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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

 

Background of Amgen and Path to the Supreme Court

 

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

 

 

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

 

 

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

 

 

Oral Argument Reflects a Divided Court

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

                       

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

 

 

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

 

 

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

 

 

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

 

 

Final Analysis and Conclusions

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

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

 

The September 2 Decision

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

Can I just say that I find it mighty depressing that everyone is talking about Hurricane Sandy in the past tense, as if the storm were already done and gone? Here in Northeast Ohio, as I write this blog post on Thursday evening, the rain continues to fall and the cold and gloomy damp lingers on. We have had continuous rain here since Sunday afternoon— and it is still raining. Trees down, power out, water everywhere. We haven’t yet arrived at the “aftermath” part of this story because the event is still taking place. Sandy just won’t leave.

 

The storm has made serious inroads into my blogging activities. There aren’t many opportunities for blogging when you are sitting in a candlelit room, huddled in blankets and listening to an ancient transistor radio, waiting for the power to return and hoping at least for a break in the weather. 

 

With intermittent Internet access at coffee shops, I have at least been able to scan the Web. I seriously wonder if Sandy is the single most commented upon event in the history of the Internet. Of course all of the major media outlets have deployed saturation coverage of the event. The most charmingcoverage I have seen is the November 1, 2012 summary on Gawker of small town newspaper reporting about Sandy, here. As Gawker put it in the introduction to the article, “Every black-clad, chain-smoking SoHo gallery owner and martini-lunching, town car-riding hedge fund manager started out life as a chubby, freckle-faced kid from South Dakota. Their parents and hometown newspapers were worried about them during the storm. These are their stories.”

 

There has also been a lot of media attention to the insurance angle of the story. A host of aggregate insurance loss estimates have been published. I know one thing for sure. All of the estimates are WAAAAY too low. Trust me on this one. It isn’t just that things are a lot worse in New York and New Jersey than people are assuming. (By way of illustration, check out this before and after photo display of the Jersey shore, here.) It is that nobody is even thinking about how much damage there was in places like Pennsylvania, Maryland, West Virginia, Ohio and Michigan. Be honest — before you read this blog post, were you even aware that the storm was bad in Ohio? Of course not, nobody cares that there is a terrible storm in Ohio when there was a hurricane in New York. (Just to prove my point,– did you know that in 2008, Hurricane Ike caused nearly $1.5 billion damage in Ohio? Of course you didn’t.) This is going to be just like it was with Hurricane Irene, where the early estimates were too low because at first nobody knew at first how bad the damage was in Upstate New York and New England. The exact same sequence of events is set up to happen with the estimates for Sandy.

 

One particularly interesting question that has come up in the insurance context has been the issue of whether or not insurers can enforce hurricane deductibles in New York, New Jersey and Connecticut. According to news reports, those states’ governors are saying that the insurers cannot enforce the deductibles.   Is that so, I asked myself? Apparently, so too did Alison Frankel, over at the On the Case blog, where she has a very interesting article discussing the question of whether or not the governors actually can prevent the insurers from enforcing the deductibles. Quick summary of her analysis: We’ll see. Among the many interesting questions is whether Sandy was still a hurricane at the time she made landfall. I will say this — homeowners and property owners in New York, New Jersey and Connecticut were already going to see their insurance rates jump. If insurers can’t enforce a hurricane dedictible, then the insurers are going to expect to be compensated for the increased risks — and so proeprty insurance rates will skyrocket. .

 

Anyway, I sure hope that we get power back soon so that, among other things, I can resume normal blogging activities. For now, I will leave you with one last link worth checking out. Woodruff-Sawyer has published its third quarter installment of their D&O Databox, which can be found here. The article has an update on third quarter securities class action filings as well as some interesting commentary on other litigation developments. Among other things, the article refers to the growing wave of executive compensation –related proxy disclosure litigation, a topic about which I had a guest post earlier this week, here.

 

To everyone out there who is stuck in a cold, dark house waiting for the power to come back on, let me tell you, from first hand knowledge, things could be worse. You could be stuck in a cold, dark house with your mother-in-law waiting for the power to come back on. FRIDAY MORNING UPDATE: The good news is that it stopped raining overnight. The bad news is that it is raining again this morning. At 8:30 am, it is still so dark that the possibility of daylight is still just a rumor. Power still out.

 

Follow-Up: Last week, I posted an article (here) about proposals by the U.S. Chamber Institute for Legal Reform to introduce legislation to address the M&A litigation problem. In a commentary to my blog post, Doug Greene, on his D&O Discourse blog, proposes his own partial solution to the M&A litigation problem. Doug’s interesting post can be found here. 

 

In Case You Missed It: Earlier this week, I posted a blog entry entitled: “The Looming Fiscal Cliff and Business Risk.” Not many people wound up seeing the article because I posted it the day that Sandy hit. Please take a look at it now if you missed it earlier this week. The post can be found here.

 

I am pleased to publish below a guest post from Bruce Vanyo, Richard Zelichov and Christina Costley of the Katten Muchin Rosenman law firm These three attorneys’ post addresses a new approach that plaintiffs’ lawyers are taking to “say on pay” challenges – that is, a preemptive attack in the form of a lawsuit seeking to enjoin the vote based on alleged misrepresentations in the proxy statement

 

I would like to thank Bruce, Richard and Christina 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 their guest post:

 

Nobody can accuse the plaintiff’s shareholder bar for suffering from a lack of creativity or being easily dissuaded from purporting to represent shareholders. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) in July 2010. Section 951 of Dodd-Frank requires a stockholder advisory vote on executive compensation (a “say-on-pay” vote). The Dodd-Frank Act, however, “specifically provides” that the say-on-pay vote (1) “shall not be binding on the issuer or the board of directors;” and (2) does not “create or imply any change to the fiduciary duties of the board members.” 15 U.S.C. § 78n-1(c)). Nonetheless, the plaintiff’s bar began filing stockholder derivative lawsuits alleging breach of fiduciary duty after any negative say-on-pay vote. The vast majority of these cases have been dismissed because the plaintiff failed to make demand on the company’s board of directors before bringing suit and such See Gordon v. Goodyear, 2012 WL 2885695, *10 (N.D. Ill. July 13, 2012) (collecting cases); see also Swanson v. Weil, 2012 WL 4442795 (D. Colo. Sept. 26, 2012); Haberland v. Bulkeley, No. 5:11-CV-463-D (E.D.N.C. Sept. 26, 2012).

 

As a result, the plaintiff’s bar has resorted to a new attack based on a tactic developed from the merger cases: suing companies before the say-on-pay vote to enjoin the vote based on alleged misleading disclosures. In the last month or so, Plaintiffs’ shareholder lawyers have issued over 30 notices of investigation concerning such suits, and over the course of the last year, they have sued over 20 companies. The complaints assert two theories (either alone or in combination). They assert that the proxy statement fails to disclose material facts necessary for the shareholders to cast an informed vote on executive compensation and/or they assert that the proxy fails to disclose material facts necessary for the shareholders to determine whether to increase the number of shares available to be granted to executives and employees as incentive compensation under company plans providing for such grants. The two theories are slightly different because the shareholder vote on executive compensation is purely advisory and exists solely because of the Dodd-Frank Act while the vote on increasing the number of shares available under a stock plan is required either by state law or the company’s articles of incorporation, bylaws or listing standards of the exchange on which the company trades.

 

While the trend has picked up recently, the first such case was filed on January 13, 2012 against AmDocs Ltd. in New York County Supreme Court. Plaintiff sought injunctive relief based on a proposal to increase the number of shares available under an equity incentive plan. Plaintiff did not challenge the proposal, but rather, the adequacy of the disclosures in the proxy statement regarding the proposal. The alleged omissions – the equity value of the shares; the timing of the issuance; the “dilutive impact” that the shares might have; the reason for issuing more shares when the existing incentive plan still had shares available; and the reason “why” the company was granting to shares to executives at an increasing rate, though management had not improved the Company’s performance – were not material, and basically amounted to asking “why” in connection with a shareholder vote plaintiff opposed. Defendants (represented by Katten Muchin Rosenman LLP) removed to the Southern District of New York, moved to dismiss, and opposed plaintiff’s request for a preliminary injunction. Plaintiff then voluntarily dismissed the claim.

 

Despite their initial loss in the case against AmDocs, plaintiffs have surprisingly had success in some of these cases. Specifically, in a case concerning Brocade Communications Systems, Inc., a plaintiff sought injunctive relief based on alleged omissions regarding a proposal to increase the number of shares in an equity options plan. Plaintiff argued the proxy: (1) omitted internal projections regarding future stock grants/share repurchases and their dilutive impact; (2) misled shareholders by claiming a repurchase plan would reduce potential dilution; and (3) failed to include a “fair summary” of the board’s analysis, including its equity utilization compared to peer companies. On April 10, 2012, the court enjoined the annual vote and required Brocade to disclose its internal projections regarding future stock grants. Similarly, WebMd, H&R Block and NeoStem settled cases filed against them by agreeing to additional disclosures requested by the plaintiff.

 

Plaintiff’s streak of success, however, recently came to halt in another case defended by Katten Muchin Rosenman LLP. On October 2, 2012, a plaintiff filed a complaint in DuPage County, Illinois seeking to enjoin a say on pay vote alleging, among other things, that the proxy statement omitted material information regarding peer companies and fees paid to compensation consultant. The case was removed to the Northern District of Illinois and the plaintiff set the hearing on the TRO nearly immediately. With just four business days in which to oppose, we filed a comprehensive brief opposing Plaintiff’s motion, and distinguishing the other cases in which the plaintiff had had success. At a hearing on October 9, 2012, the District Court denied Plaintiff’s Motion for a temporary restraining order.

 

In short, the plaintiffs’ shareholders bar continues to explore options to take advantage of the Dodd-Frank Act’s say on pay provisions. They have had some success and companies must be vigilant to defend their practices as compliant with all applicable law and not subject to injunction.

 

Next Tuesday, the country will elect its President for the next four years. Exactly one week later, Congress will return to take up a critical piece of deferred business that could dramatically affect the country for the next four years and even beyond, regardless of who wins the Presidential election.

 

In a culmination of circumstances that collectively embody the current dysfunctional political climate in Washington, the country faces what has been called a “fiscal cliff.” Unless Congress is able to implement some remedial steps, after December 31 a host of temporary tax cuts will expire and a series of dramatic spending cuts will kick in. If Congress does not act, the changes could have a significant impact on the country’s economy. The impacts could also have serious negative implications for a wide variety of businesses and industries.

 

In this post, I first take a look at the details of the impending “fiscal cliff.” I then review the range of alterative paths that events might take and consider the possible implications for affected industries and companies. I conclude with an appraisal of the business risks these possibilities might present. As discussed below, the potential consequences could include, among other things, at least the possibility of a heightened litigation risk.

 

What is the “Fiscal Cliff”?

The phrase the “fiscal cliff” refers to a likely budget crisis and to a corresponding projected slowdown in the economy if specific laws are allowed to expire or to go into effect at the beginning of 2013. The changes include tax increases that will go into effect due to the expiration of the Tax Relief, Unemployment Reauthorization and Job Creation Act of 2010, which had among other things extended the Bush-era tax cuts. The expiration of the tax cuts would result in an increase in all income tax rates, as well as the rates on estate and capital gains taxes. In addition, the alternative minimum tax will revert to 2000 tax year levels; federal unemployment benefits will expire; and the 2% federal payroll tax reduction will terminate.

 

The changes also include the automatic spending cuts (“sequestrations”) mandated by the Budget Control Act of 2011, because the Congressional budget “supercommittee” created by the legislation failed to agree on a deficit reduction plan. Annual cuts of $109 billion per year will go into effect, with over half of the cuts coming from defense spending.

 

Just to complicate matters further, the federal government will likely hit its current debt level limit in early 2013, which could introduce yet another destabilizing budget issue that Congress must address at or about the same time.

 

As detailed in an October 9, 2012 post on the New York Times Economix Blog (here), if the changes go into effect, “almost everyone who pays taxes will see a hit to take-home pay in the first paycheck in January.” The White House estimates that a family of four with an income of $50,000 to $85,000 would pay an additional $2,200 in taxes during the 2013 tax year.

 

The spending cuts will also have an enormous impact. The Bipartisan Policy Center is predicting that the cuts alone could cost one million jobs in 2013 and 2014. The Congressional Budget Office predicts that economic growth would decline by 2.9 percent during 2013. There is a real risk that the country would experience a “double-dip” recession. I note parenthetically that most of the discussion about the possible effects if the U.S. goes over the fiscal cliff is focused exclusively on the consequences for the U.S. There undoubtedly will also be consequences for the global economy as well, at a time when a host of other economic factors already threaten to undermine the still-fragile recovery from the credit crisis.

 

To be sure, there is some reason to believe that while the increased taxes and budget cuts could have serious short-run negative effects, the longer run effects could produce not only significantly reduced deficits (as much as $7.1 trillion reduction in the national debt over the next ten years, versus a $10-11 trillion increase if current policies are extended for the next ten years), but also the reduced deficit and debt could lead to higher long-term growth prospects. Indeed, because of the significant long-term problems associated with the country’s current and growing debt level, if Congress merely extends current policies, growing interest costs will become an increasingly significant drag on the country’s economy.

 

There are those who believe that perhaps the country would be better off taking the “strong medicine” associated with the tax increases and across the board spending cuts (more about which below). However, automatic spending cuts, no matter how effective as a way to reduce the deficit, do not necessarily represent good policy, or really policy of any kind. To cite but one example, even if cuts to defense spending are a good idea, cuts affecting our military capabilities should only occur in a careful and considered way, not simply by lopping off a huge slice of the defense budget. As serious as are the problems associated with the deficit, defense budget cuts can’t be administered without knowing whether or not they could compromise national security. 

 

On an even more immediate level, if Americans were to see their take home pay slashed dramatically simply due to Congress’s failure to act, there would be a political firestorm of epic proportions. The political backlash could be even further intensified if Congressional inaction results in economic constriction and massive job losses.

 

The Congressional Alternatives

There is enormous pressure for Congress to act. Indeed, the conventional view is that the consequences of inaction are so severe that Congress will almost certainly do something, even if it is just to kick the can down the road for a few more months. The problem for the country and for Congress is that the picture is scrambled. The current budget issue will soon become an economic and financial problem but at the present moment, at least for the members of Congress who will have to address the issue, the situation represents a political problem. It is not just the uncertainty due to a Presidential election that remains extremely close. Many Congressional and Senate races also are also close, and the outcomes of a number of individual races could have an impact. Margins of victory and shifting majorities could also come into play. The Congressional body that will have to address these issues before year end will be composed of an as yet indeterminate number of lame duck politicians whose motivations and interests could be effected by next week’s elections. Add to this volatile political mix the possibility of a lame duck President, as well.

 

There are a variety of other factors that could further complicate Congressional efforts to confront these issues. Perhaps the most significant is the scarcity of working days between November 13 and year end. There is not much time for Congress to grapple with issues that are both complicated and controversial. In addition, notwithstanding the serious threat that the looming budget crisis presents, there will inevitably be a certain number of Congressmen who, with an eye to the 2014 elections, are willing to provoke a crisis in order to be able to try to pin the blame on the other party.

 

In addition, there are serious commentators and observers who believe that the best thing for the county would be for the automatic tax increases and budget cuts to go into effect. As discussed in an October 26, 2012 Washington Post article (here), those who subscribe to this view (who are known as “cliff divers”) believe that only the exigencies of the crisis will put enough pressure on Congress to reach a “grand bargain” that represents a comprehensive and considered approach to the country’s deficit and debt problems. These commentators also believe that if Congress rushes to act in the little time remaining, a short-term sub-par deal could result, that, once in place, would make it harder for Congress to find the will to grapple with the fundamental issues.

 

One additional consideration that must be taken into account in assessing whether or not Congress will act is the obvious fact that merely because the country faces a looming economic crisis does not mean that Congress will find a way to do something. The reason the country is approaching the fiscal cliff in the first place  is because of the adversarial parties’ past failures to work together and the willingness on the part of some to engage in political brinksmanship. The forces that have produced past stalemates could take the country right off the cliff. All it takes for the country to go off the fiscal cliff is a little bit of political gridlock —  which happens to be the specialty of this particular Congress.

 

What This Means for Business

There are a host of problems that could arise quickly in the new year if Congress does not act before year end. But the looming crisis is already having an impact. As detailed in an October 25, 2012 Washington Post article entitled “Fiscal Cliff Already Hampering U.S. Economy” (here), companies “are bracing for the fallout by laying off workers, letting jobs go vacant and postponing major purchases.” According to the article, Department of Commerce data show that business investment stalled in September. Some companies have already begun laying off workers as a cost-containment effort in anticipation of further downturn next year.

 

These problems will quickly accelerate if Congress fails to act to avert the tax increases and spending cuts. Among other things, the impact will quickly be felt in the defense industry, where the sequestrations could quickly result in layoffs. The budge cuts could also have a significant impact on the many small businesses that depend on government contracts. The potential problems for many other industries may be more difficult to discern now, but the impacts could be diverse and wide-spread. For example, there are predictions that there could be significant adverse impacts on the commercial real estate sector as vacancy rates climb. Manufacturing, which only recently has begun to rebound from the ill effects of the credit crisis, could also be affected. A sharp increase in taxes would likely produce a sharp downturn in consumer spending, particularly for discretionary and luxury products. Even the purchase of consumer staples (such as appliances and furnishings) could face a sharp decline.

 

At a minimum, businesses face a climate of uncertainty. With uncertainty, comes risk. In light of this uncertainty and risk, some advisors are cautioning companies to be sure to incorporate precautionary disclosure in the public statements as a way to forewarn investors about the potentially harmful impacts that could arise if Congress fails to act.

 

For example, in their October 23, 2012 memorandum entitled “The ‘Fiscal Cliff’: Look Before You Leap Into the Securities Litigation Trap” (here) the Choate, Hall & Stewart law firm advises companies to “assess their exposure to the fiscal cliff” and if the risks are sufficient to “factor the relevant trends and uncertainties” into the earnings guidance, as well as into their public filings and statements to investors, particularly during the current quarterly reporting season.

 

It is worth emphasizing the reasons the law firm is advising that companies take these steps; the memo notes that in light of the potential consequences for companies from the budget crisis, the companies can be sure that the plaintiffs’ lawyers “will be on the lookout for targets of ‘stock drop’ securities fraud class action litigation.” Companies that suffer adverse impacts from the looming crisis could face allegations that resulting stock price declines are the result of a company’s misrepresentations with respect to, or failure to adequately disclose, these risks. The memo observes that “a company that warns with sufficient detail that its forecasts are subject to uncertainty because of the fiscal cliff events may both discourage litigation before it starts and have a better chance of prevailing should it be targeted nonetheless.”

 

Discussion

Congress and the county are approaching a dangerous crossroad. Though Congress can defer the day of reckoning temporarily by (again) kicking the can down the road, the ultimate showdown can only be postponed, and only then for a short time. Sooner or later Congress will have to confront the problems associated with the growing cumulative deficit and enormous debt. The country’s best interests would be served if Congress were to be able to reach the so-called “grand bargain” that addresses both revenue and spending concerns and puts the country on a long-term path towards meaningful debt reduction.  Whether a sharply divided Congress (representing a sharply divided electorate) can reach this type of agreement could prove to be a very tough proposition. 

 

In the meantime, both households and businesses face an environment of uncertainty and attendant risk. Businesses already face difficult choices about what steps to take in order to be prepared for the possibility that Congress might fail to act. The risks companies face take a number of forms, but among the risks is the increased litigation exposure that can arise when companies’ fortunes take a sudden negative turn. As we saw during the credit crisis, adverse economic circumstances can beget a huge increase in litigation.  In light of these risks, companies would be well advised to follow the recommended course of precautionary disclosure outlined in the law firm memo linked above.

 

D&O underwriters also face a difficult task in this environment. The question whether or not to adjust underwriting and risk selection in the current atmosphere will be challenging, as it unclear whether or not there really be any kind of crisis that could produce adverse claims events. It is will be equally challenging to try to anticipate which companies – or even which kinds of companies — will be most adversely affected if there really is a crisis. As if that were not enough, events will be moving fast over the next few weeks, much faster than the usual efforts to adjust underwriting practices and policies require.

 

Among the questions the D&O underwriters will have to consider is whether or not to begin taking a more cautious approach to the industries that will most obviously be affected if Congress fails to act, and if so, which industries to target. The underwriters will also have to consider how to scrutinize company disclosures in order to determine whether or not a particular company has been sufficiently precautionary. And the D&O underwriters will also have to adjust their positions as events unfold.

 

It will be interesting to see the outcome of next week’s election. I have to say, as an Ohio resident, this election can’t end soon enough. The around-the- clock political ad bombardment to which Ohio has been subjected is more than anyone should have to bear. But while it will be great to finally come to the end of this year’s electoral season and it will be interesting to see how the voting unfolds, there will be little break after the election is over. Regardless of who wins, there will be some serious issues for this country’s political leaders to face, right away.

 

In closing, I want to quote Minneapolis Star-Tribune Columnist D.J. Tice (here): “The smart way to resolve the debt crisis” will require a little more from Americans and their representatives. It will “require that Americans broadly stop telling themselves that only somebody else is responsible for the country’s budget mess, that only somebody else needs to pay higher taxes, and that only programs somebody else values need to be cut. It would require that politicians start telling the truth, and that voters reward them for it.” Tice’s position is absolutely correct. Unfortunately, he may also have identified the precise reasons why the crisis may not be averted.

 

Cliff Notes: Perhaps because of the vivid imagery involved in the characterization of the looming budget crisis as a “fiscal cliff,” the prospect of the country plunging off the budgetary precipice has inspired a number of cinematic allusions. The most evocative is the reference to the cliff divers’ approach as representing a prescription with a certain “Thelma and Louise” quality – desperate and doomed.

 

If Congress were to fail to act and the country were to race off the fiscal cliff, I think the experience for many Americans will be much like that of Wiley Coyote, shortly after chasing the Roadrunner off of a cliff – like the cartoon character, our legs will pump empty space briefly, and then, after a sudden and startling recognition that we are hanging in mid-air, we will plunge into the abyss.

 

And a Congressional debate in which some voices will contend that the best course for the country is to hurtle off the cliff will resemble the quarrel that Butch Cassidy and the Sundance Kid had as they argued about whether to try to escape their pursuers by jumping off a cliff into a raging torrent below:

 

Butch Cassidy (played by Paul Newman): Alright. I’ll jump first.

Sundance Kid (played by Robert Redford): No.

Butch Cassidy: Then you jump first.

Sundance Kid: No, I said.

Butch Cassidy: What’s the matter with you?

Sundance Kid: I can’t swim.

Butch Cassidy: Are you crazy? The fall will probably kill you.

 

For those who don’t remember the movie, the two do jump off the cliff and they manage to survive the fall. However, they don’t escape their pursuers and they ultimately are taken down in an epic gun battle.

 

One of the critical issues in building a D&O insurance program is the question of how to structure the insurance. Among the more complex issues is how to divide the program between “traditional” D&O insurance coverage and Excess Side A DIC insurance (which in effect provides catastrophic protection for individual directors and officers in certain defined circumstances). A more basic issue is how to “layer” the program between primary and excess insurers, and how much capacity each of these layers should have in the overall program.

 

The question of how to layer a D&O insurance program is certainly not new, but it remains a vital question and a source of continuing scrutiny and debate, because the way that an insurance program is structured can potentially have a significant impact in the event of a claim.

 

In the latest issue of InSights, I take a detailed look at the problems and challenges associated with D&O insurance layering and also suggest a few ways these problems and challenges can be reduced, or at least managed. The InSights article can be found here.

 

Worth Noting: Readers interested in developments regarding the duties of directors outside of the United States will want to take a look at the October 16, 2012 article from Mark Bestwetherick of the Clyde & Co. law firm entitled “Directors’ Duties and the Increasing Requirement for D&O Insurance in the UAE” (here). The article takes a look at pending changes to the UAE company law and the potential impact on the changes to director indemnification and insurance.

 

The World’s Worst Typos (In Pictures): Read ‘em and weep. Find them here.