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.

 

A federal court has ruled in the only FDIC failed bank lawsuit pending in Florida that directors cannot be liable for ordinary negligence under Florida law. On August 8, 2012, Middle District of Florida Judge Gregory Presnell granted the motion of the director defendants to dismiss the FDIC’s claim against them for ordinary negligence. A copy of Judge Presnell’s order can be found here.

 

As discussed here, in March 2012, the FDIC filed an action in the Middle District of Florida in the agency’s capacity as receiver of the failed Florida Community Bank of Immokalee, Florida, against the failed bank’s former CEO and six of the failed bank’s former directors. A copy of the FDIC’s complaint can be found here.

 

 The bank failed on January 29, 2010. In its complaint, the FDIC alleges that the bank’s collapse was caused by “grossly negligent loan underwriting and loan administration, resulting in excessive and dangerous concentrations” of commercial real estate loans and of acquisition and development loans. The FDIC seeks to recover on losses of in excess of $62 million dollars in connection with six specific loans. The FDIC asserts state law claims of negligence against the former directors and against the former CEO, as well as claims of gross negligence under FIRREA against all of the individual defendants.

 

The director defendants (except for one director who has filed for personal bankruptcy and with respect to whom the FDIC’s action as been stayed) moved to dismiss, arguing that Florida law allows recovery for bank directors only for gross negligence and therefore the claim against them for ordinary negligence should be dismissed; and also arguing that the FDIC’s allegations in the claim against them for gross negligence failed to rise to the level of gross negligence.

 

In his August 8 order, Judge Presnell granted the director defendants motion to dismiss the FDIC’s claim for ordinary negligence. He found first that Florida Statutes Section 607.830(1) imposes an ordinary standard of care on directors. However, the liability of directors is governed by Section 607.831, which provides that directors can be held liable only of one of five conditions were met. Judge Presnelll found that the only section that “conceivably “could apply is the provision requiring in order to impose liability on directors a showing that the directors’ failure constituted “conscious disregard for the best interests of the corporation or willful negligence.”

 

Judge Presnell found that the statute “conditions directorial liability on something beyond ordinary neglilgence,” and so the count in the FDIC complaint asserting a claim for ordinary negligence “must therefore be dismissed.”

 

Judge Presnell denied the directors’ motion to have the FDIC’s claim against them for gross negligence dismissed, finding that the FDIC’s allegations “are sufficient at this stage of the proceedings to state a claim for gross negligence.”

 

Even though Florida has had the second highest number of bank failures of any of the states during the current bank failure wave (trailing only Georgia), the FDIC has so far only filed this one failed bank lawsuit in Florida. There undoubtedly are other lawsuits involving other failed Florida banks yet to come. To the extent the FDIC does filed further actions in Florida and to the extent those other action involve former directors of the failed banks, the directors defendant will argue in reliance on this case that they cannot be held liable under Florida law for ordinary negligence.

 

Judge Presnell’s decision pertains only to the director defendants, and the statutes on which he relied in reaching this decision relate only to the liabilities of directors. Accordingly his decision doesn’t reach the question  whether officers (as opposed to directors) may also argue that they can only be held liable for gross negligence., or whether officers otherwise have other protections from liability for ordinary negligence.

 

Special thanks to a loyal reader for sending me a copy of Judge Presnell’s decision.

 

According to papers filed in the Southern District of New York on August 3, 2012, the parties to the Tronox securities litigation have agreed to settle the case for a total of $37 million. As I noted at the time that this suit was first filed back in July 2009 (here), the case, which alleged that the defendants had misrepresented Tronox’s environmental liabilities when the company was spun out of Kerr-McGee and thereafter, involved a host of recurring and interesting issues.

 

A copy of the parties’ stipulation of settlement can be found here. The settlement agreement is subject to court approval.

 

As discussed in greater detail here, the action was filed on behalf of those who purchased certain securities  of Tronox, Inc. between November 25, 2005 and January 12, 2009. The plaintiffs named as defendants certain former directors and officers of Tronox, as well as Kerr-McGee Corporation, Andarko Petroleum Corporation and certain Kerr-McGee executives.

 

As reflected in the their amended consolidated complaint (here), the plaintiffs alleged that Tronox’s IPO was a “scheme orchestrated by Defendant Kerr-McGee to foist the vast majority of its enormous environmental remediation and related tort liabilities, accumulated over decades, onto Tronox, so that Kerr-McGee could thereafter present itself for sale.” The plan, which allegedly involved spinning Tronox out as a separate company in an initial public offering, “reaped massive and almost immediate benefits when, on August 10, 2006, Defendant Anadarko acquired Kerr-McGee for $18 billion in cash and assumption of debt purportedly free and clear of any obligation for what had become, as of that date, Tronox’s environmental remediation and tort liabilities.”

 

The plaintiffs’ case survived, in whole or in part, multiple motions to dismiss, and following mediation, the parties agree to settle the lawsuit. As reflected in the parties’ stipulation of settlement, the $37 settlement consists of the following: Anadarko, Kerr-McGee and the Kerr-McGee director and officer defendants “shall pay, or shall cause their insurance carriers to pay $21,000,000”; the former Tronox individual director and officer defendants “shall cause their insurance carriers to pay $14,000,000”; and Tronox’s auditor, Ernst & Young, “shall pay $2,000,000.”

 

As I noted at the time the case was first filed, one of the interesting things about this case is that it presents the clear example of a securities claim based upon disclosures relating to environmental liabilities. The possibility of this kind of claim is often a key concern at the time of D&O insurance policy placement, as the question often arises whether the standard policy’s pollution exclusion will preclude coverage for a securities claim based on environmentally-related disclosures. As this case demonstrates, it is critically important for the standard pollution exclusion to be revised to carve back coverage for securities claims and derivative claims based on environmental disclosures. (It is probably worth noting that many of the modern Excess Side A DIC insurance policies often have no environmental or pollution exclusion, which could well have been relevant here, given that by the time these suits were filed, Tronox was in bankruptcy.).

 

Another interesting thing about this case is that it involved three corporate entity defendants (Tronox, Kerr-McGee, and Anadarko), but the securities of only one of the three, Tronox. The issue here has to do with the definition of the term Securities Claim in the standard D&O policy. In many policies, the term is defined to refer to any claim based upon the purchase or sale of the securities of the Insured Entity itself. The question here would be whether or not a claim involving the purchase or sale of Tronox’s securities would constitute a “securities claim” under the Kerr-McGee’s and Anadarko’s policies. Of course, the individual Kerr-McGee directors and officers would be entitled to coverage whether or not the lawsuit represented a “securities claim” within the meaning of the term; this question has to do with whether or not there would be coverage under the policies for the entities themselves.

 

In the end, it appears that the portion of the settlement pertaining to the liabilities of the former Tronox director and officer defendants is to be covered by insurance, and the portion relating to the liabilities of the Kerr-McGee director and officer defendants, as well as Kerr-McGee and Anadarko themselves, would be funded in whole or in part by insurance. This outcome suggests that in the course of negotiations these issues, if actually involved in this case, were worked out or compromised in the course of the settlement negotiations.

 

As I previously observed, the allegations in the underlying complaints are noteworthy because they represent specific examples of what I have previously identified (most recently here) as the growing disclosure risks public companies face regarding their environmental liabilities. Although more recently I have emphasized the growing risks surrounding climate change related issues, as this case demonstrates, the disclosure risks also include the risks associated with more conventional environmental liability exposures. The case also underscores the importance of addressing at the time of policy placement the possibility of securities claims arising based on environmental disclosures.

 

On August 1, 2011, in a 2-1 decision characterized by a testy but interesting exchange between the majority and the dissent, the Sixth Circuit held that a fidelity policy provided coverage for nearly one million dollars a bank employee stole from client brokerage accounts. For those who (like me) are not regularly involved in fidelity claims, the two opinions provide an interesting opportunity to consider the purpose and operation of fidelity coverage and how it relates to general liability policies. The Sixth Circuit’s decision can be found here.

 

Background

First Defiance Financial Corporation is a bank holding company. Jeffrey Hunt was a “dual employee” for First Defiance, providing investment advisory services to First Defiance customers and also trading securities for Online Brokerage Services. The clients’ assets were held in individual accounts at a third institution, National Financial Services. These client accounts were accessible only by First Defiance’s investment advisors, which acted as the “exclusive agent” on the clients’ behalf.

 

In April 2007, First Defiance learned that Hunt had transferred a total of about $859,000 from nineteen client accounts to his own bank account. First Defiance ultimately repaid the clients for their losses, including lost interest and unrealized client income. The total amount of First Defiance paid to the customers was about $930,000.

 

First Defiance provided a proof of loss to its fidelity insurer for the amount of its payment to the clients. The fidelity policy provides insurance against “[l]oss resulting directly from dishonest or fraudulent acts committed by an Employee, acting alone or in collusions with others.” In its Covered Property provision, the policy specifies that the policy covers “loss of Property (1) owned by the Insured, (2) held by the Insured in any capacity, or (3) owned and held by someone else under circumstances which make the Insured responsible for the Property prior to the occurrence of the loss.” 

 

The fidelity insurer denied First Defiance’s claim for the loss, and First Defiance initiated a coverage lawsuit against the fidelity insurer. The district court entered summary judgment for First Defiance, holding that First Defiance’s loss was covered under the policy. The fidelity insurer appealed the coverage ruling. The parties also cross-appealed the district court’s calculation of the amount that the fidelity insurer owed. I do not discuss in this post the issues relating to the calculation of the insurer’s obligations.

 

The August 1 Opinions

In a majority opinion written by Judge Jeffrey Sutton for a divided Court, the Sixth Circuit affirmed the district court, holding that the fidelity policy covers First Defiance’s losses. Judge Deborah Cook dissented, writing a separate opinion that is well worth reading.

 

The crux of the majority’s opinion is its conclusion that the money in the client brokerage accounts represented Covered Property within the meaning of the fidelity policy. In reaching this conclusion, the majority determined that money in the brokerage accounts was “held under circumstances that made the insured responsible for the property” and that that responsibility arose “prior to the occurrence of the loss.”

 

The fidelity insurer had argued that First Defiance’s responsibility did not arise prior to the loss, and that First Defiance could have incurred liability only after Hunt stole the money, giving rise at most to a potential tort claim against the bank.

 

The majority rejected this argument, concluding that the definition refers to “responsibility” before the loss, not to liability, and that “the fiduciary relationship” between First Defiance and its clients “pre-dates the theft” making First Defiance “responsible for transactions undertaken with a client’s money from the moment the fiduciary relationship was formed.” The majority added that the bank’s responsibility “need not be established by a tort verdict, which necessarily cannot happen before the theft; it can be established by the terms of the account between the bank and the client and the fiduciary duties that spring from them.”

 

In her dissenting opinion that relies on policy drafting history and the purposes of the relevant language in the fidelity policy, Judge Cook characterizes the majority opinion’s policy interpretation as “simplistic.” Judge Cook asserts that “neither the policy language nor the history of fidelity coverage supports the majority’s view that the customer accounts constituted First Defiance’s ‘Covered Property.’”

 

Judge Cook focused specifically on the language in the definition of Covered Property requiring that the employer’s responsibility must vest “prior to the occurrence of the loss.” Judge Cook reviewed how this language had been added to the policy form to clarify that “a fidelity bond, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.” The provision, Judge Cook said, adds a “temporal element” requiring that “the insured’s responsibility for the stolen property must arise prior to the loss, not by virtue of vicarious liability.” First Defiance could have but did not assume responsibility for the risk of theft prior to loss “by placing [a] guarantee in its investment agreements with its customers.”

 

In an irritable response to the dissent, the majority opinion reiterates that First Defiance was “responsible” for money in the customer accounts at the time the accounts were opened, “long before –prior to—the loss of some money in those accounts cause by Hunt’s theft.” The majority opinion emphasizes that the policy does not require that the insured entity’s contract expressly state that insured entity undertakes responsibility for theft from customer accounts, but instead the policy requires only that “the ‘circumstances’ of the relationship must make the insured ‘responsible for the money before the theft.” In a dismissive characterization of the dissent’s position on this issue, the majority opinion adds the concluding comment that this question has been “Asked and answered.”

 

Discussion

The critical issue here is the question of when First Defiance became responsible for the theft. Was it responsible for the theft from the moment the client accounts were created, or was it responsible only after the theft had taken place, on the basis of vicarious liability?

 

The question matters, because the answer to the question determines whether or not this loss properly belongs under a first-party policy like the fidelity policy at issue here, or more properly belongs under a third-party liability policy like a general liability policy.

 

Without presuming to suggest the right answer to this question, I will say that I found the dissenting opinion’s review of the history of the relevant language in the fidelity policy to be instructive. At least based on the sources referenced in the dissenting opinion, it seems that the language at issue here was added to the policy in order to clarify that the fidelity policy, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.

 

However, that observation does not alone answer the question of when the bank became responsible for the employee theft. On the one hand, I tend to agree that to agree with the majority’s common sense reasoning that the customer would certainly assume that the bank would be responsible for an employee theft from the customer’s account, and I also agree with the majority that as a practical matter its highly unlikely that there would be a written expression of this assumption in the bank’s agreement with the customer.

 

On the other hand, I tend to agree with the dissent that the expectation that the bank would be responsible for the employee’s theft simply reflects a general assumption that an employer is responsible for employee misconduct. If, for example, First Defiance had not voluntarily reimbursed the customers for their loss as a result of the theft and the customers had been forced to sue the bank, the customers would have, one way or the other, based their claims against the bank on some version of vicarious liability.

 

Framing the question in terms of that hypothetical lawsuit also seems to suggest that – even though the bank voluntarily made the customers whole – the payment to the customers was  as a result of a third party liability claim.

 

All of that said, I would have a hard time subscribing to the dissent’s view of this case if the end result was that there was no insurance at all for this loss. I would be more comfortable altogether with the dissent’s position if I were sure that if the loss were not covered under the fidelity policy, it would be picked up under another policy. I would not be comfortable at all with the dissent’s position if it would result in the loss falling into a crease between policies. In particular, I would want to know whether or not the typical general liability policy would have in fact picked up this loss.  Of particular concern is the possibility that a liability policy might preclude this loss because it was the result of an intentional act.

 

It would seem that, in a world in which there is little certainty, the safe thing for an insured organization to do in a situation like this is to submit a claim under both the fidelity and liability policies.

 

I am very interested to know the thoughts and reactions of readers who work more frequently with fidelity policies. I would like to know what others think of the majority’s position on these issues and also the dissenting opinion as well. I am also curious to know about what readers may think about the possibility that the possible coverage for this claim under a general liability policy. I encourage readers to post their comments to this post using the comment feature in the right hand column.

 

For those readers interested in a good quick introduction to fidelity coverage I recommend the Much Shelist law firm’s November 1, 2011 memo entitled “The ABCs of Fidelity Bonds: What Policyholders Need to Know” (here).

 

SEC, The Jury Has a Message for You: Many readers many be aware that on July 31, 2012, a civil jury in federal court in Manhattan acquitted Citigroup employee Brian Stoker on allegations that he had misled investors in connection with $1 billion of collateralized debt obligations. In a highly unorthodox accompaniment to the verdict form, the jury included a message to the SEC that “"This verdict should not deter the SEC from continuing to investigate the financial industry, to review current regulations, and modify existing regulations as necessary." 

 

In his August 3, 2012 New York Times article entitled “Jury Gets Encouragement from Jury That Ruled Against It” (here), Peter Lattman reports, based on his interview of one of the jurors, how the note came about. As Lattman points out, the note seems to reflect common discontent that persons in the financial industry who were responsible for the excesses that contributed to the credit crisis have not been brought to account. As Alison Frankel notes in an August 2, 2012 post on her On the Case blog (here), for the SEC, the jury’s note “has to read like one more reminder that the public is still waiting for corporate accountability.”

 

In her August 1, 2012 Summary Judgment column on the Am Law Litigation Daily (here), Susan Beck has an interview with the foreman of the jury that heard Stoker’s case. From the foreman’s comments, it seems clear that the jury thought that while there was wrongdoing it was more in the form of collective wrongdoing of the company itself rather than that of one lower level individual. Beck quotes the foreman as saying that  "He did not act in some kind of vacuum where his behavior was not tolerated or encouraged by his bosses. . .To try to hang all this on Stoker didn’t work."

 

Frankel’s column has an interesting analysis of how the acquittal in the SEC’s case against Stoker may affect the long running saga of the SEC’s settlement of its enforcement action against Citigroup in connection with the CDO transaction. As noted here, Judge Jed Rakoff has rejected the settlement and refused to stay the case. More recently, the Second Circuit stayed the case pending an appeal of Rakoff’s rejection of the settlement, in an opinion that strongly suggested that Rakoff was wrong on the merits. Frankel suggests, among other things, that in the upcoming appellate arguments, the SEC may rely on the acquittal to show that the agency was wise to settle its case with Citigroup rather than test evidence that might not have withstood muster. On the other hand, the special counsel representing Judge Rakoff in the appeal may be able to argue (perhaps in reliance on the jurors’ comments in press reports) that the jury verdict actually reflected the jurors’ belief that there was misconduct among higher ups at Citigroup, and so Rakoff was right to reject the settlement.

 

There definitely is something about this case where every single thing that happens is interesting and worthy of commentary. It will in any event be interesting to see how the appeal regarding the erstwhile settlement unfolds. The appellate case is due to be argued in late September.

 

The Unintended Consequences of the JOBS Act: When Congress passed the Jumpstart our Businesses Startups (JOBS) Act earlier this year (about which refer here), it was hoped that the legislation would encourage “Emerging Growth Companies” and facilitate job creation. However, as discussed in Jason Zweig’s August 4, 2012 Wall Street Journal article entitled “When Laws Twist Markets” (here), things are playing out a little different than expected. As Zweig puts it “No matter how Congress monkeys with the laws, one always remains in force: the law of unintended consequences.”

 

By way of illustration, Zweig cites as an example of one company trying to take advantage of the JOBS Act’s streamlined IPO procedures and reduced reporting requirements the 132 year-old British football club, Manchester United, which hopes to launch its $300 million IPO next week. Zweig also refers to “blind pools” and “blank check” investment funds that are angling to take advantage of the JOBS Act’s provisions. Neither type of company is likely to contribute to job creation in the United States. Zweig also reports that at least seven Chinese companies are converting to JOBS Act reporting provisions, in order to be able to reduce the disclosures they are required to file; as Zweig points out, this is “no trivial matter since several other Chinese-based companies have recently been accused by U.S. regulators of filing misleading financial statements.”

 

As I have previously noted (here), a company’s status as an “Emerging Growth Company” arguably is for some companies itself a risk factor of which the company’s investors should be warned, particularly those companies taking advantage of the JOBS Act’s relaxed reporting requirements.

 

It should be noted that none of the comments above about the JOBS Act have anything to do with what may be the Act’s most distinctive feature, its allowance for online “Crowdfunding.” As I discussed here, the Act’s crowdfunding provisions were intended to facilitate fundraising for start-ups, but for many reasons, “crowdfunding is unlikely to be an attractive alternative for start-up companies.”

 

So far at least, it would seem the JOBS Act has produced only unintended consequences.

 

My New All-Time Favorite Headline: The headline for the lead article in the August 4, 2012 Detroit Free Press, regarding legal controversy surrounding Michigan’s emergency management law for financially troubled municipalities, reads simply “CHAOS” in four-inch high letters. (An online version of the article, sans the headline under which the story appeared in the print edition, can be found here.)

 

Given the financial condition of many of Michigan’s municipalities, and indeed given the ongoing developments around the world, the Free Press might well consider using that same headline every day. And newspapers everywhere else, too.

 

And Finally: I am an enthusiastic (if intermittent) fan of European football, particularly English Premier League football. Owing to this interest, I downloaded onto my iPad the Fan Chants app, which has recordings and lyrics of soccer fan chants from around the world. Some of the chants are rude and even profane, but overall the chants are highly entertaining. They can also be highly addictive; for example, since writing the paragraph above referring to Manchester United, I have been sitting here silently chanting to myself “Oh Man-ches-ter (Oh Man-ches-ter) is won-der-ful (is won-der-ful)…”

 

In contemplation of all of this, it somehow seemed appropriate to share this video clip of Sheffield United fans singing the “Greasy Chip Butty Song.” (A Chip Butty apparently is a sandwich consisting of French fries on buttered bread.) Here are the lyrics for those who can’t make out the words in the video:

 

You Fill Up My Senses,

Like A Gallon Of Magnet,

Like A Packet Of Woodbines,

Like A Good Pinch Of Snuff,

Like A Night Out In Sheffield,

Like A Greasy Chip Butty,

Like Sheffield United,

Come Fill Me Again,

Na Na Na Na Na…OOOOHH!