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.

 

An amicus brief has been filed with the Supreme Court in the pending Halliburton case on behalf of several law professors — not including the article’s authors — arguing (without express reference to the article) that that the fraud on the market presumption does not require dependence on the “efficient market” hypothesis, and that instead of the "efficient market" premise  the focus in the reliance inquiry should be on the effect of the alleged misrepresentation on the share price. The amicus brief can be found here.

 

Discussion

The authors’ proposal has much to recommend it. Among other things, it preserves the ability of plaintiffs to establish reliance at the class certification stage in Section 10(b) misrepresentation cases, and it would remove the Court from the uncertain challenge of taking sides in the “efficient markets” debate. It also allows the opportunity for defendants to try to rebut the basis for applying the “fraudulent distortion” presumption, which is an option defendants have sought with respect to the current fraud on the market presumption.

 

Certain objections to the authors’ proposal can be expected. In noting the possible objections here, I am simply attempting to identify potential issues, not criticize the authors’ analysis, as that is an exercise for which I am not qualified.

 

Among other things, it likely will be suggested that the authors’ focus on the impact of the alleged misrepresentation on the company’s share price may simply be raising by other means the issues of materiality and loss causation – both of which issues the Supreme Court recently has said are merits issues not appropriately taken up at the class certification stage. (The Supreme Court addressed materiality in its 2013 decision in Amgen, and it addressed loss causation in its prior consideration of class certification issues in the Halliburton case in 2011.)

 

The authors address both of these issues in their article. In a footnote, the authors contend that their suggested analysis is “not equivalent to a legal determination of materiality” because, among other things, the determination of materiality “involves the consideration of several specific legal issues.” Similarly, the authors reject the suggestion that their proposed analysis and particularly their proposed use of an event study in the fraudulent distortion determination “conflates loss causation.” The authors state that the question they propose and the loss causation question are simply different, contending that the fact that the share price has been fraudulently distorted does not establish that loss causation exists.

 

While the authors are satisfied that their proposed analysis does not involve issues the Supreme Court has already said are not appropriately considered at the class certification stage, concerns may nevertheless remain. The question whether or not a misrepresentation distorted a company’s share price does feel a lot like an inquiry whether or not the alleged misrepresentation was material.  The proposed use of an event study or other tool to determine whether or not the alleged misrepresentation caused a distortion in the company’s share price does feel a lot like a loss causation inquiry.

 

Indeed, there would be significant irony if the Supreme Court, having already said in the Halliburton case itself that loss causation is not an appropriate issue at the class certification stage, were now to come out and say — on reconsideration of class certification issues in the very same case– that in order to determine the issue of reliance at the class certification stage, the district court must determine whether or not the alleged misrepresentation caused a distortion in the company’s share price.

 

Critics of the authors’ proposed approach may also contend that the proposed use of “event studies” or similar tools present their own set of issues. What types of “financial econometric tools” can be used to determine whether or not there has been “fraudulent distortion”? What legal principles will govern the analysis of the econometric validity of the proposed tools? Doesn’t the proposed use of econometric tools raise the specter of substituting a different economic debate for the “efficient market” debate, as the parties vie for the use of their preferred econometric tool? And as a practical matter, wouldn’t the deployment of these tools introduce a potentially cumbersome, evidentiary-based process at the class certification stage that could be ungainly, time-consuming and costly?

 

While the authors’ proposal does raise a number of questions, it does provide a way for the Court to try to step out of the “efficient market” debate while preserving a way for securities plaintiffs to try to establish class-wide reliance at the class certification stage. For that reason, the authors’ proposal merits consideration.

 

Several members of the Court likely will be looking for an intermediate path that avoids eliminating altogether the ability of securities plaintiffs to pursue Section 10(b) cases on behalf of all similarly affected shareholders. The authors’ proposal may provide an attractive intermediate path for the Court.

 

While I have identified above a number of questions that may be asked about the authors’ proposal, I will stipulate that others are far more qualified than I am to discuss these issues and other questions the authors’ proposal may raise. I hope that readers with reactions to the authors’ proposal will add their thoughts to this post using the blog’s comment feature.

 

Special thanks to Professor Ferrell for providing me with a copy of the article.

 

More About Halliburton: One of the preferred arguments among those who want to keep the Basic presumption unchanged is that Congress modified the securities laws significantly in 1995, but did not set aside the fraud on the market theory or the presumption of reliance. Justice Ginsberg cited this fact in the majority opinion in Amgen, suggesting that Congress’s inaction on the issue amounted to Congressional approval of the approach. Justice Ginsburg wrote that rather than eliminating the presumption, “Congress rejected calls to undo the fraud-on-the-market presumption of classwide reliance endorsed in Basic.”

 

However, as Alison Frankel notes in a January 7, 2014 post on her On the Case blog (here), an amicus brief filed in the Halliburton case takes a contrary view on how to interpret Congress’s supposed inaction. The amicus brief (which can be found here) was filed by five former Republican members of Congress and seven former Congressional and Securities and Exchange Commission staffers, all of whom were involved in the passage of securities litigation reform in 1995. Frankel summarized the amicus brief as saying that “The 1995 law passed by both houses, overriding a veto by President Clinton, didn’t actually end up addressing the fraud-on-the-market theory of classwide investor reliance at all – which, according to the brief, should not be construed by the Supreme Court as a rejection of efforts to repudiate the precedent.”

 

“Congress did not answer any of the competing calls to overturn, modify, or codify the Basic presumption,” the amici argue. “Congress was simply silent in response to those various requests, and this court should not take Congress’s silence as implicit acceptance or rejection of Basic’s fraud-on-the-market theory.”

 

Another amicus brief filed by a separate group of law professors and former SEC Commissioners, including Stanford Law Professor Joseph Grundfest, argues that the correct legislative history for the Court to consider is the history regarding the original passage of the Exchange Act in 1934. These professors argue that “the 1934 Act’s legislative history leaves no doubt that, had the Seventy-Third Congress addressed the question, it would not have created a private Section 10(b) right unless that right required proof of actual reliance … That history further underscores that Congress would not have condoned a presumption of reliance.” Interestingly, the professors joining this brief, which can be found here, includes Professor Ferrell, one of the authors of the paper I discussed above.

 

A Day at Lloyd’s: On Monday, January 27, 2014 – that is, the day before the 2014 PLUS D&O Symposium – at the St. John’s School of Risk Management in New York, the American Bar Association Torts and Insurance Practice Section (TIPS) will be reprising its successful program on claims processes at Lloyd’s. This year’s program is entitled “A Day at Lloyd’s of London Part II and Alternative Dispute Resolution.” The program is “designed to encourage a greater understanding between the U.S. and international insurance market of how the Corporation of Lloyd’s of London works and the practical issues that arise.”

 

Among the program moderators is my good friend Perry Granof and the faculty includes an all-star casts of insurance professionals and claims attorneys. In addition, the program’s keynote speaker is Hank Greenberg, currently the Chair and CEO of C.V. Starr. Information about the program including registration information can be found here.

 

The world of directors and officers liability has long been characterized by rapid change. But even given these well-established dynamics, 2013 was a particularly eventful year, with several different developments that could impact the D&O arena for years to come. The list of the Top Ten D&O Stories of 2013 is set out below with an eye toward these future possibilities.

 

1. U.S. Supreme Court Agrees to Revisit the “Fraud on the Market” Presumption: In a development that has the potential to change the way securities class action lawsuits are litigated, the U.S. Supreme Court has granted a writ of certiorari in the long-running Halliburton case and  agreed  to revisit the “fraud on the market” presumption.

 

Since the U.S. Supreme Court’s 1988 decision in Basic, Inc. v. Levinson, securities plaintiffs seeking class certification in Section 10(b) cases have been able to dispense with the need to show that each of the individual class members relied on the alleged misrepresentation, based on the presumption that in an efficient marketplace, a company’s share price reflects all publicly available information about a company, including the alleged misrepresentation, and that the plaintiff class members relied on the market price. Without the benefit of this presumption, it would be very difficult for Section 10(b) plaintiffs to pursue their claims as a class action.

 

The possibility that the Court could set aside the Basic presumption means that the Halliburton case could be, in the words of leading securities plaintiffs’ attorney Max Berger of the Bernstein Litowitz firm (as quoted in Alison Frankel’s November 15, 2013 post on her On the Case blog) a “game changer.” As Jordan Eth and Mark R.S. Foster of the Morrison Foerster law firm noted in their November 15, 2013 memo about the Supreme Court’s cert grant in the case (here), Halliburton “has the potential to be the most significant securities case in a generation.”

 

There are, however, a range of possible outcomes in the Supreme Court’s consideration of the case. First, though it only requires four votes for the Court to take up a case, it takes five votes to determine the outcome. Based on the various Justices’ voting patterns in recent cases (particularly in the 2013 Amgen case), it isn’t clear at all that there are five votes to set aside the Basic presumption

 

Second, in addition to their question whether the Basic presumption should be revisited, the petitioners also sought to have the Court consider “Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.” Given this additional question, the Court might explain the ways in which (and when) the Basic presumption may be rebutted, if at all, at the class certification stage, rather than setting it aside.

 

Even of the Supreme Court sets the Basic presumption aside, private securities litigation will go on. Investors in some cases will still be able to bring class actions under Section 11 of the Securities Act of 1933, which does not require a showing of reliance but holds defendants strictly liable for material misrepresentations. Claimants who purchased their shares in public offerings will still be able to pursue their claims as class actions.

 

In addition, in securities cases based on alleged omission rather than alleged misrepresentations, plaintiffs do not need to rely on the Basic presumption in order to obtain class certification. As Alison Frankel pointed out in a November 27, 2013 post on her On the Case blog (here), in the Affiliated Ute case, the U.S. Supreme Court established that securities fraud plaintiffs do not have to establish reliance to sustain claims based on a defendant’s failure to disclose material information. In other words, even if the Supreme Court dumps the Basic presumption, securities plaintiffs will still be able to obtain class certification in Section 10(b) cases based on alleged omissions.

 

It is also worth noting that the way securities cases are being litigated was already changing in significant ways. Many of the securities suits filed in the wake of the financial crisis were filed as individual actions or group actions, not as class actions. The plaintiffs’ firms have established significant client relationships with pension funds and other large institutional investors whose claims could be aggregated to present a collective action on behalf of a group of investors, even if the lawsuit  might not be able to proceed as a class action.

 

That said, there is no doubt that if the Basic presumption were set aside, the way securities lawsuits are litigated in this country would be significantly changed. In Section 10(b) misrepresentation cases, it would become much more difficult – perhaps impossible — for plaintiffs to obtain class certification. Without the benefit of being able to hold out the threat of ruinously large class-wide damages, plaintiffs’ lawyers would be less able to extract the kind of massive settlements that have become a feature of private securities litigation.

 

Among the many consequences that would result if the Basic presumption were set aside, it seems likely that the way many public companies purchase D&O insurance would change. As Joe Monteleone noted on his D&O E&O Monitor blog (here), the end result could be that “there will be less of a need to buy large towers of D&O insurance, a likely reduction in rates and perhaps an overall shrinking of the D&O marketplace with fewer players and less revenue in both the insurer and brokerage communities.” Of course, if securities litigation were to mutate into something smaller but more complex, the impact on D&O purchasing patterns and rates could take a different turn.

 

There are a lot of possible outcomes here, but any way you look at it the Halliburton case has enormous potential significance for the D&O insurance industry. The case is set to be argued in March 2014 and the case should be decided by the end of the current term in June 2014.

 

2. D&O Insurance Funds Entire $139 Million News Corp. Derivative Litigation Settlement: In the past, going back ten years or so, shareholders’ derivative suits typically did not present the possibility of significant cash payouts for D&O insurers, at least in terms of settlements or judgments. The cases did often involve the possibility of significant defense expense and sometimes included the possibility of having to pay the plaintiffs’ attorneys’ fees, but by and large there was usually not a separate cash settlement component.

 

However, these past patterns appear to have changed, at least in some shareholders derivative lawsuits. In recent years, there have been a number of derivative suit settlements that have involved a very large cash component. Consistent with this more recent pattern, in April 2013, in what the plaintiffs’ lawyers claim to be the largest derivative lawsuit settlement ever, the parties to the consolidated News Corp. shareholder derivative litigation agreed to settle the cases for $139 million. The cash portion of the settlement was funded entirely by D&O insurance. (The details about the underlying lawsuit and about the settlement can be found here.)

 

The recent trend toward the inclusion of significant cash components in derivative settlements gained momentum with the options backdating scandal. Many of the options backdating cases were filed as derivative suits rather than as securities class action lawsuits. Some of the options backdating derivative suit settlements included very substantial cash components. For example, the Broadcom options backdating derivative lawsuit settlement included the D&O insurers’ agreement to pay $118 million (as discussed here).

 

The inclusion of a significant cash component has also been a feature of the settlements of some of the merger objection suits filed in the upsurge in M&A-related lawsuits in recent years. For example, the El Paso/Kinder Morgan merger-related derivative suit settled in September 2012 for $110 million (refer here).

 

This increase in the number of derivative suit settlements that include a significant cash component can only be viewed with alarm by the D&O insurance industry. Public company D&O insurers have long considered that their significant severity exposure to be limited to securities class action lawsuits. The undeniable reality is that in at least some circumstances, derivative suits increasingly represent a severity risk as well. And the settlement amounts themselves represent only part of the D&O insurers’ derivative litigation-related loss costs. The D&O insurers also incur millions and possibly tens of million of defense cost expense in these derivative suits.

 

An even more concerning aspect of the rise of significant cash settlements in derivative cases for D&O insurers is that these settlement amounts typically represent so-called “A Side” losses. That is, the losses are paid out under the portion or the D&O insurance policy that provide insurance for nonindemnifiable loss. A derivative suit settlement typically would not be indemnifiable, because if it were to be indemnified, the company would make the indemnity payment to itself.

 

The question for the carriers providing excess Side A insurance is whether or not the premiums they are getting are adequate to compensate them for the risks of the kinds of losses associated with large cash shareholders derivative settlements. By and large, the carriers providing this insurance consider that their most significant exposure is related to claims in the insolvency context. But as the News Corp. settlement and the Broadcom settlement mentioned above demonstrates, it is also possible that the Side A insurance can be implicated in a jumbo derivative settlement.

 

The increasing risk of this type of shareholders’ derivative lawsuit settlement represents a significant challenge for all public company D&O insurers, but particularly for those D&O insurers concentrating on providing Excess Side A insurance. Those insurers will have to ask how they are to underwrite the risks associated with these kinds of exposures, and how they are to make certain that their premiums adequately compensate them for the risk.

 

3. SEC Adopts New Policies Requiring Admissions of Wrongdoing in Enforcement Action Settlements: On August 19, 2013, in connection with its entry into a settlement with New York-based hedge fund adviser Phillip Falcone and his advisory firm Harbinger Capital Partners, the SEC for the first time implemented its new policy requiring defendants seeking to settle civil enforcement actions to provide admissions of wrongdoing, in contrast to the long-standing practice of allowing defendants to resolve the enforcement actions with a “neither-admit-nor-deny” settlement.

 

In addition, as part of its September 19, 2013 entry into a total of $920 million in regulatory settlements related to the “London Whale” trading loss debacle, and as part of the SEC’s new policy requiring admissions of wrongdoing in certain “egregious” cases, JP Morgan provided the SEC with an extensive set of factual admissions.

 

The SEC implemented its new policy a third time on December 19, 2013, as part of its $107.4 million settlement of fraud charges against brokerage ConvergEx for bilking its customers by inflated fees. (The company also agreed to pay a $43.3 criminal penalty as part of a related deferred prosecution agreement.) The brokerage unit and two individual traders admitted to wrongdoing in connection with the SEC settlement, and also separately admitted criminal charges as well, as discussed here. 

 

The SEC’s new settlement policy means that, at least in the SEC enforcement actions where the agency will require admissions in order to settle,  the cases will be much harder to settle. The defendants, wary of the possible impact the admissions could have in other proceedings, will be reluctant to provide admissions. One consequence of the new policy could be that the SEC will be compelled to try more cases, which could strain the agency’s resources. For those defendants providing admissions, the impact on related proceedings could be significant.

 

A defendant’s entry into admissions of wrongdoing could also have significant implications for the availability of D&O insurance. The specific question is whether or not the admissions would be sufficient to trigger the fraud and criminal misconduct exclusion in the D&O policy. These exclusions typically preclude coverage for loss arising from fraudulent or criminal misconduct, but only after a final adjudication determines that the preclusive conduct has taken place. If the admissions were found to be sufficient to trigger this exclusion, coverage would no longer be available for the wrongdoer, and the insurer could even have the right to try to recover amounts that had already been paid (for example, the attorneys’ fees the wrongdoer incurred in defending himself or herself in the SEC proceeding).

 

On the other hand, there would appear to be a substantial question whether the specific admissions to which the Harbinger defendants agreed rise to the level to satisfy the exclusion’s misconduct requirement. While the admissions represent an extensive concession that the defendants engaged in wrongdoing – and while the admissions expressly recite that the defendants acted “improperly” and “recklessly” — at no point to the defendants admit to “fraud” or to any other level of conduct that would expressly trigger the typical D&O policy’s conduct exclusion.

 

The defendants may be able to walk a fine line in providing admissions to the SEC that avoid many of these potential problems. J.P. Morgan’s settlement in the London Whale case may provide something of a roadmap in that regard. As Wayne State Law Professor Peter Henning noted in a post on the Dealbook blog about the J.P Morgan settlement, the admissions “will be of very limited utility to private parties suing the bank for violating the federal securities laws.” Indeed, in a September 19, 2013 post on her On the Case blog entitled “Don’t Get Too Excited About JP Morgan’s Admissions to the SEC” (here), Alison Frankel says that “JP Morgan has shown that it is possible to give the SEC an admission that will permit the agency to look tough without conceding much, if anything, in private litigation.”

 

Similarly, admissions of the type JP Morgan entered could present less of an insurance coverage concern. The JP Morgan admissions contain no specific admission of criminal or fraudulent misconduct. There would appear to be less of a basis for an insurer to contend in reliance on the conduct exclusion that coverage is precluded. So if the JP Morgan settlement were to become a “model” it at least would appear to present less a D&O insurance coverage concern.

 

The SEC’s new admissions policy is still relatively new and it is hard to know for sure how it will be implemented and what its effects will be. The question as the SEC implements the policy in the months ahead will be how specific the wrongdoing admissions must be and whether they will be of a kind that could have collateral impact on related litigation and have an effect on the continued availability of D&O insurance.

 

4. SEC Awards Whistleblower More Than $14 Million: The SEC’s regulations implementing the Dodd-Frank whistleblower bounty provisions went into effect in August 2011. The agency’s process for the deployment of bounty awards has proven to be quite deliberate. The agency still has made a total of only six awards overall. However, the agency’s October 1, 2013 award of over $14 million to one whistleblower – by far the largest award so far under the Dodd-Frank whistleblower bounty program – could signal that the whistleblower moment has arrived, especially given that whistleblower reports have continued to flood into the agency.

 

According to the agency’s annual Dodd-Frank Whistleblower Program report to Congress issued on November 15, 2013  (here), there were 3,238 whistleblower reports to the SEC during the 2013 fiscal year ending on September 20, 2013, brining the total number of whistleblower reports to the agency since the program’s August 2011 inception to 6,573.

 

Though the program has so far made only a few awards relative to the number of whistleblower reports, it seems likely that the number of awards will accelerate in the future. The very painstaking process the agency follows in making awards (described in the report to Congress) shows that the agency is being very deliberate in making awards. As the agency makes more awards, it seems likely that the program will attract more whistleblower reports, particularly to the extent that the agency makes more large awards on the scale of the recent $14 million award.

 

Another question that will be interesting to follow is whether or not there will be follow-on civil lawsuits in the wake of whistleblower reports (of the kind discussed here). The concern is that increased whistleblowing activity, encouraged by the availability of whistleblower bounties, could lead to an increase not only in SEC enforcement activity but also to an increase in follow-on civil litigation, including in particular securities class action litigation. In any event, it seems likely that there will be further whistleblower bounty awards in the months ahead.

 

5. Number of Banks Drops to Lowest Level Since the Great Depression: According to a December 3, 2013 Wall Street Journal article (here). the number of reporting institutions listed in the FDIC’s latest Quarterly Banking Profile (here) represents the lowest level for the number of banks since the Great Depression.

 

As of September 30, 2013, there were 6,891 federally insured banking institutions, down from 7,141 as of September 30, 2012. There had been 8,680 banking institutions as recently as December 31, 2006, meaning that there are 1,789 (or about 20%) fewer banks in the U.S. than there were a little less than seven years ago.

 

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

 

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

 

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

 

There is every reason to believe that consolidation in the banking industry will continue. Among other things, the FDIC and the banking industry are both still dealing with the fact that – even years out from the worst of the financial crisis – a large percentage of the remaining banks are “problem institutions.” On the positive side, the number of banks on the FDIC’s "Problem List" declined from 553 to 515 during the third quarter. (The agency calls those banks that it rates as a “4” or “5” on a 1-to-5 scale of risk and supervisory concern “problem institutions.”) On the other hand, problem institutions still represent about 7.5 percent of all reporting institutions, down from about 8 percent during the second quarter.

 

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

 

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

 

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

 

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

 

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

 

6. FDIC Warns Banks to Check Their D&O Policies, Denounces Civil Money Penalties Coverage: In a highly  unusual step, the FDIC, the federal regulator responsible for insuring and supervising depositary institutions, weighed in on financial institutions’ purchase of D&O insurance. The FDIC’s October 10, 2013 Financial Institutions Letter, which includes an “Advisory Statement on Director and Officer Liability Insurance Policies, Exclusions and Indemnification for Civil Money Penalties” (here), advises bank directors and officers to be wary of the addition of policy exclusions to their D&O insurance policies and also reminds bank officials that the bank’s purchase of insurance indemnifying against civil money penalties is prohibited.

 

The FDIC is concerned that bank officials “may not be fully aware of the addition or significance of … exclusionary language.” Accordingly, the agency urges officials to apply “well-informed” consideration to the potential impact of policy exclusions. The agency urges “each board member and executive officer to fully understand” the protections available under their institution’s D&O policy, as well as the exclusions that have been added to their policy.

 

The letter also states that banks’ boards of directors should “also keep in mind” that FDIC regulations “prohibit an insured depositary institution or [holding company] from purchasing insurance that would be used to pay or reimburse an institution-affiliated party (IAP) for the cost of any civil money penalty (CMP) assessed against such person in an administrative proceeding or civil action commenced by any federal banking agency.”

 

The FDIC’s warnings about the need for bank officials to be well-informed about their D&O insurance and to be wary about the addition of policy exclusions are simply good advice. However, the FDIC was not just offering disinterested guidance. The FDIC didn’t say it, but it has a very specific concern in mind. The FDIC is worried about the inclusion in banks’ D&O insurance policies of a so-called “regulatory exclusion” precluding coverage for claims brought by regulatory agencies such as the FDIC. When a policy has one of these exclusions, the FDIC is unlikely to be able to recover under the policy for any claims the agency files against a bank’s directors and officers.

 

The FDIC is in the midst of filing and pursing a host of lawsuits against the former directors and officers of many of the banks that failed between 2007 and the present. In these lawsuits and in other suits that the agency might want to pursue, the FDIC may be stymied in trying to secure a recovery if the failed bank’s D&O insurance policy has a regulatory exclusion. The FDIC issued its advisory statement because it wants to try to enlist banking officials’ assistance in trying to ward off the inclusion of these kinds of exclusions on D&O insurance policies.

 

The problem for both bank officials and for the FDIC is that if a bank is sufficiently troubled, no amount of attentiveness will be sufficient to avoid the addition of exclusionary provisions. Banks that are in troubled condition are likely to find that they have few D&O insurance options and that the only coverage they can obtain is an insurance program that includes a regulatory exclusion or other coverage limiting provisions.

 

Nevertheless, while in some circumstances (especially with regard to troubled banks) there may be little that bank officials can do about the addition of coverage-narrowing policy exclusions, there is certainly nothing wrong with urging bank officials to be attentive to the changes in their coverage on renewal. The FDIC’s suggestion that bank officials stay informed about changes in their D&O insurance is, as noted above, good advice.

 

The agency’s separate statements about insurance for civil money penalties are interesting and represents something of a public clarification of a long-standing issue. By way of background, under FIRREA and related regulations, civil money penalties may be assessed for the violation of any law or regulation, as well as for a violation of any condition imposed in writing by the appropriate Federal banking agency in connection with any written agreement between a depository institution and the agency.

 

The agency’s issuance of the Advisory Statement and the clarification of the agency’s position with respect to insurance for civil money penalties means that the industry’s practices with respect to this type of coverage will change. Several leading carriers have indicated that they will no longer offer civil money penalties coverage and that they will remove it upon request.

 

7. Delaware Courts OKs By-Law Forum Selection Clauses: One of the more troublesome litigation developments in recent years has been the proliferation of multi-jurisdiction litigation, in which competing sets of plaintiffs’ lawyers filed lawsuits concerning the same circumstances and issues in different jurisdictions’ courts. This phenomenon has been a particular problem in litigation involving merger and acquisition activity. As one possible way to try to avert these kinds of multi-front disputes, some commentators suggested the companies should adopt by-law provisions requiring shareholder disputes to be litigated in a specified forum (usually Delaware).

 

This proposed remedy received a substantial boost on June 25, 2013, when Chancellor Leo E. Strine, Jr. of the Delaware Court of Chancery held that forum selection bylaws adopted by Chevron and Federal Express are statutorily and contractually valid. The companies’ by-laws designated Delaware as the sole forum for derivative lawsuits, lawsuits under the Delaware General Corporation Law and other lawsuits involving the “internal affairs” of the companies. A copy of the Chancellor’s opinion can be found here.

 

Chancellor Strine’s ruling undoubtedly will encourage other companies to adopt forum selection provisions in their by-laws similar to Chevron’s and Fed Ex’s. That possibility was significantly boosted when the plaintiffs in the Chevron and Fed Ex cases withdrew their appeal, leaving Strine’s ruling unchallenged.  There are, however, a number of unanswered questions remaining about the forum selection provisions. For example, it remains to be seen whether the courts of other jurisdictions will defer to the choice of forum specified in the by law provisions.

 

In a November 5, 2013 proceeding, Vice Chancellor Laster considered many of these remaining questions in a Delaware action filed by Edgen Group, to try to enjoin a separate merger objection lawsuit that had previously been filed in Louisiana. Edgen’s charter contained a forum selection clause designating Delaware as the forum for shareholder disputes. As reflected in a transcript of the Delaware proceeding (here), Vice Chancellor Laster declined to issue a temporary restraining order enjoining the Louisiana proceeding.

 

Vice Chancellor Laster observed that the case “exemplifies the interforum dynamics that have allowed plaintiffs’ counsel to extract settlements in M&A litigation and that have generated truly absurdly high rates of litigation challenging transactions.” Vice Chancellor Laster also observed that the case demonstrates why companies “have seen fit to respond” with the adoption of forum selection clauses “in an effort to reduce the ability of plaintiff’s counsel to extract rents from what is really a market externality.”

 

Laster went on to say that the Louisiana action is “quite obviously violative” of the forum selection provision in Edgen’s charter, which Laster found to be “valid as a matter of Delaware corporate law.” He also said that the filing of the Louisiana action “facially breached the exclusive forum clause” because the claim asserted in the Louisiana action “falls squarely within the clause.”

 

However, despite the showing of “irreparable harm,” Vice Chancellor Laster declined to grant Edgen’s request for injunction relief, among other things because of concern for “interforum comity.” He said, in consideration of Chancellor Strine’s opinion in the Chevron case, that the question of the enforceability of the forum selection clause should be made in the “non-contractually selected forum.”

 

The adoption of a forum selection clause offers one way to try to eliminate the curse of multi-jurisdiction litigation. However, as the Edgen case shows, one of the shortcomings of the clauses is that they are not self-enforcing. Even with a forum selection clause, there is nothing to prevent a shareholder plaintiff, like the one involved in the Edgen case, from filing an action in another jurisdiction.  The company still has to face the action in the other jurisdiction and hope that the other jurisdiction’s court will respect the requirements of the forum selection clause.

 

There are many issues yet to be worked out as companies seek to rely on forum selection clauses. The one thing that is clear is that the adoption of a forum selection clause alone will not be sufficient to eliminate the possibility that a company might still face shareholder litigation in other jurisdictions. Perhaps as time goes by a body of case law will develop in other jurisdictions’ courts establishing their willingness to enforce these clauses and to defer to the selected forum, but until that time the threat of multi-jurisdiction litigation will continue.

 

8. IPO-Related Suits and Regulatory Follow on Suits Boost 2013 Securities Lawsuit Filings: As detailed in my recent year-end analysis of 2013 securities class action lawsuit filings, new securities suit filings were up slightly for the year compared to 2012, although otherwise below historical averages. Among the more interesting developments was the rise of at least two categories of securities suits filings that helped drive filings during the year.

 

As I noted in a recent post (here), IPO activity in the U.S. during 2013 was at its highest levels since 2007. While the listing activity bodes well for the economy and the financial markets, the increased number of IPOs also led to an uptick in IPO-related securities litigation. There were a total of at least six new securities lawsuits filed between August 1 and year-end involving companies that had completed IPOs in 2012 or 2013. These IPO-related filings were a particular factor in the increase of securities suits filings in the year’s second half, compared to the two preceding six-month periods.

 

As I also noted in a recent post (here), another factor behind securities lawsuit filings in 2013 was the increase of regulatory activity triggering follow-on securities litigation. As many as 13, or almost eight percent, of the 2013 securities suit filings followed prior regulatory or enforcement activity against the defendant companies. While there have been these types of follow-on lawsuits in the past, what is different about these more recent cases is the broad array of investigative and regulatory actions that have preceded and triggered the lawsuits; the regulatory and investigative actions have involved, among other things: anticompetion investigations; alleged illegal arms trading activities; alleged trade in illegally harvested forest products; alleged Medicare fraud; and alleged corruption activities.

 

In addition, these lawsuits increasingly reflect the increasingly active efforts of regulators outside the U.S., both on the part of U.S. regulators as well as non-U.S. regulators. As regulators around the world step up their investigative and enforcement activities, the likelihood of these kinds of follow-on lawsuits will increase.

 

The follow-on lawsuits represented a significant part of 2013 securities litigation activity and may also represent a continuing securities suit filing trend in which increased numbers of securities class action lawsuit filings will arise in the wake of governmental investigative or regulatory activity. The impact of this trend will depend in part on the outcome of the Halliburton case, as discussed above; if class certification in Section 10(b) misrepresentation cases is no longer possible, many of the potential class action lawsuits will not be filed (at least as class actions). But if the Supreme Court does not set aside the Basic presumption and if securities class actions remain viable, securities suits following in the wake of regulatory activity could represent an important component of future filings.

 

9. As Dodd-Frank Provisions Stage In, Public Companies Acquire Additional Disclosure Requirements: Three and a half years ago, in the wake of the global financial crisis, Congress enacted the Dodd-Frank Act, a vast piece of legislation that included extensive reform measures. Many of the Act’s provisions were not self-executing, but instead required implementing regulations. As a result, many of the Act’s requirements are only just now staging into effect. For example, the so-called Volker Rule prohibiting depositary institutions from certain types of proprietary trading just went into effect in the final weeks of December.

 

The regulations implementing several other Dodd-Frank reforms also were proposed or went into effect during 2013. Many of these have significant implications for public company disclosures. Among the more significant of these new provisions is the proposed pay ratio disclosure requirement. The Dodd-Frank Act’s pay ratio disclosure provisions reflected a Congressional perception that CEO compensation has gotten out of line and a hope that increased disclosure might encourage greater pay equity.

 

At an open meeting on September 18, 2013, and by a vote of 3-2, the SEC approved the new proposed pay ratio rules for public comment. The SEC’s proposed pay ratio disclosure rule can be found here. The agency’s September 18, 2013 press release about the proposed new rules can be found here. The proposed rules are now subject to public comment. At this point it seems that the final rules will be adopted sometime in 2014, in which case the earliest that companies with calendar year-end fiscal years would have to report the pay ratio would be in their 10-K or proxy statement filings in 2016.

 

In coming up with rules to specify how companies should calculate and disclose the compensation ratio, the SEC had to decide who does and doesn’t count as an employee, and how median employee compensation is to be calculated.

 

With respect to the question of who is an employee, the SEC’s proposed rule takes an all-inclusive approach. Because Congress required the pay ratio to express the ratio of CEO compensation to the compensation of “all employees,” the proposed SEC rule includes all individuals employed by a company and any of its subsidiaries – including any “full-time, part-time, seasonal or temporary workers” as of the last day of the company’s prior fiscal year. Non-U.S. workers are included in the definition.

 

With respect to the method of calculating median employee compensation, the SEC opted not to mandate a specific methodology but to allow companies the discretion to use the most appropriate method of calculation base on the size and structure of its business and the way it compensates employees. Whatever methodology a company uses, it must include in its pay ratio disclosure a brief narrative description of the methodology employed.

 

While the pay ratio disclosure requirement may have derived from a belief that greater transparency might help to rein in CEO compensation and encourage pay equity, in the end, the pay ratio disclosure may prove to be of at best limited value. As the Troutman Sanders law firm noted in its September 19, 2013 memo about the SEC’s new proposed rule (here), “the SEC’s decision to provide a flexible approach to the calculation means that there will not be any meaningful way to compare the pay ratios of peer companies.”

 

In addition, the ways that different companies staff their operations will also make company to company comparisons difficult. As discussed in a September 20, 2013 Wall Street Journal article entitled “It’s Hard to Slice and Dice CEO Paychecks” (here), companies’ pay ratios “will vary based on differences in how companies deploy their workforces and how they’ll crunch the numbers.” Among other things, the ratios at companies with predominantly U.S. employees will be lower than the ratios for companies with more lower-paid workers overseas.

 

While the pay ratio disclosures may be of limited value, they could encourage opportunistic plaintiffs’ lawyers. Any time something is required to be disclosed there is an opportunity for plaintiffs’ lawyers to allege that the disclosure was incomplete or out of compliance with requirements. Indeed, just as the Dodd-Frank Act’s requirement for a non-binding shareholder vote on executive compensation led to a rash of “say on pay” shareholder litigation, it seems probable that the new pay ratio disclosure requirements will also stimulate a wave of pay ratio litigation.

 

Another set of Dodd-Frank Act disclosures provision that seems likely to have an impact in the months ahead are the Conflict Mineral Disclosure rules. The Act included a provision directing the SEC to promulgate rules requiring companies to disclose their use of “conflict minerals” originating in the Democratic Republic of Congo (DRC) or an adjoining country. It has taken some time for the regulatory process to unfold, but the conflict mineral disclosure requirements are now in effect.

 

On August 22, 2012, the SEC adopted the conflict mineral disclosure rules. The SEC’s August 22, 2012 press release can be found here and the rule itself can be found here. The specific minerals at issue are tantalum, tin, tungsten and gold. The countries covered by the disclosure rules are, in addition to the DRC, Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia. Several business groups mounted a legal challenge to the rules, but in a July 2013 order, Judge Robert Wilkins of the District Court for the District of Columbia struck down the challenge. An appeal of the ruling remains pending. Companies are required to comply with the new disclosure rules for the calendar year beginning January 1, 2013; if the rules survive the pending appeal, the first disclosures are due May 31, 2014 and subsequent disclosures are due annually each year after that.

 

As discussed in a recent post (here), the conflict minerals determinations and disclosures present a significant challenge for many companies. First and foremost, companies face a serious potential PR risk. Companies found to be out of position on conflict minerals could face a publicity firestorm from humanitarian groups and activist investors. Although it remains to be seen, adverse publicity could prove to be a problem not just for companies that must declare their use of conflict minerals but even for those that are unable to declare themselves conflict mineral free.

 

There is also a significant litigation risk associated with the conflict minerals disclosure requirements as well. Companies compelled to reveal their use of conflict minerals could be the target of shareholder suits. A particularly difficult problem would involve companies that had declared themselves to be conflict free that are later shown have been using conflict minerals after all. The negative publicity and likely share price decline could be followed by a securities class action lawsuit. Activist shareholders could also launch derivative suits against companies based on allegations such as the failure to implement adequate procedures to ensure that the company’s products were conflict mineral free.

 

Along with the Dodd-Frank’s whistleblower bounty provisions, which as outlined above are beginning to have a significant impact, the pay ratio disclosure requirements and the Conflict Mineral Requirements could also have an impact on companies in the months ahead. Among the implications of these new requirements is the possibility of a heightened litigation risk. In coming months, we will be hearing more about companies’ struggles to ready themselves for these disclosure requirements. In addition, questions surrounding companies’ preparations to meet the disclosure requirements increasingly will become a part of the D&O insurance underwriting process.

 

10, SEC Proposes Crowdfunding Rules: While federal agencies have been busy staging in the requirements of the Dodd-Frank Act, many of the same agencies have also been struggling to propose regulations implementing the requirements the JOBS Act, which Congress enacted in April 2012. Among many other things, the JOBS Act contained so-called “crowdfunding” provisions providing exemptions under the securities laws allowing start-up ventures to raise equity financing from non-accredited investors using Internet fundraising platforms. The Act left many of the details to the SEC and directed the agency to release implementing regulations within 270 days.

 

On October 23, 2013, the SEC finally approved and released for public comment the proposed rules implementing the crowdfunding provisions. The rules will not become effective, subject to any revisions, until the end of a 90-day comment period, meaning that the rules will not go into effect until some time early in 2014. The SEC’s October 23, 2013 press release regarding the new rules can be found here. The proposed rules themselves can be found here.

 

Consistent with the Act’s provisions, the proposed rules specify that a company may raise no more than $1 million in any one 12 month period through crowdfunding. The rules also specify that investors may invest up to the greater of $12,000 or five percent of their annual income or net worth if both their annual income and net worth are less than $100,000, or ten percent of their annual income or net worth if their annual income or net worth are greater than $100,000. Securities purchased in a crowdfunding offering cannot be resold for one year.

 

The proposed rules specify the information companies must provide in the crowdfunding offering documents, including the identities of the company’s directors and officers as well as the identity of anyone owning more than 20 percent of the company; a description of the company’s business and intended use of the offering proceeds; and the target price of the offered securities and the intended size of the offering; The offering document must also identify related-party transactions and the financial condition of the company. The offering documents also must include the company’s financial statements.

 

The proposed rules also specify the issuing company’s ongoing reporting requirements after the completion of the offering. The proposed rules would require companies to file an annual report no later than 120 days after the end of their financial year, with the reports to be filed with the SEC and posted on the company’s website. Because the crowdfunding securities are freely tradable after one year, the reporting requirement would be continuous in order to provide potential future investors with information about the company.

 

Although it will be a few months before companies can commence crowdfunding financings, it will be interesting to see when we finally get there how much interest there ultimately will be in raising funds through these kinds of offerings. The limitations put on the amount of funds that can be raised as well as the information requirements for the offerings, along with the annual reporting requirements, may present burdens that some start up ventures may be unwilling to undertake (especially because they will almost inevitably require the association of outside professionals, including accountants and attorneys).

 

In addition, it is important to note that some of the JOBS Act’s provisions and related crowdfunding regulations include significant liability provisions. Section 302(c) of the Act expressly imposes liability on issuers and their directors and officers for material misrepresentations and omissions made to investors in connection with a crowdfunding offering. The crowdfunding provisions themselves may blur the clarity of the distinction between private and public companies. The crowdfunding provisions expressly contemplate that a private company would be able to engage in crowdfunding financing activities. Yet, at the same time, that same private company will be required to make disclosure filings with the SEC and could also potentially incur liability under Section 302(c) of the JOBS Act.

 

Many private company D&O insurance policies contain a securities offering exclusion. The wordings of these exclusions vary widely, and some wordings could be sufficiently broad to preclude coverage for crowdfunding activities. In addition, some private company D&O insurers have already introduced exclusions expressly precluding coverage for claims arising from crowdfunding.

 

As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must assess the impact of changes introduced by the JOBS Act. It will be interesting to see both how extensively the crowdfunding liability provisions are invoked and whether a market develops for insurance products providing crowdfunding companies and their directors and officers insurance protection for crowdfunding liability. It seems likely that the carriers will develop liability insurance products targeted at crowdfunding companies, but it will be interesting to see if crowdfunding companies are interested in using their limited funds to purchase the insurance.

 

Conclusion

As I noted at the outset, there is always a lot going on in the world of D&O liability and insurance, and 2013 was no exception in that regard, But what is interesting is how so many of 2013’s key developments foreshadow coming events in 2014 and beyond. The U.S. Supreme Court’s November 2013 decision to grant the petition for a writ of certiorari in the Halliburton case looms particularly large as we head into 2014. In the same way, the impact of many other key 2013 developments will only be fully realized in 2014 and beyond.

 

For that reason, we will have to wait to see the implications of many of the key events in 2013. The one thing that seems certain is that 2014 will be an eventful year.

 

The number of securities class action lawsuit filings was up slightly in 2013 compared to 2012, although the 2013 filings remained well below historical averages. While securities litigation picked up in 2013 compared to the year before, the more interesting question going forward is what the impact of the Halliburton case now pending before the U.S. Supreme Court will be; if the Court sets aside the presumption of reliance at the class certification stage based on the “fraud on the market” theory, the landscape for securities class action litigation could be changed entirely. Depending on the outcome of the Halliburton case, annual class action securities litigation tallies like this one could look very different in future years.

 

There were 165 securities class action lawsuit filings in 2013, compared to 152 in 2012, representing a year-over-year increase of about 8.5%. 2013’s 165 filings were about 13.6% below the annual average of 191 filings for the period 1997-2012. 2013 was the fifth year in a row that the annual filings have been below the historical average.

 

The increase in the number of filings in 2013 compared to 2012 was largely the result of the increased levels of filings in the second half of the year. There were 89 new securities class action lawsuits filed in the second half of 2013 compared to 76 in the first half and compared to only 64 in the second half of 2012.

 

The 2013 securities class action lawsuits were filed against a wide variety of kinds of companies. The 2013 securities suit filings involved companies in 90 different SIC code categories. There were, however, concentrations of securities litigation activity in certain industries.  

 

As has been the case in recent years, a significant number of new securities suits involved companies in the life sciences industries.  There were 34 new securities suits against companies in the life sciences industries (represented by companies in the 283 SIC Code group [Drugs] and the 384 SIC Code group [Surgical, Medical and Dental Instruments and Supplies]).These 34 new suits against life sciences companies represented more than one-fifth (20.6%) of all 2013 filings. Of particular note is that there were 17 new filings in the SIC Code category 2834 (Pharmaceutical Preparations) alone, representing about ten percent of all 2013 filings.

 

Another area of concentration involved natural resources companies. There were a total of 13 new securities class action lawsuits against companies in the Mining, Crude Petroleum and Natural Gas categories (represented by the 1000 SIC Code series). There were also a total of eight new securities lawsuits filed involving companies in the 737 and 738 SIC Code categories (computer services and business services).

 

The 2013 securities lawsuits were filed in 34 different federal district courts but the vast majority of the lawsuits were filed in just a few federal districts. 50 of the 2013 securities lawsuits, or around thirty percent of all 2013 securities suits, were filed in the Southern District of New York. Another 23 lawsuits (about 14%) were filed in the Northern District of California and 13 suits (about eight percent) were filed in the Central District of California. There were eleven new lawsuits, representing 6.7% of all lawsuits, filed in the District of Massachusetts. These four federal districts alone accounted for 97 of the 165 filings during the year, or about 58.8% of all 2013 filings.

 

27 of the 2013 securities suit filings involved non-U.S. companies, representing about 16.3% of all filings. These figures are below 2012 levels, when there were 32 filings against non-U.S. companies representing 21 percent of all filings, and 2011 levels, when there were 61 filings against non –U.S. companies representing 32 percent of all filings. However even though down compared to the two prior years, the level of filings against non-U.S. companies in 2013 remained elevated compared to historical levels. (The average number of filings against non-U.S. companies during the period 1997-2009 was 17, representing an annual average of nine percent of filings.)

 

The non-U.S. companies that became involved in U.S. securities litigation in 2013 represented twelve different countries. The two countries with the largest number of companies were sued Canada, with eight companies, and China, with seven companies.

 

Merger-related litigation remained an important part of securities litigation filings in 2013, although down from levels seen in recent years. There were 14 merger objection lawsuit filed in federal courts in 2013, representing about 8.5% of 2013 filings. (There were of course many more merger objection lawsuits filed in state courts, but these state court filings are not part of the present analysis.) The number of 2013 federal court merger objection lawsuit filings was comparable to the equivalent figures in 2012, when there were 13 merger objection lawsuit filings. However, the number of 2013 merger objection lawsuit filings was down sharply compared to 2010 and 2011, when there were 40 and 43 merger objection lawsuit filings, respectively.

 

Though merger objection cases are down from recent years, there has been an uptick in securities lawsuit filings involving IPO companies. As I noted in a recent post (here), IPO activity in the U.S. during 2013 was at its highest levels since 2007. While the listing activity seems to bode well for the general economy as well as for the financial markets, the increased number of IPOs also led to an uptick in IPO-related securities litigation. There were a total of six new securities lawsuits filed between August 1 and year end involving companies that had completed IPOs in 2012 or 2013. These IPO-related filings were one factor in the increase of securities suits filings in the year’s second half, compared to the filing levels in the two preceding six-month periods.

 

As I also noted in a recent post (here), another factor behind securities lawsuit filings in 2013 was the increase of regulatory activity triggering follow-on securities litigation. As many as 13, or nearly eight percent, of the 2013 securities suit filings followed prior regulatory or enforcement activity against the defendants companies. These new lawsuits clearly represented a significant part of 2013 securities litigation activity; however, the fillings may be even more significant to the extent they represent a securities suit filing trend in which increased numbers of securities class action lawsuit filings arise in the wake of governmental investigative or regulatory activity. As I noted in my prior blog post, these kinds of lawsuit filings are arising in the wake of an increasingly diverse array of regulatory activity, as governments around the world step up the efforts.

 

Discussion

It is interesting to note that securities class action filing activity picked up in 2013 compared to 2012. However, the significance of this development pales by comparison to the potential significance of the Halliburton case now pending before the U.S. Supreme Court. If the Court’s reconsideration of the fraud on the market theory were to result in the Court setting aside the presumption of reliance at the class certification stage, it could become impossible for plaintiffs to have a class certified in a Section 10(b) misrepresentation cases. If that were to happen, the private securities class action litigation landscape would be completely altered. Annual analyses of class action securities litigation like this one could look very different, or even go out of existence.

 

With these kinds of potential changes looming, the subtle shifts in 2013 filings activity seem less important. Nevertheless, there are some noteworthy things to keep in mind about the 2013 securities litigation filings.

 

Even though there were slightly more securities class action lawsuit filings in 2013 than there were in 2012, 2013 continues a now several years-long trend of lower than average securities class action lawsuit filings. There has only been one year in the last nine – the credit crisis year of 2008 – when securities class action lawsuit filings were above the longer-term historical averages.

 

In my view, care should be taken in considering this apparent decline. The figures on which this impression is based represent absolute filing numbers only – that is, the figures represent only the number of lawsuits filed per year. These figures do not take into account changes in the number of publicly traded companies. The fact is that even with the recent uptick in IPOs there are still well more than a quarter fewer publicly traded companies than there were ten years ago. (Bankruptcies, mergers and going private transactions account for the decline in the number of public companies.)

 

It is hardly surprising that as the number of public companies has declined that the absolute number of securities lawsuits has declined as well. Though the  165 lawsuit filings in 2013 represent around 30 percent fewer filings than there were in 2004, that decline in the absolute number of lawsuit filings in roughly in line (although slightly greater than) the decline in the number of publicly traded companies. The decline in the number of lawsuit filings relative to the number of publicly traded companies is far less than the apparent decline in the absolute number of lawsuit filings might seem to suggest.

 

There are of course other factors at work affecting the numbers of securities lawsuit filings, beyond just the decline in the number of publicly traded companies. As a result of case law developments, particularly at the U.S. Supreme Court, the securities plaintiffs face a much greater burden trying to survive a motion to dismiss. These case law developments undoubtedly have had some deterrent effect on securities lawsuit filings. The Halliburton case could of course dramatically amplify this effect.

 

Beyond these considerations another factor affecting the filing levels in 2013 was the absence of any cyclical trend or sector development of the kind that might drive securities litigation. The uptick in filings related to the credit crisis has long since faded, and there was nothing in 2013 like the Chinese reverse merger litigation (which accounted for so many lawsuit filings in 2011). The absence of these kinds of trends mean that there were fewer filings in 2013 than there were in years in which trends of this type drove litigation activity.

 

On the other hand, the rise in IPO-related litigation activity and the increase in securities litigation following-on after regulatory activity could both potentially represent important trends to watch in 2014 – depending of course on what happens with the Halliburton case.