On Friday September 7, 2012, the University of Michigan Law School dedicated its new South Building, an impressive new facility that beautifully complements the school’s venerable Law Quadrangle (see picture below). U.S. Supreme Court Justice Elena Kagan delivered the keynote address at the dedication ceremony. (I attended the event because it coincided with my 30th law school class reunion.) Prior to the ceremony, Justice Kagan appeared on the stage with Michigan Law School Dean Evan Caminker for a question and answer session. The session is summarized below.

 

Kagan has been serving on the Court since August 2010, after a relatively short stint as Solicitor General. She previously served as Dean of Harvard Law School, following her service in various positions in the Clinton White House. She began her academic career at the University of Chicago Law School, after her judicial clerkship with U.S. Supreme Court Justice Thurgood Marshall.

 

Several of the initial questions for Justice Kagan concerned the way the Court has changed since her days as a judicial clerk. She noted that the Court is a “slow-moving institution’ Information technology “has not reached the Court,” and the justices still communicate with each other using written memoranda. The practices have not changed with technology because overall the Court “works well as an institution” and it has developed practices that “allow us to do our job.”

 

Justice Kagan did identify two things about the Court that have changed. First, a Supreme Court bar has developed, consisting of specialized lawyers who “understand what the exercise is all about” and who are “extremely good at it.” It means that the justices “get answers to our questions” and can “engage in the kind of dialog that we all want.” She commented that with the experienced practitioners, “there’s a kind of comfort level” and “informality.” She noted that states “are really getting their act together,” and that the quality of the representation of the states’ interests “has really gone up.”

 

She added that it is” frustrating” when “we don’t get good lawyers.” She noted one particularly area of weakness “on the criminal defense side” She commented that she hoped in the future that the criminal defense bar would do something along the lines of what the states have done.

 

Another thing Justice Kagan said has changed is that Court now has “a more active bench.” She noted that the current practices began with Justice Antonin Scalia who “wanted to try to make the hour more useful.” All of the more recent appointees, she observed, are more active questioners than the justices they replaced, noting as an example that she asks more questions than did Justice Stevens (whose place she took on the Court). She did allow, with respect to the justices’ questions, that it may be getting “into the place where” the level of questioning “is too much.” She said that Chief Justice Roberts is an effective “traffic cop,” but she wonders whether “he should have to do that,” adding that perhaps “we should step it back a little.”

 

She did say that the oral arguments do matter. She said that the briefs are more important, but that the arguments “can make a difference—both ways, you can sway or you can lose a case.” The lawyers know the crux of the case, and “when you hear them say it,” the justices ask themselves – particularly in cases where they are not yet sure where they stand – “how does that sound to me?” She added that oral argument can make a difference even sometimes in cases where going into the argument "you think you have it figured out.”

 

Another difference at the Court that she noted comparing to what she observed as a law clerk is that there are differences in the amount of communication around the Court. Her observation is that the level of communication between the justices outside of the conference has changed. She added that she has noted that even in the conference, there is a great deal of “back and forth,” particularly when they justices have not “yet arrived at a theory that can get five votes.” She added the observation that “it is a great court full of thoughtful and smart people.”

 

In response to a question, she commented on the role of the judicial clerks. She said that they “do what they ought to be doing.” They “are not deciding cases,” adding that the “notion” that has been advanced in certain parts of the popular press that judicial clerks get involved in deciding cases is “an unfounded idea.” She said one very important role that the clerks play is helping to winnow the thousands of petitions the court receive, adding that the clerks “principal role” is helping to “figure out what cases to take.” The clerks sort through the 10,000 petitions to “identify “the 200 to 300 cases worth looking at.” She added that they do “an extremely good job” at that.

 

She took pains to emphasize that she writes her own opinions, and while she asks her clerks to draft position statements, she warns her clerks that “if you see a single sentence you wrote in the Supreme Court Reporter, that will be a big day in your life.”

 

She did acknowledge that it does have an effect when the Court takes up a high profile case. She noted that it is “hard not to be aware there’s a lot of scrutiny.” She said that she “doesn’t think it affects the way we go about our work and they way we do our function.” Those who believe that the things they are saying “have some effect” on the Court “would be disappointed.” Even if there is “political controversy,” it “does not affect our consideration of the cases.” She felt that in a democracy, people “should be free to criticize the Court” but the Court “shouldn’t be pressured to do things,” and she is “100% certain we are not pressured.”

 

A student questioner raised the concern that recent polls had shown that the public respect for the Court as an institution has declined and that there are increasing concerns that the Court is deciding cases with decision splits determined according to the party of the Presidents that appointed the various justices. The student asked what the Court could do to eliminate these perceptions.

 

Justice Kagan responded (noting, after a lengthy pause, that it was a “very serious question”) that she is aware of the polls. She commented that in general people’s “trust in all institutions has declined,” so the decline in the public respect for the Court may “not have anything to do with what the Court has done.” She did say that she “wouldn’t want to discount the feeling that the Court has become divided politically.” She added that “it is really bad thing if the public thinks” cases are being decided on a political basis, and that it is “worth thinking about why this is and what can be done.”

 

One reason for this public view may be the number of 5-4 decisions. The cases that are decided by a 5-4 vote only represent about ten out of the 80 cases decided in a term, but some of these are “important cases.” The concerns can arise when there is perception that the votes are “consonant” with “who has nominated the justices,” something that “has not been the case historically.” She stressed that “there is not … a single vote that is made because of whether I like the President or not, or because I do or do not want to help one party or another.” She acknowledged that given the various justices’ different backgrounds and points of view, “we approach cases in different way” adding that “we may have different views on how we regard precedents.” It would be, she allowed, better “if there were fewer of these [5-4] decisions.” But as “each case comes along, you have to decide it, you can’t decide it in a way to avoid these kinds of splits.”

 

She noted that many people believe that the Court is polarized, often because of colloquy or commentary that may appear in published opinions. She said that one justice advised her that “if you take those things personally, you are going to have a long life tenure.” She understands that some people may read statements in some opinions and think “they must hate each other.” She said that, to the contrary, “we like each other a lot,” that the Court is “quite collegial,” that all of her colleagues are “quite warm.” The disagreement that occurs is “part of the job,” and she believes that all of the justices “are operating in good faith.” Besides, she noted, “life tenure is long” and it “would not be pleasant or useful to hold big grudges.”

 

Justice Kagan noted, in response to a question, that there are now three female justices and that it “would be even better if there were five” (a comment that drew audience applause). She said, however, that it makes “precious little difference in what happens in the conference room.” The value she sees from the presences of women on the Court is that it “changes how the Court looks to the outside world.”

 

When asked her views about the possibility of cameras in the Supreme Court’s courtroom she said that before she went on the Court she would have said, “Sure, why not?” She believes that “transparency is good.” However, now that she is on the Court, she wonders whether the presence of the cameras might “make me think about how I ask a question.” She also noted that following the oral arguments in the health care case, the Court issued audio tapes of the arguments, and almost immediately parts of the arguments were made into political advertisements. She worries that if there were video of the arguments, there would be much greater use of that type. She is “hopeful” that other courts will experiment to see what works best, but “wouldn’t volunteer the Court to be the first.”

 

She did have some interesting comments on her role as the most junior member of the Court. Because she has the shortest tenure on the bench, she does have certain duties. One is that she must answer the door if someone knocks while the justices are meeting in conference, and she is also responsible for taking notes in conference (two duties that she notes have a certain incompatibility). She added that she also serves on the Court’s cafeteria committee, where one of her greatest accomplishments has been to arrange to have a frozen yogurt machine installed in the cafeteria. (This statement drew applause from the audience, with respect to which Justice Kagan noted that “That was the reaction of the Court staff as well.”)

 

The New South Building at the University of Michigan Law School::

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Pre-Game Ceremony from the Michigan-Air Force Football Game: You have to watch this short but totally awesome video tape of an event that occured during the pre-game ceremony at the Michigan-Air Force Football Game on Saturday. The event was even more awesome live because it was completely unexpected;there was absolutely no warning of what was about to happen.

Many of the toxic mortgage-backed securities that were a key part of the subprime mortgage meltdown were sold in multiple separate offerings based on the same shelf registration statement but separate prospectuses. Each separate offering included multiple securities at varying tranches of seniority and subordination. In the litigation following the subprime meltdown, defendants in suits bought by mortgage-backed securities investors have had considerable success in arguing that the claimants have standing only to assert claims only with respect to the specific offerings and tranches in which the claimant had invested, and lacked standing to assert class claims on behalf of investors who purchased securities in other offerings and tranches.

 

The plaintiffs may now have a potent tool to try to fight these standing arguments. In a September 6, 2012 opinion (here), the Second Circuit ruled  — in a case involving mortgage-backed securities issued by a unit of Goldman Sachs — that the investor plaintiff had standing to assert claims relating not only to the specific offerings in which the plaintiff invested but also the claims of investors in other related offerings, to the extent that the securities in the other offerings were backed by mortgages originated by the same lenders that originated the mortgages backing the plaintiff’s securities. The Second Circuit also rejected the argument that the plaintiff lacked standing to assert claims on behalf of investors in  the different tranches. Finally, the Second Circuit also held the plaintiff need not plead an out-of-pocket loss in order to allege a cognizable diminution in the value of an illiquid security under Section 11.

 

Background

During the period of 2006 to 2007, a unit of Goldman Sachs sold mortgage-backed certificates in 17 separate offerings, using a single shelf registration statement and a separate prospectus for each of the offerings. Each offering included securities at varying tranches of seniority or subordination. The mortgages backing the offerings had been originated by different mortgage originators. For example, mortgage issued by National City Mortgage Corp. backed six of the seventeen offerings, and Countrywide originated mortgages backed five of the offerings and so on.

 

The plaintiff had purchased securities in two of the offerings. As the mortgage meltdown unfolded all of the securities were downgraded. Believing that the securities were now worth substantially less than their cost, and believing that they had been misled about the mortgage origination practices of the mortgage originators, the plaintiff filed an action against the Goldman Sachs entities asserting claims on behalf of investors who purchased securities in all 17 offerings.

 

The district court ruled that the plaintiff had standing to assert claims only on behalf of investors i n the offerings and tranches in which the plaintiff had invested, but lacked standing to represent investors who purchased shares in the other offerings and tranches. As discussed here, the district court also held that because the plaintiff had not alleged that they had failed to receive payments due under the certificates, they had failed to allege injuries cognizable under the federal securities laws. The district court dismissed the plaintiff’s case. The plaintiff appealed to the Second Circuit.

 

The September 6 Opinion

In an opinion written by Judge Barrington Parker on behalf of a three-judge panel, the Second Circuit held that the plaintiff has class standing to assert claims of purchasers of securities backed by mortgages originated by the same lenders that originated the mortgages backing the plaintiff’s securities.

 In reaching this conclusion, the Second Circuit relied on the U.S. Supreme Court’s opinion in Gratz v. Bollingerin whcih the Supreme Court held in a case involving the University of Michigan’s admission practices that a claimant could represent a class of plaintiffs where the claimant’s claims implicate "the same set of concerns" rather than a "significantly different set of concerns." ,

 

The Second Circuit said that in a securities case where the alleged misrepresentation involved the mortgage lenders’ origination practices, the plaintiff had standing to represent a class of investors in the offerings in which the same mortgage lenders were involved, because the plaintiffs’ claims and the other investors’ claims implicate the “same set of concerns.” The purchasers of securities backed by mortgages originated by different mortgage originators were “different in character and origin” and so the plaintiff did not have class standing to represent those investors. As a result the Court concluded that the plaintiff had standing to represent investors in seven out of the 17 offerings.

 

The Second Circuit also rejected the defendants’ argument that the plaintiff lacked class standing to represent investors in different tranches. The Court said that it did not believe that the “varying levels of payment priority raise such a ‘fundamentally different set of concerns’ as to defeat class standing.”

 

Finally, the Second Circuit concluded that the plaintiffs had “plausibly pled a cognizable injury – a decline in value” as a result of the securities credit downgrade, which exposed the plaintiff to much more risk concerning future payments of interest and principle. The Court specifically rejected the defendants arguments that the plaintiff had suffered no loss because it had not alleged that there had been any missed payments under the securities, and also rejected the defendants argument that the plaintiff had not sufficiently alleged injury because the plaintiff had not sufficiently alleged the existence of secondary market for the securities. The Court said that the district court had “conflated the price of a security and its ‘value,” adding that the absence of an actual market price for a security at the time of the suit “does not defeat an investor’s plausible claim of injury.”

 

Discussion

The Second Circuit’s decision in this case not only represents a substantial victory for this plaintiff, but also for the plaintiffs in all of the cases involving mortgage-backed securities where the plaintiffs seek to represent a class of investors who purchased securities in multiple offerings. The Second Circuit made it clear that the mere fact that the plaintiff did not purchase securities in another related offering is not determinative of whether or not the plaintiff has class standing to represent investors in the other offerings. The Second Circuit also made it clear that the plaintiff has class standing to represent investors in other tranches as well.

 

Plaintiffs in the other cases will undoubtedly be studying this opinion closely and will try to use it to support their claims to represent a larger class of investors. However, this opinion is not going to help all plaintiffs, at least not in the same way. The Second Circuit did not conclude that the plaintiff here had standing to represent investors in all of the 17 offerings, but only in those offerings that involve “the same set of concerns.” The plaintiff lacked class standing to represent investors whose claims represent a fundamentally different set of concerns

 

In other works, the extent of a plaintiff’s standing to represent investors who purchased securities in multiple mortgage-backed securities offerings will depend on a complex interaction between the specifics of the misrepresentation that plaintiff is alleging and the relation of the misrepresentation to the various offerings.

 

This requirement to determine whether or not the other offerings implicate the “same set of concerns” as presented in the plaintiff’s claim will be more helpful to some plaintiffs than others. But at least they will not categorically barred from representing investors who purchased securities in other offerings. And they will not be barred from representing investors who purchased securities in other tranches as well.

 

The Second Circuit’s holding on the cognizable injury issue is also significant. From the early stages of the subprime litigation wave, commentators had been suggesting that the “paper losses” of the plaintiffs in the mortgage-backed securities cases did not represent the type of injury for which the protections of the federal securities laws were designed. The district court’s dismissal of the plaintiffs’ case for failure to plead a sufficiently cognizable injury seemed to be a significant affirmation of this argument. However, the Second Circuit seems to have clearly rejected this approach, and may in fact remove a significant potential pleading obstacle for the plaintiffs in these mortgage-backed securities cases.

 

I have updated my running tally of subprime and credit crisis securities lawsuit dismissal motion ruling to reflect the Second Circuit’s ruling. The tally can be accessed here.

 

David Bario’s September 6, 2012 Am Law Litigation Daily Article about the Second Circuit’s opinion can be found here.

 

Very special thanks to a loyal reader for sending me a copy of the Second Circuit’s opinion.

 

Every fall since I first started writing this blog, I have assembled a list of the current hot topics in the world of directors’ and officers’ liability. This year’s list is set out below. As should be obvious, there is a lot going on right now in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. Here is what to watch now in the world of D&O:

 

How Significant Will the Libor Scandal-Related Litigation Be?: The Libor scandal itself first began to unfold more than four years ago, following a series of articles in the Wall Street Journal. But with the dramatic announcements in late June of the imposition of fines and penalties of over $450 million against Barclays PLC, the scandal has shifted into a higher gear and has become one of the leading stories in financial papers around the world. At this point, it is apparent that the Libor scandal is going to be one of the hot topics for months and perhaps years to come. An overview of the scandal and of the key developments in recent months can be found here.

 

As is often the case when scandal breaks, the investigative and regulatory developments have been followed by litigation. As discussed here, some of the litigation began to emerge over a year ago, but with the Barclays regulatory settlements, there has been a raft of more recent litigation. Many of the lawsuits have raised antitrust allegations, but at least one of the recent lawsuits – one brought by Barclays shareholders – involves claims under the federal securities laws.

 

It does seem probable that by the time this scandal plays itself out, there will be many more regulatory settlements, some of which might make the Barclays settlements look like pocket change. A related question is whether the banks’ civil litigation exposures are going to be similarly enormous. It is clearly far too early to know for sure. But there are a number of factors that should be kept in mind on the question of what the Libor-scandal litigation might mean for the D&O insurance industry.

 

First, many of the undoubtedly huge costs that are looming likely will not represent insured amounts. The regulatory fines and penalties will not be insured. The company investigative costs also are likely not covered. In addition, most of the antitrust litigation filed to date has named only corporate defendants. Under the typical D&O insurance policy, the companies themselves are only insured for securities claims. So the antitrust litigation, for example, would likely not be covered under the typical D&O insurance policy.

 

In addition, many of these large banks do not carry traditional D&O insurance or may only have restricted insurance. In some instances, the banks’ insurance may include a substantial coinsurance percentage or a massive self-insured retention. Other banks may only carry so-called Side A only insurance, which covers individual directors and officers only and is only available when the corporate entity is unable to indemnify the individuals due to insolvency or legal prohibition. Given that none of the potentially involved banks have failed, it seems unlikely that this Side A only coverage would be triggered.

 

In the end, while the Libor scandal related follow-on litigation could be massive, the Libor scandal may not prove to be a significant event for the D&O insurance industry. Of course, developments could prove this analysis wrong. The plaintiff lawyers may come up with creative ways to expand the universe of defendants, or claimants may meet with unexpected success in asserting claims outside the U.S. If these kinds of things were to happen, then the Libor scandal could prove to be a more serious event for the D&O insurance industry. But as things stand, it does not appear that this scandal is, by itself, going to change the market.

 

What Will the Impact of the JOBS Act Be?: On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (commonly referred to as the JOBS Act). As discussed at greater length here, the JOBS Act contains a number of IPO “on ramp” procedures designed to ease the process and burdens of the “going public process” for Emerging Growth Companies (EGCs). For example, EGCs can elect to submit their IPO registration statement for SEC review on a confidential, nonpublic basis, although the registration statement must be publicly filed at least 21 days before the IPO roadshow. Among the other features of Act that has attracted the most attention are the legislation’s provisions for “crowdfunding.” Under these provisions, a company is permitted to raise up to $1 million during any 12-month period through an SEC-registered crowdfunding portal

 

It was hoped that the legislation would encourage EGCs and facilitate job creation. However, as discussed in Jason Zweig’s August 4, 2012 Wall Street Journal article entitled “When Laws Twist Markets” (here), at least so far the one thing the Act seems to have produced is “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. 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.”

 

The Act’s reduced reporting requirements are also producing some unintended consequences.  A number of commentators have noted that while these JOBS Act provisions may serve the laudable goal of easing the IPO process, these provision also introduce risks for investors. Nor are these remarks just coming from sideline commentators. Many of the most specific warnings are coming from the companies themselves.

 

In her May 15, 2012 CFO.com article entitled “A New Risk Factor: The JOBS Act” (here), Sarah Johnson reports that for many of the companies taking advantage of the JOBS Act IPO on-ramp provisions, the fact that the companies are relying in the JOBS Act “is itself a risk factor.” Her article notes that recently a number of companies “have warned investors in their prospectuses filed with the Securities and Exchange Commission that the JOBS Act’s breaks on SEC rules could actually be a turnoff.” By way of example, she quotes Cimarron Software’s recently filed S-1, in which the company states that “we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.”

 

A common assumption about the new crowdfunding procedure is that it will be most beneficial to start-up companies. But at least according to a May 9, 2012 CFO.com article (here), due to the procedural burdens and costs associated with the JOBS Act’s crowdfunding provisions, crowdfunding is unlikely to be an attractive alternative for start-up companies.

 

According to the article, the crowdfunding provisions in the JOBS Act may be “too complex and onerous” and “not very cost-effective”   for an early-stage company. Among other things, entrepreneurs launching a new venture “may lack the financial acumen and robust business plans they’ll need to comply with the JOBS Act” and they also “may not have the cash to hire the accountants and lawyers they will need to navigate the law.”  In addition, as discussed here, many commentators are concerned that the potential for fraud on the crowd may outweigh the promise of new financing for legitimate startups. Among other reasons for these concerns is that with crowdfunding, “the risk of fraud increases because the pool of investors includes those who have no personal relationship with the business owner and who may be geographically remote from and thus unable to oversee the business itself.

 

From the perspective of the directors and officers of companies seeking to raise capital through crowdfunding, it is important to note that the crowdfunding activity entails its own liability exposures. The JOBS Act expressly incorporates provisions imposing liability on crowdfunding issuers for misrepresentations and omissions in the offerings, on terms similar to the existing provisions of Section 12 of the Securities Act of 1933. Under these provisions, a person who purchases securities issued under the crowdfunding exemption may bring an action based on any material misrepresentation or omission against the issuer, directors and executives for a full refund or damages.

 

It is also worth noteworthy that these crowdfunding provisions may blur the clarity of the division between private and public companies. The crowdfunding provisions seem to expressly contemplate that a private company would be able to engage in crowdfunding financing activities without assuming public company reporting obligations. Yet at the same time, that same private company will be required to make certain disclosure filings with the SEC in connection with the offering and could potentially incur liability under Section 302(c) of the JOBS Act

 

Private companies interested in taking advantage of the crowdfunding provisions once they become effective will want to review their D&O insurance policies’ public offering exclusions to determine whether or not these exclusions would preclude coverage for a crowdfunding liability action under Section 302(c) of the Jobs Act. The wordings of this exclusion vary widely among different policies, and some wordings could be sufficiently broad to preclude coverage.

 

Going forward, however, carriers may seek to adjust the wordings of these exclusions or other policy provisions in light of the crowdfunding liability exposure. Some carriers may try to take the position that crowdfunding liability is a kind of risk that they did not intend to cover in a private company D&O insurance policy. Indeed, some private company D&O Insurers have already introduced “Crowdfunding” endorsements designed to narrow or eliminate the carriers’ potential exposure to liability incurred in connection with crowdfunding activities.

 

As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must assess the impact of changes introduced by this broad, new legislation. It may be some time before all of the Act’s implications and ramifications can be identified and understood. It will be important for companies and their advisors to monitor these developments as they unfold

 

What Will Happen to the Pace of Banking Closures and FDIC Failed Bank Litigation Filings?: The pace of bank failures has slowed considerably during 2012. Year to date through August 31, 2012, there have been a total of 40 bank closures, compared to 74 during the period January 1, 2011 through August 31, 2011. Since January 1, 2008, 454 banks have failed, but during the month of August 2012 only a single bank failed. In addition, the number of banks the FDIC has ranked as problem institutions has also declined for five consecutive quarters.

 

But though both the number of bank failures and the number of problem institutions are declining, the FDIC’s most recent Quarterly Banking Profile shows that the FDIC still ranks over ten percent of the nation’s depository institutions as problem institutions. In other words, though the pace of bank failures may have slowed, there may be much further to go before the current banking crisis is completely behind us. 

 

As was the case during the S&L crisis two decades ago, the current wave of bank failures has also led to an influx of lawsuits brought by the FDIC, as receiver for the failed banks, against the banks’ former directors and officers. Through August 31, 2012, the FDIC had filed a total of 32 failed bank lawsuits, including 14 so far during 2012. The pace of the FDIC’s lawsuits filings has slowed considerably as the year has progressed. During the first four months of the year, the FDIC filed eleven lawsuits. However, between April 20, 2012 and August 31, 2012, the FDIC filed only three additional lawsuits. Indeed, since mid-July, the FDIC has not filed any additional failed bank lawsuits.

 

This apparent lull in lawsuit filings is surprising, for a couple of reasons. First, during the equivalent period three years prior to the apparent filing lull, there were a host of bank closures, over 50 in all. In light of the three year statute of limitations, one would have expected the last few months to have been a period of heightened filing activity.

 

The filing lull is even more surprising given that the FDIC itself has indicated that it has approved many more lawsuits than have actually been filed so far. As of August 14, 2012, the last date on which the FDIC updated its website, the agency indicated that his has now authorized suits involving 73 failed institutions; against 617 individuals for D&O liability. So far the agency has filed 32 suits involving 31 failed institutions, involving 268 individuals.

 

In view of the substantial gap between the number of authorized lawsuits and the number filed so far, it seems likely that the pace of failed bank lawsuit filings will pick back up at some point. But given the current lull, it does start to seem that perhaps there will not be as much overall failed bank litigation as had originally seemed likely. Even just a short time ago, some commentators had been predicting there might be a total of 86 FDIC lawsuits against the directors and officers of failed banks as part of the current bank failure wave. The final number may prove to be lower than projected.

 

Now That the First Dodd-Frank Whistleblower Bounty Has Been Paid, Will We See More Enforcement Actions and Follow-On Civil Litigation Based on Whistleblower Report?: 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.

 

We may now be closer to finding out whether or not these concerns were valid. 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.

 

The recent award may be the first under the bounty program, but it is clear that there will be many more to come. The SEC’s August 21 press release quotes SEC Chairman Mary Schapiro as saying that “The whistleblower program is already becoming a success. We’re seeing high-quality tips that are saving our investigators substantial time and resources.” The press release also quotes the head of the SEC’s whistleblower office as saying that since the program was established in August 2011, about eight tips a day are flowing into the SEC, adding that “the fact that we made the first payment after just one year of operation shows that we are open for business and ready to pay people who bring us good, timely information.”

 

It seems obvious that whistleblowers, motivated by the bounty program, are coming forward to report securities law violations. It also seems probable that some (perhaps many) of the situations reported would not otherwise come to the attention of the SEC, and that with these reports the pace of enforcement activity will increase.

 

These developments have companies worried. As discussed in an August 29, 2012 CFO.com article (here), some companies are worried that because of the lure of the bounty award, company employees will bypass internal reporting mechanisms and go straight to the SEC. And not only is it a concern that more companies could find themselves having to deal with SEC enforcement activity, it is entirely possible that the enforcement activity will in turn lead to follow-on litigation in the form of shareholder derivative suits, and even in some cases increased securities class action litigation.

 

It is far too early to tell whether and to what extent any of these concerns actually will come to pass, especially since there has still only been just one whistleblower bounty award. Nevertheless, there definitely so seem to be reasons for companies to be concerned.

 

Will Congress Take Steps to Increase Corporate Officials’ Liability Exposures and Narrow Their Protection?: As if it were not enough that through the Dodd-Frank whistleblower provisions that Congress has enacted provisions to increase the likelihood of SEC enforcement action, a bill now pending in Congress could increase the size of the penalties the SEC can impose.

 

As discussed in greater detail here, on July 23, 2012, Democratic Rhode Island Senator Jack Reed and Republican Senator Charles Grassley introduced a bill titled The Stronger Enforcement of Civil Penalties Act of 2012 to increase the SEC’s civil monetary penalties authority and to directly link the size of those penalties to the scope of the harm and investor losses. The Senators’ joint July 23, 2012 press release about the Bill can be found here. The Bill has been referred to the Senate Committee on Banking, Housing, and Urban Affairs.

 

The Bill proposes to update the maximum money penalties the SEC can obtain from both individuals and from entities, and further provides that the penalties may be obtained both in enforcement actions filed in federal court and in the agency’s own administrative actions (currently the SEC must file a civil enforcement action in order to seek penalties).

 

The increased penalties proposed by the new Bill are scaled to the seriousness of the offense. For the most serious offenses (specified as the third tier violations involving fraud, deceit or manipulation) the per violation penalty for individuals may not exceed the greater of $1 million; three times the gross pecuniary gain; or the losses incurred by victims that result from the violation. The maximum per violation penalty the SEC can seek from entities is limited to the greater of $10 million; three times the gross pecuniary gain; or the losses incurred by victims.

 

For less serious violations, the maximum amount the SEC may seek is correspondingly lower. For individuals, the per violation penalty may not exceed the greater of $100,000 or the gross pecuniary gain as a result of the violation. The equivalent per violation limit for entities is the greater of $500,000 or the amount of the pecuniary gain. The maximum per violation penalty amount for violations not involving fraud or deceit is the greater of $10,000 for individuals or the amount of the pecuniary gain, and for entities, the greater of $100,000 of the amount of the pecuniary gain

 

The bill was submitted at the request of SEC Chairman Shapiro, enjoys bipartisan support, and represents policies that President Obama has advocated, so it seems likely to pass into law. The practical implication seems to be not just that the SEC will seek higher penalties, but will seek penalties more often, given the proposed new authority to seek penalties in administrative actions. With greater firepower at its disposal, the SEC may become even more active, and perhaps even more aggressive.

 

In a separate development, on May 30, 2012, Representative Barney Frank introduced a bill entitled the “Executive Compensation Clawback Full Enforcement Act” (here) that by its own terms is designed to “prohibit individuals from insurance against possible losses from having to repay illegally-received compensation or from having to repay civil penalties.” The proposed Act’s appears primarily addressed to the compensation clawback sections in the FDIC’s “orderly liquidation authority” in the Dodd-Frank Act. However, the proposed Act’s separate prohibition of insurance for “civil money penalties” appears to address the long-standing question of insurance for civil money penalties imposed on bank officials by the FDIC. Rep. Frank’s bill is discussed in greater detail here. The bill has been referred to the House Subcommittee on Financial Institutions and Consumer Credit.

 

From news coverage of Rep. Frank’s introduction of the bill, the proposed Act appears to be expressly addressed to certain compensation clawback insurance products that have been introduced into the marketplace. Frank himself is quoted as saying “"the creation of insurance policies to insulate financial executives from claw-backs is one more effort by some in the industry to perpetuate a lack of accountability.”

 

The proposed Act’s provisions also seem expressly designed to address the question of insurance for the FDIC’s imposition of “civil money penalties” against senior officials at depositary institutions. The question of insurability of civil money penalties is a long-standing one. As discussed in a prior guest post on this site, the FDIC has taken the position on an individual institution level basis that insurance protecting individual bank directors and officer from civil money penalties is prohibited. But while there was some discussion of and concern about these issues, the question of insurability of civil money penalties remained an uncertain issue (at least for the banks themselves, if not for the FDIC). However, if Rep. Frank’s bill becomes law, or at least of its provisions prohibiting insurance of civil money penalties becomes law, the question would obviously be resolved.

 

What Will Be the Impact of the Amgen Case, Now Pending Before the U.S. Supreme Court?: Over the course of the past several years, the U.S. Supreme Court has shown an unusual willingness to take up securities cases. During the upcoming term, the Court will once again be considering an important securities case. As discussed here, on June 11, 2012, the Court granted the petition of Amgen for a writ of certiorari in a securities lawsuit pending against the company. As a result, next term the Court will be addressing the question of whether securities plaintiffs must establish in their class certification petition that the alleged misrepresentation on which they rely was material.

 

In the Amgen case, the plaintiff had sued Amgen and certain of its directors and officers seeing damages under the federal securities laws based on alleged misrepresentations about the safety of certain of the company’s products. The plaintiff moved to certify a class of Amgen shareholders. The defendants opposed the motion, arguing that the plaintiff was not entitled to a class-wide presumption of reliance based on the fraud-on-the-market theory, because the plaintiff could not show that the alleged misrepresentations were material. To the contrary, the defendants argued that as a result of analyst reports and public documents, the market was aware of the information that the plaintiff alleged had been concealed. The district court rejected the defendants’ arguments and certified a plaintiff class, rulings that the Ninth Circuit affirmed.

 

Amgen then filed a petition to the Supreme Court for a writ of certiorari. In its petition, a copy of which can be found here, Amgen argued that there is an “irreconcilable conflict” in the federal judicial circuits on the question of whether or not a plaintiff must establish materiality at the class certification stage. According to the cert petition, the Second and Fifth Circuits have held that a plaintiff must prove materiality for class certification and that defendants may present evidence to rebut the applicability of the fraud-on-the-market theory at the class certification. The Seventh and Ninth Circuits, by contrast, hold that district courts are barred from considering materiality at the class certification stage.

 

The Third Circuit, according to the petition, has adopted an “intermediate approach” which holds that a plaintiff does not need to demonstrate materiality as part of an initial showing before class certification, but that defendants may rebut the applicability of the fraud-on-the market theory by disproving the materiality of the alleged misrepresentation.

 

In its cert petition, Amgen stressed the “in terrorem power of certification” in the securities litigation context, which often compels defendants to enter into massive settlements. The presence or absence of this kind of pressure will, Amgen argued, depend on the circuit in which the case was filed. In the Seventh and Ninth Circuits, the company argued, defendants “will frequently be forced by practical realities, to settle cases for enormous sums regardless of whether they have a meritorious materiality defense,” while in the Second and Fifth Circuits, the plaintiffs would have to establish materiality as a precondition to class certification, and in the Third Circuit, the defendants would have the opportunity to rebut any materiality showing.

 

As the Morrison & Foerster firm said in its June 11, 2012 memorandum about the Supreme Court’s cert grant in the Amgen case,

 

A clear answer from the Supreme Court to these questions could have a significant impact on securities litigation. A decision that endorses the Ninth Circuit’s approach could made securities litigation more costly for defendants, particularly in circuits where plaintiffs are presently required to prove materiality at class certification. Conversely, a decision rejecting the Ninth Circuit’s approach could provide defendants an early opportunity to challenge the viability of class action claims.

 

In addition, there is the possibility here that the Supreme Court — rather than narrowly interpreting the existing standard for the applicability of the fraud-on-the-market presumption — does something more radical instead, like entirely redefining whether, when and how the fraud-on-the market presumption might apply. Indeed, this case presents the Court with its first clear chance to revisit the doctrine since it was first articulated nearly a quarter of a century ago.

 

In other words, the Roberts court has once again agreed to hear a case that at least potentially could have an enormous impact on the class action securities litigation exposures of public companies and their directors and officers. The case will be argued and decided during the Supreme Court term commencing in October.

 

How (and When) Will the Long-Running Credit Crisis Litigation Wave Finally Play Out?: The first of the subprime and credit crisis related securities suits was filed in February 2007. Over the course of the following years over 240 credit crisis securities class action lawsuits ultimately were filed, and during the past five years the cases have slowly been making there way through the system.

 

Many cases have been dismissed, and of the cases that have survived dismissal motions many have been settled. The latest case to settle was the high profile Citigroup case, which the parties announced on August 29, 2012 (here) had been settled for $590 million. A number of other cases have settled in recent months, including the Bear Stearns case, which settled earlier this summer for $275 million. My running tally of subprime and credit crisis-related securities suit resolutions, including settlements, can be accessed here.

 

The securities litigation related to the subprime meltdown and credit crisis has not produced any settlements on the scale of the mammoth, multi-billion dollar settlements in the era of corporate scandals a decade ago, but in the aggregate and on average, the credit crisis litigation has produced very significant settlement numbers. With these latest settlements, the aggregate amount of all of the subprime and credit crisis-related lawsuit settlements to date is about $5.5 billion. The average settlement is about $103.8 million, but if the three settlements over $500 million are taken out of the equation, the average drops to about $73.22 million.

 

The pace of settlements in these cases appears to have slowed somewhat during 2012 compared to a year ago. During 2011, 22 of the subprime meltdown and credit crisis securities suits settled, including sixteen between January 1, 2011 and August 31, 2011. However, during the same eight month period during 2012, only eleven cases settled.

 

Though the pace of settlements may have slowed, that does not necessary we are reaching the conclusion of this aggregate litigation event. Many cases continue to work their way through the system, and some of the highest profile cases are yet to be resolved, including the BofA/Merrill Lynch merger case, the AIG case, and the Citigroup bondholders’ case. As these cases and others work themselves out, they will continue to weigh on the results of the affected D&O insurers. It will be some time yet before we can calculate the final tally on the subprime and credit crisis litigation wave.

 

Will the Many Other Scandals Roiling the Financial Industry Lead to Additional Claims?: The Libor-scandal is far from the only financial scandal in which the financial industry had become mired recently. Unfortunately, a host of other scandals involving the industry have also emerged or expanded over the summer. These recent scandals may also lead to claims, and some cases already has.

 

First, there’s the money laundering scandal. In July, the U.S. Senate released a report alleged that over the last decade HSBC failed to implement anti-money-laundering protections and evaded Treasury sanctions against Iran, Myanmar, and others. The Senate report says HSBC facilitated the flow of billions of dollars between Mexico and the U.S. despite warnings drug money was involved, and provided cash to banks with ties to terrorist groups. The report also faulted the government’s Office of the Comptroller of the Currency for taking virtually no action against the bank despite being aware of problems for years. In late July, HSBC said that HSBC said that it had set aside $700 million to cover the potential fines, settlements and other expenses related to the money-laundering inquiry.

 

Second, in early August, the New York Department of Financial Services raised allegations that Standard Chartered had disregarded Treasury sanctions by allowing transactions with Iranian banks worth as much as $250 billion to pass through its New York office and that the bank had deliberately obscured the country of origin. On August 14, 2012, the New York regulator announced that Standard Chartered had agreed to a civil penalty of $340 million to resolve the charges. Investigations into the bank by other authorities including the Department of Justice and the Office of Foreign Assets Control continue. The Standard Chartered settlement followed the June 2012 announcement of the Office of Foreign Assets control that ING had agreed to pay a settlement of $619 million to settle allegations that the company had violated U.S. sanctions.

 

Third, a host of regulators are investigating the losses J.P Morgan suffered as a result of derivatives trades in the company’s London office that went seriously awry. At last report, the company’s losses from the trades (which were known in the financial markets as the “London Whale” trade) be as much as $5.8 billion.

 

Beyond these headline grabbing scandals, there have also been a host of smaller scale scandals involving the financial services industry, including Wells Fargo’s $173 million settlement with the Department of Justice of allegations that the company engaged in discriminatory residential home mortgage lending practices; Capitol One’s $210 million settlement with the Consumer Financial Protection Bureau of  allegations that the credit-card issuer pressured customers into buying consumer-credit-protection products such as identity-theft-monitoring services; and Capitol One’s $12 million settlement with the Department of Justice that the company had violated certain statutory protections for veterans, among other things, through wrongful foreclosures.

 

Indeed, this past summer so many scandals involving the financial services industry that you needed a scorecard just to keep track of them all.

 

Litigation has already followed in the wake of at least some of these scandals. As discussed here, following the initial disclosure of J.P. Morgan’s losses from the London Whale trades, shareholders filed a securities class action lawsuit against the company and certain of its directors and officers, alleging that the company’s statements regarding its trading practices and internal controls were misleading. In addition, following Standard Chartered’s settlement with the New York regulator, families of the victim’s of the 1983 bombing of the Marine barracks in Beirut sued the bank seeking compensation for its concealment of its Iran-linked transactions.

 

Investigations in connection with some of these various scandals are continuing. It remains to be seen whether as further details and developments emerge there will be further follow-on civil litigation. The sheer number of scandals seems to suggest the likelihood that there will be further lawsuits. There certainly does seem to be limit to the capacity of the financial industry to produce scandals.

 

What are the Implications of All of This for the D&O Insurance Marketplace?: After several years in which D&O insurance purchasers have enjoyed declining premiums and expanding coverage, the marketplace seems to have reached an inflection point. At a minimum, almost all of the private company management liability carriers are attempting to increase premium or otherwise add coverage restrictions to their renewals.   Based on current trends, most private company insurance buyers can expect to see increases of from 5% to 10 % (and in some cases, more) at their next renewal, with financially troubled companies and companies with adverse claims histories potentially seeing even larger increases.

 

The public company D&O insurance marketplace has also shifted recently. Economic turmoil and increased governmental regulation and enforcement activity continue to pose a challenging environment for companies and their directors and officers. At the same time, merger objection suits and other negative claims trends have led some carriers to complain of premium inadequacy. Public company D&O carriers in some case are attempting to increase in premium and retention levels. Companies that are likeliest to see upward pressure on their insurance premiums are those that have an adverse claims history or are experiencing financial challenges. Although the carriers for many kinds of companies may be pushing to increase premiums, companies in the following industries are likelier to experience premium pressure: financial services, including commercial banking; extractive natural resources; life sciences; and technology.

 

Some carriers are also attempting to add coverage restrictions, at least in some cases. Among other restrictive provisions that some carriers are seeking in at least some cases are:  separate retentions for mergers and acquisitions activity; separate retentions or other restrictive provisions relating to “crowdfunding”; and in private company management liability policies that have an employment practices coverage section providing sublimited defense cost coverage for wage and hour claims, a reduction in the sublimit.

 

Though the market environment clearly has shifted in recent months, we are not in a true “hard market.” The insurance marketplace continues to be characterized by significant levels of insurance capacity. Given the current high capacity levels, it is possible that competitive forces could undermine many of the market changes noted above. The current, more disciplined underwriting climate could either represent a transition to a sustained period of higher insurance prices and more restrictive terms, or it could merely be a temporary phase before softer market conditions resume. For the present, however, insurance buyers should be prepared for the possibility that they will see premium increases at their next renewal.

 

Labor Day has come and gone. The kids are back in school. The air is cooler and the nights are longer. There’s a definite autumnal feeling in the air. It is time to get back to work. Fortunately, The D&O Diary kept its eye on things over the summer. So if you are feeling the need to get caught up on what happened while you were out, don’t worry, we’ve got you covered. Here is a quick summary of what you missed on The D&O Diary while you were away.

 

Libor Scandal Surges, Litigation Emerges: The unfolding scandal moved into the headlines of business pages around the world in late June after Barclays agreed to over $450 million in regulatory fines and penalties. Inevitably, litigation has followed; indeed, it had begun to accumulate well before the Barclays settlements were announced.  An overview of the scandal itself  can be found here, and the details of the follow-on  litigation can be found here, here and here. Although many of the lawsuits filed so far have been based on antitrust claims, there has been at least one securities class action lawsuit filed as well, involving Barclays and its former CEO and its former Chairman (about which refer here). The scandal clearly has further to run, and there will likely be further litigation as well. As Stanford Law Professor Joe Grundfest put it, “the Libor-litigation industry is clearly a sector to watch for years to come.”

 

Mid-Year Securities Litigation Studies Released: All of the leading statistical services have issued their respective studies of securities class action lawsuit filings for the first six months of 2012. My post about the Cornerstone Research study can be found here; the NERA Economic Consulting study, here; and the Advisen study can be found here. My own analysis of the first half filings can be found here.

 

Key Insurance Coverage Decisions: In a case that addressed one of the perennial D&O insurance coverage issues, on June 27, 2012 Central District of California Judge R. Gary Klausner ruled that subsequent lawsuits related to the collapse of IndyMac bank were interrelated with an earlier suit and therefore there is no coverage under a second tower of D&O insurance for the subsequent claims. A discussion of the case and the interrelatedness issue can be found here.

 

In a different case, on June 29, 2012, the Seventh Circuit, applying Illinois law, held that when the defendants in a lawsuit include both persons who are insureds under the defendant company’s D&O policy and persons are not insureds, the policy’s Insured vs. Insured exclusion does not preclude coverage for the entire lawsuit, but only the portion attributable to the claims brought against the non-insured person defendants. The extent of coverage available when the defendants include both insured persons and non-insureds is to be determined by the policy’s allocation provisions. A discussion of the Seventh Circuit’s opinion can be found here.

 

In the latest of what is now a lengthening line of cases, on June 12, 2012, the New York Supreme Court, Appellate Division, First Department, applying Illinois law, ruled in a coverage case brought by JPMorgan Chase that owing to settlements reached with underlying carriers in a professional liability insurance program, the excess insurers in the program have no payment obligation because conditions precedent to coverage under the excess carriers’ policies had not been met. The New York case and the earlier line of cases are discussed here.

 

And as discussed here, 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 for negligent and fraudulent misrepresentation claims in the underlying action.

 

Finally, In an August 21, 2012 opinion, Central District of California Judge James V. Selna, applying California law, rejected the insured’s efforts to have the malpractice insurer’s duty to advance obligations determined under duty to defend principles. The court concluded that the insurer did not have the duty to advance the insured’s defense expenses incurred in a dispute between the insured and his former law firm. Judge Selna’s opinion is discussed here.

 

The FDIC’s Pace of Failed Bank of Lawsuit Filing Slows: As I noted when the FDIC filed two new failed bank lawsuits in mid-July, those two new lawsuits represented the first lawsuits the agency had filed in two months. Although it seemed at the time as if the two new suits might represent an end to the lull, in time following the July filing of the two lawsuits, the FDIC has not filed any further new failed bank lawsuits. Indeed, between April 20, 2012 and today, the FDIC has filed only three lawsuits, after filing eleven in the first four months of the year.

 

This apparent slowdown in FDIC failed bank lawsuit filings during the last four months is all the more surprising given that during the equivalent period three years prior well over 50 banks closed. In addition, 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 individuals.

 

Courts Wrestle With Business Judgment Rule and the Scope of Potential Failed Bank Director and Officer Liability: When the FDIC has initiated litigation against the former directors and officers of a failed bank, in many instances, the FDIC has included in its complaint a claim against the individual defendants for ordinary negligence. However, in several instances, individual defendants have successfully argued that their conduct is protected by the business judgment rule and accordingly, that they cannot be held liable for ordinary negligence.

 

The most significant holding is the August 14, 2012 decision in the Northern District of Georgia in the Haven Trust case, in which Judge Steve C. Jones dismissed the claims against both the director and officer defendants, because of his determination that under Georgia law the directors’ and officers’ conduct is protected by the business judgment rule. The Haven Trust case is discussed here. Earlier in August, 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 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.

 

However, as California attorney Jon Joseph wrote in his April 11, 2012 guest post on this blog (here), courts applying California law on the issue and considering whether corporate officers as well as directors can rely on the business judgment rule have split on the issue. Most recently, on June 7, 2012, Eastern District of California Judge Lawrence O’Neill held that the defendant officers cannot rely on the statutorily codified business judgment rule under California Corporations Code Section 309, because the statute by its terms refers only to officers not directors Judge O’Neill’s ruling is discussed here (second item).

 

Keynote Addresses at the Stanford Directors’ College: Once again this summer, I participated in the annual Stanford Directors’ College, held at Stanford Law School in Palo Alto, California. Though I was there as a faculty member, I also attended in my capacity as a blogger, and I reported on the keynote address of NASDAQ CEO Robert Greifeld and the keynote addresses of venture capitalists Marc Andreessen and Ben Horowitz here. I separately reported on the keynote addresses of Delaware Chancellor Leo Strine and Netflix CEO Reed Hastings here.

 

Interview with Professional Liability Insurance Industry Leader: On June 21, 2012, I published my interview of my good friend and industry colleague David Bell. David announced earlier this year that he was leaving Bermuda to return to Montana, where he was taking up a position as President and Chief Operating Officer of ALPS Corporation. The interview not only covers David’s reasons for making the move, but also reflects his thoughts about the industry and about life.

 

U.S. Supreme Court Grants Cert in the Amgen Case:  As discussed here, on June 11, 2012, the U.S. Supreme Court agreed to hear an appeal of a securities class action lawsuit in the Amgen v Connecticut Retirement Plans case. The Supreme Court will address a significant split in the Circuits on the question whether securities plaintiffs must establish in their class certification petition that the alleged misrepresentation on which they rely was material.  The case, which will be argued and presumably decided during the upcoming Supreme Court term, may also give the Court the opportunity to take a look at the fraud on the market theory as well.

 

Chinese Cases Face Pleading Obstacles, Settle Modestly: A number of the securities suits filed against U.S.-listed Chinese companies have survived motions to dismiss. First, 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. And as discussed here, on August 24, 2012, Southern District of New York Judge George Daniels denied in part the company’s motion to dismiss in the Duoyuan Global Water and two of its officers.

 

Not all of the suits against the Chinese companies have fared as well. For example, 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.  

 

The 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).

 

Congressional Bill Would Increase SEC’s Penalty Authority: As discussed here, on July 23, 2012, Democratic Rhode Island Senator Jack Reed and Republican Senator Charles Grassley introduced a bill titled The Stronger Enforcement of Civil Penalties Act of 2012 to increase the SEC’s civil monetary penalties authority and to directly link the size of those penalties to the scope of the harm and investor losses. The Senators’ joint July 23, 2012 press release about the Bill can be found here.

 

And Finally: It may be that everyone here at The D&O Diary has attention deficit disorder. From time to time, we do seem to have trouble staying on topic. For example, my reflections on Time and Summer probably distracted me a lot more than anything else I posted this summer. I confess that I like the Time and Summer post (which can be found here) better than anything I have written for this site. Some day I will have the courage to explain why I wrote it, but not yet. If you have not yet read it, please take a moment and at least look at the pictures and read the many readers’ comments. The post’s concluding message seems apt even as summer draws to a close.

 

Anyway, I think my favorite off-topic foray of the summer was when I posted the new Matt is Dancing video. The Where the Hell is Matt 2012 video is embedded below. The video opens with a short commercial (sorry) but stick with it, the video is so much fun. Cue it up and prepare to smile.

 

The parties to the Citigroup subprime-related securities class action lawsuit – one of the highest profile of the remaining subprime cases – have agreed to settle the suit for $590 million, in what is the third largest settlement so far out of the subprime and credit crisis litigation wave. Southern District of New York Judge Sidney Stein preliminarily approved the settlement on August 29, 2012, and scheduled a hearing for final approval on January 13, 2013.

 

A copy of the parties’ stipulation of settlement can be found here. The plaintiffs’ lawyers’ August 29, 2012 press release about the settlement can be found here.

 

The Citigroup case was among the most prominent of the subprime cases because of Citigroup’s role in the mortgage-backed securities industry that contributed so significantly to the subprime meltdown, as well as because of the high-profile individuals involved in the case, including former Citigroup CEO Charles Prince and former Treasury secretary and Citigroup board member Robert Rubin. In addition, Citigroup’s attempt to settle the subprime-related SEC enforcement action for a payment of $285 was famously rejected by Southern District of New York Judge Jed Rakoff, a decision that is now on appeal before the Second Circuit.

 

As discussed in detail here, in a November 9, 2010 Judge Sidney Stein narrowed the shareholders’ action against Citigroup and dismissed a number of the individual defendants. But what Judge Stein called the plaintiffs’ “principal” allegations survived the dismissal motion and remained in the case, as did seven of the individual defendants, including Prince and Rubin. The surviving allegation was the plaintiffs’ claim that Citigroup “did not disclose that it held billions of dollars of super-senior tranche CDOs.”

 

The basic thrust of the plaintiffs’ CDO-related allegations is that though the company disclosed that it was deeply involved in underwriting CDOs, the company did not disclose that billions of dollars of the CDOs had not been purchased at all but instead had been retained by Citigroup. In November 2007, the company disclosed that it was exposed to super-senior CDO tranches in the amount of $43 billion and that it estimated a write down of $8 to $11 billion of those assets. The plaintiff alleged that this disclosure omitted an additional $10.5 billion worth of holdings that the company had hedged in swap transactions. 

 

Judge Stein found that the plaintiffs had adequately alleged that Citigroup’s CDO valuations were false between February 2007 and October 2007. In concluding that these statements were made with scienter, Judge Stein noted that the plaintiffs’ claims "concern a series of statements denying or diminishing Citigroup’s CDO exposure and the risks associated with it." These statements, Judge Stein found were "inconsistent with the actions Citigroup was allegedly undertaking between February 2007 and October 2007."

 

Among the subprime and credit crisis cases that have settled so far, the $590 Citigroup settlement has been exceeded only by the $627 million Wachovia bondholders’ settlement and the $624 million Countrywide settlement. As Jan Wolfe points out in his August 29, 2012 Am Law Litigation Daily article about the Citigroup settlement (here), the $590 settlement in the Citigroup case may represent the largest settlement by a single financial institution.

 

Among the remaining subprime and credit crisis cases, there are several that at least potentially present the possibility of similarly large settlements, including the BofA/Merrill Lynch merger case, the AIG case and the Citigroup bondholders’ case. It remains to be seen how the Citigroup settlement will stack up when all of these cases have settled. But as I had to remind several people in telephone conversations yesterday about the Citigroup settlement, at well over half a billion dollars, the Citigroup settlement is unquestionably represents a big number. Others will have to wrestle with the question whether it is “big enough.”

 

I have in any event added the Citigroup settlement to my running tally of subprime and credit-crisis case resolutions, which can be accessed here.

 

FDIC Releases Quarterly Banking Profile: If you have not yet seen it, on August 28, 2012, the FDIC released the Quarterly Banking Profile for the quarter ending June 30, 2012. In general, the report reflects a generally improving banking industry. Among other things, the report shows that the industry had collective net income of $34.5 billion, a figure that would have been even larger were it not for the J.P. Morgan “London Whale” trading losses. This net income figure represents the 12th consecutive quarter over quarter increase in industry net income.

 

Consistent with this overall picture of improving industry health, the number of problem  banking institutions decreased during the quarter, from 772 to 732. However, because the number of reporting institutions overall also decreased, the number of troubled institutions at quarter’s end still represents a significant percentage (10.1%) of all banks. The number of troubled banks at the end of the first quarter represented 10.5% of all reporting institutions. The second quarter number does represent a significant decline in the number of problem institutions compared to the end of the second quarter of 2011, when there were 865. The FDIC notes that the second quarter 2012 decline in the number of problem institutions represents the fifth consecutive quarterly decline.

 

One interesting additional note in the FDIC’s report is that there were no new bank charters granted in the second quarter of 2012, which represents the fourth consecutive quarter in which there were no new charters. Through closure and merger, and the lack of additions of any new banks, the number of banking institutions is shrinking significantly

 

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

 

Background

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

 

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

 

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

 

The August 24 Opinion

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

 

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

 

Judge Daniels found that:

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

The August 21 Opinion

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

The August 17 Holding

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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