The U.S. Supreme Court’s blockbuster opinion in Morrison v National Australia Bank has had an enormous impact, resulting as it has in the dismissal of numerous securities suits involving non-U.S. companies that previously would have been permitted to go foward in U.S. courts. But over time it has become clear that the Supreme Court’s opinion does not answer every question, which in turn has meant challenges for the lower courts in certain circumstances.  

 

In an interesting June 1, 2012 post on the Dealbook blog entitled “Securities Law Ruling Creates Unintended Problems” (here), Ohio State University law professor Steven Davidoff examines problems that have arisen following Morrison in two specific contexts – domestic ADR transactions and derivatives transactions. Davidoff’s column points out that a couple of appeals now pending in the Second Circuit could have an enormous impact on the reach of U.S. securities to these kinds of transactions. There will be much more to be said on these topics once the Second Circuit has ruled in the pending appeals. Though the pending cases could sort out many of these problems, it is still worth considering the problems Davidoff identified in his column now.

 

Just by way of background and to set the table for discussion of these issues, it is worth briefly reviewing Morrison’s holding. Prior to the Supreme Court’s holding in Morrison, the lower courts, it attempting to determine whether or not a specific transaction was within the jurisdiction of the U.S. securities laws, applied a “conduct and effects” test to determine whether or not there had been sufficient conduct in the United States or whether there were sufficient effects in the United States to support the exercise of jurisdiction under the U.S. securities laws.

 

As Davidoff points out in his column, the Morrison court “took a sledgehammer to decades of case law” and rejected the “conduct and effects” test. Rather, the Morrison court said, the U.S. securities laws apply only to “transactions in securities listed on domestic exchanges and domestic transactions in other securities.” Though a single test, this standard has two prongs, the first of which relates to transactions on U.S. securities exchanges, and the second of which applies to all other transactions. 

 

While the lower courts have applied Morrison aggressively, problems have nevertheless arisen, particularly with respect to the meaning of the second prong. What, after all, is a “domestic transaction in other securities”? As I discussed in a prior post (here), in its March 2012 decision in the Absolute Activist Value Master Fund Limited v. Ficeto case, the Second Circuit took an active step to try to define what makes an off-exchange transaction sufficiently “domestic” for the U.S. securities laws to apply. The court said in order to establish the existence of a domestic transaction in other securities, a plaintiff “must allege facts suggesting that either irrevocable liability was incurred or title transferred within the United States.”

 

Davidoff correctly points out that the Absolute Activist Value Master Fund case could have a significant impact on the Porsche case now pending on appeal in the Second Circuit. (Refer here for background on the Porsche case.)  In the Porsche case, the lower court had dismissed a securities lawsuit brought by numerous hedge funds that entered various swap transactions in the U.S. The lower court had held that because the swap referenced a security traded on a German exchange, they were “the functional equivalent of trading the underlying VW shares on a German exchange.” The Absolute Activist Value Master Fund case suggests that rather than looking where the referenced securities trade, the proper inquiry should be on the swap transactions themselves, and whether or not “irrevocable liability” in the swaps transactions was incurred or title was transferred in the U.S.

 

Davidoff notes an ironic aspect of the Absolute Activist Value Master Fund holding, which is that it seems to require an inquiry about where conduct took place – in effect, it could be argued, reinstating a kind of a “conduct” test in order to determine the applicability of Morrison’s second prong, even though Morrison itself expressly rejected the “conduct and effects” test that previously had applied in the Second Circuit. This is an interesting observation. However, the “conduct” referenced in the old “conduct and effects” test was the allegedly fraudulent misconduct, not transactional conduct. So even if the Absolute Activist Value Master Fund holding requires an inquiry into the location of conduct, it is not the same test, because it attempts to determine where the deal took place, not where the misconduct took place.

 

Davidoff also comments that the Absolute Activist Value Master Fund holding raises a number of unanswered questions, “including what it means to incur irrevocable liability in the United States, whether a purchaser of a security from a foreign entity by an American is enough, and what happens to the foreign purchaser of unlisted American securities.”

 

I agree with Davidoff that the Absolute Activist Value Master Fund decision raises a number of questions, and also that before all is said and done, the U.S. Supreme Court may need to weigh in again in order to explicate Morrison’s second prong. However, at the same time, I think it is fair to point out that the Absolute Activist Value Master Fund decision actually answers a number of the questions Davidoff raises.

 

In emphasizing that the inquiry to determine whether or not the U.S. securities laws apply should be focused on the transaction itself, the Second Circuit rejected the arguments that the nationality of the parties to the transaction or even the identity of the security involved mattered in the determination. The Second Circuit said that “rather than looking to the identity of the parties, the type of security at issue, or whether each individual defendant engaged in conduct within the United States, we hold that a securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed with the United States.” That is, the Second Circuit’s opinion does, it seems to me, answer at least some of the questions Davidoff identifies as unanswered.

 

Davidoff also objects to the Absolute Activist Value Master Fund Limited opinion on the grounds that it “could lead to absurd results with foreigners flying into the United States to purchase derivatives on foreign securities to create jurisdiction.” I have a different interpretation of the implications of the case. My own view is that the decision provides some highly desirable risk management guidance for non-U.S. parties seeking to avoid the risks and uncertainties of U.S. securities litigation. By managing the location of essential events of financial transactions, participants in cross-border transactions can avoid U.S. securities litigation exposures. That is, rather than parties conniving to bring their transactions within the reach of the U.S. securities laws as a result of this decision, I envision parties taking prudent steps to ensure that their cross-border transactions do not wind up in U.S. courts – which many non-U.S. investors and entities doubtlessly would view as a highly desirable thing.

 

Davidoff correctly points out that there is a tension between the Second Circuit’s holding in the Absolute Activist Value Master Fund decision and Judge Berman’s opinion in the Société Générale case, in which Judge Berman, applying Morrison, held that the U.S. securities laws do not apply to ADR transactions on the U.S. exchanges. (For background regarding the Société Générale decision, refer here.) Judge Berman reasoned that because the ADR represents the foreign company’s underlying shares, an ADR transaction is “predominately a foreign transaction.” (The Société Générale opinion is also now on appeal in the Second Circuit.)

 

However, I think is important to note that, at least to my knowledge no other court has followed Judge Berman’s decision in the Société Générale case. To the contrary, numerous other courts have concluded that the U.S. securities laws do apply to domestic ADR transactions. Indeed, at least two other rulings in the Southern District of New York have allowed securities claims brought by domestic ADR purchases  to proceed – in the Vivendi case (refer here) and in the RBS case (refer here). Similarly, in the BP securities litigation pending in the Southern District of Texas and arising out of the Deepwater Horizon disaster, the court allowed the securities claims of domestic ADR purchasers to go forward. Taking these other results into account, there may be less inconsistency in the lower court decisions than Professor Davidoff’s column might suggest.

 

Of course, none of us can know for sure what the Second Circuit may do in the pending appeal in the Société Générale case or in the pending appeal in the Porsche case. But I think it is fair to point out that the lower courts have generally held that the U.S. securities laws apply when the place of the transaction is in the U.S, regardless of the identity of the security or the nationality of the parties involved. If, as Morrison requires, the focus of the inquiry is on the place of the transaction, then the U.S. securities laws should apply to domestic ADR transactions, regardless whether issuers’ common shares are listed elsewhere – just as the U.S. securities laws should apply to derivative transactions that take place in the U.S, regardless  whether the referenced security trades elsewhere. In other words, it seems possible that these post-Morrison problems could soon be sorted out.

 

Securities Suit Against U.S.-Listed Chinese Company Dismissed: In a May 31, 2012 ruling (here), Central District of California Judge George Wu granted without prejudice  the motion of defendants’ to dismiss the securities suit shareholders filed against A-Power Energy Generation Systems Ltd, certain of its directors and officers, and its auditor. The plaintiffs have been given until July 16, 2012 to file an amended complaint.

 

As discused at greater length here, the plaintiffs filed suit against the defendants in July 2011, alleging that the company’s operataing subsidiaries’ filings with a regulatory agency in  China (the SAIC) reported substantially less revenue and net income than the company reported on its SEC filings. The plaintiffs also alleged that the defendants had misrepresented certain related party transactions.

 

In granting the motions to dismiss with respect to the financial reporting discrepancies, Judge Wu said that, because the plaintiffs’ complaint does not allege whether the allegedly conflicting reports were prepared in compliance with the same financial reporting standards. "Plaintiff does not appear to h ave alleged that compliance with PRC’s GAAP is even required when filing with the SAIC or that A-Power’s subsidiaries preparaed their filings in complinace with GAAP." Without these allegations, "it is not clear to the Court that Plaitiff has adequately falsity" as the Court "would have no way of knowing whether it was comparing apples-to-apples or instead apples-to-oranges" and "Plaintiff would not have satisfactorily alleged why the SEC filings were false as opposed to the SAIC filings." 

 

The Court also granted the auditor’s motion to dismiss, stating that "at best, plaintiff has painted a picture of a negligent or grossly negligent auditor," but that "does not amount to stating a claim for securities fraud."

 

A Dearth of Consolation for Sorrows to Come: The headlines in Saturday’s issue of the Wall Street Journal were full of dire warnings and troublesome portents. “Euro-Zone Reports Deepen Gloom,” one article was titled. Another was headed “Asia Weakness Heightens Fear of Contagion.” Yet another read “Brazil Loses Steam as World Slows.” Reading the paper was an altogether depressing experience. But as discouraging as these news reports were, there was still more sad news.

 

A front page article in the Saturday Journal entitled “Spring is No Bowl of Cherries for Michigan Growers” (here) explained that due to the “freakish” weather in March, with its stretch of balmy weather followed by a hard freeze, Michigan’s entire crop of cherries has been wiped out. It is sad news indeed that even before the season has even begun, one of summer’s greatest delights has been completely precluded.

 

Cherries are one of life’s great pleasures. As my son said when a small boy and enjoying a fistful of the fruit, “Cherries make me happy.” But as good as cherries are anywhere, they are a sublime treat when eaten fresh on a July afternoon on sandy beach on the shores of Lake Michigan.

 

We all knew when we were basking in warm sunshine in mid-March that there we were going to pay for it somehow. Now we know one of the bills we have to pay. It is even worse that the whole world seems to be going to hell in a hand-basket. If the Eurozone blows up this summer the situation will be dire, and we won’t even be able to draw upon the consolation that can be found in a bowl of cherries.  Alas.

 

In a May 31, 2012 study of the FDIC failed bank litigation that contains a number of interesting observations and projections, NERA Economic Consulting projects at the current filing rate, the FDIC’s failed bank litigation ultimately could total 86 lawsuits, or much as 20% of all banks that have failed as part of the current round of bank failures. The study, which is entitled “Trends in FDIC Professional Liability Litigation,” can be found here.

 

The NERA study is based on its analysis of all failed bank lawsuits through the end of the first quarter of 2012, at which time there were 27 lawsuits involving 26 failed banks. (Through May 30, 2012, there have been a total of 30 lawsuits involving 29 institutions.)

 

Based on lawsuit filing patterns through March 31, 2012, NERA projects that ultimately the FDIC will file 86 lawsuits in total, representing about 20% of all bank failures. Through the end of the first quarter, the FDIC had authorized lawsuit against 54 institutions, suggesting that the FDIC had authorized about 60% of the number of lawsuits that NERA projects the FDIC will file. (After the end of 1Q12, the FDIC increased the number of authorized lawsuits; through May 15, 2012, the FDIC had authorized lawsuits involving 63 failed institutions, or about 73% of the number of lawsuits that NERA projects ultimately will be filed.)

 

The 20% filing rate that NERA projects is slightly less than the 24% filing rate following the S&L crisis. However, despite this lower projected filing rate, NERA projects that the FDIC’s aggregate recoveries could approach recoveries during the S&L crisis. The recoveries following the S&L crisis totaled $1.3 billion, or $2.3 billion in inflation adjusted terms, while NERA projects aggregate recoveries from the current round of bank failure litigation of about $1.9 billion.

 

The NERA report notes that the banks failures that produced the largest losses to the deposit insurance fund are more likely to be the subject of litigation. Bank failures that caused losses to the deposit insurance fund of greater than $200 million have filing rates of 62%, while bank failures that produced losses to the deposit insurance fund of under $50 million have a filing rate of only about 3% For bank failures that produced deposit insurance fund losses of between $50 million and $200 million, the filing rate has been about 19%.

 

The lower filing rate with respect to banks whose failure caused deposit insurance fund losses under $50 million could impact the number of future filings, Since the third quarter of 2010, the average deposit insurance fund losses per failed institution has dropped significantly, and for many of the banks that have failed most recently, the losses were below $50 million, suggesting a much lower likelihood that many of the most recent bank failures ultimately will involve litigation.

 

On the other hand, NERA’s analysis suggests that litigation involving some of the largest bank failures to date has yet to be filed, especially when the aggregate losses claimed in lawsuits already filed is compared to the FDIC’s projection of aggregate losses involved in all authorized lawsuits. NERA reckons claims involving some of the largest failed losses may be about to be filed. In terms of losses to the deposit insurance fund, the four largest bank failures that have not yet seen litigation are BankUnited ($5.8 billion in deposit insurance fund losses); Colonial Bank ($4.2 billion); Amtrust Bank ($2,5 billion); and United Commercial ($2.5 billion).

 

Comparing the bank failures by state to the lawsuits filed so far by state, the NERA report suggests that there have been relatively high litigation levels in Illinois, Nevada, North Carolina, and Puerto Rico, while filings in California and Florida are fewer than the number of bank failures in those states would suggest. In Minnesota, Missouri and Arizona, there have not yet been any lawsuits filed even though those states are among the top ten in terms of bank failures. However, the study notes based on the date of bank failures in those states that litigation involving failed banks in those states is not projected until after the end of the first quarter of 2012.

 

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.

 

Title II of The Dodd-Frank Wall Street Reform and Consumer Protection Act provides for “orderly liquidation authority” for the FDIC to act as a receiver of failed “systemically important” financial institutions. Section 210(s) of the Act permits the FDIC to recover compensation from any senior executive or officer deemed to be “substantially responsible” for the failure of the financial institution. The FDIC may clawback all compensation the executive or director received during the tw0-year period preceding the FDIC’s appointment as receiver.

 

In response to these provisions, at least one industry participant introduced a new insurance product designed to provide protection against these new compensation clawback measures. The new insurance product was not only intended to provide protection for the costs of defending against a clawback action, but also “indemnification for damages sought by the FDIC “for “ earned salaries, wages, commissions, benefits, or other compensation obligations repudiated and recouped by the FDIC.

 

In public statements about this new product, a spokesman for the company that introduced it conceded that product could “possibly” provide indemnification for these clawbacks “if they’re insurable under the law," adding that "the basic premise, of course, (is that) you’re not going to be able to insure something that the law says is not insurable,"

 

As least as interpreted in news coverage of Rep. Frank’s introduction of the bill, the proposed Act appears to be expressly addressed to this compensation clawback insurance product. 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.”

 

However, the proposed Act’s provisions reach more broadly than just the Dodd-Frank orderly liquidation authority clawback provisions. 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 proposed Act provides in Section 2 that an officer, director, employee or “institution-affiliated party” of “a depository institution, depository holding company or nonbank financial company” who is required by law “to repay previously earned compensation or pay a civil money penalty” shall be “personally liable for the amounts so owed” and “may not , directly or indirectly insure or hedge against, or otherwise transfer the risks associated with, personal liability for the amounts so owed.”

 

The proposed Act provide further that the Section 2 is not intended to preclude a person from “being provided funds necessary to defend against a previously earned compensation recovery,” either from the company itself or “under an insurance policy.” The proposed Act also specifies that the Act is not intended to preclude a person from obtaining insurance against being held personally liable for “penalties, judgments or other amounts assessed against a depositary institution, depositary institution holding company, or nonbank financial company.” The Act is also not intended to prohibit insurance for personal liability against “unintentional outcomes associated with the ordinary exercise of trade or business judgment”

 

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 was 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.

 

With respect to the Act’s provisions relating to compensation clawbacks, it is worth noting that the provisions prohibit insurance only with respect to the returned compensation. The proposed Act expressly allows insurance for defense costs. The insurance industry’s working presumptions about the FDIC’s clawback authority generally has been that the company’s traditional D&O insurance would, all else equal, provide defense cost protection, but that the traditional policy would not cover the returned compensation amounts. In other words, Rep. Frank’s proposed bill would not appear to change the insurance coverage arrangements that would likely apply in most situations. The bill seems only to change things with respect to the recently introduced new insurance products that promised provide insurance protection for the returned compensation.

 

Finally, it is probably worth noting that the proposed Act by its own terms applies only to corporate officials as depositary institutions, depositary institution holding companies and nonbank financial companies. Accordingly, the proposed bill would not seem to have any impact on the vast run of companies, one way or the other.

 

In a May 25, 2012 decision in a long-running case that, among other things, could have important implications for the lawsuits recently filed against Facebook, the Second Circuit reversed the lower court’s dismissal of the securities suit involving Ikanos Communications, holding that the plaintiff’s proposed amended complaint “plausibly alleged that the [undisclosed] defects constituted a known trend or uncertainty that the Company reasonably expected would have a material unfavorable impact on revenues.” A copy of the Second Circuit’s May 25 opinion can be found here.

 

Background

As discussed at greater length here, the Ikanos lawsuit relates to problems the company was having with defects concerning certain of the company’s semiconductor chips at or about the time the company completed a $120 million secondary offering in March 2006. The plaintiffs allege that the company first learned there were quality issues with the chips in January 2006. They allege that the issues became more pronounced in the weeks leading up to the offering, as the company received more complaints. The complaint alleges that the company’s board discussed the problems.

 

The plaintiffs allege that the company’s offering documents did not disclose the magnitude of the defects issue. Ultimately, the company determined that the particular chips had an “extremely high” failure rate, and the company agreed to replace all of the units it had sold. The company later reported a net loss, and its share price declined. After the company’s CEO resigned, plaintiffs filed suit.

 

The district court dismissed the plaintiff’s initial complaint for failure to state a claim, concluding that the “no plausibly pleaded fact suggests that Ikanos knew of should have known of the scope of the magnitude of the defect problem at the time of the Secondary Offering.” The plaintiff moved for reconsideration, offering a proposed amended complaint, which included the specific allegation that the defect problem was becoming more pronounced in the weeks leading up to the offering. The district court denied the motion for reconsideration, reiterating the view that no plausibly pleaded fact suggested that the company knew of should have known of the magnitude of the defect problem at the time of the offering.

 

The plaintiffs appealed. In a September 2009 Summary Order, the Second Circuit vacated the district court’s judgment denying the motion for reconsideration, noting that “it seems to us plausible that [the plaintiff] could allege additional facts that Ikanos knew the defect rate was above average.” The Second Circuit urged on remand for the district court to “consider all possible amendments.”

 

On remand, the district court again denied the plaintiffs leave to replead, finding that the plaintiff’s proposed amended complaint failed to allege that the company knew that prior to the offering that the defect rate was above average. The plaintiffs again appealed.

 

The May 25 Opinion

In a May 25, 2012 opinion written by Judge Barrington Parker, Jr.  for a three-judge panel, the Second Circuit reversed the district court and remanded the case back to the district court.

 

The Second Circuit said that in focusing on whether or not the defect rate was known to be above average prior to the offering, the district court had focused on the wrong issue. Rather, the district court should have “addressed the question of whether, in failing to disclose the scope of the defect issue with which Ikanos was then grappling, defendants concealed a ‘known trend or uncertainty that {Ikanos] reasonably expected would have a material unfavorable impact on revenues or income” as was required by Item 303 under Regulation S-K.

 

The Second Circuit said:

 

We believe that, viewed in the context of Item 303’s disclosure obligations, the defect rate, in a vacuum, is not what is at issue. Rather, it is the manner in which uncertainty surrounding that defect rate, generated by an increasing flow of highly negative information from key customers, might reasonably be expected to have a material impact on future revenues.

 

Citing its own February 2010 opinion in Litwin v. The Blackstone Group, the Second Circuit held that the plaintiff’s proposed amended complaint “plausibly alleges that the defect issue, and its potential impact on Ikanos’s business, constituted a known trend or uncertainty that Ikanos reasonably expected would have a material unfavorable impact on revenues or income from continuing operations.” The plausible inferences were not simply that it might have to replace a large number of chipsets; rather it was that  there were a number of “known uncertainties” that could materially impact revenues. The Court said that it had “little difficulty concluding” that the plaintiff had “adequately alleged that the disclosures concerning a problem of this magnitude were inadequate and failed to comply with Item 303.”

 

Discussion

This decision obviously represents a significant victory for the plaintiff in the case, as the plaintiff has after a series of long procedural battles secured the right to go forward with their case. The decision also represents a demonstration of the usefulness to securities plaintiff of pleading in reliance on Item 303 that a company failed to disclose a known risk, trend or uncertainty. As Lyle Roberts observed on his blog The 10b-5 Daily at the time when the Second Circuit issued its opinion in Litwin v. The Blackstone Group, on which the Second Circuit relied in the Ikanos decision, pleading in reliance on Item 303 may represent an attractive opportunity for plaintiffs.

 

The Ikanos decision illustrates the attributes that make Item 303 attractive to plaintiffs. The Second Circuit was not as concerned whether or not the plaintiff’s allegations were factually specific (as would relate, for example to the known defect rate). Rather the court was more concerned that the plaintiffs had alleged that there were “known uncertainties” that could materially impact revenues.

 

The defendants’ argument in this case that there were no allegations that the defect rate was “above average,” and therefore there was no need for further disclosure of the defect reports, has echoes of the argument that the U.S. Supreme Court rejected in the Matrixx Initiatives case (about which refer here) . The defendants had argued in that case that adverse product reports must be "statistically significant" in order for a manufacturer to have an obligation to disclose the reports to investors. In both the Supreme Court’s Matrixx Initiatives decision and the Second Circuit’s ruling in Ikanos, the courts rejected the argument that there is a mathematically identifiable threshold that determines whether or not disclosure of adverse information is required.

 

One very recent and high profile case in which this line of cases could prove to be helpful is the securities litigation filed last week in connection with the Facebook IPO. In the complaints filed so far, the plaintiffs’ main allegation is that Facebook failed to disclose in its IPO offering documents that it was experiencing a reduction in revenue growth due to an increase of users of its Facebook app or website through mobile devices rather than traditional PCs. The plaintiffs further allege that this information was selectively disclosed to key institutional investors but not to the investing public.

 

The Facebook  plaintiffs (or at least those that are proceeding in the S.D.N.Y., which is within the Second Circuit) will allege that this revenue downturn was material and should have been disclosed; they will argue further in reliance on Ikanos and Litwin that the question is not whether the extent of the revenue downturn was precisely known and undisclosed; the question rather should be whether the revenue downturn represented a known trend or uncertainty that could material impact the company’s results.

 

Of course, it remains to be seen whether and to what extent this line of cases will prove to make a difference in the Facebook case itself. But the cases could be valuable for plaintiffs in general in securities  cases where the plaintiff allege that the defendant company failed to disclosure a known risk, trend or uncertainty. It seems likely that these cases will encourage plaintiffs to rely on Item 303 in pleading their claims.

 

Victor Li’s May 25, 2012 Am Law Litigation Daily article about the Ikanos decision can be found here. Special thanks to a loyal reader for sending me a copy of the Second Circuit’s opinion.

 

Judge Kaplan Approves $90 Million Lehman Brothers D&O Settlement: As I discussed in a prior post (here, scroll down), Southern District of New York Judge Lewis Kaplan had stirred some attention through his initial refusal to approve a proposed $90 million settlement of the Lehman Brothers securities class action suit – a settlement to be funded entirely with D&O insurance, without the individual defendants making a cash contribution – and directing the parties to provide to him the information an independent expert had reviewed in concluding that the individual defendants did not have aggregate liquid net worth in excess of $100 million.

 

Lead plaintiffs’ counsel had offered the expert’s report in support of their contention that the plaintiff’ class would not be better off if the lead plaintiff continued to pursue the individual defendants rather than just accepting the remaining $90 million D&O insurance in settlement of the case. Judge Kaplan felt that in order to determine the appropriateness of the settlement, he needed to review in camera the financial information on which the expert relied.

 

In a May 24, 2012 opinion, written following his review of the financial information, Judge Kaplan approved the proposed $90 million settlement. With respect to financial information he reviewed, Judge Kaplan said:

 

The Court has reviewed the essential documents filed in camera in order to make a practical judgment about whether it is reasonable to compromise this case, rather than pursuing it, in light of both the likelihood of ultimate success and the likelihood in the event of success of collecting the eventual judgment give the resources of those defendants as to who information is reasonably available. While some may be concerned at the lack of any contribution by the former director and officer defendants to the settlement, Lead Counsel’s judgment that the $90 million bird in the hand is worth at least as much as in the bush, discounted for the risk of an unsuccessful outcome of the case, is reasonable.

 

Susan Beck’s May 25, 2012 Am Law Litigation Daily article about Judge Kaplan’s order can be found here.

 

The Latest FDIC Failed Bank Lawsuit: In what is the first failed bank lawsuit the FDIC has filed in several weeks, on May 24, 2012, the FDIC as receiver of the failed Innovative Bank of Oakland, California filed a complaint in the Northern District of California against 14 of the bank’s former directors and officers. A copy of the FDIC’s complaint can be found here.

 

 

Innovative Bank failed on April 16, 2010. In its lawsuit, the FDIC seeks to recover “not less than $7.1 million” the FDIC alleges the bank lost in connection with lending activities on eleven commercial loans and forty-three Small Business Administration loans. The complaint asserts claims for negligence, gross negligence and breach of fiduciary duty against the individual defendants, and also asserts fraud against one officer defendant, as discussed below.

 

The complaint alleges that the defendants “in violation of repeated and serious regulatory warnings, were grossly negligent and in breach of their fiduciary duties by failing to supervise the lending function at the Bank,” and were negligent, grossly negligent and in breach of fiduciary duties by “repeatedly permitting unsound underwriting practices and violations of written loan policies.”

 

The complaint also alleges claims of $3.3 million against one officer defendant for his “perpetration of a fraudulent scheme within the Bank’s SBA program for his own financial gain.” Two other defendants, the Bank’s CEO and Chief Lending Officer, are separately charged with negligence and gross negligence for hiring the lending officer who is accused of fraud and for retaining him as an officer “despite serious red flags and concerns being raised about the performance of his duties.”

 

This latest lawsuit is the 30th the FDIC has filed so far as part of the current wave of bank failures, but the first that the FDIC has filed since April 20, 2012. Earlier this year there had been a flurry of FDIC litigation filings but for the last several weeks there had been something of a lull. The FDIC has continued to increase its web site listing of the number of authorized suits (about which refer here), by implication increasing further the backlog of cases yet to be filed. In any event with this new lawsuit, the FDIC has now filed 12 lawsuits this year. The latest lawsuit is the sixth that the agency has filed in connection with failed banks located in California.

 

Special thanks to a loyal reader for providing a copy of the FDIC’s latest complaint.

 

According to the FDIC’s Quarterly Banking Profile for the first quarter of 2012, which can be found here and which was released on May 24, 2012, the banking industry generally continues to show improvement. The industry’s aggregate profits are up, and the industry is shedding bad loans, bolstering net worth, and increasing profitability. In addition, the number of banks that the FDIC ranks as “problem institutions” continues to decline. The FDIC’s May 24, 2012 press release about its Quarterly Banking Profile can be found here.

 

According to the report, as of March 31, 2012, there were 772 problem institutions, compared to 813 as of the year-end 2011, and 888 as of year-end 2010. (A “problem” institution is a bank to which the FDIC has rated as either a “4” or a “5” on the agency’s 1-to-5 scale of ascending order of supervisory concern. The FDIC does not identify the problem institutions by name.) The quarterly decline in the number of problem institutions represents about a 5% drop, and the decline during since March 31, 2011 represents about a 13% drop.

 

According to the FDIC, the 1Q12 decline in the number of problem institutions represents the fourth consecutive quarterly decline. The number of problem institutions is now at its lowest level since year-end 2009.  The assets of “problem” banks fell during the first quarter from $319 billion to $292 billion. As recently as the end of 2009, the problems institutions assets’ were as much as $402 billion.

 

Though the total number of problem institutions has declined, the number of reporting institutions has also continued to decline (due to mergers and closures). The 772 problem institutions represent about 10.5% of all reporting institutions as of March 31, 2012. Even though that is the lowest absolute number of problem institutions since year-end 2009, the 702 problem institutions as of year-end 2009 represented only about 8.5% of all reporting institutions at that time. Thus, though the total number of problems institutions has declined, as a percentage of all institutions the number of problem institutions remains at elevated levels.

 

In other words, the declining number of problem institutions does not necessarily mean that the number is declining because of improvement among problem institutions. In larger measure, the number of problem institutions is declining because many of the institutions formerly assessed as problems simply no longer exist, whether as a result of mergers or closures.

 

On a more positive note, the 16 bank failures during the first quarter of 2012 represents the smallest quarterly number of bank closures since the fourth quarter of 2008, when there were 12 bank failures. The 16 bank failures in 1Q12 compares to the 26 bank failures in the first quarter of 2011. (As of today, there have been a total of 24 bank failures so far during 2012, compared with 43 YTD bank failures on the same date in 2011).

 

The decline in the number of banking institutions during the current banking crisis really has been remarkable. As recently as year-end 2007, there were 8,649 reporting institutions. The 7,307 institution remaining as of March 31, 2012 represents a decline of 1,342 banking institutions, or a decline of about 15.5% during that period.

 

The remaining 7,307 banking institutions are largely concentrated in the community banking space. As of March 31, 2012, 6,643 (or about 90.9%) of the 7,307 remaining banks had assets less than $1 billion. Only about 107 institutions (or 1.5% of all institutions) had assets of $10 billion or greater.

 

While the number of problem institutions and failed institutions has been declining, the FDIC has been increasing the number of lawsuits it has authorized against the former directors and officers of failed institutions. As of the FDIC’s latest update on May 15, 2012, the FDIC has authorized suits in connection with 63 failed institutions against 549 individuals for D&O liability. This includes the 29 lawsuits involving 28 institutions that the FDIC has already filed, naming 239 former directors and officers. The implication is that there are many more lawsuits in the pipeline – although interestingly, the FDIC has not filed any new lawsuits in over a month. The last lawsuit that the FDIC filed was filed on April 20, 2012.

 

“The Most Serious Natural Resources Shortage You’ve Never Heard Of”: We can live without oil, but we can’t live without food. For decades, the world has been able to feed a growing population by using phosphorus-rich fertilizer to increase crop yields. The problem is, we are running out of phosphorous.

 

My research biologist brother-in-law has been telling me for years about the dwindling supplies of phosphorus. The looming phosphorus shortage is the subject of an April 20, 2012 article in Foreign Affairs entitled “Peak Phosphorus” (here), which warns that there “will not be sufficient phosphorus supplies from mining to meet agricultural demand within 30 to 40 years.” The consequences of the looming shortage will be felt long before the supplies finally run out. Even in the short run, increased demand and decreasing supplies “will result in higher prices, significantly affecting millions of farmers in the developing world who already live on the brink of bankruptcy and starvation.”

 

Tensions about control over phosphorus supplies have already been the source of significant issues involving Morocco (where the largest number of phosphorus mines are located) and Western Sahara, a disputed independent territory that is Morocco currently occupies. China, the country with the second largest reserves, has already once resorted to trade tariffs that effectively eliminated exports in 2008, which was a contributing factor to dramatically rising food prices that year. While the U.S. historically has been a leading source of phosphorus, the supplies from its most productive mines have been declining rapidly. As a result, the country, which has been a phosphorus exporter for decades, is now imports as much as 10% of its supply.

 

As the article notes “establishing a reliable phosphorus supply is essential for assuring long-term food security.” The most important step is to reduce the demand for phosphorus by “eliminating wasteful practices” – phosphorus can be used over and over, and effective conservation techniques could significantly expand the usefulness of remaining supplies. In addition, there is a significant promise in the development of new, phosphorus-efficient foods.

 

If we fail to respond to the challenge, however, “humanity faces a Malthusian trap of widespread famine on a scale that we have not yet experienced. The geopolitical impacts o such disruptions will be severe, as an increasing number of states fail to provide their citizens with sufficient food.” This “dark scenario” is not inevitable, but in order to avoid this destiny, the threats involved with the looming phosphorus shortage must be addressed.

 

During 2010 and 2011, a number of securities class action lawsuits were filed against U.S.-listed Chinese companies. Plaintiffs’ lawyers seemed eager to pursue these cases despite likely procedural and practical challenges such as likely difficulties in obtaining discovery, as well as language and cultural barriers. And if a recent decision in one of these cases is any indication, you can add to the list of potential difficulties the risk that it may not be possible to obtain class certification, at least where the plaintiffs are unable to establish that the defendant company’s shares trade on an efficient market.

 

China Agritech, a Delaware holding company with its principal place of business in Beijing, China, obtained its U.S. listing through a reverse merger. In February 2011, online analyst reports raised allegations that the company’s factories were either not in operation or were producing far less than reported. In addition, the online reports claimed that the company’s SEC filings reported far higher levels of net revenue than the company reported to the Chinese State Administration for Industry and Commerce. The company’s share price fell on these reports and, as discussed at greater length here, litigation ensured. The plaintiffs moved to have a class of aggrieved investors certified as a plaintiff class.

 

In May 3, 2012 order (here), Central District of California Judge R. Gary Klausner denied the plaintiffs’ motion for class certification. The court found that the plaintiffs’ allegations satisfied the class certification requirements of numerosity, commonality, typicality, and adequacy. However, the court found that the plaintiffs’ allegations did not satisfy the requirement that the questions of law or fact common to the class members predominate over questions affecting individual members.

 

The court’s particular concern had to do with the reliance element of the plaintiffs’ securities class action claims. In most contexts, reliance is an individual issue. However, in a securities class action lawsuit, courts will use the fraud-on-the-market presumption to presume reliance if the defendant company’s shares trade in an efficient market.

 

In order to determine whether or not China Agritech’s shares trade in an efficient market, the Court consider five factors: (1) the average weekly trading volume of the company’s securities; (2) the number of securities analysts following the company; (3) the extent to which market makers trade in the security; (4) the company’s eligibility to file an SEC Form S-3 (the short form registration statement for the sale of new shares); and (5 )the existence of a cause-effect relationship between unexpected corporate news and a change in the price. As Judge Klausner noted, “several courts have recognized that the fifth factor is the most important.”

 

Judge Klausner found that the plaintiffs had satisfied a number of these factors. However, the plaintiffs were unable to establish the cause and effect relationship between company disclosures and resulting movements in stock price. He concluded that the plaintiffs “are unable to establish that Agritech stock was traded on an efficient market,” as a result of which “they are unable to rely on the fraud-on-the-market presumption of reliance.” Without the presumption, the plaintiffs “are unable to establish that questions of law or fact common to class members predominate over any questions affecting only individual members.” Accordingly, Judge Klausner denied the plaintiffs’ motions for class certification.

 

As discussed in a May 22, 2012 memorandum from the Debevoise & Plimption law firm about Judge Klausner’s decision (here), the class certification denial in the China Agritech case “appears to be the first China-focused case to reach the procedural stage at which the court had to consider whether the plaintiffs could satisfy the efficient market test and the other requirements of class certification.” The law firm memo notes that the China Agritech plaintiffs’ failure to satisfy the test “may have a significant impact on other China-focused securities cases if the defendants can show that their securities were as thinly traded as China Agritech’s,” adding that “if a company’s securities are thinly traded and the company is not the subject of press coverage, investors may have different levels of knowledge about the company and their reliance on particular statements cannot be presumed.”

 

The plaintiffs who brought the case “still can pursue claims on their own behalf,” but their inability to proceed with the proposed class action “significantly limits the potential damages that can be awarded in the case.”

 

Many of the U.S.-listed Chinese companies that have been the subject of securities class action litigation may be able to raise similar questions of whether or not their shares trade or traded in an efficient market. To the extent the companies can show that their shares did not trade in an efficient market, they may be able to overcome the fraud-on-the-market presumption of reliance,  and the value of the claims against them may be substantially diminished. And as I noted at the outset, there are a host of other potential difficulties that may also impede the plaintiffs’ efforts to pursue these claims. Many of these cases were filed, but not all of them will prove to be valuable for the plaintiffs and their counsel.

 

Kudos: Everyone here at The D&O Diary congratulates Dan Bailey and his colleagues at the Bailey & Cavalieri firm for their selection as the recipients of one of the 2012 Burton Awards for Legal Achievement. The Burton Awards are a series of prestigious national awards for outstanding achievement in legal writing. As reflected I n the firm’s May 22, 2012 press release (here), the firm is the winner of this year’s competition in the category of Best Law Firm Encyclopedic Handbook, for authoring the book entitled Liability of Corporate Directors and Officers.

 

 

Dan as the book’s co-author, will accept the awardin a June 12, 2012 ceremony at the Library of Congress. The awards ceremony will feature Retired Supreme Court Justice John Paul Stevens, who will be introduced by Supreme Court Justice Sonia Sotomayor. Our congratulations to Dan and to his colleagues for this recognition for their excellent book.

 

 

A complete list of the 2012 Burton Award winnerc can be found here.

 

Facebook’s disappointing public company debut has drawn a great deal of media scrutiny and criticism. But the finger pointing has not been contained just to the front pages of the newspapers. Disappointed investors have also now resorted to the courts, and further lawsuits seem likely to follow.

 

First, on May 22, 2012, an investor who claims to have purchased shares in the Facebook IPO filed a purported securities class action lawsuit in California (San Mateo County) Superior Court against Facebook, CEO Mark Zuckerberg, CFO David Ebersman,   seven outside directors, and 32 offering underwriters.

 

The complaint (which can be found here) alleges that the offering documents “failed to disclose during the IPO roadshow” that “the lead underwriters, including Defendants Morgan Stanley, J.P. Morgan, and Goldman Sachs, all cut their earnings forecasts and that news of the estimate cut was passed on only to a handful of large institutional clients, not to the public.” The complaint further alleges that the company’s registration statement “was negligently prepared, and as a result, contained untrue statements of material facts or omitted to state other facts necessary to make the statements not misleading.”

 

In support of these allegations, the complaint cites only two articles by analyst Henry Blodgett. Specifically, the complaint cites (and quotes at length from) Blodgett’s May 19, 2012 article entitled “If This Really Happened During the Facebook IPO, Buyers Should be Mad as Hell” (here), and Blodgett’s May 22, 2012 article entitled “BOMBSHELL: Facebook Bankers Secretly Cut Facebook’s Revenue Estimates in Middle of IPO Roadshow” (here).

 

The state court securities class action complaint asserts substantive claims under Sections 11 and 15 of the Securities Act of 1933. The complaint is filed in state court in reliance on the “concurrent jurisdiction” provisions of Section 22 of the ’33 Act.

 

Second, in their May 23, 2012 press release, separate plaintiffs’ counsel announced (here) that they had filed a securities class action lawsuit in the Southern District of New York in connection with the Facebook offering. The complaint (which can be found here) names as defendants the company; its CEO and CFO; seven outside directors: and six offering underwriters, asserts claims under Sections 11, 12 and 15, on behalf investors who purchased shares in the Facebook offering.

 

According to the press release, this federal court lawsuit alleges that the defendants “failed to disclose that because Facebook was experiencing a pronounced reduction in revenue growth due to an increase of users of its Facebook app or website through mobile devices rather than traditional PCs, at the time of the IPO the Company had told the lead underwriters to reduce their 2012 performance estimates for Facebook.” The press release reports that the complaint further alleges that these revised performance estimates were “not shared with all investors, but rather, was selectively disclosed by defendants to certain preferred investors and omitted from the Registration Statement and/or Prospectus.”

 

In support of these allegations, the federal court complaint cites a May 19, 2012 Reuters article entitled "Morgan Stanley Was a Control Freak on the Facebook IPO — And It May Have Royally Screwed Itself" (here) and a May 22, 2012 Reuters article entitled "INSIGHT: Morgan Stanley Cut Facebook Estimates Just Before Facebook IPO" (here).

 

Third, on May 22, 2012, an investor who alleges that NASDAQ “failed to promptly and accurately execute” his order for Facebook shares has filed a purported class action lawsuit in the Southern District of New York against NASDAQ OMX Group and the NASDAQ Stock Market LLC, on behalf of all individuals and entities whose purchase and cancellation orders during the Facebook IPO were delayed or otherwise improperly processed.

 

The complaint against NASDAQ, which can be found here and which asserts claims for Negligence, alleges that “the IPO was badly mishandled” and that because the attempted Facebook trades were not processed “promptly and efficiently,” the parties attempting to purchase Facebook shares “were unable to determine if they had properly done so.” As a result of the misprocessing of both buy and sell orders, the class members “did not know whether they owned Facebook shares, or at what price, and were accordingly unable to timely sell those shares, suffering losses.”

 

In support of its allegations, the complaint cites the named plaintiff’s own experiences in his attempt to buy Facebook IPO shares. He alleges that when his purchase orders “failed to execute,” he “sought to cancel” the order. However, rather than cancelling the trades, his account listed the cancellations as “pending.” Despite the cancellation, the purchase order was finally executed more than three hours after it was placed and after the cancellation order. He alleges that as a result of this sequence, he was “unable to determine what shares, if any, of Facebook he held” and that he was “unable to trade in accordance with a rational trading strategy.” The complaint also cites public reports of similar experiences by other investors, as well as public acknowledgement from NASDAQ CEO Robert Greifeld of a malfunction in the trading system’s order processing system.

 

The question of the existence of concurrent state court jurisdiction under the Securities Act of 1933 as been well ventilated in a variety of cases filed in connection with the subprime meltdown and the credit crisis. As discussed at length here, both the Ninth Circuit and the California state courts upheld the finding of continuing state court jurisdiction for ’33 Act claims in connection with the Luther v. Countrywide case. At least based on the developments in that prior litigation, there would appear to be substantial grounds on which the plaintiffs in the recently filed action against Facebook might proceed in California state court. (Outside the Ninth Circuit, there would likely be less support for concurrent state court jurisdiction.)

 

In light of the high profile nature of the Facebook IPO and surrounding events, it is hardly surprising that the missteps surrounding the offering have attracted litigation. It does seem as if there is a definite trend in which the securities class action litigation has become a sort of headline hit parade. For example, when Wal-Mart announced the existence of FCPA allegations in connection with its Mexican operations, it got hit with a securities lawsuit. And shortly after JP Morgan Chase announced significant trading losses on a failed hedging strategy, lawsuits followed shortly thereafter. Given that the Facebook IPO is now the story dominating the business headlines, it was perhaps inevitable that securities litigation has now appeared. Indeed, it seems likely that further litigation will follow, as well.

 

On the eve of the tenth anniversary of the enactment of The Sarbanes Oxley Act, Cornerstone Research has released a study of the filing trends and settlements of securities class action lawsuits involving accounting allegations. The May 2012 report entitled “Accounting Class Action Filings and Settlements: 2011 Review and Analysis” can be found here. A summary of the report’s findings can be found here.

 

According to the report, the share of securities class action lawsuit filings involving accounting allegations increased in 2011, compared to the prior year. In 2011, the number of accounting cases increased in both number and as a proportion of all securities lawsuit filings, compared with 2010. The number of accounting cases increased to 70 in 2011, compared to only 46 in 2010, and the proportion of total case filings represented by accounting cases increased from 26 to 37 percent.

 

This increase in the number of accounting cases in 2011 was largely driven by the increase in Chinese reverse merger cases during 2011. The Chinese reverse merger cases “are significantly more likely to involve restatements of financial restatements, and as a result, plaintiffs are more likely to allege violation of generally accepted accounting principals” in those cases compared to other securities class actions.

 

For similar reasons, the number of accounting case filings involving financial restatements increased in 2011 compared to 2010, reversing a four-year trend of declines. For the second consecutive year, more than 60 percent of accounting case filings included allegations of internal control weaknesses. However, in 2011, only 17 percent of the internal control deficiency claims were accompanied by company announcement of internal control weaknesses, which suggests that “plaintiffs may believe that including these claims will bolster their position in litigation, regardless of whether material internal control weaknesses were actually present.”

 

Cases with accounting allegations are less likely to be dismissed than non-accounting cases. For example, of cases filed in 2006, only 38 percent of accounting cases were dismissed by the end of 2011, compared to 46 percent of non-accounting cases. Accounting cases are also more likely to settle than non-accounting cases. 56 percent of accounting cases filed in 2006 had settled by the end of 2011 compared with only 50 percent of the non-accounting cases. These same patterns on dismissal and settlements held with respect to the 2007 and 2008 filings as well.

 

During 2011, there was a sharp decline in the number of securities class action settlements (measured with reference to the date on which the settlement was approved), compared to prior years. There was also a drop in the percentage of settlements in 2011 involving accounting cases. In the five years preceding 2011, more than 60 percent of all settlements involved accounting cases, but in 2011, less than half of the settlements involved accounting cases. Nevertheless, even though the accounting cases represented less than half of the total number of settlements, these cases represented more than 70 percent of the total 2011 settlement value. The report notes that accounting cases typically involved substantially higher settlement amounts compared to non-accounting cases.

 

For cases settled during 2006 to 2011, median settlements were higher both in dollar amounts and as a percentage of “estimated damages for cases involving internal control weaknesses with accompanying company announcements. However, when internal control weakness allegations are made without any corresponding company announcement, settlements are not higher either in dollar value or as a percentage of estimated damages, compared with cases with no internal control allegations.

 

Cases involving asset valuation write-downs settle for higher dollar values than cases not involving write-downs (even when compared to cases involving financial restatements). Cases involving financial restatements “settle for a significantly higher percentage of ‘estimated damages’ compared with cases involving write-downs,” which suggests that the higher settlement dollar values for cases involving write-downs are “due in part to the higher investor losses involved with those cases.”

 

From 2006 to 2011, about 34 percent of all accounting cases involved accompanying SEC actions, compared to only about 10 percent for non-accounting cases.

 

SOX Party: And speaking of the tenth anniversary of SOX, Broc Romanek has an interesting post on his CorporateCounsel.net blog (here), recognizing the anniversary of the legislation, His post contains a number of links to interesting articles about the tenth anniversary of SOX.

 

In order to try to boost the number of companies going public, the recently enacted JOBS act provides for certain procedural and reporting advantages for “Emerging Growth Companies,” which are defined in the Act as companies within five years of their IPO and with revenues less than $1 billion. A number of companies planning IPOs are already taking advantage of the new provisions. But at the same time, those same companies are warning investors that their status as Emerging Growth Companies may itself be a risk of which investors should be aware.

 

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). The “on ramp” advantages are intended to ease the going public process. 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.

 

The Act also provides for reduced disclosure and reporting burdens for EGCs for as long as five years after an IPO – as long as the company continues to meet the definitional requirements. For example, an EGC will not be subject to Section 404(b) of the Sarbanes Oxley Act requiring an outside auditor’s attestation report on the company’s internal controls. Similarly, an EGC would be exempt from the requirements under the Dodd-Frank Act to hold shareholder advisory votes on executive compensation and on golden parachutes.

 

Since the enactment of these provisions, 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. Indeed 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 in recent days, at least 13 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.”

 

In a May 14, 2012 post on his CorporateCounsel.net blog entitled “JOBS Act: EGC Status as a Risk Factor” (here), Broc Romanek takes a detailed look at one of the recent IPO filings, the S-1 that LegalZoom filed in connection with its proposed initial public offering. He notes that right on the cover page of the filing, the company warns that “we are an ‘emerging growth company’ under the federal securities laws, and will be subject to reduced public company reporting requirements.” Among other things, the company notes in its filing that it will be taking advantage of the JOBS Act reporting exemptions as long as the company qualifies to do so, adding that “we cannot predict if investors will find our common stock less attractive because we rely on these exemptions.” The company further notes that “if some investors find our common stock less attractive as a result, there may be less active trading for our common stock and our stock price may be more volatile.”

 

These disclosures not only have the virtue of warning investors that the companies’ status as emerging growth companies may make their stock less attractive. The warnings may, according to one commentator quoted in the CFO.com article, provide "cheap insurance” that could help the company if it later runs into trouble. As the commentator noted, if the emerging growth company is later sued, the company can say “We warned you that there weren’t auditors looking independently at this.”

 

These emerging growth companies advisory statements may indeed represent good precautionary disclosure. But it is fair to ask whether the cautionary statements go quite far enough. It is one thing to say that the company’s reduced reporting requirements may make the company’s stock less attractive. What the companies don’t seem to be saying, at least not directly, is that the reduced reporting requirements could make their reported financial results less reliable. As a plaintiff’s lawyer quoted in the CFO.com article notes, the emerging growth companies’ precautionary disclosure may forewarn that their stock may not trade as high or as frequently as it might otherwise, but they are not saying that as a result of the reduced reporting requirements you “may get a nasty surprise” when the company no longer qualifies for the exemptions.

 

All of which says that while companies are now just trying to adjust to the newly enacted IPO process and reporting provisions, we will have to wait to see how all of this plays out in the securities litigation arena. For now, the companies taking advantage of the new rules do seem to be recognizing that while the new processes do present certain advantages, they do involve possibly increased risks as well.

 

The one thing that is certain is that because of the JOBS Act’s broad definition of “emerging growth companies,” a very larger percentage of companies going public will be eligible to take advantage of the new rules. Indeed, according to one report, of the 113 companies that went public in 2011, only 15 (or 13%) would not have qualified for the JOBS Act’s IPO on-ramp procedures.

 

In other words, the disclosure issues discussed above, and the related liability concerns, could be an issue for a significant number of companies. Indeed, if the JOBS Act achieves its fundamental goals, these considerations could be a concern for an increasingly larger number of companies.  

 

Delaware Seminar on Corporate and LLC Law: On Tuesday May 22, 2012, I will be participating in a panel the Delaware State Bar Association Corporate Law Section’s annual “Recent Developments in Delaware Corporate and Alternative Entity Law” seminar. The seminar will be co-chaired by Francis Pileggi of the   Eckert Seamans firm and also the author of the Delaware Corporate and Commercial Litigation Blog, and his law partner Kevin F. Brady and R. Montgomery Donaldson of the Montgomery McCracken Walker & Rhoads firm. Pileggi’s recent post on his blog about the event can be found here. 

 

The panel I will be participating in is entitled “Corporate Law Updates Via Blogs,” and my fellow panelists will include Doug Batey of the Stoel Rives law firm and the author of theLLC Law Monitor blog; University of Illinois Law Professor Christine Hurt, of  The Conglomerate blog; and Boston College Law Professor Brian Quinn, of  The M&A Law Prof blog. Batey’s recent blog post about our upcoming panel can be found here.

 

Our panel should afford the panelists an opportunity to reflect and comment upon the blogging process and experience. Along those lines, in an interesting May 18, 2012 post entitled “What Then is Blogging” (here),   Dick Cassin of the indispensable The FCPA Blog sets out some of his views and thoughts about blogs and blogging. (Thanks to Cassin for quoting one of my prior blog posts).

 

Looking for Life in All the Wrong Places?: A May 18, 2012 Wall Street Journal article entitled “Searching a Billion Planets for Life” (here) describes scientists’ efforts to write a recipe for “perfect planet”—that is, a place that is “not too cold, not too hot, not too toxic and chemically suitable for life as we know it” as a way to aid in the search for “potentially habitable alien worlds.”

 

The challenge for the scientists is that the process of trying to come up with the recipe leaves them “grappling with the nature of life itself.” Perhaps the most fundamental problem is that the analysis depends on presumptions “based on life as we know it” – that is, life on Earth.

 

The potential limitations of this Earth-biased analysis are revealed most dramatically just by looking at what has happened in recent years to our knowledge about life on Earth. Through a series of interesting discoveries, our awareness of the range of conditions in which life on Earth can thrive has expanded far beyond what was previously thought possible.

 

An interesting article in the May/June 2012 issue of The Economist’s Intelligent Life magazine entitled “Some Like it Very Hot” (here) takes a look at the scientific advances that have revealed the teeming existence of “hyper-resilient microbes,” organisms that can survive “levels of heat, cold, pressure, radiation and salt or acid concentrations that previously would have been thought fatal to all living things.” These previously unknown organisms, now known as extremophiles, have been found deep beneath the sea floor; in the depths of Mexican caverns; in the core of nuclear reactors; in hydrothermal vents on the sea bed; and are constantly being discovered in ever more unlikely and seemingly inhospitable environments.

 

Among many other things, these discoveries show that “life can sustain itself in many more environments than was previously thought possible.” This realization not only has enormous implications for the study of life on Earth; it has also given new life to the “idea that life is dispersed throughout the universe and is disseminated on meteorites or asteroids.” Or to put it another way, “the bandwidth of survivable environments – and therefore, forms of life, has broadened enormously.”

 

The implication for scientists hoping to increase their chances of finding life beyond Earth by narrowing their search only to the “perfect planets,” may be that by narrowing their search, they may actually diminish their chances of finding outside our planet. But on the positive side, the likelihood that life outside of earth might exist and someday might actually be discovered both seem to have increased significantly.

 

Personally, I find all of this quite fascinating and even exciting. The possibility that life in the universe is not rare but could actually be quite common and even widely dispersed represents an entirely new way of looking at things. Instead of the Earth as a lone life-bearing vessel whirling through an empty, heartless void, it could instead be one of countless places where life is thriving. Of course, the possibility that life elsewhere might be merely microbial might not satisfy the most febrile science fiction fantasies. It would of course be much more exciting if there seemed to be a greater likelihood of discovery of intelligent life beyond earth. But it may be too much to hope for, to expect to find intelligent life beyond earth. After all, think of how hard it is to find intelligent life on our own planet.  

 

In Case You Missed It: For the second weekend in a row, a major European soccer title has been determined in a last-minute come from behind victory. Last Sunday, it was Manchester City scoring two goals in stoppage time in their final game of the season to capture the English Premier League crown. This Saturday, Chelsea, playing against Bayern Munich on the German team’s home field, won the UEFA Champions League club team title in almost equally dramatic fashion, winning in a penalty kick shootout.

 

Bayern Munich had many chances to put the game away, and seemingly had the game won when they finally scored on a Thomas Müeller header in the 82nd minute. But then with just two minutes left in regulation, on Chelsea’s first corner kick of the game, Didier Drogba scored on a header to tie the game. As regulation time expired the game went into extra time (a thirty minute overtime period).

 

Drogba’s fine goal to tie the game looked like it might have been naught when early in extra time he committed a foul by tripping Franck Ribèry in the penalty area. It seemed like another golden opportunity for Bayern Munich to put the game away, but Chelsea’s goalie, Petr ČechArjen Robben’s penalty kick. The 30-minute period ended with the teams still tied, setting up a penalty kick shootout. , stopped

 

Bayern Munich once again appeared to have the advantage as its goalie, Manuel Neuer, stopped the first Chelsea penalty kick from Juan Mata. After each team had attempted three penalty kicks, Bayern had made all three of its attempts, while Chelsea had only made two. Bayern substitute, Ivica Olic  then missed his team’s fourth shot while Ashley Cole made the next shot for Chelsea, bringing the two teams even. On Bayern Munich’s fifth and final shot, Bastian Schweinsteiger , who looked as if taking the penalty kick was about the last thing in the world he wanted to do, hit the post. Drogba, looking calm and confident, smashed his kick into the corner of the net, securing Chelsea’s improbable victory. The game-winner might be the 34-yearold Drogba’s last act for Chelsea, as his contract with the team expires this summer.

 

It was a great game, although the Bayern Munich fans are not the only ones unhappy about the outcome. Tottenham Hotspurs, who finished fourth in the English Premier League and therefore otherwise qualified for the UEFA Champtions League competition, were dispossessed of the spot by Chelsea’s win. Chelsea, which didn’t otherwise qualify for the Champions league (since they finished sixth in the Premier League), secured an automatic spot in next year’s Champions League competition with their win on Saturday. Since only four teams from each participating country can compete, that meant that Chelsea’s win forced Tottenham out of its spot.

 

With all of this great end of season soccer just completed, it is even more exciting to look forward to the Euro 2012 national team championship competition, which kicks off on June 8, 2012 in Poland and Ukraine. 

 

In the wake of JP Morgan Chase’s startling news last week of its $2 billion trading loss, and of the equaling startling statements of Jamie DImon, the bank’s CEO, that the losing trades were, among other things, “flawed, complex, poorly reviewed, poorly executed, and poorly monitored,” there has been speculation whether these disclosures would lead to litigation. In particular, commentators have asked whether Dimon’s candid statements would hurt the company in any litigation that might arise.

 

Well, it looks like we will be finding out. On May 14, 2012, plaintiffs filed a securities class action in the Southern District of New York, against the bank; Dimon; Ina Drew, the bank’s former Chief Investment Officer: and Douglas Bronstein, the bank’s chief financial officer. A copy of the complaint can be found here.

 

According to the plaintiffs’’ lawyers’ May 14, 2012 press release (here), the complaint alleges that during the class period of April 13, 2012 through May 11, 2012, the defendants issued “materially false and misleading statements regarding certain securities trading by the Company’s Chief Investment Office (“CIO”). Specifically, Defendants misrepresented and/or failed to disclose that the CIO had engaged in extremely risky and speculative trades that exposed JPMorgan to significant losses.” The complaint specifically references the defendants’ reassuring statements made between the time the rumors about the trading activity first surfaced in April and the time of the disclosures of the trading losses, and blockbuster admissions about the trades.

 

The initial complaint is just 18 pages. Although the complaint quotes extensively from Dimon’s statements in a May 10, 2012 conference call, it does not refer to many other highly publicized features involved with the trading losses, including for example, the April rumors of trading activities by a JP Morgan trader labeled the “London whale,” whose trades had roiled the derivatives market (the complaint refers to the trades, just not to the “whale,” at least not by that name) nor Dimon’s statements to Meet the Press aired on Sunday May 13, 2012, that the bank had been “sloppy” and “stupid” and that he had been “dead wrong” when he characterized questions about the derivatives trades as a “tempest in a teapot.”

 

The complaint’s scienter allegations do not allege any motivations for alleged misrepresentations made during the relatively short class period. There are no allegations that any of the defendants’ traded on basis of allegations or that the defendants otherwise personally benefitted from the misrepresentations. The complaint does allege that the defendants did not believe their earlier statements about the bank’s derivatives trading activities at the time the statements were made. 

 

To be sure, it is not uncommon for an initial securities class action complaint to be skeletal, with more detailed allegations added in subsequent amended pleadings after lead counsel has been selected and the cases consolidated. Along those lines, there may well be other complaints filed on behalf of other prospective class representatives that may contain different or additional allegations. Subsequent complaints or amended complaints may well be more detailed. These complaints may also draw on subsequent news reports that JPMorgan’s senior management allegedly had disregarded “red flags” regarding the bank’s trading activities.

 

Even if they are able to add additional details, however, plaintiffs seeking to plead this case will be faced with the challenge of attempting to present scienter allegations sufficient to overcome the initial pleading hurdles. The defendants will argue that it is not enough for plaintiffs to rely on the magnitude of the losses or even on the fact that the losses resulted from a trading strategy that Dimon has now publicly acknowledges was flawed. In attempting to show that the early reassurances are not merely misleading but are actionable, the plaintiffs may find that they must allege more than the subsequent admissions about the trading activities.

 

How the securities class action plaintiffs will proceed and how they will fare remains to be seen. But in the meantime, there are now press reports circulating that the Department of Justice has “opened an inquiry” regarding the bank’s trading losses. The news of the DoJ inquiry follows prior reports that the SEC had opened a review of the developments. President Obama, among many others, has seized upon the bank’s trading losses as evidence of the need for greater bank regulation, including in particular the so-called “Volker Rule.”  Questions are also being raised whether the bank will or should seek to “claw back” compensation from the three trades who were released following the disclosure of the losses.

 

The fallout from the trading losses will continue to roil the markets and the media for some time to come, and could hound both Dimon and J.P. Morgan for some time as well. In the meantime, the private securities class action lawsuit will unfold, as these cases do, in the fullness of time. I will say that as interesting as it is that a securities class action complaint has been filed, it will be more interesting to see the plaintiffs’ allegations as they appear in the consolidated, amended complaint that ultimately will be filed.