Securities class action filings rise slightly in 2011 compared to the prior year but remained below historical averages according to the annual study of Cornerstone Research, prepared in conjunction with the Stanford Law School Securities Class Action Clearinghouse, which was released today. A copy of the report can be found here, and Cornerstone Research’s January 19, 2012 press release can be found here. My own analysis of the 2011 securities class action lawsuit filings can be found here.

 

According to the report, there were 188 securities class action lawsuit filings in 2011, compared to 176 in 2010, and compared to the 1997 to 2010 average annual average number of filings of 194. The two largest factors in the number of 2011 filings were the heightened number of M&A-related filings (43) and the elevated number of filings involving U.S.-listed Chinese companies. (33).

 

The Cornerstone Research report contains a number of insights about the 2011 filings beyond those that have appeared in previously published analysis of the filings. Among other things, the report notes that three percent of companies listed on the three major U.S. exchanges (NYSE, NASDAQ and Amex) were sued in securities suits in 2011. This represents the highest annual percentage since 2004 and is above the 1997 to 2010 annual average percentage of 2.4 percent.

 

On the other hand, in 2011 only 3.2 percent of S&P 500 companies were sued, “making it the least litigious year for S&P 500 companies since 2000.” Historically, larger companies have been more likely to be sued in a securities class action lawsuit, and that trend continued in 2001. Thus, while only 3.2 percent of the S&P 500 companies were sued in 2011, those companies represented 5.1% of the S&P 500 market capitalization.

 

This year’s Cornerstone Research report also contains a number of new analyses, including an analysis of the number of private securities class action lawsuits filed between 1996 and 2011 involving Foreign Corrupt Practices Act allegations. The report shows that there were four such filings in 2011, the highest annual number of filings since 2006 (when there were also four filings).

 

The report also contains a new analysis of the experience of the judges handling securities class action lawsuits during the period 1996 to 2011. The analysis shows that while there are a relatively small number of judges that handled more than ten cases during that period (65), a much larger number of judges (329) handled only one case, and the vast majority of judges (582) handled only three or fewer cases. The inference is that many securities cases are being handled by judges who are relatively inexperienced with securities cases – although there is also a smaller number of judges that are very experienced with these types of cases.

 

The report also reflects some interesting insight about the plaintiffs’ law firms’ involvement in these cases. The report sets out which law firms are selected most often as lead counsel in securities class action cases that do not involve M&A related allegations and then separately lists the firms most often selected as lead counsel in the M&A cases. The interesting thins is that the lineup of law firms leading the M&A cases looks very different than the lineup for the other cases. These differences shed some light on the changing mix of corporate and securities lawsuits and the growth in the number of M&A cases, suggesting that among other things the rising M&A related litigation activity may reflect dynamics within the securities’ plaintiffs’ bar.

 

Speaking of M&A related cases, Cornerstone Research has also recently released a separate companion report specifically focused on M&A related litigation, which can be found here.

 

Investors have a number of rights under federal and state law which they can enforce through litigation, including for example the right to file individual or class actions for damages. But can investors be required to submit these kinds of claims to binding arbitration in lieu of litigation? That is the question posed by a two different initiatives corporate reformers are currently pursuing.

 

One of the basic features of our system of corporate laws is that aggrieved shareholder can enforce their rights or seek damages by filing a lawsuit. But at the same time, our litigation system is costly and court processes can be both time-consuming and burdensome. For that reason, there have been many proposals over the years to provide for the arbitration of shareholder disputes. For example, in its November 2006 report (here), the Committee on Capital Markets recommended that public companies be allowed to have shareholder votes on the use of arbitration to resolve shareholder claims.

 

A couple of different developments are bringing these issues to the forefront now. First, on January 10, 2012, the Carlyle Group, an investment partnership preparing to conduct a public offering, submitted to the SEC an amended filing on Form S-1 that, among other things, specifies that its partnership agreement will provide that all limited partners must submit any claims to binding arbitration.

 

 A January 18, 2012 Bloomberg article by Miles Weiss entitled “Carlyle Seeks to Ban Shareholder Lawsuits Before IPO” (here) discusses the mandatory arbitration provisions described in Carlyle’s filing. Susan Beck’s January 18, 2012 Am Law Litigation Daily article about the Carlyle filing can be found here.

 

The Carlyle offering is a little unusual, because the firm does business as a limited partnership and the securities in the planned offering will consist of limited partnership units. The rights acquired with the units are defined by a limited partnership agreement. According to the company’s filing, the partnership agreement will provide that every limited partner “irrevocably agrees” that “any claims, suits, actions or proceedings arising out of or relating in any way to the partnership agreement or any interest in the partnership…shall be finally settled arbitration.” The filings explain that the kinds of actions to which this dispute resolution provision apply include without limitation disputes under the Delaware Limited Partnership Act and the federal securities laws. The filing also explains that the dispute resolution provisions specify that the each limited partner “irrevocably waives” any objection he or she may have to arbitration. (The filing’s disclosures relating to the partnership agreement’s dispute resolution provisions can be found here.)

 

The arbitration requirements reported in the filing are quite detailed. The dispute resolution provisions specify that the arbitration must take place in Wilmington, Delaware. The arbitration proceedings must be confidential and the amount of any award will not be disclosed. The provisions further specify that the person bringing the claim may only pursue arbitration in an individual capacity “and not as a plaintiff, class representative or class member,” and the arbitrators may not consolidate more than one person’s claim.

 

UPDATE: As discussed in Victor Li’s February 3, 2012 Am Law Litigation Daily article (here), Carlyle Group has announced that in response to pressure from the SEC and others, it as decided to withdraw its proposed provision requireing investors to arbitrate claims.

 

A separate unrelated development involves the efforts of certain investors to put a proposal on 2012 proxy ballots to require shareholder claims to be arbitrated. According to information provided to me by University of Michigan Law Professor Adam Pritchard, shareholders at Pfizer and Gannett are currently seeking to have proposals included on upcoming proxy ballots that would amend the companies’ corporate charters to require the arbitration of shareholder disputes.

 

The companies are seeking SEC authorization to omit the shareholder arbitration proposals from their proxy ballots, arguing that the arbitration requirement would violate both state and federal law. The companies contend that the arbitration requirement would violate Delaware law, which they contend provides shareholders with the right to litigate claims in the Delaware Court of Chancery absent a clearly expressed intent to arbitrate. The companies also argue that the arbitration requirement would violate Section 29 of the ’34 Act, which voids any contractual provision that would seek to waive any right under the statute. Finally, the companies contend that the SEC itself historically has taken the position that a mandatory arbitration charter provision would be against public policy.

 

Advocates for the shareholders seeking to introduce the shareholder proposals argue that there is liberal federal policy favoring arbitration agreements and that there is no support for the argument that an arbitration requirement would violate state law. They contend that Delaware law allows the use of corporate charters to embody agreements between a corporation and its shareholders.

 

They also argue that the Supreme Court has dealt with anti-waiver clauses in federal statutes and has consistently supported arbitration. In its January 10, 2012 opinion in CompuCredit v. Greenwood, the Court held that a right to sue provision in the federal consumer credit statute does not prohibit the enforcement of an arbitration agreement. The advocates for the shareholders argue the antiwaiver clause in Section 29 prohibits the waiver only of substantive rights, not procedural rights and is not a barrier to the enforcement of an arbitration requirement. The advocates (who include Professor Pritchard) contend that arbitration would not undermine the remedial and deterrent purposes of the federal securities law, arguing in further reliance on the CompuCredit case that the Supreme Court has said that arbitration is the equivalent of litigation.

 

Each of these initiatives is poised to be addressed shortly. The SEC will be called upon to respond to the Carlyle Group’s offering document and decide whether the offering may go forward with the dispute resolution requirement unchanged. Among other things, the SEC will have to determine whether or not Carlyle’s partnership ownership structure is a differentiating consideration. According to the Bloomberg article linked above, in 1990 the SEC refused to allow the offering of a savings and loan to go forward until the firm removed the arbitration clause from its corporate charter.

 

The SEC will also have to determine whether or not Pfizer and Gannett can omit the shareholder proposals from their proxy ballots. With deadlines for proxy mailings approaching, the SEC will have to reach a decision in time to allow the companies to prepare their proxy ballots. Of course even if the shareholder initiatives are included on the proxy ballots, a majority of shareholders would have to vote in favor of the proposals in order for them arbitration requirements to come into force.

 

Discussion

The motivations behind these efforts to require shareholder disputes to be arbitrated rather than litigated are perfectly understandable. Anyone who has ever been involved in any way in a material shareholder lawsuit knows that they are terribly costly and that they impose enormous burdens on all of the litigants. Taken collectively, shareholder litigation imposes an enormous cost on corporations in our country.  Reducing these costs is a highly desirable objective.

 

On the other hand, requiring shareholders to arbitrate their corporate claims would represent a massive change in the way that investor rights are addressed. Even if the U.S. Supreme Court thinks arbitration is equivalent to litigation, the fact is that in arbitration certain procedures are unavailable – like, for example, the ability to appeal.  And there are features of the Carlyle requirements that are clearly designed to ensure that arbitration would not be equivalent to litigation (for example, the prohibition against claimants proceeding collectively).

 

A change of this magnitude that has at least been approved by a shareholder vote has more of a sympathetic appeal. But even if the Carlyle offering is allowed to go forward with its offering with the dispute resolution procedures in its partnership agreement, or if Pfizer or Gannett have a mandatory arbitration shareholder proposal on this year’s proxy ballot, it would remain to be seen what would happen and how the arbitration provisions would be enforced when claims arise later. Court would then have to determine whether or not the provisions were valid and enforceable.

 

If any of these initiatives are permitted to go forward, it will be interesting to see what happens next. If Carlyle were able to include the mandatory arbitration provision in its charter (and if the reason Carlyle is permitted to do so is not linked to the fact that it is a partnership), it would seem likely that other companies would seek to implement similar provisions in the charters prior to their initial public offerings. And if the activist shareholders are successful in getting the mandatory arbitration issue on the Pfizer or Gannett proxy ballots, it seems likely that shareholders at other companies would pursue these same initiatives.

 

Though I could see these kinds of initiatives quickly spreading to other companies, these initiatives may not be popular with all shareholders. Indeed, I could easily imagine many shareholders actively opposing these types of efforts, taking the view that the opportunity to resort to the courts to seek redress of grievances is a basic and important right and an important tool to ensure that corporate officials abide by their legal duties.  The plaintiffs’ securities bar undoubtedly would become actively involved in resisting efforts to introduce these kinds of changes elsewhere.

 

Thus even of these current initiatives succeed, we would still be a very long way from the elimination of our current system of shareholder litigation. Nevertheless, it will be very interested to see where these current initiatives lead. The possibility for the adoption of a requirement for the mandatory arbitration of shareholder claims presents at least the theoretical chance for a radial revision on our current system of shareholder litigation.

 

One final note. The arbitration provision in the Carlyle partnership provision is far from the only restrictive aspect of the Carlyle structure. As Ohio State Law Professor Steven Davidoff notes in a January 18, 2012 post on the Dealbook blog (here), Carlyle "is propsing the most shareholder-unfriendly corporate goverance structure in modern history."  He notes that under the Carlyle structure shareholders have no right to elect directors and the company will not hold annual meetings of shareholders. In light of thse constraints and the arbitration provision, "the real question is whether prospective shareholders protest and refuse to participate in Carlyle’s IPO because of the governance issues."

 

Thanks to the several readers who sent me links to the Bloomberg article and very special thanks to Professor Pritchard for sending me the information about the Pfizer and Gannett shareholder proposals.

 

Jobs Link: One of the great blogs that I follow closely is The FCPA Professor blog, which is written by Butler University Law Professor Mike Koehler. Professor Koehler’s posts are always interesting and well written. Now there is another reason to visit the site. Professor Koehler has added a Jobs link to his site (here), in which he will post job openings in his field. Great to see a fellow blogger expanding the universe of blogging possibilities.

 

The M&A Litigation Problem: In the latest issue of InSights, entitled “Why Mergers and Acquisitions Related Litigation is Such a Serious Problem” (here), I take a look at the issues arising from the growing levels of litigation surrounding M&A transactions.  These kinds of cases are becoming increasingly common and increasingly costly, both of which pose significant problems for companies and for D&O insurers. 

 

On January 17, 2012, in a development with important implications for the evolution of post-Morrison remedies for non-U.S. investors, a Dutch court has held for the first time that a collective securities settlement is legally binding. Of even greater significance, the decision arose in a circumstance where none of the liable parties and few of the claimants were domiciled in the Netherlands. The court’s action suggests the possibility of a potentially important mechanism for aggrieved investors who bought shares outside the U.S. to obtain compensation.

 

A January 18, 2012 memorandum from the De Brauw, Blackstone and Westbroek law firm describing the Dutch court’s ruling can be found here. A January 18, 2012 memo from the Deminor Group about the ruling can be found here.

 

Background

The Non-U.S. investor proceedings in the Netherlands follow the settlement of related proceedings the U.S. As discussed at length here, Converium investors first filed a securities class action in the Southern District of New York in October 2004. The plaintiffs alleged Converium and certain of its officers and directors, as well its corporate parent, Zurich Financial Services, had made misleading statements about Converium’s financial condition, including the adequacy of its loss reserves for its North American business during the class period. (Converium had spun out of Zurich in a 2001 IPO.)

 

In 2007, while the U.S. case was pending, SCOR Holding (Switzerland) acquired the voting rights of Converium pursuant to a tender offer.

 

In rulings dated March 6 and March 19, 2008 (refer here and here, respectively) Southern District of New York Judge Denise Cote, applying pre-Morrison standards for determining the reach of the U.S. Securities laws, certified a class consisting of all persons who purchased Converium American Depositary Shares on the NYSE, and all U.S residents who purchased their Converium Shares on a non-U.S. exchange. Excluded from the class were investors who had purchased their shares on any non-U.S. exchange who were not U.S. residents at the time of their purchased.

 

The U.S. action ultimately settled for a total of $84.6 million, consisting of $75 million from SCOR and $9.6 million from Zurich. The Southern District of New York approved this settlement and entered final judgment on December 22, 2008.

 

As detailed here, in July 2010, two groups acting on behalf of the non-U.S. Converium investors entered settlement agreements with Scor and Zurich. The total amount of the two settlements is $58.4 million, of which $40 million is to come from SCOR and $18.4 million is to come from Zurich. The SCOR settlement agreement can be found here and the Zurich settlement agreement can be found here. The two groups acting on the investors’ behalf were Stichting Converium Securities Compensation Foundation, Dutch foundation formed for the purpose of seeking recoveries on behalf of the Non-U.S. Converium investors. Dutch investors in particular were represented by Vereniging VEB NCVB.

 

Pursuant to the Dutch Collective Settlement of Mass Damages Claims Act (known as WCAM), enacted in 2005, the parties then petitioned the Amsterdam Court of Appeals for approval of the settlement. An English translation of the parties’ petition, as amended, can be found here. The Act basically allows parties to seek court approval for collective settlement of mass actions entered for the benefit of class members who do not opt out.

 

On November 12, 2010, the Amsterdam Court of Appeals entered a provisional judgment acknowledging its right to recognize the settlements and scheduling a hearing for interested parties to appear and present their arguments with respect to the petition. Interestingly, the November 12 order specifically references the U.S. Supreme Court’s Morrison decision and the impact the decision has on the ability of Non-U.S. investors to pursue securities claims in U.S. courts.  The hearing to determine whether the settlement agreements will be binding was held on October 3, 2011.

 

On January 17, 2012, the Amsterdam Court of Appeals issued its ruling holding the settlements to be binding. As discussed in the De Brauw law firm memo, there two principal objections to the non-U.S. settlements. First, the objectors contended that the amount of the settlement was unreasonable because the benefit amount under the U.S. settlement was relatively greater than was the case under the non-U.S. settlement. The objectors also took exception to the amount of fees awarded to U.S. counsel was unreasonable.

 

In its January 17 ruling the Amsterdam Court rejected these objections. The rejected the objection about the settlement amount because the legal position of the non-U.S. investors was weaker than that of U.S. investors because the non-U.S. investors had been rejected from the U.S. class action. In dismissing the objection about the U.S. lawyers’ plaintiffs’ fees, the Court noted that much of the work in support of the settlement had been carried out in the U.S. by U.S. law firms, and that what was considered customary in the U.S. could be taken into account by the Dutch court.

 

Discussion

The significance of the Amsterdam court’s decision to accept the settlements as binding is that it represents the first time that the Amsterdam Court has approved a settlement “regarding the securities of a company which is not based in the Netherlands and whose securities are not traded on an exchange in the Netherlands.” At least in principle all EU member states, as well as Switzerland, Iceland and Norway will have to recognize the Amsterdam court’s ruling as binding.

 

The Court’s acceptance of the settlement, particularly given the limited connection of the settlement to the Netherlands, is particularly significant in light of the fact that the Netherlands is “the only European country where a collective settlement can be declared binding on an entire class on an ‘opt out’ basis.” As the DeBrouw law firm’s memo states, the Dutch courts not only have the power to declare the settlement to be binding but “it has the appetite to facilitate such settlements even if the parties to the settlement and the class members only have a limited connection to the Netherlands.” The decision confirms that the Netherlands is “Europe’s most attractive venue for facilitating international settlements.”

 

As a more general level, as the Deminor memo notes, the settlement also shows that “there is a legally binding settlement mechanism available in Europe that can help to solve complex securities litigation in Europe in an orderly way.”

 

These settlements represent the latest occasion when the new Dutch procedures have been used to reach settlements on behalf of non-U.S. investors in connection with securities claims that were also the subject of U.S. securities class action lawsuit claims and settlements.

 

The first and highest profile of these prior settlements was the $381 million settlement on behalf of non-U.S. Royal Dutch Shell investors. As discussed here, in May 2009, the Amsterdam Court of Appeals approved the settlement and authorized payment to Non-U.S. investors. The Dutch settlement followed an earlier settlement of a parallel U.S. securities class action lawsuit settlement on behalf of U.S. investors and arising out of the same factual allegations.

 

The Royal Dutch and the Converium settlements illustrate possible means by which, even in the wake of Morrison, non-U.S. investors can obtain recoveries for their investment losses. As plaintiffs’ attorneys cast about for alternatives for non-U.S. investors to pursue in the wake of Morrison, the use of settlements under the Dutch procedures may provide a possible remedy.

 

On the other hand, there are limitations on the usefulness of the Dutch procedure for investors. Only court authorized representatives can pursue claims on behalf of investors, and representatives cannot seek damages. Instead, the Dutch courts can only certify the class and approve out of court settlements. In addition, while the judgment of the Dutch court is in principle enforceable in courts outside the Netherlands, it remains to be seen whether or not other courts will in fact recognize the judgment.

 

But those limitations notwithstanding, the decision of the Dutch court to recognize the settlements as binding represents a significant step in the evolution of remedies for non-U.S. investors in the wake of Morrison. There is some irony that one of Morrison’s consequences is that has spurred investors to seek remedies elsewhere and thereby advance the development of remedial mechanisms outside the U.S Indeed in its preliminary ruling in the case the Dutch court specifically cited the advent of the Morrison decision as one reason that it should provide relief. In the one of Morrison’s consequences may be the encouragement of the process for developing investor remedies outside the U.S.

 

Special thanks to the several good friends who alerted me to this development and who sent me links to the law firms’ memos.

 

For policyholders whose interests are insured in London, it can be critically important to understand the Lloyd’s claims processes. In the following guest post, my good friend Perry Granof  (pictured) takes a look at recent changes to the Lloyd’s claims processes effective January 1, 2012 that will affect a wide variety of professional liability claims.  Perry is Managing Director of Granof International Group LLC, an insurance consulting and claims service firm specializing in global executive, professional and financial institutions liability. He is also also Of Counsel at the Williams Kastner law firm in Seattle, Washington.

 

 

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

 

 

Here is Perry’s guest post.  

 

 

 

 

I travelled to London in late November 2011 where I met with Lloyd’s claims representatives and first learned about the Lloyd’s Claims Transformation Programme (CTP). According to Lloyd’s, CTP is intended to provide improved customer service and greater flexibility for managing agents.

 

 

CTP was introduced to the Lloyd’s market on January 1, 2010, as a pilot program for marine hull, property, and casualty treaty classes of business. The pilot was deemed successful, achieving a 40% average improvement in claims transaction time.  According to Market Bulletin Y45221, dated September 30, 2011, the program was expanded to new claims in Financial Institutions (FI), Professional Indemnity (PI), which includes D&O, and medical malpractice, to be effective as of January 1, 2012.

 

 

CTP is intended to modernize, add quality and streamline the Lloyd’s claims handling process. However, it may give way to new disputes and potential opportunities for conflict resolution. Among the various procedural guidelines introduced by CTP is a streamlining of the triage categories from three to two. They are now “Standard” and “Complex” claim categories. The threshold is a specified dollar amount of exposure plus a sundry of other factors such as a potential or actual denial of coverage or allegations of fraud.

 

 

All complex claims, unlike Standard claims under the new Lloyd’s protocol, additionally have a second tier lead Managing Agent called a “Second”, which functions in conjunction with the “Lead” Managing Agent. Previously the Second underwriter only played a claims agreement role in certain circumstances, and an oursourced service provider represented the interests of the followers on every claim. The Second helps to ensure that an appropriate strategy is in place to help facilitate a proper resolution of the claim and that the other Managing Agents on the slip that make up the following market are fully represented and kept abreast of developments.

 

 

The Second  reviews the documentation and other considerations, which the Lead relied on in its recommendations to the market, and confers with the Lead in connection with: the “Handling of the Claim”; the “Ongoing management of the Claim”; the “Contingent Financial Planning (Reserves, Costs, etc.)”; Experts” and the “Settlement Process." The protocol also makes it clear that the “Followers”, are entitled to “contact the Lead (or Second) to raise queries or share their views on the proposed strategy to resolve the claim.”

 

 

A review of the relevant Market Bulletins, in particular Ref: 4522 and 4531, certainly justifies Lloyd’s optimism in touting the advantages of CTP. CTP will lead to an open and more effective claims handling regime among syndicates engaged in the adjustment of Complex claims. However, it could also lead to an increase in conflicts arising between the Lead, the Second and the Follower Lloyd’s syndicates, by giving non-Lead syndicates more voice and responsibilities.

 

 

Under the CTP, non-Lead syndicates clearly have standing to raise queries and share their views and can offer platforms for followers in which to dissent to positions offered by Lead carriers. Some emerging conflicts that I can foresee, especially in the PI/FI and D&O classes of business include drop down issues. When an exposure potentially exceeds the available insurance program, a lead insurer may propose a drop down arrangement to save policy limits for itself and possibly throughout the entire tower of coverage. A Second or Follower may respond arguing that the Lead must fully exhaust its coverage before the rest of the market begins contributing to the resolution of the claim. This issue has recently been addressed in the case of Citigroup, Inc. v. Federal Ins. Co., 10-20445, 2011 U.S. App. LEXIS 16316 (5th Cir. Aug. 5, 2011). In Citigroup, the Court held that the excess policies unambiguously required that the primary carrier pay its full policy limit as a condition precedent to the excess carriers filling the gap by dropping down and providing coverage. Still, Citigroup is only binding in the 5th Circuit and the case was determined by the specific policy wordings at issue.

 

 

Another source of conflict could involve situations where a Lead, a Second or Followers disagree over the placement of claims in an insurance tower covering one particular policy year, over another. This may become contentious where participating insurers have different reinsurance treaties covering different policy years, impacting their net exposures. Also, if the exposure is significant, it can become a dispute, which may not be easily soluble.

 

 

A third source of conflict could involve situations where Second and Followers may perceive a given policy limits claim, directed by the Lead resulting in disproportionate and inequitable payments of insurance proceeds, constituting a waste, and possibly giving rise to extra – contractual damages.

 

 

All of these situations, and others that I am unable to currently foresee, may require an efficient and effective dispute resolution mechanism to insure that disagreements among the syndicate companies to a tower are resolve quickly cheaply and confidentially. In reviewing Section 5.0 "Resolution of Disagreements" under Market Bulletin Ref: Y4531, which describes the 2010 “Claims Scheme Process Guidelines," there does not appear to be any mention of a disputes resolution process, other than a meet and confer provision. Also Lloyd’s underwriters are required to use their best endeavours to reach a consensus under Market Bulletin Ref: Y4522 which also makes reference to a mediation and arbitration process as "prescribed by Lloyd’s from time to time". These provisions are designed to make it easier for Lloyd’s co-insurers as opposed to non-Lloyd’s co-insurers to resolve issues amongst themselves without recourse to formal dispute resolution proceedings. Although it represents an effort to address future disputes among Lloyd’s co-insurers, this may not entirely avoid the risk of formal proceedings, especially considering the types of disputes that could arise from the issues I set forth above.

 

 

The CTP may require a new and expedited regime to resolve FI, PI & D&O coverage disputes among Lloyd’s carriers, quickly, quietly and efficiently, minimizing any disruptions of the claims handling process. This may ultimately give rise to mediation and arbitration opportunities in the United States and abroad to resolve disputes among Lloyd’s syndicates in connection with US and non-US venued claims.

 

 

Cornerstone Releases M&A Related LItigatoin Study: Iin a recent post (here), I previewed a then-forthcoming study from Cornerstone Research with regard to M&A related litigation. Cornerstone Research has now released its study, entitled "Recent Developments in Sharholder Litigation Involving Mergers and Acquisitions" (here). The final report contains additional information beyond the specific items I reviewed in my prior blog post. Special thanks to Cornerstone Research for sending me a link to the final report.

 

 

 

The North Korean Kindergarten Quintet: For today’s music interlude we are featuring a video that is simultaneously impressive and deeply disturbing. Watch these children perform and see if, in addition to being slowly but completely creeped out, you don’t find yourself gaining a little insight into the reason there were real tears when Kim Jong-Il died in December. The more basic question is why they aren’t crying all the time.

 

https://youtube.com/watch?v=gsiYtsSQYfA

There seems to be a general consensus that the amount of M&A-related litigation is increasing. The question of how to quantify the increase has attracted quite a bit of attention lately. In a recent post, I previewed a forthcoming report from Cornerstone Research that will provide detailed statistic analysis of the M&A litigation phenomenon.

 

My post attracted considerable commentary, and also drew a communication from NERA Economic Consulting, which has released its own statistical analysis of M&A-related litigation, and which they shared with me.

 

In addition, this week I separately received from Ohio State University Law Professor Steven Davidoff a copy of the January 1, 2012 paper that he and Notre Dame Finance Professor Matthew Cain have written entitled “A Great Game: The Dynamics of State Competition and Litigation” (here), in which they analyze M&A related Litigation from 2005-2010., with particular attention to the question of whether or not there is now competition between the states for this type of corporate litigation. Davidoff should be familiar to many readers as The Deal Professor from the New York Times Dealbook blog.

 

These two reports add substantial additional quantitative and analytic support for the general observations surrounding the growth in M&A-related litigation. Both of these reports corroborate the explosive growth in M&A-related litigation in recent years. I examine both of these reports below, starting first with Professors Davidoff and Cain’s analysis.

 

Professors Davidoff and Cain’s Paper

The Professors’ primary interests relate to the question of whether or not the states are competing for corporate litigation. Their interest in this question is driven in part by recent analyses suggesting that Delaware may be losing “market share” for this type of litigation. In order to determine how “both attorneys and courts interact in this game,” the authors examine state court merger litigation. The authors analyzed 955 merger transactions that took place between 2005 and 2010 and having a transaction value great than $100 million.

 

The authors found that 49.7 percent of transactions during that period attracted at least one shareholder lawsuit, and that the litigation rate increased “sharply” during the period, with only 38.7 percent of the transactions incurring litigation in 2005, compared to 84.2 percent in 2010. In addition, merger transactions increasingly are attracting multiple lawsuits. In 2005, only 8.6 percent of the deals attracted litigation in more than one jurisdiction, compared to 46.5 percent in 2010.

 

The authors found that during the sample period, 69.8 percent of cases settled, while 30.2 percent were dismissed. Only 4.9 percent of the settlements involved in increased in the amount of the transaction consideration, while 52.1 percent of the settlements involved only the disclosure of additional information. The average plaintiffs’ attorneys’ fee for settled suits is $1.4 million. Cases that settled for additional disclosure only pay the lowest level of attorneys’ fees (average attorneys’ fees of $793,000) while settlements involving an increase in the deal consideration  pay the most (average attorneys fees $8.5 million)

 

The authors used this information to calculate an expected dismissal and attorneys’ fee baseline, as a way to measure “unexplained” dismissal rates and attorneys fees. The authors used these unexplained amounts as an “indicator for state competition.” The authors found significant variation across states, with certain states awarding higher fees than others. Delaware awarded fees $400,000 to $500,000 higher while dismissing a greater portion of cases than other states.

 

The authors found some statistical support for the claims that Delaware is losing the state court litigation competition, but they also found that “the game” is complex and that the dynamic varies depending on which states are compared. The authors also found evidence that Delaware’s courts are responsive to this competition, concluding that Delaware’s courts award” higher attorneys’ fees to compensate for a higher dismissal rate,” and adjust “dismissal rates down when it loses prior cases to other jurisdictions.” The authors cite the recent $300 million award in the Southern Peru Copper case as an indication that Delaware is” competing more overtly in this game.”

 

The NERA Economic Consulting Presentation

In a December 6, 2011 presentation done in conjunction with the Wilson Sonsini law firm and entitled “Merger Objection Litigation” (here), NERA provided a detailed statistical review of M&A-related litigation. The NERA study is based on the firm’s examination of the 731 merger transactions it identified as having been announced between 2006 and 2010 and that were completed by February 28, 2011, and that had a value equal to or greater than $100 million. NERA found that 285 of those transactions were challenged in a state or federal lawsuit, through June 20, 2011. NERA also found that litigation settlements had been reached in connection with 162 of the deals.

 

The NERA study found that while there were fewer deals overall in the last three years of the 2006-2010 study period, the incidence of M&A related litigation escalated significantly in those three later years. Thus, while only 26.1% of the 2006 deals and only 21.9% of the 2007 deals attracted litigation, 45.4% of the 2008 deals, 78.6% of the 2009 deals, and 60.7% of the 2010 deals attracted litigation. Though the 2010 figure represent a slight decline from the prior year, the 2010 level of litigation still represents a significant increase compared to the earlier years in the study period.

 

The NERA study also found that throughout the 2006-2010 period, the litigation rate increased as the size of the deal increased. Thus, only about 25% of the deals under $500 million attracted litigation, but 38.7% of the deals between $500-$999 million, 40.8% of the deals between $1 billion and $1.9 billion, 53.0% of the deals between $2 billion and $4.9 billion and 70.1% of the deals equal to or greater than $5 billion attracted litigation.

 

Merger objection litigation can be expected to arise fairly quickly after the deal is announced. The NERA study shows that a third of the litigation arrives in the first two days after the deal is announced and about 60% arrived in the first week. 81% of the merger litigation arrives within the first thirty days after the deal is announced. Although the takeover target is consistently named as a defendant in this litigation, 70% of the time the named defendants also include the acquirer.

 

The vast majority of the litigation is filed in state court only. 83% of the deals that were litigated attracted only state court litigation. Another 14% attracted both state and federal litigation. Only three percent of the deals attracted only federal court litigation.

 

The NERA study suggests that many of the deals that attract litigation are attracting litigation outside Delaware. Of the deals that were litigated, 20% were litigated only in Delaware and another 13% were litigated in both Delaware and another state. So about one third of the deals that attracted litigation were litigated at least in part in Delaware. The remaining two thirds of the deals were litigated only outside Delaware. However, the presentation does not show how many of the deals that were litigated only outside Delaware involved target companies that were incorporated in Delaware. The presentation also does not show whether or not the prevalence of litigation outside Delaware changed during the 2006-2010 study period.

 

With respect to the M&A-related lawsuits in the study period that had settled, the NERA report found that the vast majority of the settlements involved cash payments of less than $1 million. 106 of the 154 settlements in the settlement analysis (nearly 69%) settled for less than $1 million. Another 33 out of the 154 in the settlement analysis settled for less than $10 million. Only 15 of the 154 settlements in the analysis settled for amounts of $10 million or greater, including only 4 with settlements between $100 million and only one with a settlement greater than $1 billion. (The NERA presentation includes a detailed list of the largest settlements at slide 19.)

 

Thus, while the settlement period included a few very large settlements, the vast majority of the settlements were for less than $10 million, and more than two-thirds were below $1 million.

 

In fully 87% of the litigated deals that had settled, the only beneficiary from the monetary settlement was the plaintiffs’ attorneys. In only 9% of the settlements did the beneficiaries include both the plaintiffs’ attorneys and class members. Thus the vast majority of monetary settlements pay only for the plaintiffs’ attorneys’ fees and expense, and the “benefits” to the class, although occasionally monetary, more often take another form, such as reduced target company termination fee; fuller disclosure; or improved corporate governance.

 

Discussion

The information in these two studies provides valuable additional perspective on the increasingly important M&A-related litigation phenomenon. The two studies corroborate that in creasing numbers of M&A transactions are attracting litigation. The NERA data also provides some interesting additional information that has not been a part of other statistical perspectives on this litigation phenomenon, including in particular the data showing how quickly the lawsuits arrive and the information showing the range of settlement outcomes.

 

The Professors’ report provides additional information about the increasing prevalence of multi-jurisdiction litigation, as well as average attorneys’ fees and dismissal rates. Perhaps most significantly, the Professors’ study provides important insight into the question of state competition for corporate litigation.

 

The data in these studies are directionally consistent with the previously released studies, including the information I previewed in a recent post about the forthcoming Cornerstone Research report. They are also directionally consistent with each other, while differing somewhat in their details. The two reports also differ somewhat from the Cornerstone Research data I previously reviewed.  (The Cornerstone Research analysis suggests a higher litigation rate both in 2007 and in 2010 than the analysis in either of the two studies discussed above, although all three of the analyses agree that that the litigation rate increased between 2007 and 2010.)

 

The difference between the analyses may be attributable to the differing data sources used in the studies. There may have been methodological differences as well. For those of use who are studying and trying to understand the growing M&A-related litigation phenomenon, it will be important to understand these differences. We can certainly hope as the various research sources release their analyses that they will help the rest of us understand not only where their data came from and how it was analyzed, but how the approach they used may differ from other analyses that have been published.

 

In any event, no matter how you slice it, the level of M&A related litigation is growing. The defense expenses and settlement amounts associated with this litigation represent a growing problem as well. All signs are that this phenomenon will remain a significant part of the corporate and securities litigation landscape for the foreseeable future. For that reason it will remain important to understand what this litigation means. The willingness of NERA and of the Professors to share their analysis is extraordinarily helpful in that regard. Along those lines, I would like to express my deep thanks here to NERA and to Professor Davidoff for their willingness to share their presentations with me.

 

Seven Nation Army: Even though I was not even really focusing on it, I had noticed recently that marching bands and sporting fans everywhere have picked up the same tune, as a rallying cry, as a communal chant, as basic crowd background noise. But if you had asked me to focus on it, I still might not have been able to name the tune. A January 13, 2011 article on Deadspin identified the tune, and also explained how it managed to take over the sportworld.

 

The song is “Seven Nation Army,” a 2003 tune from the alternative rock band, The White Stripes. Just in case you don’t think you know the tune, I have included a video below of the band performing the song. (I guarantee you if you listen to it, you will say – “Oh yeah, that song. I always wondered what that was.”) I was on the alert for it this past weekend, and I noticed that both the San Francisco crowd at the 49ers/Saints game and the west London crowd at the English Premier League game between Chelsea and Sunderland were chanting the tune during their respective games on Saturday. All very odd for an alternative rock song. But I guess it isn’t any weirder than that fact that a lot of marching banks have also picked up “Carmina Burana” from classical composer Carl Orff.

 

In any event, for today’s musical interlude, here’s The White Stripes performing “Seven Nation Army.” Now you will know what the heck all of those fans are trying to chant. (My apologies to all of those rock music aficionados – most half my age — who think I am an idiot for not knowing the song before; please consider my age, location and occupation, and I think you will see how unlikely it is that I would be fully versed in the contemporary alternative rock scene.)

 

In a January 12, 2012 opinion that quotes from (and relies upon) former Treasury Secretary Henry Paulson’s credit crisis memoirs, Southern District of New York Judge Richard Holwell granted in part and denied in part the motion to dismiss in the subprime and credit crisis related securities class action lawsuit that investors had filed against General Electric, certain of its directors and officers, and its offering underwriters. A copy of Judge Holwell’s opinion can be found here.

 

Background

As discussed in greater detail here, the plaintiffs first filed their action in March 2009, alleging that the company had failed to disclose information regarding the company’s health and the health of its financial subsidiary, GE Capital, at the height of the financial crisis. As Judge Holwell summarized it, the plaintiffs allege that “during a time when the financial markets were crumbling and companies across the United States were scrambling to disclose their holdings in subprime loans, GE withheld information regarding its substantial holdings in subprime and non-investment grade loans and touted GE as safe in comparison to its competitors, despite the fact that GE was also feeling the impact of the financial crisis.”

 

Specifically, the plaintiffs allege that GE made misstatements about its ability to fund itself through commercial paper; the quality of its loan portfolio; its ability to maintain its dividend; and its projected 2009 profits. The plaintiffs also alleged that GE violated GAAP by improperly recharacterizing certain of its assets from short-term to long term and by maintaining inadequate loan loss reserves. The plaintiffs allege that the defendants made misleading statements on these topics throughout the class period from September 25, 2008 to March 19, 2009, in violation of the Section 10 (b) of the ’34 Act; and in connection with GE’s October 7, 2008 stock offering, in violation of Section 11 of the ’33 Act.

 

Three particular alleged statements on which the plaintiffs sought to rely proved to be particularly important in Judge Holwell’s rulings on the motion to dismiss. First, with respect to the plaintiffs’ allegations regarding the company’s ability to rely on commercial paper as the credit crisis peaked in September 2008, the plaintiffs’ rely on statements in Henry Paulson’s book, On the Brink, in which Paulson states that GE CEO Jeffrey Immelt called Paulson at least twice that month  allegedly to report that the company was finding it very difficult to sell its commercial paper for any term longer than overnight.

 

Second, the plaintiffs’ relied on Immelt’s statements in December 2008 with respect to the company’s $1.24 annual dividend: “What can you count on? You can count on a great dividend,” specifically referencing the $1.24 dividend level. The company later cut its quarterly dividend for the second half of 2009 from 31 cents a quarter to ten cents per quarter.

 

Third, according the plaintiffs, throughout the class period the defendants made statements describing their loan asset portfolio as “very high quality” and using various similar descriptions. The plaintiffs contrasted this with GE’s March 2009 release in which it specified that 42% of GE Capital’s $183 billion in consumer loans were made to non-prime borrowers and at least $145 billion of its $230 billion commercial lending and leasing portfolio consisted of loans to non-investment grade companies.

 

Judge Holwell’s Opinion

In his January 12 opinion, Judge Holwell held that the plaintiffs had adequately alleged falsity as to their allegations about the GE’s ability to access the commercial paper marketplace; as to the quality of its loan asset portfolio (and in particular its exposure to subprime credits); and with respect to the reliability of the company’s annual dividend. He concluded that the plaintiffs had not adequately alleged falsity as to the other allegations.

 

In concluding that the plaintiffs had adequately alleged that Immelt had acted with scienter, Judge Holwell found, in reliance on the statements from Paulson’s book, that the plaintiffs had adequately alleged that Immelt himself made “contradictory statements to Henry Paulson.” With respect to Immelt’s December 2008 statements about the reliability of GE’s dividend, Judge Holwell rejected the competing inference that Immelt made the statements while struggling to come to terms with a rapidly changing environment:

 

Immelt’s categorical statements that investors could “count on” a dividend and that GE was having “no difficulties issuing commercial paper are not the sort of cautious statements one would expect of a CEO attempting to come to grips with the effects of the economic crisis on his company. Instead, it can be argued that Immelt was attempting to convince the public that the economic crisis was not affecting GE too drastically and that they should continue to invest in GE. Of course, a CEO is allowed to convince the public to invest in his company, but not at the expense of providing it with accurate information about the company’s financial health.

 

In concluding that GE’s CFO Keith Sherin acted with scienter with respect to certain statements about the quality of the company’s loan asset portfolio, Judge Holwell essentially said that the plaintiffs had adequately alleged that Sherin should have known the extent to which GE Capital had made extensive loans to lower quality borrowers. Judge Holwell said “it is highly improbable that Sherin, the CFO of a company 50% of whose revenues were derived from financial services in 2008, would not inquire whether his company was exposed to the subprime consumer borrower and its counterpart in the commercial sector.”

 

Significant parts of the plaintiffs’ ’33 Act claims also survived the motion to dismiss, including in particular plaintiffs’ allegations about the company’s ability to access commercial paper and the quality of the company’s loan asset portfolio and its exposure to subprime credits. Judge Holwell found that the plaintiffs’ remaining ’33 Act allegations were insufficient, but his denial of the motion to dismiss with respect to at least some of plaintiffs’ allegations means that the offering underwriter defendants remain in the case.

 

Victor Li’s January 13, 2012 Am Law Litigation Daily article about Judge Holwell’s ruling can be found here.

 

Discussion

At least a part of plaintiffs’ case would have survived the defendants’ motions to dismiss even without the benefit of Henry Paulson’s statements in his book about his September 2008 telephone conversations with Jeffrey Immelt. But Paulson’s account of the conversations clearly had an impact. At a minimum, Judge Holwell referenced the Paulson’s account of the conversations several different times in his opinion.

 

I am not aware of a prior case where the statements of a former cabinet secretary in his or her memoirs has provided even a partial basis for the denial of a motion to dismiss in a securities class action lawsuit. The plaintiffs’ reliance on Paulson’s memoirs has to qualify as one of the more unusual ways that plaintiffs have established (at least for pleading purposes) that there was a difference between what the company was saying publicly and what its officials were saying behind closed doors. (The defendants will of course argue that there was no difference or if there was it is entirely explainable, which of course are arguments they will raise as the case goes forward.)

 

It is interesting to reflect on the sheer fortuity of the fact that Paulson chose to report on those conversations in his book, and that his book was published at a time that allowed the plaintiffs to be able to rely on those statements in their amended complaint. Of course, all of this does mean that as (or perhaps if) the case goes forward, Paulson’s deposition in this case would appear to be inevitable. (Of course, this case is not the only one in which the underlying narrative involved Paulson; Paulson’s conversations with BofA CEO Ken Lewis in December 2008 also play a central role in the securities class action lawsuit arising out of the BofA/Merrill Lynch merger.)

 

It is also interesting to reflect that in the middle of one of the worst financial crises in the country’s history, Immelt could pick up the telephone and call the Treasury Secretary to tell him about the problems his company was having. The CEOs of a vast number of companies were also going through crises at that very moment, but very few of them had the option to call the Treasury Secretary to complain to him about their companies’ problems. It is rather remarkable, even given how large a company GE is, that Immelt had this option. Indeed, given what we know about what else Paulson had on his plate during September 2008 (i.e., avoiding the collapse of the entire  global financial system), it really is kind of astonishing that Immelt could just call him up and that Paulson could take his call.

 

In any event, this case will now be going forward. Given the size and prominence of the company, and the fact that the case has now survived the motion to dismiss, this case has to be added to the list of pending high-profile subprime and credit crisis-cases worth watching. Very few of these cases go to trial; most settle. In this and some of the other high profile credit crisis cases – Citigroup; the BofA/Merrill Lynch merger case; Bear Stearns; AIG – it will be very interesting to see how the likely settlements of these cases will unfold. Without knowing for sure how any one of them ultimately will turn out, there undoubtedly will be some very interesting settlements from among these cases.

 

I have added Judge Holwell’s ruling to my tally of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here.

 

More About the $40 Million Lehman Brothers Mortgage Backed Securities Settlement: The news that the parties to the Lehman Brothers mortgage-backed securities case had settled the suit for $40 million was announced in November 2011 (refer here). But the complete papers related to the settlement have only just been filed in the court docket. The papers reveal a few interesting details about the settlement.

 

First, the $40 million settlement is to be funded in two ways; $31.7 million of the settlement is to come from the company’s D&O insurance and $8.3 million is to come from Lehman Brothers Holdings itself. As the January 13, 2012 memorandum in support of the plaintiffs’ unopposed motion for preliminary approval of the settlement states, the bankruptcy court supervising the Lehman bankruptcy has approved the release of funds for these purposes.

 

Second, the parties’ settlement stipulation contains in interesting detail about the source of the D&O insurance funds for the settlement. The stipulation states (at page 15) that the $31.7 million insurance contribution to the settlement is to be paid by “certain insurers (‘Insurers’) that issued directors and officers insurance policies to LBHI, for the 2007-2008 and 2008-2009 policy periods.” What is interesting about this statement is that it suggests that the funds for this settlement are coming from two different policy periods.

 

In an earlier post (here), in which I discussed the $90 million settlement of the securities suit involving former Lehman executives, I had determined that the $90 million amount, together with defense expenses and other amounts, exhausted about $200 million of the applicable $250 million insurance tower. Based on that analysis of Lehman’s insurance, I would have assumed that the $31.7 million insurer contribution was drawn from what was left of the $250 million tower.

 

However, the reference in the parties’ settlement stipulation to the two different policy years suggests that a second tower of insurance has been broached and is being drawn upon in payment of losses arising from Lehman’s collapse.

 

In an earlier post (here) about how rapidly defense expenses were eroding Lehman’s D&O insurance, I had determined that during the 2007-08 policy period, Lehman carried a total of $250 million in insurance. I had noted that, though Lehman did not file for bankruptcy until September 2008, the May 2007-May 2008 insurance tower was the one implicated, because the first of the securities class action lawsuits was filed during that policy period and the subsequent matters related back to that initial filing (or so the insurers) argued. I noted that Lehman carried a separate $250 million tower of insurance for the May 2008 to May 2008 policy period, but that up to that point the losses had accumulated only with respect to the earlier of the two insurance programs. When I later analyzed the $90 million settlement on behalf of the directors and officers, I assumed for purposes of analysis that only a single $250 million tower was available for all purposes in connection with the Lehman collapse.

 

The cryptic note in the parties’ settlement stipulation in connection with the $40 million Lehman Brothers mortgage-backed securities settlement suggests, for the first time to my knowledge, that the second tower of insurance had been drawn in and is funding losses attributable to the events surrounding Lehman’s collapse. It would certainly change things (for example, the way that the prior $90 million settlement looks) if there were to be two insurance towers totaling $500 million potentially available in connection with these matters, rather than only a single $250 million tower.

 

If there were to be two towers rather than just one, the losses from the Lehman debacle could wind up being far more costly for the D&O insurance industry than has been assumed (depending of course on how extensive the second tower’s involvement ultimately proves to be). I suspect there are a number of readers out there who may have additional insight on these issues. I welcome additional perspective that any reader may be willing to provide (anonymously if that is the preferred approach).

 

In any event, this settlement is just further corroboration for a point I have long made about the litigation arising out of the subprime meltdown and credit crisis – that is, when all is said and done, this litigation, taken collectively, will prove to have been a massive loss event for the D&O insurance industry.

 

The Totally Awesome Sledding Crow: Here at The D&O Diary, we never, ever waste our time looking at Internet videos of animals doing amusing things. Just the same, we were distracted by this video of a crow that to all appearances is engaged in trying to perfect his snowboarding style. Watch this video carefully. The crow, standing at the apex of a snow covered roof, slides down the incline on a plastic lid. The crow then picks up the lid and tries to slide down another part of the roof. But when that doesn’t work, the crow picks up the lid, returns to the original spot, and slides down the roof again.

 

A scientific discussion of the crow’s behavior can be found in this January 13, 2012 article in The Atlantic (here). While science cautions against ascribing anthropomorphic explanations for animal behavior, I find myself imagining that as the crow is sliding down the roof, he is singing to himself “If everybody had an ocean/across the U.S.A./then everybody’d be surfin’/like Caiforn-Aye-Yay…”

 

 

https://youtube.com/watch?v=DYcgL7Nif30

The tone public companies use in their disclosure statements can affect the companies’ susceptibility to securities class action litigation, according to a recent academic study. The authors found that firms hit with securities litigation generally used more optimistic language in their disclosure statements than did firms that were not sued. Based on these findings, the authors conclude that managing “disclosure tone” could provide “a straightforward means of reducing litigation risk.”

 

In their November 2011 paper “Disclosure Tone and Shareholder Litigation” (here), University of Chicago Business School Professors Jonathan Rogers and Sarah L.C. Zechman and Ohio State Business School Professor Andrew Van Buskirk set out to determine whether or not corporate managers’ use of optimistic language increases litigation risk. Using statistical techniques, they examined the extent to which differences in qualitative language are systematically related to differences in litigation risk.

 

The authors began by examining a range of plaintiffs’ complaints, in order to determine which disclosure channels are likeliest to affect the probability of litigation. Based on their review, the authors determined that the earnings announcements are the most consistently cited type of communication referenced in plaintiffs’ complaints.

 

The authors then used dictionary-based measures of optimism to analyze the tone used in the portions of earnings announcement that plaintiffs chose to quote in their class action complaints. In order to determine whether or not the sued firm’s disclosures were “unusually optimistic” the authors compared the tone of the sued firms’ earnings announcements to the tone of disclosures made my non-sued firms at the same time, in the same industry and experiencing similar economic circumstances. The authors concluded that the firms that are hit with securities class action lawsuits use “substantially more optimistic language in their earnings announcements than do non-sued firms.”

 

The authors also took a look at the combined effect of optimistic language and insider trading. The evidence they reviewed “is consistent with optimism and insider selling jointly affecting litigation risk.” The interaction between optimism and “abnormal insider selling” is “associated with an increase probability of being sued.” The authors found no evidence that insider selling on its own exposes the company to increased litigation risk; insider selling is “only associated with litigation when firm disclosures are optimistic.”

 

The authors’ conclusions suggested to them some ways that companies can try to mitigate litigation risk. That is, though disclosure tone “is certainly not the sole determinant of litigation,” disclosure tone “is both associated with litigation risk and under the discretion of management.” All of which led the authors to conclude that “monitoring and adjusting disclosure tone could provide a straightforward means of reducing litigation risk” – that is, “managers can reduce litigation risk by dampening the tone of disclosure.” On the other hand, the authors also note that shareholder litigation can be “an effective ex post mechanism” to assure investors that managers “are not simply engaging in cheap talk when they use positive language.”

 

One final note about the authors’ methodology. In order to quantify the tone used in firms’ disclosures, the authors used a form content analysis that relies on a pre-specified word list. The analysis simply counts the occurrence of words characterized defined as optimistic or pessimistic based on prior research and linguistics theory. However, rather than relying on a single categorization, the authors used three different libraries of words, each of which was used to study firm disclosures. The word counts using the three measures were then compared against a benchmark standard that was based upon a control group of non-sued firms. The sued firms “optimism” was then compared against the benchmark standard. The authors also applied control variable to isolate the effect of a firm’s optimism that is driven by management discretion, rather than by the firm’s economic circumstances.

 

Discussion

On the one hand, the authors’ analysis might seem simply confirm a common sense proposition that companies that are hype-ish with their disclosures are likelier to get sued. But a closer reading of the authors’ analysis suggests that the authors have established a more specific and more important conclusion. That is, the authors’ analysis establishes that there is a direct statistical relationship between a firm’s use of unusually optimistic language and the likelihood of the firm being sued. This statistical relationship has two important implications.

 

First, the existence of this relationship could have important D&O insurance underwriting implications. D&O insurance underwriters interested in selecting away from companies that are likelier to be sued in securities class action lawsuits will want to develop tools to help them identify disclosure statements that are unusually optimist. The key here is that the predictive relationship is based on the use of unusually optimistic language. That is, in order for an underwriter to use the existence of the relationship as a risk selection tool, the author would have to have a developed ability to determine what constitutes unusual optimism.

 

In connection with the D&O underwriting implications of the authors’ analysis, it is also significant to note the added relationship the authors found about the interaction of optimistic disclosure and unusual insider trading. The two factors together had a combined predictive effect. In other words, the presence of insider selling in combination with overly optimistic disclosure is particularly predictive of securities litigation risk.

 

The other significant implication of the authors’ analysis has to do with their conclusions about how companies might mitigate their securities litigation risk. There is definitely some good news in the authors’ report. That is, companies that are interested in trying to control their securities litigation risk exposure can reduce their litigation risk by managing their disclosure language. The authors’ conclusion in this regard are consistent with larger messages that many of us who advocate securities litigation loss prevention have been preaching for year – that is, that companies can control their securities litigation exposure by managing the disclosure process, in order to avoid the kinds of statements that attract the unwanted attention of class action securities lawyers.

 

The SEC has commenced an enforcement action against a private company and its former Chairman and CEO in connection with the company’s repurchase of company shares from company employees and others prior to the company’s acquisition.

 

The action involves Stiefel Laboratories, which prior to its April 2009 acquisition by GlaxoSmithKline for $68,000 a share, was, according to the SEC “the world’s largest private manufacturer of dermatology products.”  On December 12, 2011, the SEC filed a complaint (here) in the Southern District of Florida alleging that the company and Charles Stiefel, its former chairman and CEO, defrauded shareholders by buying back their stock at “severely undervalued prices” between November 2006 and April 2009. The SEC’s December 12, 2011 press release about the enforcement action can be found here.

 

The company had an Employee Stock Bonus Plan through  which employees gained ownership of company shares. The company also engaged in direct share transactions with other shareholders. Because the shares did not trade on public markets, company share purchases were essentially the only way for shareholders to liquidate their shares of company stock.

 

The price for company share purchases was set through an annual l third-party share valuation each March. The company relied on a third-party accountant to perform the valuation. However, the SEC alleges that the accountant “used a flawed methodology and was not qualified to perform the valuations.” In addition, the SEC alleges that that shareholders were not told that after the valuation process, the defendants “discounted the stock by an additional 35%.”

 

In addition, beginning in 2006, the company began a series of conversations that culminated in the April 2009 sale of the company to Glaxo Smith Klein. During the course of these various discussions, the defendants received a series of valuations that were significantly higher than the third party valuation used for share repurchase purposes. The company did not advise employees or the accountant who performed the annual share price valuation of these much higher valuations. In addition, the company not only did not inform the employees about the ongoing negotiations, but repeatedly indicated that the company would remain private.

 

While these discussions were going forward, the company continued to repurchase company shares at valuations that were significantly below both the valuations that the prospective company buyers were using and that were also well below the ultimate sale price of $68,000 per share. Thus between November 2006 and April 2007, the company purchases 750 company shares at $13,012 a share. Between June 2007 and June 2008, the company purchased more than 350 additional shares at $14,517 a share, and bought an additional 1,050 shares from shareholders outside the Plan at an even lower stock price. Between December 3, 2008 and April 1, 2009, the company purchased more than 800 shares of its stock from shareholders at $16,469 per share.

 

The SEC alleges that shareholders lost more than $110 million from selling their shares back to the company based on the misleading share valuations. The SEC alleges that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, by repurchasing the shares at undervalued prices and in reliance on undisclosed material information, including both the higher valuations and the possibility of the company’s sale. The SEC’s complaint seeks declaratory relief, permanent injunctive relief, an officer and director bar, disgorgement and civil penalties.

 

Discussion

The allegations against the company and its former Chairman involve alleged misconduct that took place when the company was still a private company. I suspect that many readers will be surprised to learn that an SEC enforcement action against or in connection with the actions of a private company.

 

As explained in a January 10, 2012 memorandum from the Stites & Harbison law firm (here), Rule 10b-5 “prohibits, in connection with the purchase or sale of any security (public or private) making any untrue statement or omitting to state a material fact necessary in order to make the statements not misleading.” The allegations against the defendants here present a “cautionary tale for any private company,” underscoring the fact that federal and state securities laws govern even private company securities transactions and “restrict small closely held firms no differently than they restrict large, publicly-held corporations.” 

 

The law firm memo emphasizes that a private company in possession of material nonpublic information that is under a contractual obligation to consummate a transaction involving its own securities could face a dilemma — for example, a pending transaction may put the company in a position where it may neither disclose pending negotiation nor abstaining from repurchase obligations under stockholder or similar agreements. The memo’s authors observe that private companies should “thoughtfully scrutinize the structure of a transaction in its own securities and would be well served to tailor corporate policies to ensure compliance with securities law obligations.”

 

The SEC’s allegations here present a cautionary tale in another sense as well. Some private company D&O insurance policies may be procured or written based on the assumption that, because the company is privately held, the company and its directors and officers face no potential liability under the federal securities laws. Or at a minimum, D&O insurance policies may be structured with insufficient awareness about the possibility that even a private company potentially could fact liability under the federal securities laws. This case shows that a company and its officials can fact potential liability under the securities laws in connection with transactions involving the companies own securities, even if the company’s shares are not publicly traded.

 

Of particular concern here is the securities offering exclusion found in many private company D&O policies. The wordings of these exclusions vary widely. Depending on the wording used in any particular private company policy, the exclusion might potentially preclude coverage for the type of claim presented here. The best versions of these types of exclusions specify that they do not apply unless the company has conducted an initial public offering. But as this case highlights, a private company D&O policy could be called upon to respond to an action alleging a securities law violations; indeed, it could be called upon to respond to an SEC enforcement action even where, as here the company’s shares are not publicly traded and where there has been no IPO. There might ultimately be no coverage under the policy for amounts representing disgorgements or fines or penalties, but the question of whether or not there is coverage for defense expenses (which could be quite substantial) could well depend on the wording of the securities exclusion.

 

All of which means, at a minimum, that the wordings of the securities offering exclusion in private company D&O insurance policies need to be reviewed closely with an eye toward the possibility of claims of this type.

 

Don’t Be That Guy: According to a January 12, 2011 Wall Street Journal article (here), Alan Gilbert, the conductor of the New York Philharmonic, brought a performance of Mahler’s Ninth Symphony to a halt when the orchestra’s performance of the music piece’s final movement – a sonorous rumination on the meaning of mortality – was interrupted by a persistent cellphone ringtone the article described as having a xylophone sound with a marimba beat. The cellphone’s owner apparently was seated in the front row at the performance at Avery Fisher Hall. 

 

I suspect that the next time the cellphone owner is asked to turn off their cellphone, he or she will actually make sure the phone is powered down.

 

The number of publicly traded companies that filed for bankruptcy protection under either Chapter 7 or Chapter 11 declined in 2011, compared to the year prior, although the 2011 bankrupt companies collectively  listed greater amounts of pre-petition assets than 2010 bankrupt public companies did, according to data recently released by BankruptcyData.com (here).

 

According to the report, 86 publicly traded companies filed for bankruptcy protection in 2011, compared to 106 in 2010, and compared to 211 in 2009. The number of 2011 filings represents a 17% decline from the prior year, and nearly a 60% decline from 2009. Though the number of public companies filing for bankruptcy declined in 2011, the 2011 public company bankruptcies represented aggregate pre-petition assets of $104 billion, compared to $89.1 billion in assets in 2010. The 2009 public company bankruptcies represented $281 billion in assets.

 

The company average pre-petition assets rose to $1.2 billion in 2011 from $840 million in 2010. The increase in aggregate and average assets that the 2011 bankruptcies represent is largely a factor of two very large public company bankruptcies during the year: the $40.5 billion asset MF Global bankruptcy and the $25 billion AMR Corporation bankruptcy. Those two bankruptcies alone represented more than close to two thirds of all of the aggregate 2011 asset value. The MF Global bankruptcy represents the eighth largest U.S. bankruptcy of all times. None of the bankruptcies in 2010 are among the top ten. The two large 2011 public company bankruptcies had the effect of driving up the average bankruptcy size during the year.

 

The report notes that the increase in aggregate and average pre-petition asset size during 2011 is “all the more striking considering the low number of financial company bankruptcy filings” during the year. Bankruptcies in the Banking & Finance industry “typically reflect a higher pre-petition asset figure than other industries.” But there were only four public company bankruptcies in the sector during 2011, compared with 2010, when 21 of the 106 public traded bankruptcies involved companies in the Banking & Finance sector.

 

The sector with the largest number of 2011 bankruptcies was Health Care & Medical, which had a total of 11 bankruptcies; followed by Technology and Energy which each had nine filings each.

 

Though the number of public company bankruptcies has declined in each of the last two years, the public company bankruptcies remained at elevated levels. The 86 public company bankruptcies in 2011, though below the annual totals in 2010 and 2009, are above the totals in the years preceding the credit crisis and going all the way back to 2005, when there were also 86 public company bankruptcies.

 

In terms of what may lie ahead, the report includes the comments of one observer, George Putnam III, the founder of New Generation Research, BankruptcyData.com’s parent company, as saying that, “I expect to see an increase in bankruptcies in 2012 as some of the massive amount of debt that was issued before 2008 begins to come due.” These comments about the likely bankruptcy levels are consistent with other public commentaries (refer here) that have also suggested that 2012 could be a busy year for business bankruptcies.

 

A January 10, 2012 Los Angeles Times article about the public company bankruptcy data can be found here.

 

In several recent posts (most recently here), I have written about the problems associated with the growing wave of M&A related litigation. In writing about this topic, I have tried to marshal the evidence supporting my position, but for many reasons my analysis has been more descriptive than statistical. However, I have been provided with advance access to some of the data from a forthcoming Cornerstone Research publication to be entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions.” The data provide interesting additional statistical perspective on the recent M&A-related litigation trends.

 

UPDATE (as of Jan. 17, 2012): Cornerstone has now released its report, entitled "Recent Develpments in Shareholder Litigation Involving Merger and Acquisitions" (here) online. The full report iincludes additional information beyond what is discussed in this blog post.

 

In their preparation of the report, Cornerstone Research reviewed SEC filings related to acquisitions of U.S. public companies valued at $100 million or greater and announced during 2010 and 2011. For purposes of historical comparison, Cornerstone Research also collected information on litigation related to deals announced in 2007 valued at $500 million or greater.

 

Based on their review, Cornerstone Research identified 789 lawsuits filed in connection with U.S. public company acquisition transactions valued at $100 million or greater and announced in 2010 and 696 lawsuits for deals of that size announced in 2011.

 

Cornerstone Research found that litigation arose in connection with 91% of all deals announced during the 2010-2011 period with values greater than $100 million. The average number of lawsuits per deal announced during that period was 5.1. Both of these figures grow relatively larger as the size of the deals grows larger. Thus for deals announced in 2010-2011 with valuations between $100 million to $500 million percentage of deals involving litigation is 85%, and the average number of lawsuits per deal is 4.1, while 96% of all deals valued over $1 billion during that period attracted litigation, and averaged 6.1 lawsuits per deal.

 

Certain deals announced during the 2010-2011 proved to be particularly litigation attractive. For example, Blackstone’s $600 million acquisition of Dynegy attracted 29 lawsuits. Express Scripts’ $29.3 billion acquisition of Medco Health Solutions attracted 22 lawsuits. Attachmate’s $2.2 billion acquisition of Novell attracted 19 lawsuits. Overall, there were nine deals during that period valued at $100 million or greater that attracted 15 or more lawsuits.

 

To provide historical perspective, Cornerstone Research compared M&A litigation in 2007 and in the 2010-2011 periods, by comparing deals valued greater than $500 million announced in each of those two periods. There were 289 lawsuits in connection involving deals of that size in 2007 and 557 involving deals of that size in 2010, representing a 92% growth in the absolute number of lawsuits between the two periods. There were 473 lawsuits involving deals of that size that were announced in 2011, which is 63% higher than in connection with deals of that size announced in 2007.

 

Obviously, this growth in the absolute number of lawsuits might be attributable to an increase in the level of M&A activity involving deals greater than $500 million. In fact, there were 195 deals valued over $500 million that were announced in 2007, but only 108 and 80 deals valued over $500 million that were announced in 2010 and 2011, respectively.

 

The Cornerstone Research analysis shows that only 50% of the deals valued at $500 million or greater announced in 2007 attracted litigation, whereas 95% of the comparably sized deals announced in 2010 attracted litigation, and 96% of such deals announced in 2011 attracted litigation. In other words, the litigation activity was both absolutely and relatively greater for deals valued at $500 million or greater in the 2010-2011 period compared with comparably sized deals announced in 2007.

 

In addition, the number of lawsuits filed per deal has also increased. Deals valued at greater than $500 million announced in 2007 attracted an average of 2.8 lawsuits, whereas deals of that size announced in 2010 attracted an average of 5.4 lawsuits, and deals of that size announced during 2011 attracted an average of 6.1 lawsuits.

 

One of the recurring questions associated with the increase in M&A-related litigation has been whether or not courts in Delaware, traditionally the forum of choice for this type of litigation, has been losing “market share” to other jurisdictions that may be perceived as more plaintiff-friendly. The Cornerstone Research analysis suggests that Delaware’s courts are not in fact losing market share, at least with respect to deals meeting Cornerstone’s criteria.

 

Cornerstone Research’s analysis of this issue compares deals involving Delaware incorporated companies that were valued at greater than $500 million announced in 2007, on the one hand,  to deals involving Delaware incorporated companies where the deal was valued at greater than $500 million and announced in 2010-2011, on the other hand.

 

The Cornerstone Research analysis shows that in terms of where the lawsuits were filed in the two respective periods, in 2007, 34% of the lawsuits were filed in Delaware, while in the 2010-2011 period, 41% of the lawsuits were filed in Delaware.

 

This analysis is reinforced when the lawsuits are looked at on a per deal basis. Looking at the venue of lawsuits in which acquisitions involving Delaware incorporated companies were being challenged, the Cornerstone data show that 29 of the 2007 deals involved at least one lawsuit filed in Delaware, and 32 of the deals involving only litigation outside Delaware. By comparison, in 2011, 41 of the deals had at least one lawsuit filed in Delaware, and just nine of the deals involved litigation only outside Delaware. In other words, in the later period, a much greater portion of the deals involved litigation in Delaware, either exclusively or in combination with litigation in other jurisdictions, and a much smaller proportion of the deals involved only litigation outside Delaware.

 

Discussion

The Cornerstone Research data tend to corroborate many of the points I have made in recent posts on this blog – that is, M&A litigation is increasing, on both an absolute and relative basis; that a much higher percentage of deals is attracting merger objection litigation; and the average number of lawsuits per deal is also increasing.  The Cornerstone Research analysis is particularly interesting with respect to the number of deals that are attracting unusually higher numbers of lawsuits.

 

The data in the Cornerstone Research report are directionally consistent with many other data sources I have cited in prior blog posts on this topic, but the Cornerstone figures appear to differ in certain specific details. For example, the Cornerstone Research analysis suggests that a much higher percentage of deals attract merger objection lawsuits than the figures in other reports have suggested (refer here, for example).

 

There likely are many explanations for the differences in the details between the Cornerstone Research data and other reports, but one particular aspect of the Cornerstone analysis should be kept in mind. That is, the Cornerstone Research analysis for the 2010 and 2011 period involves only M&A transactions with announced values greater than $100 million. Deals involving smaller valuations and the related litigation are not a part of the Cornerstone Research analysis. By the same token, Cornerstone Research’s historical analysis refers only to deals announced in the 2007 period with valuations greater than $500 million, which omits an even broader range of deals (and related litigation) based on the size of the deal valuations. These data set definitions could result, at a minimum, in differences between the Cornerstone Research data and other analyses of comparable time periods.

 

But in any event, the Cornerstone Research analysis makes a very important contribution to the consideration of these issues. The Cornerstone Research report clearly shows that M&A related litigation is becoming a more significant issue. With the increasing average numbers of lawsuits per deal, M&A-related litigation is becoming an increasingly more costly problem, as the increased numbers of lawsuits in multiple jurisdictions means both procedural complications and increased defense expense.

 

The Cornerstone Research analysis of the Delaware court “market share” issue could prove to be particularly interesting. The question whether or not litigants are self-selecting away from Delaware is and will be a very hot topic. The stakes are high, as the continued involvement of Delaware courts in corporate and securities litigation could determine whether or not Delaware’s courts continue to play a leading role on legal issues in these areas. And on a more practical level, if Delaware’s courts are not losing market share after all, there is no reason for its judges to be as concerned with attempting to curry favor with the plaintiffs’ bar in order to preserve market share.

 

The Cornerstone Research data certainly offers a variety of interesting statistical perspectives on the issues surrounding the growth of M&A litigation. We can all look forward to the forthcoming publication of Cornerstone Research’s complete report on these issues.

 

Very special thanks to Cornerstone Research for their willingness to share this data with me and with readers of this blog.