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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

 

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

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

 

 

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

 

 

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

 

 

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

 

The Standard of Conduct and Business Judgment Rule

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

The Aftermath of the Failure of IndyMac Bank

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Postscript

 

 

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

 

 

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

 

 

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

 

*End*

 

 

Endnotes:

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

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

 

 

[30] Van Dellen Order at 2.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

[38] In re Citicorpat 127.

 

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

 

 

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

 

Litigation funding has long been a significant part of commercial litigation landscape outside the U.S. For example, in Australia, observers have attributed the growth in securities litigation to the availability of litigation funding. Litigation funding arrangements have also recently been approved in connection with securities class action litigation in Canada. Litigation funding has been available in the United States for some time, as well, at least to a limited extent. But recent developments suggest that we can expect increased involvement of increasingly sophisticated litigation funding investors in the U.S., with increasing involvement in commercial litigation.

 

The latest sign of the sophisticated parties increasing interest in U.S. litigation funding is the April 9, 2012 announcement of litigation finance company BlackRobe Capital Partners LLC that retired Simpson Thacher partner Michael Chepiga has joined BlackRobe as managing partner. BlackRobe was launched last year by Sean Coffey, formerly a partner at the plaintiffs’ securities class action firm, Bernstein LItowitz, along with Timothy Scrantom, who co-founded Juridica Investments, Ltd. (about which more below). In 2010, Coffey also ran unsuccessfully to become the democratic candidate in the New York Attorney General election. Many readers will remember Coffey from his days at Bernstein Litowitz when he acted as lead counsel for investors in the WorldCom securities litigation. An April 9, 2012 Am Law Daily article detailing Chepiga’s move to BlackRobe can be found here.

 

According the firm’s press release, BlackRobe aims to invest in lawsuits in exchange for a share of the recovery. The firm “targets investments between $2 million and $8 million in complex commercial litigation cases, including intellectual property, antitrust and breach of contract disputes, that have a potential for damages in excess of $50 million.”

 

The BlackRobe firm is only one of several litigation funding firms now concentrating on the commercial litigation in the U.S. Juridica Investments Ltd. and Burford Capital Ltd, both investment funds that are publicly traded in the U.K., have U.S. operations engaged in litigation funding in the U.S. IMF Australia Ltd, another litigation funder that is listed in Australia, is the corporate parent of Bentham Capital LLC, which is also in the business of funding U.S. litigation.

 

Most of these firms, as well as several others, have only gotten involved in U.S. litigation funding within the last year. Obviously, this diverse group of firms acting independently seems to have decided that there is an investment opportunity in U.S. litigation funding. There is no doubt that litigation in the United States is a very expensive proposition. Looked at in its most favorable light, litigation funding may provide a financial means to allow meritorious cases to go forward. As a October 3, 2011 Wall Street Journal article about litigation funding noted, litigation funding can provide a way for smaller companies to level the playing field against bigger opponents.

 

Just the same, the litigation funding phenomenon has its critics. The most common concern is that the spreading availability of litigation funding will encourage non-meritorious or even frivolous litigation, by removing litigants’ financial constraints. The litigation funders themselves argue in response that they are in this to make money, and that rather than encouraging frivolous litigation, the funders’ financial incentives will act as a screening mechanism through which only cases likely to provide an appropriate return on investment  (i.e., meritorious) will be funded. The involvement of highly sophisticated attorneys like Coffey and Chepiga would seem to support this point, as their presence suggests an elevated level of scrutiny.

 

Though the financial incentives and level of sophistication arguably might militate against frivolous lawsuits getting funding, there is still the risk that the presence of investors looking for lawsuits in which to invest might nevertheless increase litigation levels. Indeed, in its 2010 study of securities class action litigation (refer here), NERA Economic Consulting identified the emergence of litigation funding as the most significant development behind the increase in securities class action litigation in Australia. Setting to one side the question of whether or not the cases involved would be meritorious, it is worth asking the question whether or not it would be a good thing if increased litigation funding availability were to lead to a similar increase in litigation in the United States.

 

There are a number of other questions that also quickly come to mind. For example, will the involvement of sophisticated investors lead to potential or even actual conflicts of interest between the funders and the litigants then are funding? It is not difficult to imagine situations in which the funders’ desire to realize their investment return might conflict with the litigant’s goals and objectives. Indeed, the possibility of this type of conflict was one of the specific concerns that an Ontario court raised while considering a litigation funding arrangement in Manulife Financial Corporation securities class action lawsuit pending in the court (about which refer here). Though the court ultimately approved the arrangement in that case, the possibility of conflicts remains a concern.

 

Similarly, there is the question whether litigation funding is appropriate in the class action context. While the litigation funding unquestionably may help facilitate a recovery for the class, the amount to be paid to the litigation funder, in the form of commission or other payment, will reduce the amount of the recovery for the class. The absent class members cannot all be consulted in advance about such arrangements, which may or may not look fair after the fact.

 

A related question has to do with overall fairness. As things currently stand, there do not seem to be barriers to entry in the litigation funding field. While the involvement of highly respected attorneys such as Coffey and Chepiga provide some reassurance about the integrity of the process and the legitimacy of the arrangements, there are increasingly large numbers of firms getting involved in this space and there are no guarantees that all of the participants will be equally respectable. Ought there to be standards protecting the prospective litigants?

 

As noted in a recent post about class action litigation in Australia, there are now calls there to require litigation funding firms to be registered and to require that the litigation funding firms have appropriate procedures in place to manage potential conflicts of interest. Australia has a longer experience with litigation funding; it might not be a bad idea to heed the calls in that country to regulate the litigation funding industry and look at whether it might be a good idea to have some regulatory controls in this country as well.

 

In any event, for better or worse, the number of litigation funding firms in this country is increasing and as a result it seems likely that the litigation funding is likely to become an increasingly important factor in sophisticated commercial litigation. Because many of these firms have only just started their U.S. operations, it is too early to tell what the ultimate impact will be. Notwithstanding the involvement of highly respected attorneys such as Coffey and Chepiga, I find it hard to view these developments without serious concerns. In any event, I suspect that we will be hearing a lot more on this topic in the months ahead.

 

A May 2010 American Lawyer article detailing the development of third-party litigation funding in the U.S. can be found here.

 

In an interesting variant on the kinds of claims that the former directors and officers of a failed financial institution can face, on April 6, 2012, the SEC charged two former officers of the publicly traded holding company for the failed Franklin Bank of Houston with securities fraud. In its April 6, 2012 complaint (here), the SEC alleges that the two former officers engaged in a fraudulent scheme designed to conceal the bank’s deteriorating loan portfolio and inflate its earnings at the outset of the financial crisis. The SEC’s litigation release about the case can be found here.

 

According to the SEC’s complaint, in the second and third quarters of 2007, the bank began to experience increased delinquencies in its mortgage loan portfolio. During this same period, the bank was considering “strategic alternatives” include the possible sale of the bank. Investment advisers told the bank’s CEO Anthony Nocella and its CEO Russell McCann that the bank needed to “polish the apple” by showing positive earnings “momentum” and “stable asset quality.”

 

The SEC alleges that in order to conceal the bank’s rising loan delinquencies and improve its earnings for the third quarter of 2007, Nocella and McCann instituted three loan modification schemes by which the bank was able classify non-performing loans as performing. These alleged modification schemes, with names like “Fresh Start” and “Great News,” allegedly enabled the bank to conceal from shareholders over $11 million in delinquent and nonperforming residential loans and $13.5 in nonperforming construction loans. The SEC alleges that the bank overstated its 2007 net income and earnings by 31% and 77% respectively.

 

On May 2, 2008, in a filing on Form 8-K, the bank acknowledged that the accounting for the loan modifications should be revised and that investors should no longer rely on the bank’s filing on Form 10-Q from the third quarter of 2007. On November 7, 2008, the bank was closed by Texas state banking regulators and the FDIC was appointed as receiver. The bank’s holding company also filed for bankruptcy in 2008.

 

In its April 6 complaint against Nocella and McCann, the SEC seeks financial penalties, officer-and-director bars, and permanent injunctive relief against the two individuals to enjoin them from future violations of the federal securities laws. In reliance on Section 304 of the Sarbanes Oxley Act, the complaint also seeks to “clawback” bonus compensation that Nocella and McCann received. (See the note below about another recent action in which the SEC has sought to use Section 304 to clawback bonus compensation from executives of a company that had restated its financial statements.)

 

In its litigation release, the SEC expressly acknowledges “the assistance of the Federal Deposit Insurance Corporation in this matter,” which suggests that at a minimum that two agencies were cooperating in this matter and also suggests the possibility that the FDIC may even have referred the matter to the SEC. The FDIC’s involvement is also a reminder that  as part of its post-failure post-mortem processes, the FDIC is not only attempting to determine whether or not it has a valuable civil suit on its own as receiver, but is also looking to see whether or not wrongdoing has occurred that warrants referral to other authorities. The FDIC has not on its own pursued any claims in connection with Franklin Bank’s closure. It is also interesting to note that the SEC is only now pursuing this enforcement action, though the events complained of took place well over four years ago, and the though the bank itself failed over four years ago.

 

The SEC’s filing of its action against the two former Franklin Bank officials is not the first time the SEC has pursued an enforcement action against former directors and officers of a failed bank. As noted previously (here, scroll down), in an October 11, 2011 complaint (here), the SEC filed a civil enforcement action against four former officers of UCBH Holdings, Inc., the holding company for United Commercial Bank, which failed in November 2009. According to the SEC’s October 11, 2011 litigation release, the complaint alleges that the defendants “concealed losses on loans and other assets from the bank’s auditors, causing the bank’s holding company UCBH Holdings, Inc. (UCBH) to understate its 2008 operating losses by at least $65 million.” The complaint alleges that the further loan losses ultimately caused the bank to fail. The SEC action seeks permanent injunctive relief, an officer bar, and civil money penalties.

 

Though the FDIC has not itself filed a civil action against the former directors and officers of Franklin Bank, in June 2008, as reflected here, the bank’s holding company’s investors did file their own securities class action lawsuit against the failed bank’s former directors and officers, its auditor and its investment banks. In a March 21, 2011 order (here), Southern District of Texas Judge Keith Ellison granted the defendants’ motions to dismiss. The investors have appealed to dismissal. The appeal remains pending.

 

The SEC action against the two former Franklin Bank officials, along with the investor lawsuit, serve as a reminder that the former directors and officers of a failed bank face significant additional litigation threats beyond just the possibility of a civil action by the FDIC in its role as receiver of the failed bank. Where, as here, the failed institution or its holding company were publicly traded, the potential liability exposures include the possibility of an SEC enforcement action or a securities class action lawsuit. Even though the penalties and clawback amounts the SEC is seeking in the enforcement action would not be covered under a D&O policy, the costs associated with defending this type of enforcement action would likely be covered (assuming that D&O insurance coverage is in fact available). These costs, along with the costs of defending the type of shareholder suit filed here, erode the limits of liability of any applicable insurance, while at the same time competing claimants may be in a race to try and claim a portion of the dwindling policy limits. All of which is a reminder of the strains that post-failure litigation can put on the D&O insurance resources of a failed bank.

 

The FDIC’s Latest Failed Bank Lawsuit: The FDIC may not yet have filed a civil action against the former directors and officers of Franklin Bank, but it has been active in pursuing claims against the former officials of other failed institutions. In the FDIC’s latest failed bank lawsuit, on April 4, 2012, the FDIC filed a lawsuit in the Eastern District of North Carolina against seven former directors and officers of the failed Cape Fear Bank of Wilmington, North Carolina. In the its complaint (here), the FDIC as receiver for the failed bank seek to recover $11.2 million in losses the bank allegedly suffered on 23 loans the defendants approved between September 27, 2006 and February 27, 2009. The FDIC asserts claims against the seven defendants for negligence, gross negligence and breach of fiduciary duty.

 

It is interesting to note that the FDIC’s April 4 action against the former Cape Fear Bank officials was brought just short of the third anniversary of the bank’s April 10, 2009 closure. The highest number of bank closures during the current wave of bank failures took place during 2009 and the pace of closures increased as the year progressed. The implication is that 2012 moves forward, the third anniversary of many of the class of 2009 bank closures will be approaching. The likelihood is that pace of FDIC failed bank lawsuit filings will increase for the rest of this year, as the FDIC tries to get out ahead of the rolling statute of limitations dates for the 2009 bank failures.

 

The latest suit is the 28th that the agency has filed as part of the current wave of bank failures and the tenth so far in 2012. This suit is also the third that the FDIC has filed so far in North Carolina.

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While the number of FDIC failed bank lawsuits seems likely to be cranking higher this year, the pace of the bank failures themselves clearly is slowing. Through the end of the first quarter, the FDIC has taken control of only 16 financial institutions so far this year, putting the agency on pace for a total of 64 this year, which would be the lowest number of annual failures since 2008. Given that even the pace so far this year seems to be slowing, the 2012 annual total may well come in below the projected total of 64 closures.

 

Scott Trubey has an interesting April 8, 2012 article in the Atlanta Journal-Constitution (here) about the failed bank litigation so far and yet to come, with a particular emphasis on the litigation involving failed Georgia banks. Among the many former bank officials that the FDIC has targeted is the former NFL quarterback, Jim McMahon, who was among seven former directors and officers named as defendants in the FDIC’s lawsuit relating to the failed Broadway bank, as discussed in an April 9, 2012 Chicago Sun-Times article (here)

 

FDIC Settles Malpractice Claim Against Failed Bank’s Lawyers: According to an April 4, 2012 filing in the Western District of Oklahoma (here), the parties to the FDIC’s lawsuit against the former lawyers for the failed First State of Altus Bank of Altus, Oklahoma, have settled the case. An April 7, 2012 article from The Oklahoman newspaper describing the settlement can be found here.

 

The First State Bank of Altus failed on July 31, 2009. On October 26, 2011, the FDIC, as receiver for the failed bank, filed an action in the Western District of Oklahoma against the bank’s outside law firm, Andrews Davis, and two of its attorneys, Joe Rockett and Matthew Griffith. In its complaint (here), the FDIC as receiver for the failed bank asserted claims for professional negligence and malpractice.

 

The complaint alleges that the bank failed because of losses it suffered in connection with projects of what the complaint described as the Anderson-Daugherty Enterprise, which the complaint describes as the business efforts of the bank’s former CEO, Paul Daugherty, and Fred Don Anderson, who was CEO of a company called Altus Ventures, a substantial borrower of the bank. The FDIC alleges that the law firm assisted Anderson in planning and implementing the so-called Anderson-Daugherty Enterprise, while at the same time representing both Daugherty personally and the bank itself. The complaint alleges that as a result of these relationships, the law firm and the two individuals had substantial conflicts of interest. The law firm also was allegedly involved in counseling the bank in connection with certain loans to certain enterprises in which Daugherty and Anderson or their related entities had financial interests. The complaint alleges that the bank ultimately suffered losses of over $10 million on related loans.

 

Neither the April 4 court filing nor the newspaper article about the filing reflects any of the details of the settlement of the case. It is worth noting that though the FDIC filed the lawsuit against the failed bank’s former lawyers, it has not to date filed an action against any of the failed bank’s former directors and officers.

 

The suit against the lawyers for First State Bank is not the first instance where the FDIC has pursued claims against a failed bank’s former law firm. As discussed here, in October 2011, when the FDIC filed suit against the former directors and officers of the failed Mutual Bank of Harvey, Ill., the defendants included the bank’s former outside general counsel, as well as the former outside general counsel’s law firm. Indeed, on its website, the FDIC reports that as of March 20, 2012, the agency states, without providing any further breakdown, that it “has authorized 29 other lawsuits for fidelity bond, insurance, attorney malpractice, appraiser malpractice, and RMBS claims.”

 

SEC Files Another Strict Liability Clawback Action: The clawback action the SEC filed against the two former officers of Franklin Bank was not the only action under Section 304 of the Sarbanes Oxley Act that the SEC filed last week. In addition, on April 2, 2012, the SEC also filed a Section 304 clawback action in the Western District of Texas against the former CEO and CFO of ArthroCare. But unlike the case involving the action involving the former Franklin Bank executives, the action against the former ArthroCare executives does not allege that the two individual defendants were involved in or even aware of the alleged wrongdoing. The SEC is pursuing its action against the two ArthroCare executives on a strict liability basis.

 

In its complaint (here), the SEC alleges that during the tenure of the two ArthroCare executives, two sales ArthroCare executives engaged in a channel stuffing scheme in order to inflate the company’s revenue and earnings. The SEC has pursued a separate enforcement action against the two sales executives. ArthroCare was later required to restate its financial statements for 2006 and 2007. The former CEO and CFO both resigned from the company following the company’s own internal investigation of its revenue reporting practices.

 

In its compensation clawback complaint against the former CFO and former CEO, the SEC expressly states that it “does not contend” that the former CFO and CFO “participated in the wrongful conduct.” However, the SEC contends, Section 304 requires the former CEO and CFO to reimburse the company for their bonus compensation and stock sale profits garnered during the periods corresponding to the financial statements that were later restated.

 

The action involving the former CEO and CFO of ArthroCare is not the first occasion on which the SEC has used Section 304 to pursue a compensation clawback even though the targeted executives were not alleged to have been involved in the wrongdoing that caused their companies to have to restate the companies’ financial executives. The SEC previous pursued a clawback action against the CSK Auto; as discussed here, in that case the federal district affirmed the SEC’s authority to seek a clawback without a showing of complicity in the wrongdoing. The district court judge stated that “"the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO."

 

As discussed here, in a similar case, the SEC pursued a Section 304 clawback action against the former CFO of Beazer Homes, though the individual was not alleged to have been involved in any wrongdoing.

 

My thoughts on the deeply troubling implications of the increasing trend toward imposing liability even without culpability can be found here. As I have previously noted (here), these provisions allowing for the return of compensation without fault or culpability also raise a host of potentially troublesome insurance coverage issues. The D&O insurance marketplace has responded to these concerns, as many carriers are now willing in at least some cases to add a provision to their policy stating that the policy will cover defense expenses incurred in connection with a SOX 304 action.

 

An April 2, 2012 post on the SEC Actions blog about the SEC’s clawback action against the former ArthroCare executives can be found here.

 

On an annualized basis, the pace of securities class action lawsuit filings fir the first quarter of 2012 ran above historical averages, although the pace of filings declined compared to  the prior month in the quarter’s second and third months. Merger-related cases, which were such a significant part of 2011 filings, remained an important factor in filings in the first quarter of this year, but other pronounced 2011 filing trends diminished in the year’s first three months.

 

Overall, there were 57 new securities class action lawsuit filings in the first quarter of 2012, which represents an annual filing rate of about 228 lawsuits. This filing rate is above the 2011 filing levels, when there were 188 securities class action lawsuit filings, and the 1996-2010 annual average filing rate of 194. However, the pace of filings  was not level  throughout the first quarter. The number of lawsuit filings declined from the prior month in the second and third months of the quarter. Thus, while there were 24 new securities class action lawsuit filings in January, there were 19 in February and only 14 in March.

 

One pronounced 2011 filing trend was the number of lawsuits filed against U.S.-listed Chinese companies. Last year, 41 of the 188 filings (or about 22%) involved these Chinese companies. There were fewer of these lawsuit filings in the second half of 2011 than there were in the first half of the year, and this downward trend continued in the fist quarter of 2012, when there were only two filings involving U.S.-listed Chinese companies.

 

Overall in 2011, 68 of the 188 filings (or about 38%) involved non-U.S. companies. The number of filings against non-U.S, companies declined significantly during the first three months of 2012, when there were only six filings against foreign companies, or about 10.5% of all first quarter filings. This rate is much closer to the historical proportion of all filings involving non-U.S. companies; during the period 1996 to 2010, only about 8.5% of all filings involved companies domiciled outside the U.S.  Of the six first quarter filings involving non-U.S. companies, four involved companies from Canada, and two involved Chinese companies. Of the four Canadian companies, three were in SIC Cod 1040 (Gold and Silver Mining)

 

One 2011 filing trend that continued in the first quarter of the year was the significant percentages of all filings that were merger related. In 2011, 43 of 188 filings were merger related (22.87%). In the first quarter of 2012, 13 of 57 filings (22.81%) were merger related. The percentage of cases relat4ed to mergers was virtually unchanged in the first three months of 2012 compared to the full year of 2011. The significant numbers of merger-related cases is an important reason why the filing rate in the year’s first quarter is above longer term norms.

 

The filings during the year’s first quarter involved companies drawn from a wide variety of industries. The 57 first quarter lawsuits involved companies in 39 different Standard Industrialization Code (SIC) code categories. Companies in Life Sciences-related grouping had the greatest number of first quarter filings. There was a total of six filings in  Industry Group 283 (Drugs), and there was a total of four filings in Industry Group  384 (Surgical, Medical and Dental Instruments), The ten total filings from these two groupings represent about 17.5% of all first quarter 2012 filings. The 17.5% percentage of all filings during the first quarter involving Life Sciences companies is above the historical annual percentage of all filings involving Life Sciences companies; as discussed at greater length here, during both 2008 and 2009, about 10% of all filings involved Life Sciences companies.

 

Industry Group 737 (Computer Programming, Data Processing and Other Computer-Related Services) also had a total of four filings. No other industry group had more than three filings.

 

With one exception, the first quarter 2012 filings were widely distributed among the U.S. district courts.` During the first quarter, the 57 securities class action lawsuits were filed in 29 different district courts. The one court where there was a concentration of filings was the federal court in Manhattan. During the first quarter there were 18 filings (or just less than a third of all filings) in the Southern District of New York.

 

It is important to note that the filing figures for the first quarter of 2012 do not include two categories of cases that have been an important part of all corporate and securities litigation activity during recent periods. Thus, the 57 first quarter securities class action lawsuit filings does not include merger objection lawsuits that were filed in state courts. The first quarter figures also do not take into account securities cases that were filed during the quarter that were not filed on a class action basis. There have been a host of individual actions relating to mortgage-backed securities and alleging violations of the securities laws; because these actions were not filed on behalf of a class, they are not reflected in the tally of securities class action lawsuits. But when these other types of cases are taken into consideration, it is very clear that the level of all corporate and securities litigation is at elevated levels.

 

On March 27, 2012, the U.S. House of Representatives passed the Jumpstart Our Business Startups Act (of the JOBS Act as it is more popularly known). President Obama is expected to sign the Act shortly. The Act is intended to facilitate capital-raising by reducing regulatory burdens. The Act also introduces changes designed to ease the IPO process for certain smaller companies. Among many other things, the Act introduces changes that could impact the potential liability exposures of directors and officers of both public and private companies. A copy of the Act can be found here.

 

The Act’s Provisions

Emerging Growth Companies and the IPO Process: Many of the changes in the JOBS Act are geared toward “emerging growth companies” (EGCs), which are defined broadly in the Act as companies with annual gross revenues under $1 billion in the most recent fiscal year. EGCs are relieved of certain disclosure requirements in their IPO filings. EGCs are also allowed to file their IPO registration statement for SEC review on a confidential basis. The Act allows EGCs to “test the waters” for a prospective IPO  by allowing the companies to meet with qualified institutional investors or institutional accredited investors notwithstanding the pending offering. In addition, the Act allows EGCs to discern the level of prospective investor interest in the offering by allowing analysts to publish research relating to an EGC notwithstanding the pending IPO.

 

Reduced Disclosure Requirements for Emerging Growth Companies: The Act also provides for reduced disclosure and reporting burdens for EGCs for a period of as long as five years after an IPO, as long as the company continues to meet the definitional requirements. In these provisions, the Act unwinds many of the requirements Congress only recently added through the Sarbanes-Oxley Act and in the Dodd-Frank Act.

 

For example, an EGC will not be subject to the requirements fo an auditor attestation report on internal controls as otherwise required under Section 404(b) of the Sarbanes Oxley Act. Similarly, an EGC would be exempt from the requirements under the Dodd-Frank Act to hold shareholder advisory votes on executive compensation and on golden parachutes. EGCs also are exempt from recently enacted requirements regarding executive compensation disclosures. For example, they exempt from the requirement to calculate pay versus performance ratios and the ratio of compensation of the CEO to the median compensation of all employees. The EGCs also are not required to comply with new or revised financial accountings standards until private companies are also required to comply with the revised standard.

 

Private Capital Fundraising, Revised Registration Thresholds: The Act also introduces a number of reforms relating to private capital-raising. For example, the JOBS Act also eliminates the prohibition on “general solicitation and general advertising” applicable to Rule 144A offerings, provided the securities are sold only to persons reasonably believed to be qualified institutional investors. The JOBS Act also raises the threshold number of investors that would trigger the Exchange Act registration requirements. Instead of the current threshold of 500 investors, the AC specifies that companies will only be required to register their securities only after they have over $10 million in assets and equity securities held either by 2,000 persons or by 500 persons who are not accredited investors.

 

Crowdfunding: The Act also introduces measure designed to allow companies to use “crowdfunding” to raise small amounts of capital through online platforms. The provisions create a new exemption from registration for private companies selling no more than $1 million of securities within any 12-month period and so long as the amount sold to any one investor does not exceed specified per investor annual income and net worth limitations. The crowdfunding provisions specify that  the online portals participating in these types of offerings to register with the SEC. The Act also requires the issuing companies to provide certain specified information to the SEC, investors and to the portal. The Act expressly incorporates provisions imposing liability on crowdsourcing issuers for misrepresentations and omissions in the offerings, on terms similar to the existing provisions of Section 12 of the ’33 Act.

 

Discussion:

As if often the case when legislation introduces significant innovations, it will remain to be seen how all of these changes will ultimately play out. (I am assuming here that President Obama will sign the bill in due course.) This uncertainty is increased where, as here, many of the Act’s provisions (such as, for example, the crowdfunding provisions) are subject to significant additional rulemaking.

 

The provisions modifying the IPO process for EGSs unquestionably could encourage some smaller companies to “test the waters” and perhaps even to go public sooner. The reduced compliance and disclosure requirements for EGCs unquestionably could reduce the post-IPO costs for the qualifying companies.

 

The Act’s exemptions for the EGCs from many of the compliance and disclosure requirements that Congress only recently imposed on all public companies at least potentially could reduce the liability exposures for Emerging Growth Companies and for their directors and officers. For example, a company that does not have to conduct a say-on-pay vote is not going to get hit with a say on pay lawsuit. Similarly, the elimination of requirements for executive compensation disclosures eliminates the possibility that those companies could be subject to allegations that the compensation disclosures were misleading.

 

By the same token, the Act arguable introduces provisions that could increase the potential liabilities of some companies. For example, Section 302(c) of the Act expressly imposes liability on issuers and their directors and officers for material misrepresentations and omissions made to investors in connection with a crowdfunding offering. The crowdsourcing provisions are subject to rulemaking, but the rules must be provided within 270-days of the Act’s enactment. Among other things, the rulemaking will clarify the crowdsfunding issuer’s disclosure requirements.

 

It is worth noting that these crowdfunding provisions may blur the clarity of the division between private and public companies. The crowdfunding provisions seem to expressly contemplate that a private company would be able to engage in crowdfunding financing activities without assuming public company reporting obligations. Yet at the same time, that same private company will be required to make certain disclosure filings with the SEC in connection with the offering and could potentially incur liability under Section 302(c) of the JOBS Act.

 

These and many other changes introduced in the Act could require the D&O insurance industry to make changes in its underwriting and perhaps in policy forms to accommodate these changes. As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must try to assess the impact of changes introduced by this broad, new legislation. Though many of the Act’s provisions seem likely to reduce the potential scope of liability for many companies (particularly the EGCs), the Act could also introduce other changes that might result in increased potential  liability for other companies (particularly those resorting to crowdfunding financing).

 

As a final point, it is worth noting that President Obama has still not even signed the Act but questions about the Act are already being raised. For example, an April 2, 2012 Wall Street Journal article, noting the post-IPO accounting disclosures of discount coupon company Groupon, raised the concern that if the JOBS Act had been in place, Groupon would have been able to confidentially submit its IPO documents to the SEC, allowing its pre-IPO accounting concerns to remain below the radar. Undoubtedly, further questions will be asked as the JOBS Act goes into force and its provisions are implemented.

  

Several law firms have issued helpful memos on the Jobs Act. A March 29, 2012 memo from the Paul Weiss law firm can be found here. A March 2012 memo from the Jones Day law firm can be found here. Very special thanks to the several readers who sent me links or asked questions about the JOBS Act.

 

Supreme Court Issues Unanimous Opinion in Section 19(B) Statute of Limitations: Perhaps because the issues involved are technical, there was little notice paid to to the U.S. Supreme Court’s March 26, 2012 issuance of its unanimous opinion in the Credit Suisse Securities (USA) LLC v. Simmonds case. The Court’s opinion, which was written by Justice Antonin Scalia, can be found here.

 

As discussed here, the Supreme Court had taken up the case to address the question whether the two-year statute of limitation period applicable to claims for short-swing profits under Section 16(b) of the Securities Exchange Act are subject to tolling, and if so, what is required to resume the running of the statute.

 

The Court held that the failure of a person subject to Section 16 to file the specified disclosure statement does not indefinitely toll the two-year statute of limitations. The Court said that even if the statute were subject to equitable tolling for fraudulent concealment, the tolling ceases when the facts are or should have been discovered by the plaintiff, regardless of when the disclosure statement was filed. The Court said that the traditional principles of equitable tolling should apply and remanded the case to the district court to determine how those principles should be applied in this case. The Court split 4-4 on the question of whether the two-year statute functions as a statute of repose that is not subject to tolling.

 

The Supreme Court’s ruling on this technical issue regarding the application of the statute of limitations for short-swing profit claims does not have a widespread impact. However, the Court’s decision eliminates the possibility that the statute could be tolled indefinitely, as arguably might have been the impact of the Ninth Circuit’s opinion in the case.

 

A March 30, 2012 memo from the Bingham McCutchen firm about the decision can be found here. A March 30, 2012 memo from the Davis Polk law firm about the decision can be found here.

 

Point/Counterpoint on the "Dip" in Securities Class Action Settlements: In a prior post (here), I discussed the recent Cornerstone Research report detailing the "dip" in securities class action settlements in 2011. In an April 2, 2012 post on the New York Times Dealbook blog (here), two attorneys, Daniel Tyiukody of the Goodwin Proctor firm and Gerald Silk of the Bernstein Litowitz firm, provide their contrasting points of virew on the reported "dip." The bottom line is that the kinds of cases that have been filed in recent years have been taking longer to settle — and there are a lot of cases, particularly related to the credit crisis, in the pipeline. Silk also notes that there have been fewer restatements in recent years, and also that there have been more individual (non-class) securities that have been filed.

 

 

On first encounter, three impressions immediately emerge regarding the throngs of pedestrians walking along O’Connell Street, the main thoroughfare in Dublin’s central district: first, everyone is incredibly young; second, they are a surprisingly diverse crowd; and third, there are a hell of a lot of babies in strollers everywhere you look.

 

The D&O Diary was on assignment in the British Isles last week, and the final stop on the itinerary was Dublin, a great city with a rich history and beautiful buildings, that is brimming with  youthful energy and  full of contrasts. (The picture above depicts the River Liffey, looking west, and also reflects the glorious weather we enjoyed during our visit.)

 

It turns out that the initial impressions about the crowds on O’Connell Street have a basis in demographic fact; while we were in Dublin, the Irish government released the preliminary results of the 2011 census, which showed, among other things, that the country has been experiencing an “extraordinarily high birth rate” and the natural increase in population is the “highest on record of any previous census.” The census also found that “ethnic diversity is now an established fact of Irish life,” and that the number of non-Irish nationals increased by a third since the 2006 census.

 

The city’s youthful, lively population projects a sense of dynamism that, at least at first impression, seems to be reflected in the fabric of the city itself. The city’s gleaming airport is brand new. A sleek new tram line runs parallel to the River Liffey. New ultramodern office buildings line the tram tracks, bearing logos of global companies like PwC, J.P. Morgan, Statoil, and BNP Paribas. Unfortunately, all of the dazzling infrastructure and of the ultramodern construction projects are the glittering remnants of the time, now five years gone and receding further into the past every day, when the Celtic Tiger roared.

 

As the tram line continues east toward the city’s docklands, it quickly becomes apparent how it all went so terribly wrong. The snazzy buildings with the corporate logos quickly give way to empty “see through” buildings, and then to the hulking concrete superstructures of buildings that were incomplete when the music stopped. Along the final tram stops, huge areas optimistically cleared for even more building projects remain empty, inhabited only by the ghosts of the banks and other firms that failed when the real estate bubble burst.

 

As befits a city with both an irrepressible youthful dynamism and a legacy of seemingly insurmountable budget woes, Dublin presents a host of contradictions. On Saturday, crowds of youths  — many with babies in strollers —  thronged the city’s main shopping districts along Grafton and Henry Streets, both of which lined with global brands like H&M, Swatch, Starbucks, Disney and Apple. At the same time, thousands of protest marchers demonstrated outside the governing party’s annual convention, rallying against the new 100 euro household tax (which more than half of the obligated tax payers had failed to pay by the March 30 deadline).

 

In the wake of the financial crisis, Dublin and Ireland face a host of challenges. But during several days of record-breaking warmth in the final week of March, the city positively hummed with life. The walkways along the Liffey were lined with grateful city dwellers, their pale faces turned toward the sun like so many red-headed sunflowers. The lush, flower covered St. Stephen’s Green, which is a veritable urban oasis, was also crowded with families (including innumerable babies in ubiquitous strollers) sunning themselves and enjoying the prematurely blooming flowers and blossoming trees.

 

Nestled in the city’s center is the venerable Trinity College, founded in 1592  by Queen Elizabeth to civilize and improve her Irish subjects. I can’t say for sure what the campus might be like under ordinary conditions, but on a sunny Spring day with temperatures in the 70s, its lawns are covered with students enjoying the warmth in a way you might expect, say, on a college campus in South Carolina.

 

Near Trinity College is another area that is perhaps of even greater interest to many tourists, the pub and restaurant district know as Temple Bar. On a warm spring evening, the area’s cobble-stone streets were full of Guinness-fuelled crowds of tourists and youthful revelers. The party atmosphere was lots of fun, but by the second or third visit to the area, I began to feel like it was an entertainment zone for thirsty visitors looking for the tourist version of the Irish pub experience. When my son and I found ourselves seated next to six middle-aged Japanese women taking pictures of themselves holding (untouched) glasses of Guinness, the whole place started to feel like an Irish-themed amusement park designed to separate foreign visitors from their euros.

 

In search of something a little less tourist-intensive, and hoping to catch the Pro12 rugby league game between Munster and Leinster, I typed “best places to watch sports in Dublin” into Google, and came up with the Bruxelles pub, on Harry Street, off of Grafton. The bar was packed with rugby fans, most seemingly loyal to Leinster. The bartender poured a proper pint, and the crowd was transfixed on the flat screen televisions around the room.

 

Leinster ultimately won the game, but the important thing is that we learned the appropriate forms of address during a televised rugby game. The true rugby fan from time to time waves a hand toward the television and exclaims “Ahhh!”, in a guttural growl from deep in the throat. Periodically, it is also appropriate to shout “Come on lads!” as well as “that’s a fookin’high tackle, for sure!” Large quantities of Guinness also are apparently required. No one was taking pictures of themselves drinking beer.

 

Perhaps the high point of our Dublin visit was the walking tour of the 1916 Easter Rising. Because the events took place relatively recently; because the structures involved in the Rising are not only still standing but mostly still in use; and because the consequences of the Rising have continued to reverberate over the years, the tour’s impact is extraordinary. The Rising has been and remains the source of much controversy, as it was quickly suppressed and resulted in the swift execution of its leaders, and also resulted in the destruction of much of the city’s central business district. O’Connell Street (then called Sackville Street) itself was left in ruins. In the immediate aftermath, the leaders of the Rising were widely reviled for in effect bringing the War in Europe  to Dublin. Ireland has never adopted the anniversary of the Rising as its Fourth of July or Bastille Day.

 

But after it was suppressed and the leaders executed, the Rising came to represent the embodiment of heroic nationalism as the country struggled toward independence. Views about the meaning of the Rising have continued to shift in the years since. With the centennial of the Rising now approaching, the question of the meaning of the events is the subject of renewed focus. The Rising tour, along with a separate tour of Kilmainham Gaol, where political prisoners were held and where the leaders of the Rising were executed, was a particularly interesting and memorable part of the visit to Dublin.

 

The Rising tour meets at the International Bar on Wicklow Street, not far from Trinity College. It turns out that a tour of a different type was also taking place there. That same morning, groups of Trinity students were conducting a unique form of pub crawl. The students were arranged in groups of six and dressed in costumes (as, say, the cast from Scoobie Doo or from the Flintstones). Their apparent plan was to run through a series of six pubs. At each pub, each participant had to chug a beer, and then run to the next pub. The International was only the second pub on the circuit. I can only imagine what the participants looked like by the time they reached the fifth or sixth pub. Now, I know some readers may be thinking that this activity is simply the ancient Gaelic sport of “hurling,” but that is actually an entirely different but equally inexplicable pastime (involving giant wooden spoons with three foot long handles, where the contestants run around, and, well, I am not sure about the rest, but it is a lot of fun to watch with a pint of Guinness).

 

One of the most amusing parts of this costumed, beer-swilling foot-race was the reaction of the pub regulars, who were seated at tables along the wall opposite the bar, pints of Guinness at their elbows, and faces unchanging as huffing and puffing teams of, say, Teenage Mutant Ninja Turtles, came charging into the pub, called for a round of beers, and then went running out. Just another day in Dublin, the regulars’ unchanging faces seemed to say.

 

Although there is much to be said for a pub and a proper pint, on a warm spring day Dublin’s outlying areas offer an even more alluring attraction. Thirty minutes north of the city on the DASH commuter rail line is the seaside village of Howth . The train line terminates at the edge of the town’s snug harbor. The main road runs along the sea-front past the breakwater, and then winds up into the hills overlooking the town and the harbor. At the road’s end, a foot path winds into the cliffs and up to the summit, where there are breathtaking views of the Irish Sea and of Ireland’s Eye, a rugged offshore island. The hillsides were covered with yellow gorse blossoms. Looking south from the summit, you can see beyond Dublin to the Wicklow Mountains.

 

Ireland is a beautiful country with a rich history, as well as an enviable trove of assets. It may face some formidable challenges. But with its youth and its energy, its future holds great promise. In the meantime, its capital remains a lively and entertaining destination, a comfortably diverse place to visit and enjoy.

 

St. Stephen’s Green, Dublin:

 

Trinity College, Dublin

 

Ireland’s Eye, Off of Howth

 

 

 

 

 

 

 

 

 

The Cliffs at Howth, from breakwater

 

Looking South to the Wicklow Mountains

The Lloyd’s Building, at 1 Lime Street in London, is the vital, dynamic heart of the London insurance market, as well as the historic center of the global insurance industry. The D&O Diary is on assignment in the U.K. this week, and one of the high points of the business itinerary was a tour of the Lloyd’s building in London, supplemented by a short but gratifying introduction to a host of London insurance market professionals.

 

The Lloyd’s Building’s exterior, still striking after 25 years, often attracts the most attention (and, even now, some controversy), but it is the building’s interior that is actually the most interesting. The building’s first three floors are a web of activity, with underwriters in the boxes considering risk submissions brought to them by the brokers.

 

The boxes are a remnant of the marketplace’s earliest origins at Lloyd’s Coffee House, where in those days marine risks were underwritten at the shop’s stalls and booths. The boxes today include sleek computer screens, and they often display the names of large multinational insurance organizations. Just the same, according to time-honored practices, the brokers still queue up at the boxes to present their client’s risks and much of the business is still transacted face-to-face. Even if these processes are vestigial, they represent both a civilized tradition and a time-tested way to transact insurance business.

 

On my prior visit to the Lloyd’s building years ago, there was a sense the building was a little under utilized. Much of the third floor then was vacant. But now the building seems to be full and the sense of energy and activity is palpable.

 

Notwithstanding the building’s ultramodern décor and the omnipresence of electronic technology, the building as an insurance market retains important artifacts reflecting its long history and embodying many of its traditions. The Lutine Bell, rescued from a sunken vessel, stands in the center of the building’s first floor; the bell still sounds from time to time, but only on the occasion of a major loss. The Adam Room on the building’s eleventh floor, a re-creation of the prior building’s meeting room, represents a sharp design contrast to the rest of the building. Though it is now used for ceremonial purposes, its traditional décor provides a symbolic link to the market’s long and venerable history.

 

The London insurance market is now much bigger than just Lloyd’s itself, and around The City there are other insurers in the so-called company market who do not participate directly in the Lloyd’s marketplace. But even these other participants are located in close proximity to the Lloyd’s building. As a result of the physically compact nature of the London insurance marketplace, and also due to the marketplace’s tradition of doing business face-to-face, there is very much of a feeling of community in the marketplace. Many of the participants know each other, to a much greater degree that their counterparts might elsewhere in the global insurance industry.

 

I enjoyed a particularly rewarding encounter with the London insurance community at a reception that my firm, OakBridge, co-sponsored with Beazley Group and the Ince & Co. law firm. It was through my friendships with individuals at these two other firms that the reception came about, but the reception itself was really not for or about the sponsoring firms as such. The whole point of the reception was simply to bring together as many participants in the London management liability insurance arena as were willing to come out on a Tuesday evening. In the event, over 75 underwriters, brokers, reinsurers and lawyers attended. I saw many old friends and made many new friends.

 

I thoroughly enjoyed the opportunity to become better acquainted with my professional colleagues in London. I came away with a strong sense of the professional collegiality that is so characteristic of the place. In the U.S., the D&O insurance industry is also collegial, but because it lacks the geographic concentration of the London market, the sense of community in the U.S. is not the same.

 

As a result of the Internet and other features of modern business, all too often in the U.S. (and elsewhere) our business interactions are impersonal and detached. In my own work situation, I am literally in an office by myself, with no colleagues nearby and with my links to the business world running through Internet routers and telephone lines. Sometimes it seems that what we may have gained in process efficiency from our modern approach to business, we may have lost in so many other ways. Although our transactions are usually friendly, it is infrequent that we know or know much about those with whom we are conducting business. As I circulated among the guests at the reception the other evening, I was reminded that in a business community built on relationships, business takes place not merely among market participants, but also between friends.   And there is a lot to be said for that.

 

I would like to thank my good friend Tom Coates of R.K. Harrison for taking me and my son around the Lloyd’s building. I would also like to thank all of my friends at Beazley Group and at Ince & Co. for co-sponsoring the reception. And to all my friends in London, old and new, all I can say is that I hope someday I have a chance to repay your hospitality. And to do business, as well. Cheers.

 

The Adam Room

 

Some of Lloyd’s City Neighbors