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.

 

 

One of the most distinctive corporate and securities litigation trend in recent years has been the surge in M&A-related litigation, with virtually every deal attracting at least one lawsuit. This trend continued again in 2013, according to a recently updated study from Notre Dame business professor Matthew Cain and Ohio State law professor Steven Davidoff. As reflected their January 9, 2014 paper entitled “Takeover Litigation in 2013” (here), 97.3% of all takeovers in 2013 with a value of over $100 million experienced a shareholder lawsuit, which represents the highest litigation rate recorded.

 

Professor Davidoff’s January 10, 2013 column on the New York Times Dealbook blog about the authors’ paper and entitled “Corporate Takeover? In 2013, a Lawsuit Almost Always Followed” can be found here.

 

The professors’ paper is the latest update on the research originally presented in their January 2012 paper entitled “A Great Game: The Dynamics of State Competition and Litigation” (here), which I reviewed here. Following the original article’s publication, the professors updated their research with additional litigation data regarding M&A transactions that took place in 2011 and they updated their research again with respect to the transactions that took place in 2012.

 

The professors have limited their analysis to merger transactions over $100 million involving publicly traded target companies with an offering price of at least $5 per share. The 2013 update includes only transactions there were completed as of January 2014. The professors intend to update their 2013 data in six months to incorporate information relating to the in-process transactions

 

According to the authors’ research, only about 40% of deals meeting the research criteria in 2005 attracted litigation, whereas in 2013 almost every deal attracted at least one suit. In 2013, 78 of the 80 transactions meeting the criteria attracted litigation, representing 97.5% of all of the deals (up from 91.7% in 2012). The authors note in their paper that the 2013 figure “continues the increasing trend in takeover litigation which is now brought at a rate almost 2.5 times that of 2005.”

 

As the authors observe, “in plain English, if a target announces a takeover it should assume that it and its directors will be sued.”

 

Not only that, many of the deals attracted multiple lawsuits. The mean number of lawsuits per transaction also reached an all-time high in 2013, with an average of 6.9 lawsuits per transaction, up from 5.2 in 2012 – and only 2.2 per deal in 2005. Obviously, the plaintiffs’ lawyers view this type of litigation as good business, and more of them are trying to get into the act.

 

If there is one (slightly) positive note, it is that the authors found that the number of deals involving multistate claims has declined. In 2013, 41.6% of deals involved lawsuits in more than one state. This is down from 2012, when 51.8% of deals attracted multistate litigation. Though the 2013 figure represents a decline, it is still well above the equivalent figure for 2005, when only 8.3% of deals involved multistate litigation.

 

Much of the 2013 litigation is still in process, but the authors do include some settlement information in their paper. Their analysis shows that the 2013 cases that have settled, 84.8%of the settlements were “disclosure only” settlements, compared to approximately 85.7% in 2012.

 

In his Dealbook column about the paper, Professor Davidoff comments on courts’ increasing skepticism about the value of the “disclosure only” settlements, noting particularly in Delaware that “the judges are clearing tiring of disclosure-only settlements. As noted in a Decemvber 30, 2013 post on the MoneyBeat blog (here), Delaware Chancellor (and Delaware Supreme Court nominee) Leo E. Strine, Jr., commenting on the $237,500 plaintiffs’ attorney fee in the disclosure only settlement of the litigation challenging the takeover of Talbot’s Inc., said that “The social utility of cases like this continuing to be resolved in this way is dubious.”

 

The mean plaintiffs’ attorneys’ fees awarded per case in 2013 (at least for the cases that have settled so far was $696,000, compared to $600,000 in 2012. The median plaintiffs’ attorneys’ fees in 2013 was $485,000, down from $500,000 in 1012.

 

The authors caution that the because so many of the 2013 cases are still in process, the settlement and attorneys’ fee data are preliminary only.

 

One of the important background issues in the context of the surging M&A litigation is whether or not there is a jurisdictional competition, in which the various states (particularly Delaware) are or are not in competition with one another for this type of litigation. In that regard, the authors found that in 2013, Delaware attracted a slightly smaller share of the litigation. The authors found that Delaware attracted 45.2% of all litigation that could conceivably go to Delaware because the company was incorporated or headquartered there, compared to 46.3 percent in 2013.

 

Discussion

As I have noted in the past with respect to the authors’ research, the criteria the authors use for their analysis means that their statistical conclusions are most relevant to larger transactions involving publicly traded companies. In my experience even smaller transactions also frequently attract the unwanted attention of the plaintiffs’ lawyers. Just the same, because the authors’ research most particularly pertains to larger transactions involving publicly traded companies, the authors’ statistical conclusions must be used advisedly outside of that context.

 

This continuing onslaught of M&A-related litigation continues to be a problem for the companies involved in these transactions and for their insurers. Although as noted above these cases often are resolved with disclosure only settlements, there have also been a number of significant cash settlements as well – for example, the $110 million settlement in the El Paso/Kinder Morgan case. The growth in this kind of litigation first and foremost represents a frequency problem for D&O insurers. But as the incidence of large cash settlements in these kinds of cases increases, the upsurge of this type of litigation represents a severity problem as well. (These issues about the possible impacts on the D&O Insurance industry are discussed in greater detail here.)

 

The dramatic increase in this type of litigation in recent years has been one of the justifications that the D&O insurers have given to justify rate increases, at least at the primary layer. In addition, some primary D&O carriers are requiring the addition of a separate M&A-related litigation retention, with the level of the retention set at a level to try to avoid loss costs associated with the disclosure only type settlement. As long as the elevated levels of M&A-related litigation persist, the carriers are likely to continue to try to find defensive measures to try to limit their loss costs. As far as the companies themselves, there are also steps they can take to try to enable them to better defend themselves, as discussed here.

 

The decrease noted in the 2013 study of multistate litigation, though slight, is a positive development, and provides some hope that defendants will not be forced to have to try to fight a multi-front war. The Delaware court’s acceptance and enforcement of forum selection clauses in corporate by-laws may also help reduce the prevalence of multi-jurisdiction litigation.

 

Although the disclosure-only settlements represent their own peculiar kind of problem, as merger objection suit that fails to settle and that lingers on after the transaction closes may represent an even worse problem, as discussed here.

 

London 1927: In 1927, Claude Friese-Greene shot some of the first color film footage ever taken of London, using a technique known as Biocolour. The film images he captured are beautiful, and evoke the time 87 years ago. The images are both hauntingly familiar yet somehow eerily different. The streets were already busy with motor traffic; all the men wore hats. And in that simpler, bygone time, England emerged victorious over the Aussies in the Test Match at the Oval –yes, a long time ago… 

 

//www.youtube.com/embed/Qgxki8_R968

One of the most contentious issues in the litigation the FDIC has been pursuing in its capacity as receiver of various failed banks is whether the defendant former directors and officers can assert affirmative defenses against the FDIC for the agency’s own conduct.

 

In a part of a December 23, 2013 Eleventh Circuit opinion that may have been overlooked because the same opinion also certified to the Georgia Supreme Court important questions involving the business judgment rule under Georgia law, the Eleventh Circuit affirmed the district court’s denial of the FDIC’s effort to strike the individual defendants’ affirmative defenses based on the agency’s alleged post-receivership conduct. . The Eleventh Circuit’s opinion in the case, which arises out of the failure of Integrity Bank of Alpharetta, Georgia, can be found here.

 

Though the Eleventh Circuit’s certification of the legal questions to the Georgia Supreme Court rightfully has drawn attention, the Court’s ruling on the affirmative defenses may actually be the more interesting part of the opinion. As the first appellate court decision directly on point on the affirmative defenses question, the Eleventh Circuit’s ruling could prove to be very helpful to individual defendants seeking to defend themselves from claims asserted against them by the FDIC.

 

Background

Integrity Bank of Alpharetta, Georgia was one of the first banks in Georgia to fail as part of the current bank failure wave when it was closed on August 28, 2008. As discussed here, on January 14, 2011, in what was the third FDIC lawsuit overall against former officials of a failed bank and the first in Georgia, the FDIC filed a lawsuit against eight former officials of Integrity Bank. The FDIC’s complaint can be found here.

 

The FDIC, which filed the lawsuit in its capacity as Integrity Bank’s receiver, seeks to recover “over $70 million in losses” that the FDIC alleges the bank suffered on 21 commercial and residential acquisition, development and construction loans between February 4, 2005 and May 2, 2007. The defendants filed a motion to dismiss. The FDIC filed a motion to strike certain of the defendants’ affirmative defenses.

 

As discussed at length here, on February 27, 2012, Northern District of Georgia Judge Steve C. Jones held that the FDIC’s claims for ordinary negligence and for breach of fiduciary duty based on ordinary negligence were, as a matter of law, precluded by Georgia’s business judgment rule, and granted the defendants’ motion to dismiss those claims. Judge Jones also granted the FDIC”s motion for summary judgment to strike the defendants’ affirmative defenses based on the FDIC’s pre-receivership conduct, but denied the FDIC”s motion with respect to the affirmative defenses that the defendants asserted based on the FDIC’s post receivership conduct. (The specific post-receivership defenses that the defendants asserted were based on the FDIC’s failure to mitigate damages, reliance and estoppel.) Judge Jones’s opinion can be found here.

 

The FDIC appealed the district’s dismissal of the negligence and negligent breach of fiduciary duty claims and also appealed the denial of its summary judgment motion to strike the defendants’ affirmative defenses based on the agency’s post-receivership conduct. (The district court’s grant of summary judgment to strike the individual defendants’ affirmative defenses based on the FDIC’s pre-receivership conduct was not appealed and was not considered by the Eleventh Circuit.)

 

Importantly, and as discussed here, in November 2013, and while the FDIC’s appeal in the Integrity Bank case was pending before the Eleventh Circuit, Northern District Judge Tom Thrash, considering the motion to dismiss of individual defendants in a case involving the failed Buckhead Community Bank, certified to the Georgia Supreme Court the question of whether or not the business judgment rule under Georgia law precluded the FDIC’s claims against the individuals for negligence and for negligent breach of fiduciary duty.

 

The Eleventh Circuit’s Opinion

In a per curiam opinion of a three-judge panel, the Eleventh Circuit elected to certify to the Georgia Supreme Court the question of whether or not the Georgia business judgment rule barred the FDIC’s claims for negligence and for negligent breach of fiduciary duty. The appellate court affirmed the district court’s denial of the FDIC’s motion for summary judgment to strike the individual defendants’ affirmative defenses based on the agency’s post-receivership conduct.

 

The Court’s decision to certify the business judgment rule question was based on its identification of a “plausible conflict” between the statutory language of Georgia’s business judgment rule and the case law interpreting the language. The Court acknowledged (in a footnote) that similar questions had already been certified to the Georgia Supreme Court in the Buckhead Community Bank case. The appellate court said it was certifying the question that it was asking “broadly for the state court’s help in getting the state law right in this case.”

 

In affirming the summary judgment denial, the Eleventh Circuit rejected the FDIC’s so-called “no duty” argument. The FDIC argued (as if often does when individual defendants assert affirmative defenses against the agency in failed bank cases) that “under well-established federal common law, the FDIC owes no duty to bank directors and officers,” and accordingly affirmative defenses cannot be asserted against it as a matter of law.

 

The Eleventh Circuit expressly concluded that there is no “previously established and long-standing” rule of federal common law to support the FDIC’s “no duty” argument. The Court found that the appellate decisions on which the agency sought to rely “stand at most for the proposition that a bank’s officers and directors cannot assert tort claims against the FDIC because the FDIC owes them no duty.” The appellate court also said that the “sprinkle” of four pre-FIRREA district court cases on which the FDIC relies “completely fails to demonstrate the real existence of the indispensable ‘established and long-standing’ federal common law rule: one exempting the FDIC from defenses under state law.” 

 

The Court went on to say that

 

In asking this Court to apply a “no duty” rule – which bars tort actions brought by a bank’s directors and officers against the FDIC – to bar affirmative defenses asserted against the FDIC when it is the one advancing claims, the FDIC is asking us to extend a purported federal common law rule to a new and significantly different context. In other words the FDIC is asking this Court to act like a common law court and to create federal common law to fit this case.

 

The Court concluded the opinion by declining to create a federal common law rule on which the FDIC sought to rely, noting that the federal common law is “basically complete and closed” and that this case did not present the rare case of “a significant conflict” between some federal policy or interest and the use of state law that would otherwise permit the creation of a federal common law rule.

 

Discussion

In light of the previous certification to the Georgia Supreme Court in the Buckhead Community Bank case of the business judgment rule question, the Eleventh Circuit’s certification of the question in this case is hardly a surprise. Given that Georgia’s highest Court would be weighing in on the very Georgia state law issues that would otherwise determine the business judgment rule question in this case, it made no sense for the Eleventh Circuit to go out on a limb by propounding its views about the rule, with the possibility that the Georgia court could undercut the federal appellate court’s determination.

 

But rather than just come right out and say it was certifying the issue because the relevant questions were already going to be considered by the Georgia court, the Eleventh Circuit pronounced that there was a potential conflict in the law requiring certification. (I am sure I am not the only one who wonders if the Eleventh Circuit would have certified the question if the same basic question had not already been certified in the Buckhead Community Bank case.)

 

Much of the attention to this appellate ruling has been based on the Court’s certification of the business judgment rule question. However, the Court’s ruling that the individuals are not barred from asserting affirmative defenses may be even more significant, particularly the appellate court’s rejection of the FDIC’s “no duty” rule.

 

In many of the current failed bank cases that the FDIC has filed against former bank directors and officers, the individual defendants have tried to assert affirmative defenses against the agency. The post-receivership defenses involve the agency’s alleged failure to collect on the failed bank’s account or alleged improper disposal of the bank’s assets. The FDIC has generally sought to strike these defenses in reliance on the “no duty” argument.

 

The district courts have been divided on the question of whether or not the individuals can assert affirmative defenses based on the agency’s post-receivership conduct. Thus, though the district court in this case held that the defendants can assert post-receivership affirmative defenses, other courts — for example, the Northern District of Illinois in a February 2013 opinion in the Mutual Bank of Harvey case (refer here) – have held that the individual defendants cannot assert post-receivership affirmative defenses.

 

The Eleventh Circuit’s ruling that these defendants can assert the post-receivership affirmative defenses is significant, and not just because it is the first ruling on point from a federal appellate court on the issue. It is very significant that the Eleventh Circuit expressly rejected the FDIC”s “no duty” argument. The Court’s express holding that the FDIC had “failed to demonstrate the existence of an established and long-standing common law rule barring Defendants’ affirmative defenses” should prove to be very helpful to individual defendants in other cases. If there is no established and long-standing rule, the FDIC has no basis for asserting its “no duty” argument to try to block individual defendants from asserting affirmative defenses based on the agency’s post-receivership conduct.

 

I have long thought that the agency ought not to be able to block the post-receivership affirmative defenses. The FDIC generally argues that when it takes over as receiver that it “stands in the shoes” of the failed bank. If the bank were still viable and asserted the claims the the agency was asserting against the bank’s directors and officers, the individuals would have the right to assert affirmative defenses against the bank. If the agency is merely standing in the bank’s shoes, then the individuals ought to be able to assert those same defenses against the FDIC.

 

Of course, merely because the individuals have the right to assert the affirmative defenses does not mean that they will succeed in establishing the defenses as a factual matter or that they will gain as a result of the defenses.

 

Nevertheless, the Eleventh Circuit’s ruling in this case on the affirmative defenses will be important for many individuals caught up in the failed bank litigation. I frequently hear from individuals involved in these cases that the FDIC itself caused the very losses on which they are trying to collect by the way the agency managed the loans on which the agency’s claims are based or based on how the agency managed the collateral. The Eleventh Circuit’s ruling suggests that the FDIC’s conduct as receiver at least potentially can serve as a basis on which individuals can try to defend themselves and contest the agency’s claims against them.

 

Special thanks to a Charlie Whorton of the Rivero Mestre law firm in Miami for providing me with a copy of the Eleventh Circuit opinion and for calling my attention to the significance of the ruling on the “no duty” issue.

 

What better way to start off the New Year than with another round of readers’ mug shots. The pictures posted below should help to get 2014 off to a colorful start.

 

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, here,  here and here), I published prior rounds of readers’ pictures. I have posted the latest round of readers’ pictures below.

 

Leading off this latest round of mug shots is a picture sent in by Ari Magedoff of Axis Insurance. The picture was taken during his family vacation to the Magic Kingdom at Disney World.

 

 

 

 

 

 

 

 

 

 

 

 

 The next picture comes to us from the desk of Donna Moser at Woodruff-Sawyer.  We appreciate Donna’s mug shot because here at The D&O Diary, we are all about Keeping Calm and Carrying On.

 

 

 

 

 

 

 

 

 

 

 

 

 Dick Clarke of J. Smith Lanier & Co. in Atlanta sent in this very serene picture, which was taken the day after Christmas. Dick reports that the picture, which depicts a birdhouse at the edge of a quiet meadow, was taken at his wife’s family’s farm in south central Virginia, near the North Carolina line (closest community is Cluster Springs, Virginia).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 In another mug shot from the Southern U.S., Bill Norton of the Motley Rice law firm sent in this colorful picture taken in historic Charleston, South Carolina.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 In a nice demonstration of The D&O Diary’s global reach, the next two pictures are both from Down Under. The first picture was sent in by Storm Schroder of QBE in Sydney. Storm reports that this picture was taken “during the Australian Navy’s 2013 International Fleet Review held in Sydney during October 2013.   The Review was held to commemorate the centenary of the first entry of the Royal Australian Navy’s fleet in to Sydney, back on the 04 October 1913, of the flagship, HMAS Australia, which led the new Australian Fleet Unit comprising HMA Ships Melbourne, Sydney, Encounter, Warrego, Parramatta and Yarra into Sydney Harbour for the first time.”

 

 

 

 

 

 

 

 

 

 

 

 

The next picture from Down Under was sent in by Michael Park of Chubb in Sydney. Michael reports that this mug shot with vineyards was taken while he was holidaying in the Margaret River region of Western Australia (about a three hour drive south of Perth).

 

 

 

 

 

 

 

 

 

 

 

 

 Our final picture in this round of mug shots was taken by my colleague Jason Hull. Jason (and his D&O Diary mug) spent the first day of 2014 hiking The Elevator Shaft to the top of Casper Bowl in Jackson Hole, Wyoming.

 

 

 

 

 

 

 

 

 

 

 

 

Once again, I am absolutely delighted to see the range of pictures that readers have sent it. It is so much fun getting readers’ mug shots. My thanks to everyone that has sent in pictures.  

 

There are fewer than a half-dozen mugs remaining. 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.

 

In a December 23, 2013 ruling that will be surprising and unwelcome to D&O insurers and their insureds in New Zealand (and perhaps elsewhere) , the New Zealand Supreme Court has reversed the holding of an intermediate appellate court and ruled that, by operation of a statutory “charge” on insurance in favor of third party claimants, the former directors of the defunct Bridgecorp companies cannot have their defense costs paid under their company’s D&O insurance policies.

 

A copy of the New Zealand Supreme Court’s opinion can be found here. Special thanks to Francis Kean of Willis for sending me a link to his January 8, 2014 Willis Wire blog post about the New Zealand court’s ruling.

 

Background

The New Zealand Supreme Court’s opinion actually relates to consolidated appeals involving two defunct companies, Bridgecorp and Feltex Carpets Ltd. In both cases, directors of the failed companies seek access to their company’s D&O insurance in order to defend themselves from claims following in the wake of their company’s failures. Though the appeal involved two companies, most of the discussion in the Court’s opinion relates to Bridgecorp, and so my discussion below is focused on Bridgecorp.

 

The Bridgecorp group operated as a real estate development and investment firm. (For more information about the Bridgecorp group and its demise, refer here.) When it collapsed in July 2007, the group owed investors nearly NZ$500 million. The group’s former directors faced numerous criminal and civil claims arising out of the collapse. Several directors of Bridgecorp have been convicted of offenses under the New Zealand Securities Act of 1978. Bridgecorp’s receivers have sued the directors for damages in excess of NZ$340 based on allegations that the directors breached duties they owed the Bridgecorp companies and caused the companies loss.

 

At the time of its collapse, the Bridgecorp group carried NZ$20 million in D&O Insurance. The group also carried $2 million of statutory liability defense cost protection (the “SL policy”), but the limits of the SL policy were exhausted in payment of the directors’ attorneys’ fees. The directors then sought to have their fees paid under the D&O insurance policy. The D&O policy combines both indemnity and defense cost protection for the company’s directors and officers in a single policy subject to single aggregate limit of liability. Under the policy’s terms, defense costs are inside the limit – that is, the insurer’s payment of defense costs erodes the limit of liability.

 

The Bridgecorp receivers advised the D&O insurer that they assert a “charge” under Section 9 of the Law Reform Act of 1936, which they contend creates a priority entitlement in claimants’ favor over monies that may be payable under any insurance policy held by the person against whom the claim is made. The Bridgecorp group directors in turn initiated an action seeking a judicial declaration that Section 9 does not prevent the insurer from meeting its contractual obligation under the D&O policy to reimburse them for their defense costs.

 

As discussed here, on September 15, 2011, New Zealand High Court (Auckland Registry) Justice Graham Lang ruled in favor of the Bridgecorp’s receivers, holding that the receivers’ “charge” on the D&O insurance policy’s limits of liability under Section 9 “prevents the directors from having access to the D&O policy to meet their defence costs.”

 

Justice Lang stated that the provision provides a “procedural mechanism” to ensure that a claimant can “gain direct access to insurance monies that would have been available to the insured.” Justice Lang acknowledged that this result is “harsh” and even “unsatisfactory,” he reasoned that Section 9 was designed to “keep the insurance fund intact” for the benefit of claimants and that this legislative purpose should not be defeated merely because coverage for both defense costs and indemnity were combined in a single policy. The directors appealed Justice Lang’s ruling.

 

As discussed here, in a December 20, 2012 opinion, a unanimous three-Justice panel of the Court of Appeal of New Zealand quashed Justice Lang’s lower court ruling.In ruling that the Section 9 does not apply to the D&O policy’s defense cost coverage. The Court of Appeal noted that the policy provides coverage for “two distinct kinds of losses” that operate “independently.” The court reasoned that if the two coverages had been set up in separate policies, Section 9 could not have applied to the defense cost policy, and that the combination of the two coverages into a single policy should not affect the analysis. The court also reasoned that “it is irrelevant” that the policy proceeds would be depleted by payment of defense costs, as that is that is “the necessary consequence of the policy’s structure.”

 

The Court of Appeal also noted that the practical effect of Justice Lang’e ruling was to deny the directors of their contractual rights to defense cost reimbursement. The Court noted that a “charge” under Section 9 is “subject to the terms of the contract of insurance as they stand at the time the charge descends” and it “cannot operate to interfere with or suspend the performance of mutual contractual rights and obligations relating to another liability.” Bridgecorp’s receivers appealed the intermediate appellate court ruling.

 

The Supreme Court’s Ruling

The New Zealand Supreme Court overturned the intermediate appellate court’s ruling  in a 3-2 decision that included three different opinions. In the lead two-Judge opinion by Chief Judge Sian Elias and Judge Susan Glacebrook (in which Judge Noel Anderson separately concurred), the Court held that “the scheme, the text, the caselaw and the legislative history of Section 9 make it clear that the statutory charge attaches at the time of the occurrence of the event giving rise to the claim for compensation for damages in respect of the liability to third parties which is covered by the policy. Reimbursement to the directors of their defense costs is not within the statutory charge.” 

 

The insurer’s contractual obligation to pay defense costs as they arise is “immaterial” and the effect of the charge is such that the contractual obligation to pay the directors’ defense costs “can be met only at the peril of the insurer when there is sufficient insurance cover under the limit of the policy to meet both insurance obligations.”

 

In response to concerns that the Court’s holding would leave the directors without the means of defense, the lead opinion responded that “An insured would only be deprived of the ability of the ability to mount a defence if he or she had not other funds available for a defence and where no lawyer would act on a contingency basis. Further, an insurer may well have an incentive to fund a good defence out of its own funds as that would reduce the insurer’s exposure under the policy.”

 

In justifying the harsh result the Court’s ruling imposes, the lead opinion attempted to pin the blame for the result on the way the policy is structured. After first asserting (supported only with an obscure footnote reference) that “a combined limit is not necessarily the norm,” lead opinion then asserts that this combined limits structure is the cause of the problem:

 

These unusual cases arise because the policies in issue have made the defence costs the subject of cover in a policy that also covers third-party liability that gives rise to the defence costs. As a result, the statutory charge protects the third party claimant and prevents the performance of the defense cost obligation without risk to the insurer. This means that the insurer and the insured have struck a poor bargain because the policy has not been properly drawn, overlooking the effect of the statutory charge.

 

Judges John McGrath and Thomas Gault dissented from the lead opinion, essentially on the ground that Section 9 does not require an unproven claim to be given priority over an immediate policy obligation.

 

Discussion

As some level, the Supreme Court’s ruling is just the unfortunate outcome of a divided Court’s attempt to interpret a peculiar local statutory provision.

 

At another level, the Court’s ruling demonstrates the difficulties the D&O insurance industry faces as it attempts to deploy policies that will respond in jurisdictions where there is little developed case law interpreting the policies. The tortured procedural history of this case alone shows how unpredictable the contract’s performance can be when there is little local case law.

 

The tortured procedural history and the divided result in the Supreme Court also underscore how off target the lead opinion is in suggesting that the parties to the insurance contract struck a “poor bargain” by failing to take the operation of Section 9 into account. As if the parties should have known when they entered the contract how Section 9 would ultimately be applied, even though the various judges and courts that have looked at the question of how Section 9 should operate have been all over the map. (In that regard, Francis Kean notes in his blog post that of the nine New Zealand judges that reviewed these issues in the various New Zealand courts, five of them ruled that the Section 9 charge did not prohibit the insurer from paying the directors’ defense costs, and only four found that the charge prohibited the defense cost payment.)

 

To the extent the lead opinion’s analysis depends on its loose assertion that it is not the “norm” for D&O insurance policies to have defense expense and indemnity protection both provided in a single form, the Judges writing the opinion would have done well to consult someone –anyone—that actually knows anything about D&O insurance. It is in fact very much the norm for D&O insurance policies to combine the two coverages in a single form.

 

The lead opinion’s response to the suggestion that the Court’s holding will deprive the directors of the ability to defend themselves ignores the reality of directors’ position. The lead opinion’s suggestion that there are no problems because the directors can just defend themselves using their own assets  or get a lawyer to represent them on a contingency (say what?) ignores that fact one of the principal reasons that the insurance is even in place was so that the insurance would pay these very costs. To say, as the lead opinion does, that a director will only be deprived of an ability to defend themself “if he or she had no other funds available” simply ignores the very reason this kind of insurance exists. This insurance is catastrophe insurance. The insurance frequently operates as the insured persons’ last line of defense. The lead opinion’s “let them eat cake” dismissiveness of the position their ruling puts the directors in is, well, disappointing to say the least.

 

Perhaps it is owing to its antipodal provenance, but the lead opinion’s interpretation of Section 9 stands the very idea of liability insurance on its head. Liability insurance does not exist to protect claimants, it exists to protect the insureds. Insurance buyers procure the insurance to protect themselves from third party lawsuits. The very idea that a mere assertion of an unproven claim is enough to strip the insured under a liability policy of the protection they procured for themselves is questionable in its very approach to the insurance equation.

 

I hope that the New Zealand Parliament will give due consideration to the nature and purposes of liability insurance and make appropriate adjustments to Section 9 to ensure liability insurance can operate to protect the persons whom it was intended to protect – that is, the insured persons.

 

While awaiting a parliamentary revision (that may or may not ever come), the insurance industry will have to respond. I suspect the D&O insurance professionals in New Zealand are even now struggling to figure out how to try to structure D&O insurance policies going forward so that no other directors are put in the absolutely rotten position that these directors have been put in. One possibility is to set up the policy with defense outside the limits, so that the defense costs do not erode the limit. (Defense outside the limits is actually required in Quebec.) Another possibility is to structure the defense cost protection separately from the indemnity insurance.

 

As Francis Kean points out in his blog post, these possibilities may address the problem on future policies, but that doesn’t help on the policies that are already in place. Insureds with policies in force will understandably be concerned whether their policies will fund their defense. While companies could attempt to supplement their existing coverage to add defense cost protection, that is not going to help the companies that have pending claims.

 

I noted at the outset of my commentary that at one level this may all be just a reflection of a local problem under a New Zealand statute. But the impact of the New Zealand Supreme Court’s ruling may be felt in Australia as well. The New Zealand Supreme Court’s opinion expressly references a parallel proceeding pending in the courts of New South Wales that involves a nearly identical statute in that jurisdiction. Kean notes in his blog post that the High Court of Australia (the country’s highest court) is “due shortly to pronounce on an appeal under the equivalent legislation in New South Wales, and it is entirely possible that it will go down the same path as New Zealand.”

 

Since the U.S. Supreme Court agreed to revisit the “fraud on the market” theory by granting cert in the Halliburton case a few weeks ago, many commentators (including this blog) have considered whether the Court might wind up taking an intermediate position that addresses criticisms of the theory while preserving securities plaintiffs’ ability to try to establish reliance at the class certification stage,

 

In a December 2013 paper entitled “Rethinking Basic” (here), Harvard Law School Professors Lucian Bebchuk and Allen Ferrell suggest an intermediate path for the Court to take. They propose a “meaningful modification” of the Court’s holding in Basic, Inc. v. Levinson, to ensure that the reliance inquiry at the class certification stage avoids the “efficient market” debate and asks instead whether or not the alleged misrepresentation caused “fraudulent distortion” to the defendant company’s share price.

 

Background

Since its adoption by the Supreme Court in the Basic case, the fraud on the market theory has provided a way for securities plaintiffs to pursue their claims on behalf of similarly situated shareholders, without having to establish that each of the shareholders relied on the alleged misrepresentation. As Justice Ginsburg put it in her majority opinion in the Supreme Court’s 2013 Amgen decision, “the fraud-on-the-market premise is that the price of a security traded on an efficient market will reflect all of the publicly available information about a company; accordingly, a buyer of the security may be presumed to have relied on the information in purchasing the security.’

 

Among the many criticisms of the Court’s adoption of the fraud on the market presumption is that the “efficient market” premise on which the presumption is based is the subject of a heated and long-running debate. Coincidentally, the most recognized proponents of the two schools of thought in the “efficient market” debate were among the winners of the 2013 Nobel Prize for Economics – University of Chicago Business School Professor Eugene Fama, who is the leading proponent of the efficient market hypothesis, and Yale economist and business school professor Robert Shiller, who is the hypothesis’s leading critic.

 

From the time of the Basic decision, commentators have questioned whether the Supreme Court should be basing its decisions on disputed economic theories. Indeed, in his dissenting opinion in Basic, Justice Byron White expressed his concern that “with no staff economists, no experts schooled in the ‘efficient capital market hypothesis,’ no ability to test the validity of empirical market studies, we are not well-equipped to embrace novel constructions of a statute based on contemporary economic theory.”

 

The Authors’ Proposal

In their recent paper, the authors suggest a “reformulation” of Basic that shifts the judicial focus away from the debated issues of market efficiency to the issue of “fraudulent distortion.” The authors propose to limit class-wide reliance to “reliance on the market price of a security not being fraudulently distorted – that is, reliance on the market price not being impacted by (and thus reflecting) misstatements and omissions that produced a price different from what it would have been in the absence of fraud.”

 

In other words, the authors suggest that in order to determine whether the reliance requirement can be presumed to be satisfied, the focus should be on “whether the misrepresentation actually affected the stock price” – and not on whether the market in general or the market for a specific company’s securities are or are not efficient.

 

In order to establish whether or not “fraudulent distortion” has occurred, the authors advocate the use of “financial econometric tools” such as event studies to measure the impact of the alleged misrepresentation. The authors suggest that the burden with respect to the price distortion showing could either be on the plaintiffs or the defendants, but that either way the defendants would have the opportunity to attempt to rebut the showing. The authors suggest that their proposed approach would eliminate the problems of over-inclusiveness and under-inclusiveness in class litigation, and provide a means to eliminate frivolous suits as well.