The rating agencies are not entitled to First Amendment protection for their ratings of securities backed by mortgages originated at defunct Thornburg Mortgage, a federal judge has ruled. In a massive 273-page November 12, 2011 opinion that addresses a number of issues involved with the defendants motions’ to dismiss the securities class action lawsuit filed on behalf of the purchases of the Thornburg Mortgage Pass-Through Certificates, District of New Mexico Judge James Browning held that though the rating agencies’ ratings represent opinion,  the First Amendment does not protect the rating agencies opinion, due to the characteristics of the securities offerings involved.

 

A copy of Judge Browining’s opinion can be found here. Nate Raymond first reported on the opinion in his November 23, 2011 Am Law Litigation Daily article (here).

 

As discussed at greater length here, the plaintiffs first filed their lawsuit in March 2009, alleging that the documents prepared in connection with initial offering of the securities contained material misrepresentations and omissions. The plaintiffs alleged that they did not accurately disclose the practices involved with the origination of the mortgages underlying the securities. The defendants included the investment banking firms involved with the issuance, underwriting and distribution of the securities. The defendants also included a number of individuals who signed the registration statements. The plaintiffs also sued the rating agencies that had provided ratings of the securities in connection with the offerings. The defendants moved to dismiss.

 

In his lengthy November 12 opinion, Judge Browning granted in part and denied in part the defendants’ dismissal motions. With respect to the credit rating agencies, Judge Browning held that the plaintiffs have sufficiently pled allegations about material misrepresentations or omissions with respect to McGraw-Hill Companies and Standard & Poor’s Rating Services, but not against Fitch; Fitch Ratings; Moody’s Corp.; or Moody’s Investor Services.

 

Judge Browning also held that the First Amendment does not bar the plaintiffs’ claims against the rating agency defendants. In holding that the First Amendment does not protect the rating agencies opinions (at pages 228 through 235 of the opinion), Judge Browning among other things determined that the ratings did not address a matter of public concern. In reaching this conclusion, Judge Browning noted that plaintiffs had not alleged that the rating agency defendants “ever published their ratings to the public at large”; to the contrary, the plaintiffs’ alleged the ratings appeared only in the offering documents, which were “specifically targeted institutional investors for the investments.”

 

Judge Browning also noted that “the ratings related to statutory trusts, and not publicly traded companies, which would qualify as public figures.” The ratings “impacted only the limited group of investors who received the offering documents, the Thornburg trusts, and the companies involved with those Thornburg trusts, as opposed to the public at large.” 

 

Judge Browning said that the “general public’s interest in the free flow of advertising” is “distinguishable” from “providing credit ratings in offering documents given to a select group rather than the public at large.”

 

Though Judge Browning concluded that the plaintiffs’ allegations against certain of the rating agency defendants were sufficient to state a claim under New Mexico’s blue sky laws, he also found that the plaintiffs had not met jurisdictional requirement for the statute to apply. He allowed the plaintiffs’ leave to amend their complaint in order to s the show that the securities involved had been sold in the state.

 

Judge Browning is not the first to rule that the rating agencies’ ratings are not protected by the First Amendment, at least under the facts at issue. Indeed, Judge Browning cited and quoted from Judge Shira Scheindlin’s September 2009 in the Cheyne Financial case (about which refer here). In addition, a California state court judge ruled in an action against the rating agencies brought by Calpers that the rating agencies were not entitled to First Amendment protection (refer here).

 

Judge Browning’s opinion may nevertheless represent something of a breakthrough, because it is, according to the plaintiffs’ attorney quoted in the Am Law Litigation Daily article linked above, the first holding in a class action lawsuit that the rating agencies were not entitled to First Amendment protection.

 

But while the ruling may be, as the plaintiffs’ lawyer is quoted as saying the article, “groundbreaking,” this developing body of case law may not control the analysis in many contexts. Like Judge Scheindlin in the Cheyne Financial case, who held that the First Amendment does not apply when a rating agency disseminates ratings to a select group of investors and not the public at large, Judge Browning found it determinative of the issues that the ratings at issue appeared in documents that were distributed only to institutional investors and did not involve publicly traded companies.

 

These rulings still allow the rating agencies room to argue that their ratings are entitled to First Amendment protection where the ratings were distributed to a broader audience, involve publicly traded companies or otherwise involve matters of public interest. But thought the holdings in these cases have limitations, they nevertheless represent a growing body of case law that circumscribes limitations in rating agencies’ assertions of First Amendment defenses. 

 

Am I the Only One Who Worries About What Black Friday Says About Us as a Society?: From the front page of the Cleveland Plain Dealer, Saturday, November 26, 2011: “At Westfield SouthPark mall, police were called to Victoria’s Secret at 4:05 a.m. – five minutes after opening – to what a police report called a ‘riot.’”

 

Among the most contentious D&O claims issues are questions surrounding defense cost coverage, including in particular questions such as the allowable billable rates or the involvement of multiple firms.  In a detailed November 8, 2011 opinion, Eastern District of California Judge Lawrence O’Neill, applying California law, addressed the hornets’ nest of problems involved when these kinds of questions arise. Though the disputes involved in this case are in some ways very case-specific, the case nevertheless provides (if only by way of negative example) a good illustration of how these questions might be avoided, managed or minimized. A copy of Judge O’Neill’s opinion can be found here.

 

Background

Lance-Kashian & Company is the general partner of River Park Properties III (RPP III), which in turn was general partner of Park 41, a real estate partnership.  In late 2008, Lance-Kashian’s D&O policy was up for renewal. The company’s risk manager directed that RPP III’s name be removed from the policy as a named insured. The D&O insurance policy that was in force for 2009 did not include RPP III as a named insured.

 

In late 2009, Lance-Kashian, RPP III, and certain Lance Kashian principals were sued in a bankruptcy court adversary proceeding by the Park 41 limited partner. The company notified its D&O insurer of the claim and asked the insurer’s permission to use the Cozen O’Connor law firm as defense counsel. In late December 2009, the insurer acknowledged receipt of the claim, reserved its right to deny coverage under the policy, and consented to the Cozen O’Conner firm’s involvement in the defense, but only at specified maximum rates (partner: $350/hour; associates: $250; paralegals, $150/hour). In light of the fact that RPP III was a defendant but was not an insured under the policy, the carrier proposed to allocate the defense fees between covered and non-covered parties, allocating one-third to the covered parties and two-thirds to the non-covered RPP III. The carrier argued in support of this proposed allocation that the bulk of the claims in the underlying complaint related solely or primarily to RPP III.

 

The carrier’s initial letter was the first in lengthy series of communications between the carrier’s counsel and the company’s risk manager. Judge O’Neill’s opinion details these communications, largely conducted by email. The parties later disputed the extent to which the communications either expressly or by silence amounted to the company’s assent to the allocation and defense counsel arrangements that the carrier has proposed.

 

At least part of the email exchange confirmed the carrier’s approval in the association in the defense of the Walter Wilhelm firm at the same specified maximum rates. In a separate email, the risk manager notified the carrier of the involvement of another firm, the Allen Matkins firm, which, the risk manager advised “would probably be used as an expert witness versus defense counsel.”

 

The company’s risk manager later submitted to the carrier invoices from the various law firms for payment. The invoices in turn set off an exchange about the aggregate level of fees, the involvement of multiple counsel, and concerns about the role of the Allen Matkins firm.

 

In January 2011, the underlying adversary proceeding finally settled. In connection with the subsequent coverage litigation, the risk manager submitted a declaration stating that the total defense expenses incurred in the case were “at least $1,557,295,” of which $618,251 was paid to the Allen Matkins firm; $475,000 was paid to Cozen O’Connor; $124,777 was paid to the Walter & Wilhelm law firm; and $144,133 was paid directly to third party vendors. At that point, the carrier had paid approximately $70,000 in connection with the defense.

 

The carrier initiated a civil action seeking a judicial declaration that it was only obligated to pay one third of the attorneys’ fees to which it had consented (that is, the Cozen  O’Connor fees and the Walter  Wilhelm fees) and only at the specified maximum hourly rates. The company disputed that the carrier was entitled to any type of allocation of the defense expenses or that any portion of the defense fees were not covered. The company counterclaimed, asserting claims of breach of contract and of breach of the covenant of good faith and fair dealing. The company asserted several arguments in reliance on various parts of the California insurance code, which the company asserted governed in light of the carrier’s provision of the defense subject to a reservation of its rights. The parties filed cross-motions for summary judgment.

 

The November 8 Ruling

In his November 8 ruling, Judge O’Neill granted the carrier’s summary judgment motion “to the effect that [the carrier] reasonably set and allocated defense costs for counsel to which it had consented.” First, Judge O’Neill concluded that while the carrier had consented to the involvement in the defense of the Cozen O’Connor firm and the Walter Wilhelm firm at the specified hourly maximum rates, “the insureds point to no specific request accepted by [the carrier] for Allen Matkins’ retention.” 

 

Second, Judge O’Neill rejected the company’s argument that the carrier was obligated to reimburse all defense fees that were “reasonably related” to the insured persons’ defense. He concluded that the question was instead governed by the policy’s allocation provision, which specified that if a claim involved both covered and uncovered matters or parties, the insureds and the carrier would “use their best efforts to agree on a fair and proper allocation between insured and uninsured Loss.” The provision does go on to add: “However, [the carrier] shall not seek to allocate with respect to Claim Expenses and shall pay one hundred percent (100%) of Claim Expenses so long as a covered matter remains within the Claim.”

 

Judge O’Neill found that the record showed that the carrier “committed its best efforts to reach an allocation agreement, starting with the ROR letter and continuing with [its counsel’s] dogged efforts through numerous emails.” However, he added, “the same cannot be said for the insureds,” commenting further that “the inferences from the record are that the insureds devoted substantial efforts to attempt to settle the underlying action and decided to address allocation and insurance matter later.” There is, Judge O’Neill found “no evidence that the insureds used ‘best efforts’ to agree to an allocation.”

 

Judge O’Neill went on to reject the company’s argument that the final sentence of the allocation provision, allowing for a 100% defense cost allocation, obligated the carrier to pay 100% of defense costs. He found that the sentence obligated the insurer to pay only 100% of the defense costs of insured persons, but that the carrier has no obligation to pay the defense costs of persons who are not insured under the policy. Since the company and RPP III mounted a joint defense, the carrier is entitled to allocate the defense fees to remove the fees incurred on behalf of insured persons. Since the company “offered nothing meaningful” to “challenge” the carrier’s proposed allocation, and since “nothing in the record reveals that [the carrier’s] one-third allocation to the insureds was unreasonable or out of line with the insured’s potential liability,” he confirmed the carrier’s one-third allocation.

 

Judge O’Neill then turned to an unusual feature in the policy, which provided that the carrier’s determination as to reasonableness of claims expenses “shall be conclusive on the Insured.” He rejected the company’s argument that this provision is unconscionable, noting that “there is no conscience shocking that an insurer would seek to control defense and limit them to a reasonable range,” adding that the company was sophisticated and had the assistance of a full-time risk manager and broker, who bargained for the policy on the company’s behalf. He went on to note that “the insureds fail to demonstrate that [the carrier] was precluded legally to set the rates it would pay or that [the rates] were objectively unreasonable.”

 

Discussion

There are a number of lessons from this dispute, which I review below. There are also a number of noteworthy holdings that are worth highlighting before moving on the moral of the story.

 

First, it is interesting and important that Judge O’Neill rejected the company’s efforts to try to rely on the “reasonably related” standard and instead enforced the allocation provisions in the policy. The “reasonably related” standard harkens back to an earlier time and place when D&O policies did not have express allocation provisions. Judge O’Neill’s enforcement of the provision shows that the allocation provisions themselves control – although his interpretation of the 100% Defense Cost provision is also interesting, in effect holding that the 100% allocation does not operate to require the insurer to pay the defense costs of parties who are not insured under the policy. In effect, he held that the 100% defense cost allocation applied only when there are both covered and non-covered matters, but not when there are both covered and non-covered parties. (Those involved in counseling policyholders on policy placement will want to consider this distinction in thinking about the optimal wording for these kinds of provisions.)

 

Second, Judge O’Neill enforced the unusual (and frankly onerous) provision giving the insurer’s determination of reasonableness presumptive weight. It may have been that he felt that a sophisticated company with competent advice had to accept the contract it had negotiated. (Again, those involved in negotiating policy placements for policyholders will want to note and watch out for this type of unusual provision.) By accepting the carrier’s presumptive right on the reasonableness issue, Judge ONeill avoided getting into the issue of whether or not the carrier’s insistence on its maximum hourly rates was reasonable. Too bad, that is an issue that in my view could use some ventilation.

 

Third, and perhaps most significantly in terms of the dollars involved, Judge O’Neill held that the carrier had no obligation to pay (even according to the allocation) for the defense fees and expenses to which the carrier had not consented.

 

This last point leads to the moral of the story – which is the importance of communication with the insurer at the beginning, during the course of, and at the end of the claim. A significant number of the problems the company faced in the coverage dispute were due to the way the company communicated with the carrier. Indeed, Judge O’Neill emphasized, and even quoted twice from, the deposition testimony of the company’s CEO that during the claim and amongst all of the other business challenges the company was facing he considered the questions the insurer was raising to be a “distraction.” 

 

But the first of the lessons out of this coverage dispute comes from the deliberate move the company made at its insurance renewal to remove RPP III as an insured under its policy. This decision directly led to all of the allocation issues. The move clearly was not fully thought through because as soon as the claim came in naming both the company and RPP III, the company expected RPP III’s defense expense to be paid under the policy. This sequence shows the importance of thoughtfully addressing all potential coverage issues at the time of placement. Something as basic as who should be insured under the policy should be the subject of close consideration, and should be stress tested against likely claims scenarios. It isn’t just hindsight to say that even at the time of the renewal it was apparent that if there were to be a claim involving , say, Park 41, that both RPP III and the company would be named as defendants, and that both would require a defense. The company can bemoan the outcome of Judge O’Neill’s allocation analysis, but there wouldn’t have been an allocation in the first placed if RPP III had not been removed as a named insured under the policy.

 

The more generally applicable lesson is the importance of communicating fully and continuously with the carrier. The company here clearly understood that the carrier’s consent to defense expenses was required, yet failed to take the steps to obtain the carrier’s consent to the involvement in the defense of the Allen Matkins firm or of the third-party vendors who provided services in connection with the defense. This oversight was not a small matter since the fees of the Allen Matkins firm and the fees of the third party vendors together amount to almost half of all of the defense expenses that the company incurred. (It is probably worth noting that the company not only failed to keep the carrier informed but  misstated the role of the Allen Matkins firm as being related to expert testimony, while disclaiming the firm’s involvement in the defense.)

 

The company may well have viewed the carrier’s questions and concerns as a “distraction,” but in the end the company paid a price for disregarding the carrier’s concerns. It certainly did not help the company that Judge O’Neill could find “no evidence” that the company used its best efforts to try to negotiate an allocation. By the same token, it clearly hurt the company that it did not voice its objection to the carrier’s proposed maximum rates as well as to the allocation. In the end, Judge O’Neill’s conclusions that the allocation and rates were reasonable were eased by the fact that while the claim was pending the company evinced little objection to the carrier’s positions in the regard.

 

Of course it is always easier to say in hindsight what a company should have done. I do not mean to find fault within anyone. But I think it is clear that the better course is to keep the carrier fully informed; to confront and address issues as they come up, not after the fact; and to work out as many issues as possible at the time, rather than later. It may not always be possible to avoid disputes, but dealing with issues as they come up may reduce the number of issues in dispute. And it will certainly help to avoid any later suggestion that “best efforts” were not used to try to work the issues out.

 

Finally, the best way to avoid unwelcome coverage outcomes is to make sure as many issues as possible are addressed in advance, at the time of the policy placement. As this case show, critical issues like the identity of named insured and the presence of unusual provisions (like the presumption of reasonableness for the carrier in this policy) are best addressed at the time the coverage is placed, to avoid problems later. This lesson in turn underscores the importance of the involvement in the policy placement process of knowledgeable and experience professionals who understand the kinds of issues that may be involved if claims later arise.

 

Special thanks to Michael Goodstein of the Bailey Cavalieri firm for providing me with a copy of Judge O’Neill’s opinion. The Bailey Cavalieri firm represented the carrier in this case. I hasten to add that the views expressed in the post are exclusively my own and should not be imputed to any other person, living, dead or otherwise.

 

One of the thorniest D&O insurance coverage issues is the question of the applicability of a policy exclusion when coverage preclusive conduct has been alleged – but not proven. In a November 14, 2011 opinion (here), District of Oregon Judge Ann Aiken held that the mere allegations in the underlying claim, even if otherwise sufficient to constitute precluded “bad faith” within the meaning of a policy exclusion, were insufficient to preclude coverage where the underlying claim settled and the allegations were not proven. Though the specific exclusion involved is unusual, the dispute itself raises a number of interesting issues.

 

Background

Summit Accomodators, Inc. was in the business of facilitating so-called “1031 exchanges.” The company experienced liquidity issues in late 2008 and filed for bankruptcy. In June 2009, the trustee for the Summit Accomodators Liquidation Trust filed a civil action against Umpqua Bank, alleging that the bank knowingly aided and abetted the principals of Summit in the perpetration of a multi-million dollar Ponzi scheme.

 

Among other things, the trustee’s complaint alleged that “highest level of management at Umpqua Bank … became fully aware of the Ponzi scheme and the principals’ embezzlement. …Yet [the bank officials] continued to actively encourage and materially assist the Summit principals.” The bank is alleged to have aided the scheme by providing banking services including loans and by encouraging bank customers to use Summit’s services.  Additional lawsuits later arose. The suits were later consolidated and ultimately settled.

 

At the time the claims arose, the bank was insured under a D&O liability insurance policy. The insurer funded the bank’s defense in the litigation. However, the insurer disputed that the policy provided coverage for the underlying settlement. Ultimately, the insurer contributed 41% of the settlement amount. The bank sued the insurer for breach of contract (refer here for the bank’s complaint), seeking to recover the balance of the settlement amount from the insurer. The insurer answered the complaint and also counterclaimed for return of the 41% of the settlement that it had funded, arguing that there was no coverage under the policy for the settlement (refer here for the insurer’s Answer and Counterclaim).

 

In arguing that the policy precluded coverage for the settlement, the insurer relied on Policy Section V (illegal profit/payment exclusion):

 

The Insurer shall not be liable to make any payment for Loss, other than Defense Costs, in connection with any Claim arising out of or in any way involving:

1. any Insured gaining, in fact, any profit, remuneration, or financial advantage to which the Insured was not legally entitled;

2. payment by the Company of inadequate or excessive consideration in connection with the purchase of Company securities; or

3. conflicts of interest, engaging in self-dealing, or acting in bad faith. 

 

In disputing coverage, the insurer relied principally on subsection 3 of this provision, the “bad faith” exclusion.

 

The insurer moved for judgment on the pleadings, arguing that the applicability of the bad faith exclusion could be determined “based solely on the undisputed terms of the complaints in the underlying litigation against the bank.” (The insurer’s memorandum in support of its motion for judgment on the pleadings can be found here). The bank filed a cross-motion for summary judgment.

 

The November 14 Order

In her November 14, order, Judge Aiken denied the insurer’s motion for judgment on the pleadings and granted in part the bank’s cross-motion for summary judgment. In making her ruling, Judge Aiken did not construe the phrase “acting in bad fait,” or determine whether the underlying allegations constituted “bad faith,” as she deemed it sufficient to determine whether or not the exclusion could be triggered by the mere allegations in the underlying litigation.

 

The insurer had argued that the egregious allegations of the bank’s complicity in the alleged Ponzi scheme were sufficient to trigger the exclusion. In support of its contention that allegations alone were sufficient, the insurer argued that the reference in the policy’s definition of Wrongful Act to an “actual or alleged” act, error or omission was incorporated into all of the policy exclusions, setting up an “allegations alone” trigger for all exclusions. The insurer also contrasted subpart 1 of the exclusion at issue, which expressly required an “in fact” determination that that the precluded conduct occurred, with the “bad faith” subpart, which has no such “in fact” determination requirement.

 

Judge Aiken rejected these arguments.  First, she found that, contrary to the insurer’s “surreptitious interpretation,” the exclusion “does not actually state that it is triggered by allegations of bad faith,” and that “the word ‘alleged’ is at no point used within the exclusion.” She added that “in its attempt to avoid its contractual duty to indemnify,” the insurer “erroneously substitutes the term ‘alleged act’” in its interpretation of the exclusion.

 

Judge Aiken noted further that when the insurer “intended the policy exclusions to be activated by mere allegations, it did so expressly within the actual text of the policy.” She noted in that regard that both the policy’s Pollution Exclusion and its Bodily/Personal Injury and Property Damage Exclusion both expressly reference “alleged” activity or conduct as triggering the exclusion.

 

Finally, she noted that “at the very least,” the insurer’s “imprecise drafting allows the Exclusion to have more than one reasonable interpretation,” and accordingly she was required to construe the policy in favor of coverage.

 

Discussion

A recurring problem D&O insurers face is the question of their coverage obligations in circumstances  involving alleged egregious misconduct, when the misconduct has not yet been the subject of formal proof. Two scandals currently on the front pages of the business sections illustrate this issue. The newspapers are full of stories suggesting that MF Global improperly applied customer funds. Olympus Corp. has actually admitted that it misrepresented certain transaction costs in order to mask certain investment losses.

 

The general movement in most D&O insurance policies in recent years has been toward an “after adjudication” standard for conduct exclusions, meaning that the exclusionary language does not preclude coverage unless and until there has been a judicial determination that the precluded conduct has occurred. To the extent that the conduct exclusions in the MF Global or Olympus insurance policies apply only after an “adjudication,” the exclusions in those policies would not presently operate to preclude coverage notwithstanding the allegations or admissions involving the companies. Indeed, because so few directors and officers liability cases actually go to trial, there are rarely “adjudications” and so the preclusive effect of the conduct exclusions is rarely triggered.

 

I refer to these contemporary examples to highlight the fact that, at least as most current D&O insurance policies are written, D&O insurers are often called upon to provide coverage even in the circumstances involving egregious underlying allegations. Clearly, in the Umpqua Bank case, the insurer was deeply troubled by the allegations in the underlying complaint of the bank’s complicity in the alleged Ponzi scheme. But as disturbing as the trustee’s allegations may be, the mere fact that these things were alleged does not mean that any of these things actually happened or that they happened the way the trustee alleged.

 

The exclusion at issue in the Umpqua Bank case contained no “adjudication” requirement. It did not even, as the insurer pointed out, contain an “in fact” provision requiring that the precluded conduct occurred.  The absence of these types of provisions allowed the interpretation of the exclusionary language that the carrier took in this case, and makes the carrier’s position not unreasonable.

 

However, the exclusions’ lack of a specific trigger does not necessarily mean that mere allegations alone are sufficient to trigger the exclusion.Many (if not most) directors and officers liability complaints contain allegations asserting  “conflicts of interest, engaging in self-dealing, or acting in bad faith.” If those types of mere allegations alone were sufficient to preclude policy coverage, then the exclusion’s preclusive effect would reach so broadly that it would swallow up much of the intended coverage for which the policyholder purchased the policy in the first place. Certainly, it would seem that if the insurer was to narrow coverage so dramatically for mere allegations, then it ought to do so explicitly.

 

Indeed the potentially preclusive scope of this policy exclusion may explain why the exclusion is relatively unusual. Many purchasers and their advisors would find it better to avoid policies with this type of language, particularly given this insurer’s formulation of the language.

 

By the same token, the potential breadth of the exclusion’s preclusive effect is yet another reason to support Judge Aiken’s narrow interpretation. If the parties had intended mere allegations of  “conflicts of interest, engaging in self-dealing, or acting in bad faith” to preclude indemnity coverage, then the exclusion would have expressly included the word “alleged,” as was the case with the two other policy exclusions Judge Aiken referenced in her opinion. The presence of the word “alleged” in the other exclusions and its absence in the “bad faith” exclusion, at a minimum, allows, as Judge Aiken found, “more than one reasonable interpretation” of the question whether or not mere allegations are sufficient to trigger the “bad faith” exclusion.

 

Readers who are wondering why the name Umpqua Bank sounds familiar may recall that in an earlier post (here), I wrote about the derivative lawsuit that the shareholders of Umpqua’s holding company filed against company officials after t  62% of shareholders voted “no” in the advisory shareholder vote on the company’s 2010 executive compensation plan. The claims asserted in the lawsuit rely directly on the negative note.

 

FDIC Files Another Failed Bank Lawsuit: And speaking of bank litigation — the FDIC has filed another lawsuit against the former directors and officers of a failed bank. On November 18, 2011, the FDIC filed an action in the Western District of Washington against eleven former directors and officers of Westsound Bank, which failed on May 8, 2009. A copy of the complaint can be found here.

 

In its complaint, the FDIC seeks to recover at least $15 million in principal losses the bank suffered on 28 commercial loans. The complaint alleges that the defendants failed to properly supervise the bank’s lending operations. The complaint alleges that certain loans were approved in violation of the bank’s lending policies and in disregard of regulatory warnings.

 

The complaint further alleges that 21 fraudulent loans to the Russian/Ukrainian community would not have been made if the defendants had heeded regulatory warnings and properly supervised lending operations. Finally, the complaint seeks to recover losses on preferential loans that were made to directors and director-led companies.

 

The FDIC’s complaint against the former Westsound Bank officials is the 17th the agency has filed against former directors and officers of failed banks as part of the current wave of bank failures. Like many of the suits the FDIC previously filed, this one came well over two years after the bank’s failure. The sheer number and timing of the bank failures during the current wave (which now total over 400) and the FDIC’s deliberate litigation approach suggests that there are many other lawsuits to come in the months and years ahead.

 

The FDIC recently updated its professional liability lawsuits page on its website to reflect that the agency has approved an increased number of lawsuits. The updated page (here) shows that as of November 14, 2011, the FDIC has authorized suits in connection with 37 failed institutions against 340 individuals for D&O liability with damage claims of at least $7.6 billion. Though the FDIC has authorized lawsuits involving 37 institutions, it has filed only 17 lawsuits involving 16 institutions so far – suggesting that there are many lawsuits yet to come, just taking into account the lawsuits authorized so far.

 

With more lawsuits likely to be authorized in the future, and with banks continuing to fail (two more were closed this past Friday evening), it seem probable that the number of lawsuits involving former directors and officers of failed banks will continue to accumulate for years to come.

 

Cybersecurity Disclosure: In the quarterly Advisen webinar last week, one of the topics discussed was the SEC’s new disclosure guidelines regarding cybersecurty risks and exposures. Readers interested in learning more about the SEC’s guidelines will want to refer to the November 17, 2011 memorandum from John Nicholson of the Pillsbury law firm, entitled “Accounting for Cybersecurity: SEC Guidance in Disclosures to Investors and Regulators” (here). The memo includes a detailed discussion of the new guidelines and the challenges that companies may face in trying to comply with the guidelines.

 

Even thought the SEC’s final regulations for the Dodd-Frank whistleblower program just became effective on August 12, 2011, the agency has already filed its first report on the whistleblower program. Under Section 924(d) of the Dodd Frank Act, the SEC must report annually to Congress on its activities, whistleblower complaints and the agency’s response to the complaints. Because the agency’s November 2011 report is written as of the September 30, 2011 end of the fiscal year, it covers only seven weeks of whistleblower data for fiscal year 2011. The Report can be found here.

 

The report shows that during the first seven weeks of the program, the agency received 334 whistleblower tips. The SEC itself cautions that “due to the relatively recent launch of the program and the small sample size, it is too early to identify any specific trends or conclusions from the data collected to date.” Nevertheless, even though it is early yet, there are some interesting tidbits in the report’s data.

 

First, a surprising number of the reports originated outside the United States. That is, not only did the agency receive individual whistleblower submissions from individuals in 37 different states, but it also received reports from individuals in eleven different foreign countries. These non-U.S. whistleblowers 32 submissions represented roughly ten percent of all of the whistleblower submissions during the reporting period. The country with the highest number of submissions was China (10), followed by the U.K. (9).

 

Second, though many commentators had expected that the Dodd Frank whistleblower provisions would trigger a flood of FCPA-related reports, and though there were so many reports from outside the U.S., whistleblower submissions reporting FCPA violations represented only four percent of the submissions during the reporting period, a level of submissions that has puzzled some commentators (refer for example here).

 

When the Dodd-Frank Act was first enacted, there was a great deal of concern that the bounty rewards in the whistleblower provisions would trigger a flood of whistleblower reports. (The bounty provisions require an award of between 10% and 30% of the amount of SEC recoveries based on the whistleblower submissions, when the SEC’s recovery exceeds $1 million). Some might find the 334 of whistleblower submissions during the reporting period surprisingly low.

 

But in addition to the reporting period only representing seven weeks, it is also worth noting that there still have been as yet no bounty awards under the Dodd-Frank whistleblower program. The SEC’s recent report shows that the agency maintains a fund of over $452 million in order to fund future whistleblower awards.

 

A former SEC official who helped draft the whistleblower provisions has said that he expects that in coming years “the SEC will exceed its previous records in both number of actions brought and the amount of sanctions collected as a result of whistleblower assistance.”

 

The $452 million fund available for bounty awards suggests that we will indeed see significant numbers of whistleblower submissions in the future. Based on the history of other government whistleblower programs that offer steep financial motivations, the expectation that there will be significant numbers of whistleblower report in the future seems well founded. For example, an entire industry has grown up in support of qui tam actions under the False Claims Act, with serial claimants and specialized law firms organized to pursue these claims systematically. David Barrio has a very interesting November 17, 2011 in the AmLaw Litigation Daily article (here) discussing the serial qui tam claimant and his “industrious” law firm that has over a 16-year period recovered over $2.5 billion from pharmaceutical companies accused of ripping off Medicare and Medicaid. 

 

And while the SEC’s first report since the whistleblower program covers only a short time period and reflects only a small number of whistleblower submissions, among those submissions are some significant items. As discussed in Jean Eaglesham’s November 16, 2011 Wall Street Journal article (here), among the reports the SEC received during the initial reporting period were tips that the Bank of New York Mellon and State Street Corp. were improperly charging large institutional clients for currency trades.

 

These examples show the potential significance of the whistleblower program. As these types of whistleblower reports translate into bounty awards, more submissions will follow. The SEC’s initial report for the short reporting period provides a cryptic but tantalizing glimpse of the likely future of this program.

 

EEOC Releases 2011 Report: And speaking of annual government reports, the Equal Employment Opportunity Commission has also released its fiscal 2011 Performance and Accountability Report. The EEOC’s report, which can be found here, contains a detailed overview of the agency itself. The report also contains some data relating to the agency’s enforcement activities.

 

Among other things, the agency’s report shows that in fiscal 2011, the agency received a record number of charges during fiscal 2011. The 99,947 charges the agency received during 2011 slightly exceeded the 99,922 charges the agency received in 2010. This relatively slight annual gain in the number of charges between 2010 and 2011 contrasts with the steep increase in the number of charges between FY 2004 and FY 2009, when the annual increases in the number of charges ranged from 12 to 38 percent. This rapid ramp up of the number of charges has produced increased what the report describes as the agency’s “inventory.” The report details the steps the agency is taking to try to reduce its accumulated inventory.

 

Cases Against U.S-Listed Chinese Companies Continues to Accumulate: As I have previously noted elsewhere, one of the significant factory in securities class action litigation filing activity during the past 18 months has been the flood of new cases involving U.S.-listed Chinese companies. One of the frequent comments about this surge of filings has been that sooner or later this phenomenon has to play itself out, since sooner or later the plaintiffs’ lawyers will just run out of companies to sue.

 

But while this filing phenomenon has to come to an end sooner or later, the lawsuits involving U.S. listed Chinese companies are still continuing to come in. In their November 16, 2011 press release (here), plaintiffs’ attorneys’ announced that they had filed an action in the Central District of California against Keyuan Petrochemicals and certain of its directors and officers. In their complaint, which can be found here, the plaintiffs allege that the company failed to disclose certain related party transactions and that the company’s financial statement did not reflect the company’s true financial condition.

 

With the filing of this complaint, there have now been a total of 36 securities class action lawsuits in 2011 involving U.S. listed Chinese companies, and a total of 47 since January 1, 2010.

 

Viral Video Explained: Earlier this week I included an embedded link to a bizarre video showing a group of elderly Chinese singing and dancing to the Lady Gaga song “Bad Romance.” A November 17, 2011 post on The New Yorker’s website (here) has an interesting explanation of the video, which apparently has gone viral, much to the puzzlement of the Chinese. The New Yorker post includes the video, for those who have not yet seen it.

 

Companies that obtained their listings on U.S. exchanges by way of a reverse merger with a publicly traded shell have been the focus of a great deal of scrutiny and even litigation in recent months, particularly with regard to Chinese reverse merger companies, as discussed here.

 

Reverse merger companies are also now the focus of regulatory attention. The following guest post from Anjali C. Das (pictured to the left), a Partner in the Chicago office of Wilson Elser Moskowitz Edelman & Dicker, discusses recent regulatory actions from the SEC and the U.S. stock exchanges with respect to reverse mergers. Anjali’s practice focuses on professional liability insurance coverage. She represents the interests of domestic and foreign primary and excess insurers in connection with a variety of shareholder claims and class actions against directors and officers, financial institutions, investment banks, insurance companies, and ERISA plan fiduciarieues.

 

 

Many thanks to Anjali 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. Here is Anjali’s guest post.

 

 

 

            For the past year, Chinese reverse merger companies have been the target of numerous shareholder suits, government investigations, and scathing analyst reports for alleged financial and accounting fraud. In some instances, the companies are purported to be a complete sham. In response to Congressional inquiries and public outcry by investors who claim they were duped, the United States Securities and Exchange Commission ("SEC") launched an investigation last year of foreign (non-U.S. based) reverse merger companies ("RMCs") and their auditors. The SEC has since suspended or halted trading of dozens of RMCs due to untimely, incomplete, or inaccurate financial information from these companies. This past summer, the SEC issued a bulletin (here) cautioning investors of the potential pitfalls of investing in RMCs, citing instances of fraud and inadequate audits. 

 

 

            Until now, it has been relatively easy for foreign private companies to access U.S. capital markets by merging with an existing public shell company through a so-called "reverse merger." For instance, a private company located overseas in China might merge into a public shell company listed on a U.S. exchange, whereby the bulk of the company’s control and operating activities remain in China.  As some U.S. investors have discovered, this may pose logistical and other hurdles in terms of obtaining accurate information about the company’s financial and business activities.

 

 

            On November 9, 2011, in an effort to stem the tide of fraud and investor abuse, the SEC unveiled new rules (here) approved and adopted by each of the three major U.S. stock exchanges which impose more stringent listing requirements for RMCs. 

 

 

            NASDAQ’s new rules (here) prohibit an RMC from applying to list unless and until it meets each of the following requirements: (1) the company has previously traded in a U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange for at least one year following the reverse merger (also known as the one-year "seasoning period"); (2) prior to listing, the company must timely file all required periodic financial reports for the prior year with the SEC, including an annual report which contains audited financial statements and information about the reverse merger transaction; and (3) the company must maintain a minimum closing share price of $4 for a "sustained period" — at least 30 of the most recent 60 trading days as of the date of the listing application as well as the date of listing.

 

 

            NASDAQ’s rules identify two exceptions from these new listing requirements for RMCs. First, an RMC that completes a firm commitment underwritten public offering at or around the time of listing with gross proceeds to the company of at least $40 million is not subject to the new listing requirements. The second exception applies to an RMC that has filed with the SEC at least four annual reports containing audited financial statements following the filing of all required information about the reverse merger transaction, in addition to fulfilling the one-year trading requirement.

 

 

            The SEC approved similar new listing requirements for the New York Stock Exchange and the NYSE Amex (here and here). In approving these new rules, the SEC expressed its belief that these enhanced listing requirements were specifically designed to curb the potential for accounting fraud and manipulation associated with RMCs by increasing the transparency of their trading history and financial statements. While it is too early to tell just how effective these new listing requirements will be in preventing future fraud on U.S. investors, the rules underscores regulators’ commitment to fighting these abuses by RMCs. Meanwhile, the SEC’s continues to maintain an aggressive stance against purported fraud by China-domiciled issuers and charged Longtop Financial Technologies on November 10 with failing to file timely and accurate financial statements (here).

 

 

Olympus Garners Securities Class Action Lawsuit After All: In a recent post, I speculated that the reason there had not yet been a securities class action lawsuit filed against Olympus Corp. in the wake of its high-profile accounting scandal is that most of its shareholders acquired their shares on the Tokyo stock exchange and therefore — under the "transaction" standard enunciated by the U.S. Supreme Court in the Morrison case — cannot assert a claim under the U.S. securities laws

 

 

I also noted that, according to news reports, about one percent of its public float trades in the U.S. on the pink sheets in the form of American Depositary Receipts. Well, either the ADRs represent greater value than i understood when I wrote my blog post or some plaintiffs lawyers are going after some fairly small potential recoveeries.

 

 

 

According to their November 14, 2011 press release (here), a plaintiffs’ firm has filed a securities class action in the Eastern District of Pennsylvania against Olympus and certain of its directors and officers The complaint purports to be filed only on behalf of "purchasers of Olympus American Depository Receipts (pinksheets:OCPNY) (pinksheets:OCPNF) between November 7, 2006 and November 7, 2011, inclusive."

 

 

The plaintiffs did not include the Olympus shareholders that had purchased their shares on the Tokyo exchange, in an obvious effort to avoid Morrison problems. The Morrison effect on this case is that it is a much smaller scale case than would have been filed pre-Morrison.    

 

 

Meanwhile, a November 15, 2011 artice in The Asian Lawyer entited "What Will be the Legal Fallout for Olympus Corp." (here) discusses the various legal and cultural reasons why a significant litigation recovery or even regulatory fine involving Olympus Corp. is unlikely in Japan.         

 

 

LexisNexis Top Insurance Law Blogs of 2011: On November 11, 2011, the LexisNexis Insurance Law Community announced the top Insurance Law Blogs of 2011. The D&O Diary is honored to be listed among the 2011 designees.  The LexisNexis press release also lists all of the other designees, with links to their sites. Congradulations to all of the designees, and thanks to the LexisNexis Insurance Law Community for the selection. And thanks to all of the readers out there  who keep this blog alive.

 

Guaranty Bank of Austin, Texas’s August 21, 2009 closure is the fourth-largest bank failure during the current wave of bank failures and the tenth largest bank failure in U.S. history. The bank’s failure, which came just 15 months after its publicly traded holding company spun out of Temple-Inland, Inc., was, the Treasury Department Office of Inspector General later concluded, due to the bank’s heavy investment in Option ARM mortgage-backed securities.

 

Though Guaranty Bank failed well over two years ago, and its holding company parent filed for bankruptcy an almost equally long time ago, its closure is only now giving rise to significant litigation based on the events surrounding the holding company’s December 2007 spin out from Temple-Inland and the bank’s August 2009 failure.

 

The latest of these recent lawsuits was filed on November 11, 2011, in the Northern District of Texas on behalf of the bank holding company’s shareholders who purchased their shares between December 12, 2007 and August 24, 2009 (that is, between the corporate spin out and the bankruptcy). The plaintiffs’ lawyers’ November 11, 2011 press release about the lawsuit can be found here.

 

The shareholders’ complaint, which can be found here, names Temple-Inland itself as a defendant, as well as five individuals: Kenneth Jastrow, who was Temple-Inland’s Chairman and CEO until December 28, 2007, and was also Chairman of both the bank and of the bank holding company until August 26, 2008; Randall Levy, Temple-Inland’s CFO; Kenneth Dubuque, who was the bank holding company’s and the bank’s CEO and director until November 19, 2008; Ronald Murff, the bank holding company’s CFO; and Craig Gifford, the holding company’s controller.

 

The complaint alleges that in the years prior to the holding company’s spin-off, the bank was required by a regulatory order to terminate its mortgage origination operations. In order to maintain its targeted rates of return, the bank “accumulated an unsafe and unsound concentration of higher yielding, but highly risky, homebuilder focused” Option ARM mortgage backed securities, largely originated in California.

 

The complaint alleges that Temple-Inland, which had previously wholly owned the bank holding company, recognized the threat that the bank posed to its own financial condition, and so devised the plan to spin off the bank holding company. The complaint alleges that during the period after the spin-out plan was devised and spin-out was completed, the defendants were aware that the real estate market’s conditions, particularly in California, were rapidly deteriorating and that delinquency rates there were “dramatically increasing.”

 

The defendants allegedly knew or recklessly ignored that the bank’s MBS portfolio was “materially impaired” and ignored questions asked prior to the spin-off about the adequacy of the bank’s capital. The complaint alleges that as of the date of the spin-off, the bank and its parent holding company were “insolvent and under-capitalized,” and that its financial statements did not reflect its true financial condition, largely as a result of its failure to properly value its impaired MBS assets.

 

The complaint alleges that the holding company did not fully recognize its losses on its MBS assets until later in 2009, shortly after which the bank was closed and put into FDIC receivership. The holding company’s bankruptcy followed within days thereafter.

 

The complaint alleges that the defendants’ misrepresented the holding company’s financial condition throughout the class period in violation of the Sections 10 and 20 of the Securities Exchange Act of 1934.

 

There are a number of interesting things about this lawsuit, the first of which is that it represents a late-arriving example of a basic subprime-related securities class action lawsuit. As I have documented on this site (refer here), there have been literally hundreds of subprime and credit crisis related securities class action lawsuits filed since the first of these cases was filed in February 2007. More recently, this wave of litigation seemingly has just about dwindled away. Yet here we are nearly five full years later, and subprime-related cases are still continuing to come in.

 

The belated arrival of this lawsuit raises yet another issue. Given that this lawsuit was filed well over two years after the bank’s failure and the holding company’s bankruptcy, it seems likely that the defendants will assert the statute of limitations as a defense. The complaint itself does not expressly address the possible statute of limitations issues, but the complaint does suggest at least a couple of factors on which the plaintiffs might try to rely in responding to statute of limitations issues.

 

That is, the complaint specifically cites two sources that only recently became available. These two sources are: the U.S. Treasury Department Office of Inspector General’s April 29, 2011 Material Loss Review of Guaranty Bank (here), which among other things, concluded that the bank failed because of its losses on its MBS portfolio; and the August 22, 2011 complaint filed in the Northern District of Texas by the trustee for the liquidation trust in the holding company’s bankruptcy (on behalf of the trust and as assignee of the FDIC) against Temple-Inland and five individual defendants, including  three of the individuals named as defendants in the recently filed shareholder suit. The complaint in the trustee’s lawsuit can be found here.

 

The trustee’s complaint makes for some interesting reading. Among other things, it accuses Temple-Inland of “fraudulently looting” the bank and the holding company of “assets exceeding one billion dollars,” and further alleges that “after fraudulently stripping” the bank and the holding company of assets “beyond the point of solvency and adequate capitalization,” the defendants came up with the plan of “spinning off the fatally crippled and doomed to fail” holding company.

 

The plaintiffs in the shareholder lawsuit may well contend that that until they were aware of the conclusions in the Inspector General’s report and of the allegations in the liquidation trustee’s complaint, they were not in a position to file their complaint, or were unaware of the allegations on which they based their complaint, and therefore that the statute of limitations should run from the disclosure of these allegations, rather than from the date of the bank failure. The defendants undoubtedly will contend that the circumstances that cause the bank’s demise were apparent at the time of its August 2009 failure and that the statute ought to run from that time.

 

Another interesting aspect of the shareholder’s complaint is the involvement corporate officials from the two separate companies, including one individual who is sued in dual capacities, as an officer and director of both companies. These allegations raise some potentially interesting questions about the extent to which each company’s respective D&O insurance programs are implicated by the claim. The liquidating trustee’s complaint presents the same issues. These issues are further complicated by the holding company’s August 2009 bankruptcy.

 

Temple-Inland likely has a current program of D&O insurance in force. The bank holding company’s D&O insurance likely lapsed some time shortly after the holding company’s bankruptcy. Unless there is some basis to relate the claim back to the holding company’s now lapsed policy, there may be no insurance available for the individuals defendants to defend themselves in their capacities as former directors and officers of the holding company – and given the bankruptcy, whatever limits there might even theoretically be available under the bankrupt holding company’s D&O program are likely to be significantly impaired.

 

With respect to Temple-Inland’s D&O insurance, there is an interesting question with respect to coverage for Temple-Inland itself. While most public company D&O insurance policies provide Securities Claim protection for corporate entity insureds — and while the claims alleged against Temple-Inland in the shareholder lawsuit are asserted under the federal securities laws — these allegations may or may not represent Securities Claims under the applicable insurance policy definition.

 

Many D&O insurance policies orient the definition of the term Securities Claim around allegations involving the securities of the insured corporate entity. The allegations in the recently filed shareholder lawsuit arguably pertain solely to the bank holding company’s securities, not to Temple-Inland’s securities (although the mechanics of the bank holding company’s spin-out from Temple-Inland fuzzies this up a little bit). There will be an interesting question as to whether or not the securities law allegations against Temple-Inland represent a Securities Claim within the meaning of the company’s D&O insurance policy. It is worth noting in that regard that the claims asserted against Temple-Inland in the trustee’s lawsuit are not based on alleged violations of the securities laws, and therefore also potentially might not trigger the entity coverage under the typical D&O insurance policy.

 

There obviously are many questions yet to come in these cases. At this point it may be sufficient to note that even after all this time, the litigation consequences of the subprime meltdown and of the bank failure wave are continuing to accumulate. Especially with respect to the failed banks, the litigation wave will continue to accumulate for years to come, and it will be an even longer time before all of the litigation has finally played out. Unfortunately it also looks like the economic consequences from the global financial crisis are also going to take many years finally to play out, as well.

 

Lehman Mortgage Backed Securities Lawsuit Settlement Depletes Remaining D&O Insurance Proceeds: Earlier this year, when the parties to the Lehman Brothers Equity and Debt Securitholders litigation announced that they had reached a $90 million, the amount of that settlement if approved appeared that it would deplete most but not all of the remaining limits under the Lehman Brothers’ D&O insurance program. As discussed at length here, I calculated that the $90 million settlement, together with other settlements and accumulated defense expenses, looked like it would leave about $25 million or so of insurance remaining in the $250 million program.

 

It now looks as there was slightly more left in the program than I had calculated. It also looks as if, based on the separate $40 million settlement of the Lehman Brothers Mortgage Backed Securities litigation, that whatever the amount of insurance that was remaining in the program, it has now been exhausted. According to a November 11, 2011 Reuters article (here), the D&O insurers will contribute a total of $31.7 million toward the$40 million settlement, an amount that should just about entirely deplete whatever was left in the program. Bankruptcy court approval is required.

 

I have added this Lehman Brothers Mortgage Backed Securities lawsuit settlement to my running tally of subprime and credit crisis securities class action lawsuit case resolutions, which can be accessed here.

 

MF Global’s D&O Insurance: I am sure many of you like me wondered which carriers were on the D&O insurance program for MF Global.  Judy Greenwald’s November 11, 2011 Business Insurance article (here), doesn’t list all of MF Global’ s D&O insurance carriers, but it does identify the primary carrier in the program, and it does reveal that MF Global carried a total of $250 million in D&O insurance. I am sure that a certain amount of the $250 million program is Excess Side A/DIC insurance, but given that MF Global has filed for bankruptcy even those Excess Side A/DIC layers would appear to be implicated by the claims arising from the company’s collapse.

 

Sometimes the World is a Very Strange Place: At least some of our country’s exports are succeeding in China, if this broadcast entitled “Lao Lai Qioa Gaga” from Hunan TV is representative. In this video, which really does have to be seen to be believed, a Chinese old folks choir belts out a spirited cover of Lady Gaga’s hit, “Bad Romance.” An unexpected interpretation of the work, I would say — although arguably not any more bizarre than Lady Gaga’s own video interpretataoin of the song.

 

For those of you who like me have been watching in disbelief as the accounting scandal engulfing Olympus Corp. has slowly unfolded like a slow-motion train wreck, I am sure you have many questions, but one that occurs to me in particular to ask is – why haven’t there been any lawsuits yet? After all, the company has lost over 70% of its market capitalization value (representing more than $6.4 billion) since the scandal first came to light in mid-October.

 

Not only that, but after weeks of denial, on November 8, 2011, the company admitted in a press release (here) that “it has been discovered that the Company had been engaging in deferring the posting of losses on investment securities, etc. since around the 1990s,” and that the fees the company paid to advisors in connection with three business acquisitions “had been, by means such as going through multiple funds, used in part to resolve unresolved losses on investment securities, etc., by such deferral in the posting of these losses.” The company also separately announces on November 8, 2011 (here) that its board had voted to dismiss a company officer whom the company said in a press release “was found to be involved in such deferral in posting of the losses.” In addition, the company also announced that its Standing Corporate Auditor had resigned.

 

A few facts start to fill in the explanation of why there have been no lawsuits yet, despite all of these circumstances and revelations, and despite the magnitude of the drop in the company’s market capitalization.

 

First, the company’s shares trade on the Tokyo Stock Exchange. While American Depositary Receipts trade on the Pink Sheets in the U.S., those securities, according to Jonathan Stempel’s November 9, 2011 Reuters article entitled “Olympus Investors May Find Courthouse Door Closed” (here), represent only about one percent of the company’s float, and no single investor has as much as even $1 million of the ADRs.

 

With the vast preponderance of the company’s shares trading on the Tokyo exchange, only a very small number of Olympus investors, representing a very small share of the company’s pre-loss market capitalization, would be able to assert claims in U.S. court under U.S. law, in light of the “transaction” test first articulated by the U.S. Supreme Court in its June 2010 holding in the Morrison v. National Australia Bank case (about which refer here). Under the Morrison holding, the U.S. securities laws simply do not apply with respect to the transactions in which those investors who bought their Olympus shares on the Tokyo exchange.

 

The investors might try to sue Olympus and its directors and officers in U.S. court under Japanese law, but that does not really seem like a realistic alternative. Toyota’s investors tried to assert  Japanese securities law claims in their securities class action lawsuit filed in the wake of that company’s sudden acceleration scandal. As discussed here, in July 2011, Central District of California Judge Dale Fischer rejected the argument that she had jurisdiction over the Toyota shareholders’ Japanese law securities claims. Among other things, she said that the requirements of comity strongly militated against her exercising jurisdiction over the Toyota shareholders’ Japanese law claims. 

 

While the Olympus shareholders might well consider the possibility of pursuing the claims under Japanese law in Japan, the problem they have is that Japan’s courts do not have a class action procedure like that in the U.S., and as the Reuters article linked above discusses, there may be questions about how damages would be calculated under Japanese law. (That said, prior corporate scandals in Japan have triggered securities litigation in that country, as discussed here.)

 

One alternative gambit the Olympus shareholder might try in order to be able to pursue claims in the U.S. is to try to assert claims under the law of one of the U.S. states. That is a maneuver the shareholder plaintiffs are trying to pull off in the BP shareholder litigation arising out of the Gulf oil spill, as discussed in Alison Frankel’s November 9, 2011 article on Thomson Reuters News and Insight about the BP case. But as Frankel discusses, this effort to try to assert class claims under state securities class is fraught with difficulties.

 

With all of these difficulties, we may not see any shareholder litigation arising out the Olympus scandal any time soon. In the meantime, though, there is a growing list of questions about this increasingly bizarre story, such as – what were the investment losses that the company was trying to mask, and how big were they? Exactly how were the merger transactions used to mask those losses? Are there other losses that have not been disclosed or were there other transactions used to mask those or other losses? Are there other inflated assets that have to be written off? Who among the company’s management were aware of these accounting maneuvers?

 

This is one of the more striking stories to come along in a long time, both in terms of the scale and the duration of the coverup, as well as the complexity of the means of the deception. It seems likely that whether or not there ultimately is any shareholder litigation, that there will (or should be) some type of regulatory action. (Refer here for the strory about the Tokyo Metropolitan Police investigation of the scandal.)

 

In any event, this case surely is another reminder of the impact of the Morrison decision. There is no doubt that if all of this had come up before Morrison, there would have been a raft of lawsuits in U.S court against Olympus and its directors and officers about all of this.

 

And speaking of the breadth of Morrison’s impact, Victor Li has a very interesting November 9, 2011 Am Law Litigation Daily article (here), describing how the lawyers for Aloca have successfully moved to reopen the bribery case brought against the company by Aluminum Bahrain, after the case had been administratively stayed to allow a criminal probe to go forward. The company recently sought to reopen the case in order to be able to move to dismiss it under Morrison. The company will now have a chance to try to have the claims, which are based on RICO, dismissed. (For more background about the Alcoa case, refer here.)

 

One final thought about the Olympus case. For those who have been trying to think about where the Dodd-Frank whistleblower provisions might lead, it is worth thinking about the fact that the scandal began with the company’s CEO confronting the board. It does not take too much imagination to picture someone like him or another officer of a company subject to the SEC’s jurisdiction running to the SEC with this story. The bounty provisions under the Dodd-Frank Act certainly would in these circumstances present a hefty incentive for the prospective whistleblowers.

 

When They Ask Later How Europe Went Bankrupt: There’s a scene in Ernest Hemingway’s novel, The Sun Also Rises, where Bill Gorton, the New York  friend of the book’s main character, Jake Barnes, asks Jake’s rival, Mike Campbell, “How did you go bankrupt?” Campbell responds, “Two ways. Gradually and then suddenly.”

 

I thought of this exchange as I was reading an article in the October 29, 2011 issue of The Economist about the euro crisis. I think the likely timing of the “suddenly” part of the euro crisis might be discerned in this sentence in the article: “[i]n the next three years Italy and Spain will have to refinance about €1 trillion-worth of bonds, not counting additional borrowing to finance their deficits.”  A three-year time frame may sound more like "gradually" — that is, unless bond investors start assessing how likely likely ithe refinancing really is. .

 

 

And Finally: How about a map of every McDonald’s in the United States?  (Did you know that the furthest you can get from a McDonald’s Restaurant in the Continental U.S. is 110 miles?) 

 

An inevitable part of the current wave of bank failures has been the FDIC’s filing of lawsuits against former directors and officers of the failed institutions. And though the FDIC’s initiation of this litigation has been gradual, the lawsuits have now started to accumulate in significant numbers. And just as this FDIC litigation was perhaps inevitable once the banks started to faile, so too it was also perhaps inevitable that the FDIC lawsuits would be accompanied by D&O insurance coverage litigation.

 

As discussed below, the failed bank insurance coverage lawsuits are now starting to arrive. If the initial cases are any indication, one of the main coverage battlegrounds will be the typical D&O insurance policy’s Insured vs. Insured exclusion. Specifically, the question will be whether the FDIC as receiver pursuing the failed bank’s claim against the bank’s former directors and officers is acting as an “insured” under the D&O policy so as to preclude coverage under the policy.

 

First up in this analysis is Michigan Heritage Bank of Farmington Hills, Michigan, which failed on August 29, 2009 (about which refer here). As discussed in greater detail here, on August 8, 2011, the FDIC, as the bank’s receiver, filed a lawsuits in the Eastern District of Michigan against a single former officer of the bank.

 

What followed next is that on November 1, 2011, Michigan Heritage’s D&O insurer filed an action in the Eastern District of Michigan seeking a judicial declaration that there is no coverage for the underlying lawsuit or for the bank officer’s defense expenses under the bank’s D&O policy. A copy of the insurer’s declaratory judgment complaint can be found here.

 

Among other things, the carrier seeks a judicial declaration that the policy’s Insured vs. Insured exclusion precludes coverage for the underlying lawsuit. The insurer’s argument is that as the bank’s receiver, the FDIC is asserting the bank’s own claims and is seeking to recover the bank’s losses. Therefore, the carrier contends, the FDIC’s lawsuit is a claim “by, on behalf of, or at the behest of” the bank, and as the bank and the defendant loan officer are both insureds under the policy, the policy’s Insured vs. Insured exclusion precludes coverage.

 

A very similar sequence has also followed with respect to Westernbank, of Mayaguez, Puerto Rico, which failed on April 30, 2010. As reflected here, on December 17, 2010, the FDIC, through its outside counsel, sent a letter to Westernbank’s D&O insurer asserting claims against the bank’s former directors and officers.

 

Westernbank’s directors and officers , in turn, on October 6, 2011, filed an action in local Puerto Rico court seeking judicial declaration that the FDIC’s claim is covered under the bank’s D&O policy. The complaint, which is in Spanish, can be found here. According to an October 14, 2011 press release from the direcrors and officers’ counsel, the complaint seeks a judicial declaration with respect to “the controversial and critical question whether the FDIC-R can be deemed an insured under the Policy so as to excuse [the carrier] from providing coverage.”

 

Though these declaratory judgment actions have only just been filed, they are in many ways a vestige of an earlier time. As I discussed in a blog post way back in August 2008, when the current bank wave was only just starting to unfold, the question whether the Insured vs. Insured exclusion precluded coverage for claims by the FDIC as receiver against former directors and officers of failed banks was hotly contested during the S&L crisis. As I said in my earlier post, and as appears likely now, the Insured vs. Insured exclusion could be a critical part of the failed bank insurance coverage litigation during the current round of bank failures as well.  

 

During the S&L crisis, where the FDIC had its greatest success in overcoming the Insured vs. Insured exclusion was where it was able to argue successfully that the Insured vs. Insured exclusion precluded coverage only with respect to collusive lawsuits. Because it was able to show that its claims and lawsuits were fully adversarial, it was able to establish that the exclusion did not apply.

 

The FDIC was not uniformly successful in arguing that the exclusion only precluded collusive claims, and there has in fact been some intervening case law to the effect that the Insured vs. Insured exclusion applies even when the underlying claim is not collusive.

 

It will in any event be interesting to see how these coverage cases develop. The one thing that seems certain is that as the FDIC failed bank litigation continues to accumulate, so too will the related coverage litigations. Many of the related coverage suits likely will also involve these same Insured vs. Insured issues.

 

Another issue that is likely to be litigated in coverage cases arising out of FDIC failed bank litigation is the enforceabilty of the so-called Regulatory Exclusion, which when present in the D&O policy precludes coverage for claims brought by the FDIC and other regulators. Not all policies implicated in the bank failures have these exclusions, but where they are present they are likely to be relied upon by the carriers to contest coverage. It is probably worth noting that these issues were fully litigated during the S&L crisis and the courts generally found that the regulatory exclusion precluded coverge for FDIC claims. My prior blog post about the regulatory exclusion can be found here.

 

A good summary of the D&O insurance coverage issues involved in FDIC failed bank litigation can be found here.

 

Special thanks to the several loyal readers who sent me links to ths source documents referenced above.

 

Overall levels of corporate and securities litigation declined during the third quarter of 2011 relative to recent quarters but 2011 annualized filings remain above historical levels, according to a recent report from the insurance information firm Advisen entitled “Securities Litigation Activity Dips, An Advisen Report: Q3 2011,” which can be found here. My own survey of the third quarter 2011 securities litigation filing activity can be found here.

 

Preliminary Notes

It is critically important to recognize that the Advisen report uses its own unique vocabulary to describe certain of the corporate and securities litigation categories.

 

The “securities litigation” and “securities suits” analyzed in the Advisen report include not only securities class action lawsuits, but a broad collection of other types of suits as well, including regulatory and enforcement actions, individual actions, derivative actions, collective actions filed outside the U.S. and allegations of breach of fiduciary duty. All of these various kinds of lawsuits — whether or not involving alleged violations of the securities laws — are referred to in the aggregate in the Advisen report as "securities suits."

 

One subset of the overall collection of "securities suits" is a category denominated as "securities fraud" lawsuits, which includes a combination of both regulatory and enforcement actions, on the one hand, and private securities lawsuits brought as individual actions, on the other hand. However, the category of "securities fraud" lawsuits does NOT include private securities class action lawsuits, which are in their own separate category ("SCAS").

 

Due to these unfamiliar usages and the confusing similarity of category names, considerable care is required in reading the Advisen report.

 

The Report’s Findings

There were 316 “securities suits” (as that phrase is used in the Advisen report) during the third quarter of 2011, which is down from the 367 “securities suits” filed in 2Q11 and 421 filed in 1Q11. This quarterly decline is attributable in part to the decline of breach of fiduciary duty suits (primarily merger objection suits) in 3Q11, when there were 76 breach of fiduciary duty suits filed, compared to 130 filed in the year’s second quarter.

 

In addition, the quarterly decline in overall corporate and securities lawsuit filing activity is also due in part to the decline in 3Q11 compared to 1Q11 in what the Advisen report calls “securities fraud suits” (which as noted above encompasses both regulatory actions as well as private securities lawsuits brought as individual rather than class actions). According to the study, the number of these so-called “securities fraud suits” declined to 109 in the third quarter, compared to 156 in the first quarter and 101 in the second quarter.

 

According to the Advisen study, the number of securities class action lawsuits filed during the third quarter was also down relative to the second quarter. The Advisen study reports that there were 56 securities class action lawsuits filed during 3Q11, compared to 61 during the second quarter. Though the third quarter filings were down relative to the prior quarter, the third quarter filing activity level was higher than the 2010 quarterly filing average of 47. Over 70 percent of Q311 class action lawsuit filings named companies in four sectors as defendants: information technology, healthcare, financial and industrial.

 

Litigation involving non-U.S. companies, filed both in the U.S. and elsewhere, was an important part of “securities suit” filings during the third quarter and overall during 2011. In the first three quarters of 2011, 16 percent of all “securities suits” were filed against non-U.S. companies, compared to 11 percent for both 2009 and 2010. During the third quarter, fifteen percent of all “securities suits” were filed against non-U.S. companies, down from 19 percent during the second quarter.

 

With respect to this activity involving non-U.S. companies, an increasing percentage of this “securities suit” activity is outside the U.S. The study reports that in the first three quarters of 2011, there were 55 “securities suits” filed in courts outside the U.S., 17 of which were filed during the third quarter. These 55 cases represent five percent of all YTD “securities suits,” which is “higher than the 3-percent level recorded in most recent years.”

 

Many of the cases involving non-U.S. companies in U.S. court involve Chinese companies. The number of “securities suits” filed in U.S. court involving Chinese companies has rise from five in 2009 to 24 in 2010, and up to 55 during the first three quarters of 2011.

 

Even though we are now well past the peak of the credit crisis (at least as a temporal matter if not as an economic matter), overall corporate and securities litigation activity remains highly concentrated in the financial sector. According to the Advisen report, 35 percent of all “securities suits” filed during the third quarter targeted companies in the financial sector. A large portion of the “securities suits” filed against financial companies in the third quarter involve regulatory actions, as 48 percent of all “securities suits” filed against financial companies involved regulatory actions.

 

But while the filing activity concentration in the financial sector remains elevated, the 3Q11 “securities suits” were “more broadly dispersed” during the quarter “than in previous years, especially compared to 2008 and 2009.” Suits against information technology firms and healthcare companies each represented 13 percent of all “securities suits,” while suits against industrials represented 11 percent of all such suits.

 

The average value of settlements of “securities suits” during the third quarter was $17.4 million, down from $22.8 million in the second quarter and from $18.2 million for all of 2010. The average securities class action lawsuit settlement during the quarter was $45.7 million.

 

Advisen 3Q11 Securities Litigation Webinar: On Thursday November 17, 2011 at 11:00 am EST, I will be participating in one-hour long Advisen webinar to discuss third quarter 2011 corporate and securities litigation filing activity. The panelists for this free webinar will also include Steve Gilford of the Proskauer law firm, Alliant Insurance’s Susanne Murray, and Advisen’s Dave Bradford. The panel will be moderated by Advisen’s Jim Blinn. More information about this free webinar, including registration information, can be found here.

 

One of the primary purposes for which policyholders purchase D&O insurance is to provide directors and officers with defense cost protection in the event claims are made against them. However, a September 15, 2011 decision by a justice of the New Zealand High Court in Auckland (here) found that former directors of the defunct Bridgecorp companies are not entitled to advancement under the companies’ D&O insurance policies of the costs of their criminal defense where the companies’ liquidators and receivers have raised (but not yet proven or even filed) claims against them exceeding the policy’s limits of liability.

 

Though the decision reflects a peculiar feature of New Zealand law, it nevertheless may have some noteworthy implications, particularly in light of the larger D&O insurance industry’s ongoing efforts to develop insurance solutions that operate globally and respond locally.

 

Background

The Bridgecorp group operated as a real estate development and investment firm. (For more information about the Bridgecorp group and its demise, refer here.) When it collapsed in July 2007, the group owed investors nearly NZ$500 million. The group’s former directors face numerous criminal and civil claims arising out of the collapse. Trial on the criminal charges was to take place this fall. The accompanying civil charges have been stayed pending the outcome of the criminal claims.

 

Separately, the liquidators and receivers for the Bridgecorp group companies have advised the directors that they intend to initiate civil proceedings against them, alleging that the directors breached their statutory and common law duties, and seeking an order requiring the directors to pay more than NZ$450 million.

 

At the time of its collapse, the Bridgecorp group carried NZ$20 million in D&O Insurance. The group also carried $2 million of statutory liability defense cost protection (the “SL policy”), but the limits of the SL policy have already been exhausted in payment of the directors’ attorneys’ fees. The directors now seek to have the D&O insurance fund their continuing criminal defense, which they estimate will amount to NZ$3 million through trial, exclusive of any post-trial proceedings.

 

The Bridgecorp group liquidators and receivers advised the group’s D&O insurer that they assert a “charge” under Section 9 of the Law Reform Act of 1936, which they contend creates a priority entitlement in claimants’ favor over monies that may be payable under any insurance policy held by the person against whom the claim is made. The Bridgecorp group directors in turn initiated an action seeking a judicial declaration that Section 9 does not prevent the insurer from meeting its contractual obligation under the D&O policy to reimburse them for their defense costs.

 

The September 15 Ruling

On September 15, 2011, New Zealand High Court (Auckland Registry) Justice Graham Lang ruled in favor of the Bridgecorp group’s liquidators and receivers, ruling that the receivers’ and liquidators’ “charge” on the D&O insurance policy’s limits of liability under Section 9 “prevents the directors from having access to the D&O policy to meet their defence costs.”

 

Section 9 (which is set out verbatim in paragraph 19 of Justice Lang’s opinion) arises out of the personal injury context and gives the claimant a “charge” over liability insurance policy proceeds as of the date the claimant’s injury arose. As Justice Lang stated, the provision provides a “procedural mechanism” to ensure that a claimant can “gain direct access to insurance monies that would have been available to the insured.”

 

Justice Lang acknowledged that the Bridgecorp group’s receivers’ and liquidators’ “charge” on the D&O policy’s proceeds is “conditional” upon the need for the prospective claimants’ ability to establish that the directors are liable, as well as upon the need for the directors or the claimants to establish that the directors are entitled to coverage under the policy.

 

Notwithstanding the fact that the receivers and liquidators claim on the policy proceeds is merely “conditional,” Justice Lang nevertheless held that it operated to bar the payment of the directors’ immediate criminal defense expenses. Justice Lang reasoned that because the receivers and liquidators claims are “for a sum significantly greater than the amount of cover available under the D&O policy,” the insurer is “bound to keep the insurance fund intact.”

 

Though the result might be different where the amount claimed is less than the limit of liability, where as here the amount of the claims exceed the limits of liability, any payments the insurer makes “must be for the purposes of satisfying any liability the directors may have to civil claimants,” to the point that if the insurer were to pay any defense costs, it “would be liable to restore the amount of any such payment to the pool of money available under the policy” in order to meet the claims of any claimants.

 

Justice Lang acknowledged that this result “may be harsh” for the directors, produces some “unsatisfactory consequences,” and may “seem unfair.” But he nevertheless reasoned that this result was “clearly in accordance with the object and purpose of [section] 9.” He added that the outcome was “partly the result of the fact that the Bridgecorp companies elected to take out an insurance policy that provided cover for both defence costs and claims for damages and compensation,” and is a “direct consequence of the statutory regime the Act introduced nearly 80 years ago.”

 

Discussion

At one level, this decision represents nothing more that the application of a peculiar feature of New Zealand statutory law. Moreover, informed sources advise me that the decision in under appeal, so it may or may not stand even within its own jurisdiction.

 

But at another level, this decision does raise some noteworthy implications of wider significance. The first and foremost is that it shows the significant danger that both policyholders and insurers may face with respect to the scope of D&O insurance coverage available around the world in the many jurisdictions where the interpretive case law is as yet undeveloped.

 

The threat of D&O claims throughout the world has expanded significantly in recent years, and with this increased exposure the potential significance of D&O insurance protection has also grown. Global companies increasingly seek to put in place D&O insurance protection applicable in the various countries in which they operate. But as this decision shows, D&O insureds facing claims in jurisdictions where the interpretive case law is undeveloped may not always know how the local courts will interpret and apply their policy.

 

One possible solution to this concern might be the inclusion in the D&O insurance policy of a choice of law provision designed to ensure that the policy will be interpreted according to the laws of jurisdictions where the coverage interpretations are more developed and therefore more predictable. Of course, this solution may be dependent upon the willingness of the court’s in the forum jurisdiction to recognize and apply the choice of law provision as written, as well as the apply the specified law according to expectations and assumptions. (Refer here for more thoughts about the potential need for choice of law provisions in D&O insurance policies.)

 

As Justice Lang himself acknowledged, there is something particularly “unsatisfying” about an outcome where the mere inchoate and as yet unfiled claim of a prospective claimant can take priority over the insured persons’ immediate need for criminal defense cost protection under the policy, particularly where, as Justice Lang also acknowledged “the Bridgecorp companies took the policy out at least in part for that specific purpose.”

 

In that regard, it is worth noting that this policy does not appear to contain so-called “entity coverage” (see paragraph 14 of the opinion). Accordingly, this policy clearly was intended solely for the protection of the insured directors and officers. Yet even though the policy for the individual insureds’ protection, Justice Lang’s interpretations of Section 9 subordinates the insureds’ immediate entitlement to the policy proceeds to the mere unproven claims of prospective claimants. The consequences of this topsy-turvy inversion is not just “harsh,” but grotesque as it leaves these individuals facing serious criminal charges without the very protection the insurance was designed to provide.

 

Justice Lang acknowledge that this result might not apply where the amount of the claims do not exceed the D&O insurance policy’s limits of liability, which would seem to suggest even more perversely that the more serious the claims against the directors and officers, the less likely they are to be able to rely on the defense protection under their D&O insurance policy.

 

The solution for the protection of corporate directors and officers in New Zealand would seem to be to separate out their defense cost coverage from the liability protection under their D&O insurance policy. If the Bridgecorp case is affirmed on appeal, it would seem that the New Zealand D&O insurance marketplace will have to evolve to provide a policy that avoids that pitfalls that this case presents — or seek to have Section 9 amended to recognize the need for corporate defendants to be able to rely on their D&O insurance to defend themselves.

 

One other possible solution to the problem presented by this case is to arrange for defense costs to be outside the limits of liabilty (that is, to structure the policy so that defense expenses do not erode the limit of liability). Although D&O insurance typically is not structured that way, it sometime is — indeed, if I am not mistaken, in Quebec it is required by applicable regulations that defense costs must be outside the limits of D&O insurance policies.

 

One thing this decision shows is how early the D&O insurance industry is in the process of trying to provide comprehensive global D&O insurance policies that will operate predictably in the various jurisdictions in which it may be applied. The D&O insurance industry has been working hard in recent years to develop policies that will operate globally and respond locally. The Bridgecorp decision underscores the significant challenge that the industry faces in trying to ensure that D&O insurance will predictably be available at the local level, particularly in jurisdictions where the coverage interpretations are as yet undeveloped. 

 

Perhaps it is owing to its antipodal provenance, but it seems to me that Section 9 (at least as interpreted by Justice Lang) stands the very idea of liability insurance on its head. Liability insurance does not exist to protect claimants, it exists to protect the insureds. Insurance buyers procure the insurance to protect themselves from third party lawsuits. The very idea that a mere assertion of a prospective claim, no matter how spurious, is enough to strip the insured under a liabiltiy policy of the proection they procured for themselves is questionable in its very approach to teh insurance equation. I hope that the appellate court (or if necessary the New Zealand Parliament)  will give due consideration to the nature and purposes of liabiltiy insurance and vacate the ruling of this case.

 

An October 4, 2011 memorandum about the Bridgecorp decision from the  Minter Ellison Rudd Watts law firm can be found here. An October 2011 Bulletin from Willis New Zealand about the decision can be found here.

 

Special thanks to the several loyal readers who sent me links about this opinion.