Smaller companies increasingly are the subject of data breaches  and those smaller companies “are the number-one target of cyber-espionage attackers,” according to a recent study detailed in a April 24, 2013 CFO.com article entitled “Should You Consider Cyber Insurance?” (here). Smaller companies increasingly are the subject of cyber attacks due to “inadequate security infrastructure for protecting financial information, customer data and intellectual property.”

 

As the cyber threats “become more pervasive,” smaller businesses are “taking out insurance policies designed to bolster their protection form the potentially crippling costs that can accompany data breaches and other cyber attacks.” Take up for this product is, according to the article, particularly strong for companies in the high-technology, financial services and health-care industries. As the article explains, these policies may be particularly valuable for smaller companies that lack the resources to undertake as robust of a preventive program as a larger company might.

 

As the article explains, the policies provide both first-party coverage (such as notification costs) and also protect against third party liability claims (such as lawsuits for damages). In a serious incident, this insurance protection, according to one commentator quoted in the article “can sometimes be a life-or-death issue for smaller companies.” The policies also cover forensic IT examinations to determine how a breach occurred and some policies even provide for public relations services to mitigate negative publicity. Again, these services could be particularly valuable for a smaller company that may not have sufficient crisis management resources available.

 

This type of insurance is of course no substitute for proactive cybersecurity risk management, “such as sound data-protection protocols and employee education.” In any event, as part of the application process, the insurance company will want reassurance that these kinds of efforts and protocols are in place. The insurance provides company owners and managers reassurance that the company will be able to weather the storm if problems do emerge.

 

According to the article, as news about cyber breaches become increasingly common, more and more companies will conclude that the cost-benefit analysis weighs in favor or purchasing this type of insurance.

 

In what the plaintiffs’ lawyers claim to be the largest derivative lawsuit settlement ever, the parties to the News Corp. shareholder derivative litigation have agreed to settle the consolidated cases for $139 million. The company also agreed to tighten oversight of the company’s operations and to establish a whistleblower hotline, as well as other corporate therapeutics. The cash portion of the settlement is to be funded entirely by D&O insurance. The settlement is subject to court approval.

 

The parties’ April 17, 2013 memorandum of understanding regarding the settlement can be found here. The plaintiffs’ lawyers’ April 22, 2013 press release in which, among other things, the plaintiffs’ lawyers state that the settlement is “the largest cash derivative settlement on record” can be found here. The lead plaintiffs’ press release can be found here. As reflected in the press releases as well as is stated in the many media reports about the settlement (refer for example, here), the entire cash portion of the $139 million settlement is to be funded by D&O insurance.

 

The first of the lawsuits against the News Corp. board was filed in Delaware Chancery Court in March 2011, asserting claims in connection with the company’s $675 million acquisition of Shine Group, Ltd., a U.K.-based television production company owned by Elizabeth Murdoch, daughter of News Corp. Chairman Rupert Murdoch. Elizabeth Murdoch allegedly made $250 million in the acquisition.. Later complaints expanded on claims relating to the Shine Group acquisition and  added extensive additional claims seeking to hold the company’s directors accountable for the scandal surrounding the company’s use and attempted cover-up of illegal reporting tactics of some News Corp. journalists in the U.K. The various cases were later consolidated in the Delaware Chancery Court.

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In their Third Amended Consolidated Complaint (here), the plaintiffs alleged that the company’s board’s oversight of the company’s affairs represented a “textbook example of failed corporate governance and domination by a controlling shareholder.” The complaint alleges that for years “the Board has condoned Murdoch’s habitual use of News Corp. to pursue his quest for power, control and political gain and to enrich himself and his family members, at the Company’s and its public shareholders’ expense.” The complaint alleges that the ongoing scandals have not only harmed the company’s reputation and cost it millions of defense costs and other expenses, but also that the company’s share price is artificially depressed because of the negative association of the company with Murdoch.

 

The defendants filed a motion to dismiss the consolidated amended complaint. The parties argued the motion to dismiss on September 19, 2012 (refer here). While the dismissal motion was pending, the parties engaged in mediation that ultimately resulted in settlement.

 

The plaintiffs’ lawyers claim that this is the largest cash shareholders’ derivative settlement ever, and I am certainly in no position to dispute that. I have been tracking derivative suit settlements for years. There have been several shareholder derivative suit settlements that were nearly as large as the News Corp. settlement but as far as I can tell none that were quite as big:

 

  • The El Paso/Kinder Morgan merger-related derivative suit settled in September 2012 for $110 million (refer here)

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  • In 2005, the Oracle derivative suit settled based on the payment by Oracle CEO Larry Ellison of a total of $122 million (refer here and here).

 

  • In September 2009, the parties to the Broadcom Corp. options backdating-related shareholders’ derivative suit agreed to settle the case, as to most but not all of the defendants, for the D&O insurers’ agreement to pay $118 million (as discussed here).

 

  • In September 2008, the parties to the 2002 AIG shareholders’ derivative lawsuit agreed to settle the case for a payment of $115 million (of which $85.5 million was to paid by D&O insurance) in what was touted at the time as the largest Delaware Chancery Court derivative lawsuit settlement (about which refer here).

 

These settlements are all dwarfed by the  $2.876 billion judgment entered in June 2009 against Richard Scrushy in the HealthSouth shareholders’ derivative lawsuit in Jefferson County (Alabama) Circuit Court, but that astronomical judgment represents its own peculiar point of reference, like some odd parallel universe. It also was of course a judgment following trial rather than a settlement.

 

Another peculiar point of reference is the $1.262 billion judgment that Chancellor Leo Strine entered in October 2011 the Southern Peru Copper Corporation Shareholder Derivative Litigation (about which refer here). That case also represents its own form of litigation reality, and it too represents a derivative suit judgment following trial, rather than a settlement.

 

Another derivative lawsuit resolution that is worth considering in the context of the “largest ever” question is the December 2007 settlement of the UnitedHealth Group options backdating-related derivative lawsuit. As discussed here, the lawsuit settled for a total nominal value of approximately $900 million. However, while the press reports at the time described the settlement as the largest derivative settlement ever, the value contributed to the settlement consisted of the surrender by the individual defendants of certain rights, interests and stock option awards, not cash value in that amount.

 

Aside from the question of the News Corp. derivative suit settlement’s sheer size, there is also the fact that the settlement was funded entirely by D&O insurance. Given the amount of the settlement, the settlement costs undoubtedly were distributed across the several carriers that participated in News Corp.’s D&O insurance program. This large settlement not only represents a serious and unwelcome development for the specific carriers involved but it also represents a potentially unwelcome event for the D&O insurance industry in general, for what it might represent as far as the severity potential of shareholders’ derivative litigation.

 

In the past, going back ten years or so, shareholders’ derivative suits typically did not present the possibility of significant cash payouts for D&O insurers, at least in terms of settlements or judgments. The cases did present the possibility of significant defense expense and also of the possibility of having to pay the plaintiffs’ attorneys’ fees, but by and large there was usually not a cash settlement component. As the significant examples above show, that has clearly changed in more recent years.

 

This trend gained particular momentum with the options backdating scandal. Many of the options backdating cases were filed as derivative suits rather than as securities class action lawsuits (largely because the options backdating disclosures did not always result in the kinds of significant share price declines required to support a securities class action lawsuit). Many of the options backdating cases settlements included a cash component, and as illustrated by the Broadcom case mentioned above, some of the options backdating derivative suit settlements included very substantial cash components

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The inclusion of a significant cash component has also been a feature of the settlements of some of the merger objection suits that have been filed as part of the current upsurge in M&A-related lawsuit that have been filed in recent years, as illustrated by the El Paso settlement mentioned above.

 

This upsurge in the number of derivative suit settlements that include a significant cash component can only be viewed with alarm by the D&O insurance industry. For many years, D&O insurers have considered that their significant severity exposure consisted of securities class action lawsuits. The undeniable reality is that in at least some circumstances, derivative suits increasingly represent a severity risk as well. And the settlement amounts themselves represent only part of the D&O insurers’ loss costs. The D&O insurers also incur millions and possibly tens of million of defense cost expense in these derivative suits. I can only imagine that in the News Corp. derivative suit, for example, that the cumulative defense expense was in the millions of dollars.

 

An even more concerning aspect of the rise of significant cash settlements in derivative cases for D&O insurers is that these settlement amounts represent so-called “A Side” losses. That is, the losses are paid out under the portion or the D&O insurance policy that provide insurance for nonindemnifiable loss. A derivative suit settlement obviously is not indemnifiable, because if it were to be indemnified, the company’s would make the indemnity payment to itself. For the “traditional” D&O insurance carriers, there is perhaps no particular pain associated with the fact that the loss is paid under the “Side A” portion of the policy, as opposed the other policy coverage (that is, the “Side B” or “Side C” coverage that are more typically called into play). But these days many companies carry –in addition to their traditional D&O insurance that includes all three coverages (that is, they include Sides A, B and C coverage) — additional layers of excess Side A insurance.

 

This excess Side A insurance would not be available to provide funding for, say, a securities class action lawsuit, at least if the corporate defendant were solvent, because the settlement of a securities class action lawsuit is an indemnifiable loss to which coverages B and C might apply but to which coverage A does not apply. However, the Side A coverage does apply to a shareholders’ derivative lawsuit settlement because the settlement amount represents a nonindemnifiable loss. So while a jumbo securities class action settlement typically would not trigger coverage under an Excess Side A policy, a jumbo derivative settlement would trigger the Excess Side A policies.

 

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

 

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

 

Dan Fisher has an interesting April 22, 2012 article in Forbes (here) discussing the questions associated with the funding of this type of settlement exclusively through D&O insurance.

 

Finally, as Alison Frankel points out in an April 22, 2013 post on her On the Case blog (here), the News Corp. settlement includes what she describes as an “historic concession”: in the settlement, News Corp. agreed “to disclose its campaign and political action committee contributions to shareholders and its lobbying and Super PAC spending to the board.” Frankel quotes sources to the effect that the News Corp. case represents the first time that a derivative lawsuit has been used as a vehicle to obtain enhanced disclosure of corporate political spending.

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What are the factors that affect the timing of securities class action lawsuit dismissals and that affect the timing and size of securities suit settlements? These are the questions examined in an April 2012 PLUS Journal article entitled “When Are Securities Class Actions Dismissed, When Do They Settle and For How Much? An Update” (here) by Stanford Law School Professor Michael Klausner and his colleagues Jason Hogland and Matthew Goforth. In this article, the authors update their earlier research on these same questions.

 

In order to examine these issues, the authors examined the 652 securities class action lawsuits filed between 2006 and 2010. Of the 652 cases, 119 (18%) are ongoing, 257 (40%) have settled, 206 (32%) have been dismissed with prejudice, and 74 (11%) have been voluntarily dropped. Disregarding amounts paid in settlement by third parties (such as offering underwriters), of the cases from this period that settled, the mean settlement amount is $36 million and the median is $9 million.

 

The authors followed the progression of these cases through the motion to dismiss stage. They found that, among other things, as a result of a combination of dismissal motion rulings, voluntary withdrawls and settlements reached before a dismissal motion ruling, over half of all securities class action lawsuits “end well before discovery and before even a second complaint is filed.”

 

In 25% percent of cases, the motion to dismiss is granted with prejudice, on average within 19 months of the date on which the complaints were first filed. An additional 9% of cases were voluntarily dropped before the dismissal motion was heard, and another four percent were dropped after the motion to dismiss was granted without prejudice. Thus, a total of 38% of cases “ended relatively quickly and painlessly for defendants.”

 

In addition, another 13% of cases settled before the motion to dismiss was heard and another 2% of cases settled after the court granted a motion to dismiss without prejudice but before the plaintiffs filed an amended complaint. These cases “entailed costs to defendants and their insurers, but they did not involve extended litigation.”

 

In 34% of cases, the court granted the motion to dismiss without prejudice, of which 85% of plaintiffs filed a second complaint. The outcome of the second complaint cases roughly parallels the outcomes at the first complaint stage. On average about 30 months passed between the initial filing and the resolution of these second complaint stages. Only five percent of cases reached the third complaint stage, and even fewer involve subsequent complaints. The authors conclude that “relatively few cases entail the filing of a second, third or later consolidated complaint.”

 

Of all cases that are ultimately dismissed with prejudice, 66% are dismissed at the first complaint stage, 28% are dismissed at the second complaint stage, and 6% are dismissed at the third complaint stage. (Only one case was dismissed at the fourth complaint stage and one was dismissed at the fifth complaint stage.)

 

Certain factors clearly affect the likelihood of dismissal. For example, when a securities suit involves a parallel SEC enforcement action, the class action was dismissed in only 12% of cases. Cases that involved restatements “were dismissed less frequently than cases that involve non-restatement accounting issues, which in turn were dismissed less frequently than are non-accounting cases.”

 

In looking at the timing of settlement, the authors categorized the procedural stages of the cases as early pleading (that is, up through the first dismissal motion ruling), later pleading (involving the pleading stages following the first ruling but before the final determination), and discovery (involving the period after the dismissal motion has finally been denied). Forty three percent of settlements occur in the early or late pleading stage, that is while there is still a possibility of dismissal. Just under 60% of settlements occur in the discovery stage, some shortly after the motion to dismiss is denied.

 

For cases that settle after the motion to dismiss is denied, the time it takes the cases to settle ranges from one month to 46 months, but the mean length of time for a case to settle after the dismissal motion is denied is 16 months.

 

The authors found that settlement size is related to settlement timing. Settlement size increases as the cases move through the early pleading stage to the discovery stage. The mean settlement for cases that settle in the discovery stage is over $60 million, while the mean settlement of cases that settle in the early pleading stages is less than $20 million.

 

However, though the settlements tend to grow larger as the cases progress, the settlements as a percentage of shareholder losses decline as the cases advance through the various stages. The authors attribute this seeming contradiction to company size, as larger companies tend to settle later than smaller companies. Though cases involving larger companies settle for larger amounts in terms of absolute numbers of dollars, smaller companies tend to settle for a larger fraction of shareholder losses.

 

The authors concluded by noting that their findings in this latest updated study are consistent with the finding in their prior study, which had focused on cases filed between 2000 and 2004. The authors note that “it appears that the forces shaping the patterns of dismissal and settlement over the past decade have remained stable.”

 

The SEC’s conflicts minerals disclosure rules, promulgated as required under provisions of the Dodd-Frank Act, became effective on January 1, 2013, requiring companies to make their first conflict minerals disclosures on or before May 31, 2014 for the 2013 reporting year, as I detailed in a recent post. But though it is widely recognized that the conflicts minerals disclosure requirements impose challenging compliance requirements on reporting companies, many companies have yet to commence their efforts to be prepared for the reporting deadline. In addition, there is some suggestion that the very existence of the requirements may be having the perverse effect of exacerbating the conditions that the disclosure requirements were intended to address.

 

The conflict mineral disclosure requirements are intended to identify the use in manufactured products of certain specified minerals from the Democratic Republic of Congo and adjacent countries. The four specific conflict minerals are tin, tantalite, tungsten and gold (the so-called 3TGs). The minerals are found in many high tech products. For example, tantalite is an essential part of most cellphones. The countries covered by the disclosure rules are, in addition to the DRC, Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia (the “Covered Countries”)

 

On a positive note, some companies are in fact undertaking aggressive efforts to try to be able to determine whether its parts suppliers on rely on conflicts minerals. For example, as described in an April 15, 2013 post on the New York Times Bits blog (here), Hewlett-Packard has identified ore smelters around the world that are identified with its products in order to enable its part suppliers to ensure that their minerals were not obtained from conflict zones. (H-P’s April 15, 2013 announcement regarding the ore smelters can be found here.) H-P intends to rely on a third-party to audit the smelters documentation as a way to monitor the possible presence of conflicts minerals.

 

However, a recent article in the Wall Street Journal suggests how difficult it may be for companies to rely on documentation to monitor their parts suppliers’ compliance. In an April 14, 2013 article entitled “Inside Congo’s Link in the Gold Chain” (here), the Journal showed how easily smugglers are able to obtain false documentation for gold smuggled out of the DRC. Smuggler networks ferry gold out of the DRC to neighboring counties (such as Uganda or the South Sudan), where it is recertified and then flown to key entry points around the Middle East (particularly Dubai). As the Journal notes, “the faint paper trail disappears as soon as it arrives in Dubai.” In Dubai, the smuggled minerals are mixed into scrap bars, which are then sold for cash or smuggled into other countries.

 

Even worse, these highly profitable smuggling operations may be a direct result of the new disclosure requirements.  The disclosure requirements are built on the belief that if minerals’ source of origin is identified and disclosed, buyers can avoid minerals from the conflict regions. Because the flow of minerals is helping to finance the conflict within the DRC, the hope is that reducing the global market for the minerals will create incentives for peace there. However, as the Journal article shows, “the opportunities for illicit gains only increased” after Congress created the disclosure requirements with the Dodd-Frank Act. The smugglers’ potential profits are significantly boosted because the new disclosure requirements have “squeezed the legitimate market for the Congolese minerals.” Perversely, the requirements could actually increase the profits available for those trading in the conflict minerals.

 

Just to add to the confusion, the SEC’s conflicts minerals disclosure rules have been challenged in the courts. As I discussed previously, on October 19, 2012, the U.S. Chamber of Commerce and the National Association of Manufacturers filed a petition for review with the Court of Appeals for the District of Columbia requesting that the SEC’s rule be set aside in whole or in part. The challenge remains pending.

 

As if that were not enough, the situation could be even further complicated with the introduction of additional conflicts minerals rules from other countries and organizations. For example, Canada and the European Union are both considering new disclosure requirements that may differ from the U.S. requirements. The requirements under consideration in Canada could be broad than those in the U.S. and could include additional countries and minerals, raising the possibility of overlapping yet inconsistent rules, which has the potential to create confusion and inefficiencies.

 

With all of the murkiness surrounding the situation, many companies are slow of the mark in getting ready to meet the new disclosure guidelines. As discussed in an April 16, 2013 Compliance Week article (here), a recent PwC survey determined that many company have “intentionally delayed” conflicts minerals compliance efforts. Though of course there are companies (such as H-P) that are actively working to be able to meet the initial disclosure mandates, many other companies are, according to the PwC study, are “playing the waiting game.” Nearly 17 percent of respondents in the PwC survey “haven’t done much or are waiting to see what happens” with the legal challenge. As noted by a PwC representative in the article, “waiting until the legal challenge is resolved to begin compliance efforts is a huge gamble and n unwise approach.” There is a real concern that “many companies are getting too late a start to adequately meet the May 2014 deadline.”

 

In short, the landscape surrounding the conflict minerals disclosure requirements is fraught with peril. On the one hand, companies taking a more passive approach run a significant risk of being unable to meet the initial disclosure deadline. On the other hand, murky and potentially changing or conflicting requirements make it difficult for the companies to proceed efficiently. And finally, the complex and uncertain circumstances surrounding the global distribution of conflict minerals present significant challenges for all of the process participants to make the source of origin determinations that underlie the disclosure requirements mandate.

 

In other words, there is a great deal of risk surrounding the new disclosure requirements. The murkiness and confusion surrounding the requirements and the challenging nature of the compliance obligations suggest that, unless the courts set the requirements aside, the conflicts mineral disclosure requirements will become an increasing source of concern as the first disclosure deadline approaches.

 

I expect that conflicts minerals disclosure is going to an increasingly important source of comment and concern in the months ahead.

 

The fallout from the ongoing banking crisis continues to emerge, with the arrival in recent days of still more bank failures and of even more FDIC lawsuits involving failed banks. Unfortunately, the hopes that that all of the bank failures might be safely behind us, or, as I recently suggested on this blog, the hopes that we might be in a “lull” in the failing of failed bank lawsuits, have been dashed. As developments this past week show, banks continue to fail and the FDIC is continuing to actively pursue litigation against the directors and officers of failed banks – and even against the failed bank’s outside professionals.

 

With respect to the bank failures, the FDIC announced on its website this past Friday night the closure of three more banks, two in Florida and one in Kentucky. The two Florida banks are the Chipola Community Bank of Marianna, Florida and the Heritage Bank of Northern Florida of Orange Park, Florida. The Kentucky bank is the First Federal Bank of Lexington, Kentucky. Prior to the closure of these three banks on Friday, there had only been a total of five bank closures so far during all of 2013, and only two since February 1, 2013. It really did seem as if the bank failure wave might finally have played itself out and that the banking crisis of the past few years had safely moved into the moping up phase. These three latest bank failures suggest that the banking failure wave may yet have further to go and that we could continue to see still more bank closures as the year unfolds.

 

With respect to the failed bank lawsuits, just this past Tuesday I had noted that pace of the FDIC’s new lawsuit filings seemed to have slowed. In the preceding month, the FDIC had filed just one new lawsuit and the agency had filed only four new lawsuits since February 1, 2013. However, I did also note that late April 2010 had been a particularly busy period for bank failures and that during late April 2013 nearly two dozen banks would be reaching the third anniversary of their closure date. (The FDIC typically files its failed bank lawsuits close to the third anniversary owing to statute of limitations considerations.)

 

As I anticipated might happen given the number of bank closures in April 2010, this past week the FDIC filed at least two new failed bank lawsuits in connection with two banks whose third year anniversary date fell just after the date on which the FDIC filed its complaints.

 

First, on April 15, 2013, the FDIC filed a lawsuit in its capacity as a receiver for the failed City Bank of Lynwood, Washington filed a complaint against the bank’s founder and former CEO and against a loan officer in the bank’s real estate department. City Bank failed on April 16, 2010, so the FDIC filed its complaint the day before the third anniversary of the bank’s closure. In its complaint, a copy of which can be found here, the FDIC asserted claims against the two defendants for negligence, gross negligence and for breaches of fiduciary duties for “approving, in violation of the City Bank Loan Policy and prudent, safe and sound lending practices, at least 26 loans between May 2005 ad October 2008.” The FDIC’s complaint seeks damages of “not less than $41 million.” An April 16, 2013 Seattle Times article about the lawsuit can be found here.

 

Second, and also on April 15, 2013, the FDIC in its capacity as receiver of the failed Riverside National Bank of Ft. Pierce, Florida, filed a complaint in the Southern District of Florida against eight former directors and officers of the failed bank. Riverside National Bank also failed on April 16, 2010, so again the FDIC took it right down to the wire, filing its complaint the day before the three year statute of limitations period expired. In its complaint, a copy of which can be found here, the FDIC seeks to recover “in excess of $8 million” in damages caused by the defendants’ alleged breaches of duties, gross negligence and negligence “based on defendants’ permitting an excessive number of poorly underwritten loans to be made that were secured solely or largely by the stock of [affiliates of the bank’s holding company].” Owing to the familiarity with the circumstances involving these affiliates, the defendants “had personal knowledge of the dangers inherent in such stock loans.” An April 17, 2013 South Florida Business Journal article about the lawsuit can be found here.

 

So after filing only two lawsuits between March 1, 2013 and April 12, 2013, the FDIC filed two new lawsuits in a single day on April 15, 2013. As I noted in my recent post, there were 22 bank failures during the period between April 16, 2010 and April 30, 2010. I speculated that this large group of bank failures in a compressed period in late April 2010 might produce a flurry of new lawsuit filings during the last two weeks of April 2013; the arrival of these two latest lawsuit bears out this supposition and suggests that we may see further suits in the next few days as the third anniversary of these various April 2010 bank closures approaches. In any event, the arrival of these two new suits puts to rest any suggestion of a “lull” in the filing of new failed bank lawsuits.

 

In addition to these two latest lawsuits against former directors and officers of failed banks, the FDIC has also recently filed a lawsuit against the outside law firm of a failed bank. On March 15, 2013, the FDIC, in its capacity as receiver for the failed Orion Bank of Naples Florida, filed a lawsuit in the Middle District of Florida against the Nason Yeager Gerson White & Lioce law firm, and against two partners of the firm, Alan I. Armour II and Ryan P. Aiello. Orion Bank failed in November 2009. In its complaint, a copy of which can be found here, the FDIC alleges that the defendants “inexcusably failed to recognize a slew of glaring red flags.”

 

The complaint alleges that the bank had retained the firm in connection with certain loans to entities controlled by a local businessman, Francesco Mileto, a borrower who already owed the bank $43 million. The complaint alleges that by June 29, 2009, the date the new loans closed, the defendants “should have known that these loans were in fact the center of a conspiracy among the Bank’s officers to manipulate the Bank’s accounting, deceive the Bank’s Board of Directors … and illegally finance the purchase of stock in the Bank’s own holding company.” The “obvious red flags” did not dissuade the defendants from disbursing $26.5 million in violation of the terms and conditions of the loans and in violation of the law. The defendants’ allegedly “turned a blind eye to the Bank’s officers’ brazen disregard for the internal and legal constraints on their lending.” As a result, the bank allegedly sustained losses in excess of $31 million. The complaint asserts claims of legal malpractice, professional negligence and breach of fiduciary duty.

 

According to a April 17, 2013 South Florida Business Journal article about the lawsuit, here, Mileto and Orion Bank’s former CEO have both previously been sentenced to prison for inflating the bank’s capital levels through a scheme to purchase bank stock using  the proceeds of loans from the bank. 

 

The arrival of this lawsuit against the failed bank’s outside law firm is interesting. In many ways, the FDIC’s litigation approach during the current bank failure wave has been quite similar to the approach that the FDIC and the other banking regulatory agencies followed during the S&L Crisis. The one way the FDIC’s approach this time seemed to differ is that the last time around, the banking regulators had aggressively pursued the outside professionals that had advised the failed banks and the failed banks’ boards of directors. From my perspective, the FDIC has not been as aggressive in pursuing the FDIC’s outside professionals.

 

To be sure, there have been some noteworthy cases where the FDIC has filed claims against failed banks’ outside professionals. For example, as discussed here, in November 2012, the FDIC filed an action against PwC and Crowe Horvath, the former accountants for the failed Colonial Bank of Montgomery, Alabama. In addition, as discussed here, in the October 2011 lawsuit that the FDIC filed its capacity as receiver of the failed Mutual Bank of Harvey, Illinois, the FDIC’s complaint named as defendants not only certain former directors and officers of the bank, but also the bank’s outside General Counsel, who was also a director of the bank, and the General Counsel’s law firm.

 

But even though as these cases show there have been instances where the agency has pursued claims against failed banks’ former accountants or former lawyers, the FDIC has not as actively pursued claims against outside professionals as it did during the S&L crisis. The FDIC states on the professional liability lawsuit page on its website that, other than lawsuits involving the former directors and officers of failed banks, the agency has authorized an additional 51 lawsuits for “fidelity bond, insurance, attorney malpractice, appraiser malpractice, accounting malpractice, and RMBS claims.” The website does not specify from among these 51 additional authorized lawsuits how many relate specifically to attorney or accountant malpractice. The FDIC’s recent filing against the former outside law firm for the failed Orion Bank, as well as the prior two cases cited above, does show that at least in certain instances the FDIC does intend to pursue claims against failed banks’ outside attorneys and accountants.

 

In any event, with the FDIC’s filing of the latest two failed bank D&O lawsuits described above, the FDIC has now filed a total of 56 lawsuits against the former directors and officers of failed banks during the current bank failure wave, including 12 so far during 2013. The professional liability lawsuit page on the FDIC’s website states that as of April 12, 2013, the agency has authorized lawsuits against former directors and officers of in connection with 109 failed institutions, inclusive of the now 56 lawsuits involving 55 failed institutions that have already been filed. The gap between the number of suits authorized and the number filed suggests the possibility of as many as 53 additional lawsuits are yet to come. In addition, each month for the past several months, the FDIC has increased the number of lawsuits it has authorized, so the number of potential lawsuits in the pipeline likely is even greater than the current gap between the numbers of authorized and filed lawsuits suggests. In other words, it seems likely that we will continue to see the arrival of additional failed bank lawsuits in the weeks and months to come.

 

One final note. As I previously noted, in response to media pressure, the FDIC recently has added a new page to its website on which the agency has linked to settlement agreements that the agency has reached in connection with claims and lawsuits that agency has failed or asserted as part of the current bank failure wave. There is a lot of information in the settlement agreements to which the agency has linked on the page. As Joe Montelone notes in an interesting April 19, 2013 post on his blog, The D&O and E&O Monitor, the agency’s publication of these agreements on its website raises a number of interesting issues and presents some potential challenges for defendants and D&O insurers in other claims and lawsuits.

 

A Note to Readers: This past Wednesday, I added a new post about the $500 million settlement agreement that the parties reached in the Countrywide mortgage backed securities litigation. I composed and published the post while sitting in the boarding area at the Cleveland airport, waiting to board a delayed flight to Chicago (I spent quite a bit of time this past week sitting in airports waiting for various delayed flights). In my haste to publish the post before boarding the flight, I put the post up on my site with a typo in the blog post title – I referred to “Countrywide” as “Countywide.” I am grateful to a number of readers who caught the typo and who sent me notes about it. However, I have not corrected the error, for a very simple reason. If I were to make the change, the software running my blog would think I had added a new blog post, and would send out emails to all of my readers as if I had added a new post.

 

We all get too many emails. I don’t want to add to the burden by having a bunch of potentially confusing emails going out to all of my readers. Because I don’t want to burden everyone with a completely unnecessary email, I am just going to have to live with the typo. So – my apologies for the error, it is just one of the side effects of the way in which this blog is created, developed and maintained. I hope that readers can look at the typo and recognize that I am living with the embarrassment of the error rather than contributing to email pollution. My thanks to everyone who sent me notes about the typo. I always appreciate it when people help me out by spotting possible errors. In this instance, the error will have to stand uncorrected.

 

In what is the largest settlement so far of an mortgage-backed securities class action lawsuit filed as part of the subprime and credit-crisis securities litigation wave, the parties to the consolidated Countrywide mortgage-backed securities suit pending in the Central District of California have agreed to settle the litigation for $500 million. The settlement is subject to court approval. The plaintiffs’ lawyers’ April 17, 2013 press release describing the settlement can be found here.

 

The consolidated litigation that has been settled involves several different lawsuits and several different sets of claimants. Background regarding the litigation can be found here.  All of the claimants allege that they purchased mortgage-backed securities that had been issued by Countrywide prior to its acquisition by Bank of America, and that the offering documents accompanying the offering contained misrepresentations and omissions about the mortgages underlying the securities. Among other things, the claimants alleged that the defendants had misrepresented the underlying process that had been used in the origination of the mortgages and the creditworthiness of the mortgage borrowers.

 

This litigation has a long and complicated procedural history. Among other cases that are consolidated in this litigation is the Luther v. Countrywide case, which I have written about several times in the past, as pertains to questions of concurrent state court jurisdiction under Section 22 of the ’33 Act. (Refer here for the background of the Luther case and a discussion of the jurisdictional issues involved.)

 

Further complicating the attempts to settle the case is that during the pendency of the case, Central District of California Judge Marianne Pfaelzer entered several orders dismissing certain groups of claimants on standing and tolling issues. These dismissed claimants preserved rights to appeal these rulings. However, all of the claimants claims are settled through this settlement, including even those whose claims had been dismissed and who might have appealed the dismissal rulings.

 

According to Steve Toll of the Cohen Milstein Sellers & Toll law firm, who is lead counsel for the class plaintiffs, a plan of allocation will have to be agreed to in order to apportion the settlement amount among the various groups of plaintiffs. The plaintiffs’ lawyers will have to negotiate a proposed allocation amongst themselves and submit a plan of allocation when the settlement papers are submitted to the court.

 

The $500 million settlement is by far the largest settlement of a mortgage-backed securities class action lawsuit (MBS) as part of the current subprime and credit crisis litigation wave. The next largest MBS securities suit settlement is the December 2011 $315 million Merrill Lynch mortgage backed securities settlement, followed by the $125 million Wells Fargo mortgage backed securities suit settlement. There have of course been larger subprime and credit crisis-related securities class action settlements, led by the massive $2.43 billion BofA/Merrill Lynch merger settlement, among others. However, these other larger settlements did not relate to mortgage backed securities, which, as the procedural history of these cases show, posed a different set of hurdles for the prospective claimants. Overall, this settlement ranks as the sixth largest settlement among all subprime and credit crisis-related securities suit settlements, as shown by the settlement table that can be found here.

 

I have in any event added the Countrywide Mortgage Backed securities settlement to my running tally of settlements and other case resolutions of the subprime and credit crisis-related lawsuits, which can be accessed here.

 

As it has been doing on a monthly basis during the current banking crisis, the FDIC has once again updated the page on its website describing the failed bank litigation that the agency has initiated. According to the latest update, as of April 12, 2013, the agency has now filed a total of 54 failed bank lawsuits during the current bank failure wave. But though the new suits continue to come in, the agency’s filing pace appears to have slowed, at least for now. In the month since its last web update, the agency has only filed one additional lawsuit, and only four overall since February 1, 2013, even though the significant numbers of institutions reached the third anniversary of their closure during that period (Due to statute of limitations concerns, the agency typically files its failed banks suits shortly before the a failed bank’s third anniversary.)

 

Since its last update last month, the FDIC did initiate one lawsuit in its capacity as receiver for New Century Bank of Chicago, Illinois, which failed April 23, 2010. On March 26, 2013 (that is, just a few weeks before the third anniversary of the bank’s failure), the agency filed a complaint in the Northern District of Illinois alleging that the six former directors and officers named as defendants “acted negligently and grossly negligently and breached their fiduciary duties by disregarding the Bank’s loan policy, prudent lending practices, and regulatory warnings in connection with numerous commercial real estate and other loans during the period April 2005 through July 2008.” The FDIC seeks to recover “more than $33 million in losses.”

 

With the addition of just this one lawsuit, the FDIC has filed only two new complaints against former directors and officers of failed banks since March 1, 2013 and only four new complaints since February 1, 2013. By contrast, during January 2013, the FDIC filed five new complaints, just in that one month alone. In the two month period including December 2012 and January 2013, the FDIC filed a total of nine new lawsuits.

 

This relative slowdown since February 1, 2013 is all the more noteworthy given the number of banks that failed during the corresponding period three years ago. During the period February-April 2010, there were a total of 49 bank closures. By way of comparison, there were only 51 bank closures during all of calendar year 2012, and there have only been five so far during 2013. Early 2010 was a very active period for bank closures, and so given that the FDIC tends to file its suits, if at all, as the third anniversary approaches, it seemed that 2013 was going to be an active period of new lawsuit filing.

 

In addition, each month the agency updates its website to show the increased numbers of lawsuits that have been authorized. At its most recent update, the agency indicated that the number of lawsuits authorized has once again increased during the past month. As of April 12, 2013, the FDIC has now authorized suits in connection with 109 failed institutions against 888 individuals for D&O liability. This figure of 109 authorized lawsuits is inclusive of the 54 filed D&O lawsuits naming 407 former directors and officers that have already been filed. These figures suggest that there is a backlog of 55 cases that have been approved and not yet filed. The backlog seems to be growing. Given the monthly increase in the number of authorized lawsuits, you would really expect to see the agency’s new lawsuit pace moving along an active clip, not as seems to be the case, entering some sort of a lull.

 

There are a number of possible reasons for the apparent slowdown in the number of failed bank lawsuit filings. The first is just timing. I mentioned above that during the period February to April 2010, 49 banks closed, but of those 49 bank failures, 23 occurred in April 2010 alone (a very busy month for bank failures). Of the 23 bank closures in April 2010, 22 took place on or after April 16, 2010. In other words a very large percentage of the banks that failed during this period failed in late April 2010, and thus still have not yet reached the third anniversary of their closure. The third anniversary is coming up, but we are not quite there yet. There could be a flurry of new failed bank lawsuit filings in the next few days.

 

Another possible explanation for the apparent lull of new failed bank lawsuit filings over the last few weeks is that the agency may have entered tolling agreements with the failed banks directors and officers to see if they agency can reach a negotiated settlement with the directors and officers and with their bank’s D&O insurer. If the parties have entered tolling agreements, lawsuits involving some of the banks still could be filed later.

 

Finally, there are a number of cases in which the agency has reached a negotiated settlement with the directors and officers and with the D&O insurer without the agency actually filing the lawsuit. If the agency was able to reach a settlement agreement of this type in a number of cases, that too might account for the apparent filing slowdown over the past several weeks. (The agency has posted the settlement agreements in a number of these kinds of settlements on its website.)

 

Nevertheless, given the number of banks that failed in the first half of 2010 and given the growing number of lawsuits the agency has filed, it seems as if the failed bank lawsuit filing pace should be picking up again soon. As I have previously noted, there have previously been lulls in the FDIC’s failed bank lawsuit filing activity (refer here, for example, wiht respect to the two month lull during mid-year 2012). But the prior lulls have in most instances been quicly followed by a period of quickened filing actiivity (as discussed, for example, here).. Circumstances may be poised for the same filing pattern again now.

 

Another FCPA Civil Lawsuit: There is no private right of action in the FCPA. Nevertheless, civil litigation has followed in the wake of the proliferation in the number of governmental enforcement actions alleging violations of the FCPA, as investors allege that company management have violated their corporate duties in allowing the bribery to take place or that, by failing to disclose the briber, management has misrepresented the company’s internal controls or financial condition.

 

The latest example of these kinds of civil suits is interesting because at least so far there is no formal enforcement action against the company involved or its senior officials, although the bribery allegations have been the subject of very high-profile publicity.

 

According to their April 12, 2013 press release, plaintiffs’ lawyers have filed a securities class action lawsuit in the Southern District of New York against Wal-Mart de Mexico SAB (“Walmex”) and Ernesto Vega, the Chairman of Walmex’s board of directors and Chairman of the Board’s audit and corporate practices committee. The complaint, a copy of which can be found here, purports to be filed on behalf of investors who purchased ADRs of Walmex between February 21, 2012 and April 22, 2012. The complaint alleges seeks damages under the ’34 Act.

 

The investors’ complaint alleges that during the class period the defendants made false and misleading statements about Walmex’s business practices with respect to unlawful or unethical bribery conduct. Specifically, according to the plaintiffs’ lawyers press release, the complaint alleges that Walmex “failed to disclose that it had been involved in a bribery scheme,” and that as a result of the defendants’ misleading statements the company’s ADRs traded at inflated prices during the class period.

 

Unlike many of these kinds of civil actions, the plaintiffs do not base their assertions on allegations derived from a prior regulatory enforcement action; so far, there has been no formal regulatory enforcement action taken against the company. Rather, the plaintiffs’ allegations rely heavily on information in an April 22, 2012 New York Times article entitled “Wal-Mart Hushed Up a Vast Mexican Bribery Case” (here). The lengthy article detailed the extensive payment program that executives at Walmex allegedly had pursued in order to obtain Mexican zoning approvals, reductions in environmental impact fees and the allegiance of neighborhood leaders. According to the article, an internal Wal-Mart investigation not only found evidence of the payments, but also that Walmex executives knew about the payments and took steps to conceal the payments from Wal-Mart’s headquarters. The lead investigator recommended that Wal-Mart expand the investigation, but instead, according to the article, Wal-Mart’s leaders shut it down.

 

The new compliant quotes extensively from the New York Times article; parts of the complaint are nothing more than lengthy block quotes from the article. Among other things, the Times article notes that in December 2011, after learning of the Times’s reporting in Mexico, Wal-Mart informed the Justice department that it had begun an internal investigation into possible FCPA violations. In subsequent regulatory filings, the company has stated that it is investigating possible improper payments in other countries. To date, there have been (so far as I am aware) no formal regulatory actions taken against Wal-Mart or its officials.

 

Nevertheless, though there had to date been no enforcement action, the Walmex investors have initiated a securities class action lawsuit based on the information provided in the Times article. The case is not the first civil action seeking damages in connection with alleged FCPA violations in the absence of a formal regulatory action. However, it does provide a high-profile example of the way in which FCPA allegations can lead to private civil litigation.

 

One other interesting feature of the Walmex situation is that the alleged bribery allegations first came to light in September 2005 when a whistleblower contacted a senior Wal-Mart lawyer. It is an interesting question of what might happen in similar circumstances today, given the potentially rich whistleblower bounty payments potentially available under the Dodd-Frank whistleblower provisions. The bounty provisions provide a significant incentive for a whistleblower of the kind involved here to go straight to the SEC. These circumstances provide a powerful illustration of the kinds of circumstances that could make the Dodd-Frank whistleblower provisions so significant and could lead to increased regulatory and enforcement activity.

 

Insurance to provide coverage for breaches of representations or warranties in M&A transaction documents has been available in the marketplace for several years, but the specialty insurance product has not always been fully understood. More recently, interest in the product has grown and the product has improved, and so take-up for the product has increased as well.

 

In the following guest post, Joseph Verdesca and Paul Ferrillo of the Weil, Gotshal & Manges law firm take a close look at reps and warranties insurance and explain what M&A transaction participants need to know about the product.

 

I would like to thank Joseph and Paul for their willingness to publish their article on this site.. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Joseph and Paul’s guest post follows:

 

No less than two years ago, had one tried to initiate a conversation with a Private Equity Sponsor or an M&A lawyer regarding M&A “reps and warranties” insurance (i.e., insurance designed expressly to provide insurance coverage for the breach of a representation or a warranty contained in a Purchase and Sale Agreement, in addition to or as a replacement for a contractual indemnity), one might have gotten a shrug of the shoulders or a polite response to the effect of “let’s try to negotiate around the problem instead.” Perhaps because it was misunderstood or perhaps because it had not yet hit its stride in terms of breadth of coverage, reps and warranties insurance was hardly ever used to close deals. Like Harry Potter, it was the poor stepchild often left in the closet.

 

Today that is no longer the case. One global insurance broker with whom we work notes that over $4 billion in reps and warranties insurance was bound worldwide last year, of which $1.4 billion thereof was bound in the US and $2.1 billion thereof was bound in the EU. Such broker’s US-based reps and warranties writings nearly doubled from 2011 and 2012. Reps and warranties insurance has become an important tool to close deals that might not otherwise get done. This article is meant to highlight how reps and warranties insurance may be of use to you in winning bids and finding means of closing deals in today’s challenging environment.

 


When Is Reps and Warranties Insurance Best Used?

Deal Size. Reps and warranties insurance is best suited to deals of a certain size range and type. Given the amount of limits that can be purchased in the marketplace for any particular deal, insurance pricing and the size of a typical escrow or indemnity requirement, the “sweet spot” for reps and warranties insurance are deals between $20 million and $1.5 billion. While reps and warranties insurance might have a role to play in larger or smaller deals, it can play a central role in facilitating transactions within this size range. The type of deal is relevant because it is much easier to obtain reps and warranties insurance when the business being acquired is privately owned rather than publicly held. In sum, insurance companies generally prefer to insure transactions where an identifiable seller (rather than a diverse stockholder base) is standing behind the representations of the target business.

 

Sell-Side Examples. For those finding themselves selling a business or asset, situations that may warrant purchase of a reps and warranties policy for the transaction include the following examples

• Minimization of Seller Liability. A Private Equity or Venture Capital seller near the end of a Fund’s life wishes to limit post-closing indemnification liabilities on the sale of a portfolio company in order to safely distribute deal proceeds to the Limited Partners, but the buyer wants a high cap on potential indemnities or a long survival period for the reps at issue. Insurance could be the means to bridge this gap.

• Removal of Tax Contingency from Negotiations. A seller restructures itself immediately prior to the closing of a deal for tax purposes. During due diligence, both seller’s and buyer’s tax advisors agree the deal should be recognized as a tax-free reorganization. In the remote event that the IRS took a different position, the tax consequences to the buyer would be significant. The Seller wishes to retire with the proceeds from the deal, and does not want to provide an indemnity to the buyer for this potential risk. Insurance could serve to remove this risk from the scope of matters needing negotiation between the parties.

• Minimization of Successor Liability Risk. In an asset sale transaction where a portion of assets and liabilities remain with the seller, the buyer would have no control over the seller’s conduct post-closing and does not want to be subject to potential liabilities related to such excluded assets on a successor liability theory. If the seller is unwilling or unable to provide an indemnity for such matters, insurance could help the parties past this issue.

Buy-Side Examples. For those wishing to acquire a business or asset, situations that may warrant purchase of a reps and warranties policy for the transaction include the following examples:

• Bid Enhancement. A competitive auction process is being held by a seller of prime assets. A potential buyer wishes to distinguish his or her bid from others by arranging and agreeing to look to a reps and warranties insurance policy to take the place of an indemnity from the seller. Such a use of insurance could elevate the likelihood of the buyer winning the auction.

• Public M&A Indemnity. In a public M&A acquisition, the buyer could arrange for reps and warranties insurance to provide the indemnity that would not otherwise typically be available in light of the publicly held nature of the target.

• Distressed M&A Indemnity. Similarly, in a distressed M&A setting in which the buyer is concerned about the credit risk of the seller post-closing, the use of reps and warranties insurance would enable the buyer to be indemnified for breaches of reps and warranties in the acquisition agreement, while avoiding the seller’s credit risk.


What Should the Insurance Cover?

While each policy is unique, a reps and warranties policy generally covers “Loss” from “Claims” made by Buyer for any breach of, or an alleged inaccuracy in any of, the representations and warranties made by the Seller in the Purchase and Sale Agreement (“PSA”). Though a rep and warranty policy can be structured to cover very specific reps or warranties, coverage is generally afforded on a blanket basis for all reps and warranties. The definition of “Loss” in the policy should generally mimic the extent of the Indemnity negotiated in the PSA (which could include things like consequential or special damages). Loss can also include defense costs, fees, and expenses incurred by the Insured (for instance, the Seller) in defense of a Claim brought by a third party (for instance, the Buyer) arising out of alleged breach of a representation or warranty. Note that such policies almost always have a self-insured retention (“deductible”) associated with them. The size of the retention can vary considerably from deal to deal, but usually in some fashion equates to the amount of the hold back negotiated.

 

What Should the Insurance Exclude?

Though the exclusions in a reps and warranties policy are not as numerous as those contained in a traditional directors and officers liability policy, they should do exist and be thoughtfully considered and negotiated. Reps and warranties policies do not cover known issues, such as issues discovered during due diligence or described in disclosure schedules. They also do not cover purchase price, net worth or similar adjustment provisions contained in the PSA. “Sell-Side” reps and warranty policies do not cover claims arising from the adjudicated fraud of the seller. Either buy side or sell side policies might have deal-specific exclusions where the carrier involved simply cannot get comfortable in insuring the particular representation or warranty at issue. Lastly, a rep and warranty policy would also generally not cover any breach of which any member of the deal team involved had actual knowledge prior to the inception of the policy or any material inaccuracy contained in the “No Claims Declaration” typically in connection with the issuance of the policy.

Cost of Coverage

Reps and warranties insurance is priced based on a number of factors, including most prominently the nature of the risk involved, the extent of the due diligence performed by the parties, and the relative size of the deductible. Reps and warranties insurance is currently generally priced as a percentage of the limits of coverage purchased. Nowadays, in the United States, a price range of 2.0% to 3.5% of the coverage limits is typical. Thus, a $20 million reps and warranties insurance policy on a moderately complicated deal might cost approximately $600,000. Who pays this premium is generally a function of the deal, and depends to some extent upon who is deriving the benefit from the insurance. If, for instance, a buyer-side policy is being purchased because a seller doesn’t want to deal with putting up an indemnity or hold-back, the premium would generally be the seller’s responsibility.

 

In order to facilitate the due diligence process (described below), many carriers require payment of an up-front underwriting fee. These fees can run from $25,000 to $50,000, and are used by the carrier typically to hire outside counsel to advise it during the underwriting process.

 

Deductible

Carriers typically determine the policy’s deductible according to the transaction value of the deal. In our experience, the current standard deductible ranges from 1% to 3% of the transaction value. The deductible will, however, vary from deal to deal based upon the risk involved. Buy-side policies alternatively tend to use the “hold-back” negotiated between the parties as a deductible.

 

Process to Get the Insurance in Place

The reps and warranties insurance market has evolved in response to prior concerns about the amount of time and effort necessary to put a policy in place. The carriers and brokers understand that, as with the deals themselves, the need for the insurance is typically on a very fast track.

 

Many of the large national insurance brokerages have specialized units that deal with reps and warranties insurance. These units, for the most part, are run not by “insurance people” but by former M&A lawyers who left private practice to become dedicated resources at the brokerages. They are fully familiar with the ins and outs of M&A and private equity transactions, and very little time is needed to get them up to speed. Though not all brokerages provide the same level and depth of resources, the right broker can become quickly integrated into the deal team and, importantly, will serve as an advocate with the insurance carriers.

 

Within 24 hours, a good broker will have you engaged with one of the handful of carriers that are known to service the reps and warranties insurance area. Be advised that not all carriers are created equally, and your broker should assist in advising as to selection of the best carriers for your purposes (including as to responsiveness, experience in corporate transactions, and reputation for proper claims payment decisions).

 

The best insurance carriers in this arena will typically provide a price and coverage quote (called a “Non-Binding Indication” or “NBIL”) within two or three days of the first conversation. Either in connection with the receipt of the NBIL or in a subsequent phone call, you should expect to receive a list of due diligence requests, and likely a request of the carrier for data room access (both the broker and carrier are accustomed to negotiating and executing a Non-Disclosure Agreement early in the process). The best carriers in this arena are, in our experience, capable of running a very efficient due diligence process and getting up to speed as a quick as possible regarding potential risks associated with the deals (e.g. intellectual property, environmental, etc.).

 

Within a week of receipt of the NBIL, the carrier, its counsel, the insured, its business people, its deal team members and its counsel (including sometimes the private equity sponsor) will typically discuss the due diligence done on the transaction, and answer questions of the insurance carrier to ensure the absence of any risks that might imperil the insurance transaction. Assuming the due diligence call goes well (and there might be follow up diligence calls as well on particular issues), the carrier involved will normally issue a draft insurance policy, which is normally then negotiated with the parties (assisted by the broker). A key issue will be “conforming” the insurance so that it matches what would otherwise have been provided by the PSA in the absence of the insurance (or otherwise serves the particular need for which it is being purchased). In negotiating such policy, focus will often be placed on defining the scope of losses included and excluded, the impact of knowledge qualifiers, the term of coverage, operational restrictions, subrogation provisions, and a host of additional issues beyond the scope of this article.

 

In Summary: Reps and warranties insurance (1) can be purchased quickly and efficiently, and won’t delay the deal, (2) can provide real coverage for troublesome aspects of a deal for which alternative solutions may not be readily available, and (3) can serve as a flexible tool to distinguish one’s offer in a competitive bidding situation. Teaming up with a well-experienced broker and insurance carrier is essential to making this happen. We have enjoyed the benefits of utilizing reps and warranties insurance into numerous transactions, and would be happy to share with you our thoughts in this arena in further detail.

Lee Farkas, the criminally convicted former Chairman and majority shareholder of  the defunct Taylor Bean and Whitaker Mortgage Corporation, must repay the nearly $1 million in defense fees the company’s D&O insurer had advanced on his behalf, according to an April 11, 2013 Fourth Circuit opinion. The terse three-page appellate opinion adopts the ruling of the lower court, holding that Farkas’s criminal conviction triggered the D&O insurance policy’s “in fact” conduct exclusions which in turn triggered the insurer’s right to recoup the defense fees it had previously paid. The Fourth Circuit’s opinion can be found here, and the March 21, 2012 district court opinion, which the appellate court affirmed, can be found here.

 

Background

In June 2010, Farkas was indicted on multiple counts of committing and conspiring to commit bank, wire and securities fraud. On April 19, 2011, a jury found Farkas guilty of all 16 counts of fraud and conspiracy to commit fraud. As detailed here, Farkas was, among other things, alleged to have conspired with employees of the failed Colonial Bank to sell the bank approximately $400 million of mortgage assets that had no value. Taylor Bean was also alleged to have engaged in numerous other transactions with the bank that had no value. The bank’s collapse followed after the fraudulent scheme unraveled.

 

After he was indicted, Farkas sought to have his criminal defense fees paid by the company’s D&O insurer. With bankruptcy court approval, the D&O insurer advanced $928,977 toward Farkas’s defense. Farkas incurred significant additional defense expenses, and the carrier’s request for the bankruptcy court’s leave to pay those additional amounts was pending when the jury returned the guilty verdict. Following the verdict, the carrier informed Farkas that, as a result of the verdict and in reliance on the policy’s conduct exclusions, it would no longer fund Farkas’s defense costs, and it reserved its right to seek recoupment from Farkas of the amounts it had previously advanced.

 

Farkas filed an action in the Eastern District of Virginia seeking a judicial declaration that the jury verdict did not terminate the insurer’s defense obligation, and that in any event all of the fees he had incurred prior to the jury verdict must be paid. The D&O insurer filed a counterclaim seeking a judicial declaration that Farkas was not entitled to coverage under the policy and that Farkas was obligated to repay the amounts the insurer had previously advanced. The parties cross-moved for summary judgment. In her March 21, 2012 opinion, Eastern District of Virginia Judge Leonie Brinkema granted the insurer’s motion for summary judgment. Farkas appealed.

 

In arguing that as a result of the jury verdict coverage for Farkas’s criminal defense fees was precluded under the policy, the insurer relied on the policy exclusion specifying that “The Insurer shall not be liable to make any payment for Loss in connection with a Claim against an insured …arising out of, based upon or attributable to the committing in fact of any criminal, fraudulent or dishonest act, or any willful violation of any statute, rule or law.”

 

In seeking to have Farkas repay the amounts that it had advanced, the insurer relied on the language in the policy specifying that “advanced payments by the Insurer shall be repaid to the Insurer by the Insureds or the Company, severally according to their respective interests, in the event and to the extent that the Insureds or the Company shall not be entitled under the terms and conditions of this policy to payment of such Loss.”

 

The Fourth Circuit’s Opinion and the Ruling Below

On April 11, 2013, in a terse three-page per curium opinion, a three-judge panel of the Fourth Circuit affirmed the district court’s ruling. The appellate court said that “having carefully reviewed the briefs, record and appellate law, we affirm for the reasons stated by the district court in its thorough opinion.”

 

In her March 2012 opinion, Judge Brinkema had granted summary judgment for the D&O insurer, finding that the jury verdict in the criminal case represented an “in fact” finding that triggered the conduct exclusion; rejected Farkas’s argument that he was entitled to the payment of the defense costs incurred by not yet paid before the verdict was returned; ruled that the insurer was entitled to recoup from Farkas the defense cost amounts it has advanced prior to the verdict; and rejected Farkas’s argument that the district court should stay its ruling while Farkas’s criminal appeal was pending. (Farkas’s criminal conviction was in any event subsequently affirmed.)

 

In ruling that the jury verdict triggered the policy’s conduct exclusion, Judge Brinkema stated that “there can be no reasonable dispute that the jury verdict here is an objectively verified and pertinent factual finding.” She added that none of the courts that have held that an “in fact” wording in a policy exclusion requires a final adjudication had defined a final adjudication as an appeal. She concluded that “there is simply no support in the case law for plaintiff’s position that a jury verdict does not trigger the ‘in fact’ requirement in the exclusion.”

 

With respect to Farkas’s contention that the insurer should at least pay the defense costs he had incurred but that the insurer had not yet paid when the verdict was returned, Judge Brinkema said that Farkas’s argument “ignores the consequence of a particular claim being excluded.” Farkas’s conduct “was never actually covered under the Policy, and he was therefore never entitled to the monies advanced to him.” Pursuant to the policy language, the insurer, she found, “has the right to seek recoupment of any costs that it advanced before it determined that an exclusion applied.”

 

Discussion

The question of an insurer’s right to seek recoupment of advanced defense expenses is a recurring topic. As I have previously noted (here), although D&O insurers frequently assert their right to seek recoupment, it is still relatively rare for the insurers to actually do so. Among other reasons why the insurers rarely seek reimbursement is that it is relatively unusual for a D&O claim to proceed to the point that there has actually been a factual determination triggering an exclusion. Indeed, one of the many reasons why civil claims triggering D&O coverage frequently settle is that an insured defendant would risk a factual determination that might preclude policy coverage if the defendant were to press the case forward rather than settle.

 

This case’s criminal context obviously presents a different set of circumstances than does a civil case. A criminal defendant does not have the option of a pre-trial settlement that avoids a potentially coverage precluding outcome.

 

Just the same, the coverage outcome here is also due in part to an unusual feature of the policy at issue According to the court record, the D&O insurance policy at issue here was first issued to the Taylor Bean firm in 2008 and subsequently extended by endorsement. Even in 2008 it was standard for most D&O insurance policies to be issued with the “final adjudication” wording, rather than the “in fact” wording. With the final adjudication wording, the preclusive effect of the conduct exclusion does not apply under there has been a final judicial determination that the precluded conduct has occurred. The presence of the “in fact” exclusion language in the Taylor Bean policy is an anachronism that is unexpected and frankly a little bit surprising.

 

Because the policy had the “in fact” exclusionary language, Judge Brinkema had little trouble concluding that the jury verdict precluded coverage. Had the policy had the now-standard “final adjudication” language, the parties would then have had to argue about whether or not the criminal judgment against Farkas was “final” while his appeal was pending. I am well aware that there is extensive case law on the question whether or not a district court judgment if final and enforceable while an appeal is pending. But if the policy had contained the “final adjudication” language rather than the “in fact” language, Farkas might have had a better argument that the insurer was obligated to continue to advance his defense fees unless and until the conviction was affirmed.

 

It is worth noting that these circumstances demonstrate why the preferred exclusionary trigger is not just the “final adjudication” wording but rather the “final non-appealable adjudication” formulation. If the policy had the “non-appealable adjudication” wording, the insurer here would have been obligated not only to advance the amounts Farkas had incurred prior to the verdict but that the insurer had not yet paid, but also to continue to advance his defense expenses for his appeal. Farkas would have been able to continue to use his preferred counsel through his appeal (rather than, as Judge Brinkema noted, counsel appointed for him under the Criminal Justice Act). Farkas may well feel that the appeal might have turned out differently if he had been able to rely on his preferred counsel. I know for sure that if it were me, I would certainly want to be able to use my preferred counsel while appealing a criminal conviction.

 

The fact that Farkas had to rely on appointed counsel for his appeal suggests that he did not have resources of his own to rely on — which begs the question of why the carrier went to the trouble to obtain an order requiring Farkas to repay the advanced amounts. I mentioned at the outset of this discussion that it is relatively rare for carriers to seek recoupment of advanced amounts, and among other reasons why it is rare is that often there is no point for the carrier to seek recoupment because usually by the time a serious D&O claim has concluded, the defendant is usually broke – which seems to be the case here, which in turn begs the question why the carrier even bothered to pursue a recoupment order.  It probably is worth noting in that regard that the D&O insurer did not initiate the coverage lawsuit here, Farkas did. The carrier only sought recoupment in its counterclaim, after Farkas had sued the insurer. Whether the carrier ultimately will recover anything under the recoupment order is a different question.

 

"Everything I Can See From Here": Two Men, a Dog, a Ball, and ….

 

Everything I Can See From Here from The Line on Vimeo.

Securities class action lawsuits involving accounting allegations are less likely to be dismissed, take longer to resolve, and make up a much greater proportion of total securities suit settlement dollars than non-accounting cases, according to a new report from Cornerstone Research. The report, entitled “Accounting Class Action Filings and Settlements: 2012 Review and Analysis,” and which can be found here, shows that the number of securities cases involving accounting allegations declined in 2012, both in absolute numbers and as a percentage of all securities suit filings. However, a number of factors suggest that the number of accounting cases could increase in the months ahead. Cornerstone Research’s April 10, 2013 press release regarding the report can be found here.

 

The report defines a securities suit as an “accounting case” if the lawsuit involves allegations of Generally Accepted Accounting Principles or weaknesses in internal control over financial reporting. The alleged GAAP violations vary widely, but include allegations of accounting irregularities, restatement of financials, and asset write-downs.

 

During 2012, new accounting case filings decreased both in number and in proportion of new securities class action filings, to the lowest levels in six years. The number of accounting cases decreased from 78 in 2011 to 45 in 2012, and the proportion of total filings that accounting cases represented decreased from 42 percent to 30 percent. As a result of declines during 2012 in the number of cases involving Chinese reverse merger companies, as well as a general decline in the number of securities class action lawsuit filings in the second half of the year, the number of securities suit filings overall declined during 2012. The drop in Chinese reverse merger cases alone accounted for approximately two-0thirds of the drop in new accounting cases from 2011 to 2012

 

The total number of accounting restatements actually increased in 2012. However, the total number of accounting cases involving financial restatements decreased during 2012, returning to levels seen in 2009 and 2010, after a significant increase in 2011. Perhaps many of the 2012 restatements did not result in lawsuits because the “many of the restatements during 2012 did not have a significant effect on stock price.” It is also possible that a time lag between the time of the restatement and an eventual filing may result in more restatement related filings in 2013.  

 

For the third consecutive year, the majority of accounting cases included allegations of internal control weaknesses. Over the past three years, nearly two out of three accounting cases included allegations relating to internal controls, a much higher proportion than during the period 2007 through 2009.

 

Accounting cases typically are less likely to be dismissed than non-accounting cases. Of the securities class action lawsuits that were filed in 2007, only 35 percent of accounting cases were dismissed by the end of 2012, compared with 52 percent of non-accounting cases. In addition, 60 percent of accounting cases filed in 2007 settled by the end of 2012, compared to 41 percent of non-accounting cases. Of all cases filed during the period 2007 to 2010, only five percent of accounting cases were voluntarily dismissed, compared with 24 percent of non-accounting cases.

 

Accounting cases continue to represent a substantial portion of the total dollar value of all settlements. While accounting cases represented less than 70 percent of the number of 2012 securities lawsuit settlements, accounting cases represented over 90 percent of the total value of the settlements.

 

Both average and median settlement amounts are higher for accounting cases compared with non-accounting cases. During 2012, the average and median settlement amounts for accounting cases were approximately $73 million and $15 million respectively, compared with $16 million and $6 million for non-accounting cases. This difference is due in part to the fact that accounting cases often involve other factors associated with higher settlement amounts, such as an accompanying SEC action. The report also notes that cases in which the company has announced internal control weaknesses are associated with both higher median settlement amounts and a higher settlement share of “estimated damages.”

 

The report notes that factors such as the Dodd-Frank whistleblower program, a recent increase in the number of restatements by accelerated filers, and the JOBS Act’s extension of the exemption from auditor reports on internal controls for emerging growth companies are all factors that could contribute to an increase in the number of securities class action lawsuit filings involving accounting allegations.