One of the many gifts my wife brought to our marriage was a generations-long family tradition of spending summers in Pentwater, Michigan. If I were, like a true Michigander, to hold up the back of my left hand as a map of Michigan’s mitten-shaped lower peninsula, I would point to the outside knuckle at the base of my little finger, to show where Pentwater is located, on the eastern side of Lake Michigan, between Muskegon and Ludington.

Pentwater was established in the years after the Civil War as a lumbering and furniture- making center. There is still some manufacturing in town, but the lovingly maintained Victorian homes are now mostly occupied by retirees. The village’s main street runs parallel to the Lake Michigan shoreline, and perpendicular to Pentwater Lake, which connects to the big lake through a channel. Along the Lake Michigan shoreline north of channel outlet is Mears State Park beach. Our cottage is along the shoreline a mile north of the state park.

In Pentwater, we are “off the clock,” both figuratively and literally. Solar time governs daily activities. The day begins at sunup, with a walk through the woods into the village, along the channel, and out to the signal beacon at the end of the channel breakwater. From that vantage point, the beach curves away, about 20 miles north to Big Sable Point, and about 10 miles south to Little Sable Point. The vast expanse of the lake spreads far beyond the horizon, to Wisconsin, 60 miles away. The lake bottom close into shore is only a few feet deep. A couple of miles out, though, the lake is over 500 feet deep, and a little further north the lake is nearly a thousand feet deep. Lake Michigan is big — its surface area is about the same size as West Virginia. Arching over it is the vast blue dome of the sky.

Sheboygan, Wisconsin is directly across on the other side. The good people of Sheboygan are revered in our house, as — according to solemn assurances we provided our children when they were small — at sunset the faithful citizens of Sheboygan catch the sun before it falls in the lake, and then using means both secretive and mysterious, transport the sun back around to the Michigan side of the lake in time for sunrise the next morning.

At midday, the noon whistle in the village sounds, which means it is time to take the bicycles out from under the cottage. We ride out Park Street, past the volunteer fire department, past the library, past the school, and out across the Pentwater River into the countryside. The road traverses a short stretch of the Manistee National Forest, and then rolls out into fields of corn, orchards, pumpkin patches, and Christmas tree farms. As a lifetime city dweller, it is always a little bit of a surprise to me how close the countryside is.

In the afternoon, we pull the kayaks out from behind the dunes and down to the water’s edge. These are the open cockpit, flat bottom kind of kayaks. They are more stable in the lake’s choppy water. When our kids were small, we would have point-to-point races and distance challenges, but these days I prefer a more leisurely paddle along the Lake Michigan shoreline, or through the channel and into Pentwater Lake. It always strikes me how out on the water, even just a couple of hundred feet offshore, the trees, houses and people back on shore look so small and the lake seems  so immense. I suppose that is the reason we go on vacations, to get that kind of perspective. From a distance, all those problems that loom so large can seem so small and unimportant.

These days I prefer a more leisurely paddle along the Lake Michigan shoreline (drone picture captured in July 2024).

As I paddle along, the small boy in me comes out, and I imagine that I am a voyageur, looking for natives with whom to trade for pelts and furs. Actually, the presence of natives is not such a stretch. A prized photograph in my wife’s family’s archives shows her great-grandmother standing on the beach, next to a Native American on a pony. (The presence of the Native American has never been fully explained to me). One of the most interesting features of the photograph is the appearance of the hills in the background. Today the hills are thickly wooded with huge, mature trees, but in the picture the hills are as bare as the face of the moon. The trees were cleared as lumber to help rebuild Chicago after the Great Fire. The wood from the first cut of the virgin forest is still so highly prized that today salvage crews retrieve sunken lumber from shipwrecked boats entombed in the icy depths of the lake’s bottom.

After kayaking, it is time for a swim. My experience with lake swimming prior to first coming to Lake Michigan had been uniformly unpleasant, involving algae-laden brown water and muddy lake bottoms. Swimming in Lake Michigan is an entirely different experience. The lake bottom and shore line are covered with fine, white sand. The vast freshwater reservoir itself is a parting gift of retreating glaciers. The water remains generally clear and clean and refreshing. In the last century, the lake has endured a number of insults – industrial pollution, farm runoff, and invasive species. It is a wonder that the lake is as healthy as it is. We all have a stake in maintaining its health. We can live without oil but we can’t live without water, and the Great Lakes together contain over 20% of the world’s fresh water. A late afternoon swim is a compelling reminder of water’s restorative power.

When the kids were smaller, we would all gather for dinner at the large dining table in our cottage – our kids, my brother-in-law’s kids, and my wife’s cousin’s kids. A hungry, tumultuous mob. We would have barbecued chicken, corn on the cob and green beans from the Farmers’ Market, and fresh bread baked in the wood-fired clay oven my brother-in-law and the kids built next to his cottage a few summers ago. (For obscure reasons, the clay oven is referred to as “Bob.”) We also have local fresh fruit – cherries, apricots, melons, and blueberries. Among the many gifts my wife brought to our marriage is a particular talent for transforming blueberries into delicious treats – blueberry pie, blueberry crisp, blueberry cobbler, blueberry muffins, and more.

We pick the blueberries ourselves at Hayes Farm, out beyond the Driftwood Golf Course (nine holes for ten bucks. If no one’s there, you put your money in a coffee can by the first tee. Just make sure to bring a sand wedge.). With the kids working as conscripted labor, we can harvest many buckets of blueberries in a short time. The farm owners encourage pickers to eat blueberries while picking, which is part of the pleasure. The smaller, sweeter Jersey blueberries are better for baking. The larger, juicier Bluecrop blueberries are better for eating fresh, or for freezing. We put together dozens of freezer bags of the berries, so that in February, we can have the blueberries on oatmeal, like sweet purple marbles of preserved summer sunshine.

On Thursday evening, there is a band concert in the bandstand on the village green. Families gather and sit on blankets or folding chairs, and little kids run around playing chase games or eating ice cream cones from the House of Flavors ice cream parlor across the street. My kids used to like to sit in the branches of a big maple tree behind the bandstand, but two years ago the maple was struck by lightning and they had to remove the rest of the tree. The band members range from their mid-teens to their mid-80s. They play a medley of tunes, including marches, college fight songs, and patriotic melodies. For example, the band might play the Wisconsin fight song, the official words of which, I am informed and believe, are: “On Wisconsin! On Wisconsin! We don’t know the words! We don’t know the words, so we’ll just MAKE THEM UP! Rah Rah Rah!”

The highlight of the concert is when the band plays “Stars and Stripes Forever,” which features a crowd-pleasing piccolo solo. Out in front steps a little girl no bigger than your thumb. With presence and aplomb, she plays the solo as if she were the designated herald for the dawning of the new age.

After the concert, the thing to do is to walk up Hancock Street to the Antler Bar. The Antler Bar looks exactly like you’d expect a place in rural Michigan called the Antler Bar would look. There is a big set of antlers on the wall behind the bar, and several other sets on the other walls. The walls are also covered with sports memorabilia. Like all right-thinking people everywhere, the management of the Antler favors the University of Michigan. (The Village Pub up the street favors Michigan State. We do not patronize The Village Pub – even though it does have a cool outdoor terrace with a view of Pentwater Lake). For the boating crowd, the Antler serves upmarket draft beers like Stella Artois and Guinness, but the thing to do is to order a longneck Bud, and then drop a quarter in the jukebox. You can play any song you like, as long as it’s by Bob Seger.

Because Pentwater is on the western edge of the Eastern Time Zone and so far north, it doesn’t get dark there until quite late. In late June and early July, the sun doesn’t set until about 9:30 pm, and it isn’t completely dark until almost 10:45 pm. Even after a round or two in the Antler, the sun will likely still be above the horizon. Walking home along the beach, we can watch the sun set. As the sun sinks slowly toward the horizon it casts a cascade of colors across the western sky; and  the orange, reds and yellows of the sunset give way to purples, blues and greens after the sun has gone down. After sunset, a small gesture of appreciation for the good people of Sheboygan always seems appropriate. All hail the citizens of Sheboygan, faithful Stewards of the Sun.

When darkness has finally gathered, the sky reveals a brilliant array of stars. Because there are no nearby metropolitan areas, the stars are uncommonly clear. The Milky Way is a broad smear of stars arching across the sky. In August, when the skies are clear, we go down to the beach with blankets and lay on our backs to watch the Perseids meteor shower. The shooting stars arch across the sky about one a minute or so. At times the shooting stars appear so frequently that it can feel as if you are the one that is falling.

In mid-August, the village hosts its annual Homecoming celebration. There are games and prizes on the village green, a sand-castle contest on the state park beach, and a Coast Guard water rescue demonstration in Pentwater Lake. In the afternoon, there is a parade through the village. Proud veterans in uniform carry the flag, and girls in shiny costumes twirl batons. There are squadrons of antique cars (this is Michigan, after all). Political candidates work the crowd. There are floats from various local businesses, and there are also separate floats for Mrs. Asparagus and for the Cherry Princess. The highlight of the parade is the locally famous Scottsville Clown Band. The Clown Band marches in costume, with some dressed, for example, as clowns. A disturbingly large number of the (male) band members are dressed as women. The parade culminates with a band concert on the village green.

On the Saturday evening of Homecoming weekend, the village shoots off fireworks from the channel breakwater. The brilliant colors of the fireworks are beautiful as they reflect off the Lake’s shifting surface. The Homecoming fireworks are always a bittersweet pleasure, because they signal that summer is coming to an end. The next day, it is time to close up the cottage, pack up the car, and head home to school and to work.

When my oldest daughter was young, she would cry as we pulled away from the cottage. I know she was crying because summer was over, but as time has passed, and now that she has a job and a life of her own out on the West Coast, and she can’t come out to the Lake most summers, I appreciate that she was also crying for the fleeting days of her youth, gone now and beyond retrieval. That is a part of parenting I never anticipated — that as a parent I would mourn my own children’s lost youth.

I always wondered what Pentwater looks like out of season. In October a couple of years ago, I had a business trip to Lansing, and afterwards I drove out to Pentwater to have a look. It was one of those sunny October days when it was warm enough to wear shorts and to walk barefoot on the beach. The scene was strange – everything was familiar but somehow altered. The cottages were all closed, the trees had changed colors, and the dune grass was dry and brown. The sun was much further South in the sky than I had ever seen it, and at an odd angle too. As I walked along with the warm sun in my face and the warm sand underfoot, and not another soul around for miles, I thought to myself, I could do this forever.

Forever.

The word reverberated as if it had been sung in my ears by a heavenly host of angels.

Man. I went to see what the beach looked like out of season and came away with a glimpse of eternity so convincing it took my breath away.

Tell you what. Get yourself something cool to drink, and let’s go out and sit on the screen porch. We can talk about anything you like. Or we can just listen to the breeze rinse through the pines, and further off, the waves falling on the shore.

Yes, better just to sit quietly. July doesn’t last forever. We should savor it.

Another busy day in the village

Painted Ladies of Pentwater

Pentwater Lake

The Channel

Until we journey to the Timeless Shore, we should savor the time we have

 

More Pentwater Pictures

Northern Lights, August 2024

Looks like its time for an evening drink with a friend

Moonlight over Lake Michigan

The fallout from the alleged manipulation of LIBOR and other interbank offered rates continues to accumulate. In the wake of Barclays’ record fines, the regulatory investigation continues, and authorities reportedly have also launched criminal investigations. Along with the governmental investigatory and enforcement activity has also come civil litigation activity as well.

 

The latest suit to be filed is an antirust action filed I on July 6, 2012 in the Southern District of New York. The complaint, which can be found here, alleges that Barclays, several Barclays entities, and several other banks, conspired to artificially manipulate the reported European Interbank Offered Rates (“EURIBOR”), which, the complaint alleges is “the baseline interest rate used in the valuation of more than $200 trillion in derivative financial products.”

 

 The complaint, which purports to be filed on behalf of a class of persons or entities in the United States who purchased EURIBOR-related financial instruments between January 1, 2005 and December 31, 2009, relies heavily on documents, emails and other materials and information amassed as part of the governmental investigations. The complaint alleges that the defendants entered an agreement in restraint of trade, in violation of Section 1 of the Sherman Act. The complaint also alleges violation of the Commodity Exchange Act. The plaintiff’s lawyers’ July 6, 2012 press release about the EURIBOR antitrust suit can be found here.

 

Allison Frankel has a thorough overview of the Euribor antitrust lawsuit in a July 9, 2012 post on her On the Case blog (here).

 

The recent EURIBOR antitrust action is far from the only civil action to follow in the wake of the governmental investigation.  According to a May 2012 PLUS Journal article  by Eric Scheiner and Jennifer Quinn Broda of the Sedgwick, Detert, Moran & Arnold law firm entitled “Move Over Subprime? Financial Institutions and Brokers Face Increasing Concerns Over Allegation of Improper Libor Manipulation” (here), in 2011, at least 21 class action lawsuits were filed I n various U.S. federal courts against numerous Libor member banks. These lawsuits were instituted by institutional investors who purchased interest rate swaps tied to Libor and who claim they lost millions through the alleged manipulation of the interbank rate or who lost money on other interest-rate sensitive investments and instruments. Further background about these antitrust suits, which have now been consolidated, can be found here.

 

Nor are these institutional investor lawsuits the only suits to emerge. According to a June 27, 2012 memo from the Kennedys law firm (here),   there have also already been at least two shareholders derivative lawsuits filed, one brought by a Bank of America shareholder and another by a Citigroup shareholder, against former and current directors and officers of those firms, alleging breaches of fiduciary duty “regarding lack of oversight relating to the bank’s purported manipulation and suppression of LIBOR as early as 2006.”

 

The ultimate scope of the Libor scandal remains to be seen, but the stakes involved are clearly enormous. To date, only Barclays has paid regulatory fines, but many other banks, perhaps dozens of banks are likely to become involved. The costs involved – both for defense expenses and for fines and penalties – will be massive. How massive remains to be seen, as we clearly are still just at the outset of this unfolding scandal.

 

What all of this may mean from an insurance perspective also remains to be seen. The regulatory fines and penalties are not likely to be covered. The companies’ costs incurred in the regulatory investigations also are not likely to be covered, as the typical D&O policy provides little coverage for entity related investigative costs, particularly outside of the securities law context.

 

The D&O insurance implications of the civil litigation are  not entirely clear.  The antitrust lawsuits primarily target the company defendants. There have been no individual defendants named in the antitrust suits. The typical public company D&O insurance policy provides entity coverage only for securities claims, which do not appear to be involved in the antitrust suits. In addition, private company D&O insurance policies often have antitrust exclusions. The derivative lawsuits may represent an entirely different matter. The derivative suits name individuals as defendants and alleged breaches of fiduciary duties, not antitrust violations. The derivative claims would be far more likely to be covered under the typical D&O policy.

 

The ultimate consequences for the companies involved and their insurers will only emerge over the coming months and years as this scandal continues to unfold. It does seem likely that the related civil litigation will continue to accumulate. To the extent additional derivative claims are filed, or if shareholders of target banks file securities claims, the follow-on civil litigation could develop into a significant event for the D&O insurance industry. At this point, the one thing that is clear is that it will pay to watch closely as the investigation unfolds and the follow-on civil litigation continues to emerge.

 

A July 2012 memo about the Libor investigation and possible insurance implications from my friend Nilam Sharma of the Ince & Co. law firm and her colleague Simon Cooper can be found here.

 

Special thanks to the several loyal readers who sent me copies of the EURIBOR antitrust complaint. Edvard Pattersson’s July 7, 2012 Bloomberg article about the EURIBOR antitrust suit can be found here.

 

Former CFO’s Dismissal Motion Denied in Longtop Financial Securities Suit: Longtop Financial Technologies may be unique among U.S.-listed Chinese companies that have been caught up in the wave of accounting scandals and related securities litigation. Unlike many of the others, Longtop did not obtain its U.S.-listing by way of a reverse merger, but instead, in order to obtain its NYSE listing, it went through the full IPO process. Nevertheless, as discussed here, its share price collapsed in April and May 2011 following online research reports critical of the company’s accounting practices.

 

As detailed here, securities litigation against the company and certain of its directors and officers followed. One of the individual defendants, Derek Palaschuk, the company’s former CFO, moved to dismiss.  As detailed in Jan Wolfe’s July 2, 2012 Am Law Litigation Daily article (here), Palaschuk’s motion has now been denied. In a June 29, 2012 opinion (here), Southern District of New York Judge Shira Sheindlin, acknowledging that the online research reports may well have been biased owing to the online analysts’ financial interests as short sellers of Longtop’s stock, nonetheless rejected Palaschuk’s motion.

 

The motion involved only the CFO and not the company itself, owing to the fact that the company, though it has been served, has not yet entered an appearance in the case. As Wolfe put it in the Litigation Daily post, after reading Scheindlin’s opinion, “we can understand why Longtop might be avoiding U.S. courts.”

 

Corporate Directors in the Hot Seat: As research by Stanford Law Professor Michael Klausner and others has found, outside corporate directors are only rarely directly held personally liable for their actions as corporate directors. Nevertheless, directors are increasingly “in the thick of it,” according to an interesting article by Philippa Masters entitled “Corporate Directors on the Firing Line” (here) in the latest issue of Corporate Counsel, dated July 9, 2012.

 

The article opens with an interesting discussion of the recent events that have swamped the beleaguered board at Yahoo (whose members were memorably described by departing Yahoo CEO Carol Bartz as “doofuses”). The article describes how shareholder activists and others are increasingly seeking to hold directors accountable for problems at their companies. As a result of these recent developments, there has been an upsurge in litigation involving corporate directors – for example, in the form of “say-on-pay” litigation and M&A-related litigation, as well as in FDIC failed bank litigation. The article also notes the increased use of such theories as the responsible corporate officer doctrine, to try to hold corporate officials liable.

 

The article is a little longer than the usual online fare, but I recommend taking a few minutes to read the entire piece. It is wide-ranging and interesting.

 

Questioning the Theory of Shareholder Value Maximization: One of the currently accepted tenets of corporate oversight is that companies should be managed to best maximize shareholder value. An interesting June 26, 2012 post on the Dealbook blog (here) takes a look at a recent book by Cornell Law School professor Lynn A. Stout, in which the professor questions the shareholder value “myth.” According to Stout, the misleading shareholder valuation theory is the product of misguided analysis from economists and business professors that has been propagated by the “corporate governance do-gooder movement,” as a result of which short term investors like hedge funds have manipulated companies into delivering short-term stock price driven results at the cost of companies’ long run interests.

 

Stout contends that based on a proper reading of the law, corporate officials are empowered to take a broader range of considerations into account. They might, for example consider the interests of their customers and their employees and may even consider social responsibility. Stout calls for a return to “managerialism,” where executives and directors can run companies without being preoccupied with shareholder value. It is, she contends, in the long run interest of all constituencies that companies move away from short-term strategies and toward consideration of longer range issues.

 

Evergreen Fund Suprime-Related Securities Litigation Settled: The parties to the subprime-related Evergreen Ultra Short Opportunities Fund Securities have settled the case. According to the parties’ June 29, 2012 stipulation of settlement (here), the parties have agreed to settle the case for a payment of $25 million. The settlement is subject to court approval.

 

As described in greater detail here, investors first sued the fund, affiliated entities and certain individuals associated with the fund, in a securities class action lawsuit in June 2008. The plaintiffs alleged that, contrary to its marketing materials, the fund was not managed to preserve capital and avoid principal fluctuations, but rather was composed of illiquid, risky, speculative and volatile securities, particularly mortgage-backed securities. The fund ultimately liquidated at a substantial loss to investors. On March 31, 2010, the court entered an order granting in part and denying in part the defendants’ motion to dismiss.

 

The settlement stipulation does not reveal whether any portion of the $25 million settlement is to be funded with insurance. I have in any event added the Evergreen Fund settlement to my running tally of subprime and credit crisis-related case resolutions, which can be accessed here.

 

Evolutionary Biology and the Dynamics of Law Firm Management: Readers of The New Yorker magazine will recall an article that appeared in the magazine in March 2012 discussing the writings and research of evolutionary biologist Edward O. Wilson and the theory of altruistic behavior among animals. An amusing June 28, 2012 post on the Adam Smith, Esq. blog (here) takes a look at the biological theories of altruistic and individualistic behaviors to suggest that law firms that develop altruistic group behaviors are more likely to survive and thrive than are firms that built upon aggressive individualism.

 

Special thanks to loyal reader Matt Rossman for the link to the Adam Smith, Esq. blog post as well as the article above about Professor Stout’s study of shareholder value.

 

In a June 29, 2012 opinion (here), 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 by 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.

 

Background

The underlying claim (referred to as the “Miller action”) involves a lawsuit brought by five individuals against Strategic Capital Bancorp, Inc. (SCBI) and two of its officers. In their suit, the plaintiffs asserted claims for fraud, civil conspiracy for alleged violations of the Illinois Consumer Fraud and Deceptive Business Practices Act. Three of the plaintiffs in the Miller action are former SCBI directors and therefore qualify as “Insureds” under the SCBI D&O policy. The other two Miller action plaintiffs are not Insureds under the policy.

 

The SCBI D&O policy includes an exclusion (of a type found in most D&O policies, and usually referred to as an “Insured vs. Insured” exclusion) precluding coverage for “Loss on account of any Claim made against any Insured: …brought or maintained by or on behalf of any Insured or Company in any capacity.” The Policy also contained an allocation provision, specifying that when loss from a Claim incudes both “covered and uncovered matters” the amount “shall be allocated” between covered Loss and uncovered loss based upon the relative legal exposures of the parties to the covered and uncovered matters.”

 

SCBI submitted the Miller action as a claim under its D&O policy. The carrier denied coverage for the claim in reliance on the Insured vs. Insured exclusion. Coverage litigation ensued. The District Court ruled in favor of the carrier, holding that the “plain language” of the exclusion precludes coverage for civil proceedings “brought or maintained by any Insured.” SCBI appealed.

 

The June 29 Opinion

In an opinion written by Judge David Hamilton for a three judge panel, the Seventh Circuit affirmed in part and reversed in part the holding of the district court. The appellate court affirmed the district court to the extent the lower court had held that coverage under the policy for the claims brought by the three former directors was precluded by the Insured vs. Insured exclusion, but reversed the district court to the extent that the lower court had held that the exclusion also precluded coverage for the claims brought by the plaintiffs who were not Insureds. The Seventh Circuit, In reliance on its 1999 decision in the Level 3 Communications, Inc. v. Federal Insurance Co.  case (here)– which the Court said was “practically indistinguishable“ from this case — held that there was coverage under the policy for the claims brought by the non-insureds, and that defense costs and any indemnity amounts would have to be allocated between covered Loss and uncovered loss using the policy’s allocation provisions.

 

In the Level 3 case, the Seventh Circuit had also addressed the question of the application of an Insured vs. Insured exclusion in a D&O policy to a claim that ultimately included both insured and noninsured claimants. Initially, the claimants in the underlying case had only consisted of non-insureds. However, six months after the underlying lawsuit had been commenced, an insured person joined as a plaintiff. The Seventh Circuit held in the Level 3 case that in that situation “the insurance contract requires allocation of covered and noncovered losses rather than barring all recovery because of the presence of an insured on the plaintiff’s side of the case.”

 

The D&O insurer in this case attempted to distinguish the Level 3 case based on two factual differences: timing and “majority rule.”   The carrier first argued that in the Level 3 case, the insured plaintiff did not join the underlying suit until six months after it was filed. The Seventh Circuit said that its ruling in Level 3 had not depended on the timing, and so rejected this attempt to distinguish the earlier case.

 

Second, the carrier argued, in reliance on what the appellate court described as a “counting noses” approach that coverage in a mixed claimant case like this should be based o n the number of insured plaintiffs or proportion of damages claimed by insured plaintiffs. The court said that this “proposed additional requirement for a majority of non-insureds claimants or dollars has no basis in the …policy language.”

 

The appellate court also noted that the carrier attempted to rely on the Eleventh Circuit’s 2005 opinion in the Sphinx International v. National Union Fire Insurance Co. case (here), which also involved a claim brought both by insured persons and noninsureds. In that case, a former director initiated a securities suit and then published a nationwide notice soliciting other shareholders to join the suit. The former director then amended his complaint to add the additional plaintiffs.  The Eleventh Circuit held that coverage was precluded for the entire suit based upon the company’s D&O policy’s Insured vs. Insured exclusion., which precluded coverage for loss arising from a Claim brought “By or at the behest of … any DIRECTOR or OFFICER … unless such claim is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of any DIRECTOR OR OFFICER of the company.” The Eleventh Circuit had held that the director plaintiff had actively solicited the other plaintiffs, and therefore the exclusion precluded coverage for the entire claim.

 

The Seventh Circuit found the Sphinx decision to be distinguishable by its fact, including in particular with regard to the policy language involved in that case. The Seventh Circuit also noted that Sphinx itself had distinguished the Level 3 case because the policy language in the earlier case was “too dissimilar” to the language at issue in Sphinx “to be decisive.”

 

Discussion

One of the reasons carriers include Insured vs. Insured exclusions in their policies is that, in addition to avoiding collusive suits, the carriers don’t want to pick up coverage for corporate infighting. Internecine battles can be vexatious and often are not susceptible to resolution on a rational business basis. Given this justification for the inclusion of an Insured vs. Insured exclusion in the policy, I can see how the carriers would take the position that if any one of the plaintiffs is an insured person, the entire claim should be excluded. The argument would be the involvement of even one insured presents too great a risk that the carrier might be dragged into corporate infighting or persona score settling.

 

There may be something to this argument; the carrier did succeed in convincing the district court that the involvement of even one insured as a plaintiff – or more specifically, the involvement here of three insured persons among the five claimants  – is sufficient to preclude coverage for the whole claim.

 

The problem with this argument – that one insured person plaintiff “taints the entire suit,” as the appellate court put it– is that it can lead to some hard questions. As the appellate court noted, the carrier here took this “proposed rule” to “its logical limit,” arguing that it should apply and control even if there were 99 plaintiffs who were not insureds and only one insured person plaintiff. The appellate court also noted that the carrier had argued that the rule should apply even if separate complaints by an insured person plaintiff and non-insured were consolidated, even if only for pretrial proceedings. These examples from the logical limits of the insurer’s argument proved to be more than the court could accept, leading the appellate court to follow a solution based on allocation of between covered Loss and uncovered loss.

 

For carriers that nonetheless believe that Insured vs. Insured exclusion should apply even if only one of many plaintiffs is an insured person will want to consider the Seventh Circuit’s analysis of the Sphinx International opinion. The more encompassing exclusionary language at issue in that case seems likelier to preclude coverage when claimants include both insured person plaintiffs and non-insureds, particularly where the insured person plaintiff is actively involved in t he litigation.

 

For all D&O insurance practitioners the potentially different claims outcome based on the differences between the exclusionary language at issue in the Sphinx International case and the language involved here underscores the critical importance of these differences in policy wordings. In particular, those of us who are involved in representing policyholders in the insurance purchasing process will want to play close attention to the language used in the Insured vs. Insured exclusion in prospective policies, in order to determine whether it more closely resembles the language at issue in the Sphinx International case or the language involved here.

 

It is probably worth noting one particular challenge the carrier faced on appeal in the Seventh Circuit. The three judge panel that heard this case included Judge Richard Posner. Judge Posner wrote the opinion in the Level 3 case. Given that fact, it was always going to be the case that the Level 3 decision was toing to loom large here.

 

For general background regarding the Insured vs. Insured exclusion, please refer here and, here (in the bankruptcy context) and here (in failed bank litigation).

 

The number of securities class action lawsuit filings came in slightly above historical averages during the first half of 2012, with filings against natural resources companies, life sciences companies, and foreign issuers leading the way. Filings related to mergers and acquisitions transactions continued to be an important factor in the number of filings, although not as significant of a factor as was the case in 2011.

 

During the first half of 2012, there were 103 new securities class action lawsuit filings. This figure annualizes to 206, which would be above the 1997-2010 annual laverage number of filings of 194. Though securities suit filings were active during the year’s first half, the filings were not evenly distributed during the period. There were 58 filings in the first quarter — 44 in January and February alone — but only 45 filings in the second quarter. Given the relative filing slowdown after the first two months of the year, it may be that by year’s end the overall filing level may not remain at the relatively elevated levels that we saw in the first half. .

 

A surprising number of the first half filings involved companies domiciled or with their principle place of business outside the U.S. There were 18 filings in the year’s first six months against these non-U.S. companies, representing about 17.5% of all filings. This level of filings against non-U.S. companies is down from 2011, when 36.2% of all filings involved non-U.S. companies, but the filings against non-U.S. companies are still up from 2008-2010, when the filings against non-U.S. companies averaged about 13.4% of all filings.

 

The largest numbers of these filings involving non-U.S. companies related to companies domiciled in or with their principal place of business in China. There were seven of these suits against Chinese companies during the first half. In addition, there were three more companies that are headquartered or domiciled in Hong Kong but that have their operations in China .Taking all of these into account, there were ten China-related filings. This level of filing against China-related companies is down from 2011, when filings against Chinese reverse merger companies largely drove the filings during the year. The numbers of filings against Chinese-related companies in 2012 still is a little unexpected, as the wave of filings involving Chinese companies in 2011 was largely assumed to be a temporary phenomenon. To be sure, the filings against Chinese-related companies is down significantly from 2011. Nevertheless, the continued level of filings against Chinese-related companies is noteworthy.

 

It should be noted that there were also six filings against Canadian companies, many of them natural resources companies (about which see more below).

 

There were a number of “ripped from the headline” lawsuits in the first six months, including in particular the fillings during the first half against J.P. Morgan, Wal-Mart, Facebook and Netflix. Given the anemic rate of IPO activity during the first six months of 2012, the numbers of IPO related lawsuits are a little bit of a surprise. There were six suits involving IPO companies, including the high profile IPO fizzles Facebook and Groupon.

 

About 15% of the first half filings involved M&A related allegations, which while significant is down from 2011, when M&A related filings accounted for about 22.9% of all filings.

 

The first half securities suits were filed in 38 different district courts. The court with the largest number of filings in the year’s first six months was the Southern District of New York, which had 33 filings (or roughly a third of all filings in the first half). No other court had nearly as many filings. The courts with the highest filing levels after the Southern District of New York were the Central District of California (6); and the Northern District of California, Northern District of Illinois and District of Massachusetts, each of which had five filings. These top five courts together had more than half of all first half filings (52.42%).

 

Many kinds of companies were sued in securities suits in the first half. The companies involved were drawn from 62 different Standard Industrial Classification (SIC) code categories.  However, there were concentrations of filings in certain specific areas

 

The largest concentration of filings was in the 283 SIC code grouping (Drugs), where there were a total of 13 filings, included eight  in the 2834 SIC code category (Pharmaceutical Preparations). Another area of concentration was in the 384 SIC code group (Surgical, Medical and Dental Instruments), which had six filings. The single category within this group that had the highest number of filings was SIC code category 3845 (Electrochemical and Electromagnetic Apparatus). Taking all of these groups and categories together, there were a total of 19 filings against life sciences companies, or about 18.4% of all filings.

 

Outside of life sciences companies, the next highest concentration of filings was in the SIC code series from 1000 to 1400 (which includes mining and natural resources companies), in which there were 15 first half filings (about 14.5% of all filings). The largest single category with this group was SIC code category 1311 (Crude Petroleum and Natural Gas), which had eight filings.

 

Another group with a significant number of first half filings was the SIC code group 737 (Computer Programming and Data Processing), which had a total of eight filings. Finally, there were four filings in SIC code group 8200 (Educational Services),.

 

It is worth noting that there were only a modest number of filings in the 6000-level SIC code series (Finance Insurance and Real Estate). In recent years, subprime and credit crisis-related filings has driven filings among companies in these categories, which as recently as 2010 predominated all filings. However, during the first half of 2012, there were only ten filings against companies in these SIC Code categories, representing about 9.7% of all filings.

 

Discussion

The above comparison to historical filing levels is based on absolute numbers of filings. It could be argued that on a relative basis, the filing rate is actually increasing. According to data on the World Federation of Exchanges website, in the ten year period between January 1, 2002 and December 31, 2011, the number of companies trading on either NYSE or NASDAQ has declined by about 25% (from 6,586 to 4,900), yet in absolute terms the number of filings remains within about the same range (that is, around 200 per year). Relative to the declining numbers of public companies, the rate of securities class action lawsuit filings arguably is increasing.

 

The level of securities litigation activity involving mining and natural resources companies is interesting. Historically, companies in these categories have seen relatively little securities class action filing activity. The single largest factor in the increase of filing activity is litigation arising from M&A transactions. But litigation has also arisen due to the fluctuating pricing of minerals or petroleum; questions about mineral or petroleum reserves; or as a result of extraction mishaps, such as crude oil spills. It does seem as if the increased global competition for natural resources has made companies in these categories more vulnerable to securities class action litigation activity than they have been in the past.

 

There are some important aspects in which my analysis will likely vary from other published versions. There is a significant amount of judgment about what to include in the tally of filings and then about how to categorize the various filings. To use one example of this problem, it is unlikely that other published versions will show the same figures as I have for the number of China-related companies. There are a variety of ways these companies might be tracked, whether limited purely to Chinese domiciled companies, or broadened to also include companies that have their principal place of business in China or companies that have their principal business activities in China. I have used the most inclusive grouping, including within the group companies that have the business activities in China, even if they are not Chinese domiciled and even if they don’t have their principle place of business in China. This categorization may result in a larger tally of China-related companies than you may see published elsewhere. This same precaution about categorization applies equally to the more basic task of tallying up the lawsuit filings; due to differences in counting methodology, my tally is likely to vary from other published counts.

 

Failed Bank Litigation Fizzle?: A number of commentators, including even me, had been projecting that as 2012 progressed then numbers of FDIC failed bank lawsuits would escalate sharply. In the event, quite the opposite has happened, at least so far. In particular, during 2Q12, new FDIC filed bank lawsuit filings have slowed to a crawl.

 

As reflected on the FDIC’s website (here), during the first quarter of 2012, there were nine new FDIC lawsuits against the former directors and officers of failed banks, including four in March along. However, during the second quarter of 2012, the FDIC filed only three new failed bank lawsuits total. The agency filed no lawsuits at all during June.

 

It may well be that new failed bank lawsuit activity will pick back up in the year’s second half. Indeed. on its website, the FDIC indicates that a lawsuits involving a total 65 failed institutions have been authorized (inclusive of the 30 lawsuits involving 29 institutions that have already been filed), which suggests that there may be as many as 36 lawsuits that have been approved but not yet filed.

 

With all of these authorized lawsuits, it seems probable that new lawsuit filings will soon resume and that the period during the second quarter will turn out to have been a short-term lull only. Nevertheless, the relative dearth of new failed bank lawsuit filings during the second quarter is noteworthy and even a little puzzling.

 

The FDIC has in any event continued to take control of failed financial institutions during the first half of the year. There were a total of 31 bank failures during the period, which though well below the  pace of closures during the last few years, is still above even the annual total for 2008, where there were 25 bank failures during the entire year. In other words, even if the pace of failed bank litigation filing seems to have dipped during the second quarter, the problems associated with the current wave of bank failures continue to accumulate and the likelihood is that the fallout from the bank failures will have to be sorted out for years to come.

 

Collegiate Hunter Gatherers: An article in the July 2, 2012 issue of the New Yorker entitled “The Hunter Games” (here)  takes a look at the annual Scavenger Hunt at the University of Chicago known to the undergraduate students there simply as “Scav.” What began a few years ago as a modest diversion has grown into an enormous nerd ritual that exceeds traditional limits of normal human behavior. To cite but one example of the kinds of things the annual event leads to, the article mentions that “in 1999, for five hundred points, a pair of physics students built a working breeder reactor in a Burton-Judson dorm room in one day, converting thorium powder collected from inside of vacuum tubes into weapon-grade uranium, using a device made from scrap aluminum and carbon sheets. A concerned nuclear physicist attested to the machine’s efficacy.”

 

The list of objects to be found or constructed is devised by a group of judges, whose bylaws provide that the planning meeting “could not be adjourned while beer remained on the table.”  Here is a representative sample of a typical challenge: “Build a laptop charger using only materials available in the sixteenth century.” Another requirement is to create “a Scrabble game consisting of nonexistent words, for which the player has to supply definitions (‘mervifeet’ is a medical condition in which only the outer edges of the afflicted person’s feet touch the ground).”

 

The article catalogues the event’s sheer lunacy. However, the article also notes that, despite its “pervasive commotion,” only about ten percent of the undergraduate student body takes place in the event. Others consider it a distraction. The student newspaper parodied the kinds of items on the Scav search list with its own spoof list, including items such as: “Bite your own teeth. Birth a child that is larger than yourself.” One undergraduate is quoted in the article as saying that the Scav is “just really white and socially awkward,” adding that “there’s nothing wrong with being white and socially awkward, but as someone who is not white or socially awkward, it’s not exactly appealing to me.”

 

The Scav may not be universally popular, and it is undeniably a veritable nerd Olympics, but it still stands as an ironic contrast to the University of Chicago’s well-known tag (quoted in the article) that the school is the place “Where Fun Goes to Die.” The contestants come off in the article as brainy and humorous. And seriously odd.

 

When plaintiffs first filed their securities class action lawsuit against IndyMac Bancorp back in March 2007, the suit was one of the first of what later became a wave of subprime and credit crisis-related securities class action lawsuits. The suit itself, which has come to be known as the Tripp litigation, initially was dismissed and ultimately went through multiple rounds of dismissal motions. In March 2008, during the round of preliminary motions, and in what is the fifth largest bank failure in U.S. history, regulators closed IndyMac Bank. In August 2008, IndyMac Bancorp itself filed for bankruptcy. By the time all of these events had completely unfolded, including in particular the many rounds of dismissal motion rulings, the sole remaining defendant in the Tripp litigation was the company’s former CEO, Michael Perry.

 

According to papers filed in the Central District of California this week, Perry has now reached a settlement of the securities suit against him. As reflected in the parties’ June 26, 2012 stipulation (here), the parties have agreed to settle the case for a payment of $5.5 million. According to the stipulation, the settlement amount will be entirely funded from “insurance policies providing coverage to former officers and directors of IndyMac for the period March 1, 2007 through March 1, 2008.” The settlement is subject to court approval.

 

The litigation involving IndyMac’s former directors and officers includes not only this securities suit, but also a separate securities suit relating to IndyMac’s alleged misrepresentations regarding its exposure to Option ARM mortgages. In addition, there are two different FDIC lawsuits against former IndyMac executives. Indeed, the FDIC’s first lawsuit against former directors and officers of failed banks filed during the current wave of bank failures was filed against two former IndyMac executives (about which refer here). The FDIC also filed a separate lawsuit against Perry. The FDIC’s suit against Perry has been watched closesly as a result of the ruling in the case that Perry, as a former officer, is not entitled to rely on the business judgment rule under California law (the business judgment rule being construed by the district court as protective of directors only, not officers).

 

As noted in an accompanying post, as a result of a June 27, 2012 determination in the IndyMac insurance coverage litigation, there is insurance coverage if at all for these various lawsuits under the 2007-2008 insurance program, meaning that the various claimants in the various cases are in competition with each other for the proceeds of the 2007-2008 insurance program.  It is probably fortunate for the claimants in the Tripp litigation that the parties in the Tripp litigation were able to reach a settlement before the June 27 ruling in the insurance coverage litigation, as the competition for insurance under the 2007-2008 program could have even further complication the settlement of the Tripp litigation.

 

The stipulation provides that insurers from the 2007-2008 insurance program that will be funding this settlement may be required to seek the approval of the bankruptcy court in the IndyMac Bancorp bankruptcy proceedings in order to obtain the bankruptcy court’s approval to use the proceeds for the settlement. The stipulation adds that the parties to the settlement “expressly acknowledge and agree that all obligation of the Defendant with respect to the Settlement Amount are subject to the funding of such Settlement Amount by the Insurers,” adding that the Defendant “shall under no circumstances have an obligation to fund such amount from personnel assets.” The stipulation does provide that if the settlement amount is not paid according to the terms of the stipulation, the settlement is null and void.

 

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

 

One of the perennial D&O insurance coverage questions is whether or not subsequent claims are “interrelated” with a prior claim and therefore deemed first made at the time of the prior claim. This question can be particularly critical when the subsequent claims arose during a successor policy period; the answer to the “interrelatedness” question can determine whether the claims trigger one or two insurance programs.

 

In the wave of litigation that arose in connection with the subprime meltdown and the credit crisis, many of the organizations involved were hit with multiple lawsuits filed over period of time, and thus often presenting, in connection with the determination of the availability of D&O insurance coverage, the interrelatedness question.

 

A June 27, 2012 opinion in the D&O insurance coverage litigation arising out the collapse of IndyMac bank takes a close look at these issues. A copy of the opinion can be found here. In his opinion, Central District of California Judge R. Gary Klausner concluded, based on the relevant interrelatedness language, that a variety of lawsuits that first arose during the bank’s 2008-2009 policy period were deemed first made during the policy period of the bank’s prior insurance program, and by operation of two other policy provisions were excluded from coverage under the 2008-2009 program. Because of high profile of the IndyMac case and the sweeping reach of Judge Klausner’s opinion, his ruling could prove influential in the many of the other subprime and credit crisis cases presenting interrelatedness issues.

 

Background

IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).

 

As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation. The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division. There are a total of eleven separate lawsuits and claims pending. The first of these lawsuits was a consolidate securities class action lawsuit initiated in March 2007, which Judge Klausner refers to in his June 27 opinion as the Tripp litigation. (As noted in an accompanying post, the Tripp litigation has recently and separately settled.)

 

Prior to its collapse, IndyMac carried D&O insurance representing a total of $160 million of insurance coverage spread across two policy years, the first applying to the 2007-2008 period and the second applying to the 2008-2009 period. The insurance program in place for each of the two policy years consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance. The lineup of insurer involved changed slightly in second year.

 

In the insurance coverage litigation, the carriers in the 2008-2009 raised essentially three arguments: first, that the lawsuits and claims that arose during the 2008-2009 policy period were interrelated with the Tripp lawsuit, and therefore are deemed first made during the 2007-2008 policy period; that because the subsequent claims and lawsuits are interrelated with the Tripp lawsuit, which was noticed as a claim during the prior period, the subsequent claims and lawsuits are excluded from coverage under the 2008-2009 program under the applicable “prior notice” provision; and all of the subsequent claims are excluded from coverage under a specific exclusion endorsed onto the policies in the 2008-2009 program precluding coverage for claims related to the Tripp litigation. The former IndyMac officers and directors filed counterclaims contending that they were entitled to coverage under the 2008-2009 program. The various parties filed cross-motions for summary judgment.

 

The June 27 Opinion

In his June 27 opinion, Judge Klausner, applying California law, granted the insurers’ motions for summary judgment and denied the former IndyMac directors and officers cross-motions. Although his opinion is detailed, it boils down to his conclusions that each of the three sets of policy provisions at issue are unambiguous; that under each of the three sets of policy provisions, the subsequent claims are interrelated with the Tripp litigation; and by operation of the prior notice and Tripp litigation exclusions, all of the subsequent litigation is precluded from coverage under the 2008-2009 insurance program.

 

In concluding that the subsequent claims were interrelated with the Tripp litigation within meaning of the relevant language in the various policies, he noted that the policies’ definition of “interrelated wrongful act” is unambiguous and “describes a broad range of relationships between the original claim and other lawsuits that will be deemed as part of that same claim and made at the time of the first claim.”

 

The prior notice exclusion in the various policies, Judge Klausner noted, “describes a broad relationship between subsequent claims and claims that were made during prior policies such that these subsequent claims will be excluded from coverage.”

 

The Tripp litigation exclusion, Judge Klausner noted, is unambiguous and “excludes from coverage cases that have a broad range of relationships to the facts in the Tripp Litigation.”

 

Judge Klausner found that all of the subsequent claims and lawsuits “are sufficiently related to the Tripp litigation to be excluded under at least one clause of the [2008-2009] policies.”  The set of allegations that Judge Klausner found to be common among the various claims and lawsuits was the assertion that IndyMac failed to follow its underwriting standards and the resulting alleged issuance of high risk mortgages. Judge Klausner found that this commonality extended among the various suits and claims even if the specific allegations in a particular claim or suit “may fall outside the temporal scope of the Tripp litigation.”

 

Discussion

Judge Klausner’s opinion in this case is potentially significant, and not just because it means that the insurance under IndyMac’s 2008-2009 insurance program will not be available for the defense and settlement of the various subsequent claims. As I noted at the outset, many of the claims, lawsuits and disputes that have arisen in the wake of the subprime meltdown and the credit crisis present this same interrelatedness issue. Judge Klausner’s broad reading of the interrelatedness provisions, and in particular his willingness to interpret the policy provisions as not limited temporally but instead as having a broad meaning and reach, could prove influential.

 

It is important to note as an aside that Judge Klausner did not consider wording differences between the interrelatedness provisions in the “traditional” A/B/C policies and in the Side A policies in the 2008-2009 to be particularly significant (although, to be sure, he did note the differences). From an outcome determinative standpoint, the broad scope Judge Klausner gave to the interrelatedness provision could be the most significant feature. Because the interrelatedness language at issue, or substantially similar language, is found in most current D&O insurance policies, Judge Klausner’s analysis and the broad scope he gave to the policy language, could prove significant in a broad variety of other cases.

 

There is one aspect of Judge Klausner’s analysis that may limit its applicability to other disputes. That is that his ultimate conclusion that the various subsequent claims and lawsuits are precluded from coverage depended on the operation of all three of the policy provisions on which the insurers’ relied. It may be argues that it not enough for Judge Klausner to reach his conclusion that there is no coverage under the second tower that the subsequent claims were interrelated with the Tripp litigation; his conclusion that the subsequent claims were precluded from coverage also depended on the operation of the prior notice exclusion and the Tripp litigation exclusion arguably may distinguish this case from other interrelatedness disputes that may arise.

 

The practical effect of Judge Klausner’s decision is that there is insurance coverage, if at all, for the various subsequent claims under the 2007-2008 program. Although the 2007-2008 program represents a total of $80 million in insurance, the program has been eroded by over five years of attorneys’ fees in the Tripp litigation, as well as by the settlement of the Tripp litigation. The claimants in the various subsequent claims will now be in competition with each other for the remaining proceeds, while at the same time any amounts remaining will be further eroded by additional attorneys’ fees. The finite and dwindling amount of insurance and the sheer number of claims and claimants could make it challenging to resolve the claims and suits, at least to the extent insurance funds are to be involved. This observation is relevant to all claimants but it is probably worth noting that it is also applicable to the FDIC in connection with the two lawsuits the agency has filed in its role as IndyMac’s receiver against former officers of the bank.

 

A June 27, 2012 memo from the Wiley Rein law firm discussing Judge Klausner’s opinion can be found here.

 

I would like to thank the several loyal readers who sent me copies of this opinion. I appreciate everyone’s willingness to make sure that I am aware of significant developments so that I can pass them along to my readers.

 

Leading off the second day of the annual Stanford Directors’ College at Stanford Law School in Palo Alto, California was a keynote address from Delaware Chancellor Leo Strine. Strine is surprisingly outspoken and his presentation was lively and interesting.

 

The centerpiece of his presentation was a discussion of the lessons for directors based on the cases he has seen over the years. As a preliminary matter, and actually throughout his discussion of these issues, he emphasized that it is very rare that outside directors are actually held individually liable. He pointed out that, for example, cops, teachers and doctors are held liable much more frequently. But even if an outside director’s chance of being held liable is low, the chance of “looking like a chump” or that you have “failed your mission” is very high if you don’t watch out for certain things.

 

First, from the outset, the director should understand his or her role. In particular, if the director is unable or unwilling to make a decision adverse to management, they should not be in the position. The director also needs to understand the business, how it makes money and its principal risks. The director can’t be voting on things he or she does not understand. Where people tend to get in the most trouble is when they fail to do the work to understand the company and the specifics of the issues on which they are voting.

 

Second, conflicts of interest cause most of the worst trouble. Making sure that there aren’t interested parties involved in the object of board attention is critical. Along those lines it is vital that the board members remain independent, which can be compromised over time if a director’s relationship with the manager. The director needs to be sure that they he or she is still able to be adverse to management when that is what the situation requires.

 

Third, a very specific danger arises when directors are insufficiently skeptical of M&A activity originating within the company itself, particularly through a management buyout brought up when the company is otherwise not for sale or in play. Strine said that this is not the way a company should operate. If a CEO thinks there is a strategic move the company ought to be making, then the directors should be advised and guide the process. The CEO should not be taking advantage of inside information and tampering with employees and enlisting the company’s outside advisors in the interest of a management initiated buyout. (Stine was quite emphatic when he described the problem with this type of situation.)

 

Fourth, one the CEO’s key roles is preparing for management succession. Strine said that if the CEO has been in office three years and there is not a designated successor, the CEO has failed in one of his or her key roles. One of the most important jobs for the CEO is the “build the bench.” Strine cited the example of Johnson & Johnson, which has been a very successful company for decades with a succession of CEOs (all of whom who have been very low profile) that have continued to move the company forward.

 

In response to a question, Strine discussed the massive fee award he granted to the plaintiffs’ attorneys’ in the Southern Peru case. As discussed here, that case had resulted in an award of $1.263 billion, which with interest, approach nearly $2 billion. Strine awarded fees of $285 million, which he defended saying, the only reason the plaintiffs received the massive judgment in the case was the efforts of the plaintiffs’ lawyers. He said that he has much more trouble with cases like the disclosure-only merger objection suit settlement, where the plaintiffs’ lawyers wind up walking away with a $400,000 fee award.

 

The real problem is not a case where plaintiffs’ attorneys produce real value. If the plaintiffs has “delivered something really beneficial, they should be rewarded accordingly.” Rather, the problem is that there are too many incentives for plaintiffs’ attorneys to bring suits where the only beneficiaries are the attorneys. We have, Strine said, an “excess of litigation” that “has no meaningful societal benefit.” Strine commented that the extra costs associated with this litigation have caused the cost of capital for American companies to rise.

 

Strine rejected the suggestion that the Delaware courts might be managing fee awards because of a competition from other states’ courts. Strine stressed that Delaware’s courts are not “trying to attract litigation.” Just the same, he took care to question the effort of other states to try to develop specialized business courts. You can, he said, file suits in “goofy place” and what you will wind up with is corporate law that is “junk.” The movement to form specialized business courts has been “problematic” because all too often those courts have “become places where you can forum shop.” His view is that all courts, by their own account are “overburdened.” That being the case, Strine contends, the each court should “stay in its own lane.” When something is appropriately “in someone else’s lane, then let them do it.”

 

On Monday evening, the keynote speaker at dinner was the CEO of Netflix, Reed Hastings. Hastings also serves on the boards of Microsoft and Facebook. Hastings focused his discussion on the role of the board at very large publicly traded companies, taking pains to emphasize that he was not discussing the boards’ roles at smaller public companies, private companies or at non-profits.

 

Hastings said several times that for the board of a large publicly traded company “the fundamental job is to replace and compensate the CEO.” Where the company has the resources to hire outside consultants as needed, it is not the board’s role to offer counsel or advice. He was dismissive of new directors who come in and try to  “add value” by offering advice. He contends that board members offering advice creates a conflict of interest, because management might feel obliged to follow the advice even if it is poor and if the advice turns out to be mistaken, there is no accountability for the board member.

 

It is fair to say that Hastings remarks drew a very lively response from the audience. He emphasized in responses to questions from the audience that he was only talking the largest public companies, not other types of companies that might need the board’s involvement and guidance. He also said that he was not talking about companies in special circumstances where the situation might require the board to become much more involved. The interaction between Hastings and the audience might have been one of the high points of the conference for me. The audience was engaged in the discussion and Hastings was animated and articulate in discussing his position.

 

Hastings did tell one story from earlier in his career that is worth repeating here. He told the story to emphasize that a CEO must have both leadership qualities and a strategic vision. He said that when he first started working as a young software designer, he kept unusual hours and often had used coffee mugs strewn around his cubicle. He noticed that every few days the coffee mugs would appear on his desk, cleaned. He assumed the janitorial staff was cleaning the mugs. But one morning he arrived at the office at 4 am, and found the company’s CEO in the kitchen, cleaning Hastings’ coffee mugs. The CEO explained that he felt that Hastings did such great work, it was the least the CEO could do for him. Hasting said that this incident made him feel such deep personal loyalty to the CEO that Hastings would have “followed him to the ends of the earth” – which, Hastings said, is where the CEO led the company. It isn’t enough, Hastings said to be able to create a loyal work force, you also have to have a strategic vision.

 

For the record, Hastings did acknowledge that the whole Netflix pricing change was a mistake for which he took responsibility.

 

The D&O Diary is on assignment this week at The Stanford Directors’ College at the Stanford Law School in Palo Alto, California. As always, the conference is well-attended (it is, in fact, sold out, as usual) and the agenda is full of timely topics and interesting speakers.

 

The conference began on Sunday evening with opening keynote speech from Robert Greifeld, the CEO of the NASDAQ OMX group. NASDAQ is one of the event’s sponsors, and Greifeld joked  with conference co-Chair Joseph Grundfest that next year his firm would increase its sponsorship level so that he would not have to speak at the conference — a line that drew a knowing laugh from an audience that was all too familiar with the public discussion of the possible involvement of NASDAQ in the problems that surrounded the recent Faacebook IPO.

 

To Greifeld’s credit, he did not run from the topic of the Facebook IPO, and in fact it was the first issue he addressed. He acknowledged that a “design flaw” in NASDAQ’s IPO process allowed problems to come into the early trading, particularly with respect to the timing of order cancellations. He acknowledged that there may have been some “overconfidence” and even “arrogance” in the team that was running the IPO process because they were relying on procedures and routines that had been used in 480 IPOs over the course of several years without a problem.

 

In retrospect, Greifeld said, the pre-offering testing was not rigorous enough. He said that the company has tremendous pride in its technology group, but that perhaps the business unit because too “subservient” to the technology group, as a result of which, there was “not enough business judgment” in the process. He said that the company has reached out for external help from IBM to examine the trading process from an outside perspective. IBM will report at the end of July.

 

As for whether the events surrounding the Facebook IPO will undermine the market for IPOs generally, Greifeld acknowledged their may be some short run effects. However, he added, he expects that over time, IPOs will track the overall market. Over the medium and long term, the markets will mirror GDP growth in the economy, because the markets are tied to the fundamental economic health of the economy.

 

He did observe that the equity markets have had issues since 2008, as since that time there has been a “steady flow” of money from equity investments to fixed income investments – even though in the current interest rate environment, fixed income investments are effectively paying zero return. This, he notes, is not good news for the equity markets.

 

He added that the markets are now “fundamentally different” than they were ten years ago. They are much more fragmented with many more trading platforms, which has produced beneficial competition but has also led to fragmentation. These developments, and other recent developments such as dark pools and high frequency trading, are more beneficial to larger cap companies, because it can help to ensure that the spreads on trading in their securities are tight. For other companies, these developments are bad, and can affect the market liquidity in trading for their shares.

 

Today’s sessions began with a Keynote Presentation from Marc Andreessen and Ben Horowitz, the founders and general partners of venture capital firm Andreessen Horowitz. Andreessen is well known as the founder of early Internet browser company Netscape and Horowitz was the co-founder of Opsware (formerly Loudcloud). Their presentation was in a Q&A format, and one question they received provoked a particularly interesting answer.

 

In response to a question about how a Board should prepare a company for an IPO, Andreessen’s initial response was that the company should first consider every other possibility other than going public. He emphasized that the IPO process and the life for a company post-IPO has changed so much in recent years, that now a company completing an IPO is immediately surrounded by a host of constituencies all of which are prepared to try to extract a “pound of flesh” from the company. If the company has to go public, Andreessen would prefer that the company remains a “controlled” company – that is, subject to control by the founder. He explained that the way for investors to make money on technology investments is for the investors to pick a founder, like a Jeff Bezos, Sergey Brin or Michael Dell, and to make a long-term commitment to them to try to achieve their goals for the enterprise.

 

He went on to say that a faulty premise has emerged around corporate governance, in that there is now a perception that corporate governance ought to operate on basic principles of democracy, particularly as embodied on the “one man, one vote” principle. From Andreessen’s perspective, democracy is not the correct model. According to Andreessen, the correct analogy is the military, and specifically, war. In a wartime environment, politicians cede control to the military commanders so that they can deploy assets and take initiative necessary to “take the hill.” The objectives are more likely to be met if the founders retain control.

 

Horpwitz discussed a number of topics that he has previously addressed on his blog, Ben’s Blog. In particular, he discussed the difficulty for a yoind company to try to function with outside managers who are brought in from the outside for their management knowledge but who lack the institutional history and tribal knowedge of the entrepreneur found. In his view, it is easier to teack the entrepreneurial founder the basic principles of management than it is to try to teach the professional manager the firm history and tribal knowledge.

 

The conference continues to run though Tuesday, and I hope to be able to continue to report while I am here. On Tuesday, I will be participating in a session at the conference on the topic of Indemnification and D&O Insurance with my good friends Priya Cherian Huskins of the Woodruff Sawyer insurance brokerage firm, and Chris Warrior of Beazley. The complete program guide for the conference can be found here.

 

In a harsh June 21, 2012 opinion (here), Southern District of New York Judge Paul A. Crotty rejected the motion to dismiss of Goldman Sachs and three individual defendants in the securities class action lawsuit pertaining to the infamous “built to fail” Abacus CDO transaction and other ill-fated deals. Judge Crotty did, however, grant the defendants’ motion to dismiss with regard to the plaintiffs’ claims based on the company’s failure to disclose its receipt of a Wells Notice.

 

What makes the decision interesting, besides the sharpness of the Judge’s tone, is that in order to establish that Goldman’s alleged misstatements and omissions about its business ethics and conflicts of interest practices and policies are actionable, the plaintiffs relied on Goldman’s misstatements and alleged fraudulent conduct in connection with the Abacus transaction and three other CDO deals. Judge Crotty found that Goldman’s alleged conduct and statements in connection with the CDO deals made the statements to Goldman’s shareholders about its business practices and ethics materially misleading.

The order is also interesting because of the weight Judge Crotty gives to admissions Goldman made in the Consent it entered in its July 2010 agreement to settle the enforcement action the SEC had filed against Goldman about the Abacus transaction. As described here, in the Consent, in which Goldman neither admitted nor denied liability, the company “acknowledges” that the Abacus marketing materials “contained incomplete information” and that it was a “mistake” for the materials to state that the Abacus CDO reference portfolio was selected by ACA Management without disclosing the role of short-interest investor Paulson & Co. or that Paulson’s interests were adverse to those of the Abacus CDO investors.

These concessions fell short of an admission of fraud, but as Jan Wolfe notes in a June 22, 2012 Am Law Litigation Daily article about Judge Crotty’s decision (here), “if Goldman and its lawyers thought that this linguistic compromise would help it avoid trouble in shareholder suits, it turns out they were wrong.”

In addition to the Abacus transaction, the plaintiffs’ conflict of interest allegations also are based on three other CDO transactions – Hudson, Anderson and Timberwolf. With respect to the Hudson transaction, the plaintiffs allege that Goldman had said its interests were aligned with those of CDO investors based on a $6 million equity investment, while omitting that it also had a 100% short position at the time, representing a $2 billion interest.

With respect to the Anderson CDO transaction, Goldman stated that it would hold up to 50% of the equity tranche, worth $21 million, but omitted its $135 million short position. And with respect to the Timberwolf transaction, Goldman stated that it was purchasing 50% of the equity tranche, but failed to disclose that it was the largest source of assets in the structure and held a 36% short position in the CDO.

The plaintiffs claim that Goldman’s conduct, discloses and omissions with respect to these CDO transactions made a number of the company’s disclosures  to shareholders about its conflicts of interest policies and procedures and its commitment to legal compliance and ethics (including its commitment to “integrity” and “honesty”) materially misleading.

The defendants argued that these statements are non-actionable statements of opinion, puffery or merely corporate mismanagement. Judge Crotty called these arguments “Orwellian,” adding that:

Words such as “honesty”, “integrity”, and “fair-dealing” so not mean what they say; they do not set standards; they are mere shibboleths. If Goldman’s claim that “honesty” and “integrity” are mere puffery, the world of finance may be in more trouble than we recognize.

Judge Crotty concluded that Goldman’s conduct and disclosures in connection with the four CDO transactions “made its disclosures to its own shareholders, concerning its business practices, materially misleading,” adding that given “Goldman’s fraudulent acts, it could not have genuinely believed its statements” about its business practices and ethics. Goldman should not be able to “pass off” its “repeated assertions” as “mere puffery.” Moreover, Goldman’s “allegedly manipulative, deceitful and fraudulent conduct” in hiding its conflicts of interests in the four CDO transactions “takes the Plaintiffs’ claim beyond mere mismanagement.”

On the issue of scienter, Judge Crotty specifically relied on Goldman’s concessions in the SEC settlement, among other things, including internal emails. He noted that Goldman clearly played an active role in the Abacus asset selection process: “How else could Goldman admit that it was a ‘mistake’ not to have disclosed such information.” Crotty found that “given Goldman’s practice of making material misrepresentations to third-party investors, Goldman knew or should have known” that its statements about its conflicts of interest practices and business ethics “were inaccurate and incomplete.”

Judge Crotty also concluded that scienter allegations as to each of the individual defendants were sufficient, as each of them “actively monitored” Goldman subprime deals and assets and each knew that Goldman was “trying to purge those assets from its books and stay on the short side.”

Judge Crotty did, however, dismiss plaintiffs’ claims that Goldman had misled its shareholders by failing to disclose its receipt of a Wells Notice, noting that because a Wells Notice “indicates not litigation but only the desire of the Enforcement staff to move forward,” and therefore is a “contingency” that need “not be disclosed.” He also found that the plaintiffs’ had not shown that the company’s nondisclosure of the Wells Notice made the company’s prior disclosures about “ongoing governmental investigations” materially misleading.

Discussion

Judge Crotty’s opinion clearly quells any suggestion that Goldman’s SEC settlement – in which it made a number of admissions – offers an alternative to the “neither admit nor deny” SEC settlement approach which has proven so controversial. A frequent justification for the “neither admit nor deny” approach is that defendants can’t admit liability in an SEC settlement for fear the admissions will be used against them in related shareholder litigation. Some (including even Judge Jed Rakoff, who has been so critical of the neither admit nor deny settlements) had suggested that the Goldman settlement — in which the company admitted no fraud but only mistakes – offered a middle ground.

However Judge Crotty found that Goldman’s attempts to argue in support of its motion to dismiss the share holder suit that it had neither admitted nor denied liability in the SEC settlement were “eviscerated” by the company’s concession that it had made a “mistake” in not disclosing Paulson’s role in the Abacus transaction. The fact that the plaintiffs were able to rely on the company’s SEC settlement concessions, and that the concessions also entered directly into Judge Crotty’s analysis of both misrepresentation and scienter issues, eliminates the Goldman settlement approach as an enforcement action settlement alternative that other defendants might be able to accept.

It is interesting that so many of the misstatements or omissions on which the shareholder plaintiffs rely were not made directly to shareholders themselves, but rather were made to CDO investors. The misleading omission in statements to the CDO investors were relied upon to show that statements that were made to Goldman shareholders about the company’s business practices and ethics were misleading.

There is a particularly harsh aspect to Judge Crotty’s decision, in that the statements to shareholders to  which he referred in denying defendants’ motion to dismiss were the company’s statements about it business ethics and integrity. What makes this particularly troubling is that his assessment that these statements were misleading was not based – as would usually be the case at this stage of the proceedings – on plaintiffs’ mere unproven allegations. Judge Crotty’s conclusions were based, at least in part, on the company’s own admissions.

Goldman likely recognized long ago that this case might well survive a motion to dismiss. (The company wouldn’t have agreed to pay over half a billion dollars to settle the SEC enforcement action if it didn’t recognize that there were serious problems with the Abacus transaction, and in addition the separate state court fraud action brought by the bond insurer on the Abacus transaction had previously survived a dismissal motion.) Nevertheless, Judge Crotty’s opinion, and in particular the harshness of its tone, has to represent an unwelcome and troubling development.

One final note has to do with Judge Crotty’s ruling with regard to the Wells Notice nondisclosure allegations. The question of whether the receipt of a Wells Notice must be disclosed is frequently debated, and many companies, out of an abundance of caution, will disclose it. Judge Crotty’s conclusion that a Wells Notice represents a “contingency” that need not be disclosed will clearly be relevant for companies considering whether nor not they must disclose receipt of a Wells Notice, and may lead more companies to withhold disclosure of receipt of a Wells Notice.

I have in any event added the Goldman decision to my running tally of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here.

Professor Peter Henning has an interesting post about the Goldman decision on the Dealbook blog (here).

Is the Business Judgment Rule Available as a Defense for Corporate Officers: One of the questions that is receiving close scrutiny in the litigation the FDIC has filed against former directors ad officers of failed banks as part of the current wave of bank failures is whether or not corporate officers – as opposed to corporate directors – can rely on the business judgment rule as a defense to claims of ordinary negligence. As discussed here, at least one court has held under Georgia law that officers can rely on the business judgment rule to preclude claims for ordinary negligence.

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. The ruling in the FDIC lawsuit against former IndyMac CEO that Perry could not rely on the business judgment rule is on interlocutory appeal to the Ninth Circuit.

Because of this mixed case law, the June 7, 2012 ruling in the FDIC’s lawsuit against certain former officers of County Bank of Merced, California is of interest. In the decisions, which can be found here, 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.

However, with respect to the defendant officers’ efforts to rely on the common law business judgment rule, Judge O’Neill also denied the defendants’ motion to dismiss — but not on the basis that they could not rely on the business judgment rule; rather, he said only that “the business judgment rule is an affirmative defense which involves factual issues to preclude its application to dismiss the complaint’s claims.”

While Judge O’Neill did find that the defendants’ entitlement to rely on the common law business judgment rule is a factual issue, what he did not say is that the defendants were not entitled to rely on it as a matter of law. Which can be interpreted to suggest at least by negative inference that there is a common law business judgment rule separate and apart from the statutory provision, and defendants can rely on the common law rule, if they can establish as a factual matter that the qualify for the rule’s protection.

Hat tip to Alan Makins, who had a post about the ruling in the County Bank case in his California Corporate & Securities Law Blog, here.