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.

 

A significant side-effect from the current bank failure wave has been the FDIC’s assertion of claims against the former directors and officers of many of the failed banks. The FDIC’s claims have in turn raised significant questions of insurance coverage under many of the failed banks’ D&O insurance policies. As discussed in a prior post (here), one of the significant coverage issues that has come up is whether or not the claims of the FDIC, which it is asserting in its capacity as receiver for the failed banks, are precluded under the Insured vs. Insured exclusion found in most D&O insurance policies. (The Insured vs. Insured Exclusion is sometimes referred to as the I v I exclusion.)

 

In what is as far as I know the first decision on this issue as part of the coverage litigation arising out the current bank failure wave, the federal court in Puerto Rico has ruled that the I v I exclusion in the D&O insurance program of the failed Westernbank of Mayaguez, Puerto Rico does not preclude coverage for the FDIC’s claims against the failed bank’s former directors and officers. A copy of the court’s October 23, 2012 decision can be found here.

 

Regulators closed Westernbank on April 30, 2010, which according to the FDIC cost the insurance fund $4.25 billion. In October 2011, certain of the former Westernbank directors and officers had sued the bank’s primary D&O insurer in state court in Puerto Rico (about which refer here). The FDIC as receiver for Westernbank moved to intervene in the state court action, and on December 30, 2011, removed the state court action to the District of Puerto Rico. On January 20, 2012, the FDIC filed its amended complaint in intervention, in which it named as defendants certain additional directors and officers,  and, in reliance on Puerto Rico’s direct action statute, the D&O insurers in the bank’s D&O insurance program. A copy of the FDIC’s amended complaint can be found here.

 

In its complaint, the FDIC, as Westernbank’s receiver, seeks recovery of over $176 million in damages from the former bank’s directors and officers as well as their conjugal partners, based on twenty-one alleged grossly negligent commercial real estate, construction and asset-based loans approved and administered from January 28, 2004 through November 19, 2009. In its complaint in intervention in the directors and officers coverage action against the bank’s D&O insurers, the FDIC seeks a judicial declaration that its claims against the directors and officers are covered under the policies. All of the defendants moved to dismiss the respective claims against them.

 

In his October 23 opinion and order, Judge Gustavo Gelpi denied all of the motions to dismiss. His rulings with respect to the D&O insurers’ motions to dismiss the coverage actions against them appear on pages 16 and following in the October 23 opinion.

 

The D&O insurers had moved to dismiss the coverage actions that had been filed against them in reliance on the I v I exclusion in the primary insurance policy. The exclusion provides that “The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against an Insured …which is brought by, or on behalf of, an Organization or any Insured Person other than an Employee of an Organization, in any respect and whether or not collusive.” The insurers argued that as receiver for the failed Westernbank, the FDIC stood in the shoes of Westernbank, which is an insured under the policy, and therefore the FDIC’s claims against the failed bank’s directors and officers were precluded from coverage under the D&O insurance policies by operation of the I v I exclusion.

 

As Judge Gelpi noted in his opinion these same issues were raised and litigated in a number of cases during the S&L crisis two decades ago. And as Judge Gelpi also notes in his opinion, these prior courts had split on the question of whether or not a D&O insurance policy’s Insured vs. Insured Exclusion precludes coverage for claims brought by the FDIC in its capacity as receiver against a failed bank’s former directors and officers. In summarizing these cases, Judge Gelpi noted that the question of the applicability of the exclusion in this context “is ambiguous.”

 

Judge Gelpi then, “with these differences in mind,” turned to the “purposes of the exclusion, the complaint and the specific terms of the policy for guidance.” He noted that the “obvious purpose” of the exclusion is to protect against collusive law suits; however, he also noted that the exclusion itself on which the insurers sought to rely made the exclusion applicable to Insured vs. Insured claims “whether or not collusive.”

 

The question to which Judge Gelpi then turned is whether or not the FDIC’s claims against the former directors and officers of Westernbank were “brought by, on behalf of or in the right of, and Organization or any Insured Person.” Judge Gelpi noted that the policy defines the term “Organization” as the named entity, each subsidiary and debtors in bankruptcy proceedings. After citing these provisions, Judge Gelpi summarily concluded that “Accordingly, the court finds that the FDIC’s course of conduct does not run afoul of this provision.” In reliance on prior cases that had concluded that the I v I Exclusion “does not prelude the FDIC from seeking redress from the Insurers.” 

 

By way of further elaboration, Judge Gelpi noted that the FDIC is suing “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

 

Discussion

Judge Gelpi’s ruling in this case is a significant victory for the individual directors and officers who hoped to be able to rely on the D&O insurance policies in order to be able to defend themselves against the FDIC’s claims against them, as well as for the FDIC, which hopes to be able to recover the losses it claims from the D&O insurance policies.

 

As the first decision on this insurance coverage issue in connection with the current bank failure wave, Judge Gelpi’s ruling will also obviously be of great interest to other failed bank directors and officers who face FDIC claims and whose D&O insurance carriers have tried to deny coverage in reliance on their respective policies’ Insured vs. Insured Exclusions. But while Judge Gelpi’s decision unquestionably will be helpful to the directors and officers in the other cases, it is far from the final word on the subject.

 

For starters, the split of authority in the cases from S&L crisis era remains. As Judge Gelpi noted, the courts have gone both ways on these issues and the carriers undoubtedly will continue to attempt to rely on the cases holding that the Insured vs. Insured exclusion does preclude coverage for claims brought by the FDIC.

 

A further reason that Judge Gelpi’s decision is unlikely to provide the final word on the subject is that other courts may not find the logic on which Judge Gelpi relied as compelling as he did. Judge Gelpi does not, for example, appear to have even considered the question of whether or not an action by the FDIC in its capacity as receiver of a failed bank (and therefore in effect, “standing in the shoes of the failed bank”) is an action “in the right of” the Organization, within the language and meaning of the exclusion. Other courts may consider it important in considering the exclusion’s potential applicability to address this issue expressly, as Judge Gelpi’s opinion does not. These other courts, in more careful consideration of this issue, might also conclude that the FDIC asserting claims as a failed bank’s receiver is asserting claims “in the right of” the failed bank and therefore that the exclusion applies.

 

In support of his conclusion, Judge Gelpi also considered it important that the FDIC was not only suing in its capacity as receiver, but was also suing on behalf of “depositors, account holders, and a depleted insurance fund.” Indeed, many of the courts that had ruled during the S&L crisis era that the Insured vs. Insured exclusion did not preclude coverage for claims by the FDIC had made their decisions in reliance on the same or similar observations about the FDIC’s claims.

 

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action. The policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

 

All of which is a long way of saying that though the policyholders and the FDIC prevailed in this case, these issues are likely to continue to be litigated, and the split of cases we saw during the S&L crisis is likely to continue.

 

Very special thanks to the several readers who supplied me with copies of Judge Gulpi’s opinion.

 

Another Georgia Failed Bank Lawsuit: On October 23, 2012, the FDIC, as receiver for the failed United Security Bank of Sparta, Georgia filed its latest failed bank lawsuit. The complaint, which the FDIC filed in the Northern District of Georgia, can be found here.

 

United Security bank failed on November 6, 2009. The FDIC’s lawsuit as the bank’s receiver is filed against a single defendant, Pierce Neese, the bank’s former CEO and also a bank director. The FDIC’s complaint asserts claims of Negligence and Gross Negligence against Neese in connection with 16 loans made between November 10, 2005 and March 27, 2008, which the agency alleges caused damages to the bank of over $6.373 million.

 

An unusual feature of the FDIC’s complaint, and perhaps the explanation why there is only a singe defendant is the case, is the agency’s allegation that from 2002 until March 2006, Neese “was effectively the Bank’s senior credit officer and functioned as a ‘One-Man Bank.’” Even after the bank established itself as a three-person LLC at the direction of regulators, Neese “continued to function as the Bank’s ‘one-man’ LLC until the Bank failed. According to the complaint, the bank even had print advertisements stating, “Meet Our Loan Committee, Pierce Neese.” The FDIC alleges that by dominating and usurping the loan approval process, Neese rendered the usual lending controls ineffective.

 

The FDIC’s complaint against Neese is the latest that the FDIC has recently filed as banks that failed in 2009 approach the third year anniversary of their closure (about which refer here). The complaint is also is the 35th lawsuit that the FDIC has filed as part of the current failed bank wave and the 17th that the agency has filed so far in 2012. The FDIC’s lawsuit against Neese is also the tenth lawsuit the FDIC has filed in connection with a failed Georgia bank. Although Georgia has had more failed banks than any other state, the percentage of all failed bank lawsuit involving failed Georgia banks is even greater than the percentage of all bank failures involving Georgia banks. For now at least, it seems as if the regulators are focusing on Georgia more than other states.

 

The growing problem of M&A-related litigation has been well-documented on this site (refer for example here). The prevalence of M&A litigation has grown to the point that virtually every M&A transaction involves litigation, and often involving multiple lawsuits in multiple jurisdictions. These growing problems have been well-documented (refer for example here and here), but coming up with solutions has proven challenging.

 

An October 2012 paper by the U.S. Chamber Institute for Legal Reform entitled “The Trial Lawyers’ New Merger Tax” (here) takes a comprehensive look at M&A litigation and proposes a number of possible legislative solutions to the problems associated with multi-jurisdiction litigation. The paper is being released in conjunction with the U.S. Chamber Institute for Legal Reform’s annual Legal Reform Summit, being held on October 24, 2012 at the U.S. Chamber of Commerce in Washington. D.C.

 

The paper opens with a description of the current state of M&A-related litigation. The paper certainly does not hold back in characterizing the state of M&A litigation. Among other things, the paper describes M&A litigation as “extortion through litigation” that permits trial lawyers to “hold transactions hostage until they collect a ‘litigation tax’ draining a share of the merger’s economic benefit away from shareholders and into the lawyers’ own pockets.”

 

The paper includes a detailed review of recent statistical studies documenting the M&A related litigation trends, noting in particular (and citing the Cornerstone Research’s analysis of M&A litigation, about which refer here) that on average each transaction is subject to five lawsuits, and that many deals attract more than 15 suits. In some cases, merger deals have attracted as many as 25 lawsuits.

 

The paper also notes that increasingly these multiple lawsuits are filed in multiple jurisdictions, which forces defendants “to litigate in numerous jurisdictions that are incapable of coordinating with each other, particularly state courts in different states,” which “dramatically increases the cost of defense and increases the settlement pressure regardless of the merits of the underlying claims.” Because “no   procedure exists to consolidate identical cases filed in the courts of different states and in federal court,” judges today “cannot stop the abuse.”

 

Although there are many aspects of the M&A litigation problem, the paper focuses its proposed solutions on the multiple jurisdiction litigation issue, in part because it is “a principal source of the trial lawyers’ settlement leverage.” The paper suggests several possible legislative reforms to “prevent plaintiffs’ lawyers from exploiting” the burdens imposed by multiple jurisdiction litigation by “eliminating forum shopping and forum multiplication.”

 

In order to address these issues, the paper suggests three possible legislative reforms (not necessarily mutually exclusive) at the federal level. First, the paper suggests that Congress could “enact a statute requiring all merger-related litigation to be brought in the state of incorporation of the defendant company.” (The paper notes that this proposal has also been advanced by committee of the Association of the Bar of the City of New York.) Second, the paper suggests that Congress could amend the “carve outs” in SLUSA and CAPA to required that class actions brought under the carve-outs “may be filed only in the courts of the defendant company’s state of incorporation.”

 

Third, to address the fact that many of these merger related lawsuits are brought in federal court, the paper suggests that Congress could enact legislation providing that any lawsuits relating to mergers or acquisitions that are brought in federal court should be transferred immediately to a federal court for the district containing the state capital.

 

The paper also notes that there is also possibility for legislative reform at the state level, but state legislative reform could be cumbersome and could take time because to be effective it would require enactment by a significant number of states. The paper does note that the M&A litigation problem could be addressed if states enacted legislation specifying the merger objection litigation must be brought in the state of incorporation.

 

The paper contains a number of possible solutions to the multiple jurisdiction litigation problem which are worthy of further discussion and consideration. There is no doubt that the multiple jurisdiction litigation does nothing to benefit shareholders and in fact accomplishes only the multiplication of legal costs and burdens, and therefore there is no doubt that active steps should be taken in order to try to eliminate this problem.

 

As important as it is to address the multiple jurisdiction litigation problem, however, it is worth noting that even if the multiple jurisdiction litigation problem is addressed that will not address all of the concerns with M&A litigation. As the paper itself notes about the legislative reforms proposed, “although these reforms will not entirely eliminate the problem of abuse, they will stop the multiplication of litigation and forum shopping and … and enable companies to fight back against unjustified claims” which, the paper concludes, would make it “more difficult for trial lawyers to collect the litigation tax.”

 

It is probably also worth noting that though the paper’s proposal regarding M&A litigation filed in federal court could reduce the problems when separate M&A-related suits are filed not just in state court but also in federal court, the proposal would not eliminate the problem. Even the transfer scheme that the paper contemplates for the suits filed in federal court would still allow for the possibility of parallel suits proceeding simultaneously in state and federal court. While it would be hoped that the courts would coordinate their actions in order to try to eliminate duplicative litigation burdens and expense, there is nothing about the federal court transfer proposal that would assure that the duplicative litigation would not go forward. 

 

I do think it is interesting that all of the proposals suggested are focused on reforming litigation procedures. The paper does not mention another reform M&A litigation reform proposal that at least for a time had a certain amount of cachet – that was the notion of incorporating a forum selection clause in the company’s charter documents in order to require certain types of shareholder suits to be brought in the courts of the company’s state of incorporation. This idea certainly has its advocates; however, as discussed here, companies that adopted these forum selection by laws found themselves targeted in a wave of shareholder suits challenging the by-laws. It appears that with the litigation and controversy, the forum selection by-law idea may not enjoy the same currency that perhaps it once did.

 

I will say that by addressing the multiple jurisdiction problem rather than trying to come up with a broader proposal attempting to eliminate abusive M&A-related litigation altogether, the paper has chosen a target about which it will easier to reach a consensus on the need for reform and that can be addressed at least in part with some identifiable legislative actions. The reform proposed in the paper is achievable and could help to reduce a serious problem facing corporate America. It is not necessary to agree with all of the paper’s rhetoric in order to agree with the proposed legislative reforms. The proposals suggested in the paper are serious and merit further discussion and consideration and I hope that Congress will take up these issues – at least once they have addressed the looming “fiscal cliff.”

 

Towers Watson Launches 2012 D&O Liability Insurance Survey: Towers Watson is once again taking up its annual D&O Liability Insurance Survey. This survey has a long and venerable tradition in the D&O insurance industry. The Survey went off-line briefly for a few years, but now it is back. The annual survey report, which Towers Watson makes freely available, is a valuable resource for everyone in the D&O insurance industry.

 

Because the survey results are so valuable for everyone in the industry, everyone participant has a stake in seeing that the survey is as representative as possible of the overall D&O industry. The survey is only as good as the data that results from the survey participants, and the more participants there are the better will be the survey results. So everyone has a stake in seeing that as many D&O insurance buyers as possible complete the survey.

 

The 2012 Towers Watson D&O Liability Insurance Survey can be found here. I hope that every D&O Diary reader will forward the survey link to their clients and encourage them to complete the survey. Again, the more companies the complete the survey the better the form will be. So please take the time to forward the survey to your client companies and encourage them to complete the survey form. Please note that the survey must be completed by November 30, 2012.

 

A summary regarding the 2011 Towers Watson D&O Liability Survey can be found here.