We make it our business to cover a lot of ground here at The D&O Diary, and apparently so do this blog’s readers, at least judging by the first round of pictures readers have sent in as “mug shots” of The D&O Diary coffee mug. 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.

 

We have mailed out dozens and dozens of mugs (and I would be remiss if I did not pause here to express my thanks to Mrs. D&O Diary, whose assistance in helping to mail the mugs has been indispensable). The early picture returns are starting to come in. If the first batch of pictures is any indication, the collective “mug shots” will constitute a formidable gallery. Here a few pictures culled from the first batch.

 

The D&O Diary writes about issues affecting the liabilities of corporate directors and officers, and that means this blog’s beat includes the world of corporate and securities litigation. In light of this blog’s business litigation bailiwick, what better place is there to picture The D&O Diary mug than on Wall Street itself, outside the New York Stock Exchange? The photo below was taken by Gregory Del Gaizo of the Robbins Arroyo law firm of San Diego, who took this mug shot while visiting the East Coast on business.

 

 

With nearly 40% of its readership outside the United States, The D&O Diary has a global reach. So the D&O Diary mug fits in abroad just as well as at home. Our good friend Aruno Rajaratnam, of Ince & Co. law firm’s Singapore office, took this “mug shot” of these musicians at Indira Gandhi Airport in New Delhi. Aruno reports that “The musicians just gave me a cursory nod at first when I said I wanted a photo of them…..then when I placed the mug in front of them, they were very amused!”

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The D&O Diary also knows how to relax. George Washington University Law Professor Larry Cunningham sent in the following rooftop shot from East Hampton, New York (Cunningham’s name will be familiar to readers as he is the editor of a volume of Warren Buffett’s essays that I reviewed in a recent post, here):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loyal reader (and frequent blog post commentator, as well as occasional guest post contributor) Donna Ferrara of Gallagher Management Liability sent in this shot from the McFaul Environmental Center, in Bergen County, New Jersey, near her home.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

And finally, Jeff Gauthier of the Great American Executive Liability Division sent in this picture taken at the Pinehurst Country Club in Pinehurst, North Carolina.  Jeff’s explanation for this, well, unusual picture, taken at the famous Pinehurst No. 2 course, is set out below the picture:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Bobby Jones described Pinehurst as the St. Andrews of United States golf. Pinehurst is the site of Ben Hogan’s first professional win; the 1940 North and South Open. Home of the 1951 Ryder Cup where play was suspended midway through the match so both teams could attend the North Carolina vs. Tennessee college football game in Chapel Hill, NC.

Pinehurst No. 2 (there are 8 courses in the Pinehurst family) was completely renovated in 2011 (led by Ben Crenshaw’s design team) in an effort to restore it to Donald Ross’ original design. No rough, larger playing areas, more strategic shot options and a return to the natural aesthetics of sand, hardpan and native wire grass. * Caddies note: wire grass is more commonly referred to as “love” grass because everyone getting involved with it gets screwed.

Pinehurst No. 2 hosts both the men’s and women’s U.S. Open, back to back, in 2014. This is the first venue ever to host both events in succession.

In 1999 Payne Stewart jarred the longest winning putt in U.S. Open history on the 18th green of Pinehurst No. 2. Payne’s celebratory pose is now immortalized in bronze not far from his accomplishment. The D&O coffee mug does its best to replicate the pose …

 

My thanks to everyone who has sent in pictures so far. Even with over one hundred mugs mailed out already, I still have a few left for anyone who is interested – and who is willing to send back a picture – on a first-come, first-served basis. Just let me know if you would like one of the well-traveled and world famous D&O Diary mugs.

 

As I said in the title of my original post about the mugs, the best things in life are free. I don’t know if you have noticed, but it seems that lately more and more of the Internet is going behind pay walls and toll booths. You can be assured, however, that The D&O Diary will remain free. Always has been and always will be.

 

My thanks to all of this blog’s readers for their loyal support. Cheers.

 

On June 4, 2013, the Second Circuit, in an insurance coverage action involving the defunct Commodore International computer company, affirmed that excess D&O insurance is not triggered even if losses exceed the amount of the underlying insurance, where the underlying amounts have not been paid due to the insolvency of underlying insurers. The Second Circuit’s June 4, 2013 opinion can be found here.

 

The Second Circuit’s opinion is important because it represents the first time the Circuit has revisited its venerable and influential 1928 opinion in the Zeig v. Massachusetts Bonding & Insurance Co.

 

As I noted in my discussion of the district court’s decision (here), this is a tale haunted by the ghosts of several long-lost companies – not only the ghost of Commodore itself (the manufacturer of the classic Commodore 64 computer), but also the ghosts of Reliance Insurance Company, which went into regulatory liquidation in 2001, and of The Home Insurance Company, which went into liquidation in 2003. This case not only analyzes the requirements to trigger the obligations of excess insurers, but it also serves as an important reminder of the chaos that can follow when carriers become insolvent.

 

Background

Commodore filed for bankruptcy in 1994. In the bankruptcy proceeding, various claims were asserted against the company’s former directors. The individuals sought insurance protection for these claims from Commodore’s D&O insurers. Commodore had a D&O insurance program with total limits of $51 million, arranged in nine layers, consisting of a primary layer of $10 million and eight excess layers in varying amounts. Unfortunately for Commodore’s former directors, the first and fourth level excess layers were provided by Reliance and the third and sixth level excess layers were provided by The Home.

 

The primary D&O insurance was exhausted by payment of losses. However, due to Reliance’s insolvency, the individuals were unable to obtain insurance for losses that went into the next layers of insurance. The individuals sought to have the solvent excess insurers that provided the insurance layers above the insolvent carriers pay their defense expenses and other loss costs. These “next level” excess insurers filed an action seeking a judicial declaration that they had no obligation to “drop down” to fill the gaps created by the insolvent insurers, and also seeking a declaration that their excess insurance obligations had not been triggered because the underlying layers had not been exhausted by payment of loss. The individual directors contended that the excess insurers’ payment obligation had been triggered because their liabilities exceeded the amount of the underlying insurance.

 

The solvent excess insurers’ policies all contained a similar provision essentially providing that the payment obligation under the policies is triggered only “in the event of exhaustion of all of the limit(s) of liability of such Underlying Insurance solely as a result of payment of losses.”

 

As discussed here, on September 28, 2011, Southern District of New York Judge Richard Sullivan granted the insurers’ motion for summary judgment. He ruled that the “next level” excess insurers had no obligation to drop down to fill the gaps caused by the insolvency of Reliance and of The Home. (Judge Sullivan’s ruling on the “drop down” issue was not appealed and was not before the Second Circuit). Judge Sullivan also concluded that the “next level” excess insurers obligations had not been triggered merely because the individuals’ liabilities exceeded the amount of the underlying insurance.

 

Judge Sullivan found that the “express language” in the excess insurers’ policies required exhaustion of the underlying limits by actual payment of loss in order to trigger coverage. He said that it is “clear from the plain language of the Excess Policies … that the excess coverage will not be triggered solely by the aggregation of Defendants’ covered losses. Rather the Excess Policies expressly state that coverage does not attach until there is payment of the underlying losses.”

 

Following further proceedings in the District Court, the individual directors appealed Judge Sullivan’s summary judgment ruling.

 

The June 4 Opinion

In June 4, 2013 Opinion written by Judge José Cabranes for a unanimous three-judge panel, the Second Circuit affirmed Judge Sullivan’s ruling. The appellate court said that “the plain language of the insurance policies supports the view of the insurer appellees.”

 

The individual directors had argued that the excess insurers’ payment obligation attached when defense or indemnity obligations reached the excess insurers’ respective attachment points. The Second Circuit said that “’obligations’ are not synonymous with ‘payments’ on those obligations,” adding that “to hold otherwise would make the ‘payment of’ language in these excess liability contracts superfluous.” The appellate court added that “because the plain language of the contracts specifies that the coverage obligation is not triggered until payments reach the respective attachment points, the District Court properly denied the Directors’ request for a declaration that coverage obligations are triggered once the Directors’ defense and indemnity obligations reach the relevant attachment point.”

 

Interestingly, the Second Circuit noted that the District Court had never actually said that the underlying insurers must make the payments before the excess insurers’ obligations were triggered. The appellate court noted that the District Court, echoing the excess policies’ themselves, “described the requirements in the passive voice and did not specify which party was obligated to make the requisite payments.” The District Court, the appellate court noted, “did not err in doing so,” as denying the directors’ request “did not require ruling on whether the underlying insurers, in particular, were required to made the payments; the Directors simply sought a declaration that the excess policies’ coverages are triggered once the respective attachment points were reached.”
 

 

The Second Circuit also rejected the individual directors attempt to rely on the Second Circuit’s 1928 Zeig opinion. (Zeig had held that an insured under a property insurance program could obtain the benefits of an excess policy where the insured’s loss exceeded the amount of the underlying insurance.) The appellate court did not overrule Zeig; rather, the Second Circuit distinguished Zeig.

 

First, the Second Circuit differentiated between the “context” in Zeig, in which the prior Court had been interpreting a first-party property policy, and the context in this this case, in which the Court was interpreting a third-party excess liability policy. The relevance of the question whether or not the amount of loss exceeded the amount of underlying insurance is clearly different in the context of a property policy than in the context of a third-party liability policy. The Second Circuit noted, quoting with approval from the Judge Sullivan’s opinion, that a third party liability insurer was within its right to require actual payment of the underlying amounts, so as to protect against collusive settlements.

 

Though the Second Circuit did not overrule Zeig, it did comment in a footnote that “though not relevant to our decision, it bears recalling that the freestanding federal common law that Zeig interpreted and applied no longer exists. See Erie R.R. Co. v. Tomkins, 304 U.S. 64 (1938), overruling Swift v. Tyson, 41 U.S. 1 (1842).”  

 

Discussion

If nothing else, this case serves as a reminder of the critical importance of carrier solvency. Carriers do not become insolvent frequently, but when they do, it is a mess. Here we are fully twelve years after Reliance went into liquidation (and nearly twenty years after Commodore went into bankruptcy) fighting about the problems caused when the carriers went bust. Unfortunately for the former Commodore directors, their insurance program had doubled down on the carriers that went insolvent; its insurance program included two layers of excess insurance each for both Reliance and The Home.

 

The Second Circuit’s holding that the excess insurers’ payment obligations were not triggered even though the individuals’ losses exceeded the amount of the underlying insurance is consistent with other recent decisions in which courts have interpreted the excess insurer’s trigger language to require exhaustion of the underlying insurance by the actual payment of loss (refer for example here and here).

 

Though the Second Circuit’s decision is consistent with other recent decisions on this topic, there are still a number of interesting things about this opinion. First of all, as noted above, this case apparently represents the first occasion on which the Second Circuit has revisited its venerable Zeig decision, a case on which policyholders have relied for years to try to compel their excess insurers to pay losses that exceeded the excess insurers’ layers.

 

The Second Circuit did not overturn Zeig, it merely distinguished the case. (For that matter, the Second Circuit didn’t even make clear which state’s law it was applying; in a footnote, the appellate court noted that the parties disputed whether Pennsylvania law or New York law applied, observing that “because there is no conflict between the relevant substantive law in these states however, we dispense with any choice of law analysis.”)

 

Just the same, I question whether or not Zeig remains good law after this decision in the Commodore case. As I noted above, the Second Circuit expressly noted that that “freestanding common law” that Zeig interpreted “no longer exists.” In light of this statement, I doubt whether Zeig represents reliable authority that could be cited and relied upon for the propositions it otherwise represents.

 

It is worth noting that for several years now, the D&O insurance marketplace has featured the availability of excess insurance policies with trigger language that allows the amount of the underlying limits of liability to be paid either by the insurer or the insured for the excess insurer’s payment obligation to be triggered. However, even if the policies of the solvent excess carriers in this case had included this modern language, the excess carriers’ payment obligations might not have been triggered; the clear suggestion of the Second Circuit’s analysis of the “payment of” language is that the underlying amounts had not been paid here, either by the insolvent insurers or by the insured persons — which serves as a reminder that even the modern language does not solve every excess trigger problem.

 

It was interesting in the Second Circuit’s opinion that the appellate court expressly did not reach the question of whether the individual directors’ payment of the losses would have been sufficient to satisfy the “payment of” triggers of the excess policy. The Second Circuit’s commentary on this issue, and its analysis of the passive voice “payment of” language in the excess policy’s trigger, will give policyholders in coverage cases involving excess policies that lack the modern trigger a basis on which to argue for coverage. The policyholders could argue, if they have in fact themselves paid the underlying loss, that their payment of the loss satisfies the “payment of” trigger where the excess policy uses the passive voice and does not specify who must make the payment in order for the excess coverage to be triggered. 

 

Owing to the insolvency of Reliance and The Home, the individual directors here are left to face the underlying claims without the benefit of insurance. This dire circumstance provides a vivid illustration of the value of Excess Side A/DIC insurance, which by its terms would drop down and provide coverage in the event of the insolvency of an underlying insurer. Excess Side A/ DIC policies were available at the time that Commodore procured its D&O insurance, but the inclusion of these types of policies in a program of D&O insurance was not as common then as now. (The policies available then were more restrictive than those available today, as well.) If Commodore’s insurance program had included an Excess Side A/DIC policy, the individual defendants might have been able to rely on that policy to defend themselves despite the gaps caused by the insurers’ insolvency.

 

In any event, the time has finally come to draw a curtain on this production. At this point in a Shakespearean play, the stage directions would say: Exeunt stage left. And off into the night would troop the spirits of Commodore, Reliance and The Home – followed by the spirits of the several individual directors who have passed away while this seemingly interminable drama has dragged on. Among them would be the departing spirit of the late Alexander Haig, who during his mortal span of years was a Commodore director and who also served as Secretary of State under Ronald Reagan. He was not in fact “in control” during the tense hours after Reagan’s attempted assassination any more than he is now.

 

Special thanks to a loyal reader for sending me a copy of the Second Circuit’s opinion.

 

What is the Quickest Goal Ever Scored in a Soccer Game?:  I don’t know for sure, but I doubt that there have been many goals scored faster than this goal by Enganamouit Gaelle Deborah, a striker for the FC Spartak women’s soccer club in Russia. FC Spartak went on to defeat FC Pozarevac 7-0 in the championship game of the Serbian Women’s League. Pay close attention, because if you blink you might miss the goal. 

The possibility of securities litigation following the disclosure of  a cyber security breach has been a topic of significant recent attention, including on this site. There already have been securities class action lawsuits filed following significant cyber breaches, at least in some cases. More recently, however, the stock prices of several major companies that recently announced that they had experienced cyber attacks barely moved. For example, announcements earlier this year by Facebook, Apple and Microsoft that they have been the target of sophisticated cyber attacks did not affect the companies’ share prices. And despite the high-profile disclosures, these companies were not hit with securities lawsuits about the breaches, either.

 

Without a significant stock price decline, prospective claimants lack one of the critical predicates for a securities lawsuit. If the stock market shrugs off news of cyber security breaches, there may less securities litigation related to the cyber breaches than some commentators have conjectured.

 

The question of the market reaction to cyber breach news is the subject of recent paper from three professors at the University of Maryland business school. In their paper entitled “The Impact of Information Security Breaches: Has There Been a Downward Shift in Costs?” (here). The authors – Lawrence A. Gordon, Martin F. Loeb and Lei Zhou – examined 121 security incidents involving 85 firms during the period 1995 to 2007, in order to determine the impact of the disclosure of the cyber breaches on the share prices of the companies involved.

 

The authors divided their study into three time periods: the 1995 to 2007 period as a whole; the period from 1995 to 2001; and the period from 2001 to 2007. The authors choose to split their study this way based on their desire to determine (in light of the results of prior research) the possible impact of the 9/11 terrorist attacks on the sensitivity of the market to news of cyber breaches. Of the 121 cyber breach events in the study, 60 occurred in the pre-9/11 period and 61 occurred in the post-9/11 period.

 

The authors found that for the period of the study as a whole the impact of the news of cyber security breaches on the stock price of the involved company is “significant.” As the authors put it, “those who are concerned about the economic impact of information security breaches on the stock market returns of firms apparently have good cause for concern.”

 

However, the authors found that the results were split between the two subsidiary time periods. During the pre-9/11 time period, “the overall impact of security breaches … on the stock market returns of firms is statistically significant.”

 

The result for the post-9/11 period differed. That is, “for the second time period, the authors discerned “a significant decrease in the market’s negative reaction to announcements” of security breaches.

 

Based on the differing results of the two time periods, the authors concluded that the results “support the general argument that investors shifted their attitudes in the way they view information security breaches.” The authors suggested that “investors have grown accustomed to seeing news of a corporate information security breach without major consequences to the firm’s long-term profitability. “ For that reason, “investors appear to have little reaction (in terms of revaluing a firm’s shares) to the news that a firm has had an information security breach.”

 

The authors did note that their analysis of the post-9/11 results “does not necessarily imply that investors seem to have become totally desensitized to news about corporate information security breaches.” Their analysis is based on average effects; “some news of specific breaches did have a significant impact on the market capitalization of specific firms.” They concluded that “while executives may take some comfort from the fact that average breaches are not a major threat to their firm, they still must be concerned over the possibility of a particular information security breach threatening their firm’s survival.”

 

The authors’ conclusions about the post-9/11 impact on company share prices of the news of a cyber breach does suggest, at a minimum, that many companies experiencing cyber breaches are unlikely to also have to deal with securities litigation related to the breach.

 

On the other hand, the authors’ observation that even post-9/11 some companies did experience a significant impact on their share prices from the disclosure of a cyber breach does suggest at the same time that at least some companies announcing a cyber breach could also face the prospect of securities litigation related to the breach.

 

It would have been interesting if the authors had take their study to the next step, to try to describe what types of companies or what types of breaches were involved in the instances where the companies experiencing the breach did sustain a significant stock price decline. Unfortunately, the authors’ analysis does not reach those issues.

 

It is noteworthy that nearly six years has elapsed since the end of the period that was the focus of the authors’ study. The intervening period has been characterized by rapid technological change; the rise of global cyber spying activities arguably sponsored by national governments; and even the rise in cyber warfare activities. It is hard to know, one way or the other, whether the results for the intervening time period would be consistent with the results of the time period that was focus of the study.

 

The authors’ conclusion that, on average, companies disclosing cyber breaches do not experience significant share price declines does raise the question of whether cyber breach-related securities litigation will prove to be as widespread as some have conjectured. On the other hand, the authors’ conclusion that, notwithstanding the average figures, some companies in some circumstance disclosing cyber breaches are experiencing significant stock price declines  suggests that a threat of cyber breach-related securities litigation remains a possibility for a least some companies disclosing cyber breaches.

 

Even in the absence of a significant stock price decline and ensuing securities litigation, companies disclosing a security breach and their directors and officers could still face the possibility of corporate litigation related to the breach.  Companies that do not experience a share price decline following a cyber security incident may not get hit with securities class action litigation, but they are still susceptible to derivative lawsuits alleging, for example, that company directors breached their fiduciary duties by failing to ensure adequate security measures. Shareholder may claim that senior management and directors were either aware of or should have been aware of the breach and the company’s susceptibility to cyber incidents. (Of course, any lawsuit of this type would face significant hurdles, including the requirement to make a formal demand on the board as well as the business judgment rule.)

 

The authors of the report expressed their own unease with the suggestion that investors may have become desensitized the new of cyber security breaches. They questioned whether “corporate executives are likely to see this as a cue from investors to keep their firms’ information security investments at the status quo.” This view “seems misguided in light of the fact that an unforeseen major breach …has the potential to threaten a firm’s survivability.”

 

In other words, corporate officials must remain vigilant, as the failure to do so could have serious consequences for their companies. The management of these cyber security risks remains a significant responsibility. The failure to manage these risks continues to represent a significant liability exposure – whether or not a significant liability breach will include the risks of breach-related securities litigation.

 

Special thanks to Bill Boeck of Lockton Financial Services for providing me with a link to the academics’ study.

 

Insuring Against Cyber Risks: Separate and apart from the liability exposures of companies’ directors and officers, cyber security risks also present a host of related first-party and third-party exposures for companies. In response to these company liability concerns, the insurance industry has evolved an insurance product to protect against these cyber risks. This evolving insurance industry response is the subject of a short May 22, 2013 New York Law Journal article entitled “Insuring Against Cyber Risks: Coverage, Exclusions, Considerations” (here) by Howard Epstein and Theodore Keys of the Schulte Roth & Zabel law firm.

 

The authors conclude that “Insurance products that address these cyber risks are still evolving. However, for directors and officers seeking to address these risks, these insurance products should be part of the equation.”

 

Welcome Aboard: We are pleased to announce that Keith Loges has joined RT ProExec, a division of RT Specialty. Keith is a proven and well recognized professional with over 25 years experience in the Executive and Professional Liability industry.  Keith represents RT Specialty’s commitment to further establishing itself as the premier Executive and Professional Liability wholesaler. Keith will be located in the RT Specialty Atlanta office and you can reach him at:

5565 Glenridge Connector, Suite 550

Atlanta, GA 30342

Office: 678-981-6487

Cell: 678-833-8483

E-mail: keith.loges@rtspecialty.com

 

In two administrative enforcement actions last month, the SEC charged two municipalities – Harrisburg, Pa. and South Miami, Fla. – with securities fraud. These high-profile actions sounded alarm bells and raised concerns about possible securities violations involving other state and local governments. But while these two actions have grabbed a great deal of attention, the unfortunate fact is that allegations of securities law violations against local governments are nothing new. However, the recent problems do raise serious concerns for state and local government bond investors, which in turn raise concerns about what the liability implications may be for the government entities and their officials.

 

On May 6, 2013, in the first of the two most recent actions, the SEC instituted settled administrative proceedings against Harrisburg, charging the city with securities fraud for its “misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated.” The SEC’s press release describing the action and the city’s entry into a consent cease and desist order details the misleadingly reassuring or incomplete statements the city provided at a time when its financial woes were well known to city officials.

 

The press release states that the Harrisburg action “marks the first time that the SEC has charged a municipality for misleading statements made outside of its securities disclosure documents.” The agency’s administrative order was accompanied by a separate report addressing the disclosure obligations of public officials and “their potential liability under the federal securities laws for public statements made in the secondary market for municipal securities.”

 

The Harrisburg action was followed a few days later with a separate settled administrative action against the City of South Miami. As detailed in its May 22, 2013 press release, the agency charged the city with “defrauding bond investors about the tax-exempt financing eligibility of a mixed-use retail and parking structure being built in its downtown commercial district.”  Post-offering changes to the project’s lease arrangements jeopardized the offering’s tax exempt status by, among other things, providing offering proceeds directly to a private developer. The agency alleged that in annual certifications following the offering the city incorrectly stated that it was in compliance with terms of the offering and that there had been no events that would affect the tax-exempt status. The city avoided possible harm to the bond investors by entering into separate settlement with the IRS and by restructuring a portion of the offering.

 

It is not just municipalities that are having difficulties with the securities laws. In March 2013, the SEC lodged settled administrative proceedings against the State of Illinois, in which the agency alleged that the state “failed to disclose that its statutory plan significantly underfunded the state’s pension obligations and increased the risk to its overall financial condition. The state also misled investors about the effect of changes to its statutory plan.”

 

In August 2010, the agency entered settled administrative proceedings against the State of New Jersey, alleging that the state failed “to disclose to investors in billions of dollars worth of municipal bond offerings that it was underfunding the state’s two largest pension plans.” According to the SEC’s August 18, 2010 press release, New Jersey was “first state ever charged by the SEC for violations of the federal securities laws.” Interestingly in the consent order, the state neither admitted nor denied the agency’s allegations.

 

As the statements quoted above make clear, the SEC’s recent actions represent new developments, as the agency expands its reach and exerts its authority in new ways. However, there is nothing new about the agency’s assertion of securities law violations against local governments. Over the years, the SEC has pursued a number of high profile enforcement actions in connection with municipal bond offerings. A lengthy list of the SEC’s enforcement actions against municipalities between 2003 and 2010 can be found here, including actions against issuers, public officials, and offering underwriters. Earlier cases can be found here and here.

 

A recurring issue that has led to allegations of securities law violations has been disclosures relating to pension obligations (as the Illinois and New Jersey actions demonstrate). One of the highest profile securities enforcement actions involving a municipality prior to the more recent actions described above was the securities complaint the SEC filed in April 2008 against five former San Diego officials, in which the agency alleged that the officials had “failed to disclose to the investing public buying the city’s municipal bonds that there were funding problems with its pension and health care obligations and these liabilities placed the city in serious financial jeopardy.”

 

As discussed in greater detail in Steve Malanga’s June 1, 2013 Wall Street Journal op-ed column entitled “The Many Ways That Cities Cook Their Bond Books” (here), pension obligation reporting deficiencies are likely to continue to plague local governments, which is an area that the SEC is giving “special scrutiny.” These and other financial reporting shortcomings may put bond investors at risk, as local officials struggling with financial woes attempt to put their local government’s other obligations ahead of the locality’s obligation to honor the commitments it made in the bond offering.

 

All of these developments suggest that bond investors “should be practicing a stronger form of ‘buyer beware’” – but, as Malanga notes, even a heightened level of investor caution may be “difficult if governments issue reports designed to disguise their true financial condition.” If investors were to “finally catch on to this,” it might “put an especially deep chill on the market for municipal securities.” Local governments that are “less than forthcoming” will “deserve the consequences.”

 

It is certainly the case that investors who lack confidence in the accuracy of a locality’s financial reports can try to protect themselves by avoiding investments in the locality’s bonds. But that does little for investors who have already invested and believe they were misled. Even the SEC’s various enforcement actions, which are designed to enforce the securities laws and vindicate the principles they represent, do little directly for investors who were harmed by the alleged misrepresentations.

 

At least some investors in these circumstances have tried to take matters into their own hands, by initiating their own actions to try to redress their injuries. For example, as discussed here, in May 2010, bond investors initiated a securities class action in the Southern District of Florida against the city of Miami, Florida, alleging that the city had made “fraudulent material misrepresentations and omissions regarding the City of Miami’s then-current financial condition and future prospects.” Among other things, the plaintiff alleged that the city was “improperly and illegally shuffling money between various City of Miami accounts in an effort to cover up its existing fiscal crisis.” (As noted here, in 2012, following document discovery in the case, the plaintiff voluntarily dismissed her action with prejudice to herself but without prejudice to the class.)

 

In addition, as I noted in an earlier post (here), investors in certain municipal revenue anticipation notes filed an action in the Central District of California against the city of Alameda, California and related municipal entities, alleging that the city officials knew that the funding mechanism for the notes “was not economically feasible.”

 

All of these developments suggest that local governments and their officials could face increased exposure to the possibility of litigation involving alleged securities law violations, whether from enforcement authorities or from investors.

 

Readers of this blog may well wonder whether there are insurance products that could protect municipalities from these kinds of risks. Certainly, Public Official Liability Insurance includes liability protection not only for individual public officials but also for the public entities themselves. But many of these policies include an express exclusion precluding coverage for claims arising out of any debt financing. Some  public entities have procured insurance designed to provide protection for these kinds of claims, but many municipalities have not, even if they otherwise purchases public official liability insurance. Given the developments described above, it may be increasingly important for local governments to seek to procure this type of protection. On the other hand, as regulators and claimants more aggressively pursue these types of claims, obtaining this type of coverage could prove increasingly challenging and costly.

 

The local governments’ troubled financial condition and the absence of insurance in many cases does raise the question of what investor claimants’ litigation objectives may be. The taxpayer base of a beleaguered city hardly represents an attractive target. It may be that the claimants’ true targets are not the city or its officials; for example, in the city of Alameda case noted above, the defendants in the case included not only the various municipal entities, but also the offering underwriters that sponsored the city’s note offering.

 

Whatever the case may be, it seems clear that given an increasingly active SEC and the apparently growing willingness of investors to pursue private securities litigation, there is a growing risk that state and local governments facing pension funding challenges and other budgetary woes could also find themselves facing proceedings alleging securities law violations. These developments have a number of risk management implications for these local governments, including considerations of risk transfer through insurance, where available. 

 

Grading Securities Enforcement: In an interesting and provocative May 16, 2013 New York Law Journal article (here, subscription required) , Columbia Law Professor John Coffee  grades the private securities enforcement activity of the plaintiffs’ bar and the public enforcement activity of the SEC. His grade for the plaintiffs’ bar is relatively high but his grade for the SEC is far less favorable.

 

In grading the plaintiffs’ bar, Coffee notes a bifurcation that has developed among the plaintiffs’ securities law firms. Securities class action activity is increasingly concentrated among a few established law firms. The recent rise of M&A litigation is in part a reflection of the fact that smaller plaintiffs’ firms lack institutional clients and the resources to carry a big securities case. The elite plaintiffs’ firms tend to be involved in securities cases that result in “mega-settlements” while the smaller firms, to the extent they are involved in securities class action cases at all, tend to be involved only in the smaller cases that result only in smaller settlements that bring down annual settlement averages and medians.

 

For Coffee, the bottom line for the plaintiffs bar is that the “big league” plaintiffs’ law firms had “a good year” in 2012, while the smaller firms “limped through 2012.” Coffee concludes his grade report for the plaintiffs’ firms by noting that even the elite plaintiffs’ firms should “gather ye rosebuds while ye may, as the plaintiffs’ bar needs to worry about where future cases will come from.”

 

Coffee’s review of the SEC is far less flattering. He notes that the agency’s enforcement activity is increasingly concentrated in three areas: insider trading cases; Ponzi scheme; and financial services misrepresentations (mostly involving broker-dealer fraud). What is missing is enforcement activity involving public company misstatements. Coffee assesses this absence as due to the fact that the agency “lacks the ability to handle the large, factually complex case,” noting that when the agency attempts to take on large corporate defendants, “it must either decline to sue or settle cheaply.” Coffee states that “truly complex factual cases against a major financial institution are probably beyond the SEC’s practical capacity.” Coffee suggests that the SEC should borrow a page from the FDIC’s play book and start “hiring private counsel to handle the cases that are too big or burdensome for it.”

 

Coffee concludes by giving the SEC an enforcement grade of “B-“ because the agency is “in denial” – “it will not admit that it cannot handle complex cases, will not refer to private counsel, and so must settle on a basis that often seems inadequate.”

 

Special thanks to a loyal reader for sending me a link to Coffee’s article.

 

At times of trouble, D&O insurance can represent the last line of defense for corporate directors. For that reason, corporate board members rightfully are concerned about their insurance and want reassurance that their company’s policy will provide them the protection they will need. Unfortunately, directors don’t always know the questions to ask and only find out about problems after the claims have emerged.

 

In the following guest post, Paul Ferrillo and Ronit Berkovich of the Weil, Gotshal & Manges LLP law firm take a detailed look at the most important questions for directors and officers of troubled companies to ask about their D&O insurance. The authors address basic issues such as carrier and limits selection, as well as important questions about policy terms and conditions. This article was also published as a post on the Weil Bankruptcy Blog

 

I am grateful to Paul and Ronit for their willingness to post their article on this site. I welcome guest post submissions on topics of interest to this site’s readers. Please contact me directly if you are interested in publishing a guest post on this site.

 

Here is Paul and Ronit’s guest post:

 

We often get called into corporate calamities where “heavy water” is starting to overwhelm the bilge pump of the corporate yacht. Often in those situations good people like directors and officers, who are tasked with figuring out what to do to “save the ship,” must at the very same time try to figure out if they have enough directors and officers (“D&O”) liability insurance to weather the storm and protect them from the sharks.

 

Nautical allusions aside, trying to figure out if your D&O insurance is good enough when you are about to enter rough waters is not ideal for many reasons. First, it takes time to do so (and depending upon circumstances, there may be no time to tinker with the D&O coverage). Second, and more importantly, if there is a problem with your coverage, many carriers are reluctant to modify policy wording (to potentially “enhance” coverage) when a company is having financial difficulty because the carrier itself is worried about its own potential exposure to directors and officers claims (whether they might be lawsuits or regulatory investigations). To many less-forward thinking carriers, doubling down (in some respect, even if it serves to protect their insureds) sometimes makes no sense.

 

Finally, despite years of heavy claim activity and many large bankruptcies spurred by the financial crisis, we often still see the same problems with policies and towers of insurance. Why is that? We honestly cannot say. Sometimes corporations (and their boards) do not focus enough on D&O insurance issues because they are frankly too busy with other issues. Sometimes D&O insurance decisions are based not on “substance” issues, but on cost issues, which is generally not the right answer for many reasons. Furthermore, much of the literature dealing with D&O insurance tends not to be broadly disseminated to the folks who need the information most (like corporate directors and officers), and instead is left to the devices of risk managers and brokers who do not have much experience dealing with troubled company D&O issues.

 

Our goal in this piece is to place front and center the most important issues relating to “troubled company” D&O issues, so that directors and officers will understand what they need to know, and what to ask when questioning management on D&O coverage. These are not the only issues that should be addressed when considering the scope and breadth of D&O coverage, but certainly ones that should be at the top of any director’s and officer’s list. And truth be told, this advice should hold true for all companies and boards (not just troubled ones) because, as noted above, the best time to fix D&O issues is when the sailing is smooth, and not when the corporate yacht is about to sink.

 

Know Your Primary Carrier – Really Well

D&O insurance is frequently purchased in a “stack” or a “tower” of insurance, led by a primary carrier and multiple excess carriers. The excess policies are usually written in “follow form” nature, meaning they, in most cases, follow the terms and conditions of the primary carrier.

 

However, because neither insurance policy forms nor D&O carriers are fungible commodities, it is very important to understand who is the company’s primary D&O carrier, what coverage such carrier offers (either in its base form or by endorsement), and whether or not they “pay claims.” In many ways, the primary D&O carrier is like a critical vendor or business partner with whom the company cannot do without. In fact, the primary D&O carrier can sometimes be the most important business partner (and friend) a company and a director or officer can have. The hope is that when the seas are rough (like in an insolvency or restructuring scenario), the primary carrier will be there to respond to claims and ultimately protect the personal assets of the directors and officers involved – even in times where indemnification or advancement is unavailable or refused by the corporation.

 

A couple of points to consider:

 

1. What is the carrier’s claims handling and claims paying reputation? Is it business-friendly and coverage-neutral, or is the carrier known to try to find “outs” to coverage? Does the carrier have a free-standing claims department or does it farm out claims to coverage counsel? And if the company has multiple offices overseas, how does the D&O carrier handle cross-border claims or investigations? Through a bit of investigation, one can often learn from others (such as defense counsel or experienced D&O brokers) information that might indicate which way a carrier leans on these important questions. Obviously, the best carrier is one that will hang with the directors and officers even in the worst of times, and will not “run and hide” behind coverage defenses so it does not have to pay.

 

2. What is the carrier’s underwriting response to questions and potential modifications? What is the carrier’s responsiveness to requests to enhance coverage for the insured? These questions relate to the prior question. Directors, officers, and companies want a business partner in their primary carrier, not a “silent partner.” Many of the better carriers often will consider (and implement) policy changes even days or weeks before a bankruptcy filing to clarify policy language for the potential benefit of the insureds. Those are the types of carriers that a director or officer wants on his or her side.
Do You Have Enough Coverage?

 

This can be the most worrisome aspect to any director or officer caught up in a corporate storm. Unfortunately, this is also an area that is confusing because there are often no clear or “right” answers as to what limits should be purchased.

 

The most important thing a director or officer can do in this regard is ask many questions of management. Common sense suggests that for a $1 billion public company, $20 million of D&O insurance likely does not make sense. Similarly, for companies with substantial debt and perhaps not a lot of cash on hand, a low D&O limit also would not make sense. In addition to common sense, there are other available metrics directors and officers can consider. Very often, an experienced D&O broker can perform an exercise called benchmarking, which is designed to create an apples-to-apples comparison of the D&O insurance purchased by similarly situated companies. Thus, a company can look to a competitor in its space, or at its size, to determine what type and level of D&O insurance comparable companies have purchased. Finally, many larger companies with public debt or equity exposure can perform “mock” damages analyses to understand what a potential securities claim against them might look like from a damages and defense cost perspective. The variable here is that the cost of a simultaneous regulatory or criminal investigation, as discussed below, can vastly skew those amounts.

 

Can a company increase the limits of its D&O coverage midterm, or even after bad news surfaces? This is a question we often get. The answer is that it depends on the facts and the circumstances of the particular situation. Sometimes the circumstances a company faces are not so dire, and carriers will cooperate with the company’s desire to protect its directors and officers by agreeing to increase the limits of its tower (for a price, of course). Other times, the situation may be so severe that a request to increase limits will be politely declined. The later polite declination really proves our point. Directors and officers should ask questions up front regarding coverage amounts, and not wait until the corporate ship starts to keel over to request higher amounts. By then it might be too late.

 

Coverage for Regulatory and Criminal Investigations

Troubled companies often encounter a simultaneous regulatory (SEC/DOJ) or criminal investigation at the same time they are facing civil litigation. This is the potential “double whammy” of defense costs, which often can run into the millions depending on the situation. Thus, directors and officers need to know what sort of coverage their D&O insurance provides for such investigations because, to the extent such investigation constitutes covered loss under the D&O policy, every dollar spent on investigations will generally reduce the overall limits available to ultimately settle the underlying litigation.

 

The rules of the road are well established in this area. Directors and officers are generally covered under the company’s directors and officers insurance for regulatory and criminal investigations and inquiries. Corporations are generally not covered for their involvement in such situations, unless individual directors or officers are also simultaneously named in the investigation (these rules of the road are often different in the private equity space, which is beyond the scope of this article). Specialized policies in the D&O marketplace exist to cover regulatory and criminal investigation in those situations where only the company is named, though those policies are reported to be expensive. All other things being equal, a director or officer should ensure that he or she is covered for regulatory and criminal investigations and inquiries.

Why Does the Insured Versus Insured Clause (and Its Carve-outs) Really Matter?

The insured versus insured clause has been included in D&O policies for a long time. It finds its genesis in a carrier’s need to guard against collusive lawsuits brought by one insured (say, for instance, the company) against another insured (like a director or officer), solely designed to get to the proceeds of the company’s D&O policy.

 

Indeed, carriers may have valid reasons for not wanting to cover these types of lawsuits. But there are other types of potential “insured versus insured” lawsuits that should be covered (and thus “carved-out” of the insured versus insured exclusion) because they generally would not be collusive (and normally are just as hotly contested as suits brought by traditional third parties). Here is a list of certain types of lawsuits which we believe should be explicitly covered under the D&O policy (i.e., carved-out) to protect the interests of the directors and officers.

 

1. Shareholder derivative actions

2. Suits that generally arise in bankruptcy when bankruptcy-formed constituencies, such as creditors’ committees, bondholder committees, or equity committees bring an action derivatively on behalf of a bankrupt company for alleged breaches of fiduciary duty by the company’s directors and officers. Similarly, suits by trustees, liquidators and receivers against directors and officers should also be covered. As we have seen from very high-profile suits involving companies like The Tribune Company, Extended Stay, and BearingPoint, bankruptcy-formed constituencies and trustees have become much more aggressive and litigious over the years, and the threat of such suits simply cannot be ignored.

3. Whistleblower suits brought under the provisions of either Sarbanes-Oxley or Dodd-Frank.

 

What is Non-Rescindable Side A Coverage?

There are two general coverage sides to a D&O policy (leaving for another day the concept of outside director coverage). Coverage “Side A” is for non-indemnifiable loss, meaning loss for which a company cannot indemnify or is financially unable to indemnify. Under this side, the directors and officers are the insureds. Coverage “Side B,” on the other hand, is for indemnifiable loss. Under this side, the company is insured for securities claims.

 

Coverage Side A covers a range of different scenarios. For example, under Delaware law (where many corporations are incorporated), a company cannot indemnify its directors and officers for the settlement of a shareholder derivative action. And in bankruptcy, a company often will be unable to advance defense costs and to indemnify its directors and officers for claims. Indemnification claims by directors and officers against the company may be treated as unsecured claims that get pennies on the dollar, or may even be subordinated in certain circumstances.

 

As several of the noteworthy “financial fraud”-related bankruptcies have taught us, having “non-rescindable” Side A coverage is very important. “Non-rescindable” Side A coverage means what it says. Even in cases where a carrier may challenge as false statements made by a potentially complicit CEO or CFO in the company’s insurance application for D&O coverage (attaching to such application, for example, financial statements that later need to be restated), non-rescindable Side A coverage generally cannot be rescinded for any reason, which should allow the directors and officers to sleep better at night. Directors and officers should know that non-rescindable Side A coverage is generally standard in today’s D&O marketplace, and thus primary policies that do not have such coverage should be immediately updated.

 

What is Side A Excess Difference in Conditions Coverage (and Why Is It So Important)?

As noted above, having non-rescindable Side A D&O coverage is critically important. Having “Side A Excess Difference in Conditions” D&O coverage can be even more important. Why? This coverage reacts in two different, wonderful ways to protect directors and senior management.

 

First, it acts as “excess” Side A D&O insurance, meaning, in English, that it sits above the company’s traditional tower of insurance, and will pay Side A non-indemnifiable claims when the traditional tower is exhausted by either traditional indemnifiable claims or non-indemnifiable claims. Take, for example, a Company that has $50 million in traditional D&O coverage and $25 million of Side A Excess Difference on Conditions coverage, where $45 million of that insurance has already been exhausted by the settlement of a simultaneously commenced securities class action and SEC investigation. In such a case, the directors and officers would still have $30 million of Side A insurance to deal with, for example, the settlement of shareholder derivative litigation.

 

Second, most Side A Excess Difference in Conditions D&O Insurance has something called a “drop down” feature, meaning that if, for example, an underlying excess carrier refused to pay its limit of insurance for some coverage-related reason, the Side A Excess Difference in Condition carrier might have the contractual obligation to “drop down” and fill that layer. Thus, it is a critically important feature that potentially will help fill potential gaps in coverage. Also, note that most Side A Excess Difference in Conditions policies have very few exclusions (e.g., most do not have an insured versus insured exclusion), so they can be particularly helpful to directors and officers in navigating difficult claims.

 

What is the Priority of Payments Clause, and Why Is It Important?

A Priority of Payments clause specifies how a carrier should handle competing claims on a policy’s proceeds. For example, most Priority of Payments Clauses (some carriers call them “Order of Payments” clauses) specify that Side A claims get paid first, and then traditional Side B company reimbursement and indemnity claims get paid thereafter. Obviously, this approach is tremendously important to directors and officers who may need to defend themselves in securities class actions or bankruptcy-related or inspired litigation.

 

Some Priority of Payments clauses give the right to the company or a company officer (like a CEO or CFO) to “withhold” or “delay” payments made under Side B of a D&O policy until the time at which those payments are properly designated by the appropriate party. This type of discretion is potentially not a good thing. Why? Giving such potential discretion to the company or a company officer to withhold or direct payments under Side B of a D&O policy might be creatively viewed by some as giving the debtor in bankruptcy “a say” or “control” of the proceeds of the D&O policy, a situation that could be used by a creditor or other bankruptcy constituency to control or delay payments to the directors and officers under Side A of the Policy, again potentially leaving them without resources to pay their counsel. Years of experience counsels that carriers are very able to make policy reimbursement calls in bankruptcy settings, and the order of payments under a D&O policy should be left to them and not others.

 


Severability of the Application and Exclusions

The concept of “severability” is important in D&O policies for a simple reason: there are very often multiple insured persons under a D&O policy (often dozens), and it would be a bad thing if the wrongful, criminal, or even fraudulent conduct of one insured (say for instance a CFO who subsequently pleads guilty to “cooking the books”) could vitiate, void, or adversely affect coverage for the rest of the insureds under the policy. For this reason, most applications for D&O policies are fully severable (meaning statements made in the application by one insured person are generally not attributable to other directors and officers for the purpose of potentially rescinding coverage under the policy), and most “conduct exclusions” contained in D&O policies (like the fraud and criminal acts exclusion) are also fully severable as between insured persons, meaning one bad egg will not affect the coverage for the directors and management team.

 

Making a Better D&O “Mousetrap”

Admittedly, some of the above items are a bit difficult to understand conceptually for the non-insurance professional, and admittedly, directors and officers often have more pressing issues to deal with when trying to help their companies navigate through troubled waters. But as we have seen time and time again in our practice, very often D&O insurance becomes the lifeline for directors and officers when companies face trouble.

 

How can a director or officer stay on top of these issues in the most efficient manner possible? Here are a couple of suggestions:

 

(1) Ask the right questions to the right people, like the company’s risk manager, CFO, or general counsel, as to what is covered and what is not, and ask about the above issues to make sure you are comfortable that at least these points are properly covered. Again, common sense often prevails here, and if a director or officer does not like the answers he or she is getting, then corrective action should be demanded before it is too late to act.

 

(2) Make D&O insurance issues a board topic at least twice a year so that board members can stay abreast of coverage developments, options, and modifications.

 

(3) Make sure management sends out the company’s D&O program and tower of insurance at least once a year for a “tune-up.” In this area, coverage options often change, and better coverage can often be obtained so long as the right diagnosis is made by qualified persons such as an experienced D&O broker, or even sometimes, experienced outside counsel.

 

One of the more interesting recent developments in the world of corporate and securities litigation was the $139 million settlement of the News Corp. shareholders derivative suit. Not only is this settlement apparently the largest ever cash settlement of a shareholders derivative suit, but the entire amount of the settlement is to be funded by the company’s D&O insurance. In the latest issue of InSights, which can be found here, I take a detailed look at the News Corp. settlement and discuss the settlement’s significance and possible implications.

The improvement in the banking sector continued in the first quarter of 2013, according to the FDIC’s Quarterly Banking Profile for the first quarter of 2013, which the agency released on May 29, 2013. A copy of the Quarterly Banking Profile can be found here. Overall the industry reported aggregate first quarter net income of $40.3 billion, which represents a 15.8% increase in aggregate net income compared to the first quarter of 2012. More than half of the reporting institutions reported year-over-year increases in their quarterly earnings and the number of unprofitable banks dropped to 8.4% of reporting institutions, down from 10.6% in last year’s first quarter.

 

The agency’s May 29, 2013 press release about the Quarterly Banking Profile quotes FDIC Chariman Martin J. Gruenberg as saying that “Today’s report shows further progress in the recovery that has been underway in the banking industry for more than three years. We saw improvement in asset quality indicators over the quarter [and] a continued increase in the number of profitable institutions.”

 

Gruenberg also noted that there were “further declines” in the number of problem banks and bank failures during the quarter. The number of “problem institutions” did indeed decline again in the first quarter of 2013. (A “problem institution” is an insured depositary institution that is ranked either a “4” or “5” on the agency’s 1-to-5 scale of risk and supervisory concern. The agency does not release the names of the banks on the “problem” list.)

 

During the quarter, the number of problem institutions declined, from 651 at the end of 2012 to 612 at the end of the first quarter of 2013. The number of problem institutions has declined significantly from the end of 2010, when there were 884 problem institutions. The FDIC reports that the decline in the number of problem institutions in the first quarter of 2013 represents the eighth consecutive quarter in which the number of problem institutions declined. The aggregate assets that the problem institutions represent also decline during the quarter, from $233 billion at the end of 2012, compared to $213 billion at the end of the first quarter. (By way of comparison, the equivalent figure at the end of 2009 was $402 billion.)

 

Though the number of problem institutions has declined, so too has the number of banking institutions. The number of reporting institutions declined from 7,083 at the end of 2012 to 7,019 at the end of the first quarter. And so while the number of problem institutions is declining, the percentage of problem institutions remains stubbornly high. The 612 problem institutions at the end of the first quarter represents 8.7% of all reporting institutions (down slightly from 9.1% at the end of 2012). And so while the banking sector overall is improving, a troublingly large number of banks continue to struggle to recover.

 

One of the more noteworthy effects of the crisis that banking sector has been through over the last several years has been the dramatic shrinkage in the number of banks. At the end of 2007, there were 8,534 banking institutions, meaning that between December 31, 2007 and March 31, 2013, 1,515 banks went out of existence, representing a decline of over 17%. Yet despite that substantial decrease (resulting from closures, mergers and so on), there are still 612 problem institutions in the industry, as of March 31, 2013.

 

If there is some good news here about the persistently high number of problem institutions, it is that the numbers of bank that actually are failing finally seems to be declining. There were only four bank closures in the first quarter of 2013, the smallest quarterly number since the second quarter of 2008, when two banks failed. Year to date, there have been 13 failures in 2013, compared to 24 during the same period in 2012. 51 banks total failed in 2012. Overall, 478 banks have failed since January 1, 2008.

 

The banking industry as a whole remains on the road to recovery. However, the problems from the credit crisis continue to haunt the industry. The number of problem institutions, though improving both in absolute numbers and in percentage terms, persists at an elevated level.

 

A recurring D&O insurance coverage issue is the question of whether or not the D&O insurance policy provides coverage for a plaintiffs’ fee award. The question often arises in the context of a settlement of a shareholders’ derivative suit that includes an agreement to pay the plaintiffs’ attorneys fees as part of the settlement. In many instances, the settling company’s D&O insurer will contest coverage for the plaintiffs’ attorneys’ fees.

 

In a May 28, 2013 Law 360 memorandum by Anthony Tatum and Shelby S. Guilbert, Jr. of the King & Spalding law firm entitled “Securing D&O for Attorneys’ Fees in Securities Cases” (here, subscription required), the authors present their views on this recurring coverage issue. The authors contend that “the plain language of most D&O policies, as well as the reported cases where this issue has been litigated, demonstrate that plaintiffs’ attorney’s fees should be covered.”

 

Carriers rely on several arguments when they contend that the plaintiffs’ fees are not covered under the policy. The principal argument on which they rely is that the plaintiffs’ attorneys’ fees portion of a derivative settlement represents a cost the company incurred in order to secure the benefits obtained for the company in the derivative lawsuit. The insurers argue that because the fees represent the cost of procuring a benefit for the company, they do not represent “damages” or otherwise represent covered “Loss” under the policy. Carriers will also sometimes argue further that under the “American rule,” each party to civil litigation bears its own costs, and so the agreement to pay the plaintiffs’ attorneys’ fees is a voluntary payment rather than a “Loss” to the company.

 

In their article, the authors argue that the typical D&O insurance policy has a very broad definition of Loss, typically including “damages, settlements, judgments and defense costs.” This broad definition typically contains no restriction or limitation removing plaintiffs’ attorneys’ fees from the definition of “Loss.” The authors assert that “when D&O insurers include broad definitions … but fail to specifically bar recovery of plaintiffs’ attorney’s fees, D&O policyholders have a compelling plain language argument that plaintiffs’ attorneys’ fees are covered loss.”

 

The authors argue further that, in addition to the policy language, “case law also generally supports the view that plaintiffs’ fees are covered loss.” The authors review at length the 2011 opinion of the First Department of New York’s Appellate Division in XL Specialty Insurance Co. v. Loral Space & Communications (here), in which the intermediate appellate court held that an insured’s payment of attorneys’ fees to plaintiffs’ counsel in a derivative lawsuit was covered loss, even though the lawsuit arguably benefitted the insured company. The authors also review two other decisions from other jurisdictions that the authors contend are “consistent” with the Loral case.

 

The authors conclude, with respect to the cases  they reviewed, that

 

The takeaway from all of these cases is that consistent with the plain language of most D&O policies, courts generally view plaintiffs’ attorneys’ fees as just another type of damages. Plaintiffs’ attorneys’ fees fall squarely within the scope of most D&O policies’ definitions of key terms like “loss,” “damages and “claim,” and unless a D&O policy specifically excludes coverage for plaintiffs’ attorneys’ fees, such fees should be covered.

 

Policyholders are unanimous in their agreement with the authors’ views of this issue. In my experience, policyholders are shocked to learn that the carriers would even try to contend that the plaintiffs’ attorneys’ fee portion of a derivative settlement would not be covered. Nevertheless, while I am generally on the policyholder side of these issues these days, I do think it is important to note that the questions surrounding these issues have not been quite as definitively resolved as the authors suggest in their memo.

 

Among other things, it is very important to note that while a majority of three judges in the Loral case did conclude that the plaintiffs’ attorneys’ fees were covered, the ruling was accompanied by a spirited dissent by two other judges who argued strenuously that the fees should not be covered under the policy. As I discussed in a prior post regarding the decision (here), the dissent said that in order for the derivative fee award to be covered, it would have to represent "an actual loss, not an expense or the cost of doing business." The dissent reasoned that in this case, Loral "did not sustain a loss but rather benefitted from the judgment."

 

A fee award a derivative suit, the dissent observed, represents "the equitable entitlement of the successful derivative plaintiff to recover the expenses of his/her attorneys’ fees from all the shareholders of the corporation on whose behalf the suit was brought." The dissent observed that "if not spreading the cost of attorneys’ fees sounds in unjust enrichment, the obvious corollary is that shifting the cost to shareholders as a group cannot be characterized as a loss."

 

At a minimum, the vigorous dissent in the Loral case shows that judicial views on this issue are hardly uniform, and in view of the close vote in the case at the intermediate appellate level, the state of the law on these issues arguably is not settled. The narrowness of split between the majority and the dissent on this issue suggests that this dispute is far from resolved. The underlying issue is likely to continue to be debated in other cases.

 

I have long wondered whether all would be better off if this issue were addressed in the policy, along the lines of the way the industry developed a policy solution to the contentious issue that Section 11 settlements were not covered under the Policy. The way the industry addressed that issue is that it became standard to include in public company D&O policies language stating that the insurer would not take the position that a settlement of a ’33 Act case was not covered under the Policy. Perhaps the industry will adopt a similar approach on this derivative lawsuit fee award issue.

 

In the meantime, while we await a solution to this issue in the policy, policyholders will continue to argue that amounts agreed to in payment of plaintiffs’ attorneys’ fees in derivative settlements represent covered loss under the policy.

 

I would be very interested in hearing from others on this issue, particularly readers on the insurer side of the aisle who may have a different perspective on this recurring issue.

 

In two decisions last week – one in the Sixth Circuit and one in the First Circuit – federal appellate courts set aside lower court dismissals of securities class action lawsuits. Although the two cases are different and the two appellate opinions address different legal issues, the two decisions both seem to suggest a similar message to the lower courts to be a little less hasty in dismissing cases.

 

The Sixth Circuit opinion is particularly interesting, because the Court not only articulated a very precise (and plaintiff-friendly) standard for pleading strict liability in a Section 11 claim, but also expressly declined to follow the Second and Ninth Circuits on the Section 11 pleading requirements, setting up a split in the circuits that could attract the attention of the U.S. Supreme Court.

 

The Sixth Circuit Opinion

On May 23, 2013, a unanimous three-judge panel of the Sixth Circuit entered an opinion affirming in part and reversing in part the lower court’s dismissal of a securities class action lawsuit against Omnicare and certain of its directors and officers. As discussed here, the case has an extended  procedural history, and the recent appeal represents the case’s second trip to the Sixth Circuit.

 

The specific issue before the appellate court in the most recent appeal involved the question of what plaintiffs are required to plead in order to establish a claim under Section 11. The plaintiffs claimed that in connection with a December 2005 securities offering, the company’s offering documents had falsely stated that the company was in compliance with legal requirements, when the company was in fact engaged in a variety of illegal activities including kickback arrangements with pharmaceutical companies and the submission of false claims to Medicare and Medicaid.

 

In February 2012, the district court granted the defendants’ motion to dismiss, finding that the plaintiffs were required but failed to plead that the defendants knew that the statements about the company’s legal compliance were false. The plaintiffs appealed the dismissal to the Sixth Circuit. On appeal, the plaintiffs argued that Section 11 provides for strict liability and it was therefore inappropriate for the district court to require them to plead knowledge in connection with their Section 11 claim.

 

The defendants, in reliance on the Second Circuit’s 2011 decision in Fait v. Regions Financial Corporation, as well as Ninth Circuit case authority, argued that in order to plead a Section 11 claim, the plaintiffs not only had to plead not only that the allegedly misleading statement was objectively false, but also that the defendants “disbelieved” the statement – that is, that the plaintiffs had to plead both objective and subjective falsity.

 

The Sixth Circuit rejected the defendants’ arguments, noting that, by contrast to Section 10(b) and Rule 10b-5, which require a plaintiff to plead scienter, Section 11 is “a strict liability claim,” adding that “once a false statement has been made, a defendant’s knowledge is not relevant to a strict liability claim.” Under Section 11, the Sixth Circuit said, “if the defendant discloses information that includes a material misstatement, this is sufficient and a complaint may survive a motion to dismiss without pleading knowledge of falsity.”

 

The Sixth Circuit expressly declined to follow the Second and Ninth Circuits, based on its observation that those courts had misinterpreted the U.S. Supreme Court’s 1991 decision in Virginia Bankshares, Inc. v. Sandberg. By contrast to the Second Circuit’s interpretation of the Virginia Bankshares case, the Sixth Circuit said the Virginia Bankshares case “was not faced with and did not address whether a plaintiff must additionally plead knowledge of falsity in order to state a claim.” Moreover, the Virginia Bankshares case involved a Section 14(a) claim, rather than a Section 11 claim. The Sixth Circuit observed that “it would be unwise for this Court to add an element to Section 11 claims based on little more than a tea-leaf reading in a Section 14(a) case.” Accordingly, the Sixth Circuit refused to extend Virginia Bankshares to impose a knowledge of falsity requirement in a Section 11 claim.

 

The Sixth Circuit concluded that the plaintiffs’ allegations of Omnicare’s alleged misrepresentations regarding its legal compliance were sufficient to state a claim under Section 11, reversed the district court’s dismissal on the ground, and remanded the case to the lower court. However, the Sixth Circuit did affirm the district court’s dismissal of the plaintiffs’ GAAP-based misstatements and omissions.

 

The First Circuit’s Opinion

On May 24, 2013, a unanimous three-judge panel of the First Circuit (including former U.S. Supreme Court Justice David Souter, sitting by designation), in an opinion written by Judge Jeffrey Howard, entered an order vacating the dismissal of the securities class action lawsuit pending against CVS Caremark.

 

CVS Caremark was formed through a March 2007 merger between CVS Corp. and Caremark Rx Inc. The plaintiffs alleged that the success of the merger depended on the success of integrating the two companies’ operations. The plaintiffs allege that following the merger, the defendants made a number of statements about the success of the integration efforts and the level of service provided to important pharmaceutical services customers. In particular the plaintiffs cited a number of statements following the merger about the successful integration of the two companies’ computer systems and operations.

 

The plaintiffs allege that these statements concealed problems the company was having with computer integration. The plaintiffs allege that integration problems resulted in the company’s loss of major clients whose business was worth $3 billion in annual revenues to the company. The plaintiffs allege that the truth about the company’s problems was revealed in a November 5, 2009 conference call with analysts. In the call, the company’s CEO, Thomas Ryan announced, among other things, that the company had suffered “some big client losses” and that “service issues” had led to the loss of at least one of the large clients. Ryan also announced that due to the loss of business, the company would not make its previously announced projected growth in earnings per share. Ryan also announced the unexpected retirement of the head of the “chief architect” of the merged companies’ integrated business model.

 

In their securities class action complaint, the plaintiffs alleged that Ryan’s statements revealed that the company’s failure to integrate the predecessor companies’ operations had resulted in the loss of billions of dollars of customer contracts. In support of this allegation, the plaintiffs cited several analyst reports, which among other things, stated that the company had “stunned” the marketplace with the information about the loss of customer business and “the breakdown” of the Caremark business model. Following the November 5 conference call and quarterly earnings announcement, the company’s share price declined 20 percent.

 

The district court granted the defendants’ motion to dismiss, holding that the plaintiffs’ complaint did not plausibly allege that Ryan’s statements in the November 5 call caused the drop in the company’s share price, with one exception – Ryan’s statements that the company would not make the projected growth in earnings per share. However, because this projection was a protected “forward looking statement,”’ it could not form the basis of a claim against the defendants. The plaintiffs appealed the district court’s ruling, except that they did not appeal the district court’s conclusion regarding the forward looking statement.

 

On appeal, the plaintiffs argued that Ryan’s statements in the November 5 call represented a concession that the post-merger integration had been less successful than the company had claimed and the resulting service quality issues and loss of client business were due to these integration difficulties. The defendants argued that the November 5 conference call did not represent a “corrective disclosure” because Ryan never said that there were integration problems; that the market was previously aware of the customer losses; and that the plaintiffs cannot bootstrap their theory that Ryan’s statements in the November 5 call caused the share price decline by relying on statements from analysts’ reports.

 

In its May 24 opinion, the First Circuit vacated the district court’s dismissal and remanded the case for further proceedings. In concluding that the plaintiffs had plausibly alleged that the November 5 call had revealed the company’s problems with service and systems integration, the First Circuit cited a number of factors: first, during the call, Ryan had for the first time revealed that “service issues” had led to the loss of contracts; second, the market reacted with “alarm” to the news of the magnitude of the company’s lost business and the problems that led to the loss; and third that the unexpected retirement of the “architect” of the integration “alerted the market to problems” with the integrated business.

 

The Court concluded that the plaintiffs’ allegations “indicated that the drop in CVS Caremark’s share price was causally related to its misstatements regarding the integration of CVS and Caremark, and these allegations are sufficiently plausible to foreclose dismissal.”

 

However, the defendants also argued that the plaintiffs had not sufficiently pled an actionable misstatement or omission and also had not sufficiently pled scienter. Accordingly, rather than reversing the district court’s opinion, the appellate court merely vacated the district court’s dismissal, for the court “to consider alternative grounds for dismissal if it chooses.”

 

Discussion

In each of these two cases, the appellate courts set aside the district court’s dismissal of the respective plaintiffs’ securities class action lawsuits. Although the two appeals involved different facts and presented different legal issues, there arguably is a common message to the district courts in the two appellate opinions. In that regard, it is worth noting the concurring opinion of Northern District of Ohio Judge James Gwin in the Omnicare case (Gwin sat by designation on the Sixth Circuit panel that heard the Omnicare appeal).

 

Judge Gwin wrote separately to underscore district courts’ discretion under Fed. R. Civ. Proc. 54(b) to revive previously dismissed claims while the case remains pending if newly discovered evidence so warrants. In making this point, Judge Gwin cited Fed. R. Civ. Proc. 1, which states that district courts are charged with enforcing rules “to secure the just, speedy, and inexpensive determination” of an action. Judge Gwin concluded his concurring opinion by noting, with reference to Fed. R. Civ. Proc. 1, that “there’s a reason that ‘just’ precedes ‘speedy’”.

 

To paraphrase Judge Gwin, the message to the district courts seems to be – slow down there, not quite so speedy with the dismissals. That is, for all of the statutory and case law hurdles that the plaintiffs must overcome in order to try to state a securities claim, a quick dismissal still is not always going to be the appropriate outcome. As formidable as the obstacles are, the obstacles are not insurmountable.

 

The Sixth Circuit’s holding in the Omnicare case is particularly interesting, and seemingly holds open the prospect that it will be substantially easier for Section 11 claimants in the Sixth Circuit to state a claim that it will be for Section 11 claimants in the Second and Ninth Circuits. In a May 24, 2013 column on her On the Case blog,  here, Alison Frankel quotes the defense counsel in the Omnicare case as saying that the Sixth Circuit’s ruling could “open the floodgates” for litigation in the Circuit.  The split in the Circuits, and the stark fact that claims that could go forward in the Sixth Circuit will not go forward in the Second and Ninth, seems likely to attract the interest of the U.S. Supreme Court – particularly since the apparent split appears to be the result of directly conflicting interpretations of the U.S. Supreme Court’s decision in the Virginia Bankshares case.

 

Although the two appellate cases were quite different from each other in a number of respects, it is interesting to note that both cases involved companies in the pharmaceutical business. That is, they both parts of the larger life sciences sector that has so consistently attracted securities class action litigation over the years (refer for example here). In the past, it has been reassuring that though companies in the life sciences sector disproportionately attract litigation, the cases filed in the sector seemed to also involve a relatively high dismissal rate. The outcome of these two appeals, at least, suggests that at least these some of the dismissals (that is, these two cases, for instance) may not have been warranted.

 

It is important to note that though these respective plaintiffs have succeeded in having the district court dismissals set aside, the plaintiffs are a long way from home. In particular, the parties in the CVS Caremark case will have to go back to the district court and wrangle over threshold questions such as whether or not the plaintiffs have adequately alleged misrepresentation and scienter. The plaintiffs in the Omnicare case, having weathered their second appeal in the case, will have to go back and continue to prosecute their claims in the case, which have now been pending for years. There is nothing that says that the plaintiffs in either case will every have anything to show for their efforts.

 

Even though the plaintiffs prevailed in these appeals, these cases serve as a reminder of how challenging it is for securities class action plaintiffs and their lawyers to take on one of these kinds of lawsuits. The claims not only face formidable legal and procedural obstacles but also require the claimants and their counsel to be willing to carry the case for years. Whether or not the Sixth Circuit’s opinion in the Omnicare case will “open the floodgates,” any prospective claimant seeking to rely on the decision will still have to be come prepared with copious reserves of endurance and perseverence.

 

Special thanks to a loyal reader for sending me a copy of the Sixth Circuit opinion.

 

As discussed in an article in the Sarasota Herald Tribune (here), on May 22, 2013, a Middle District of Florida jury returned a verdict against Sarasota law firm Icard Merrill, and one of its partners, Robert Messick, in a legal malpractice action arising out of the collapse of the failed First Priority Bank of Bradenton, Florida.

 

The FDIC had claimed that Messick had represented multiple parties in a single loan transaction that had cause a significant loss to the bank. The FDIC, in its role as receiver for the failed bank, had sought damages of over $4 million, but the jury reduced the damage award to $1.2 million. The trial court is now considering post-trial motions. The May 23, 2013 press release from the law firm that had represented the FDIC in the case can be found here.

 

According to the FDIC’s professional liability lawsuits page on its website (here), legal malpractice cases are among the 51 actions that the agency has authorized above and beyond the actions the agency has authorized to be filed against the former directors and officers of failed banks. As discussed here, in at least one failed bank lawsuit the agency has filed, the agency’s complaint named as defendants certain former directors and officers of the bank and also named as defendants the bank’s former outside General Counsel and former outside law firm. In addition to negligence, gross negligence and breach of fiduciary duty claims against the former directors and officers, the FDIC’s complaint alleged legal malpractice claims against the former General Counsel and his law firm.

 

While it is clear that the FDIC intends to pursue attorney malpractice claims as part of its litigation approach in the current bank failure wave, the FDIC’s pursuit of legal malpractice claims does not seem to as significant component of the agency’s litigation strategy as it was during the S&L crisis. Information on the FDIC’s website shows that during the S&L crisis, the agency and the RTC filed a total of 205 attorney malpractice suits in connection witih  10 percent of all failed institutions. From those cases and some prelitigation settlements, the agencies recovered more than $500 million, averaging about $2.5 million for each suit filed. The primary source of recovery in most of the cases was attorney malpractice insurance policies.

 

The agency clearly aims to include attorney malpractice claims and recoveries this time around. It just seems that the attorney malpractice claims will not loom as large as part of the agency’s failed bank recoveries as they did during the S&L crisis. The agency does not appear to be filing nearly as many legal malpractice claims this time around, either in absolute numbers or as a percentage of bank failures.

 

In part this decline in the number of failed bank legal malpractice actions may be due to one important change in the relationship between bank’s outside counsel and the bank’s board. Prior to the S&L crisis, it was quite common for a bank’s outside counsel to sit on the bank’s board. The potential conflict in responsibilities led to many of the claims that the FDIC and the RTC filed during the last bank failure wave. Since then, it became much less common for outside counsel to serve on bank’s boards. So a factor that led to many of the claims during the S&L crisis simply is not present for nearly as many of the bank failures during the current bank failure wave.

 

The Coming Hurricane Season: Once again, the NOAA has released its predictions for the upcoming hurricane season. According to NOAA’s May 23, 2013 release, the agency is predicting an “active” Atlantic hurricane season with as many as 3 to 6 major hurricanes. In a conversation with an industry colleague about the agency’s predictions, I expressed my skepticism about the reliability of the agency’s and even suggested that the entire prediction effort had very low value.

 

My friend took my criticisms as a challenge, and managed to locate and send to me a link to a very interesting September 2011 blog post from a Houston Chronicle blog called SciGuy. The post can be found here. Although the blog post analysis shows that NOAA’s hurricane prediction track record is better than a random guess, it has only been slightly better than a random guess. On the other hand, hurricane seasons are much more variable than anyone but a meteorologist might predict, so in that respect it is quite something that the agency has managed to perform as well as it has.

 

While I will concede that this detailed analysis proves that the agency’s predictions have predictive value, the agency’s track record is only slightly better than a random guess. The math may validate the agency’s efforts but given how slight the predictive value is, I reserve my right to continue to contend that the entire prediction effort has very low value.