directorship article (here), the new statutory provisions “represent a major milestone in a comprehensive exercise to rewrite and modernize Hong Kong’s Companies Ordinance.”  The New Companies Ordinance introduces a number of changes, including new provisions codifying the duties and liabilities of directors of Hong Kong companies.  As discussed briefly below, these new provisions may have important D&O insurance implications.

 

The text of the New Companies Ordinance (NCO) can be found here. Part 10 of the New Companies Ordinance, which contains the new provisions regarding directors’ duties and liability, can be found here. A January 2014 PricewaterhouseCoopers summary of the changes in the NCO can be found here. A January 2014 summary from the Vistra firm of the NCO provisions pertaining to directors’ duties and liabilities can be found here.

 

With respect to the directors’ duties, in Section 465, the NCO codifies directors’ duties to exercise “reasonable care, skill and diligence.” The statutory provisions specify both objective and subjective standards for directors’ duties. A director is required to exercise the care, skill and diligence “that may reasonably expected of a person carrying out the functions carried out by the director in relation to the company,” as well “the general knowledge, skill and experience that the director has.”

 

As noted in the February 27, 2014 memo from the Meyer Brown JSM law firm (here), “directors are required to achieve at least the objective standard set out in Section 465 and the standard will be higher if they possess particular knowledge or skills.”  Section 465 provides that the remedies for breach of the duty are the same as at common law or equity – that is, compensation or damages. Because the directors’ duties are owed to the company, “any claim is likely to be brought by shareholders or liquidators by way of derivative claim.”

 

With respect to the potential liability of officers, the NCO introduces the concept of a “Responsible Person,” who is a director or officer of the company who “authorizes or permits, participates in, or fails to take all reasonable steps to prevent” the violation of the NCO. Because the NCO removes the “willful” misconduct threshold that applies under the current Companies Ordinance, the NCO lowers the threshold for the imposition of liability and potentially increases directors and officers liability exposure.

 

The NCO permits companies to indemnify directors for liabilities incurred to third parties, subject to specified conditions. However, as is the case under the existing Companies Ordinance, the NCO prohibits companies from indemnifying directors for liabilities to the company itself or an associated company, as well as “any liability incurred “in criminal proceedings.  

 

Significantly, Section 468 (4) NCO expressly provides that the NCO’s indemnifications provision “does not prevent a company from taking out and keeping in force insurance for a director … against any liability attaching to the director in connection with any negligence, default, breach of duty or breach of trust (except for fraud” in relation to the company or associated company” or “any liability incurred by the director in defending any proceedings.”

 

In light of the new codification of the directors duty of care, skill and diligence and the NCO’s “new formulation of “Responsible Persons,” directors will, according to the Meyer Brown JSM memo, face “a risk of increased exposure.”  Moreover, because the NCO prohibits indemnification under certain circumstances, “directors must therefore rely on the protection afforded by Side A of the D&O Insurance and should ensure that the cover extends to any breach of statutory provisions,” such as the NCO.

 

In addition, because the NCO permits indemnification of directors for liabilities to third parties, “companies should ensure that the reimbursement cover under Side B of the D&O insurance is sufficient to cover any reimbursement.” I know our Hong Kong colleagues are well aware that these changes have been coming but for the rest of us, it is important to know that these changes are about to take effect.

 

As for Hong Kong itself, it is a great place, as I noted in my Travel Post (here) about my visit to the city. I took the picture at the top of this post from Victoria Peak while I was there.

federal depositThe commercial banking industry is continuing its rebound from the subprime meltdown and the global financial crisis. According to the FDIC’s latest Quarterly Banking Profile for the period ending December 31, 2014 (here), the industry’s overall earnings continue to improve, largely as a result of reduced loan-loss provisions. However, operating revenue declined during 2013 compared to the prior year, as result of reduced mortgage activity and reduced trading revenue. The FDIC’s February 26, 2014 press release regarding the latest quarterly and year-end banking industry results can be found here.

 

Just as the industry overall continues to improve, the number of “problem institutions” continues to decline as well. (A “problem institution” is a bank that the FDIC ranks as a 4 or a 5 on its scale of financial stability. The agency does not release the names of the banks its regards as problem institutions.) In the fourth quarter of 2013, the number of problem institutions declined for the eleventh straight quarter, from 515 at the end of the third quarter 2013, to 467 at year end (representing a decline of 9.32%). 

 

While the number of problem institutions continues to decline, the problem institutions still represent about 6.86% of all reporting institutions. Moreover, as positive as the decline in the number of problem banks may be, it seems likely that the problem banks are not improving themselves out of the “problem” status – the likelier explanation for the declining number of problem institutions is that they are simply being absorbed by other more stable banks, or that they are simply failing. Along those lines, the FDIC reports that mergers absorbed 73 banks during the fourth quarter and 271 for the full year.  The 6,812 institutions remaining as of the end of the fourth quarter represents the smallest total number of U.S. banking institutions since the great depression (about which refer here).

 

Just the same, the number of problems institutions remaining is a far cry from the end of the first quarter of 2011, when there were 888 problem institutions. Not only has the number dropped by nearly  half since that time, but the 467 problem institutions remaining at the end of 2013 represents a decline of 184 from year-end 2012, a decline just in that one year of 28.26%.

 

24 institutions failed in 2012, which is the smallest number of annual bank failures since 2008, representing less than half of the 51 banks that failed in 2012, and far below the high water mark of 137 failed banks in 2010. Only two of the 2013 bank failures took place in the year’s fourth quarter, which is the smallest number of quarterly failures since the second quarter of 2008. However, it is worth noting that there have already been three bank failures so far during the first quarter of 2014.

 

In addition to releasing the latest Quarterly Banking Profile, the FDIC also recently updated the information on its website regarding its failed bank litigation activity. The latest update, as of February 24, 2014, shows that the FDIC has now filed 90 lawsuits against the former directors and officers of 89 failed banks. The agency has already filed six lawsuits during 2014, including five during January alone.

 

The likelihood is that the agency will continue to file additional lawsuits in the months ahead. The website discloses that it has authorized lawsuits connection with 135 failed institutions against 1,089 individuals for D&O liability. These figures are inclusive of the 90 D&O lawsuits the agency has filed naming 694 former directors and officers. The gap between the number of authorized and filed lawsuits suggests that there may be as many as 45 unfiled lawsuits in the pipeline, and since the number of authorized suits has increased every month for the last several years, the likelihood is that there may be even further lawsuits ahead, as well.

 

Parties Settle Long-Running Indy Mac D&O Insurance Coverage Dispute: According to a February 26, 2014 Law 360 article (here), the parties to the long-running Indy Mac D&O insurance coverage dispute have agreed to settle the case, just weeks before oral arguments in the Ninth Circuit were to take place in the case. As reflected in the parties’ February 21, 2014 Joint Notice of Settlements in Principle (here), the parties notified the court that they have “reached agreements in principle to resolve each of the Consolidated Appeals.”

 

As readers will recall, in June 2012, Central District of California Judge R. Gary Klausner said that the various claims that had been filed against the form directors and officers of the failed IndyMac bank  (including the claims filed by the FDIC in its capacity as received of the failed bank) were all interrelated with the first filed claim, and therefore triggered only one $80 million of D&O insurance, rather than two. The individuals and the FDIC appealed the ruling. For more about Judge Klausner’s ruling refer here.

 

In the meantime, the FDIC’s underlying lawsuits against the former IndyMac officers went forward.  As discussed here, in December 2012, the jury in the FDIC’s failed bank lawsuit  against three IndyMac officers returned a $168.8 million verdict against officers. Unfortunately, by that time, most if not all of the single $80 million tower of D&O insurance that Judge Klausner has said was the only one triggered was largely if not entirely exhausted. In other words, the FDIC’s jury verdict might not be all that valuable in the end unless the individuals and the FDIC could get Judge Klausner’s ruling overturned on appeal.  In addition to the individuals and the FDIC’ the bankruptcy trustee in IndyMac’s holding company’s bankruptcy also claimed entitled to a portion of the contested D&O insurance.

 

According to their Joint Notice of Settlements in Principle, the parties to the insurance dispute are now preparing settlement documents memorializing their agreement. In addition, the parties’ settlement agreement will require the approval of the bankruptcy court presiding over the bankruptcy of IndyMac’s holding company.  Unfortunately for curious people like me, neither the parties’ submission nor the Law 360 article discloses any of the details about the Court.  

 

If I had to guess, I would say that each of the carriers in the second tower agreed to contribute some portion of their total limit exposed. Given the magnitude of the jury verdict, I suspect that each participant in the tower contributed the same share toward to total settlement fund, although it is also possible that each successive layer contributed an increasingly smaller share toward the insurance fund. Of course, I have no idea what actually happened. I will say that this was probably a very complex, multisided negotiation.

 

As I impressed as I am that the parties were able to reach a negotiated resolution of this long-running dispute, I have to say that the inner insurance geek within me is a little disappointed.  It would have been interesting to see how the appellate court would address the interrelatedness issues at the center of the coverage dispute. I guess I will go have to read some policy forms or something like that to satisfy my insurance jones.

supct2014The state law fraud claims of certain victims of the Stanford Ponzi scheme against various law firms and brokerage firms are not precluded under the Securities Litigation Uniform Standards Act (“SLUSA”) and plaintiffs therefore may pursue their state law class actions against the defendants, according to a February 26, 2014 decision from the U.S. Supreme Court. The Court’s opinion in Chadbourne & Parke, LLC v. Troice can be found here.  

 

The Court rejected the defendants’ arguments that – even though the certificates of deposit the plaintiffs purchased from the Stanford International Bank were not “covered securities” under the statute – SLUSA nevertheless precluded the plaintiffs’ state court claims because the investors had been told the CD sales proceeds would be invested in securities of a type that would represent “covered securities”under SLUSA.

 

In an opinion written by Justice Stephen Breyer for a 7-2 majority (with Justices Kennedy and Alito dissenting), the Court held that SLUSA does not apply because “there is not the necessary ‘connection’ between the materiality of the misstatement and the statutorily required ‘purchase or sale of a covered security.’” The Court’s clarification of SLUSA’s scope could help eliminate confusion about SLUSA’s preclusive effects that has divided the lower courts. The Court’s ruling will permit at least some claimants to pursue state law claims that a broader reading of SLUSA would have precluded.

 

Background

 

Congress enacted SLUSA in 1998 in order to prevent erstwhile securities law claimants from circumventing the restrictions of the Private Securities Litigation Reform Act (PSLRA) by filing their claims in state court under state law. As the Supreme Court said in 2006 in the Dabit case, “To stem the shift from Federal to State courts and to prevent certain State private securities class action lawsuits alleging fraud from being used to frustrate the objectives of the [PSLRA], Congress enacted SLUSA.”

 

SLUSA precludes most state-law class actions involving a “misrepresentation” made “in connection with the purchase or sale of a covered security.” The lower courts have wrestled with the question of what it required in order to satisfy the “in connection with” requirement and trigger SLUSA preclusion.

 

In these cases arising out of the Stanford Ponzi scheme scandal, the investor plaintiffs contend they were misled to believe that the CDs in which they invested were backed by quality securities traded on major exchanges (though it later appeared that the CDs in fact had little or nothing behind them). The defendants – two law firms, an insurance brokerage firm and an investment firm — moved to dismiss the state law class actions that had been filed against them, arguing that, though CDs themselves were not “covered securities” within the meaning of SLUSA, the state court class action claims were nevertheless precluded under SLUSA because the plaintiffs claimed they were induced to purchase the securities by misrepresentation that the CDs were backed by SLUSA-covered securities.

 

The district court before which the cases were consolidated granted the defendants’ motions to dismiss and the plaintiffs appealed. In a March 19, 2012 opinion (here), a three-judge panel of the Fifth Circuit reversed the district court, specifically holding that the alleged purchases of covered securities that back the CDs were “only tangentially related to the fraudulent scheme” and therefore that SLUSA does not preclude the plaintiffs from using state class actions to pursue their claims.

 

The defendants filed a petition to the U.S. Supreme Court for a writ of certiorari. In its petition, the defendant Chadbourne & Parke law firm argued that split in authority among the various circuit courts has resulted in inconsistent interpretations and applications of SLUSA preclusion. The firm argued that the Fifth Circuit had adopted an interpretation of the “in connection with” standard that resulted in a determination that SLUSA preclusion did not apply, allowing the case against the firm to go forward, while at the same time rejected a conflicting standard prevailing in the Second, Sixth and Eleventh Circuits that would have resulted in the application of SLUSA preclusion here. The petitioners argued that the Circuit split not only threatened inconsistent outcomes among the Circuits, but it frustrated the very purposes for which Congress enacted SLUSA – that is to establish “national standards” for class actions “involving nationally traded securities.”

 

The Court’s Opinion      

 

In its opinion, the majority affirmed the Fifth Circuit and ruled that because “the plaintiffs do not allege that the defendants’ misrepresentations led anyone to buy or to sell (or to maintain positions in) covered securities,” SLUSA does not apply.

 

In reaching this conclusion, the Court emphasized that SLUSA’s focus is on transactions involving covered securities, not, as here, transactions in uncovered securities, noting that “an interpretation that insists upon a material connection with a transaction in a covered security is consistent with the Act’s basic focus.” The court added that the phrase “material fact in connection with the purchase or sale” “suggests a connection that matters. And for present purposes, a connection matters where the misrepresentation makes a significant difference to someone’s decision to purchase or to sell a covered security, not to purchase or sell an uncovered security, something about which the Act expresses no concern.”

 

The Court added that every securities case in which it had found a fraud to be “in connection with a purchase or sale of a security” has involved victims who made an investment decision involving “an ownership interest in the financial instruments that fall within the relevant definition.”

 

The Court also said that its interpretation of SLUSA’s “in connection with” language was consistent with the underlying regulatory statutes, the Securities Act of 1933 and the Securities Exchange Act of 1934. The Court said that both the language and purpose of these statutes “suggests a statutory focus upon transactions involving the statutorily relevant securities.” Nothing in the regulatory statutes “suggests their object is to protect persons whose connection with the statutorily defined securities is more remote than words such as ‘buy,’ ‘sell,’ and the like indicate.”

 

Justice Kennedy, in a dissenting opinion, argued that one of SLUSA’s purposes was to “protect those who advise, counsel or otherwise assist investors from abusive and multiplicitous class actions designed to extract settlements from defendants vulnerable to litigation costs.” The majority’s holding, Justice Kennedy said, “will subject many persons and entitles whose profession is to give advice, counsel, and assistance in investing in securities markets to complex and costly state-law litigation based on allegations of aiding and abetting or participating in transactions that are in fact regulated by the federal securities laws.”

 

In the majority opinion, Justice Breyer agreed that in passing the PSLRA and SLUSA “Congress sought to reduce frivolous suits and mitigate legal costs for firms and investment professionals that participate in the market for nationally traded securities, “ but he also said that “we fail to see how our decision today undermines that objective.” Justice Breyer added that “the only issuers, investment advisers, or accountants that today’s decision will continue to subject to state law jurisdiction are those who do not sell or participate in selling securities traded on U.S. national exchanges.”

 

On the other hand, Justice Breyer added, “to interpret the necessary statutory ‘connection’ more broadly than we do here would interfere with state efforts to provide remedies for victims of ordinary state-law fraud.”  The broader interpretation of SLUSA’s preclusive effect that the dissent urged would undermine these state-law goals: “Leaving aside whether this would work a significant expansion of the scope of liability under the federal securities laws, it unquestionably would limit the scope of protection under state laws that seek to provide remedies to victims of garden-variety fraud.”

 

Justice Breyer also rejected the dissent’s suggestion that the majority’s interpretation would inhibit the ability to governmental regulators to enforce the securities laws, noting that in connection with this very fraud, Allen Stanford had been successfully prosecuted criminally and had been held liable in a SEC enforcement action. The reach of underlying federal securities laws, unlike the SLUSA, are not restricted only to covered securities, and therefore the courts interpretation of the SLUSA’s “in connection with” requirement should not affect the regulators’ enforcement authority.

 

Discussion

 

The Court’s decision is of interest if for no other reason than that it arises in the context of the high profile Stanford Ponzi scheme scandal, and involves two prestigious national law firms and a prominent brokerage firm. These factors ensure that this decision will receive a great deal of attention, regardless of the significance of the actual decision itself.

 

There likely will be some concerns that the Court’s decision could open up third-party advisors to state law aiding and abetting claims of a kind for which the advisors could not be held liable under federal law. While this concern arguably is well-founded, it should be noted that this expansion will only apply in cases involving the purchase or sale of noncovered securities – that is, securities that are not traded on a national exchange. In cases involving the purchase or sale of securities that trade on national exchanges, SLUSA’s preclusive effect will still apply and accordingly the third-party advisors could not be subjected to state law fraud claims.

 

At a minimum, the Court’s ruling should resolve the split that has emerged among the lower courts in their interpretation of the “in connection with” requirement. The resolution of this split should reduce the possibility of inconsistent outcomes in different cases based on nothing more than the judicial circuit in which the different cases were filed.

 

The Court’s ruling should also help to define the scope of SLUSA preclusion in more complex cases where the alleged fraudulent scheme involves a multi-layered transaction. These kinds of questions have become unfortunately uncommon in recent times: for example, the same kinds of questions arose in connection with the Madoff feeder funds suits. (The Court in those cases concluded that SLUSA preclusion applies.)

 

The Court’s ruling in this case is in a very real sense just the latest skirmish in the ongoing battle that the plaintiffs’ securities bar has been waging since Congress enacted the PSLRA. The plaintiffs’ bar has been trying to find ways to circumvent the procedural hurdles that Congress imposed for securities cases in the PSLRA. The plaintiffs’ lawyers’ first move was to try to file their cases in state court, under state law, rather than in federal court, rather than under federal law. To try to eliminate this effort to sidestep the PSLRA, Congress enacted SLUSA. This case raised the question of whether SLUSA’s preclusive effect will apply in claims against remote actors and transactions that do not directly involve covered securities.

 

This round, at least, seems to have gone to the plaintiffs’ bar, but the relief from SLUSA’s preclusive effect that this decision represents is limited – it will only help when the underlying transaction does not involve a security traded on a national exchange. On the other hand, it does clarify that when securities trading on national exchanges are not involved, the plaintiffs are free to pursue state law fraud claims. This may be particularly significant in cases to which SLUSA preclusion does not apply and in which the defendants are third party advisors of the type involved here; these defendants cannot be held liable for aiding and abetting under the federal securities laws, but at least where the underlying transaction involves noncovered securities, the defendants can at least be subjected to state law claims including where available aiding and abetting claims.

 

As interesting as this decision may be, it is not the main event during this Supreme Court term for those interested in the Court’s interpretation of the federal securities laws. The main event of course is the pending Halliburton case, in which the Court will take up the question of whether or not to dump the fraud on the market theory. Because the Halliburton case is scheduled to be argued next week, it is interesting to see whether the Court said anything in this decision that might shed some light on how the Court will view the Halliburton case.

 

Although it would be easy to read too much into it, the voting pattern on this case is interesting. It is not surprising that Justice Breyer wrote an opinion, on which he was joined by the other liberal-leaning Justices, that is favorable to plaintiffs. It is also not surprising that Justices Kennedy and Alito dissented based on a more defense oriented approach. What is interesting is that Chief Justice Roberts joined the majority, as did Justices Scalia and Thomas. (Justice Thomas also wrote a short concurring opinion.)  Roberts, you will recall, also joined the liberal Justices in the majority opinion in the Court’s 2013 decision in Amgen. Are Roberts’ tendencies with the more liberal Justices on securities cases?

 

There is little in the majority opinion itself that might shed on light the issues raised in Halliburton. It is perhaps noteworthy that Justice Breyer made a point of agreeing in his opinion with the dissent’s assertion that in its enactment of the PSLRA and of SLUSA, Congress “sought to reduce frivolous sutis and mitigate legal costs” from “abusive class actions.” But while this would seem to aid Halliburton in its argument that class action lawsuits should be restrained, it may also arguably aid the plaintiffs, as they can say that notwithstanding those purposes and all of the reforms that Congress has worked on the securities laws and on the securities litigation process, Congress chose not to address the “fraud on the market” theory.

 

In any event, as interesting as this case is, attention will quickly shift to next week’s oral argument in the Halliburton case. All part of the inexplicable fascination that the Court has had in recent years with taking up cases involving the federal securities laws.

 

litfundingOne of the most interesting and noteworthy litigation developments recently has been the rise of litigation finance in the United States. The nascent litigation finance industry has attracted a number of new entrants, and many of the latest entrants are attempting to establish their own particular niche. In the guest post below, my good friend Ommid Farashahi of the Bates Carey firm interviews Adam Gerchen of Gerchen Keller Capital, one of the latest entrants in developing litigation finance industry.

 

I would like to thank Ommid for submitting his guest post. I welcome guest posts submissions from responsible authors on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post.

 

Here is Ommid’s guest post and interview of Adam Gerchen: 

 

Litigation finance has garnered a lot of attention recently.  When a friend of mine, Adam Gerchen, told me last winter that he was launching his own investment firm focused on commercial litigation, Gerchen Keller Capital (“GKC”), I was intrigued.  When he told me about their approach to the space, including financing litigation on the defense–side, I was even more interested.  How could funding for defendants possibly work?  Well, so far it all has seemed to work for GKC, which recently completed a $250 million capital raise – its second in less than a year – bringing the firm’s total assets under management to more than $300 million.

 

I sat down with Adam recently to discuss the firm and the industry more broadly, as well as to provide the readers of The D&O Diary Adam’s thoughts on the interplay between litigation finance and insurance. 

 

What first attracted you to litigation finance?

 

The founding team, in their various roles at law firms, corporations, and investment funds, observed first-hand the internal constraints placed on legal budgets, and the need more broadly for financing solutions addressing litigation costs.  Law firms continue to face a shifting financial landscape and client demand for alternative fee arrangements.  And companies both big and small have little ability to tap the inherent value of claims or to finance their legal spend with corporate finance products.  That market demand provides an opportunity for us to deliver solutions for our clients while achieving attractive returns for our investors.  

 

Besides offering products on the defense-side, how does GKC differentiate itself from other players in the space?

 

We wanted to separate ourselves in the industry in part by focusing on what we don’t do.  By focusing solely on commercial litigation, and eschewing, on the plaintiff’s side at least, product liability claims, mass torts, securities litigation, and consumer class and mass actions, we felt GKC could attract a different breed of client, a quality of counsel and size of organization that historically never explored litigation finance.  Our concentration on litigation with sophisticated parties has also been an important differentiator for the investors in our various funds as well.    

 

Why would large organizations with potentially sizable cash positions find third-party financing attractive? 

 

Regardless of the financial strength of a company, internal legal budgets are normally tight and are established to fight wars of necessity, not choice.  One of our partners, Travis Lenkner, witnessed firsthand the limitations of litigation spend even at a Fortune 100 company.  The reality is, universally, whether from the C-suite or public shareholders, GCs face continual pressure to push their law firms to structure alternative fee arrangements.  We are one of the tools that help address those forces.

 

Can you walk the readers through how a typical litigation finance transaction works?

 

There is no typical transaction, in that the specific needs and goals of our client and the risk profile of the case drive our pricing, structure, and ultimate investment.  But in general, we provide limited-recourse capital to companies or law firms and receive a return on our investment only when the underlying litigation is resolved successfully.  For instance, we can offer a line of credit up to $5 million that is drawn as expenses arise during a legal proceeding with our investment return consisting of a percentage of the ultimate outcome of a case.    The difficulty on the defense side is defining “success” ex ante.  The basic construct of those investments involve classifying “success” at various stages of the litigation process (e.g., a $15 million settlement before summary judgment) and sharing the delta when outcomes are better than those predetermined levels.  In the interim, GKC pays all costs of defense and only achieves an investment return if one of those “successful” outcomes is attained. 

 

What type of clients has expressed an interest in your defense-side products?

 

The most interested parties have been repeat defendants that continually face ongoing legal spend in similar types of cases (e.g., product liability defendants, securities class actions, etc.).  We have even explored with one Fortune 500 company taking over an entire portfolio of a specific class of claims, moving off of their income statement a sizable annual spend.  The ideal candidate for financing on the defense side is not a first time litigant who believes anything besides dismissal with prejudice is a negative outcome.

 

What are the biggest concerns law firms and companies have expressed to you about litigation finance?

 

Most often, our potential counterparties want to confirm that we are not financing plaintiffs in the sorts of cases that produce outsized awards for trial lawyers but are unrelated to actual business disputes—massive class actions, tort suits, and the like.  We also start each conversation by explaining the legal and ethical considerations surrounding litigation finance.  Because we deal exclusively with sophisticated companies and law firms, and never with consumers, many of the stereotypes about “litigation funders” simply do not apply, and any lingering issues are easily satisfied.  Even so, we have spent a tremendous amount of time and resources fleshing out these points and addressing them in the most comprehensive manner.  We feel confident, as do the companies and law firms with which we have partnered, that we are adhering to the highest ethical standards in the industry.  Recent court decisions about issues related to litigation funding — including a federal court case here in Chicago upholding the confidentiality of documents shared with a third-party funder — have vindicated our careful approach.

 

How should the insurance sector view litigation finance firms?  Friend or Foe?

 

We serve the same clients as insurance carriers and we are all focused on evaluating risk and allowing companies to offset that risk when it serves their needs.  As is true of the top insurance carriers, our clients include Fortune 500 companies and some of the leading law firms in the world. While not always in a D&O or E&O context, litigation finance is becoming mainstream and an important tool for these businesses, and we think overall the space should be viewed positively by the marketplace for bringing efficiency and financing tools that meet market demand.  On the defense side, we believe our involvement incentives all parties to resolve litigation in an efficient and timely manner.  From an insurance carrier perspective, resolution in this manner can only be viewed positively.  We also believe that per the earlier response, repeat defendants whom understand the risks and costs of litigation are the ideal candidates to explore our defense products.  Insurance providers, especially in a casualty context, might find our products quite attractive.

 

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Adam, than you very much for your time, insights, and candor.  Something tells me that we will be talking again about all of these topics again soon.   

scalesofjusticeSince the early stages of the financial crisis, nearly 500 banks have failed across the U.S., and even though we are now well past the peak of the financial crisis, banks continue to fail. Yet during the same time as scores of banks were failing, many more banks did not fail – which raises the question of why some banks failed while others did not.

 

Among the many questions asked after a bank fails is whether the failed bank’s directors and officers violated legal duties they owed to their institution and brought about the institution’s failure. Even the FDIC recognizes that merely because a particular bank failed does not mean that a failed bank’s directors and officers can be held liable. The agency has asserted claims against the former directors and officers of only some of the banks that have failed.

 

According to the recent Cornerstone Research report about the FDIC failed bank litigation (here), the FDIC has so far filed lawsuits in connection with about 17% of bank failures. However, because of the approximately three year lag that typically follow between the time a bank fails and any lawsuit, the agency has not (yet) filed litigation in connection with the more recent bank failures. Most of the failed bank litigation to date has involved institutions that failed in 2010 or prior. Thus, for example, the FDIC has filed lawsuits or asserted claims in connection with 46% of the banks that failed in 2009, and 34% of the banks that failed in 2010.

 

But merely because the agency chooses to sue the former directors and officers of only some failed banks but not others does not establish that the individuals the FDIC has chosen to sue violated their legal duties. Holding these individuals liable requires affirmative evidence that they breached their duties.

 

As Christopher Laursen of NERA Economic Consulting discusses in his February 18, 2014 paper entitled “Failed Bank D&O Litigation, Trends and Economics” (here), “it is not sufficient to merely demonstrate – with the benefit of hindsight – that D&O made decisions that ultimately led to losses.” That is, directors and officers were not negligent – much less grossly negligent – merely because their decision-making failed to anticipate unanticipated outcomes.

 

The fact is that “even the most well-informed individuals and institutions failed to anticipate the massive deterioration that occurred across financial markets.” Indeed, it is clear from Congressional testimony and other sources that the banking regulators themselves “did not expect the severity and direction of the financial crisis.” Given this backdrop, “it is not surprising that bank D&O often made decisions based on information available at the time, which did not lead to expected results.”

 

In order to address the question of whether or not failed banks’ directors and officers breached their duties, it is worth looking at why some banks failed while others did not. According to Laurson, the bank failures over the last several years fell roughly into two distinct waves. The first wave of failures, in 2008 and 2009, generally involved larger banks and resulted from losses in assets related to residential real estate. The second wave, roughly from 2010 to the present, has been centered on smaller community banks that specialized in construction and development and commercial real estate lending.

 

Laursen’s detailed analysis shows that larger banks that failed were more concentrated in residential real-estate loans and mortgage-backed securities than surviving banks of similar size. By the same token, compared to banks that survived, medium and smaller banks that failed had at least a two-fold concentration in construction and development loans.

 

These data, while suggesting a pattern, are not sufficient to tell a story. In order to understand what happened at any specific bank (and in particular to determine whether or not the bank’s directors and officers breached any duties), it is critical to compare the failed bank to an appropriate peer group of banks. If the surviving banks in the peer group used similar underwriting standards and strategies as did the banks that failed, then “the performance gap may not be attributable to D&O conduct.” The difference in performance “may merely be a product of unforeseen worse conditions and outcomes.”

 

What the FDIC has sought in the many lawsuits it has filed to characterize as negligent misconduct may be “largely based on poor guidance from regulators and unexpected deterioration in economic and financial conditions.” 

 

In order for the individual defendants in the failed bank lawsuits to defend themselves against the allegations of wrongdoing, it is necessary in light of “the unanticipated and unprecedented nature of the financial crisis” to “distinguish the effects of underwriting practices from the effects of deteriorating markets.” If the bank’s failure is attributable only to the unforeseen conditions and outcomes rather than individual misconduct, then the individuals should not be held liable.

 

The need for expert testimony to support these arguments is the point and purpose of Laursen’s paper. In addition, however, the report contains extensive useful and interesting information about the factors surrounding the banks’ failures and the environment that contributed to the banks’ failures. He certainly has a valid point that merely because a bank failed does not establish that the bank’s directors and officers violated their duties, and that if a bank’s closure was merely the result of unanticipated outcomes rather than director and officer misconduct, then the directors and officers should not be held liable.

 

So, You’re Saying You Wouldn’t Have Paid $19 Billion for WhatsApp?: In case you missed it, on February 24, 2014, Fortune published onlilne an excerpt from Warren Buffett’s forthcoming annual letter to Berkshire shareholders (here). In the excerpt, Buffett uses two real estate investments he made as examples of his investment philosophy. Essentially, he will only make an investment if the prospective investment can be expected to produce an income stream over the next five years sufficient to make the purchase price make sense. Buffett’s advice for investors who aren’t sure they can make this calculation should invest in a low cost index fund, like the Vanguard S&P fund. Buffett’s reasons for suggesting an S&P fund are quite reassuring; he has a great deal of confidence in the future of the American economy.

 

bluegoldglobeMore companies – both inside the U.S. and globally – are experiencing economic crimes, and as companies expand their international operations and their reliance on the Internet and mobile technologies, economic crime increasingly has become a “borderless threat,” according to PricewaterhouseCoopers’ recent survey of global companies. The survey report, entitled “Global Economic Crime Survey 2014,” details companies’ changing costs from and perceptions of economic crime, particularly cybercrime. The U.S. Supplement to the PwC survey report can be found here, and the key U.S. supplement highlights can be found here. PwC’s February 19, 2014 press release regarding the survey report can be found here.

 

During the period August to October 2013, 5,128 respondents in 95 countries completed the survey. There were 115 U.S. respondents, over half of whom were from publicly traded companies, and over three-quarters of whom were from organizations with more than 1,000 employees. The term “economic crime” as used in the survey and in the survey report encompasses thirteen specific types of fraud, including: espionage; competition law/antitrust law; illegal insider trading; tax fraud; mortgage fraud; IP infringement/theft of data; money laundering; human resource; accounting fraud; cybercrime; bribery ad corruption; procurement fraud; and asset misappropriation.

 

The U.S. survey respondents reported a “larger global footprint” than respondents outside of the U.S.; 80% of U.S. respondents reported worldwide operations, compared to 61% globally. U.S companies are also likelier than their global counterparts to pursue opportunities in markets with “high levels of corruption risk.” In addition to growing their international operations, U.S. companies are expanding the role of the Internet and mobile technology in their operations, which can bring risk from beyond their immediate geographic footprint. U.S. companies increasingly are operating in a “borderless” economy in which they “may not need to have a brick-and-mortar operation in a country to have a presence and a possible risk.”  In addition, reliance on agents and other third-parties in other countries may expose U.S. companies to increased economic crime risks, including corruption, cybercrime and economic sanctions.

 

Perhaps as a result, the percentage of U.S. companies reporting that they had suffered an economic crime in the past two years (45%) was greater than the global average (37%). In addition, U.S. companies reported that they had experienced increased levels of fraud across all types of crime since PwC’s last survey in 2011, except asset misappropriation and insider trading. However, asset misappropriation still remains the most common fraud that U.S. organizations suffered.  At the same time, U.S. companies reported increased levels of accounting fraud and of bribery and corruption. The report speculates that the increased reports of accounting fraud and of bribery and corruption “may be attributable in part to more companies implementing internal controls, more robust compliance programs and increased risk assessments, leading to more frauds being detected.”

 

The one the thing that is clear is that economic crime hurts companies’ bottom lines. Of the U.S. survey respondents that reported economic crimes in the last two years, 54% reported that their companies had experienced fraud losses in excess of $500,000, with 8% reporting fraud losses in excess of $5 million. The risks associated with these kinds of costs obviously provide substantial incentive for companies to implement fraud prevention and detection measures. The report points out that the indirect costs associated with fraud, such as damage to company brand, reputation and employee morale, provide even further incentives, as does the policies of the SEC and the DoJ, which recognize the existence of compliance programs as a mitigating factor in setting penalties for legal violations.

 

The survey’s findings regarding cybercrime are particularly interesting. Of the U.S. respondents reporting that they had suffered an economic crime in the last two years, 44% identified cybercrime as one of the frauds experienced, while 44% of all U.S. respondents “indicated that they thought it was likely they would suffer a cybercrime within the next 24 months.” 71% of U.S. respondents indicated that their perception of cybercrime had increased over the past two years, compared to 48% of global respondents.

 

Compared to their global counterparts, U.S. companies lost more in financial terms from cybercrime than their global counterparts. 7% of U.S. respondents lost $1 or more from cybercrime, compared to 3% of global organizations. 19% of U.S. organizations lost $50,000 to $1 million, compared to 8% of global respondents.

 

The report also has a number of interesting observations about bribery and corruption activities. The report states that of the U.S. respondents reporting that they had experienced an economic crime in the past two years, 14% had identified bribery and corruption of the type of fraud suffered, up from 7% in PwC’s 2011 survey. 17% of both U.S. and global respondents reported that their organizations had been asked to pay a bribe within the last 24 months. 15% of U.S. respondents reported that their organizations lost an opportunity to a competitor whom they believed had paid a bribe, compared to 22% of global respondents.  4% of U.S. respondents and 5% of global respondents reported financial losses of $1 million or more through bribery and corruption. 28% of U.S. organizations and 27% of global organizations reported financial losses of $50,000 to $1 million.

 

Perhaps as a result of their actual experiences over the last two years, U.S. companies think it is more likely now than they did in 2011 they will experience losses from fraud across all categories of economic crime in the next two years.  The report itself states that “the interplay among enhanced global regulatory scrutiny, more skilled and technologically sophisticated fraudsters, and the emergence of an increasingly borderless business environment presents ongoing challenges to organizations as they combat fraud during the economic recovery period.”

 

Consistent with its overall message that both the risk of fraud and that companies’ perceptions of the risks of fraud are increasing, the report has extensive information about the steps companies can take to try to combat fraud.  The report concludes that companies increased awareness of the risks of fraud likely “will prompt organizations to make the up-front investment in fraud prevention and detection methods, which continuously prove less costly than implementing damage control measures after the fact.”

 

It is not a point of emphasis in the PwC survey report, but investors, regulators and other constituencies increasingly are seeking to hold company management liable when their companies suffer economic crimes. In the U.S., we have long seen follow-on lawsuits after companies disclose the existence of bribery investigations. As I noted at year-end, these kinds of follow-on lawsuits are becoming increasingly frequent in connection with the disclosure of other types of regulatory investigations as well. And as recently seen in connection with the Target cyber breach, investors and others are seeking to hold company management accountable for cybercrime as well. In each of these types of examples, claimants have sought to hold company officials liable for failing to take steps to protect their companies from these kinds of incidents.

 

The point here is that among the many risks associated with increased levels of economic crime is the risk of increasing director and officer liability exposure. It seems increasingly likely that claimants will seek to hold company management liable for the alleged failure to take steps to protect their companies from the occurrence of these kinds of economic crimes. The most important thing for company management to do is to focus on the kinds of preventive measure and detection practices outlined at length in the PwC survey report. However, in addition, company management will want to review their D&O insurance program to try to ensure that their insurance program is sufficient to protect them in the event claimants later contend that they did not do enough to protect their companies from economic crime.

 

The Time of My Life: On Saturday, as I was at the grocery store cash register, the cashier asked my date of birth. I told her the date in 1956 when I was born, and then for some reason it suddenly occurred to me that I have been alive for a longer period (58 years, as of my next birthday) than the length of the period between 1900 and 1956. The startling thing about this observation is to think how much happened between 1900 and 1956, and then to reflect that I have been alive for even longer than that.

 

Think about it. The period between 1900 and 1956 included the discovery of man-powered flight; the development of the mass produced automobile; the invention of radio and of television, as well as the invention of the computer and the transistor; the discovery of penicillin; two World Wars; the Great Depression; the development of the atomic bomb and rocket technology.

 

How do the changes of the last 58 years compare? Since 1956, we have had the advent of unmanned and manned space flight; the sequencing of the human genome; the development of the personal computer and of the cell phone, as well as the invention  and proliferation of the Internet; we have had the elimination of legal racial segregation; the invention of laser guided missiles and unmanned drones: the construction of Interstate highway system; the fall of the Berlin Wall and the collapse of the Soviet Union; and the introduction of e-mail, voice mail, digital photography, instant messaging, social networking, spreadsheets, GPS…

 

On Saturday evening, as my wife and I enjoyed the bottle of wine in connection with the purchase of which the cashier had originally asked for my date of birth, we debated the question of which of the two periods was more eventful. My mother in law, who lives with us and who is the self-appointed Final Authority on every topic, declared that the more recent period was more eventful, because of the computer. I am skeptical; so many of the developments in the more recent period are the consequences or result of developments or events in the first period. Even the computer itself was first invented during the earlier period.

 

What do you think? (Other than that I am getting old and that it probably would do me some good to get out more, at least on Saturday night.)