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.)

 

The advisory shareholder vote required under the Dodd Frank Act went through its first cycle in 2011, and by and large most companies’ shareholders approved the companies’ executive compensation plans. Only about 45 companies (less than 2%) received negative “say on pay” votes from a majority of investors. But that does not mean that the say on pay process was an empty exercise. Indeed, as we move forward in the second year of advisory votes, the impact of the say on pay process may now start to tell.

 

First, as detailed in a February 22, 2010 Wall Street Journal article entitled “ ‘Say on Pay’ Changes Ways” (here), many of the companies that sustained negative say on pay votes last year “are working hard to avoid an embarrassing repeat as annual meeting season begins again.” According to the Journal article, “the boards of many of the companies that failed the votes have consulted with investors and hired outside compensation advisers and proxy solicitors” and some “have made broader management changes that could help remedy performance issues at the heart of some shareholder concerns about pay.”

 

According to the Journal article, two of the companies that sustained negative say on pay votes last year – Beazer Homes USA and Jacobs Engineering – have already obtained positive say on pay votes this year with over 95% shareholder approval

 

The impact of the first say on pay cycle was not limited just to companies that sustained a negative vote last year. Institutional investors themselves have also been affected by the first cycle of votes. In a very interesting February 22, 2012 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Lessons Learned: The Inaugural Year of Say-on-Pay” (here), Anne Sheehan, the Director of Corporate Governance at the California State Teachers’ Retirement System (CalSTRS), comments that “the first year of Say-on-Pay was a learning opportunity as it helped us to refine our voting process for future years.” Her article makes it clear that not only did CalSTRS vote against many company’s pay packages last year, it may well do so again this year. In 2011, CalSTRS cast 23% percent negative say on pay votes.

 

In her post, Sheehan explains, with reference to CalSTRS, that “we believe that poorly structured pay packages harm shareholder value by unfairly enriching executives at the expense of owners – the shareholders.” She explained that CalSTRS “predominately voted against companies’ Say-on-Pay proposals because of disconnects between pay and performance.” In consideration of its 2012 votes, CalSTRS intends to focus on companies whose peer group comparisons lead to pay packages targeted to produce above the median, “particularly when companies targeted the 75th or 90th percentile.” CalSTRS is concerned about companies that are “over paying for on-par or below-average performance.”

 

Sheehan’s post and her description of the approach of CalSTRS heading into the second say-on-pay cycle makes it clear that there will be continued pressure on many companies regarding their compensation practices and disclosures, not just the relatively few companies that sustained negative votes in 2011.

 

The threats companies face as result of the say on pay process include not just investor scrutiny, but also even the possibility of shareholder litigation. As discussed in prior posts on this blog (refer for example here and here), some of the negative say on pay votes last year were followed by shareholder litigation regarding executive compensation issues.

 

To be sure, the number of these cases was relatively small, perhaps fewer than ten out of the roughly 45 companies that had negative say on pay votes. And many of these suits have been dismissed based on the application of the business judgment rule. In effect, courts have generally proceeded on the assumption that compensation is a matter within the board’s business judgment, although at least one court in a case involving Cincinnati Bell did decline to dismiss a say-on=p-pay lawsuit.

 

As discussed in a February 5, 2012 memo from Kenneth B. Davis, Jr. and Keith L. Johnson of the Reinhart Boerner Van Deuren law firm entitled “Say-on-Pay Lawsuits – Is This Time Different?” (here), “boards would be ill advised to take too much comfort in the belief that the business judgment rule will always be held to immunize compensation decisions from shareholder attack in the face of a substantial negative say-on-pay note.” In particular, the authors contend, “companies that fail to adequately explain and support their compensation awards will increasingly find themselves targeted for follow-up, through whatever means and remedies investors have available.”

 

The memo authors’ views in this regard to a large extent mirror the sentiments Sheehan expressed in her blog post. The authors state that “the early reports are that with the experience of the first season of say-on-pay behind them, many institutional investors are now prepared to take a more active role in identifying and opposing the compensation arrangements they find troublesome.” Among the motivations behind this focus on compensation is a perception that the say-on-pay focus may be “the best remaining avenue for challenging ineffective boards.” For that reason, many institutional investors intend to “ramp up focus” on the votes and in particular to “vote against boards that are unresponsive to shareholder concerns.”

 

As a result of all of this, the authors conclude that disgruntled investors unhappy with board responsiveness on compensation issues will continue to consider litigation as an option. In fact, the authors “expect the volume of this litigation will likely increase.” Companies “should continue to consider litigation risk among the many costs of failing to win substantial shareholder support for their executive compensation arrangements.”

 

The authors conclude that in order to reduce litigation risk and increase investor support, boards should “improve their disclosures around executive compensation, engage with and respond to legitimate shareholder concerns and attend to removing both conflicts of interest and behavioral biases from the board’s compensation oversight practices.”

 

How all of this will play out remains to be seen. At a minimum, it seems clear that even though the say on pay vote is merely advisory, it remains a matter of significance even as it enters its second year. Institutional investors clearly intend to try to use the vote as a means to try to address executive compensation issues. The continued focus has a number of significant implications for companies, including in particular the possibility of litigation risk for companies sustaining a negative say on pay vote.

 

Special thanks to Ken Davis for sending me a copy of his interesting article on Say-on-Pay litigation.

 

Indemnification is the first and most important line of defense for the protection of directors and officers. But corporate officials are not always entitled to indemnification. For example, under Delaware law, they cannot claim mandatory indemnification if their defense is not successful. And they cannot seek permissive indemnification is they did not act in good faith.

 

A February 7, 2012 decision of the Delaware Court of Chancery takes a detailed look at the contours of these indemnification limitations, in the challenging context of a case involving a former CEO who was terminated for cause and who pled ultimately guilty to criminal charges. The court reviewed the indemnification questions in consideration both of statutory indemnification provisions as well as a separate indemnification agreement and concluded that further discovery was required in order to permit a determination whether or not the former CEO did or did not act in good faith in connection with at least some of the amounts for which he sought indemnification The decision, which can be found here, raises a number of interesting implications.

 

I should acknowledge at the outset Francis Pileggi’s February 19, 2012 post on his Delaware Corporate and Commerical Litigation blog (here), which first brought this decision to my attention.

 

Background

Mark Hermelin was the CEO of K-V Pharmaceutical Company from 1975 to 2008, as well as a member of the company’s board from 1975 to 2010. In 2008, the company became aware of concerns that it had manufactured oversized morphine. K-V launched an internal investigation into the cause of the manufacture and distribution of the oversized tablets. In the course of the investigation, K-V discovered it had manufactured additional oversized tablets of other pharmaceuticals. K-V notified the FDA of the oversized morphine tablets, but did not report its discovery of the other oversized tablets.

 

K-V’s audit committee subsequently conducted an internal investigation and ultimately terminated Hermelin as CEO for cause. K-V’s announcement of the termination in an 8-K triggered an investigation by the local U.S. attorney, and regulatory actions by the FDA and the Department of Health and Human Services. Hermelin sought advancement and indemnification for defense expenses he incurred in connection with these investigations and regulatory actions.

 

The outcome of Hermelin’s involvement in each of these proceedings is relevant to the consideration of his bid for indemnification. First, the audit committee investigation resulted in his termination. Second, the AUSA’s investigation ultimately resulted in Hermelin’s entry of a guilty plea to two counts of criminal misdemeanor strict liability based upon an application of the Responsible Corporate Officer doctrine. Third, in connection with the HHS investigation, the agency issued a formal determination to exclude Hermelin from all federal healthcare programs for twenty years (which given Hermelin’s age is tantamount to a lifetime ban); and finally, in the FDA matter, K-V and Hermelin among others entered a consent decree whereby the defendants agreed to destroy certain drugs and refrain from manufacturing or distributing any drugs until the company complied with certain quality control requirements.

 

In seeking indemnification, Hermelin relied not only on the statutory indemnification provisions, but he also sought to rely on a separate indemnification agreement he had entered with the company. As the Delaware court observed in the indemnification proceedings, the indemnification agreement generally make mandatory what are permissive provisions for indemnification under the relevant statutory provisions.

 

The February 7, 2012 Ruling

In a February 21, 2012 ruling, Vice Chancellor Sam Glasscock summarized his consideration of the indemnification issues as a determination whether Hermelin had succeeded on the merits in any of these proceedings, thus entitling him to indemnification as a matter of law, or whether additional discovery is required to determine whether Hermelin acted in good faith, in which case Hermelin would be entitled to indemnification under the indemnification agreement.

 

In seeking to establish that he had been successful in certain of these proceedings, Heremlin argued among other things that the outcomes had been successful in the sense that the avoided worse outcomes for himself and for the company, and in some respects that he had in effect “taking one for the team.”

 

Vice Chancellor Glasscock concluded that Hermelin had been successful in connection with the FDA matter, and therefore was entitled to mandatory indemnification for his fees in connection with that proceeding. He concluded further that Hermelin had not been successful in the criminal matter, the HHS investigation or the audit committee investigation, and was not therefore entitled to mandatory investigation in connection with those matters.

 

But as for whether Hermelin was entitled to permissive indemnification (made mandatory under the indemnification agreement) in connection with the criminal matter, the HHS investigation or the audit committee investigation, Vice Chancellor Glasscock determined that further discovery is required, as Hamelin will still be entitled to indemnification for these matters under the indemnification agreement unless KV can establish that Hermelin’s conduct underlying these matters for which he seeks indemnification does not meet the good faith standard required under the relevant Delaware statutes.

 

In reaching these conclusions, the Vice Chancellor referenced a number of the specific provisions of the indemnification agreement, including in particular the provisions specifying a presumption that Hamelin is entitled to indemnification and putting the burden of proof on the company to overcome the presumption. The Vice Chancellor also referenced the provisions of the agreement specifying that a specific outcome, order or plea will not by itself create a presumption that the indemnitee had a nonindemnifiable state of mind.

 

The Vice Chancellor did note the “dearth of case law addressing the scope of relevant evidence with respect to good faith” under the Delaware statutory provisions. The Vice Chancellor did note that none of the matters for which Hermelin seeks indemnification “contained a finding that Hermelin acted in bad faith or an admission of culpability by Hermelin.” The Vice Chancellor noted in particular with respect to Hermelin’s strict liability misdemeanor guilty pleas, that the “record is inadequate with respect to Hermelin’s conduct.” Similarly with respect to the HHS matter and the audit committee investigation that the record does not reflect findings that Hermelin acted in bad faith. The Vice Chancellor concluded that the parties must supplement the record before he can make the necessary determinations.

 

Vice Chancellor Glasscock concluded by noting that the probable explanation for the dearth of case law addressing the relevant scope of evidence with respect to good faith is that most disputes of this type likely often settle, particularly where as here the parties are subject to an indemnification agreement that at least as an initial matter compels the company to foot both parties’ costs to litigate the matter. He concluded by observing that “I leave it to the parties to determine whether the elusive joys and potential benefits of such litigation outweigh the substantial costs that will result.”

 

Discussion

This case provides a number of valuable insights. First, it provides a very useful perspective on the actual mechanics of the Delaware statutory indemnification provisions. Indeed, as Francis Pileggi points out on his blog post to which I linked above, the case presented a question of first impression under Delaware law as to the evidence relevant for the determination whether or not executive has acted in good faith for permissive indemnification purposes.

 

Second, and more to the point, it underscores the value to corporate executives of having a separate indemnification agreement. The Vice Chancellor’s consideration of Hermelin’s agreement’s provisions emphasize the importance of several aspects the agreement, including in particular the presumption of indemnification; the burden of proof on the company of overcoming the presumption; and the specification that the mere fact of the entry of an order or plea will not be determinative of the issue of whether or not the indemnitee acted in good faith.

 

This case does underscore the breadth of a corporate official’s indemnification rights under Delaware law in an expansively constructed indemnification agreement. Here, Hermelin may yet obtain indemnification for much of his attorney’s fees notwithstanding (1) his termination for cause from the company; (2) his entry of a criminal guilty plea (resulting in his incarceration and the imposition of a substantial fine); and (3) an agency’s entry of a lifetime exclusion order against him. Indeed, unless the company can bear its burden under the agreement of showing that Hermelin did not act in good faith, he will have a mandatory right under the agreement for the indemnification of his fees.

 

This outcome does underscore the fundamental tension that may underlie many indemnification provisions and agreements. That is, a corporate official seeking to negotiate an indemnification agreement will want to have the agreement drafted as broadly as possible. The company on the other hand may want the agreement constructed more narrowly. This tension highlights the fact that it is always critical in connection with the consideration of any draft indemnification to establish whose interests are being examined.

 

Vice Chancellor Glasscock’s consideration of Hermelin’s rights of indemnification for the fees he incurred in connection with the criminal proceedings is particularly interesting. It is important to note that the criminal charges against Hermelin were made pursuant to the responsible corporate officer doctrine. As I have discussed in prior posts (here and here), the word “responsible” in the doctrine’s title does not mean the officer is responsible for the alleged misconduct, but only that the officer is responsible for the company. A criminal charge under this doctrine is, as the Vice Chancellor noted, a strict liability offense. As such, these nothing specific about a guilty plea that establishes that the defendant officer acted with a culpable state of mind, much less that the official acted with bad faith. Accordingly, a corporate official convicted of a strict liability criminal defense may nevertheless be entitled to corporate indemnification, in the absence of any finding of bad faith.

 

Moreover, given the absence of any finding of willfulness or deliberate misconduct, the guilty plea may not (depending on the actual policy exclusion wording) trigger the conduct exclusion in a D&O insurance policy. In other words, the defense fees at least could be fully insurable under the corporate reimbursement provisions of the typical D&O insurance policy. The typical presumptive indemnification provision found in many D&O insurance policies (presuming indemnification to the maximum extent permitted by law) underscores the possibility of this outcome.

 

I anticipate that there will be some who question whether or not Hermelin ought to have any right to indemnification under these circumstances. At this point, he may or may not be, it has not yet been determined. If the remaining indemnification disputes do not settle and the company proves he acted in bad faith, he will not be indemnified. He only receives indemnification if the company cannot prove he acted in bad faith, in which case I would say, why shouldn’t he receive indemnification?

 

Vice Chancellor Glasscock put it this way: “Delaware law furthers important public policy goals of encouraging corporate officials to resist unmeritorious claims and allowing corporations to attract qualified officers and directors by agreeing to indemnify them against losses and expenses they incur personally as a result of their services.” He added, the complete the picture that “prohibiting unsuccessful ‘bad actors’ also relieves stockholders of the costs of faithless behavior and provides corporate officials with an appropriate incentive to avoid such acts to begin with.”

 

Accordingly, any argument that Hermelin should not be entitled to indemnification has to proceed on the theory that he is a “bad actor.” As Vice Chancellor Glasscock concluded, however, there is not a sufficient basis on the current record to conclude that Hermelin is a bad actor. I should add that the presence of the guilty plea to the strict liability criminal charge is an distracting and confusing irrelevancy. The criminal charge is basically a status offense; Hermelin was charged because of his title, not necessarily because of his actions – or even fault, as the charges were strict liability offenses.  

 

I have pointed out elsewhere the fundamental problems with the imposition of liability without culpability. As I have previously argued, this deeply troublesome trend is fundamentally inconsistent with traditional notions of justice and fair play. The problems associated with these types of prosecutions should not be compounded by efforts to try to use the prosecutions as a basis to try to strip corporate officials of their indemnification rights, at least in the absence of affirmative evidence of bad faith.

 

I suspect others may have strong views on this subject. I invite readers to add their views to the  dialog using this blog’s comment feature.

 

Readers with a penchant for historical references will definitely want to peruse Vice Chancellor’s musings on page 7 and page 13 about the proper historical allusion for Hermelin’s posture in the underlying actions, in light of his contention that his tactics of concession secured benefits and avoided worse detriments for himself and for the company. The possibilities include a Pyrrhic victory, a Hobson’s choice, a Morton’s Fork, or a Buridan’s Ass. Vice Chancellor Glasscock is of the view that the most appropriate historical reference for Hermelin’s defense is Lee’s surrender at Appomattox.

 

M&A Plaintiffs’ Attorneys as Toll Booth Operators: I have recently detailed on this blog the many problems associated with the upsurge in M&A related litigation, including among other things the problems associated with rising plaintiffs’ fee awards in these cases. I have also noted that the plaintiffs’ fee awards can be quite substantial even where there is no cash recovery for the benefit of the shareholders on whose behalf the plaintiffs’ lawyers supposedly brought the case.

 

A case in point is the recent $8.8 million plaintiffs’ fee award in the litigation related to the XTO Energy acquisition. As detailed in Nate Raymond’s February 14, 2012 article on Am Law Litigation Daily (here), a state appellate court has affirmed the award of these fees, notwithstanding the fact that plaintiffs’ attorneys recovered no cash for the plaintiff class. The appellate court’s ruling is the subject of Ronald Barusch’s scathing February 20, 2012 post on the Wall Street Journal’s Dealpolitik blog (here).

 

Among other things, Barusch contends that in the settlement, the shareholders received “nothing but words.” The author contends based on the appellate court’s decision that the fee award was calculated on “what appears to be a totally irrational basis” The author concludes that with “outrageous” outcomes like this, these kinds of cases these class actions “have become toll booths for just about every big merger.”

 

A Variation on the Chinese Company Litigation: As I and many others have noted, one of the most pronounced trends during 2011 was the wave of shareholder litigation involving Chinese companies. In an interesting variation on this litigation trend, a shareholder In one of the Chinese companies caught up in its own scandal has now been sued. According to a February 21, 2012 Wall Street Journal article (here), one of the investors in John Paulson’s hedge funds, which had invested in the scandal-ridden Sino-Forest Corp. (about which refer here and here), has filed a purported class action lawsuit in the Southern District of Florida against Paulson’s firm for failing to conduct sufficient due diligence in the firm.

 

According to the Journal article, Paulson’s fund lost about $500 million last year on its investment in Sino-Forest, although this figure includes the loss of the fund’s paper gains on the investment. The net total loss was $100 million. The lawsuit alleges gross negligence and a breach of the fund’s duties to investors for “failing to expend the resources to conduct the proper initial due diligence in Sino-Forest’s operations.”

 

Though the wave of litigation involving the Chinese companies seems to have peaked last year, litigation continues to arise. This latest suit presents the latest variation of efforts by U.S. investors to try to recoup losses based upon the companies involved in the accounting scandals. The interesting thing about this latest twist is that the litigation is extending not only to the Chinese companies and their directors and officers, as well as offering underwriters and auditors, but now it is even extending to shareholders.

 

Photography and the Physics of Canine Balance: All I can say is — take a look at the oddly compelling photos in this collection captioned “Maddie the Coonhound Standing on Things” (here)

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Most management liability insurance policies these days are written on a claims made basis – -that is, they cover claims that are first made during the policy period. But what determines when a claim is first made? A February 15, 2012 decision from the Western District of Texas and applying Texas law took a look at these in an insurance dispute arising under a condominium association insurance policy and concluded that under the facts presented the claim had first been made prior to the inception of the policy. The February 15 decision can be found here.

 

Background

Deer Oaks Office Park Association is an office park condo association that owns and maintains office condos in San Antonio. Deer Park was insured under a condo association insurance policy with a policy period from January 30, 2010 to January 30, 2011. The policy included a directors and officers liability insurance extension.

 

Prior to the policy’s inception, Thomas Jeneby, purchased a unit in the condo development, intended to use if for medical offices. He later alleged that he indicated his intent to install an elevator in the unit to facilitate patient access. Deer Oaks later declined to approve the elevator. Jeneby contended that Deer Oaks had made misrepresentations about his ability to install an elevator. He also had complaints about Deer Oaks’ condo maintenance.

 

Eventually, and during the policy period of the policy, Jeneby filed a lawsuit against Deer Oaks. Deer Oaks  submitted the lawsuit to its insurer. The insurer declined to provide a defense claiming that the claim had been made and that Deer Oaks had notice of the claim prior to the inception of the policy. In making this argument, Deer Oaks relied on a September 23, 2009 letter from Jeneby’s attorney to Deer Oaks, in which the attorney presented multiple complaints about Deer Park and attributing monetary losses to Deer Oaks.

 

Among other things, the letter stated that Jeneby is “adamant that he bout this building in reliance of the fact that he would be allowed to install an elevator.” The letter also complained about numerous maintenance problems. The stated that Jeneby’s disputes with Deer Oaks have been going on for two years “with expenses and loss of business continuing to increase.” Jeneby’s attorney concluded the letter by stating that “if I have not heard a response back from your client by October 2, 2009, then my client has instructed me to file suit in District Court.”

 

After the insurer declined to provide Deer Oaks with a defense against Jeneby’s lawsuit, Deer Oaks filed an action seeking a judicial declaration that the insurer was obligated to defend the claim. The parties to the insurance coverage dispute filed cross-motions for summary judgment.

 

The February 15 Ruling

In her February 15, 2012 ruling, Magistrate Judge Nancy Stein Nowak granted summary judgment in favor of the insurer and denied DeerOaks’ cross motion.

 

Deer Oaks had argued that the September 23, 2009 letter did not constitute a claim nor did it provide Deer Oaks with notice of claim. In making this argument, Deer Park relied on the fact that the policy did not define the term “Claim,” and also relied on International Insurance Company v. RSR, a 2005 decision from the Fifth Circuit, to argue that under the circumstances of this case, a “claim” means a “demand for money, property or legal remedy, and that because the letter did not explicitly demand, property or a legal remedy, it did not provide notice of Jeneby’s claims.

 

Magistrate Judge Nowak disagreed, saying that although Deer Oaks’ “use of available case law is resourceful,” its argument “fails.” She found that “the only reasonable interpretation” of the September 23, 2009 letter is that is “asserted a right to hold [Deer Oaks] liable for all of the costs Jeneby had spent and lost because of [Deer Oaks’] acts.” The letter’s “bottom line,” the Court said, was “if you do not comply with my demands, I will sue you.” The Court concluded that “under any construction, the letter constituted a claim,” and it also “constituted notice.” Because Deer Oaks “had notice before the effective date of the policy, the claim fell outside the policy and [the insurer] had no duty to defend.”

 

Discussion

To a certain extent, the value of this case may be limited by the fact that it involved a policy that did not define the term “claim.” Although there was a time many years ago when it was common for management liability policies to lack a definition of the term, in more recent years it has become very uncommon for management liability policies to be issued without a definition of the term “claim.” Indeed, the reason that many insurers incorporated the term in to their policies is that they found that without a policy definition of the term, courts were inclined to infer a very broad definition of the term.

 

As the Magistrate Judge herself noted in discussing the Firth Circuit case on which Deer Oaks sought to rely, the appellate court had sought to apply an interpretation of the term claim that was “most favorable to the insured.”  However, this dispute illustrates the fact that a broad definition of the term does not always work out in the policyholder’s favor. By applying a broad meaning to the term, the Magistrate Judge had little trouble determining that the letter sent prior to the policy’s inception was a “claim,” and therefore that the claim had first been made prior to the policy period.

 

The outcome of this case is very fact specific, turning as it does in part on the unusual absence of a definition of the term “claim” in the policy, as well as the other specific circumstances involved. There is one very peculiar aspect of the letter that does make this a troublesome case just the same. Oddly, the September 23, 2009 letter does not appear to demand anything from Deer Oaks. The letter recites Jeneby’s grievances, states that Jeneby has incurred costs, and threatens a lawsuit. But as far as I can tell, the letter does not expressly demand anything in particular from Deer Oaks.

 

The Magistrate, applying the Fifth Circuit case law, found that the term “claim” could include “the assertion of a right to hold the insured liable,” notwithstanding the absence of any explicit demand. But I wonder whether this letter would be sufficient to constitute a claim under the usual policy definition of a claim as “a demand for monetary damages or non-monetary relief.”

 

In any event, this case does illustrate the point that broad definitions and interpretations do not always work to the policyholder’s advantage, and that what the position that any particular policyholder may want to take in any specific case may well depend on the actual circumstances involved.

 

One final note. The court’s opinion, and apparently the parties’ arguments, seemed to focus on whether or not Deer Park had notice of claim. This seems odd to me. The issue from my perspective seems to me to be when the claim was first made. The question of notice seems beside the point.

 

A February 17, 2012 memorandum from the Traub Lieberman law firm discussing this ruling can be found here.

 

In Case You Missed It: If you did not see my blog post yesterday on the meaning of “relatedness” in the context of a D&O insurance policy, please refer here.

 

Yes, the Title Says it All, and, No, I Am Not Making This Up: I am quite sure that no reader of this blog would ever stoop so low as to click on a link to an article captioned “Japanese Fart Scrolls.” Certainly, no one here at The D&O Diary would stoop so low as to try to extract humor value from a web site entry entitled “Japanese Fart Scrolls.” Our motto: Dignity, always dignity.

 

Of all the questions surrounding liability insurance, the one issue that seemingly ought to be most obvious is the amount of insurance potentially available to respond to claims. Indeed, the question of the amount of insurance potentially available for a single claim usually is relatively straightforward and usually is answered by reference to the limit of liability identified on the face of the policy. When multiple claims arise, however, things become more complicated, particularly if multiple claims arise during separate policy periods.

 

In our litigious society, it is not uncommon for a given set of circumstances to trigger multiple complaints. A liability insurance policy will typically provide that if claims are related, they are treated as a single claim and that the claims made date for the claim is the date on which the first complaint was filed. Fair enough, you may say. The hard question is — what is it that makes claims “related”? The question of whether or not two claims are related can matter deeply, because if two claims made in two different policy periods are unrelated, then two limits of liability (or two separate towers of insurance) are triggered; but if they are related, then only a single limit (or tower of insurance) applies.

 

“Relatedness” is not self-defining. It is, in fact, a concept that recedes away from you the harder you try to think about it. At a certain level of generalization, everything in the universe is related, all joined together in the all-powerful and all- knowing mind of almighty God. Yet from another perspective, nothing is related, as all of creation consists of nothing more than chaotic, swirling bits of matter randomly spinning away within the cosmic void.

 

And even if we are more practical and less theoretical, what is the type of relationship that determines relatedness – is it temporal or spatial relationship? Is it causal or logical relationship? Must events involve the same actors acting with the same purpose and intent and using the same methodology for the events to be related – and if the actors, purposes and methodology don’t have to be identical, how much may they vary without eliminating the link of relationship between different events?

 

D&O insurance policies attempt to retrieve these issues from the outer realms of philosophy. Typically the policy will define the term “Related Claims” as “all Claims for Wrongful Acts based upon, arising from, or in consequence of the same or related facts, circumstances, situations, transactions or events or the same or related series of facts, circumstances, situations, transactions or events.” Unfortunately, these words do not eliminate the fundamental definitional predicament, because the meaning of the defined phrase –“related”– depends on a determination of what makes given facts or circumstances “the same or related.” (This is what I meant when I said that the more you try to think about these issues, the more they recede away from you.)

 

The problems these kinds of questions present are playing a prominent role in some very high-profile cases arising out of the global financial crisis. To pick just two examples about which I have previously written on this blog, the collapse of both Lehman brothers and Indy Mac bank not only triggered a wave of claims, but also have generated a fierce debate whether the onslaught of claims, filed as they were over a period of months, has in each case triggered only one tower of insurance or two. As discussed here, in the case of Lehman Brothers, the question is whether the claims trigger only a single $250 million tower of insurance, or two. In the case of IndyMac, as discussed here, the question is whether the claims trigger only a single $80 million tower of insurance, or two. (The possibility that IndyMac’s second tower of insurance might be drawn into the claims was discussed in open court at a recent discovery proceeding in one of the IndyMac cases, as I noted here.) Obviously in these cases as in many others, the outcome of “relatedness” question will make an enormous difference for everyone involved.

 

One of the many vexing aspects of these relatedness issues is that the various parties are not always interested in the same kind of analytic outcome in every situation. Although the insured persons (and claimants, to be sure) in the Lehman Brothers and IndyMac cases clearly are interested in a finding that the various claims are unrelated, a finding of unrelatedness is not always in the policyholders’ interests. For example, policyholders may want to find that claims are related if the question is not how many limits of insurance apply, but rather is how many policy retentions apply.

 

Most D&O policies will typically provide with respect to the retentions something along the lines of “a single Retention amount shall apply to Loss arising from all Claims alleging the same Wrongful Act or related Wrongful Acts.” Under this language, a finding that multiple smaller claims are unrelated could leave the policyholder responsible for multiple policy retentions and render much of the loss deriving from the various claims as uninsured.

 

As should be apparent, these issues arise frequently, and over t he years, many courts addressed the “relatedness” question. However, anyone expecting to find clarity from the various cases will be disappointed. Taken collectively, the cases illustrate nothing so much as how elusive these issues can be.

 

The courts addressing the “relatedness” question typically will frame the inquiry as one designed to determine whether or not there is a sufficient “nexus” between events or transactions to treat them as a single claim. The parties in the case interested in a determination that the events or transactions represent a single claim will typically argue that the events or transactions involve “ a single course of conduct” or a “continuing series of events” The parties arguing in favor of a finding that the events or transactions represent multiple claims will argue that the events or transactions involve “discrete acts” or “disparate actors” and the presence of events separated by time, geography, methodology, purpose and outcome.

 

Many of the published case decisions in this area arose out of the insurance coverage litigation that followed in the wake of the S&L crisis. In those cases, policyholders (or more typically, the FDIC) argued that each of the various allegedly negligently made loans represented a separate act of negligence and therefore a separate claim. The insurers argued that because all of the loans were made by the same group of loan officers applying the same aggressive lending approach, the loans were interrelated and the allegations of negligence therefore constituted only a single claim. The FDIC had some success making these arguments in at least some cases. Yet in other cases, seemingly no different, these arguments were unsuccessful, particularly where the question was whether multiple loans made across multiple policy periods triggered multiple limits of liability.

 

As a result of these and many other judicial decisions, there are a multitude of cases for either side to cite in any relatedness dispute today. Indeed, in their 2009 article entitled “Interrelated Acts, Unrelated Case Law” (here), Robert Chesler and Syrion Anthony Jack of the Lowenstein Sandler law firm comment that “unfortunately for both insurers and policyholders, the case law regarding these issues is hopelessly irreconcilable.” The unpredictability of the issue “stems in part from the fact-intensive analysis that most courts apply in attempting to resolve such disputes.”

 

I do not mean to suggest there are never times when the obvious outcome is clear. For example, if there are two complaints, one a securities class action suit and the other a shareholders derivative suit, and each based on the same, say, options backdating allegations, those two complaints are related. If however, one complaint alleges options backdating and the other alleges, say, the failure of a development stage product to clear a regulatory threshold, then those two complaints probably are unrelated. It is the realm between these two points of relative clarity where the problems emerge.

 

My perception is that courts generally approach the analysis of these issues with an unconscious bias in favor of whatever outcome will maximize the amount of insurance available. Insurers can overcome these biases, and it clearly matters to them that they do, since limits and retentions are instrumental in determining premiums and ultimately in determining profitability. In the end, the outcome of any particular “relatedness” dispute is going to depend on the facts presented, the policy language involved, the case law applicable in any given jurisdiction – and the predilections of the decision maker.

 

With all of these variables in play, outcomes can be unpredictable. Yet the outcomes can and often do make an enormous difference in the amount of insurance available to respond to the claims presented.

 

I suspect that many readers will have reactions to my views here, perhaps even strong reactions. I hope that readers with views on this topic will take the time to share their views with others by posting their thoughts on this site using the Comment feature.

 

More About M&A Litigation: Regular readers know that I have written extensively of late about the rising tide of litigation related to mergers and acquisitions. All too often this litigation fails to produce anything except fees for the lawyers involved. The expensive pointlessness of so much of this litigation is well detailed in a February 16, 2012 Bloomberg article entitled “Merger Lawsuits Often Mean No Cash for Investors” (here). The problems associated with this kind of litigation are increasingly a matter of increased awareness and heightened scrutiny.

 

More About the Developments in the Netherlands: In a recent post (here), I wrote about the recent decision of a Dutch court authorizing the use of the Dutch collective-settlement statute to settle disputes on a classwide, opt-out basis. The significance of this development is discussed in a good, brief February 18, 2012 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here). The article concludes that:

 

The Court’s decision illustrates that the Dutch Act provides a viable class action settlement mechanism for complex multi-jurisdictional securities class actions. In particular, if the claims asserted face significant obstacles under U.S. law, the Dutch Act should be considered as a potential strategic alternative to resolve the dispute globally in conjunction with a United States settlement. Further, where a U.S. court will not hear investor claims because the shares of the company allegedly involved in wrongdoing were listed and purchased on a European-based stock exchange, the company should be aware that it (with European and American investors) can seek to resolve those claims on a classwide basis in a European forum.

 

A Bad Karma Reverse Hat Trick: In Sunday’s 5th Round FA Cup fixture between Liverpool and Brighton at Anfield (Liverpool’s home pitch), Brighton scored four goals and Liverpool scored only three, yet Liverpool won, 6-1 — because Brighton scored three "own goals," the first time that has happened in FA cup competition. Two of the three own goals were put in the net by Brighton’s unfortunate defender, Liam Bridcutt. And you thought you were having a tough day at the office.

 

 

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In their paper “A Great Game: The Dynamics of State Competition and Litigation” (here), Ohio State Law Professor Steven Davidoff and Notre Dame Finance Professor Matthew Cain analyzed the M&A related litigation during the period 2005 to 2010. I discussed this article in a prior post, here. In a newly released February 2, 2012 paper entitled “Takeover Litigation in 2011” (here), Professors Davidoff and Cain supplement their prior research with the preliminary statistics for takeover litigation in 2011.

 

The authors review all 2011 transactions involving U.S. exchange traded companies with a deal size over $100 million, an offer price of at least $5 per share, with a publicly available merger agreement and a closing date by January 12, 2012. There were 103 transactions that met these criteria, which represents a slight decline from the 124 transactions in 2010. However, the 2011 figures do not include pending transactions from 2011, so these figures could change as more of the deals are completed.

 

But while the absolute number of transactions declined slightly in 2011, the number of transactions that attracted lawsuits increased, at least as a percentage matter. The authors found that while 84.6% of mergers attracted litigation in 2010, the percentage rose to 94.2% in 2011. The authors noted  in their original paper that in 2005 only 38.7% of deals attracted litigation, so the litigation is now brought “at a rate almost 2.5 times that of 2005. The authors expect that as the pending 2011 deals are completed “we expect that the ultimate 2011 litigation rate will match or exceed the 94.2% figure.”

 

In addition, the mean number of complaints per deal remained basically constant in 2011, to with a 2011 per deal mean of 4.8, from 4.7 in 2010. These mean figures represent a doubling of the 2005 mean number of lawsuits of 2.2. The percentage of deals that attracted multistate litigation declined slightly to 47.4% in 2011, from 47.6% in 2010.

 

Disclosure only settlements increase to 84% of all 2011 settlements, compared to approximately 80 percent in 2010.

 

The authors note that “so far for 2011 average attorneys’ fee awards are down substantially.” The mean plaintiffs’ attorneys fees awarded in all settlements declined in 2011 to $784,000, from $1.255 million in 2010. The mean attorneys’ fee award was smaller in disclosure only settlements, with the 2011 mean disclosure only attorneys fee award of $530,000, down from$710,000 in 2010. The mean fee award for settlements that involved other consideration declined to $1.952 million in 2011, down from $3.284. However the decline in median fee awards for both disclosure settlements and other settlements was much slighter than the decline in the mean. The median 2011 disclosure only settlement fee award was $450,000, compared to $546,000 in 2010, and the median fee award in 2011 for settlements involving other consideration was $1.1 million, compared to $1.25 million in 2010.

 

Delaware drew a much larger share of M&A-related litigation in 2011. The state attracted 64.3% of all lawsuits involving target companies incorporated in Delaware or with their headquarters in Delaware, compared to 44.1% in 2010. The 2011 rate was “the highest rate in the seven years we have tracked these figures.”

 

Delaware also seems to be dismissing fewer cases, “thus allowing more cases to be settled.” 85.7% of Delaware cases settled in 2011, compared to 79% of 2010 cases. The authors note that this finding is consistent with the analysis in their earlier paper, noting that “when Delaware loses cases to other jurisdictions it historically has dismissed fewer cases and allowed more to settle, consistent with conduct designed to reattract litigation.”

 

Consistent with the overall 2011 attorneys’ fee award trends, Delaware awarded lower average fee awards in 2011. The mean 2011 Delaware fee award was $1.051 million, compared to $2.052 in 2010. Delaware did continue to award higher attorneys’ fees than other jurisdictions, as Delaware’s 2011 average of $1.051 million was substantially above the overall 2011 average of $784,000.  

 

The authors emphasize however that all of the 2011 statistics are preliminary “should be read with caution” particularly given the delay in the availability of some information (particularly with respect to attorneys’ fees). The authors expect to update their information as the year progresses.

 

Special thanks to Professor Davidoff for providing me with a copy of his latest paper.

 

A D&O Primer: Readers interesting in a good, basic overview of the D&O insurance policy will want to take a look at the recently published paper “D&O Insurance: A Primer” by Lawrence Trautman and our good friend  Kara Altenbaumer-Price. Their paper can be found here

 

2011 Securities Litigation Overview: The Haynes & Boone law firm has a February 3, 2012 memo entitled “Securities Litigation Year in Review 2011” (here) which has a detailed overview of 2011 securities litigation developments. The memo has several very interesting sections including a section on extraterritorial litigation; a section on litigation involving auditors; and a section on litigation involving rating agencies.  

 

In the wake of the disastrous April 2010 Deepwater Horizon oil spill, BP was hit with a wave of litigation from plaintiffs asserting claims of personal injury, wrongful death and property damage. The claimants also included BP shareholders raising allegations that they had been misled regarding BP safety efforts and processes. In a 129-page February 13, 2012 opinion (here), Southern District of Texas Judge Keith Ellison, while granting the defendants’ motion to dismiss certain of plaintiffs’ allegations, denied defendants’ motion to dismiss many of the allegations of BP investors who had purchased BP American Depositary Shares (ADS) on the New York Stock Exchange.

 

However Judge Ellison granted the defendants’ motion to dismiss all of the claims – including claims asserted under New York state law and English common law – of U.S.-domiciled investors who purchased their BP shares on the London Stock Exchange.

 

Finally, in a separate 82-page order also dated February 13, 2012 (here), Judge Ellison granted without prejudice defendants’ motion to dismiss the claims on a separate group of Plaintiffs (the “Ludlow plaintiffs”).

 

Background

The Deepwater Horizon oil spill lasted for eighty seven days and cost BP somewhere between $20 billion and $40 billion. Over the course of the disaster, over four million barrels of oil spilled in the Gulf at a rate of about 60,000 per day. From the date of the initial explosion to the final date of the class period in the securities class action lawsuit, BP’s market capitalization fell over $91 billion.

 

As detailed here, investors filed the first of their securities class action lawsuits against BP, related entities and certain of its directors and officers in May 2010. The various suits were transferred to the Southern District of Texas. The cases were ultimately consolidated, and the New York Controller and the Ohio Attorney General were appointed as lead plaintiffs. Judge Ellison also appointed a separate subclass consisting of the Ludlow plaintiffs. The New York and Ohio plaintiffs alleged that BP had made a series of fraudulent misstatements about its safety efforts and procedures beginning in 2007. The Ludlow plaintiffs’ allegations related to specific statements about the company’s Gulf operations in the thirteen months prior to the Deepwater Horizon explosion.

 

The New York and Ohio plaintiffs named as defendants BP, certain BP-related entities and ten former directors and officers. The Ludlow plaintiffs alleged claims against certain BP entities and nine individual defendants. The defendants moved to dismiss.

 

The Court’s February 13, 2012 Rulings

In his February 13 opinions, Judge Ellison agreed with the defendants that certain of the New York and Ohio plaintiffs’ allegations were legally insufficient, and that the plaintiffs’ allegations as to certain of the individual defendants were also insufficient. However, he also held, at least with respect to the claims of ADS investors, that other allegations were sufficient and that adequate claims had been asserted against the BP entities, former BP CEO Tony Hayward, and against Douglas Suttles, BP’s Chief Operating Officer for Exploration and Production from January 2009 to January 2011.

 

Judge Ellison held that the ADS investors had adequately pled misrepresentations regarding BP’s progress in the year’s preceding the Deepwater Horizon disaster in implementing the recommendations of an independent committee BP had organized and that had been chaired by former U.S. Senator Howard Baker (the so-called Baker Report); regarding its ability to respond to a spill in the Gulf of Mexico; regarding its reported retaliation against employees who raised safety concerns; and regarding post-spill estimates of the spill amounts. Judge Ellison also found that he could not conclude at this stage that the alleged misrepresentations were immaterial.

 

With respect to the plaintiffs’ allegations concerning the company’s implementation of the Baker Report recommendations, Judge Ellison said that “the Deepwater Horizon explosion, subsequent investigation, and other facts Plaintiffs allege pointing to similarities between the Deepwater Horizon accident and BP’s history of safety failures support Plaintiffs’ contention that BP seriously overstated the ‘progress’ it had made in implementing the Baker Panel’s recommendations.”

 

Judge Ellison also found that the plaintiffs had “sufficiently pleaded facts to demonstrate that BP misrepresented the size of the spill it was prepared to respond to in the Gulf and misrepresented the Company’s general spill response capabilities.”

 

In addition, he found that “the alleged facts sufficiently, even forcefully, establish that BP was knowingly retaliating against workers who reported safety concerns, even while issuing statements explicitly denying any retaliation.”

 

Judge Ellison granted the motions of eight of the ten individual defendants, ruling either that the plaintiffs had not adequately tied the individuals to the allegedly misleading statements or had not adequately alleged scienter. However, he concluded that the scienter allegations were sufficient as to the BP entity defendants, Hayward and Suttles. With respect to Hayward, Judge Eillson noted that “Hayward defined his position as CEO to include a special and targeted focus on process safety. Taking him at his own word, the Court finds that Plaintiffs have sufficiently pleaded scienter with respect to Hayward.”

 

With respect to the BP entities and Suttles, Judge Ellison focused in particular on the disclosures following the accident regarding the size of the spill and BP’s recovery capabilities. He observed that “the difference between what BP was actually able to recover and what it claimed it could recover is so great that the projected numbers … appeared to have been invented out of thin air.” Though BP claimed it could recover nearly 500,000 barrels of oil a day, forty-nine days after the explosion, BP was recovering only 15,000 barrels a day.

 

However, based on the U.S. Supreme Court’s holding in Morrison v. National Australia Bank, Judge Ellison granted the defendants’ motion to dismiss the Section 10(b) claims of U.S. investors who had purchased ordinary BP shares on the London Stock Exchange. He also held that these investors New York common law class action claims were precluded under SLUSA. Finally, he held that the Court lacked original jurisdiction over these investors claims under English law, holding that because the Court lacked jurisdiction over the Section 10(b) claims, the court lacked supplemental jurisdiction over the Englsh law claims.

 

In granting the defendants’ motion to dismiss the Ludlow plaintiffs’ claims without prejudice, Judge Ellison found that certain of the defendants’ statements in the months preceding the Deepwater Horizon disaster were materially misleading. However, with respect to those statements, Judge Ellison found that the plaintiffs had not adequately pled scienter. Judge Ellison observed that “the court is acutely aware that federal legislation and authoritative precedents have created for plaintiffs in all securities actions formidable challenges to successful pleading. Today’s decision is a reflection of that. By no means, however, does the Court mean to signal that no pleadings that Plaintiffs could proffer would be successful. An amended complaint may well be able to adduce additional information responsive to this Court’s concerns.” He granted the Ludlow plaintiffs’ twenty days in which to file an amended complaint.

 

Discussion

Though Judge Ellison’s rulings eliminate many of the New York and Ohio plaintiffs’ allegations and several of the individual defendants, substantial parts of their claims survived the dismissal motion and will go forward. Moreover, the possibility remains that the Ludlow plaintiffs may be able to amend their pleadings sufficiently to survive a renewed motion to dismiss.

 

The dismissal of the ordinary shareholders’ claims is a more substantial blow. As Nate Raymond notes in his February 13, 2012 article on Am Law Litigation Daily about Judge Ellison’s rulings (here), the ADS investors may represent a smaller part of BP investors.

 

Nevertheless, the claims that will for sure going forward are substantial. In his recitation of these allegations, Judge Ellison betrayed a sense of outrage, undoubtedly a reflection of the magnitude of this disaster. Neither the survival of these allegations nor the Court’s unmistakable sense of outrage bodes well for BP. The possibility of a trial in the Southern District of Texas is a prospect that BP could not rationally contemplate. However, the nature and magnitude of the allegations and the sheer size of the market cap loss could make any attempt to settle this case extremely difficult, notwithstanding the reduced size of the investor class. For all of these reasons, it will be very interesting to watch this case as it goes forward.

 

Judge Ellison’s holdings regarding the U.S. investors who purchased their shares on the London exchange add an interesting additional element to his opinion. His ruling that Morrison precludes the claims of these investors (sometimes referred to as F-squared investors, because the involve U.S. investors who purchased shares in a foreign company on a foreign exchange), is consistent with rulings of other courts who have been faced with f-squared investor claims in the wake of Morrison. However, his conclusion that the New York common law claims were precluded under SLUSA and that he lacked jurisdiction over the English law claims are interesting and could be important in other cases where plaintiffs’ seek to circumvent Morrison. (It is worth noting in that regard that the court presiding over the Toyota shareholders’ securities class action has rejected the efforts of plaintiffs in that case to rely on Japanese law.)

 

Alison Frankel has a detailed analysis of the Court’s consideration of the Morrison issues in her February 13, 2012 post on Thomson Reuters News & Insight, here.

 

The fact is, however, that these F-Squared investors have just as much reason to feel aggrieved by the defendants’ alleged misrepresentations as the ADS investors. The F-squared investors just don’t get access to a U.S .court, which leaves them with the dilemma of whether they can pursue their claims elsewhere. Hurdles to trying to pursue these kinds of claims in England (lack of class action procedures, loser pays rules) might encourage these displaced investors to consider claims elsewhere – perhaps Canada or the Netherlands? It will be interesting to see whether these investors try their luck elsewhere.

 

Judge Ellison’s concluding remarks in which he granted the Ludlow plaintiffs leave to attempt to replead their allegation sounded remarkably sympathetic. He not only acknowledged how hard it is for plaintiffs to try to overcome the threshold pleading obstacles, but he sounded like he was sorry about it, as if he felt that  perhaps that plaintiffs ought not to be faced with such onerous initial pleading hurdles. Those sentiments are of course cold comfort to the Ludlow plaintiffs if they are unable to overcome the pleading hurdles with their amended pleadings. (For those who are curious, Ellison, who was a Rhodes scholar and who clerked for Justice Harry Blackmun, was appointed to the bench by President Clinton.)

 

One final note. I was struck in reading Judge Ellison’s opinion how influenced he was by BP’s communications after the disaster. These opinions provide a very stark reminder that the way that a reporting company manages bad news can substantially affect the company’s securities litigation exposure. These opinions and Judge Ellison’s retelling of the tale provide some pretty stark lessons for other companies trying to deal with bad news. A negative lesson from these circumstances is that there are things a company can do to avoid further damaging the company even after disaster has struck – and there are things a company can do to make things worse, too

. 

A February 13, 2012 Bloomberg article regarding Judge Ellison’s rulings can be found here. In an earlier post (here) I discuss Judge Ellison’s September 2011 ruling dismissing the BP Deepwater Horizon derivative suit in favor of an English forum.

 

 

During last week’s PLUS D&O Symposium, several of the panels discussed the problems surrounding the current onslaught of M&A-related litigation – and appropriately so, as the surging levels of M&A litigation is one of the most distinct and troubling current litigation trends. During the course of the discussion at the conference, several of the speakers referenced developments, materials and statistics. I thought it might be useful to assemble these various references in one site. (I have linked to some of these resources in prior posts on this site.)

 

First, though, by way of background about M&A-related litigation developments, I thought it might be useful to reference and to link to a recent paper that provides a good introductory explanation of what the M&A-related litigation is all about. In a February 6, 2012 paper entitled “Anatomy of a Merger Litigation” (here), Douglas Clark of the Wilson Sonsini law firm and Marcia Kramer Mayer of NERA Economic Consulting walk through the litigation developments surrounding a single merger transaction, by way of illustration and as a vehicle to discuss and consider a variety of aggregate statistics regarding merger litigation. The paper provides a useful starting point for understanding the current M&A-related litigation phenomenon. NERA’s related statistical analysis of M&A litigation can be found here.

 

With respect to the conference panels, I am sure that many attendees were as struck as I was by the statement of Stanford Law School Professor Michael Klausner that if you take state court M&A-related litigation into account, then corporate and securities litigation filings are at “an all-time high.” I have in fact made the same point myself, but it just has so much more credibility coming from Professor Klausner. In making these statements, Professor Klausner was referring (with respect to the state court M&A litigation) to the recent Cornerstone Research paper entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions” (here).

 

In connection with the initial panel discussion of these litigation statistics, John Spiegel of the Munger Tolles law firm referred to a recent paper by Ohio State University Professor Steven Davidoff and Notre Dame University Finance Professor Matthew Cain. The January 1, 2012 paper, entitled “A Great Game: The Dynamics of State Competition and Litigation” can be found here. (I discussed Professors Davidoff and Cain’s paper in a prior post, here.)

 

Among the many issues discussed relating to the M&A-related litigation were the problems associated with multiple suits pending in separate jurisdictions relating to the same transaction. Among the suggestions that have been proposed as a way to avert the problems associated with multi-jurisdiction litigation and to discourage plaintiffs from forum shopping is the adoption by companies of a by-law amendment designating Delaware as the sole forum for all corporate and securities litigation. This suggestion has attracted a great deal of interest and a number of companies have adopted by-law amendments designating Delaware as the sole forum for corporate and securities litigation.

 

As several of the panelists mentioned during the conference, certain plaintiffs’ lawyers have now launched a litigation assault on these by-law amendments. On Monday and Tuesday this past week, the lawyers filed at least nine complaints against companies that had adopted these types of by-law amendments. Nate Raymond’s February 8, 2012 Am Law Litigation Daily article discussing the suits can be found here. Alison Frankel’s February 8, 2012 article on Thomson Reuters News & Insight about the cases can be found here. Francis Pileggi’s February 7, 2012 post about the cases on his Delaware Corporate and Commercial Litigation blog can be found here.

 

The nine companies targeted in the suits are: Chevron; Priceline.com; AutoNation; Curtiss-Wright; Danaher Corporation; Franklin Resources; Navistar International; SPX Corporation: and Superior Energy Services. An example of one of the complaints, which are substantially the same, can be found here.

 

The plaintiffs complain that the by-law applies to broad categories of kinds of litigation, is not limited just to derivative or class litigation, and applies to individual claims. But while the shareholders are required by the by-laws to bring their claims in Delaware, the bylaws provide no forum restrictions on the corporations themselves. The plaintiffs also complain that the bylaws seemingly require claim to be brought in Delaware even where there may not be personal jurisdiction over prospective defendants (for example, in connection with claims against individual directors and officers).

 

The plaintiffs in these suits seek a judicial declaration that the by-laws are invalid. The interesting attribute of the by-laws in dispute is that in each case, the by-laws were adopted by board action and not put to shareholder vote. So even if these particular board adopted by-laws are struck down, the cases may not address the question of whether a forum selection by-law that has been adopted by shareholder vote can be enforced (for example, on former shareholders, or even where there is no personal jurisdiction over prospective defendants).

 

It is worth noting that in the only judicial decision to date to consider a forum selection by-law, the by-law was found to be unenforceable. As discussed here (scroll down), in January 2011, Northern District of California Judge Richard Seeborg found Oracle’s forum selection by-law to be unenforceable, in part because it had not been put to shareholder vote. Because Seeborg was applying federal common law rather than Delaware law, his ruling may have only limited impact on the Delaware proceedings.

 

At least one member of the Delaware Chancery Court has voiced his approval at least of the concept of a forum selection by law; in the Revlon Shareholders’ Litigation, the Delaware Court of Chancery suggested that corporations organized under Delaware law are "free" to adopt "charter provisions selecting an exclusive forum or inter-entity disputes." In the wake of this suggestion, many lawyers began to recommend that their client companies adopt charter provisions designating the Delaware Court of Chancery as the preferred forum. The newly filed litigation may provide guidance on this important issue.

 

Finally, if you have not yet checked it out, the PLUS Blog has a number of video highlights from the PLUS D&O Symposium, including among other things an interview with yours truly.

 

Another FDIC Failed Bank Lawsuit: Another topic of discussion at the PLUS D&O Symposium was the growing wave of FDIC litigation against former directors and officers of failed banks. On Thursday, February 9, 2012, the FDIC filed its latest lawsuit in the District of Nevada, against four former officers of the failed Silver State Bank of Henderson, Nevada. The FDIC’s complaint can be found here.

 

The lawsuit is the 22nd that the FDIC has brought as part of the current bank wave. Interestingly, this complaint was brought well over three years after the September 2008 failure of Silver State Bank. Informed sources advise that the parties had entered a tolling agreement. A February 10, 2012 Las Vegas Review-Journal article discussing the new suit can be found here.

 

A Preview of Warren Buffett’s Annual Letter to Shareholders: Berkshire Hathaway’s 2011 annual report will not be published for a few more weeks yet. But readers interested in a preview of Warren Buffet’s annual letter to Berkshire shareholders, which is the highlight of the company’s annual report, may want to take a few minutes to review an excerpt of the forthcoming letter that was published on February 9, 2012 in a blog on the CNN Money website (refer here). The basic thrust of the excerpt is that due to the impact of inflation and taxation, stocks outperform bonds and gold. The interesting excerpt is vintage Buffett.

 

“Investing,” Buffett writes, “is forgoing consumption now in order to have the ability to consume more at a later date.” Real risk then is not volatility, but the possibility that your investment will lose purchasing power — that is, that you will actually only be able to consume less later. Investments denominated in currentcy, such as bonds or money market funds, though often charactized as "safe"  lose value due to the "inflation tax," not to mention actual taxes. Buffet says, "right now, bonds should come with a warning label." .

 

A Piano Duet: For today’s musical interlude, I feature a video of a 90-year old couple, playing an entertaining piano duet in the atrium of the Mayo Clinic. They have been married 62 years and they can still play a mean piano.