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.

 

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.