In a January 18, 2013 order (here), the U.S. Supreme Court granted a writ of certiorari to hear the appeals of three separate petitioners in cases arising out of the Ponzi scheme of R. Allen Stanford. The petitioners are two former law firms for the Stanford International Bank and an insurance brokerage that allegedly was involved in the sale of certificates of deposits for the bank. The petitioners are asking the Supreme Court to decide whether or not the plaintiffs are precluded under the Securities Litigation Uniform Standards Act (“SLUSA”) from asserting state-law class action claims against the three firms. By taking up the case, the Supreme Court will decide important issues about SLUSA’s scope that have divided the lower courts.

 

Congress enacted SLUSA in 1998 in order to prevent erstwhile securities law claimants from circumventing the restrictions of the Private Securities Litigation Reform Act (PSLRA) by filing their claims in state court under state law. As the Supreme Court said in 2006 in the Dabit case, “To stem the shift from Federal to State courts and to prevent certain State private securities class action lawsuits alleging fraud from being used to frustrate the objectives of the [PSLRA], Congress enacted SLUSA.”

 

SLUSA precludes most state-law class actions involving a “misrepresentation” made “in connection with the purchase or sale of a covered security.” The lower courts have wrestled with the question of what it required in order to satisfy the “in connection with” requirement and trigger SLUSA preclusion.

 

In these cases, the investor plaintiffs contend they were misled to believe that the CDs in which they invested were backed by quality securities traded on major exchanges (though it later appeared that the CDs in fact had little or nothing behind them). The defendants moved to dismiss the state law class actions that had been filed against them, arguing that, though CDs themselves were not “covered securities” within the meaning of SLUSA, the state court class action claims were nevertheless precluded under SLUSA because the plaintiffs claimed they were induced to purchase the securities by misrepresentation that the CDs were backed by SLUSA-covered securities.

 

The district court before which the cases were consolidated granted the defendants’ motions to dismiss and the plaintiffs appealed. In a March 19, 2012 opinion (here), a three-judge panel of the Fifth Circuit reversed the district court, specifically holding that the alleged purchases of covered securities that back the CDs were “only tangentially related to the fraudulent scheme” and therefore that SLUSA does not preclude the plaintiffs from using state class actions to pursue their claims.

 

In reaching its decision, the Fifth Circuit panel exhaustively reviewed the prior case law in which other Circuit courts had considered the question of what connection between an alleged fraud involving uncovered and a downstream transaction in covered securities is required for SLUSA preclusion to apply. The Fifth Circuit’s review of the case law shows that there are divergent and potentially inconsistent views among the various Circuit courts on this question.

 

The two defendant law firms and the defendant insurance brokerage firm filed petitions for writ of certiorari to the U.S. Supreme Court. The cert petitions of the Proskauer Rose and Chadbourne & Parke law firms can be found here and here, respectively. The cert petition of the insurance brokerage, Willis of Colorado, Inc., and its related entities and firms, can be found here. (Hat tip to the SCOTUS Blog for the links to the cert petitions.)

 

In its petition, the Chadbourn & Parke law firm argued that split in authority among the various circuit courts has resulted in inconsistent interpretations and applications of SLUSA preclusion. The firm argued that the Fifth Circuit had adopted an interpretation of the “in connection with” standard that resulted in a determination that SLUSA preclusion did not apply, allowing the case against the firm to go forward, while at the same time rejected a conflicting standard prevailing in the Second, Sixth and Eleventh Circuits that would have resulted in the application of SLUSA preclusion here. The petitioners argued that the Circuit split not only threatened inconsistent outcomes among the Circuits, but it frustrated the very purposes for which Congress enacted SLUSA – that is to establish “national standards” for class actions “involving nationally traded securities.”

 

The Supreme Court’s consideration of these three consolidated cases promises to be interesting and potentially significant. If nothing else, the consolidated cases involve a high-stakes dispute relating to a high-profile fraud. This consideration alone ensures that the Supreme Court’s consideration of these three consolidated cases will receive significant attention.

 

On a more basic level, the Supreme Court’s consideration of these issues should resolve the split among the Circuits in their interpretation of the “in connection with” requirement in the SLUSA preclusion provision. Resolving this split should reduce the possibility of different outcomes in different cases based on nothing more than the judicial Circuit in which the different cases were filed.

 

More importantly, the Supreme Court’s consideration of these issues will help define the scope of SLUSA preclusion in more complex cases where the alleged fraudulent scheme involves a multi-layered transaction. These kinds of questions have been unfortunately common in recent times: for example, the same kinds of questions arose in connection with the Madoff feeder fund suits. (The Courts in the Madoff feeder fund cases concluded that SLUSA preclusion applied.)

 

In a very important sense, the Supreme Court is just the latest battle in the continuing struggle that first emerged after the enactment of the PSLRA. The struggle involves the efforts of the plaintiffs’ securities bar to try to find ways to circumvent the strict standards that Congress imposed in the PSLRA. The plaintiffs’ lawyers first tried to avoid the PSLRA by pursuing their claims in state law suits to which the PSLRA. To avoid that, Congress enacted SLUSA. In these consolidated cases, the Supreme Court will determine the extent to which plaintiffs pursuing claims against remote actors are or are not subject to the constraints of the PSLRA as well as the subsequent Supreme Court case law interpreting the PSLRA

 

In their cert petition, Chadbourne Park argues that the plaintiffs’ filed their claims as state law class action precisely for the reason of circumventing Supreme Court case decisions that restricted federal securities law claims against third party advisors, which is precisely the outcome SLUSA was intended to prevent. In making these arguments, the law firm emphasizes that the aiding and abetting claims the plaintiffs are attempting to assert under state law are not allowed under federal law. The Supreme Court’s determination of these consolidated cases will significantly determine the extent to which plaintiffs can pursue state law securities-related claims against third party advisors. The determination matters because of the possibility it presents that the plaintiffs could pursue these state law claims in circumstances in which federal statutory and case law would not permit such claims.

 

The Supreme Court’s cert grant in these three consolidated cases is just the latest in a series of securities-related disputes that the Court has been willing to take up. The Court already has the Amgen case on its docket this term; the Amgen case has already been argued and the Court’s decision in expected before the end of the current term in June.

 

It used to be that years would pass between Supreme Court cases considering securities law issues. In the past five or six years, though, the Court has seemed to want to take up several securities cases each term. While the Court’s willingness to take up more securities cases certainly provides great blog fodder, it has made the securities litigation environment more volatile and it has occasionally introduced significant and unanticipated changes (as happened for example with the Supreme Court’s paradigm-shifting opinion in Morrison v. National Australia Bank). In final analysis, that is the real reason it is interesting when the Supreme Court agrees to take up a securities case – you never know for sure what might happen when the Supreme Court makes its determination.

 

The Deepwater Horizon platform explosion and oil spill took place in the Gulf of Mexico, about 250 miles southeast of Houston. The environmental damage took place in the Gulf and along the Gulf shore in the Southeastern United States. When BP’s shareholders tried to sue the board of directors of BP — a corporation organized under the laws of England — in a derivative suit filed in federal court in the U.S. alleging breaches of fiduciary duty, they clearly hoped their suit would do better in a court closer to the site of the disaster and ensuing spill. But the district court dismissed the suit on forum non conveniens grounds. In a January 16, 2013 opinion (here), a three-judge panel of the Fifth Circuit affirmed the dismissal.

 

As discussed here, plaintiffs filed the first of several derivative lawsuits in connection with the Deepwater Horizon oil spill in May 2010. Though many of the lawsuits were first filed in the Eastern District of Louisiana, the cases were ultimately consolidated through the multidistrict litigation process in the Southern District of Texas. However, while the lawsuits were filed in U.S. courts, they asserted claims under the U.K. Companies Act 2006 (about which refer here). The defendants moved to dismiss the consolidated derivative litigation in the grounds of forum non conveniens.

 

In a September 15, 2011 ruling, Judge Keith Ellison of the Southern District of Texas determined that, notwithstanding the fact that the Deepwater Horizon disaster took place in the U.S. and caused extensive environmental damage here, “the English High Court is a far more appropriate forum for this litigation,” and accordingly he granted the defendants’ motion to dismiss the cases.  Judge Ellison’s decision can be found here. My prior post discussing Judge Ellison’s opinion can be found here.

 

In its January 16 per curiam opinion, the Fifth Circuit panel affirmed the district court’s decision, concluding that the lower court had not abused its discretion in granting the dismissal on forum non conveniens grounds.

 

Among other things, the Fifth Circuit reviewed the multipart analysis a district court must use in order to determine whether or not to dismiss a case on forum non conveniens grounds. Among the most important of considerations is whether or not there is an alternative forum where the matter can be heard. In order to satisfy the availability requirement, the district court had conditioned its dismissal on the Defendants filing a stipulation that they would submit to the jurisdiction of the English courts, which the Defendants had done. The Fifth Circuit concluded that the stipulation satisfies the availability requirements.

 

Another important consideration a district court must consider in connection with a motion to dismiss on forum non conveniens grounds is the existence of a local interest in the dispute. The Fifth Circuit concluded that the district court had not abused its discretion in determining that, because this dispute was not intended to redress the impact of the Deepwater Horizon disaster in the United States but rather was intended to compensate the British company BP for its financial and reputational harm, England had the greater local interest in the matter.

 

The Fifth Circuit also concluded that the district court had “reasonably” determined that public interest factors weighed heavily in favor of England as a more convenient forum, given that the English statute on which the plaintiffs sought to rely had only recently been enacted leaving the U.S. courts with little jurisprudence to use to try to apply the statute properly.

 

The plaintiffs chose to file their suit in the U.S. rather than in the U.K. undoubtedly had something to do with a perception that a court in closer proximity to the damages caused by the spill might prove to be a more receptive forum. The selection of a U.S. court over an English one also reflects the more general advantages a plaintiff enjoys here by comparison to English courts – for example, the absence in the U.S. of a “loser pays” model, among other things.

 

These kinds of advantages often encourage plaintiffs with claims involving non-U.S. companies to try to pursue their claims in U.S. courts. But the outcome of the dismissal motion in the BP derivative suit represents just one more example of the many ways prospective litigants are finding it increasingly more difficult to pursue corporate and securities claims against non-U.S. companies in U.S. courts. Courts interpreting the U.S. Supreme Court’s Morrison decision have significantly narrowed the circumstances in which securities claims involving foreign companies can go forward in U.S. courts. The Fifth Circuit’s affirmance of the dismissal of the BP derivative suit underscores the difficulties prospective claimants may fact in pursuing derivative suits involving non-U.S. companies here as well.

 

Among the many other lawsuits filed in connection with the Deepwater Horizon disaster, there also was, in addition to this shareholders’ derivative suit, a securities class action lawsuit. Though the separate securities class action lawsuit will be going forward at least in part, the preliminary motions in the securities suit also demonstrate some of the challenges plaintiffs now face in trying to pursue claims in the U.S. against non-U.S. companies. As discussed here, in a February 2012 ruling, Judge Ellison denied in part the motions of defendants to dismiss the securities class action lawsuit that BP shareholders had filed in connection with the Deepwater Horizon disaster.

 

Though Judge Ellison denied the motions to dismiss with respect to the claims asserted by securities class action plaintiffs who had purchased BP ADRs on the U.S. securities exchanges, he granted the motion to dismiss all of the claims – including claims asserted under New York state law and English common law – of U.S.-domiciled investors who purchased their BP shares on the London Stock Exchange. Judge Ellison specifically concluded that because the federal securities laws do not apply to the securities transactions on LSE, he also lacked supplemental jurisdiction to consider the English common law claims. By shaving off the claims of the shareholders who purchased their shares, Judge Ellison dramatically narrowed the scope and range of potential damages in the securities class action lawsuit.

 

Jan Wolfe’s detailed January 18, 2013 Am Law Litigation Daily article about the Fifth Circuit’s ruling in the BP derivative suit can be found here.

 

If to err is human, then writing a blog is a most human endeavor. Tight deadlines and late-night drafting sessions ensure that mistakes infiltrate even carefully composed posts. It is a painful exercise for me to review old posts and see the errors that managed to make it onto my site.

 

In my best efforts to try to avoid mistakes, I try to read my draft posts very carefully (or as carefully as I am able at the late hours at which I am usually composing my posts). Over time, I have developed reading habits that I now carry over to all of my reading. Through this process, I have noticed a number of recurring writing errors that I have outlined below.

 

I have acknowledged the many  errors in my own writing here to assure readers that my comments below about writing are not just the pedantic rant of some self-appointed grammar scold. I offer my observations here with all due humility and in recognition that we all make mistakes, I offer these observations in the hope that others might find them helpful. In this post, I concentrate on word choice errors. Perhaps in a later post I will come back to grammatical errors.

 

Word Choice

Sometimes when I am reading along I will see a word so completely misplaced that I wonder what in the world the author was thinking – or whether the author was thinking. Just yesterday morning I read this sentence on a blog that I follow: “Chief Justice Roberts and Justice Alito dominated the questioning of the water district’s counsel, Paul Wolfson, and appeared exacerbatedby Mr. Wolfson’s argument that the property owner must accept a conditional permit to be able to challenge the condition as violative of Nollan and Dolan.” Don’t you hate it when Supreme Court Justices get “exacerbated” in public? I suspect (although I am not entirely certain) the author meant to say that the two Justices were “agitated.”

 

The preceding example illustrates the kind of word usage errors to which all of us are prone. Here are some recurring word choice mistakes I have noted where the context makes it clear that the author intended to use another word. I am sure some of these errors are Auto Correct blunders, while others are the product of simple inattention. Some of the boo-boos are doozies.

 

Tenant/Tenet: A “tenant” is a person who has a lease. A “tenet” is guiding principle or doctrine. So when I want to refer to a matter of belief, I might use the phrase “a fundamental tenet.” If I were instead to use the phrase “fundamental tenant,” I would be referring to someone who pays a lot of rent.

 

Marquee/Marquis: The sign that projects out from the façade of a movie theater is a “marquee.” A “marquis” is a nobleman ranking below a duke but above an earl or count. So a featured product or attribute is a “marquee product” or a “marquee attribute.” I guess a “marquis product” would be something made by the British aristocracy. 

 

Clique/Click: A “clique” is a small, exclusive group. A “click” is a small, sharp sound. If you are a member of a “clique,” you are smug and self-satisfied. If you are a member of a “click” you are in the sound-making business. (I can’t believe that anyone could make this mistake, but I recently saw it in an angry letter-to-the-editor).

 

Tack/Tact: One of the meanings of the word “tack” comes from sailing, and means to change the boat’s direction relative to the wind by shifting the boat’s sails. The sailing term has come to be used metaphorically. For example, when someone changes their approach to a situation, we might say they are “taking a different tack.” The word “tact” refers to a sense of propriety. I recently read a legal essay in which the author said that “the defendant’s counsel decided to try a different tact.” Maybe the lawyer started holding his tea cup with his little pinky raised?

 

Rein/Reign: A “rein” is a leather strap attached to a bridle and used to lead a horse. A “reign” refers to the period during which a sovereign occupies the throne. These words get mixed up when somebody is trying to say that he or she wants to control something the way they might control a horse (as in “I am going to have to rein him in”) but instead they use the word “reign” and thereby inappropriately invoke the monarchy.

 

Tortious/Tortuous/Torturous: I would say that about half the time anyone uses any one of these three words, they actually meant to use one of the other two. The word “tortious” is a legal term, which essentially means of or pertaining to a tort or wrong. “Tortuous” means full of twists or turns, as in “a tortuous path.” The word “torturous” means causing torture or suffering. The most common confusion of these words occurs when a non-lawyer intends to use the word “tortious.” I have a very simple suggestion on how to avoid confusing these three words. That is, if you didn’t already know the difference between these three words before you read this blog post, then you should just avoid using any of these three words altogether.    

 

Reticent/Reluctant: There appears to be a common misconception that the word “reticent’ is simply a highfaluting form of “reluctant.” Though the two words are somewhat similar, they are not equivalent. The word “reticent” means to be disposed to be silent. The word “reluctant” means unwilling or disinclined. It does not make sense to say that someone is “reticent to get involved.” Here’s my advice: If you feel the urge to use the word “reticent,” just say “shy.” Why use three syllables when one will do just fine?

 

Waive/Wave (Waiver/Waver): A “waiver” is an intentional relinquishment of a known right. A “waver” is somebody saying goodbye to a loved one at the airport. When you “waive” your rights, you are agreeing not to assert them. When you “wave” your rights, you are trying to dry them off in the breeze. 

 

Council/Counsel: These words get conflated when someone is trying to refer elliptically to a lawyer or to legal advice. The word “counsel” can be used as a noun or as a verb; that is, it can be used to describe an advisor or to describe advice. A “council” is an assembly of persons gathered for deliberations. Near my house when I was a child, there was a Catholic church called “Our Lady of Good Counsel.” By contrast, the moniker “Our Lady of Good Council” refers to a popular assemblywoman. Anyway, if you are referring to a lawyer or to legal advice, the word to use is “counsel.” To avoid confusion, just say “lawyer” or “advice” and be done with it.

 

Advice/Advise: The confusion of these two words somehow feels like a blood relative to the confusion of council and counsel. When a lawyer counsels you, she is advising you. When a lawyer gives you her counsel, she is giving you her advice. Here’s how to keep them straight: “advise” is a verb and “advice” is a noun.

 

Site/Cite: A “site” is a location. A “cite” is a reference or quotation. This blog is a web site. When I refer to a legal case on this site, it is a cite to that case. I try to keep this distinction in my sights.

 

Used to/Use to: The confusion of these two short phrases use to bother me, but then I got used to it.

 

When Words are Lacking: It is one thing to confuse words, but it is an entirely different problem when there are no words. An anecdote will illustrate the problem.

 

Like many newlyweds, when I was newly married I was unsure how to address my new mother-in-law and father-in-law. I wanted to use their first names, but that seemed a little bit forward at that point. I decided I would just ask them how they wanted me to address to them, in the hope that they would then authorize me to use their first names. In making this calculation, I did not make sufficient allowances for the peculiarities of the specific people I was dealing with. (I know better now.) My mother- in- law, a scholar of Chinese art, said that the Chinese have words for everything, and they even have words for a son- in- law to use to address his mother- in- law and father-in- law. She suggested that I use these Chinese words to address them. If I recall correctly, the words were something like “kung-kung” and “tai-tai.” She wasn’t kidding. (I didn’t learn the Chinese words, but I did learn something important about my new in-laws.)

 

The point of this story is that there are a lot of things for which there are no words in English, such as forms of address for a son-in-law to use when addressing his father-in-law or a mother-in-law. As illustrated in this January 8, 2013 article from The Atlantic, there are also many emotional states and circumstances for which other languages have names but for which there are no English equivalents. My personal favorite from this list is “Backpfeifengesicht (German): A face badly in need of a fist.”

 

Once you get started, apparently there are a lot of things for which are no words in English and there are a lot of lists of words in foreign language for which there are no English equivalents. I have linked here and here to a couple of the better lists. Here is a good example from one of the lists: “Zeg (Georgian): It means ‘the day after tomorrow.’ Seriously, why don’t we have a word for that in English?”

 

And Now, A Complete Waste of Time: On the website for Abbey Road Studios, the studios have a page with a live webcam feed of the street crossing that the Beatles made famous with their Abbey Road album cover. The camera is set up at a reverse angle from the album cover shot, but if you watch the webcam feed for a few minutes during the daytime you will see various people in the crosswalk trying to take pictures of their group striking the album cover road crossing pose. I watched for about ten minutes yesterday morning and saw several different groups of people trying to capture the album shot. Click here if you want to watch the webcam feed — but only if you are prepared to waste the next quarter of an hour. (Another day I will write the essay about our amazing modern technology and the ridiculous ways we use it.).

 

In what is as far as I know the first determination of liability in connection with the recent wave of litigation filed against U.S. listed Chinese companies, a Hong Kong-based arbitration panel has entered an award in favor of an investment unit of C.V. Starr of over $77 million against China MediaExpress Holdings and related persons and entities, based on the panel’s determination that the company was a “fraudulent enterprise.” The panel’s December 19, 2012 award, which can be found here, makes for fascinating reading. (Hat tip to Jan Wolfe, who reported the award and related U.S.-court filings in a January 16, 2013 Am Law Litigation Daily article, here.)

 

In October 2010, China MediaExpress obtained a U.S. listing through a reverse merger with a U.S. listed publicly traded shell corporation. Prior to the reverse merger, the predecessor entity was owned by Zeng Cheng (“Cheng”) and Ou Wen Lin and Lin’s brother. China MediaExpress allegedly was in the business of providing advertising on inter-city busses. The company’s financial statements showed growing profits and large cash reserves. Starr invested a total of $53.4 million in China MediaExpress in two private transactions in January 2010 and October 2010. 

 

In early 2011, online analysts published reports questioning China MediaExpress’s financial statements. Shortly thereafter, China MediaExpress’s auditor and CFO resigned, as well as members of its board of directors. (Refer here for background.) Trading in China MediaExpress’s shares was halted. Pursuant to provisions in its stock purchase agreements with China MediaExpress, Starr initiated two Hong Kong arbitration proceedings against China MediaExpress, as well as Cheng, the Lin brothers and related entities. Separately, Starr initiated a securities fraud class action against China MediaExpress, its principals and related entities, and the company’s auditor in the District Court of Delaware. (In addition, certain other shareholders separately filed a securities class action lawsuit against China Media Express in the Southern District of New York, about which refer here.)

 

The arbitration panel, which was chaired by former Delaware Supreme Court Justice Andrew Moore II, heard evidence in the two consolidated arbitrations in May 2012. On December 19, 2012, the panel delivered its Award.  A copy of the arbitration award was filed in the District of Delaware lawsuit on January 13, 2013 (refer here).

 

The 49-page award makes for some fascinating reading. Among other things, the panel concluded that the company was “a fraudulent enterprise that caused Starr to lose the total value of its investment.” Cheng, the panel concluded, has “no credibility whatsoever”. Ou Wen gave the impression on the witness stand that “he would say whatever he thought would advance his case.” 

 

Among many things that troubled the panel was what had happened to the supposedly thriving business that had been represented to Starr. The company attempted to argue that the business had been destroyed by short sellers, a contention the panel described as “ridiculous,” observing that:

 

To put it bluntly, this claim of Cheng and CME that short sellers destroyed his business is nonsense. It is a fabrication evidently designed to hide the fact that CME never had the business it represented to the world that it had or that, if it did, it has been ravished by dishonest conduct on the part of those who conducted the business. Coupled with the conduct when challenged with the matters raised by [the company’s auditors] and other matters, Cheng’s claim that the short sellers destroyed his business indicates that Starr was correct with it contended that CME was a fraudulent enterprise.

 

The one specific transaction Cheng offered to explain what happened to all of the cash that the company had reported on its balance sheet was “a land transaction at Shoushan Waterfall.” However, the “evidence concerning this transaction was so implausible and contradictory that it is impossible to accept his claim that any money invested in that transaction was for the benefit of CME and its shareholders even if money of CME was used to finance this transaction.” Overall, the evidence Cheng offered regarding this transaction (which had not been approved by the Board or reported to shareholders and involved a company in which Cheng had an ownership interest) established that Cheng was “in breach of his fiduciary duty.” The evidence concerning the transaction “simply reinforces the conclusion that Cheng was both an unreliable witness and a dishonest businessman.”

 

As Jonathan Weil said in his January 11, 2013 Bloomberg column about the latest accounting scandal involving a Chinese company, “Chinese stocks may not make for trustworthy investments, but they sure can be entertaining to watch from a distance.”

 

The arbitration panel’s award represents a devastating judgment against China MediaExpress and its key officials. It remains to be seen how Starr will be able to use this judgment in its separate U.S. securities fraud suit and whether it will be able to collect on the Hong Kong panel’s award. It will also be interesting to see what the claimants in the separate securities class action lawsuit will be able to make of the arbitration award. On the one hand, the panel’s brutally worded conclusions about the company and its principals are damning. On the other hand, the issue preclusive effect of these determinations in separate proceedings involving separate parties and separate evidentiary standards is the kind of thing good lawyers could argue about for a long time.

 

In any event, whatever the ultimate effect of the arbitration’s panel’s determinations may prove to be, the fact is that, according a statement by Starr’s lawyer quoted in the Am Law Litigation Daily article linked above, the panel’s ruling represents the “first time any of these issues concerning Chinese reverse mergers have been adjudicated.” The implication for other companies involved in these cases – many of which involve allegations even more sensational than were raised here – is ominous.

 

As the current wave of bank failure litigation has unfolded, the directors and officers of banking institutions rightly have become more concerned about the own potential liability exposures and interested in learning more about how they might be able to reduce their risks and exposures. In the following guest post, Joseph T. Lynyak III , Michael Halloran, and Rodney R. Peck of the Pillsbury law firm take a look at the current litigation environment facing directors and officers of financial institutions and provide some practical steps that these officials can take to try to mitigate their risks

.

I would like to thank Joe and Rob for their willingness to publish their articcle on this site. I welcome guest posts from responsible commentators on topics of relevance to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Here is Joe’s and Rod’s guest post.

 

 

 

In this article, we analyze the steps that officers and directors of bank and non-bank financial companies and their holding companies and affiliates can take to address personal liability for alleged breaches of duty to manage and supervise a financial company’s operations, allegations which are being made in an increasing number by federal and state regulatory agencies, including the federal banking agencies and the U.S. Consumer Financial Protection Bureau (CFPB).

 

On December 10, 2012, a California jury returned a verdict of $169 million in a case brought by the FDIC against three former IndyMac Bancorp Inc. executives after determining that those officers were negligent in making loans to homebuilders by continuing to push for growth in loan production without proper regard for creditworthiness and market conditions. Soon thereafter, the former CEO of IndyMac Bank agreed to pay $1 million from his personal assets in addition to available insurance proceeds to settle another FDIC claim related to the failure of IndyMac Bank. In an unrelated yet problematic series of developments, the newly formed CFPB recently assessed civil money penalties against three holding companies for aggressive marketing practices in an aggregate amount exceeding $500 million.

 

Approximately 25 lawsuits were filed in 2012 by the FDIC against former officers and directors of failed institutions, up from 16 in 2011. In total, more than 40 lawsuits have been filed against officers and directors of failed institutions since 2010. Since the beginning of 2007, approximately 467 financial institutions have failed. The FDIC has indicated that it is continuing its investigation of many bank failures and additional actions can be expected. Outside directors, in addition to inside directors and senior officers, were named in 30 of the cases. (See, Cornerstone Research, “Characteristics of FDIC Lawsuits Against Directors and Officers of Failed Financial Institutions,” December 2012.)

 

These and similar administrative and civil enforcement actions brought by governmental entities have caused considerable concern among officers and directors of financial services companies. Specifically, many individuals have raised questions whether—and in what circumstances—management or members of a board of directors might be held personally liable for similar penalties or damages, and if so, what prudent actions could be taken to mitigate that risk.

 

Although these issues are complex and the risk will vary based upon differences between the corporate laws of state jurisdictions and the possible applicability of several banking and securities laws (among others), this article presents an overview and proposed approach to analyzing the risk of personal liability. It also includes a methodology to evaluate protections that might be available under current corporate governance provisions.

 

What follows is a summary of pertinent legal issues relating to the risk of personal liability, distinctions to be drawn between liability arising in the bank and non-bank context, and steps that directors and officers might take to minimize personal liability risk, as well as a methodology for taking an inventory of existing protections available to a board and management.

 

Overview and Summary—State Corporate Laws

From a traditional corporate law perspective, both officers and directors of a corporation owe a duty to the corporation to avoid self-dealing and conflicts of interest (the “duty of loyalty”) and an affirmative obligation to use reasonable efforts to properly manage and supervise the business of the company (the “duty of care”). The degree or standard by which an officer or director must comply with his or her duty of care is generally governed by the corporate law of the state in which the company is incorporated. That standard can range from an obligation to act in a reasonable manner and avoid negligent actions or decisions, to a diminished level of care that creates personal liability only in the case in which one acts in a grossly negligent fashion.

 

Because most state legislatures have considered these questions, each state’s Corporations Code has its own version of the duty of care, and in many jurisdictions the courts have further refined that standard by judicial interpretation. For example, in several states, liability for breaching the duty of care can only be actionable when a director or officer is grossly negligent, while in other states the standard of gross negligence protects only outside directors while management is held to the higher standard of mere negligence. Further, in many jurisdictions there is recognition—either by statute, case law or common law—that directors and/or officers may rely upon the so-called “business judgment rule” that protects them against personal liability provided that the officer or director took reasonable steps to come to a decision even when the decision is proven to be wrong.

 

In addition, several states have authorized limitations of liability for corporate misfeasance by permitting a corporation to adopt provisions in its articles or bylaws that further limit liability for board members or management. Importantly, in recent years, several states have adopted expanded indemnification rights for corporate stakeholders by permitting a corporation to adopt in its articles and bylaws very broad rights to indemnify officers and directors against individual damage claims brought against them in their individual capacities.

 

The lesson to be learned is that concerned officers and directors should establish a baseline to identify by what state law standard they will be measured when being judged regarding compliance with the duty of care, as well as related state law limitations regarding liability.

 

Additional Concerns for FDIC-Insured Institutions, Subsidiaries and Holding Companies

In addition to the state law standards regarding a director or officer complying with his/her duty of care, there are several other significant considerations that require attention for an officer or director of an FDIC-insured institution or a bank or savings and loan holding company.

 

First, an important U.S. Supreme Court decision, Atherton v. FDIC, confirms that there is no federal common law regarding the duty of care for a national bank or a federal savings association. Accordingly, based upon the Atherton decision (which interpreted a provision of the Federal Deposit Insurance Act, or the “FDI Act”, for receivership claims brought by the FDIC following a failure of a bank or thrift), the standard for national bank and federal association officers and directors generally follows state law, except that state law cannot impose a standard lower than gross negligence. Of course, for banks and bank holding companies organized under state corporate laws, the duties of care on the part of officers and directors are governed by such laws (subject to the partial preemption under the Atherton decision).

 

Second, applicable regulations for national banks and federal savings associations provide a useful alternative that permits a national bank or federal savings association to adopt for corporate governance purposes the Corporations Code of the state in which the institution is located, the Model Business Corporations Act or the Delaware General Corporations Code. This is a potentially valuable option that should be carefully considered. For example, in states in which liability for bank officers is based upon the higher standard of mere negligence, adopting the corporate law of Delaware not only lowers the standard for breach of the duty of care to gross negligence, but may also provide enhanced protection in regard to indemnification and the availability of the Delaware version of the business judgment rule.

 

However, it should be noted that Section 18(k) of the FDI Act (and thus, FDIC’s regulations) severely (and unfairly) limits indemnification rights of officers and directors of FDIC-insured institutions, their subsidiaries and their holding companies in instances in which civil money penalties and other regulatory enforcement orders are assessed against an “institution affiliated party,” which includes officers and directors of an FDIC-insured institution, its subsidiaries and any parent holding company. Even though defense costs may be paid or advanced by an institution (and commercial insurance may be purchased to pay such expenses), the proceeds of the insurance cannot be used to pay for penalties assessed.

 

Mitigation Considerations for Officers and Directors

If there is a key conclusion that can be drawn from this discussion, it should be that individuals acting as officers and directors of financial intermediaries should engage in advance planning and clearly understand the nature of their rights in regard to administrative enforcement actions that might be brought by one of the federal banking agencies or the CFPB. Importantly, when complying with his or her duty of care, an officer or director should ensure that the record reflects reasonable steps to comply with that standard.

 

In that regard, an officer or director should be provided with legal advice as to what degree of diligence and review should be incorporated into the decision-making process, as well as how that process is reflected in the records of the institution. Particularly in the case in which the business judgment rule is available, the business records of the entity should reflect that all appropriate steps were taken prior to decisions being made.

 

It should be noted, however, that a distinction should be drawn between an FDIC receivership claim and assessment of civil money penalties by the CFPB or one of the federal banking agencies. In the case of a receivership claim following a bank failure, the above-referenced duty of care for personal liability purposes (e.g., negligence, gross negligence, etc.) is most often a determinative factor. However, in the administrative context in which civil money penalties are being assessed, culpability need not be based upon the failure to comply with a duty of care, but rather, can be based upon an institution’s compliance or non-compliance with an enforcement order previously issued in which officers and directors are ordered to take specific remedial steps to achieve compliance.

 

A Methodology for Determining and Achieving Reasonable Risk Mitigation to Avoid Personal Liability

As even the casual observer can see, being an officer or director for a financial institution—whether FDIC-insured or otherwise—presents a range of challenges. Complicating the situation is the nature of legal representation of companies, in that counsel for a company is usually not deemed to be providing individual legal advice to officers or directors, and hence the use of in-house counsel or a company’s outside lawyers to provide personal advice may not be appropriate or available in all cases.

 

We suggest that several steps be considered to address the concerns discussed by this article.

 

First, as noted above, officers and board members should obtain an overview of the rules governing compliance with the duty of care applicable to the company, including how courts and agencies have interpreted those rules. Among other things, identifying process issues and evidencing development of policies and procedures is essential, as well as ensuring that business records reflect robust discussion and reasonable reliance on experts (i.e., to be able to take advantage of the business judgment rule).

 

Second, a corporate governance review should take place to determine whether corporate documents such as articles and bylaws include the most favorable indemnification rights permitted under applicable law. (In that regard, it is important to note that in most cases such protections are optional under state corporate law and must be affirmatively adopted by a company’s board of directors.)

 

Third, employment agreements and indemnification agreements should be reviewed and updated on an annual basis to maximize contractual rights for designated officers and directors.

 

Fourth, extreme care should be exercised when transactions or other matters arise in which the director or officer may be seen as having a conflict of interest. All corporate processes should be followed, including full disclosure of the nature of the conflict, approval of the matter by a majority of disinterested directors, advice of counsel, etc.

 

Fifth, directors should work with management to establish internal tracking systems on matters requiring attention (“MRA”) arising out of regulatory examinations. Repeat violations of law or failure to remediate troublesome conditions by the next examination can be seen as a lack of proper board oversight. Careful attention should be given to the regulators’ evaluation of management and appropriate action taken when poor ratings are given. However, reliance on the regulators’ evaluations of management alone may not be sufficient because it appears that regulatory evaluations of management in many cases of failed banks have not been significantly downgraded by the regulators until a year or two before the bank’s failure. (Cornerstone Research, supra.)

 

Finally, a legal review of a company’s directors’ and officers’ liability insurance policies should be conducted and benchmarked against similar institutions in similar circumstances. It should also be noted that the contractual terms of directors’ and officers’ liability policies are frequently negotiable, and can result in valuable additional liability protection.

 

Other Standards of Liability Impacting Officers and Directors of a Financial Company

Although this article focuses on corporate and banking liability standards applicable to officers and directors of a financial intermediary, other standards of care arise in particular circumstances as part of the performance of the activities of an officer or director of a financial company. For example, in several instances under the federal securities laws, a corporate officer for a registered company can be held liable in civil or SEC actions for material misstatements in offering materials unless the director has engaged in a “due diligence” review. In regard to companies and “institution affiliated parties” that are subject to Section 8 of the FDI Act, liability might be viewed as a strict liability standard if a federal banking agency views the actions of an officer or director as having engaged in a violation of a federal law, regulation, or unsafe or unsound banking practice. Similarly, the newly established CFPB may also directly access civil money penalties and other remedial measures if an officer or director has participated in the violation of a covered federal consumer protection law.

 

Please note that this article summarizes several complex liability topics and by its nature is a starting point for further inquiry by officers and directors of banks and non-banks participating in the financial services industry.

 

Joseph T. Lynyak III is a partner in the Finance practice at Pillsbury Winthrop Shaw Pittman LLP in Washington, D.C., and Los Angeles. He can be reached at (213) 488-7265 or joseph.lynyak@pillsburylaw.com.

 

Rodney R. Peck is a partner in the Corporate & Securities practice at Pillsbury in San Francisco. He can be reached at (415) 983-1516 or rodney.peck@pillsburylaw.com.

 

The U.S. Supreme Court’s 2011 decision in Wal-Mart Stores v. Dukes continues to agitate the employment practices litigation arena while at the same time both EEOC enforcement activity and wage and hour litigation continue to surge, according to the annual review of workplace litigation by the Seyfarth Shaw law firm. The law firm’s January 14, 2013 press release about this year’s ninth edition of the annual Workplace Class Action Litigation Report can be found here. The report’s introductory “trends” chapter and the “top ten” settlements chapter can be found here.

 

Among the many changes that the Wal-Mart case has brought about during the past year is that it resulted in a decline in the levels and numbers of employment discrimination class action settlements in 2012. According to the report, the 2012 total for all employment discrimination class action settlements was about $49 million, which is well below the $348 million level in 2010, the year before the Wal-Mart decision, and the lowest annual level since 2006. (As discussed n greater detail here, in its June 2011 decision in the Wal-Mart case, the Supreme Court established a heighted standard to satisfy the “commonality” required in order to certify a class.)

 

This decline in aggregate settlements is due to the fact that employers settled many fewer employment discrimination cases during 2012, fewer than “at any time over the past decade and at a fraction of levels as in the period from 2006 to 2011.” The decline reflects the difficulty in the wake of Wal-Mart in certifying a nationwide class, as well as the ability of the defendants “to dismantle large class cases or to devalue them for settlement purposes.” Indeed, according to the study, the Wal-Mart case has “caused both federal and state courts to conduct a wholesale review of the propriety of previous class certification orders in pending cases.”

 

At the same time, though, governmental enforcement activity remained at “white hot” levels in 2012. According to the report, more discrimination charges were filed with the EEOC in 2012 than in all but one previous year since the Commission was founded. The Commission is particularly focused on its “systemic investigation program” in which the agency is emphasizing the “identification, investigation and litigation of discrimination claims affecting large groups of ‘alleged victims.’” According to the study, the agency is focused on “high-impact, high-stakes litigation.”

 

In particular, the EEOC’s prosecution of “pattern or practice lawsuits” is “an agency-wide priority.” The Commission completed work on 240 systemic investigations in fiscal year 2012, resulting in 94 ‘probable cause’ determinations and 46 settlement agreements or conciliation agreements that yielded a total recovery of $36.2 million for systemic claims.

 

And while workplace litigation overall has remained level with prior years, wage and hour related litigation “continued to out-pace all other types of work place class actions.”   Thus, while ERISA litigation was down slightly for the year (from 8,414 cases in 2011 to 7,908 in 2012, a decline of about 6%) and employment discrimination filings were also down (from 14,411 in 2011 to 14,260 in 2012, a decline of 1%), there were 7,908 FLSA lawsuit filings in 2012, representing about a 16% increase from the 6,779 filings in 2011. In addition, state court wage and hour class action lawsuit filings also surged in 2012. The report projects that “the vigorous pursuit of nationwide FLSA collective actions by the plaintiffs’ bar will continue in 2013.”

 

While the U.S. Supreme Court’s Wal-Mart decision, as well as its 2011 ruling in AT&T Mobility v. Concepcion (recognizing the enforceability of contractual arbitration agreements), have unquestionably had an impact on the workplace litigation arena, the plaintiffs class action bar has moved quickly to respond. According to the report, 2012 saw “rapid strategic changes based on evolving decisions and developments.” The plaintiffs’ bar “began the process of ‘re-booting’ class–wide theories of certification, as well as establishing liability and damages on a class-wide basis.”

 

As a result, “workplace class action litigation case law is in flux, and more change is inevitable in 2013.” Among other things, the report suggests that as a result of these changes, “future employment discrimination class action filings are likely to increase due to a strategy whereby state or regional-type classes are asserted rather than nationwide, mega-cases.”

 

A January 14, 2013 Corporate Counsel article about the Seyfarth Shaw report can be found here. Special thanks to Gerald Maatman, the report’s co-author and chair of the Seyfarth Shaw class action litigation group, for providing me with a copy of the report and press release. Maatman’s January 14, 2013 post on the Workplace Class Action Blog about the report can be found here.

 

On January 10, 2013, in a detailed and interesting opinion with features that may be helpful to other life sciences securities suit defendants, Middle District of Tennessee Judge Kevin Sharp granted the motion of Biomimetic Therapeutics to dismiss the securities class action lawsuit that had been filed against the company over its disclosures concerning developments in the clinical trials of its flagship product. A copy of Judge Sharp’s opinion can be found here.

 

The clinical trials were conducted in support of the company’s efforts to obtain FDA approval of its bone grafting product called Augment. Biomimetic conducted the clinical trial pursuant to protocols it had proposed and that had been approved by the FDA. As later became apparent, Biomimetic based its analysis of the testing results on a different patient population than had been identified in the FDA-approved protocols. The results associated with the different population were more favorable to the company.

 

The FDA expressed concerns to Biomimetic about the population used and other aspects of the clinical trials in a December 3, 2012 deficiency letter. The FDA also raised a number of concerns about the trials in a May 10, 2011 briefing document released in advance of the public expert panel meeting. Following the meeting, the expert panel narrowly voted in favor of approval of the Augment’s safety and efficacy.

 

Biomimetic’s share price declined 35% following the FDA’s May 10, 2011 disclosure of the testing concerns. Its share price declined a further 12% following the narrow expert panel vote, out of concerns that in view of the narrowness of the expert panel vote, FDA approval without additional processes was unlikely.

 

Following the share price decline, shareholders filed a securities class action lawsuit in the Middle District of Tennessee against Biomimetic and certain of its directors and officers. The shareholders alleged that throughout the class period, the defendants made unjustifiably positive statements about the Augment clinical trials and omitted to disclose the specific concerns that the FDA had raised about the trials.

 

According to the court, the “heart” of the plaintiffs’ allegations was that the defendants had engaged in a regulatory “bait and switch” by changing the patient population used to analyze its trial results in a way that allowed the company to report more favorable results that would have been shown if the original population were used. The plaintiffs also alleged that the defendants had failed to disclose the other problems with the clinical trials, including in particular that Biomimetic had failed to include processes to capture measurements on additional items that were of particular concern to the FDA.

 

The defendants moved to dismiss the plaintiff’s complaint.

 

The January 10 Opinion

In his January 10, 2013 opinion, Judge Sharp granted the motion to dismiss without leave to amend, finding that the plaintiffs’ allegations failed to meet the pleading requirements of the PSLRA.

 

Judge Sharp rejected the argument that the company’s use of a modified patient population to analyze the trial results violated the FDA-approved protocol. He also found that in a press release and in an earnings call, the company had “acknowledged the confusion that had been generated between the classifications of patient populations.” In light of these disclosures, the company’s statements about the patient populations “do not suggest a knowing and deliberate intent to deceive or defraud, let alone highly unreasonable conduct.”

 

In reaching this conclusion, Judge Sharp put particular emphasis on the fact that the company had “never suggested approval by the FDA was assured,” adding that “quite to the contrary,” the company “repeatedly and consistently warned that there were no guarantees that Augment would be approved.”

 

Judge Sharp also found that plaintiffs’ allegations that the defendants had deceptively omitted to disclose other clinical trial deficiencies were also insufficient. He concluded that “the alleged deficiencies and the omission in the clinical trials do not raise a strong inference of fraudulent intent as required by the PSLRA.”

 

In particular, Judge Sharp rejected, as insufficient, the plaintiff’s argument that the company was “cutting corners by failing to conduct certain tests or studies.” He noted that

 

The notion that [Biomimetic] would recklessly forego necessary tests and studies or hide adverse events makes little sense, even disregarding Defendants’ assertion that they poured their own money into the company. Plaintiffs’ own allegation is that Augment is [Biomimetic’s] flagship product and necessary to the companies [sic] success, begging the question why it would sabotage all of the company’s efforts on the point.

 

Along those lines, Judge Sharp noted that neither the company nor the individual defendants had engaged in securities sales after the company received the FDA’s deficiency letter.

 

One particularly interesting aspect of Judge Sharp’s opinion is his consideration of the plaintiffs’ allegations that the defendants had deceptively failed to disclosed the FDA’s concerns in the deficiency letter while at the virtually the same time had made positive statements about the progress of the Augment clinical trials. Judge Sharp noted that “a deficiency letter is not a final FDA decision, but a request for more information, and in fact, very few [applications] are approved without the issuance of a deficiency letter.” Judge Sharp then cited with approval language from a prior opinion to the effect that “it simply cannot be that every critical comment by a regulatory agency has to be seen as material for securities law reporting purposes.” He concluded that based on the overall factual allegations, the company “had a reasonable basis for optimism” notwithstanding the concerns noted in the deficiency letter.

 

Discussion

As I noted in my recent analysis of 2012 securities class action lawsuit filings, life sciences companies continue to be a favored target for securities class action litigation. The reason the companies attract securities suits has a lot to do with the complex and unpredictable regulatory process to which the companies are subject. The regulatory process is. As this case shows, many things can happen during the course of a clinical trial, which in turn can significantly affect investors’ perceptions of the prospects for the company involved.

 

There are several aspects of Judge Sharp’s opinion that should be heartening to life sciences companies that find themselves targeted by securities litigation as a result of setbacks the companies experience in the clinical trial process.

 

First, Judge Sharp showed an uncommon willingness to immerse himself in the complexities of the regulatory process and the science involved with the Augment clinical trials. Because of his willingness to understand the complex details, he was able to understand what had happened concerning the change in patient population used for analytical purposes. He was also able to understand the company’s disclosures about the populations used. Because he had this understanding, he was not persuaded by the plaintiffs’ characterization of the change in patient populations as a “bait and switch.” Of course, other life sciences securities suit defendants may not always have a court as wiling to do the hard work to develop those kinds of detailed understandings of the process and of the science. But this case does show the possibilities arising from trying to make those kinds of arguments to the court.

 

A second and more interesting aspect of Judge Sharp’s opinion has to do with his analysis of the plaintiffs’ allegations concerning the defendants’ alleged failure to disclose the concerns noted in the deficiency letter. Although he does not come right out and say that life sciences companies do not have an obligation to disclose an FDA deficiency letter, Judge Sharp’s opinion certainly will provide support for other life sciences securities suit defendants who want to argue that the mere fact that the FDA has sent a deficiency letter alone is not necessarily material and that the failure to disclose concerns identified in a deficiency letter does not by itself amount to securities fraud. This aspect of Judge Sharp’s opinion could prove to be quite helpful for other life sciences securities defendants.

 

Another important aspect of Judge Sharp’s opinion has to do with his analysis of the company’s precautionary disclosures. He clearly considered it important that the company avoided any suggestion that approval of Augment was assured and emphasized the possibility that Augment might not be approved. The company’s precautionary disclosures, along with the absence of any insider or company stock sales at sensitive times, seems to have gone a long way toward reassuring Judge Sharp that the defendants had not set out to deceive anyone. Judge Sharp’s opinion underscores the importance for life sciences companies to avoid overly optimistic statements about future regulatory outcomes as well as for the companies to use the disclosure documents to “bespeak caution” to investors about the uncertainties of the regulatory process.

 

One final note about Judge Sharp’s opinion has to do with the simple fact that the dismissal was granted. Because of the unpredictability of the FDA regulatory process and because of the resulting volatility of life sciences companies’ share prices, the companies tend to attract significant levels of securities litigation. But though the companies may attract lawsuits,  that does not always mean that the suits are always great cases for the plaintiffs. As one industry observer noted (refer here), “courts continued to grant with relative frequency life sciences companies’ motions to dismiss due to plaintiffs’ inability to sufficiently plead scienter.”

 

One of the reasons Saul Steinberg’s iconic 1976 New Yorker cover – the one showing that civilization ends at the Hudson River – is so humorous is that it accurately captures the way some (many?) New Yorkers look at the rest of the world.

 

Before moving to Cleveland almost two decades ago, I lived in Washington, D.C., another city that all too often considers itself the only relevant reference point in the entire universe. So I had no illusions when I made the move to Cleveland — I knew that I was about to take up residence in what many consider fly-over country.

 

I don’t mind the jokes about my adopted city. (From my perspective, the funniest thing about the jokes is how little they have to do with the actual city in which I live.) I have gotten used to the occasional telephone conversation in which it is clear that the person on the other end is confusing Ohio with Iowa. Or even Idaho.

 

Nevertheless, it still catches me short when somebody asks me what time zone I am in. The question might make sense if Cleveland were anywhere near the time zone line. The fact is that it is a long way from Cleveland to the Central Time Zone. Before a Clevelander would have to re-set their watch to Central Time, he or she would have to go all the way across the rest of Ohio (more than 160 miles), and then he or she would have to go clear across Indiana (another 140 miles). Let’s put that into perspective. Cleveland is about as close to the Central Time zone as New York is to Richmond, Virginia.

 

The basis of this time zone confusion puzzles me. I am sure that very few people – even New Yorkers — would ever assume that, say, Fort Myers, Florida is in the Central Time Zone. Yet Cleveland and Fort Myers are at the same longitude (81 degrees west). For some reason, Cleveland apparently drifts out westward into the Plains States in the imaginations of many.

 

The time zone question is only one of the many things that show how much confusion there is about Cleveland’s location. On several occasions, I have had someone say to me, “There’s going to be a meeting in Cincinnati. Since its right there in your back yard, why don’t you attend?” The problem is that it is further from Cleveland to Cincinnati (250 miles) than it is from New York to Washington (229 miles). I doubt many New Yorkers think that Washington is right in their back yard.

 

An extreme example of this location confusion occurred when a colleague suggested to me that I ought to look into a business prospect in Evansville, Indiana, again as if that were right around the corner. However, it is further from Cleveland to Evansville (470 miles) than it is from Washington to Boston (442 miles).

 

I also know that in the popular imagination, Cleveland is very far north. Looking out the window now at my snow-covered yard, Cleveland certainly has the appearance of a northern city. But the fact is that at 41 degrees north, Cleveland is at the same latitude as Barcelona, Rome and Istanbul. For that matter Paris and Munich, at 48 degrees north, are both even further north than Montreal (46 degrees north). London, at 51 degrees north, is even further north than Moose Jaw, Saskatchewan (50 degrees north). 

 

I know that Cleveland is not the only U.S. city that suffers geographical confusion. The U.S. is a big country and the geographic relationship of its many parts does not always conform to armchair assumptions (particularly to those of residents of the U.S. East Coast). For example, if a random sample of people were asked which city is further west, Atlanta or Detroit, just about everyone would say Detroit. However, Atlanta (at 84 degrees west longitude) is further west than Detroit (83 degrees west longitude).

 

There are a host of expectation-defying geographical features of this country. One of the most interesting and surprising has to do with El Paso. Most people would be very surprised to learn that El Paso is closer to San DIego (724 miles) than it is  to Houston (747 miles).

 

The surprising distance from El Paso to Houston is a reflection of the sheer size of Texas. I was interested during a recent trip to Germany to observe that Texas is almost twice the size of Germany in geographic area — Texas is 268,581 square miles, Germany is 137,847. (For some reason, this observation seemed to trouble my German hosts.) Texas, it turns out, is larger even than France (260,558 sq. mi.), which really kind of astonishes me. Texas is big. But though Texas is both the second largest and the second most populous U.S. state, its population (26 million) is less than a third of that of Germany (81 million) and less than half of France (65.3 million).

 

A few years ago, before smart phones became ubiquitous, I was out at a business dinner, and it suddenly became extremely important to my table mates for us to determine whether California or Japan is geographically larger.  Large stakes depended on the answer to this question. We thought of an industry colleague whom we all agreed would still be at work despite the late hour. (She was.) We called her and she was able to determine for us that California (165,695 sq. mi.) is materially larger than Japan (145,925 sq. mi.) But though California is the most populous U.S. state, its population (38 million) is less than a third of that of Japan (126.6 million).

 

The extreme case of this mismatch between geographic area and population density is the comparison between the U.S. and China. The two countries are about the same size (roughly 3.7 million square miles), but China’s population (1.35 billion) is about four times that of the U.S. (315 million). There are a lot of empty places in the U.S. – and no, that wasn’t a reference to Oakland.

 

We live in an age of GPS devices and smart phones with map applications. At any moment, we can fix our own physical location with pinpoint precision. The entire world has been turned into one gigantic diagram with a continuous read-out to tell everyone “you are here.” However, it doesn’t do anyone any good to know you are “here” if you don’t have any idea where that is and how it all fits together.

 

So – in case you hadn’t noticed, it does kind of bother me when people don’t know what time zone Cleveland is in. Ladies and Gentlemen, Cleveland is in the Eastern Time Zone. So are Detroit, Indianapolis, Dayton, and Chattanooga. And so is Quito, Ecuador.

 

There is more to knowing where you are than just establishing your own physical location.

 

A distinctive feature of the current wave of FDIC failed bank litigation is the aura of déjà vu surrounding the suits. The resemblance of the current lawsuits to those filed during the S&L crisis is uncanny. And not only are the suits similar, but in many instances they even involve the same lawyers as last time around.

 

Just the same, any suggestion that the risks and exposures for financial institution directors and officers have not changed since the S&L crisis would be mistaken. The liability risks for FI Ds & OS have changed dramatically in recent years. In that earlier era, there was no Sarbanes Oxley Act and no Dodd-Frank Act, and there was no criminal money laundering liability. There was no Consumer Financial Protection Bureau or its requirements for compliance with consumer protection laws. There were no data privacy liability exposures of the type now emerging. Through these and a myriad of other legislative and judicial developments, the liability exposures of financial institution directors and officers have changed exponentially.

 

The individual directors and officers at financial institutions must navigate a difficult course in a treacherous environment. Fortunately for these individuals and their advisors, there is now a comprehensive resource to guide them. Samuel Rosenthal, a partner in the New York office of the Patton Boggs law firm, has written an exhaustive single-volume desk book  entitled Director and Officer Liability in Financial Institutions (here). Rosenthal’s 1045-page book is an indispensable reference for anyone who wants to understand and address the liability exposures of financial institution directors and officers.

 

Rosenthal’s book is built on a familiarity with the earlier litigation from the S&L crisis era as well as an awareness of the fraught circumstances now facing financial institution directors and officers following the subprime meltdown and ensuing credit crisis.

 

What makes this book so valuable is that it not only broadly organizes the traditional background regarding director and officer liability exposures but it also incorporates a thorough review of the new range of liability risks that have emerged as a result of legislative and judicial developments in recent years.

 

Thus for example, Rosenthal not only reviews the traditional civil liabilities facing financial institution directors and officers under the common law and federal statutory law, but also the myriad new criminal provisions to which FI Ds & OS are now subject, as well as the new potential consumer protection and privacy exposures they now face. Rosenthal brings many years of practical experience to this review; here is his perspective on the many recent changes:

 

This period over the last twenty-five years has witnessed a stunning trend in enforcement efforts has it has moved from traditional concepts dependent upom mens rea to one criminalizing conduct that might have been regarded – at best – to be a civil violation years ago. Directors and officers can be sued, barred from the industry or even jailed for conduct that years ago would have merited little or no attention from regulatory authorities and prosecutors.

 

In recognition of this new environment, Rosenthal’s book provides a detailed yet practical overview of the current state of governmental enforcement actions to which FI Ds&Os could be subject, including in particular a thorough summary of the recent civil actions and enforcement actions of the relevant federal agencies, as a way to afford insight into these agencies’ current expectations and approach.

 

Finally the book provides a practical manual for directors and officers of financial institutions on how they can best try to defend themselves – from the investigative stage through ensuing civil and criminal proceedings. The defense overview section includes a separate chapter on the indispensable question of how the directors and officers can pay for their costs of defense. This section includes a critical review of the relevant indemnification and D&O insurance issues.

 

The one thing that is hard to capture in this short book review like this is how detailed and specific this book is. The book’s scope and depth are extraordinary. As I browsed the book’s lengthy table of contents, I found myself turning frequently to the interesting and perceptive discussion of a host of issues on which I am currently involved. In each case, the book’s treatment of the topic was thorough and helpful.

 

Just the same, the book is written with the directors and officers themselves in mind. The book is intended to inform them of their duties and exposures; of the steps that can take to try to mitigate their risks; and what they should do when claims arise. The book also aims for those who counsel financial institution directors and officers. The book will also be valuable for anyone involved in claims concerning FI Ds&Os, including regulators, claimants, defense counsel, and D&O insurance claims counsel.

 

In short, Rosenthal’s  book is a comprehensive, practical and helpful guide for financial institution directors and officers written by a knowledgeable and experienced practitioner. For anyone called upon to address liability and enforcement issues, having this book at hand will be like having a hotline to a skilled and trusted advisor. This book is an essential resource that everyone involved in D&O liability issues should have on their desks.

 

One of the most vexing problems that can arise in the D&O claims context is when the amount of insurance available proves to be insufficient to resolve the pending claims. Although this problem can arise in many claims contexts, one particular context in which the problem can arise is in the context of claims by the FDIC as receiver of a failed bank against the bank’s former directors and officers.

 

In the following guest post, John F. McCarrick takes a look at these issues in the failed bank context and proposes a solution. John is a partner in the New York offices of the law firm White and Williams LLP, and focuses his practice on director and officer liability and related insurance coverage issues. The comments in this article are those of the author and do not represent the views of White and Williams LLP or any of its clients.

 

I would like to thank John for his willingness to publish his guest post on this site. I welcome guest posts from responsible commentators on topics of relevance to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Here is John’s guest post. 

 

            It’s a point of increasing discussion – and heated debate – in FDIC claims against the directors and officers of failed banks: the available D&O insurance limits of liability are insufficient to meet the FDIC’s settlement expectations, Who bears responsibility for purchasing adequate bank D&O insurance limits? And who should be blamed if the available D&O insurance coverage proves to be insufficient? To make matters worse, quantifying adequate D&O insurance is akin to aiming at a moving target. D&O insurance is a wasting asset; amounts spent on defense costs and on resolving non-FDIC claims reduce – on a dollar-for-dollar basis – the limits of liability left to settle an FDIC claim made during that same policy period. Should defendant directors and officers of a failed bank be expected to contribute to settlements out of their own, now-thinner wallets. Is this a fair outcome? On a more practical level, isn’t there a better way to avoid this outcome?

 

The Scorecard to Date

Since January 1, 2007, 467 U.S. financial institutions have failed. Of this total, the FDIC thus far has sued the directors and officers of 40 failed banks, and has reported agency authorization to file an additional 49 lawsuits. According to Cornerstone Research, the failures of the 40 institutions that are the subject of FDIC-initiated D&O lawsuits had a median estimated cost to the FDIC of $134 million.   Only six of these lawsuits had settled as of December 2012.

 

One FDIC case has gone to trial. On December 7, 2012 a jury in federal court in Los Angeles awarded $169 million to the FDIC in its suit against three former officers of IndyMac. Given the absence of significant personal assets of the three former IndyMac officers to satisfy this judgment, the FDIC is seeking to intervene in pending coverage litigation in an effort to recover some or all of the remaining D&O limits from IndyMac’s 2007 and 2008 D&O insurance towers. However, even a complete win by the FDIC in the D&O coverage litigation would allow the FDIC to recover just a percentage of the awarded jury verdict.

 

            The FDIC’s track record in settlement recoveries is not significantly better. The chart below shows reported settlement amounts compared to FDIC estimated losses.

Name of Institution

FDIC Est’d Cost of Failure

Claimed Damages in Complaint

Settlement Amount
 

(Millions)

(Millions)

(Millions)

Westsound Bank

$108

$15

$2

County Bank

$135

$42

TBD

Heritage Community Bank

$42

$20

Not Reported

Washington Mutual Bank

$0

TBD at Trial

$64[1]

First National Bank of Nevada

$862

$193

$40

Corn Belt Bank & Trust Co.

$100

$10

Not Reported

Source: Cornerstone Research,Characteristics of FDIC Lawsuits Against Directors and Officers of Failed Financial Institutions (December 2012)

 

 

Shortly after the above Cornerstone Research report was issued, former IndyMac CEO Michael Perry reportedly reached an agreement with the FDIC to settle the FDIC’s lawsuit against him for a payment by Perry of $1 million out of his own assets plus an additional $11 million in potential insurance funds through an assignment of Perry’s rights under his D&O policies.

 

With respect to the FDIC D&O cases still pending, the insured deposit losses paid by the FDIC in each case generally far outstrip the available D&O insurance proceeds. Moreover, because each failed bank’s D&O policies must respond to not only FDIC claims, but also other potential sources of D&O claims, including for example, shareholder and derivative claims, debtor claims brought by or on behalf of the bank holding company and claims brought by creditors of the failed bank, the FDIC is often faced with a materially-depleted insurance asset when it comes time to settle FDIC litigation against the directors and offices of a failed bank. To make matters worse (for the FDIC), the available limits of liability under D&O policies are eroded on a dollar-for-dollar basis by defense costs incurred prior to any settlement across all of these categories of claims and in defending collateral regulatory investigations. 

 

A Solution That is Not Novel

If the perceived inadequacy of D&O insurance limits is an issue of real concern for the FDIC, there is a simple solution to this problem: use the FDIC’s regulatory authority to require the purchase of D&O insurance limits in an amount proportional to the amount of risk created for the FDIC by aggregate insured deposits. This approach is by no means novel or creative: in fact, the FDIC already mandates that banks purchase fidelity bond insurance coverage.

 

By statute, the Federal Deposit Insurance Company can require insured financial institutions to maintain fidelity bonds to insure against such losses, and the FDIC has chosen to mandate that requirement. Other federal banking regulators, as well as most state regulators, also require universal fidelity coverage. For instance, the Comptroller of the Currency requires national banks to have "adequate fidelity coverage."

 

Similar mandatory purchases of fidelity bond coverage are detailed in the Employee Retirement Security Act of 1974, as amended (“ERISA”). ERISA Section 412(a) requires that every fiduciary of an employee benefit plan and every person who handles funds or other property of the plan must be bonded, with limited exceptions.

 

The amount of the ERISA fidelity bond is fixed at the beginning of each plan year and cannot be less than 10 percent of the amount of the funds handled. The amount of funds handled is determined by the amount of funds handled by the person, group, or class to be covered by the bond and by their predecessor(s), if any, during the previous reporting year.[2]

 

The FDIC also presumably has the authority to specify the kinds of D&O products most directly accessible for primarily FDIC recovery purposes. The following chart shows some of the obstacles faced by the FDIC, and the D&O insurance market solutions that have developed in response to similar concerns raised by other kinds of D&O insureds.

 

Types of Available D&O Insurance

FDIC Perceived Concern

Available D&O market solution

Comments

Inadequate insurance limits

Ample D&O limits capacity through U.S., Bermuda and Lloyd’s markets

Limits could be tied to FDIC exposure for insured deposits, as a correlated percentage of those deposits

Dilution of available limits

Side-A D&O insurance

Side A limits are preserved for claims against D&Os when advancement or indemnification from the bank is unavailable due to its insolvency, and provides no coverage for the bank’s own liability

Preserved limits for potential

FDIC claims

Side-A insurance potentially sitting excess of a traditional ABC D&O tower

Underlying limits would be used for defending and resolving competing D&O claims, including by shareholders and creditors, preserving limits for a more limited set of liability exposures above the standard D&O limits

Denial of coverage by

underlying D&O insurers

Side A DIC insurance

DIC (Difference-in-conditions) contains, as one coverage trigger, a denial of coverage by an underlying D&O insurer

So why are these D&O market solutions available now, and why weren’t they available in the late 1980s during the last significant wave of bank failures?

 

The Changed Landscape for Bank D&O Liability — and for D&O Insurance

The battleground over available D&O insurance for regulatory claims over failed banks bears little resemblance to that of the so-called S&L crisis of the late 1980s. Although D&O insurance had been available for 30-odd years before the wave of FDIC/RTC litigation against failed banks and S&Ls, D&O insurance was still, in the late 1980s, a relatively immature insurance product — one that had been designed primarily for public companies and their directors and officers facing shareholder class actions and derivative litigation exposures.

 

The S&L crisis and accompanying D&O litigation brought by banking regulators arguably comprised the first systemic loss event for the financial institutions sector of the D&O insurance industry, and the industry’s arsenal of defensive weaponry — in the form of “insured v. insured” exclusions, regulatory exclusions, aggregation of losses and multiple deductibles — were tested, to varying outcomes, in state and federal courts throughout the United States. The experience was both difficult and instructive for D&O insurers and bank policyholders. As a result of that experience, D&O underwriters became more aware of the size and scope of potential claims involving bank insureds, and began underwriting to a fuller set of potential exposures. Buyers of D&O bank policies obtained more certainty about how the policies would respond in the event of a bank failure.

 

In the intervening years since the S&L crisis, there have been two major developments impacting bank D&O insurance. The first is that a series of lengthy competitive (or “soft”) underwriting market cycles (punctuated by short “hard” markets) has led to a material broadening of D&O policy terms across all underwriting segments, such that the typical D&O policy of today is materially broader in scope than the typical D&O policy of 1987. Expanded insuring agreements, key definitions and liberalizing endorsements, coupled with narrower exclusions and exclusion triggers, have collectively resulted in a materially broader D&O insurance contract, covering a wide range of entity and individual insureds. 

 

A related development has been an increase in the number of insurers willing to sell D&O policies. This increase in competition, coupled with broader D&O policy terms, has meant that D&O buyers could purchase materially broader coverage from a larger number of insurers, at lower prices.   D&O insurers also now offer a number of other related D&O insurance products, such as Side-A only coverage, independent director liability coverage, and investigations coverage to D&O insurance buyers.

 

The foregoing is an overly-abbreviated list of significant changes relating to D&O insurance that have had the intended effect of making D&O insurance available to buyers on materially better (and broader) terms, and at lower prices. Banks have benefitted from these insurance market developments, and D&O insurance is a routine – albeit voluntary — purchase for large and small banks in the United States.

 

 The second significant development relating to bank D&O liability insurance since the late 1980s is that banks have materially changed the way they operate and make money. There are numerous reasons why banks have changed their business models since the late 1980s but here are a few of the most significant reasons:

 

1.      The repeal of Sections 20 and 32 the Glass-Steagall Act in 1999 allowed larger banks to engage in commercial activity outside traditional bank deposit and lending activities, including investment banking, securities underwriting and insurance, and even smaller banks were forced to adapt their business models;

2.      The rise of mortgage securitizations encouraged banks to sell off their mortgage portfolios, and focus on earning money primarily through loan initiation fees; and

3.      Proprietary trading allowed banks to make money by trading for their own accounts.

 

Of course, not all banks engaged in all of these activities; however, market competition among banks is being increasingly driven by their success in business activities outside traditional bank deposit and lending activities. In the wake of the credit crisis, it is clear that these non-banking activities have the ability to generate – and indeed, have generated — significant D&O and professional liability claims activity from shareholders, customers, creditors and non-banking regulators, posing significant competition for the very D&O insurance limits the FDIC targets as its primary source of recovery in failed bank D&O litigation.  

 

These two significant developments — broader D&O polices sold for lower premiums and a potentially broad range of business activities carried out under a bank banner — set the stage for a drastically different test for the next wave of bank failures.

 

That next wave of bank failures arrived beginning in 2008 courtesy of the so-called subprime crisis. Falling house prices undermined the packaged securities holding residential mortgages, leading to a near collapse in credit availability, choking off cash flow for banks and their customers.

 

Of the banks most significantly impaired by the credit crisis, some banks were acquired by larger, more stable banks – with some unfortunate results. Other banks simply failed, requiring the FDIC to compensate depositors for their insured deposits, and place the failed banks into an unduly liquidation process. Litigation inevitably followed — not just by the FDIC, but also by shareholders of bank holding companies, bank employees whose 401(K) retirement savings were held in the bank’s now worthless stock, and bank creditors too.

 

The FDIC does not appear to have kept up with the collateral liability and D&O insurance developments impacting the financial institutions whose customer deposits the FDIC insures. But, as discussed above, there appear to be some relatively simple fixes available.

 

For example, the FDIC could require that a bank purchase a minimum level of insurance limits of Side-A D&O coverage, under the reasoning that the FDIC would not want its regulated limits of liability impaired by defense costs, settlements or judgments payable to other claimants by, for example, the insured entity or non-officer employees. Such a required purchase would not prohibit a bank or bank holding company from purchasing broader types of D&O policies including, for example, conventional D&O policies that insure the named entity for securities related claims and other non-FDIC claims.

 

It is not the ordinary preference of bank managers (or the bank’s shareholders) to allocate substantial additional monies each year to D&O insurance premiums. Moreover, bank D&O insurance rates increase across the board when – as was the case in 2007-2010 — the entire industry sector is financially weakened. Nevertheless, it seems apparent that a scenario in which defendant directors and officers of failed banks must make personal settlement contributions to facilitate the settlement of an FDIC claim in light of impaired or otherwise inadequate D&O insurance limits proves the point that current models used in estimating and purchasing appropriate bank D&O limits are flawed, and negatively impact the FDIC’s ability to obtain a reasonable recovery for taxpayers — while placing bank managers’ personal assets at great risk.

 

This type of solution probably would not have been feasible in the late 1980s, when fewer than 10 insurers regularly underwrote D&O insurance. Today, there are more than 60 insurers selling D&O insurance for U.S. risks, enhancing the ability of banks to secure necessary additional limits of liability from numerous well-capitalized D&O insurers. Of this number, 26 carriers also actively underwrite Side A D&O insurance, suggesting that there are numerous purchasing choices for D&O insurance in general, and Side A insurance, in particular.

 

Conclusion

Neither policyholders nor D&O insurers favor unnecessarily outsized settlements of bank D&O claims, and there is always a legitimate concern that policyholders could be waste money unnecessarily on overly large or complex D&O insurance programs. On the other hand, absent some compelling reasons — such as fraud, self-dealing and the like – it is a questionable rationale for the FDIC to demand personal settlement contributions from directors and officers of failed banks based primarily on allegations of simple negligence and for failing to procure sufficient D&O insurance to meet the FDIC’s resolution expectations. If indeed a key driver of demands for personal contributions by the FDIC is inadequate amounts of D&O insurance, there is an easy fix to that problem.

[1] Composed of $39.575 million cash obtained from the D&O insurance policies, cash payments from the defendants of $425,000, and their agreement to pay the FDIC an additional cash amount based upon the amounts defendants actually receive, after tax, from certain of their claims pending in the WMI Chapter 11 proceedings (with a $24.7 million pre-tax face value).

 

[2] If there is no previous reporting year, then the amount is estimated under ERISA Reg. Sec. 2580.412-6.