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

 

AUSTRALIA

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

MEXICO

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

 

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

 

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

 

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

 

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

 

DISCUSSION

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

The March 1 Decision

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Many thanks to Kara for her willingness to publish her article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Definition of claim

 

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

 

 

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

 

 

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

 

 

Co-defendant language

 

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

 

 

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

 

 

Definition of loss

 

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

 

 

Conduct exclusions and adjudication language

 

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

 

 

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

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

 

 

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

 

 

Civil fines and penalties coverage

 

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

 

 

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

 

 

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

 

 

Separate investigations policies

 

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

The February 27, 2012 Ruling

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

. 

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

 

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

 

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

 

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

 

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

 

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

 

Berkshire Itself

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The U.S. Economy

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

 

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

 

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

 

Insurance

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

 

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

 

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

 

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

 

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

 

Investments

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

The February 7, 2012 Ruling

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

Background

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

 

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

 

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

 

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

 

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

 

The February 15 Ruling

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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