The Federal Insurance Office (FIO) has – nearly two years overdue – finally published its long awaited report to Congress on its recommendations for the modernization of insurance regulation in the United States. The broadly ranging 65-page report identifies limitations in the current state-based regulatory model but does not recommend that federal regulation should displace state regulation entirely. Rather, the report proposes a hybrid model, where the current state-based system is generally preserved except where the need for greater uniformity or the requirements of an increasingly global insurance industry are best served by regulation at the federal level.

 

The FIO’s December 2013 report, entitled “How to Modernize and Improve the System of Insurance Regulation in the United States,” can be found here. The FIO’s December 12, 2013 press release about the report can be found here.

 

Section 502 of the Dodd-Frank Act created the FIO as a unit within the U.S. Department of Treasury to monitor all aspects of the insurance industry and, among other things, to identify issues contributing to systemic risk. Section 502 (p) of the Act expressly provided that “not later than 18 months after the date of the enactment of this section, the [FIO’s] Director shall conduct a study and submit a report to Congress on how to modernize and improve the system of insurance regulation in the United States.” The Act was enacted in late July 2010, and the modernization report was officially due on January 21, 2012, nearly two years ago. In preparing the report the FIO solicited public comment and also held public hearings as well.

 

The Dodd Frank Act was of enacted in the wake of the global financial crisis, in order to try to address the issues that were thought to have caused the crisis. As the FIO’s recent report acknowledges, one of the critical developments at the peak of the crisis was the near collapse of insurance giant AIG. However, it is worth noting that the problems that led to AIG’s near demise did not involve its insurance operations (which were and are regulated at the state level), but rather involved the company’s alternative financial products division (which theoretically at least was regulated at the federal level).

 

Thus even though a critical part of financial crisis was the near collapse of one of the largest participants in the global insurance industry, that development in and of itself does not present a case for setting aside the current model of insurance regulation in the United States. Indeed, the insurance industry generally weathered the financial crisis in reasonable good order, which could be interpreted to make the case for preserving the current regulatory model.

 

On the other hand, as the FIO report notes, the current balkanized regulatory model, involving as it does 56 different insurance regulators (if the regulators in the District of Columbia and territories are included in the count) “creates inefficiencies and burdens for consumers, insurers, and the international community.” The report observed that “the need for uniformity and the realities of globally active, diversified financial firms compel the conclusion that federal involvement of some kind in insurance regulation is necessary.”

 

However, the FIO does not suggest that the limitations in the current system imply that a federal regulator should displace state regulation completely. The report observes that the creation of a new federal regulatory agency to regulate all or part of the $7.3 trillion insurance sector “would be a significant undertaking.” For the federal government to amass the “personnel, resources and institutional expertise to execute such an endeavor” would require a substantial and unequivocal commitment from the political branches of government.

 

The report concludes that “the proper formulation of the debate” is not whether insurance regulation should be state or federal, “but rather whether there “are areas in which federal involvement in regulation under the state-based system are warranted.”

 

With this approach, and based on an extensive overview of the current state of the industry and the current approach to regulation, the report recommends a number of steps that could be taking to modernize and improve the regulatory system. The steps are divided into two categories: short term steps for the states to take; and steps toward direct federal involvement in regulation in certain areas.

 

Among other things, the report suggests that states should come up with new policies related to resolving failed insurers; monitor the impact of different rate-regulation and market conduct examination practices; develop plans to reduce losses in natural disasters. The report also suggests that the states should develop a uniform regime for the oversight of reinsurance captives. In addition, the report suggests that the states “should move forward cautiously with the implementation of principles-based reserving.”

 

As far as regulation at the federal level, the report recommends, among other things, the development and implementation of federal standards and oversight for mortgage insurers; in order to effect uniform treatment of reinsurers, develop provisions for reinsurance collateral requirements; and identify issues or gaps in the regulation of large national and internationally active insurers. The report also proposes that the FIO will study and report on the use of personal information in insurance pricing. The FIO also proposes to make recommendations pertaining to the availability of certain types of insurance for military personnel and Native Americans. The FIO will also monitor state progress on modernizing the collection of surplus lines taxes “and determine whether federal action may be warranted in the near term.”

 

According to news reports (here), the industry has generally been supportive of the FIO’s approach, although there clearly is wariness of the steps toward federal regulation that the report recommends. In addition, as noted in a December 14, 2013 memo about the report from the Nelson Levine de Luca & Hamilton law firm (here), one of the more “surprising” aspects of the report is its suggestion that “if states do not reform their laws and processes to meet the recommendations of the report, they could face federal action. “ The memo went on to note that the report suggests that “Congress should strongly consider direct federal involvement if states do not implement the FIO’s recommendations.”

 

The report includes several recommendations that may be of particular interest to readers of this blog. For example, among the report’s recommendations for the state is the proposal that the states should “develop corporate governance principles that impose character and fitness expectations on directors and officers appropriate to the size and complexity of the insurer.” The report explains this recommendation by noting:

 

Many U.S.-based insurers are expanding rapidly in geography, size and complexity, thereby imposing even greater de­mands on leadership. For example, internationally active insurers are increasingly engaged in sophis­ticated enterprise risk management practices to measure and understand risks posed to the enterprise from any angle or perspective. With standards appropriately scaled to the size and complexity of the firm, state regulators should adopt director and officer qualification standards that require individuals serving in those roles to have the expertise to assess strategies for growth and risks to the enterprise. For an insurer that exceeds size and complexity thresholds, state regulators should adopt an approach designed to ensure that individuals nominated to serve in the firm’s leadership ranks have sufficient capacity to understand and challenge an insurer’s enterprise risk management.

 

Another recommendation in the report that will be of interest to this blog’s readers is its suggestion that “the National Association of Registered Agents and Brokers Reform Act of 2013 should be adopted and its implementation monitored by the FIO.” This proposed legislation, which can be found here, is intended to create a uniform agent and broker licensing clearinghouse is supported by the Independent Insurance Agents and Brokers of America. (More information about this proposed legislation can be found here.)

 

The FIO report contains a wealth of information, including some very interesting data showing how important the insurance industry is in the United States. Among other things, the report states that 2012 U.S. insurance premiums totaled $1.1 trillion, representing 7 percent of the country’s GDP. Insurers directly employ 2.3 million people in the U.S, representing 1.7 percent of non-farm payrolls. As of year-end 2012, insurers reported $7.3 trillion in total assets, including $6.8 trillion in invested assets

 

Special thanks to a loyal reader for sending me a copy of the FIO report.

 

And in the End: The Beatles ended their Abbey Road album with the simple song called “The End.” The song features short but memorable lyrics – “And in the end, the love you take is equal to the love you make – and a sonic quality that make the track truly unforgettable. In a December 13, 2013 post on Something Else Reviews entitled “Deep Beatles: ‘The End,’ from Abbey Road (1969)” (here), music journalist Kit O’Toole takes a closer look at the song, which she says “serves as more than a mere final track to an album”; the song, she says, “effectively summarizes [the Beatles’] career trajectory as well as the end of the 1960s.”

 

The song features one of the only drum solos that Ringo Starr has ever recorded, as well as the dueling guitar solos featuring the other three Beatles. As O’Toole says, “after the angst expressed in ‘Carry That Weight’ and the ‘You Never Give Me Your Money’ reprise, ‘The End’ injects pure adrenaline and joy in the proceedings.”

 

Even if you think you know the song, read O’Toole’s account of how the song was recorded and how the pieces came together, and then listen to the song again on the embedded video link below. (The video starts with “Golden Slumbers” and ends with “The End”.)

 

O’Toole ends her article quoting Paul McCartney as saying “I’m very proud to be in the band that did that song and that thought those thoughts and encouraged other people to think them to help them get through little problems here and there.” It really is a great song.

 

After you have watched the video, you might want to visit the website for Abbey Road Studios (here) which has a webcam set up on the famous Abbey Road cross walk. If you check out the webcam shot during the daytime (London time) you won’t have to wait long to see random groups of people trying to recreate their version of the Abbey Road album cover.

 

//www.youtube.com/embed/hc5YuMsDTRE

Largely as a result of changes in the industry following the enactment of the Affordable Care Act, health care organizations have seen their D&O insurance rates increasing and the available terms and conditions tightening, according to a December 10, 2013 report from Marsh. Moreover, these changes are likely to continue in 2014, according to the report. A copy of the Marsh report, entitled “As Reform Takes Effect, Health Care D&O Rates Increase,” can be found here (registration required). Marsh’s December 11, 2013 press release about the report can be found here. Hat tip to Claire Wilkinson at the Insurance Information Institute blog (here) for the link to the Marsh report.

 

According to the report, since the 2010 passage of the ACA, health care organizations have been undergoing rapid consolidation, as they seek to form accountable care organizations (ACOs), which are joint ventures or affiliations “aimed at better coordinating services, reducing costs and improving the quality of care.” Because the formation of these ACOs expressly contemplates that the participating organizations will collaborate and share information, “some insurers have expressed concerns about the antitrust issues.”  

 

Among the insurers’ concerns is that, while the Federal Trade Commission and the Department of Justice have developed antitrust safe harbors for federally recognized ACOs, the extent of protection available under the safe harbors is “untested,” particularly in connection with private antitrust litigation.

 

As a result of these concerns, D&O insurers have been raising their rates for health care organizations, as well as restricting the coverage available under their policies for antitrust claims. According to the report, average primary D&O rate for smaller health care organizations (those with assets of $150 million or under and fewer that 1,000 employees) increased by 12.7% in the third quarter of 2013. 96% of organizations in this sector renewed their insurance with rate increases. Average primary D&O insurance rates for midsize and large health care organizations increased by 9.6%, with a median increase of 7.0%. 96% of all midsize and large health care organizations renewed with an increase during the third quarter.

 

Graphical information in the report shows that for all health care organizations, both primary D&O premiums and overall premiums have been increasing steadily since the fourth quarter of 2011.

 

Along with these rate increases, some insurers have been restricting the coverage available under their policies for antitrust claims. These restrictions include in some instances the introduction of sublimits and/or coinsurance for antitrust claims. According to the report, at least one insurer has taken “a particularly aggressive stance” by restricting availability of antitrust coverage to a maximum of $5 million across all financial and professional lines, and imposing a mandatory coinsurance of 20% to 30%.

 

The article notes that in addition to the antitrust concerns, the health care industry’s shift to the accountable care model entails a number of other liability risks. For example, the establishment of provider networks raises the possibility of “contractual liabilities and lawsuits from customers, competitors, and regulators over such issues as errors in providing nonmedical services.” An ACO also could assume “higher risks related to the pricing of services, medical expenses in excess of agreed capitation levels, or contract mismanagement for its members.”

 

As a result of these changes and heightened risks, D&O insurers are seeking a great deal more renewal underwriting information, particularly with respect to ACO formation and strategy. Among other things, they are seeking additional information about contractual terms, data security, and indemnification and insurance relationships between counterparties.

 

In addition to the D&O issues, another concern ACOs will face are the “managed care errors and omissions (E&O) inherent in population management strategies. These issues may arise as efforts to control costs lead to quality of care concerns. These kinds of issues will require many organizations that in the past may not have purchased managed care E&O insurance to add the coverage to their professional liability insurance program.

 

The article concludes with as the industry continues to transition to accountable care, risks and exposures will continue to emerge. As a result, health care organizations “should be prepared to face additional rate increases as they renew their D&O insurance program in 2014” and to address underwriters’ questions about their strategies for the formation of ACOs.

 

The article notes that D&O insurers will be closely monitoring developments in the consolidated Blue Cross Blue Shield antitrust litigation pending before Judge David Proctor bin the Northern District of Alabama (about which refer here). The report notes that “as a protracted legal struggle is expected, the case will likely have no immediate impact on pricing – but it has added to the antitrust concerns for underwriters.”

 

For those of you looking ahead to 2014, one date you will want to note on your calendar is January 29, 2014. That is the effective date of the Brazilian Clean Companies Act, a new anti-bribery statute that signals Brazil’s intention to crack down on corruption. The Act represents an operational and compliance challenge for Brazilian companies and for foreign companies doing business in Brazil. It also represents a potentially significant development in the risk environment for D&O insurers doing business in Brazil.

 

Following highly publicized public protests last year, the Brazilian Senate approve the Clean Companies Act on July 4, 2013. Brazilian President Dilma Rouseff signed the Act into law on August 1, 2013. The Act subjects Brazilian companies and foreign entities with a Brazilian registered office, branch or affiliate i to civil and administrative sanctions for bribery of domestic or foreign public officials. Violations of the Act can be sanctioned by civil fines of as much as 20 percent of a company’s gross billings, or if the prior year’s revenue cannot be calculated, of up to R$ 60 million (about US$26 million).

 

A December 6, 2013 memo from the Morrison & Foerster firm describing the Act can be found here. An August 9, 2013 memo from the Covington & Burling law firm with a detailed description of the Act can be found here.

 

The Brazilian Act has certain features in common with the U.S.’s Foreign Corrupt Practices Act and the U.K.’s Bribery Act. Like those two statutes, the Act has an international reach, applying to acts committed both in Brazil and abroad. Because of this international applicability, companies “can expect Brazil to cooperate more with US and UK regulatory authorities than it does today,” according to a memo about the Act by São Paulo attorney Gabriela Roitburd.

 

At the same time, there are important differences between the Act and the FCPA and the Bribery Act. Unlike the Bribery Act, the Clean Companies Act is a “strict liability” statute. In order for sanctions to be imposed on a company, prosecutors are not required to show that company representatives acted with criminal or corrupt intent. In addition, according to the Morrison & Foerster memo, “a company cannot avoid liability under [the Clean Companies Act] by proving that it had ‘adequate procedures’ in place.” However, companies can mitigate potential fines based on cooperation with Brazilian authorities and by having effective internal compliance procedures. Companies will also receive a cooperation credit for voluntary disclosure.

 

Unlike under the FCPA and the Bribery Act, the Clean Companies Act does not impose criminal liability on legal entities for acts of bribery. Violations of the Act can result only in the imposition of civil and administrative sanctions (which, though not involving criminal sanctions, nonetheless potentially can be quite harsh). The Act does not alter existing laws under the Brazilian Criminal Code imposing criminal liability on individuals for acts of bribery. In addition, unlike under the FCPA, the Clean Companies Act does not contain an exception for so-called “facilitation payments.”

 

Discussion

The extent of the changes that may follow the Act’s effective date is uncertain. In the words of the São Paulo attorney Gabriela Roitburd, “how aggressively Brazilian authorities will enforce the Act and in which areas they will focus their efforts remain to be seen.” Skeptics might well question the extent to which the Act alone will change anything.

 

Just the same, there are reasons to suspect that the Act could represent a very significant development. The Act’s enactment not only took place in the midst of a highly charged political environment, but it also follows a period in which Brazilian authorities have already started cracking down on corrupt activities; based on examples cited in its memo, the Morrison & Foerster law firm notes, with respect to existing enforcement activities, that “authorities are not shying away from pursuing big, powerful targets.” The memo goes on to observe that “the risks involved in sectors that require significant interaction with public officials have multiplied.”

 

There is a larger context within which the Act’s enactment takes on a more global significance. As the Morrison & Foerster memo notes, the Act “represents a firm statement of intent from the Brazilian government to align itself with global trends and tackle corruption head on.” It is this sense in which the Brazilian’s adoption of the Act represents a part of a “global trend” that the Act takes on a greater significance.

 

During numerous conversations with industry colleagues outside the U.S. this fall, I have heard over and over again that regulators outside the U.S. are becoming increasingly active and that there has been an upsurge in claims notifications involving regulatory and enforcement actions outside the U.S. The Brazilian adoption of the Act seems to set the stage for an augmentation of this current trend.

 

Ranked by GDP, Brazil has the world’s sixth largest economy. It is the largest economy in South America. Its enactment of this statute potentially will have an impact on other counties and economies, perhaps even outside of Latin America. To the extent, Brazilian’s adoption of the Act encourages other countries to try to crack down on bribery and corruption, it could accelerate the already pronounced trend toward greater regulatory activity around the world.

 

At a minimum, the Act’s adoption raises the possibility of greater regulatory and enforcement activity in Brazil, involving both Brazilian companies and foreign companies doing business in Brazil. The possibility of this increased regulatory and enforcement activity in turn raises the possibility of increased D&O claims activity, as companies targeted by prosecutors seek to have their defense costs and other expenses reimbursed by their insurers. The possibility (noted above) for collaboration between Brazil and both the U.S. and the U.K. on anticorruption enforcement further reinforces the possibilities for greater D&O claims activity.

 

Brazil’s adoption of the Act is significant in and of itself, for what it means for the country’s efforts to try to crack down corruption. It potentially is also emblematic of a more global move toward greater regulatory enforcement. These developments in turn have important significance for companies doing business in Brazil and for the larger global economy. All of these developments have important implications for the global D&O insurance industry.

 

The extent to which coverage would be available for any particular company under its D&O insurance for matters of the kind described above will of course depend on the nature of the specific allegations raised and the particular wording of the company’s policy. The extent of coverage available for investigative costs is a recurring issue, and the extent of coverage for investigations and enforcement actions involving the entity is particularly dependent on policy wording. In connection with enforcement actions, fines and penalties typically would not be covered, so enforcement action-related coverage questions would most likely involved defense cost protection. To the extent enforcement actions under the Brazilian Clean Companies Act lead to follow on civil litigation (as has happened in the U.S.  following FCPA enforcement actions), the related civil actions would involved further costs for which the insured persons would seek D&O insurance coverage.

 

It is not news that the choices CEOs make can significantly impact the companies they lead. But at least according to a recent academic study, CEOs’ ability to affect their companies is not limited just to the decisions they make in their corporate posts, but also includes decisions they make in their personal lives. According to the study’s authors, CEOs’ decisions and actions in the personal lives can affect their companies’ performance. As shown below, CEOs’ personal decisions can also lead to shareholder claims against their companies.

 

In a December 3, 2013 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “The Impact of CEO Divorce on Shareholders” (here), David Larker and Allan McCall of the Stanford University Accounting Department and Brian Tayan of the Stanford Graduate Business School examine the impact that CEO divorce can have on a corporation. The authors summarized their findings by saying that “recent events suggest that shareholders pay attention to matters involving the personal lives of CEOs and take this information into account when making investment decisions.”

 

(The authors’ recent blog post is abbreviated version of their more detailed October 1, 2013 paper entitled Separation Anxiety: The Effect of CEO Divorce on Shareholders, which can be found here).

 

The authors note that there are at least three potential ways that CEO divorce might impact a corporation and its shareholders. The first is that the property settlement associated with their divorce — in which the CEO might be forced to sell personal shares in their company – could affect a CEO’s control or influence. The share sale could “reduce the influence that he or she has over the organization and impact decisions regarding corporate strategy.”

 

Second, CEO divorce can affect the productivity, concentration and energy levels of the CEO. The authors cite prior research the concluded that employee divorce can affect firm productivity. In the extreme, the authors note, the distraction of divorce can lead to premature retirement. (The authors’ paper cites the example of A.G. Lafley, who stepped down early from his post as Proctor and Gamble’s CEO following his divorce filing).

 

Third, CEO divorce can influence a CEOs attitude toward risk. A sudden change in a CEO’s wealth can affect the executive’s risk appetite and therefore affect decision making. The authors’ research suggests that both the board of directors and shareholders need to consider the consequences to the corporation when a CEO and spouse separate. In some cases, the board might want to consider a change in CEO compensation to “restore” the CEO’s incentives so they are consistent with the original expectations and the company’s risk tolerance.

 

It is interesting to me that in their summarization of their findings, the authors did not limit their conclusions simply to matters pertaining to CEO divorce but rather stated more generally that shareholders should pay attention to matters “involving the personal lives of CEOs.” Indeed, recent events suggest that shareholders should be concerned not just CEO divorce but CEOs’ personal relationships as well.

 

A recent example where a CEO’s relationship caused problems at the executive’s company and even lead to the filing of a securities class action lawsuit arose at the IT outsourcing company iGate Corporation. On May 20, 2013, the company disclosed that its Board had terminated its CEO Phaneesh Murthy after an internal investigation revealed the CEO had a relationship with a subordinate employee in violation of company policy and the CEO’s employment contract. The company’s shares declined nearly 10 percent on this news. Then on May 22, 2013, the company further disclosed that the CEO’s termination was “for cause” and that the former CEO was not entitled to severance under his contract. The company’s shares slid further on this news.

 

As discussed here, on June 14, 2013, plaintiff shareholders filed a securities class action in the Northern District of California against iGate and its former CEO. The plaintiffs alleged that the defendants had failed to disclose that (i) the Company’s Chief Executive Officer and President was involved in an improper relationship with a subordinate employee in violation of iGATE’s explicit policies to the contrary; and (ii) the CEO’s improper conduct created a risk that he would be terminated from the Company, jeopardizing the Company’s future success.

 

Although the circumstances at iGate may seem to have their own distinct features, the departure of a CEO amid allegations of an improper relationship is not unprecedented, nor is the arrival of a shareholder lawsuit following the CEO’s departure.

 

For example, former H-P CEO Mark Hurd denied that he had a personal relationship with an outside publicist for the company, but (as discussed here) the board’s investigation into the publicist’s sexual harassment allegations ultimately led to Hurd’s resignation based on allegations that Hurd submitted expense report that had been falsified to obscure his relationship with the publicist. Following these events, an H-P shareholder filed a shareholders derivative lawsuit against the company’s board in the Northern District of California, alleging mismanagement and breach of fiduciary duties. (The case ultimately was dismissed, refer here). 

 

Of course, neither of these cases related to CEO divorce, which is the topic of the academics’ paper. But they do show how the CEO’s personal relationships generally can affect their company and can even lead to shareholder claims. The authors’ study shows how a CEO’s decisions in their personal life can affect corporate performance and investment risk. The difficulty for investors (and indeed for D&O insurance underwriters) who might want to understand this risk is that their interest in this kind of information runs directly into the CEO’s right of personal privacy.

 

The study’s authors have no difficulty identifying investors’ interest in knowing information about CEO’s personal lives. The authors understandably are more hesitant when it comes to describing company’s corresponding disclosure obligations in that regard. The authors note that companies do not always disclose when a CEO gets divorced, and that reports often only come out later when, for example, the CEO sells shares to satisfy the terms of the divorce settlement. In the end, the authors avoid any prescriptions about corporate disclosure obligations but simply pose the questions, “Is divorce a private matter, or should companies disclose this information to shareholders? If so, how detailed should this disclosure be?”

 

If the disclosure questions are awkward when it comes to CEO divorce, the questions are even trickier when it comes to issues such as CEOs’ personal relationships. Clearly, where a CEO has had a relationship (or engaged in any other behavior) that violates company policies, that is a matter that must be disclosed to investors. A CEO’s personal relationship arguably might trigger a disclosure obligation when a personal relationship has a clear and direct impact on company performance. However, beyond that, I think just about everyone would recognize that other details of CEO’s private life generally are off limits.

 

Just the same, the interests of investors (and of D&O underwriters) are affected by the choices that a company’s CEO makes, and that is true not just of the CEO’s corporate choices but even of their personal choices. We have all grown used to the notion that a company’s compliance environment starts with the “tone at the top.” Given the CEO’s rightful expectation to privacy, there may be no realistic way to try to underwrite the likelihood that a CEO’s personal life will lead to problems affecting corporate performance (or lead to shareholder lawsuits). However, a company’s culture, and the CEO’s role in that culture, can be underwritten.

 

This discussion does remind me of an earlier post I wrote years ago concerning another academic study in which the authors found an inverse correlation between the value of a CEO’s house and the future performance of their company. As discussed here, the study’s authors found a "significantly negative stock performance following the acquisition of very large homes by company CEOs," a negative trend that persists for several years after the home purchase.

 

All of which says to me that while in general the choices a CEO makes in their personal life often are nobody else’s business, the fact is that at least some of a CEO’s personal choices might nevertheless tell you something about the company they are running. As a minimum, as the authors of the CEO divorce study conclude, the CEO choices in their personal lives can affect corporate performance and therefore represent a form of corporate risk.

 

It is nothing new for private securities litigation to follow in the wake of a company’s announcement that it is the target of an SEC investigation. Similarly, civil litigation following after a company’s announcement of the existence of an FCPA investigation is a phenomenon I have frequently noted on this blog. A number of these more traditional kinds of post-investigation civil lawsuits have been filed in 2013.

 

But in addition there have also been as host of lawsuit filings this year following company announcements of a wide variety of other kinds of regulatory investigations.  These latest lawsuit filings following a broader array of regulatory investigations represent something of a new phenomenon and also represent a significant part of the 2013 securities class action lawsuit filings. They may also point toward a likely future source of securities suit filings as we head toward the New Year.

 

During 2013, there have been a number of the more traditional type of securities suit filings following after a company’s announcement of an SEC investigation. For example, Corinthian Colleges, the for-profit education company, was hit with a securities class action lawsuit in June 2013 after the company announced an SEC investigation as well as the SEC’s request for information relating to student recruitment, attendance, completion rate, placement and loan practices. In July 2013, plaintiffs filed a securities suit against Star Scientific following the company’s announcement that it had received subpoenas from the SEC and from the U.S. Attorney’s office about related party transactions at the company. In March 2013, ITT Educational Services, another for-profit educational company, received a securities suit following the company’s announcement of an SEC investigation of student loan arrangements.

 

There have also been new securities suit filings this year following companies’ announcements of FCPA investigations. For example, in August 2013, plaintiffs filed a securities class action lawsuit against Juniper Networks following the company’s announcement of an ongoing SEC and DoJ investigation into possible FCPA violations. In April 2013, plaintiffs filed a securities lawsuit against WalMart de Mexico following publicity surrounding allegations of bribery and other misconduct in connection with company operations in Mexico.

 

The arrival of securities lawsuit following the announcement of these kinds of investigations has long been a feature of securities lawsuit filings. In addition to these more traditional types of filings following SEC and FCPA investigations, there have been a number of other filings this year that involve very different kinds of post-investigation lawsuits.

 

The recent securities suit filed in the Eastern District of Virginia against Lumber Liquidators and certain of its directors and officers represents a good example of these more diverse kinds of post-investigation lawsuits. On November 26, 2013, plaintiff shareholders filed their complaint (a copy of which can be found here) against the hardwood flooring retailer following the company’s disclosure that the U.S. Department of Agriculture, the U.S. Fish and Wildlife Service, the Department of Homeland Security and the Department of Justice had executed search warrants on the company’s corporate offices in connection with the company’s possible violation of the Lacey Act for the alleged importation of illegally logged wood products from forests in eastern Russia and China.

 

There have been a number of other recent securities suits filed following companies’ announcement of a broad range of governmental investigations. For example, on November 29, 2013, plaintiffs filed a securities suit against DFC Global following an industry-wide investigation of payday lending by the U.K.’s Office of Trading, which was accompanied by severe losses in the company’s U.K. lending portfolio. 

 

And on September 25, 2013, Valley Forge Composite Technologies received a securities suit relating to the company’s February 2013 announcement that it was being investigated by the U.S. Attorney’s office for the company’s alleged export to Hong Kong of military semiconductors in alleged violation of the International Traffic in Arms Regulation (ITAR).

 

Other companies have also received securities suits during 2013 following company announcement of governmental or regulatory investigations. In September 2013, BioScrip was hit with a securities class action lawsuit following its announcement of its receipt of a civil investigative demand from the U.S. Attorney’s Office and the New York A.G.’s Medicare Fraud Unit relating to its distribution of certain pharmaceuticals.

 

In August 2013, plaintiff shareholders filed a securities suit against NuVasive following the company’s July 2013 announcement that it had received a federal administrative subpoena from the Office of the Inspector General of the U.S. Department of Health and Human Services in connection with possible false or misleading claims submitted to Medicare and Medicaid.

 

And in September 2013, plaintiffs filed an action in the Southern District of New York against PetroChina Company Limited, following the company’s announcement in late August of an investigation of the company’s corporate parent by a Chinese governmental ministry and the investigation of several company officials by the State-Owned Asset Supervision and Administration Commission for “severe breaches of discipline,” which is widely interpreted to mean corruption and bribery.

 

In April 2013, investors filed a securities class action lawsuit against Autoliv relating to the company’s announcements in early 2011 that the DoJ and the European Commission were investigating units of the company for anti-competitive practices and antitrust violations. The investigation resulted in the company’s June 2012 agreement to plead guilty to price-fixing for certain auto parts.

 

Collectively, these post-investigation cases (including the more traditional types of cases involving SEC and FCPA investigations) represent nearly ten percent of all of the securities class action lawsuits so far this year, so they represent an important phenomenon in and of themselves. But these fillings may be even more significant to the extent they represent a securities suit filing trend in which increased numbers of securities class action lawsuit filings arise in the wake of governmental investigative activity.

 

There are several things about these cases that make them particularly interesting to me. The first is just the broad array of governmental investigations that preceded the lawsuit filings. It is no secret that U.S. governmental regulators have become increasingly more active and arguably even more aggressive. As a broader range of regulators actively enforce a broader range of laws and regulations, companies face the possibility of a growing number of types of investigations accompanied by a greater risk of follow-on civil litigation.

 

Another thing that interests me about these examples is the international element of several of the claims. At least three of these lawsuits involve or related to governmental investigations by regulators outside the U.S., and several of the suits involve the investigation by U.S. regulators of possible misconduct outside the United States.

 

I put these post-investigation lawsuits with an international element in the context of several meetings I had this fall with industry colleagues from outside the United States, who uniformly commented to me that regulatory activity outside the U.S. is surging. D&O underwriters from outside the U.S. commented told me that they are receiving unprecedented levels of claims notifications involving non-U.S. regulatory actions.

 

These actions involving non-U.S. regulators are arising at the same time that U.S. regulators are also increasingly active. Indeed, one feature of several of the current high-profile investigations in the financial services industry (for example, Libor, currency exchange, and trade sanctions) is the level of cross-boarder collaboration and cooperation between various governments’ regulators.

 

Assuming that the Supreme Court does not completely alter the securities class action litigation environment in the Halliburton case, it seems likely to me that this phenomenon of post-investigation filings that loomed so significantly in 2013 will be even more important in 2014. The likelihood is that there will be more cases involving an even broader array of regulatory and investigative activity with an added likelihood that non-U.S. regulatory activity will be involved in a growing number of these kinds of cases.

 

Last week I happened to be at a meeting in which one of the more prominent securities defense attorneys asked one of the leading securities plaintiffs’ attorneys what kinds of companies or things the plaintiffs’ lawyers were going to be going after next. The plaintiffs’ attorney demurred to the question, basically saying when I find out myself I will let you know. The plaintiffs’ lawyer was unwilling to make any predictions but I will speculate here that as we head into 2014 this phenomenon of follow-on post-investigation civil litigation is going to be increasingly important (assuming of course that Halliburton does not change the entire litigation landscape).

 

 

With the arrival of the new Chair of the SEC, Mary Jo White, the agency has undertaken a variety of new enforcement initiatives. Among the most interesting is the agency use of data anallytics to try to uncover public company accouunting abuses. The following guest post from Christopher L. Garcia, Paul Ferrillo  of the Weil, Gotshal & Manges law firm and Matthew Jacques of AlixPartners takes a look at this new information gathering initiative from the SEC.

 

I would like to thank Christopher, Paul and Matthew for their willingness to publish thieir post on this site. I welcome guest post submissions on topics of interest to readers of this blog. Anyone interested in publishing a guest post on this blog is encouraged to contact me directly. Here is Christopher, Paul and Matthew’s guest post: 

 

            Since her confirmation as Chair of the U.S. Securities and Exchange Commission (“the SEC”), Mary Jo White has made clear that her administration will focus on identifying and investigating accounting abuses at publicly traded companies, a focus that has been echoed by Chairperson White’s co-Directors of Enforcement, George Canellos and Andrew Ceresney.[1] This renewed focus is perhaps unsurprising: whistleblower complaints relating to corporate disclosures far outstrip complaints in other popular enforcement areas, such as insider trading and FCPA, and yet the last several years have witnessed a steady decline in accounting fraud investigations and enforcement actions.[2]

 

            Accordingly, on July 2, 2013, the SEC announced two initiatives in the Division of Enforcement designed to support this renewed focus on uncovering and pursuing accounting abuses in public companies 

·        The Financial Reporting and Audit Task Force (“the Task Force”), “an expert group of attorneys and accountants” dedicated to detecting fraudulent or improper financial reporting,[3] and 

·        The Center for Risk and Quantitative Analytics, which is dedicated to “employing quantitative data and analysis to high-risk behaviors and transactions” in an effort to detect misconduct.[4] 

While the Task Force portends a new era in accounting fraud enforcement by creating a veritable “SWAT Team” tasked with reviewing financial restatements and class action filings, monitoring high risk companies, and conducting street sweeps,[5] the announcement that the SEC is employing “data analytics” to in order to detect indicia of accounting fraud is potentially the more significant development. 

 

First dubbed the “Accounting Quality Model” (“AQM”) by the SEC’s Chief Economist Craig M. Lewis, and later coined “Robocop” by the media, the use of data analytics represents advances in enforcement techniques made possible by a prior SEC compliance initiative called XBRL (eXtensible Business Report Language), which mandated a standardized format for public companies to report their results. This article attempts to bring together all of the concepts related to the AQM in an understandable way for directors and officers of public companies. In short, the AQM may mean that companies may receive more frequent inquiries from the SEC based upon the substantive quality of their financial statements alone. Though just one tool in the SEC’s enforcement tool box, the SEC’s AQM initiative certainly represents how 21st Century information gathering may give the SEC a leg up in detecting accounting fraud.

 

            What is XBRL?

            First, a brief word about XBRL, which has made the SEC’s AQM initiative possible. In mid-2009, the SEC mandated the use of XBRL (XBRL was voluntary beginning in 2006) for most companies reporting financial information to the SEC. According to the SEC’s XBRL web site, “Data becomes interactive when it is labeled using a computer markup language that can be processed by software for sophisticated viewing and analysis.  These computer markup languages use standard sets of definitions, or taxonomies, to enable the automatic extraction and exchange of data.  Interactive data taxonomies can be applied — much like bar codes are applied to merchandise — to allow computers to recognize that data and feed it into analytical tools.  XBRL (eXtensible Business Reporting Language) is one such language that has been developed specifically for business and financial reporting.”[6] 

 

          Put differently, financial information is essentially “coded” or “tagged” in a standardized fashion to allow the SEC, to understand it more readily. For example, an accrual, like an executive compensation accrual, is identified and coded as an accrual, along with other types of accruals. In short, XBRL is like as a hyper-advanced Twitter hashtag for the financially savvy that allows financial information reported to the SEC to be categorized and sorted quickly and effectively for further analysis.

 

            Standardized Financial Reporting Facilitates the AQM Initiative

            So how does mandatory financial reporting using XBRL make AQM possible? Through the standardization of reporting, tagging and coding of terms through XBRL, the SEC is able to quantify or “score” the degree to which a company may be engaged in any number of problematic accounting practices. For example, the model analyzes SEC filings to estimate the number and size of discretionary accruals within a company’s financial statements.  Discretionary accruals are accounting estimates that are inherently subjective and susceptible to abuse by companies attempting to manage earnings.  Once anomalous accrual activity is detected, the model then considers other factors that are “warning signs” or “red flags” that a company may be managing its earnings.  The SEC has publicly provided limited examples of these factors, which include: the use of “off-balance sheet” financing, changes in auditors, choices of accounting policies and loss of market share to competitors.  Ultimately the AQM quantifies how a company’s discretionary accruals and red flags compare to those of other companies within that company’s industry peer group.  Outliers (those with financial statements that “stick out”) in the peer group possess qualities that indicate possible earnings management. As SEC’s Dr. Lewis summed up in December 2012: “[AQM] is being designed to provide a set of quantitative analytics that could be used across the SEC to assess the degree to which registrants’ financial statements appear anomalous.”[7]

 

            It is then up to the SEC to take “the next step” which could vary from company to company. In some cases, a “high score” might warrant a letter from the SEC’s Department of Corporate Finance (“Corp Fin”) asking for explanations regarding potential problem areas. More dramatically, a “high score,” alone or in conjunction with other information, including information provided by a whistleblower, may result in an informal inquiry by the staff of the Enforcement Division, with attendant requests for documents and interviews, or, worse, a formal investigation. Thus, problems for a Company could escalate dramatically with cascading effects, including difficult discussions with the incumbent auditor, and, worst case scenario, a full blown audit committee investigation. 

 

 

            What AQM Could Mean for Public Company Directors and Officers

 

            A few years ago, AQM may have been viewed no differently than any of the laundry list of items public company officers and directors need to worry about. But arguably in the last 12 months the world has changed: The Division of Enforcement has announced a renewed focus on rooting out accounting fraud, the Task Force the SEC has formed is deploying new strategies to detect and investigate accounting irregularities, and whistleblowers are incentivized to bring allegations of accounting improprieties to the attention of regulators. 

 

 

            So is there a silver bullet to the AQM? How should companies respond to the renewed focus of the SEC on accounting fraud and earnings management issues? There are no right answers to these questions, only perhaps some prudent advice:

 

 

·        Get your XBRL reporting right the first time. There are many reports that public companies are continuing to make numerous XBRL coding mistakes. It is likely the AQM will not be able to identify an innocent coding mistake. Such mistakes, however, may land a company on the top of SEC’s “Needs Further Review” list. Though the audit firms have apparently steered away from giving advice on XBLR, there are numerous experts and boutique firms that can help provide guidance to registrants. Making errors in this area, even if innocent, is simply not an option in this new era.

 

 

·        Consider all of your financial disclosures. The AQM focusses on identifying outliers. One easy way to become an outlier is to be opaque with disclosures where other companies are transparent. Take a fresh look at your financial disclosures for transparency and comparability across your industry.

 

 

·        Listen to the SEC’s guidance. As we have noted above there are a number of new SEC programs and initiatives focused on detecting financial reporting irregularities. Stay current on SEC activity to avoid surprises.

 

 

·        It is not just the SEC. XBRL is available to the public. As a greater library of XBRL financial statement data is created, analysts, investors, other government agencies, media outlets and others will build their own versions of the AQM. Be prepared for greater scrutiny and inquiries from these groups.

 

 

·        Be conscious of red flags. For example, a change in auditor is thought to be a significant red flag that might warrant further attention from the SEC.

 

            Finally as we explained above, times have changed and the SEC, upon implementation of the AQM, is ever more likely to knock on your door. Be prepared for interactions with the SEC, in particular the Enforcement Division, that are not in keeping with historical experience. As we advised with the new whistleblower program, be prepared to respond quickly and substantively to any potential SEC inquiry that might have been generated solely by the AQM or one of the many other new tools being employed by the staff. Elevate those inquires, as appropriate, to the Audit Committee and handle them with the requisite diligence. Further, have your crisis management plan ready, just in case there is a genuine and serious accounting issue that needs attention. Given the potential damage an accounting problem can have on a company’s reputation, its investors, and its stock price, have internal and external crisis advisors ready to act if necessary to investigate quickly any potential impropriety. Also have your disclosure lawyers and crisis management advisor ready to communicate with the marketplace in whatever ways are appropriate and at the appropriate time. Indeed, in light of the SEC’s renewed focus on accounting improprieties, today, more than ever, a crisis management plan to deal with a potential accounting failures is absolutely essential. 

 

[1] See e.g. Speech of Mary Jo White to the Council of Institutional Investors Fall Conference, dated September 26, 2013

 

[2] See Henning, The S.E.C. is ‘Bringin’ Sexy Back’ to Accounting Investigations, NY Times.com, at  http://dealbook.nytimes.com/2013/06/03/the-s-e-c-is-bringin-sexy-back-to-accounting-investigations/?_r=0

 

[3] See Remarks of Chair Mary Jo White at the Securities Enforcement Forum, October 9, 2013, at http://www.sec.gov/News/Speech/Detail/Speech/1370539872100

 

[4] See SEC Release 2013-121, “SEC Announces Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis,” July 2, 2013.

 

[5] See Speech of Co-Director of Enforcement, Andrew Ceresney, dated September 19, 2013, at http://www.sec.gov/News/Speech/Detail/Speech/1370539845772

 

[7] See speech of Craig Lewis, entitled “Risk Modeling at the SEC: The Accounting Quality Model,” dated December 13, 2012, at https://www.sec.gov/News/Speech/Detail/Speech/1365171491988

 

According to the FDIC’s latest Quarterly Banking Profile (here), as of September 30, 2013, there were 6,891 federally insured banking institutions, down from 6,940 at the end of the second quarter and down from 7,141 as of September 30, 2012. There were 8,680 banking institutions as recently as December 31, 2006, meaning that there are 1,789 (or about 20%) fewer banks in the U.S. than there were a little less than seven years ago.

 

The latest quarterly figures represents the lowest level for the number of banks since the Great Depression, according to a front page December 3, 2013 Wall Street Journal article (here). The Journal article details how the industry has shrunk to its current level from its high water mark of over 18,000 banking institutions as recently as 1984.

 

Two banking crises since 1984 account for a significant part of the decline. Between 1985 and 1995, as a result of the S&L crisis, 1,043 institutions failed (as discussed here).  More recently,  the global financial crisis has taken its toll on the U.S. banking industry – since January 1, 2007, 534 banking institutions have failed, or more than six percent of all of the banks in business at the beginning of the period.  But though there have been a huge number of bank failures in recent years, the closures alone do not account for the continuing decline in the number of U.S. banks.

 

According to the Journal article, the reasons for the continuing decline in the number of banks include “a sluggish economy, stubbornly low interest rates and heightened regulation.” These problems are particularly acute for smaller banks, which often depend on lower margin loans. Declining interest margins hurt smaller community banks more than larger banks, because the smaller banks’ business models – what the Journal describes as “traditional lending and deposit gathering”—rely on interest income. These pressures have caused a number of smaller institutions to merge or consolidate.

 

At the same time, no new banks are forming to replace the banks that are disappearing. According to the latest Quarterly Banking Profile, there was only one new banking institution formed in the first three quarters of 2013 (the first federally approved banking start up in nearly three years), while 159 institutions were merged out of existence and 22 institutions failed during that same period.

 

As one banking executive quoted in the Journal article asks with respect to the pressures facing smaller banks, “Can you be too small to succeed?” The problems smaller banks face was detailed in an interesting November 30, 2013 article in the Economist (here), about the travails of Marquette Savings Bank of Erie, Pa. The bank, which has weathered the financial crisis in relatively good shape is facing pressure from regulators to sell the mortgages it originates as well as to change its appraisal practices. Although the regulators pressures derive from justifiable concerns, they also threaten to undermine the keys of the bank’s success.

 

There is every reason to believe that consolidation in the banking industry will continue. Among other things, the FDIC and the banking industry are both still dealing with the fact that – even years out from the worst of the financial crisis – a large percentage of the remaining banks are “problem institutions.”  On the positive side, the number of banks on the FDIC’s "Problem List" declined from 553 to 515 during the third quarter. (The agency calls those banks that it rates as a “4” or “5” on a 1-to-5 scale of risk and supervisory concern “problem institutions.”)On the other hand,problem institutions still represent about 7.47 percent of all reporting institutions, down from about 7.96 during the second quarter.

 

Even though the number and percentage of problem institutions is down from the low point during the worst of the financial crisis — there were 888 problem institutions at the end of the first quarter of 2011 – the number of problem institutions remains stubbornly high. Many of the remaining problem institutions are unlikely to leave the list based on their own financial improvement. Many are likely to drop of the list either by merging or by failing.

 

Of course, the vast majority of banks are not problem institutions. But whether healthy or not, most remaining banks are small. Of the 6,891 banks at the end of the third quarter, 6,223 (or slightly more than 90 percent) have assets of under $1 billion. Many of these institutions are thriving and will continue to thrive. But others will face economic and regulatory pressures that may lead them to merge and combine.

 

It is hard to say where all of this will lead. It does seem likely that the number of bank failures will continue to slow, and it is always possible that an improving economy will enable more banks to remain strong and independent. However, at least right now, the likeliest outcome would seem to be that the number of banks will continue to shrink.

 

There are a number of practical consequences from the shrinking number of banks. Among other things, the Journal article raises the question whether as smaller community banks go out of existence, will it become harder from smaller businesses outside urban areas to obtain the credit they need.

 

All of these developments have consequences for the D&O insurance industry as well, or at least the portion of the industry focused on providing insurance for banking institutions. The carriers in this sector are already reeling from losses arising from the wave of bank failures and related litigation. These losses are continuing to accumulate at the same time that the overall universe of potential buyers continues to shrink. The carriers are struggling to spread an adverse loss experience across a shrinking portfolio. The accumulating losses from prior underwriting years and the shrinking customer pool means that it is harder for these carriers to show an underwriting profit on a current calendar year basis. The heightened loss experience and shrinking customer base suggests that these carriers will be facing pressure on their premium levels for some time to come.

 

At the same time that the carriers are dealing with these forces, they are also dealing with another dynamic that will even further complicate things for them. A shrinking customer base means less business for everyone. Carriers worried about maintaining their portfolios will have to figure out how to respond as competitors go after their business. As much pressure as there may be to maintain premium levels, competition may force carriers to adjust their premiums to avoid losing business.  

 

It is still a tough time for banks. It is also a tough time for their D&O Insurers as well.

 

The Desolation of Smog: SIxty years ago, London was more polluted than Beijing is today. (Here).

 

 

Are bank directors and officers sufficiently different from directors and officers of ordinary business corporations that the protections of the business judgment rule available to other directors and officers are not available to protect directors and officers of a bank? That is a question that Northern District of Georgia Judge Thomas W. Thrash, Jr. asked in November 25, 2013 decision in an FDIC failed bank case against certain former directors and officers of the failed Buckhead Community Bank.

 

In a ruling that is sure to stir up plenty of discussion, Judge Thrash said that he “is not convinced that the business judgment rule in Georgia should be applied to bank officers and directors and is not convinced that Georgia law is settled on the issue.” Judge Thrash denied the defendants’ motion to dismiss the FDIC’s claims against the individual defendants for ordinary negligence and certified the question of the applicability of the business judgment rule to the Supreme Court of Georgia. A copy of Judge Thrash’s November 25, 2013 opinion can be found here.

 

Background

As discussed here, on November 30, 2012, the FDIC as receiver of The Buckhead Community Bank filed a complaint in the Northern District of Georgia against nine former directors and officers of the failed bank. The FDIC’s complaint can be found here.

 

The bank failed on December 4, 2009. The FDIC’s complaint asserts claims against the defendants for negligence and for gross negligence and alleges that the defendants engaged in “numerous, repeated, and obvious breaches and violations of the Bank’s Loan Policy, underwriting requirements and banking regulations, and prudent and sound banking practices” as “exemplified” by thirteen loans and loan participations the defendants approved that cause the bank damages “in excess of $21.8 million.”

 

When I wrote about the filing of this case in a prior blog post I noted that "an interesting feature of the lawsuit is that the FDIC has included allegations of ordinary negligence." I found this interestsing because of the recent decision in the Northern District of Georgia in the Integrity Bank case, applying Georgia law and holding that because of their protection under the business judgment rule, directors cannot be held liable of ordinary negligence. In light of that earlier decision, I noted that “it would seem that the defendants in the new lawsuit have a basis on which to seek to have the negligence claims against them dismissed.” (The Integrity Bank decision itself is before the Eleventh Circuit on an interlocutory appeal).

 

The defendants in the Buckhead Community Bank case did indeed move to dismiss the FDIC ‘s ordinary negligence claims against them,  arguing that bank directors cannot be held liable for ordinary negligence under Georgia’s business judgment rule. The defendants also moved to dismiss the FDIC”s gross negligence claims, arguing that the agency’s complaint failed to provide sufficient allegations to maintain claims for gross negligence.

 

The November 2013 Opinion

In his consideration of the defendants’ motion to dismiss the ordinary negligence claims, Judge Thrash reviewed the several recent decisions in which various judges of the Northern District of Georgia held under Georgia law that in light of the protection of the business judgment rule the former directors and officers of failed banks involved in each of the cases could not be held liable for claims of ordinary negligence. 

 

However, after reviewing these cases and their holdings, Judge Trash said, “I most respectfully disagree with my able and learned friends and colleagues.” Judge Thrash then went on to say the following:

 

There is every reason to treat bank officers and directors differently from general corporate officers and directors. In general, when a business corporation succeeds or fails, its stockbrokers bear the gains and losses. The business judgment rule is primarily applied in Georgia because “the right to control the affairs of a corporation is vested by law in its stockholders – those whose pecuniary gain is dependent upon its successful management.” (citation omitted). But when a bank, instead of a business corporation fails, the FDIC and ultimately the taxpayer bear the pecuniary loss. The lack of care of the officers and directors can lead to bank closures which echo throughout the local and national economy. To some extent, the failure of bank officers and directors to exercise ordinary care led to the very financial crisis that continues t affect the national economy. By all accounts, the loose lending practices alleged by the FDIC in this case were rampant within Georgia’s community banks.

 

Judge Thrash noted that in O.C.G.A. Section 7-1-490, the Georgia legislature had explicitly stated that “directors and officers of a bank or trust company shall discharge the duties of their respective positions in good faith and with that diligence, care and skill which ordinary prudent men would exercise under similar circumstances in like positions.”

 

He further noted that this is not a case where shareholders are suing their company’s directors and officers, but rather it is a case where the FDIC as receiver “is suing following allegedly negligent banking practices.” When the FDIC proceeds with a case as a receiver, the case “is not simply a private case between individuals but rather a case that involves a federal agency appointed as a receiver of a failed bank in the midst of a national banking crisis.”

 

Judge Thrash concluded that he “is not convinced that Georgia law affords the Defendants the protection of the business judgment rule in a lawsuit by the FDIC.” After reviewing the case law, he concluded that there is no clear, controlling precedent on the issue. Accordingly, “given the uncertainty surrounding the application of the business judgment rule to bank officers and directors,” he decided to certify to the Georgia Supreme Court “the unsettled question of law of whether the business judgment rule should supplant the standard of care required of bank directors and officers by O.C.G.A. Section 7-1-490 in a suit brought by the FDIC as receiver.”

 

Judge Thrash then denied the defendants motions to dismiss both the negligence and gross negligence claims, finding that the FDIC’s allegations as to each claim were sufficient. However, in light of the certified question of law, the denial of the motion to dismiss as to the negligence claim was without prejudice.

 

Discussion

Judge Thrash did not in fact rule that bank directors and officers as such are not entitled to the protection of the business judgment rule. He merely found that he was not persuaded that the business judgment rule applied in this context, and certified to the Georgia Supreme Court the question whether the business judgment rule should be available in a case like this one.

 

In the current wave of failed bank litigation, a number of courts have wrestled with the question of whether or not the business judgment rule protected the former directors and officers of a failed bank from claims of ordinary negligence. But even in the cases that have held under applicable law that the business judgment rule does not protect the defendants from negligence claims, the court’s conclusion that the business judgment rule did not protect them did not depend on the mere fact that the defendants were bank directors and officers.

 

The basis upon which Judge Thrash explains his uncertainty about whether or not bank directors and officers are protected by the business judgment rule changed  as he explained his position. He seemed to start with a general assertion that bank directors and officers are simply different than the directors and officers of ordinary business corporations (“there is every reason to treat bank officers and directors differently from general corporate officers and directors”). This opening line of reasoning would seem to suggest that bank directors and officers are held to a different, higher standard than the directors and officers of an ordinary business corporation, and therefore that the business judgment rule is simply not available to them in any circumstance.

 

But Judge Thrash then focused particularly on the context of a failed bank, within the larger context of a more general banking crisis. In that context, he seems to suggest, and in particular, with respect to claims brought by the FDIC in its capacity as receiver of the failed bank, bank directors and officers should not be entitled to the protection of the business judgment rule.  That is, he seems to end up by saying that the business judgment rule is unavailable not  because they are bank directors and officers, but because the claimant is the FDIC as receiver.

 

It will be interesting to see what the Georgia Supreme Court does with this case. But it does seem that Judge Thrash’s questions about the availability of the business judgment rule has less to do with the rights and responsibilities of directors and officers of a banking institution in Georgia and more to do with the identity of the claimant. It is worth noting in that regard that in asserting its claims as receiver of the failed bank, the FDIC steps into the shoes of the failed institution, with the rights that the institution had against the officers. It would seem that there is nothing about the FDIC’s claims as receiver that should deprive directors and officers of the defenses they would have had  in a claim the bank itself had brought against them.

 

From my view, unless Georgia law holds bank directors and officers to a higher standard than directors and officers of ordinary business corporation, there would seem to be no basis to deprive them of the right to rely on the business judgment rule that is available to other corporate directors and officers under Georgia law. It would be a hard line of analysis to sustain that the rule is always available except when the FDIC as receiver of a failed bank is asserting the claim.

 

I recognize that there may be many different views on this topic. I welcome comments from readers who take a different view of this topic.

 

Very special thanks to a loyal reader for sending me a copy of Judge Thrash’s opinion.

 

Led by Twitter’s successful offering earlier this year, IPO activity in the U.S. during 2013 has been at its highest levels since 2007. While the listing activity seems to bode well for the general economy as well as for the financial markets, the increased number of IPOs has also led to an uptick in IPO-related securities litigation. The recent rash of IPO-related securities suits is significant in and of itself but also arguably take on added significance in light of other significant securities litigation developments.

 

According to the website IPO Scoop, as of November 28, 2013, 188 IPOs have priced so far in 2013, compared to 146 during all of 2012. The 2013 total is already on track for this year to have the highest number of completed IPOs since 2007, when there were 279 IPOs. IPO activity fell off sharply in 2008 and 2009 during the worst of the credit crisis, but it has been recovering since then. Signs are that IPO activity will remain elevated going into 2014 – although of course any one of a number of things (including the budget mess in Washington) could change the marketplace for IPOs.

 

One of the things that has come along with the increased numbers of IPOs this year has been in an increase in the number of securities class action lawsuits alleging misrepresentations in IPO companies offering documents.  This uptick in IPO-related securities litigation drew my attention last week, when two new securities actions involving IPOs completed earlier this year were filed.  

 

First, on November 22, 2013, plaintiffs’ lawyers’ issued a press release (here) announcing that they had filed a securities suit in the Southern District of New York against Tremor Video, certain of its directors and officers, and its offering underwriters. Tremor completed its IPO on June 27, 2013. According to the press release, the plaintiff’s complaint (which can be found here) alleges that the company’s offering documents failed to disclose that the online advertising market had shifted to mobile browsing, as opposed to desktop browsing, where the company was at a significant disadvantage, and that the company was losing sales to competitors as a result.

 

Similarly, in a November 26, 2013 press release (here), plaintiffs’ lawyers announced that they had filed an action in the Northern District of California against Violin Memory, certain of its directors and officers.  Violin Memory just completed its IPO on September 27, 2013. According to the press release, the plaintiffs’ complaint alleges that the company’s offering documents failed to disclose that the company’s sales and revenues were being negatively impacted by uncertainties surrounding the federal government budget mess and the government shutdown. A copy of the complaint can be found here. 

 

These recent IPO-related lawsuits follow a host of others filed just since August 1, 2013, including several lawsuits involving companies that completed IPOs in 2012 and earlier. The IPO-related securities suits filed just since August 1 include the following.

 

On October 25, 2013, plaintiffs filed a securities lawsuit in the District Court of Massachusetts against NQ Mobile and certain of its directors and officers. Among other things, the plaintiffs allege that the company made certain material misrepresentations in its offering documents issued in connection with the company’s May 5, 2011 IPO. Further information about the NQ Mobile lawsuit can be found here.

 

On August 27, 2013, as detailed here, plaintiffs filed a securities lawsuit in the Southern District of New York, against Lightinthebox Holding Co. and certain of its directors and officers.  The company completed its IPO on June 6, 2013. The plaintiffs allege that the company’s offering documents contained misrepresentations.

 

On August 8, 2013, plaintiffs filed a securities class action lawsuits in the Northern District of California against CafePress and certain of its directors and officers (as detailed here). Among other things the plaintiffs allege that the offering documents the company issued in connection with its March 29, 2012 IPO contained misrepresentations.

 

On August 1, 2013, plaintiffs filed a securities class action lawsuit in the Northern District of California against Vocera Communications, alleging material misrepresentations in connection with the company’s March 28, 2012 IPO, as discussed here.

 

These filings are a reminder that IPO-related lawsuits represent a significant part of securities class action lawsuit filings. Though these suits may collectively seem like only a small handful, they do represent about ten percent of all securities class action lawsuits that have been filed since August 1, 2013.

 

At a practical level this is hardly surprising, since claims under Section 11 of the Securities (the operative liability provision for IPO-related securities claims), unlike Section 10(b) of the Exchange Act, has no scienter requirement and operates as a strict liability statute. The relative prevalence of IPO-related securities suits is of course directly related to the level of IPO activity, as the above discussion shows. The 2012  Cornerstone Research year-end securities litigation repoirt (here) shows that in 2008 (that is, the year fater the last hgih water market for IPO activity) 24% of securities class action lawsuits filed included Section 11 allegatoins; but  as IPO activity dropped off in subsequent years, filings with Section 11 allegatoins declined as well; in 2012 only 10% of securities class action filngs contained Section 11 allegatoins.

 

IPO-related claims may take on greater importance in the months ahead in light of pending developments at the U.S. Supreme Court. As discussed at greater length here, the U.S Supreme Court has recently granted cert in the Halliburton case and will be revisiting the fraud on the market presumption first enunciated in Basic v. Levinson. Although there are a range of possible outcomes in the Halliburton case, one possibility is that the Court could throw out the fraud on the market presumption, making it just about impossible for plaintiffs to obtain class certification in a Section 10(b) misrepresentation case, because reliance would not be presumed but would have to be shown for each class member.

 

However, reliance is not an element of a Section 11 claim. A Section 11 claimant is not dependent on the fraud on the market theory in order to obtain class certification. In other words, even if the Supreme Court throws out the fraud on the market theory in the Halliburton case, making class certification in Section 10(b) cases effectively impossible, claimants in Section 11 claims will still be able to pursue class action claims. In that circumstance, Section 11 claims would be even more attractive to plaintiffs’ attorneys, which would make IPO-related claims an even higher priority for the plaintiffs’ attorneys than they are now. At a minimum, IPO-related class action securities claims will remain even if the Supreme Court throws out the fraud on the market presumption.

 

The kind of IPO-related claims discussed above already represent an important category of securities class action litigation. Depending on what the Supreme Court does in the Halliburton case, these kinds of cases potentially could become even more significant.

 

China Lifts IPO Moratorium: According to news reports, Chinese securities regulators are about to lift a ban on initial public offerings in the country that has been in place since November 2012. The ban was put in place to crack down on fraud and misconduct. The ban will now be lifted as part of an overhaul of the rules governing initial offerings.

 

The new IPO rules from the China Securities Regulatory Commission represent a move to a U.S.-style registration system in which the regulator will focus on whether the company seeking a listing has meet information disclosure requirements. The prior system was approval-based and dependent on whether the issuer could sustain its operations. Under the new system, investors will judge the value and risks of offerings and help to set the share price in open-market trading. According to the Wall Street Journal (here) , as many as 50 companies are expected to have registrations completed in time for offerings in January 2014.

 

Briefly Noted — South Africa: Creditor Claims Against Directors and Officers?: A November 29, 2013 memo from the Routledge Modise law firm (here) take a look at the question of whether or not creditors may pursue claims against the directors and officers of companies involving in “business rescue” proceedings (which seem to be similar to bankruptcy proceedings in the U.S.). The article concludes based on a review of relevant case law that under the applicable common law principles creditors may have certain rights to pursue claims against the directors and officers for “fraudulent and/or reckless trading.”

On November 27, 2013, the parties to the consolidated Lehman Brothers securities litigation filed with the court a stipulation of settlement pertaining to the securities class action lawsuit brought by Lehman investors against the bankrupt company’s former auditors, Ernst & Young. The accounting firm has agreed to settle the investors’ claims for a payment of $99 million. A copy of the parties’ November 27, 2013 stipulation of settlement can be found here. A November 28, 2013 Bloomberg article about the settlement can be found here. The settlement is subject to court approval.

 

Lehman’s spectacular September 2008 collapse was one of the central events in the global financial crisis. In the wake of the company’s fall, investors filed a series of securities class action lawsuits against the company’s former directors and officers; offering underwriters; and former auditor. Background regarding the litigation, which was consolidated before Southern District of New York Judge Lewis Kaplan, can be found here and here.

 

Although there were numerous defendants named in the consolidated securities litigation, investors had specifically targeted the company’s former auditors. In part this was a result of the scathing March 11, 2010 report of Anton Valukas, the bankruptcy examiner, who concluded that the company had engaged in “balance sheet manipulation.”  (Background regarding the Lehman bankruptcy examiner’s report can be found here.) Among other things, his report detailed the company’s use of a device known as Repo 105 to manage its balance sheet. The bankruptcy examiner found that the company’s auditors were aware of but did not question the company’s use of Repo 105. His report also concluded that there were “colorable claims” against E&Y on the grounds that it “did not meet professional standards” for its “failure to question and challenge improper or inadequate disclosure.”

 

In their consolidated Third Amended Complaint, which was filed on April 23, 2010 (and which can be found here), the plaintiffs alleged that E&Y had falsely certified Lehman’s 2007 financial statements; falsely conducted represented that it had conducted its audits in accordance with Generally Accepted Accounting Standards; and falsely represented that Lehman’s interim financial statements during the class period required no material modification to confirm to GAAP.

 

On September 8, 2011, Judge Kaplan entered an order dismissing all of the claims the plaintiffs had asserted against E&Y under the Securities Act and with respect to all Exchange Act claims against E&Y based on purchases of Lehman stock prior to July 10, 2008. However, Judge Kaplan denied E&Y’s dismissal motion with respect to Exchange Act claims based upon purchases of Lehman stock after July 10, 2008, through September 15, 2008.

 

On November 27, 2013, the parties filed a stipulation of settlement reflecting E&Y’s agreement settle the claims against the firm based on the accounting firm’s agreement to pay $99 million. The settlement papers reflect that the plaintiffs’ attorneys’ intent to seek attorneys’ fees of $29.7 million, as well an amount not to exceed $5 million plus interest in reimbursement of litigation expenses.

 

The E&Y settlement is the latest in a series of settlements in the consolidated Lehman Brothers securities litigation. As reflected here, the parties had previously agreed to settle the claims against the former Lehman Brothers directors and officers for $90 million. The parties had also agreed to two separate settlements with the company’s offering underwriters; as reflected here, the first of these settlements was for $417 million, and, as reflected here, the second of these settlements was for $9.018 million. The parties had also agreed to a separate $120 million settlement with UBS on behalf of certain Lehman structured products investors, as reflected here.

 

With the addition of the E&Y settlements, the settlements to date in the consolidated Lehman Brothers securities litigation now total about $735 million. These settlements, viewed in the aggregate, collectively represent the second largest settlement amounts in any of the subprime and credit crisis related securities lawsuits, exceeded only by the massive $2.43 billion BofA/Merrill Lynch merger securities suit settlement (about which refer here). The $735 million in settlements in the consolidated Lehman Brothers securities litigation exceeds the next closest subprime and credit crisis-related securities suit settlement, the $730 million settlement in the Citigroup Bondholders settlement (about which refer here).

 

The $99 million E&Y settlement in the consolidated Lehman Brothers securities litigation is not the first instance in which auditors have contributed significantly toward the settlement of a credit crisis related securities suit, but it may be the largest. KPMG did agree to contribute $37 million toward the $627 million Wachovia bondholders’ settlement. KPMG also agreed to contribute $24 million to the $624 million Countrywide settlement.

 

If Fraud on the Market is Dumped, Can Plaintiffs Still Get a Class Certified by Alleging Omissions?: As many commentators have noted (including this blog), the Supreme Court’s decision to revisit the “fraud on the market” theory in the Halliburton case could make the case the most important securities case before the Court in a generation. If the court invalidates the fraud on the market presumption, plaintiffs in misrepresentation cases under Section 10(b) of the Exchange Act would not be able to have classes certified in those cases. Without the presumption of reliance for class members, questions of individual reliance would predominate, which would bar class certification.

 

But as Doug Greene noted on his D&O Discourse blog (here), though this would mean very significant changes in the way securities suits are litigation, Halliburton “will not do away with securities litigation.” If the Supreme Court overturns the fraud on the market presumption in misrepresentation cases, the plaintiffs’ lawyers will adjust.

 

One of the ways that the plaintiffs’ lawyers will adjust is that they will change the way they plead their cases. The presumption of reliance based on the fraud on the market theory that the Supreme Court recognized in Basic v. Levinson relates to misrepresentation cases. As the Latham & Watkins law firm points out in its November 27 2013 memo about the Supreme Court’s decisions to take up the Halliburton case (here), a different presumption applies when the plaintiffs allege that investors were misled because the defendants omitted material information.

 

The Supreme Court has recognized that a plaintiff can’t show that it relied on an omitted fact. In 1972, in Affiliated Ute Citizens of Utah v. United States (here), the Supreme Court recognized a presumption of reliance on an omission of material fact by a party with a duty to disclosure that information. The Affiliated Ute presumption of reliance does not depend on the fraud on the market theory. The Affiliated Ute presumption could provide securities plaintiffs an alternative way to try to seek class certification, even if the Supreme Court overturns the fraud on the market presumption for misrepresentation cases. The plaintiffs could try to recast the way they plead their securities claims, based on allegations of material omissions rather than on material misrepresentations.

 

In a November 27, 2013 post on her On the Case blog (here), Alison Frankel takes a detailed look at the Affiliated Ute case. Among other things, Frankel notes that “it’s widely accepted that if the Supreme Court reverses Basic and does away with fraud-on-the-market reliance, class actions based on misrepresentations will be decimated. But not cases based on omissions, thanks to Affiliated Ute.” She concludes her post by noting that “if the Supreme Court undoes Basic, you can bet that … class action lawyers will be dusting off this ruling and recasting their claims.”

 

I don’t know what the Supreme Court will do in the Halliburton case. But I suspect we are going to be hearing a lot more about Affiliated Ute, particularly if the Halliburton case results in the setting aside of the fraud on the market presumption .

 

The ABA Journal Blawg 100 for 2013:Because I am concerned my first posting of this news might have been lost in the pre-Thanksgiving rush, I am repeating it again here. The news is that The D&O Diary has been selected once again for the ABA Journal’s Blawg 100, the publication’s annual list of the top 100 legal blogs. The Journal’s list of the 2013 Blawg 100 can be found here. The D&O Diary is listed in the “Niche” category.

 

It is an honor in and of itself to be recognized, but it is even more of an honor to have my blog associated with those of so many excellent bloggers whose work I follow and respect.

 

The ABA Journal is asking readers to weigh in and vote on their favorites in each of the Blawg 100’s thirteen categories. Readers can cast their ballot by visiting the Blawg 100 page on the Journal’s website, here. I would be honored if there are readers out there that would be willing to take the time to register to vote and to cast a ballot for The D&O Diary as their favorite blog in the “Niche” category. Voting ends at close of business on Dec. 20, 2013.

 

My very special thanks to the loyal readers who nominated me for be a part of the Blawg 100. I couldn’t maintain this blog without the tremendous reader support that I enjoy so much.