According to a November 13, 2012 press release from their defense counsel (here), the five bank officer defendants in an action the FDIC filed against them as the failed bank’s receiver have settled the case for an assignment to the agency of their rights under the bank’s D&O insurance policy.

 

The case involves the former County Bank of Merced, California, which failed on February 6, 2009, when the FDIC was appointed as its receiver. As discussed here, in January 2012, the FDIC filed an action in the Eastern District of California against five former officers of the bank, each of whom served on the bank’s Executive Loan Committee. The complaint alleges claims against them for negligence and breach of fiduciary duty, in connection with 12 loans the bank made between December 2005 and June 2008 that the FDIC says caused the bank losses in excess of $42 million.

 

In August 2012, the five individuals filed their own separate lawsuit in the Eastern District of California against the bank’s D&O insurer. A copy of their complaint can be found here. The individuals contend that the carrier has wrongfully denied coverage under the policy and wrongfully refused to defend them. The individuals seek a judicial declaration that the claim against them is covered under the policy and also asserts claims for breach of contract and for bad faith.

 

From the individuals’ complaint, it appears that the carrier is denying coverage based on the insured vs. insured exclusion (about which refer here). The individuals contend that the policy’s base form had a regulatory exclusion, which had it remained in the policy would have precluded coverage for the FDIC’s action against them. The individuals allege further that the bank had purchased an endorsement to the policy that removed the regulatory exclusion from the policy. The individuals essentially contend that the point of the endorsement to remove the regulatory exclusion was to ensure that the policy provided coverage for claims brought by the FDIC, and the carrier therefore should not be able to rely on a different exclusion to try to deny coverage for an FDIC claim.

 

According to defense counsel’s press release, in their settlement with the FDIC, the five individuals assigned their claim for bad faith and breach of contract to the FDIC, while retaining their right to try recover from the D&O insurer their defense fees incurred prior to the settlement The parties also exchanged covenants not to bring any further actions against each other, and the settlement also included a covenant by the FDIC not to assert any claims against the five individuals’ property or assets. The FDIC will control and prosecute the assigned claims against the insurer at the agency’s own cost and expense. The officers maintained their right to continue their own retained claims.

 

As I have previously noted (here), questions of D&O insurance coverage may represent the real battle ground in the current wave of FDIC failed bank litigation, and as I also noted in that same post, one of the critical coverage issues of contention may be whether or not the insured vs. insured policy precludes coverage for the FDIC’s claims against the former officers and directors of the failed bank.

 

Perhaps of greater interest in this context, in the case that I discussed in the prior post to which I linked in the preceding paragraph, the former bank officials involved in the case were also able to settle the FDIC’s claim against them for their agreement to the entry of a judgment against them together with an assignment of their rights under their D&O insurance and a covenant by the FDIC not to execute the judgment against them.

 

It remains to be seen whether or not the FDIC’s willingness to resolve these cases against the former bank officers and directors on this basis will work for the agency. They will still have to succeed in establishing that the D&O insurers’ policies provide coverage for the claims (as well as fight off the carriers’ likely procedural objections to the validity of the agreed judgment and assignment). But it is in any event interesting to see that the FDIC is willing to resolve cases on this basis, at least in certain circumstances (perhaps only when particular coverage issues are involved as well).

 

There may well be legitimate arguments about the merits or demerits of these types of deals. Of course, it certainly could be argued that the D&O insurer, having denied coverage, should not be heard to object to the fact that the individuals have taken steps to protect themselves. However, the problem with these type of consent judgment/covenant not to execute type deals is that this approach can run the risk of slipping into a collusive arrangement, with the insured individual willingly agreeing to a settlement amount that has no relation to the his or her true liability exposure. Without meaning to suggest anything one way or another about this particular deal, I will say that in my prior life as an insurer-side coverage attorney, I did see deals that were questionable.

 

All of that said, however, these types of deals have undeniable attractions for the individual defendants involved, and I would expect that other defendants in other failed bank cases will undoubtedly be looking to see if they can reach settlements with the FDIC on a similar basis. Whatever the merits or demerits of these types of deals, we undoubtedly will see many more of them before the current round of failed bank litigation finally plays itself out.

 

Special thanks to a loyal reader for seding me a copy of the defense counsel’s press release.

 

Management Liability Insurance and the Potential Liabilities of Law Firm Managers: Attorneys are well aware of their need to procure and maintain errors and omissions insurance – or what they typically think of as malpractice insurance. But while they understand their need to have insurance in the event of claims against them asserting that they erred in the delivery of client services, attorneys, or at least some of them, can be reluctant to accept their need to also maintain insurance protecting their firm’s managers against claims for wrongful acts committed in the management of their firm.

 

Attorneys resistant to the need for this type of insurance (or advisors who have to try to persuade them of the need) will want to take a look at the November 14, 2012 Wall Street Journal article entitled “Creditors Seek to Sue Dewey’s Ex-Leader” (here). The article describes a motion that the unsecured creditors of the failed Dewey & LeBouef firm have filed in the firm’s bankruptcy proceedings. The unsecured creditors seek the leave of the bankruptcy court to file an action against the firm’s former Chairman, its former executive director, and its former chief financial officer, seeking to hold the three individuals liable for alleged misconduct the unsecured creditors contend led to the firm’s demise.

 

The unsecured creditors bid to pursue claims against the former law firm managers illustrates a point I have often made when discussing management liability insurance for law firms, which is that law firm managers face the possibility of potential claims for an wide variety of potential claimants. Indeed, as I think this situation illustrates, the law firm managers at least potentially face potential claims from the same general range of claimants as does any privately held business and therefore the need for management liability insurance is the same.

 

Lawyers are of course nothing if not argumentative and I can anticipate the likely lawyer reaction (being a recovering attorney myself) to the attempt to draw these kinds of conclusion from this situation. First, some lawyers might argue that the lawsuit the unsecured creditors want to file is solely about the insurance that the law firm maintained, and in the absence of the insurance, the unsecured creditors would not be pursuing the claim. I would object to this argument on two grounds; first, it is speculative (as it requires us to make assumptions about the claimants’ motivations) and also it assumes facts not in evidence (that is, that the claimants would not be pursuing the claims in absence of the insurance).

 

But the real problem with this argument is that is presumes that prospective defendants would be better off without the insurance. That strikes me as a dicey proposition and not one that personally I would not want to have to test. Most self-interested persons faced with the prospects of angry creditors asserting millions of dollars of claims would be very grateful to have a D&O insurance policy to defend and indemnify them.

 

Special thanks to a loyal reader for drawing my attention to the Journal article.

 

In a November 13, 2012 opinion (here), Western District of Texas Judge Sam Sparks has upheld the right of the SEC under Section 304 of Sarbanes Oxley to seek to clawback bonus compensation paid to the CEO and CFO of Arthrocare, after the company restated its prior financial statements., even though the CEO and CFO had no involvement in or even awareness of the misconduct that caused the company to misreport its financial results. Judge Spark’s opinion provides a detailed theoretical underpinning for the SEC’s authority under Section 304 and represents a broad affirmation of the SEC’s rights to seek to recoup bonus compensation as provided in the statute. .

 

Michael Baker and Michael Glick were, respectively the CEO and CFO of Arthrocare during the period 2006 through the first quarter of 2008. The company later restated the financial statement it had filed with the SEC during this period, owing to the alleged fraud of two of the company’s senior vice presidents, John Raffle and David Applegate. The SEC brought separate enforcement actions against Raffle and Applegate, which resulted in agreed judgments against them. The SEC then filed an action against Baker and Glick, seeking to recover on behalf of Applegate the bonus compensation the company had paid them in connection with the financial reporting periods that the company restated.

 

The defendants moved to dismiss the SEC’s action, arguing in essence that the SEC did not have the right under the statute to pursue claims against them when they had not involvement in or even awareness of the misconduct that led to the restatements.

 

Judge Sparks rejected these arguments, citing with approval from District of Arizona G. Murray Snow’s opinion in the case involving Maynard Jenkins, the CEO Of CSK Auto (about which refer here). Judge Sparks noted that though “it might be surprising at first glance” for the corporate officials to have to reimburse their companies when they have done nothing illegal, there are “good policy reasons” for Section 304’s broad scope. He specifically noted that “by requiring reimbursement, even in the absence of any wrongdoing, Congress was logically extending and expanding the regulatory scheme for publicly traded companies in reaction to the various accounting scandals which triggered Sarbanes Oxley.” The construction of the statute urges by Baker and Glick “would render Section 304 redundant of existing fraud laws.”

 

Judge Sparks also rejected the arguments of Baker and Glick that Section 304 is unconstitutional. Specifically he rejected their arguments that the clawback statute violates the due process clause, is void for vagueness or violates the excessive fines clause.

 

In reaching these conclusions upholding the SEC”s rights to seek to clawback bonus compensation in reliance on Section 304, Judge Sparks got to the heart of Section 304’s sanctions and its purposes:

 

Baker and Applegate, who were senior vice presidents, apparently used their positions of authority to perpetuate serious misconduct, over a significant time period of time. Baker and Glick should have been monitoring the various internal controls to guard against such misconduct; they signed the SEC filings in question and represented they in fact were guarding against noncompliance. As such, they shouldered the risk of Section 304 reimbursement when noncompliance nevertheless occurred.

 

Sparks went on to note that Section 304’s requirements are “crystal clear”; the Act “tells executives precisely what they must do to avoid reimbursement liability.” They must, Sparks noted, “ensure the issuer files accurate financial statements.” They are to do so by establishing and maintaining internal controls. Judge Sparks went further to find that there is a “reasonable relationship” between the conduct and the penalty; “where, as here …corporate officers are asleep on their watch,” they are liable for a penalty that is limited to the amounts of their bonus compensation.

 

As noted above, there have been prior rulings upholding the SEC”s right to pursue clawback actions under Section 304 even in the absence of allegations that the corporate executives from whom compensation clawback is sought were involved in or even aware of the misconduct that led to the restatement. However, Spark’s opinion provides a broad theoretical justification for the SEC’s use of the provision and may represent something of an encouragement to the agency to use  its authority under the statute; indeed, in his conclusion, Sparks said:

 

Apologists for the extraordinarily high compensation given to corporate officers have long-justified such pay as asserting CEOs take “great risks,” and so deserve great rewards. For years, this has been a vacuous saw, because corporate law, and private measures such as wide-spread indemnification of officers by their employers, and the provisions of Directors & Officers insurance, have ensured any “risks” taken by these fearless captains of industry almost never impact their personal finances. In enacting Section 304 of Sarbanes Oxley, Congress determined to put a modes measure of real risk back into the equation. This was a policy decision, and while its fairness or wisdom can be debated, its legal effect cannot. Section 304 creates a powerful incentive for CEOs and CFOs to take their corporate responsibilities very seriously indeed.

 

The question of the SEC’s clawback authority has even broader implications in the wake of the enactment of the Dodd-Frank Act, which makes a much broader range of corporate officials potentially subject to clawback liability.  As discussed here and here, under Section 954 of the Dodd-Frank Act, the national securities exchanges are required to promulgate rules requiring reporting companies to adopt and disclose procedures providing for the recovery of any amount of incentive based compensation paid to any current or former executive that exceeds the amount which would have been paid under an accounting restatement in the three years prior to the date on which the company was required to prepare the restatement. The Dodd-Frank provision is quite a bit broader than Sox Section 304, as it extends to all executives and it reaches back three years and to all incentive based compensation.

 

I have long felt that Section 304 represents part of a dangerous legal trend that tends to want to try to impose liability without culpability (as I discussed at length here).  However, I also agree with Judge Sparks that while we may debate the merits or demerits of the SEC’s authority under Section 304, the provision is the law and it does give the SEC broad authority to recoup bonus compensation. I still think attention needs to be given to the unfortunate trend toward imposing liability without culpability, and by way of example of a looming problem, I question whether the SEC’s clawback authority should have been (as it was in the Dodd-Frank act) extended to reach corporate officials beyond those who have responsibility for certifying financial results. At a minimum, I would argue that the theoretical justification that Sparks gives for the SEC’s authority Section 304 does not work as well when the clawback authority is extended beyond the officers responsible for financial statement certification.

 

I have previously discussed the potential D&O insurance implications of Section 304 clawback actions here.

 

Alison Frankel’s November 16, 2012 post on her On the Case blog about Judge Sparks’s opinion can be found here. I know that sometimes it may feel that I just follow Frankel around and write about what she has written about. I fee compelled to point out that I had written my post about Judge Spark’s opinion before I learned that she had also written about this case. Besides, her blog is so comprehensive, if I coudln’t write about things she has written about, I would be left without anything to write about. I will say to all of my readers, if you are not reading Frankel’s blog every day, you are making a serious mistake.

 

Securities class action plaintiffs often allege that the defendants’ statements about their company’s internal controls are misleading. Typically, these internal control-related allegations are made in connection with allegations of accounting misrepresentations, as the plaintiffs contend that the alleged internal control deficienciesp allowed the accounting errors behind alleged accounting misrepresentations.

 

In a November 7, 2012 ruling (here), Judge Lewis Kaplan held in the Weatherford International securities class action litigation that the plaintiff’s internal control misrepresentation allegations were sufficient to survive a motion to dismiss, even where the accounting misrepresentations alleged were not sufficient to survive the dismissal motion. While this ruling may not be unprecedented, it does represent an unusual holding where the internal control allegations were found to be sufficient on a standalone basis. Because Judge Kaplan’s holding depended in part on the relevant corporate officer’s internal control certification, the ruling may also have important implications with respect to the certifications required under Sarbanes Oxley.

 

Background

The plaintiff’s complaint relates to Weatherford’s alleged understatement of tax expenses in its financial statements for the tax years 2007 through 2009 and for the first three quarters of 2010. The plaintiff alleged that beginning in 2007, the company reported industry low effective tax rates, something that was of particular interest to securities analysts and investors. The defendants allegedly touted the company’s low effective tax rate.

 

On March 1, 2011, the company announced that it was restating its financials for the period described in the preceding paragraph due to “material weaknesses” in internal control over financial reporting of income taxes. In particular, the company said that “the Company’s processes procedures and controls related to financial reporting were not effective to ensure that amounts related to current taxes payable, certain deferred tax assets and liabilities, reserves for uncertain tax positions, the current and deferred income tax expense and related footnote disclosures were accurate.” The company ultimately concluded that it had understated its tax liabilities during the period of the restatement by about $500 million.

 

The company share price declined on the news of the restatement and the plaintiff filed a securities class action lawsuit alleging two categories of misrepresentations: (1) those arising directly from the understatement of the company’s tax expenses and (2) those pertaining to Weatherford’s maintenance of its internal controls over its financial reporting. The complaint named as defendants the company itself; four individual directors and officers; and the company’s outside auditor.

 

With respect to the internal controls, the complaint alleged that in its filings with the SEC during the period of the restatement, the company’s CEO and CFO (Becnel) had certified that they were “responsible for establishing and maintaining” financial reporting controls; for designing the controls; and for evaluating and for reporting to the board all significant deficiencies and material weaknesses in the design or operation of the controls.

 

However, in the company’s March 2011 restatement announcement, the company identified a number of “material weaknesses” in internal controls, including that the inadequacy of staffing and technical expertise with regard to taxes; ineffective review and approval with respect to taxes; ineffective processes to reconcile tax accounts; and inadequate controls over the preparation of quarterly tax provisions.

 

The defendants moved to dismiss the plaintiffs’ complaint..

 

The November 7, 2012 Ruling

In his November 7 Memorandum Opinion, Judge Kaplan denied the motions to dismiss of the CEO (Becnel) and of the company itself with respect to the plaintiffs’ allegations concerning the alleged misrepresentations of the company’s internal controls. In denying the motion, Judge Kaplan noted Becnel’s personal participation in the design of the company’s internal controls, as Becnel himself had affirmed in the certifications in the company’s SEC filings. Judge Kaplan found further, in light of

 

the stark realities about the inadequacies of the internal controls that were revealed in the March 2011 restatement, the audit delays and control deficiencies expressly raised to him during the class period, and the fact that the Tax Department uniquely was experiencing problems even while he knew that its functions were of specific importance to the Company, the [amended complaint] sufficiently alleges scienter with regard to his statements.

 

Judge Kaplan found that these allegations were also sufficient to establish scienter with respect to the company itself, but not with respect to the other three individual defendants.

 

While Judge Kaplan found that the plaintiff’s allegations of alleged misrepresentations concerning the internal controls were sufficient as to Becnel and the company, he found that the plaintiff’s allegations regarding the understatement of the company’s tax expense were not sufficient as to any of the defendants.

 

Among other things, Judge Kaplan concluded that the alleged internal control misrepresentations alone were not sufficient to establish that the alleged misstatements of the company’s tax expense were made with scienter. Judge Kaplan said that “while Weatherford’s poor internal controls may give rise to liability with respect to the defendants’ statements about internal controls, the weak internal controls provide little if any circumstantial support that the statements that the understated tax expense were made with scienter.”

 

Judge Kaplan also rejected that the size of the restatement of the company’s tax expense, together with the extent to which the company touted its low effective tax rate in public statements, was sufficient to establish that the understatements of the company’s tax liability were made with scienter. He noted that the size of the fraud alone does not create an inference an inference of scienter, adding that “what is noticeably missing from the [amended complaint] is any allegation that the Weatherford defendants had any contemporaneous basis to believe that the information they related was incorrect.”

 

Though Judge Kaplan had granted the motions of the three individual defendants other than Becnel with respect to the Section 10(b) allegations against them concerning the alleged internal control allegations, he denied those three defendants’ motions to dismiss the plaintiff’s control person liability claims under Section 20(a), meaning that at least some claims against all four of the individual defendants survived the motion to dismiss, as well as the internal control claims against the company itself.

 

Discussion

Judge Kaplan’s decision represents the rare case where allegations of internal control misrepresentations were found to support a finding of scienter, a determination that is particularly unusual where as here the accompanying alleged accounting misrepresentations were found not to be sufficient to state a claim. Judge Kaplan’s holding that the alleged internal control allegations were sufficient on a standalone basis to survive a motion to dismiss, without an accompanying finding that alleged financial misrepresentations were sufficient to state a claim, represents a novel development, even if not entirely unprecedented.

 

Judge Kaplan’s ruling is particularly interesting to the extent it relies on the certifications that the CFO, Becnel, provided in the company’s SEC filings. Since the enactment of the Sarbanes Oxley Act, CEOs and CFOs have been providing certifications with respect to their company’s internal controls. There have been cases in which the internal control certifications have supported securities fraud claims (refer, for example, to Judge Shira Scheindlin’s November 2, 2007 ruling in the Scottish Re Group case), but those are typically n the context of claims in which the claimant has also established the sufficiency of financial misrepresentation allegations.

 

Judge Kaplan’s ruling represents a recognition that the internal control statements can be sufficient to state a claim for liability, even if the claimant is unable to establish sufficient claims of financial misrepresentation. The possibility that corporate executives can be held liable on a standalone basis for misrepresentations concerning internal controls arguably adds some teeth the responsibilities corporate executives undertake when they provide the internal control certifications required by Sarbanes Oxley.

 

Very special thanks to a loyal reader for providing me with a copy of Judge Kaplan’s opinion.

 

Nobody Could Make This Up: The November 11, 2012 Chapel Hill (N.C.) News-Observer, in an article entitled "Man Says He Saw a U.F.O. Fly Over Carrboro" (here), reports that  "Roy Mars was peeing in his compost last weekend — it adds nitrogen — when he looked up and saw something streak across the sky." (Hat Tip: Jim Romenesko)

 

Trial in the FDIC’s failed bank lawsuit against three former officers of IndyBank commenced on November 6, 2012 in the federal court in Los Angeles. According Scott Reckard’s November 9, 2012 Los Angeles Times article (here), the parties’ counsel have delivered their opening statements. The case, which was the first failed bank lawsuit the FDIC filed as part of the current bank failure wave, is also the first to go to trial.

 

As detailed here, the FDIC first filed the lawsuit against the former IndyMac officers in June 2010. The FDIC’s lawsuit seeks to recover damages from the individual defendants for "negligence and breach of fiduciary duties." The lawsuit alleges "significant departures from safe and sound banking practices."  As discussed here, in July 2011, the FDIC filed a separate lawsuit against IndyMac’s former CEO, Michael Perry.

 

There are three individual defendants in the case that is now in trial:  Scott Van Dellen, the former President and CEO of IndyMac’s Homebuilders Division (HBD), who is alleged to have approved all of the loans that are the subject of the FDIC’s suit; Richard Koon, who was HBD’s Chief Lending Officer until mid-2006 and who is alleged to have approved a number of the loans at issue; Kenneth Shellem, who served as HBD’s Chief Compliance Officer until late 2006, and who is alleged to have approved many of the loans at issue.

 

The case against the three former IndyMac officers has been very vigorously litigated; I detailed the particularly memorable hearing regarding one discovery dispute that arose in the case here. (While writing this article, I reread the article about the discovery dispute; Central District of California Judge Dale Fischer’s comments during the hearing make for very interesting reading, and I commend the article to readers looking for a little diversion.) Among other significant pretrial rulings, in October 2012, Judge Fischer also held that under California law the individuals were not entitled to rely on the business judgment rule, as discussed here.

 

And in June 2012, as discussed here, in a significant ruling in a related D&O insurance coverage case, Central District of California Judge Gary Klausner held that all of the various IndyMac lawsuits (including the one the FDIC filed against the three former IndyMac officers) were interrelated to the first filed lawsuit, and thus triggered only a single tower of D&O insurance. This holding was of particular significance both to the former IndyMac officers and to the FDIC, as the FDIC’s lawsuit was filed during the policy period of the second insurance tower. The ruling that the subsequent lawsuit are all interrelated to the first filed lawsuit means that the only insurance available for the individuals (and out of which the FDIC might recover from the insurers) is whatever is left under the first tower of insurance.

 

According to their July 2012 motion to stay the FDIC’s lawsuit against them, the three defendants represented to the court that defense fees in various IndyMac-related lawsuits as well as the costs associated with settlements that had been reached in several of the cases will deplete or threaten to deplete all of the remaining proceeds under the first tower of insurance.  (The motion asserts that defense fees in excess of $50 million and settlements totaling $29 million would deplete the $80 million insurance tower.) The defendants sought to stay the FDIC’s lawsuit against them so that they could pursue their appeal of Judge Klausner’s insurance coverage ruling. The defendants’ motion can be found here. Judge Fischer denied the defendants’ motion to stay the proceedings.

 

The upshot of the unavailability of the second tower of insurance and the apparent exhaustion of the first tower is that the three individual defendants face the prospect of that there might not be any insurance available to protect them in the event that the trial results in an award of damages against them (subject of course to the outcome of the pending appeals of Judge Klausner’s insurance coverage ruling).

 

The FDIC’s original complaint had named a fourth individual, William Rothman, as a defendant as well. According to a footnote in the motion to stay referenced above, Rothman had settled with the FDIC in exchange for Rothman’s assignment to the FDIC of Rothman’s rights under the second tower of insurance.  The separate suit against IndyMac’s former CEO, Michael Perry, remains pending.

 

In any event, it will be very interesting to see how this case proceeds. It is highly unusual for a case like this to proceed to trial, particularly where there may be limited or even no insurance out of which the FDIC may be able to recover any judgment. (Interestingly, in the defendants’ motion to stay referenced above, counsel for the defendants asserts that “the FDIC specifically structured this lawsuit in order to reach the Tower 2 Policy,” in which case Judge Klausner’s insurance coverage ruling upset a part of the FDIC’s strategy in their case against the three individual defendants.) Obviously, the outcome of the appeal in the insurance coverage case is of keen interest to the FDIC as well as to the individual defendants.

 

I am sure that there are many readers who will be following this trial closely and who may be able to monitor the case more closely than I can. I would be grateful if readers would be willing to keep me informed about the case.

 

As I have frequently noted on this blog (most recently here), one of the most distinctive litigation phenomenon has been the rise in litigation involving M&A activity. It has gotten to the point that virtually every merger now also involves a lawsuit (or, more often, multiple suits). These cases have proven attractive to plaintiffs’ lawyers because the pressure to close the deal has allowed the claimants to attract a quick settlement, often involving an agreement to publish additional disclosures or adopt corporate therapeutics and the payment of plaintiffs’ attorneys’ fees.

 

However, as noted in a November 9, 2012 post on the Harvard Law School Forum on Corporate Governance and Financial Reform by Boris Feldman of the Wilson Sonsini law firm, there recently has been a new twist to the M&A litigation phenomenon; increasingly, plaintiffs’ lawyers have “refined their business model” and now they aim to “keep the litigation alive post-close.” Moreover, Feldman notes, the plaintiffs are pursing these post-close M&A cases “even in situations where objective factors suggest a lack of merit to the claims: e.g., high premium; no contesting bidders; overwhelming shareholder approval; customary deal terms.”

 

Feldman posits three reasons that plaintiffs’ attorneys are pursuing these post-close merger claims. First, due to changes in the plaintiffs’ bar, some lawyers are struggling to modify their business model, as a result of which some lawyers have “decided to pursue cases that they would have let run dry in the past.”

 

Second, Feldman acknowledges that the post-close cases have their own in terrorem value, even if it is only a form of “nuisance value.” The continuing case subjects corporate executives to time-consuming and burdensome discovery, sometimes in the context of a deal that may or may not have worked out all that well. The case also threatens a trial on processes and analysis that led to the acquisition, a form of exposure the company may prefer to avoid. Therefore, Feldman notes, “even post-close suits have some ‘go away’ value to the surviving company.”

 

Third, Feldman speculates that at least some of the plaintiffs’ attorneys may be pursuing a longer term strategy, by showing that they are willing to persevere for years, even in a weak case, in the hope that the defendants “may just say ‘pay them and get rid of it’ before the deal closes.” By these lights, “a plaintiffs’ lawyer rationally could pursue a frivolous case, at great expense, post-close, even with low odds of getting a recovery, “simply as a way to improve the profitability of the rest of his inventory.”

 

Feldman notes that the post-close merger cases have their own peculiar dynamic, different than the dynamic of cases pre-close. Among other things, post-close, the plaintiffs’ lawyers have an incentive to try to drag things out. Pre-close, the plaintiffs’ lawyers want to accelerate procedures and discovery, to keep the pressure on the parties to the underlying transaction to settle the case. Post-close, the plaintiffs want to keep the case as long as they can, in part on the hope that as time goes by they might manage to find documents or other materials or information that will support their case, and in part on the hope that as time goes by, the defendants will get weary of the case and pay to make it go away.

 

According to Feldman, defendants in these post-close cases may want to take a more active role, and in particular actively push toward summary judgment. He suggests that though courts have been reluctant to grant summary judgment in the past, judges will “eventually decide that most merger claims are strikesuits and will extirpate them before trial.”

 

As support for this contention that more courts may be willing to grant summary judgment in post-close cases, Feldman cites the recent grant of summary judgment in favor of Intel in the case arising out of Intel’s acquisition of McAfee. (In a November 2, 2012 order (here), California Superior Court Judge James P. Kleinberg granted the defendants’ motion to dismiss in the case, just two weeks prior to the scheduled trial date.)

 

With reference to the grant of summary judgment in the Intel case, Feldman argues that the plaintiffs’ Achilles Heel in the cases may be the exculpatory provisions in the Delaware Corporations Code, which preclude damage claims against directors for breaches of fiduciary duty unless plaintiffs can establish serious conflicts of interest or bad faith. Feldman contends that “it will be the rare case indeed where plaintiffs have such evidence against a director, much less a majority of the Board.” Feldman predicts that many more courts will be willing to jettison cases at the summary judgment stage on this basis.

 

Finally, Feldman notes that even if these cases survive summary judgment, they could prove difficult for the plaintiffs. The cases are challenging to try to settle, as there are no opportunities for non-monetary settlements and as the justification for additional deal consideration will be lacking after shareholder approval. At the same time, the cases will prove difficult for plaintiffs to try, as, Feldman suggests, “very few judges will be willing to second-guess the decisions of independent, well-advised boards of directors as to what their company was worth.” In the final analysis, Feldman suggests, the “ultimate irony” may be that even if plaintiffs’ keep their cases alive post-merger, they will have difficulty figuring out “a way to monetize them that survives judicial scrutiny.”

 

I think Feldman’s analysis is interesting, particularly his estimation of the strong likelihood that defendants will prevail if they push the post-close merger cases to summary judgment or trial. At the same time, however, I think it is important to note that Intel’s summary judgment victory was considered noteworthy precisely because it was so unusual for the defendant company to continue to fight the continuing litigation. (See for example, Nate Raymond’s commentary about the summary judgment ruling on the On the Case blog, here.)

 

Even if Feldman is right about the defendants’ prospects if they continue to fight these cases, the far likelier outcome is that the defendant companies will, as the plaintiffs’ undoubtedly hope, tire of the cases rather than fighting them and seek some type of a compromise. Unfortunately, the plaintiffs’ may continue to pursue post-close merger cases as a way to try to extract something from the merger, even if they are unable to secure a pre-close settlement, simply because the likeliest outcome is that they will eventually get rewarded for doing so. Whether more companies will, like Intel, prove willing to fight the cases remains to be seen.

 

Rating Agencies Take Another Hit: In a post last week, I noted the decision of an Australian Court holding S&P liable for ratings of certain complex financial instruments. The rating agencies took another hit later in the week, in a decision by an Illinois state court judge denying the motion of McGraw-Hill, S&P’s parent, to dismiss an action brought against the rating agency by the Illinois attorney general. The court’s ruling that the alleged misrepresentations are not protected opinion is particularly noteworthy.

 

Illinois Attorney General Lisa Madigan had commenced the action, alleging that during the period 2001 through 2008, S&P had misled the investing public by claiming that its ratings of certain structured financial products were independent, objective and unbiased. The AG alleged that the rating agency’s repeated representations regarding its independence and objectivity were demonstrably false. The Illinois AG asserted claims under the Illinois Consumer Fraud and Deceptive Business Practices Act and under the Uniform Deceptive Trade Practices Act. The defendants moved to dismiss.

 

In her November 7, 2012 opinion (here), Illinois (Cook County) Circuit Court Judge Mary Ann Mason denied the defendants’ motion to dismiss. Her opinion emphasized certain alleged attributes of the ratings themselves. That is, first, that because of the alleged “opaque” nature of the securities (meaning that there was no ready source of information by which investors could otherwise gauge the investments), the rating agency’s assertion that its ratings were independent, objective and unbiased were “of enhanced importance to investors.” Second, because the opinions allegedly were issued pursuant to an “issuer pays” business model, as a part of which the rating agency’s had an incentive to provide the rating the issuer desired in order to secure future business, “allowed the profit motive to override its objectivity and independence.”

 

The defendants moved to dismiss on the ground that its ratings represent protected opinion. However, as Judge Mason noted, the AG’s claims are not based on the rating agency’s opinions but rather its “repeated statements of fact regarding S&P’s independence and objectivity.” Judge Mason expressly rejected the defendants’ arguments that the ratings were protected by the first amendment, because the statements about the agency’s objectivity and independence and not simply opinions; that are, Judge Mason said, “verifiable representations regarding the manner in which S&P assures the integrity and independence central to the credibility of its ratings.”

 

Judge Mason went on to note that “the logical extension “ of the defendants’ arguments “would be to immunize rating agencies from investor claims based on investor claims clearly intended to influence those same investors.” She noted that the entire value of the system from which the rating agencies hope to profit “depends on the investing public’s confidence in the credibility and independence of its ratings.” If the investors lack that confidence, the “ratings lose their value to issuers and issuers lack motivation to seek out the agency’s ratings in the future.”

 

Judge Mason’s ruling is interesting and her reasoning could be persuasive to other courts, at least in other cases in which the misrepresentation that rating agency defendants are alleged to have made relate to the agencies’ supposed independence and objectivity. However, as Alison Frankel notes in an interesting November 9, 2012 post on her On the Case blog (here), Judge Mason’s ruling may not open the floodgates; in particular, as Frankel notes, federal laws may preempt claims against rating agencies involving post-2007 conduct. It could be that Judge Mason’s reasoning is less useful in cases involving alleged misrepresentations after 2007, and the pre-2007 alleged misrepresentations may be untimely.

 

Libor Investigations in Asia: In earlier posts (refer, for example, here), I have examined the regulatory investigations into possible manipulation of the Libor benchmark interest rates. A number of countries are also investigating possible Libor manipulation, including countries in Asia. As detailed in an interesting November 2012 memorandum from the Ince & Co. law firm entitled “LIBOR – The Asia Story” (here), the Asian countries investigating possible Libor or other benchmark interest rate manipulation include Singapore, Korea, and Japan. Interestingly, the related developments in Singapore include a lawsuit brought by an RBS trader who claims he was wrongfully terminated for his involvement in benchmark rate manipulation in order to deflect attention from the bank for its involvement in the Libor scandal.

 

The authors of the Ince law firm memo include my good friends Nilam Sharma and Aruno Rajaratnam, and their colleague Victoria Gregory.

 

I am pleased to publish below a guest post written by Robert F. Carangelo, Paul A. Ferrillo, David J. Schwartz, and Matthew D. Altemeier of the Weil, Gotshal & Manges law firm and the authors of The 10b-5 Guide, the most recent edition of which can be found here.. The guest post reflects the authors’ report and analysis of the recent oral argument at the U.S. Supreme Court in the Amgen case. Background regarding the Amgen case can be found here.

 

 

I would like to thank the authors for their  willingness to publish their article on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is the authors’ guest post:

 

 

On November 5, 2012, the United States Supreme Court heard oral argument in Amgen Inc. v. Connecticut Retirement Plans & Trust Funds (No. 11-1085) (“Amgen”).  In Amgen, Plaintiff/Respondent Connecticut Retirement Plans and Trust Funds (“Connecticut Retirement”) brought a putative class action under the Exchange Act of 1934, alleging that Defendant/Petitioner Amgen and several of its directors and officers misstated and failed to disclose safety information concerning two of its drugs. Amgen contends that it did not mislead investors and that the information it allegedly concealed was widely known.

 

 

 

Background of Amgen and Path to the Supreme Court

 

The issue in Amgen is the predominance requirement of Federal Rule of Civil Procedure (“Rule”) 23(b)(3), which states that a court may not certify a class for trial without determining that “questions of law or fact common to class members predominate over any questions affecting only individual members.” Because of the near-impossibility of establishing commonality of direct reliance on alleged misstatements in securities fraud litigations, plaintiffs typically rely on a rebuttable presumption of common indirect reliance on the integrity of the market price for the securities at issue. The Supreme Court first recognized this presumption in Basic Inc. v. Levinson, 485 U.S. 224, 241-47 (1988), relying in part on the “fraud-on-the-market” (“FOTM”) theory. The FOTM theory assumes that the market price of securities traded in an efficient market reflects all publicly-available material information, including any material misrepresentations.

 

 

Twenty-five years after Basic, Amgen asks the Court to decide whether class action plaintiffs must prove the materiality of alleged misstatements to use the Basic presumption at the class certification stage (and thus allow a Court to find that common issues of reliance predominate). In Amgen, the district court certified the proposed class for trial even though Connecticut Retirement provided no evidence to establish materiality, ruling that plaintiffs “need only establish that an efficient market exists” to take advantage of the Basic presumption at that phase of the litigation. Conn. Ret. Plans & Trust Funds v. Amgen, Inc., 2009 WL 2633743, at *12 (C.D. Cal. Aug. 12, 2009). The Ninth Circuit affirmed this determination, following the Seventh Circuit’s approach in Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010), and holding that plaintiffs must “plausibly allege—but need not prove . . . that the claimed misrepresentations were material” at the class certification stage. Conn. Ret. Plans & Trust Funds v. Amgen Inc., 660 F.3d 1170, 1172 (9th Cir. 2011). This approach, however, differs from that of the Second and Fifth Circuits, which require proof of materiality under such circumstances. See In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008); Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 401 F.3d 316 (5th Cir. 2005).

 

 

The Amgen parties’ prior written submissions to the Court mirror this circuit split. Amgen argues that, because the FOTM theory assumes that efficient markets incorporate only material information, courts have no basis to presume that immaterial statements are reflected in the market price of a security (and thereby affect all plaintiffs in common). Br. for Pet’rs at *17-19, Amgen (No. 11-1085), 2012 WL 3277030 (U.S. Aug. 8, 2012). Connecticut Retirement, on the other hand, contends that the only indispensable FOTM prerequisites are (1) that the security in question was traded in an efficient market, and (2) that the alleged misrepresentations were public. Br. for Resp’t in Opp’n to Cert. at *9, Amgen (No. 11-1085), 2012 WL 1666404 (U.S. May 11, 2012). Once these two predicates are established, says Connecticut Retirement, certification is proper because “falsehood and materiality affect [all] investors alike” and “if the misrepresentations turn out to be immaterial, then every plaintiff’s claim fails on the merits.” Id. at *13.

 

 

Oral Argument Reflects a Divided Court

 

 

During oral argument, questioning by Justices Kagan, Breyer, Ginsburg and Sotomayor suggested an inclination to affirm class certification, reasoning that once plaintiffs establish the existence of market efficiency and a public statement, materiality becomes a common question that courts need not determine at the class certification stage. Counsel for Amgen emphasized that the question before the Court was not materiality, but indirect reliance via the Basic presumption, the commonality of which cannot be established without proof that the alleged misrepresentations were in fact material (and thus actually moved the market).  Counsel for Amgen added that, as with any other FOTM predicate, a finding that materiality is lacking at the class certification stage does not foreclose individual plaintiffs from later moving forward with actions based on direct reliance. Justices Ginsberg and Kagan disagreed on this point, indicating their view that a finding of immateriality at the class certification stage would effectively end the case.

 

 

Justice Breyer also expressed concern that proof of materiality is premature at the class certification stage given materiality’s dual role as both a condition under Basic and an element of the substantive claim. Counsel for Amgen replied that “[t]he point of the class certification . . . is the question whether there is class coherence in the first place. It’s not the merits.” Indeed,

 

 

[t]he real question in this case is what is the purpose of Rule 23? If you think that the purpose of Rule 23 is to postpone to the merits everything that can be postponed without a risk of foreclosing valid individual claims, we lose. But that’s not the purpose. The purpose is for a court to determine whether all of the preconditions for forcing everyone into a class action are present before you certify. (emphasis added)

 

 

According to Petitioner, the alternative of pushing everything to the end “is like letting the fruits justify the search.”

 

 

Counsel for Respondent, on the other hand, contended that a class action is the most efficient method for adjudicating materiality because the presence of an efficient market establishes the relevant security’s “ability to absorb [public] information, both material and non-material,” for all plaintiffs at once. Counsel representing the United States in support of Respondents contributed to this argument:

 

                       

The most efficient course is to actually focus on common issues. . . . In the current [embodiment] of Rule 23(b)(3), you want to certify class actions that are both meritorious and those that are not, so it reaches a binding judgment.

 

 

One major point of dispute during oral argument was Justice Breyer’s suggestion that, unlike other FOTM predicates, materiality “is a common element of the tort . . . it will [always] be litigated, so there is no special reason . . . for litigating [it] at the outset.” However, Justice Scalia strongly disagreed on this point:

 

 

But there . . . is a reason for deciding it earlier, and the reason is the . . . enormous pressure to settle once the class is certified. In most cases, that’s the end of the lawsuit. There’s . . . automatically a settlement.

 

 

In this vein, Justice Scalia noted several times that materiality is a precondition to obtaining the “shortcut” provided by Basic’s presumption of reliance. Justice Scalia underscored this point by openly wondering whether the Court should overrule Basic “because it was certainly based on a theory that — that simply collapses once you remove the materiality element.”  As Justice Scalia noted, “[i]t’s not an efficient market if it’s, you know . . . random[.] It takes account of material factors.”

 

 

Final Analysis and Conclusions

 

Unfortunately, the oral argument in Amgen offers few additional clues as to how the Court will rule. The Justices’ questions indicate that the Court is divided along its usual ideological lines, with Chief Justice Roberts holding the swing vote. However, the authors continue to believe that Amgen has the better argument in this case. In our view, Justice Scalia, through his questioning, effectively made the point (and will be able to persuade a majority of the Court) that for a plaintiff to avail itself of the significant procedural benefit that the Basic presumption already provides, it has to show materiality at the class certification stage.

 

Many professional liability insurance policies contain an exclusion that, though referred to as the antitrust exclusion, precludes coverage for a much broader array of claims than just claims alleging violation of the antitrust laws. A recent decision by the First Circuit, interpreting an Errors and Omissions insurance policy and applying Massachusetts law, in which the court found that the policy’s antitrust exclusion precluded coverage for a variety of different claims against the insured, underscores how broadly the preclusive effect of the antitrust exclusion can sweep. A copy of the First Circuit’s September 2, 2012 opinion can be found here.

 

Background

The Saint Consulting Group is a consulting company that advises its clients in land use disputes. The firm had developed what the First Circuit called a “niche practice” in representing grocery store chains hoping to block or delay the opening of Wal-Mart stores. The firm was hired by a grocery store chain to try to block two Wal-Mart stores in the Chicago area. The developers who were trying to organize the Wal-Mart development filed suit against Saint, alleging in an amended complaint that the Saint’s activities violated the Sherman Antitrust Act. The developers’ complaint also alleged violations of RICO and tortious interference with prospective business advantage.

 

The court dismissed the developers’ complaint, holding that the developers’ claims were precluded by the Noerr-Pennington doctrine (about which see more below). The developers’ have sought leave to file an amended complaint. The developer’s motion to amend apparently remains pending.

 

Saint submitted the lawsuit to its E&O carrier, which denied coverage for the claim in reliance on the E&O policy’s antitrust exclusion. The antitrust exclusion provides that the policy does not apply

 

to any claim based upon or arising out of any actual or alleged price fixing; restraint of trade, monopolization, or unfair trade practices, including actual or alleged violation of the Sherman Anti-Trust Act, the Clayton Act, or similar provisions [of] any state, federal or local statutory law or common law anywhere in the world.

 

Saint filed a coverage lawsuit against the carrier in Massachusetts state court, alleging breach of contract as well as related claims. The carrier removed the case to federal district court, where the judge granted the carrier’s motion to dismiss Saint’s lawsuit, holding that Saint’s claims were expressly excluded by the antitrust exclusion. Saint Appealed.

 

The September 2 Decision

In a September 2, 2012 opinion written by Judge Michael Boudin for a unanimous three-judge panel, the First Circuit affirmed the district court’s dismissal of Saint’s lawsuit.  The Court opened its analysis by stating that “the underpinning” of the developers’ complaint was that Saint and its client were “engaged in a campaign designed to frustrate feared competition from Wal-Mart.” The Court then reviewed the antitrust exclusion, which the court concluded clearly barred coverage for the developers’ claims based on the Sherman Act.

 

The “far more interesting question,” the Court noted, is whether the antitrust exclusion also reached the other counts in the developers’ complaint that relied on the same facts but “are not limited to and do not expressly identify their target as restraints of trade.” The Court concluded that it did, noting that the exclusion “extends by its terms to any claim ‘based upon or arising out of’ any actual or alleged … restraint of trade.” Under Massachusetts case authority, this “arising out of language” sweeps broadly enough to preclude coverage “even though the statute or tort is denominated in different terms.”

 

The court added that “it can hardly be disputed that the factual allegations” of the developers’ amended complaint “allege a conspiracy to forestall competition through misuse of legal proceedings and through deception.” Even the counts in the developers’ complaint that are not described as antitrust claims “depend centrally on the alleged existence of such a scheme.”

 

Saint tried to argue that the antitrust exclusion should not apply because the court in the underlying claim had concluded that Saint’s activities were protected from liability under all of the developers’ legal theories by the Noerr-Pennington doctrine. (The doctrine holds that liability under the antitrust laws cannot be imposed for activities aimed at legislatures, even where the activities’ motives and effects are to forestall competition). The First Circuit rejected this argument, noting that “the exclusion does not depend on whether a successful defense can be advanced: it excludes meritless claims quite as much as ones that may prove successful.”

 

Saint’s had another argument related to the Noerr-Pennington doctrine. It argued out that Noerr-Pennington activities comprise a large part of their business. Saint argued that if claims based on Noerr-Pennington activities were precluded from coverage that coverage under the policy would be illusory. The First Circuit paraphrased, with approval, the holding of the district court that the Saint had not alleged that the E&O carrier made explicit representations that its policy would cover without exclusions all of Saint’s core activities, adding that “that Saint may have expected more protections than it got suggests mainly that it may not have read carefully the policy it purchased.”

 

Discussion

Many professional liability insurance policies, at least in their base form, contain antitrust exclusions. Indeed, many of the leading carriers’ private company D&O insurance policies have antitrust exclusions. These exclusions are often referred to, as I have in this blog post and as the First Circuit did in its opinion, in shorthand form, as antitrust exclusions. But as the First Circuit’s opinion shows, these exclusions can have a broadly preclusive effect far beyond claims explicitly denominated as antitrust claims.

 

In certain respects, it is of course no surprise that the exclusion sweeps beyond just claims denominated as antitrust claims, since the exclusion does expressly refer to other types of claims, including in particular claims for “restraint of trade.” It is noteworthy in that respect that the First Circuit’s broad interpretation of the “arising out of” that the exclusion’s preclusive effect is not merely limited to claims for or denominated as “restraint of trade” but to any related claims regardless of how denominated based on the allegations.

 

Many professional liability carriers have an antitrust exclusion in the base policy forms. Typically, E&O insurers will not agree to remove or modify this exclusion. However, in at least some circumstances, private company D&O insurers will agree to remove this exclusion, or at least to modify it to provide sublimited coverage or defense cost coverage.

 

As this case shows, the antitrust exclusion can have a broadly preclusive effect, not just to antitrust claims, and not even to restraint of trade claims, but other claims not denominated as such that “arise out of” those types of alleged violations. Given this broadly preclusive effect, private company D&O insurance policyholders and their advisers should have a strong bias in favor of policies that do not contain this exclusion, and where coverage is available without the exclusion, should have a strong preference for policies lacking the exclusion.

 

The significance of this fact – that there should be a strong preference for policies without antitrust exclusions – is often underappreciated because of the way the exclusion is referred to; that is, as an antitrust exclusion. Denominated that way, it sounds like it only refers to alleged violation of the antitrust laws, which many smaller businesses (rightly or wrongly) do not consider to be a significant risk for them. But on its face the exclusion applies to much more than just antitrust claims, and as the First Circuit’s decision in this case shows, the exclusion’s preclusive effect can sweep very broadly – so broadly in fact that the insured felt that if the exclusion really does sweep as broadly as the carrier here contended, that coverage under its policy was “illusory.”

 

Make no mistake, in certain types of claims, the antitrust exclusion can represent a significant diminution of coverage, and so the preference for policies without antitrust exclusions, particularly private company D&O policies should not be overlooked. The availability of this type of critical policy revision upon request underscores the importance for insurance buyers of having an experienced and informed insurance advisor involved in their insurance purchases, to ensure that all opportunities for coverage improvement are fully explored.

 

I will say that I find one statement by the appellate court particularly harsh; I refer to the Court’s statement that if Saint “expected more coverage than it got suggests mainly that it may not have read carefully the policy it purchased.” To me, this statement suggests the appellate believes that its coverage conclusion was facially obvious from the words in the exclusion.

 

Perhaps it is obvious to the appellate court that the exclusion would be broadly applied to a wide variety of claims regardless of how denominated. In my experience, most clients are outraged to find out how broadly some carriers will attempt to construe policy exclusions. That doesn’t mean that these clients don’t read their policies carefully, it means that they have broad expectations of coverage. Those expectations are embodied in certain principles of insurance policy construction, such as, for example, that policy exclusions will be interpreted narrowly and that the burden is on the carrier to show that an exclusion applies. I think it is entirely reasonable that an insurance buyer might expect that an insurance policy it purchased would provide coverage for what it considers to be its core business practices. The appellate court may have disagreed and reached a different conclusion, but to me that hardly justifies saying that the insured company’s expectation of coverage was simply a reflection of a failure to read the policy; it was, rather, a failure to appreciate that a court would read the policy differently. (All of that said, I recognize that the court’s statement really was a reflection of the court’s impatience with Saint’s lawyers’ arguments on appeal rather than any comment on Saint itself.)

 

Though many include the rating agencies among the list of culprits that contributed to the global financial crisis, the rating agencies have up until now largely dodged attempts to hold them liable. While there have been a small number of cases (refer for example here) where courts have denied the motions of rating agencies to dismiss claims that had been filed against them, those few cases have not (or least not yet) resulted in the imposition of liability against the rating agencies.

 

However, in a gargantuan September 5, 2012 opinion that appears to represent the first imposition of liability on a rating agency in a case arising out of the financial crisis,, an Australian Judge that ruled that S&P’s AAA rating of a complex financial instruments was “misleading and deceptive” and “involved negligent misrepresentations” and therefore that S&P was liable to twelve local Australian governments that purchased the investments. The 1,459 page ruling by Federal Court Justice Jayne Jagot can be found here. A November 5, 2012 Bloomberg news article describing the ruling can be found here.

 

The financial instruments in question were structured financial product known as a constant proportion debt obligation (CPDO), which one witness in the case described as “grotesquely complicated” (a description that Judge Jagot affirmed to be  “accurate”). The CPDO structure involved a special purpose vehicle that issued notes allowing investors to invest in the CPDO’s performance. The CPDO was a complex and highly leveraged vehicle that would make or lose money through notional credit default swap (CDS) contracts referencing two CDS indices. (Got that? Good.)

 

The CPDO was created in April 2006 by ABN AMRO, which had determined that in order to obtain a AAA rating, the rating model needed to show a very low likelihood of default (less that 0.728%). ABN AMRO determined what model inputs were needed in order to produce a determination that the instrument’s likelihood of default was within the desired range. According to Judge Jagot’s opinion, ABM AMRO convinced S&P to use the these desired inputs, even though ABN AMRO had reason to know that at least some of the inputs did not correspond to known marketplace conditions. Judge Jagot found that S&P used these inputs even though it could have determined on its own that at least some of the inputs did not correspond to marketplace conditions.

 

Thereafter, ABN AMRO created and sold additional versions of the CDO, including the Rembrandt 2006-2 CPDO and Rembrandt 2006-3 CPDO. S&P gave these later financial instruments the same AAA rating using the same methodology. Judge Jagot found that S&P gave these later offerings the same AAA rating and using the same methodology even though during the period between these two subsequent offerings a number of questions had been asked internally within S&P about the methodology (Internal S&P emails from this time period and cited by Judge Jagot in her opinion contain statements asking whether there was “a crisis in CPDO land” and asking whether the rating agency had been “bulldozed” by ABN AMRO.)

 

In late 2006 and early 2007, the Local Government Financial Services Pty (PGFS), an authorized deposit-taking institution organized by and actin g on behalf of Australian local governments (“councils”), purchased a total of A$40 milli0on of Rembrandt 2006-3 CPDO. Between November 2006 and June 2007, a number of councils in New South Wales purchased a total of A$16 million of these CPDO notes from LGFS, which kept the remainder of notes it had purchased on its own balance sheet.

 

As 2007 progressed, the global financial crisis began to unfold, which, among many other things, caused spreads to widen between the instruments credit default swaps and the referenced CDS indices. As the spreads widened, S&P downgraded the notes and the value of the notes declined substantially. LGFS sold the notes it continued to hold for a principal loss of $16 million. The various local councils cashed out in October 2008, receiving back less than 10% of the capital they had invested.

 

Judge Jagot found that S&P’s AAA rating of the Rembrandt notes was “misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia, which included LGFS and the councils.” She also found that ABN AMRO “engaged in conduct that was misleading and deceptive and published information or statements false in material particulars and otherwise involved negligent misrepresentations to LGFS specifically and to the class of potential investors with which ABN AMRO knew LGFS intended to deal.” Judge Jagot also concluded that LGFS has also engaged in “misleading and deceptive conduct.”

 

Judge Jagot concluded that ABN AMRO and S&P were equally liable to LGFS for the entity’s losses, although a part of LGFS’s claimed losses were reduced by LGFS’s own conduct. She also concluded that S&P, ABN AMRO and LGFA were each proportionately liable for one third of the councils’ losses. S&P has said publicly that it intends to appeal the ruling.

 

As a decision of an Australian court, the ruling will have no direct legal bearing on the outcome of any of the many cases pending against the rating agencies in the United States. Moreover, Judge Jagot’s ruling is very fact intensive and involves a host of specific factors that uniquely related to the circumstances at issue.

 

Nevertheless, the opinion (though dauntingly long and complicated) is very interesting and it offers a fascinating glimpse of the processes involved in rating at least one of the very complicated financial instruments that caused so many problems during the financial crisis. Judge Jagot’s opinion provides a look behind the scenes that can only be described as disturbing. Of course, S&P disputes her conclusions and intends to appeal her rulings. But Judge Jagot’s painstaking analysis suggests that, here at least, the rating agency was, as one email Judge Jagot  put it, “bulldozed” by the financial firm that created the instrument the rating agency was rating, and did not independently verify the validity of the inputs employed in the rating model it used.  

 

These conclusions are consistent with the allegations that have been raised in the many claims against the rating agencies here in the U.S.  — that the rating agencies were insufficiently independent and used inadequate ratings methodologies in providing the highest investment rating to complex financial instruments in the run up to the financial crisis. The fact that a court expressly found that a rating agency misled investors as a result of which the rating agency must be held liable to the investors has no precedential effect in these other cases. But it could have an effect on the context within which these other courts consider the allegations against the rating agencies. At a minimum, Judge Jagot’s ruling could hearten the claimants in those other cases.

 

Without having read the entirety of Judge Jagot’s nearly 1,500 page opinion, I can’t say for sure whether or not she considered the issue that has proven so critical in so many of the cases here in the U.S. – that is, that the rating agency’s ratings are mere opinions for which the rating agency’s cannot be held liable unless the claimant can show that the rating agency did not in fact actually hold the stated opinions. The absence of this consideration could perhaps explain the difference in outcome between the Australian case and so man of the cases here in the U.S. Many of the cases in the U.S. have ben dismissed on this basis. The Australian case does show what kinds of things might come to light if the cases against the rating agencies are allowed to foreword.

 

ABN AMRO was of course acquired in October 2007 by a consortium of investors led by the Royal Bank of Scotland and that included Fortis, in a transaction that contributed substantially to the near collapse of both RBS and Fortis, both of which subsequently required massive government bailouts. There is a lot of competition among the deals completed in the run up to the financial crisis for the title of worst deal of all time (think, for example of BofA’s acquisition of Countrywide). But there is a good case to be made that the ABN AMRO deal takes the cake. Anybody trying to understand how it all went wrong might want to start by taking a look at the Judge Jagot’s opinion in this case. 

 

Felix Salmon has an absolutely terrific November 5, 2012 article on Reuters about Judge Jagot’s opinion, here. Salmon is lavish in his praise for Jagot and her understanding of the complex financial instrument involved in the case.

 

On November 1, 2012, in what is the first lawsuit the FDIC has filed as part of the current bank failure wave against a failed bank’s accountants, the FDIC, as receiver for the failed Colonial Bank, has filed an action in the Middle District of Alabama against Pricewaterhouse Coopers and Crowe Horwath. PwC served as the bank’s external auditor and Crowe provided internal audit services to the Bank. A copy of the FDIC’s complaint can be found here. (Very special thanks to Francine McKenna of the re: The Auditors blog for providing me with a copy of the FDIC’s complaint.).

 

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

 

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

 

In the criminal cases against the bank employees, the government alleged that the two bank employees caused the bank to purchase from Taylor Bean and hold $400 million in mortgage assets that had no value. The employees also allegedly engaged in fraudulent actions to cover up overdrafts of Taylor Bean at the bank. The employees are also alleged to have had the bank engage in the fictitious trades with Taylor Bean that had no value.

 

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

 

The FDIC does have one problem in asserting these claims. In its role as receiver, the FDIC stands in the shoes of the failed bank, and is subject to all of the defenses that could have been asserted against the bank. As Alison Frankel discusses in her On the Case blog (here), the accounting firms are likely to raise the in pari delicto defense, “which holds that one wrongdoer can’t sue another for the proceeds of their joint misconduct” The FDIC has anticipated this defense in its complaint, alleging that the two bank employees that facilitated the Taylor Bean fraud were “rogue employees” who acted our of their own self-interest and not at the direction of or to the benefit of the bank, but rather to the detriment of the bank. 

 

In the wake of the current bank failure wave, the FDIC has filed a number of lawsuits against the directors and officers of failed banks. As of my latest tally (refer here, scroll down to second item), the FDIC has filed 35 suits against failed bank directors and officers. However, until now, the FDIC has not filed any actions against the former auditors of a failed bank. The Colonial bank suit is particularly interesting because it not only names the failed bank’s former outside auditor, but it also names the accounting firm that was performing the bank’s internal audit functions. There may be more accounting malpractice actions to come; on its website, the FDIC reports that the agency has “authorized 46 other lawsuits for fidelity bond, insurance, attorney malpractice, appraiser malpractice, accounting malpractice, and RMBS claims.”

 

Readers of this blog may recall that in August 2012, certain former Colonial Bank directors and officers agreed to settle the securities class action lawsuit that had been filed against them in connection with allegations surrounding the bank’s collapse. The $10.5 million settlement was to be funded entirely by D&O insurance. The securities suit settlement is discussed here. Significantly, the settlement did not include the bank’s offering underwriters or its outside auditors. Among the individual defendants party to the securities suit settlement was Colonial’s colorful and controversial former Chairman and CEO, Bobby Lowder. In addition to Colonial, Lowder has long been associated with Auburn University. I discussed Lowder’s Auburn connection in a prior post, which can be found here.

 

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

 

Speaking of Failed Banks: Shareholders of yet another failed bank holding company have now initiated a securities class action lawsuit. On November 2, 2012, the shareholders of Tennessee Commerce Bancorp filed a securities class action lawsuit in the Middle District of Tennessee against the holding company and certain of its directors and officers. A copy of the complaint can be found here.

 

Tennessee Commerce Bank failed on January 27, 2012. According to the plaintiff’s lawyers’ November 2 press release (here), the defendant directors and officers and the holding company violated the federal securities laws by “issuing false and misleading information to investors about the Company’s financial and business condition.”  The lawsuit asserts that “defendants misrepresented and failed to disclose that the Company had serious internal control deficiencies causing it to be unable to monitor its loan portfolio; obtain up to date and current appraisals of collateral; follow bank rules of procedures relating to the Company’s allowance for loan losses; and remediate internal control deficiencies..” The lawsuit is filed on behalf of investors who purchased shares in the holding company during the period from April 18, 2008 through September 13, 2012.

 

The volume of securities litigation against non-U.S. companies has ‘reached record levels” despite the U.S. Supreme Court’s 2010 decision in Morrison v. National Australia Bank, according to a recent report from NERA Economic Consulting. The report, written by Robert Patton of NERA, and entitled “Recent Trends in U.S. Securities Class Actions Against Non-U.S. Companies” can be found here. The report was written as a chapter to the 5th edition of The International Comparative Legal Guide to Class & Group Actions 2013, a collection of articles on class and group actions worldwide published by Global Legal Group in association with Commercial Dispute Resolution (CDR).

 

According to the report, the number of U.S. securities class action lawsuits filed against non-U.S. companies reached a peak in 2011, when there were 60 filings. In the first half of 2012, there were 20 filings against non-U.S. companies. While the 2012 filing pace is off from 2011, it is still higher than prior to 2011 and well above the annual average of 18 filings during the period 2000 to 2007. The filings against non-U.S. companies in 2011 represented 28.1 percent of all securities class action lawsuit filings, and while that percentage for the first half of 2012 has declined to 19.8 of all filings, that filing level is well above levels in 2008, 2009 and 2010.

 

The report notes that both in 2011 and 2012, the proportion of U.S. class actions filed against non-U.S. companies exceeded the proportion of non-U.S. companies listed on the U.S. stock exchanges. The report notes that during 2011 and 2012, non-U.S. companies listed on the U.S. exchanges were likelier to be sued than were U.S. companies, reversing a trend from the preceding three years, when foreign companies listed on the U.S. markets were less likely to be sued than U.S. companies.

 

The report notes the irony that the increase in the number of suits filed against non-U.S. companies has occurred after the U.S. Supreme Court’s 2010 opinion in the Morrison case. It has been widely believed that the transaction-based test enunciated in Morrison would reduce the number of securities suits involving non-U.S. companies

 

According to the report, the reason for the proliferation of suits involving non-U.S. companies has been the wave of litigation involving U.S.-listed Chinese companies. While there were only few of these cases filed in 2008 and 2009, in 2010, there were 15, and in 2011, there were 34, representing 17 percent of all 2011 securities class action lawsuits filings and nearly two-thirds of all securities suits involving non-U.S. companies. In the first half of 2012, the rate of filing against non-U.S. Chinese companies has declined, with ten cases filed. The report notes with respect to the suits against Chinese companies  that “this wave of litigation appears unlikely to re-emerge,” not only because rules regarding reverse mergers (the principal mechanism by which Chinese companies have obtained U.S listing) have become stricter, but also because Chinese companies “have become less likely to seek a U.S. listing, due to an increased perceived cost of litigation.”

 

Even though Morrison has not yet had a perceptible impact on the number of filings involving non-U.S. companies, Morrison has had an impact. As claimant classes are defined to omit claims on behalf of shareholders who purchased shares on non-U.S. exchanges, the shareholder classes on whose behalf the securities claims are asserted have become narrower. As the report states, “Morrison’s effect is more likely to narrow the scope of a claim against a non-U.S. company than to eliminate the claim entirely.”

 

The report also reflects an analysis of securities suit settlements in cases involving non-U.S. companies. The analysis shows that in each year during the period 2008 through the first half of 2012, the average settlement was lower in each year for cases involving non-U.S. companies than for cases against U.S. companies, often by a substantial margin. Although the median settlements for these two groups during the same time period are closer, in each year since 2009, the median settlement in cases involving non-U.S. companies is lower than cases against U.S. companies.

 

A significant factor driving the lower settlement trend for cases involving non-U.S. companies is the relatively low settlement of cases involving U.S.-listed Chinese companies (a phenomenon I previously discussed on this blog, here). The median settlement in cases involving Chinese companies during the period January 2010 through June 2012 was $3.0 million, compared to $9.0 million in cases involving settlements for other non-U.S. companies. In addition, the smaller class sizes in cases involving non-U.S. companies owing to Morrison (as noted above) could also be having an effect.

 

The report concludes by noting that the data in the report “underscore that the Morrison decision has not eliminated the risk of U.S. securities class action litigation to non-U.S. companies with securities traded in the U.S.”

 

Special thanks to the several readers who sent me a link to the NERA Report.

 

The Week Ahead: This week, I will be traveling to Chicago for the annual PLUS International Conference. On Thursday, November 8, 2012, I will be participating in a panel discussing D&O insurance in Asia that will be chaired by industry maven Joe Monteleone and that will also include my good friend Aruno Rajaratnam, as well as Dan Harris, the author of the China Law Blog, and Arthur Dong of Lantai Partners.

 

I also plan to attend many of the other sessions and conference events. I hope that if you see me around the conference you will please stop to say helllo and introduce yourself, particularly if we have not previously met. I look forward to seeing everyone at the conference.