On August 24, 2012, in a decision involving a U.S.-listed Chinese company that is of particular interest because of the significance the court attached to the discrepancies between financial figures the defendant company reported to the Chinese government and the figures it reported to the SEC, Southern District of New York Judge George Daniels denied in part the motions to dismiss of the company and two of its senior officials. He did grant the dismissal motions of the company’s outside auditor and principal outside investor, as well as the control person allegations against the company’s directors. A copy of Judge Daniels opinion can be found here.

 

Background

Duoyuan Global Water (DGW) listed its American Depositary Shares on the NYSE through a June 24, 2009 IPO. In its initial reports following the IPO, DGW reported positive financial results. The first indication of trouble arose when accounting concerns surfaced concerning a separate but affiliated company Duoyuan Printing (which is itself now the subject of a separate securities suit, refer here). Because of the close relationship between the companies (they operate in the same location, and have the same Chairman, among other things), questions arose about DGW. In September 2010, the board’s audit committee retained Skadden Arps to review DGW’s accounting.

 

In April 2011, an online report critical of DGW appeared on the Muddy Waters research analysis website. Among other things, the report accused DGW of replacing the 2009 report to the Chinese State Administration for Industry and Commerce (SAIC) with a forged version to cover up the fact that revenues had been “astronomically inflated.” That same day the company’s CFO resigned. Shortly thereafter, four members of the board resigned to protest the lack of access that Skadden was being given to company documents. Skadden withdrew its representation as well. As detailed here, securities litigation ensured.

 

The plaintiffs based their allegations that the company’s IPO documents and subsequent filings contained financial misrepresentations were based largely on discrepancies between financial figures that two of DGW’s subsidiaries had reported in China to the SAIC and figures the company reported in its SEC filings. The plaintiffs also alleged other misrepresentations, including alleged misstatements concerning the number DGW’s distributors and the number of its employees. The plaintiffs asserted claims under both Section 11 of the ’33 Act and Section 10(b) of the ’34 Act. The defendants moved to dismiss.

 

The August 24 Opinion

In his August 24 opinion, Judge Daniels granted the plaintiffs’ motions to dismiss as to a number of the alleged misrepresentations on which the plaintiffs sought to rely, including the allegations concerning the number of distributors and the number of employees. He denied the motions of the company and its CEO and CFO to dismiss with respect to plaintiffs’ claims of financial misrepresentation based on the discrepancies between the company’s reports to the SAIC and its reports to the SEC.

 

The defendants had argued that the discrepancy in figures did not mean that the SEC reports were false or misleading, particularly given that the SAIC reports were separately filed by each of two of DGW’s Chinese subsidiaries and the SEC reports were consolidated, and given the difference s between accounting conventions involved in the different reporting protocols.

 

Judge Daniels found that:

 

Although Plaintiffs have not proven that the filings were in fact false, the extreme discrepancies alleged in the financial reports, coupled with the logical inference that can be made regarding these figures, at this stage of the proceedings, sufficiently alleges that the statements made in the SEC filings are false. Defendants merely maintaining that the discrepancies are explainable is an insufficient reason to discredit the [amended complaint]. Assuming that that the SAIC filings are true, the CAC states sufficiently that the SEC filings are false. Based on the fact that DGW had more negative disclosures in China and positive disclosures with the SEC, the reasonable conclusion is that there is a fraudulent motive to overstate the numbers yet no fraudulent motive to understate them.

 

In concluding that the plaintiffs’ allegations in this respect were sufficient not only for purposes of their Section 11 claims but also with regard to their Section 10(b) claims, Judge Daniels further concluded that the plaintiffs had satisfactorily alleged scienter.

 

In reaching this conclusion, he noted that the company’s CEO and CFO respectively “knew or should have known that the U.S. reported revenues, operating income and net income were much greater than those in the SAIC filings.” In response to the defense objection that the plaintiffs’ have not alleged that the CEO and CFO even had access to the SAIC reports that DGW’s Chinese subsidiaries had filed, Judge Daniels noted that the two officers “were CEO and CFO of a multinational corporation, and as such, were required to be aware of the Company’s financials.”

 

Judge Daniels noted further that in addition to the two officials’ “executive positions and the large discrepancy between the SEC and SAIC figures,” he also relied on the Muddy Waters report as evidence of the two officials’ scienter, because statements the two provided were “in complete opposition to the alleged facts that were uncovered about DGW by Muddy Waters.” Judge Daniels did note that the Muddy Waters report, while not dispositive, may be relied on as evidence of the two officials’ scienter.

 

Discussion

Because so many of the suits filed against U.S.-listed Chinese companies involved allegations, like those made here against DGW, of discrepancies between figures reported to the SAIC and to the SEC, Judge Daniels’ opinion potentially could boost the plaintiffs in many of those other cases.

 

On the other hand, other courts have been less willing than Judge Daniels to assume that the discrepancies meant the lower figures were false. For example, as noted here, in November 2011, the court in the China Century Dragon Media securities case granted the defendants motions to dismiss in a case alleging similar discrepancies between SAIC and SEC reports. The court in that case did allow the plaintiffs leave to amend, in part to provide further explanation what the discrepancies meant the SEC filings were false. The court said that though the SAIC numbers and the SEC numbers were different, that is “merely consistent with” the possibility that the SEC figures were false, but “does not suffice to make that claim plausible.”

 

Other courts may be more reluctant that Judge Daniels to conclude, based on individual corporate officers’ positions alone, that the officers were aware of the figures reported in China. Judge Daniels seemed particularly willing to make this assumption, even though the figures were filed by separate Chinese subsidiaries. These assumption would be much more convincing if accompanied by allegations concerning the purpose and significance of SAIC reports, in order to show that they were, for example of equal importance as the SEC reports or otherwise so significant that the two officials would have had to have known of their content.

 

It is also worth noting that it is entirely plausible that, contrary to Judge Daniels assumption, that there might be good reasons to falsify the SAIC reports. Although not many defendants would want to make this argument, it is possible that the SAIC reports were falsified for reasons having to do with the purposes of the SAIC reports – for example if they determine taxes due.

 

Perhaps the most interesting aspect of Judge Daniels opinion is his willingness to rely on the Muddy Waters research report as support for his conclusion that the plaintiffs has sufficiently pled scienter. Many of the other securities suits involving U.S. listed Chinese companies also rely on reports of online research analysts like Muddy Waters – indeed, some of the complaints in these cases consist of little more that a recapitulation of the analysts’ reports. The plaintiffs in those other cases will certainly take heart from Judge Daniels’ reliance on the Muddy Waters report in this way.

 

I must confess that I find Judge Daniels reliance on the Muddy Waters report in this regard troublesome. It is well-known that many of the online research analysts also maintained short positions on the shares of the companies they were analyzing and therefore were financially motivated to drive down the company’s share price. There are certainly plausible inferences that might be drawn about motivations of the analysts, but I am uncomfortable with the notion that content from one of these financially motivated third-party online analysts can serve as a basis to establish the state of mind of officials inside the company.

 

In any event, however, and even though a number of the plaintiffs’ claims and a number of the defendants have been dismissed, the plaintiffs’ case against the company and its two senior executives will be going forward. How the plaintiffs will fare remains to be seen, as they, like other plaintiffs in this case will have to overcome procedural hurdles (refer for example here). As I have previously noted, in other cases involving U.S.-listed Chinese companies that have reached the settlement stage, the settlement amounts have proved to be modest. It remains to be seen if these plaintiffs will be an exception to this pattern.

 

Special thanks to a loyal reader for providing me with a copy of the August 24, 2012 opinion.

 

Delaware Supreme Court Affirms Massive Judgment, Attorneys’ Fees in Southern Peru Case: On August 27, 2012, the Delaware Supreme Court affirmed the more that $2 billion judgment and more than $300 million attorneys’ fee awarded in the Southern Peru case. A copy of the Supreme Court’s opinion can be found here (Hat Tip: Delaware Corporate and Commercial Litigation Blog).

 

As discussed here, the lawsuit relates to Southern Peru’s April 2005 acquisition of Minerva México, a Mexican mining company, from Groupo México, Southern Peru’s controlling shareholder. In October 2011, Chancellor Leo Strine concluded that as a result of a “manifestly unfair transaction,” Southern Peru overpaid for Minerva Mexico. A copy of Chancellor Strine’s 106-page opinion can be found here. Chancellor Strine later adjusted the award applying prejudgment interest and awarded attorneys’ fees. Groupo Mexico appealed.

 

There are a number of very good write-ups about the Delaware Supreme Court’s opinion affirming the lower court ruling, particularly Alison Frankel’s August 27, 2012 post on here On the Case blog (here) and David Bario’s August 27, 2012 Am Law Litigation Daily article (here).

 

There is a host of well established legal principles that govern insurers’ defense obligation under the standard liability insurance policy where the insurer has the duty to defend the insureds. But many professional liability insurance policies are not written on with the duty on the insurer to defend (which is usually described as a “duty to defend” basis). Because many professionals want to control their own defense, liability insurance for these professionals often provides that the insured professionals will defend themselves, with the obligation on the insurer to advance defense expenses as they are incurred, subject to all of the policy’s terms and conditions.

 

Because the defense obligations under the more traditional duty to defend coverage are well established and are more familiar to many courts, the courts all too often attempt to resolve issues arising under duty to advance policies by referring to principles developed with regard to duty to defend policies.

 

A recent Central District of California decision in a dispute arising under a legal malpractice policy takes an interesting look at these issues. In an August 21, 2012 opinion (here), Judge James V. Selna, applying California law, rejected the insured’s arguments to have the malpractice insurer’s duty to advance obligations determined under duty to defend principles, and applying the more stringent principles  the court determined to be applicable to the insurer’s duty to advance, the court concluded that the insurer did not have the duty to advance the insured’s defense expenses he incurred in a dispute between the insured and his former law firm.

 

Background

Between May 2007 and March 2008, Gregory Glenn Petersen was an attorney with and shareholder of the Jackson, DeMarco, Tidius & Peckenpaugh law firm (JDTP). Before, during and after the time Petersen was with JDTP, he represented the San Diego Police Officers’ Association (SPDOA), as well as several individual police officers in litigation related to employment benefits and labor negotiations. The SPDOA and the individual officers later terminated Petersen as their counsel, and subsequently brought a legal malpractice action against, inter alia, JDTP and Petersen.

 

JDTP’s professional liability insurer paid all of JDTP’s and Petersen’s defense costs incurred in excess of the policy’s $150,000 retention. JDTP paid the retention amount. The malpractice action ended in a settlement that the insurer funded under the policy.

 

Thereafter, JDTP served an arbitration demand on Petersen, in which, as amended, JDTP sought to recover its payment of the $150,000 retention, as well as about $100,000 in fees the firm allegedly incurred in dealing with Petersen’s departure from JDTP and in connection with the malpractice cases. Petersen submitted the arbitration dispute as a claim under JDTP’s professional liability insurance policy, seeking to have the insurer fund his defense and indemnify him. The insurer denied coverage for the dispute and Petersen filed an action for declaratory judgment against the insurer and for damages. In his declaratory judgment claim, Petersen sought a judicial declaration that the insurer has an immediate duty to advance his expenses incurred in defending against the JDTP arbitration claim. The parties filed cross-motions for summary judgment.

 

Among other things, JDTP’s professional liability insurance policy provides that “the Assureds and not the Company have the duty to defend Claims” (the “Company” being a reference to the insurance company), providing further that, subject to the policy’s other terms and conditions, “the Company on behalf of the Assureds shall Advance Claim Expenses … in excess of the applicable RETENTION, if any, before the final disposition of a Claim against the Assureds.”

 

The August 21 Opinion

In seeking a judicial declaration that the insurer must advance his defense expenses, Petersen argued in reliance on principles established under duty to defend policies that “to prevail on his claims he need only show a possibility that there is a covered claim.” He reasoned that “the duty to advance claims expenses is sufficiently analogous to the duty to defend that the same standard should apply.” The insurer argued that the “possibility of coverage” standard and other rules of law governing a policy with a duty to defend do not apply to a policy containing only a duty to advance claims expenses.

 

The court reviewed several cases on which the parties relied, determining first that the courts have indeed differentiated the duty to advance claims expenses from the duty to defend. Judge Selna also reviewed a decision on which Petersen sought to rely arising out of the WorldCom securities litigation and under New York law. Judge Selna discounted that case because it arose under New York law rather than California law, and concluded in any event that it was not persuasive of Petersen’s position.

 

After considering the cases applying California law and arising under policies providing for a duty to advance defense expenses rather than a duty to defend, Judge Selna turned to the policy in dispute. He noted to the “policy provides for the claims expenses to be advanced subject to several conditions”, including the insured’s obligation to obtain the insurer’s consent to reasonable attorneys’ fees and to settlements; as well as subject to the policy’s allocation provisions. Combined with the policy’s “explicit disclaimer of any duty to defend,” Judge Selna found that the policy “is not consistent with the broader duty to defend.”

 

Accordingly, Judge Selna determined that he “will not apply any legal rule … based on a duty to defend policy to the present case” and concluded that Petersen had the burden of establishing “that the underlying claims are within the basic scope of coverage.”

 

Judge Selna then proceeded to determination that the claims presented within JDTP’s arbitration demand were within the policy’s scope of coverage, he ruled that “the uncontroverted facts show beyond a genuine issue of material fact that the arbitration asserted against Peterson does not require the Insurers to advance claims expenses because he is not covered by the Policy.” Judge Selna granted the insurer’s motion for summary judgment and denied Petersen’s  cross-motion.

 

Discussion

In my current professional role as a representative of policyholders’ interests, I often read cases these days rooting for the policyholders. But for a large part of my career, I represented insurers’ interests, both as an advocate and as an advisor. I recall all too well from those days representing insurers how vexing it was when courts were insufficiently precise in their understanding of insurer’s policy obligations. I found it particularly confounding when courts would blur the lines and apply principles applicable to the duty to defend policies in the determination of insurer’s obligations under duty to advance policies.

 

Even though these days I root for policyholders’ interests when reading case decisions,in the end, what I really want is for coverage disputes to be resolved based on a correct judicial understanding of the parties’ respective obligations under the insurance policy. In this case, the court correctly understood the insurer’s defense obligations and correctly declined to apply principles derived from duty to defend cases to the determination of the insurer’s obligations.

 

In the long haul, all parties’ interests will be served if coverage disputes are resolved based upon a correct judicial understanding of the parties’ policy obligations. In particular, all parties’ interests will be served if courts do not inappropriately seek to determine carriers’ obligations under a duty to advance policy applying principles determined in connection with duty to defend policies.

 

One thing that should be clear from all of this is the basic point that insurers’ obligations under a duty to advance policy are different from insurers’ obligations under duty to defend policies. In some situations, policyholders have a choice of which kind of defense provisions to have in their policies (this is particularly true in the private company D&O insurance context).

 

It is critically important when the policyholder is choosing which kind of defense arrangement to have in its policy for the policyholder to be fully informed about the differences in the kinds of defense arrangements. There are advantages and disadvantages to each type of arrangement; being able to understand and explain these differences requires an informed understanding of the claims process and how the difference defense arrangements might affect future claims. This is one more reason why it is particularly important to have an experienced and knowledgeable advisor involved in the professional liability insurance placement process.

 

Special thanks to a loyal reader for providing me with a copy of the August 21 opinion.

 

Among the more noteworthy aspects of the recently enacted Jumpstart Our Business Startups (JOBS) Act are the legislation’s crowdfunding provisions. These provisions are intended to allow small businesses a new means of raising funds directly from investors using the Internet. But many commentators are concerned about these provisions. Among other things, some have noted that the transaction costs that the Act required fund-raising companies to incur may deter start-ups from using crowdfunding. And a number of other commentators have raised concerns about fraud.

 

The possibility of crowdfunding fraud, and some suggestions about possible means of preventing the fraud, is discussed in an August 22, 2012 Thomson Reuters News & Insight article entitled “Crowdfunding: Small-Business Incubator or Securities Fraud Accelerator?” (here), written by Lyndon Tretter of the Hogan Lovells law firm. The author notes that many commentators are “concerned that the potential for fraud on the crowd may outweigh the promise of new financing for legitimate startups.” Among other reasons for these concerns is that with crowdfunding, “the risk of fraud increases because the pool of investors includes those who have no personal relationship with the business owner and who may be geographically remote from and thus unable to oversee the business itself.”

 

The author notes that, while the JOBS Act expressly provides investors the opportunity to seek a recovery if they believe they have been misled, because each crowdfunding investor will only have a relatively small stake in the enterprise, they may lack the incentive or resources to pursue a recovery. Even in the aggregate, the investors’ collective investments may not be enough to attract the interest of the traditional class action attorney, so the civil liability provisions “may not prove to be very useful in practice.”

 

To address these concerns, the author proposes that the SEC promulgate rules designed to address the likeliest sources of abuse: the promise of unrealistic returns on investment and the ability of insider to use the money they raise for themselves of their own benefit. The author specifically proposes that the SEC use its rulemaking to require the fund raisers to state the personal investments that the insiders have made in the enterprise; require particularized disclosure of the anticipated use of the offering proceeds; require disclosure of any salary, benefits or compensation the issuer is expected to pay in the next year; and require disclosure of any transaction with a related party that the issuer anticipates in the coming year. The author also suggests that the SEC encourage investors to consider the benefits of investing locally, under circumstances when investors might have a better chance to monitor the company directly.

 

The author also proposes augmenting the JOBS Act’s civil liability provisions, among other things by allowing claimants to recover their attorneys fees incurred in pursuing a claim if the claimant can show that an individual insider intended the issuer’s disclosure to be misleading.

 

I think the author has done a commendable job of trying to think of ways to protect investors and to try to make the crowdfunding less susceptible to fraud. Unfortunately, it seems inevitable that there will be those who abuse the crowdfunding mechanism. It is bad enough that the crowdfunding procedure specified in the JOBS Act will be cumbersome and costly, as I noted in a prior post. But if there are highly publicized instances where crowdfunding is abused and investors are defrauded, prospective investors may be deterred altogether, and in the end the process could not only be costly but ineffective.

 

It will be interesting to see the SEC’s rules when they are finally released. But it will be even more interesting to see what becomes of the crowdfunding mechanism – in particular, what kinds of companies use the process, whether they process becomes a standard means of fundraising, and whether or not there are problems with fraud or other abuse. I wonder whether with all of the potential problems crowdfunding will prove to be an important and useful innovation or a just another failed initiative.

 

One of the trends I noted in my analysis of securities class action lawsuit filings in the first half of 2012 was the apparent rise in securities suits against companies in the natural resources sector. Among other things, I noted that about 14.5% of first half filings were against companies in the natural resources industries, with the largest concentration of cases in the Crude Petroleum and Natural Gas category.

 

An August 21, 2012 memo from the King and Spaulding law firm entitled “Securities Litigation and the Energy Sector” (here) takes a closer look at the rising levels of litigation involving companies in the energy industry. Among other things, the article reports that securities class action lawsuits against energy companies “have increased in the past three years.”

 

Among other reasons for the increase in litigation against companies in the energy industry has been the increase in the number of high profile events involving worker and environmental safety. As a result, safety disclosures have been a prominent part of securities class action lawsuits involving energy companies, including, most significantly, the class action lawsuits involving BP, Massey Energy and Transocean. In each of these cases, investors alleged that companies had misrepresented their safety records or safety procedures. In both the BP and Transocean cases the allegations related to safety were dismissed, based on the determination that general statements about corporate safety goals and commitments were not actionable because they were too vague. However, the Massey Energy case survived the dismissal motion.

 

Although not discussed at length in the law firm memo, another reason for the recent rise in litigation involving companies in the energy sector has been the surge of litigation against U.S.-listed Chinese companies. For example, of the 39 U.S.-listed Chinese companies sued in securities class action lawsuits in 2011, at least eight involved companies in the energy industry.

 

The most traditional source of litigation involving energy companies have been allegations of misrepresentations concerning reserve estimates. The law firm memo reviews questions that have arisen more recently regarding new procedures for estimating oil and gas reserves, and notes that “many industry and federal officials have questioned whether companies are taking advantage of the new rule by over-reporting reserves to increase their company’s value.” The memo notes that several federal agencies including the SEC are looking into the accuracy of reserve estimates. The SEC has in fact subpoenaed several companies, as have two states’ attorney general offices. The law firm memo notes with respect to these investigations that:

 

The results of these investigations have yet to be seen. If any developments come from the subpoenas, then securities class actions and derivative suits will likely follow and we could see more cases like focused on false reserve reporting prior to 2010.

 

The law firm memo notes that hydraulic fracturing, or fracking, is a “hot button issue for many oil and gas companies.” The SEC is among many regulators raising questions about fracking. In particular the SEC has shown interest in having companies provide greater disclosure about fracking. Using the comment-letter process, the SEC has required companies to provide additional information, for example, about specific operational and financial risks associated with fracking, or regarding the expenditures required to comply with regulatory requirements.

 

The law firm memo notes that the New York attorney general has subpoenaed a number of oil and gas companies “requesting information regarding disclosures about the environmental risks of fracking.” The memo notes that how companies respond to these disclosure pressures “could lead to shareholder litigation and increased SEC involvement.”

 

A number of factors have contributed to the recent rise in securities litigation involving companies in the energy industry. At least one factor – the rise in litigation involving U.S.-listed Chinese companies – seems unlikely to continue in the future. But as the law firm memo outlines, there are a number of other factors that suggest that companies in the energy sector could continue to face an elevated risk of securities litigation in the months and years ahead.

 

Libor-Related Claims and D&O Insurance: As I have previously noted, one of the big stories of the summer is the Libor-related scandal and follow on litigation. The scandal and ensuing litigation have a number of implications, not the least of which are the D&O insurance implications of the investigations and claims. An August 22, 2012 article in The Metropolitan Counsel entitled “Libor-Related Insurance Claims Provide A Roadmap To The Issues Faced By Policyholders In Large Exposure D&O Claims” (here) by Alexander Hardiman of the Anderson Kill law firm takes a brief look at the insurance issues involved in the Libor scandal-related claims.

 

In a decision that gives broad effect to a D&O insurance policy’s contractual liability exclusion, on August 17, 2012, Middle District of Pennsylvania Judge William Nealon granted the insurer’s motion for summary judgment, holding under Pennsylvania law that the insurer had no obligation to defend or indemnify the policyholder in the underlying action. A copy of Judge Nealon’s opinion can be found here.

 

Background

In 2004 and 2005, Uni-Marts sold a group of convenience stores in Pennsylvania. The buyers later contended that Uni-Marts had made misrepresentations and omissions about costs and expenses to induce prospective buyers. The buyers initiated a lawsuit in Pennsylvania state court against UniMarts (referred to as the Alliance Action). The complaint in the Alliance Action contained five causes of action against Uni-Marts: 1) fraud in the inducement; 2) negligent misrepresentation; 3) breach of the Fuel Supply Agreement;4) breach of the Purchase Agreement; and 5) breach of the Right of First Refusal Agreement. The Alliance Action ultimately settled for Uni-Marts’ agreement to pay the buyers $2 million and $25,000 in settlement administration costs, as well Uni-Marts’ agreement to certain changes in the contracts.

 

Uni-Marts sought coverage under its D&O insurance policy for its costs of defending the Alliance Action as well as for the cash amounts of the settlement. The D&O insurer denied coverage relying among other things on the policy’s contract exclusion, which provided that no coverage will be available “based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement, provided that this Exclusion … shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement.” The carrier filed an action in federal court seeking a judicial declaration that coverage was precluded. The parties filed cross-motions for summary judgment.

 

The August 17 Holding

There was no dispute that count three through five in the Alliance Action were based on Uni-Marts’ alleged liability under a written contract. The parties disputed whether or not coverage was precluded by the policy’s contractual liability exclusion for the negligent misrepresentation and fraud in the inducement counts in the Alliance Action. Uni-Marts argued that the two tort claims arise out of pre-contractual conduct and stand alone from the contract claims.

 

Judge Nealon held, “giving plain meaning to the unambiguous language of the contract exclusion,” that the fraudulent inducement and negligent misrepresentation claims “certainly are ‘based upon, arising out of, or in consequence of any actual or alleged liability’ under the contracts.” The tort claims, Judge Nealon found, “arise from the same essential facts and circumstances from those which underlie the breach of contract claims.” 

 

Of particular importance to Judge Nealon in reaching this conclusion is the fact that “the financial information relied upon by the class plaintiffs [in the Alliance Action] was incorporated into the Purchase Agreements.” Judge Nealon interpreted the plaintiffs in the underlying action as having alleged that the specific financial representations on which the plaintiffs relied as having been incorporated into the Representations, Warranties and Covenants section of the Purchase Agreement. Based on this determination, he concluded that “the fraud in the inducement and negligent misrepresentation claims are based upon, arise from, or are in consequence of Uni-Marts’ liability under the agreements.”

 

Judge Nealon also went on to make a “but for” analysis with respect to the fraudulent inducement and negligent misrepresentation claims, asking “would the store owners’ fraud in the inducement and negligent misrepresentation claims exist even in the absence of the contracts and breach thereof. The answer to that question is no. Had the class plaintiffs not entered into the contracts and had Uni-Mart no breached the contracts, there would be no independent tort claims” because “the injuries suffered by the class plaintiffs would not have occurred had there been no contracts and no breach thereof.”

 

Judge Nealon concluded by noting that requiring the insurer “to cover this loss, which its essence is derived from a business agreement gone bad, would be greatly expanding the coverage of the D&O policy beyond that which is called for by the plain language.”

 

Discussion

For many readers, this case my present something of a surprise outcome. Certainly, claims for fraudulent inducement and negligent misrepresentation arguably represent the very kinds of things for which policyholders purchase D&O insurance. However, the outcome of this case can be understood as a reflection of two factors that interacted in this situation: the exclusion’s broad preamble, and Judge Nealon’s determination that the financial misrepresentations had been incorporated into the agreement.

 

In a prior post about the contractual liability exclusion generally, I have noted how extensively a contract exclusion with the broad “based upon, arising out of” preamble can sweep. While most private company D&O insurance policies have some form of contract exclusion, not all policies have adopted the broad preamble. The scope of language in the exclusion can substantially affect the extent of coverage available under the policy. In general, courts have applied a broadly preclusive interpretation to exclusions with the broad preamble language.

 

However, not every decision has swept so broadly as to preclude coverage for the types of tort claims asserted here; in particular, Judge Nealon was forced to try to distinguish a relatively recent Western District of Pennsylvania decision in which the court, under very similar circumstances, found that misrepresentation claims were not precluded from coverage. The way that Judge Nealon distinguished the prior case and reached the conclusion that the exclusion here precluded coverage was through his determination that all of the financial misrepresentations on which the plaintiffs relied had been incorporated into the Purchase Agreement. I suspect that not every reader will be persuaded by this analytic legerdemain. But this determination is in any event a distinct characteristic of this decision that may allow it to be distinguished in any future cases involving both breach of contract and misrepresentation claims.

 

The troublesome thing about the breadth of the preclusionary effect given here to the contractual liability exclusion is that some type of transaction is at the heart of many claims under a private company D&O insurance policy. The danger is that insureds could find themselves without coverge for claims of a kind that might well have assumed would be covered, but because of the involvement in the claim of an underlying transaction and because of the expansiveness of the D&O insurance policy’s contract exclusion are precluded from coverage.

 

The real problem here may be the expansiveness of the preamble to the exclusion. Clearly, the use of the broad "based upon" and "arising out of" language was instrumental to the outcome (setting aside of course the concerns about Judge Nealon’s determination that the financial representations had been incorporated into the Purchase Agreement).

 

Many carriers will insist on using the broad preamble for the contractual liability exclusion and will refuse to use the narrower “for” preamble language. However, given the extent of the preclusive effect that courts have found in interpreting policies with the broad omnibus wording, policy forms using the narrower "for" wording are, in this respect at least, clearly superior from the policyholder’s perspective, particularly if carriers whose policies have the broader wording choose to try to apply the exclusion to preclude a wide swath of claims.

 

I would argue that the "for" wording is much closer to the original purposes for the inclusion of the contract exclusion in private company D&O insurance policies – that is, an exclusion with the "for" wording makes it clear that insurers do not intend to pick up the insured company’s contractual liability, without extending the potential preclusive effect, for example, to tort claims alleging a different variety of wrongful conduct.

 

SEC Awards First Whistleblower Bounty: When the whistleblower bounty provisions in the Dodd-Frank Act were enacted, there were concerns that the provisions – allowing whistleblowers an award between 10% and 30% of the money collected when information provided by the whistleblower leads to an SEC enforcement action in which more than $1 million in sanctions is ordered – would encourage a flood of reports from would be whistleblowers who hope to cash in on the potentially rich rewards.

 

However, if the SEC’s first award under this program is any indication, some whistleblowers may decide to curb their enthusiasm. As reflected in the SEC’s August 21, 2012 press release (here), the agency has now made its first whistleblower award for the relatively modest amount of $50,000. According to the press release, “the award represents 30 percent of the amount collected in an SEC enforcement action against the perpetrators of the scheme, the maximum percentage payout allowed by the whistleblower law.”

 

The press release also explains that the whistleblower’s assistance led to a court ordering more than $1 million in sanctions, of which approximately $150,000 has been collected thus far. The court is considering whether to issue a final judgment against other defendants in the matter. Any increase in the sanctions ordered and collected will increase payments to the whistleblower.

 

There undoubtedly will be other awards, some of which undoubtedly will be larger. But for the first example, this modest award itself is unlikely provide much encouragement to prospective whistleblowers.

 

In the latest development in the long-running  investor lawsuit  involving the collapsed Cheyne Financial structured investment vehicle, Southern District of New York Judge Shira Scheindlin has held that the rating agency defendants in the case must face the investors’ claims for common law fraud under New York law. A copy of Judge Scheindlin’s August 17, 2012 opinion can be found here. (Hat tip to The S.D.N.Y Blog.)

 

As discussed at length here, the plaintiffs invested in certain notes that had been issued by Cheyne Financial, a $5.86 billion structured investment vehicle. The notes were collateralized by certain assets, included residential mortgage backed securities (RMBS). The notes Cheyne issued received the highest possible ratings from the rating agencies. Cheyne collapsed amid the subprime meltdown in 2007. Cheyne was unable to pay the senior debt as it became due and Cheyne is now in bankruptcy. The investors lost substantially all of their investment.

 

After Cheyne collapsed, the investors filed suit against Morgan Stanley, which had promoted and distributed the notes; Bank of New York Mellon, which had provided certain custodial and administrative services for Cheyne; and the rating agencies (including Moody’s and S&P and their corporate parents). The plaintiffs asserted thirty-two claims under twelve different legal theories. Essentially, the plaintiffs alleged common law fraud under New York law; common law tort claims alleging misrepresentation; and assertions based on alleged breach of contract.

 

As discussed here, on May 4, 2012, Judge Scheindlin dismissed plaintiffs’ claims for negligence, breach of fiduciary duty and aiding and abetting, but she denied the rating agencies’ motions to dismiss with respect to the negligent misrepresentation claims, finding that, based on the plaintiffs’ allegations, the ratings qualified as actionable misstatements under New York law. The rating agencies and Morgan Stanley separately moved for summary judgment on the plaintiffs’ fraud claims.

 

In her August 17, 2012 opinion, Judge Scheindlin denied the rating agencies’ motions for summary judgment on the common law fraud. The defendants had argued that the ratings were opinions for which they could not be liable, because they were not disbelieved when made Judge Scheindlin said that “while ratings are not objectively measurable statements of fact, neither are they mere puffery, or unsupportable statements of belief akin to the opinion that one type of cuisine is preferable to another,” adding that:

 

Ratings should best be understood as fact-based opinions. When a rating agency issues a rating, it is not merely a statement of that agency’s unsupported belief, but rather a statement that the rating agency has analyzed data, conducted an assessment, and reached a fact-specific conclusion as to creditworthiness. If a rating agency knowingly issues a rating that is either unsupported by reasoned analysis or without a factual foundation, it is stating a fact-based opinion that it does not believe to be true.

 

Judge Scheindlin also found, referring to internal rating agency communications and emails (including an instant message involving two S&P analysts, in which one analyst comments that “it could be structured by cows and we would rate it”), that the plaintiffs have “offered sufficient evidence from which a jury could infer that the ratings were both misleading and disbelieved by the Rating Agencies when issued.” Judge Scheindlin also found that the plaintiffs had presented sufficient evidence to raise an issue of fact as to whether the defendants acted with the requisite state of mind. Finally, she concluded that the plaintiffs had raised disputed issues of fact whether or not each of the plaintiffs had relied on the alleged misrepresentations.

 

In an interesting twist, at the end of her opinion, Judge Scheindlin added an “Addendum” in which she “ordered” the plaintiffs “to show cause by August 31, 2012 why their negligent misrepresentation claims against the Rating Agencies should not be dismissed” based on the Second Circuit’s August 14, 2012 opinion in Anschutz Corp. v. Merrill Lynch & Co. (here). The Second Circuit affirmed the dismissal of negligent misrepresentation claims against the credit rating agencies, which were accused of issuing misleading and unsupported ratings on auction rate securities that had been issued by Merrill Lynch. The appellate court said New York law requires a showing that the rating agencies had a duty, as a result of a "special relationship," to give Anschutz correct information. The Second Circuit said the claimant had failed to establish such a relationship, so the dismissal of its case against the agencies could not proceed. Alison Frankel has a detailed analysis of the Second Circuit’s opinion in an August 15, 2012 post on her On the Case blog, here.

 

An August 18, 2012 Bloomberg article discussing Judge Scheindlin’s opinion can be found here.

 

FDIC’s Slow Failed Bank Lawsuit Filing Pace Continues: Almost exactly a month ago, I noted that the FDIC seemed to have broken the apparent lull in failed bank lawsuit filings, when if filed two lawsuits in quick succession. I anticipated that perhaps the two new lawsuits might indicate that the pace of filings would be picking up, particularly given that as the year progresses, the third anniversary of so many bank closures would be approaching (potentially triggering the applicable statute of limitations).

 

However, it now appears that the assumption that the lawsuits would be picking up may have been premature. Since the two lawsuits were filed in July, the FDIC has filed no new lawsuits, as reflected on the professional liability lawsuits page on the agency’s website. Indeed, in the four-month period between April 20, 2012 and August 20, 2012, the agency has filed only three new lawsuits, after filing eleven new lawsuits in the preceding four months. This low number of filings during the last four months as during the equivalent period is all the more surprising given that during the equivalent period three years prior approximately 50 banks closed.

 

Another reason why it seems reasonable to expect that the FDIC would be filing new lawsuits is that, according to its website, the agency has authorized so many more lawsuits than it has filed – and it has been increasing the number of authorized lawsuits each month. In the latest update to its website on August 14, 2012, the agency indicated that his has now authorized suits involving 73 failed institutions; against 617 individuals for D&O liability (those figures represented an increase from the prior month’s numbers of with 68 failed institutions against 576 individuals). So far the agency has filed 32 suits involving 31 failed institutions, involving 268 institutions.

 

Clearly the difference between the number of suits authorized and the number of suits filed suggests that there are many more cases in the pipeline – and with the increases in the numbers of authorized suits, the logjam in the pipeline seems to be increasing. It is entirely possible that the agency is trying to work out resolutions of at least some of the backlog of cases without filing suit, and in the connection may have entered tolling agreements. But just the same it does seem that we should start to see lawsuits coming in – which we may yet see before the year is out.

 

In an August 14, 2012 opinion 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. Judge Jones also ruled that the FDIC must replead its gross negligence claims against the former directors and officers to provide specific allegations as to each defendant’s alleged involvement in or responsibility for the alleged wrongdoing.

 

A copy of the August 14 opinion can be found here. An August 15, 2012 memo from the Alston & Bird law firm describing the August 14 ruling can be found here.

 

Haven Trust Bank of Duluth, Georgia was one of the first banks to fail as part of the current bank failure wave. Regulators closed the bank on December 18, 2008. As described in greater detail here, on July 14, 2001, the FDIC as receiver for the bank filed a lawsuit against 15 of the bank’s former directors and officers. The FDIC’s complaint specifically alleges improper lending practices and seeks to recover over $40 million. Among other things, the FDIC alleges that the bank suffered losses of over $7 million on improper loans to family members of two bank insiders. In its complaint, the FDIC asserts claims for negligence, breach of fiduciary duty, and gross negligence.

 

The defendants moved to dismiss, arguing that Georgia’s business judgment rule protects bank directors and officers from personal liability for ordinary negligence and from liability for breach of fiduciary duty in the absence of allegations of bad faith, fraud or abuse of discretion. The defendants also contended that the FDIC had not pled a valid claim for gross negligence.

 

In his August 14, 2012 opinion, Judge Jones granted the defendants’ motions to dismiss the FDIC”s claims for negligence of for breach of fiduciary duty. He determined first that, contrary to the arguments of the FDIC, t was appropriate to consider the business judgment rule at the motion to dismiss stage. Judge Jones then went on to conclude that “when Georgia’s business judgment rule is applied to claims for ordinary negligence, Georgia courts hold that such claims are not viable.” He also specifically confirmed that the business judgment rule is applicable in the banking context. Based on these determinations, Judge Jones dismissed the FDIC’s claims for ordinary negligence and breach of fiduciary duty (based on ordinary negligence).

 

Judge Jones denied the defendants’ motion to dismiss the gross negligence count, finding that “the complaint has alleged in a collective/group manner sufficient facts for which a jury might reasonably conclude that Defendants were ‘grossly negligent’ as defined by Georgia law.” However, noting that the “factual allegations must give each defendant ‘fair notice’ of the nature of the claim” against them, Judge Jones ordered the FDIC to replead its gross negligence claim “to provide specific allegations as to each Defendant’s involvement or responsibility for the alleged wrongs, decisions, approvals, transactions and loans referenced in the original Complaint.”

 

Judge Jones’s rulings in the Haven Trust Bank case are consistent with his earlier rulings in the FDIC’s action against certain former directors and officers of Integrity Bank, another failed Georgia banking institution. As discussed here, in February 2012, Judge Jones ruled in the Integrity Bank case that Georgia’s business judgment rule protects the directors and officers of banks from claims for ordinary negligence and for breach of fiduciary duty based on negligence. In a footnote in this August 14 opinion in the Haven Trust case, Judge Jones expressly stated that he “adheres to and incorporates by reference into [the August 14 opinion], the Court’s prior holdings (in the context of a motion to dismiss, motion for judgment on the pleadings and motion for reconsideration) on the business judgment rule” in the Integrity Bank case.

 

Coincidentally, and also on August 14, 2012, Judge Jones entered a 52-page opinion in the Integrity Bank case denying the FDIC’s motion for reconsideration of the prior ruling in that case on the applicability of the business judgment rule and certifying the entire order for interlocutory appeal. A copy of the August 14 opinion denying the FDIC’s motion for reconsideration in the Integrity Bank case can be found here.

 

These rulings in the Georgia cases are significant for a number of reasons. First and foremost, more banks have failed in Georgia during the current wave of bank failure than in any other state. The determination of the issues regarding director and officer liability under Georgia law potentially could affect the FDIC’s potential claims against the directors and officers of many other failed Georgia banks. In addition, because Georgia banks were heavily represented among the earliest failures during the bank failure wave, the FDIC’s claims against Georgia banks have moved further along than claims the FDIC later filed elsewhere.

 

The determinations in the cases that have advanced further inevitably will have an effect on the cases that were filed later – and indeed, may have an impact on whether or not the FDIC’s even files a complaint in connection with banks that failed later. Certainly, if the FDIC cannot pursue claims for ordinary negligence in Georgia (and perhaps elsewhere), that could cause the FDIC to forebear from filing suit in at least some situations. For that reason, it will be important to see whether the Eleventh Circuit elects to take up the interlocutory appeal in the Integrity Bank case. A opinion from the Eleventh Circuit would obviously not only prove determinative in existing and potential future failed bank suits in Georgia, but could prove influential in suits and potential suits elsewhere in the Eleventh Circuit, and perhaps even outside the Circuit.

 

Along those lines, and in terms of what is happening on these issues elsewhere, earlier this month a judge in the Middle District of Florida, ruled in the FDIC’s failed bank lawsuit relating to the failed Florida Community Bank of Immokalee, Florida, that under Florida law directors cannot be held liable for ordinary negligence, as discussed in a prior post, here. The ruling in that case did not reach the question of whether or not officers can be held liable for ordinary negligence under Florida law.

 

Very special thanks to a loyal reader for providing me with a copy of the two August 14 orders in the Haven Trust and Integrity Bank cases.

 

More About Libor Scandal-Related Litigation: In an earlier post (here), I took a closer look at the Libor scandal, including in particularly the litigation that has arisen in the wake of the scandal. Since I added that post, there have been other lawsuits filed (refer here and here). It is clear that the Libor scandal litigation will be an important part of the litigation landscape for months and years to come.

 

An August 4, 2012 Economist article entitled “Suing the Banks: Blood in the Water” (here) takes its own look at the Libor-scandal litigation. The article notes that many law firms are looking at the Libor scandal as a potentially lucrative source of business. The article states that “so far, at least 28 serious lawsuits have been filed.” All of these cases, the article notes, are “either assigned or likely to be assigned” to Southern District of New York Judge Naomi Buchwald.

 

The Economist article notes that “if there is a hesitation” it is because, notwithstanding Barclays’s massive regulatory settlements “a case will not be easy to make.” Establishing culpability “will not be straightforward.” Among other things, “no one is forced to use [Libor], and those who do often add further costs (such as a credit spread).” In addition, “it will not be easy to determine what the rate should have been” since that will require determining “what the rate should have been each trading day, minus any potential benefit.” Working this out will be “mind-wrenchingly complex for many.”

 

Just the same, as the article notes in conclusion, other legal action tied to Libor is “percolating” in Japan, Canada and Singapore, and “it would not be a shock if there were not more cases in America as well.”

 

In an interesting opinion that includes among other things a noteworthy discussion of issues arising under the Morrison v. National Australia Bank case, one of the last securities suits filed as part of the ed credit crisis-related litigation wave has been dismissed. In an August 13, 2012 opinion (here), District of Columbia District Court Judge Amy Berman Jackson has dismissed the securities class action lawsuit that had been filed against the failed Carlyle Capital Corporation in the wake of its March 2008 collapse.

 

Background

As discussed here, in one of the last cases to be filed as the subprime and credit crisis-related litigation wave wound down, in June 2011, a plaintiff filed a securities class action complaint in the U.S. District for the District of Columbia against certain individual officers and directors of the now defunct Carlyle Capital Corporation (CCC), its investment manager and related entities. The action was filed on behalf of two groups of claimants: those who bought Restricted Depositary Shares (RDS) in the company’s July 2007 RDS offering; and those who purchased Class B shares on the Euronext exchange between the offering and the companies March 2008 demise. The complaint asserts claims under the federal securities laws; for common law misrepresentation; and for violation of the Dutch and UK securities laws.

 

The complaint alleges that CCC was organized under the laws of Guernsey to profit from the spread between the its portfolio of residential mortgage-backed securities (RMBS)and the cost of financing those assets through short term repurchase agreements and other forms of financing. Its principal place of business was in Washington, D.C. The complaint alleges that the entity was a “house of cards” because it was committed to acquiring “volatile, risk-securities that could only be purchased using massive borrowing with the securities purchased serving as collateral.” The company’s RMBS portfolio deteriorated during 2007, even prior to the company’s offering. The complaint alleges that the deterioration and the liquidly issues associated with the companies repo agreement financing were not disclosed to investors.

 

The complaint alleges that following the offering, the defendants continued to misrepresent the company’s financial condition, particularly with respect to its RMBS portfolio. Despite the deteriorating market for RMBS, CCG continued to acquire additional RMBS. The complaint alleges that as the marketplace nearly reached a “meltdown” in August 2007, the company did not recognize its portfolio losses. In early 2008, a cascade of margin calls forced the company’s managers to put the company into liquidation under the authority of the Royal Court of Guernsey. The defendants moved to dismiss.

 

The August 13, 2012 Opinion

In a 67-page opinion, Judge Jackson summarizes her view of the case by saying that “this complaint is an attack on how CCC was managed, and ultimately, it questions the wisdom behind that adoption of its business model in the first place. But chiding CCC with the benefit of hindsight for its failure to resist the stampede to purchase mortgage-backed securities is not the same thing as alleging fraud, particularly given the stringent standards of the PSLRA.”

 

She first dismissed the aftermarket claims in reliance on the U.S. Supreme Court’s Morrison decision, because they were asserted against a non-U.S. company by shareholders who had purchased their shares on a foreign exchange. However, she rejected the defendants’ efforts to also have the claims asserted on behalf of the RDS investors dismissed in reliance on Morrison. The RDS share offering had actually taken place in the United States, as a result of which, Judge Jackson found, the U.S. securities laws were applicable to those transactions.

 

In reaching this conclusion, she rejected the prior decisions in the Société Générale case (about which refer here), in which the court had concluded on the basis of Morrison that the U.S. securities laws were not applicable to ADR transactions in the U.S.; and she also rejected the prior decision in the Porsche case (about which refer here), in which the court held that the U.S. securities laws do not apply to derivative transactions in the U.S. where the referenced security traded only on a foreign exchange.

 

Judge Berman said that in her view the “gloss” on Morrison that these two courts developed is “inconsistent with the bright line test set forth in Morrison, which focuses specifically and exclusively on where the plaintiff’s purchase occurred.” She added that “while defendants’ contention that an investor could not purchase an RDS in the United States without a corresponding overseas transaction may be true, it does not change the fact that a purchase in the United State still took place.” 

 

But while the claims of the RDS investors were not precluded under Morrison, the claims still were not sufficient to overcome the initial pleading hurdles because, Judge Jackson concluded, the plaintiffs failed to allege an actionable omission or misrepresentation.

 

The plaintiffs alleged that that the defendants had failed to disclose the financial problems CCC was experiencing just before and at the time of the offering. Judge Jackson said that “it is difficult for the Court to conclude that the Offering Memorandum did not put investors on notice of the fact that CCC’s business model had recently shown signs of major strain given the clear disclosure.” She added that “there is no requirement that negative information be presented with the particular spin that plaintiffs say they would have preferred. What matter is whether the relevant facts were disclosed and were clearly available to plaintiffs.” She added that “the fact that defendants did not use the specific terminology preferred by plaintiffs does not mean the disclosures were misleading.”

 

Judge Jackson also ruled that the plaintiffs’ common law misrepresentation claims also were insufficient due to the plaintiffs’ failure to establish the existence of a false statement or material omission, and also because the plaintiffs failed to allege individual reliance.

 

Discussion

The collapse of the Carlyle fund was swift and substantial. Within just eight months of the July 2007 offering, the company had defaulted on over $16.6 billion of its indebtedness and had been forced into liquidation. Notwithstanding the scale and suddenness of the company’s demise, Judge Jackson required that the plaintiffs establish more than that the fund had what proved to be a deeply flawed business model. In addition, she also found that much of the information that the plaintiffs claimed had been omitted had in fact been disclosed, but the plaintiffs invested in the fund anyway.

 

While Judge Jackson’s conclusions that the plaintiffs’ allegations were insufficient are interesting, the most interesting part of her opinion may be her analysis of the Morrison issues, particularly as pertains to the claims of the RDS investors. She focused exclusively on the place of the transaction and rejected the suggestion that Morrison should be applied to preclude the RDS investor’s claims because the domestic RDS transactions required a corresponding foreign transaction.

 

 At the time of the Société Générale and Porsche decisions, they each seemed to suggest that Morrison reached even more broadly than had seemed to be the case when the Supreme Court first issued the decision. However, Judge Jackson’s unwillingness to be influenced by those cases’ “gloss” on Morrison suggests that in the end Morrison might not have as sweeping of a preclusive an effect as those decisions had suggested. To be sure, the Porsche appeal remains pending. But Judge Jackson’s refusal to follow these cases “gloss” and in particular her understanding of Morrison that the analysis must focus exclusively on the place of the transaction at issue appears correct.

 

I have in any event added the Carlyle Capital decision to my running tally of subprime and credit crisis case dispositions, which can be accessed here.

 

Goldman Sachs Derivative Suit Dismissed: Just a few days ago, the U.S. Department of Justice said it would not pursue criminal charges against Goldman Sachs or its employees related to allegations the bank deceived investors and Congress about its activities in the subprime mortgage market. On Tuesday, the company got more good news on its legal woes arising out of the subprime meltdown. On August 14, 2012, Judge William H. Pauley III granted the defendants’ motion to dismiss the complaint in the Goldman Sachs Mortgage Servicing Derivative Litigation. Judge Pauley dismissed the complaint with prejudice. A copy of Judge Pauley’s opinion can be found here.

 

The plaintiffs had sued Goldman, as nominal defendant, and certain of its directors and officers, alleging that the individuals breached their fiduciary duties to the company by failing to ensure that the company’s mortgage servicing operation has sufficient resources to comply with regulatory requirements and by allowing the mortgage servicing operation to employ “robo-signing” on foreclosure documents. The plaintiffs also alleged that the defendants caused the company to accept TARP funds but then failed to comply with the conditions for accepting it, and that the defendants caused the company to include troubled loans in its residential mortgage backed securities.

 

In his August 14 order, Judge Pauley found that the plaintiffs had failed to plead sufficient facts to establish that a demand on the board to raise these claims would have been futile. Judge Pauley specifically found that the plaintiffs had failed “to raise a reasonable doubt as to a majority of the Board of Directors’ disinterested ness.” The plaintiffs also failed to show that the directors lacked independence or that the decision they were not an exercise of valid business judgment.

 

The plaintiffs had attempted to argue that directors were not disinterested because they faced a substantial likelihood of liability. Judge Pauley concluded that the plaintiffs had failed to allege any “red flags that would have alerted the Board Defendants of broken controls in Goldman’s mortgage servicing business” or of the company’s inclusion of troubled loans in its RMBS. as would be required to serve as a basis for liability. Judge Pauley emphasized, by contrast to other cases on which the plaintiffs sought to rely, that the mortgage servicing operations were not “central” to Goldman’s operations and represented only a small part of the company’s total revenue, which undercut the plaintiffs’ argument that the director defendants must have known of the weaknesses at the company mortgage servicing operation.

 

I have added Judge Pauley’s ruling to my list of subprime and credit crisis lawsuit dismissal motion rulings, which again can be found here.

 

Ancient Lawsuit is Past Sell-By Date: The plaintiffs’ July 2011 filing of a securities class action lawsuit against Fairfax Financial Holdings was noteworthy because the plaintiffs’ filed their complaint more than five years after the end of their purported class period. As I noted at the time in my post about the 2011 filing (here), the plaintiffs anticipated the obvious statute of limitations objections and in their complaint, they argued that the statute of limitations – including the five-year statute of repose – had been tolled by their 2006 filing of a complaint raising the same allegations. That prior complaint had been dismissed because the named plaintiff was a Canadian who could not establish subject matter jurisdiction for his claims under the pre-Morrison standards applicable at the time.

 

As might have been expected, the defendants moved to dismiss the 2011 action on statute of limitations grounds. And as discussed in Jan Wolfe’s August 14, 2012 Am Law Litigation Daily article (here), on August 13, 2012, Judge John F. Keenan granted the defendants’ motion, base on his ruling that the prior filing may have tolled the running of the two-year statute of limitations, but it did not toll the running of the five-year statute of repose. In his opinion (which can be found here), Judge Keenan said that “the absolute language of the statute of repose plainly precludes judicial circumvention of the repose period, even in class action suits.” He added that “the legislative history suggests that Congress intended statutes of repose to impose an absolute limitation on litigation."

 

Judge Keenan also indicated that he would have dismissed the case even if not time-barred, holding that the plaintiffs failed to allege facts sufficient to show how the alleged misstatements were material and to plead loss causation.

 

Jan Wolfe’s article about Judge Keenan’s ruling points out that the issue about whether or not the statute of repose can be tolled is currently on appeal in at least a couple of cases. This clearly is an issue that needs to be sorted out because other district courts have concluded, contrary to Judge Keenan, that the statute of repose can be tolled. For an example of a case in which a court concluded that the statute of repose can be tolled, take a look at my discussion of Judge Laura Taylor Swain’s ruling in the Morgan Stanley Mortgage Pass-Through Certificates case (here, second item in the blog post). For those who are interested in this issue, the question has to do with whether or not the U.S. Supreme Court’s American Pipe opinion – which held that a prior class action filing tolls the running of the statute of limitations – also applies to the statute of repose. The question of so-called American Pipe tolling is an important one that potentially impacts a number of cases. With the appeals now pending in the Second Circuit, there should more developments in this area in the months ahead.

 

Two of the significant securities litigation trends we have been following are the subprime-related securities litigation and the securities suits that have been filed against U.S.-listed Chinese companies. As discussed below, in the past few days courts granted dismissal motions in each of these kinds of cases.

 

Jiangbo’s CFO’s and Auditors’ Dismissal Motions Granted

First, just when it seemed that the plaintiffs’ in the many securities suits involving U.S. listed Chinese companies might be making some progress (about which refer here, scroll down to second item), a Florida federal judge has granted dismissal motions in a securities suit involving a Chinese company. On August 1, 2012, Southern District of Florida Judge Marcia Cook, in the securities class action lawsuit involving Jiangbo Pharmaceuticals, granted the motions to dismiss of the company’s CFO, Elsa Sung, and of its auditor. The dismissals are without prejudice. A copy of her opinion can be found here.  (Hat tip: Courthouse News Service.)

 

Jiangbo became a listed company in the U.S. as a result of the Chinese company’s reverse merger with a U.S.-listed publicly traded shell company. As detailed here, shareholders first filed their action in July 2011, following the company’s June 7, 2011 filing on Form 8-K, in which the company announced that members of its audit committee had resigned due to the company’s senior executives’ lack of cooperation with an internal investigation of possible accounting concerns. (The audit committee members’ letters of resignation, which details the extremes to which senior company officials went to avoid the investigators, can be found here and makes for interesting reading.) Among other things, the plaintiffs alleged that the company overstated its reported cash balances and failed to report related party transactions.

 

The company itself has failed to appear in the case, but the company’s former CFO and former auditor –who are both located in the U.S. – have appeared, and they both moved to dismiss. In her August 1 opinion, Judge Cook granted their motions, finding that while the plaintiffs sufficiently alleged that the company’s reported cash balances were materially misleading, the plaintiffs had not sufficiently alleged scienter as to the CFO and the auditor.

 

In granting the CFO’s motion to dismiss, Judge Cook said that the inference that the CFO intentionally or recklessly overstated the company’s cash balances “is not as compelling as the competing inference that Sung failed to disclose Jiangboa’s true financial condition because she either was unaware of, or, at most, was grossly negligent in failing to discover the true amount of the Company’s cash balances.”

 

Judge Cook went on to note that the plaintiffs’ arguments that the CFO “must have known” of the company’s over-reporting of its cash balances were based on “conclusory” allegations that the CFO was involved in day-to-day operations and therefore must have known the cash balances were incorrect. “In fact,” Judge Cook noted, “Sung worked mainly in Florida, while the Company conducted its operations in Laiyung.” These facts “support the competing inference that Sung did not know the Company’s true financial condition.” Judge Cook also found that the plaintiffs had not alleged that there was anything in particular about the cash balance amounts that would make them “suspicious”

 

Judge Cook concluded that “even though Plaintiffs sufficiently allege that Jiangbo’s financial statements may have contained materially false or misleading information regarding its cash balances, they have not alleged sufficient facts to yield a strong inference of scienter as to Sung.” Judge Cook reached a similar conclusion with respect the plaintiffs’ allegations against the company’s auditor. Judge Cook did grant the plaintiffs leave to amend, noting that “further facts regarding the magnitude of the fraud and Sung’s knowledge or involvement in the Company’s operations and preparation of the financial statements may well be sufficient to show scienter in this case.”

 

Deutsche Bank’s Dismissal Motion Granted

In an August 10, 2012 order, and based on Deutsche Bank’s motion for reconsideration of her prior ruling in the case, Southern District of New York Deborah Batts granted Deutsche Bank’s motion to dismiss the subprime-related securities suit that had been filed against the company and certain of its directors and officers. A copy of the August 10 opinion can be found here.

 

As discussed here, the plaintiffs had alleged that the company had failed to properly record provisions for credit losses, residential mortgage-backed securities, commercial real estate loans, and exposure to monoline insurers. In an August 19, 2011 order (here), Judge Batts granted the defendants’ motions to dismiss with respect to certain of the plaintiffs’ allegations, but she also ruled that the plaintiffs had adequately stated claims under the Securities Act of 1933 with respect to the company’s 2007, February 2008 and May 2008 securities offerings.

 

However, just four days after she allowed the plaintiffs’ claims to proceed with respect to those three offerings, the Second Circuit released its decision in Fait v. Regions Financial Corporation. As discussed here, the Second Circuit held that estimates of goodwill and loan loss reserves were not “facts,” but rather are “opinions” and that  in order to state a Securities Act claim, a plaintiff must allege not only that the statements were false, but that the defendants’ opinions were not honestly believed when made. In reliance on Fait, Deutsche Bank moved to have Judge Batts reconsider the portion her August 2011 ruling in which she had permitted certain of the plaintiffs’ claims to go forward.

 

In her most recent ruling, Judge Batts granted the defendants’ motion for reconsideration and granted their motion to dismiss as well. Judge Batts said that plaintiffs’ allegations about valuation measures used in the offering documents “suggest that Defendants were wrong, and perhaps egregiously so, in their internal valuation metrics. “ However, after Fait, “it is clear…that such valuations are a matter of opinion rather than fact.” Accordingly, she concluded, the plaintiffs “must allege that Defendants did not honestly believe those valuations when made. The Complaint in this matter contains no such allegations.” Because the plaintiffs state in their complaint that their claims rely exclusively on theories of strict liability and negligence, Judge Batts denied the plaintiffs leave to amend.

 

The plaintiffs’ allegation in their complaint that they were relying exclusively on theories of negligence and strict liability are fairly standard in Securities Act claims, as plaintiffs typically do not want to have to meet the higher pleading standards required under the Federal Rules of Civil Procedure for pleading fraud. Indeed, companies are generally said to be strictly liable under the Securities Act for material misrepresentations or omissions in securities offering documents. But, according to Fait, the things that the plaintiffs are alleging her to be misleading are not facts at all, but opinions. For the plaintiffs to have to allege that the defendants didn’t believe those things when they said them raises a high barrier for the plaintiffs to have to get over.

 

I have in any event added Judge Batts’s ruling in the Deutsche Bank case to my tally of subprime and credit crisis-related dismissal motion ruling, which can be accessed here.

 

Something to Keep You Awake: A spider really can crawl in your ear while you are sleeping. Here’s the story, with (creepy) pictures.

 

The U.S. Supreme Court’s decision in Morrison v. National Australia Bank presents significant obstacles for claimants who want to pursue securities claims against non-U.S. companies in the U.S courts, as the short sellers who tried to sue Porsche in the Southern District of New York found out—their prior federal court securities suit was dismissed on the basis of Morrison.   However, the short-sellers’ state court common law claims will now be going forward, as a result of a recent New York state court decision that may suggest one way that litigants may be able to avoid Morrison’s constraints.

 

On August 6, 2012, New York (New York County) Supreme Court Judge Charles E. Ramos rejected Porsche’s motion to dismiss the case on forum non conveniens ground. A copy of Judge Ramos’s decision can be found here.

 

As discussed here, the plaintiffs in the federal court suit — hedge fund investors who lost money short-selling shares of German auto manufacturer VW — allege that during 2008, Porsche and certain of its executives made a series of misrepresentations in which Porsche claimed that it did not intend to acquire control of VW, while at the same time it allegedly was secretly accumulating shares with the purpose of obtaining control. In October 2008, after Porsche disclosed its intent to obtain control, VW’s share price rose significantly and the short sellers suffered significant trading losses.

 

The short-sellers federal court complaint asserted claims under the U.S. securities laws and also for common law fraud. As discussed here, on December 30, 2012, Southern District of New York Judge Harold Baer dismissed the securities claims on the grounds that the subject transactions, securities-based swap agreements, represented a foreign transaction and are therefore not within the purview of the U.S. securities laws. Judge Baer declined to exercise supplemental jurisdiction over the common law claims. Judge Baer’s ruling is now on appeal to the Second Circuit.

 

In March 2011, several of the same short sellers launched a separate action in New York Supreme Court against Porsche alleging claims for fraud and unjust enrichment. Porsche moved to dismiss the state court complaint on the grounds of forum non conveniens and for failure to state a claim. Porsche also moved in the alternative to stay the state court action pending the outcome of the Second Circuit appeal in the federal court action.

 

In his August 6 order, Judge Ramos denied Porsche’s motion. First, Judge Ramos held that “a balancing of the relevant factors reveals that Porsche has not met the heavy burden of demonstrating that this action should be dismissed on the ground of forum non conveniens.” In reaching this conclusion, he noted that the plaintiffs are located in New York; that Porsche allegedly made multiple misrepresentations directly to the plaintiffs in New York; that Porsche representatives transmitted multiple communications to the plaintiffs and others in New York; and that the five principal plaintiffs’ witnesses are all located in New York.

 

He also noted that though many critical witnesses reside in Germany, “large corporations such as Porsche with ample resources have minimal difficulty bringing foreign witnesses or documents to New York Court,” and that the company regularly transacts business in the U.S.

 

Finally, Judge Ramos rejected Porsche’s “characterization” of the case as alleging “the manipulation of the German stock market and the trade of German securities”; rather, the question is whether New York courts “may hold responsible a foreign entity, who conducts business globally, for fraudulent misrepresentation purportedly aimed at New York plaintiffs.” New York “clearly has a vested interest in such an action.”

 

Judge Ramos also concluded that the plaintiffs had adequately stated claims for fraud and for unjust enrichment, and he declined to stay this action pending the outcome of the federal court appeal.

 

Discussion

The outcome of Judge Ramos’s decision is obviously interesting in and of itself, but it is also particularly interesting in light of the fact that the prior federal securities lawsuit was dismissed on the basis of the Morrison decision. These plaintiffs, stymied by Morrison in their attempt to assert federal securities claims, have nonetheless managed to find a way to pursue claims against the non-U.S. defendant in U.S. court, by asserting common law claims that are not subject to Morrison’s constraints.

 

These plaintiffs ability to pursue their claims against Porsche in a U.S. court may suggest ways that other prospective claimants might be able to circumvent Morrison’s constraints and to pursue misrepresentation claims in U.S. courts against non-U.S. companies.

 

However, there are things that may constrain other prospective claimants from pursuing a similar strategy. For starters, the plaintiffs in this case were only successful in avoiding a forum non conveniens dismissal because of the case-specific factors that tied the case and the underlying circumstances to New York. Other prospective claimants may or may not be able to marshal equally compelling evidence of a connection to a U.S. jurisdiction.

 

The other thing that may make this case somewhat distinct is that many of the alleged misrepresentations on which the plaintiffs relied allegedly were made directly to them by Porsche’s representatives. The existence of these direct misrepresentations significantly boosted the plaintiff’s ability here to assert claims for common law fraud – and more particularly to be able to establish the critical element of reliance. (Alison Frankel has a particularly good explicatioin of Judge Ramos’s considertion of the reliance issue in an August 9, 2012 post on her On the Case blog, here.) Other litigants, perhaps relying on market-wide statements, may be less able to show all of the elements necessary to raise claims for common law fraud or other common  law claims.

 

But while there undoubtedly are considerations that may complicate matters for other prospective claimants who want to pursue misrepresentation claims against non-U.S. companies, this case nevertheless does show at least a possible way to pursue those claims in U.S. courts without the constraints of the Morrison decision. It should no noted that, according to David Bario’s August 9, 2012 article in the Am Law Litigation Daily about Judge Ramos’s ruling (here) , the defendants apparently intend to pursue an appeal of the ruling.

 

While the Second Circuit appeal in the federal court case remains pending, on March 1, 2012 the Second Circuit did release its opinion in the Absolute Activist Value Master Fund decision, which provided significant interpretation of Morrison and, as discussed here, could have a substantial impact on the appeal in the Porsche case.

 

Yet another alternative for investors who want to pursue claims against Porsche would be to sue them in the company’s home country courts – which is what at least some investors have done. As discussed here, other investors have also initiated an action against Porsche in Stuttgart based on the same allegations.

 

Perhaps the Chinese Reverse Merger Company Cases Have Legs After All: Maybe the plaintiffs will be able to make something out of the wave of lawsuits against U.S.-listed Chinese companies after all. Last week, the Second Circuit revived the suit against China North Petroleum Holdings, which the district court had dismissed. And on August 8, 2012, Southern District of New York Judge Katherine Forrest denied the motion to dismiss the securities class action lawsuit that had been filed against China Automotive Holdings. A copy of Judge Forrest’s opinion can be found here.

 

China Automotive Holdings obtained its U.S. listing as a result of a reverse merger. As detailed here, the plaintiff shareholders first filed their action in October 2011, alleging that the company had misrepresented its financial condition by accounting improperly for certain convertible notes, which had the effect of overstating the company’s earnings. The company ultimately replaced its auditor and restated its financial statements for prior periods in order to properly account for the convertible notes. During the class period the individual defendants collectively sold over $40 million of their personal holdings in company securities. The defendants include the company, certain of its directors and officers, and the company’s prior auditor. The company and the auditor moved to dismiss. (The individual defendants have not yet been served and have not appeared in the case.)

 

In her August 8, 2012 opinion, Judge Forrest denied the company’s motion to dismiss but granted the auditor’s motion (with leave to amend).

 

In denying the company’s motion, Judge Forrest rejected two substantial arguments that the company had raised; first, the company had argued  that because almost all of the insider sales on which the plaintiff relied were made pursuant to a Rule 105-1 trading plans, the plaintiffs cannot rely on the trades in order to establish scienter; and the company argued that the plaintiffs cannot establish loss causation, because the decline in the company’s share price was attributable to the market’s loss of confidence in the Chinese Reverse merger companies.

 

In rejecting the company’s arguments that the insider sales were made pursuant to Rule 10b5-1 trading plans, Judge Forrest found that because the trading plans were entered during the class period, they “are not a cognizable defense to scienter allegations on a motion to dismiss.”

 

And in rejecting the argument that the plaintiffs have not established loss causation because the decline in the company’s share price was due to marketplace concerns about Chinese reverse merger companies, Judge Forrest noted that “although Chinese Reverse Merger companies have faced ‘public scrutuny’ … to hold that plaintiffs failed to plead loss causation solely because other Chinese Reverse Merger Companies’ stock dropped contemporaneously with [the company’s] stock price decline would place too much weight on one single factor.”

 

Judge Forrest holding with respect to the Rule 10b5-1 trading plans is interesting. These kinds of plans can serve as a basis for the dismissal of a securities fraud lawsuit (refer for example here). However, these kinds of plans can be abused; indeed, Angelo Mozillo’s notorious alleged manipulation of his Rule 10b5-1 trading plan was a significant feature of the Countrywide securities class action lawsuit (about which refer here). In the present case, the timing of the individual defendants’ plans undercut the company’s ability to rely on the plans’ existence to rebut the inference of scienter.

 

Judge Forrest’s loss causation ruling is also interesting and may be useful for other plaintiffs in cases involving Chinese Reverse Merger companies. Many of these companies also experienced a significant share price decline because of the market’s suspicion about these kinds of companies. Judge Forrest’s ruling that the mere fact that there has been a marketplace decline does not alone undercut loss causation could be relevant in many other cases, particularly those cases that were filed after the general marketplace concerns had already emerged.

 

Though the plaintiffs have survived the initial pleading hurdle they may yet have a challenging road ahead. The fact that the individual defendants have not yet been served or entered an appearance gives a glimpse of the logistical, practical and procedural challenges the plaintiffs may face as they try to move this case forward. Among other things, they may face challenges in trying to get a class certified, as has proven to be the case in a least one other lawsuit involving a U.S.-listed Chinese company (about which refer here). And even claimants that have managed to get their suits against U.S.-listed Chinese companies all the way to the settlement stage have found that they often are forced to accept only modest settlements, often because the Chinese companies carry only very modest levels of D&O insurance (about which refer here).

 

But from the plaintiffs’ perspective, the important thing now is they have survived the initial pleading threshold and will now be taking the case forward.  There were many of these cases involving U.S.-listed Chinese companies filed in 2010 and 2011, and they will be interesting to watch. At least recently, it seems that the cases have been faring better than I had anticipated. Stay tuned for further developments, though.

 

Jan Wolfe’s August 8, 2012 Am Law Litigation Daily article about the China Automotive case can be found here.

 

Friends Don’t Let Friends Drink and Dial: A Tennesee man called 911 because he was running low on beer. I am not making this up.