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.

 

As I have discussed in prior posts (refer here for example), one of the recurring D&O insurance coverage issues that has arisen in connection with the FDIC’s failed bank litigation is the question whether or not the FDIC’s claims as receiver for the failed bank against the bank’s former directors and officers trigger the D&O policy’s insured vs. insured exclusion. In a terse January 4, 2013 opinion (here), Northern District of Georgia Judge Robert L. Vining, Jr. held that, owing to the “multiple roles” in which the FDIC acts in pursuing claims against the former directors and officers of a failed bank, there is “ambiguity” on the question whether the FDIC’s lawsuit triggers the insured vs. insured exclusion.

 

Background

Omni National Bank of Atlanta Georgia failed on March 27, 2009 (refer here). The FDIC was appointed as receiver for the failed bank. On March 16, 2012, the FDIC initiated a lawsuit in the Northern District of Georgia against ten former directors and officers of the bank, asserting claims against the defendants for negligence and gross negligence in connection with the approval of certain loans on low-income residential properties.

 

The bank’s D&O insurer initiated a separate declaratory judgment action seeking a declaration that there is no coverage under the bank’s D&O policy for the FDIC’s claims against the bank’s former directors and officers.

 

The D&O insurer filed a motion for summary judgment the declaratory judgment action, on three grounds: first: the carrier argued that because the FDIC as receiver “steps into the shoes” of the failed bank, the FDIC’s claim represents a claim “by, on behalf of, or at the behest of, the Company,” and therefore is precluded from coverage under the policy’s insured vs. insured exclusion; second, that the losses the FDIC seeks to recover do not fall within the policy’s definition of “loss,” which includes the so-called “loan loss carve-out”; and third that the policy does not in any event provide coverage for wrongful acts alleged against the former directors and officers that took place after the policy’s expiration.

 

The January 4 Opinion

In his January 4, 2013 opinion, Judge Vining denied the carrier’s motion for summary judgment with on the first two grounds, but granted summary judgment with respect to the alleged wrongful acts that took place after the policy’s expiration.

 

In rejecting the insurer’s argument that coverage is precluded by the policy’s insured vs. insured exclusion, Judge Vining said that “it is unclear whether the FDIC-R’s claims are ‘by ‘or ‘on behalf of’ the failed bank.” He added that “it is unclear what exactly is encompassed by the phrase ‘steps into the shoes.” These “ambiguities” arise, Judge Vining found, “in part because the FDIC-R differs from other receivers or conservators that might step into the shoes of a failed or insolvent bank.”

 

Judge Vining then reviewed the FDIC’s authority under FIREEA to recover losses, and the fact that in recovering losses the FDIC has authority to act on behalf of the bank’s depositors, creditors and shareholders.  Judge Vining noted that “the FDIC-R has multiple roles.” Accordingly, he concluded that “the FDIC-R has show that some ambiguity exists in the insured versus insured exclusion,” and he denied the carrier’s motion for summary judgment in reliance on the exclusion.

 

Judge Vining also rejected the carrier’s motion for summary judgment based on the argument that the financial losses the FDIC sought to recover did not constitute covered loss under the policy. Judge Vining found that “ambiguity exists in the definition of ‘loss’” because the “loan loss carve-out” does not “clearly exempt tortious claims” which is “the basis” for the FDIC’s claims in the underlying D&O liability action.

 

Discussion

Although D&O insurers have raised the insured vs. insured exclusion as a defense to coverage in connection with a number of FDIC failed bank claims, Judge Vining’s ruling in the Omni National Bank is so far as I am aware only the second ruling in connection with the current failed bank wave in which a court has made a ruling regarding the applicability of the insured v. insured exclusion to an action brought by the FDIC in its capacity as a receiver for a failed bank.

 

As discussed here, in October 2012, District of Puerto Rico Judge Gustavo Gelpi denied the D&O insurer’s motion to dismiss the coverage action the FDIC had brought against the carrier under Puerto Rico’s direct action statute. The D&O carrier involved had sought to dismiss the suit on the grounds that the D&O policy’s insured vs. insured exclusion precluded coverage for the FDIC’s claims in its capacity of the failed Westernbank against the bank’s former directors and officers. Judge Gelpi declined to dismiss the action, noting that the FDIC has authority under FIRREA to act “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

 

In both cases, the respective judges held that the carriers were not entitled to a determination as a matter of law that the exclusion precluded coverage. Both Judge Gelpi in the prior case and Judge Vining here determined that the Insured vs. Insured did not preclude coverage as a matter of law because the FDIC has the authority under FIRREA to act on behalf of a variety of different constituencies. The FDIC as well as individual directors and officers seeking coverage under their bank’s D&O insurance policies undoubtedly will seek to rely on these rulings in order to try to fight other carrier’s attempts to assert the Insured vs. Insured exclusion as a defense to coverage.

 

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action.

 

The carriers will further argue that the policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

 

Though these rulings unquestionably are helpful for the FDIC and the individual directors and officers, it seems likely that these issues will continue to be litigated in other cases.

 

Special thanks to a loyal reader for providing me with a copy of Judge Vining’s January 4 Order.

 

If you were among the many who extended the holiday vacation all the way through the short week following New Year’s Day, you may not have seen the year-end retrospective articles that I posted last week, including my list of the Top Ten D&O Stories in 2012 (here), and my year-end analysis of 2012 securities class action lawsuit filings (here). As it turns out, I am not the only one to have posted year-in-retrospective posts over the last several days. Several other bloggers and commentators have done the same. Here is a quick tour through several of the noteworthy year- end retrospectives.

 

First, over at the Delaware Corporate and Commercial Litigation Blog, Francis Pileggi and his colleague Kevin Brady (both of the Eckert Seamans law firm) have posted their list of the “Key Delaware Corporate and Commercial Decisions of 2012” (here). The post begins with the authors’ selection of the top five cases from 2012 and includes both the authors’ list of the top Delaware Supreme Court decisions and Court of Chancery decisions for the year. The authors helpfully link to their own prior posts on the key cases as well as to the decisions themselves. I should add that the Delaware Corporate and Commercial Litigation Blog is one of the top blogs out there, one that truly is indispensable.

 

By way of interesting contrast, readers may want to refer to Professor Jay Brown’s Race to the Bottom Blog, where the Professor and his blog colleagues are running an interesting series on the topic of “Delaware’s Five Worst Shareholder Decisions of 2012”(refer here).

 

Andrew Trask has a couple of year-end posts on his Class Action Countermeasures blog. On January 2, 2013, Trask posted his list of the ten most significant class action cases of 2012 (here), and then on January 3, 2013, he added his list of the “Ten (Most) Interesting Class Action Articles of 2012” (here). In the latter post, Trask noted (in bold letters, no less) there “there just wasn’t that much that merited the title ‘interesting’ in class action scholarship” in 2012.

 

On the Conflict of Interest Blog (here), author Jeff Kaplan has posted his list of the top ten largest federal corporate criminal fines, noting that “what is interesting is that fully half of the ten largest federal corporate criminal fines in history were imposed or agreed to in 2012. I cannot recall a year with so many new cases on the list.” The list is led by BP’s massive $1.286 fine in connection with the Deepwater Horizon environmental disaster. (The list does not include the recent Libor scandal settlements, as the list is limited just to DoJ criminal fines.)

 

Over at The FCPA Blog, Dick Cassin has posted his 2012 Enforcement Index (here). Cassin reports that twelve companies settled FCPA enforcement actions in 2012, paying a total of $259.4 million. None of the 2012 enforcement settlements were sufficient to make The FCPA Blog’s all-time top ten FCPA criminal fines list but Pfizer’s $45.2 million disgorgement did make the blog’s top ten FCPA disgorgements list.

 

On his Drug and Device Law Blog, Jim Beck has listed “The Best Prescription Drug/Medical Device Decisions of 2012” (here). The post lists the authors’ top ten favorite judicial decisions involving drugs, medical devices and vaccines in 2012.

 

And in the world of accounting, Francine McKenna has listed top 20 posts from her own re: The Auditors blog (here). She helpfully embedded into the post a video of The Kinks’ classic hit “Tired of Waiting” (as an explanation of why has included a list of her own blog posts – that is, because she is tired of writing. Francine, I can relate!).  

 

On a more entertaining note, you can find Inside Counsel’s list of the “10 Strangest Law Suits of 2012” here.

 

And finally, no post on this blog ever really feels complete without a video interlude, so here’s a link to YouTube’s Top Ten Viral Videos of 2012. There were some very amusing videos this year, many of which we have previously embedded on this site. In a salute to the videos, here’s a link to one that we haven’t previously included on this site. Enjoy.

 

https://youtube.com/watch?v=316AzLYfAzw

Seven former independent directors of Satyam – the Indian company known as the “Indian Enron” due to the high-profile accounting scandal that swamped the firm in 2009 – have secured their dismissal from the U.S. securities litigation the company’s shareholder filed in the scandal’s wake.  Southern District of New York Judge Barbara Jones’s January 2, 2013 opinion granting the directors’ dismissal motions can be found here. The opinion contains an interesting take on the U.S. Supreme Court’s 2010 Morrison decision and also, in its observation that the director defendants “were themselves victims of fraud,” provides an interesting perspective on the issues surrounding the liabilities of outside directors.

 

Background

Satyam was quickly dubbed the "Indian Enron" when it was revealed in January 2009 – in a stunning letter of confession from the company’s founder and Chairman — that more than $1 billion of revenue that the company had reported over several years was fictitious. Investors immediately filed multiple securities class action lawsuits in the Southern District of New York.

 

The plaintiffs’ consolidated amended complaint alleges that in addition to fabricating revenues senior company officials siphoned off vast sums from the company to entities owned or controlled by the Chairman and members of his family. The defendants include three inside directors, who were alleged to be primarily responsible for the accounting fraud; and seven independent directors, five of whom were alleged to be on the company’s audit committee; certain entities affiliated with the company’s chairman and individuals associated with those companies; and certain PwC-related entities.

 

As discussed here, in February 2011, Satyam agreed to settle the securities claims against the company itself for a payment of $125 million. The settlement did not resolve the claims against the other defendants, including the individual defendants, all of which remained pending. In May 2011, PwC agreed to settle the claims against the PwC-related entities for a payment of $25.5 million (about which refer here).

 

The director defendants moved to dismiss the securities suits on two grounds. First, they argued in reliance on the Morrison decision that certain claimants who had acquired their Satyam shares outside the U.S. could not assert claims under the U.S. securities laws. Second, they argued that the claimants’ claims did not satisfy the pleading requirements to establish a securities claim.

 

The January 2 Opinion

In her January 2 Opinion, Judge Jones granted the directors’ motions to dismiss on both grounds. First, Judge Jones held that the plaintiffs had not pled sufficient facts to establish a strong inference of scienter at least as compelling as the non-fraudulent inferences. Judge Jones observed that “the majority of the allegations” involve “an intricate and well-concealed fraud perpetrated by a very small group of insiders” that and “only reinforce the inference” that the directors defendants were themselves victims of fraud.”  

 

Judge Jones also granted the director defendants’ motion to dismiss the claims of some of the claimants based on the Morrison decision. The director defendants had moved to dismiss the claims of shareholders who had acquired their Satyam shares on the Indian stock exchanges. The director defendants also moved to dismiss the claims of current and former Satyam employees who had acquired their Satyam shares through their participation in Satyam employee stock option plan. The director defendants argued in reliance on Morrison that because those claimants’ claims did not involve either shares listed on a U.S. exchange or a domestic securities transaction, the claims were not cognizable under the U.S. securities laws. (The director defendants did not seek to dismiss the claims of those who had acquired Satyam American Depositary Shares (ADS) on the NYSE.)

 

In opposing the motion to dismiss the claims of shareholders who purchased their Satyam shares on the Indian securities exchanges, the plaintiffs argued that Morrison did not apply because those shareholders had placed their buy orders in the U.S. and had suffered injuries in the U.S. Judge Jones said that this argument “is predicated on precisely the approach that the Supreme Court rejected in Morrison.” She added that “an investor’s location in the United States does not transform an otherwise foreign transaction into a domestic one.”

 

In opposing dismissal of the claims of Satyam employees who acquired Satyam ADSs through the company’s employee stock option plan, the plaintiffs argued that because the employees acquired ADSs through the stock option plan, and because ADSs traded on the NYSE, Morrison did not preclude the employees’ claims. Judge Jones found that the relevant question was not whether or not ADSs trade on a U.S. exchange; the question was whether or not the employees had acquired the ADSs in the U.S.. In reviewing the materials relating to the stock option plan, Judge Jones found that the “exercise of options to acquire Satyam ADSs occurred in India and therefore fall outside the scope of Section 10(b).” Judge Jones rejected the plaintiffs’ suggestion that the stock option exercise was nevertheless a domestic securities transaction merely because the ADSs acquired were the same as the ADSs that traded on the NYSE. Judge Jones said that fact that Satyam’s ADSs were also listed on the NYSE is “irrelevant” the employees acquired their ADSs in India.

 

Discussion

Many outside directors have significant concerns about their potential securities liability, particularly with the respect to the possibility that they might be held liable for management improprieties.  However, the fact is that outside directors are rarely held liable under the U.S. securities laws. Judge Jones’s scienter determination arguably suggests one reason why that is so. 

 

Notwithstanding the massive scale of the Satyam fraud and the fact that several of the director defendants sat on the audit committee, Judge Jones found that the plaintiffs had failed to satisfy the scienter pleading requirements. In reaching this conclusion, Judge Jones emphasized that the fraud, as massive as it was, had been perpetrated by a small group of insiders, and that the director defendants themselves were “victims of the fraud.” Judge Jones’s determination in this regard may provide some reassurance to outside directors concerned that they could be held liable for management misconduct of which the directors are unaware.

 

Judge Jones’s ruling that the claims of the Satyam shareholders who purchased their shares on the Indian exchanges were not cognizable under the U.S. securities laws is consistent with the developing body of case law under Morrison.

 

However, Judge Jones’s ruling with respect to the claims of the Satyam employees who acquired their shares through the stock option plans is interesting. It is n one respect consistent with prior decisions holding that the mere fact that a class of securities trades on a U.S. exchange does not mean that the U.S. securities laws apply to any transaction involving of that class of securities regardless of where it takes place. Judge Jones’s determination is nevertheless interesting because as far as I am aware it represents the first application of Morrison to securities purchased through a foreign-based employee stock option plan.  Judge Jones’s opinion shows how Morrison should be applied to determine whether or not employees acquiring securities through a foreign-based plan can assert claims under the U.S. securities laws.

 

Jan Wolfe’s January 3, 2012 Am Law Litigation Daily  story about Judge Jones’s opinion can be found here. Special thanks to a loyal reader for providing me with a copy of the opinion.