On April 25, 2012, Cornerstone Research released a report written by Stanford Business School Professor Robert Daines and Cornerstone Research Principal Olga Koumrian entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions – March 2012 Update” (here). This memorandum is the latest in a series of recent papers documenting the growth in merger related litigation in the United States. The research described in this paper is consistent with the prior reports but it also contains some new additional insights.

 

The report opens with a number of observations about the incidence of litigation in connection with mergers valued at $500 or greater during the period 2007 to 2001. The report shows that while in 2007 only about 53% of such deals attracted litigation, by 2011 almost all deals (96%) of those deals attracted litigation.

 

In addition, with respect to the deals of that size that attracted litigation during that period, the number of lawsuit per deal also increased between 2007 and 2011. Thus, while in 2007, the average number of lawsuits per litigated deal was 2.8, in 2011, the average number of lawsuits per litigated deal was 6.2 million. The report also shows that these trends were not limited just to the largest deals; during 2010 and 2011, for deals valued between $100 million and $500 million, 85% of the deals attracted litigation, and the average number of lawsuits per litigated deal was 4.1.

 

The absolute count of lawsuits involving deals with values of $500 million or greater also nearly doubled during that period, with 289 lawsuits filed in 2007 and 502 lawsuits filed in 2011.

 

The authors also note that as of March 2012, 67 lawsuits have already been reported for thirteen out of seventeen deals announced during January and February 2012. 

 

Certain deals attracted far more than the average number of lawsuits. A table in the report shows that fifteen deals with a valuation of $100 million or greater during the period 2007-2011 attracted fifteen or more lawsuits. Interestingly, of these fifteen, twelve of these deals were announced in 2010 or 2012. The report notes that size alone does not explain which deals attracted these large numbers of suits, and that in fact several relatively small acquisitions attracted fifteen or more lawsuits.

 

The report also shows that deals in certain industries seem to attract the most numbers of lawsuits. Thus, deals in the energy industry attracted an average of 8.6 lawsuits per deal, and deals in the consumer goods industries attracted an average of 6.0 lawsuits per deal.

 

There is a common perception that there is a “race to file” these lawsuits after deals are announced. However, the report shows that while filings arrive quickly after deal announcements, the time to filing has not accelerated in any material way since 2007. Indeed, the proportion of lawsuits filed in the first week after the deal announcement declined from 55 percent in 2007 to 39 percent in 2011. In all years studied, “a significant percentage of lawsuits were filed more than four weeks after a deal’s announcement.”

 

One phenomenon that has been the subject of discussion with respect to this type of litigation is whether or not there has been a “flight from Delaware” as claimants seek to pursue claims in the courts of other states. This study shows that with respect to merger litigation involving Delaware corporations, the share of M&A lawsuits filed in Delaware was higher in 2011 (45%) than in 2007 (34%) and that the percentage has increased steadily since 2008. However, according to the report, the “most striking trend in venue choice” is that challenges to the same deal in both Delaware and some other venue (as opposed to just Delaware alone or to some other venue alone) are now more common than in 2007. Most lawsuits brought in non-Delaware courts were filed in California, Texas and New York, “likely reflecting where many deal targets are headquartered.”

 

The report shows that M&A shareholder lawsuits “typically settle and often settle quickly.” Of the 2010 and 2011 lawsuits where the authors were able to track the resolution, 28 percent were voluntarily dismissed, four percent were dismissed by the court, and 67 percent settled. This represents a “significant change in outcomes observed a decade ago.” A prior study cited in the report shows that in 1999 and 200, 59 percent of cases were dismissed and only 28 percent settled. Of the 202 unique settlements involving 2010 and 2011 deals, 194 were reached before the merger closed. The median time between lawsuit filing and settlement was forty-four days.

 

Settlement terms have also changed over time. Whereas during 1999 and 2000, the majority of settlements (52%) involved cash awards and only 10% involved additional disclosures only, only 5% of 2010 and 2011 lawsuits related to M&A deals involved cash payments, and a large majority (83%) involved additional disclosure only settlements.

 

The average fee awards in connection with the M&A suits in 2010 and 2011 in connection with deals valued at $500 million or greater was $1.2 million. However, this average was pulled upward by some larger awards. Only 23% of plaintiff fee awards were $1 million or higher, while 44 percent were at or under $500,000 or under. Of the largest plaintiffs few awards, several were associated with settlements that did not involve any payment to shareholders. Average fees per deal fluctuated between 2007 and 2011, and while the average fees as a percentage of deal value in 2010 and 2011 remained higher that in 2007, the average fees as a percentage of deal value declined in 2010 and 2011 compared to 2009.

 

Discussion

The analysis in the Cornerstone Research report corroborates many of the observations noted in prior analyses of these same topics. That is, M&A related litigation is becoming increasingly more prevalent, and each deal is attracting an increasing number of lawsuits. At a minimum, the Cornerstone Report helps explain why M&A related litigation has become increasingly more expensive to defend. The impact of M&A litigation settlements and of plaintiffs’ fee awards on the cost of this litigation is less clear, but overall the implication is that the growing frequency of this type of litigation remains a very significant corporate and securities litigation trend, with important implications for D&O insurers.

 

One very important consideration to be kept in mind when comparing the various reports regarding M&A litigation is that each of the reports has used its own deal size definition to define the merger transactions that are the basis of each report’s analysis. The definitions used in the various reports are not necessarily consistent. At a minimum, the differences in the definitions used can make comparisons between the reports challenging. In any event, it is important in considering the analysis in any one of the reports to keep clearly in mind what definitions the report has used in determining what merger transactions to include the study.

 

The FDIC’s Latest Failed Bank Lawsuit: On April 20, 2012, the FDIC filed its latest failed bank lawsuits against ten former directors and officers of the failed First Bank of Beverly Hills. In its complaint (here), which the FDIC filed in its capacity as receiver for the failed bank, the FDIC seeks to recover losses of at least $100.6 million the bank allegedly suffered on nine poorly underwritten acquisition, development and construction loans and commercial real estate loans from March 2006 through July 2007.

 

The bank failed on April 24, 2009, or just short of three years prior to the date the FDIC filed its lawsuit. The complaint asserts claims against the ten defendants for negligence, gross negligence and breach of fiduciary duties. The complaint alleges that the defendants approved or allowed the loans in question in willful disregard of the bank’s own loan policies and with “willful blindness” to the risks and imprudence of the loan decisions. The complaint alleges that at the same time the defendants were approving these risky strategies, they were “weakening the Bank’s capital position by approving large quarterly dividend payments to the Bank’s parent company,” of which several defendants were shareholders. The complaint alleges that the individual defendants “lined their own pockets” with these dividends.

 

The FDIC’s lawsuit against the former directors and officers of the First Bank of Beverly Hills is the 29th the FDIC has filed as part of the current wave of failed bank litigation, and the fifth so far involving a failed California bank. In its latest website update, the FDIC announced that as of April 25, 2012, the agency has authorized lawsuits in connection with 58 failed institutions against 493 individuals for D&O liability, inclusive of the 29 filed D&O lawsuits naming 239 former directors and officers. Given the large number of failed banks like the First Bank of Beverly Hills approaching the third anniversary of their closure, it seems likely that we will be seeing a flurry of new FDIC failed bank lawsuits in the months ahead.

 

In the meanwhile, the FDIC continues to take control of additional failed banks. This past Friday evening, the FDIC closed five additional banks, the most the FDIC has closed in a single day this year. These additional closures bring the 2012 year to date number of bank closures to 22. This flurry of bank closures is a little bit surprising as up to this point, the pace of closures had begun to suggest that the FDIC was winding down its new bank closures. The five closures on Friday night suggest that there may still be a number of bank failures yet to come.

 

For Almost As Long As Our Country Has Existed, Man Has Dreamed of Traveling to Cleveland: NASA announces its plan to put a man on a bus to Cleveland. Get the details here.

 

The final stop on The D&O Diary’s Asian Tour was the island city-state of Singapore. Located only about 60 miles north of the equator, Singapore is a sun-drenched commercial center that has managed despite its slight size to become one of the world’s wealthiest countries.

 

Prior to boarding my flight to Singapore, I purchased a bottle of water, drank about half of it, and stuck the unfinished bottle in a side pocket of my backpack. As I boarded the flight, I stuck the backpack in the overhead compartment. I guess the lid popped off of the water bottle, and all of the remaining water spilled out. Now, if you are about to spend four hours sitting next to a total stranger, it is a very poor idea to start things off by dumping about eight ounces of cold water on them. I was vigorously cursed out in a language I was unable to identify, and all of my apologies were disdained — even though during the course of the flight it became apparent that my damp seat mate spoke English fluently.  Fortunately, no permanent harm was done, and this episode, though embarrassing, did not otherwise affect my Singapore visit.

 

The whole country of Singapore covers an area only slightly larger than Chicago, but with double the population. It is also one of the world’s wealthiest countries, with the highest percentage of U.S. dollar millionaires of any country in the world (15.5% of all households). It is a global trade, financial and manufacturing center. As a result, and despite its equatorial location, it has a tidy, orderly, prosperous feel.If you were suddenly dropped there,  and if it were not for the cars driving on the right-hand side, you would probably guess you were in a particularly well-off suburb of Miami. I suspect that most Americans would find Singapore a particularly comfortable place to visit.

 

As far as I can tell, the basic institutional unit in Singapore is the shopping mall. There not only seems to be an endless supply of upscale malls, but they all seem to be busy as well. Singapore’s two casinos have only been open for less than four years, but, flush with Chinese gamblers, Singapore is already a larger gambling market than Las Vegas. The Marina Sands Singapore Casino, which sort of like a massive, three-hulled cruise ship tipped on its end, with a gigantic skateboard stretching across the towers, dominates the downtown Marina district. 

 

My stay in Singapore was relatively brief, much shorter than my visits to my other Asian destinations, but I was there long enough to get a strong sense of the essential commercial energy of the place. Location is one of the country’s natural advantages; its proximity to India and China and to the emerging economies of South East Asia makes it the natural hub for regional commerce. As a result, the city is extraordinarily cosmopolitan. At the PLUS event that was the reason for my visit, there were attendees not only from Singapore itself, but a wide variety of other countries, including India, Malaysia, Thailand, Mauritius, and United Arab Emirates, among many others.

 

One of the literal high points on my brief visit was a ride on the Singapore Flyer, which, depending on who you ask, may be the highest ferris wheel in the world. It does in any event provide some astonishings views of the city, of the Singapore harbor, and of Indonesia to the South and Malaysia to the North.

 

In addition to the climate, economy and atmosphere, another reason to visit Singapore is its food. I can’t recall the last time I enjoyed so many interesting meals in such a short amount of time. Among many other local specialties I enjoyed is rendang, a spicy meat dish with a lot of kick, mee siam, a spicy seafood noodle dish, and tandoori murgh (yogurt marinated chicken). A particular high point for me was the opportunity to sample a rich diversity of local dishes while sitting on the verandah of the Singapore Cricket Club, a local landmark, as the guest of my good friend, Aruno Rajaratnam, whose hospitality helped make my Singapore visit so enjoyable.

 

One particularly interesting area to explore and to eat is Holland Village, a small enclave of shops, restaurants and bars in the western end of the urban center. There is a lively, street-café feel to the area, but the main attraction is the several indoor food courts where you can quickly sample a wide-variety of regional foods. On a warm, sunny afternoon, it was a very pleasant to sit in a shady café drinking Tiger Beer and watching the incredibly diverse local populace stroll by.

 

The PLUS event in Singapore was extraordinarily successful. The event was held at The American Club and it drew a standing-room only crowd. As I noted above, many of the attendees had traveled a long way just to attend. It is clear that there is a great deal of interest among the insurance professionals in South East Asia in the networking and educational opportunities that PLUS affords. It was a privilege for me to be able to address and to meet so many Asian insurance industry professionals. I congratulate the PLUS leadership for taking the initiative in launching the Asian events, and I congratulate the local committee that organized the events, particularly Aruno Rajaratnam and Shasi Gangadharan. I can only hope that the two events this past week in Hong Kong and Singapore are just the first of many PLUS Events in Asia. I also hope that PLUS will continue to offer our Asian industry colleagues the opportunity to become a part of our professional community. On a personal note, it was personally gratifying to learn how many of my industry colleagues in South East Asia are loyal readers of The D&O Diary.

 

What I Learned in Asia: The world is incredibly large, rich and diverse. But as large as the world is, it is still possible for me to start the day in Singapore and have dinner at my home in Ohio. Modern technology and transport have shrunk the world. Nor is this merely a geographic phenomenon. I found in my business meetings during my travels that my Asian counterparts are dealing with many of the same challenges and issues as I am every day.

 

However, one important difference is the pace of economic activity in Asia, which is far beyond anything I have ever experienced. In many ways, business growth in the developed economies all too often is about taking existing business away from competitors. In Asia, there is true, organic economic growth. The future opportunities in the growing economies of South East Asia and in the newly developing countries, like, for example, Cambodia and even Myanmar, are enormous.

 

One particular regret I have about my Asian trip is that I was not able to take any of  my kids with me to see what I saw. I think it is going to be incredibly important for our future work force to understand what is happening in Asia and in the larger global economy. Today and increasingly in the future, our young people will be competing not only with their counterparts down the street but also with their counterparts on the opposite side of the world. We all need to recognize that the global counterparts are extraordinarily motivated and are also positioning themselves to compete in an economy that they fully understand is global.

 

Our Asian counterparts are training their work force to be adaptable and to be able to function in a variety of languages and cultures. To be sure, one advantage we have in the United States is that the rest of the world is racing to learn our language. But at the same time, I fear that we have been too slow to recognize that is not going to be enough simply to expect the rest of the world to speak English. Our future work force will have to be culturally adaptable. Our chronic cultural parochialism could put our work force at a substantial disadvantage in the global economic competition.

 

However, if the increasingly global economy presents a challenge, it also represents an opportunity. That is, there may be an opportunity to participate in the developing economies’ growth – which could be a positive spin on the possibility that future growth and many of the future jobs will in Asia, rather than at home. It will under any circumstances be critically important for our future work force here to be able to function globally.

 

An additional note is that Asia is far from a block or economic unit. To the contrary, cultural differences, natural geographic and resource advantages, as well as differences in political and legal systems, will have an enormous impact on how different Asian countries will fare going forward. To cite but one example of this, it will be critically important to see which countries strike the appropriate balance between the ability of economic participants to extract profits and the ability of those participants to shift “external” costs onto their society. For example, in China, the willingness to allow businesses to prosper while society chokes on the fumes ultimately could undercut the country’s long run success.

 

One of the side effects of the wealth creation that has followed economic development in Asia is the emergence of a rising middle class. With the growth of the middle class has come a convergence around a common set of life styles, living patterns and even values. At its most superficial, this convergence includes the emergence of global brands with nearly universal appeal. But it also includes rising expectations about housing, education, and health care, as well as about the free flow of information and ideas.

 

As a result of this convergence, it is not just technology and transport that have shrunk the world. Rather, it is an increasingly shared set of experiences, expectations and aspirations that characterize ever greater parts of the world. The growing global economy may include both challenges and opportunities; but at its most basic level, it may mean that we live in a more integrated world. Although a global economy seems to mean global competition, there will also be possibilities for global collaboration within a more integrated world.

 

I find the possibilities for global collaboration the most interesting of all. Indeed, if there is a common thread through all of the business meetings on my trip, it is the common assumption that collaboration presents the greatest promise, both in and with Asia. Throughout my Asian travels, I was struck with how enthusiastic everyone I  met was about finding ways to collaborate. I left Asia with three hopes; one, that I might return again soon;two, that the apparently extensive prospects for collaboration in Asia might quickly bear fruit; and three, that I am able to stay in close touch with my many new Asian friends.  

 

More Singapore Pictures:

The Marina Sands Casino, Singapore:

 

Looking out to the Singapore Strait (from the Singapore Flyer):

 

 

 

 

 

 

 

 

 

 

 

A Country of Shopping Malls: 

 

The D&O Diary’s Asian mission continued this week, with Hong Kong the next stop on the itinerary following Beijing. If Beijing is a Chinese city wearing a new Western-style business suit, then Hong Kong is a Western city with a Chinese heart.

 

Hong Kong is topographically complicated; it is divided by bays, harbors and waterways; and it includes islands, peninsulas and even a bit of the mainland. All in, it is physically smaller than Los Angeles, though its population of 7 million is nearly double that of L.A. On Hong Kong Island, the city spreads along the slopes of rugged mountains covered with lush vegetation. Packed into every bit of buildable ground, Hong Kong is a densely populated urban area with crowded streets jammed with traffic.

 

Despite the density and slope, however, Hong Kong is still a surprisingly walkable city. At the second story level, a network of walkways connects much of the central city, by-passing the busy city streets. In addition, a clever center city escalator system connects the lower business district along the waterfront with the residential area in the “Mid-Levels.”

 

One basic thing you need to know about Hong Kong (that I did not) is that it has a humid, subtropical climate. Its latitude and climate are both about the same as Honolulu. I definitely did not pack the right clothes at all. Hong Kong is also yet another island locale with right hand drive vehicles, along with Great Britain, Japan, Ireland, Australia, Bermuda, New Zealand and Singapore. The currency is the Hong Kong dollar, which currently is valued at about 7.7 HK$ to the US$. Invoices and bar bills are simply presented in dollars, which can induce heart attacks late at night when you get a bar bill for $250 for a couple of rounds of drinks.

 

Upon arrival on a steamy Saturday, we set out for an afternoon walk, starting amongst the thick foliage of the Hong Kong Park and of the Zoological and Biological Gardens. Our roving stroll quickly revealed the incredible diversity of Hong Kong’s sights and sounds. First, in one of those chance events that makes travel so interesting and rewarding, we happened upon a musical rehearsal at St. John’s Cathedral , which is close by the parks. The church’s cool interior was a welcome relief against the humid afternoon heat, and we were treated to a rehearsal of the musical ensemble Die Konzertisten . The ensemble was rehearsing Leonard Bernstein’s Chichester Psalms, which the choir and orchestra were going to be performing in concert that evening.

 

We then strolled into an area of narrow pedestrian lanes and alleyways lined with shops and vendors selling clothes, toys, leather goods and shoes, and vegetables and fruit. Butchers carved meat right out along the street and fish vendors displayed tanks full of lobsters, crabs and assorted other kinds of sea life. You can buy fried or dried octopus, fermented bean curd, curry fish balls , put chai ko (a sweet pudding cake), and  chee cheong  fun (rice noodle roll stuffed with meat). Or maybe you might just want to walk past and content yourself with wondering what, say, snake meat might taste like.

 

After wandering through this colorful street market scene, the thought did occur to us that it would be awfully nice to find a place to sit down and have something cool to drink. Almost simultaneously with the thought, we found ourselves in the Soho neighborhood, full of restaurants and bars. We went into the Globe Pub on Graham Street, which turned out to be every bit as British as if it were in Notting Hill. We sat at the bar and drank draft Old Speckled Hen ale. Though it was evening in Hong Kong, back in merry England it was still early afternoon, so we were able to watch an English Premier League game live. The bar was full of vocal Arsenal fans, who were disappointed that the Gunners played to a nil-nil draw against London rivals Chelsea. After the game, we returned to our hotel quite persuaded that Hong Kong is a fabulous town.

 

The next morning dawned clear and bright, so we took the Peak Tram to the top of Victoria Peak. At about 1,800 feet, the Peak (as it is known locally) is the highest mountain on Hong Kong Island. Oddly and incongruously, the tram terminates near the top at a modern shopping mall. Outside the mall, a paved pathway winds around the Peak through parklands and near some very high end residential real estate. The path affords glorious panoramic views of the harbor and the Kowloon Peninsula to the North and of the South China Sea to the South.

 

After we descended, we went to the waterfront and took the famous Star Ferry across Victoria Harbor to Kowloon. With a bit of wandering, we found our way to Kowloon Park, a cool, shady oasis on a muggy afternoon. We didn’t know that we had wandered into the Sunday afternoon singles’ scene for young South East Asians. The park was full of young men and women in their late teens and early 20s – Malays, Thais, Vietnamese, Cambodians, and a host of other ethnic groups and nationalities that I could only guess at. Many of the women were wearing head scarves and others were wrapped in colorful silks fabrics. Some groups sat on fabric ground covers and chatted. Others were playing music and dancing. One group of gently swaying and elaborately dressed women played drums, tambourines and bells. I felt as I were from another planet.

 

As the afternoon light faded, we took the ferry back to across to Hong Kong Island, and hopped into a cab to go back to Soho for dinner. Seconds after we jumped out, I realized I had left my backpack in the cab. Shock and surprise gave way to distress as it sunk in that in a city as massive as Hong Kong where there are literally thousands of essentially identical taxi cabs, there was no chance I would ever see my backpack again.

 

We went to get some (excellent) Thai food but not even a couple of Singha beers could raise my spirits. As I picked at my Pad Thai, I slowly remembered all of the things I had been carrying in my bag – my camera (with all of the pictures from my trip); guide books (borrowed from the Shaker Heights Public Library); a CD play with a Berlitz Mandarin language  CD in it (also borrowed from the library); a memory stick with my presentation; important traveling accessories, like a corkscrew and a bottle of aspirin and several packages of gum. And then – I remembered the envelope. The envelope with the cash. Over 400 U.S. dollars, plus US$300 worth of Singapore dollars. My spirits, already low, plunged to new depths. (I know you are thinking — what kind of idiot carries around that much cash in a backpack? Well, apparently the same kind of idiot that would leave a backpack in a taxi cab. That is to say, a complete and total idiot.)

 

Back at the hotel, I told the concierge what had happened. He was friendly and polite and he dutifully took down all of the information. He said that he would call the taxi commission and that he would let me know if he learned anything useful. However, the look on his face pretty much told me that I was never going to see my backpack again.

 

When I went up to my room, I picked up my iPad for a quick email check. To my astonishment, in my inbox was an email with the following Re line: “Your Missing Bag in a Hong Kong Taxi.” The email, from a woman whose email domain was “christiandior.fr,” said

 

My husband and I just got in a taxi in Hong Kong where we found your missing bag. We got your name card from your bag and tried to call you without success. Now we left the bag with the taxi driver Mr. [name] (you could find attached his Driver ID card picture), his phone no is : [phone number]. Please contact him asap. Good luck!

 

Attached to the mail was a photo of the driver’s taxi license, with his name, the name of his taxi company, his taxi ID number, and the driver’s picture.

 

I ran back downstairs to the concierge. He called the driver’s cell phone number and got him on the phone. They quickly figured out that the cab was not far from my hotel. Within minutes, I was reunited with my bag. The driver went home with a tip so big that he couldn’t stop thanking me. After the driver left, the concierge said, “I have been working at this hotel for a long time. Guests are always leaving things in taxicabs. Of course we always try to do whatever we can, but this is the very first time that anyone actually got their stuff back.” 

 

The whole sequence reaffirms my faith in humanity. The lengths to which the lovely French woman went to try to find me fills me with a sense of gratitude and indebtedness. And then there’s the driver. He not only returned my bag, but he returned all of its contents – including every last one of the US and Singapore dollars. All I can say that as unlucky as I was to leave my bag in the cab, it was incredibly good fortune that these two were there to protect me from my stupidity. By the way, the pictures accompanying this post were nearly lost forever.

 

My Hong Kong sojourn also included the highly successful inaugural meeting of the Professional Liability Underwriting Society in Asia. It was a standing-room only event at the Royal Hong Kong Yacht Club. I thoroughly enjoyed the chance to meet and to address so many industry colleagues from Hong Kong and from all across Asia. I was also delighted to learn that so many of them are loyal readers of The D&O Diary. (The Internet is such an amazing thing).

 

I came away from Hong Kong with very warm feelings for the place. It is a dynamic city of incredible charm as well as a seemingly endless supply of diverse sights and sounds. Put Hong Kong down as a new entry on the list of favorite travel destinations. The next time I visit, though, I will remember to put my valuables in the hotel room safe. And friends, if on some future occasion you should find yourself riding with me in a cab, before we exit the vehicle, please ask me to make sure that I remembered to take all of my belongings.

 

More Hong Kong Scenes:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In a prior post,  I discussed Fordham Law Professor Richard Squire’s April 2012 article entitled “How Collective Settlements Camouflage the Costs of Shareholder Litigation” (here). After my post appeared, Professor Squire communicated to me his concerns about my comments regarding his paper. Because his comments and concerns about my post were quite substantial, it seemed that the best approach would be simply for Professor Squire to publish his response in full in a separate blog post. I have set out Professor Squire’s response below. I am very grateful to Professor Squire for taking the time to present his views in full here. I encourage readers to review Professor Squire’s paper as well. As Professor Squire indicates at the conclusion of his guest post, he and I will be participating in a session at Fordham Law School on May 8, 2012 to discuss his paper. Information about the session can be found here . Here is Professor Squire’s response:

 

 

I am most grateful to Kevin both for devoting a full blog entry to pay my current article on D&O insurance, titled “How Collective Settlements Camouflage the Costs of Shareholder Litigation,” and for giving me here the chance as a guest blogger to respond to his comments. This has been a valuable opportunity for me to learn more about the D&O field from Kevin, a recognized expert whose knowledge of the market for D&O insurance greatly exceeds my own. 

 

 

In his generously extensive comments about my article, Kevin identifies several places in which he thinks I describe the dynamics of D&O insurance settlements accurately. At the same time, however, he expresses numerous concerns with my proposed method for reforming such settlements. In this blog entry, I wish to focus on his concerns, and in particular to say why I think several of them are not warranted or are addressed by other aspects of my article that Kevin’s comments do not mention. 

 

 

To provide context, it will be useful to begin with a summary of my article, which has five interrelated points as follows:

 

 

1.      In a shareholder lawsuit against a defendant with one or more D&O insurance policies, the current practice is to require any settlement of the suit to be a single, collective resolution that binds all defense-side parties, meaning the defendant and each of its insurers.

 

 

2.      The current system of collectivized settlements encourages strategic liability-shifting among defense-side parties. This strategic behavior imposes a variety of costs on shareholders, only some of which have been previously recognized by judges and academic commentators.

 

 

3.      The collective action problem we see in shareholder lawsuit settlements is not inevitable.  Rather, it is “contrived” in the sense that it is a byproduct of how D&O insurance contracts are written and enforced.

 

 

4.      At least in theory, settlements could be de-collectivized in a manner that greatly reduced or eliminated the costs to shareholders from strategic liability-shifting. My article describes such an approach, which I calls “segmented” settlements.

 

 

5.      Even if de-collectivizing the settlement process would benefit shareholders, corporate managers would oppose it because the change would reduce the managers’ ability to use D&O insurance to shift settlement liability to insurers and thus to insulate corporate earnings reports from the impact of the managers’ conduct that gives rise to shareholder litigation.

 

 

Kevin’s comments suggest that he agrees with me on points 1, 2 and 5. Most of his criticisms of my paper are aimed at points 3 and 4—my arguments that settlements could in theory be de-collectivized and that such a change would benefit shareholders.  His comments also stress how “policyholders” would resist my proposal, though in so doing he does not acknowledge the degree to which he and I are in agreement on this point as long as by “policyholders” we mean the corporate managers who actually make the decisions to buy D&O insurance on behalf of themselves and their corporations.

 

 

Since most of Kevin’s concerns are focused on the desirability of my alternative system of segmented settlements, I will illustrate my proposal here with a very simple example. Imagine a corporate manager who is covered by a single D&O policy with a limit of $1 million. This means that if the manager is sued in a shareholder lawsuit, the insurer is responsible for the first $1 million in liability, and the manager is responsible for the excess, if any. Under the current system of collective settlements, the insurer could not settle with the plaintiff unless the plaintiff also agreed to waive his rights to collect from the manager, including his right to collect damages in excess of the $1 million policy limit. Conversely, the manager and plaintiff could enter into a settlement for, say, $1.2 million, and then use the “duty to contribute” (a duty not previously identified in the academic literature, but whose existence and importance Kevin confirms) to force the insurer to “tender” (pay) its $1 million policy amount in support of the settlement. In this way, any settlement must be “collective”—i..e, jointly binding on both the insured (the manager) and the insurer. 

 

 

One of the main problems with this system of collective settlements is that it can lead to plaintiff overcompensation. Since the manager and plaintiff can enter into a settlement whose costs are borne mostly by a third party—i.e., the insurer—they can jointly gain at the insurer’s expense by entering into a settlement that exceeds the expected damages at trial. In my article I call this the “cramdown” dynamic.  The manager’s incentive to engage in this settlement is that it avoids the risk of a trial at which the total damages in case of a verdict for the plaintiff may exceed the $1M policy limit by a large amount, leaving the manager with greater personal liability than she incurs by settling. 

 

 

Under a system of “segmented” settlements, by contrast, the manager and insurer could settle separately out of the case, and by so doing could neither shift liability onto the other nor bind the other in a settlement without the other’s consent. So, for example, the insurer could settle separately with the plaintiff, in which case the insurer would pay the plaintiff a settlement amount and the plaintiff in exchange would waive his right to collect the first $1 million in damages awarded at trial (if any). If the manager did not also settle, then a trial would occur, but only damages awarded in excess of $1 million would be collectible. Conversely, the manager could settle separately from the insurer, whereby the plaintiff would waive his right to collect any damages awarded that exceed $1 million. Under this system, “cramdown” settlements could not occur, and collective-action costs would be reduced for the reason that defense-side parties would no be able to shift liability onto each other.

 

 

Many corporate defendants have not just one D&O policy, but rather a primary policy plus one or more excess policies, forming an insurance “tower.” Adding these additional insurance layers increases the opportunity for strategic conduct but does not otherwise alter the basic conflict of interests created by a collectivized settlement approach nor the benefits of the alternative approach I describe.

 

 

With that overview for context, I’ll now turn to Kevin’s specific concerns and criticisms.

 

 

Holdouts:  Kevin argues that strategic holding out by insurers would still occur under if settlements were de-collectivized. To illustrate, he gives an example of a case in which all defense-side parties have settled except for one mid-level insurer.  I actually anticipate something close to this hypothetical on pages 29 and 30 of my article.  Contrary to Kevin’s argument, under the system I describe a mid-level insurer in that position would not have an incentive to hold out, as by doing so the insurer could not externalize liability onto the policyholder or other insurers.

 

 

To make the example concrete, let’s assume a policyholder with a tower of five D&O policies worth $1M each.  We’ll assume further that all defense-side parties, including the policyholder, have settled with the plaintiff except for the excess insurer occupying the $2M to $3M slice of the tower. This means that if a trial occurs, the plaintiff could collect only those awarded damages (if any) that fall between $2M and $3M, and these would be collectible solely from the holdout insurer.  Thus, regardless of whether the holdout insurer ultimately settles or goes to trial, no damages liability can be shifted to the policyholder.  

Kevin expresses in connection with this example a concern that defense costs (i.e., attorneys’ fees and similar expenses) might reduce this "sole remaining layer" of coverage, leaving the policyholder exposed (though, to be sure, only to defense costs plus damages in the $2M to $3M range—i.e., the unsettled remaining slice).  I anticipate this concern on pages 29-30, but I offer a simple solution:  "We can predict that [if settlements were de-collectivized] liability policies would be written so that the non-settling insurers in such cases [in which the policyholder had separately settled] bore the defense-side trial expenses without regard to policy limits, as otherwise those insurers could externalize onto other defense-side parties some of the costs of their refusal to settle."   

 

 

Kevin earlier in his post had expressed “trepidation” about the “world of academic analysis,” which seems to him “unbound by constraints that operate in the world to which I am accustomed.” But there is nothing otherworldly about my simple solution to the holdout problem with respect to defense costs. Under most other types of liability insurance (such as auto and homeowners insurance), defense costs do not count toward the policy limit.  It is D&O insurance that is unusual in its use of "burning candle" policies. Thus, by suggesting that defense costs would no longer count toward policy limits in situations in which the policyholder has settled out of the case, I am incorporating a solution to the cost-shifting hazard that will already be familiar to people with real-world knowledge of liability insurance.  

 

 

After presenting his holdout hypothetical, Kevin goes on to write that my proposal would "substitute a different cramdown dynamic for the existing one" and would "put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their insured."  It seems to me that his concerns here stem from this same misunderstanding about how holdouts would be handled under my proposal.  For this reason, I don’t think these concerns are warranted.  Under my proposed system, defense-side parties would have significantly less ability to engage in strategic cost-shifting than they do now.

 

 

Distributional Impact:  Kevin observes that the distributional impact of separate settlements would be to reduce liability for primary insurers and increase it for excess insurers.  This observation is accurate, as my article acknowledges at several points. But it is not grounds for concern, as the excess insurers would adjust by charging higher premiums ex ante, and so they would not on net be worse off.  However, because the current system’s cramdown dynamic would be eliminated, overall settlements would be lower, as there would be a reduction in plaintiff overcompensation (a phenomenon which Kevin acknowledges occurs under the current system).  So overall insurance costs will be lower, a benefit to policyholders.

 

 

Expected Trial Liability:  Kevin devotes several paragraphs to criticizing my reliance on the concept of "expected trial liability" (meaning expected damages if the case goes to trial).  In particular, he criticizes my article for arguing that this figure is "objective" rather than "subjective" and can be reduced to a "single knowable measure."  Here I think Kevin is attacking a straw man.  Nowhere does my article claim that expected trial damages are knowable with certainty ex ante or that parties will form identical estimates of them.  To the contrary, I acknowledge that estimates will differ, and on pages 35 and 36 I model what settlement negotiations look like when they do.

 

 

Similarly, Kevin criticizes me for not taking into account "myriad factors" that affect negotiations, including "whether some insurers believe they have unique coverage defenses."  But on pages 37-40 I do model the impact of coverage exclusions on settlement negotiations.  

 

 

To be sure, I don’t model the impact of another factor Kevin identities—namely, the pendency of related lawsuits.  But the fact that a model does not include every conceivably relevant factor does not mean that we can derive no insight from its results.  Indeed, the article’s models are what revealed to me how the cramdown effect under the current system can lead to plaintiff overcompensation, a result whose accuracy Kevin confirms.  More generally, while Kevin calls into question the usefulness of abstract models in the study of complex insurance negotiations, he does not identify any specific results produced by the article’s models that he thinks are inaccurate or unrealistic.

 

 

Delay:  Kevin worries that separate settlements would introduce delay.  But delay results from holdout problems, and de-collectivizing the settlement process would greatly reduce the advantages to holding out.  Indeed, under my system, as each defense-side party settles out of the case, the incentive both for the plaintiff and for the remaining defense-side parties to settles increases.  This is because each settlement reduces the plaintiff’s potential recovery at trial but not the trial expenses that both sides would have to incur if trial occurred.  Returning to the example above involving the mid-level insurer holdout, that insurer’s incentives to settle are maximized when it is the only defense-side party left in the case, since at that point it will bear all of the defense-side trial costs.   And the plaintiff’s incentive to settle is maximized as well since the damages recoverable at trial have been pared down to a thin slice, but winning that slice would still require the plaintiff to incur the full costs of putting on his case.  Since there is no advantage to anyone under my proposed system of delaying resolution of a lawsuit, we can expect less rather than more delay than we see now.

 

 

Achievability:  Kevin criticizes me for writing that "segmented settlements could easily be achieved contractually," a statement he says "lacks a connection to the insurance marketplace" because insurance buyers would resist such a change.  But all I meant was that nothing prevents segmented settlements as a matter of contract law.  I acknowledge full well that D&O insurance buyers—i.e., corporate managers—benefit from the current system of collectivized settlements. See, for example, my abstract:  "Yet corporate managers probably prefer the status quo."  That’s why on pages 42 and 43 I argue that, if reform were to occur, it probably would have to be initiated by courts. 

 

 

Reinsurance:  In my article I make the uncontroversial observation that excess insurance and reinsurance are substitutes:  both help insurers diversify their risk exposure. A simple example will illustrate.  Imagine that Company A buys a $10 million primary policy and a $10M excess policy.  Meanwhile, Company B buys a $20M liability policy, and its insurer then purchases coverage for the top half of this policy from a reinsurer.  In both cases we have a division of risk between two insurers.

 

 

I think it interesting that in the D&O market we see Company As rather than Company Bs—that is, we see towers rather than reinsurance. I raised the question in my article whether this might reflect a preference among insurance buyers for a system that encourages covered settlements through the cramdown dynamic. Kevin criticizes me on this point, arguing that there are "a finite number of reinsurers and they require a spread of risk every bit as much as the insurers do."  But the fact that currently there is a relatively small number of reinsurers is not a criticism of my hypothesis; rather, it is a restatement of the question my hypothesis seeks to answer—i.e., the question why this particular insurance market has developed to rely on towers rather than reinsurance. And his claim that reinsurers also "require a risk spread" is misleading since reinsurance is, by definition, risk-spreading, as my example of Companies A and B illustrate.

 

 

Finally, Kevin claims that the presence of towers is explained solely by the preferences of insurers, but this claim is in tension with his earlier claim that D&O insurance is a buyers’ market, and it fails to explain why the carriers should prefer the tower model over the reinsurance model.

 

 

***

 

As I said at the beginning of my comments, I am most grateful to Kevin for not only highlighting my article on his blog but also giving me the chance to respond as a guest as I’ve done here. As Kevin mentioned, he and I will be co-panelists at a conference at Fordham Law School (where I’m privileged to teach) next month, where I’ll have the opportunity to be able to discuss these matters with him further. I hope Kevin’s readers have found my exchange with him interesting. If any reader has any comments or questions on the subject matter discussed here, I’d welcome hearing from you at rsquire@law.fordham.edu.  

 

 

The D&O Diary is on assignment in Asia this week, with a first stop in Beijing and with other Far Eastern stops scheduled after that. Even traveling “over the top,” Asia is very far away. When the flight progress monitor shows your plane traveling over Irkutsk and Ulan Bator, you know you are far from home.

 

Beijing is a vast, sprawling, teeming city. At first blush, it is a thoroughly modern city, its wide boulevards lined with ranks of modern steel and glass office towers. Yet inside the Forbidden City or the Temple of Heaven (both of which, like the city itself, are huge), Beijing reveals itself as an ancient city with a long and fascinating history. And yet again, in the warren-like hutong neighborhoods (at least the ones that remain), with their narrow alleys and winding passageways, Beijing can feel daunting, mysterious and even a little dangerous.

 

With the city’s ubiquitous modern buildings and traffic congestion, it is something of a shock to suddenly find yourself standing in Tiananmen Square, facing the entrance to the Forbidden City, the enormous portrait of Chairman Mao hanging over the entry gate (pictured above). It is hard to believe that barely forty years ago, more than a million people gathered in the Square waving Little Red Books, and that only 23 years ago a single soul faced down a Red Army tank. The street where the lone protestor stood is now clogged with tour buses, Porsche SUVs and Mercedes sedans. The Square itself is full of tour groups and vendors hawking Mao hats and “genuine” Rolex watches.

 

The Forbidden City is an enormous complex of buildings, courtyards and temples that defies easy description. Its grounds are larger than those of the Palace at Versailles. I visited it twice on this trip and still feel as if I only saw a very small part. Many of the buildings were dazzlingly restored for the 2008 Beijing Olympics, and during my visit the courtyards were full of blooming fruit trees and blossoming flowers.

 

Over the centuries, twenty-four Ming and Qing emperors lived in the Forbidden City, but the tour guides seem to concentrate on the last Ming emperor, Chongzhen, who slew his own family and then hanged himself in 1644 to avoid capture by rebel armies and the oncoming Manchu invaders, and Puyi, “the Last Emperor,” who abdicated in 1912 and who fled the Forbidden City in 1924.

 

Emerging at the Northern gate of the Forbidden City, you suddenly leave behind the venerable vestiges of the country’s imperial past and plunge into the tumult of the city’s jarring present. Vendors, beggars with shocking wounds and deformities, school kids, and tourists jostle and push along a walkway not nearly large enough for the crowds. Beijing can be simply overwhelming at times.

 

Perhaps detecting my sensory overload, my tour guide suggested that we retreat to a tea house. We had to take a city bus (fare = 1 yuan, about 16 cents) to where he had parked his car in a hutong. We then drove through back streets to a quiet tea house, where a chatty young woman performed a simple tea ceremony. We sampled seven different varieties of tea – this one for longevity, that one for your complexion, this one for serenity. Perhaps it was the soothing effect of the warm drink, but I wound up buying an enormous quantity of tea and even a couple of tea cups and saucers. After the tea, the guide (happy to increase his tea-sotted client’s fee) took me on a tour of the Yonghe Temple, a Qing-dynasty Buddhist monetary that still houses chanting and incense-burning monks. 

 

The tea-induced serenity proved short-lived. With 19.6 million people, Beijing is well more than twice as large as New York City. It is almost incomprehensible that it is only the third largest city in China. With 23 million people, Shanghai is the second largest, and with nearly 29 million, Chongqing is the largest. The sheer scale is beyond anything I have ever experienced.

 

Beijing is also a city of five million vehicles, and at any moment it is easy to believe that all five million are out on the roads at the same time – but that is a mistaken impression. Each weekday, traffic regulations bar one-fifth of the cars from the inner city based on vehicle registration number, and trucks are banned altogether during the daytime. But even with these restrictions, the roads are jammed at all hours. Picture the worst traffic you have ever seen in, say, L.A., multiply times ten, and then allow for the fact that rules of the road are viewed as purely advisory. A red left-turn arrow does not mean no left turn; it means jockey for position until you see an opening and then go for it (and for Beijing drivers, an “opening” means only ten or fewer pedestrians directly ahead).

 

Contemporary Beijing has many other attributes of any modern city. I was surprised and disappointed to find that the Westin hotel in which I was staying felt like a Westin hotel anywhere, and  the Financial District in which it was located had the exact feel of say, Tyson’s Corner, Virginia or Stamford, Connecticut, except with even less charm.  On the cross street adjacent to the hotel were a Starbuck’s, a KFC, a Pizza Hut and a TGI Friday’s. I felt as if I were in a containment zone for Americans hoping to have as little contact with China as possible.

 

Fortunately, the area near my hotel is not representative. There are several areas full of restaurants and street life. One afternoon, we had lunch in a lakeside restaurant in the Back Lakes area (pictured left), where we were served plate after plate of spicy, delicious food – chicken with walnuts; mushrooms in a spicy sauce; saffron rice dusted with crushed, fragrant flowers, thick noodles flecked with bits of pork; a gigantic fish with its head and fins still intact; and plates of sweet and savory dumplings. And what would a visit to Beijing be without a meal of Peking Duck? We enjoyed a very special meal at the famous Da Dong Roast Duck restaurant, a multicourse (and breathtakingly expensive) extravaganza that culminated in the table-side carving of the wood-roasted duck. I saw just enough of the city on these outings to know that there is an incredible diversity of things to see and do, but I just did not have the chance to explore these areas the way I would have liked. Stuck in the American containment zone, I was simply (and disappointingly) out of position to fully explore the parts of the city with a pulse.

 

My Beijing sojourn did include the obligatory excursion to the Great Wall. Sixty miles north of Beijing, past the sixth and last of the city’s ring roads, the flat plain gives way to jagged mountains shrouded in mists. A Ming dynasty section of the Wall bristles along a rugged ridge-top. Today, a chair lift sweeps visitors up to the top, but to see the guard towers at the highest elevations, you still must scramble up a long, steep incline of uneven steps. When you finally reach the top, panting and sweating, you are greeted by a wise-cracking vendor in a Mao hat:”Where you from? Ohio? Cool! You need cold beer, Ohio, only eight yuan [about $1.30], very cold.”

 

The Mutianyu section of the Wall that we visited was built in very rugged terrain, and is surrounded by thick forest. On the day of our visit, the woods were full of flowering trees and I can only imagine how beautiful the view is on a clear day. As it was though, a thick mist obscured the view. The clouds closed in and a fine rain began to fall shortly after we returned to the bottom.

 

To descend to the bottom, we did not take the chair lift back but instead we rode a toboggan that traveled along a curved metal track. The slope is steep, and as I careened along at breakneck speeds, I thought to myself that the momentum could easily carry me off the track and into the woods. I suppose life-threatening pleasures are just part of the checklist when on travel to distant lands. Fortunately, no one was killed, in our group at least, and after several in our group had filled their backpacks with souvenir tee shirts, chopsticks, and straw hats, we gathered for lunch in a restored old schoolhouse. Along the serving table were heaping plates of duck, pork, and noodles, toether with enormous bottles of beer.

 

Somehow the metal toboggan run seems to me like a metaphor for Beijing itself. The city’s incredible pace and dazzling prosperity are very impressive, but there is a dark edge to the city’s vitality. In ways that are readily apparent, the city is literally choking on its prosperity. All the Gucci and Cartier stores and speeding Audi A6s with tinted windows cannot hide – and indeed may even underscore – the fact that all is not well.

 

One cultural difference many Americans visitors to Beijing often note is that it is quite common for people on the street to hawk loudly and spit onto the pavement. Some Americans may find this unpleasant or even rude but after just a few days in the city, I began to better understand the behavior. After only one day, my throat was scratchy. By the second day my throat was sore. After that, I found that I had to keep popping throat lozenges just to get by. I am sure that before too long I would be hawking and spitting just like a native.

 

I had arrived during a particularly clear interlude (as shows in many of my pictures). But the thicker air soon settled back in. Nearby buildings nearly disappeared in the haze. The sun faded into a diffuse, low wattage glimmer behind a blanket of smog.

 

Nor is the foul air the only sign that all is not well. At first it seemed trivial to me, but the fact that the government has blocked Facebook, Twitter and Google, along with many other parts of the Internet, really does show that for all of its apparent prosperity and dynamism, China remains a closed and controlled society. In several different conversations, I heard complaints about difficulties getting housing, health care and educational services. Inflation is becoming an increasing concern as well. When the yuan was eight to the dollar, Beijing may have been a bargain, but at 6.3 yuan to the dollar, it is no longer cheap. Several different business people shared with me their concerns about rising prices and shrinking or disappearing margins, as well as the scarcity of credit. After years of growth at a breakneck pace, there are increasing concerns that the economy could be headed off the tracks.

 

In the end, Beijing remains for me an immense puzzle of conflicting impressions. Because it is so vast and multi-faceted, even after a week there, I felt that I had barely scratched the surface. One very special experience while I was there illustrates the challenge of trying to get to the heart of the place.

 

Early one morning, I took a cab to the Temple of Heaven, now a huge park with walkways, pavilions and gardens, as well as the actual temple buildings where Ming and Qing emperors fasted and prayed annually for a bountiful harvest. The temple buildings, though 19th century restorations, are beautiful, but the grounds and gardens are the main attraction. Wandering amongst the blossoming trees and surrounded by families and school children, it was easy to feel as if I were indeed in a blessed place.

 

Near one of the ornate pavilions (pictured to the left), a group of traditional musicians attracted my attention. I sat and listened to them for a long time. Their music sounded strange to my ears; there seemed to be no rhythm or melody, at least that I could discern. The singing sounded, to me, tuneless and off-key. I found the music strange and absolutely fascinating. I would have liked to have spoken to the musicians, to know more about their music and their instruments. But as it was, I hesitated even to take their pictures for fear of being intrusive or causing offense.

 

Like the music, I found Beijing itself interesting and enigmatic, a complex puzzle with many surfaces and hidden meanings. The only thing I know for sure is that I must go back, to try to get closer to the heart of a fascinating city.

 

A containment zone for Americans :

 

 

 

 

 

 

 

 

 

 

Tianamen Square, genuine Rolex watches, you buy, how much? 

 

 

 

 

 

 

 

 

 

 

The Hall of Prayer for Good Harvests at the Temple of Heaven:

 

 

 

 

 

 

 

 

 

 

Flames Must be Fully Clothed at All Times:

 

 

 

 

 

 

 

 

 

 

And if your relics have a persistent problem, we can get them extra strength anti-itching powder:

 

 

 

 

 

 

 

 

 

 

We Make Our Dumpling By the Book: 

 

 

 

 

 

 

 

 

 

 

At those other tourist sites,  you have to put up with a lot of uncivilized sightseeing: 

The negotiated resolution of securities class action lawsuits – and absent dismissal, there is rarely any other types of securities suit resolution – is always complicated and occasionally messy, and often involves inefficiencies and sometimes produces distortions and even excesses. Anyone who has ever been through a securities suit settlement negotiation likely will have had the thought that there has to be a better way for resolving the cases.

 

In an April 12, 2012 paper entitled “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits” (here), Fordham Law School Professor Richard Squire catalogues the many shortcomings in the current securities class action settlement process and sets out his proposal to improve the process and to eliminate process inefficiencies and excesses. UPDATE: Please note that Professor Squire also completed a separate response to this blog post in a seprate guest post of his own. His guest post can be found here.

 

According to Squire, securities class action settlements suffer from a “collective action problem,” owing to the fact that current practices and law require a single case resolution that collectively binds the defendant and all of its D&O insurers – even though the D&O insurance itself is “segmented” in a tower of insurance with the insurers in the different layers having different settlement positions and differing perspectives and interests regarding the settlement.

 

Among other things, Squire notes that insurers in the primary layers and lower level excess layers are often compelled to contribute toward settlement when the settlement demand (or more accurately, the settlement opportunity) exceeds their layer. This compulsion, Squire notes, is often effectively given legal force through a rarely identified but nonetheless very real “duty to contribute.” These forces lead to a number of ills, including “plaintiff overcompensation at insurer expense”; overpriced liability insurance; and lawsuits of doubtful merit.

 

Identifying the requirement for collective settlements as the source of the problem, Squire proposes allowing “segmented settlements” – that is, allowing each defense-side party (and in particular each of the carriers in the D&O insurance tower) to “settle with the plaintiffs separately for its respective slice of the damages ranges.” Under this approach, trial would occur unless all slices settled and the plaintiff would collect at trial only those awarded damages (if any) that fell within the unsettled slice.

 

Squire postulates that this approach would eliminate the conflict of interest between the defense-side parties, “removing the cramdown dynamic that can lead to plaintiff overcompensation.” The elimination of this dynamic will, Squire contends, ultimately lead to more shareholder lawsuit settlements being paid by corporations rather than by insurers, an outcome Squire that further contends would “benefit shareholders, as it would improve the accuracy of a firm’s reported earnings as a measure of the contribution of that firm’s managers to overall shareholder wealth.”

 

I have set out below my thoughts about Squire’s proposal. I note at the outset that I approach commenting on academic papers with trepidation. Even though D&O insurance and D&O claims resolution are areas to which I have devoted my entire professional life, the world of academic analysis, even with respect to a topic within my area of expertise, seems unbound by constraints that operate in the world to which I am accustomed. My usual trepidation is even greater where, as here, I am already committed to commenting in person on the academic analysis in a public forum. Specifically, on May 8, 2012, I will be attending a conference at Fordham Law School at which I will be participating in panel in with my friends Tom Baker of U.Penn. Law School and Sean Fitzpatrick of Endurance Risk Solutions. The purpose of the panel is to discuss Professor Squire’s paper.

 

As a threshold matter, I will say that an important aspect of Squire’s analysis for which I give him high marks is his understanding of the central importance of D&O insurance in the securities class action settlement process. All too often, commentators under-appreciate the significance of the role that D&O insurance plays in the process. A particularly important insight Squire has with respect to the role of D&O insurance is that the different D&O insurers’ interests and positions in the settlement process differ based on where they are in the insurance tower.

 

Squire’s understanding of the role of D&O insurance is particularly accurate when he describes the “cramdown” effect – that is, the pressure that the insured company and the upper level excess carriers can bring to bear on the primary and lower level excess insurers to force the lower level insurers to throw in their limits. Squire perceptively describes what is too often unconsidered, which is the presumed “duty to contribute” that compels lower level insurers to tender their limits where there is pressure to settle a case at a number beyond their limit of liability.

 

Squire is also on target with his identification of the undesirable consequences this dynamic can produce. It can, as he notes, produce plaintiff overcompensation (which he also correctly notes, inures disproportionately to the benefit of the plaintiffs’ lawyers) and it can result in higher priced liability insurance. And the opportunity for further occasions of overcompensation undoubtedly attracts additional lawsuits.

 

Having identified these problems with the current system, the question is whether Squire’s proposed solution would in fact solve the problems in an appropriate and acceptable way, a question to which I turn below. However, having noted above the respects in which I agree with Squire’s understanding of the process and the dynamic, I must also as a preliminary matter identify the respects in which my understanding differs from Squire’s. These considerations may or may not alter the ultimate merits or demerits of Squire’s proposed solution to securities suit settlement; but to the extent these considerations might (and they well might, given that much of Squire’s analysis depends on these understandings and assumptions), it is worth my setting out here my differing understandings.

 

First and foremost, D&O insurance provides a contractual way for companies to manage their indemnification obligations, and to ensure that these indemnification obligations can be honored even if the company itself is unable to do so when the need arises. Because D&O insurance derives from the indemnification obligation, and because the company’s indemnification obligation includes both the obligation to provide for defense expense and for indemnity amounts, the D&O insurance policy has always provided coverage for both defense expense and for settlements and judgments.

 

Second, companies buy D&O insurance in a marketplace that has been “soft” for almost all of the last 25 years. During that time, dozens of new insurers have entered the marketplace, while at the same time there are many fewer public companies than there were even a short time ago. With an abundance of insurance capacity chasing a dwindling number of insurance buyers, the marketplace is heavily tilted in the favor of the buyers. Buyers expect and get very broad coverage for prices that remain advantageous for the buyer. Owing to the constraints of competition, insurers have a limited ability to impose defensive measures or to constrain coverage. The insurers’ options are two-fold: either to play ball or to sit out the game. Most decide to continue to play.

 

Third, as a result of the number of persons insured under D&O policies and the number of insurers that are involved in the typical D&O insurance tower, there are in connection with any securities class action settlement many participants, each with their own counsel. Often there are other parties (auditors, underwriters) who are named as defendants but who are strangers to the D&O policy. Not only are the insurers’ interests not aligned but often the insured persons’ interests are not aligned, and the insured persons’ interests often differ from the other named defendants. The carriers’ interests differ not only according to their attachment point in the insurance tower, but also based on situation specific factors such as how much defense expense has been expended and what the anticipated defense expense burn rate will be. The various carriers’ approach to settlement may also depend upon whether they believe they may have coverage defenses that potentially affect their payment obligations.

 

Not only are there a host of negotiating parties, there often are a host of proceedings involved, other than just the securities class action lawsuit. If a securities suit is serious enough to implicate the excess insurance, there will almost always be multiple other actions ongoing at the same time – usually a parallel derivative suit, often a pending SEC investigation or enforcement action, sometimes even a DoJ investigation or prosecution. The existence of these other proceedings can complicate the settlement dynamic in myriad ways. Serious securities class action settlement negotiations usually do not take place in a vacuum.

 

A final point about securities suits that should be emphasized is that securities class action lawsuits go to trial so rarely that the possibility of trial can safely be disregarded for most practical purposes. Everyone involved in the case knows it will never go to trial. There are very good reasons that these cases very rarely go to trial. The most important is that the theoretical damages almost always exceed the available insurance and in many cases outstrip the defendant company’s financial resources as well. A less dramatic constraint is that trials are costly, burdensome, and unpredictable and would constitute a huge distraction on senior company management. By the same token, the company could ill-afford a judicial determination that conduct that would preclude coverage has taken place. The plaintiffs have their own concerns; the expense of a complex jury trial could be enormous yet at the same time involves the risk of a defense verdict.

 

Together with these preliminary observations about D&O insurance and about the settlement process, I should also add the following observations on Professor Squire’s understandings and assumptions about D&O insurance.

 

First, Professor Squire assumes that corporate buyers consciously and deliberately structure their D&O insurance in multi-layered tiers because that creates “conflicts of interest among insurers that serve the interests of corporate managers,” as, he postulates, the conflicts “actually make insurance-covered settlements more likely.” There may be some buyers out there who are so canny that they manage their insurance buying decisions with these calculations in mind.

 

My own experience is that most insurance buyers would prefer to buy fewer, larger layers of insurance, because that would afford claims administrative simplicity, eliminate the headaches that always arise in the claims context when the insured company has to fight its way through multiple layers, and would simplify the insurance acquisition process.

 

The reason that D&O insurance programs are layered is because of the carriers’ preferences, not the buyers’ preferences. No D&O insurer could sustain the concentration of risk that would be involved with exposing outsized amounts of capital to any single large corporate exposure. Professor Squire assumes away this concern by saying that insurers could issue a single policy and simply “protect themselves from this risk through reinsurance.” However, there are a finite number reinsurers and they require a spread of risk every bit as much as the insurers do. The layering of D&O insurance is an inevitable by-product of an insurance marketplace where any given company’s insurance needs exceed the ability of any one insurer (or even one insurer and its reinsurers) to absorb all of the concentrated exposure associated with one risk.

 

Professor Squire also sees something amiss with the fact that D&O insurance policies cover both defense expenses and indemnity amounts. From my perspective, this arrangement is a natural reflection of the outgrowth of D&O insurance as a way for companies to contractually manage their indemnification obligations. In any event, the typical insurance buyer would consider it a strange notion indeed that their D&O liability insurance would not provide defense expense protection or at least that they would have to buy a defense cost policy separate from their liability policy.

 

With respect to Professor Squire’s analyses of the settlement dynamic, I note that in all of Professor Squires hypothetical settlement examples (and all of his examples are in fact hypothetical), he refers to the “expected trial liability” or “the actuarially fair settlement amount.” These are abstractions. There is no such thing in the securities context as “expected trial liability,” simply because there is effectively no data to describe such a thing. (For the same reason, talk of a party’s “bias to toward trial” or “aversion to trial” is equally inapposite.) By the same token, the idea that there is an objectively knowable amount equivalent to an “actuarially fair settlement amount’ is equally unwarranted.

 

What we actually have is a much rougher, much more approximate concept that usually is described as “what cases like this settle for.” Basically every single person in the settlement room will have their own version of this number, as well as their own concept of what features of the case make the comparables relevant. These points of reference are subjective, not objective; rarely the subject of agreement between the parties, at least at the outset; dependent on a host of assumptions; and allow for a range of possible outcomes that might constitute reasonable case resolutions depending on the myriad of factors.

 

In addition, the procedural posture of the case matters; the existence of related pending actions matter; the level of defense expenditure and the anticipated defense expense burn rate matters; the extent to which the defendants’ interests are aligned matters; whether some insurers believe they have unique coverage defenses matters; these and many other features matter and will influence the settlement dynamic and possibly affect the outcome of negotiations.

 

My point is that the settlement dynamic is complex and multifaceted. The very idea that settlement negotiations can be reduced to a mathematical formula with a few variables that explain outcomes in all cases – or even one case – is an interesting theory, as is the idea that settlement outcomes might be measured against a single, knowable measure that represents the “fair” outcome.  The idea that settlement of the class action could be taken in isolation from the myriad other factors – for example, the existence of other related pending proceedings – is an interesting hypothesis.

 

Turning to the specifics of Professor Squire’s proposal that settlements should be segmented rather than collective, I have the following observations. It is possible that the alternative settlement arrangement Professor Squire has proposed could work to produce settlements that are fairer to all participants and that could eliminate the many ills that Professor Squire has identified. I suspect his proposal would be particularly attractive to the carriers that are most routinely in the primary and first level excess layers. It would less attractive to the insurers that are most often in the upper excess layers. And it would be extremely unattractive to policyholders.

 

First, with respect to the upper level excess participants, if all defense side participants have to negotiate their own settlements, there could be an unfortunate dynamic that forces the excess to the settlement table and forces them to pony up money that they otherwise shouldn’t have to pay and wouldn’t pay now. This effect, the direct result of reducing the protection to the excess carrier from the underlying layers, would increase the loss costs of the excess insurers. This would likely make excess insurance more expensive and partially or entirely offset any savings that might be available if primary and lower level excess carrier loss costs were reduced. In other words, to eliminate the cramdown effect, the segmented settlement process would substitute a “cram-around” effect, or maybe a “cram-up” effect.

 

Second, the possibility of a settlement holdout will not be eliminated. But the process when there is a holdout will change. Let’s consider the possibilities. Assume that all of the other participants have settled except one middle layer insurer. Sure, there would be a lot of pressure on the holdout. But there would be enormous pressure on the policyholder, too. Every additional dollar of defense expense incurred will reduce the sole remaining layer, forcing the policyholder toward a possible trial with ever-dwindling amounts of defense costs protection and little or no insurance remaining for any judgments that might result. For all the reasons outlined above, the policyholder could never run this trial risk, and so could be forced to contribute to settlement to avoid the range of unpalatable outcomes. Indeed, crafty insurance players aware of this possible dynamic might become strategic obstructionists, in order to compel the policyholder to absorb settlement costs and possibly allow the obstructing insurer to negotiate a discount settlement deal.

 

My concern is that one almost inevitable outcome of the segmented settlement process that Professor Squire has proposed is that policyholders would be compelled to contribute more frequently and in much greater quantities toward settlement. To the extent I read Professor Squire’s proposal correctly, he fully anticipates this process effect. For example, he says “If the settlements were segmented, more of them would be paid for by corporations rather than by their insurers.” Indeed, as I understand his analysis, he reckons this as one of the positive factors supporting his proposal, because it would force more companies to recognize in their securities litigation loss costs in their financial statements.

 

However, if I am right about the way that this settlement dynamic would work out, the introduction of a segmented settlement process would simply substitute a different cramdown dynamic for the existing one. The new dynamic would be particularly pernicious as it would threaten to put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their own insured. I am at a loss to see how this could ever be viewed as an appropriate or desirable arrangement of affairs between an insurer and a policyholder. No insurer interested in maintaining its reputation as a good corporate citizen would ever propose such a thing. No well-informed policyholder would ever propose such a thing, either.

 

Another practical concern is that requiring segmented settlements would prolong cases. Process participants jockeying for position would have every incentive to try to game the system, hoping that the eroding limits and the ongoing litigation burden will compel other participants, particularly the policyholder, to pony up to get rid of the case. Company management would be burdened and distracted by a complex multistage process that never seems to end and distracts them from the things they need to do to make their businesses successful. Litigation is bad enough as it is, but one settlement deal ends it. If multiple deals were required, it could go on and on and on… And all of these problems would be magnified enormously if there are other related procedural matters pending. 

 

My most important objection to Professor Squire’s proposal is that it is commercially impractical. He simply asserts that “segmented settlements could easily be achieved contractually.” This statement lacks a connection to the insurance marketplace. The theoretical possibility that in the long run segmented settlements might lower insurance costs or reduce the number of lawsuits will have no meaning to an insurance buyer, when compared to the very real possibility that the segmented settlement arrangement would cause the buyer to have to absorb loss costs that would otherwise be covered. No company would ever agree to do it — nor should any company ever agree to it.

 

All of that said, there unquestionably are serious ills with the current securities suit settlement process, many of which ills Professor Squire identifies in his paper. I am not sure I know how to remedy these ills. One possibility that Professor Squire considers and rejects is the possibility of a quota share arrangement, where the various carrier participants’ interests are arranged vertically, rather than horizontally. Under this arrangement, each carrier would share ratably in each dollar of loss costs, so the carriers’ interests in trying to save loss costs would be aligned in a way that would eliminate the conflict of interest problems Professor Squire identifies.

 

The shortcoming of the quota share approach is that it would be very difficult for all of the participating insurers to cede control to a single decision maker. In the absence of a single point of control, the claims process could be reduced to chaos. But on the plus side, there are multiple places in the insurance world now where quota share arrangements already are in place and functioning successfully. There is a lot to be said for an insurance arrangement that already actually exists as a possible solution for an insurance-related problem.

 

I would like to thank Professor Squire for allowing me the opportunity to read his interesting and thought-provoking paper and for allowing me to comment about his paper here. I enjoyed reading his paper and writing this comment – it kept from going crazy on a very long plane flight. I hope that readers of this blog will review the Professor’s paper on their own and will post their thoughts and comments about his paper here using this site’s comment feature.

 

And in Other News: With a long plane flight on Saturday, I not only had the leisure to type out this long blog post, but I also had the opportunity to read the Financial Times weekend edition at length and in full. With a more thorough reading than I am usually able to enjoy, I gleaned a couple of very interesting observations from articles in the paper.

 

First, in a April 14, 2012 article entitled “Unorthodox Behavior Rattles Russian Church” (here), the article’s author notes the following about Kirill I, the patriarch of the Russian Orthodox Church: “Last week bloggers discovered that a photograph of the patriarch on the Church’s website had been altered to remove a $30,000 Bruguet watch from the churchman’s wrist. While someone had used Photoshop to erase the offending object, they had forgotten to erase the watch’s reflection on a nearby mahogany table.”

 

And in an April 14, 2012 article entitled “Who Needs the Shard When You Have Shakespeare?” (here), commenting on the latest addition to the London Skyline (now under construction), the article’s author notes that

 

The skylines of European cities have traditionally told us something about what they believe in, and they still do. Until Harold Macmillan eased restrictions on buildings exceeding the height of St. Paul’s, London’s skyline consisted of two 100m-high buildings: St. Paul’s and the Big Ben clock tower. It was easy to see what London stood for: the Church and parliamentary sovereignty and not necessarily in that order. The skyline of modern London, with its dozen or so buildings more than 100m-tall, also sends a message. It is best summed up by the London Eye, which proclaims the city less a workplace than a tourist attraction. The rest of the buildings are about money.

 

On the Road Again: This upcoming week I will be a panelist at a session in Beijing co-sponsored by the American Bar Association Torts and Insurance Practice Section and by the China Council for the Promotion of International Trade. Information about the conference, which is entitled “Doing Business in the United States: What you Need to Know about Investing, Product Liability and Dispute Resolution,” can be found here. I will be on a panel entitled “Directors and Officers Liability, Securities Issues and Class Action Exposure” with my good friend Perry Granof, as well as Patrick Zeng of Zurich China, whom I am looking forward to meeting for the first time on this trip.

 

From Beijing, I will be going on to Professional Liability Underwriting Society (PLUS) Chapter events in Hong Kong and Singapore. Perry Granof will also be joining me educational sessions at these PLUS Chapter Events, as will my old friend Joe Monteleone. To those readers who may be attending the PLUS Chapter events, I am looking forward to seeing you. If we have not met before, I hope you will please take the opportunity to introduce yourself.

 

With the distances, time differences and commitments involved, I am not sure what sort of publication schedule will be possible over the next few days. The D&O Diary’s normal publication schedule should resume the week of April 30, 2012. 

 

On April 11, 2012, as required by the Dodd-Frank Act, the SEC released its study of cross-border private securities litigation, entitled “Study on the Cross-Border Scope of the Private Right of Action Under Section 10(b) of the Securities Exchange Act of 1934” (here). This Commission study considers possible alternative approaches to the question of cross-border private securities litigation. It also provides a useful and detailed over view of the ways in which the lower courts have been approaching these issues in the wake of the U.S. Supreme Court’s decision in the Morrison v. National Australia Bank case.

 

By way of background, the Supreme Court in the Morrison case found that the ’34 Act itself did not expressly apply extraterritorially but rather applied only to transactions on domestic exchanges and domestic transactions in other securities.  Shortly thereafter, in connection with its passage of the Dodd-Frank Act, Congress supplied an extraterritorial reach to the Exchange Act in connection with actions brought by the SEC and the DoJ. Section 929P(b)(2) provide extraterritorial effect for these types actions when certain defined types of conduct take place in the United States or when it takes place outside the United States with a foreseeable effect in the U.S.

 

Section 929Y of the Dodd Frank Act directed the SEC to solicit public comment and then conduct a study to consider whether there should be an extension of a private right of action on the same basis as for the regulators, or in some other manner. This same statutory provision required the SEC to consider the potential implications on international comity and the potential economic costs and benefits of extending the cross-border scope of private actions.

 

The SEC’s April 11 report, weighing in at 106 pages including indexes and appendices, represents the Commission’s response to this statutory requirement. The report carefully lays out the history of Morrison as well as the lower court case law that has developed since the Supreme Court released its opinion. The report also carefully catalogues all of the various comments the SEC received with respect to the statutory mandate to produce this study.

 

The report is detailed, interesting and informative. Nevertheless, the SEC could have saved itself a lot of effort (not to mention a lot of paper) if it had just bypassed all of the intervening steps and admitted that  its position has not changed since it filed, in collaboration with the Solicitor General, its amicus brief in connection with the Morrison case, when it was before the U.S. Supreme Court.

 

After all of the preliminary review, the Commission lays out the available alternatives. The Commisoin does not take a position on the question of whether or not Congress shoudl overturn Morrison. Indeed, the report specifically states that an option woudl be for Congress "to take no action." 

 

However, in reviewing the alternatives that Congress might take, it leads with the position it advocated before the Supreme Court, which is to preserve some form of the “conduct and effects test” that prevailed prior to the Supreme Court’s decision in Morrison, but with the test narrowed so that “a private plaintiff seeking to base a Section 10(b) private action on it must demonstrate that the plaintiff’s injury resulted directly from conduct within the United States.”  The report notes that the direct injury requirement “could serve as a filter to exclude claims that have a closer connection to another jurisdiction.”

 

The Commission noted that this was the position it took with the SG before the Supreme Court, adding that “the Commission has not altered its view in support of this standard.”  Indeed, in the study, the SEC takes the opportunity to reiterate in the report the arguments that it raised in support of this position before the U.S. Supreme Court.

 

The report does, however, note that even the narrow direct injury test could nonetheless pose challenges to international comity when litigants are able to seek and obtain remedies that would not be available in their own country. The direct injury test could require a fact-intensive inquiry that could result in burdensome costs both for U.S. courts and foreign corporations.

 

The report also suggest, in addition to some form of the conduct and effects test, four options to “supplement and clarify the transactional test.” First, the report suggests the possibility that investors would be permitted to pursue a Section 10(b) claim in connection with the purchase or sale of any securities that are of the same class of securities registered in the United States, regardless of the location of the transaction. A second non-exclusive option is to allow private rights of action against broker-dealers and other intermediaries that engage in securities fraud while purchasing or selling securities overseas for U.S. investors or otherwise providing services to U.S. investors.

 

A third option is to permit a private right of action if investors can show they were fraudulently induced while In the U.S. to enter a transaction, regardless of where the transaction took place. Fourth, it could be clarified that an off-exchange transaction takes place in the U.S. if either party made or accepted the offer to purchase or sell the security while in the U.S.

 

Congress did ask for this report. But it is really hard to know what if anything Congress is likely to do with it. There is a sense in reading this report that the SEC is energetically fighting the last war, right up to and including repeating the arguments that the Commission made to  (and that were rejected by) the U.S. Supreme Court. It is probably important to keep in mind that Congress asked for this report before the extensive body of case law was built up in the lower courts interpreting the Morrison decision. But now that the case law has developed, you do have to wonder whether Congress is really prepared to set all of that aside to start tinkering on its own with these issues.

 

To be sure, Congress has shown a remarkable willingness to tinker with the securities laws. Congress has been willing to pass the Sarbanes-Oxley Act, the Dodd-Frank Act, and the JOBS Act, all just in the last ten years, and before that there was the PSLRA, SLUSA, and even CAFA. So I guess we should never assume that Congress won’t take up these issues. However, I am guessing that this will not be a high priority item. Especially in the wake of the JOBS Act, I just don’t see Congress taking any actions that would likely increase the amount of private securities litigation.

 

All of that said, I do think there is one issue we could all use a little help with; that is, when the Supreme Court articulated the transaction test, the Court specified that the U.S. securities laws apply  not only to transactions on domestic exchanges but also  to “domestic transactions in other securities.” The Supreme Court did not explain what it mean in this so-called second prong of the transactions test, but it has given the lower court fits and it has the potential to cause a lot of mischief. The lower courts are trying to piece together a coherent interpretation of the second prong, but until there is either a uniform lower court consensus on this standard or where get further guidance from the U.S. Supreme Court, lower courts are going to struggle with this. While that is probably OK in the long run, it wouldn’t be a bad thing if Congress could clarify when the U.S. Supreme Court applies to non-exchange transactions.

 

One final note, on April 11, 2012, SEC Commissioner Luis Aguilar filed a dissenting statement regarding the SEC’s report, in which he states among other things " I write to convey my strong disappointment that the study fails to satisfactorily answer the Congressional request, contains no specific recommendations, and does not portray a complete picture of the immense and irreparable investor harm that resulted and that will continue to result due to Morrison v. National Australia Bank, Ltd." Aguilar advocates the enactment for private litigants of a standard that is identical to that for the SEC and the DoJ in Section 929P of the Dodd Frank Act.

 

On April 11, 2012, PricewaterhouseCoopers released its 2011 Securities Litigation Study, entitled “The Ever-Changing Landscape of Litigation Comes Full Circle” (here). According to the study, “we’ll remember 2011 as the year that plaintiffs’ attorneys’ renewed their focus on mergers and acquisitions (M&A) and foreign issues (FIs), specifically those based in China.” PwC’s April 11 press release about the study can be found here.

 

The PwC study is directionally consistent with other studies of 2011 securities litigation, although it differs in some of the details, primarily due to methodological differences. I discuss the methodological differences and their impact below. My own 2011 securities class action litigation can be found here.

 

According to the PwC study, the overall number of federal securities class action lawsuits increased for the third consecutive year, with 191 cases representing a 10% increase over 2010 and a 22% increase over 2009.For the first time since 2009, total filings in 2011 exceed PwC’s calculated annual average (180) of cases filed since the enactment of the Private Securities Litigation Reform Act.

 

Among factors in driving the 2011 filings increase was the growth in M&A litigation, which increased 17% over 2010, and cases involving foreign issuers, which increased a “whopping” 126%, with 61 cases in 2011 involving foreign issuers, compared to 27 in 2010. The 2011 foreign issuer filings represented 32% of all 2011 filing, while the 2010 foreign issuer filings represented 16% of all 2010 filings.

 

According to the study, 48 of the 191 filings in 2011 involved M&A related allegations, compared with 41 in 2010, and only six in 2009. The increase is the number of M&A cases is higher not only in terms of the number of cases, but also significantly higher as a percentage of the total number of deals that trigger lawsuits . The study emphasizes that these cases are often filed quickly after the transactions are announced; of the 48 M&A-related filings in 2011, 34 were filed prior to closing, 25 of which occurred within a quarter of the proposed closing date. The cases also often settle quickly, as the parties to the transaction seek to move forward with the deal and move on. Multiple filings in connection with the same deal can result in “a complex web of cases that defendant companies need to administer and litigate” and require “considerable legal resources” not just to address the litigation but “to settle the matter so the deal can close.”

 

As other studies have noted, a big factor driving the 2011 cases involving foreign issuers was the upsurge in cases involving U.S.-listed Chinese companies. The combined 37 cases involving Chinese companies represented 61% of the cases involving foreign issuers and 19% of all 2011 filings. 28 of the 37 Chinese companies obtained their U.S.-listings by way of reverse merger. Using SEC data, the PwC calculates of the 159 Chinese companies that obtained U.S. listings through a reverse merger during the period January 1, 2007 through March 31, 2010, 23% were sued in securities class action lawsuits filed in 2010 or 2011.

 

The report notes that private litigants are not the only ones that have responded to the accounting allegations involving Chinese companies; the SEC and the PCAOB have also been quick to respond. But based on the challenges the regulators have faced in trying to pursue regulatory actions, the private litigants “may face considerable challenges to pursue litigation for breaches of U.S. securities laws.” The litigants will not only face “challenges of securing access to individuals and paper and electronic documentation” but there may also be questions whether there are “sufficient funds to make the effort worthwhile.”

 

The PwC report notes that U.S.-listed Chinese companies were not the only foreign issuers to see an increase in filings in 2011. European companies also saw an uptick. The eleven cases brought against Europe-based companies in 2011 are  slightly higher than the eight cases per year between 2006 and 2010. Cases against non-U.S. North American companies also increased, from six cases in2010 to ten cases in 2011, exceeding the average of seven cases between 2006 and 2010.

 

The report notes that for the first time since 2007, companies in the high-tech industry were named in more filings that those in the financial services industry, returning to pre-crisis levels. High tech companies were named in 23% of all 2011 filings, while companies in the financial services industries were named in 12% of all cases (representing a 10% drop from 2010 and the lowest level since 2006). The study did cite one category of cases notable for its near absence, which is “efficacy cases against pharmaceutical companies,” which decreased from 11 filings in 2010 to just one case in 2011.

 

The majority of filings name the two most senior corporate officers as defendants. 86% of cases named the CEO and 69% named the CFO. The audit committee and compensation committee members were named in 15 cases (9%) and 11 cases (6%), respectively. However the involvement of these committee members, which is up from recent years, is largely a factor of the cases involving Chinese companies. Ten of the cases naming audit committee members involved foreign issuers, including nine in China.

 

With respect to settlements, the number of securities class action lawsuits that settled in 2011 declined by 30% to the lowest level since 1999. However, according to the PwC study, the total value of settlements increased 17% from $2.9 billion in 2010 to $3.4 billion in 2011, reversing a six-year trend of falling total settlements between 2005 and 2010. (The PwC study’s conclusion in this respect differs from other published reports, as discussed below).  $2.6 billion of the $3.4 billion 2011 total settlements related to credit crisis related lawsuits. With fewer settlements and a larger total, the average settlement in 2011 increased 71%, from $30 million in 2010 to $51.2 million in 2011.

 

As for what may lie ahead, the study suggests that “M&A related cases will be a feature of securities litigation for the foreseeable future,” and in particular that we will see “another year of M&A litigation in 2012.” With respect to regulatory and legal developments both inside and outside the United States, the report notes that “the increase in international regulations and enforcement, the emerging signs that other parts of the world are moving toward class action securities litigation, and the continued focus of U.S. regulators and plaintiff attorneys make it increasingly likely that an international company will at some point become the subject of litigation, or fall under regulatory scrutiny.” While the exact issue may be unknown, “the probability is forever increasing.”

 

Discussion

PwC is the latest in a series of studies of 2011 securities class action litigation. Some of the differences in the statistics reported in the various studies are attributable to differences in methodology. For example, in counting securities class action lawsuit filings, “multiple filings against the same defendant with similar allegations are counted as one case.” Other observers count separate actions against the same defendant in different judicial districts as separate filings, at least until the cases are consolidated. This methodological difference may account for at least some of the differences between the PwC study and the other reports.

 

The PwC’s analysis regarding settlements is a particularly good illustration of differences that may result from  differing  methodology. As discussed here, just last month, Cornerstone Research caused quite a stir when it released its annual study of securities class action settlements and announced that both the number and total value of 2011 settlements represented ten-year lows. While the PwC analysis also found a decline in the number of settlements, the PwC report concluded that the total value of settlements increased 17% from 2010 and reversed a six-year trend of falling total settlements. The PwC study reported a sharp increase in the average settlement size (to $51.2 million), while the Cornerstone Research study reported a decline in the average settlement to $21 million.

 

The differences in the two reports analysis of the 2011 settlements has to do with the way in which the two groups assigned a settlement year to individual case settlements. In the PwC study, “the year of settlement is determined based on the [date of the] primary settlement announcement.” The Cornerstone Research report, by contrast, assigns an individual settlement to the year in which it receives final court approval. As the two studies conclusions show, this simple difference in methodology can result in sharply different conclusions. Depending on which way you look at it, overall settlements and average settlements are either up or down dramatically.

 

There are now several different groups presenting annual studies of securities class action filings and settlements. Even though they groups purport to be studying the same phenomena, their conclusions can sometimes vary materially, as was shown in the preceding paragraph. For that reason, it remains important to review all of the various reports. And it is even more important to understand the way that methodology may affect the analysis and the conclusions.

 

The automatic stay in bankruptcy may be lifted to permit MF Global’s D&O and E&O insurers advance the defense expenses of individual defendants in the underlying litigation arising out of the company collapse, notwithstanding the objections of the failed company’s commodities customers, according to an April 10, 2011 ruling from Southern District of New York Bankruptcy Judge Martin Glenn. The court lifted the stay without reaching the question of whether or not the policies’ proceeds are property of the debtors’ estate. A copy of the court’s April 10 decision can be found here.

 

As detailed here, on October 31, 2011, MF Global filed for bankruptcy after concerns about the company’s investments in European sovereign debt set in motion a chain of events that led to the company’s collapse. Following the company’s collapse, numerous directors, officers and employees have been named as defendants in action brought by securities holders, commodities customers and others alleging a host of legal violations. In response to these lawsuits, the various defendants have submitted notices of claims under MF Global’s insurance policies. Among the many lawsuits were a number of securities class action lawsuits, which have now been consolidated. Refer here regarding the securities class action litigation.

 

According to the Court’s April 10 opinion, during the policy period May 31, 2011 to May 30, 2012, MF Global maintained a total of $220 million of D&O insurance and $150 million of E&O insurance. The primary insurers in this insurance program had sought relief from the stay in bankruptcy to permit the insurers to pay the defense costs of the insured individuals in the various underlying matters. During an April 2, 2012 hearing on the question of whether or not the stay should be lifted, the Court was advised that lawyers have submitted claims for reimbursement or advancement of defense expenses totaling $8.3 million.

 

The objectors to the motion for relief from the stay included certain commodity customers of MF Global’s broker-dealer operations. The commodity customers objected to the lifting of the stay, arguing that the use of the policy proceeds to pay the individuals’ defense expenses would diminish the funds available of funds to pay claims against the debtors. The customers further argued that payment of defense costs is premature while the issue of the ownership of the policy proceeds remains unresolved.

 

Notwithstanding the commodity customers’ objections, the Court granted the carriers’ motions to lift the stay, finding that the carriers’ had adequately shown “cause” to lift the stay. The Court found that because there is sufficient “cause” to grant relief from the stay, it was not necessary for the Court to determine whether the policies’ proceeds are property of the estate. In concluding that the carriers’ had sufficient shown “cause to lift the stay,” among other things, the Court concluded that the individual insureds’ needs for payment of their defense costs “far outweighs the Debtors’ hypothetical or speculative need for coverage,” and that lifting the stay “would not severely prejudice the Debtors’ estates,” while the “failure to do so would significantly injure the Individual Insureds.”

 

The Court considered it particularly important that the primary D&O policy had a provision giving priority to payments under the insuring provisions that protects the individuals (a so-called “Priority of Payments” provision). This provision, the Court said, provide that “coverage potentially afforded to the Individual Insureds for non-indemnifiable losses must be paid prior to any payments for matters implicating coverage potentially provided to the Debtors.” The Court rejected the objectors’ contention that these provisions run afoul of the Bankruptcy Code, noting that the Debtors’ interests in the policies are limited by their terms, including the Priority of Payments Provision. The provisions “cannot be excised” because doing so would “rewrite” the policies and “expand the Debtors’ rights under them.” The Court reached similar conclusions with respect to the E&O policy as well.

 

The Court further found that New York State Insurance Law Section 3420(a)(1) requires the insurers to abide by the policy provisions notwithstanding any provisions in the Bankruptcy Code. The Court also concluded that the commodity customers’ rights, if any, to the policy proceeds had not yet vested. Finally the Court concluded that the equities favored permitted the insurers to pay the defense costs, noting that while claimants can pursue their claims “without the constraints of the automatic stay,” yet they seek to enjoin the individual insureds, who are not debtors and who are not protected by the automatic stay, “from seeking coverage under valid, applicable insurance policies.”

 

In granting relief from the stay, the Court further imposed reporting requirements on the parties to monitor the expenditures, subject to “soft cap” of $30 million, which in turn is subject to further adjustment by agreement of the parties or further order of the Court. In a final footnote, the Court noted that the cap is intended as an aggregate limit for defense costs from the D&O and E&O policies combined. The Court observed that “as is common in such circumstances, the insurers usually agree on allocation of policy proceeds for the advancement of defense costs,” but that “nothing in this Opinion addresses the allocation issues.”

 

The Bankruptcy Court was of course correct in lifting the stay to permit the insurers to pay the individual insureds’ defense expenses. Failure to do so would not only have undermined the individual insureds’ ability to defend themselves in the underlying litigation, but it would have frustrated the very purpose of the insurance. Claimants often confuse the purpose of liability insurance and assume that it is there for their protection and benefit. But liability insurance exists to protect insured persons from liability, not to create a pool of money to compensate would-be claimants.

 

To be sure, the payment of defense fees erodes the amounts available for any later settlements or judgments. That is a feature of this insurance, and is concern that affects all claims triggering this type of insurance. This concern is a particular troublesome in catastrophic claims like this one, but that has also been true in many other recent high profile claims involving failed companies, including, for example, the Lehman Brothers claims, where the stay was also lifted to permit defense expenses to be paid and where the huge defense expense rapidly depleted the available insurance and also made settlement of the underlying claims challenging.

 

Bloomberg’s April 10, 2012 article regarding the ruling in the MF Global bankruptcy can be found here. Detailed background regarding the D&O insurance coverage issues in the Lehman Brothers’ bankruptcy, including the questions surrounding the advancement of defense expenses, can be found here.  A summary of the relevant issues affecting D&O insurance in the bankruptcy context can be found here.

 

‘Sup Hillz?:  If you somehow managed to miss the Internet vibe about "Hillary’s texts" then you need to check the April 10, 2012 Washington Post blog post here — and also be sure to click through to the "Texts from Hillary"  site (here)  for a good laugh.

 

 

Among the important questions that will need to be answered in connection with the current wave of failed bank litigation is the question of extent to which the non-director officers will be able to defend themselves in reliance on the business judgment rule.

 

 

In the following guest post, Jonathan Joseph (pictured to the left) takes a look at the extent to officers may defend themselves in reliance on the business judgment rule in cases to which California law applies. These questions go to the heart of the

officers’ potential liabilities and the legal standards that will be applied to address those questions.

 

 

Jonathan Joseph is a member of the California State Bar and has focused for over 33 years on regulatory, corporate, securities and transactional matters for banks and bank holding companies and officers and directors of distressed and failed institutions.  He currently serves as the Co-Vice Chair and Secretary of the Financial Institutions Committee of the Business Law Section of the California State Bar (2008 – present). He is the founder and managing partner of Joseph & Cohen, Professional Corporation in San Francisco, CA. Mr. Joseph is also a member of the Washington D.C. Bar and the State Bar of New York. He may be contacted at Jon@josephandcohen.com. A substantially similar version of this article was initially published in Issue No. 1 2012 of the Business Law News of the California State Bar. The original article on which this revised version is based was originally written before the initial decisio in FDIC v Perry was reported (about which decision, refer here).

 

 

Many thanks to Jon for his willingness to publish his article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Jon’s article follows. Footnotes appear below following the article text.

 

 

 

 

The exact nature of the duties and liabilities of corporate officers who are not directors is a subject that has received little attention from courts and commentators. [1]  Many cases which relate to the duties and liabilities of corporate fiduciaries explore whether negligence and breach of care claims are protected by the business judgment rule and the courts that have spoken have done so mostly in terms of its application to decisions or judgments of corporate directors. [2] While the standard of liability for non-director officers remains relatively unexplored, there is widespread consensus among the courts on the policy justifications for the deferential treatment of directors under the business judgment rule.[3]

 

 

Recently, two Federal banking agencies have brought civil damage actions in California against corporate officers of failed federally-insured depository institutions in which they assert that the widely recognized deference accorded by courts to decisions by directors does not apply to corporate officers. These cases seek damages for the alleged negligence of non-director officers as well as officers who were also directors for huge losses suffered when regulators closed the institutions based largely on pre-closure decisions made in good faith that didn’t turn out well. Three of these cases, which are all triangulating on the same issues, are discussed below. [4] 

 

 

While none of these cases has proceeded to trial, rulings at the motion to dismiss and judgment on the pleadings stage in two of these matters, all within the Central District of California, have emerged with contradictory results — including one ruling in August to the effect that the business judgment rule doesn’t apply to non-director officers. This is troubling to some California practitioners as the great weight of authority by courts and commentators has favored application of the business judgment rule to officers acting in their capacity as officers within the scope of their delegated authority.[5] 

 

 

In most states, including California, Delaware and New York, despite the case law being sparse, there has been little dispute that the business judgment rule or BJR applies equally to corporate officers and directors. Consequently, these pending Central District cases are worthy of focus since any final rulings upholding the position asserted by the Federal banking agencies could have far flung effects. If the BJR is ultimately held not to protect good faith decisions by officers of California based banks, that holding would extend to officers of any California corporation.

 

 

These cases touch upon significant underlying themes being widely debated in American society today (e.g., Occupy Wall Street) as to who should be held responsible for the tremendous costs of bailing out the largest American banks in 2008, why more executives and directors of such institutions haven’t been held accountable and whether corporate executives and directors could have anticipated the acute global financial meltdown in 2008 and thereafter.[6]

 

 

 

The Standard of Conduct and Business Judgment Rule

 

 

The general standard of conduct applicable directors and officers of California corporations in the performance of their functions as they relate to matters in which they are disinterested is a corporate governance principle widely recognized throughout the United States. The standard is well summarized by the American Law Institute’s Principles of Corporate Governance [7]:

 

 

“A director or officer has a duty to the corporation to perform the director’s or officer’s functions in good faith, in a manner that he or she reasonably believes to be in the best interests of the corporation, and with the care that an ordinary prudent person would reasonably be expected to exercise in a like position and under similar circumstances.”

 

 

In California, as elsewhere, when it is applicable, the business judgment rule.[8] precludes judicial second-guessing of decisions made by corporate fiduciaries in good faith or where the decision can be attributed to any rationale business purpose.[9]  The rule is procedural and process oriented. It sets up a presumption that decisions are based on sound business judgment and the “presumption can only be rebutted by a factual showing of fraud, bad-faith or gross-overreaching" [10]  based on a widespread “judicial policy of deference to the business judgment of corporate directors in the exercise of their broad discretion in making corporate decisions." [11] The relevant consideration is whether the process employed was either rational or employed in a good faith effort to advance corporate interests even if a judge or jury considering the matter after the fact, believes a decision to have been “substantively wrong, or degrees of wrong extending through stupid to egregious." [12]

 

 

Two Federal Banking Agencies Seek Damages for Breach of the Duty of Care

 

 

Since the global financial crisis began in 2008, four hundred twelve banks have been closed across the United States through December 15, 2011 including thirty-eight banks in California. [13] As of December 8, 2011, the FDIC has authorized suits in connection with 41 failed institutions against 373 individuals for director and officer liability with damage claims of at least $7.6 billion. [14]  Credit unions also failed during this period, although the actual number of failures is lower. {15]  Federal banking regulators are required to investigate insured depository institution failures and bring lawsuits to recover damages. Enforcement authority under Federal law was strengthened in 1989 after Congress concluded that a large number of saving and loan failures during the 1980’s were due to outright fraud and other egregious conduct. [16]

 

 

Thus, it isn’t surprising that the banking agencies have instituted damage suits in connection with some of the most recent failures and more will undoubtedly be authorized in the coming months. [17] As stated above, both the Federal Deposit Insurance Corporation (“FDIC”), in Van Dellen and Perry, and the National Credit Union Administration (‘NCUA”), in Siravo, have asserted that corporate officers in California are not protected by the business judgment rule. [18] Their basic argument is that section 309 of the Corporations Code applies on its face to directors, not officers and that there is no common law business judgment rule in California case law that applies to limit the liability of officers.

 

 

The Aftermath of the Failure of IndyMac Bank

 

 

Van Dellen and Perry involve two different actions by the FDIC as receiver arising out of the failure of IndyMac Bank, FSB in 2008. On July 11, 2008, IndyMac Bank, Pasadena, CA was closed by the Office of Thrift Supervision and the FDIC was named Conservator. With about $32 billion in assets when it was closed, the failure is the second largest since 2008 and the FDIC has estimated that the loss was $8 billion. Van Dellen was filed in July 2010 against former officers of the homebuilder division of IndyMac Bank alleging breach of fiduciary duty and negligence in approving loans made by the division. 

 

 

The FDIC’s other companion IndyMac case is more recent. It was filed against former Chairman of the Board and CEO Michael Perry in July 2011 seeking $600 million in damages, alleging in a single count that Perry, solely in his capacity as an officer (i.e., CEO), had been negligent. [19]  The complaint in Perry is noteworthy for several reasons including that i) the allegations artfully bypass his actions as a director, ii) the complaint is comprised of a single claim for ordinary negligence, and iii) no outside directors were named. The latter is presumably due to the FDIC’s conclusion that the BJR would immunize the outside directors’ conduct. [20]  Alternatively, it is possible that the outside directors settled or are negotiating to settle the FDIC’s claims against them.

 

 

In addition to anticipating the weakness of claims for ordinary negligence against the bank’s directors when it filed the Perry action solely against Michael Perry, the FDIC may also have concluded that it couldn’t support gross negligence theories against directors (including Perry). In Siravo, the NCUA had originally named the former outside directors of WesCorp and alleged they had been negligent, but lost this argument on a motion to dismiss based on the courts assessment that the BJR was applicable. On August 1, 2011, after earlier allowing the FDIC to amend its complaint several times, Judge George Wu issued his Siravo Order in which he dismissed all claims against the directors on business judgment rule grounds – without leave to amend. [21].

 

 

The Failure of WesCorp Federal Credit Union – NCUA v. Siravo

 

 

Siravo involves losses arising out of the failure of Western Corporate Federal Credit Union (“WesCorp”), which was the largest corporate credit union in the United States when it was placed into conservatorship by the NCUA on March 19, 2009. On October 1, 2010, the NCUA placed WesCorp into involuntary liquidation. WesCorp was originally seized after the NCUA concluded that its liquidity was imperiled by $6.8 billion in anticipated losses stemming from investments in private-label mortgage-backed securities (“MBS”). The NCUA originally brought suit against former officers and directors of WesCorp alleging they breached their duty of due care and were grossly negligent when they approved investments in MBS. Due to Judge Wu’s decision to dismiss the NCUA claims against WesCorp’s outside directors, the only remaining defendants in Siravo, as of the date this article went to print, were five officers.

 

 

The Siravo Order was issued pursuant to a motion to dismiss brought by the officer and director defendants pursuant to Rule 12(b)(6). The standard for such a motion required the court to 1) construe the NCUA’s complaint in the light most favorable to the plaintiff, and 2) accept all well-pleaded factual allegations as true, as well as all reasonable inferences to be drawn from them. [22]  The court was not required to accept as true “legal conclusions merely because they were cast in the form of factual allegations." [23] and the complaint against the defendants will not be upheld if it “tenders ‘naked assertion[s]’ devoid of ‘further factual enhancement.’" [24] Rather, the court concluded that to survive a motion to dismiss, the plaintiff must allege facts that, if accepted as true, are sufficient to “raise a right to relief above the speculative level,” and to “state a claim to relief that is plausible on its face." [25]

 

 

The director defendants in Siravo argued that the facts as pled in the amended complaint made clear that they had operated far above the standard of culpability necessary for a claim to survive application of the business judgment rule. The director defendants further argued that the complaint failed to focus, as required, on the “process” in which they made their decisions, but rather attacked simply the content and results of their decision.

 

 

In considering director defendants’ motion to dismiss, Judge Wu held that the plaintiff would effectively have to plead “fraud, breach of trust, conflict of interest, bad faith, oppression, corruption, complete abdication of responsibility, willful ignorance or gross overreaching” in order to overcome the business judgment rule as applied to the directors. [26]  In the final analysis, Judge Wu concluded that the directors “may have made choices – or not made choices – with which the NCUA disagrees, but that does not mean they failed in their responsibilities so severely that they lose the protection of the business judgment rule." [27]

 

 

The director defendants also argued that the business judgment rule extends to officer defendants such as a WesCorp executive who had been the Chief Investment Officer. The NCUA argued that a 1989 California decision, Gaillard v. Natomas Co. [28]  held that only directors are protected in California by the business judgment rule. In denying the motion to dismiss the officer defendants from the breach of duty claim, the court focused on the plain language of section 309 of the Corporations Code (which is applicable only to directors) and refused to recognize the common law application of the BJR to an officer in California. The Judge noted that some California decisions had included officers within the scope of the BJR’s protection, but found nevertheless that Gaillard v Natomashad considered the issue and concluded that the WesCorp officer defendants did not enjoy the rules protection. The court may have been swayed by an inference that executives had received increased compensation as a result of a shift in WesCorp’s investment emphasis which increased the compensation paid to top executives. [29]

 

 

Judge Fischer Rules that the BJR May Be Raised by Corporate Officers

 

 

Just one month after Judge Wu’s ruling in Siravo, Judge Dale S. Fischer issued the Van Dellen Order which also considered the issue of whether the common law business judgment rule extends to good faith conduct by corporate officers in California. The procedural posture in Van Dellen was slightly different than in Siravo. In Van Dellen the officer defendants had filed an Answer raising affirmative defenses. The FDIC moved for partial judgment on the pleadings pursuant to Federal Rule of Procedure 12(c) as to some of the affirmative defenses including the business judgment rule. However, because a motion for judgment on the pleadings is functionally identical to a motion to dismiss, the applicable standard is essentially the same as for a Rule 12(b)(6) motion. [30]  Judge Fischer rejected the reasoning employed by Judge Wu and reached the opposite conclusion. The Judge distinguished Gaillard v. Natomas and held that as a matter of law the FDIC had failed to demonstrate that the business judgment rule is inapplicable to officers in Californa. [31]

 

 

The Van Dellen officer defendants had argued that the common law component of the BJR applies even if Section 309 does not apply to officers and that Gaillard v. Natomas was a duty of loyalty case inapplicable to whether the BJR is a defense to breach of care claims. Presumably, the Judge was aware of Professor Melvin Eisenberg’s criticism of Gaillardin his 1995 study for the California Law Revision Commission [32]  since her ruling closely tracked the Eisenberg Law Revision Commission Analysis. She held that “California has recognized that ‘[t]he common law business judgment rule has two components’ and ‘[o]nly the first component is embodied in Corporations Code section 309’… most California cases discussing § 309 involve directors and not officers, … the common law component of the business judgment rule may apply to officers even if § 309 does not." [33]

 

 

Motion to Dismiss Ruling in FDIC v. Perry Could Be Tie Breaker

 

 

The Perry case is also being considered in the Central District of California before Judge Otis Wright. Perry has filed a motion to dismiss pursuant to Rule 12(b)(6). The motion was considered on November 7, 2011 following briefing by the FDIC and Perry. Perry’s motion points the court to the Van Dellen Order and notes that the FDIC’s position that section 309 applies to directors only is beside the point since the second, uncodified component of the BJR, applies to directors and to officers. [34]

 

 

Perry also attacked the FDIC’s reliance on Gaillard. Perry pointed out that Gaillard related to golden parachutes provided to a corporation’s officers and involved self-dealing. Perry argues that Gaillard correctly held that the BJR was inapplicable because the officers therein had a personal interest in golden parachutes, but the second aspect of the court’s holding was incorrect because the officers were not entitled to the protection of the BJR only because they had engaged in self-dealing. [35] Perry does not involve any self-dealing or duty of loyalty allegations.

 

 

The officer defendants in Siravo intend to raise the Van Dellen Order at a hearing in early 2012. It is possible, therefore, that Judge Wu might modify his prior BJR ruling as it relates to officers. In Perry, the courtis expected to rule on Perry’s motion to dismiss in the next few months. While the issue may seem narrow, the implications in California could be far-reaching if the FDIC’s position prevails. The FDIC argues that good reasons exist as to why the BJR should not apply to corporate officers. In contrast to outside directors, they state that because officers receive higher absolute pay levels, they stand to reap substantial rewards for serving and taking risks and for this reason, the FDIC reasons they should face greater risks. [36]  Perry’s reply is that FDIC’s assertion that policy reasons support limiting the BJR protection only to directors is entirely off base. Perry asserts that not a single state has implemented such a policy. [37]

 

 

The BJR represents sound public policy that, as a general rule, should continue to be applied by the courts as a presumption that good faith judgments by officers and directors of California corporations can only be rebutted by a factual showing of fraud, bad faith or gross overreaching. To employ a different rule as advocated by the banking agencies – one that permits judging the content of decisions by corporate fiduciaries with the benefit of hindsight – would, in the long run, be injurious to shareholder interests. [38]  Such a holding would tend to chill the ability of corporate executives, including bankers, to take legitimate and reasonable business risks that could benefit their corporations and shareholders.

 

 

Professor Melvin Eisenberg has noted that the BJR is premised on the idea that business judgments are necessarily made on the basis of incomplete information and in the face of obvious risks, so that typically a range of decisions is reasonable. Fact finders are ill-equipped to distinguish between bad decisions and proper decisions that turn out badly based on 20-20 hindsight. If courts too often erroneously treat decisions that turned out badly as bad decisions, and unfairly hold directors and officers liable for such decisions, corporate decision makers might tend to be unduly risk-averse. The business judgment rule protects directors and officers from such unfair liability and encourages risk taking. [39]

 

 

The Van Dellen Order, dated September 27, 2011, and the Siravo Order, dated August 1, 2011, both considered the business judgment rule as it relates to tort claims against corporate officers under California law and reached conflicting results. The Perry cased involves the same issue. A motion to dismiss the single claim for negligence in Perry was heard on November 7, 2011. No ruling had been delivered as of early December 2011. The ruling, when issued by the Perry court, could be viewed as a tie-breaker. Alternatively, since the issue presents an unsettled question of an important legal principle in California, if the Court in FDIC v. Perry follows the Siravo result (i.e., ruling against Perry), it could pave the way for an appeal by Perry to the Ninth Circuit.

 

 

These decisions and future rulings in other FDIC civil damage actions against bank executive officers that have also been brought by the FDIC recently in California and appeals of District Court decisions could shape California law as it applies to officers of California corporations and federally-insured depository institutions headquartered in California for years. Consequently, California business leaders and corporate practitioners should follow these cases closely. 

 

 

Given the justifications and importance of the business-judgment rule and the uncertainty of its status and formulation in California, particularly as it applies to officers of corporations in the exercise of judgment when making business decisions, it may be desirable to codify the rule legislatively unless the Ninth Circuit or the California Supreme Court act first and find that the business judgment rule applies to officers.

 

 

Postscript

 

 

On December 13, 2011, the District Court in Perry denied Michael Perry’s motion to dismiss, holding that the business judgment rule does not apply to officers under California law. The Court’s order was based on the Judge’s conclusion that no authority exists for the proposition that the common law BJR applies to officers and he further inferred that when the legislature adopted section 309 it must have meant to eliminate the common law business judgment rule. His finding is surprising because the legislative history doesn’t explicitly state the legislature intended to override the common law business judgment rule when it enacted section 309 in 1977.   Consequently, the Court’s reasoning isn’t particularly persuasive.

 

 

In an amended order issued on February 21, 2012, Judge Otis Wright approved Perry’s request for an immediate interlocutory appeal of his order. Judge Wright found that his order involved “a controlling question of law as to which there is substantial ground for differences of opinion” and that the immediate appeal “may materially advance the ultimate termination of the litigation.”

 

 

This author’s view is that the Ninth Circuit should overrule the District Court’s decision in Perry. This can be accomplished by holding that Gaillard v. Natomas was misapplied by the District Court since Gaillard is only applicable to cases involving breach of the duty of loyalty. The Appellate Court should also correct the District Court’s unfounded conclusion regarding the legislative intent underlying section 309 by finding that in 1977 when section 309 was enacted the common law business judgment rule as applied to officers was not eliminated. Consequently, the BJR would continue as a valid defense for officers of California corporations and federally chartered institutions headquartered in the State.   Common sense and public policy call out for such a result.

 

*End*

 

 

Endnotes:

 

[1] Lawrence A. Hamermesh and A. Gilchrist Sparks III, Corporate Officers and the Business Judgment Rule: A Reply to Professor Johnson, 60 Bus. Law. 865, vol. 60, May 2005 (“Hamermesh & Gilchrist Sparks”); Hellman v. Hellman, 860 N.Y.S.2d 817, 19 Misc.3d 695 (2008) (“Hellman v Hellman”).

 

[2] Hamermesh & Gilchrist Sparks at 867; Hellman v Hellman at 719.

 

 

[3] Hamermesh & Gilchrist Sparks at 867; Berg & Berg Enters., LLC v. Boyle, 178 Cal. App. 4th 1020, 1045, 1048 (2009) (The business judgment rule "has two components—one which immunizes directors from personal liability if they act in accordance with its requirements, and another which insulates from court intervention those management decisions which are made by directors in good faith in what the directors believe is the organization’s best interest…”).

 

[4] See FDIC as Receiver for IndyMac Bank, F.S.B. v. Scott Van Dellen, et al., No. 2:10-cv-04915- DSF-SH (C.D. Cal. Jul. 2, 2010 )(“Van Dellen”); See also Van Dellen Memorandum Order by Judge Dale S. Fischer filed Sept. 27, 2011(Doc. No. 75) in Van Dellen (“Van Dellen Order”); National Credit Union Administration as Conservator for Western Corporate Federal Credit Union v. Siravo, et al., No. cv-10-01597 GW (MANx) (C.D. Cal.) (“Siravo”); FDIC as Receiver of IndyMac Bank, F.S.B. v. Perry, No. 11-cv-5561-ODW-MRWx (C.D. Cal. Jul. 6, 2011) (“Perry”).

 

[5]  1 American Law Institute, Principles of Corporate Governance: Analysis and Recommendations § 4.01, Comment a (1994); H. Henn and J. Alexander, Laws of Corporations and Other BusinessEnterprises, § 242 (3d ed. 1983); Frances T. v. Village Green Owners Ass’n,42 Cal. 3d 490, 507 n. 14 (1986); Biren v. Equality Emergency Med. Group, 102 Cal.App. 4th 125, 137 (2002)(“Biren”);PMC, Inc. v. Kadisha, 78 Cal. App. 4th 1368, 1386-87 (2000) (“Kadisha”); McMichael v. U.S. Filter Corp., 2001 U.S. Dist. LEXIS 3918, *31-*32 (C.D. Cal Feb. 22, 2001 (applying Delaware law); Hameresh & Gilchrist Sparks("policy rationales underlying the development and application of the business judgment rule to corporate directors similarly justify application of the rule to non-director officers, at least with respect to their exercise of discretionary delegated authority");Stephen M. Bainbridge, The Business Judgment Rule As Abstention Doctrine, 57 VAND. L. Rev. 83 (2004) (same). An earlier study also supported application of the business judgment rule to non-director officers within the scope of their delegated authority. (A. Gilchrist Sparks, III and Lawrence A. Hamermesh, Common Law Duties of Non-Director Corporate Officers, 48 Bus. Law. 215 (1992);Compare Lyman P.Q. Johnson, Corporate Officers and the Business Judgment Rule, 60 Bus. Law. 439 (2005) (arguing that the business judgment rule should not shield corporate officers to the degree that it protects directors).

 

[6]  Both the then Chairwoman of the Federal Deposit Insurance Corporation, Sheila Bair, and Federal Reserve Chairman Ben Bernanke have conceded in sworn testimonythat few could have foreseen the 2008 financial crisis.Ms. Bair testified that “[a]t the time the bubble was building, few saw all therisks and linkages that we can now better identify.” FDIC, Statement of Sheila C.Bair on the Causes and Current State of the Financial Crisis before the FinancialCrisis Inquiry Commission (Jan. 14, 2010), available at http://www.fdic.gov/news/news/ speeches/chairman/spjan1410.html  . Mr. Bernanke similarly testifiedthat “I fully admit that I did not forecast this crisis.” Declassified Testimony ofBen Bernanke before a Closed Session of the Financial Crisis Inquiry Commission (Nov. 17, 2009), at 48-49, available at http://www.scribd.com/doc/48878840/FCIC-Interview-with-Ben-Bernanke-Federal-Reserve.

 

[7] See  American Law Institute, Principles of Corporate Governance: Analysis and Recommendations § 4.01 and cmt. 1 (2005).

 

[8] Cal. Corp. Code § 309(a); Berg & Berg Enters., LLC v. Boyle, 178 Cal. App.4that 1048.

 

 

[9] Berg & Berg Enters., LLC v. Boyle, 178 Cal. App. 4that 1045; see also Marble v. Latchford Glass Co., 205 Cal. App. 2d 171, 178 (1962) in which the court said that it would “not substitute its judgment for the business judgment of the board of directors made in good faith.”

 

[10] Eldridge v. Tymshare, Inc., 186 Cal. App 3d 767, 776 (1986).

 

 

[11] Berg & Berg Enters., LLC, 178 Cal. App. 4th at 1020 (quoting Barnes v. State Farm Mut. Auto. Ins.Co.,16 Cal. App. 4th 365, 378 (1993)).

 

[12] In re Citicorp Inc. Shareholder Derivative Litig.,964 A.2d 106, 127 (Del. Ch. 2009)(“In re Citicorp”).

 

[13] See http://portalseven.com/banks/.

 

[14] See http://www.fdic.gov/bank/individual/failed/pls/index.html, which states, in part: “The FDIC follows the policies adopted by the FDIC Board in 1992, Statement Concerning the Responsibilities of Bank Directors and Officers, which can be found at http://www.fdic.gov/regulations/laws/rules/5000-3300.html#fdic5000statementct, and require Board approval before actions are brought against directors and officers. Professional liability suits are only pursued if they are both meritorious and cost-effective. Before seeking recoveries from professionals, the FDIC conducts a thorough investigation into the causes of the failure. Most investigations are completed within 18 months from the time the institution is closed. Prior to filing the claim, staff will attempt to settle with the responsible parties. If a settlement cannot be reached, however, a complaint will be filed, typically in federal court.”

 

[16] See Michael P. Battin, Bank Director Liability under Firrea, 63 Fordham L. Rev. 2347 (1995), available at http://ir.lawnet.fordham.edu/flr/vol63/iss6/11.

 

[17] See Jonathan D. Joseph, Claims Against Failed Bank D&O’s Will Spike in 2012, available at http://josephandcohen.com/2011/09/.

 

[18] For a Federally-chartered financial institution the applicable law is the law of the state in which the institution has its main office or principle place of business. For state-chartered banking corporations the applicable law is the law of the state of incorporation. See Atherton v. FDIC, 519 U.S. 213, 224 (1997).

 

[19] Former Chairman and CEO, Michael Perry, has a much different perspective than the FDIC. His personal blog site, Not To Big To Fail, at http://nottoobigtofail.org/ sets forth facts from his perspective about Indy Mac and the FDIC’s lawsuit against him including copies of briefs filed in the case.

 

[20] The FDIC’s allegations attempt to adroitly bifurcate the inextricably interwoven actions of a single person serving as an officer and director. This is no easy task and in many contexts may be almost impossible. In Hellman v Hellman, the court stated"given the typical involvement of both directors and officers, and the typical overlap of roles and communications, it is likely to be fiendishly complex for a court, let alone a jury, to sort out when and where any given defendant is acting . . . in a distinct capacity as a director or officer…". Hellman v. Hellman at 720. 

 

[21] See Siravo Order by Judge George Wu filed August 1, 2011 (Doc. No. 153 incorporating Docs. 110, 115 and 147) in Siravo (“Siravo Order”).

 

[22] See Sprewell v. Golden State Warriors, 266 F.3d 979, 988, (9th Cir.), amended on denial of reh’g, 275 F.3d  1187 (9th Cir. 2001); Pareto v. FDIC, 139 F.3d 696, 699 ( 9th Cir. 1998); See also Fleming v. Pickard, 581 F.3d 922, 925 (9th Cir. 2009).

 

[23]  Warren v. Fox Family Worldwide, Inc., 328 F.3d 1136, 1139 (9th Cir. 2003).

 

[24] Ashcroft v. Iqbal, 129 S.Ct 1937, 1949 (2009) (quoting Bell Atlantic Corp.,v. Twombly, 550 U.S. 544, 556 (2007).

 

[25] Bell Atlantic Corp., v. Twombly, 550 U. S. at 556, 570. Dismissal pursuant to Rule 12(b)(6) is proper only where there is a “lack of a cognizable legal theory or the absence of sufficient facts alleged under a cognizable legal theory. Balistreri v. Pacifica Police Dep’t, 901 f.2d 696, 699 (9th Cir. 1990).

 

[26] Siravo Order (Doc. No. 110 and 115 therein) (citing FDIC v. Castetter, 184 F.3d 1040, 1046 (9th Cir. 1999); Frances T. v. Village Green Owners Ass’n, Id at 509; Bader v. Anderson, 179 Cal.App 4 th 775, 787 (2009); Berg & Berg Enters., LLC at 1045)).

 

 

[27]Siravo Order (Doc. No. 147 therein).

 

 

[28] 208 Cal.App 3d 1250 (1989).

 

 

[29] Siravo Order (Doc. No. 110 at 12). See also Hill v. State Farm Mutual Insurance Co., 166 Cal.App. 4th 1438, 1469, 83 Cal.Rptr.3d 651, 673 (2008) (which was not cited by Judge Wu despite that fact that in dicta it endorsed the better-reasoned view that officers are just as entitled to the protection of the BJR as directors). Even though the court concluded that the business judgment rule was not a basis for dismissing the claim for negligence against the officers, it did conclude that the NCUA had failed to allege in particular what one officer “did or did not do so as to make a claim for breach of fiduciary duties plausible against him under Twombly and Iqbal.” The NCUA was permitted to amend its complaint against the officer for breach of fiduciary duty. See Doc No. 110.

 

 

[30] Van Dellen Order at 2.

 

[31] Van Dellen Order at 3 (“Because most California cases discussing § 309 involve directors and not officers, and because the common law component of the business judgment rule may apply to officers even if § 309 does not, the FDIC has not established that the California business judgment rule is inapplicable as a matter of law.’)

 

[32] See Melvin A. Eisenberg, California Law Revision Commission, Whether the Business-Judgment Rule Should Be Codified 40, 47 – 49(May 1995) (“Eisenberg Law Revision Commission Analysis”) who points out that the common law business judgment rule applies to directors and officers and the holding in Gaillard v. Natomasto the effect that Corporations Code Section 309 “codifies California’s business-judgment rule” is incorrect. Eisenberg states: “Section 309 codifies the standard of careful conduct, with which the business-judgment rule is inconsistent….The better position, however, is that although Section 309 does not codify the business-judgment rule, neither does it overturn the rule.”

 

[33] See Perry Order at 3 citing BirenandKadishaat 1386-1387(“[A]n officer or director who commits a tort because he or she reasonably relied on expert advice or other information cannot be held personally liable for the resulting harm”) and Lee v. Interinsurance Exch., 50 Cal.App. 4th 694, 714 (1996).

 

[34]  See Perry Reply in Support of Motion to Dismiss at 8 (Doc. No. 26, filed October 24, 2011).

 

[35] Id at 10. Perry also points out that the FDIC’s reliance on FDIC v. Castetter, 184 F.3d 1040, 1041 n.1 (9th Cir. 1999) was misplaced since the only appellees in that case were directors and the Ninth Circuit actually held that ordinary negligence claim against former bank officials based on allegedly unsound banking practices was barred by the business judgment rule.

 

[36] See PerryOpposition of Plaintiff Federal Deposit Insurance Corporation to Defendant Michael Perry’s Motion to Dismiss at 17 (Doc. No. 22, filed October 11, 2011).

 

[37] See Perry Motion to Dismiss at 20 (Doc. No. 18, filed Sept. 15, 2011) (“The Delaware Supreme Court has expressly held that “the business judgment rule….protect[s] corporate officers and directors…other jurisdictions similarly apply the business judgment rule both to directors and officers: Arizona, Pennsylvania, Illinois, Texas, Connecticut, New York, Washington, Louisiana, Georgia and Florida, to name just a few.”).

 

[38] In re Citicorpat 127.

 

[39] See Eisenberg Law Revision Commission Analysis at 44 – 45, 49 – 50 (“Given the justifications and importance of the business-judgment rule, and the uncertainty of its status and formulation in California, it would be desirable to codify the rule legislatively. The simplest approach would be to amend California Corporations Code Section 309 by incorporating the formulation of the business-judgment rule in the American Law Institute’s Principles of Corporate Governance Section 4.01(c)”).

 

 

© Jonathan D. Joseph. 2012. All Rights Reserved. A substantially similar version of this article was initially published in Issue No. 1 2012 of the Business Law News of the California State Bar. The original article upon which this revised version is based was originally written before the initial decision in FDIC v Perry was reported.