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.

 

********

 

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.)

cfThere were ten securities class action lawsuits filed in Canada in 2013, the same number as were filed in 2012 and only slightly below the annual average number of 11. 6 filings during the period 2006-2012, according to a February 19, 2014 report from NERA Economic Consulting entitled “Trends in Canadian Securities Class Actions: 2013 Update” (here). NERA’s February 20, 2014 press release about the report can be found here.

 

Of the ten Canadian securities class action lawsuits filed in 2013, eight were filed in Ontario. Two of the eight Ontario suits also had parallel cases filed in other provinces.  Of the two cases that were not filed in Ontario, one as filed in Alberta and one was filed in Quebec.

 

Five of the ten companies that were sued in Canada in 2013 also had securities class action lawsuits filed against them in the United States. There were four additional Canadian companies that were sued in securities class action lawsuits in the U.S. that have not (yet) been sued in Canada.

 

Eight of the companies named in Canadian securities class action lawsuits in 2013 are listed on the Toronto Stock Exchange (TSX). During the period 2008-2013, 48 TSX companies have been sued in Canadian securities class action lawsuits, representing about 3% of the average number of companies listed during that period, implying an annual average litigation risk of about 0.5%.

 

At year end 2013, there were a total of 54 pending securities class action lawsuits in Canada, nearly double the number four years ago.  At year end there were also 20 cases pending against Canadian companies in U.S. courts. Of the 111 securities class action lawsuits filed in Canada between 1997 and 2013, half have been filed just in the last five years. This recent increase in filing is due in significant part to the enactment at the end of 2005 of the Bill 198 secondary market civil liability provisions. Obviously, the global financial crisis was a significant contributing factor as well.

 

The industry sectors with the largest number of filings in 2013 were mining, oil and gas, and non-energy minerals, which together accounted for 40% of the 2013 filings. On the other hand, the finance industry, which in the past has accounted for a large number of Canadian securities class action lawsuit filings, only accounted for one of the twenty filings in the last two years.

 

Six Canadian securities class actions settled in 2013, for a total aggregate settlement amount of $52 million. The average settlement was $8.6 million and the median was $9.9 million. Of the 44 Canadian securities class action settlements during the period 1997-2013 for which NERA has records, the median settlement was $12.7 million. Due to the effect of the outsized Nortel Networks settlement, the average settlement during that period was $89.5 million

 

Discussion

 

Canada is one of the few countries outside of the U.S. where securities class action litigation has become well-established. To be sure, the litigation rates remain well below those of the U.S. For example, while the implied annual securities class action frequency for TSX companies is about 0.5%, the annual frequency rate for U.S.-listed companies in 2013 was 3.3% (refer here, Figure 12). The risk of securities class action litigation remains much greater for U.S. listed companies than for companies listed on the TSX.

 

But though Canadian litigation levels remain well below the levels in the U.S., it is clear that class action litigation is becoming established in Canada. Indeed, as the NERA report emphasized, a Canadian litigation funding industry has grown up to help finance this litigation, and this type of funding increasingly is gaining judicial acceptance.

 

In addition, as the pending cases work their way through the system, a number of threshold issues (such as statue of limitations issues and the standard for leave to proceed) are getting sorted out. As these issues are resolved, Canadian securities litigation will mature and become an even more developed phenomenon.

 

The development of Canadian securities class action litigation raises an interesting possibility, in light of pending developments in the United States. The Halliburton case now pending before the U.S. Supreme Court (about which refer here) could significantly alter securities class action litigation in the U.S. If the U.S. Supreme Court were to throw out the fraud on the market theory and make class action litigation impossible in Section 10 misrepresentation cases, the plaintiffs’ attorneys will be forced to find other ways to pursue investors’ claims.

 

To the extent Canadian jurisdiction can be established, disappointed investors might well seek out class remedies available in Canada, particularly since under Bill 198, investor claimants do not have to show that they relied on alleged misrepresentations. The loser pays regime and other aspects of litigating under Bill 198 may present impediments, but if the ability to bring Section 10 misrepresentation cases is eliminated in the U.S., the Canadian alternative may represent a more attractive alternative, at least in cases where jurisdiction can be established.

 

nystateIn an unusual development in a closely watched case, K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co., the New York Court of Appeals has reversed its own June 2013 ruling in the case in which it held that a legal malpractice insurer that breached its duty to defend is barred from relying on policy exclusions to avoid paying a judgment against its insured.

 

In a February 18, 2014 opinion (here), the Court of Appeals held that its earlier ruling in the case “cannot be reconciled” with its own prior case precedent, and therefore the Court vacated its earlier ruling in the K2 Investment Group case.  Under the Court’s prior precedent, which as now been revalidated, insurers that have breached the duty to defend are not precluded from relying on other policy exclusions in defending against a suit for indemnification.

 

The revised ruling in the K2 Investment Group case eliminates a holding that had created confusion in the lower courts and left carriers uncertain how to proceed. A February 18, 2014 memo from Kaufman Dolowich Voluck law firm  about the Court of Appeals reversal of its earlier ruling in the K2 Investment Group case can be found here. A February 19, 2014 memo from the Tressler law firm about the case can be found here.

 

The coverage dispute arises from legal malpractice claims that had been filed against Jeffrey Daniels, who was insured under a professional liability policy issued by American Guaranty & Liability Insurance. The insurer denied that it had a duty to defend Daniels. Daniels defaulted on the underlying claim, resulting in the entry of a default judgment against him. The claimant in the underlying claim then sought to enforce the judgment against the insurer. The insurer asserted that the loss was not covered, relying on two exclusions which it contended precluded coverage. Litigation ensured and the coverage dispute ultimately made its way to the New York Court of Appeals.

 

As discussed here, in June 2013, the New York Court of Appeals held that having breached its duty to defend, the insurer could not rely on other grounds to contest the duty to indemnify. The Court said that “an insurance company that has disclaimed its duty to defend may litigate only the validity of its disclaimer.” If, the Court said, “the disclaimer is found bad, the insurance company must indemnify the resulting judgment even if policy exclusions would otherwise have negated the duty to indemnify.”

 

As Joe Monteleone noted on his D&O E&O Monitor Blog (here), the June 2013 decision created confusion in the courts – owing the decision’s apparent conflict with existing New York case law — and left insurers uncertain how to proceed. As discussed in the Kaufman Dolowich memo linked above, the decision also emboldened some policyholders to argue that a breach of the duty to defend stripped an insurer of all rights under the Policy.

 

Arguing that the June 2013 opinion failed to address existing New York Court of Appeals precedent, the insurer filed a motion for re-argument. Several amici joined the request. The Court agreed to re-hear the case, which was re-argued in January 2014.

 

In a February 14, 2014 majority opinion written by Judge Robert Smith (who had written the initial opinion in the case in June 2013), the Court held that the earlier opinion in the case “cannot be reconciled” with the Court’s 1985 opinion in the Servidone case, which held that the breach of the duty to defend “does not create coverage” and thus does not prohibit an insurer from relying on applicable policy exclusions. The Court concluded that there was no reason to overrule the Servidone case. Recognizing principles of stare decisis, he Court said that

 

When our court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or until the legislature decides otherwise. In other words, the rule of stare decisis, while it is not inexorable, is strong enough to govern this case.

 

The Court’s June 2013 opinion in the K2 Investment Group case had been highly criticized by insurer advocates for breaking from existing precedent. For example, in a June 13, 2013 post on its Insurance Law Blog (here), the Traub Lieberman firm said that the Court of Appeals June 2013 opinion in this case “announced a new rule” and that previously “New York courts at both the state and the federal level consistently rejected the notion that by having breached a duty to defend, an insurer is estopped from relying on coverage defenses for purposes of contesting an indemnity obligation.” The June 2013 decision, the law firm memo says, “departs from this long-established jurisprudence.” 

 

The Court of Appeals February 2014, then, eliminates this apparent departure from the established jurisprudence. As the Tressler law firm put it in the memo linked above, if the Court had not overturned its earliler decision, insurers “would have been stuck with a very unsettled landscape on insurance law in New York.”

 

While the Court of Appeals decisions eliminates a ruling that insurers had found objectionable, it nevertheless continues to be a good idea for carriers to file a declaratory judgment action when taking the position that they have no duty to defend. The Court of Appeals quoted an earlier case stating that insurers are “well advised” to file a declaratory judgment action in those circumstances, which, the Court noted, “continues to be sound advice.”

 

rbsIn a reminder that litigation from the credit crisis is still kicking around and that there are still some significant credit crisis cases that are yet to be resolved, Royal Bank of Scotland has agreed to settle the  Harborview Mortgage-Backed Securities litigation for a payment of $275 million dollars. The settlement is subject to documentation and court approval.   A copy of plaintiffs’ counsel’s February 19, 2014 press release about the settlement can be found here. The parties’ February 14, 2014 letter to the court regarding the settlement can be found here.

 

As discussed in greater detail here, this securities class action lawsuit had been brought in 2008 by institutional investors that purchased certain mortgage backed securities in one of 14 public offerings during 2006 and 2007 of the “Harborview” series of mortgage backed securities, of which a unit of RBS was the primary issuer and underwriter.

 

As discussed here (scroll down), in March 2010, Judge Harold Baer, Jr. granted in part and denied in part the defendants’ motion to dismiss. Judge Baer denied defendants motions to dismiss related to “misstatements and nondisclosure of mortgage originators’ ‘disregard’ for loan underwriting standards.”

 

The loan originators in question included certain mortgage lenders whose names “are now synonymous with sub-prime lending and the housing market collapse,” including Countrywide, American Home Mortgage Corporation, IndyMac, BankUnited, and Downey Savings. Judge Baer concluded that “plaintiffs have pled sufficient factual allegations to plausibly infer that the underwriting guidelines were disregarded by mortgage originators, and in conflict with the disclosures made in the Offering Documents.” Judge Baer found the plaintiffs had alleged that the originators “systematically ignored their stated underwriting practices” and that “plaintiffs have also sufficiently, albeit just barely, connected these allegations to the offerings in question.”

 

In subsequent litigation, the parties disputed which investors had standing to purchase these claims, and Judge Baer entered several order addressing the definition of the class.

 

According to the plaintiffs’ press release, the $275 million settlement, if approved, would be the third-largest MBS securities class action lawsuit settlement. For those curious about the two larger MBS settlements, as discussed here, the Countrywide MBS securities lawsuit settled in April 2013 for $500 million, and the Merrill Lynch MBS securities lawsuit settled in 2011 for $315 million (refer here).

 

Neither the press release nor the parties’ letter to the court states how the settlement is to be funded or if any portion of the settlement will be funded by insurance. According to Nate Raymond’s February 19, 2014 Reuters article about the settlement (here), last month RBS announced that it had set aside 3.1 billion pounds(about US $5.2 billion) to cover legal claims against it, including 1.9 billion pounds to resolve claims primarily related to mortgage-backed securities. 

 

cadaAs if it were not bad enough that hackers are attacking retail businesses like Target and Neiman Marcus to obtain consumer credit card information, it turns out that the bad guys are also targeting health-care records. According to sources cited in a February 18, 2014 Wall Street Journal report entitled “Nursing Homes Are Exposed to Hacker Attacks” (here), investigators have uncovered a Internet file-sharing site where hackers have posted critical health-care organization network systems information that could allow others to access electronic medical records and payment information from health-care providers.

 

According to sources cited in the Journal article, the networks of about 375 U.S-based health related institutions, including hospitals, physicians’ offices, pharmaceutical companies, and health-plan managers were compromised by hackers in September and October 2013. Some of the information accessed by these intrusions has wound up on a file-sharing site, where hackers dump data. The information on the site details the type of equipment used in computer networks, the internal addresses for computers and other devices, and the passwords to network firewalls run by health-care providers.

 

Information available on the file-sharing cite drawn from three specific nursing homes identified in the article apparently was obtained by access to the software of a specific medical software vendor that the three institutions used. The article also states that health-care organizations increasingly are having trouble protecting data because medical equipment such as dialysis and imaging machines can be accessed through the Internet. (The machines are attached to the Internet so that the machines’ software can be administered or updated remotely.) There are, the article notes, an increasing number of entry points hackers can use to access health-care facilities to try to access electronic medical records or billing systems containing credit card information.

 

The incentives for the hackers’ are significant. According to the article, medical records sell for about $60 each on the black market, while credit-card information typically goes for about $20. For that reason, “the bad guys in the cyberuniverse definitely have set their sights on health-care records,” according to one commentator quoted in the article. However, according to a report cited in the article, security practices at health-care providers generally are not keeping pace with the high volume of attacks.

 

The findings in the article have a number of important implications for health-care providers and their service providers, particularly the importance of assessing network security vulnerabilities and addressing concerns. However, as the sequence of events following the disclosure of the Target breach shows, another concern for these companies is their potential litigation exposure. Target has been hit with a wave of consumer class actions following news of the breach in its systems, as were other retailers whose networks were recently hacked. The hackers’ focus on health-care records underscores that fact that health-care organizations may face the same litigation exposures as the retailers. This exposure is not limited just to hospitals and other patient care facilities (such as nursing homes and diagnostic testing centers), but also includes health care service and equipment providers, including potentially even software firms and medical equipment manufacturers.

 

These litigation risk exposures, as well as the need for companies hit with a breach to try to deal with notification requirements and remediation issues, highlight the need for companies in these industries to ensure that their insurance program includes a robust program of privacy liability and network security insurance. Nor are these concerns limited just to firms in these health-care related industries – there is not a day that goes by that there is not a report of another company experiencing a breach. Today, it was Kickstarter, the Internet funding portal (about which refer here). Tomorrow it will be another company in another industry.

 

The point is that we have long since reached the point where privacy liability and network security insurance is an indispensable part of every organization’s insurance program.

 

It is also important to keep in mind that the litigation exposure associated with a network security breach is not limited to just the possibility of consumer actions. As was evidenced in connection with the Target breach, a significant network security breach can also lead to D&O lawsuits as well (as discussed here).  I suspect that we will find in the months ahead that these kinds of lawsuits may become increasingly common.  As I have noted previously, among the risks of D&O litigation arising from the possibility of a cyber breach includes the prospect of shareholder litigation arising from disclosures regarding the company’s privacy and network security practices.

 

We are already to the point where companies need to take these litigation possibilities into account when considering such basic issues as how much D&O insurance to purchase.

 

What “Transactional” Skills Should Lawyers in Training Be Taught?: The American Bar Association and a number of other bar groups are exploring the possibility of establishing minimum requirements within accredited law schools related to building practical skills and competencies. The issue these initiatives present is the question of what topics constitute “skills and competencies,” particularly for transactional attorneys.

 

To address this issue, the Berkeley Center for Law, Business and the Economy at Boalt Hall Law School, UC Berkeley, has developed an on-line survey to try to establish what competencies professional s in transactional practices consider important. The survey’s authors hope the survey results will help both practitioners and legal educators assess and if appropriate work to amend the current proposed guidelines. Though the survey is directed to practicing attorneys, it is also open to others who work with transactional attorneys (such as bankers, accountants, etc.).

 

The survey’s authors hoping to get as broad of a response as possible. The authors are asking everyone to complete the survey and to ask colleagues and contacts to complete the survey as well. The survey can be found here. When the survey is complete, the results will be available on the Center’s website, here.

 

Can You Please Do That Somewhere Else?: I frequently think newspaper editors don’t read their own headlines. The latest example of this appeared  in the February 18, 2014 issue of USA Today, which carried an article headed “Monster Asteroid Whizzes by Earth.”

alaskaIn a February 8, 2014 article entitled “A Shrunken Giant” (here), the Economist magazine examined BP’s efforts to regain its footing after the disastrous April 2010 Deepwater Horizon explosion and oil spill. The article concludes by stating that “Repairing the balance sheet and books is one thing. Repairing BP’s reputation for management excellence will take longer.” While the article tracks the need for BP’s management to rehabilitate its reputation only back as far as the 2010 Gulf oil spill, a recent Ninth Circuit decision is a reminder that BP’s environmental challenges and management woes go back even further, to the company’s prior environmental disaster – the company’s 2006 Prudhoe Bay oil spills.

 

In a February 13, 2014 opinion (here), the Ninth Circuit reversed in part the district court’s dismissal with prejudice of the securities class action lawsuit brought by holders of BP ADRs alleging that the company and certain of its directors and officers had made misleading statements about the condition and maintenance of the company’s Prudhoe Bay pipelines and about the company’s environmental compliance practices.

 

Rejecting the district court’s suggestion that the plaintiffs’ complaint alleged at most “simple mismanagement, but  not securities fraud,” the Ninth Circuit said that “while we agree that BP’s actions exemplify corporate mismanagement, the pleadings also charge that BP is a company that has publicly shirked responsibility for its role in causing the Prudhoe Bay spills at every step of the way,” adding that while mismanagement “would be a plausible explanation” for the company’s misinformation, the alleged facts “support the inference that BP was, at the very least, deliberately reckless as to the false and misleading nature of their public statements.”

 

Background 

In March 2006, BP sustained the first of two significant oil spills from pipelines in its Prudhoe Bay operation in Alaska. The spill, which was widely publicized, triggered a government investigation. According to the Ninth Circuit, it quickly came to light that the pipeline that leaked had not had an important corrosion test since 1998. The U.S. Department of Transportation order correction actions in a Corrective Action Order, which were to be completed by June 2006. However, BP failed to complete the action until a month after the deadline. The diagnostic tests, completed in July 2006, showed significant pipeline corrosion. Shortly after that, on August 5 and 6, 2006, the company discovered leaks at a second Prudhoe Bay pipeline. BP was forced to temporarily shut down its Prudhoe Bay operations.

 

In October 2007, BP’s Alaska unit pled guilty to a misdemeanor violation of the Clean Water Act. In its plea agreement, BP admitted that it was aware of corrosion in the pipeline where the first spill occurred in 2005. In 2011, BP resolved separate civil suits that had been brought by the Department of Justice and the State of Alaska. The company entered consent decrees that required it to take certain remedial and prophylactic measures.

 

In d addition, certain BP security holders filed complaints alleging that BP and certain of its directors and officers had made misleading statements in violation of the securities laws. The plaintiffs alleged that four specific sets of statements were misleading.

 

Following the first spill, Margaret Johnson, a senior VP and the head of BP’s Prudhoe Bay operations, made public statements that BP’s most recent inspection data prior to the spill showed that the pipeline where the spill occurred had a “low and manageable corrosion rate.” In a later statement, Johnson said the spill was “anomalous” and that the conditions contributing to the spill were not present at BP’s other Prudhoe Bay pipelines. The company’s CEO stated at an April 2006 news conference that the March spill had occurred “in spite of the fact that BP had world class corrosion monitoring and lead detection systems.” In addition, the company’s 2005 Annual Report (issued on June 30, 2006) stated that management believes that BP was in compliance in all material respects with applicable environmental laws and regulations.

 

On March 14, 2012, Western District of Washington Judge Marsh Pechman dismissed the plaintiffs’ securities suit with prejudice, finding that while a number of the statements on which the plaintiffs relied were actionably false, the plaintiffs did not plead facts giving rise to a strong inference of scienter. A copy of Judge Pechman’s opinion can be found here.

 

The Ninth Circuit’s Opinion 

In a February 13, 2014 opinion written by Eastern District of New York Senior Judge Raymond J. Dearie (sitting by designation) for a three-judge panel of the Ninth Circuit, the appellate court reversed in part and affirmed in part the district court’s dismissal of the plaintiffs’ complaint.

 

The appellate court found that the plaintiffs had adequately alleged both falsity and scienter as to Margaret Johnson’s assurances about the low and manageable corrosion rate at the pipeline where the first spill occurred, and as to Johnson’s statements that the conditions at BP’s other Prudhoe Bay  pipelines were different from the conditions at the pipeline where the spill occurred. The court also found that the plaintiffs had sufficiently alleged falsity and scienter as to the statement in the 2005 Annual Report that management believes that the company is in compliance with environmental laws and regulations. However, the appellate court agreed with the district court that the plaintiff’s had not sufficiently alleged scienter with regard to the CEO’s statements that the company had a “world class” leak detection system and corrosion monitoring program.

 

In finding contrary to the district court that the plaintiffs had sufficiently alleged that Johnson made the allegedly misleading statements with scienter, the Ninth Circuit relied heavily on Johnson’s education, position and responsibilities, as well as her alleged incentive to misrepresent the facts, based upon which the appellate court concluded that “not only would Johnson be aware of corrosion problems, but she would be among the first to know.  A strong inference of scienter is therefore found in the pled facts.”

 

In reaching its conclusion that Johnson had made the statements with scienter, the appellate court also relied on the “core operations” inference, noting that because Johnson was the person overseeing operations in the area where the spill took place, “we find it absurd to believe that she did not have knowledge of information contradicting her statements.”

 

The Ninth Circuit also applied the “core operations” inference in concluding that the statements in the 2005 Annual Report about the company’s environmental compliance were made with scienter. The Court said that “in light of the magnitude of the violations, the immense public attention on BP in the wake of the spills, and the contemporaneous documents demonstrating management’s awareness of the company’s non-compliance with the Corrective Action Order [entered after the first spill], we find it ‘absurd’ that management was not aware of BP’s significant, existing compliance issues that rendered the statement misleading.”

 

Even though the Ninth Circuit had concluded that the plaintiffs had sufficiently alleged that Johnson’s statements and the statement in the 2005 Annual Report had been made with scienter, the appellate court separately undertook a “holistic” review of the allegations to determine whether the allegations create a strong inference of scienter. The district court had undertaken the same exercise and had concluded that the allegedly misleading statements “more closely resemble simple corporate mismanagement than actionable securities fraud.” The Ninth Circuit said

 

To some extent, corporate mismanagement would be a plausible explanation for how misinformation travels to the corporate suite. But in this case, facts alleged in the complaint support the conclusion that BP had been aware of the corrosive conditions for over a decade, and yet chose not to address them…. And it suggests that BP had every reason to know, at the very least, that they did not have accurate information regarding the conditions of the Prudhoe Bay pipelines. When we consider the allegations holistically and accept them to be true, as we must, the inference that BP was, at the very least, deliberately reckless as to the false or misleading nature of their public statements is at least as compelling as any opposing inference.

 

The appellate court concluded by saying that “in the end, we conclude that after six years of preliminary litigation, the allegations should now be tested on the merits.” The case will now go back to the district court for further proceedings.

 

Discussion 

There are no references in the Ninth Circuit’s opinion to the 2010 Deepwater Horizon disaster. However, it felt to me as if the shadow of the subsequent Gulf oil spill overhung the appellate court’s consideration of the Prudhoe Bay spill securities suit.  Just as the Deepwater Horizon disaster looks even worse in light of the company’s involvement in the prior spills at Prudhoe Bay, the company’s reassuring statements after the first Prudhoe Bay spill take on an even more disturbing quality in light of the subsequent incident in the Gulf of Mexico. I think that as a result there is a tone of barely restrained outrage in the appellate court’s opinion. In some ways, the court arguably got carried away with its indignation – for example, the court’s statement that BP has “publicly shirked its responsibility” for the Prudhoe Bay spill “every step of the way” cannot be squared with the guilty plea the company entered in the environmental enforcement proceeding or the consent decrees (which included numerous admissions) the company had entered with the DoJ and the State of Alaska.

 

The extent to which the Court relies on circumstantial support for its conclusions on the issue of scienter may be less than satisfying to some readers of the court’s opinion. The Court’s conclusion that Johnson must have know or should have known the information contradicting her statements – as well as the Court’s “core operations” inference that it is “absurd” to suggest that she didn’t know of the contradictory information – is different from direct support for the conclusion that she actually knew the contradictory information or that she intended to mislead.

 

If nothing else, this decision shows how critically important a company’s statements after it has disclosed bad news can be. The three statements the appellate court concluded were actionable all took place after the first spill. The problem with Johnson’s statements, as the Ninth Circuit viewed them, is that in her effort to sound reassuring, she allegedly understated the extent to which the company was aware of the pipeline conditions that contributed to the spill, as well as the extent to which the conditions might exist in the company’s other pipelines. This case is a reminder that the way the company responds to bad news – and in particular how it manages its communications after bad news – can significantly affect the company’ s potential liability exposures under the federal securities laws.

 

Those responsible for companies’ disclosure documents will also want to consider the court’s conclusion that the statements about the company’s environmental compliance were actionable. The statement itself seemingly was carefully couched. The statement said only that “management believes” that the company was in compliance, and was further qualified by adding “in all material respects.” The statement also followed a much longer statement referencing the unpredictability of future developments and the environmental risks inherent in the company’s operations.

 

Nevertheless, the Ninth Circuit concluded that the statement was actionable, basically because of the magnitude of the environmental violations the company subsequently acknowledged. The lawyers whose responsibility it is to draft disclosure document statements of this type will want to consider whether there are ways to craft statements about regulatory compliance that will not be found to be misleading if regulatory issues later arise.

 

The Economist article cited above suggests that BP still has further to go to rehabilitate the reputation of its management in the wake of the Deepwater Horizon disaster. The Ninth Circuit’s recent opinion is a reminder that BP’s management’s reputational deficit runs further back than the Gulf oil spill. The Ninth Circuit’s revival of the Prudhoe Bay securities suit also means that the company’s costs of extricating itself from the consequences of the past sins will be even greater than the company might have been assuming.

 

Veritas: This week’s issue of the Economist also has an article about efforts to try to invigorate trade in Ningxia, an autonomous region in China’s northwest. The article reports that “Ningxia is hoping to sell nutritious goji berries to people worried about their bodies, certified Halal foods to Muslims worried about their souls, and fine red wines to people relaxed about both.”

 

And Finally: In his essay about growing old, entitled “This Old Man,” in the February 17, 2014 issue of the New Yorker (here), Roger Angell (after he admits that he told a friend following his wife’s death that he didn’t know how he was going to get through it): “I am a world-class complainer but find palable joy arriving with my evening Dewar’s, from Robinson Cano between pitches, from the first pages once again of ‘Appointment in Samarra’ or the last lines of the Elizabeth Bishop poem called ‘Poem.’ From the briefest strains of Handel or Roy Orbison, or Dennis Brain playing the early bars of his stunning Mozart concertos. (This Angel recording may have been one of the first things Carol and I acquired just after our marriage, and I hear it playing on a sunny Saturday morning in our Ninety-fourth Street walkup.)”