In many jurisdictions, corporate officials sued for their actions undertaken in their corporate capacity may be able to defend themselves in reliance on the “business judgment rule.” This rule is designed to prevent courts from second-guessing the decisions of directors and officers. The defense has become particularly important in connection with the extensive litigation the FDIC is now pursuing against the former directors and officers of failed banks.

 

Among the many questions that have arisen in the FDIC’s failed bank cases as individual defendants have tried to rely on the protection of the business judgment rule is whether or not the defense protects officers as well as directors (about which refer here) or whether it affords less protection to the directors and officers of banks than it does to corporate officials at other kinds of companies (about which refer here). The business judgment rule represents something of a hot topic now given that  the Georgia Supreme Court will be considering  questions recently certified to it from both the Northern District of Georgia (about which refer here) and from the Eleventh Circuit (about which refer here) on issues pertaining to the scope of the rule’s protections under Georgia law. Many of the recent case decisoins on the topic, as well as the questions that have been certified to the Georgia Supreme Court, have to with the extent of the rule’s limitations. Disturbingly, some courts seem to be reducting the business judgment rule’s protections.

 

 

While I have had occasion to post items on this blog about the business judgment rule, I have not stepped back and taken a comprehensive look at the rule and where it fits in the larger picture of directors’ and officers’ liability litigation. In the course of doing some Internet research, I noted that D&O maven Dan Bailey of the Bailey & Cavalieri law firm had recently published an article on the topic. Dan’s article notes a “disturbing trend” in the case law toward the dilution of the business judgment rule’s protections. Because I think this is a very important topic, I approached Dan to see if he would be wiling to publish his article as a guest post on this site. Fortunately, Dan agreed, and his article appears below.

 

 

I would like to thanks Dan for his willingness to publish his article as a guest post on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. If you would like to publish a guest post, please contact me directly. Here is Dan’s guest post. 

 

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The business judgment rule (BJR) has served for decades as the single most important protection against personal liability for directors and officers. First developed by courts over a century ago, this common law defense prevents courts from second-guessing the quality of a business decision by directors and officers. The two primary underpinnings of the BJR are:

 

1. Courts should not substitute their inexperienced business decisions for the good-faith decisions of independent and diligent business exexcutives, who have a far greater ability to make appropriate business decisions based on their extensive commerical knowledge, experience and training.

 

2. Executives should be encouraged to take prudent risks for the benefit of the company and its constituents, and should not be stymied by the fear of personal liability if a decision ultimately harms the company.

 

The BJR generally applies to business decisions made by disinterested and reasonably informed directors and officers who honestly and rationally believe their decision was in the best interest of the company. If the BJR applies, directors and officers should not be liable for the quality or results of their decisions, but only the process used to make the decision.

 

As summarized below, several recent cases and litigation tactics demonstrate this important defense for directors and officers is not full proof, and suggest a disturbing trend (outside of Delaware) toward diluting the benefit of the BJR. At a minimum, these cases and tactics highlight the volatile liability exposure which directors and officers face despite the BJR and the need for strong D&O financial protections to address that exposure.

 

A. BJR Inapplicable to Officers

Most courts and commentators have assumed without much discussion or analysis that the BJR rule applies to both directors and officers. But, several recent decisions by federal district courts in California ruled that the BJR applies only to independent directors, not officers.

 

The Delaware Supreme Court[1] and federal courts in Florida,[2] New York,[3] Illinois[4] and Georgia[5] have made the BJR available to officers. But, more than two decades ago a federal court in Pennsylvania, applying Delaware law,[6] and a California appellate court[7] stated the BJR is not applicable to officers. Commentators Sparks and Hamermesh, in a 1992 article, suggested a somewhat limited applicability to officers:

 

While there are no cases directly on point, the concept of an officer as the repository of delegated management authority by the board suggests that the availability of a business judgment rule defense may only be available to a corporate officer when that officer is operating within the scope of the delegated authority …  As a result, officers face a dual risk. Liability may attach if the officer is adjudged in hindsight to have acted outside the scope of his or her delegated authority or to have failed to act on a matter that was not (sic) within his or her expected areas of responsibility.[8]

 

More recently, five decisions by federal district courts in California ruled that the business judgment rule applies only to independent directors, not officers.

 

Although these cases are arguably driven by a California statute which codifies the BRJ only for directors, these cases reflect the potential for a disturbing judicial abandonment of an important protection for officers. In FDIC v. Perry, 9] the FDIC alleged that the CEO of IndyMac Bank breached his fiduciary duties to the failed bank by allowing IndyMac to generate and acquire more than $10 billion in risky residential loans, resulting in more than $600 million in losses to the bank. The CEO argued the lawsuit should be dismissed based on the business judgment rule. The court ruled that under California law, both the common law and statutory business judgment rule applied only to directors, not officers, and therefore the court refused to dismiss the lawsuit.

 

With respect to the common law business judgment rule, the court found no prior decision in California which applied the business judgment rule to officers. The court noted one California case which held the business judgment rule did not apply to “interested directors who effectively were acting as officers,” although the inapplicability of the business judgment rule in that prior case could be explained by the directors’ “interested” status rather than the directors’ de facto officer status. Without explanation, the court rejected the notion that the general judicial policy of deference to business decisions should apply to officers, which is obviously disturbing since courts are generally ill-equipped to substitute their business decisions (using the benefit of 20/20 hindsight) for the real-time business decisions of executives.

 

With respect to the California statutory business judgment rule, the court observed that the statute provides that directors who perform their duties as directors in accordance with the statutory standards have no liability for failing to properly discharge their duties as such. The statute, though, does not mention officers. In explaining the statute’s omission of officers, the court cited to the legislative committee’s comments to the statute, which seems to acknowledge that officers were intentionally excluded from the statute for the following reason:

 

Although a non-director officer may have a duty of care similar to that of a director, his ability to rely on factual information, reports or statements may, depending upon the circumstances of the particular case, be more limited than in the case of a director in view of the greater obligation he may have to be familiar with the affairs of the corporation.

 

In FDIC v. Hawker,[10] a California district court likewise ruled that the California statutory business judgment rule does not apply to officers because the statute references only directors and because the legislative comments to that statute do not include officers. However, the court ruled that the common law business judgment rule did not justify a dismissal of the claim against officers because issues of fact existed as to the conduct of the officers. That ruling implicitly suggests that the common law business judgment rule can apply to officers if the subject conduct of the officers falls within the scope of the common law business judgment rule.

 

In an unreported August 1, 2011 ruling in National Credit Union Administration v. Siravo, Case No. CV-10-01597 (C.D. Cal.), a different Federal District Court judge in California also ruled that the business judgment rule did not apply to officers, based on the plain language of the California statutory business judgment rule which applies only to directors.

 

In FDIC v. Van Dellen,[11] a California Federal District Court again ruled that officers are not protected by the business judgment rule both because the codification of the rule in California Corporations Code Section 309 only refers to directors and because prior California authority did not extend to officers the judicial policy of deference to a director’s exercise of good faith business judgment in management decisions.

 

In FDIC v. Faigin, 12] a California Federal District Court followed FDIC v. Perry and held that the business judgment rule does not apply to officers.

 

The wisdom of excluding officers from the BJR is certainly debatable. Officers are more knowledgeable and involved in the company’s operations than independent directors, thereby suggesting a more rigorous standard of conduct than applicable to directors. But, the underlying justifications for the business judgment rule (i.e., courts are ill-equipped to second-guess business decisions and should encourage prudent risk-taking) equally apply to claims against directors and officers.

 

B. BJR Inapplicable to Bank Directors and Officers

The BJR generally applies to directors and officers of any non-profit, private or public company because the underpinnings of the BJR are not dependent upon the type of organization. However, a recent decision by a district court in Georgia concludes that the BJR should not apply in a lawsuit by the FDIC against directors and officers of a failed bank.[13] In denying the defendant directors’ and officers’ motion to dismiss, the court concluded that the widespread impact of a bank failure justified a harsher standard on directors and officers of a failed bank than applicable to other types of organizations, and therefore directors and officers of the failed bank should not enjoy the protections of the BJR:

 

[W]hen a bank, instead of a business corporation fails, the FDIC and ultimately the taxpayers bear the pecuniary loss. The lack of care of the officers and directors of banks 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 diligence lead to the financial crisis that continues to affect the national economy…. [T]his is not a case where shareholders are suing their own officers and directors, but instead it is a case where the FDIC as receiver is seeking damages following allegedly negligent banking practices. A case where the FDIC is receiver “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.”

 

Although the court recognized that federal courts in Georgia have “uniformly” applied the BJR to protect bank officers and directors, the court did not apply the BJR to a claim by the FDIC against the failed bank directors and officers. However, the court certified that question to the Georgia Supreme Court. One month later, the 11th Circuit Federal Court of Appeals certified the same question to the Georgia Supreme Court in a different lawsuit by the FDIC against directors and officers of a failed bank.[14]

 

C. BJR Inapplicable to Intimidated Directors

One of the key elements of the BJR is the requirement that the defendant director or officer must be disinterested (i.e., the business decision must be based on the corporate merits of the decision rather than extraneous considerations or influences). Courts most frequently find this requirement lacking, and thus the BJR inapplicable, where the director or officer has a conflict of interest with respect to the decision, such as a personal financial interest in the decision or a close familial or business relationship which may impact the decision.

 

A recent Delaware Chancery Court decision ruled that otherwise disinterested directors may be considered “interested” and thus lose the BJR protection by allowing another “interested” director to intimidate them into making a particular decision.

 

In New Jersey Carpenters Pension Fund v. Info GROUP, Inc.,[15] a director who owned 37% of the company’s outstanding stock encountered a personal cash liquidity crisis and concluded that the best option to address that liquidity crisis was to promptly sell the company, regardless of whether the timing, price or process of the company sale was in the best interests of the company. The director lobbied the other directors to pursue a sale even though the rest of the Board (consistent with the advice of an investment banker) believed the market conditions would make it difficult to obtain a good price for the company.

 

The conflicted director intensified his efforts to bring about a sale of the company by repeatedly threatening other directors with lawsuits if they failed to sell the company, being generally disruptive at board meetings and waging a public campaign to fire the CEO. Eventually, the Board was “overwhelmed” by the conflicted director and pursued a sale of the company. As explained in an email from one director to another, the majority of the directors apparently “just want to dump the company and run…based on the pain, trauma, time, and everything else.” The conflicted director continued to disrupt the sale process by influencing the list of potential bidders, conducting unsupervised negotiations and leaking confidential information about the sale to various parties. Ultimately, the Board accepted an offer to purchase the company at a price per share below the then current market price.

 

In addition to finding the BJR inapplicable to the conflicted director, the court refused to dismiss the claims against the other directors based on the BJR because “it is reasonable to infer that [the conflicted director] dominated the Board Defendants through a pattern of threats aimed at intimidating them, thus rendering them non-independent for purposes of [applying the BJR to their] voting on the Merger.”

 

Although the extreme facts of this case may explain the court’s ruling, the notion that directors may lose their BJR protection by reason of a dominating or intimidating director or control person is disconcerting. The line between frank discussions/disagreements and intimidation/domination can become blurred. When dissenting views or disagreements arise, the Board should be extra cautious to create a clear and credible record that whatever decision is ultimately made is supported by legitimate and compelling business reasons and is not influenced by extraneous considerations.

 

D. BJR Inapplicable to Uninformed Directors

Another key element of the BJR is the requirement that the defendant directors and officers make an informed decision by conducting a reasonably diligent investigation before acting. Typically, this requirement is satisfied if the directors spend considerable time in making the decision and obtain advice from qualified experts. However, a recent federal Third Circuit Court of Appeals ruling reversed the dismissal of claims against directors of a bankrupt non-profit company based on the BJR even though the defendant directors received the advice of counsel, conducted several meetings and pursued various options before making the challenged decision to file for bankruptcy protection.

 

In Official Committee of Unsecured Creditors v. Baldwin, 16] the court of Appeals ruled that the District Court improperly granted a motion for summary judgment in favor of the defendant directors based on the BJR, notwithstanding the directors’ apparent diligence. The Court of Appeals ruled that plaintiffs presented credible evidence that the Board (i) received numerous red flags that senior officers upon whom the Board relied in making its decision were neither competent nor diligent, (ii) eschewed a viability study prior to filing bankruptcy, and (iii) diverted assets to another charitable organization which had an interlocking Board with the bankrupt company. As a result, triable issues of fact existed which precluded summary judgment in favor of the defendant directors.

 

This decision demonstrates that all aspects of a Board’s decision should be reasonable and thorough. Although it is unusual for a court to second-guess the adequacy of the directors’ diligence, if any part of the decision-making process is less than robust, the BJR may not be available even if all other aspects of the decision-making process are proper.

 

E. Circumvent BJR

A more subtle way plaintiffs are now avoiding the applicability of the BJR is by bringing traditional D&O mismanagement claims as federal securities law claims. The BJR only applies to common law breach of fiduciary claims (which are usually asserted in shareholder derivative lawsuits), and does not apply to federal securities law claims (which are usually asserted in securities class action lawsuits).

 

Historically, plaintiffs have had little ability to remedy D&O mismanagement through a securities law claim. In 1977, the U.S. Supreme Court ruled that a federal securities law claim must be based upon deceptive conduct (i.e., misrepresentations and omissions of material facts), rather than on allegations of mismanagement.[17] For more than 30 years, that ruling effectively eliminated attempts by the plaintiffs’ bar to circumvent the BJR through the assertion of mismanagement claims in the guise of a securities claim.

 

However, more recently plaintiffs are again testing the bounds of what is mismanagement and what is deceptive misconduct. In the aftermath of several high-profile incidents of sudden and accidental events (e.g., explosions, coal mine collapses and natural disasters), plaintiffs have tried to assert a securities class action in lieu of or in addition to a derivative lawsuit for mismanagement. If successful, this strategy both circumvents the powerful BJR defense and creates the potential for recovery of huge damages to a large class of shareholders.

 

An example of this strategy is the D&O litigation arising out of the 2010 Gulf of Mexico oil spill. Although the Deepwater Horizon rig explosion and resulting oil spill was sudden and unexpected, securities class actions were filed against the directors and officers of British Petroleum (BP), alleging that prior to the explosion and spill the defendants misrepresented and failed to disclose information regarding the adequacy of BP’s safety programs and BP’s resulting risk exposure. The defendant D&Os argued to the court, among other things, that the securities claims should be dismissed because the true nature of the alleged wrongdoing was merely mismanagement. With surprising ease and with little analysis, the court rejected the defendants’ argument, noting that the plaintiffs alleged the defendants launched an ongoing public relations campaign before the Deepwater Horizon incident to improve BP’s safety image with investors and that the subsequent alleged safety misrepresentations were not limited to the Deepwater Horizon catastrophe.[18]

 

The line articulated by the courts in these cases between mismanagement (which is subject to the BJR) and deception (which is not subject to the BJR) appears very thin. In almost any situation involving alleged mismanagement, plaintiffs now seem able to also successfully allege a securities claim based on deception. In other words, creative plaintiffs are more likely now to circumvent the protections of the BJR by converting a mismanagement claim into a securities law claim. If this litigation strategy continues, directors and officers will be facing an increasing number of securities claims arising out of unexpected events which harm the company and its shareholders.

 

F.  Fewer Inexpensive Derivative Settlements

In response to the strong protection afforded by the BJR, shareholder derivative lawsuits are frequently settled by (i) the company agreeing to certain governance reforms and other corporate “therapeutics,” and (ii) the defendant directors and officers (through their insurers) agreeing to pay a modest plaintiff attorney fee award. Although this type of settlement structure creates questionable benefit to the company and primarily benefits only the plaintiff attorneys, the fee payment by the D&O insurer can be justified in many cases in light of the potentially large defense costs which would be incurred absent the modest settlement.

 

The continued viability of this common settlement practice may be questionable in some jurisdictions in light of recent case law which refused to approve this type of settlement arrangement. For example, in one case the court refused to approve a $2.85 million plaintiff fee award in a derivative suit settlement involving only corporate reforms. The Court found the corporate reforms to be “cosmetic” and “far too meager” in light of the alleged wrongdoing. To justify these reforms, plaintiffs’ counsel argued at the settlement approval hearing that after substantial discovery the plaintiffs are unable to prove the alleged wrongdoing. In a colorful summary of why the proposed plaintiff fee was rejected, the court stated:

 

By approving this Stipulation of Settlement, the court would be compensating Plaintiffs’ counsel handsomely and encouraging plaintiffs’ attorneys in the future to go on fishing expeditions against corporations. Sometimes when an attorney goes fishing he catches a fish, and sometimes he does not – but when he does not, he should not eat filet mignon afterwards.[19]

 

In another recent case, 20] plaintiffs dismissed their derivative lawsuit because the company’s Board took certain actions requested by the plaintiffs in their lawsuits. Plaintiffs’ counsel requested a fee award from the court because they contended their derivative lawsuit was the catalyst for the Board’s actions. The defendants disagreed, contending the Board’s actions were taken independent of the derivative lawsuit. The Court found the derivative lawsuit was meritless and would have been dismissed by the court if plaintiffs had not voluntarily dismissed it. As a result, the court refused to award any fees to plaintiffs’ counsel.

 

Likewise, the Seventh Circuit Court of Appeals ruled in 2012 that a derivative lawsuit should be dismissed because it “serves no goal other than to move money from the corporate treasury to the attorneys’ coffers.” The derivative lawsuit alleged that two directors of the company also served on the boards of other companies that allegedly competed with the company, in violation of antitrust laws. The Court of Appeals noted that neither the Department of Justice, the Federal Trade Commission nor any consumer had complained about the interlocking directorships. As a result, the court concluded the lawsuit was a meaningless effort by the plaintiff lawyers to generate a fee and therefore should be rejected:

 

The only goal of this suit appears to be fees for the plaintiffs’ lawyers. It is impossible to see how the investors could gain from it—and therefore impossible to see how Sears’ directors could be said to violate their fiduciary duty by declining to pursue it…. It is an abuse of the legal system to cram unnecessary litigation down the throats of firms whose directors serve on multiple boards, and then use the high cost of anti-trust suits to extort settlements (including undeserved attorneys’ fees) from the targets.[21]

 

These cases suggest the ability to settle derivative suits by agreeing to corporate reforms and a plaintiff attorney fee payment may be increasingly limited in certain situations. That may result in plaintiffs litigating derivative suits longer, more aggressively attacking the BJR and insisting on a monetary component to the settlement in order to show greater benefit to the company and thus a larger plaintiff fee award. In other words, these seemingly pro-defendant rulings may ironically increase the erosion of the BJR and the defendants’ loss payments in future derivative suits.

 

G.  Parallel Derivative Lawsuits

As a result of a decrease in securities class action litigation in the last few years, the plaintiffs’ bar is now pursuing other types of litigation against companies and their directors and officers (including shareholder derivative lawsuits) in an attempt to replace the lucrative fees which they would otherwise earn in large securities class action settlements. Although the settlement amounts in derivative lawsuits are usually far less than securities class action settlements, this increase in derivative litigation is resulting in an increase in court decisions analyzing the BRJ. Not surprisingly, some of those decisions apply the BJR broadly and some apply it narrowly. This risk of adverse BJR rulings is aggravated by an increase in parallel derivative lawsuits in different states asserting the same claims, as described below.

 

Because derivative lawsuits assert breaches of state law fiduciary duties, those lawsuits are typically filed in state courts. Unlike the MDL procedure in the federal court system where securities class actions are litigated, there is no defined procedure for consolidating or coordinating multiple derivative lawsuits in multiple states. Therefore, the same derivative lawsuit can be, and with increasing frequency is, prosecuted in multiple states. Defendants are forced to defend identical derivative lawsuits by different shareholders around the country, thereby significantly increasing the defense costs in those cases, creating the potential for inconsistent rulings in those lawsuits, and making it much harder for defendants to reach a global settlement in all of those multiple lawsuits.

 

A recent ruling by the Delaware Supreme Court[22] involving parallel derivative lawsuits in Delaware and California highlights the challenges and opportunities in defending these multi-jurisdictional derivative claims. In that case, nearly identical shareholder derivative lawsuits were filed in both California and Delaware. The California cases were dismissed by the court because the plaintiffs failed to first make a demand on the company’s board of directors to pursue the claims. Defendants then sought to dismiss the nearly identical Delaware derivative lawsuit based upon the California court ruling. However, the Delaware Chancery Court ruled that it was not compelled to follow the California ruling and refused to dismiss the Delaware case. On April 4, 2013, the Delaware Supreme Court reversed that ruling and held that Delaware courts should follow the prior ruling in California if the two cases are essentially the same, even if the cases largely involve issues under Delaware law. As a result, plaintiffs do not get two-bites-at-the-apple if one case is dismissed or settled before the other case.

 

The Pyott decision does not eliminate or discourage plaintiff lawyers from filing overlapping derivative cases in multiple states. In fact, the Delaware Supreme Court in Pyott also rejected the Chancery Court’s related ruling that the California shareholder plaintiffs were inadequate representatives of the company to prosecute the derivative suit due to their rush to file their complaint without conducting a reasonable investigation. But, the Pyott decision can help defendants to resolve those multiple-cases at one time whether or not all of the plaintiffs participate in the resolution. The Decision can also help defendants and their D&O insurers when negotiating a settlement in the multi-state lawsuits by creating a reverse auction negotiation environment. Consistent with this Decision, one plaintiff in one of the cases can settle the derivative suit with defendants, and once the settlement is approved by the court, the remaining derivative suits in other states will likely be dismissed. As a result, any one plaintiff is incentivized to settle for an amount less than the settlement demands of the competing plaintiffs, thereby potentially precluding the competing plaintiffs from sharing in the fee award.

 

H.  Procedural Assertion of BJR

Even if the BJR otherwise applies, there is a question as to when during the course of the litigation a defendant director or officer can assert the defense. Courts have debated whether the BJR is an affirmative defense and therefore whether the rule can be raised in a motion to dismiss. As acknowledged by a district court in Florida, “courts that have considered this subject concur that it is ‘debatable’ whether a court should consider the protection of the business judgment rule on a motion to dismiss.”[23] If the applicability of the rule appears on the face of the complaint and is not dependent on additional evidentiary facts, it is likely that a court will allow the rule to be asserted in the context of a motion to dismiss.[24] However, courts “traditionally disfavor application of the business judgment rule at the motion to dismiss stage because application of the rule generally requires a fact-intensive analysis that would be incompatible with notice pleading.”[25]

 

I. Conclusions

The BJR remains an important and strong defense in Delaware and many other states. In the context of executive compensation, M&A transactions and other volatile D&O decisions, courts in those states continue to protect directors and officers from liability under most situations. However, as explained above, plaintiff lawyers in search of fees are assaulting this important liability shield with various tactics, and some courts in some states are supporting those efforts. Time will tell if these developments are long-term trends or short-term aberrations

 

The recent erosion by some courts of the BJR may be a reaction, in part, to the recent economic environment and a sense that someone should be held responsible for causing or contributing to the credit crisis and related Great Recession. However, as explained by the Delaware Chancery Court in a recent derivative lawsuit against directors and officers of Citigroup relating to their alleged involvement in the subprime mortgage collapse, the justifications for the BJR equally apply regardless of the size of the losses in the derivative lawsuit or other external circumstances:

 

Citigroup has suffered staggering losses, in part, as a result of the recent problems in the United States economy, particularly those in the subprime mortgage market. It is understandable that investors, and others, want to find someone to hold responsible for these losses, and it is often difficult to distinguish between a desire to blame someone and a desire to force those responsible to account for their wrongdoing. Our law, fortunately, provides guidance for precisely these situations in the form of doctrines governing the duties owed by officers and directors of Delaware corporations. This law has been refined over hundreds of years, which no doubt included many crises, and we must not let our desire to blame someone for our losses make us lose sight of the purpose of our law. Ultimately, the discretion granted directors and managers allows them to maximize shareholder value in the long term by taking risks without the debilitating fear that they will be held personally liable if the company experiences losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable.[26]

 

If this more balanced view (which continues to be endorsed by Delaware courts) is rejected with increased frequency by courts in other states, the liability exposure of directors, officers and their insurers will significantly increase over time, which could have a disturbing impact on the quality of corporate governance.

 

[1] Kelly v. Bell, 266 A.2d 878, 879 (Del. 1970).

 

[2] AmeriFirst Bank v. Bomar, 757 F. Supp. 1365, 1376 (S.D. Fla. 1991).

 

[3] Detwiler v. Offenbecher, 728 F. Supp. 103, 149 (S.D.N.Y. 1989).

 

[4] Selcke v. Bove, 258 Ill. App. 3d 932, 196 Ill. Dec. 202, 629 N.E.2d 747 (Ill. App. 1st Dist. 1994).

 

[5] FDIC v. Blackwell, 2012 U.S. Dist. LEXIS 109676 (N.D. Ga. Aug. 3, 2012).

 

[6] Platt v. Richardson, 1989 U.S. Dist. LEXIS 7933 (M.D. Pa. June 6, 1989).

 

[7] Gaillard v. Natomas Co., 208 Cal. App. 3d 1250, 256 Cal. Rptr. 702, 711 (1989).

 

[8] Sparks & Hamermesh, Common Law Duties of Non-Director Corporate Officers, 48 Bus. Law. 215, 234–35 (1992).

 

[9] 2011 U.S. Dist. LEXIS 143222 (C.D. Cal., Dec. 13, 2011).

 

[10] 2012 U.S. Dist. LEXIS 79320 (E.D. Cal. June 7, 2012).

 

[11] 2012 U.S. Dist. LEXIS 146648 (C.D. Cal. Oct. 5, 2012).

 

[12] 2013 U.S. Dist. LEXIS 94899 (C.D. Cal. July 8, 2013).

 

[13] FDIC v. Laudermilk, 2013 U.S. Dist. LEXIS 166924 (N.D. Ga., Nov. 25, 2013). Cf, FDIC v. Adams, 2013 U.S. Dist. LEXIS 168211 (N.D. Ga., March 21, 2013) (BJR applies to claims under Georgia law by FDIC against directors and officers of failed bank).

 

[14] FDIC v. Skow, 2013 U.S. App. LEXIS 25490 (11th Cir. Dec. 23, 2013).

 

[15] 2011 Del. Ch. LEXIS 147 (Del. Ch., Sept. 30, 2011).

 

[16] 2011 U.S. App. LEXIS 19312 (3d Cir., Sept. 21, 2011).

 

[17] Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977).

 

[18] In re BP p.l.c. Sec. Litig., 758 F. Supp. 2d 428 (S.D. Tex., Feb. 13, 2012).

 

[19] In re Cirrus Logic, Inc., 2009 U.S. Dist. LEXIS 131583 (W.D. Tex., Jan. 8, 2009).

 

[20] Central Laborers’ Pension Fund v. Blankfein, 2011 N.Y. Misc. LEXIS 4555 (Sup. Ct. NY, Sept. 21, 2011).

 

[21] Booth v. Crowley, et al., 2012 U.S. App. LEXIS 11927 (June 13, 2012).

 

[22] Pyott v. La Municipal Police Employees’ Retirement System, 2013 Del. LEXIS 179 (April 4, 2013).

 

[23] Lancer Offshore, Inc. v. Citgo Group Ltd., 2008 U.S. Dist. LEXIS 25740 (S.D. Fla. Mar. 31, 2008).

 

[24] FDIC v. Briscoe, 2012 U.S. Dist. LEXIS 153603 (N.D. Ga. Aug. 14, 2012); FDIC v. Spangler, 2011 U.S. Dist. LEXIS 147188 (N.D. Ill. Dec. 22, 2011).

 

[25] Data Key Partners v. Permira Advisors LLC, 2013 Wisc. App. LEXIS 640 (Wisc. App. Aug. 1, 2013). See also, Colgate v. Disthene Group, Inc., 2013 Va. Cir. LEXIS 9 (Buck. Co. Cir. Ct., Feb. 4, 2013) (applicability of business judgment rule is an issue of proof for trial and is not properly addressed by demurrer).

 

[26] In re Citigroup Ins. Shareholder Der. Lit., 964 A.2d 106, 139 (Del. Ch. 2009).

 

In my year-end survey of corporate and securities litigation, one of the trends I noted regarding the litigation that had been filed in 2013 was the rise in lawsuit filings following in the wake of governmental investigations and regulatory actions, particularly with respect to investigations and regulatory actions outside the United States. If two recently filed lawsuits are any indication, this lawsuit filing trend has continued as we have headed into the New Year.

 

On January 21, 2014, plaintiffs’ lawyers filed a securities class action lawsuit in the District of Utah against Nu Skin Enterprises and its CEO and CFO in the wake of news reports that governmental authorities in China are investigating the sales practices of the company’s representatives of that country. The plaintiffs’ lawyers January 21, 2014 press release about the lawsuit can be found here.

 

 The Wall Street Journal reported on January 16, 2014 (here) that the previous day the China People’s Daily newspaper had published reports that the company was operating an illegal pyramid scheme in the country. The Journal alsoreported that the allegations were being investigated by China’s State Administration of Industry and Commerce. In a January 16, 2014 press release (here), the company responded to the allegations. The company’s share price declined sharply on the news of the investigations.

 

In their complaint (here), the plaintiff shareholders allege that Nu Skin and its executives “failed to disclose either its fraudulent sales practices and non-compliance with laws and regulations in China, or their potential impact on the company.” The complaint alleges further that the defendants “knew that the Company’s operations in China were an illegal pyramid scheme in violation of Chinese law and, as such, the business operations and prospects were false and would tumble [sic] when the illegal practices came to light.” The plaintiffs allege that the defendants’ misrepresentations and omissions violated Sections 10(b) and 20 (a) of the Exchange Act as well as Rule 10b-5.

 

In a separate lawsuit, on January 15, 2014, plaintiffs filed a shareholders’ derivative action in Cook County (Illinois) Circuit Court against certain current and former directors and officers of Archer Daniels Midland Company, as well as against the company as nominal defendant. The plaintiff’s complaint relates to the company’s December 20, 2013 settlement with the U.S. Department of Justice and the SEC in connection with allegations that between 2002 and 2008 the company’s subsidiaries in Germany and Ukraine had been involved in a scheme to bribe Ukrainian officials in order to obtain tax refunds from the Ukrainian government, in violation of the Foreign Corrupt Practices Act (FCPA).

 

As reflected in the company’s December 20, 2013 press release (here), entered into a non-prosecution agreement with DOJ and a consent decree with SEC and has agreed with these agencies to monetary relief totaling approximately $54 million. The SEC’s press release regarding the settlement can be found here.

 

In their complaint (redacted version here), the plaintiff shareholder allege that the individual defendants  — despite operating in countries with “less-developed legal and regulatory frameworks” — allowed the company “to operate in these countries without implementing or maintaining any of the internal controls for the Company’s compliance with the requirements of the FCPA” The complaint further alleges that “as should be expected when there is no one ensuring compliance, ADM repeatedly violated the FCPA.”

 

The complaint alleges that “the defendants’ failures to implement any internal controls at ADM designed to detect and prevent FCPA violations have severely damaged the FCPA,” referencing the company’s settlements with the DoJ and the SEC. The complaint asserts claims for breach of fiduciary duty, waste of corporate assets and unjust enrichment. The complaint seeks to compel the company to institute remedial measures, as well as the entry of a judgment “against the Individual Defendants and in favor of the company for the amount of damages sustained by the company as a result of the Individual Defendants’ breach of fiduciary duty, waste of corporate assets, unjust enrichment, and aiding and abetting breaches of fiduciary duties.”

 

There are several noteworthy things about these lawsuits, including the fact that both of the lawsuits were filed after the defendant companies had been hit with regulatory actions involving company operations overseas. It is also worth noting that both of these companies have extensive overseas operations and that both of them derive a significant portion of their revenue from their overseas operations. In a world in which regulators both inside and outside the U.S. are increasingly active in investigating and enforcing regulations in connection with companies’ operations outside the U.S., companies that operate globally are facing a growing prospect for regulatory and investigative actions involving their overseas operations. As these cases highlight, among the risks for U.S. companies associated with this growing investigative and regulatory exposure is the likelihood of follow on civil litigation in the U.S.

 

To be sure, the possibility of a follow-on civil action in the wake of an FCPA investigation is nothing new; indeed, it is a phenomenon that I have frequently noted over the years on this blog (refer for example here). I have even previously noted that actions of this type, while frequently filed, are not always successful (refer for example here). But while this type of follow on suit is not new, these kinds of actions are representative of and part of the rise in civil lawsuits in the U.S. against U.S. companies following on after an investigative or regulatory action involving operations outside the U.S.

 

The Nu Skin action is particularly noteworthy in several respects. First, it arises out of the investigation of the overseas operations of a U.S. company by an overseas regulator. Second, it involves an area of regulatory oversight and scrutiny that in the past may not have been as likely to give rise to a regulatory investigation, but that may represent the increasing regulatory and investigative exposure that U.S. companies face in connection with their overseas operations.

 

As both U.S. and non-U.S. regulators focus increased regulatory scrutiny on operations in these countries outside the U.S., the likelihood is that regulatory investigative and enforcement actions will continue to increase. As these regulatory and investigative actions increase, the likelihood is that the follow in civil action will continue to increase as well.

 

In earlier posts (here and here) I detailed the growing threat of regulatory enforcement outside of the U.S., including in particular the rise of cross-border regulatory and enforcement collaboration.

 

Knowing it When You See It: An article in the January 20, 2014 New Yorker entitled “The Billionaire’s Playlist”  (here) describes how Russian oligarch and philanthropist Leonard Blavatnik first accumulated his wealth by acquiring aluminum assets in the aftermath of  the collapse of the Soviet Union. Blavatnik had a number of American investors in his enterprise at the time, including the billionaire entrepreneur Sam Zell.

 

The article cites Zell as saying that he “found the climate extraordinarily difficult.” Zell described his involvement by saying “We were making small investments, doing a lot of different things to see if we could function [in Russia].” Zell said, “We concluded that we could not.” Asked we not, Zell said, “Start with the Foreign Corrupt Practices Act and go from there.”

 

Many insurance buyers now regularly include a separate component of Side A insurance as part of their D&O insurance program. However, even though it has become an increasingly common part of many companies’ D&O insurance programs, Side A D&O insurance is not always fully understood. In the following guest post, Robert F. Carangelo and Paul A. Ferrillo of the Weil. Gotshal & Manges law firm take a look at the “myths and realities” of Side A D&O insurance.

 

I would like to thank Robert and Paul for their willingness to publish their article on this site. I welcome guest post contributions from responsible commentators on topics of interest to readers of this blog. Anyone interested in submitting a guest post should contact me directly. Here is Robert and Paul’s guest post:

 

 

Almost like King Solomon’s mines, there is no greater mystery in the world of Directors and Officers (D&O) insurance than that of “Side A” D&O insurance. As described by a good friend and mentor, it is like “some ethereal layer of D&O insurance that sits on top of a traditional tower of D&O insurance. Sometimes it is there. Sometimes it is not. Almost ‘Houdini-like.’” Though amusing, this comment actually reflects the views of many sophisticated professionals in the D&O and securities litigation spaces. This article will serve as the legend to the “map” of Side A D&O insurance for Directors and companies to use to better understand its myths and realities, including what it covers and what it does not cover, and what type of Side A insurance is worth purchasing.

 

 

By way of background, Side A D&O insurance (also referred to as “Coverage Part A”) covers non-indemnifiable (or “not indemnified,” depending on the wording) Loss[i], meaning that a Company (1) cannot advance or indemnify its directors and officers under its bylaws, or (2) is financially unable to do so (such as when a company files a proceeding under Chapter 11 of the United States Bankruptcy Code).

 

 

The latter proposition in pretty simple: no money in the corporate treasury means no advancement or indemnity – and that is why Side A D&O insurance exists from “dollar one” of the D&O tower of insurance. It provides coverage for the Directors and Officers only (not the company), and most Side A policies contain some language to clarify that it is not an asset of the estate.

 

 

The former proposition is often misunderstood. For a company organized under the laws of Delaware, the settlement of a shareholder derivative action is non-indemnifiable, but defense costs associated with a shareholder derivative action are indemnifiable. A judgment against a Director that he or she committed “bad faith” under Delaware Law also is non-indemnifiable (and also is outside of Delaware’s raincoat provisions). Most other things are indemnifiable (like the settlement of a securities class action against a solvent company), and that is why there is a lot of confusion about when the Side A policy is available (or not).

 

 

Various Side A D&O Products

 

Though there are some variations around the edges of each insurance policy, there are generally three different types of Side A D&O coverage.

 

 

Side A Excess D&O insurance is exactly what that phrase says. It is excess Side A coverage above the company’s traditional D&O tower (which itself has Side A coverage, Side B Company Reimbursement Coverage, and Side C Corporate Entity coverage imbedded therein). It generally follows the form of the underlying primary D&O insurance policy, but again only on a Side A basis (note that not all Side A policies truly follow form and should be checked for “liberalization” endorsements). Buyers should be careful, as sometimes Side A excess D&O carriers include exclusions or restrictions in definitions or elsewhere rather than putting them up front. Companies buy traditional Side A excess D&O coverage to supplement their traditional tower of insurance by providing some “sleep insurance” in case of a corporate calamity like a restructuring, and to provide for a separate pot of insurance for the settlement of a shareholder derivative action.

 

 

Side A Excess Difference in Conditions (DIC) coverage is a little different. It is excess Side A D&O insurance, but it tends to be a bit broader, and tends to have fewer exclusions, like, for instance, the traditional “insured versus insured” exclusion or a “pollution exclusion” that are normally contained in a primary D&O policy. Side A DIC could respond when the Company itself refuses to advance or indemnify. Side A DIC coverage also can drop down and fill in gaps in a tower of insurance when an underlying carrier fails or refuses to pay for any reason under a policy, or attempts to rescind or avoid coverage. Side A DIC coverage also provides coverage if an underlying excess carrier becomes insolvent. Side A DIC coverage is not a one-trick pony, and is therefore useful to have in a company’s risk management toolbox.

 

 

Independent Director Side A D&O coverage (or “IDL”) is Side A excess coverage for independent directors only. It is not shared with officers, or inside directors. It thus is a separate source or pool of D&O insurance to help settle “the bad case” against the independent directors, for example, in a shareholder derivative action or a bankruptcy proceeding. Side A IDL is more commonly procured by bigger companies, which have boards generally consisting mostly of independent directors.

 

 

How Much Side A Excess Insurance Should You Buy?

 

This is a question that we often get asked by companies. Unfortunately, the question usually comes after it is too late:

 

 

·        After the filing of a major shareholder litigation, with corresponding shareholder derivative litigation, driven by a large stock drop;

 

 

·        After the commencement of a major regulatory investigation; or

 

 

·        After the need arises to file for Chapter 11.

 

 

As we have counseled in prior articles (see, e.g., Berkovich and Ferrillo, “Securing The Directors and Officers Liability Insurance Lifelines”, available here), these are obviously the worst times to try to purchase additional Side A coverage to protect the directors and officers, mainly because: (1) carriers generally will not offer additional coverage when conditions are bleak, and (2) the cost will be prohibitive.

 

 

There is no “correct” answer as to how much Side A coverage a company should have, and in what form because that calculation depends on many factors. But assuming a Company has sufficient resources to fulfill its risk management needs under ideal circumstances (and to protect its most valuable assets, e.g., its people), here are some observations and guidelines based on experience gleaned from difficult situations companies have faced over the last several years:

 

 

·        Many companies do not buy enough insurance to cover their most dangerous exposure: their market capitalization risk in the event a company suffers a dramatic stock drop due to “bad news,” e.g., a failed product, a missed quarter, or worse yet, inaccurate or fraudulent financial statements.

 

 

·        There are metrics to find out what “enough” means. Some brokers use bench-marking (i.e., comparing companies of the same size to see what the “the other guy” buys). Others do market capitalization analyses using average settlement figures used by NERA and Cornerstone. The most sophisticated D&O brokers use both. Understand though that those metrics normally only cover “settlement costs” of securities class actions and derivative actions. In a worst-case scenario, there also could be millions of dollars in defense costs from both the litigations themselves, and from the costs of the inevitable regulatory investigations. These fees erode the limits of the traditional insurance coverage, which makes an adequate supply of Side A coverage even more important (especially for the independent directors). Lastly, another metric is simply a rule of thumb to which some companies adhere, i.e., if a Company buys $200 million in traditional insurance coverage, it will allocate 1/3 of that coverage for Side A Excess coverage (in some form of product described above). We do not ascribe perfection to any particular analysis. Instead we urge consideration of all of these methods in making an adequate purchase of Side A Excess D&O insurance. Because the worst news a director needs to hear after learning that the company needs to restate its financial statements is that its management also did not buy enough insurance (or the right type of insurance) to cover the costs of the litigation and regulatory investigations.

 

 

·        Buy Your Side A From Experienced, Claims-Paying Carriers: Another common (but frustrating) misconception is that all Side A carriers are alike, and that all Side A carriers pay claims. We can tell you from experience that this misconception has been the source of much frustration for public companies, their D&O insurance brokers and their securities lawyers. So how can you better understand which carriers pay claims and which do not? Sophisticated D&O brokers who have been involved with major shareholder and merger disputes often deal with numerous carriers, so they can often give very good advice. Ask other risk management professionals who they use as Side A carriers, and learn from their experience. Finally, ask your securities litigators (who often see many Side A carriers in mediations) who they prefer to see on their side of the table, and who they do not want. This is too important a question to ignore or take for granted. Experienced (paying) carriers have credibility that can make a real difference. If things are bad enough that you have to rely on Side A coverage, having a carrier that has the respect of the plaintiff bar, defense bar and mediators alike can prove invaluable. Resolving tough claims is always easier when defense counsel and the carriers work well together and trust each other. Reputation is important. A Side A claim is no place to break in an inexperienced carrier.

 

 

·        When in Doubt, Err Towards Side A DIC Coverage: For the reasons set forth above, it is simply more useful than standard Side A Excess Coverage (without the DIC feature).

 

 

·        Buy Side A in “Big Chunks”: From a securities litigator’s perspective, there is nothing more harrowing than entering into a mediation process (in the attempt to settle “a bad case”) and learning that there are 15-20 D&O carriers sitting around the table with you, all of whom may have the same view as you, or, more likely, differing views as to what the underlying case is worth, and what coverage exclusions apply (or not) to the case. For a Fortune 100 company that buys a lot of D&O, that situation might not be avoidable, but we have seen multiple D&O carriers show up for much smaller companies (extending limits of $5 to $10 million per layer). In this insurance market, it is possible to buy more than $50 million in Side A limits from the same carrier. At least one carrier offers up to $100 million in limits. Obviously, for resolving matters, fewer carriers are much better and ultimately worth the additional costs.

 

 

·        Counterparty Risk to Inexperienced A-Side Carriers: Overlayering limits does not help mitigate counterparty exposure. Actually, it increases it. Fewer layers allow you to cherry pick your carriers. Start with claims behavior, look at surplus, solvency, and what other programs your enterprise has with them—how much of their skin is in your game? Small specialty Side-A-only carriers have less to lose by stonewalling or foot dragging, but with only the relatively modest Side A premiums to rely on, it is easy to see how they may balk when asked to pay millions. “Go to” primary carriers that pay claims make the best Side A play—too much is at stake, and with their bigger piece of the premium pie, they have the resources to deliver. As we see it, you are far better off buying a bigger Side A tower with larger layers than risking a Tower of Babel through over-layering a smaller one. Let the DIC features do their job and offset counterparty risk.

 

 

·        Negotiate Your Side A Terms Hard: In the current environment, the Side A D&O market is very competitive, with some carriers even agreeing to forego an “insured versus insured” exclusion (which is very important in bankruptcy settings). One carrier has gone even further. If a company buys its primary policy and its Lead Side A excess DIC policy from this carrier, it in essence “deletes” the “insured versus insured” exclusion up the whole tower of insurance. That could potentially be a huge advantage for directors and officers involved in a corporate meltdown or bankruptcy. If possible, such wording should be sought out by companies since it makes their Side A coverage more user-friendly in the event something bad happens.

 

 

We hope the above helps to decipher Side A D&O insurance. But given that judgment calls must be made in this process, it is always wise to consult not only with your securities lawyers, but also with a sophisticated D&O broker to get additional advice. This is too important an area to leave to chance.

 

[i] For purposes of this article, the term “Loss” means defense costs, expert costs, judgments and settlements.

Securities class action lawsuit filings “saw a small increase” during 2013, while securities class action settlements reflected a dynamic in which “large settlements got larger and smaller settlements got smaller” during the year, according to the annual report from NERA Economic Consulting. The January 21, 2014 report, entitled “Recent Trends in Securities Class Action Litigation: 2013 Full-Year Review” can be found here. NERA’s January 21, 2014 press release about the report can be found here. As discussed below, the report has particularly significant analysis  — based on the decline in the number of publicly traded companies — about the likelihood of an average publicly traded company becoming involved in securities litigation.

 

A preliminary word is order to highlight and explain the differences between the filing figures appearing in the NERA report and those published by other commentators (including this blog, as reflected in my own 2013 securities litigation filing study, which can be found here).

Two aspects of the NERA’s lawsuit counting methodology result in NERA reporting higher filing figures than other commentators. Both of these items are identified and described in endnote 2 to the NERA report. First, NERA includes in its lawsuit tally not only cases involving alleged violations of the federal securities laws, but it also includes cases filed in federal court that “allege violation of common law, including breach of fiduciary duty” (for example, in merger objection lawsuits), as well as cases filed in federal court that allege violation of “foreign or state law.” Second, multiple lawsuits filed against the same defendant involving the same basic allegations that are filed in separate circuits are counted as separate lawsuits (multiple suits in the same circuit are counted only once).

As a result of these counting methodologies, the filing figures that NERA reports are higher than those reported by other commentators. NERA itself notes with respect to its counting methodology that “different assumptions” than those that NERA used “would likely lead to counts that are directionally similar” but that might “in certain circumstances lead observers to draw a different conclusion about short-term trends in filings.” In other words, in drawing conclusions about filing trends, it is very important to understand how the assumptions made and methodologies used affect the analysis.

Based on its counting methodology, NERA determined that there were 234 securities class action lawsuits filed in 2013, representing a 10% increase over the 213 filed in 2012, and a slight increase over the 2008-2012 average of 224. NERA noted an increase even with respect to what it describes as “standard” securities class action lawsuits (that is, suits alleging violations of Section 10(b) of the ’34 Act or Sections 11 or 12 of the ’33 Act.) NERA noted that there were 165 of these “standard” lawsuits in 2013, representing a 15% increase over the 143 filed in 2012, and representing the highest annual number of “standard” filings during the 2009-2012 period (although still well below the 218 “standard” cases filed in 2008 during the surge of filings associated with the credit crisis).

I have frequently noted that securities lawsuit filings trends are often described solely with respect to the absolute number of filings, without taking account of the fact that the number of publicly traded companies has been declining for years. The NERA report expressly addresses this concern, noting that during 2013, there were 43% fewer publicly traded companies than there were in 1996. Taking this decline in the number of publicly traded companies into account, the number of 2013 securities lawsuit filings suggests that “an average company listed in the U.S. is 83% more likely to be the target of a securities class action lawsuit in 2013 than in the first five years after the passage of the PSLRA.”  In my view this is a particularly significant conclusion that should be underscored for anyone who wants to understand the likelihood that any particular publicly traded company might become involved in securities litigation.

As noted above, the NERA study includes within its tally of securities lawsuit filings federal court merger objection cases that involve only alleged breaches of fiduciary duty, even if the cases do not involved alleged violations of the federal securities laws. Taking this counting methodology into account, the NERA study reports that merger objection cases represented the largest distinct group of filings in 2013, even though the merger objection filings during the year were down compared to the peak of such filings in 2010. In 2013, there were 50 merger objection filings, compared to 56 in 2012 and compared to 70 in 2010. Though down from the 2010 peak, the 2013 merger objection filings remained well above prior years; for example, there were only 9 such filings in 2007.

Filings against non-U.S. companies had surged in 2011, largely as a result of filings that year against U.S.-listed Chinese companies. The filings against foreign issuers declined in 2013 compared to 2011, although these filings were still above historical levels. In 2013, there were 35 filings against non-U.S. companies, representing 15% of all filings, compared to 62 such filings in 2011 representing 27.7% of all filings that year. By contrast, in 2009, there were only 23 filings against non-U.S. companies, representing only 11.1% of all filings that year.

The 2013 filings levels against non-U.S. companies were closer to the proportion that foreign companies represent among all U.S.-listed companies than was the case in 2011. That is, in 2013, foreign companies represented 16.3% of all U.S.-listed companies and were involved in about 15% of all securities lawsuit filings, whereas in 2011, foreign companies represented about 16.4% of all U.S. listings, but were involved in about 27.7% of all securities lawsuit filings.

The NERA report also contains an analysis of motions to dismiss in securities cases. The report notes that a motion to dismiss is filed in about 95% of cases, although courts reach a decision in only about 80% of cases because cases are sometimes resolved before the court rules or because plaintiffs voluntarily withdraw their suits. Out of the motions to dismiss for which a court decision was reached, the motion is granted 48% of the time, granted in part and denied in part 25% of the time, and denied 21% of the time.

About 75% of all cases settle or are otherwise resolved before a motion for class certification is filed. Moreover, because courts actually rule on the motion for class certification in only 58% of the cases in which a motion for class certification is filed, courts actually rule on a motion for class certification in only about 15% of all securities cases. Of the cases in which the court rules on the motion, the motion for class certification is granted about 77% of the time. However, the NERA reports that the Supreme Court’s 2011 ruling in the Halliburton case and 2013 ruling in the Amgen case are likely to have an impact on these figures going forward, as is the anticipated ruling in the Court’s 2014 consideration of the Halliburton case.

Only 100 securities class action lawsuits settled in 2013, only slightly above the record low number of settlements in 2012, when there were 96 (which was the lowest number of settlements since 1996). There were also relatively fewer cases dismissed in 2013 as well (only 79, compared to 87 in 2012 and 118 in 2011). Resolved cases “relatively few compared to historical norms.” The report discusses the possibility that dismissals and other case resolutions may be pick up after the Supreme Court rules in the its current consideration of the Halliburton case.

Largely as a result of the presence of eight very large settlements during the year, the average settlement amount in 2013 broke prior records, reaching $55 million, an increase of 53% over the previous year’s average of $36 million and 31% over the previous high of $42 million in 2009. While the average settlement during the year was up, the median settlement was down. The median settlement amount in 2013 was $9.1 million, representing a 26% decrease from the median of $12.3 million in 2012. Overall, the report concludes, a few large settlements drove the average up, while many small settlements drove the median down; hence the report concludes that “large settlements got larger and smaller settlements go smaller.”

With respect to plaintiffs’ attorneys’ fees, the report notes that during the period 2011-2013, for settlements below $5 million, median fees represented 30% of the settlement, whereas for settlements above $1 billion, the percentage falls to about 9.6% of the settlement. Aggregate plaintiffs’ fees were $1.13 billion in 2013, well above the $650 million aggregate in 2012, but well below the $1.543 billion in 2010.

Though I have attempted to summarize the NERA report above, the report itself contains a wealth of other information that I have not come close to capturing here. The report is relatively brief, but it is full of useful and interesting information and is well worth reading at length and in full. It is worth noting, as the report itself notes several times, that the Halliburton case now pending before the U.S. Supreme Court has the potential to significantly alter the litigation environment on which this statistical analysis is based.

In a front-page, above-the-fold article on Saturday, January 18, 2014 — that is, more than a month after Target first learned from the Secret Service that the company had been the subject of a massive cyber security hack – the New York Times reported that the company was vulnerable to the cyber attack because its systems were “astonishingly open – lacking the virtual walls and motion detectors found in secure networks like many banks’.”

 

The Times article is merely the latest part of a massive wave of negative publicity that has surrounded the company since it first announced the cyber attack a month ago. The Times article portrays the company as still struggling desperately just to get a handle on what happened and to try to start to repair the damage.

 

The recent events at Target underscore the damaging impact that a cyber breach can have on a company, its customers, and its business partners. As the situation unfolds, many lessons undoubtedly will be drawn from this incident. Among many other things, the recent events at Target will provide an opportunity to consider public company disclosure practices regarding privacy, network security and cyber vulnerability. 

 

As my good friend Lauri Floresca of Woodruff Sawyer noted in a January 13, 2014 post on her firm’s Cyber Liability Blog (here), the Target cyber breach will serve as a “significant test case” for assessing the SEC’s disclosure guidance – both with respect to Target’s disclosures prior to the incident and also with respect to its future disclosures, as its grapples with the consequences of the breach. A January 16, 2014 memo from the Akin Gump law firm entitled ‘Cybersecurity Update: Are Data Breach Disclosure Requirements on Target?” (here) raises many of these same issues.

 

Readers will recall that in October 2011, the SEC issued guidance on cyber liability disclosure, as discussed here. Among other things, the Guidance suggested that appropriate risk factor disclosures might include:

 

  • Discussion of aspects of the registrant’s business or operations that give rise to material cybersecurity risks and the potential costs and consequences;
  • To the extent the registrant outsources functions that have material cybersecurity risks, description of those functions and how the registrant addresses those risks;
  • Description of cyber incidents experienced by the registrant that are individually, or in the aggregate, material, including a description of the costs and other consequences;
  • Risks related to cyber incidents that may remain undetected for an extended period; and
  • Description of relevant insurance coverage.

 

As Floresca points out, in its most recent SEC filing on Form 10-K, dated March 20, 2013 (here), Target identified certain cyber liability concerns among the company’s risk factors. The company’s risk factors included the following:  

 

If our efforts to protect the security of personal information about our guests and team members are unsuccessful, we could be subject to costly government enforcement actions and private litigation and our reputation could suffer.

The nature of our business involves the receipt and storage of personal information about our guests and team members. We have a program in place to detect and respond to data security incidents. To date, all incidents we have experienced have been insignificant. If we experience a significant data security breach or fail to detect and appropriately respond to a significant data security breach, we could be exposed to government enforcement actions and private litigation. In addition, our guests could lose confidence in our ability to protect their personal information, which could cause them to discontinue usage of REDcards, decline to use our pharmacy services, or stop shopping with us altogether. The loss of confidence from a significant data security breach involving team members could hurt our reputation, cause team member recruiting and retention challenges, increase our labor costs and affect how we operate our business.

…….

A significant disruption in our computer systems could adversely affect our operations.

We rely extensively on our computer systems to manage inventory, process guest transactions, service REDcard accounts and summarize and analyze results. Our systems are subject to damage or interruption from power outages, telecommunications failures, computer viruses and malicious attacks, security breaches and catastrophic events. If our systems are damaged or fail to function properly, we may incur substantial costs to repair or replace them, experience loss of critical data and interruptions or delays in our ability to manage inventories or process guest transactions, and encounter a loss of guest confidence which could adversely affect our results of operations.

It is interesting to consider these disclosures in light of the events since the company has announced that nearly 40 million payment card records and encrypted PINs and nearly 70 million records containing customers’ information have been compromised.

 

As I noted above, since it first disclosed the breach, the company has been subjected to a massive barrage of negative publicity. According to the Times article, the company has had to form and populate a huge team of “hundreds of employees” to try to understand the breach and to communicate with their clientele and business partners about what has happened. The company’s already damaged reputation has taken further hits as the company has been forced to reveal further information about more comprehensive breaches beyond those initially disclosed.

 

Message boards and social networking sites are full of vituperative messages from angry customers upset that their private information has been lost.  The company has been hit with nearly 70 class action lawsuits filed on behalf of consumers and others. The company’s CEO has issued an apology and he and other senor managers have been compelled to respond to a steady stream of media requests. The firm has also seen a revenue downturn as current and prospective customers have steered away from the company’s stores out of privacy and security concerns. The Times article quotes one sources as saying that the “total damage to banks and retailers” resulting from the Target network security breach “could exceed $18 bilion.”

 

Hindsight is always 20-20, but in light of the magnitude of the crisis that the cyber breach has caused the company, it seems fair to ask whether or not the company’s risk factors fully captured the magnitude of the risks that a cyber incident posed for the company. As Floresca notes in her blog post, among the questions that may be asked is whether Target’s disclosures sufficiently disclosed the “probability of cyber incidents occurring” and the “quantitative and qualitative magnitude of those risks.”  To be sure, it could be argued that no one could have envisioned a breach of this magnitude. But now that the Target breach has happened, the disclosure practices that may have seemed sufficient in the past may no longer suffice. 

 

As the Akin Gump memo stated in the memo to which I linked above, “issuers should consider whether or not their current risk factor disclosures, as well as their ‘forward-looking statements’ language, are adequate in light of these high-profile cybersecurity incidents.” In particular, the memo notes that “in light of these high-profile cyber attacks, companies may want to take a fresh look at the SEC’s 2011 Disclosure Guidance to determine if their current risk factor disclosures should be supplemented to identify risks as technology evolves and more incidents occurs,” adding that the company should discuss its risks “in a way that avoids boilerplate language and statements of general risk applicable to all users of information technology.”

 

Even before the latest cyber security breaches, the SEC had already made it clear that corporate disclosure of cyber-security related risks is a priority for the agency. In light of the magnitude and high-profile nature of the Target incident, it seems probable that the agency’s focus on cyber security risks will be even higher profile. How that may translate into action remains to be seen, but it does seem likely that the company will select a company to use as an example in order to communicate its concerns about cyber disclosure issues.

 

As noted above, Target has already been hit with a host of lawsuits related to the recent network breach. To my knowledge, so far these lawsuits do not include a directors and officers’ liability lawsuit. Whether or not Target is hit with a D&O lawsuit, the possibility of an incident like this resulting in a D&O lawsuit seems obvious, at least to me. There have of course been D&O lawsuits in the past following cyber breaches, most notably in connection with Heartland Financial’s cyber breach. As norms about cyber disclosure evolve, and as expectations in connection with cyber disclosure change, it seems probable that the likelihood of a securities lawsuit alleging misrepresentations or omissions in connection with cyber disclosure will increase.

 

The recent events at Target have been hugely disruptive for the company, which presents object lessons for the many other companies. The most obvious companies to whom these lessons apply are other retail businesses. However, it would be a mistake to assume that the lessons only apply to other retail businesses. There are lessons for any enterprise here. While it is true that the hackers involved in the Target breach were targeting credit card information, other hackers may have other motivations. Other hacker groups may be more interested in intellectual property (such as proprietary technology) or corporate strategy.

 

The lesson from the Target breach is not that companies with credit card information are vulnerable. It is that the world is a dangerous place and that skilled and motivated hackers will target vulnerable companies. While some hackers are focused on consumer credit card information, companies that do not possess this type of information cannot assume they are immune from this type of attack.

 

The really disturbing thing to me about this story is that Target itself was unaware of the breach and only earned about it after being told by the Secret Service. This is obviously an extreme example, but I think many companies have a false sense of security when it comes to their exposure to a cyber breach. I think may companies would do well to consider what has happened to Target and to think about what it might mean for their enterprise if it were to be subjected to a cyber breach of the same level of sophistication and pervasiveness.

 

A settlement of an antitrust lawsuit alleging that a group of hospitals conspired to underpay their nurses did not represent excluded “disgorgement” and therefore was not excluded from coverage under William Beaumont Hospital’s management liability insurance policy, according to a January 16, 2014 Sixth Circuit decision. The opinion will likely be of particular interest to policyholder advocates disputing insurers’ position that an amount for which insurance coverage is sought represents excluded disgorgement or restitution. A copy of the Sixth Circuit’s opinion can be found here.

 

Background

In 2006, two nurses, neither of whom worked for Beaumont, filed a class action against eight Detroit-area hospitals including Beaumont, alleging that the hospitals had violated the Sherman Act by conspiring to depress nurses’ wages, and by exchanging information about nurses’ wages, which had the effect of depressing wages. The nurses, who sought to “recover for the compensation properly earned …but unlawfully retained by such hospitals,” claimed damages of over $1.8 billion.  The trial court granted summary judgment on a portion of the nurses’ claims but allowed the claims that the hospitals had unlawfully shared information to proceed.

 

Beaumont submitted the nurses’ antitrust lawsuit as a claim under its management liability insurance policy. The policy expressly provided coverage for antitrust claims, at a stated “covered percentage” of 80 percent. The policy was amended by endorsement to include within the definition of “Loss” the “multiplied portion of any multiplied damages award.” The endorsement went on to provide with respect to a Claim “based upon, arising from or in consequence of profit, remuneration or advantage to which an Insured was not legally entitled,” that Loss “shall not include disgorgement by any Insured or any amount reimbursed by any Insured Person.”

 

Upon receipt of Beaumont’s claim, the insurer agreed, subject to a reservation of its rights under the policy, to advance eighty percent of the hospital’s defense costs (which came to about $3.4 million). The insurer also participated in discussions to settle the underlying claim. While the settlement negotiations were underway, Beaumont filed an action seeking a judicial declaration that the insurer was obligated to indemnify the hospital for any settlement amounts. The insurer counterclaimed, arguing that the settlement represented disgorgement and also that it did not represent a loss and therefore was not covered under the policy.

 

Beaumont ultimately settled with the nurses for approximately $11.3 million. Subject to a right of reimbursement, the insurer paid the hospital 80 percent of the settlement, or about $9 million.  Both the hospital and the insurer continued to pursue their respective claims in the coverage action. The court in the coverage action granted Beaumont’s motion for judgment on the pleadings and dismissed the insurer’s counterclaim. The insurer appealed the lower court’s ruling to the Sixth Circuit.

 

The January 16 Opinion

In a January 16, 2014 opinion written by District Court Judge James G. Carr (sitting by designation) for a three-judge panel, the Sixth Circuit affirmed the lower court’s ruling on behalf of Beaumont and rejected the insurer’s argument that the settlement represented a “disgorgement” for which coverage is precluded under the policy and also rejected insurer’s argument that insuring the settlement amount would be against public policy.

 

The insurer had argued that the underlying complaint alleged that the hospital had gained nursing services at below-market compensation and that the settlement was disgorgement of the value of that advantage. In support of its position, the insurer relied on case law (including the Seventh Circuit’s 2001 opinion in Level 3 Communications Inc. v. Federal Insurance Company) holding that even amounts labeled as damages that are “restitutionary in character” are uninsurable.

 

The hospital, in turn, argued that disgorgement and restitution are distinct remedies, and that the policy explicitly excludes only disgorgement, and that in any event, the nurses sought only compensatory damages, not restitution or disgorgement. The hospital argued further that money unlawfully retained is not the same as money wrongfully acquired and that money paid to resolve a legal dispute is not necessarily a return of something to which the payor was not legally entitled in the first place.

 

The appellate court said that it found Beaumont’s arguments “convincing,” noting that though the insurer “used the terms disgorgement and restitution interchangeably,” the exclusionary clause on which the insurer sought to rely “itself specifically states that only disgorgement is not a covered loss.” The court observed that disgorgement and restitution are close “but not interchangeable.” Referring to a dictionary definition of “disgorge” meaning “to give up illicit or ill-gotten gains,” the Court said

 

We find that the hospital never gained possession of (or obtained or acquired) the nurses wages’ illicitly, unlawfully or unjustly. Rather, according to the nurses’ complaint, Beaumont retained the due, but unpaid, wages unlawfully. This is not a mere semantics. Retaining or withholding differs from obtaining or acquiring. The hospital could not have taken money from the nurses because it was never in their hands in the first place. While the hospital’s alleged actions are still illicit, there is no way for the hospital to give up its ill-gotten gains if they were never obtained from the nurses. Therefore, the damages Beaumont paid in settlement of the claim does [sic] not constitute disgorgement.

 

The court went on to note that the nature of the damages the nurses sought was purely in the form of compensatory damages for an antitrust violation, rather than a return of a wrongfully withheld amount.

 

The appellate court also rejected the insurer’s argument that coverage for the settlement was barred as a matter of public policy because (the insurer argued) payment of the settlement amount would permit the hospital to profit from its own wrongdoing by allowing it to transfer the cost of its wrongdoing to its insurer. The court found that the insurer had failed to show that the payment of the settlement would violate Michigan public policy, and rejected the insurer’s attempt to rely on Level 3 and other cases because these other cases, in which the insured unlawfully obtained something from the underlying plaintiff, are inapposite in this case where the hospital did not obtain anything from the nurses, bur rather allegedly unlawfully withheld compensation from them.

 

Discussion

There are a variety of interesting things about this opinion, but for me the important thing is to focus on the nature of the claims being settled. The plaintiff class consisted nurses from eight different hospitals, not just from Beaumont. (Indeed, the two named plaintiffs who initiated the antitrust lawsuit didn’t even work at Beaumont). To me it doesn’t even make sense to say that the settlement represented either a disgorgement or restitution of unpaid wages, as Beaumont never owed any wages to the nurses at the other seven hospitals; therefore it could not have underpaid them, and the amount paid in settlement with them could not have represented either a disgorgement or restitution of underpaid wages as to those claimants.

 

The plaintiffs sought – and the settlement represented – a form of compensatory damages for the alleged conspiracy to suppress wages at all eight of the hospitals, not just at Beaumont, and the settlement represented damages for the alleged conspiracy to suppress wages at all eight hospitals. Viewed in that light, this decision is best understood as holding that a policy exclusion precluding coverage for disgorgement amounts does not exclude coverage for a settlement representing a compromise of a compensatory damages claim.

 

Just the same, policyholder-side advocates will be particularly interested in two aspects of the Court’s analysis of the disgorgement issue: first, that the difference between disgorgement and restitution is important, and that in the absence of an express policy preclusion of restitutionary amounts, a policy exclusion precluding coverage for disgorgement may not preclude coverage for restitution; and second, a policy exclusion of disgorgement amounts does not preclude coverage for amounts wrongfully withheld (as opposed to amounts that were wrongfully acquired).

 

The first of these two considerations may be particularly significant, as the question of whether or not a liability policy may provide coverage for restitutionary amounts is a frequently recurring issue. Many carriers take the position that coverage for restitutionary amounts is precluded. Policyholder advocates resisting this position may find value in the Court’s analysis that restitution is not the same of disgorgement and that a policy provision precluding coverage for disgorgement may not preclude coverage for restitutionary amounts.

 

However, carriers seeking to deny coverage for restitutionary amounts often rely on public policy arguments rather than just provisions of their policy. They argue that public policy prohibits coverage for the restitution of amounts wrongfully obtained. That is where the Court’s analysis of the difference between amounts that are wrongfully acquired and amounts that are wrongfully retained is instructive; while public policy may or may not preclude coverage for amounts that are wrongfully acquired, the same public policy arguments may not – at least according to the Sixth Circuit and at least under Michigan law — preclude coverage for amounts that are wrongfully retained.

 

One argument that carriers usually also assert when the try to deny coverage for restitutionary amounts is that the insured suffered “no Loss,” as the insured was simply restoring amounts to which it was not entitled in the first place. The Sixth Circuit did not address “no loss” argument in detail here. It may have been that the carrier did not emphasize this argument, as the nature of the nurses’ claims does not lend itself well to a “no loss” argument. The plaintiffs were not just suing Beaumont to force the hospital to pay the amount it had underpaid its own nurses; the plaintiffs were trying to collect damages from Beaumont to compensate nurses at all eight of the hospitals for suppressing wages. It can’t be said that Beaumont suffered “no loss” for paying compensatory damages to a class of nurse claimants from the eight hospitals, as its settlement with the class of nurses from the eight hospitals clearly represented something more than or different from the amount it has underpaid the nurses at its own hospital.

 

The Sixth Circuit’s decision in the Beaumont Hospital case is the latest in which a court has been willing to examine the true nature of the amount for which an insurer is arguing coverage is precluded because the amount represents a precluded disgorgement. As discussed here, in a June 11, 2013 opinion, the New York Court of Appeals held that Bear Stearns is not barred from seeking insurance coverage for a $160 million portion of an SEC enforcement action settlement labeled as “disgorgement,” where Bear Stearns’ customers rather than Bear Stearns itself profited from alleged misconduct. In both of these cases, the courts were willing to examine the nature of the amount for which coverage is sought, rather than simply accepting the insurer’s characterization of the amount as disgorgement for which coverage is precluded.

 

In trying to make use of the Sixth Circuit’s opinion, policyholder advocates will have to contend with the fact that the opinion was published with the designation “Not Recommended for Full Text Publication.” It is unclear what this designation could possibly be intended to mean. First of all, the full text of the opinion has been published on the Sixth Circuit’s website and is freely available to anyone in the world with Internet access. The opinion obviously has been published and the full text obviously is available, so the designation the court gave the opinion is a peculiar bit of flummery.

 

I am always concerned when an appellate court designates something as “not for publication” or otherwise as restricted in some way. At a minimum, by operation of the applicable appellate rules, the restricted designation has no effect on litigants’ ability to cite to the opinion, as under Fed. R. App. Proc. 32.1, a restricted publication designation is no constraint on parties’ rights to cite the opinion. 

 

Given this rule, it makes me very uneasy that any court would still try to provide a restricted designation. I worry that when a court issues an opinion with a restricted designation that the designation represents some form of confession that the opinion is not their best work, as if they just don’t think it is good enough to be published. I worry that the designation says  we didn’t work as hard on this opinion or maybe that we weren’t as thorough as we are on the opinions that are good enough to publish. I am not sure what courts think they are doing by putting a restricted designation on an opinion, but it is a questionable practice that in the age of the Internet really should be dropped.

 

In any event, in light of Fed. R. App. Proc. 32.1, litigants can cite to the Sixth Circuit’s opinion in the Beaumont Hospital case, but they will still have to figure out how to deal with the fact that the appellate court released the opinion with a restricted publication designation.

 

One final note. This case underscores a point I have made in prior posts on this site, which is that anttrust coverage is an important part fo the protection that is (or should be) provided by management liablity insurance. The underlying claim here underscores the diversity of kinds of disptes that might arise as antitrust claims. Unfortunately, many management liability policies contain antitrust exclusions, some of which can be quite broad. As I have emphasized in the past, there ought to be a strong preference in favor of insurance options that do not contain antitrust exclusions or that restrict antitrust coverage as little as possible.

 

Annals of Parenting: After our kids had returned to college following the recent holidays, I was cleaning out their car, and I found this in the trunk. I suppose there is that moment for every parent when they have to decide if they really want to know why their children had a papier-mâché Godzilla mask in the trunk of their car?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A company’s obligations to its directors and officers with respect to the purchase and maintenance of D&O insurance is a topic of ongoing interest and concern for the individuals involved. In the following Guest Post, Burkhard Fassbach and Thilo Fleck take a look at this topic with a particular focus on the issues involving German board members and managing directors. Burkhard Fassbach (pictured to the  left), who is a partner with the Dusseldorf-based D&O advisory firm Hendricks & Co., is licensed to practice law in Germany and is standing legal counsel to the German operation of the London-based Howden Broking Group. Thilo Fleck is a founding partner of Berner Fleck Wettich, a Dusseldorf-based corporate law firm.I would like to thank Burkhard and Thilo for their willingness to publish their article on this site. I welcome the opportunity to publish guest posts written by responsible commentators on topics of interest to this blog’s readers. Here is Burkhard and Thilo’s guest post:  

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The following article outlines the basic thougths for an innovatively designed contractual model clause for German Management Service Agreements. The model clause is presented at the end of this article.  

Preliminary Remarks

Whilst negotiating their Management Service Agreements, Executive Board Members, Managing Directors and their legal advisors are foremost focusing their attention on issues concerning pay packages, remuneration, bonuses, retirement pension plans and company cars. More often than not, D&O Insurance Cover is simply not on the radar screen. However, most Managing Directors’ Agreements of Services contain a contractual provision, in which the company undertakes to bind D&O Insurance Cover for the benefit of its Directors and Executive Board Members. Unfortunately, such stipulations can be drafted rather simplistically, and thus deliver a deceptive sense of protection. Rather, the Company’s Contractual Undertaking to bind D&O Insurance Cover for the benefit of its Executive Board Members and Managing Directors stipulated in the Management Service Agreements needs to meet the protective requirements accurately. This is crucial in the framework of a “worst case” scenario.

 

Worst Case Scenario

By drafting such a model clause, the starting point of all considerations needs to be the worst case scenario of a D&O claim. The maximum credible “incident” happens, when the company acts in a hostile manner and brings an action to court against its director by suing for a financial loss, which may potentially result in total destruction of the director’s economic livelihood, potentially finishing his or her professional career forever. Executive Liability will then be subject to public court proceedings over the course of the various stages of appeal up to the German Federal High Court of Justice. The publicity and the media coverage involved in such court proceedings turns out to be a severe burden for the sued directors and it actuality leads to an occupational ban for the directors, who are already ousted from corporate power and can hardly take over new management positions. Rather, they get stuck in the sidings. The director’s nerves are on edge at the latest, once civil court proceedings are accompanied by criminal investigations initiated by the public prosecution office.

 

Insured Event and Limit of Cover

In accordance to the claims-made principle, the insured event is triggered in the event that a claim for a financial loss is initially made in writing against an insured person with regard to breach of duty the insured person has committed in the course of activities for the Policyholder. Oftentimes, a very substantial sum of money in dispute is at stake and the director sued by the company can only hope that the insured limit of the D&O insurance cover is sufficient to settle the asserted claim. In particular, because high legal expenses to defend the claim are credited against the insured limit. The situation gets even worse, should claims be made at the same time against several directors who access the insured limit of the D&O Insurance cover. If in such an event, the insurer determines – on the basis of a forecast about the foreseeable course of the D&O claim proceedings – that the insured limit will not be sufficient, the insurer has to initiate the so-called reduction- and distribution proceeding. This may result in insured persons’ having to assume substantial amounts of the legal expenses related to defend the claim out of their own pockets as well as expenses by appraisers involved with the claims matter. Should the plaintiff win the trial, enforcement measures related to the private assets of the directors may become inevitable.

 

Furthermore, a high limit of indemnity may not grant the ultimate protection. It has to be borne in mind that – in particular in the framework of a corporate group structure – the insured limit needs to be shared between many insured persons. The equivalent wording in D&O Insurance Policies reads as follows: “Within one period of insurance, the insurer’s duty to provide indemnification is limited to the overall insured sum for each insured event and for all insured events in the aggregate.” For instance, the Executive Board Members of a holding company can consume the entire limit of insurance cover with one single insured event. Should a Managing Director of a subsidiary company then commit a breach of duty within the same period of cover, this Managing Director can stand without any protection and, thus, may be totally exposed. Therefore, Managing Directors of subsidiary companies should not trust in the D&O Insurance cover of the holding company’s Master Cover. Rather, they should bind stand-alone D&O cover for the subsidiary company.

 

Legal Framework for Executive Liability in Germany

In general, pursuant to the German Stock Companies Act and the Laws on Limited Liability Companies, Executive Board Members and Managing Directors are subject to unlimited liability with their private assets. Almost every D&O claim in Germany is a matter of internal liability and not third-party claims. This means the company is asserting claims against its directors. With regard to German Stock Companies, the following statutory provisions are applicable: Executive Board Members shall exercise the director’s due care and prudent business behavior in the course of the management of the business. Executive Board Members who breach their duties may be required to compensate the company with regard to financial losses arising from their breach of duty. In the German two-tier board system, the Executive Board Members cannot expect mercy from the Supervisory Board. The German Federal High Court of Justice has ruled in a landmark decision known as ARAG v. Garmenbeck that, in general, the Supervisory Board is obliged to pursue the company’s claims against the Executive Board Members.

 

Due to the organizational function of the Supervisory Board to monitor and control the activities of the Executive Board, the Supervisory Board at its own responsibility has a duty to investigate and review the potential existence of the Company’s claims against the Executive Board. In the event the findings of the Supervisory Board made on the basis of a diligent and proper risk analysis conclude that the Executive Board is subject to liability, the Supervisory Board shall evaluate whether or not, if yes, to what extent the pursuit of claims before a court results into compensation for financial losses. Thereby, certainty that a claim for damages will be successfully awarded by court is not required. In the event the Company is entitled to compensation for financial losses on the basis of the findings, the Supervisory Board in general has a duty to pursue such claims. Only by way of exception, the Supervisory Board can waive pursuance of such claims, if important reasons and good cause regarding the good of the company are compelling reasons not to pursue the claims and such circumstances outweigh the reasons which justify the assertion of claims or are at least of the same value. The Supervisory Board shall thereby only in exceptional cases consider any other aspects not related to the good of the company, which only concern the Executive Board Members personally.

 

Contrary to German Stock Companies, there is no general duty to pursue claims against Managing Directors of Limited Liability Companies. However, the shareholders of Limited Liability Companies nowadays pursue claims against Managing Directors more frequently due to the potential balance sheet protection of an existing D&O Insurance Policy. Likewise, Managing Directors of Limited Liability Companies shall exercise the due care of a prudent business director in matters of the Company. Managing Directors who breach their duties are subject to liability towards the company with regard to the financial loss arising from breach of duty.

 

Besides internal liability, whereby the company is asserting claims against its directors, the majority of D&O claims based on external liability are related to outside claims made by insolvency administrators against the Managing Directors and Executive Board Members.

 

The D&O Insurer’s Behavior in Claims Adjustment

In the insured event of a D&O claim, the insurer has a statutory right to choose between out-of-court settlements by means of adjusting justified claims or the defense of unjustified claims made against insured persons. The D&O insurer is obliged to indemnify the insured persons against claims, which are made against the insured persons by a Policyholder or a third party on the basis of the insured person’s responsibility and to defend unjustified claims. Hence, the level of premiums for D&O Policies reached its historical low point in the year 2013, whilst at the same time the number of D&O claims is on the rise and snowballing at high speed, the D&O premiums are de-facto calculated on the basis of a pure cover for legal expenses. The D&O insurer exercises the statutory right to elect between adjusting claims or defending claims almost invariably in a knee-jerk reaction by defending the claims made against insured persons and grant cover for the legal expenses related to defending the claims and thereby the issues of Executive Liability are subject to review by the courts. Out-of-court claims adjustment is the rare exception. If at all, the insurer only offers lousy settlements solely to save legal expenses for defending the claim, which would have been absolutely inevitable otherwise. In fact, the Policyholders are literally driven and forced to pursue the claims before the courts. A well-positioned and established D&O expert in the market who constantly keeps an eye and monitors the claims adjustment behavior of the D&O insurers can consider the insurer’s reliability in claims’ handling – besides the quality of the Policy wording. The best advice on the Policy Wording alone is worth nothing, if the D&O insurance cover does not work properly and smoothly due to unruly conduct by the D&O insurer in the event of a claim.

 

The D&O Insurance Policy in the Company’s Safe

It is of utmost importance that the Company’s Contractual Undertaking stipulated in the Management Service Agreements to bind D&O Insurance Cover for the benefit of its Executive Board Members and Managing Directors needs to ensure that the company meet the duty to provide the Executive Board Members and Managing Directors with a copy of the current D&O Policy and Policy Wording. Unfortunately, many companies still treat the D&O Policy as a secret, hidden in a safe to be kept apart from the Executive Board Members and Managing Directors. Thereby, it is not taken into consideration that only the insured persons are entitled to receive insurance benefits from the insurer under the D&O Policy. The company should not put off the insured persons by pointing to the insurer’s duty to provide the insured persons with a copy of the certificate of insurance at the time a claim is made against them. Furthermore, it is necessary to ensure that the Policyholder is not entitled to cancel or to amend the rights of the insured persons under the D&O policy.

 

Network of D&O- Expert Attorneys

The D&O insurer’s core benefit promise under the Policy is to defend unjustified claims made against insured persons and to indemnify insured persons against justified claims. Executive Board Members and Managing Directors have a key and fundamental interest in keeping their clean reputation and fully clear their name, spoiled by allegations of breach of duty by successfully defending the claims. Therefore, the best possible defense is required. In order to succeed, the Executive Board Members and Managing Directors should be able to appoint the best attorneys in the field of Executive Liability and D&O Insurance. Firstly, the insured person needs to know who the best attorneys in this practice area are. With regard to the quality of the D&O cover, it is crucial that the insurer actually pays the attorney bills of the top-class lawyers. Such specialist lawyers are billing on hourly rates rather than on the German statutory rules for the remuneration of lawyers. As a basic principle, the insured persons under D&O Insurance Policies do not have the free choice to select the lawyer they want. In order to ensure that the insured persons have access to the best lawyers, the D&O Policy Wording should stipulate that prior consent and agreement with the insurer is not required with regard to the attorney selection and the attorney fee arrangement if the attorney is introduced to the insured person by way of an expert attorney network. There are some D&O broker wordings in Germany which contain such provisions about an attorney network and have agreed upon such a procedure with the insurer in advance.

 

Quality of the D&O Policy Wording

The D&O Policy Wordings vary considerably with regard to quality. Only a renowned D&O expert can examine the quality of the D&O Policy Wording and can identify the pitfalls. Since the D&O market is constantly on the move, such an expert review should be made in the cycle of the annual Policy renewals. Attention needs to be paid to the following issues:

 

Arbitration Proceedings

The Policyholder and the insured persons can avoid the publicity of a court proceeding (District Court up to the German Federal High Court) and media attention with adverse effect by referring the matter of Executive Liability to an arbitration court. It needs to be borne in mind that the proceedings before the public civil courts can last for many years and turn out to be a massive burden for the involved parties. Therefore, best quality D&O Policy Wordings stipulate that the insured person can request that the issues of Executive Liability are subject to an arbitration proceeding, should claims for financial losses be made. The court of arbitration should be assembled by expert lawyers from a highly professional network of corporate litigation attorneys. Even in complex matters of litigation, the timeframe for an arbitration proceeding should be significantly shorter than proceedings before the public civil courts. However, it is a disadvantage that there is no possibility of serving third party notices in the course of an arbitration proceeding.

 

Operational Activities

D&O Policy Wordings can contain hidden and invisible exclusions of cover. This applies in particular for instance in the area of operational activities of Managing Directors and Executive Board Members. In the event a Managing Director picks up a calculator and causes errors in calculation with severe impact, the D&O Insurer denies coverage by arguing that the D&O Policy is only applicable for management decisions and the D&O Insurance cover is not designed for failure in day-to-day business.

 

This exclusion is plainly visible in D&O Policies for service companies and in particular in the financial services sector. For example, decisions by a bank’s management board in terms of granting loans are basically excluded in the D&O insurance.

 

Cover in the event of set-off

Evermore frequently, it is noted that the policyholder declares that claims relating to employment contracts, claims which are directly connected with them in particular relating to salaries and pension benefit (salary demand), and claims which arise from severance and termination contracts are to be offset against liability claims which would be insured within the scope of the terms of the D&O Policy. This can result in severe financial liquidity problems on the part of the insured persons. Therefore, good D&O Policy Wordings include provisions which enable continuing salary payments and assume severance payments.

 

Guarantee of Continuity

At the time of the placement of the D&O Policy no insured person can know and trust whether the scope of insurance cover both with regards terms and conditions and the limit of indemnity will still be in existence at some point in the future when a claim is actually made. In the event that the insurer – in the framework of the annual D&O renewal negotiations – makes demand for restrictions on the D&O Policy Wording terms and conditions, such as exclusions of cover for corruption and cartel, and the insurer may even at the same time reduce the limit of indemnity, then the restricted cover is applicable retroactively for breaches of duty in the past. High quality D&O Wordings stipulate that old liability remains covered and that if the policy is continued with restrictions on its conditions and/or a reduced limit of indemnity, then, with regard to breaches of duty committed prior to the commencement of the amendment, the original scope of cover applies as agreed immediately prior to the restriction of cover and/or reduction in limit of indemnity.

 

Extended Reporting Period

The Executive Board Members and Managing Directors have to keep in mind that they will be leaving the company – for whatever reason – at some time in the future. On the last day in office the Executive Board Members and Managing Directors can still commit a breach of duty. Management Liability claims for Managing Directors of a Limited Liability Company and Executive Board Members of a Stock Company become time-barred and lapse in five years. In the event the company is listed on the stock exchange, the claims lapse in ten years. Claims made by Financial Institutions against its directors arising from the management service agreement or the position in the corporate board due to breach of duty also lapse in ten years. Noteworthy, the period of limitation begins to run once the financial loss, which is caused by the breach of duty, occurs. The D&O Policy needs to be maintained and upheld or, in the event the Policy is terminated, the Extended Reporting Period needs to be sufficient.

 

D&O Claims Advisory

Should the insured event occur, the Policyholder as well as the insured person should have immediate access to a D&O claims specialist. The D&O Claims specialist will assume a coordination role and moderation tasks in the talks and negotiations between insured persons, their legal counsel and the plaintiff as well as correspondence and communications with the insurer. Such activities include meeting appointments with the involved parties as well as the legal review of coverage issues. As a result, the flawless and proper function of the D&O insurance cover shall be safeguarded.

 

D&O Contract Law Protection Policy

D&O claims settlements take up considerable periods of time. The processing is therefore protracted and hardly in the interests of the insured persons. Naturally, D&O insurers attempt to refuse the insurance coverage with the presentation of exclusion circumstances or the assertion of pre-contractual breaches of duty. Numerous passages in the wording of the D&O insurance policies – even in well drafted policies – can result in construction in the event of dispute and prevent spontaneous coverage. Insurers are also inclined to adduce exclusion circumstances again and again, as a result of which the time- lag mentioned above becomes unreasonable for the participants.

 

D&O contract law protection helps in this situation. Even with the first delay in the claims handling by the D&O insurers with the assertion of an exclusion circumstance or the vagueness of the cover, a lawyer specializing in D&O insurance law is appointed with the drafting of legal action against the insurer. All facets of the case are dealt with in this draft of the legal action, in order to ensure that the time-lag in the exchange of arguments is reduced to a minimum. The legal expenses for actions related to pursue claims for coverage are generally equivalent to the costs of legal expenses to defend the D&O claim in the liability proceeding under civil law, so that there is increasing risk that the legal expenses are doubled, with the effect that the insured persons are fighting a war on two fronts. Thus, the economic livelihood of the insured persons is clearly at risk and therefore, the supplementary D&O Contract Law Protection Policy is almost compulsory.

 

Financial Loss Legal Protection Insurance Policy

D&O liability insurance often results in so-called “total losses.” In these cases, the extent of the compensation claim asserted corresponds exactly to the D&O sum insured. Even if the claim that has actually been incurred or is claimed exceeds the D&O sum insured, legal action is always taken for the insured amount. This does not just apply for the large D&O cases of the Federal State banks, Siemens or Lufthansa, but also for liability scenarios in small and medium-sized enterprises.

 

In D&O liability insurance, the rule applies that defense costs are offset against the documented sum insured. If a settlement is made at the level of the D&O sum insured or if the amount is awarded by court judgment, the D&O insurer will pay the indemnification less the costs already expended. This can involve enormous amounts, where settlement by the insurer persons can jeopardize their economic existence.

 

This gap in the D&O cover is bridged by the financial loss legal protection insurance policy. The legal protection insurer assumes the share of the costs after the exhaustion of the D&O sum insured, so that a full claim settlement is made possible via the D&O liability insurance.

 

The claims settlement practice of D&O insurance is substantially determined by the assertion of exclusion circumstances. The accusation of intentional, deliberate or willful breach of duty is in the spotlight in this context. Nothing is easier to prove for the D&O insurer than, for example, an intentional infringement of guidelines, by-laws or instructions. Even if well-conceived D&O insurance policies give provisional legal protection in accordance with the wording of the policies, D&O insurers more and more frequently reject the legal costs cover because the willful act is all too obvious.

 

The financial loss legal protection insurance policy also bridges this gap in cover. In legal protection terms and conditions, willful intent exclusion is phrased in such a way that legal costs are only not assumed, if an insured person intended to bring about the occurrence of a claim and thereby cause a financial loss. Therefore, the willful breach of duty alone does not result in the exclusion from cover. It has to be determined by a binding judgment that the insured person has willfully brought about a claim and financial loss.

 

This is clearly fraud, particularly in the area of breach of fiduciary duty, so that the legal protection insurance also no longer applies. However, as the overwhelming number of cases end with stays of proceedings with or without fines, the legal protection function of the financial loss legal protection insurance policy generally survives.

 

Guidelines for the design and the drafting of Management Service Agreements

As a result it is noteworthy, that the Company’s Contractual Undertaking stipulated in the Management Service Agreements to bind D&O Insurance Cover for the benefit of its Executive Board Members and Managing Directorsis even more important and crucial than the D&O Insurance Policy itself. The binding of D&O insurance cover as well as maintaining the D&O Policy is thereby eluded from the sole discretion of the Policyholder. Furthermore, such a contractual clause and provisions shall ensure best possible quality of the D&O insurance cover. Hence the D&O market is subject to constant movement, the insurance cover needs to be reviewed by an expert in the field of D&O Insurance in the framework of the annual D&O Policy renewal. 

Innovatively designed Model Clause for the Company’s Contractual Undertaking stipulated in the Management Service Agreements to bind D&O Insurance Cover for the benefit of its Executive Board Members and Managing Directors in Germany

 

1.      The Company shall bind D&O insurance cover for the benefit of Mr. John Doe (Managing Director / Executive Board Member). Should a D&O Policy already be in place, the company undertakes to maintain and uphold the existing D&O insurance cover. In this respect and in the framework of the placement of a D&O Policy as well as in the annual renewal procedure of an existing D&O Policy, the company appoints a well-established and market renowned D&O expert to review and analyze the quotes in the tendering procedure, the annual renewal quotes, the terms and conditions of cover, the rating and the claims-handling practice of the insurer as well as adequate limit of indemnity. The company shall provide Mr. John Doe with a copy of the D&O expert opinion. (Alternatively: The company shall notify Mr. John Doe with immediate effect, should the company not follow the recommendations made by the D&O expert).

 

 

2.      At the time of the inception of this Management Service Agreement the D&O insurance cover is applicable to the extent and pursuant to the D&O Policy and the terms and conditions of cover as enclosed as an exhibit to this Management Service Agreement. The company undertakes towards Mr. John Doe that the minimum standard of insurance cover (limit of indemnity, general and particular conditions of cover) as defined in the enclosed exhibit will not be undercut in the period of validity of this Management Service Agreement and shall likewise be not undercut subsequent to the termination of this Management Service Agreement for the runtime of the statutory period of limitation regarding claims for director’s and officer’s liability. The company shall elaborate and optimize the D&O insurance cover pursuant to the advice and annual recommendations given by the D&O Expert in accordance with subsection 1 of this clause. (Alternatively: The company intends to elaborate and optimize the D&O insurance cover pursuant to the advice and the annual recommendations given by the D&O Expert in accordance with subsection 1 of this clause.) In the event that the minimum standard of insurance cover as defined in the enclosed exhibit cannot be upheld or cannot be further elaborated and optimized due to an increasingly fierce D&O market in the future, the company undertakes – on the basis of the D&O expert opinion – to provide the best possible D&O insurance cover for the benefit of Mr. John Doe, which can be bound in the tougher market situation.

 

 

3.      In order to back up and flank the D&O insurance cover, the company shall bind Insurance Policies for financial loss legal protection and for D&O contract law protection as supplementary legal protection insurance.

 

 

4.      The company shall provide Mr. John Doe with a copy of the current D&O Policy and the D&O Policy Wording as well as a copy of the current Insurance Policies and Policy Wordings for financial loss legal protection and for D&O contract law protection as supplementary legal protection insurance.

 

 

5.      In the event Mr. John Doe leaves the company for whatever reason and resigns from his duties as Managing Director / Executive Board Member, the company shall maintain and uphold the D&O Insurance Cover for at least the runtime of the statutory period of limitation with regard to Executive Liability claims or, in the event the Policy is terminated, the company shall ensure the existence of an Extended Reporting Period equivalent to the statutory period of limitation with regard to Executive Liability claims. The company shall provide Mr. John Doe with the respective proof for this purpose.

 

 

6.      In the event a claim is made and the insured event thereby occurs, the company shall – also for the benefit of Mr. John Doe – appoint a well-established and market renowned D&O claims specialist, who shall ensure the flawless and proper functioning of the D&O insurance cover, assume legal review of coverage issues and implement the insurance benefits promised by the D&O insurer, in particular by the assumption of a coordination role and moderation tasks in the talks and negotiations between insured persons, their legal counsel, and the plaintiff as well as correspondence and communications with the insurer.

 

Third-party litigation funding continues to attract investors, as evidenced by relatively new litigation funding firm  Gerchen Keller Capital’s recent $260 million capital raise, which brings their total investor commitments to $310 million (as discussed in a January 12, 2013 New York Times article, here). As litigation has become more prevalent, courts have had to grapple with the phenomenon. As highlighted in a recent discovery ruling in a trade secrets lawsuit between Miller U.K. Ltd. and equipment-maker Caterpillar, courts seem to be becoming increasingly comfortable with the involvement third-party litigation financing.

 

Miller first sued Caterpillar in the Northern District of Illinois in 2010, alleging that Caterpillar had misappropriated trade secrets. According to Magistrate Judge Jeffrey Cole, “the case has been bitterly contested at every turn.” The parties have had extensive discovery disputes, including a dispute about whether or not Caterpillar could discover Miller’s third-party financing arrangements, as well as of the documents and information Miller had supplied prospective funding firms in order to try to obtain financing.

 

In a January 6, 2014 opinion (here), Magistrate Judge Cole granted in part and denied in part Caterpillar’s motion to compel. The opinion is interesting in a number of respects, particularly with regard to the Magistrate Judge’s consideration of the legality of third=party litigation financing under Illinois law.

 

Miller had sought to block discovery of its litigation financing agreements, contending that it was not relevant to the parties’ trade secrets dispute. Caterpillar argued that it was entitled to discover the financing transaction documents because, it argued, the financing agreement violated Illinois laws barring “maintenance and champerty” and that discovery of the financing transaction documents would allow Caterpillar to raise the supposed illegality of the funding document as a defense to certain of Miller’s claims. (As discussed here, “maintenance" is the intermeddling of a disinterested party to encourage a lawsuit and “champerty” is the "maintenance" of a person in a lawsuit on condition that the subject matter of the action is to be shared with the maintainer.)

 

After a detailed review of the relevant legal considerations, as well as the recognition that litigation funding remains controversial, the Magistrate Judge concluded that Caterpillar’s contention that Miller’s financing arrangement violated Illinois law prohibiting champerty and maintenance is “utterly unsupported.” He also rejected Caterpillar’s argument that discovery of the transaction documents would allow Caterpilllar to determine who the “real party in interest” is in the case or that Caterpillar was entitled to discovery of the transaction on that basis.

 

The Magistrate Judge did conclude that Caterpillar was entitled to discovery of certain of the documents that Miller had provided to prospective financing firms, particularly those where Miller had not take steps (such as entering a written confidentiality agreement) to ensure that the documents provided remained confidential.

 

As the Wall Street Journal noted in its January 12, 2014 article entitled “Litigation Investors Gain Ground in U.S.” (here), based on the Magistrate Judge’s opinion shows that the litigation funding “climate looks friendlier in Illinois,” and that restrictions on third-party litigation financing also have been “relaxed or abolished” in a number of other states, including Texas, South Carolina, Massachusetts and Florida. The Journal article quotes the counsel for Miller in the Caterpillar case as saying that “the courts are acknowledging that it’s a legitimate method of financing.”

 

Just the same, as the Magistrate Judge’s opinion expressly acknowledges, litigation funding remains controversial. Its critics contend that the availability of the financing could spur frivolous lawsuits or give the third-party funders undue influence over the case.

 

Hoping to try to head off these criticisms, some of the financing firm’s have voluntarily adopted their own code of best practices. For example, Bentham IMF, the U.S. affiliated of the Australian-based funding firm, has adopted its own Code, which embodies principles concerning fairness, transparency, responsibility and accountability. However, critics contend that these measures are insufficient. The Journal article quotes a representative of the U.S. Chamber Institute for Legal Reform as saying this type of code falls short because  “there is no oversight, no regulation, nothing dealing with conflicts of interest, or disclosure” of funding agreements “either to defendants or to the judge.”

 

It may be, as the Journal article suggests, that courts are becoming more comfortable with third party litigation financing, but the practice seems likely to remain controversial. Though the debate over the social utility of the practice is likely to continue, the capital raising success of funding firms like Gerchen Keller Capital mentioned above suggests that the prevalence of litigation funding is likely to continue to grow.

 

As I have previously noted, the requirements of the capital markets do provide a certain kind of discipline, but history has shown that capital does not invariably make the best choices. Moreover, with the kinds of investment returns that the early entrants in the litigation funding arena are producing, new capital will continue to be attracted to the arena. The prospect for rich returns and low barriers to entry increase the likelihood that less meritorious litigation could find funding, or even that funds desperate to produce returns comparable to other funders might finance more speculative suits. Recent history shows what can happen when an asset class gets frothy, and there is nothing about litigation as an asset class that makes it immune from these kinds of risks. My further thoughts about litigation funding can be found here.

 

The global financial services industry is still reeling from the regulatory investigations surrounding the Libor scandal. Nevertheless, it seems that yet another scandal may be about to envelop the industry. In the following guest blog post Eric C. Scheiner and Jennifer Quinn Broda1]of the Sedgwick law firm take a look at what looks like will be the next scandal to beset the financial industry – that is, the alleged improprieties involving the foreign exchange market.

 

 

 

I would like to thank Eric and Jennifer for their willingness to publish their post on this site. This article will also be published in the PLUS Journal. I welcome guest post submissions from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you would like to submit a guest blog post. Here is Eric and Jennifer’s guest post:

 

 

 

On the heels of the London Interbank Offered Rate (Libor) scandal, regulators appear to have found a new area of potential improprieties with regard to the foreign exchange market (frequently referred to as “Forex” or “FX”). The Forex market fluctuates, but can reportedly reach a value of up to $4.7 to $5.3 trillion per day.[2] To date, at least fifteen banks are reportedly under investigation by various regulators regarding the Forex market.[3] Moreover, more than a dozen currency traders have been suspended or put on leave as a result of the ongoing investigations. Some banks have already hired criminal defense attorneys to represent employees with regard to the investigations. While these investigations remain in the preliminary stages, and no wrongdoing has been announced to date, there are indications that regulators and plaintiffs’ attorneys are ramping up their scrutiny of unregulated rates.

 

This article will provide background as to how the Forex market works, the conduct at issue and the special role “chat rooms” may be playing with regard to the investigations. Further, we will discuss how the investigations first started, how they have developed to date (including what banks have suspended or put individuals on leave), and the recently filed Forex civil litigation. Finally, given the largely unregulated nature of setting certain types of benchmark rates, this article will explore other potential areas that are already under investigation or which may be the subject of investigations going forward (e.g., the precious metals market, including gold) and the potential coverage implications these investigations and civil suits may have on insurers.

 

Background

In essence, the Forex market is the market on which currencies are traded. It is a global and decentralized market.  Much like when an individual wants to buy foreign currency in anticipation of international travel, a common method for a company or investor to make a large currency transaction is to review information posted by various banks about their prices for a given currency and pick the best rate. However, as with making a trade in the stock market, for larger currency exchanges, the banks will post two different prices: the bid price and the offer (or ask) price.  The bid price is the price the market would pay for a given currency and the ask price is the price at which the market would sell the currency. The difference between these two prices is how the banks profit on these transactions (commonly called the bid/ask spread). In essence, the banks try to buy currency at a lower rate and sell it later at a higher rate for a profit.

 

There are other pricing issues that can play a factor in whether a person wants to make a currency trade. For example, the banks commonly charge various forms of commission.4]  Further, the price can depend on the size of the transaction, whether the currency is being bought and sold, and even the nature of the relationship between the bank and the client looking to make the trade. 

 

In light of these various issues and complexities, the companies and investors who are not as concerned with trying to squeeze the best rate out of the banks seek to use a benchmark rate. For example, index funds that track the market may use currency benchmark rates in order to keep their returns in-line with the indices.5] While this may not sound like a particularly significant issue, even small fluctuations may impact these funds’ value. Given that Morningstar Inc. estimates $3.6 trillion in index funds track global indices, there may be a large pool of potentially impacted investors.6] 

 

The most common benchmark rates in the currency market are set at 11:00 am and 4:00 pm London time.[7] This is because London is considered to be the global center of the Forex market, with an estimated 40% of trades taking place there.[8] These rates, commonly referred to as “fixes,” are essentially daily rates that can be used to trade currency. Of these “fixes,” the most commonly used one is computed at 4:00 pm by a joint venture between State Street’s WM unit and Thompson Reuters (Thompson Reuters was also involved with setting the Libor rates).9] However, at least one recent article discussed potential investigations into “Tokyo fixing”, referring to Japanese currency benchmarks (which are set at 9:55 each morning in Tokyo).[10] The potential attempted manipulation of these “fixes” appears to be the focus of regulators’ investigations.   

 

For the currencies that are traded more frequently (21 in total), the WM/Reuters fix is calculated by reviewing currency trade data from various trading platforms for 60 seconds at 4 pm.[11] Since the currency market is very large, it could be difficult to manipulate these “fixes.” However, with enough coordinated large trades in the one minute window (in a process known as “banging the close”), it could be possible to manipulate the “fixes.” Assuming these “fixes” were manipulated, and the banks knew in advance the direction the rates were going to be fixed, traders could clearly profit from that knowledge. 

 

The Investigations to Date

It appears that the Forex investigations began in April of 2013, when the U.K. Financial Conduct Authority (FCA) asked certain banks for information regarding potential manipulation.[12] From there, the investigations picked up steam, with more and more banks being identified as potentially involved or publicly acknowledging that they have received inquiries from regulators. The banks that have been identified or made announcements regarding Forex regulatory investigations to date include: Barclays, Citigroup, Inc., Credit Suisse AG, Deutsche Bank, Goldman Sachs Group, HSBC, JP Morgan Chase & Co., Morgan Stanley, Royal Bank of Scotland, Standard Chartered and UBS. The various regulators investigating the issue include the U.S. Department of Justice, the Commodity Futures Trading Commission, the European Commission, the Swiss Financial Market Supervisory Authority, the Hong Kong Monetary Authority, the Monetary Authority of Singapore and regulators in Brussels.[13]

 

 

Significantly, over a dozen currency traders reportedly have been suspended or put on leave while the inquiries take place at Barclays (6), Citigroup (1), JP Morgan (1), Standard Chartered (1), Royal Bank of Scotland (2) and UBS (1).14] These traders were located in New York, London and Tokyo.  Also, Barclays and UBS have reportedly hired criminal defense lawyers to represent employees with regard to the investigations.[15]

 

For the most part, the regulators that have made public statements about the investigations have only stated that the investigations remain in the early stages. Barclays, Royal Bank of Scotland and Deutsche Bank have indicated that they are cooperating with various regulators. From various reports, it appears that regulators are requesting emails, instant messages and phone records of several employees at these banks looking for evidence of potential wrongdoing.[16] A spokesman for the U.S. Department of Justice has stated that the criminal division has started a far-reaching probe, and that they are “responding aggressively and taking it very seriously.”[17]

 

The Use of Chat Rooms

Several media reports have indicated that the regulators are, in part, investigating the use of chat rooms that are available via the Bloomberg trading terminals. Some of the names of the chat rooms appear suspect enough, with titles such as “the Cartel,” “the Bandits Club” and the “Dream Team.” In addition, and as can be common in trading chat rooms and message boards, the banter between traders reportedly includes boasts about the ability to manipulate the market, as well as sharing market-sensitive information.[18] Whether those comments are actually true or not, the potential implications will be taken seriously by regulators given the climate and recent issues concerning rate manipulation surrounding Libor. Several of the traders that participated in these chat rooms are also reportedly past or present members of a Bank of England committee that oversees the currency market (the Foreign Exchange Joint Standing Committee chief dealer’s subgroup).[19] UBS, Barclays, Citigroup and RBS have now banned or significantly limited the use of all chat rooms, and other investment banks are reportedly considering similar options.20] Further, Deutsche Bank executives are warning employees to be cautious about the words they choose to use in emails and chat rooms, as their comments can be taken out of context.[21]  

 

Forex Civil Lawsuits

Not surprisingly, civil lawsuits are now starting to be filed against a number of banks asserting investors have been damaged by the alleged manipulation of the Forex market. To date, there have been at least two purported class action lawsuits filed against Barclays, Citigroup, Credit Suisse, Deutsche Bank, JP Morgan Chase, Royal Bank of Scotland and UBS in the United States District Court for the Southern District of New York. The first of these was filed on November 1, 2013 by pension fund Haverhill Retirement System and alleges a single cause of action for antitrust violations under the Sherman Act.[22] The second purported class action was filed on November 8, 2013 by the Korean electronics firm Simmtech Co., Ltd. In addition to alleged antitrust violations, the Simmtech action also alleges violations of the New York General Business Law.[23] Despite numerous Forex traders having been suspended at many of the defendant banks, neither complaint names any individuals as defendants.

 

The allegations in each complaint are substantially similar and allege that the defendant banks traded ahead of client orders and rigged the WM/Reuters Rates by pushing through trades before and during the 60-second window when the benchmark is set.  By pushing a concentration of orders through during this 60-second window, it is alleged that the traders colluded to push the rate up or down, via the process referred to above as “banging the close.”  As a result, the complaints allege that the returns class members received from the currency trades tied to the WM/Reuters Rate were fixed or stabilized at levels lower than the free market would have returned absent the alleged manipulation. Further, the lawsuits assert that class members were deprived of the benefits of free, open and unrestricted competition in the currency trading market.

 

 

The lawsuits remain in the very early stages, and whether they ultimately obtain class certification remains to be seen. However, damages have the potential to be significant, with some speculating that the impact of the alleged Forex market manipulation could rival the recent Libor-rigging scandal.[24] Further, as the alleged Forex market manipulation becomes more widely reported on, additional civil lawsuits are all but guaranteed to be filed against the banks participating in the Forex market. In fact, a lawyer representing Simmtech recently stated that several South Korean companies have inquired about joining the Simmtech action.[25] 

 

 

That said, to date the plaintiffs’ firms have had problems making the antitrust allegations in the Libor litigation stick. In the consolidated Libor litigation, the judge overseeing those cases pending in the Southern District of New York (Judge Naomi Reice Buchwald) dismissed the antitrust claims on the grounds that the plaintiffs failed to allege antitrust injury. Such a claim requires a loss that stems from an anticompetitive aspect of the defendants’ business practices.  Specifically, the court found that while the plaintiffs may have suffered a vertical loss (i.e., harm resulting from the Defendants’ conduct), they had not plausibly alleged a horizontal effect (i.e., that the process of competition was harmed because the defendants failed to compete with each other).  In other words, the court found that no competition was actually harmed as a result of the defendants’ alleged behavior. While that ruling is in the process of being appealed, given the size and nature of the Forex market, the plaintiffs in the cases filed to date will likely face similar arguments.

 

 

Another possible allegation by potential plaintiffs would be violations of the Commodities Exchange Act (CEA). CEA claims were brought by one class of plaintiffs in the consolidated Libor litigation and the district court overseeing that litigation has allowed some of those claims to go forward.[26] One of the key issues the Libor district court reviewed with regard to the CEA claims was whether the plaintiffs could plead “actual damages” on their specific (in that case, Eurodollar) futures contracts as a result of the defendants’ manipulation. If there was manipulation of the Forex “fixes,” it likely would require large coordinated trades. In this regard, it may be possible for an individual investor, or combined group of investors, who made large trades based on the “fixes” to show damages if there was indeed manipulation. However, much would depend on the size of the trades and level of purported manipulation.  

 

 

Aggrieved investors may also attempt to rescind agreements and/or trades that were tied to the Forex “fixes.” We have seen this in the Libor arena in the U.K. civil action entitled Graiseley Properties Ltd v. Barclays Bank plc, generally known as the Guardian Care Homes case (there isa similar action in the U.K. pending against Deutsche Bank, entitled Deutsche Bank AG v. Unitech Ltd.). In both theGuardian Care Homes and Unitech cases, the investors are arguing that they would not have entered into the financial transactions at issue with each bank had they known that Barclays and Deutsche Bank, respectively, were manipulating the benchmark underlying the transactions (i.e., Libor).  If successful, the claimants may be able to use Libor manipulation as a basis to rescind the contracts, walk away from the deals and potentially receive damages. In this regard, if any index funds or other investors had agreements with any of the banks being investigated for manipulation of the Forex market that tied some component of the deal to the Forex “fixes,” similar allegations could be made against those banks if there was manipulation. Similarly, U.S. investors who may have had large investments tied to the Forex “fixes” may make individual allegations of fraud against the banks.

 

 

The discussion above of potential claims that may be brought against the banks involved in the Forex investigations is not intended to be exhaustive. Since these investigations are still in the early stages, it is possible that other types of allegations of wrongdoing could arise that would lead to different claims being made in civil litigation. However, much has yet to be revealed with regard to these investigations. 

 

 

The Metals Market and Other Potential Areas of Concern

Other markets have received some press concerning potential manipulation, including the metals markets, and other commodities such as oil, as well as interest-rate swaps and derivatives.[27] Reports have surfaced that European Union regulators have searched the offices of a unit of McGraw-Hill Financial that assess the price of “Dated Brent,” which is the benchmark rate for greater than half of the crude oil worldwide.[28] However, of these various other markets of potential concern, the one that has received more of the press as of late is the gold market.[29] Similar to the Forex market, the benchmarks for gold are also called “fixes.” The London gold “fixing” is conducted twice a day (10:30 am and 3:00 pm, London Time) by Barclays, Bank of Nova Scotia, Deutsche Bank, HSBC and Societe Generale over the telephone and after reviewing recent orders.[30] 

 

According to reports, the U.K. FCA has recently heightened its review of the metal markets generally, including the hiring of outside consultants to assist in its investigations. Germany’s financial regulator, BaFin, is also reportedly investigating suspected manipulation of gold and silver benchmark rates.[31] The gold “fix” price is used by investors and companies alike to value their holdings, but is also used in derivative markets for purposes of pricing and trading options, swaps and futures.[32]

 

Insurance Implications

Given the amount of electronic information that is likely being requested from the various banks involved to date, the costs of these investigations are likely to be significant. For example, it has been reported that Deutsche Bank is currently sifting through “tens of millions of pages of transcripts of electronic chats, email messages and other communications to determine whether its employees engaged in improper conduct in the foreign-exchange markets.”[33] That said, costs incurred in connection with the regulatory investigations may not be covered or only provided on a limited basis depending on policy wording.

 

If regulators determine that manipulation did in fact occur and additional civil litigation follows, defense costs could be substantial for many of these banks. However, coverage available under a Banker’s E&O policy could be limited by the claims being asserted. For instance, many E&O policies specifically exclude antitrust claims and similarly exclude fraud (though fraud exclusions now more commonly have varying adjudication provisions).

 

If fines or penalties are levied for wrongdoing, and those fines rival the $3.6 billion in fines that have been levied to date with regard to the manipulation of Libor, it could impact the stock price of a given bank. Moreover, there have been several reports that the suspension of traders at the various banks may cause disruption in the Forex market, which could lead to allegations of lost profits.  Such circumstances could set the stage for either U.S. securities class actions or derivative actions being asserted not only against the banks, but also the directors and officers. As such, both D&O and E&O policies have the potential to be implicated, depending on the wording of the policy and the specific allegations asserted.

 

Finally, employment practices liability policies may also be impacted in light of suspensions of senior traders. These traders are often highly compensated, and as such are not able to easily find comparable employment. If a suspended trader believes they are the “fall guy” for conduct the bank knew about, and possibly even encouraged, then employment practices claims for wrongful termination may also be brought against the banks.     

 

Conclusion

The regulatory investigations are still in the preliminary stages, and there has been no admission of wrongdoing by any of the banks to date. However, in light of the ongoing investigations, as well as the suspensions of traders by multiple banks, it appears likely that regulators will find some wrongdoing occurred. Additionally, the plaintiffs’ bar is obviously already paying attention with the filing of at least two civil cases to date and more are expected to follow. As a result, any issues relating to potential manipulation of the Forex “fixes” and other unregulated rates should be closely watched by insurers going forward. 

[1] Eric C. Scheiner and Jennifer Quinn Broda are partners in the Chicago office of Sedgwick LLP where they represents insurers and reinsurers in investigating and litigating claims under various types of professional and commercial lines of coverage. They can be reached at Eric.Scheiner@sedgwicklaw.com  and Jennifer.Broda@sedgwicklaw.com .

 

[2] Liam Vaughan, Gavin Finch and Ambereen Choudhury, “Traders Said to Rig Currency Rates to Profit Off Clients,” Bloomberg.com, June 12, 2013, http://www.bloomberg.com/news/print/2013-06-11/traders-said-to-rig-currency-rates-to-profit-off-clients.html .

 

[3] Daniel Schafer, Alice Ross and Delphine Strauss, “Foreign Exchange: The big fix,” Financial Times, November 12, 2013, http://www.ft.com/intl/cms/s/2/7a9b85b4-4af8-11e3-8c4c-00144feabdc0.html .

 

[4]  The issue of charging inappropriate commissions is the subject of other Forex-related litigation. See “BYN Mellon’s FX Lawsuit to Proceed – Analyst Blog,” Nasdaq.com, August 7, 2013, http://www.nasdaq.com/article/bny-mellons-fx-lawsuit-to-proceed-analyst-blog-cm265741.

 

[5] Katie Martin, Chiara Albanese and Clare Connaghan, “Banks Scour Emails Amid Probes Into Currency,” Wall Street Journal, October 9, 2013, http://online.wsj.com/news/articles/SB10001424052702304520704579124843662842728 .

 

[6] Liam Vaughan, Gavin Finch and Ambereen Choudhury, “Traders Said to Rig Currency Rates to Profit Off Clients,” Bloomberg, June 12, 2013, http://www.bloomberg.com/news/2013-06-11/traders-said-to-rig-currency-rates-to-profit-off-clients.html .

 

[7] See Jill Treanor, “Financial Conduct Authority Launches Currency Markets Investigation,” The Guardian, October 16, 2013, http://www.theguardian.com/business/2013/oct/16/financial-conduct-authority-currency-markets-investigation-benchmarks  (noting that “The benchmark rates are published hourly for 160 currencies and half hourly for the 21 biggest currencies, including sterling. . . “). 

 

[8] Chiara Albanese, “Barclays Scrambles to Plug Staff Gap After Suspensions,” Wall Street Journal,November 5, 2013, http://online.wsj.com/news/articles/SB10001424052702303936904579179480185824454.  

 

[9] Martin, et al., “Banks Scour Emails Amid Probes Into Currency.”

 

[10] Ben McLannahan and Jeremy Grant, “Threat of Currency Probes Stepping Up Pace In Asia,” Financial Times, November 21, 2013, http://www.ft.com/intl/cms/s/0/17d727d6-50dd-11e3-b499-00144feabdc0.html#axzz2ngI7jRgL .

 

[11] Martin, et al., “Banks Scour Emails Amid Probes Into Currency” (noting that “a spokesman for WM referred a reporter to a document on the company’s website that describes the methodology for computing the fixes”). 

 

[12] Edward Ballard and Margot Patrick, “U.K., Hong Kong Widen Forex Market Probe,” Wall Street Journal, October 16, 2013, http://online.wsj.com/news/articles/SB10001424052702303680404579139431625314154  ; “Currency-Rigging Probe Widens,” Business Spectator, November 2, 2013, http://www.businessspectator.com.au/news/2013/11/2/financial-services/currency-rigging-probe-widens.

 

[13] “Citigroup Faces Forex Probe,” Zacks.com, November 4, 2013, http://www.zacks.com/stock/news/113440/citigroup-faces-forex-probe ; An Jani, “Singapore Joins Global Currency-Market Probe,” Wall Street Journal, October 24, 2013, http://online.wsj.com/news/articles/SB10001424052702303615304579155080130234424 ; Katie Martin and Chiara Albanese, “CTFC Asked Major Forex Banks to Scrutinize Records,” Wall Street Journal, October 21, 2013, http://online.wsj.com/news/articles/SB10001424052702304402104579149803155720032 ; Martin, et al., “Banks Scour Emails Amid Probes Into Currency.”

 

[14] “Currency-Rigging Probe Widens,” Business Spectator, November 2, 2013,  http://spectator01.businessspectator.com.au/news/2013/11/2/financial-services/currency-rigging-probe-widens ; http://www.bbc.co.uk/news/business-24767239;   David Enrich and Katie Morgan, “Currency Probe Widens as Major Banks Suspend Traders,” Wall Street Journal, November 1, 2013, http://online.wsj.com/news/articles/SB10001424052702303618904579171390414686878 . 

  

[15] Enrich, et al., “Currency Probe Widens as Major Banks Suspend Traders.”  

 

[16]   Tom Schoenberg, “U.S. Said to Open Criminal Probe of FX Market Rigging,” Bloomberg.com, October 11, 2013, http://www.bloomberg.com/news/2013-10-11/u-s-said-to-open-criminal-probe-of-fx-market-rigging.html .

 

[17] John Letzing, Chiara Albanese & Katie Martin, “Currency-Trading Probe Gains Momentum,” Wall Street Journal, October 30, 2013, http://online.wsj.com/news/articles/SB20001424052702304200804579164841995315318 .

 

[18] Enrich, et al., “Currency Probe Widens as Major Banks Suspend Traders.” 

 

[19]   “Currency-Rigging Probe Widens,” Business Spectator, November 2, 2013; Duncan Mavin and Katie Martin, “Leave for Two Who Helped Oversee U.K. Forex Trade,” Wall Street Journal, October 30, 2013, http://online.wsj.com/news/articles/SB10001424052702304073204579168012956444926 .

 

[20]   Giles Turner, David Enrich & Ben Wright, “UBS Restructuring Forex Unit,” Wall Street Journal, November 28, 2013, http://online.wsj.com/news/articles/SB10001424052702304017204579225410879951156 ; James Shotter and Daniel Schafer, “UBS Joins Crackdown on Staff’s Use of Chat Rooms,” Financial Times, November 27, 2013, http://www.ft.com/intl/cms/s/0/ffd6de82-5790-11e3-86d1-00144feabdc0.html?siteedition=intl#axzz2ngI7jRgL .

 

[21] David Enrich, Katie Martin & Jenny Strasburg, “FBI Tries New Tactic in Currency Probe,” The Wall Street Journal, November 20, 2013, http://online.wsj.com/news/articles/SB10001424052702304607104579210041033806468 .

 

[22] Haverhill Retirement System, et al. v. Barclays Bank PLC, et al., Case No. 13-7789, United States District Court for the Southern District of New York (filed Nov. 1, 2013).  

 

[23] Simmtech Co., Ltd.et al. v. Barclays Bank PLC, et al., Case No. 13-7953, United States District Court for the Southern District of New York (filed Nov. 8, 2013).

 

[24] Virgina Harrison, “Bigger than Libor? Forex probe hangs over banks,” CNNMoney, November 20, 2013, http://money.cnn.com/2013/11/20/investing/forex-probe-lawyers/.

 

[25]   Chiara Albanese, Katie Martin and David Enrich, “Banks Fix on Sales Probes,” Wall Street Journal, November 19, 2013, http://online.wsj.com/news/articles/SB10001424052702303755504579207963677009926.

 

[26]   See FTC Capital GmbH, et al. v. Credit Suisse Group AG, et al., Case No. 11-02613, United States District Court for the Southern District of New York (filed April 15, 2011).

 

[27]   Tom Schoenberg, “U.S. Said to Open Criminal Probe of FX Market Rigging.”

 

[28]   Id.; see also Mavin, et al., “Leave for Two Who Helped Oversee U.K. Forex Trade.”

 

[29]   Liam Vaughan, Nicholas Larkin & Suzy Ring, “London Gold Fix Drawing Scrutiny After Forex, Libor Probes,” Bloomberg Businessweek, November 26, 2013, http://www.businessweek.com/news/2013-11-25/gold-fix-drawing-scrutiny-amid-knowledge-tied-to-daily-eruption.

 

[30] Patrick Jenkins and Jack Farachy, “Regulators Urged to Probe Metals Markets Abuse,” Financial Times, November 10, 2013, http://www.ft.com/cms/s/0/c8c50b88-48a1-11e3-a3ef-00144feabdc0.html#axzz2nrha8Blb ; Suzy Ring, Gold Benchmarks Said to Be Reviewed in U.K. Rates Probe, Bloomberg.com, November 20, 2013, http://www.bloomberg.com/news/2013-11-19/gold-benchmarks-said-to-be-under-review-by-u-k-as-probe-widens.html .

 

[31]   Ludwig Burger, “German Watchdog Starts Probe Into Gold Price Fixing: Report,” KDAL610, November 26, 2013, http://kdal610.com/news/articles/2013/nov/26/german-watchdog-starts-probe-into-gold-price-fixing-report/.

 

[32] Matt Clinch, “Gold Benchmark Price Review Launched: Report,” CNBC, November 20, 2013, http://finance.yahoo.com/news/gold-benchmark-price-review-launched-083238326.html.

 

[33]   Enrich, et al., “FBI Tries New Tactic in Currency Probe.”

 

 

As noted in a recent guest post on this site (here), the SEC recently announced the so-called “Robocop” initiative to try to detect improper or fraudulent financial reporting. However, as the authors of the prior post explain in a second guest post below, the Robocop initiative is one of two efforts the agency recently launched to try to detect financial reporting fraud. In the following post, Christopher L. Garcia, Paul Ferrillo of the Weil, Gotshal & Manges law firm and Matthew Jacques of AlixPartners take a look at the second of the two initiatives, the SEC’s creation of the Financial Reporting and Audit Task Force.

 

Chris Garcia and Paul Ferrillo will join a number of other private and public sector professionals – including Margaret McGuire, Vice Chair of the SEC Enforcement Division’s Financial Reporting and Auditing Task Force and Senior Counsel to the Directors of the Enforcement Division – to discuss key SEC Enforcement initiatives for 2014, as well as other topics,during a Directors’ Roundtable panel CLE event on Tuesday, January 28, 2014 from 8:30 AM – 10:45 AM at The University Club in Washington, DC. There is no fee to attend. Details about the event can be found here.

 

I would like to thank Chris, Paul and Matthew for their willingness to publish their 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 Chris, Paul and Matthew’s guest post:

 

On July 2, 2013, the United States Securities and Exchange Commission (the SEC) announced two new initiatives aimed at preventing and detecting improper or fraudulent financial reporting (see July 2, 2013 SEC Press Release, available here). We previously noted that one of these initiatives, a computer-based tool called the Accounting Quality Model (AQM, or “Robocop”), is designed to enable real-time analytical review of financial reports filed with the SEC in order to help identify questionable accounting practices.

 

 

In addition to the AQM, the SEC announced the creation of the Financial Reporting and Audit Task Force (the Task Force). The Task Force comprises 12 experts from across the SEC’s Enforcement Division whose mission will be to “concentrate on expanding and strengthening the Division [of Enforcement’s] efforts to identify securities-law violations relating to the preparation of financial statements, issues of reporting and disclosure, and audit failures.” (Id.; see also, Gaetano, “David Woodcock and Margaret McGuire, SEC Financial Reporting and Audit Task Force,” July 2013, available here). To fulfill this mission, the Task Force, which includes both forensic and GAAP accountants, will be responsible for “closely monitoring high-risk companies to identify potential misconduct, analyzing performance trends by industry, reviewing class action and other filings related to alleged fraudulent financial reporting, tapping into academic work on accounting and auditing fraud, and conducting street sweeps in particular industries and accounting areas.” (See speech by Andrew Ceresney, Co-Director of the Division of Enforcement, at the American Law Institute Continuing Legal Education, September 19, 2013, Washington, DC, available here). In carrying out these tasks, the Task Force will be aided by other critical offices and divisions within the SEC, including the Office of the Chief Accountant and the Division of Corporate Finance. Together, the Task Force and those assisting it constitute a veritable A-Team focused on rooting out accounting improprieties and fraud.

 

 

Why Corporate Directors Must Take Note of the Task Force

There is little question that corporate directors should take note of this substantial deployment of SEC resources. In 2010, the SEC created five specialized units in areas of market abuse, structured and new products, asset management, foreign corrupt practices, and municipal securities and public pensions. In the succeeding years, each of the units utilized the very strategies that the Task Force has been asked to exploit, including monitoring high-risk companies, analyzing performance trends by industry, and conducting street sweeps in particular industries. The result was an increase in inquiries made by the SEC, not to mention several significant enforcement actions, including a withering assault on insider trading; settled actions against banks, including most notably Goldman Sachs, relating to complex structured products; and a high-watermark in FCPA-related enforcement actions.

 

 

We anticipate a similar result in the area of financial reporting and disclosures as a consequence of the creation of the Task Force. Indeed, in a speech last fall, Andrew Ceresney, Co-Director of the Division of Enforcement, explicitly noted that the goal of the Task Force will be to “focus on case generation” and “generat[ing] new accounting fraud investigations for staff in the Division to pursue.” (Id.). In the same speech, Mr. Ceresney went so far as to describe the Task Force as the SEC’s “Apollo 13 moment”:  “Often, when you get a group of smart people in a room focused on a problem, you can find the answer. Kind of reminds me of that scene in Apollo 13 where they bring all of the disparate tools available on the space capsule into a room, dump it on to a table in front of a bunch of smart people, and say find a way to fix the problem. And so we created the Financial Reporting and Audit Task Force … .” (Id.). The problem the Task Force solves for the Enforcement Division is how the SEC can better marshal resources to identify accounting issues; the result, if past is prologue, will be increased engagement by the Commission with public companies concerning such issues.

 

 

Potential Areas of Emphasis of the Task Force

Based on our study of comments made by various SEC officials, we believe that the new Task Force will be focused on a few key areas described below. While it may be prudent for directors to attempt to ensure that their organizations steer clear of financial reporting deficiencies, it may also be important to pay particular attention to the areas of the Task Force’s focus in order to stay out of its crosshairs:

 

 

·        Not Just Fraud – It is easy to look back at certain headline-grabbing frauds of the past (Adelphia, Worldcom, Enron, etc.) and think “Well, that’s not our company.” However, recent SEC actions demonstrate that the SEC in not merely interested in pursuing cases that rise to the level of fraud; the Enforcement Division has brought a number of non-fraud actions against companies and individuals. For example, in June 2013 the Commission brought a settled action against PACCAR Inc. for having ineffective internal controls over the financial reporting process – without any allegations of fraud or intentional wrongdoing.

 

 

·        Getting Caught with a Hand in a Cookie Jar – Accounting guidance requires companies to record expenses when they are probable and estimable through the establishment of an accrual (or reserve) on the books. Setting these reserves, and reversing them, requires professional judgment. As we have already reported, the SEC has indicated that the AQM will be used to detect potentially problematic accrual and reserving practices. The Task Force will similarly be focused on identifying such practices.

 

 

·        Valuation Questions – Management judgment likewise plays an important role in determining the value of assets or securities on a company’s balance sheet. Andrew Ceresney noted in his September 19th speech with respect to losses and reserves: “We recognize that accounting requires that management (and auditors) use their professional judgment but we will not tolerate decisions that are reached in bad faith, recklessly or without proper consideration of the facts and circumstances.” (Id.). In the same speech, Mr. Ceresney noted that the SEC’s focus on such accounting errors extends beyond management to audit committees:  “We have brought actions against audit committees in the past for failing to recognize red flags and we intend to continue holding committees and their members accountable when they shirk their responsibilities.” (Id.).

 

 

·        Revenue Recognition Issues – Reserve issues and valuation issues play into the broader question of whether a company is taking measures to “smooth earnings.” As Margaret McGuire, Vice Chair of the Task Force, recently noted, “revenue recognition is always an issue.” (Id., emphasis added). With the recent growth of social media companies and cloud-based computing services, many companies are faced with difficult questions about how to account properly for these new technologies. (See, e.g., Frier, “IBM Defends Cloud- Computing Accounting Amid SEC Probe,” July 31, 2013, available here).

 

 

·        Material Weaknesses and Internal Controls – Material Weaknesses and Internal Controls present another area of renewed emphasis for the SEC. As Brian T. Croteau, Deputy Chief Accountant of the SEC, was recently quoted saying: “[I] continue to question whether all material weaknesses are being properly identified. It is surprisingly rare to see management identify a material weakness in the absence of a material misstatement. This could be either because the deficiencies are not being identified in the first instance or otherwise because the severity of deficiencies is not being evaluated appropriately.” (Id. at fn. 4).

 

 

·        Multiple revisions of financial statements over a short period of time – Though sometimes multiple revisions of financial statements happen with good reason, the SEC considers this area to be a “warning sign” that the company involved might not be maintaining appropriate books and records and will likely draw the scrutiny of the Task Force.

 

 

Making Good Use Of Peacetime

What does all of this mean for corporate directors? It means that there is no better time than the present – during peacetime, before any inbound inquiries from the SEC are received – to have “tough” discussions with management around the areas of focus identified above, as well as the areas with which directors normally concern themselves. Audit Committee members should have detailed discussions with management and the company’s auditors regarding these issues, not only to make sure that practices are appropriate, but also to identify “red flags” or “warning signs” in their financial statements that might attract SEC attention, whether by the Division of Corporation Finance, the Office of the Chief Accountant, or the Division of Enforcement. Similarly, companies should take proactive measures to ensure and encourage full and candid internal reporting and communications up the ladder so potential issues are not overlooked, ignored or “missed,” and also revisit their “whistleblower” practices to make sure internal reports of potential wrongdoing are dealt with efficiently and effectively (and without fear of retaliation). Indeed, dealing effectively and appropriately with whistleblowers alleging accounting irregularities is more important now than ever before. In Fiscal Year 2012, the SEC received more whistleblower complaints in the area of financial reporting and disclosures (18-percent) than in any other area (See, e.g., SEC 2013 Annual Report to Congress on the Dodd-Frank Whistleblower Program, available here).

 

 

In sum, renewed attention to accounting issues on the part of directors – to match the renewed attention being paid by the SEC – will undoubtedly pay dividends if the SEC ever comes knocking, which seems increasingly likely in the current environment.