A fundamental tenet of corporate law is that a business corporation is organized and carried on for the benefit of its stockholders.  In recent times, an increasing number of for-profit organizations have formed in order to pursue social and environmental goals. There is a growing investor movement toward the financial support of organizations that have social benefit purposes at the center of their existence. However, it may be difficult for directors and officers of these organizations to pursue these social purposes without running afoul of traditional fiduciary duties requiring corporate managers to maximize shareholder value.

 

In order to address these concerns, a group of lawyers and academics have proposed a new form of enterprise, the benefit corporation. The idea behind this organizational form is to create an enterprise that can utilize the tools of business financing and management to address social and environmental issues. In order to deal with the legal issues involved with organizing a business enterprise for broader goals, the proponents of this idea have crafted Model Benefit Corporation Legislation.

 

Since 2010, the model legislation has been adopted in whole or in part in seven states, including California, New Jersey and Virginia, and is under consideration in a number of others. New York’s version  became law  on February 10, 2012. Although the model legislation’s provisions address a number of issues, the “heart” of the model benefit corporation legislation is its provisions addressing concerns related to potential director and officer liability.

 

In this post, I examine the circumstances that have led to the proposal for the development of the benefit corporation concept; the specifics of the organizational form described in the Model Benefit Corporation Legislation; and the aspects of director and officer liability addressed in the legislation. I conclude with my thoughts about the proposed organizational form, including the implications from both a liability and insurance standpoint.

 

My analysis of these issues relies heavily on the November 16, 2011 paper entitled “The Need and Rationale for the Benefit Corporation” (here).  A number of contributors participated in the creation of this document, but the paper’s principal authors are William H. Clark, Jr. of the Drinker Biddle law firm, and Larry Vranka of Canonchet Group LLC. I also refer below to the Model Benefit Corporation Legislation, which can be found here. Information about benefit corporations generally can be found at the Benefit Corporation Information Center. The January 7, 2012 article in The Economist magazine the first piqued my interest in benefit corporations can be found here.

 

Background

Two recent trends have come together to create the need for a new form of business enterprise. On the one hand, there is a growing class of investors joining the socially responsible investing movement. These investors hope to create a direct social impact through targeted equity and debt investments. (A November 2010 J.P. Morgan study on impact investing can be found here.) On the other hand, for-profit social entrepreneurs, who are interested in pursuing mission-driven businesses, are increasingly common.

 

An earlier initial response to these developments was the 2007 formation of the B Lab, a non-profit organization whose purpose was to devise and implement a certification system for companies interested in distinguishing themselves in order to try to attract the socially focused investors. B Lab promulgated a number of certification standards for these companies. The difficulty is that these standards were to be adopted within the existing legal framework.

 

A critical component of the existing legal framework is the basic principal that business corporations exist to maximize shareholder value. This principal constrains the ability of businesses, at least within the existing framework, to consider the interests of constituencies other than shareholders. To be sure, a number of states, in response to takeover battles in the 80’s, did implement so-called “constituency” statues that enable boards and senior company officials to take in account community interests when considering a takeover bid.  Unfortunately, among the states that have not adopted constituency statues is Delaware, the place of incorporation for many companies. In addition, even in the states that have adopted constituency statutes, there is a dearth of case law interpreting the statutes, and so there is very little guidance on what other interests a board may consider and to what extent. In addition, constituency statutes are often merely permissive, not mandatory.

 

Owing to the absence of clear legal standards in these areas, directors may be hesitant to consider social goals or the interests of other constituencies for fear of breaching their fiduciary duties to shareholders. The legal uncertainties and need for greater clarity have led to the proposal of a new form of business enterprise to address the needs of for-profit mission-driven businesses.

 

The Benefit Corporation

In order to address the legal concerns, reformers have proposed the benefit corporation. The three distinct aspects of the benefit corporation are that it has 1) a corporate purpose to create a material positive impact on society and the environment; 2) expanded fiduciary duties of directors that require consideration of nonfinancial interests; and 3) an obligation to report on its overall social and environmental performance as assessed against third-party standards.

 

These attributes are embodied in the Model Benefit Corporation Legislation, which has provided the basis for the benefit corporation statues that have been enacted in the seven states. (The seven states are Maryland, Hawaii, Vermont, Virginia, California, New Jersey and New York. Four other states are currently considering similar legislation.) 

 

               

Under the model legislation, the benefit corporation is required to have a purpose of “general public benefit” and allowed to identify one or more “specific public benefit” purposes. The model legislation lists seven non-exhaustive possibilities for specific public benefit goals, which include: providing products or services to low income individuals; providing economic opportunities for individuals or communities; preserving the environment; improving human health; promoting the arts or sciences; increasing the flow of capital to public benefit enterprises; or the accomplishment of any other particular benefit to society or the environment.

 

The model legislation further provides that in considering the best interests of the corporation, the directors of the corporation “shall consider the effects of any action or inaction” on the shareholders; the employees of the corporation; the customers; community or societal factors; the local and global environment; the short-term and long-term interests of the benefit corporation; and the ability of the benefit corporation to accomplish its general and specific benefit purposes.

 

In addition to providing this broad array of factors directors must consider, the model legislation provides certain protections for the benefit corporation directors (and officers). First, the model legislation provides that consideration of the interests of all stakeholders shall not constitute a violation of the general fiduciary duty standards for directors. Second, the model legislation expressly exonerate the directors and officers from monetary damages for any action taken in compliance with the preexisting standards for director duties; and for the failure of the benefit corporation to pursue or create its stated general or specific public benefit. These provisions are intended to eliminate directors’ concerns that they could face damages liability for the enterprise’s failure to fulfill its purposes or for considering the interest of constituencies other than shareholders.

 

The model legislation does provide for a form of injunctive relief action, to require the benefit corporation to live up to its commitments. Under these provisions, shareholders have the right to bring a legal action in the form of a “benefit enforcement proceeding” on the grounds that a director or officer has failed to pursue the stated general or specific purpose or failed to consider the interest of the various stakeholders identified in the statute. However, only shareholders or directors can bring a benefits enforcement proceeding; beneficiaries of the corporation’s public purpose have no right of action. The exclusion of any right of action by third parties protects the benefit corporation from unknown, expanded liability that might create disincentives to becoming a benefit corporation

 

Discussion

The purpose of the benefit corporation is to provide an appropriate enterprise vehicle for for-profit mission-driven businesses. Among the objectives in structuring the benefit corporation form is the need to address critical issues regarding the duties and potential liabilities of directors and officers. The key objectives of the model legislation are to ensure that directors and officers of the benefit corporation do not incur liability for considering the interests of constituencies other than shareholders and to ensure that the directors and officers do not incur monetary liability for allegedly failing to fulfill the organization’s general or specific benefit purposes.

 

It is important to note that although the model legislation provides that the directors and officers cannot be held liable for damages under the benefit corporation provisions, the benefit corporation provisions do not exempt the directors and officers from liability for violating general standards of fiduciary care. The exemption from monetary damages in the model legislation provide only that directors is “not personally liable for monetary damages for (1) any action taken as a director if the directors performed the duties of office in compliance [existing statutory provisions specifying the duties of directors generally]; or (2) failure of the benefit corporation to pursue or create general public benefit or specific public benefit.” Parallel provisions provide similar protections for officers. 

 

The point is that the exemption from monetary damages under the benefit corporation provisions does not exempt the directors and offices from claims for damages for violation of their general fiduciary duties. By the same token, however, the model legislation specifies that the directors and officers of the benefit corporation cannot be held liable for considering the interests of constituencies other than shareholders.

 

The model legislation does provide for a “benefits enforcement action,” for shareholders to pursue injunctive relief if the organization is not pursuing its benefits objectives or providing required reporting. Even though this action does not allow for damages, it does create a context within which defense costs could be incurred.

 

In other words, not withstanding the liability protections in the model legislation, directors and officers of a benefit corporation continue to face the possible liability exposures and defense expense exposures.

 

As a for-profit venture organized to pursue a public good, a benefit corporation does not really fit within the usual D&O insurance framework, which divides the world between non-profit and commercial enterprises. In addition, the benefit corporation regime has unique aspects that could have insurance implications, such as the possibility of a benefit enforcement action.

 

In just over two years, seven states have enacted legislative provisions allowing for benefit corporations. Implementing legislation is under consideration in several more states. It seems likely that adoption of benefit corporation legislation will become more generalized in the months and years ahead. It also seems likely that as the benefit corporation form become more widespread that insurers will be called upon to address the insurance needs of this new type of enterprise. The unique features of these organizations raises the possibility that new insurance solutions, targeted to the unique needs of these kinds of companies, will be required.

 

In any event, benefit corporations represent an interesting innovation on the corporate enterprise landscape. If, as seems likely, more states adopt benefit corporation enabling legislation, the issues involved in addressing these companies’ insurance requirements will become an increasingly common concern.

 

During 2011, plaintiffs filed a wave of securities class action lawsuits against U.S.-listed Chinese companies. There were 39 of these lawsuits filed in 2011 (out of 218 total securities class action lawsuit filings in 2011), as discussed here.  Often the complaints in these lawsuits consisted of little more than a repetition of the allegations that had been raised against the company in an Internet analyst report.

 

While the Internet reports often raised sensational allegations against the companies, the claimants still faced the problems associated with trying to substantiate these allegations – a challenging task under any circumstances, but even more so given political, legal and cultural differences involved, as well as language and other barriers. It should come as no surprise then that a few of these cases might just peter out.

 

Although there is no way to know for sure from the bare record, that certainly seems to be the case in the securities class action lawsuit that had been filed in 2011 against Yongye International.

 

As discussed at greater length here, plaintiffs first filed a securities class action lawsuit against Yongye and certain of its directors and officer in the Southern District of New York in May 2011. The complaint relied on a May 11, 2011 Seeking Alpha article entitled “Yongye International’s Reported Production: SEC Filings Raise Red Flags” (here). The article stated in part “that the company and its joint-venture partner could not have produced, and therefore sold, the reported plant product tonnages given the company’s stated manufacturing capacity and shipments.” Ultimately several class actions were filed, which were later consolidated and lead counsel was appointed. Lead counsel filed an amended complaint in December 2011. The amended complaint again was reliant on the allegations in the Seeking Alpha article.

 

On March 8, 2012, the company announced (here) that the lead plaintiff’s action had been voluntarily dismissed, with prejudice as to the lead plaintiff. A copy of the court’s March 6, 2012 order of voluntary dismissal can be found here.  It is impossible to tell from the bare record what led up to the voluntary dismissal. However, from the court docket, it can at least be discerned that following a February 1, 2012 hearing in the case, Judge Richard J. Sullivan ordered that the plaintiffs file a further amended complaint by March 5, 2012. It appears that rather than submitting the amended complaint on March 5, the plaintiffs filed a motion to voluntarily dismiss the complaint, with prejudice as to the lead plaintiffs.

 

It was  noted when these cases were flooding in that not perhaps all of these cases would prove to be meritorious and indeed some of them have been dismissed (refer for example here). On the other hand, other cases have survived the initial dismissal motions (refer for example here). The critical point is that even in those cases in which the plaintiffs’ claims survive the initial pleading threshold, their claims stiff face substantial challenges, not the least of which are problems involved with effecting service of process and in conducting discovery in China, as well as deriving from the geographic distances and language issues involved. (Refer here).

 

The tactical retreat in the Yongye case, even before the initial rounds of pleading were complete and before the threshold motions had even been filed, suggests at a minimum that the barriers involved in pursuing these cases in some instances may be prohibitive. And, without in any way suggesting that it was in fact the case with the Yongye lawsuit, some of the cases may have been filed in reliance on Internet reports and analysis that could prove difficult to substantiate.

 

Many of these cases are still only in their earliest stages. It remains to be seen have they will fare. There is the possibility that in many instances the cases against the U.S.-listed Chinese companies will not in the end amount to very much.

 

The Great Lionel Messi: Even those of you that do not follow International soccer have probably seen stories recently suggesting that FC Barcelona’s talented Argentine striker Lionel Messi may be the greatest soccer player ever. Even Time Magazine recently had an article asking the question. If you are wondering what all the fuss is about – which you might well do if you have only seen pictures of Messi, he looks, as one commentator suggested, like the valet parking attendant to whom you would hesitate to give your car keys – you will want to see this video of Messi’s amazing five-goal performance in Wednesday’s UEFA Champions League qualifier game between Barcelona and Bayer Leverkusen. A couple of the goals are the result of terrific passing but the rest of the goals are pure Messi.

 

As one commentator noted on the Eurosport blog (here):

 

To describe Lionel Messi as a good player, a great player, is a statement so facile as to render it pointless. Such is the utter brilliance of the Barcelona forward, we are not just running out of superlatives, as the old cliché has it, we are running out of ways to say we are running out of superlatives. He is a man for which conventional language is no longer sufficient.

 

But before we roll the videotape, let us pause for a few words in appreciation for APOEL Nicosia, the team from Cyprus that is the gatecrasher in the European club championship. If defending champion Barcelona is the team to beat, APOEL is the underdog team to watch and root for. APOEL knocked out the French powerhouse Lyon on Wednesday, in what one commentator said “ might have been the biggest sports moment in Cyprus’s history.”

 

Now, for Mr. Messi:

 

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Though the current bank failure wave has been rolling for several years now and though there have been over 425 bank closures during that period, the much anticipated FDIC failed bank litigation has been slower to gain momentum – that is, perhaps, at least until now. Through the end of 2011, the FDIC had filed 18 lawsuits against former directors and officers of failed banks. But now with the latest FDIC lawsuits, described below, the FDIC has already filed seven so far in 2012, three of which just in the last nine business days. There is a definite sense that the pace of litigation activity is picking up.

 

The latest FDIC failed bank lawsuit was filed in the Northern District of Illinois and relates to the failed Broadway Bank of Chicago, Illinois. Broadway Bank failed on April 23, 2010. The FDIC’s compliant, which can be found here, alleges that at the time of failure that bank had assets of 1.06 billion and that the bank’s failure cost the insurance fund $391.4 million. According to news reports, the failed bank is the former family bank of a former Illinois state treasurer.

The FDIC’s lawsuit, filed in its capacity as the failed bank’s receiver, seeks to recover over $104 million in losses the bank allegedly suffered on commercial real estate loans. The complaint names nine individuals as defendants, seven director defendants and two officer defendants. The complaint asserts claims against the nine defendants for gross negligence; breach of the fiduciary duty of care; and negligence.

The complaint alleges that the defendants “recklessly implemented a strategy of rapidly growing Broadway’s assets by approving high-risk loans without regard for appropriate underwriting and credit administration practices, the Bank’s written loan policies, federal regulations and warnings from the Bank’s regulators.” With regard to the regulators’ warnings, the complaint alleges that the Director Defendants approved “two of the worst Loss Loans” on June 24, 2008 after a meeting earlier the same day with the Bank’s regulators in which the regulators “specifically warned the Director Defendants about the risks that these types of loans posed to the Bank.” That same day regulators had discussed with the Director Defendants the need to “enter a Memorandum of Understanding” that would “impose restrictions on the Bank to stop this type of high risk lending.”

One of the director defendants, James McMahon, who served on the bank’s board from 2003 to December 22, 2008 issues a press release about the FDIC’s complaint, in which McMahon notes that the bank had been founded “by an immigrant who left Greece in 1962 to find a better life in America,” and had become a “vital force in the financial life of the community.” The bank had been “unable to withstand the greatest market decline since the Great Depression and, along with over 400 other community banks” had been “forced to close their doors.” With respect to the lawsuit, McMahon states “with the advantage of 20-20 hindsight, the FDIC now blames Broadway’s former officers and directors for not anticipating the same unprecedented market forces that also surprised central bankers, national banks, economists, major Wall Street firms and the regulators themselves.” McMahon concludes by noting that the allegations in the complaint are “utterly without merit and I expect to be fully vindicated by the Court.”

With this lawsuit, the FDIC has now filed 25 lawsuits against the former directors and officers as part of the current wave of bank failures. The Broadway bank lawsuit is the fifth that the FDIC has filed so far in Illinois, the most of any state except Georgia, where the FDIC has filed six suits. There clearly are more cases in the pipeline, as the FDIC has stated on its website that, as of February 14, 2012, the agency has authorized suits in connection with 49 failed institutions against 427 individuals for D&O liability with damage claims of at least $7.8 billion.

Thus the 25 lawsuits filed so far represent only about half of the lawsuits that had been authorized as of the middle of February, and the 205 individuals named in those 25 lawsuits represent less than half of the individuals against whom lawsuits have been authorized. The number of authorizations undoubtedly will continue to climb in the months ahead, as will the number of lawsuits.

With this latest suit, the FDIC has now filed three new lawsuits in just the last nine business days. These three cases include the February 24, 2012 lawsuit filed in the Northern District of Georgia involving two former officers of the failed Community Bank and Trust of Cornelia, Georgia (about which refer here, scroll down) as well as the March 2, 2012 lawsuit filed in the Northern District of Georgia against 12 former directors and officer of the failed Freedom Bank of Commerce, Georgia (about which refer here, scroll down). There is a definite sense that the pace of the FDIC’s litigation activity has picked up. Though this latest lawsuit was filed well in advance of the three-year statute of limitations, the two prior suits were much closer to the cut-off, and with the three-year deadline date looming for the failed bank class of 2009 – the largest year for failed banks – it seems likely there will be increasing numbers of suits ahead.

Very special thanks to John M. George, Jr. of the Katten & Temple law firm for sending me a copy of the Broadway bank complaint and for sending me James McMahon’s press release. The Katten & Temple law firm represents Mr. McMahon.

Corruption Investigation Follow-On Civil Suits Reach Canada: The occurrence of follow-on civil actions being filed in the wake of corruption and bribery investigations is a phenomenon I have noted frequently on this blog. It now appears this type of follow on civil suit has now reached Canada.

As discussed here, the share price of SNC-Lavalin Group recently declined sharply after the company announced an internal investigation of the accounting for certain payments in connection with a company project in Libya . As reflected in their March 1, 2012 press release (here), plaintiffs’ lawyers have now initiated a securities class action lawsuit in Quebec Superior Court against the Company and certain of its directors and officers.

The plaintiffs’ complaint alleges that the company violated its continuing disclosure obligation by misrepresenting the company’s internal controls and accounting. Among other things the complaint alleges that an anonymous letter the company’s senior management alleged that for years shell companies had been used to funnel money from SNC-Lavalin to members of the Libya’s Gadhafi family. UPDATE: On January 12, 2016, the plaintiffs filed their fourth amended consolidated complaint, which can be found here.

The phenomenon of follow on civil litigation has been a factor in the U.S. for years. As anticorruption efforts spread elsewhere, the likelihood is not only that more companies will face scrutiny from government officials, but they may also face civil litigation as well. At a minimum this case shows how Canada’s litigation environment is continuing to evolve, and its litigation landscape is becoming both more extensive and more complex.

Special thanks for a loyal reader for alerting me to this case.

On March 7, 2012, Towers Watson released the report of its 2011 Directors and Officers Liability Survey. This report, which summarizes the results of the firm’s annual survey, reflects the survey respondents’ D&O insurance arrangements and purchasing patterns. The annual Towers Watson report is much-anticipated for its insights into the practices of corporate insurance buyers, and this year’s report does not disappoint. The 2011 report can be found here.

 

The Survey Pool

As with the results of any survey, it is very important in connection with this survey report to understand the characteristics of the survey participants. In particular, it is very important to understand that the pool of respondents to the 2011 survey is heavily weighted toward very large companies. Excluding nonprofits and charities, the average annual revenues of the survey participants was $4.254 billion. The average asset size (excluding nonprofits and charities) was over $5 billion. The average market capitalization of the public company participants was $5.3 billion. Only 19 of the public company participants had market caps under $1 billion. Even the private company respondents were very large; about half of the private company respondents had assets over $1 billion.

 

The respondents were also concentrated in certain industries. Over half of the respondents were concentrated in just four industries: financial service/insurance; manufacturing; energy and utilities; and financial services excluding insurance. The pool of respondents including only small percentages of respondents from other industries, including communications; natural resources; transportation; and healthcare/pharmaceuticals.

 

The Survey Results

Over half of the survey respondents reported that the premium charged for their primary D&O insurance policy had declined at the last renewal. However, this result diverged between the public company and private company respondents. Among public companies, 62% reported a decline in the premium for their primary D&O insurance policy, but only 35% of private company respondents reported a decline. In addition, a slightly higher percentage of private company respondents saw a premium increase (18%) compared to public companies (14%). The report states that these data can be interpreted to suggest “a potential hardening in the private/nonprofit segment with insurers looking to drive rates.”

 

The survey’s information regarding limits purchasing patterns is very highly reflective of the respondent pool’s composition of very large companies. Thus, excluding charities and nonprofits, the average total limits purchased among all survey respondents is $98 million. Even among private company respondents, the average total limits purchased was $36.3 million. The average total limit for public company respondents was $126.8 million. However, among public companies with market caps under $250 million, the average total limits purchased was $25.7 million and the median was $15 million. Among private companies with assets under $250 million, the average limits purchased was $8.3 million and the median was $5.5 million. A quarter of public companies reported that they had increased their limits at the most recent renewal, compared to 14% of private and nonprofit organizations.  

 

Over three quarters (77%) of respondents reported that, in addition to primary D&O insurance, they purchased excess insurance from at least one additional insurer. 57% of all respondents purchased excess Side A or Side/DIC insurance. However, 78% of public company respondents reported that they purchased Side A or Side A/DIC insurance. Consistent with the heavy representation in the respondent pool of very large companies, the average Side A and Side A/DIC limits purchased among public company respondents was $54.6 million, and the median was $30 million. These average and median figures were much lower for smaller public companies; for example, for public companies with market caps under $250 million, the average was $13 million and the median was $10 million.

 

Though the majority of respondents said that the most important consideration in purchasing D&O insurance was the scope of coverage for the directors, only a very small percentage of respondents reported that the purchased independent director liability insurance. For example, only 7% of public company respondents reported that they purchased IDL insurance.

 

Excluding charities and nonprofits, 56% of respondents, and 68% of public company respondents, reported that they have international operations. Of the public companies with international operations, 39% reported that they purchased local D&O insurance policies in foreign jurisdictions, while 17% of private companies reported that they have international units that purchase local policies. These figures undoubtedly reflect the predominance in the respondent pool of larger organizations, as the survey itself showed that the larger the company, the more likely it was to purchase local policies. The report itself notes with respect to the local policy purchasing patterns that the “results continue to demonstrate the strides organizations have made in understanding the complexities and exposures when conduction business outside the United States.”

 

66% of the survey respondents reported having had a D&O claim in the past then years. The larger companies were more susceptible to claim activity, with the largest companies reporting the highest levels of claim activity. About two-thirds of respondents who had claims reported that they were satisfied with their insurers’ handling of the claim, but nearly 20% of the respondents reported that they were dissatisfied with how the insurers handled the claims. (This 20% figure is consistent with same level of dissatisfaction reported in the 2010 survey.)

 

Discussion

The Towers Watson survey report is a very valuable resource for the D&O insurance industry and for D&O insurance buyers. The survey report provides valuable insight into limits purchasing patterns, program structure and program design. All of us in the industry should be grateful that Towers Watson has undertaken the survey and made its report publicly available.

 

Anyone using or relying on the survey data, however, should take into account the fact that the pool of survey respondents was weighted toward very large companies, even among the private company respondents. Because a number of the survey results directly reflect that presence of a significant number of larger companies among the respondents, some results may be less relevant for smaller companies. In addition, as noted above, the survey pool was heavily weighted towards companies in certain industries. This should be taken into account in connection with companies from industries that were not as well represented in the respondent pool.

 

The survey’s results with respect to Side A purchasing patterns and with respect to the inclusion of local policies among companies with international operations are interesting. These results show the extent to which these program structures are becoming pervasive, at least among larger public companies. 

 

The survey’s results regarding the survey respondents’ claim experience represents something of a mixed review for the industry. On the one hand, about two thirds of respondents were generally satisfied with the way their insurers handled their claims. On the other hand, fully one out of five of respondents was dissatisfied, and this level of reported dissatisfaction was consistent in both the 2010 and the 2011 survey reports. This level of reported dissatisfaction suggests that there may be significant opportunities for the D&O insurance industry to deliver claims services in more customer focused way.

 

One final note about the survey. Everyone in the industry benefits from this survey and the survey report is a resource that is available to everyone. I hope that the industry will keep this in mind in future years and in particular make sure that the survey itself is distributed as broadly as possible so that the survey results are as fully representative as possible. Everyone can do their part to make the survey results even more meaningful in the future.

 

Very special thank to the survey report’s principal author, Larry Racioppo of Towers Watson, for providing me with a copy of the report.

 

The Latest FDIC Failed Bank Lawsuit: On March 2, 2012, the FDIC filed its latest failed bank lawsuit, against certain former directors and officers of the failed Freedom Bank of Georgia, of Commerce Georgia. The FDIC’s complaint, which was filed in the Northern District of Georgia, can be found here. In its lawsuit, the FDIC seeks to recover over $11 million dollars it alleges was caused by the twelve individual defendants’ negligence and gross negligence.

 

With this lawsuit, the FDIC has now filed 24 lawsuits in connection with the current wave of bank failures, including six so far in 2012. Of the 24 lawsuits overall, six have involved failed Georgia banks. Like many of these cases, this latest suit was filed just short of the expiration of the three-year statute of limitations. (The March 2 filing date came shorty before the third anniversary of the bank’s March 6, 2009 closure.) Because so many banks failed during 2009, it may be expected as the current year progresses we will be seeing an increasing number of lawsuits involving the class of 2009.

 

Scott Trubey’s March 6, 2012 Atlanta Journal Constitution article about the Freedom Bank case can be found here.

 

In this post, I review two recent law firm memos examining the state of class action litigation in Australia and Mexico, respectively. I first review class actions in Australia, and then examine class actions in Mexico below.

 

AUSTRALIA

Class actions, which have been available as a procedural alternative in Australia since 1992 are “now an established part of Australia’s litigation landscape, according to a March 2, 2012 memorandum from the King & Wood Mallesons law firm entitled “Class Actions in Australia: The Year in Review 2011” (here). Though the “introduction of class action regimes has not yet led to the flood of litigation that some commentators had prediction,” the memo notes, class actions “remain a significant concern for both directors and in-house counsel alike due to the scale of many of these claims.”

 

According to the memo, an average of only 14 class actions is filed every year in the Federal Court (including all types of cases, including consumer actions), representing less than 1% of all Federal Court proceedings. The authors note that during 2011, a number of significant new shareholder class actions were commenced, including cases involving Nufarm, Gunns, and ABC learning. Though there “was no single standout settlement” during the year,  the total value of 2011 shareholder class settlements was over $500 million.

 

During 2011, “significant pre-litigation requirements” were introduce in Federal Court, which requires parties to file statements setting out the “genuine steps” they have taken to try to resolve a dispute or to clarify the issues between them. The memo notes though is early yet to assess the impact of these requirements on class actions, “plaintiff representatives have stated that they consider the regime a powerful tool for obtaining information on liability from defendants sooner, thereby pushing class actions to early resolution.” With these rules in place, the authors expect that Federal Courts will “take a much more active approach to managing class actions in its jurisdiction.”

 

The Australian class action system has a number of distinctive features, including the use of an “opt out” class action system, whereby class members are included in the class unless they take positive steps to remove themselves from the class. The Australian approach to class actions is also characterized by the increasing presence of litigation funders that sponsor claims. These two characteristics have come together in the growth of “closed classes,” which limit the group members to persons who have retained the solicitors involved or have entered an agreement with the litigation funders.

 

Though this “closed class” approach has been criticized, they have also been approved by the courts, “even though the effect is to convert the statutory opt out regime into an opt in regime and so exclude potential claimants.” The memo notes that “the increased use of closed classes reflects a desire by funders and solicitors to have certainty of returns,” and may even be of benefit to defendants, “enabling them to better ascertain their potential liability and thereby promote settlement.”

 

Another recent development has been the rise in the involvement of law firms “not traditionally identified with class actions.” This has not only led to the rise of competing class action lawsuits, but it has also led to the procedural issues, due to the complexity of the litigation procedures involved. A series of decisions cited in the memo demonstrates that “class action practice remains technical” and any party involved in class litigation “must remain mindful of the additional requirements imposed concerning the conduct of such proceedings.”

 

On the other hand, “recent settlements also show that acting in class actions, either as the plaintiffs’ lawyers or the litigation funders, may be a good investment.” The authors cite one recent settlement in which the court approved plaintiffs’ attorneys’ fees of A$25 million. The authors also note that in the Oz Minerals shareholder class action, two plaintiffs’ firms were awarded just under A$5 million in legal fees, and the litigation funder reported a net gain of A$12.8 million.

 

During 2011, claimants showed an “increased willingness” to include advisors as class action defendants. The authors note that “in some cases, this is a pragmatic decision given the insolvency of the true target of the litigation” and reflects “a recognition by plaintiff lawyers that advisors, covered as they may be by professional indemnity insurance and with professional reputations to protect, could alter the settlement dynamic,” though the involvement of multiple defendants could result in greater costs, complexity and delay. The authors cite 2011 class actions in which the defendants include auditors, stock brokers and financial advisors.

 

In an observation that may be of particular interest to readers of this blog, the authors note that “one development that was predicted but has not been common” is “the inclusion of company directors as individual defendants to class actions.” The authors suggest that this “reflects the belief that it is the company that has the deeper pockets and reputation to protect, and it is generally the more lucrative target.” The authors do note at least a couple of exceptions, in which the target company was insolvent or in administration, where directors and advisors “remain attractive defendants.”

 

The involvement of litigation funding firms has been part of the scene for years but questions continue to arise, even through satellite litigation, including disputes over the funders’ funding arrangements. In addition, in 2011 draft regulations were introduced that would impose a requirement that all litigation funders have adequate policies and procedures in place to manage any conflicts of interest. Others have called for the funders to be licensed and registered. Despite this agitation, though, “litigation funding in Australia is an increasingly sophisticated business.” The authors also note that the funders’ “financial imperative,” which encourages selectivity to ensure returns, “will continue to impose some degree of discipline on the funding industry.”

 

The report notes that during 2011, courts considering proposed settlements took the involvement of litigation funders into account in assessing the settlements. The courts expressly took into account the amount to be paid to the funder.

 

The authors conclude their memo with the an expression of their expectation that during 2012, class action proponents will continue to push class action proceedings into nontraditional areas, and that many of the claims may be advanced by “new entrants” into the class action arena, including “overseas sources of funding.” The authors also expect that during 2012 there may be important rulings on critical issues such as causation and reliance, the potential liability of outside advisors (such as auditors and rating agencies). In addition, the question of increased governmental regulation of litigation funding is “expected to remain a live issue well into 2012.”

 

MEXICO

Beginning March 1, 2012, companies doing business in Mexico will face the risk of class action lawsuits in Mexican federal courts, according to a March 2012 memorandum from the Jones Day law firm entitled “New Class Action Rules in Mexico Create Significant Risks for Companies Doing Business in Mexico” (here).

 

Pursuant to a series of legislative enactments, private plaintiffs, government entities and certain nonprofits may bring consumer, financial, antitrust and environmental claims as “collective” lawsuits. The legislation authorizes the courts to award classwide-damages and injunctive relief. The provisions allow for a highly expedited class certification process, although the litigation regime is built on an “opt in” rather than an “opt out” scheme.

 

The memo’s authors note that among the many unknowns about this new Mexican class action regime is the res judicata effect of a judgment in a collective action. The memo notes that “it is not known whether an individual who fails to opt in to a collective action … will be precluded from bringing future lawsuits.”

 

The legislation’s features relating to fees may impose a certain limitation on the attractiveness of these kinds of actions. Thus, although an unsuccessful plaintiff will not be required to pay any portion of the defendant’s legal fees, the new laws cap plaintiffs’ fees based on a calculation linked to the minimum wages in Mexico City. The purpose of these provisions is to reduce the percentage of a judgment that goes to the plaintiffs’ attorneys. Obviously these provisions “reduce the incentive for plaintiffs’ attorneys to bring such lawsuits.

 

The memo, which also contains helpful comparisons between the new Mexican collective action scheme and collective actions under Brazilian law and class actions under U.S. law, concludes that “while there are a whole host of questions about the new laws that remain unanswered,” the new collective action procedure “presents significant new risks for businesses operating in Mexico.”

 

DISCUSSION

In the wake of the U.S. Supreme Court’s June 2010 decision in the Morrison case, non-U.S. investors have been forced to consider alternatives to securities claims in U.S. courts as a way to try to recoup losses based on alleged misrepresentations and omissions. Developments in Canada and Netherlands have raised the profile of procedures available in those countries as potential alternative means for shareholder recoveries.

 

Australia remains yet another alternative jurisdiction. With its opt out class action system and the availability of litigation funding to finance claims, the Australian class action scheme as certain attractive features. In addition, class action litigation is already a recognized part of the litigation landscape there. The Australian class action regime has previously been employed to facilitation shareholder class recoveries. Nevertheless, the Australian class action system is still evolving, with many critical legal issues yet to be addressed. As the authors of the legal memo note, “we have not yet seen a marked increase in the prevalence of Australian shareholder class actions.”

 

In the post-Morrison environment, class action litigation developments in any jurisdiction will be watched closely. The relative maturity of the Australian class action litigation scheme and the extent of activity already in that country will make Australia a country worth watching closely. The willingness of plaintiffs’ lawyers and litigation funders to take on these cases suggests that Australia may be a country in which shareholder class action litigation advances significantly in the years ahead.

 

As for Mexico, the new regime has only just become effective, and there are too many unanswered questions about the new provisions to make any sort of assessment. It is noteworthy that an increasing number of jurisdictions are adopting procedures that provide means for aggrieved persons to seek collective relief. As more countries adopt procedures of this type, aggrieved investors increasingly will seek to use these procedures. The U.S. Supreme Court’s Morrison decision may have had the unanticipated effect of accelerating this process.

 

In its June 2010 decision in the Morrison v. National Australia Bank, the U.S. Supreme Court enunciated a "transactions" test to determine the applicability of the U.S. securities laws. The Court said that the U.S. securities laws apply only to "transactions in securities listed on domestic exchanges and domestic transactoins in other securities." Subsequent courts have wrestled with the second prong as they struggled to determine what constitutes a "domestic transaction in other securities."

 

In a March 1, 2012 opinion (here), the Second Circuit in the Absolute Activist Value Master Fund Limited v. Ficeto case for the first time examined the requirements under Morrison’s second prong, holding that in order to establish the existence of a domestic transaction in other securities, a plaintiff “must allege facts suggesting that either irrevocable liability was incurred or title transferred within the United States.” The opinion helpfully suggests the kinds of allegations that would satisfy this test, and also clarifies that certain allegations that are not relevant in determining whether or not this standard has been satisfied.

 

Background

The plaintiffs in this case are nine Cayman Island hedge funds (the “Funds”) that invested on behalf of hundreds of investors around the world, including also U.S. investors. In 2004, the Funds engaged Absolute Capital Management Holdings Limited (“ACM”) to act as investment manager. The complaint alleges that various individual ACM officers and employees engaged in a “pump and dump scheme,” using in part a California broker-dealer in which several of the individual defendants had ownership interests. (The SEC’s related February 25, 2011 enforcement action against many of the same individuals can be found here.)

 

The plaintiffs allege that the defendants caused the Funds to purchase billions of shares of thinly capitalized U.S. companies. All of these companies were incorporated in the U.S. and their  shares were quoted on the OTC BB or on Pink Sheets. However, the Funds’ shares in these companies were purchased directly from the companies themselves in private offerings in the form of private investment in public equity transactions (“PIPE” transactions).

 

The plaintiffs allege that the defendants used transactions to and between the Funds to generate commissions and to inflate the prices of the companies’ shares. The plaintiffs further allege that after the companies’ share prices were inflated, the individual defendants unloaded their personal holdings in the companies’ securities for a substantial profit. The Funds allegedly suffered losses of over $195 million.

 

The Funds filed suit against certain ACM officers and employees, as well as against the California brokerage and its principles. The defendants moved to dismiss. The district court dismissed the case on the basis of Morrison, and the plaintiffs appealed.

 

The March 1 Decision

Apparently because the securities the Funds had purchased were procured by Cayman Island hedge funds through PIPE offerings, the parties did not argue and the Second Circuit did not address whether or not the plaintiffs allegations satisfies Morrison’s first prong relating to “transactions in securities listed on domestic exchanges.” The Second Circuit addressed only Morrison’s second prong, attempting to determine “under what circumstances the purchase or sale of a security that is not listed on a domestic exchange should be considered ‘domestic’ within the meaning of Morrison.” The Court noted in that regard that Morrison itself “provides little guidance as to what constitutes a domestic purchase or sale.”

 

Examining prior decisions addressing the question of what determines the timing of a purchase or sale, the Second Circuit said that “given that the point at which the parties become irrevocably bound is used to determine the timing of a purchase or sale, we similarly hold that the point of irrevocable liability can be used to determine the locus of a purchase or sale.” In order for a plaintiff to allege sufficient facts to support a plausible inference that the parties incurred irrevocable liability within the United States, the plaintiffs must allege that “the purchaser incurred irrevocable liability within the United States to take and pay for a security, or that the seller incurred irrevocable liability within the United States.”

 

The Second Circuit went on, in recognition of the Eleventh Circuit’s June 2011 decision in the Quail Cruise Ship Management case also interpreting Morrison’s second prong (about which refer here, scroll down), to note that “a sale of securities can be understood to take place at the location at which title is transferred.”

 

Combining these two tests, the Second Circuit concluded that “to sufficiently allege a domestic transaction in securities not listed on a domestic exchange, we hold that a plaintiff must allege facts suggesting that irrevocable liability was incurred or title was transferred within the United States.”

 

Having thus enunciated what is required in order to satisfy Morrison’s second prong, the Second Circuit proceeded to reject other tests the parties had proposed. In particular, the Second Circuit said the location of a broker-dealer alone should not be used to determine the location of a securities transaction (although the location of a broker could be relevant to the extent the broker carries out tasks that irrevocably bind the parties to buy or sell securities).

 

The Second Circuit also rejected the argument that the identify of the securities themselves could be used to determine whether a transaction is domestic, even if the securities are issued by United State companies and are registered with the SEC. The Second Circuit said that it “cannot conclude that the identity of the securities necessarily has any bearing on whether a purchase or sale is domestic.”

 

Similarly, the Court held that the identity of the buyer or seller alone is not determinative of the issue whether a transaction is domestic. Even if both the buyer and the seller are both foreign, that alone would not resolve the question of whether or not a transaction is domestic. The Second Circuit also rejected the argument that the Court must determine with respect to each defendant whether that defendant engaged in at least some conduct in the United States, noting that the transaction test does not require each defendant alleged to be involved in the fraudulent scheme to have engaged in conduct in the United States.

 

In summing up its rulings, the Second Circuit said that “rather than looking to the identity of the parties, the type of security at issue, or whether each individual defendant engaged in conduct within the United States, we hold that a securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed with the United States.”

 

Having determined the standard to be applied, the Second Circuit held that the allegations of the plaintiffs in this case were not sufficient to establish that the transactions at issuer were “domestic” and therefore subject to the U.S. securities laws — which is hardly surprising given that the plaintiffs had framed their allegations before the U.S. Supreme Court issued its Morrison decision. The Second Circuit held that the case should be remanded to the district court so that the plaintiffs could attempt to amend their pleading to try to address Morrison’s requirements. The Second Circuit specifically said that the kinds of allegations to be included to establish that the transactions at issue were domestic include “facts concerning the formation of the contracts, the placement of the purchase orders, the passing of title, [and] the exchange of money.”

 

Discussion

Prior to the Second Circuit’s ruling in this case, and In trying to flesh out what makes a transaction “domestic” under Morrison’s second prong, the courts had worked out two competing standards. The first of these standards, enunciated in June 2011 by Southern District of New York Judge Barbara Jones in the SEC v. Goldman Sachs case, held that the place of the transaction is determined based upon the place where” irrevocable liability” is incurred (as discussed here). An alternative interpretation of the standard was described in the Eleventh Circuit’s 2011 opinion in the Quail Cruise Ship Management case (about which refer here, scroll down), in which place of the location of the transfer of title could be sufficient to establish that a transaction was domestic. (Judge Jones, in reliance of the District Court opinion in the Quail Cruise Ship Management case, had held that the place of the closing alone was insufficient to determine whether or not a transaction was domestic.)

 

Rather than chose between these two potentially competing lines of analysis for determining under Morrison’s second prong whether or not a transaction is domestic, the Second Circuit simply incorporated both, holding that facts suggesting either that irrevocable liability was incurred in the United States or that title was transferred in the United States were sufficient to establish that a transaction was “domestic.”

 

By affirming both tests, the Second Circuit arguably broadened the circumstances that could be sufficient to satisfy Morrison’s second prong. On the other hand, by stating firmly the kinds of things that would not be sufficient (such as the identity of the buyers or sellers and the identity of the securities), the Second Circuit arguably restricted the circumstnaces under which plaintiffs may be able to argue that a transaction is domestic.  Finally, by enumerating the kinds of issues the plaintiffs should attempt to address (such as the facts concerning the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money), the Second Circuit provided at least some guidance of the kinds of things plaintiffs should include in their allegations in order to try to satisfy Morrison’s second prong.

 

Even in the short amount of time since the U.S. Supreme Court issued the Morrison opinion, a considerable number of disputes had arisen in which plaintiffs asserting claims under the U.S. securities laws had tried to rely on Morrison’s second prong in order to establish that the U.S. securities laws apply to the non-market transaction that is the basis of their claim. The Second Circuit’s opinion could have a significant impact on these non-market transaction cases, especially those pending in the Second Circuit.

 

Among other cases that would seem to be significantly affected by the Second Circuit’s opinion in this case is the appeal in the Porsche case now pending in the Second Circuit. As noted here, in December 2010, Southern District of New York Judge Harold Baer had held in the Porsche case that a swap transaction could not come within Morrison’s second prong where the referenced security traded on a non-U.S. exchange. The Second Circuit’s holding in the Absolute Activist Value Master Fund Limited case, in which the Second Circuit said among other things that the identify of the securities involved in the transaction is not determinative, would seem to suggest that the district court’s holding in the Porsche case may not withstand scrutiny on appeal.

 

Although it remains to be seen, the Second Circuit’s ruling in the Absolute Activist Value Master Fund Limited case could expand the number of types of cases in which plaintiffs seeking to assert securities claims involving non-market trades may be able to survive a motion to dismiss made in reliance on the Morrison decision.

 

A March 2, 2011 memo by the Cahill law firm about the Second Circuit’s opinion can be found here. A March 2, 2012 memo by the Debevoise law firm about the opinion can be found here. Special thanks to the several loyal readers who send me copies of the Second Circuit’s opinion.

 

Fourth Circuit Excoriates Prosecutors for Use of Uncivil Language: In a recent post (here), I quoted the pointed words of Central District of California Judge Dale Fischer in a hearing in one of the FDIC lawsuits arising out of the failure of IndyMac bank, in which she urged lawyers to cut the overheated rhetoric and to get to the point.

 

Judicial impatience with lawyers’ verbal excesses seems to be catching on. As noted in a February 16, 2012 post on the Volokh Conspiracy blog (here), the Fourth Circuit, in a footnote in a January 18, 2012 opinion (here), takes U.S. prosecutors to task for the language the lawyers used in their briefs in the case.

 

The footnote, which appears at the conclusion of the Court’s opinion (written by Fourth Circuit Judge Allyson Kay Duncan), opens with the observation that “we feel compelled to note that advocates, including government lawyers, do themselves a disservice when their briefs contain disrespectful or uncivil language directed against the district court, the reviewing court, opposing counsel, parties, or witnesses.”

 

The government’s brief, the Court notes, is “replete with such language;” : it “disdains the district court’s ‘abrupt handling’ of Appellant’s first case; “sarcastically refers to Appellant’s previous counsel’s ‘new-found appreciation for defendant’s mental abilities’”; criticizes the district court’s "oblique language" on an issue unrelated to the appeal; states that a district court opinion "revealed a crabby and complaining reaction to Project Exile;” insinuates that the district court’s concerns "require[ ] a belief in the absurd that is similar in kind to embracing paranormal conspiracy theories;"  and accuses Appellant of being a "charlatan" and "exploit[ing] his identity as an African-American."

 

The Court said that “the government is reminded that such disrespectful and uncivil language will not be tolerated by this court.”

 

It certainly can be hoped that these two judicial reactions to the lawyers’ rhetoric represents a growing willingness to take a stand against lawyers’ use of excessive, vituperative or abusive language. There is no doubt that lawyers’ increasing willingness to use intemperate language of this type is disrespectful to the Court; inconsistent with basic notions of professionalism; and undermines civility in the profession. If courts were to become more engaged in calling out lawyers who employ excessive language of this type, perhaps lawyers might tone it down and keep things a little more civil.

 

In his blog post about the opinion cited above, Eugene Volokh includes an interesting additional gloss on the critical footnote, and also quotes at length from the letter of apology that the government lawyer responsible for the language wrote to the Court.

 

Chancellor Strine: In an interesting March 1, 2012 article in the American Lawyer (here), Susan Beck takes a detailed look at the new Chancellor of the Delaware Court of Chancery, Leo Strine. I commend the article to anyone who is interesting in business litigation in Delaware. And as Francis Pileggi pointed out in a March 3, 2012 post on his Delaware Corporate and Commercial Litigation Blog (here), Professor Stephen Bainbridge has also published an interesting perspective on Chancellor Strine, in a March 1, 2012 post on his Professor Bainbridge.com blog (here), in which Bainbridge compares Strine to one of the minor biblical prophets.

 

Strine has only been in the Chancellor position since last June, and he has already triggered a profusion of interesting commentary.

 

One of the perennial D&O insurance issues is the question of coverage for investigative costs. Several recent cases have taken a close look at these recurring issues.  In the following guest post, my good friend Kara Altenbaumer-Price (pictured) examines recent developments in this area and the important factors that can affect the analysis. Kara is the Director of Complex Claims & Consulting for insurance broker USI.  

 

Many thanks to Kara for her willingness to publish her 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.

 

 

The potentially high cost of internal investigations has increased demand for insurance coverage. This article explores how investigation costs may, at least in part, not be covered by traditional directors and officers (D&O) policies, and options that may provide greater protection.

 

 

Traditional D&O insurance policies afford some level of investigations coverage.  As with any insurance arrangement, however, the parties must carefully assess whether the risk being covered is the same risk that they seek to have covered.  Thus, while companies may believe they have purchased so-called “investigations coverage,” these policies are often seriously lacking in comparison to the number, size, complexity, and cost of modern investigations.  These limitations can be so consequential that the insured’s expectations for the policy will not be substantially met.  This article addresses a number of the gaps between common expectations and commonly available policies and suggests how companies and individuals can more accurately locate the extent of coverage that they desire.

 

 

Before discussing some of the pertinent aspects of investigation insurance products, we turn to a   2010 U.S. federal court ruling that illustrates some of the issues and potentially costly gaps in investigations coverage that can arise for any company, public or private. The case addressed a not atypical sequence of investigation-related events that gave rise to significant costs for a public company. Office Depot found itself the subject of an inquiry by the U.S. Securities and Exchange Commission (SEC) related to potential violations of Regulation FD (Fair Disclosure). This regulation requires that public companies release the same information — at the same time — to the public as they do to investors and securities professionals. Office Depot chose to cooperate with the SEC by voluntarily providing requested documents and making its officers and employees available for sworn testimony without the issuance of subpoenas. About the same time, an internal whistleblower raised issues related to Office Depot’s accounting. The Company self-reported the allegations to the SEC, which expanded its investigation. Office Depot’s audit committee also began an internal investigation, which led to a financial restatement

 

 

The SEC later issued a Formal Order of Investigation against the Company, which included “allegations of wrongful conduct generally attributable to [Office Depot’s] officers and directors” but did not identify any individuals by name. The Formal Order led to subpoenas issued to the Company and a group of its current and former officers and directors, some of whom had previously voluntarily testified in the informal investigation. Two years later, the SEC reached a settlement with the Company and issued Wells Notices informing several Company officers of charges the SEC planned to bring against them.

 

 

Over the course of the SEC and internal investigations, Office Depot incurred costs of over U.S. $20 million and turned to its D&O carriers for reimbursement. The primary carrier acknowledged coverage for approximately U.S. $1 million in costs incurred by officers and directors in responding to SEC subpoenas and Wells notices and costs incurred in several related shareholder securities lawsuits, but denied coverage for the Company’s voluntary response to the SEC or the internal investigation. The company then sued its primary insurance carrier; the excess carrier intervened into the suit. The issue in the litigation was whether the costs of voluntarily responding to the SEC and conducting an internal investigation related to the same issues were covered by the policy. The court held that “the disputed investigatory costs do not fall within the … policy’s definition of loss ‘arising from’ a covered ‘Securities Claim’ made against [Office Depot], or a covered ‘Claim’ made against one of its officers, directors or employees.

 

 

First, the court held that the informal SEC investigation and the company’s internal investigation did not meet the policy’s definition of “securities claim.” Specifically, the policy language exempted an “administrative or regulatory proceeding against or investigation of” the Company unless “such proceeding is also commenced and continuously maintained against an Insured Person.” The court determined that the use of the term “proceeding” and the absence of the term “investigation” in the carve-back language for proceedings involving both the Company and insured individuals meant that coverage did not include investigations, whether formal or informal. Second, the court held that while the policy did provide coverage for investigations of insured individuals, it did not provide such coverage unless the individuals were “‘identified in writing’ by the investigating authority as a person against whom a civil, criminal, administrative or regulatory proceeding ‘may be commenced’ or in case of an investigation by the SEC … after service of a subpoena upon such Insured Person.” The court agreed with the carriers’ assertion that “[b]ecause the SEC informal and formal investigations began well before either one of these discrete signal points, …the investigations do not fall within the Policy’s definition of a ‘Claim.’” It did not matter that three individuals ultimately received Wells Notices. Third, the Company had argued that “relation back” language in the policy served to pull pre-claim costs into coverage. The language at issue was a common provision in the policy providing that when an insured notifies the carrier of facts that could later give rise to a claim and a claim does indeed later arise, the claim relates back to time of the original “notice of circumstances.” The court held that the relation back language in the notice of circumstances portion of the policy related only to determining when the claim was made for determining the applicable policy period for a “claims made” policy. Office Depot had a substantial retention — or deductible — on its primary D&O policy, effectively resulting in no loss transfer in this case.

 

 

The implications for D&O insurance coverage related to investigations are significant. In order to ensure the maximum coverage possible for costs associated with investigations, several portions of a policy must be addressed. In considering these changes, it is also important to remember that D&O insurance policies are not off-the-shelf products. Instead, they differ widely from carrier to carrier and insured to insured and can — and should — be tailored to meet a given company’s needs.

 

 

Definition of claim

 

Generally, a D&O policy does not provide coverage until a “Claim” has been made against a company. More importantly, costs incurred before a formal “Claim” has occurred under the policy do not apply toward a company’s self-insured retention, nor do they get retroactively picked up later by the policy. What constitutes a claim is a defined term under each D&O policy and almost universally includes lawsuits, written demands for monetary relief, and administrative proceedings in court or before an administrative body. Policies differ widely, however, in how they cover — or not — government investigations. Many provide coverage upon the receipt of a subpoena, a Wells Notice, or a target letter. As was discussed above, however, these triggers imply a formal investigation and can occur very far into an investigation.

 

 

Indeed, significant legal costs can be spent in trying to prevent an informal investigation from becoming formal, and policy language varies widely in how it covers — or doesn’t cover — these costs. This can be avoided by ensuring that the definition of “Claim” in your policy incorporates government investigations and, if possible, informal investigations. In 2010, at least one major insurance company released a new D&O policy form that provided for coverage of informal investigations of insured individuals by updating its public company D&O form to include coverage for certain “preclaim” inquiries. The policy defines “pre-claim inquiry” as a “verifiable request for an Insured Person … to appear at a meeting or interview or produce documents that, in either case, concerns the business of that Organization or that Insured Person’s insured capacities.” The request must come from a government enforcement body, or the entity or its board must request that individual to appear in relation to an inquiry into or investigation of the entity by an enforcement body. Interestingly, the policy goes on to define “pre-claim inquiry costs” independently of “defense costs” so as to exclude the costs of responding to document requests if the documents are in the control of the company, meaning that coverage for document production is only provided if those documents are in the control of an individual insured, which very few documents will be. By specifically including coverage for the costs associated with attending a request for an interview by an enforcement body, the policy seems to be focused only on the costs of lawyers’ preparation time. The policy, in its unendorsed form, excludes coverage for all   investigations — formal or informal — of the company unless those investigations are also maintained against insured persons.

 

 

A number of other carriers responded to this insurer’s new policy. For example, one released an endorsement that provides coverage for individuals incurred in responding to “a request by an Enforcement Unit for an Insured Person to appear for an interview or meeting with respect to the Insured Capacity of such Insured Person or an Organization’s business activities.” Like the policy discussed earlier, this insurer’s endorsement also includes scenarios in which the company requests that an insured individual appear for an interview or meeting in relation to a government inquiry. The endorsement specifically excludes coverage for costs associated with a “document production demand or discovery request.” This exclusion is notable since the cost of producing potentially millions of pages of documents in a large investigation can be substantial.

 

 

Co-defendant language

 

A number of D&O policies that provide investigations coverage either restrict coverage to insured individuals or require individuals to be co-defendants before a company’s costs in defending itself could be covered. The trigger in these policies is usually when an insured individual is named in a Wells Notice or target letter or, in some cases, when an insured individual receives a subpoena. In addition to the late coverage trigger discussed above, this language presents an additional problem in that it does not match up with the reality of how investigations are pursued. It is rare for a government investigation to name an individual up front. Instead, if anyone is named in the early stages, it is the entity itself. Even when it is clear to the entity’s lawyers and forensic accountants that one or more individuals are the targets of an investigation, the D&O policy is not triggered unless the individuals are named.

 

 

Because individuals do not have the same incentive to cooperate that entities do, individuals are often named only as an investigation is nearing its end. As a result, if such language is included, as is demonstrated by the Office Depot case above, little to no coverage may be afforded even if “investigations coverage” was purchased.

 

 

Definition of loss

 

Presuming that a policy does provide investigations coverage, a policy will still only cover those costs that are defined as “loss” under the policy. Loss will almost universally be defined to include costs associated with defending any Claim under the policy. While “defense costs” is often undefined, some policies do explicitly define it. In order to ensure broad investigations coverage, it is important to consider all the costs of defending an investigation, not just legal fees. Significant fees can be spent on forensic accountants, document production vendors, and other specialists in responding to the often very in-depth investigations of a government regulator. It is important to consider all of these costs when defining “loss” and “defense costs” under a D&O policy and, where possible, explicitly define the costs to include non-lawyer defense costs.

 

 

Conduct exclusions and adjudication language

 

D&O policies typically contain certain conduct exclusions that prohibit coverage in cases of certain intentional conduct, such as fraud, criminal conduct, or intentional violations of the law. Mere allegations of such conduct, however, do not prevent coverage. Instead, each policy should contain language that defines when these conduct exclusions are triggered. For example, policies may state that a guilty plea triggers the conduct exclusion, while others may state that a determination by a court that the conduct occurred triggers the exclusion.

 

 

In the context of investigations coverage, the broadest trigger is “final adjudication in the underlying action,” meaning that the conduct exclusion will not be triggered until a court

involved in the enforcement action at issue makes a final adjudication of wrongdoing. This prevents a carrier from bringing a declaratory coverage action in another court in order to cut off defense costs. Also, because the vast majority of government investigations are settled without court involvement or are filed in a court simultaneously with an agreed settlement, in many cases the conduct exclusions will never be triggered. Two changes in SEC enforcement methods may have particular impact on these conduct exclusions.

 

 

First, the SEC is considering releasing more detailed findings of its investigations. Currently, when an investigation is settled, often only a brief release is issued stating the statutory violations and a bare bones recitation of the factual allegations. Releasing more detailed factual findings could lead to coverage issues as additional facts are laid out that could implicate conduct exclusions. Second, changes made in 2010 to the SEC’s Enforcement Manual designed to spur cooperation provide leniency — or in some cases, immunity — to individuals who provide valuable evidence to the SEC. It is likely that more individuals will “confess” to the SEC in order to obtain these benefits. This could create coverage issues in policies containing certain conduct exclusions. Additionally, cooperation by one individual implies that other individuals will be negatively impacted by that individual’s testimony. As more individuals cooperate and as others become the “target” of that cooperation, the need for separate legal representation rises, also causing an increase in defense costs.

 

 

Civil fines and penalties coverage

 

Historically, the insurance market has considered civil fines and penalties to be uninsurable for public policy reasons. Recently, however, the demand for investigations coverage and increased competition among D&O carriers has led some carriers to offer civil fines and penalties coverage. While it is still unclear when and how much these policies will pay out in the event of claims, it is important to understand that such coverage is now available.

 

 

When evaluating such coverage, however, companies should read the policy terms very closely to understand exactly what is being offered for the price. Endorsements may appear to be broad, but may be limited by the statutes under which coverage is provided. For example, a number of carriers are now offering coverage for a certain amount of civil fines and penalties assessed under the U.S. Foreign Corrupt Practices Act (FCPA).

 

 

However, the language of a given endorsement, when read closely, may reveal that it provides coverage only to insured individuals and only for civil penalties assessed by the U.S. Department of Justice (DOJ). Another important consideration in fines and penalties  coverage is the actual language of the FCPA and similar statutes, as well as the reality of settlements and whether such insurance could be tapped at all under the terms of a government settlement. The statute states that whenever a civil fine or penalty “is imposed … upon any officer, director, employee, agent, or stockholder of an issuer, such fine may not be paid, directly or indirectly, by such issuer.” Also, it is now standard language in SEC settlement documents that individuals stipulate that their companies will not pay their fines, including any payments from insurance proceeds. Arguably, this issue may be solved by assigning a portion of the D&O premium to the fines and penalties coverage and requiring that premium amount to be paid by individual officers and directors.

 

 

Separate investigations policies

 

In addition to updating its public company D&O form, a major insurer has also released a new stand-alone policy designed to cover investigation costs. The policy addresses one of the primary issues present in expanding investigations coverage — the eroding of insurance limits for use by officers and directors when the company’s investigations costs are transferred to insurance. The policy provides up to $25 million in coverage for investigations by the SEC, DOJ, and similar authorities into violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 or any of the acts’ associated rules and regulations. It covers both formal and informal government investigations and can be endorsed to provide up to $5 million coverage for investigations related to violations of the FCPA. In addition to investigation costs, the policy also covers insurable settlements other than disgorgement, fines, penalties, or remediation costs. A separate policy gives companies the option to look only to an investigations policy for coverage and choose not to seek coverage under their D&O policies, even if some coverage is provided.

 

 

A major insurance broker also announced the creation of a policy that covers legal, accounting, auditing and consulting costs associated with FCPA investigations. Although the insurance carrier underwriting the FCPA Corporate Response form was not publicly named, the form is designed to cover both FCPA and UK Bribery Act investigation costs incurred by both insured individuals and the company. Although it is not clear from the literature released on the policy, it appears to cover informal investigation costs, at least to some degree. Similar policy releases from other insurance carriers are likely as corporate demand increases.

 

 

When considering the options for transferring a portion of the risk associated with investigations to insurance, companies must consider the broader implications of this decision as well. When an insurance policy is expanded to cover investigation costs, that may, in practice, offer better protection for the company than to individual officers and directors. This can arise if most or all of the policy’s coverage is consumed by the company. This can leave little or no money for insured individuals to defend themselves in the investigation or in any follow-on civil litigation from shareholders. When assessing whether to purchase investigations coverage, companies may also consider whether overall limits should be increased, or whether additional limits should be set aside for insured individuals only under the “Side A” portion of the D&O policy reserved for losses incurred by individuals that the company cannot indemnify due to insolvency or law, to ensure adequate limits remain available.

 

 

The FDIC’s latest Quarterly Banking Profile for the period ending December 31, 2011, released February 28, 2012 (here), reflects a generally improving banking landscape and a continuing reduction in the number of problem institutions. But though the industry is showing improvement, the number of problem banks, though down from immediately prior periods, still remains elevated compared to historical levels.

 

According to the report, as of year- end 2011, there were 813 problem institutions, compared to 844 as of the end of the third quarter and 884 as of year-end 2010. (A “problem” institution is a bank to which the FDIC has rated as either a “4” or a “5” on the agency’s 1-to-5 scale of ascending order of supervisory concern.) The quarterly decline in the number of problem institutions represents about a 3.6% drop, and the decline during calendar year 2011 represents about an 8% drop. According to the FDIC, the 4Q11 decline in the number of problem institutions represents the third consecutive quarterly decline.

 

The total assets of problem institutions also declined during the fourth quarter of 2011, from $339 billion at September 30, 2011 to $319.4 billion at year-end 2011. The $319.4 billion 2011 year-end total represents a substantial decline from the $390 billion at the end of 2010 and the $402 billion at the end of 2009.

 

Though the number of problem institutions began to decline during 2011, the number of problem banks remains at elevated levels compared to historical standards. At recently as year-end 2007, there were only 76 problem institutions listed. Even at the end of 2008 during the height of the global financial crisis, there were only 252 problem financial institutions. In other words, though the number of problem financial institutions is declining, that does not necessarily mean the current banking crisis has passed.

 

It should also be noted that the declining number of problem institutions does not necessarily mean that the number is declining because of improvement among problem institutions. It could just be that some of the problem banks no longer exist. For starters, the number of reporting institutions overall has been declining for several years. At year end 2011, there were 7,357 reporting institutions, down from 7,658 at the end of 2010 and 8,305 at the end of 2009. The overall decline is mostly due to mergers and failures. These same factors likely also account for much of the decline in the number of problem institutions.

 

It is impossible to know how much of the decline in the number of problem institutions is due to improvement and how much is due to these other factors. The good news is that the number of bank failures is definitely down. So far, YTD 2012, there have been only 11 bank failures, compared to 23 at this same point last year. The declining rate of failures seems like a positive sign. But again, as noted above, when there are over 800 problem institutions and when banks are continuing to fail, it is hard to conclude that we are entirely out of the woods on the current wave of bank failures and problem banks.

 

At the same time, much of the news In the FDIC’s latest Quarterly Banking Profile is positive. The overall picture for the industry is one of recovery, with growing net income, declining loan loss provisions, and declines in noncurrent loan balances. There is a concern that revenues appear to have slipped, but overall the picture for the banking industry is positive. With these positive signs, the hope is that the improving conditions will allow even the problem institutions to benefit and recover.

 

Another Failed Bank Lawsuit: As the number of failed banks and problem institutions continues to decline, the number of FDIC failed bank lawsuits is ramping up. On February 24, 2012, the FDIC filed its latest lawsuit. This one was filed in the Northern District of Georgia against two former a former director and officer and a former director of the failed Community Bank & Trust of Cornelia, Georgia. A copy of the FDIC’s complaint can be found here.

 

Community Bank & Trust failed on January 29, 2010. In its complaint, the FDIC seeks to recover in excess of $11 million in losses allegedly caused by the two defendants’ breaches of fiduciary duty, negligence and gross negligence related to the bank’s home loan program between January 6, 2006 and December 2, 2009. The complaint alleges that the bank’s senior head of retail lending violated his legal duties in approving loans in violation of the bank’s loan policies. The bank’s CEO is alleged to have breached his duties in failing to supervise the loan officer and in failing to take corrective measures.

 

The suit is the 23rd that the FDIC has filed as part of the current wave of bank failures. According to its website, as of February 14, 2012, the FDIC has authorized suits in connection with 49 failed institutions against 427 individuals for D&O liability with damage claims of at least $7.8 billion. This includes the now 23 filed D&O lawsuits naming 184 former directors and officers. In light of the differences between the number of authorized suits and the number filed to day, there clearly are many suits yet to come – and the number of suits authorized has also been increasing monthly. The banking industry may be slowly improving but the litigation levels are just now starting to ramp up.

 

Special thanks to a loyal reader for sending me a copy of the complaint.

 

During the current bank failure wave more banks have failed in Georgia than in any other state. For that reason, the recent dismissal motion ruling in  the first failed bank case the FDIC filed involving a failed Georgia bank takes on a heightened level of significance. Northern District of Georgia Judge Steve C. Jones’s February 27, 2012 ruling the FDIC’s lawsuit against eight former directors of the failed Integrity Bank (here) is not only the first to address the liability standard under Georgia law for directors of failed banks but also the ruling  addresses important issues regarding the defenses that defendant directors may raise and rely upon against the FDIC.

 

Background

Integrity Bank of Alpharetta, Georgia was one of the first in Georgia to fail when it was closed on August 28, 2008.  As discussed here, on January 14, 2011, in what was the third FDIC lawsuit overall against former officials of a failed bank and the first in Georgia, the FDIC filed a lawsuit against eight former officials of Integrity Bank. The FDIC’s complaint can be found here.

 

By way of important context, it should be noted that two former Integrity officials have already drawn criminal charges involving activities at the bank, as discussed here. One of the two indicted Integrity officials, Douglas Ballard, is also named as a defendant in the FDIC’s civil lawsuit. As noted here, in July 2010, the two individuals entered criminal guilty pleas in the case. 

 

The FDIC, which filed the lawsuit in its capacity as Integrity Bank’s receiver, seeks to recover “over $70 million in losses” that the FDIC alleges the bank suffered on 21 commercial and residential acquisition, development and construction loans between February 4, 2005 and May 2, 2007. The defendants filed a motion to dismiss. The FDIC filed a motion to strike certain of the defendants’ affirmative defenses.

 

The February 27, 2012 Ruling

In his February 27 ruling, Judge Jones denied n part and granted in part the defendants’ motions to dismiss. The defendants had first sought to dismiss the complaint in reliance on exculpatory provisions adopted in the bank’s articles of incorporation. Judge Jones concluded under Georgia law the exculpatory provisions would not be applicable to the action by the FDIC, and he therefore denied the defendants’ motion to dismiss to the extent reliant on the exculpatory provision.

 

The defendants also moved to dismiss the claims against them for ordinary negligence, arguing that the actions were protected under Georgia law by the business judgment rule and therefore they could not be held liable for claims of ordinary negligence. Judge Jones held, after reviewing case law interpreting the business judgment rule under Georgia law that “in light of this authority and the application of the business judgment rule, the Court finds that the Plaintiffs’ claims for ordinary negligence and breach of fiduciary duty based upon ordinary negligence fail to state a claim upon which relief can be granted.”

 

However, Judge Jones also held that FDIC’s remaining claims for gross negligence and breach of fiduciary duty based up on gross negligence remain, “as they encompass conduct which would fall beyond the ambit of the protections of the business judgment rule.” Judge Jones also separately held that the complaint raised allegations from which if true “a jury might reasonably conclude that Defendants’ were ‘grossly negligent’ as defined by Georgia law.” Accordingly, Judge Jones denied defendants’ motion to dismiss the acclaims for gross negligence and breach of fiduciary duty based on gross negligence.

 

Finally, the FDIC had moved to strike certain of the defendants’ affirmative defenses, arguing that the defenses were not available against the FDIC in its capacity as receiver of the failed bank. Judge Jones agreed with the motion to the extent the affirmative defenses sought to rely on the FDIC’s actions in its corporate capacity (FDIC-C) prior to the its takeover of the bank. However, Judge Jones denied the FDIC’s motion to strike the affirmative defenses based on a failure to mitigate, estoppel and reliance “ to the extent those defenses are based upon post-receivership conduct by Plaintiff in its capacity as receiver.”

 

Judge Jones did find, however, that while the defendants’ could not rely on the FDIC-C’s conduct as the basis of an affirmative defense, “the murkier question is whether the defendants can rely on the FDIC-C’s conduct to rebut causation or offer an alternative theory of causation.”  Judge Jones denied the FDIC’s motion to strike the causation defense, but indicated that he would call for further briefing on the question of whether or not the defendants can rely on the FDIC’s pre-receivership conduct to rebut causation or to support an alternative theory of causation.

 

Discussion

Judge Jones’s rulings in the Integrity Bank case may be the first under Georgia law in the failed bank context saying that, in light of the business judgment rule, the standard of liability for former directors and officers of the failed bank is gross negligence. To that extent, his ruling is positive for the many directors and officers of failed banks facing liability claims from the FDIC.

 

However, Judge Jones also found that the relatively unexceptional allegations in the FDIC’s complaint were sufficient to state a claim for gross negligence. To that extent, Judge Jones’s ruling is less helpful to those many Georgia failed bank officials, because it seems less likely those individuals might be able to get out of an FDIC failed bank lawsuit on a motion to dismiss.

 

Judge Jones’s rulings on the FDIC’s motion to strike may be even more interesting, however.  His rulings were not merely a matter of Georgia law, but rather were based on his interpretation of the U.S. Supreme Court’s 1994 decision in O’Melveny & Myers v. FDIC. His holding that affirmative defenses for failure to mitigate, estoppel and reliance could be raised against teh FDIC in its capacity as receiver (even if not available with respect to the agency’s actions in its capacity as FDIC-C) could proved helpful to individual defendants in many FDIC failed bank lawsuits — and not just those pending in Georgia.  

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By the same token, his unwillingness to conclude that the defendants cannot rely on the FDIC-C’s conduct to rebut causation or offer an alternative theory of causation at least potentially opens the door for other defendants to try to assert these defenses.

 

The ultimate significance of this decision, whether in the case itself or in other cases in Georgia or elsewhere, remains to be seen. Certainly, Judge Jones’s rulings will be looked to by other courts trying to sort out these issues. The suggestion on his standard of liability rulings is that cases in Georgia may be narrower but perhaps harder to dismiss outright at the motion to dismiss stage. On the other hand, his rulings on the defenses that may be raised against the FDIC may prove helpful for other defendants. In most instances, the FDIC has been able to argue that its conduct is not at issue in suits it brings in its capacity as receiver. Judge Jones’s ruling suggests that the FDIC’s conduct as receiver at least can at least potentially serve as the basis of an affirmative defense. His ruling on the causation question opens the door that the FDIC-C’s pre-closure conduct could also be brought into question as well.

 

With so many failed banks in Georgia, and with the likelihood of a proliferation of failed bank suits in that state, Judge Jones’s rulings could prove to be significant.

 

Many thanks to the several loyal readers who sent me copies of the Integrity Bank decision. Special thanks to Bob Ambler of the Womble Carlyle firm. Womble Carlyle represents one of the individual defendants in the Integrity Bank case.

 

The annual letter to Berkshire Hathaway shareholders of Warren Buffett, the company’s Chairman, is anticipated every year as much (or arguably more) for its commentary on the financial world and the economy as it is for its discussion of the company’s performance. This year’s letter (here), released on February 25, 2012, does not disappoint. The letter contains numerous insights into the U.S. economy and the financial marketplace. Buffett’s letter also reflects his well-known penchant for homespun humor and telling anecdote, although in smaller rations than in years past.

 

In this year’s Buffett refers to some familiar themes. Several of the topics can charitably be described as “well-worn.” Also, as I noted in my review of last year’s letter, Berkshire itself has become so huge and diverse that simply summarizing its results nearly consumes the editorial   potential of the shareholder letter medium.  Though some of the topics may be shopworn, Buffett nevertheless manages to work in sufficient insight to make his letter well worth reading, even for those who don’t own Berkshire stock. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.) My summary of the letter’s main themes follows.

 

Berkshire Itself

By any measure, Berkshire Hathaway is an astonishing construction. During 2011, the company had net income of $10.3 billion on revenues of $143 billion. Though the company’s earnings were down from 2010 (when the company earned $13 billion), the company’s book value, a measure of assets minus liabilities, rose during the year to $164.9 billion from $157.3 billion at the end of 2010. The 4.6 percent increase in book value outpaced the S&P 500’s 2.1 percent return. At year end the company had $37.3 billion cash on hand, despite several multi-billion dollar investments during the year.

 

For many years, Berkshire was fairly described as an insurance holding company with a very impressive investment portfolio. Those descriptive attributes remain accurate, but they are no longer sufficient. Berkshire is now an extraordinary collection of businesses, including not only the more than 70 businesses that operate directly under the Berkshire umbrella, but an additional 140 businesses within the Marmon unit (among many others). Buffett notes in his letter than there are eight Berkshire subsidiaries that would be in the Fortune 500 if they were stand-alone companies (“That leaves only 492 to go. My task is clear, and I’m on the prowl.”)

 

As a result of a number of acquisitions in recent years, Berkshire is also now a holding company of huge industrial operations. A large part of the letter is devoted to discussing the company’s five largest non-insurance operations (BNSF, Lubrizol, Marmon Group, Iscar and Mid American Energy), only one of which Berkshire has held for more than five years. In the aggregate these five companies had full-year pre-tax earnings of more than $9 billion. (Five years previously, the single one of these companies that Berkshire owned then, MidAmerica, had earnings of only $393 million).

 

The sheer magnitude of these large recent investments is underscored by Buffett’s recitation of the extent of BNSF’s essential operating assets; he notes that “we must, without fail, maintain and improve our over 23,000 miles of track along with 13,000 bridges, 80 tunnels, 6,900 locomotives and 78,600 freight cars.” By the same token, MidAmerica’s pipelines “transport 8% of the country’s natural gas,” and its investments in wind generation and solar projects amount to “far more than any other regulated electric utility in the country.”

 

With these and many other businesses, Berkshire is now an essential component of the U.S. economy, which makes Buffett’s comments about the economy (discussed below) that much more vital. Buffett does not exaggerate when he says “when you look at Berkshire, you are looking across corporate America.” No matter what else you may want to say about the company, it has become huge. It is so big that not even Buffett knows all of its businesses. In mentioning that at last year’s shareholder’s meeting, one of the businesses, Wells Larmont, sold 6,126 pairs of gloves, Buffett comments that the unit’s gloves were a product “whose very existence was news to me.” Similarly, I was interested to learn from reading the annual report that Berkshire now also owns Brooks, the running-shoe company.

 

Whether or not the whole thing has become more than a single person can comprehend much less handle seems a legitimate question, but Berkshire shareholders themselves are more interested in the question of what happens to the company when the 81 year-old Buffett is no longer in charge. The succession question took on a whole new layer of urgency after the March 2011 departure of former MidAmerica Chairman David Sokol, the previously presumptive front-runner as Buffett’s successor who left under a cloud due to his stock purchases ahead of Berkshire’s decision to acquire Lubrizol (about which for refer here).

 

Arguably for the first time, Buffet indicates in his latest shareholder letter that a successor has been selected, an individual about whom the company’s board has had “a great deal of exposure,” whose “managerial and human qualities they admire” and about whom they are enthusiastic. Buffett does not name this individual, but the smart money seems to be on Ajit Jain, the head of Berkshire’s reinsurance operations. Buffett also mentions that there are two back-up candidates as well.

 

Buffett himself has made the question of who will succeed him separate from the question of who will manage Berkshire’s now $77 billion investment portfolio. To address this separate question, Buffett seems to be conducting on-the-job auditions. In the shareholder letter, Buffett describes the recent engagement of Todd Combs and Ted Wechsler as investment managers. Buffett reports that Combs has built a $1.75 billion portfolio and that Wechsler will soon built a similar portfolio. The tryout process from here is unclear, but Buffett does say with respect to these two investment managers that “Each will be handling a few billion dollars in 2012, but they have the brains, judgment and character to manage our entire portfolio when Charlie and I are no longer running Berkshire.”

 

These hints and indications about the long-term future of Berkshire management may not be enough to mollify the market’s general concerns about Buffett’s age; as the Wall Street Journal pointed out on Friday, one of the reasons the company’s share price has lagged in recent months compared to the larger market may be due to succession planning concerns. Berkshire has slumped 4 percent in New York in the last 12 months, compared with a gain of 4.6 percent for the Standard & Poor’s 500 Index.

 

The U.S. Economy

As he did in last year’s letter, Buffett takes great pains to emphasize his belief that “America’s best days lie ahead.” The Berkshire businesses are clearly acting on this belief. In 2011, the operating companies spent $8.2 billion on property, plant and equipment, 95% in the U.S., “a fact that may surprise those who believe our country lacks investment opportunities.” Even though there will be projects abroad, “the overwhelming majority of Berkshire’s capital commitments will be in America.”

 

However, In considering Buffett’s optimistic analysis of the U.S. economy, it is probably worth noting two “unforced errors” he acknowledges in the shareholder letter. First, he characterizes his $2 billion investment in Energy Future Holdings bonds, dependent as they were on natural gas prices rising substantially, as “a mistake – a big mistake.” He also acknowledges that his belief a year ago in a housing recovery within a year or so as “dead wrong.” If Buffett missed so badly on a couple of basic assumptions about such fundamental economic components as energy prices and housing construction, could he be wrong about the overall economy as well?

 

Buffett would argue (an in fact, does argue, in the letter) that he has only been off on the timing, not on the economic fundamentals. In the letter, he states that though the housing industry has been in a “veritable depression,” housing “will come back – you can be sure of that.” In making this argument, he asserts that while housing construction remains in the doldrums, the number of households increases, and every day we are creating more households than houses. He states that “demographics and our market system will restore the needed balance – probably before long. When that day comes, we will again build one million or more residential units annually. I believe pundits will be surprised at how far unemployment drops once that happens.”

 

Insurance

In this year’s letter, Buffett replays an oft-repeated message when explains the importance of “float”—that is, the funds that an insurance company gets to hold between the time it collects premiums and the time that it pays claims. As in past years, Buffett emphasizes that when the insurance operations are profitable, the cost of float is less than zero, in effect paying the company for holding the funds while also allowing the company to earn investment returns as well.

 

However, as Buffett puts it, the “wish for all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss.” Buffett (not for the first time) cites by way of example State Farm, “by far the country’s largest insurer and a well-manage company besides,” which has “incurred an underwriting loss in eight of the last eleven years.” As Buffett puts it, “there are a lot of ways to lose money in insurance, and the industry is resourceful in creating new ones.”

 

Buffett notes that the Berkshire companies have achieved underwriting profitability for nine consecutive years, in the interim producing underwriting profits of $17 billion. (He does not mention, however, that during the fourth quarter, the insurance operations had an underwriting loss of $107 million, due to catastrophe losses in the reinsurance operations.)   He emphasizes that cost-free float “is not an outcome to be expected for the P/C industry as a whole.” In most years, including 2011, “the industry’s premiums have been inadequate to cover claims plus expenses.” For many years, the industry’s overall return on tangible equity for many decades has fallen far short of the average return realized by American industry, “a sorry performance almost certain to continue.”

 

The problem, as Buffett sees it, is that too few insurers are “willing to walk away if the appropriate premium can’t be obtained.” Many insurers, he notes, “simply can’t turn their back on business that their competitors are eagerly writing.”

 

With respect to the Berkshire insurance businesses, Buffett notes that if there were a $250 billion mega-catastrophe (“a loss about triple anything it has ever faced”) Berkshire “would likely record a moderate profit for the year because of its many streams of earnings.” At the same time, however, “all the other major insurers and reinsurers would be far in the red, and some would face insolvency.”

 

Investments

For many readers, the greatest value of Buffett’s letters is his occasional asides, where he comments on some aspect of the financial markets or global economy. Buffett’s message this year is that many investments often assumed to be safe (such as bonds or gold) are far less likely to produce investment returns than are investments in equities, which Buffett characterizes as the “safest” investment by far.

 

The problem with bonds and other currency denominated investments is not just the tax drain on the investment returns, but the even more devastating effect of inflation. By way of illustration, Buffett notes that the value of the dollar has fallen “a staggering 86% in value since 1965.” As a result of inflation, currency-denominated investments “have destroyed the purchasing power of investors in many countries.” Even though bonds and other currency-denominated investments are often characterized as “safe,” they are in truth “among the most dangerous of assets” and “their risk is huge.” Interest rates “do not come close to offsetting the purchasing power risk.” In the current low interest rate environment “bonds should come with a warning label.”

 

As for gold, which is the current investment favorite in certain circles, Buffett suggests it has two significant shortcomings, which is that it is “neither of much use nor procreative.” Most of the gold’s industrial and jewelry uses are not quite enough to absorb ongoing production. Meanwhile, “if you own one ounce of gold for an eternity, you will own one ounce at the end.” Buffett imagines all of the gold assembled into one $9.6 trillion cube, and comparing it to a similarly valued cube composed of productive assets such all of the U.S. cropland and 16 Exxon Moblls. In a century, the second cube will have delivered trillions of dollars of value, with the ability to continue to produce value into the future, whereas the cube of gold “will still be unchanged in size and incapable of producing anything.”

 

Buffett contrasts these first two categories with investment in productive assets, such as businesses, farms or real estate. He notes that “ideally” these assets “should have the ability in inflationary times to deliver output that will retain its purchasing power.” Buffett sees a future in which the U.S. will “move more goods, consume more food, and require more living space than it does now.” Our country’s businesses “will continue to efficiently deliver goods and services wanted by our citizens.” So Berkshire’s goal will be to “increase its ownership in first class businesses.” Buffett contends that “over any extended period of time this category of investing will prove to be the runaway winner” among the three categories of investments, and, more importantly, “it will be by far the safest.”

 

Another investment area Buffett addresses is share buybacks. He discusses this question both because Berkshire itself for the first time implemented a share buyback program in 2011, and because during 2011 Berkshire invested $11 billion  in IBM, which is in the midst of an aggressive buy back program. Buffett explained that the Berkshire’s buyback program is not intended to support the share price, but is merely a mechanism to take advantage of opportunities when the market has priced the shares below its intrinsic value.

 

In discussing IBM’s share buy back, Buffett explains that when Berkshire buys a stock In a company repurchasing its shares, Berkshire not only hopes that the company in which it has invested will continue to grow its earnings, but that its stock will underperform the market for a long time. Buffett notes that in the end the worth of Berkshire’s investment in IBM will be determined by IBM’s earnings, but an important secondary factor will be the share buy back program, as the lower the price at which the company buys its own shares, the more shares it will buy, and the larger will be Berkshire’s percentage ownership of the remaining shares (and therefore of IBM’s earnings). Buffett jokes that if the number of outstanding IBM shares is reduced to 63.9 million, “I will abandon my famed frugality and give Berkshire employees a paid holiday.” (Were the number of outstanding shares were reduced to 63.9 million, that would mean that Berkshire would own 100% of the outstanding shares.)

 

In commenting on the counterintuitive notion that an investor owning shares of a company that is net buyer of its own stock should hope for the company to be undervalued, he explains that “you are hurt when stocks rise. You benefit when stocks swoon.” Buffett explains that emotions too often complicate the matter. Most people he notes, including even those who will be net buyers in the future, “take comfort in seeing stock prices advance.” Buffett concedes that in his early days he too rejoiced when the market rose. But when he read Ben Graham’s book The Intelligent Investor, “low prices became my friend.”

 

Discussion

Buffett is perhaps best known as a buy and hold investor, a person with a few simple investment principles that he follows rigorously. He cultivates and communicates an air of conservative consistency. The basic message from Buffett for years has been that with him, and with Berkshire, you know what are going to get. For that reason, a couple of developments during 2011 seem particularly noteworthy to me, both of which are things that I suspect many long-standing observers thought they would never see.

 

First, as noted above, Berkshire instituted a share buy back program, which although seemingly sound, also seems inconsistent with long-standing Buffett principles about putting cash to work.

 

The other development during 2011 that to me seems particularly noteworthy is that for the first time Berkshire has made a significant investment in a technology company. Much of Buffett’s current reputation as a visionary investor has much to do with his very public refusal to get caught up in the frenzy during the dot com era tech stock bubble. Buffett’s refusal to invest in tech companies because he doesn’t understand them has become such an iconic example of his simple but clear investment philosophy that Alice Schroeder began her recent biography of Buffett with a retelling of Buffett’s actions during that era. Of his decision to invest in IBM, Buffett says only that “it wasn’t until a Saturday in March last year that my thinking crystallized.”

 

Buffett says little else to explain or describe his unexpected decision to invest in a major technology company, except to say that, like his investments in Coke in 1988 and railroad in 2006, his IBM investment “was late to the IBM party.” To be fair, though, his extensive discussion of IBM’s share buy backs provide some explanation for the investment, and perhaps even a little bit of a defense of his decision finally to invest in the company only after a long and significant gain in its share price. He seems to be suggesting that it was part of his plan all along to buy the shares when he expected the company to be undervalued in the marketplace for a while, because the share buy back program would make Berkshire’s shares more valuable.

 

Long-time Buffett devotees know that this is far from the first time that Buffett has managed to find exceptions to his own loudly proclaimed general investment principles. To cite just one noteworthy prior example, in his 2002 shareholder letter, Buffett denounced derivatives as “time bombs” and “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal,” yet only a short time later, during 2007,  he entered massive derivative contracts that has affected the company’s financial results in every reporting period since. (Buffett takes great pains in his 2011 letter to detail how profitable these derivative positions have proven to be, thank you very much. He also notes that due to current marketplace requirements to post collateral, he won’t be making any further derivative investments any time soon.)

 

Buffett may have succeeded over time in portraying himself as the master of principled investing, but in recent years his actions have clearly shown that his principles may be, well,  flexible. Observers may ask that if Buffett has yielded on these points, might Berkshire now consider paying a dividend?

 

My own view it that though Buffett may have proven flexible on some points, we are unlikely to see a Berkshire dividend on his watch. Over and over again in this year’s letter, he reiterates the critical importance of maintaining minimum liquidity of at least $20 billion, and he details the importance of retained earnings. For example, he emphasizes how MidAmerica’s ability to retain earnings has allowed the company to make industry-leading investments in alternative energy. He also stresses how the value of Berkshire’s investments is enhanced when the companies in which it has invested retain their earnings.

 

Buffett may have demonstrated a certain amount of unwonted investment flexibility in recent years, but I still doubt that the payment of a dividend is something he would ever consider. Indeed, given his ownership position, a dividend would be a highly unwelcome taxable event for Buffett personally, which is yet another even more important reason it won’t happen during Buffett’s lifetime.

 

There are some other significant matters about which Buffett is silent in his letter. Thus, even though he mentions the company’s 2011 purchase of Lubrizol multiple times, he does not mention the serious questions that arose at the time about David Sokol’s investment in Lubrizol shares prior to Berkshire’s decision to acquire the company. He also stays away from the high profile issues in which he has become publicly involved during the past year, including questions about taxation fairness. (In my view, it is just as well that he stayed away from the taxation issue and other politically sensitive topics.)

 

There may be a few omissions, and there are a few things, like the name of Buffett’s successor, that are alluded to but not revealed. But overall you can’t criticize Buffett for hiding things. Very few investment managers, or even people in general, are as forthright about their mistakes. Buffett not only discloses his investment mistakes, but he puts them right up front. Perhaps he is confident enough to highlight his mistakes because he is sure that the things he got right far outweigh the things he has gotten wrong.

 

Buffett has always had a remarkable record selecting investments. His more recent track record in selecting large industrial companies to acquire may be even more impressive. As Berkshire has become more of an industrial company, it has become an increasingly important part of the U.S. economy. It is deeply encouraging that Buffett remains bullish on the U.S. economy. It is even more encouraging that his optimism consists of more than mere words. His acquisitions and investments say even more than his words about his belief in the U.S. economy. For the sake both of Berkshire shareholders and everyone else in this country, we can only hope that Buffett is right.

 

The Coolest Soccer Team in Europe?: I have embedded below a video of the third of Uruguayan striker Edinson Cavani’s three goals in a January 9, 2011 Italian Serie A game between Cavani’s team, Napoli, and league rival Juventus, not only because the Italian announcer’s call of the goal sets some type of record for operatic exclamation, but also because the goal itself is flat out ridiculous. (I am not certain, but I think the announcer may have had some type of seizure while announcing the goal.) You have to watch the slow motion replay to even be able to see the “scorpion kick” Cavani uses to put the ball in the goal.

 

I feature this video here because it dramatically demonstrates what many have been saying more recently following Napoli’s unexpected 3-1 win last week over Chelsea, the talent-laden but inexplicably struggling English Premier League team, in UEFA Champions League round of 16 action.  That is, as Brian Phillips puts it in a February 24, 2012 post on Grantland.com, you should root for Napoli now because they are “the coolest soccer team in Europe.” (Warning: the blog post contains humor some may find offensive.)