As I have noted in prior posts (most recently here), plaintiffs’ lawyers have rushed to file “say on pay” lawsuits, either after a negative advisory shareholder vote on executive compensation, or more recently before the vote occurs based on alleged deficiencies in the proxy materials related to the vote. In the latest in a lengthening string of cases, yet another court has now rejected the plaintiffs’ “say on pay” claims. As discussed below, a California state court judge has rejected plaintiffs’ claims pertaining to the executive compensation proxy disclosures at Clorox Corporation. While this ruling and the other prior decisions could discourage plaintiffs’ lawyers from pursing these kinds of say on pay cases, it seems likely that executive compensation-related litigation will continue.

 

A special hat tip to Jordan Eth and Mark R.S. Foster of the Morrison & Foerster law firm, who discussed the Clorox decision in a September 25, 2013 memo, here.

 

The plaintiff first filed his lawsuit in California (Alameda County) Superior Court on October 10, 2012, seeking to enjoin the shareholder vote on compensation issues schedule to take place at the company’s annual shareholders meeting. The plaintiff alleged that that Proxy Statement Clorox filed in advance of the shareholders’ meeting omitted material information related to executive compensation. On November 13, 2013, Superior Court Judge Wynne Carvill denied the motion for preliminary injunction, concluding that the plaintiff had failed to show irreparable harm if the vote went forward, and finding that the plaintiff’s “evidentiary showing with respect to the merits of his claim was meager, at best.” The shareholder vote took place the next day.

 

The plaintiff subsequently filed an amended complaint seeking to have the shareholder vote set aside. The parties then filed cross-motions for summary judgment relying on expert witness statements and deposition testimony. On September 23, 2013, Judge Carvill entered judgment in the defendants’ favor in reliance on his August 21, 2013 tentative statement of decision in the case. (A copy of the tentative decision can be found here.)

 

In concluding that the defendants did not have a duty to say more in the proxy statement, Judge Carvill noted that

 

What the Plaintiff has done is simply discovered what additional information was presented to the [compensation committee] and not included or summarized completely in the Proxy and then described why such information would be “helpful.” Were this court to find on this record that material information was withheld, it would be a license to file suit when anything was withheld, for any information can always be labeled as potentially “helpful.” Delaware law provides no such license.

 

The Court’s decision in the Clorox case follows on several other recent cases in which the courts have dismissed plaintiffs’ claims based on alleged deficiencies in the proxy statements, including the August 2013 California state court decision in the Symantec case and Northern District of Illinois Amy St. Eve’s April 2013 decision in the proxy disclosure-related say on pay case involving AAR.

 

As the MoFo attorneys noted in their recent memo, these courts rejected the plaintiffs’ proxy statement disclosure claims and recognized “that the asserted claims were trying to impose new obligations.” The memo’s authors comment that the defendants’ recent track record in these cases “should deter plaintiffs counsel from bringing disclosure claims against public companies.”

 

Just the same, executive compensation remains, as the authors note, “a hot topic for shareholders, for proxy advisory firms, and for the SEC.” For that reason, companies can “expect continued scrutiny of their executive compensation decisions and disclosures.” Even if lawsuits related to say-on-pay disclosures “abate in light of recent rulings,” it can be expected that “plaintiffs’ counsel will continue to look for and find ways to target companies and their directors in this type of litigation.”

 

One place that plaintiffs’ lawyers may turn next as they continue to agitate on executive compensation issues is the SEC’s new pay ratio disclosure requirements. As I discussed in a post earlier this week, the SEC’s proposed new rule will not be finalized until after the comment period, and are unlikely to go into effect until 2015 or 2016. Nevertheless, the very existence of disclosure requirements creates an opening for plaintiffs’ to allege that companies did not follow the pay ratio disclosure guidelines or used calculations and comparisons that made the disclosure misleading.

 

The current round of say on pay litigation may or may not have finally played itself out. Either way, it seems likely that we will continue to see plaintiffs’ lawyers attempting to pursue compensation related claims.

 

Portions of the JOBS Act are Now in Effect, But Crowdfunding is Still a Long Way Off: An important provision of the JOBS Act went into effect earlier this week, but there has been some confusion in the mainstream media that what went into effect was the Act’s crowdfunding provision. However, as discussed in detail in a November 24, 2013 post on the New York Times You’re the Boss blog (here), “equity crowfunding – as most people understand it – remains a long way off.”

 

What went into effect earlier this week is a new rule lifting the longstanding ban on “broadly advertising a private stock placement,” a restriction that has been in place since Congress enacted the Securities Act of 1933. The important thing to understand is that, with a few exceptions, this type of private offering can only be sold to an institutional investor or an accredited investor – someone meeting the specified net worth requirements. Under the new rules, companies may now advertise their private offerings widely, but they may only sell the stock to accredited investors.

 

The elimination of the general solicitation ban is something different than what is commonly known as crowdfunding. The JOBS Act crowdfunding provisions were meant to provide a way for ordinary people to make small investments in small companies. The law “limits how much investors can put into these stocks and restricts issuing companies to raising $1 million in a year.” The law also specifies the types of financial disclosures the company seeking to conduct a crowdfunding offering must provide investors.

 

None of these provisions apply to companies conducting a private placement offering. The company can “raise as much capital as they wish, [qualified[ investors can sink as much as they would like, and no financial disclosure is required.”

 

As the blog post points out, some of the confusion may have arisen from crowdfunding’s boosters, who are growing impatient that the SEC has not yet released its rules implementing crowdfunding. The SEC has “not yet even proposed these regulations, much less finalized them.” As a result, some of the platforms that were organized to try to facilitate crowdfunding are “attempting to turn themselves into platforms to facilitate private placements.” But if these would-be crowdfunding process participants are growing impatient, they may yet have much further to wait. It could be some time yet before the SEC releases its proposed crowdfunding rules.

 

In any event, if you have read this far, now you know that the recent implementation of the rules lifting the solicitation ban for private placements did not institute crowdfunding. It may be some time before crowdfunding gets off the ground. Now that you know, you have to make sure to point this out when you are around somebody that thinks that the recent JOBS Act provision implementation had anything to do with crowdfunding.

 

NCUA Files Libor Manipulatoin Antitrust Suit: Even though the federal judge presiding over the consolidated Libor antitrust litigation has granted the defendants’ motion to dismiss the antitrust claims, the federal credit union regulatory agency has filed a new action against Libor rate-setting banks alleging violation of the Sherman Act. As described in the National Credit Union Administration’s press release (here), on September 23, 2013, the agency filed an action in the District of Kansas in its capacity as receiver for five failed corporate credit unions alleging that thirteen Libor rate-setting banks manipulated the Libor benchmark rate, costing the failed credit unions millions in lost interest. The NCUA’s complaint can be found here.

 

The arguably surprising thing about the NCUA’s complaint is that it alleges only antitrust claims. As discussed here, in March, Southern District of New York Judge Naomi Reece Buchwald ruled in the consolidated Libor antitrust action that the claimants lack antitrust standing because the defendants’ alleged actions did not affect competition, as the rate-setting banks were not in competition with one another with respect to Libor rate-setting. Judge Buchwald said ““the alleged collusion occurred in an arena in which defendants never did and never were intended to compete.”

 

The claimants in the consolidated antitrust action had sought to amend their complaints, but as Alison Frankel discusses in a September 24, 2013 post on her On the Case blog (here), in August, Judge Buchwald refused to allow the claimants to file their second amended complaint and confirmed her previous finding that the class does not have standing to assert antitrust claims because the claimants have failed to allege that defendant banks were in competition with respect to Libor rate-setting.  

 

In the wake of Judge Buchwald’s decision, other claimants have opted to file their Libor manipulation claims in state court, alleging state law claims (as shown for example here), or to try to proceed on other legal theories – for example, under the federal securities laws. However, the NCUA did not attempt to pursue any of these alternative approaches; instead, its complaint alleges only antitrust law violations. This approach is all the more puzzling as the NCUA case almost certainly will wind up be consolidated before Judge Buchwald for pre-trial purposes, even though the agency filed the action in Kansas. Moreover, the agency has not raised any additional allegations that would establish that the rate-setting banks were in competition with respect to the Libor rate-setting, as Frankel discusses in her blog post.

 

Based on appearances, it would seem that the agency believes that Judge Buchwald’s antitrust analysis is incorrect and will be overturned. According to Frankel, some of the claimants in the consolidated action have already filed a notice of appeal. There is of course a possibility that the Second Circuit will overturn Judge Buchwald’s ruling. On the other hand, the Second Circuit could also affirm Judge Buchwald. You would think that NCUA would have hedged its best by seeking relief on alternative grounds or at least based on different theories other than an alleged antitrust violation. Just the same, as Frankel points out, “there are billions riding on this appeal.”

 

Prosecutors Use of FIRREA to Pursue Banks Gets a Another Boost: As I discussed in a recent post, regulators and prosecutors have resurrected a statute from the S&L crisis era to pursue financial fraud claims related to the financial crisis. FIRREA allows the government to seek recoveries for violations “affecting federally insured financial institutions.” Using this statute, the federal government has recently filed a number of actions against banks alleging that the defendant banks engaged in fraudulent activity and harmed themselves. The government has relied on this theory to bring claims against Bank of America, JP Morgan Chase and BNY Mellon. The government also relied on claims under FIRREA in the civil action it filed against Moody’s and its Standard & Poor’s unit in connection with the unit’s credit rating activities (as discussed here).

 

The banks have tried to argue that in order for the statute to apply the affected institution must be the victim or an innocent bystander to the alleged fraud, and that the statute was not meant to apply to the type of “self-affecting” claims the government has raised. Several courts have rejected these defense arguments, and on September 24, 2013, the government’s attempts to rely on this theory got another boost when Southern District of New York Judge Jesse Furman denied Wells Fargo’s motion to dismiss in an action the DoJ brought alleging that the bank had defrauded the government by knowing certifying to federal regulators that thousands of mortgages were eligible for Federal Housing Administration insurance.

 

In his opinion (here), Judge Furman said that Wells Fargo’s theory that FIRREA was not meant to apply to the type of “self-affecting” claim the government asserted against it “is unsupported by the text of the statute which does not exempt from the relevant affected financial institutions those that perpetrate fraud on themselves.”

 

The government’s success in establishing its ability to rely on FIRREA to bring fraud claims against banks could be even more important going forward, as prosecutors continue to try to assert financial crisis related claims. Even though the crisis retreats further into the past each day, FIRREA has a ten-year statute of limitations, which, now that the government has established that it can use the statute to pursue claims that banks managed to harm themselves for their own fraudulent activity, allows prosecutors plenty of time to continue to assert claims related to the financial crisis.

 

As detailed in a September 24, 2013 Bloomberg article (here), even though the statute is a “relic” of the S&L crisis, it has become “the weapon of choice for federal prosecutors investigating the root causes of the financial crisis.” In additional to the extended limitations period, the statute provides a lower burden of proof that is required in a criminal case, and it allows the government to extract hefty penalties. The extended timeline that FIRREA affords makes the statute a formidable weapon for the government as it continues to pursue financial crisis-related claims.

 

Plaintiffs’ Lawyers Continue to Target U.S.-Listed Chinese Companies: As has been well-noted (on this site and elsewhere), in 2011 and 2012, plaintiffs’ lawyers filed a host of securities class action lawsuits against U.S.-listed Chinese companies. But the number of these lawsuit filings declined in 2012 (when there were 18) compared to 2011 (when there were 40) and it seemed that these kinds of filings would dwindle in 2013. However, as evidenced by an action filed earlier this week in the Southern District of New York, plaintiffs lawyer are still continuing to file lawsuits against U.S.-listed Chinese companies.

 

According to their September 23, 2013 press release (here), plaintiffs’ lawyers have filed an action against L&L Energy and certain of its directors and officers alleging that the defendants misled investors by misrepresenting or failing to disclose that “(1) the Company improperly accounted substantial revenue from operations that were already shut down; (2) the Company claimed acquisitions and divestitures of various properties through swap transactions that never occurred through the exchange of assets it never owned in the first place; (3) the Company lacked adequate internal and financial controls.” Through subsidiaries, L&L Energy mines, process and distributes coal in China.

 

The complaint (which can be found here) relies heavily on a report from short-seller GeoInvesting that appeared on Saving Alpha on September 19, 2013. The complaint alleges that:

 

that the Company has been “defrauding investors by booking substantial revenue from operations that have been idled for quite some time.” Specifically, GeoInvesting stated that the Company’s numerous acquisitions and divestitures through the years have amounted "to a bait and switch shell game" by utilizing "swap transactions that never occurred." Moreover, the article concluded "that revenue of $77.6 million disclosed in LLEN’s 2013 10K, generated from its Hong Xing coal washing factory, was actually close to zero, if it is not actually zero" as the factory "has been shut down since 2012."

 

GeoInvesting’s Saving Alpha article can be found here. The Company’s September 24, 2013 press release refuting the GeoInvesting claims can be found here.

 

This latest complaint has many features in common with many of the actions that plaintiffs’ lawyers filed during 2011 and 2012, including the assertion of misrepresentations of assets and accounting fraud, as well as the appearance of the allegations in an online article written by a short-seller.

 

L&L Energy itself has its own set of links to the wave of lawsuits filed during 2011 and 2012, in that the company itself was sued in 2011 in a securities class action lawsuit filed in the Western District of Washington.. As detailed here, the prior lawsuit, which raised a different set of allegations against the company, has been dismissed without prejudice, and the plaintiffs in that case have filed a further amended complaint.

 

Though the securities suit filings against U.S.-listed Chinese companies are down significantly from the high water mark in 2011, the fact is that plaintiffs’ lawyers are still continuing the file suits against the Chinese companies. Of the roughly 118 securities class action lawsuits filed so far this year, 19 (or bout 16%) have involved non-U.S. companies. Of the 19 non-U.S. companies, 6 (or about 5% of all 2013 filings YTD) have involved companies organized or headquartered in China or with their principal place of business in China. (Yet another complaint involves a company from Taiwan.) .

 

These factors have been more pronounced so far during the year’s second haff. Of the roughtly 42 new securities lawsuits that have been filed since July 1, 2013, nine (or about 21%) have invoved non-U.S. companies. Of the nine non-U.S. companies, three have been from China, representing about 7% of all second half filings.

 

A recent post detailed how corruptoin allegations have led to the filing of a securities lawsuit against a U.S.-listed Chinese company can be found here.

 

Among the many measures Congress included when it enacted the sweeping Dodd-Frank Act in 2010 was a provision directing the SEC to require companies to disclose the ratio of CEO compensation to median employee compensation. The statutory provision, incorporated into Section 953(b) of the Act, reflected a perception that CEO compensation had gotten out of line and a hope that increased disclosure might encourage greater pay equity. Now, more than three years later, the SEC has finally gotten around to proposed rules to implement the statutory requirement.

 

The pay ratio disclosure requirements have produced a great deal of controversy and seem likely to be cumbersome and costly to implement. Whether the disclosure requirements, which will not take effect until 2015 or 2016, will produce any of the intended benefits seems uncertain at best.

 

Background

At an open meeting on September 18, 2013, and by a vote of 3-2, the SEC approved for 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. Statement by the two dissenting Commission members, Michael Piwower and Daniel Gallagher, can be found here and here, respectively. The dissenting Commissioners’ comments make for interesting reading. The proposed disclosure requirements would apply to most public companies but will not apply to Emerging Growth Companies as defined under the JOBS Act; smaller reporting companies; and foreign private issuers.

 

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 counts as an employee, the SEC’s proposed rule takes an all-inclusive approach. Because Congress required the pay ratio to express the ratio 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 worker” as of the last day of the company’s prior fiscal year. Non-U.S. workers are included in the definition. The proposed rule also makes it clear that companies are not permitted to make full-time equivalent adjustments for part-time workers or annualizing adjustments for temporary or seasonal workers.

 

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. This approach, which has been applauded by larger multinational employers, is intended to provide companies with greater flexibility in complying with the disclosure requirements. Whatever methodology a company uses, it must include in its pay ratio disclosure a brief narrative description of the methodology employed.

 

The pay ratio disclosure will be required in a company’s annual filing on Form 10-K and any proxy or information statement required under Regulation S-K to include compensation disclosure. Companies will have to comply with the rules in the first fiscal period after the effective date of the rules. Because of the period required for public comment and the likely volume of comments, it seems unlikely the agency will adopt a final rule before the end of 2013. If the rule is adopted in 2014, 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.

 

Discussion

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. A study cited in the Journal article concludes that larger, more global companies will likely report “significantly higher pay ratios” than smaller, domestically focused firms. Ratios will also be skewed for companies that outsource work or that rely heavily on part-time and seasonal employees.

 

In other words, reported pay ratios will likely say as much or more about the size and business approach of the reporting company than it will about the company’s executive compensation practices. Indeed, there is every possibility that attempts to discern meaning from the pay ratio disclosure could, as the SEC itself said in its proposal, lead to “potentially misleading conclusions and to unintended consequences.” At best, as Commissioner Daniel Gallagher said in his dissenting statement, “the pay ratio computation that the proposed rules would require is sure to cost a lot and teach very little.”

 

As the Covington & Burling law firm noted in its September 19, 2013 memo about the proposed rule (here), the pay ratio disclosure requirement in the Dodd-Frank Act is “yet another example of Congress using the SEC to advance public policy goals not squarely rooted in the SEC’s historic mission of protecting investors.”

 

However, it is not as if there are no winners here; as Covington notes in its memo, the new rule will “certainly increase the costs and time required for companies to accurately prepare executive compensation disclosure” and will likely include the need “for many companies to retain outside advisors to assist in the statistical sampling and compilation process.”

 

So in the end, the congressionally mandated disclosure requirement is unlikely to produce meaningful information for investors to use in comparing companies but is likely to prove a boon for costly outside consultants. And I am just guessing here, but I suspect among the groups that will manage to extract a profit from the new requirements are plaintiffs’ attorneys.

 

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. I think you can set a watch on it – during the first year after the disclosure requirements go into effect, there will be litigation in which plaintiffs’ lawyers contend that the pay ratio disclosure misled investors or was implemented in a way intended to deceive investors about the company’s executive compensation.

 

Along with “say on pay” and conflict minerals disclosure, the pay ratio disclosure requirement is yet another burden that Congress imposed on U.S. reporting companies in the Dodd-Frank Act. Somewhere along the line there needs to be some objective assessment of whether the putative value of these requirements that Congress is piling on to companies justifies the burdens the requirements impose on companies.

 

And Now — A Word About K&R: As part of my work in the management liability insurance arena, I am frequently called upon to help with the placement of kidnap and ransom (K&R) insurance. Despite my frequent involvement with placement of the insurance, and notwithstanding my more than three decades in the business, I have never actually been involved in a K&R claim. Frankly, other than as is required for the placement of the insurance, I generally don’t think about the product much at all.

 

I had my consciousness raised about K&R insurance earlier this year when I attended an educational event sponsored by one of the leading global insurers. The insurer was in the process of rolling out a new K&R insurance product and had invited to the session the security consultants whose services they would use for any K&R policyholder that experienced a kidnapping or hostage incident. The consultants’ description of their role – particularly their role in communicating with captors and negotiating the amount and process for payment of the ransom – was absolutely fascinating.

 

I had occasion to think about K&R insurance again while reading this past week’s issue of the Economist. An article entitled “A Holy Mess” (here) describes the September 6, 2013 kidnapping of Nigeria’s Anglican archbishop. The article goes on to explain that these kinds of abductions have become all too common in the country. During the first half of 2013, Nigeria had the most kidnap attempts in the world, accounting for 26% of all incidents globally. Mexico was second with 10% and Pakistan third with 7%.

 

The abductors obviously hope to be able to use the hostage as a means to extract a ransom payment. One of the things that the security consultants had said in the presentation I attended earlier this year is that while the captors’ initial demands may be outlandish, the amount of the actual ransom payments often is quite modest. The magazine article confirms this point, noting that “Captors usually start with huge demands before being haggled down. Settlements of $12,000 to $30,000 are standard, though there have been instances of people getting away with as little as $600.”

 

The services available under the provisions of the K&R policy, including in particular the services of security consultants to manage an abduction crisis, may well prove to be indispensable for the company and for the individuals involved. This is also an area where a more general risk mitigation approach can be helpful. As the magazine article notes, “a flashy car and swanky suit can enough to catch a villain’s eye.”

 

In any event, K&R insurance may not be a product that often attracts a significant amount of attention, but in certain situations it can prove to be critically important. Though, as the magazine article highlights, there are countries where the risks are particularly great, a K&R policy should be a part of every company’s insurance program, even for those companies whose personal do not travel to the riskiest countries.

 

Of Thee I Sing: I travel a lot for work. Fortunately, my extensive work-related travel does not require me to journey to any of the more notorious kidnapping hotspots. Those who follow this blog regularly know that I have enjoyed the opportunity over the last 24 months or so to visit some pretty great places – including, for example, Amsterdam, Barcelona, Munich and Beijing. However, I wouldn’t want to leave readers with the impression that my travel itineraries only include these kinds of glamorous destinations. My work requirements much more frequently require travel to many notably less glitzy locales.

 

Much of my day-to-day business comes from the Great Lakes and Ohio River Valley regions. I am much more likely to be in Ohio, Michigan, Pennsylvania and Indiana than I am in some foreign spot. Just this past week, I found myself in Elkhart, a surprisingly pleasant town in northeastern Indiana. The town went through some rough times during the economic downturn, but the local manufacturing businesses are definitely rebounding. The two-story brick storefronts that line the main street have been well-preserved. Parklands protect both banks of the St. Joseph River as it rolls through the center of town. I had lunch one day while there on the terrace of an upscale restaurant overlooking the river and the park. The town overall has a feel of friendly, slower-paced prosperity. My overall impression was that Elkhart would be a very nice place to live.

 

I have learned to be more attentive to the virtues of places like Elkhart. In part this is just the result of having lived a long time and gained perspective on life. But in part it is a result of a conversation I had a few years ago while I in a taxi cab trying to make my way into Chicago from O’Hare airport. The traffic was particularly heavy and my cab was barely moving. As we inched along, I struck up a conversation with the cab driver, who turned out to be a naturalized U.S. citizen of Pakistani origin. The cab driver told me about how he had left his home country and traveled to the U.S. some two decades before and how he had made a life for himself here.

 

The conversation took an unexpected turn when the cab driver asked me where I was from. When I told him I live in Ohio, he said to me that Ohio is the most beautiful state in the entire country. Now, I am a pretty big Ohio booster, but not even I am going to try to claim that Ohio is our country’s most beautiful state. I asked him why he thought Ohio was so beautiful, and he said that all you have to do is travel around the western part of the state. I asked him what he meant, and he said you have to understand that he comes from a crowded, hot and dry country. He said that when he travels to Ohio, he sees big, green, open, fertile, prosperous fields stretching all the way to the horizon. What could be more beautiful, he asked, than rich, fruitful, bountiful fields producing food that will feed thousands of people?

 

The cab driver was just getting started. He went on to say that he thought that a lot of Americans have no idea how fortunate they are to live in their country. He said the thing that he values the most is that people treat each other with dignity and respect. He said that of course there are people who have said hateful things to him because of his appearance or his accent. There are, he noted, ignorant fools everywhere. But generally everyone else is respectful. He described in tones of wonder how, when he visits his sons’ school, the teachers – the teachers! – say to him “Yes, sir “and “No, Sir.” He said that the teachers say to him that they want his sons to get the best education they can get – and they mean it. He added that it is the same if you go into a store. The store clerks are courteous and ask if they can help you. They say “yes, sir” and “no, sir” and they thank you for coming into their store.

 

It has now been several years since my ride with the talkative cab driver, but I reflect on his comments frequently. When I travel though Ohio’s and Indiana’s farmlands now I make a point to notice that the fields really are quite beautiful – particularly in late September when the trees lining the fields are starting to show their fall colors.  And when I travel to places like Elkhart now, I do notice that in fact just about everyone is very friendly and courteous.

 

We are, after all, a nation of immigrants. Just about everyone’s family is from somewhere else. My wife and I each have a grandparent who immigrated to this country (in my case, two). Just the same, it does take some perspective to see how fortunate we are to be here. I am grateful that I had the chance to talk to the cab driver. I still am not prepared to argue that Ohio is the most beautiful state in the country, but I am glad I had a chance to see Ohio and this country through his eyes. It isn’t just that I learned what it means to him to be an American. It is that I learned a little bit more about what it means for all of us to be Americans.

 

I have, upon reflection, developed a theory about the cab driver. I now suspect that he tells every passenger that their state is the most beautiful state in the country.

 

Coincidentally, there was an article about Elkhart in the Saturday Wall Street Journal magazine supplement, WSJ Money. The article (here) describes how a reclusive resident who recently passed away unexpectedly left a fortune worth over $150 million to the town.

 

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 company’s provision of the admissions could have significant implications for the continuing regulatory and litigation proceedings against the company related to the London Whale losses. The company’s admissions also have important implications for other companies about the SEC’s new policy requiring admissions of wrongdoing.

 

The SEC’s September 19, 2012 press release about the company acceptance of a $200 million penalty can be found here. The September 19, 2013 Cease and Desist Order entered in the SEC administrative proceeding against the company – to which the Annex with the company’s admissions is attached – can be found here. A September 19, 2013 statement from George Canellos, the co-Director of the SEC enforcement division about the settlement can be found here.

 

The Office of the Comptroller of the Currency’s September 19, 2013 press release announcing the agency’s entry of a $300 million civil money penalty against the company for “unsafe and unsound practices related to derivatives trading activities” can be found here. The Federal Reserve’s September 19, 2013 press release announcing its entry of a $200 million penalty against the company for “deficiencies in the bank holding company’s oversight, management, and controls” can be found here. The U.K. Financial Conduct Authority’s September 19, 2013 press release announcing its entry of a $220 fine for “serious failings” can be found here. JP Morgan’s own September 19, 2013 press release about the settlements can be found here.

 

The settlements relate to extensive trading losses that the bank incurred losses at its London trading desk in early 2012. The London traders’ positions had previously been profitable but as the gains turned to losses, the traders sought to hide the magnitude of the losses by deviating from prior practices in “marking” the value of their positions.  The changes hid the existence and size of the losses – for a time. The company ultimately reported losses of greater than $6 billion and was forced to restate its previous published financial statements for the first quarter of 2012.

 

The Company’s admissions in the Annex to the Cease and Desist Order make for interesting reading. Among other things, the Annex admits (in paragraph 10) that the London traders “intentionally understated mark-to-market losses.” The Annex also shows that the bank’s own internal control processes to evaluate traders marks was inadequate, built on flawed processes, and compromised by dependence on input from the traders themselves. Concerns about the processes and about the valuations became apparent as counterparties began demanding collateral.

 

The Annex details a sequence of events showing that the concerns about the valuations were not sufficiently elevated to senior management, and then once management became aware of the concerns and began putting remedial steps in place, were not sufficiently elevated to the Audit Committee of the company’s board of directors.

 

Among other things, in the Annex J.P. Morgan acknowledged “that its conduct violated the federal securities laws.” The Cease and Desist Order recites a finding that the company violated the books and records provisions under Section 13 of the ’34 Act.

 

In his statement about the settlement, the SEC enforcement co-director said:

 

In addition to failing to keep watch over how the traders valued a very complex portfolio, JP Morgan’s senior management broke a cardinal rule of corporate governance: inform your board of directors of matters that call into question the truth of what the company is disclosing to investors. Here at the very moment JP Morgan’s management was grappling with how to fix its internal control breakdowns and disclose the full scope of its trading disaster, the bank’s Audit Committee was in the dark about the extent of these problems.

 

By not sharing these troubling facts with its directors, JP Morgan deprived them of information they vitally needed to make proper judgments about how to address the company’s problems – including what information could be relied upon as accurate and what information needed to be disclosed to investors.

 

While the various regulatory settlements resolve a host of proceedings against the company, other proceedings continue. Among other things, the CFTC’s enforcement proceeding is continuing, as is the DoJ’s investigation and the criminal proceedings against London colleagues of the “London whale” trader who allegedly participated in efforts to cover up the losses. In additional, the shareholder class action lawsuit filed against the company and certain of its directors and officers is also ongoing.

 

Though the Annex to the Cease and Desist Order contain extensive admissions from the company, the document is as noteworthy for what it does not contain as for what it does contain. Thus, while the company acknowledges that its conduct “violated the federal securities laws,” the company itself does not specify which laws it violated.  The Order does state the conclusion that the company violated the books and records provision of the federal securities laws, but as Wayne State Law Professor Peter Henning points out in a September 19, 2013 column on the New York Times Dealbook blog (here) , this conclusion is of limited value outside the context of the administrative proceeding, since there is no private right of action for a violation of the books and records provision.

 

While the Annex details various failings by a group of persons described generically as “Senior Management,” the document does not specify which specific individuals where responsible for which misconduct. By using the rather vague group description, the Annex avoids saying that any specifically identified individual acted improperly or failed to act properly. Simply put, the Annex – and by extension – the settlement, does not hold any one member of the company’s senior management responsible.

 

Perhaps even more significantly, while the Annex contains extensive factual admissions, the Annex does not contain any conclusive language; there are no admissions, for example, that the company and of its senior officials acted with an intent to deceive or that they acted fraudulently or even recklessly.

 

As a result, the Annex, while undoubtedly useful to the regulators and claimants in the ongoing proceedings against the company, may not prove to be all that helpful in the end. For example, the Annex will support the plaintiffs in the ongoing shareholder action, but there do not appear to be admissions in the Annex that would in and of themselves establish liability under Section 10(b). There do not appear to be admissions that establish that the company or its senior officials acted with scienter.

 

As Professor Henning noted in the Dealbook blog, 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.”

 

Now that we have the JP Morgan settlement, with it admissions of wrongdoing in hand, along with the prior settlement the SEC reached with Harbinger (about which refer here), we can begin to assess what the SEC’s new policy requiring admissions of wrongdoing may mean for other companies going forward. It appears it will be sufficient to satisfy the SEC’s admissions wrongdoing requirement to provide extensive factual admissions without accompanying descriptive admissions about the factual misconduct and even without specific admissions of what laws the misconduct violated. It apparently will also be sufficient – at least to settle an administrative proceeding – for the company to admit wrongdoing without any specific member of senior management admitting misconduct or responsibility.

 

The SEC’s new policy requiring admissions of wrongdoing in certain cases is still new and it will undoubtedly evolve. Just the same, other companies facing an SEC requirement of admissions wrongdoing will be studying the JP Morgan settlement to see what will be sufficient to satisfy the requirement. As Alison Frankel put it on her blog post, “I suspect that future SEC defendants are going to look the JP Morgan settlement as a model for how to quench regulators’ thirst for blood without spilling a drop in parallel shareholder litigation.”

 

Context matters here. In a civil enforcement proceeding, a federal district court judge’s approval would be required to finalize the settlement. A judge might require more specific admissions or more direct admissions of individual wrongdoing. Because JP Morgan negotiated the settlement in an administrative action rather than a civil enforcement proceeding, no court approval is required. Based on this important context consideration, I would say that other defendants in administrative proceedings might try to use the JP Morgan settlement as a model; defendants in civil enforcement actions may have to be prepared to make more extensive concessions.

 

In my prior post about the Harbinger SEC settlement, I expressed concerns that the SEC’s requirement of admissions of wrongdoing could create significant D&O coverage issues and potentially could trigger the conduct exclusion typically found in most D&O insurance policies. While that concern still remains, admissions of the type JP Morgan entered could prove to present less of n insurance coverage concern. The JP Morgan admissions arguably 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.

 

Background regarding the securities class action lawsuit arising out of the London Whale disclosures can be found here.

 

A Disaster Full of  Durable Images: Whales, Teapots and Hedges: One of the aspects that has always made this situation interesting to me is the colorful name given the London trader whose losses cause all of these losses. As early as April 6, 2012, the Wall Street Journal was reporting that trading markets were buzzing about the outsized positions that a London trader was taking; the article itself noted that others in the market were referring to the trader as the "London Whale" in reference to the size of the trader’s positions.

 

The invocation of the Leviathan is not only the only colorful and enduring image from this debacle. In an earniing confernce call on April 12, 2012, JP Morgan CEO Jamie Dimon tried to downplay the publicity surrounding the London trader’s positions by describing the controversy as a "complete tempest in a teapot."

 

Yet less than a month later, on May 10, 2012, when the company was forced to admit that the London trader’s positions had caused the company what it then thought was only $2 billion in losses, Dimon said that  the trading strategy was "flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective an economic hedge than we thought.”

 

Readers continue to send in photographs of their D&O Diary mugs. Readers also continue to demonstrate both creativity and a willingness to travel great distances to get just the right mug shot.

 

Readers will recall that in a recent post, I offered to send out to anyone who requested one a D&O Diary coffee mug – 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, and here), I published prior rounds of readers’ pictures. The pictures have continued to arrive and I have published the latest round below.

 

The first two photos in this collection display a sports oriented theme. The first picture, sent in by our good friend Paula Cobbett of Sullivan Brokers Wholesales Insurance Solutions was taken at an America’s Cup race on San Francisco Bay. Paula reports with respect to her picture that “the D&O Diary Cup still stands strong, even as America’s Cup looks as it might go to the KIWIs.”

 

 

 

 

 

 

 

 

 

 

The second sports shot, sent in by Mo Offereins of AON in Chicago, was taken at Conway Farms Golf Club in Lake Forest, Illinois, which is Mo’s home course, and which recently hosted of the 2013 BMW Championship.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Next up, Jacqueline Vinar of Alliant Insurance Services sent in several pictures from her recent family vacation in Rehoboth Beach, Delaware, including this shot of the famous Rehoboth Beach Water Tower. I must confess that the pictures from Rehoboth struck a chord with me, because my family vacationed there too when I was a child.

 

 

While I don’t have any mug shots from Asia this time, I still do have one great picture from a colorful international location. Clay Newton of FX Energy sent in this picture taken in front of the Palace of Culture and Science in Warsaw, Poland.

 

 

 

 

 

 

 

 

 

 

 

 

Finally, for their mug shot, Steven Robinson and Kyle Dougherty of the ACE Group in Philadelphia decided to visit the roots of the insurance industry in the United States, as detailed in this self-explanatory picture:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 I can’t tell you how much fun it is to get readers’ pictures. When I started this project, I had no idea where it would lead. I certainly didn’t expect that people would carry their mugs half way around the world just to collect a great mug shot on location, or that people would take their mugs with them on a family vacation. All of the shots are great, thanks to all who have sent them in. I look forward to receiving and publishing many more pictures.

 

I recently ordered another supply of mugs, so if there are more readers out there who would like to have a mug, please just let me drop me a note. Just remember, if you get a mug, you have to send back a picture. If you order a mug, please be patient, it may take a few days to mail the mug to you.

 

In a series of recent conversations with industry colleagues around the world, one of the recurring themes has been the growing risk of regulatory investigation and enforcement action companies outside the U.S. are facing. One very particular aspect of the companies’ growing risk is that it frequently is the case that the increased risk may not be connected to regulators in their home country. Increasingly the source of the risk may involve regulators from the U.S.

 

The extraterritorial reach of U.S. regulators was on display in a September 17, 2013 article in the New York Times Dealbook column entitled “Wielding Broader Powers, S.E.C. Visits Hedge Funds in London” (here). The article notes that the SEC, which has “actively pursued actions by American banks and other financial institutions overseas, is broadening its reach by asserting its purview to foreign hedge fund managers.” Relying on authority given to the agency in the Dodd-Frank Act, the SEC is “paying visits to more than a dozen hedge fund managers registered with the S.E.C. to determine whether they are in compliance with American regulations.”

 

According to the article, the agency’s actions are raising “concerns that the visits would lead to the importation of American-style regulation to British hedge funds that have American clients.” The article explains that the actions in London follow increased regulatory activity involving hedge funds in the U.S., including in particular several high profile insider trading prosecutions. The article also explains that the actions arguably are not entirely random as the hedge funds that have been contacted are the ones, for example, with large numbers of U.S. clients. But the information that the agency has requested is “voluminous.”

 

Another recent article from the New York Times Dealbook column also highlighted the overseas reach of U.S. regulators. A  September 16, 2013 article entitled “Complying with U.S. Tax Evasion Laws is Vexing for European Banks” (here) discusses the difficulties that Non-U.S. banks are having complying with a new U.S. law, the Foreign Account Tax Compliance Act. The article reports that “foreign banks and financial firms are increasingly finding that complying with the law is a major headache.” Among other things, the banks are finding that they must install new computer systems in order to comply with the law’s reporting requirements.

 

According to the article, the new U.S. tax law

 

effectively makes all foreign banks and foreign financial institutions arms of the I.R.S. by requiring them to disclose data on American clients with accounts containing at least $50,000, or to withhold 30 percent of the dividend, interest and other payments due those clients and to send that money to the I.R.S. The law applies to banks and financial institutions even if their home countries have secrecy laws. Those that do not comply could face significant fines or be locked out of doing business with American clients.

 

Nor is this overseas imposition of U.S. regulation on Non-U.S. companies limited just to companies in the financial sector. A September 17, 2013 Wall Street Journal article (here) detailed how the U.S. Food and Drug Administration, as part of its effort to block exports to the United States from the Indian drug manufacturing plant of Indian-based Ranbaxy Laboratories Ltd due to alleged safety violations, the U.S. agency has required the company “to hire a third-party expert to inspect the Mohali facility and certify to the FDA that any violations have been addressed and that the company has processes in place to ensure continuing compliance.”

 

The extraterritorial reach of the Foreign Corrupt Practices Act has been well-established, with numerous high profile actions involving non-U.S. companies and non-U.S. executives. A recent post on the International Trade Compliance Update blog (here) details recent SEC and U.S. Department of Justice “clarifications on the FCPA’s application to non-U.S. companies.” The blog post explains that “U.S. authorities can more often than not find a jurisdictional ‘hook’ allowing them to pursue an anti-bribery enforcement action, as evidenced by the numerous FCPA cases brought against non-U.S. companies. Furthermore, recent SEC matters involving foreign nationals illustrate the broad interpretation by U.S. authorities of the scope of conduct sufficient to establish personal jurisdiction in the civil context.”

 

Other examples of the reach of U.S. regulators outside of the U.S. abound. Among more recent examples are the U.S. enforcement actions relating to the J.P. Morgan “London Whale” trades and the Libor manipulation scandal. In both cases the misconduct took place outside the U.S. but the U.S. authorities, rather than deferring to the authorities where the wrongdoing took place, are either taking an active role in the enforcement action or taking the lead.

 

The long and short of it is that U.S. regulators are actively asserting their authority outside of the U.S. In an environment where there already is a growing perception of increasing regulatory risk, the U.S. authorities’ vigorous assertion of regulatory authority outside the U.S. represents a particularly hazardous part.

 

These developments not only have important compliance implications for many non-U.S. companies. They also raise important issues about the liability exposures of the potentially affected companies as well as for their directors and officers. The liability exposures include not only the potential regulatory and enforcement risk but also the possibility of follow on civil actions, brought by shareholders or others. The “others” that might bring claims include supervisory board members in those jurisdictions with the dual-board structure.

 

These issues in turn raise important D&O insurance implications. The issues also present a particularly difficult challenge for D&O insurance underwriters involved in underwriting companies outside the U.S. as they must attempt to understand and anticipate these kinds of actions from U.S. regulators and how they may affect the companies under consideration.

 

Over the coming weeks, I hope to have several opportunities to discuss these growing regulatory concerns with industry colleagues in Europe, In the U.S. and elsewhere. I think these growing concerns represent a significant development in the world of D&O, with particular importance for those working with companies based outside the U.S. but with significant involvement with U.S. clients and customers.

Not only have the number of 2013 filings of FDIC’s lawsuits against the former directors and officers of failed banks already exceeded any prior year’s filings, but the pace of filings in the second and third quarter this year exceed the filing rate in an any equivalent period during the prior three years, according to a new report from Cornerstone Research. The September 2013 report, which is entitled “Characteristics of FDIC Lawsuits against Directors and Officers of Failed Financial Institutions,” can be found here. Cornerstone Research’s September 16, 2013 press release about the report can be found here.

 

As a preliminary matter, it is worth noting that the report’s litigation filing figures are as of August 8, 2013, and its information about the number of failed banks is as of August 27, 2013. As reflected on the FDIC”s website, there have been additional lawsuit filings since August 8 (as noted here) and there have been additional bank failures since August 28 (as noted here). Where possible below, I have added parenthetical information to update the figures from the Cornerstone Research’s report to reflect these subsequent lawsuits and bank failures.

 

According to the Cornerstone Research report, during 2013, the FDIC’s pace of new lawsuit filings against directors and officers of failed banks has been elevated as compared to prior periods. As of August 8, there had been a total of 32 FDIC lawsuits filed against former directors and officers of failed banks during 2013. (As of September 13, 2013, the figure is up to 35). Those YTD figures already exceed the year-end failed bank lawsuit filing figures for 2012 (when there were 25) and 2011 (when there were 16). The filings during the second and third quarters of 2013 exceeded the filings during any equivalent prior period. If the filings continue their year to date pace, by year end there could be as many as 53 failed bank lawsuits during 2013. As of September 13, 2013, there have been a total of 79 lawsuits filed during the current bank failure wave.

 

Because the FDIC typically files its failed bank actions toward the end of the three-year statute of limitation period, and because the end of 2009 and the beginning of 2010 represented the high water mark period for bank failures, it is not entirely a surprise that the filings levels have picked up in recent periods. Of the 32 lawsuits filed this year through August 8, 2013, nine were against institutions that had failed in 2009 and the remaining 23 were involved institutions that failed in 2010.  

 

While failed bank lawsuit filings have been up during 2013, the number of new bank closures is down since the peak number of closures in 2010 (when there were 157 failed banks). According to the report, as of August 27, 2013, there had been 20 bank failures this year. (There have been two more bank failures since August 27, bringing the updated year to date total to 22.) The report projects that by year end 2013, there may have been as many as 31 failed banks this year. The report notes that between January 1, 2007 and August 27, 2013, there were a total of 488 failed banks. (With the two additional bank closures since August 27, the total is now up to 490).

 

About 15 percent of the banks that have failed have been the subject of an FDIC lawsuit. However, the figures are higher for the bank failures during 2009 and for 2010, as the bank failures from those years are now past or approaching the third anniversary of their closure date. With respect to the 2009 bank failures, 35 institutions, or about 25 percent of the failures that year, have already been the subject of an FDIC lawsuit. In addition, the directors and officers of a number of other banks that failed during 2009 reached settlements with the FDIC without a lawsuit being filed. Taking into account both the bank failures that resulted in lawsuits and the bank failures were there were settlements without lawsuits, at least 41 percent of the 2009 failed institutions have been the target of FDIC claims.

 

For the 2010 bank failures, about 30 institutions, or about 19 percent, have already been the subject of an FDIC lawsuit. Another nine banks that failed in 2010 have settled with the FDIC without a lawsuit being filed, meaning that a total of at least 25 percent of the 2010 failed banks has been the target of an FDIC claim.

 

The lawsuits generally have targeted the larger failed institutions and those with a higher estimated cost of failure. Of the 75 lawsuits filed through August 8, 58 involved institutions that had total assets greater than $217 million, which is the median asset size of failed institutions since January 2007. The failed bank lawsuits so far in 2013 have generally targeted even larger institutions; the median total assets figure for the failed banks targeted in the first quarter was $644 million and the second quarter was $1.1 billion.

 

The 75 failed banks that were the target of lawsuits up to August 8 had a median estimated cost to the FDIC of $158 million. In the 69 of the complaints in which the FDIC stated a damages amount, the FDIC has claimed a total of $3.6 billion in damages, with the average damages claim of about $53 million and the median damages claim of $27 million.

 

The greatest number of the FDIC’s failed bank lawsuits has been filed against failed Georgia banks, which is hardly surprising given that Georgia had the largest number of failed banks. So far (as of August 8), Georgia has had 17 lawsuits, Illinois and California have had ten and Florida has had nine. Of the 76 lawsuits through August 8, 46 (or about 60.5%) are from just those four states.

 

The report includes a detailed summary (on page 10 of the report) of the ten FDIC failed bank lawsuits that have settled, including in most cases the settlement amounts, and in several of the cases, the amount that D&O insurance contributed toward the settlement 

 

One of the recurring D&O insurance coverage issues that has arisen during the current wave of failed bank litigation has been the question whether coverage for an action by the FDIC in its role as receiver of a failed bank against a failed bank’s directors and officers is precluded by the Insured vs. Insured exclusion found in most D&O insurance policies. The D&O insurers’ argument is that because the FDIC as receiver “stands in the shoes” of the failed bank, the exclusion precludes coverage to the same extent as if the action had been brought by the bank itself.

 

As discussed most recently here, a number of courts have found the language of the Insured vs. Insured exclusion to be ambiguous on the issue of whether it precludes coverage for an action by the FDIC. However, in a sweeping 18-page August 19, 2013 opinion (here), Northern District of Georgia Richard W. Story held that the Insured vs. Insured exclusion unambiguously precludes coverage for an action brought by the FDIC in it is capacity as receiver of a failed bank against the failed bank’s former directors and officers.

 

Although this ruling will not put an end to the coverage disputes, it represents a significant ruling on which D&O insurers will seek to rely in disclaiming coverage for FDIC failed bank lawsuits. Significantly, Judge Story rejected a number of the arguments on which the FDIC typically relies in trying to argue that the Insured vs. Insured exclusion does not preclude claims brought by the FDIC as receiver.

 

A special hat tip to Joe Monteleone and his blog The D&O E&O Monitor for the link to Judge Story’s opinion

 

Background

Community Bank & Trust failed on January 29, 2010. As noted here (second item), on February 24, 2012, the FDIC filed an action against two former officers of the bank. The complaint alleges that Charles Miller, the bank’s senior head of retail lending, violated his legal duties in approving loans in violation of the bank’s loan policies. Trent Fricks, the bank’s CEO, is alleged to have breached his duties in failing to supervise the loan officer and in failing to take corrective measures.

 

The bank’s D&O insurer agreed to defend the individual defendants under a reservation of rights and initiated a separate lawsuit seeking a judicial declaration that it had no duty to defend or indemnify the individuals. The insurer filed a motion for summary judgment in the coverage lawsuit, seeking a ruling as a matter of law that coverage for the FDIC lawsuit was precluded. The FDIC argued that the policy provisions on which the insurer sought to rely were ambiguous and that it was entitled to further discover of the insurer’s internal communications about insurer’s own interpretation of the policy provisions.

 

In moving for summary judgment, the insurer relied on its policy’s Insured vs. Insured exclusion, which, in pertinent part precludes coverage for loss “on account of any Claim made against any Insured … brought or maintained by or on behalf of any Insured or Company in any Capacity.”

 

The August 19 Opinion

In his August 19, 2013 opinion, Judge Story held that the FDIC was not entitled to further discovery because the policy’s insured vs. insured exclusion unambiguously precluded coverage. Judge Story noted that under FIRREA, the FDIC as receiver succeeds to “all rights, titles, powers and privileges of the insured depositary institution,” which means, in the language of the U.S. Supreme Court in its 1994 decision in O’Melveny & Myers v. FDIC, that the FDIC, as a failed bank’s receiver, “steps into the shoes” of the failed bank.

 

Judge Story noted further that in the O’Melveny case, the Supreme Court held that because the FDIC steps in the shoes of the failed bank, any defenses that could have been raised against the bank can be raised against the FDIC. Judge Story said that:

 

In this case, this Court finds that the FDIC has stepped into the shoes of CB&T, and under O’Melveny, whatever claims would have been good against CB&T are also good against the FDIC. The Insured vs. Insured exclusion expressly excludes from coverage suits brought by an insured against another insured. If CB&T had sued Miller and Fricks, the exclusion would have applied to absolve Plaintiff from a duty to provide coverage for Miller and Fricks. As such, the exclusion applies equally to the FDIC.

 

Judge Story went on to note that other than in the context of a derivative suit (for which the Insured vs. Insured exclusion as an express coverage carve back), “it is exceptionally rare for someone other than the FDIC … to raise a claim on behalf of a federally insured bank.” The fact that “the only party that could bring an action on a federally insured bank’s behalf is the FDIC” demonstrates that “the exclusion speaks specifically to this circumstance.”

 

The FDIC sought to rely on a number of court decisions that had held that the Insured vs. Insured exclusion does not apply to the FDIC. Judge Story observed that none of those decisions were binding on him, while the Supreme Court’s O’Melveny decision “strongly indicates that the exclusion should be given effect.” He also noted that it is hard to discern the supposed “majority of opinions” on which the FDIC sought to rely since “the language of the exclusions among the cases is different.”

 

In a particularly noteworthy aspect of his ruling, Judge Story declined to follow a line of insurance coverage decisions from the S&L Crisis era which had held that the Insured vs. Insured exclusion did not preclude coverage for the FDIC’s lawsuits. Among other things Judge Story noted that “in none of those cases did the insured vs. insured exclusion state that it applied to claims brought ‘on behalf of’ an insured as is the case here.” He noted further that the outcomes of other cases interpreting the exclusion’s applicability to FDIC lawsuits “usually turns more on the language of the exclusion rath than the adoption of the courts of a supposed majority or minority rule.” 

 

Judge Story also rejected the FDIC’s argument that the exclusion did not apply because its purpose was to preclude coverage for collusive suits and its lawsuit was not collusive. Judge Story said “this Court cannot refuse to give effect to an unambiguous term of the policy based on an assumption of why the language was put in the policy.”

 

Finally, Judge Story declined to follow cases that had held that public policy considerations argued against applying the exclusion to preclude coverage for claims brought by the FDIC. He said that he “disagrees with the notion that it is appropriate to rewrite a contract between private parties in the name of saving the taxpaying public money. Again, there is no rule that the federal insurance fund should always win.”

 

Discussion

Judge Story’s ruling stands in interesting contrast to the January 4, 2013 ruling of Northern District of Georgia Judge Robert L. Vining, in insurance coverage litigation arising out of the FDIC’s failed bank lawsuit against former directors and officers of Omni National Bank of Atlanta, that because of the “multiple roles” in which the FDIC acts in pursuing claims against the former directors and officers of a failed bank, there is “ambiguity” on the question whether the FDIC’s lawsuit triggers the insured vs. insured exclusion. (For further background on Judge Vining’s decision, refer here).

 

Similarly to Judge Vining, in October 2012, District of Puerto Rico Judge Gustavo Gelpi declined to dismiss a direct action the FDIC had brought under the Puerto Rico direct action statute against the D&O insurer of the failed Westernbank, noting that the FDIC has authority under FIRREA to act on behalf of a number of different constituencies and therefore that “the FDIC”s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under [the Insured vs. Insured] Exclusion.” (For more about Judge Gelpi’s decision, refer here.)

 

Notwithstanding these prior rulings, Judge Story found that the Insured vs. Insured exclusion unambiguously precluded coverage for the FDIC’s action as receiver of the failed bank against the bank’s former directors and officers. The fact that the various courts have reached such divergent conclusions suggests that this D&O insurance coverage question remains an unsettled and disputed issue. Indeed the fact that two judges in the same federal district could reach such diverging opinions shows just how unsettled this issue is.

 

Though the issue has been and remains an unsettled question, Judge Story’s opinion in the Community Bank & Trust coverage litigation nevertheless remains an important decision. Among other things, he firmly rejected a number of arguments on which the FDIC typically relies in trying to argue that the exclusion does not apply to the agency’s failed bank lawsuits. His refusal to follow the S&L Crisis era decisions on the issue could prove useful for the agency in other coverage disputes. The D&O insurers undoubtedly will also rely on Judge Story’s rejection of the FDIC’s argument that the exclusion only applies to collusive suits, as well as his rejection of the public policy arguments, in contending in other cases that the Insured vs. Insured exclusion precludes coverage for the FDIC”s failed bank lawsuits.

 

As Joe Monteleone observed in his blog post about Judge Story’s ruling, “this is a very significant win for insurers in the current round of coverage litigation with the FDIC involving bank failures since 2007.”

 

As important as the ruling is, Judge Story’s opinion will be no means put an end to the coverage disputes on the question whether the exclusion applies to the FDIC’s failed bank lawsuit. It is not just that a judge in the same judicial district reached a contrary conclusion on the same issue. It is also that Judge Story himself emphasized that the various cases on the issue are best understood as a reflection of the specific policy language at issue. Because even Judge Story himself found that the outcome of the question depends on the specific policy language involved, the parties to similar coverage disputes will continue to argue whether or not the specific language in their case does or does not operate to preclude coverage. But though the parties will continue to argue, the insurers do now have one more case on which to rely in arguing that the Insured vs. Insured exclusion precludes coverage for an FDIC failed bank lawsuit.

 

Further background regarding the coverage disputes involving the Insured vs. Insured exclusion can be found here and here.

 

Living in the 21st Century: This past Friday night, Mrs. D&O Diary and I were out to dinner with some friends. During our dinnertime conversation, we discussed the question of why these days so many people take pictures of their food and then post the pictures on the Internet. I don’t think we came to a table consensus on the issue, but during the discussion I did take of few pictures with my phone of my wife’s grilled green beans appetizer (pictured). Still not sure why people take picture of their food and post the pictures on the Internet.

 

The picture by the way was taken at Felice’s Urban Cafe, a modest sort of hipster healthful foods-type restaurant installed in a retrofitted house on Larchmere Boulevard in Cleveland. For my main dish, I had the Lake Erie Walleye. It was awesome. Readers who find themselves in the Cleveland area and who want to give Felice’s a try are welcome to give me a call. If you like, we can take pictures of our food with our cell phones and post the pictures on the Internet – and then we can try and figure out why?  

 

I want to make sure that all readers – particularly those based outside the U.S. — are aware of an upcoming Professional Liability Underwriting Society (PLUS) event.

 

On October 9-10, 2013, PLUS will be sponsoring an educational and networking event in Zurich. The Professional Liability Regional Symposium will address a wide range of issues relating to the liabilities of directors and officers and to the insurance implications arising from those liabilities. The program includes a number of interesting sessions and a stellar lineup of speakers. The program is the inaugural PLUS event in Continental Europe.

 

I will be participating as a moderator of two of the panels at the event. Both panels feature leading European D&O insurance professionals and attorneys. The first panel, which will take place on October 9, is entitled “Corporate Officials’ Liability Exposures: Identifying Current and Emerging Risks and Developing D&O Insurance Solutions.” The second panel, scheduled to take place on October 10, is entitled “Increasing Regulatory Oversight and Investigation: Implications for Liability and Insurance.” The event will also include a keynote presentation from Noona Barlow of AIG who will talk about European D&O Coverage issues, and David Birmingham of DB Consulting, who will discuss Managing the Risk of the Long Arm of U.S. Enforcement.

 

In addition to the educational sessions, the event will afford a great opportunity for networking. The event’s first day will include a networking reception. In the past few days, I have spoken to numerous industry colleagues in London and in Continental Europe who are planning on attending the Zurich event. I hope that other D&O insurance professionals from around Europe and around the world will also plan on going to Zurich for the conference and taking advantage of the opportunity to attend the informative sessions and to meet industry colleagues. Further information about this event can be found here. I look forward to everyone there.

 

A federal court has denied the motion of the accountants of the failed Colonial Bank’s holding company to dismiss the claims the FDIC, in its capacity as the failed bank’s receiver, had filed against them. As discussed here, the FDIC’s November 2012 lawsuit was the first the agency had filed against a failed bank’s accounting firm as part of the current failed bank litigation wave. The FDIC alleged that the accountants should have but failed to detect the scheme of bank employees to make and then hide fraudulent loans to failed mortgage lender Taylor Bean & Whitaker.

 

Middle District of Alabama Judge W. Keith Watkins’s September 10, 2013 opinion, which can be found here, discusses important questions concerning what law governs the question  whether the misconduct and knowledge of former bank employees can be imputed to the FDIC as receiver. Judge Watkins determined, in reliance on the U.S. Supreme Court’s 1994 opinion in O’Melveny & Myers v. FDIC, that state law governs the question, but declined to rule on the question whether under Alabama the bank employees’ misconduct and knowledge could be imputed to the FDIC as receiver in this case.

 

When Colonial Bank failed in August 2009, it was the sixth largest U.S. bank failure of all time (as discussed here). In is complaint against the accountants, the FDIC alleges Colonial’s failure was triggered by the massive, multi-year fraud against the bank by the bank’s largest mortgage banking customer, Taylor Bean & Whitaker.

 

As I detailed in a prior post, here, In April 2011, Lee Farkas, Taylor Bean’s ex-Chairman, was convicted of wire fraud and securities fraud. Prior to Farkas’s conviction, two Colonial Bank employees pled guilty in connection with the Taylor Bean scheme. As reflected here, on March 2, 2011, Catherine Kissick, a former senior vice president of Colonial Bank and head of its Mortgage Warehouse Lending Division, pleaded guilty to conspiracy to commit bank, wire and securities fraud for participating in the Taylor Bean scheme. As reflected here, on March 16, 2011, Teresa Kelly, the bank’s Operations Supervisor and Collateral Analyst, pled guilty on similar charges.

 

In the criminal cases against the bank employees, the government alleged that the two bank employees caused the bank to purchase from Taylor Bean $400 million in mortgage assets that had no value. The employees also allegedly engaged in fraudulent actions to cover up overdrafts of Taylor Bean at the bank. The employees are also alleged to have had the bank engage in the fictitious trades with Taylor Bean that had no value. As Judge Walker said in his September 10 opinion in the FDIC’s suit against the accountants, “Like cat-skinning, bank fraud lends itself to multiple approaches.”

 

In its complaint against PwC, the bank’s holding company’s outside auditor, and Crowe Horvath, with performed internal audit for the bank’s holding company, the FDIC alleges that while Taylor Bean was carrying out its “increasingly brazen” fraud, PwC “repeatedly issued unqualified opinions” for Colonial’s financial statements, and Crowe “consistently overlooked serious internal control issues” – and, more the point, both failed to detect the fraud. The complaint alleges that if the firms had detected the fraud earlier, it would have prevented losses or additional losses that the bank suffered at the hands of Taylor Bean. The complaint asserts claims against the firms for professional negligence, breach of contract, and negligent misrepresentation. The complaint alleges that in the absence of the firm’s wrongful acts, the Taylor Bean fraud would have been discovered by 2007 or early 2008, and “losses currently estimated to exceed $1 billion could have been avoided.”

 

The accountants moved to dismiss, arguing that the misconduct and knowledge of the individual criminal defendants could be imputed to the FDIC, because as receiver it stepped into the bank’s shoes. The accountants also argued that because their services were performed for the holding company and not the bank, the FDIC as the failed bank’s receiver lacked standing to assert negligence and breach of contract claims against them.

 

In their motions, the accountants argued that federal law governed the question of whether the individuals’ knowledge and misconduct can be imputed to the FDIC, and that under federal law, the knowledge and misconduct could be imputed to the FDIC and therefore that the FDIC was estopped from asserting the failed bank’s claims.

 

Judge Watkins ruled, in reliance on the O’Melveny decision, that state law governed the imputation question. Judge Watkins noted that “when it considered virtually the same question presented by this case – whether the knowledge and conduct of a bank’s insiders could be imputed from the bank to the FDIC acting as receiver – the Supreme Court concluded the [sic] FIRREA did not offer an answer and that state law therefore governed.”

 

However, because Judge Walker found that there are factual questions whether or not the individual criminal defendants were acting within the scope of their authority when the participated in the scheme to defraud, he could not grant the dismissal motion based on the imputation of the individuals’ knowledge and misconduct.

 

Judge Walker also found that there is a factual question whether or not the bank had standing to assert the negligence claims the bank’s holding company’s accountants. Judge Walker also found that there is a factual question whether or not the holding company’s intended to make the bank a third party beneficiary of the accounting services agreement between the holding company and the accountants sufficient to allow the FDIC as the failed bank’s receiver to be able to assert breach of contract claims.

 

Readers of this blog may recall that in August 2012, certain former Colonial Bank directors and officers agreed to settle the securities class action lawsuit that had been filed against them in connection with allegations surrounding the bank’s collapse. The $10.5 million settlement was to be funded entirely by D&O insurance. The securities suit settlement is discussed here. Significantly, the settlement did not include the bank’s offering underwriters or its outside auditors.

 

Among the individual defendants party to the securities suit settlement was Colonial’s colorful and controversial former Chairman and CEO, Bobby Lowder. In addition to Colonial, Lowder has long been associated with Auburn University and its storied football program. I discussed Lowder’s Colonial Bank and Auburn connections in a prior post, which can be found here.

 

Coincidentally, Judge Watkins (according to Wikipedia) attended Auburn as an undergraduate; however, in an educational move that undoubtedly creates complicated loyalties during the college football season, he attended the University of Alabama for law school. Regardless of his loyalties as between Auburn and Alabama, he undoubtedly will be rooting for Alabama against Texas A&M this Saturday.

 

As I also noted in a prior post (here), in July 2012, the FDIC as receiver for Colonial Bank, as well as the bankrupt bank holding company on its own behalf, filed an action against the bank’s bond insurer. Among other things, the complaint alleges that the losses caused by the misconduct “constitute recoverable losses under the Bonds up to the full aggregate limits of liability of the Bonds.” The complaint states that the bond insurer “has neither accepted nor denied the Plaintiffs’ claims under the Bonds.” The complaint alleges that the insurer “has failed to investigate the claims and losses in a reasonable and appropriate manner.” In September 2012, the parties jointly moved the court to revise the schedule in the case to permit them to engage in settlement discussion.