In a November 30, 2011 order (here), Central District of California Judge R. Gary Klausner has denied the motion of the FDIC as receiver of the failed IndyMac Bank to intervene in a declaratory judgment action involving IndyMac’s D&O insurance. The FDIC sought to intervene because of its interest in recovering under the policies in connection with two lawsuits it filed as IndyMac’s receiver against former IndyMac directors and officers. Judge Klausner’s denial of the FDIC’s intervention motion may be relevant in other failed bank coverage disputes where the FDIC is interested in preserving D&O insurance policy proceeds for its claims in competition with claims of claimants to the policy proceeds.

 

Background

IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).

 

As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation. The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division. There are a total of twelve separate lawsuits pending. The underlying actions allege various improprieties, mostly centering around mortgage backed securities.

 

Prior to its collapse, IndyMac carried D&O insurance representing a total of $160 million of insurance coverage spread across two policy years. The insurance program in place for each of the two policy years consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance. The lineup of insurer involved changed slightly in second year.

 

As I also noted in a prior post (here), in early 2011, a unit of IndyMac had filed a declaratory judgment action seeking to establish coverage under the various policies in connection with claims that had been filed against the unit. In an August 2011 order, discussed in the prior blog post, Central District of California Judge R. Gary Klausner granted the defendants’ motion to dismiss the action as premature.

 

Separately, in March 2011, the four Side A carriers in the second of the two insurance towers filed their own separate declaratory judgment proceedings, against certain former IndyMac directors and officers, seeking to establish that terms in their policies preclude coverage for the various lawsuits. The directors and officers counterclaimed and also added as counter-defendants the four traditional ABC carriers in the second tower.

 

In October 2011, the FDIC, which in its capacity as IndyMac’s receiver has initiated two lawsuits against certain former IndyMac directors and officers of IndyMac, moved to intervene in the separate coverage action that the Side A carriers had initiated. The FDIC had moved to intervene on alternative grounds under the Federal Rules of Civil Procedure — as of right; and alternatively under permissive intervention. The FDIC argued that because it is a plaintiff in the two underlying actions, it has an interest in seeing that the coverage dispute is resolved so that it can recover any eventual judgment in those actions out of the insurance proceeds.

 

The November 30 Ruling

In his November 30 opinion, Judge Klausner denied the FDIC’s motion to intervene. Judge Klausner held that the FDIC had not established its entitlement to intervene as of right because it “has not obtained a judgment against the Insured Defendants and may never do so,” and so presently it has at most “the hope of an eventual judgment.” Accordingly, he held, the FDIC has “no legally protected interest” in the coverage dispute.” He added that even if it had a legally protected interest, that interest is not related to the subject matter of the coverage lawsuit. Because the FDIC’s lawsuit against the former directors and officers and the separate insurance coverage action “involve different legal issues,” they are “not related for purposes of mandatory intervention.”

 

Judge Klausner held that FDIC’s alternative motion for permissive intervention also fails because the FDIC’s action against the former directors and officers, on the one hand, and the separate insurance coverage dispute, on the other hand,  do “not present common questions of law or fact.” He added that because the FDIC has not yet obtained a judgment against the Insured Defendants it “does not have an interest that it needs to protect” and its claims “are not yet ripe for adjudication” and therefore it does “not have standing as a permissive intervenor.”

 

Discussion

The FDIC’s interest in preserving its ability to collect the proceeds of a failed bank’s D&O insurance is not limited to this case. In connection with a host of other failed banks, the FDIC’s interest in the D&O insurance policy proceeds is in competition with the interests of a variety of other claimants, including in particular shareholders of the holding companies of the failed banks.  The various parties will be in a race to try to see who gets there first, and if they can get there before the insurance is substantially or entirely depleted by defense expenses. The FDIC’s interest in taking part in coverage litigation makes perfect sense.

 

But so too does Judge Klausner’s ruling here. It appears that until the FDIC has reduced its claims to a judgment it may have difficulty presenting its purported claims to the D&O insurance policy proceeds in a coverage action. The question of whether or not there is coverage under a D&O policy for a given claim scenario is different from the question whether or not the FDIC has any entitlement to the policy proceeds.

 

Special thanks to my friends at Bates Carey Nicolaides LLP for providing me with a copy of Judge Klausner’s opinion. Bates Carey represents one of the insurers in the pending coverage action.

 

ABA Journal Top 100  Blawgs: The D&O Diary is proud to have been selected as one of ABA Journal’s Blawg 100 for 2011, the Journal‘s fifth annual list of the best blogs about lawyers and the law. This year’s Top 100 designees were selected from over 1,300 nominees. It is a particular honor to be selected along with the other five business law designees, which include some of the best blogs on the Internet: Professor Jay Brown’s Race to the Bottom Blog; Broc Romanek’s The CorporateCounsel.net blog; Professor Stephen Bainbridge’s ProfessorBainbridge.com; the Truth on the Market blog, which is maintained by a number of academics; and Francis Pileggi’s Delaware Corporate and Commercial Litigation blog .

 

Between now and December 31, 2011, you can vote for your favorite among the top six business law blogs, by clicking on the ABA Journal Blawg 100 badge in the right hand column. Everyone here at The D&O Diary would appreciate your support. Thanks to the readers who make this blog possible and worthwhile.

 

In a strongly worded November 28, 2011 opinion (here), Southern District of New York Judge Jed Rakoff rejected the proposed $285 million settlement of the enforcement action that the SEC brought against Citigroup Capital Markets. But while he emphatically rejected the proposed settlement, his opinion may also suggest how the SEC might salvage this situation without a trial and even how it might structure settlements in the future in order to avoid the kind of blistering criticism that Rakoff administered in his November 28 opinion.

 

In October 2011, the SEC filed a civil enforcement action against Citigroup in the Southern District of New York and simultaneously filed a proposed Consent Judgment in which Citigroup offered to pay a total of $285 million (consisting of a disgorgement of profits of $160 million, plus $30 million in interest, and a civil penalty of $95 million). The complaint related to a billion-dollar fund that Citigroup created that allowed the company “to dump some dubious assets on misinformed investors.” The fund was marketed as consisting of attractive assets, whereas the fund was arranged to include a “substantial percentage of negatively projected assets.” Citigroup had then taken a substantial short position in the assets. Citigroup realized profits of $160 million, while investors lost more than $700 million.

 

Because Citigroup had agreed to the proposed settlement and Consent Judgment “without admitting or denying the allegations in the complaint,” Judge Rakoff had in an October 27, 2011 opinion raised a number of pointed questions about the proposed settlement (about which refer here).

 

In his November 28, 2011 opinion, Judge Rakoff stated that he was “forced to conclude that proposed Consent Judgment that asks the Court to impose substantial injunctive relief, enforced by the Court’s own contempt power, on the basis of allegations unsupported by and proven or acknowledged facts whatsoever, is neither reasonable, nor fair, nor adequate, nor in the public interest.” Judge Rakoff emphatically rejected the SEC’s argument that the public interest was not an appropriate consideration in his assessment of the proposed settlement.

 

He concluded that the settlement was not in the public interest because it “asks the Court to employ its power and assert its authority when it does not know the facts.” He added that “an application of judicial power that does not rest on the facts is worse than mindless, it is inherently dangerous.”

 

Judge Rakoff added that in a case like this that “touches on the transparency of financial markets have so depressed our economy and debilitated our lives,” there is “an overriding public interest in knowing the truth.” But instead of establishing what had gone wrong here, the SEC entered a settlement in which the defendant company neither admitted nor denied the allegations. He added that the SEC “of all agencies” has “a duty inherent in its statutory mission to see that truth prevails.” The Court, he said, “must not in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”

 

Several different times, Judge Rakoff emphasized the paramount importance of judicial independence, particularly when it is called upon to exercise its injunctive power, which, he added, “is not a free-roaming remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated.” Without facts, established either by admission or denials, the use of the court’s injunctive powers “serves no lawful purpose and is simply an engine of oppression.”  

 

Judge Rakoff also noted that the proposed settlement left the defrauded investors “substantially short-changed” as it “deals a double blow to any assistance the defrauded investors might seek to derive from the SEC litigation in attempting to recoup their losses through private litigation” since they “cannot derive any collateral estoppel assistance from Citigroup’s non-admission/non-denial of the SEC’s allegations.”

 

Judge Rakoff concluded his opinion by consolidating the case with a parallel action against the Citigroup official responsible for the toxic fund and scheduling the case for trial on July 16, 2012.

 

At lease according to the November 28, 2011 statement of SEC Enforcement Division Director Robert Khuzami about the opinion, here, the SEC Enforcement Division is deeply aggrieved by Judge Rakoff’s rejection of the settlement. Judge Rakoff’s blistering opinion certainly leaves the parties with some unattractive choices.  It also raises a larger concern that the SEC might not only have to take this case to trial, but in general might have to be prepared to take more cases to trial. This could threaten to overwhelm the SEC’s resources and ultimately even lead to less vigorous enforcement as the increased trial load forces the SEC to conserve resources by bringing fewer cases.

 

But on further reflection and on closer review, Judge Rakoff’s opinion may offer a way out, both for these parties and for the SEC in general. In footnote 7 on page 13 of the opinion, Judge Rakoff draws a sharp contrast between this settlement involving Citigroup and the SEC’s earlier settlement with Goldman Sachs, which Judge Rakoff noted “involved a similar but arguably less egregious scenario.” (For a detailed background on Goldman’s settlement of the SEC action, refer here.)

 

The Goldman settlement, he noted, involved a substantially higher civil penalty (i.e., a $535 million penalty on only $15 million in profits, compared to the proposed Citigroup settlement in which the company agreed to pay a $90 million penalty on $160 million of profits). But even more importantly, as Judge Rakoff noted, the consent judgment in the Goldman case involved an “express admission” from Goldman that the marketing materials for its toxic securities “contained incomplete information.” Judge Rakoff also noted that the Goldman consent judgment involved remedial measures beyond those to which Citigroup agreed, and also involved Goldman’s undertaking to cooperate with the SEC in ways in which Citigroup had not.

 

The contrast that Judge Rakoff drew between the Goldman settlement and the Citigroup settlement may suggest a way that the SEC and Citigroup may yet be able to settle this case (and for that matter, for future parties to try to avoid the objections that Judge Rakoff raised in connection with this proposed settlement).  

 

First, just as when the SEC and the Bank of America previously faced Judge Rakoff’s rejection of the proposed settlement of the SEC’s action against BofA, it seems that Citigroup is going to have to make a greater monetary contribution for a proposed settlement to pass Judge Rakoff’s scrutiny. (Judge Rakoff’s summary of the sequence of events surrounding the SEC’s settlement with BofA is described here.)

 

But if the parties want to avoid the July 2012 trial date, they are also going to have to work out a deal that omits the “neither admits nor denies” formulation. Judge Rakoff disparaged the SEC’s long-standing practice of including formulations of this type in its enforcement action settlements as “hallowed by history but not by reason.” 

 

In order to reach a settlement that will pass muster with Judge Rakoff, Citigroup apparently also will have to agree to express admissions of the type included in the Goldman consent judgment. Citigroup has an obvious interest in avoiding any admissions, not the least because of the impact the admissions might have on pending investor litigation. But it is worth noting that Goldman’s admissions to which Judge Rakoff referred approvingly may not be prohibitive. Goldman admitted only that its marketing materials contained “incomplete information,” and that it was a “mistake” that the materials did not explain the role of Paulson & Co. in selecting the assets underlying the toxic securities. As distasteful as Citigroup might find it to make this type of admission, it would have to be far preferable to facing trial.

 

Whether or not the parties are able to work out a formulation that is mutually acceptable and that satisfies Judge Rakoff remains to be seen. The one thing that is for sure is that if the parties are not able to work out a revised deal that passes Judge Rakoff’s muster, there will be a very interesting trial in his courtroom next July.

 

One final thought. I found it particularly interesting that one of Judge Rakoff’s objections to the absence of any factual admission as part of the settlement was that this absence deprived the investor plaintiffs the benefit they might hope to derive from the SEC litigation. I am sure the private plaintiffs’ securities bar was heartened by this comment. No doubt the litigants in this case will be interested to see if there are any helpful admissions in any forthcoming settlement – as will private litigants with respect to SEC enforcement action settlements going forward.

 

Wayne State University Law Professor Peter Henning has an interesting November 28, 2011 post about Judge Rakoff’s opinion on the Dealbook blog (here). Among other things, Professor Henning questions whether admissions on the order of Goldman’s would be enough to satisfy Judge Rakoff. David Bario’s November 28, 2011 Am Law Litigation Daily article about Judge Rakoff’s opinion can be found here. Alison Frankel’s November 28, 2011 post about the opinion on Thomson Reuters News & Insight can be found here.

 

Special thanks to the several readers who sent me links to Judge Rakoff’s opinion.

 

Here’s One for My Friends at the SEC (Who Could Probably Use a Little Cheering Up): So, a lawyer dies and goes to heaven. (I know, I know, an implausible opening, but bear with me.) The lawyer has just walked through the pearly gates and she’s surveying the scene. She sees an old man walking down the street in judicial robes. So she says to St. Peter, “Who’s the old guy in the robes?” And St. Peter says, “Oh, that’s just God. He thinks he’s a federal judge.”

 

One of the most noteworthy recent trends in corporate and securities litigation has been the dramatic growth in the frequency of lawsuits relating to mergers and acquisitions activity. These lawsuits are not only becoming increasingly more common, but also increasingly more costly. The growth in this litigation activity has been so rapid that the significance of these trends may remain underappreciated.

 

In this post, I first set the stage to examine these trends by reviewing the current landscape for traditional securities class action litigation, which differs in many ways from current conventional wisdom, and which provides a context for assessing the merger-related litigation trends. I then review important recent developments in M&A related litigation activity, both in terms of increasing frequency and escalating severity. I conclude with a review of the implications of these developments.

 

The Current Securities Class Action Litigation Environment

Traditionally, any discussion of corporate and securities litigation focused primarily (and sometimes exclusively) on securities class action litigation. In many ways, this makes perfect sense, as these kinds of lawsuits were for many years the most frequent and the most severe type of corporate and securities lawsuit.

 

More recently, the relative significance of securities class action litigation as a percentage of all corporate and securities litigation risks has shifted. As the insurance information firm Advisen has well-documented (refer here), securities class action litigation activity as a percentage of all corporate and securities litigation has declined dramatically over the past several years. Whereas securities class action lawsuits once represented among the most likely sources of litigation, in 2010 securities class action lawsuits represented less than 16% of all corporate and securities lawsuit filings.

 

As Advisen has also documented and as is discussed below, one reason for this relative decline is the growth in M&A-related litigation filings. Moreover, as is also discussed below, securities class action litigation is not the only source of corporate and securities litigation severity exposure; M&A-related lawsuits also represent a growing severity risk.

 

But, to set the stage for the discussion of M&A-related litigation trends and their significance, there are some important misperceptions about traditional securities class action litigation activity that I want to address.

 

A frequently recurring question is whether overall securities class action litigation filings are declining. Usually this discussion focuses exclusively on the absolute number of annual new securities class action lawsuit filings. In 2010, depending on the source to which you are referring, the absolute number of new lawsuit filings either declined compared to historical averages ( e.g., refer here regarding  the 2010 Cornerstone Research study) or held steady or perhaps grew (refer here regarding  the 2010 NERA Economic Consulting  study). The reasons these studies reach different conclusions are worthy topics for a separate blog post. But regardless of the conclusions about the absolute numbers of annual lawsuit filings, the key fact often  missing from the analysis is a consideration of how the absolute number of filings relates to the changing number of public companies.

 

The fact is, since, 1999, the number of companies listed on U.S. exchanges has declined every year. If you refer to the annual data from the World Federation of Exchanges (here), you will see that the number of companies listed on U.S. exchanges has declined from over 8,500 in 1999 to about 5,100 in 2010 – a decline of about 40%.

 

When the absolute number of annual lawsuits is compared to the declining number of companies trading on U.S. exchanges, it is clear that the frequency of securities class action lawsuit filings has not declined, but arguably is increasing, and at a minimum is at least holding steady.

 

But while frequency has not declined, median severity has increased. In 2010, the median securities class action settlement was $11.1 million, which is well over double the 1999 median settlement of $5.0 million and triple the 1996 median settlement of $3.7 million. These figures are not adjusted to account for the effect of economic inflation, but these figures nevertheless reflect a  substantial increase.

 

In short, even amidst the changing litigation landscape in which securities class action lawsuit filings have declined as a percentage of all corporate and securities litigation, the threat of securities class action litigation remains a very serious litigation exposure for publicly traded companies.

 

It is against this backdrop that the growth in M&A litigation must be considered.

 

The Exploding Growth in M&A-Related Litigation

Whatever else you want to say about M&A-related litigation, it is clear that there is a lot more of it now than there used to be, both in terms of absolute numbers of lawsuits filings and also relative to the number of merger transactions. Indeed, Advisen has commented that the number of M&A-related lawsuits has “skyrocketed “in recent years.

 

Reported data (refer for example here and here) show that as recently as ten years ago, there were only a handful of M&A related lawsuits filed each year. For example, in 2001, there were only four M&A related lawsuits filed, compared to the 341 filed in 2010 (up from “only” 191 the year prior). Just in the four- year period ending in 2010, the annual number of merger-related lawsuit filings has increased over 600%.

 

These numbers are even more startling when it is considered that these lawsuit filings are increasing even as the number of merger transactions is declining. The number of merger targeted companies declined in each of the three years from 2008 to 2010, yet the absolute number of merger-related lawsuits increased in each of those three years relative to the prior year. In 2010, there were 214 fewer companies targeted for mergers than there were in 2007, representing a decline of over 37%. Yet the number of merger-related lawsuits filed in 2010 was more than triple the number filed in 2007. Today, one out of every two companies announcing an acquisition is sued, and that is true whether or not the acquisition is friendly or hostile, and even whether or not the board of the target company has accepted or rejected the proposed acquisition.

 

There are a host of possible explanations for these filing trends. The first is that a changing case law environment has made securities class action litigation a more challenging game for plaintiffs (for example, as a result of the U.S. Supreme Court’s holdings in the Tellabs case and the Morrison case). In addition, the declining number of public companies over the past several years means that there are fewer prospective securities class action litigation targets. These developments may have encouraged plaintiffs’ lawyers to seek out an alternative business model.

 

And in the M&A related litigation, the plaintiffs’ attorneys seem to have found relatively easy money, as these cases often involve a quick resolution (due to the fact that the parties are often highly motivated to complete the underlying transaction) and the payment of plaintiffs’ attorneys’ fees, which average around $400,000 per case. These attributes of M&A related litigation were discussed in an August 27, 2011 Wall Street Journal article, written from the shareholders’ perspective, entitled “Why Merger Lawsuits Don’t Pay” (here) and in a July 12, 2011 Fox Business article entitled “M&A Lawsuits Skyrocket as Fee-Hungry Law Firms Smell Easy Money” (here).

 

The surest sign that M&A-related litigation represents an attractive proposition for the plaintiffs’ lawyers is the level of lawsuit competition that merger transactions increasingly are engendering. Increasingly, the announcement of a merger can trigger multiple separate lawsuits filed by separate plaintiffs’ firms in multiple separate jurisdictions, producing complicated procedural and jurisdictional issues (refer for example here and here) and also adding dramatically to the cost of litigation.

 

This latter point, about the costs involved, brings us to the heart of the matter. Not only are M&A cases increasingly more frequent, they are increasingly more costly, in a number of ways. I emphasize the costs involved because there is a perception in certain quarters that while M&A lawsuits may be numerous, they represent only a minor nuisance. To put this in insurance terms, M&A lawsuits are described as a high frequency, low severity risk. In fact, this is something I myself have said in the past. However, the truth now is, when all of the costs are considered on an all-in basis, that the cases actually are quite expensive, and increasingly are becoming more so.

 

Start with defense expenses. Because these cases often involve high stakes and short fuses, their defense often can trigger an explosion of legal fees. When you add in the additional expense involved when there are multiple cases in multiple jurisdictions, the expenses multiply. And when you add in the fact that these cases increasingly are continuing on even after the underlying merger transaction has closed, the defense costs can increase exponentially. Much of the time, these defense expenses are borne by the target company’s D&O insurer.

 

The D&O Insurers not only absorb the sometimes massive defense expenses, but they also often have to absorb the plaintiffs’ fees as well, as the payment of the plaintiffs’ attorneys’ fees often is a covered component of the case settlement. (Refer here for a recent discussion of the issues surrounding D&O coverage for a plaintiffs’ fee request in a derivative lawsuit settlement.)

 

The plaintiffs’ fees alone can sometimes be staggering. In the August 2010 Morgan Kinder lawsuit, the plaintiffs’ fee requests amounted to as much as $50 million (that is, 25% of the $200 million settlement, refer here). The plaintiffs’ fee request in the September 2011 Del Monte settlement was $22.3 million (refer here). And in the May 2010 settlement of the Atlas Energy case, the plaintiffs’ fee request was as much as $17.25 million ($25% of the $69 million settlement, refer here).

 

It should be emphasized that the plaintiffs’ fee request can be substantial even where there is otherwise no cash component to the settlement. For example, in the April 2010 XTO Energy settlement, in which there otherwise was no cash component, the plaintiffs’ fee request was $8.8 million (refer here) . In the September 2009 Pepsi Bottling settlement, which otherwise did not involve a cash payment the plaintiffs’ fee request was $7.7 million (refer here). Similarly in the February 2011 Atlas Energy case, the fee request was $4.0 million (refer here).

 

And beyond that – and the most important point here – it is increasingly common for the settlement of these cases to also involve significant cash payments. Indeed, the settlements in many of these cases suddenly are starting to resemble in order of magnitude the settlements of securities class action lawsuits. Thus, the Kinder Morgan case, as referenced above,  settled in August 2010 for $200 million (refer here); the Del Monte case, as noted above,  settled in September 2011 for $89 million (refer here); the May 2010 ACS settlement was $69 million (refer here); and the 2011 Intermix Media settlement was $45 million (refer here). In many instances, where these settlement amounts are not designated as an increase in the acquisition price, these settlement amounts may be insurable.

 

And not only have these cases become more expensive in every way, there are signs that the competition between jurisdictions could even further exacerbate this situation. At November 11, 2011 Columbia Law School conference about the Delaware Chancery Court, various observers commented on the question of whether the Delaware courts, the traditional forum for this type of litigation, were losing “market share” to other jurisdictions’ courts, possibly because plaintiffs’ lawyers believe they (and their clients too, don’t forget) think they can do better elsewhere.  Francis Pileggi has a good summary of the discussion at the conference in a November 11, 2011 post on his Delaware Corporate & Commercial Litigation blog (here).

 

As Alison Frankel discussed in a November 14, 2011 post on her Thomson Reuters News and Insight blog, here, this debate compelled one Delaware jurist to conduct a visual demonstration to try to prove that plaintiffs’ lawyers can expect to recover substantial fees in Delaware courts. It is an obvious concern if Delaware’s judges feel obliged — in order remain competitive in the jurisdictional competition and to try to preserve declining market share — to prove that plaintiffs’ lawyers will be rewarded for resorting to the state’s courts.

 

Discussion

Contrary to popular perception, the new M&A litigation model represents both a high frequency and a high severity risk. The severity risk is particularly acute given the exacerbating effects of escalating defense expenses and rising plaintiffs’ attorneys’ fees. Increasingly, M&A litigation is a recurring and very expensive feast for which D&O insurers are picking up increasingly larger tabs.

 

Another important point that should not be lost here is what the increasing risk of M&A related litigation means in combination with the ongoing risk of securities class action litigation. When all of the factors are considered – including the declining number of public companies and the increasing absolute number of lawsuits – it is apparent that publicly traded companies today  face a significantly increased risk of serious corporate and securities litigation than they did in the recent past.

 

Indeed, the probability of a U.S.-exchange listed company facing a merger lawsuit or a securities class action lawsuit in 2010 was more than double what the equivalent probability was as recently as 2006, as the number of public companies has declined and the number of lawsuits has increased. To be specific, the probability in 2006 that any given public company would get hit with a merger lawsuit or securities class action lawsuit was 2.8%; the equivalent probability in 2010 was 5.7%.  The probability of any given company being involved in serious corporate and securities litigation has never been greater.

 

All of these developments mean that publicly traded companies’ litigation risks represent an increasingly  serious and expensive problem, and that M&A-related litigation is increasingly a big part of that problem – in general, of course, but also for the companies’ D&O liability insurers as well.

 

Now, I am not the first to make some of these points about M&A-related litigation. But I think there still is a perception that if M&A-related litigation represents a problem for the D&O insurance industry, it is principally a problem for the insurers that are active in providing primary D&O insurance (refer for example here), and that this is not a problem for the carriers that confine their public company D&O exposures to the excess layers. The point I hope the above analysis gets across is that when you take into account the defense expenses, the plaintiffs’ fees and the M&A related indemnity exposure, the M&A-related litigation increasingly represents a risk for all of the carriers in companies’ D&O insurance programs. M&A litigation increasingly involves a threat of a flame-through loss, increasingly approaching the order of magnitude of securities class action litigation.

 

With both increasing frequency and severity, the casual observer might well assume that pricing for D&O insurance would also be increasing. The casual observer’s assumption would, however, fail to take into account the iron laws of supply and demand. There are more D&O insurers now than there were ten years ago, representing in the aggregate much greater levels of insurance capacity, while at the same time, there are many fewer public companies. What you have are increasing numbers of D&O insurers chasing decreasing numbers of public company D&O insurance buyers.  As a result, overall industry pricing has declined steadily since 2003.

 

It might well be asked how long this combination of circumstances in the D&O insurance marketplace can continue. Some commentators are already proclaiming that they thing they see a market turn on the horizon. I am making no predictions. I have been in this business one way or the other for nearly three decades and I think that every single day during that period someone has been predicting a hard market. We are still waiting. All I know is that if someone were looking around for reasons to explain increasing D&O insurance pricing (if it were in fact increasing), they wouldn’t have to struggle to find explanations. However, I also know that the insurance industry rarely changes as an act of will – it usually changes only as a matter of necessity. Until necessity requires, then, the D&O insurance industry likely will continue on in the same direction – even as the dashboard indicator lights flash caution.

 

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?)