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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

The November 2013 Opinion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The pictures readers have taken with their D&O Diary mugs have continued to arrive, and so it is time for another round of readers’ mug shots.

 

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

 

The first two pictures reflect different views of New York City. The first picture is from Jackie Aaron of the Shearman & Sterling law firm. Jackie sent in this “hometown photo’ and provided the following description of the scene depicted in the picture: “Pier I in the Hudson River (at about 68th Street).  Riverside Park is on the right, New Jersey is on the left, and the George Washington Bridge is in the center.”

 

 

 

 

 

 

 

 

 

 

 

 

Then, in a very different depiction of New York, here is a picture sent in by Jim Sandnes of the Boundas, Skarzynski, Walsh & Black law firm. Jim took this shot from his office window, looking north. The sunset is reflected on off the sides of the world financial center buildings and work lights shine from the Freedom Tower and 4 World Trade Center.

 

 

 

 

 

 

 

 

 

 

The next shot, send in by Allison Kernisky of the Holland & Knight law firm in Miami, is from a very different part of the country. Allison reports that she took this picture from her living room window (the view from her living room window is a little different than the view from my living room window — about which see more below). Allison reports that in this picture you can see “a freshly-arrived yacht anchored at the mouth of the Miami River. Not just any yacht, Fountainhead belongs to recent SEC trial winner Mark Cuban. Perhaps this is the first stop in a victory lap around the world. It’s a little hard to see in the photo but the top deck at the ship’s aft is a basketball court complete with hoop. No sightings of Mr. Cuban as of yet.”

 

 

 

 

 

 

 

 

 

 

 

 

The next picture was sent in by Wendy Goundrey who works in the Chubb Insurance Company of Europe office in London. She provided the following description of her picture: “Sid the Sloth lives on my desk and loves my new mug so much its hard to keep him away from it.”

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The following picture sequence reflects a mug exchange that I had with Kamal Hubbard of the Stanford Law School Securities Class Action Clearinghouse. I sent Kamal a D&O Diary mug, and Kamal sent me a Stanford University mug. Kamal also sent the following pictures of the Stanford campus. The first picture depicts the Stanford quad and the second picture depicts the Rodin sculpture garden on the Stanford campus. Both pictures reflect the beautiful, sun-drenched buildings on the Stanford campus. (I have been fortunate enough to be a faculty member at the Stanford Law School Directors College for the last several years, and each time I visit I am struck by how beautiful Stanford is.)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As a meteorological counterpoint to Kamal’s pictures of Stanford, the following picture reflects my part of the reciprocal mug exchange and photo shoot. In this picture, I am standing in my front yard, holding the Stanford mug that Kamal sent me and enjoying the seasonally appropriate weather in Shaker Heights, Ohio, on Thanksgiving Day. I know exactly what you are thinking after looking at the sequence of the mug exchange photos — that’s right, not everyone is forunate enough to be able to live in Northeast Ohio.

 

 

 

 

 

 

 

 

 

 

 

 

It is so much fun to receive readers’ pictures and to see how (and where) they have decided to photograph their mugs. My thanks to everyone who has sent in a mug shot.

 

We are down to the last of the mugs. If there are still readers out there who would like to have a mug and have not yet ordered one, just drop me a note and I will be happy to send one along to you, as long as remaining supplies last. Just remember that if you order a mug, you have to send back a picture. Also, please be patient if you order a mug, it may be several days before we can mail out the next round of mugs.

 

The purchase of reps and warranties insurance is an increasingly common element of mergers and acquisitions transactions. But while the uptake of reps and warranties insurance has increased, concerns remain about how a reps and warranties insurance will respond if a claim arises based on an allegation that a seller has breached a financial statement warranty and the buyer is claiming damages because the deal price was based on a multiple of the allegedly misrepresented financial item.

 

A November 26, 2013 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Multiple-Based Damage Claims Under Representations & Warranty Insurance” (here), by Jeremy S. Liss, Markus P. Bolsinger and Michael J. Snow of the Kirkland & Ellis law firm, “highlights the possibility for a buyer to recover multiple-based damages under R&W insurance.”

In an M&A transaction, either the buyer or seller can purchase reps and warranties insurance, although typically it is the buyer that purchases the policy. If the buyer purchases the policy, the insurance company agrees to insure the buyer against loss arising from breaches of the representations that the sellers have made in the transaction documents.

The claims under a reps and warranties policy can be complicated enough when there allegedly has been a breach of one of the reps and warranties. The claims can be even further complicated if the allegation is that the seller breached a financial statement warranty, and a multiple of the allegedly misstated financial statement item served as a basis of the deal price.

In the law firm memo, the authors cite an example (apparently based on an actual situation) in which the seller allegedly had breached its financial statements representation leading to an inflated EBITDA figure. Because the purchase price had been based on an EBITDA multiple, the purchase price had been inflated as well. The buyer submitted a claim under its reps & warranties insurance policy, seeking damages based the overpayment it had made due to the purchase price multiple of the misstated EBITDA amount. According to the memo, the buyer and the reps and warranties insurer were able to settle the claim based in part on a multiple of the misstated EBITDA.

The memo’s authors’ example is important because it underscores the value of the reps and warranties insurance. The purchase price in many M&A transactions similarly are based on multiples of financial statement items. This authors’ example shows how the reps and warranties insurance can protect the buyer from loss arising from a financial statement misrepresentation where the purchase price is a multiple of the financial statement item.

The authors point out that the question of whether or not a buyer can recover special damages, indirect damages and damages based on a multiple are often an important part of deal negotiations. Some deals can founder if the deal contract will include categorical damages waives (including multiple-based damages). As the authors note, “buyers often assert that excluding multiple-based damages in a transaction where buyer has priced the target based on an earnings multiple can deprive it of protection against breaches of the representations and warranties most important to pricing decision.”

However, reps and warranties insurance allows a buyer to protect itself against a breach of the “pricing representations” and to be assured that it will receive “appropriate compensation for its purchase price overpayment” This insurance alternative also allows deal negotiations to go forward without difficult discussions with the seller over damages limitations.

The example in the authors’ memo provides an illustration of an important way that the inclusion of reps and warranties can actually facilitate the completion of a deal. The use of deal insurance may help complete a deal that might otherwise have foundered over a seller’s requirement for a damages waiver.

The authors also make another good point about the advantages that reps and warranties insurance affords. That is, because the reps and warranties insurer is a repeat participant in a competitive insurance market, the insurer has “an incentive to act reasonably when responding to a claim.” The insurer “is subject to market pressures that do not similarly influence a one-time seller when facing an indemnification claim under an acquisition agreement.” The insurer’s desire to be able to continue to attract business will want to “enhance its reputation as a reliable counterparty that pays valid claims under its policies.” In other words, the insurer may be subject to influences that the seller would not, which can be critically important if claims based on alleged representations and warranties breaches arise.

In a prior post (here), I reviewed additional reasons that the participants in an M&A transaction may want to consider reps and warranties insurance.

Number of Problem Institutions, Bank Failures Continue to Decline: In its Quarterly Banking Profile for the third quarter of 2013, the FDIC provides information portraying a generally health banking sector. Among other details in the quarterly figures, the FDIC reports that the number of problem institutions continues to decline, while remaining stubbornly high.

The FDIC’s quarterly banking profile for the third quarter of 2013 can be found here. The FDIC’s November 26, 2013 press release about its release of quarterly banking profile can be found here.

The number of banks on the FDIC’s “Problem List” declined from 553 to 515 during the quarter. (The agency calls those banks that it rates as a “4” or “5” on a 1-to-5 scale of risk and supervisory concern “problem institutions.”) The number of reporting banks also decreased during the quarter to 6,891, from 6,940 in the previous quarter, meaning the during the third quarter, problem institutions still represented about 7.47 percent of all reporting institutions, down from about 7.96 during the second quarter.

The quarterly decline in the number and percentage of problem institutions during the third quarter represented the tenth consecutive quarterly decline in the number of problem institutions. The number of “problem” banks is down more than 40 percent from the recent high of 888 at the end of the first quarter of 2011. The 888 problem institutions as of March 31, 2011 represented about 11.7% of all the 7574 reporting institutions at that time.

The number of bank failures also continues to decline. During the third quarter there were six banks failures, bringing the 2013 YTD bank failure total (through September 30, 2013) to 23, compared to 50 during the same period in 2012. Since September 30, there has been one additional bank failure. A total of about 532 banks have failed since January 1, 2008.

Russia Clarifies Director Liability Standards: According to a very interesting November 2011 memorandum from the Squire Sanders law firm (here), in August 2013, the Supreme Commercial Court of the Russian Federation issued a detailed Resolution “providing a more coherent roadmap to guiding conduct and pursuing civil relief against officers and directors ho act in violation of their fiduciary duties to the companies they serve.”

According to the memo, Russia has long provided that directors must act “reasonably” and “in the best interests of the company.” However, according to the authors, to date Russia has done a “poor job” enforcing these requirements that otherwise allow normal business efforts to go forward. Instead, the system has favored “an ineffective criminalization of conduct while at the same time failing to provide a workable civil framework to protect investors from self-dealing agents.”

The Resolution clarifies that directors may be held liable to a company for losses incurred as a result of bad faith actions. The Resolution also clarifies that bad faith may be found if a director has acted despite a conflict of interest; concealed information or knowingly provided incorrect information; entered into a transaction without having obtained the requisite approvals; entered a transaction knowing that a counterparty was unable to perform its duties; or knew or should have known that a transaction was unfavorable to the company.

The Resolution also makes it clear that directors may be held liable for “unreasonable actions,” which include failing to perform adequate due diligence and failing to comply with the company’s internal procedures.

A director may be relieved from liability if he or she can show that he or she has not gone beyond ordinary business risk; that an unfavorable transaction was part of series of transactions that were expected to be favorable to the company, or made with the intent to avoid some more adverse consequences; or the losses have been recovered from another source.

The authors conclude the memo with an example of an actual case in which the Moscow Commercial Court awarded damages against a managing director based on losses of 7.5 million rubles ($240,000) that were found to have arisen from the directors’ bad faith conduct (having knowingly entered into an unfavorable transaction and having failed to perform due diligence and without observance of the company’s internal procedures)

My day to day work does not routinely encompass issues involving the liabilities of directors of Russian companies, but it certainly appears that the potential liabilities of directors of Russian companies have changed in a way that could have important implications for the D&O insurance buying patterns of Russian companies. If there are readers out there with additional perspective on these developments, I think we would all welcome your thoughts and comments.

A Break in the Action: With the Thanksgiving holiday upon us, the D&O Diary will be taking a short break. The normal publication schedule will resume next week. Happy Thanksgiving to all.

Over the weekend, voters in Switzerland rejected by a roughly two-to-one margin a referendum that would have restricted executive salaries at Swiss companies to twelve times that of the company’s lowest paid employee. The vote outcome is interesting because it follows so closely on the heels of a ballot initiative  earlier this year in which Swiss voters approved a long list of items (collectively referred to as the Minder Initiative, in reference to the politician who proposed the reforms) addressing and regulating executive compensation for Swiss companies.

 

Though Swiss voters rejected the 1:12 Initiative for Fair Pay, the executive compensation debate is likely to continue, there and elsewhere. Among other things, here in the U.S. the SEC’s proposed new pay ratio disclosure rules, due to be implemented in the months ahead, are likely to spur further controversy and discussion of pay equity issues.

 

As discussed in a November 25, 2013 Wall Street Journal article (here), the Swiss 1:12 pay ratio initiative arose out of a popular perception of a growing wealth gap between executives and everyday workers. An interesting feature of the 1:12 Swiss initiative is that it sought to create a relationship not just between the compensation of the CEO and of employees in general; the initiative sought to establish a relationship between the compensation of the CEO and the compensation of the company’s lowest paid employee. The proponents of the initiative basically argued that nobody should be able to make in a month more than another employees would make in an entire year.

 

The vote on the 1:12 initiative followed Swiss voters’ March 2013 vote in favor of a package of measures (named for Swiss politician Thomas Minder) addressing executive compensation. As discussed here, more than two thirds of voters cast ballots in favor of a 24-item package of measures that, among other things, will require a binding shareholder vote on executive compensation at all publicly traded Swiss companies. The measures also ban signing bonuses, golden parachutes and other forms of executive compensation.

 

Despite the earlier vote on the so-called Minder Initiative, the 1:12 initiative was unsuccessful. Swiss business interests and government officials had come out strongly against the 1:12 initiative on the grounds that defeating the initiative was important to help the country maintain its attraction as a business location and thus to continue to attract secure jobs. Individual companies argued that the proposed initiative would restrict the companies’ ability to attract experienced employees capable of leading complex international operations.

 

The ratio of executive compensation to employee compensation has also been on the radar screen here in the United States, as well as in Switzerland. As discussed at length here, pursuant to the requirements of the Dodd-Frank Act, the SEC has promulgated regulations requiring reporting companies to disclose the ratio between the CEO’s compensation and median employee compensation. The proposed rules remain in the comment stage and likely will not take effect for most companies until 2015 or 2016. Nevertheless, the pay ratio disclosure requirements are likely to ensure that the topic of the appropriate relationship between executive compensation and employee compensation will remain on the docket.

 

The SEC’s pay ratio disclosure requirements differ from the requirements of the Swiss 1:12 initiative in several key respects. First, the Dodd-Frank pay ratio provisions did not mandate a proscribed pay ratio, opting instead for a disclosure approach rather than an absolute compensation requirement. Second, the Dodd-Frank pay ration disclosure requirements seek to illuminate the relationship between CEO compensation and median employee compensation – that is, the focus is on overall employee compensation and overall fairness. The Swiss initiative, by contrast, was based on the relationship between the CEO (presumably the highest paid employee) and the lowest paid employee. The Swiss initiative incorporated an implicit (and arguably more radical) assumption about the need for social leveling.

 

The defeat of the Swiss measure hardly marks the end of the debate over executive compensation, even in Switzerland. Perceptions involving income disparities and pay equity, as well as social equality and economic fairness, will continue to drive debate on these issues. The sentiments behind the Occupy movement and the discussion about the 1 percent ensure that the questions will continue to be debated.

 

I have long thought that much of the discussion of these issues suffers from a reflexive bur relatively unexamined view that the “fat cat” executives are just getting paid “too much.” Many of the same people who rail against CEO compensation wouldn’t think twice about the massive amounts that star athletes and media stars can command.   Most people understand that LeBron James can command an astronomical pay check because he has unusual talents and abilities that are easily appreciated; as a result, there are no populist movements to try to drive down professional athletes’ compensation. It is much harder to appreciate how difficult it is to run a modern, complex, global company, and so there is a much greater willingness to conclude that corporate executives are paid “too much,” even if the individuals in question also have a highly unusual set of talents and experiences.

 

The executive compensation debate is at its least meaningful when it is simply about “how muc”h the executives make, as if the mere fact that compensation is above some vague (and subjective) level alone establishes that the compensation is unwarranted.

 

Where the executive compensation debate is much more meaningful is when it is focused on the fact that in some cases, the highly compensated executives are their own paymasters. To use the analogy to compensation in the sports world again, one of the reasons that there is less concern about salaries in the sports world than in the corporate world is that the athletes get paid what the market will bear as a result of an arm’s length negotiation – LeBron doesn’t set his pay, the marketplace does.

 

When corporate executives have too much control over their own pay, the objections to executive compensation are far more compelling, Cynical observers may even question whether some board members are capable of exerting control, as they are often the beneficiaries of similar compensation arrangements in their own primary employment position.

 

I happen to think that it takes an enormous amount of skill and experience to run a complex global company in this day and age. I also think that there are far fewer individuals who are capable of running a company well than is commonly perceived. I think that the small number of people who have the right skills to run a complex global company well are entitled to be compensated very well, subject to certain specific concerns.

 

First, pay must be based on performance. The sorriest spectacle in the corporate arena is the occasional instance where outsized executive pay follows corporate underperformance.

 

Second, because of the problems that arise when there is a perception that corporate executives are acting as their own paymasters, the compensation setting process for top executives needs to involve significant controls to ensure that an independent and objective authority is in fact controlling executive compensation.

 

Third, transparency around these issues is indispensable for maintaining confidence in the process. I don’t know that the impending pay ratio disclosure requirements are going to add much in that regard. Just the same, the pay ratio disclosure requirements proceed from a legitimate assumption, which is that better disclosure around compensation issues will help foster investor confidence – and, as many of the executive compensation critics hope, will also act as a check on outsized executive compensation issues.

 

One thing that should not be lost in the discussion is the fact that executive compensation is now very much of a political issue. Even though the recent Swiss pay ratio initiative was voted down, the earlier Swiss initiative passed. By the same token, the executive compensation related provisions of the Dodd-Frank Act were incorporated in the legislation for political reasons.

 

The public debate about executive compensation will certainly continue. Indeed, the implementation of the new SEC pay ratio disclosure requirements could raise the temperature on these issues. It seems likely that controversy could follow some pay ratio disclosures. The possibility that we might wind up with pay ratio mandates of the kind that the Swiss voters recently rejected seems remote. But if populist discontent on executive compensation issues reaches a sufficient level, there could be political initiatives in this country that include even the possibility of compensation mandates and constraints. Look at it this way — if executive compensation can become a ballot box issue in a business-oriented country like Switzerland, it could become a populist issuer for voters here as well.

 

The political sensitivity of these issues, particularly at a time where there is a growing perception of pay inequity and economic inequality, militates strongly in favor of voluntary measures calculated to try to reduce controversy and increase investor confidence in executive compensation issues. While I have no comprehensive solution to propose here, I believe that well–advised companies will be focused in developing and implementing measures calculated to develop confidence in the companies’ compensation-setting processes and to provide transparency around those processes, as well as around the compensation itself.

 

The ABA Journal Blawg 100 for 2013: I am delighted to report that The D&O Diary has been selected once again for the ABA Journal’s Blawg 100, the publication’s annual list of the top 100 legal blogs. The Journal’s list of the 2013 Blawg 100 can be found here. The D&O Diary is listed in the “Niche” category.

 

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

 

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

 

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

 

On November 21, 2013, in a terse, two-page summary order (here), the Second Circuit affirmed a district court ruling applying New York law and holding that a D&O insurance policy’s professional services exclusion precludes coverage for claims brought against  broker-dealer David Lerner Associates, based on the firm’s offering underwriter and financial products sales activities. The March 29, 2013 opinion of Eastern District of New York Judge Joseph F. Bianco, which the appellate court affirmed, can be found here.

 

Background

David Lerner Associates (DLA) is a broker-dealer that served as the underwriter and sole distributor for securities of the Apple Real Estate Investment Trust (REIT). In May 2011, the Financial Industry Regulatory Authority (FINRA) filed a disciplinary complaint against DLA (subsequently amended to include David Lerner individually). FINRA’s amended complaint alleged that DLA sold over $442 million of the REIT’s securities, allegedly by misrepresenting the value of the securities while failing to perform adequate due diligence.

 

In June 2011, investors who had purchased the Apple REIT securities filed three class actions against DLA, David Lerner and others, arising out the same circumstances as the FINRA action. The three class actions and a separate individual action were consolidated in the Eastern District of New York.

 

DLA submitted the FINRA action and the various private lawsuits to its D&O insurer, seeking coverage for its costs of defending the actions. The insurer denied coverage in reliance on the D&O policy’s professional services exclusion, which provides in pertinent part that

 

The Underwriter shall not be liable to may any payment for Loss in connection with any Claim made against the Insured based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving the Insured’s performance of or failure to perform professional services for others

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The policy does not define the term “professional services.”

 

DLA filed a lawsuit against its D&O insurer alleging breach of contract and seeking a declaratory judgment that the D&O insurer is obligated under its policy to indemnify and defend DLA in the regulatory action and private lawsuits. The D&O insurer filed a motion to dismiss DLA’s action.

 

The District Court’s March 29 Ruling

In his March 29, 2013 Memorandum and Order, Eastern District of New York Judge Joseph Bianco granted the D&O insurer’s motion to dismiss. 

 

Judge Bianco held that the insurer does not have a duty to indemnify or defend DLA in the underlying litigation “due to the unambiguous language of the professional services exclusion.” He said that the allegations in the underlying complaints alleging that DLA — while acting as the underwriter and sole distributor of the Apple REIT securities had failed to engage in due diligence —  “quintessentially and unambiguously fall within the common-sense understanding of the term ‘professional service.’”

 

Judge Bianco rejected DLA’s argument that because the term “professional services” was undefined in the policy, it was ambiguous and should be construed against the insurer. After reviewing New York case law, Judge Bianco said that

 

It is clear under New York law that the allegations in the underlying lawsuits against DLA – relating to its purported failure to, inter alia, conduct due diligence on the REITs in connection with providing investment advice to its customers in the sale of this financial product – constitute “professional services” under the common understanding of the term, and, thus, the exclusion from coverage under the policy unambiguously applies here.

 

Judge Bianco added that “to perform due diligence on REITs and market those securities, individuals are employed in an occupation, they rely on specialized knowledge or skill, and the skill is mental rather than physical. There is simply no question, based on the allegations in the underlying lawsuits, that the professional services exclusion applies.”

 

The Second Circuit’s November 21, 2013 Summary Order

On November 21, 2013, in a two-page summary order, a three judge panel of the Second Circuit affirmed Judge Bianco’s dismissal, quoting with approval from Judge Bianco’s opinion and stating that “the claims for which DLA seeks coverage fall within the professional services exclusion of the policy at issue.” 

 

The Second Circuit emphasized that under New York law insurance policy terms are to be “read in light of common sense speech and the reasonable expectations of a business person.” The appellate court also noted, as the district court had observed, that “the standard test for professional services is whether the employees acted with the special acumen and training of professionals when the engaged in the acts.”

 

Discussion

The determination of whether or not claims based on certain specified activities are precluded by a D&O insurance policy’s professional services exclusion is the other side of the coin from the determination of whether or not the claims constitute “professional services’ within the meaning of the coverage provisions of an Errors and Omissions (E&O) insurance policy.

 

Indeed, these judicial determinations that DLA’s underlying activities represent professional services do raise the question of why DLA submitted these claims to its D&O insurer, rather than to its E&O insurer. Neither the district court opinion nor the Second Circuit opinion refers to the possibility of coverage for these claims under a separate E&O policy.

 

There is always the possibility that DLA did not carry E&O insurance; however, give the size of its operations (the district court opinion notes that the firm has offices in two states and about 370 registered representatives), I find it unlikely that the firm did not have E&O insurance. My guess is that the firm also submitted these claims to its E&O insurer and that the E&O insurer also denied the claims, either because the offering underwriting activities that are the basis of the underlying claims fall outside the definition of “professional services” in the E&O policy or because the claims against DLA were not asserted by the customer for whom DLA performed the underwriting services (Apple REIT) but by third parties. I want to emphasize that I am speculating here, I have no way of knowing for sure why this insurance dispute arises under DLA’s D&O policy and there is no mention of DLA’s E&O policy.

 

It is not uncommon for coverage disputes to arise involving the professional services exclusion in a D&O insurance policy. A frequently recurring issue (that was not involved here) has to do with the use of the broad preamble language in the exclusion – that is, that the exclusion precludes coverage for claims “based upon, arising out of or in any way involving” the delivery of professional services. Insurers whose policies have this broad preamble will seek to apply the exclusion broadly, to sweep in a broad range of disputes involving the insured company’s operations. For that reason, it is preferable when the alternative wording is available to use the narrower “for” preamble, rather than the broader “based upon, arising out of” lead-in language. However, the narrower language often is not available.

 

It is interesting that one of the elements of the dispute in this case had to do with the fact that the D&O insurance policy precluded coverage for claims arising from the delivery of professional services but the policy does not define the term “professional services.” By contrast, in the typical E&O insurance policy, which designed to provide coverage for claims arising from the delivery of professional services, the term “professional services” is invariable a defined term, and typically is defined very narrowly. (For a recent discussion of the ways in which an E&O insurance policy’s definition of the term “professional services” can affect the availability of coverage under the policy, refer here.)

 

The difference in the ways that the two types of policies treat the term “professional services” raises the possibility that specific activities might constitute “professional services” for purposes of the D&O insurance policy’s exclusion, but might fall outside the definition of “professional services” for purposes of triggering coverage under the E&O insurance policy – which is one reason why it is preferable for financial services firms to have the D&O and E&O insurance provided by the same carrier.

 

As always when I stray into topics involving E&O insurance, I am interested in the thoughts and reactions of readers who work more frequently with those policy forms than I do. I encourage readers to add their comments to this post using the blog’s comment feature.

 

Shareholder claimants seeking to pursue a misrepresentation claim under the Ontario Securities Act must obtain leave of court to proceed based on a statutory requirement that the plaintiff must show a “reasonable possibility that the action will be resolved at trial in favor of the plaintiff.” Ontario’s courts agree that this requirement sets a “low bar,” but they have struggled to establish just how low this bar is.

 

In a November 5, 2013 decision in a securities suit against Kinross Gold Corporation and certain of its directors, Justice Paul Perell of the Ontario Superior Court of Justice examined the Act’s leave requirements and concluded that though the bar to obtain leave is low, the shareholder claimants had not met the statutory requirements and therefor leave to proceed was denied. A copy of the November 5 decision can be found here.

 

Though the decision will not end the debate about just how low the requirements are, the decision does show that even though the bar is low, the leave requirements do serve as a “genuine screening mechanism” and claimants may fail to meet the requirements.

 

Kinross is a Canadian international mining company. The plaintiffs are trustees of a Canadian pension fund who filed an action in the Ontario Court of Justice asserting a statutory claim for damages under the Ontario Securities Act and a claim for common law misrepresentation. The plaintiffs purported to represent a class of investors who purchased Kinross shares between May 3, 2011 and January 16, 2012.

 

The plaintiffs alleged that the defendants had made three misrepresentations. First, the plaintiffs alleged that Kinross ought to have written down goodwill associated with respect to two West African gold mines; Second, that Kinross had failed to disclose that drilling operations at one of the two West African mines had shown high concentrations of low grade ore; and third that Kinross had misrepresented that expansion efforts at one of the two West African mines remained on schedule.

 

Kinross was also targeted in a separate securities class action lawsuit that had been filed against the company and certain of its directors and officers in the Southern District of New York, under U.S. securities laws. The defendants had moved to dismiss the S.D.N.Y. action. The dismissal motion was granted in part, but it was denied with respect to the U.S. plaintiffs’ claim that the company had misrepresented that the accelerated schedule for developing one of the West African gold mines was achievable.  A copy of Southern District of New York Judge Paul Engelmayer’s March 22, 2013 order granting in part and denying in part the defendants’ motion to dismiss the U.S. action can be found here.

 

The plaintiffs in the Ontario case sought the court’s leave to proceed with their action and also sought to have the action certified as a class proceeding. The defendants opposed the request for leave and the request for class certification.

 

Part XXIII.I of the Ontario Securities Act provides a statutory cause of action for a company’s misrepresentations in its continuous disclosure documents. Section 138.8 (1) of the Act provides that the misrepresentation action may not proceed without leave of court to proceed, with leave to be granted only if “there is a reasonable possibility that the action will be resolved at trial in favor of the plaintiff.

 

Courts considering this leave requirement have reached what Justice Perell described as a “consensus” that the leave test imposes only a “low evidentiary threshold” (refer for example, here and here) – but Justice Perell added that “the test is nevertheless a genuine screening mechanism that requires the court to assess and weigh the evidence and to determine whether the plaintiff’s chance of success is a reasonable possibility.”

 

But while courts considering the question have agreed that the bar to meet the leave test is low, Justice Perell commented that “I do not think the debate about the measure of the height for the bar for the test for leave is over.” He described the debate about just how low the threshold is as a “limbo dance” as the courts have tried to resolve the questions of “how low is the low threshold and what must a plaintiff do to show that he or she has a reasonable possibility of success.”

 

For his part, Justice Perell determined that the leave test is a “genuine screening mechanism” that requires the court “to assess and weigh the evidence and that requires the court to determine wither the plaintiff’s chance of success is reasonable possibility.”

 

Applying these standards to the plaintiffs’ claims and assessing the allegations and the expert testimony on which the plaintiffs sought to rely, Justice Perell concluded that the plaintiffs failed the test for leave, and he denied class certification for both the statutory claims and the common law claim.

 

The plaintiffs are likely to appeal Justice Perell’s ruling, particularly the extent to which he assessed and evaluated the expert testimony on which the plaintiffs sought to rely in support of their allegations.

 

While this case may have much further to go yet, it does provide a useful reminder that though the bar for claimants to obtain leave to proceed is low, the grant of leave is not automatic. There are still minimum standards that must be met, and if the claimants do no meet these standards, leave to proceed will be denied.

 

It is interesting to note that the shareholder claimants were denied leave to proceed in the Ontario proceeding while the dismissal motion was denied in part in the S.D.N.Y. action. The difference in outcome is attributable to the fact that the U.S. claimants’ allegations differed slightly from those of the Ontario claimants. The Ontario plaintiffs sought to try to raise these same allegations in the Ontario proceeding and to rely on the dismissal motion ruling the S.D.N.Y. action, but Justice Perell rejected their efforts to rely on these allegations because they had not pleaded these allegations in their complaint. Justice Perell commented that “I do not see how the circumstances of a differently pleaded action in a different jurisdiction have any relevance to considering whether to grant leave in the case at bar.”

 

Special thanks to a loyal reader for supplying me with a copy of Justice Perell’s Reasons for Decision.

 

Coverage Under Canadian D&O Policy for Costs Incurred Defending Bankruptcy Claims Involving Bankrupt U.S. Subsidiary Not Precluded: In a February 25, 2013 decision (here), the Ontario Court of Appeal held that coverage was not precluded under the Canadian D&O policy for costs incurred in defending the claims of bankruptcy trustee against the directors and officers of a U.S. subsidiary of the Canadian policyholder.

 

As discussed in a November 14, 2013 memo from the McMillan law firm (here), the Court of Appeal rejected the insurer’s argument that coverage was precluded by the policy’s insured vs. insured exclusion and due to the failure of the policyholder to satisfy the policy’s notice requirements.

 

During the period 2010 to 2012, plaintiffs’ lawyers rushed to file a wave of securities suits against U.S.-listed Chinese companies. In general, the cases filed as part of this wave that have reached the settlement stage have settled for relatively modest amounts. However, at least one of these cases has now resulted in an absolutely eye-popping damages award.  

 

On November 14, 2013, Southern District of New York Judge Shira Scheindlin entered a default judgment order including a damages award of $882.3 million against Longtop Financial Technologies Ltd. and its former CEO, Wai Chau Lin. A copy of the order can be found here. However, as impressive as the size of this award is, the plaintiffs now have to try to enforce the judgment against the company and former CEO, both of whom are located in China and both of whom already proved elusive for purposes of service of process.

 

Unlike many of U.S.-listed Chinese companies, Longtop Financial did not obtain its U.S. listing through a reverse merger, but instead it became a public company through a conventional IPO in 2007. Its shares traded on the NYSE. At one point, its market capitalization exceeded $1 billion. Questions bgan to dog the company when Citron Research published an April 26, 2011 online report critical of the company. Among other things, the report questioned the company’s “unconventional staffing model,” alleged prior undisclosed “misdeeds” involving management, and referenced “non-transparent” stock transactions involving the company’s chairman, among other things. Other critical research coverage followed.

 

Longtop’s problems took another turn for the worse in May 2011 when, in advance of the high profile IPO of Chinese social networking company, Renren Network, Longtop’s CFO, who sat on Renren’s board as chair of the audit committee, resigned to prevent the questions at Longtop from affecting Renren’s IPO.

 

Then on May 23, 2011, in a filing with the SEC on Form 8-K, the company announced that both its CFO and its outside auditor, Deloitte Touche Tomatsu (DTT) had resigned. In its accompanying press release (here), the company said that DTT stated that it in its May 22, 2011 letter of resignation that it was resigning as a result of, among other things,

 

(1) the recently identified falsity of the Company’s financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of Longtop management in DTT’s audit process; and (3) the unlawful detention of DTT’s audit files.

 

DTT further stated that it was “no longer able to rely on management’s representation’s in relation to prior period financial reports, and that continued reliance should no longer be place on DTT’s audit reports on the previous financial statements.”

 

Securities class action lawsuits followed. The actions were consolidated before Judge Scheindlin in the Southern District of New York. The defendants in the lawsuits included the company, certain of its directors and officers (including the company’s former CFO, Derek Palaschuk) and Deloitte Touche Tohmatsu.

 

In her November 14 order, Judge Scheindlin reviewed the plaintiffs’ efforts to effect service of process on the company and on Wai Chau Lin, the company’s former CEO. In December 2011, the plaintiffs served the company with a copy of the complaint in English and simplified Chinese through its registered agent for service of process in the United States.

 

The plaintiffs first attempted to serve Lin with the summons and complaint pursuant to the Hague Convention on Service Abroad. However, this attempt proved unsuccessful as the service papers were returned in March 2013.after a Chinese government bureau reported that it had “failed to find the charge person and nobody came to the court to take documents.” Judge Scheindlin separately authorized the plaintiffs to serve Lin via email. The plaintiffs subsequently filed proof of service on Lin via email.

 

Both the company and Lin failed to appear or otherwise respond to the complaint. After the time to respond had elapsed, the clerk of court entered defaults against the company and the two defendants. The plaintiffs then moved for entry of default judgment, including in their motion an expert report on damages supporting a damages claim of $882.3 million. On November 14, 2013, Judge Scheindin entered a default judgment against the Company and Lin, in the form and amount the plaintiffs had requested.

 

The default judgment order finds the company and Lin jointly and severally liable for the damages amount of $882.3 million plus prejudgment interest of 9% from February 21, 2008 to the date of payment.

 

While the amount of the damages award is impressive, the question remains of how valuable the order will prove to be. The likelihood that a Chinese court would recognize and enforce the judgment, and that the plaintiffs could find assets of the company or Lin to satisfy the award, is remote.

 

The plaintiffs’ hopes that they might be able to extract some recovery from the Deloitte affiliate that acted as Longtop’s auditor were dashed in April 2013, when Judge Scheindlin dismissed the last of the remaining claims against the audit firm.

 

The one remaining defendant that plaintiffs have in their sights is the former CFO, Derek Palaschuk, whom the plaintiffs were able to serve in Canada in 2012 and who filed a motion to dismiss the plaintiffs’ claims against him. In a June 29, 2012 opinion (here), Judge Scheindlin, though acknowledging that the online research reports may well have been biased owing to the online analysts’ financial interests as short sellers of Longtop’s stock, nonetheless rejected Palaschuk’s motion. Among other things, she found that the plaintiffs had sufficiently alleged that in various company press release and financial filings, Palaschuk had made misleading statements about the company’s financial condition and the basis for its growth.

 

In her November 14 order, Judge Scheindlin retained jurisdiction over the action for purposes of the plaintiffs’ ongoing case against Palaschuk.

 

As impressive as the size of the damages award against the company and Lin may be, it also illustrates the problem that the plaintiffs in these cases face. The plaintiffs face enormous procedural challenges just trying to prosecute these actions in the ordinary course; routine procedures as basic as service of process may present insurmountable obstacles. The prospects for effecting a recovery may be remote.

 

Though a number of plaintiffs’ firms rushed to file the various cases against U.S.-listed Chinese companies between 2012 and 2012, many of these cases seem unlikely to moneymakers for the plaintiffs. Even large awards like the one Judge Scheindin entered here may prove to represent empty victories.