An employer’s management liability insurance policy does not provide coverage for employees’ claims that – contrary to statutory requirements — the employer collected and failed to remit gratuities, because amounts owing due to a preexisting statutory duty do not represent covered loss, according to a recent decision of a Massachusetts federal court applying Massachusetts law. The September 10, 2012 decision can be found here. The decision is the subject of a November 26, 2012 post on the InsureReinsure.com blog, here.

 

Background

The Kittansett Club is a golf club in Marion, Massachusetts. According to the allegations in the underlying complaint, the club typically adds an 18% gratuity to food and beverage bills. A lawsuit filed on behalf of servers and bartenders at the club alleged that the club did not remit the gratuities to the servers at the club, but rather retained the gratuities or distributed them to management, in violation of a Massachusetts statute requiring employers imposing service charge or tip to remit the amounts to the service staff. The claimants also alleged breach of an implied contract, interference with contractual relations and unjust enrichment. The claimants sought restitution, injunctive relief, liquidated damages and attorneys’ fees. The club ultimately settled the servers’ claims.

 

The club submitted the servers’ complaint as a claim under its management liability insurance policy. The policy included both a directors and officers liability coverage part and an employment practices liability part. The club’s insurer denied coverage for the claim, arguing that the damages the claimants sought to recover did not arise from an alleged wrongful act but rather from a pre-existing statutory duty. When the insurer denied coverage for the claim, the club initiated a coverage action against the insurer in Massachusetts state court. The insurer removed the action to federal court, and the parties cross moved for summary judgment.

 

The September 10 Ruling

In her September 10, 2012 Memorandum and Order, Judge Denise J. Casper granted the insurer’s motion for summary judgment. In considering the insurer’s position, Judge Casper reviewed a number of cases — including in particular the Fourth Circuit’s February 2012 opinion in Republic Franklin Insurance Co. v. Albemarle County School Board — standing for the proposition that amounts owing as a result of a statutory obligation do not represent covered “loss” under a liability insurance policy. Judge Casper quoted the Fourth Circuit’s decision as saying that the case authorities on which it relied.

 

stand for the proposition that a judgment ordering an insured to pay money that the insured was already obligated to pay, either by contract or statue, is not a ‘loss’ covered under an insurance policy that requires that the loss be caused by a ‘wrongful act.’ The alleged ‘loss’ in such cases arises from the contract or the statute itself, not from the failure to abide by it.

 

Judge Casper held that the right of restitution for gratuities the club’s servers asserted “arose not from the wrongful act, but the Insureds’ pre-existing duty” under the Massachusetts statute requiring employers collecting tips or service fees to remit those amounts to the service staff.

 

The claimants in the underlying claim sought not only payment of the unpaid gratuities but also statutory treble damages, attorneys’ fees and costs. The insurer argued that these amounts were also outside the definition of loss because they represented penalties for which the policy did not provide coverage. Judge Casper concluded that these other amounts were compensatory in nature, and therefore not excluded as penalties that could be covered under the policy – “if no exclusion applied.”

 

The insurer further argued that the policy’s Earned Wages exclusion operated to preclude these other amounts, and Judge Casper agreed. The exclusion provides that there is no coverage under the policy “for any Claim related to, arising out of, based upon, or attributable to the refusal, failure or inability of any Insured(s) to pay Earned Wages.” The policy defines “Earned Wages” to mean “wages or overtime pay for services rendered.” Judge Casper concluded that “the usual and ordinary meaning of wages in this context would include gratuities.” Therefore, she concluded, “the Exclusions excluding coverage for any claims arising out of an insured’s failure to pay Earned Wages unambiguously applies in this case and the Insureds are not entitled to coverage under the Policy.”

 

Discussion

At one level, Judge Casper’s decision is no surprise. As Judge Casper herself noted, after concluding that the alleged misconduct in the underlying complaint constituted a “wrongful act” within the meaning of the policy, that fact does not, she said, “allow the Insureds to ignore their statutory obligations by shifting costs to their insurer.” Insured companies cannot, Judge Casper seems to be saying, withhold compensation from their employees and then shift the bill for the unpaid amounts to their insurer.

 

The “no loss” argument on which the insurer relied is based on increasingly well-established case authority; as the InsureReinsure.com blog notes, Judge Casper’s decision “joins a series of cases” including the Fourth Circuit’s decision in the Republic Franklin case) holding that “when an Insured is only being forced to return that which it never had a legal right either to receive or retain, insurance is not available.”

 

The more troublesome aspect of this decision relates to the fact that the claimants in the underlying claim sought further relief beyond just the remittance of the unpaid gratuities; they sought amounts that Judge Casper expressly found to be compensatory in nature. In addition, the golf club itself incurred expenses defending against the claimants’ claims, yet all of these amounts were found to be precluded from coverage under the policy’s Earned Wages exclusion.

 

This latter part of Judge Casper’s opinion illustrates how broadly these types of wage claim exclusions can sweep. If nothing else, Judge Casper’s ruling in this case is a reminder to insurance practitioners to review these exclusions to determine whether or not they would apply more broadly than intended. The exclusionary language of the type on which the insurer relied in this case typically is found in an exclusion referred to as the FLSA exclusion or the wage and hour exclusion, designed to preclude coverage primarily for alleged overtime and minimum wage violations. As this case shows, these exclusions can be worded so as to sweep far beyond just overtime and minimum wage claims.

 

Finally, it is worth noting that at least some contemporary management liability policies include some sublimited defense cost coverage for FLSA and wage and hour claims. From the face of Judge Casper’s opinion it does not appear that this policy provided this type of sublimited defense cost protection. This case does however provide a reminder that the sublimited defense cost protection afforded in these types of coverage extensions should be worded broadly enough to extend defense cost protection, for example, to all of the “Earned Wage” violations otherwise precluded from coverage under this policy.

 

One Pound Fish: Here at The D&O Diary, we consider it our duty to constantly scan the horizon in search of important trends of which our readers should be aware. It is in that spirit that we have embedded below the “One Pound Fish” song video, which, with nearly 4 million YouTube views, has gone totally viral. The video features a Pakistani fishmonger in London named Mohamad Shahi Nazir singining a Punjabi folk tune. Background about the video — including the song’s lyrics — can be found here. I will leave it to others to try to explain the complex combination of circumstances that can come together to make, well, for example, a “One Pound Fish” song video, into an Internet phenomenon. Just remember, you saw it here first.  I have to say, you gotta love this guy. (The video starts a little slowly, the song starts about 30 seconds into the video.)

 

When H-P announced on November 20, 2012 that it was taking an $8.8 billion charge after it discovered “accounting improprieties, misrepresentations and disclosure failures” at its Autonomy unit (which H-P acquired in October 2011 for $11.1 billion), there was a great deal of speculation that litigation would quickly follow. The intervening Thanksgiving weekend may have slowed down the filing of the first of the lawsuits, but only a little bit. The first of what will likely be many related lawsuits has now arrived.

 

On Monday November 26, 2012, plaintiffs’ lawyers filed a securities class action lawsuit in the Northern District of California against H-P and certain of its directors and officers. A copy of the plaintiff’s complaint can be found here. The plaintiffs’ lawyers’ November 26, 2012 press release can be found here.

 

The complaint names as defendants the company itself; Leo Apotheker, who was H-P’s CEO until September 2011 and who was CEO at the time the Autonomy deal was agreed upon; Meg Whitman, who became CEO in September 2011, but who had also served on H-P’s board at the time the Autonomy deal was agreed to; H-P’s CFO, Catherine Lesjak; and the company’s Chief Accounting Officer, James T. Murrin. The complaint was filed by an individual H-P shareholder on behalf of a class of investors who purchased H-P stock between August 19, 2011 (the date the Autonomy deal was announced) and November 20, 2012 (the date H-P announced the alleged improprieties at Autonomy).

 

The complaint alleges that the defendants violated the liability provisions of the Securities Exchange Act of 1934. Significantly, and as noted below, the complaint relates not just to the accounting improprieties at Autonomy, but also to the earlier $8 billion goodwill charge associated with H-P’s Enterprise Services business, as noted below.

 

According to the plaintiff’s lawyers’ press release, the complaint alleges that the defendants “concealed that the Company had gained control of Autonomy in 2011 based on financial statements that could not be relied upon because of serious accounting manipulation and improprieties.” The “true facts,” according to the complaint, “which were known by the defendants but concealed from the investing public,” were that

 

(a) at the time Hewlett-Packard acquired Autonomy, the business’s operating results and historic growth were the product of accounting improprieties, including the mischaracterization of sales of low-margin hardware as software and the improper recognition of revenue on transactions with Autonomy business partners, even where customers did not purchase the products; (b) at the time Hewlett-Packard had agreed in principle to acquire Autonomy, defendants were looking to unwind the deal in light of the accounting irregularities that plagued Autonomy’s financial statements; and (c)  Enterprise Services’ operating margin had collapsed from 10% in 2010 to approximately 6% as of April 30, 2011, 4% as of October 31, 2011, and 3% as of April 30, 2012, due to various reasons, including unfavorable revenue mix and underperforming contracts.

 

The reference to the Enterprise Services division relates to the H-P unit that incorporated the business formerly known as Electronic Data Systems Corporation (“EDS”), which Hewlett-Packard had acquired in August 2008 for $13.0 billion. On August 22, 2012, H-P took an $8 billion impairment charge on the goodwill associated with the EDS acquisition. The sequence of disclosures that the complaint cites is arranged to portray a pattern of misrepresentations regarding H-P’s Enterprise Services division, of which Autonomy was a part following H-P’s acquisition of the company.

 

It is interesting to note that the complaint names as defendants only the four current and former H-P officers. It does not name any of the other members of the H-P board, nor does it name any of the outside firms that advised H-P in connection with the Autonomy transaction and that presumably assisted with the due diligence review of the target company. It also seems noteworthy that the complaint does not name any of the former Autonomy directors or officers, even though at least some were also officials at H-P following the acquisition. (The absence of any Autonomy defendants may be due to the fact that Autonomy’s shares were not traded on U.S. exchanges immediately prior to the acquisition, and so, under the Supreme Court’s Morrison decision, the alleged pre-acquisition misrepresentations are beyond the ambit of the U.S. securities laws.)

 

This is of course the first complaint to be filed; there likely will be others, as this event seems likely to keep many lawyers busy for many years. Subsequent complaints may name others as defendants.

 

There is of course some irony that H-P and its senior management are targets of this litigation, as –at least from their perspective and according to the account — the company is itself the victim of the fraud. Indeed, in its press release regarding the Autonomy revelations, the company disclosed that it has contacted the U.K. Serious Fraud Office and the SEC. The company will clearly argue that it could not have knowingly or recklessly misled its investors in violation of the securities laws, as it was itself misled.

 

The complaint does not allege any specific grounds for the assertions that the defendants knew but concealed from the investing public during the class period that Autonomy had misrepresented its operating performance and financial condition.The complaint does not provide any explanation of what the defendants’ motivation would have been to make these misrepresentations. Perhaps in recognition of these potential issues, the complaint refers not only to H-P’s revelations about the accounting improprieties at Autonomy, but also references H-P’s earlier goodwill impairment charge in connection with the EDS transaction. It seems as if the plaintiffs hope to contend that both the EDS and Autonomy deals were part of failed strategy for the company’s Enterprise Services business, which the company sought to try to conceal until the problems could no longer be hidden from shareholders – although if this is the plaintiff’s theory, it is at this point only implied in the complaint, not explicitly stated.

 

As I said, there will likely be other lawsuits to come. The other suits and the likely amended complaints may further elaborate the plaintiffs’ theory of this case.

 

The ABA Blawg 100: I am delighted to report that The D&O Diary has once again been named to the American Bar Association’s Blawg 100, the bar organization’s list of the top blogs about lawyers and the law. The ABA’s Sixth Annual Blawg 100 list can be found here. We are delighted to be included again in this year’s list, if for no other reason than the blogs we follow and respect the most are all on the list as well.

 

As it has done in past years, the ABA is once again inviting readers to choose the top blogs in each of 14 different categories. Voting begins today and ends at close of business Friday, December 21, 2012 Winners will be announced by January 3, 2013. You can vote for your favorite blog here (registration, which is free, is required to vote). You can also vote by clicking on the “Vote for this Blog” box in the right hand column. Everyone here at The D&O Diary would be very grateful to any readers who might consider casting a vote for this site.

 

The Deadline for the Towers Watson D&O Survey is Approaching: As I have previously noted on this site, Towers Watson is once again conducting its annual D&O insurance survey. Everyone in our industry benefits from the survey results, so we all have a stake in making sure that the survey responses are as representative as possible of the industry as a whole. The deadline for this year’s survey is this Friday, November 30, 2012. Please take a moment and think about whether you have a client that could help with this year’s survey. The survey form itself is relatively short and only takes a few minutes to complete. The survey form can be found here. Please take a moment and forward this link to any prospective survey respondents you can think of.

 

This mix of items from around the web may be just the thing after a long weekend of leftover turkey –even though we are well aware that nothing can come close to a heaping helping of Turkey Tetrazzini three days after Thanksgiving. 

 

Adding up the Likely Legal Costs from H-P’s Autonomy Accounting Scandal: Last week’s news that H-P is taking an accounting charge of $8.8 billion dollars following the company’s discovery of “serious accounting improprieties” at Autonomy, which H-P acquired last year, is likely to generate more than just headlines in the business pages. As the various parties try to sort out responsibility for this debacle, litigation that could take years to resolve seems likely, according to Ohio State Law School Professor Steven Davidoff and Wayne State Law Professor Wayne Henning in their November 21, 2012 post on the New York Times Deal Professor Blog (here).

 

H-P’s announcement of the accounting issues and related charges included the company’s statement that it had notified the Serious Fraud Office and the SEC of the supposed accounting improprieties H-P had uncovered at Autonomy. But the likely litigation fall out from the company’s disclosures are likely to include not only regulatory investigations and enforcement actions, but also civil litigation, perhaps involving Autonomy’s former executives and even perhaps officials at H-P itself, as well as H-P’s advisors in connection with the Autonomy transaction.

 

However, all of these likely investigative and litigation initiatives could be complicated by the fact that Autonomy was a U.K company whose shares did not trade in the U.S and by the fact that H-P’s acquisition of Autonomy took place outside of the U.S. It may difficult for prospective claimants to pursue their claims in the U.S. particularly under the U.S. securities laws, as a result of the U.S. Supreme Court’s decision in Morrison v. National Australia Bank.

 

Despite these potential complications, litigation nonetheless seems likely. The professors conclude that “while the matter will probably involve tens of thousands of hours and millions of dollars spent on investigation and litigation, none of this is likely to restore the $8.8 billion the company lost.” 

 

Insurance Coverage for Data Breach Claims: One of the growing liability risks that many companies face is the exposure arising from the possibility of a serious breach of the company’s computer systems. The costs associated with a data breach can be enormous, as the companies involved respond to state law notification requirements and possible third-party claims. As the potential costs associated with data breaches mount, a recurring question has been the availability of insurance to protect against these costs.

 

A November 2012 memorandum from the Kelley, Drye & Warren law firm entitled “Insurance Coverage for Data Breach Claims” (here) takes a look at these recurring insurance coverage questions. The memorandum reviews the considerations affecting the availability for data breach claims under CGL and Property Insurance policies, as well as under specialty insurance policies. The authors conclude that “any time a potential data breach occurs, it is essential for an insured to consider all forms of insurance that it carries and to provide prompt notice to its insurer(s) of any policy that even potentially could apply.”

 

More About the Plaintiffs’ Lawyers’ Latest Say-on-Pay Litigation Gambit: A recent guest post on this site (here) discussed the plaintiffs’ lawyers latest say-on-paylitigation tactic, which involves a pre-emptive lawsuit filed in advance of the annual say on pay vote that challenges the adequacy of the compensation-related disclosures in the company’s proxy statement.

 

A November 19, 2012 memorandum from the Pillsbury Winthrop Shaw Pittman law firm entitled “Plaintiff’s Firms Gaining Steam from New Wave of Say-on-Pay Suits?” (here) describes the plaintiffs’ lawyers “new strategy” of trying to “hold companies liable: suits to enjoin the shareholder vote because the proxy statement fails to provide adequate disclosure concerning executive compensation proposals.” According to the memo, plaintiffs’ lawyers have filed at least 18 of these lawsuits in recent months. The memo notes that these new cases “have met with some success – with two court orders enjoining shareholder meetings and five settlements prior to companies’ annual meetings.”

 

Accompanying the memorandum are two helpful and interesting tables, detailing the outcomes of the various say on pay related lawsuits during the period 2010 through 2012, as well as the disposition of the latest injunctive relief actions that have been filed more recently.

 

Leftovers Again: Did you know that Turkey Tetrazzini is named in honor of the famous early 20th century Italian opera star, Luisa Tetrazzini? Neither did we. In honor of the patron saint of leftover Thanksgiving turkey, here is an audio tribute to Signora Tetrazzini, La regina del staccato:

 

 

The FDIC has been more actively filing failed bank lawsuits than may have been apparent. With the November 20, 2012 update to its online list of failed bank lawsuits, the FDIC made known that it has in recent weeks filed a number of lawsuits that had not previously hit our radar screens. In addition to the agency’s recently filed lawsuit in Georgia (which I discussed in a recent post, here, second item), the agency has also recently filed three additional lawsuits in West Virginia, California and Florida, bringing the total number of failed bank lawsuits the FDIC has filed during the current bank failure wave to 39.

 

The FDIC filed the first of these three additional lawsuits on October 26, 2012 in the Southern District of West Virginia. Acting in its capacity as receiver of the failed Ameribank, of Northfork, West Virginia, the agency has sued five of the bank’s former officers for the defendants alleged negligence, gross negligence and breach of fiduciary duty in allegedly improperly delegating their duties and for failing to properly supervise a third-party mortgage broker and originator, Bristol Home Mortgage Lending. A copy of the FDIC’s complaint in the Ameribank case can be found here.

 

The second of these three lawsuits was filed November 6, 2012 in the Central District of California. The FDIC filed its complaint in its capacity as receiver for the failed Pacific Coast National Bank of San Clemente California. The complaint, which can be found here, asserts claims against six former officers and directors of the bank for negligence, gross negligence and breaches of fiduciary duty in operating and managing the lending function of the Bank.

 

The FDIC filed the third of these three lawsuits on November 9, 2012 in the Middle District of Florida. The FDIC filed its lawsuit in its capacity as receiver of the failed Century Bank of Sarasota, Florida. The agency’s complaint, which can be found here, asserts claims against five former directors (one of whom was also an officer) of the failed Bank for negligence and gross negligence in connection with ten “speculative and high risk transactions.”

 

The new California and Florida lawsuits were both filed as the third-year anniversary of the failures of the banks in question approached. Both of the banks involved had failed on November 13, 2009, and so the FDIC filed those complaints just prior to the third-year anniversary. Interestingly, the West Virginia lawsuit was filed well after the third-year anniversary had passed; the bank involved had failed on September 18, 2008, yet the lawsuit was not filed until October 23, 2012. In the absence of other considerations, the defendants in the West Virginia lawsuit could have significant statute of limitation. It seems likely that some sort of tolling agreement was in place although the complaint says nothing about any agreement.

 

With these three new lawsuits and the others that have recently been filed and noted on this blog, the FDIC has now filed a total of 39 D&O lawsuit as part of the current bank failure wave, 21 of which have been filed in 2012. There had been a period during the mid-part of this year when it seemed as if the agency had entered some sort of a filing lull; as noted here, between the beginning of May and the end of September, the agency filed only two new lawsuits, after a flurry of filing activity earlier in the year. However, since October 1, 2012, the agency has now filed seven new failed bank lawsuits, and the seeming lull during the summer appears to have ended.

 

The high water market in terms of numbers of bank failures was during late 2009 and early 2010, so during the coming months the third anniversaries of the failures of an increasing number of banks will be coming up, which suggests there could be even further filings ahead. Indeed, with the latest update to the FDIC’s litigation page (here), the agency disclosed that as of November 15, 2012, the FDIC has authorized suits in connection with 84 failed institutions against 700 individuals for D&O liability. These figures are inclusive of the 39 filed D&O lawsuits naming 308 former directors and officers that the agency has already filed. Given the number of authorized suits, it seems likely that the new failed bank lawsuit filings will mount in the months ahead.

 

With the addition of the lawsuits filed above, the FDIC has now filed failed bank suits in eleven different states as well as the in Puerto Rico. The states with the largest number of lawsuits are Georgia (11), California (7) and Illinois (6), which is not surprising as these states are also among the leaders in terms of numbers of failed banks. However, Florida is also among the states with the highest numbers of bank failures but even with the new lawsuit described above, the state still has had only two failed bank lawsuits.

 

As Alison Frankel recently reported in her On the Case blog (here), the insider trading charges to which former Morgan Stanley hedge fund manager Joseph “Chip” Skowron pled guilty cost the company a lot of money. And, as demonstrated in the lawsuit the company recently filed against Skowron, Morgan Stanley wants its money back – the company wants not only the almost $5 million of legal fees it paid on Skowron’s behalf, but also the more than $32 million in compensation the company paid Skowron, and even the $32 million the company paid to resolve the SEC’s case against Skowron.

 

An action of this type is unusual, as Frankel’s blog post well documents. (This particular case is also procedurally unusual and complex, as Frankel also shows). But Morgan Stanley’s efforts to recoup all of its costs from Skowron triggered a question to me from several readers on a parallel topic: that is, when can a D&O insurer recoup amounts it has paid out after an insured has pled guilty or  when circumstances otherwise establish that there is no coverage for amounts the insurer has paid?

 

The recoupment question most often comes up in the insurance context with respect to attorneys’ fees. D&O insurers generally take the position that when they pay defense fees under their policy, they are merely advancing defense fees subject to an ultimate determination on whether or not the amounts are actually covered under the policy, and that in the event of a determination of noncoverage they are entitled to be reimbursed for the amount they had advanced.

 

The carrier’s position in this respect may be particularly understandable when it is paying defense fees under the policy’s corporate reimbursement coverage (usually referred to as Side B coverage); in those circumstances, the insurance is providing a funding mechanism for the insured company’s own indemnification obligations. Just as the insured company would typically have the obligation only to advance defense expenses subject to a right of recoupment if it is determined that the indemnitee is not entitled to indemnification, the carrier’s payment on the insured company’s behalf also represents advancement subject to recoupment.

 

But even when the carrier’s is paying defense fees under another insuring agreement (whether it is the individual protection coverage under Side A or the entity coverage under Side C), the carrier will contend that at the outset of a claim a definitive coverage determination is not possible and so the insurer is merely advancing defense costs until it is possible to make the determination.

 

Just the same, it is relatively rare for a D&O insurer to try to recoup defense fees it pays. That is largely because it is pretty unusual in the context of a D&O claim for there to be final factual determinations, because most D&O claims settle long before the factual determinations are made. (Indeed, among the many reasons that securities suit rarely go to trial is the defendants’ concern that an adverse verdict would not only result in a finding of liability against them, but could also result in the loss of their insurance coverage.)

 

There is another practical reason that it is relatively rare for D&O insurers to attempt to recoup defense fees it has paid; that is, by the time an individual or company grinds all the way through a serious D&O claim, the person or company is usually broke. There is not much left for the insurer to go after. It is the very rare case where it is going to be enough left for it to be worth the insurer’s expense and time to try to recoup amounts paid out.

 

There is of course another reason why it is rare for D&O insurers to seek recoupment; in general, it is not a public relations move for insurance companies to go around suing the persons they insure.

 

Nevertheless, over the years there have been a certain number of cases where the D&O insurer has attempted to recoup defense expenses. The law in this area is not entirely uniform. In some jurisdictions, the courts have held that, if at the outset of a claim the carrier has reserved the right to seek recoupment in the event of a determination of noncoverage, the carrier has the right to seek to recoup defense costs incurred in connection with claims that are not covered under the policy. Court that follow this approach reason that allowing the insurer to recoup the defense costs where a timely reservation of rights was issued promotes the policy of ensuring that defenses are afforded even in questionable cases. Other courts following this line have reasoned that it would be inequitable for the insured to retain the benefits of the defense without repayment where there was no coverage under the policy.

 

On the other hand, other courts have held that the policy itself must specific address the carrier’s right to seek recoupment and that the mere fact that the carrier has reserved its rights to seek recoupment is not sufficient to create a right that is not otherwise found the policy.

 

A more interesting question, and one that comes up even less frequently than the question of the insurer’s right to recoup defense expenses, is the insurer’s right to recoup amounts paid as damages or in settlements. An insurer has the right of subrogation, that is, the right to proceed against a third party that caused the loss, to recoup the amount of that loss. Most D&O policies contain subrogation provisions, but even in the absence of an explicit subrogation provision, the carriers will contend that they have rights of equitable subrogation entitling them to go against the persons that caused the loss.

 

The subrogation provisions of many D&O policies often specifically address the question of when the D&O insurer may subrogate against an insured person under the policy. In most modern D&O insurance policies, the clause will specify that the insurer can exercise the right of subrogation against an insured person if the person from whom recovery is sought has been convicted of a deliberate criminal act or has been determined by adjudication to have committed a deliberate fraudulent act. However, because so many D&O claims settle, these preconditions for a subrogated recovery against an insured person are rarely met.

 

But the subrogation provisions and rights only address the conditions on the carrier’s right to assert a claim in the right of the party on whose behalf the carrier paid the claim. The carrier’s own right to recover amounts it paid for which it later appears there is no coverage arguably is a different question. (It is an interesting thought-problem to contemplate whether a carrier seeking recoupment of amounts paid pursuant to a settlement or judgment is proceeding by way of subrogation or in its own right; in the D&O context it may well depend on the insuring agreement pursuant to which the payment was made. If the payment was made pursuant to the corporate reimbursement coverage then the recoupment action would appear to represent subrogation; if the payment was made pursuant to either the individual protection or entity liability coverage parts, then it might be argued that the carrier’s recoupment rights are direct, not by way of subrogation.)

 

Although some D&O policies do contain provisions specifying that the carrier may seek recoupment of amounts advanced as defense expenses in the event of a determination of noncoverage, it is relatively unusual for these provisions to address the carrier’s right to recoupment of amounts other than defense expenses. In the absence of specific contractual provisions addressing the issue, the carrier would be obliged to rely on equitable arguments – that is, that it would be inequitable for the carrier to have to bear costs it was not contractually obligated to undertake and that rightfully should be borne by the person whose conduct caused the loss.

 

I know of various instances where carriers have sought to recoup amounts paid as defense expenses, but I cannot recall an instance where a carrier sought to recoup amounts it paid by way of judgments or settlements — but that isn’t to say that it never happens; in fact, I expect that it has happened, and I would be very interested if readers aware of any occasions where this has happened could share their recollections with other readers by using the comment feature on this blog.

 

I will say that it is interesting how a particular situation, like Morgan Stanley’s new lawsuit against Skowron, can set off a whole cascade of thoughts and associations. My thanks to the several readers who contacted me with their thoughts and questions about the Morgan Stanley lawsuit.

 

One of the more interesting story lines in the securities class action litigation arena in recent years has been the emergence of substantial class action opt-out litigation, whereby various claimants representing significant shareholder ownership interests select out of the class suit and separately pursue their own claims – and settlements. The class action opt-out litigation emerged as a significant phenomenon in the litigation arising out of the era of corporate scandals a decade ago. After attracting a great deal of attention and concern at the time, the phenomenon seemingly faded into the background — that is, until several large public pension funds and mutual fund families opted out of the $624 million Countrywide subprime-related securities lawsuit settlement, about which I previously commented here.

 

Now more than a year after the high-profile Countrywide opt-out suit, some of the same claimants, represented by the same law firm, have now opted out of the class action Pfizer securities litigation pertaining to the company’s disclosures about the safety of its Celebrex and Bextra pain medication. In their November 15, 2012 complaint (here), seven public pension funds (including CalPERS and CalSTRS) and dozens of mutual funds from four separate mutual fund families have filed a separate lawsuit against the company and five of its individual directors and officers. The Pfizer opt-out litigation has a number of interesting features and raises a number of possible implications.

 

Pfizer’s disclosures and marketing practices relating to the two pain medications have already caused some serious problems for the company. On August 31, 2009, a Pfizer subsidiary agreed to plead guilty to a criminal felony charge. In order to settle the criminal charges, the company paid a fine of $1.195 billion, in what was at the time the largest criminal fine in U.S. history. The company also agreed to pay another $1 billion to settle related civil claims, and also agreed to pay an additional $894 billion to state governments and private litigants to settle the bulk of personal injury litigation and state government probes concerning the two pain medications.

 

In addition, since December 2004, the company has also been involved in securities class action litigation related to the company’s disclosures about the two pain medications, as discussed in detail here. The lead plaintiff in the pending class action securities suit is the Teachers’ Retirement System of Louisiana. Much has happened in this long-running case. On July 1, 2008, Southern District of New York Judge Laura Taylor Swain denied the defendants’ motion to dismiss (refer here), after which the parties proceeded to conduct discovery. On March 28, 2012, Judge Swain granted the plaintiff’s motion to certify a class (refer here, and refer here for the amended order of class certification). Judge Swain certified a class of shareholders who purchased their shares between October 31, 2000 and October 15, 2005. On September 7, 2012, pursuant to the notice sent to the class concerning the litigation, the opt-out claimants filed a request for exclusion from the class.

 

Though the opt-out claimants have selected out of the class suit, they enjoy numerous advantages in their separate lawsuits as a result of the years of class litigation. First, the opt-out claimants are actively relying on the long pendency of the class litigation in order to try to avoid possible statute of limitations concerns. In paragraph 548 and following of their separate complaint, the opt-out claimants contend the timely filing and pendency of the class litigation tolls the statute of limitations (through what is known as American Pipe tolling).

 

In addition, in their complaint the opt-out litigants expressly rely on information developed in the class litigation in support of their claims. In citing the sources on which they are relying as the bases for their allegations, the plaintiffs state in their complaint that they are relying on “documents and information, including internal emails produced by Pfizer, deposition testimony provided by its former officers and employees and court filings in related cases brought against the Defendants” in the consolidated securities (as well as other related cases filed against Pfizer). Of course, the opt-out claimants also get the res judicata benefits of the Judge Swain’s dismissal motion ruling as well.

 

Which is another way of saying that the opt-out litigants, like all of the other prospective class members, are the beneficiaries of the class action litigation which had been filed and was being litigated on their behalf.

 

Which does raise the question — given that the class representative has been actively and successfully pursuing the class litigation on behalf of a class of shareholders including these opt-out claimants for almost eight years, why are the opt-out claimant selecting out of the class?

 

The answer is that the institutional investor opt-out claimants think the can do better for themselves by proceeding separately. In a November 15, 2012 Am Law Litigation Daily article (here), counsel for the opt out claimants is quoted as saying, among other things, that in other opt-out claims that his firm has filed in connection with other pending securities class action lawsuit, the firm has resolved the opt-outs claims for “multiples” of what they would have recovered as class claimants. The article explains that the firm has represented opt-out claimants in numerous cases, many of which have resulted in confidential settlements. In addition, based on counsel’s remarks in the news article, there has been a level of significant opt-out activity in recent years that has been going on beyond the radar scree — indeed, the plaintiffs’ firm filing the Pfizer opt-out complaint reportedly has been involved in 14 additional opt-out suits just in the first nine months of 2012.

 

The comments in the Am Law Litigation Daily article suggest that institutional investors’ interest in opt-out litigation is growing, largely due to the growing perception that their recoveries will be increased by proceeding outside of the class. The opt-out claimants also avoid the cumbersome process and delays involved in the class settlement process. Mutual funds, which traditionally have not been involved in opt out litigation, have become more interested and involved in opting out. The article quotes Columbia Law Professor John Coffee as saying that “the trend is toward opting out,” and the article also notes that if the U.S. Supreme Court in the Amgen case currently pending before the court raises further barriers to securities lawsuit class certification, the trend toward individual securities suits could accelerate.

 

Though the Pfizer opt out suit is undeniably part of trend, it also is somewhat distinct and perhaps even unique, at least in certain respects. That is, in most of the other high profile opt-out litigation of which I am aware, the prominent opt-outs have chosen to select out of the class only after the class action lawsuit has already been settled. In this instance, the long-running securities suit remains pending.

 

The interesting challenge this poses for the opt-outs’ counsel is that without a class settlement already on the table, the opt-outs have no ready gauge of how a prospective settlement of their case might compare to the recoveries that will be available to the class when and if the class claims ultimately settle. That is, it will be harder for them to ensure that they did better or are going to do better by proceeding separately. Of course, it does remain to be seen whether or not the opt-out suit or the class action settles first.

 

The opt-out litigation raises much bigger problems for Pfizer and the other defendants. Not only does the existence of the opt-out litigation mean that they will only be able to fully resolve the now years-old litigation in a piecemeal process, but it also means that settlement talks will represent a complicated process built around the awareness that settlement of either the class or opt-out litigation will have an enormous impact on whichever piece remains unresolved. Given the likely fragmented and complex process, defense costs undoubtedly will mount, as well.

 

For many years, class action lawsuits have been a favored whipping boy for conservative commentators. But for all of the ills that the class action process can sometimes involve, the prospect of a litigation process in which mass group claims are fragmented and can only be resolved in a piecemeal fashionis no improvement. Given the apparently increasing institutional investor interest in pursuing claims separate from the larger investor class, we could very quickly be getting to the point where resolution of class litigation is only one part of a multistep process.

 

To be sure, it is only going to be in institutional investors’ interests to opt out in certain kinds of cases. As Adam Savett, the CEO of TXT Capital, notes in the Am Law Litigation Daily article, it will only make sense for institutional investors to opt out when the scale of shareholder losses are huge and where there is a solvent, deep-pocketed defendant available from whom to try to recover.

 

But even not every securities class action lawsuit will also involve parallel opt-out litigation, there have still been enough opportunities for some plaintiffs’ lawyers to develop a specialty and a growing practice in the opt-out suits. While this unquestionably represents an opportunity of sorts for the opt-out plaintiffs’ attorneys and their institutional investor clients, it creates a host of problems for other players in the securities litigation process.

 

The class plaintiff”attorneys will see their prospective class recoveries shrink as large institutional investors representing a significant part of the class pursue their own suits separate from the class. The class plaintiffs’ attorneys will watch their own prospective fee recoveries shrink commensurately even as the opt-out plaintiffs’ attorneys’ enjoy the benefits inuring from the class plaintiffs’ attorneys efforts. The defendants will not only incur the additional litigation costs associated with a multi-front war, but they will see their overall litigation resolution costs rise (perhaps significantly) as opt-out plaintiffs pursue separate claims seeking recoveries greater than would be available to the class. Even the courts will face added burdens as suits previously resolved in a single process are fractured into multiple parts. To the extent the added defense fees and settlement costs are insured, these increased costs will drive insurance losses.

 

For all of these concerns, however, it now appears that significant institutional investor opt out litigation increasingly will be a regular feature of securities class action litigation – which has important implications for all concerned. A key consideration to keep in mind while considering all of this is that sophisticated and well-informed institutional investors are opting-out because they believe that at least in certain cases they wil do better by proceeding outside the class. Which in turn raises serious questions about what that means for the investors remaining in the class.

 

Speciall thanks to a loyal reader for providing me with a copy of the Pfizer opt-outs’ complaint.

 

Another Georgia Failed Bank Lawsuit: During the current wave of bank failures, Georgia has been the state with the highest number of bank failures. For that reason, it may be unsurprising that the state also has the highest number of failed bank lawsuits. But though the fact that Georgia more bank failure lawsuits than any other state might be expected, the number of lawsuits filed in Georgia is disproportionately high, higher than would be expected just from Georgia’s share of the total number of bank failure. And late this past week, the FDIC filed yet another bank failure lawsuit in Georgia.

 

On November 15, 2012, the FDIC, as receiver for the failed Community Bank of West Georgia, in Villa Rica, Georgia, filed a lawsuit in the Northern District of Georgia, against three of the bank’s former officers and eight of its former directors. The complaint asserts claims for both negligence and gross negligence “for numerous, repeated and obvious breaches and violations of the Bank’s loan policy and procedures, underwriting requirements, banking regulations and prudent and sound banking practices” as “exemplified” by 20 loans made between May 17, 2006 and October 7, 2007, that allegedly caused the bank losses in excess of $16.8 million. A copy of the FDIC’s complaint can be found here.

 

Interestingly, three of the individual defendants are named “only to the extent of liability insurance.” The complaint recites that the three individuals have each separately filed for Chapter 7 bankruptcy, and that in connection with each of the separate bankruptcy proceedings, the FDIC has obtained an order from the bankruptcy court allowing the agency to name the individuals as defendants “nominally and only to the extent of insurance coverage.” The FDIC expressly does not seek to recover from personal assets. (The question of whether or not a liability insurance policy can apply when the insured person can have no liability is an interesting one that I am sure will be addressed in the course of the FDIC’s suit.)

 

Another interesting feature of the FDIC’s suit is that it was filed well after the expiration of the three-year period following the bank’s closure. The bank was closed on June 26, 2009, but the FDIC did not filed its lawsuit until November 15, 2012 – which, all else equal, would seem to raise statute of limitations concerns. It seems likely that at some point prior to the expiration of the three year period that the parties entered a tolling agreement; however, the complaint says nothing either way in this regard.

 

There is one other interesting feature of the lawsuit, which is that the FDIC has included allegations of ordinary negligence. This is interesting because of the recent decision in the Northern District of Georgia in the Integrity Bank case, applying Georgia law and holding that because of their protection under the business judgment rule, directors cannot be held liable of ordinary negligence. More recently (as discussed here), in the FDIC’s lawsuit against former directors and officers of the failed Haven Trust bank, Northern District of Georgia Judge Steve C. Jones affirmed that Georgia’s business judgment rule is applicable to the actions of bank directors and officers. Based on that determination, Judge Jones dismissed the FDIC’s claims against the directors and officers for ordinary negligence and breach of fiduciary duty. In light of that earlier decision, it would seem that the defendants in the new lawsuit have a basis on which to seek to have the negligence claims against them dismissed. (The FDIC, undoubtedly anticipating this argument, included in its complaint specific allegations asserting that the defendants are not entitled to rely on the business judgment rule, at paragraph 55.) 

 

This latest lawsuit is the 11th that the FDIC has filed as part of the current bank wave involving directors and officers of a failed Georgia bank. Because the FDIC has not updated its online litigation page in over a month, I am not completely sure of the current overall number of lawsuits filed, but I believe that this latest suit represents the 36th that the agency has filed against directors and officers of failed banks so far. In other words, over 28 percent of all the D&O lawsuits the FDIC has filed so far have been filed in Georgia. Of the approximately 440 banks that have failed during the current bank failure wave, about 80 were in Georgia, or about 18 percent of the total. For whatever reason, the FDIC’s D&O litigation activity is disproportionately concentrated in Georgia. By contrast, Florida, which also has seen a significant number of bank failures as part of the current bank failure wave, has only seen one lawsuit – so far.

 

Scott Trubey’s November 16, 2012 Atlanta Journal-Constitution article about the latest lawsuit can be found here. Special thanks to a loyal reader for providing me a link to Trubey’s article and alerting me to the latest lawsuit.

 

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.