A group of former executives of a Lehman Brothers subsidiary   is seeking to block the bid by senior Lehman executives to use $90 million of the remaining D&O insurance proceeds to settle the cases pending against them. As discussed here, on August 24, 2011, the senior executives filed a motion with the Lehman bankruptcy court seeking access to $90 million in insurance funds to settle the securities suits pending against them. On September 8, 2011, seven executives of Lehman’s Structured Asset Securities Corp. (Sasco) objected to the requested $90 million drawdown, arguing that it would leave the Sasco executives without sufficient insurance funds remaining to settle the claims pending against them. A copy of the Sasco executives’ opposition papers can be found here.

 

The Sasco executives, like the senior Lehman executives who seek the $90 million, are defendants in a number of securities class action lawsuits involving events leading up to Lehman’s collapse. As I detailed in my prior post about the senior Lehman executives request for the $90 million in insurance proceeds, defense expenses and other costs (including an arbitration settlement) have already significantly eroded the $250 million insurance tower. The Sasco executives claim they now have an opportunity to settle the $4 billion claims pending against them for $45 million. They contend that if the senior executives draw down the $90 million they seek, there will be insufficient remaining insurance funds to settle the claims against them.

 

In their opposition papers, the Sasco executives argue that the $90 million drawdown would represent a “disproportionate and inequitable portion” of the remaining funds. They argue that “permitting one class of insureds to use such tactics to divert a disproportionate share of insurance proceeds for their benefit to the exclusion of other classes of insureds is inequitable, contrary to the purpose of the available D&O insurance and would have an adverse economic impact on the Debtors’ estate.”

 

The Sasco executives note that the fight is with respect to Lehman’s 2007-2008 tower of insurance, which originally totaled $250 million. (This tower is described in detail in an earlier post about Lehman’s D&O insurance, here.) The Sasco executives contend that their claim actually implicated the separate $250 million 2008-2009 tower,  as it was during that policy period that the claims were first made against them. However, the carriers in the 2008-2009 D&O insurance tower apparently contend that the claims against the Sasco executives relate back to claims first  made during the 2007-2008 insurance tower’s policy period, and therefore it is the 2007-2008 tower that is implicated with respect to the claims against the Sasco executives. The Sasco executives dispute this position of the insurers, but they note in the motion papers that they cannot establish their entitlement to the proceeds of the 2008-2009 tower without protracted and expensive coverage litigation.

 

It is worth noting that the senior executives request for the $90 million drawdown would not in and of itself deplete the amounts remaining in the $250 million 2007-2008 tower. As discussed in my post about the settlement, it looks as if the drawdown would leave about $50 million remaining, which would seem to be enough to fund the Sasco executives’ proposed $45 million settlement. In their motion papers, however, the Sasco executives assert that the senior Lehman executives “will quickly attempt to settle other claims asserted against them, exhausting the remaining limits under the 2007-08 D&O policy,” contending that the senior executives “seek to appropriate all of the remaining proceeds …for their own benefit, to the exclusion of the Sasco defendants.”

 

The Sasco executives argue that they have “an equal right to insurance protection” as the senior executives and that it “would be inconsistent with the purpose of D&O insurance to permit one class to monopolize the protection.” The Sasco defendants seek to have the bankruptcy court deny the senior executives’ motion for the $90 million drawdown and to enter an order adopting an “allocation scheme” that more equitably divides the remaining proceeds. They note that they are not arguing that the proposed $90 million settlement is “unreasonable,” they simply object to the fact that the senior executives’ requested drawdown would leave them using the remaining proceeds to enter a settlement of the claims against them.

 

This situation represents a classic example of the too-many-insured, too-many-claims, not-enough-insurance problem. These problems come up in all sorts of contexts, although rarely in cases as high profile as this. The most basic problem is that even with $250 million in insurance, there is not nearly enough insurance to defend and settle all of the claims involving insured persons. The question is how the insufficient insurance proceeds should be applied.

 

There are procedural mechanisms available to deal with these types of situations, such as interpleader, where the insurer(s) simply deposit the insurance with the court and the court sorts out the entitlements. The insurers themselves would have to initiate an interpleader action. The Sasco executives are hoping to enlist the bankruptcy court to perform an equivalent allocation on an equitable basis. In their motion papers, they reference an earlier bankruptcy case where the D&O insurance policy proceeds were allocated in a pro rata basis. This type of scheme might well be equitable, but the problem is that given the number of individuals involved and the seriousness of the claims against them, a per capita allocation might leave everyone with insufficient funds to settle any of the claims against them.

 

The one thing that seems likely if the Sasco executives are unable to secure for themselves a portion of the 2007-08 insurance tower to settle the claims pending against them, they will be under pressure to try to establish that they are entitled to proceeds of the 2008-09 tower. Such a bid would involve very significant questions regarding the interrelatedness of the claims made against them with the prior claims on which the carriers are relying to argue that the claim against the Sasco executives do not involve 2008-09 insurance tower, but instead relate back to the 2007-08 tower.

 

It will in any event be interesting to see how the bankruptcy court responds to these competing claims to the proceeds of the D&O insurance coverage. The situation certainly underscores the fundamental tension that arises from the fact that the D&O insurance must provide protection for a significant number of individual directors and officers, and the fact that in the event of a catastrophic claim, the various individuals can find themselves in competition for the D&O insurance policy proceeds. One way to address this problem of course is to buy more insurance. But as the Lehman example shows, there may be limits to how much can be accomplished simply by buying more insurance. If $250 million is not enough insurance, higher limits is not going to solve much for most companies.

 

This may be one of those problems that may not be susceptible to solution, but one possible approach to ameliorate this situation is through program structure. For example, if the outside directors had their own separate tower of insurance, those amounts could be applied toward defending and settling the claims against them while the proceeds of the main policy could be applied toward the settlement of the claims against the officers. Of course, even this arrangement would not have eliminated the possibility of the kinds of problems that have arisen here. It is at least one way to try to address problems due to the fact that so many individuals are entitled to and would want the benefit of the proceeds of the main D&O insurance policy’s protection.

 

A September 10, 2011 Wall Street Journal article about the Sasco executives’ motion can be found here.

 

SEC Seeks to Enforce Subpoena Against Longtop Financial Auditor: The SEC is going on the warpath to try to enforce a subpoena that it served on Longtop Financial’s former auditor, Deloitte Touche Tohmatsu (DTT), which is the Shanghai-based affiliate of the global accounting firm, Deloitte Touche. As discussed here, Longtop is one of the many U.S.-listed Chinese companies to be caught up in accusations of accounting impropriety in recent months. DTT resigned as Longtop’s auditor earlier this year.

 

The allegations surrounding Longtop attracted the attention of the SEC, and at least according to news reports, the company recently received a Wells Notice from the SEC. The SEC also apparently tried to subpoena DTT in connection with its investigation of Longtop. As reported in the SEC’s Sept. 8, 2011 press release (here), DTT failed to produce the requested documents and so the on September 8 the SEC filed a motion with the United States District Court for the District of Columbia requiring DTT to comply with the subpoena. The SEC’s motion papers can be found here.

 

The SEC’s motion papers report that DTT’s U.S. counsel had sent a letter to the SEC asserting that (1) the firm could not be compelled to produce documents created prior to July 21, 2010, the effective date of the Dodd-Frank Act, and (2) that in any event producing any documents could subject the firm to sanctions for violations of Chinese secrecy laws.

 

The SEC contends that DTT’s arguments are “apparently based on a misunderstanding of the legal basis for the subpoena,” arguing further that the subpoena was not dependent on the additional powers given the SEC in the Dodd-Frank Act but rather was based on the SEC’s long standing subpoena power. The SEC argued further DTT’s “vague assertions of possible conflicts with a foreign law provide no justification” for DTT’s “continued non-compliance with the Subpoena.” The SEC argued that DTT’s “speculative” assertion that compliance would subject it to sanctions is “illusory” and furthermore a risk DTT “knowingly accepted by availing itself of the U.S. securities markets.”

 

As detailed in Nate Raymond’s September 8, 2011 Am Law Litigation Daily article about the SEC’s motion to enforce the subpoena (here), this situation represents something of a test case for the SEC, as (according to one commentator quoted in the article) “the SEC for obvious reasons wants to know if it can get to these documents in the future.” Another commentator in a September 10, 2011 Wall Street Journal article (here) said that the SEC’s move to enforce the subpoena represents a “major escalation.” The Journal article also notes that the dispute also “highlights the shortcomings of regulation in China, which is complicated by vague laws, competing regulatory agencies and a tight rein on information.”

 

Whatever the significance of the SEC’s action ultimately may prove to be, it is clear that the SEC has ramped up its activity levels in seeking to take action in connection with the U.S.-listed Chinese companies caught up in the accounting scandals. In addition to the Wells notice recently served on Longtop, the SEC also recently served a Wells notice on the Chairman of another Chinese company, Puda Coal (about which refer here).

 

The other thing about the challenges the SEC is facing in trying to enforce its subpoena is that it shows how difficult it will be for any party to pursue legal action against many of these Chinese companies. If the SEC can’t even enforce a subpoena against an audit firm that is registered with the PCAOB, it obviously is going to be a challenge for private litigants to try to pursue discovery from China-based firms and individuals. Indeed, because many claimants have recognized these limitations, they have tried to focus their actions against the outside professionals (underwriters, auditors, attorneys) that have facilitated the Chinese companies’ entries into the U.S. securities markets. But as the SEC’s struggles to enforce its subpoena show, some of these professionals may also be difficult to pursue.

 

Lawyers’ Relief Act: If you have not had a chance to read Eric Dash’s September 8, 2011 New York Times article “Feasting on Paperwork” (here), I recommend taking a few minutes now to read it. Unbeknownst to the rest of us, the Dodd-Frank Act was actually a stimulus package intended to rescue lawyers from the impact of the economic crisis on their profession. The Act is, in the words of one commentator quoted in the article, “a full employment act” for lawyers and consultants. The article goes on to note that new regulation “has long been one of Washington’s unofficial job creation tools.”

 

I don’t know whether to be appalled at the brazen profit-extracting presumption that the lawyers quoted in the article unapologetically express or to be impressed by their naked opportunism. There is little wonder, as the article states, that lawyers and consultants “are salivating at the prospect of even more business opportunities.” The firms are, as noted by one lawyer quoted in the article, “only getting started.”

 

The overwhelming impression is the main consequence of the Act is the enrichment of a small number of professionals at the expense of the entire economy. And lawyers wonder why they do not enjoy a higher regard in our society. The article reminds me of the old joke about how research scientists are now going to use lawyers rather than rats in their scientific experiments — there aren’t enough rats; there is no danger that the scientists will become emotionally attached to the lawyers; and there are some things that rats just won’t do.

 

The Moral of the Ducks: Even when you are completely blown away by unexpected events, the thing to do is to regroup, quickly get it back together, and march on.

https://youtube.com/watch?v=SEBLt6Kd9EY

According to papers filed on September 6, 2008, the parties to the consolidated MBIA securities action pending in the Southern District of New York have agreed to settle the lawsuit for $68 million. The settlement is subject to court approval. As noted below, the settlement has some interesting features.

 

The parties’ stipulation of settlement can be found here and the plaintiffs’ motion for preliminary approval of the settlement can be found here. Nate Raymond’s September 7, 2011 Am Law Litigation Daily article describing the settlement can be found here.  

 

As discussed here, in January 2008, MBIA joined a group of several other bond insurers there were sued in securities class action relating to their alleged failures to disclosure the exposures they had as a result of insurance guarantees they had extended ion mortgage related securities. The lawsuit against MBIA followed the company’s disclosure of the extent of the guarantees the company had extended on collateralized debt obligations. Among other things, the disclosure revealed the extent to which the company had issued insurance on so-called CDOs-squared.

 

As discussed here (scroll down), in March 2010, the Court granted in part and denied in part the defendants’ motion to dismiss. The dismissal motion grants were without prejudice to the plaintiffs’ filing amended pleadings as to the dismissed portions. In April 2010, the plaintiffs amended their complaint (refer here) and the defendants renewed their motions to dismiss. While the motions were pending, the parties began settlement negotiations.

 

In their motion seeking preliminary approval of the settlement, the plaintiffs, in explanation of the amount of the settlement state that

 

In light of MBIA’s financial condition and likelihood that this Action and other litigation against MBIA would substantially deplete Defendants’ insurance coverage, Lead Plaintiff and Lead Counsel also believed that there was a substantial risk that, even if they were successful in establishing liability at trial (and after appeals from any verdict), Defendants would not have been able to pay an amount significantly larger than the Settlement Amount or even as much as the Settlement Amount.

 

Obviously, this statement clearly implies that that at least some portion of the settlement is to be funded with D&O insurance. However, neither the motion papers nor the settlement stipulation specify what portion of the settlement is to be funded by D&O insurance. There is nothing in the filings to indicate whether the D&O insurers’ settlement contribution will deplete the remaining amount of insurance.

 

Without knowing one way or the other whether D&O insurance is to fund the entire amount of this settlement, it is clear that the fact that the D&O policy limits were rapidly eroding was a factor in this settlement and may even have affected the amount of the settlement.

 

This settlement is only the latest in a series of subprime and credit crisis related litigation in which the fact that the remaining limits were rapidly eroding was a factor in the timing and even the amount of the settlement. Other cases where there seems to have been a factor are the recent settlement involving in the Lehman executives (refer here); the recent  Colonial Bank settlement  (refer here); the D&O portion of the WaMu  settlement (refer here); and the New Century Financial settlement (here).

 

As I discussed at length in my recent post about the Lehman executives’ settlement (here) , the rapid depleting o f the D&O limits puts pressure on the plaintiffs to reach a settlement quickly. If they play hardball and hold out for a better settlement or try to holdout by demanding that individuals contribute to the settlement out of their own assets, the plaintiff’s lawyer may manage only to reduce the ultimate recovery as the D&O insurance limits drain away while negotiations drag on. This feature of many of these cases makes many of the subprime and credit crisis-related cases particularly challenging to try to settle, particularly where the defendant company is insolvent or in poor financial condition. This feature may also result in lower settlement amounts in many cases, at least where there is not solvent of financially stable company to fund additional settlement amounts.

 

I have in any event added the MBIA settlement to my list of subprime and credit crisis securities class action lawsuit settlements, which can be accessed here. As discussed here, the subprime-related securities suit against another of the bond insurers, Ambac, settled for a total of $33 million .

 

Every fall since I first started writing this blog, I have assembled a list of the current hot topics in the world of directors’ and officers’ liability. This year’s list is set out below. As should be obvious, there is a lot going on right now in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. Here is what to watch now in the world of D&O:

 

1. How Massive Will the Total Cost of the Subprime and Credit Crisis Litigation Wave Turn Out to Be?: Even though the subprime and credit crisis-related litigation wave is now well into its fifth year, only a small number of the cases have settled. But in recent weeks, a number of cases have settled in quick succession, and these settlements have been very substantial.

 

The recent settlements include the largest so far in subprime and credit crisis-related cases, the $627 million Wachovia bondholders settlement, about which refer here. Other settlements include the following: Washington Mutual, $208.5 million (refer here); Wells Fargo Mortgage Backed Securities, $125 million (refer here); National City, $168 Million (refer here); Colonial Bank, $10.5 million (refer here); and Lehman Brothers executives, $90 million (refer here).

 

With these latest settlements (many of which are subject to court approval), there have now been a total of 29 settlements collectively representing a total of almost $3.4 billion, for an average settlement of $116 million (although that average is obviously skewed upward by the $627 million Wachovia bondholders settlement and the $624 million Countrywide shareholders settlement)

 

As impressive as these cumulative numbers are, there are still many more cases pending. Of course, a certain number of the pending cases will ultimately be dismissed. But many will not, and eventually those remaining cases will be settled. Although it is impossible to conjecture how large  the total tab for all these cases ultimately will be, the implication from the cases that have settled is that the total amount will be massive.

 

The possibilities here may have significant implications for D&O insurers. Of course, not all of these amounts will be covered by D&O insurance. But a significant chunk will be. Indeed, a number of the recent settlements will be funded entirely by D&O insurance, including the WaMu settlement, the Colonial Bank settlement and the Lehman Brothers settlement. Interestingly, the Lehman settlement will come close to exhausting what is left of Lehman’s $250 million insurance tower.

 

In other words, the D&O insurers have had some very big bills to pay and could have some even bigger bills to pay in the months ahead. To the extent the ultimate loss amounts are fully reserved, these funding requirements will not cause a problem. But to the extent the carriers have not adjusted their loss reserves in anticipation of these losses, the cumulative impact of the coming settlements could be disruptive.

 

2. How Extensive Will the FDIC’s Failed Bank Litigation Efforts Become?: Since January 1, 2008, 392 banks have failed, including 70 so far in 2011 (as of September 2, 2011).  Fortunately, though the closures are continuing to mount, it appears that the failures finally may be starting to wind down. Since the current wave of bank closures began, there have been concerns that, just as it did during the S&L crisis in the late 80s and early 90s, the FDIC will again aggressively pursue claims against the directors and officers of the failed banks. At least so far, the FDIC’s litigation activity has been relatively modest. However, the signs are that the FDIC has merely been gearing up, and that substantial numbers of failed bank lawsuits could be just ahead.

 

As of September 2, 2011, there have been a total of eleven FDIC lawsuits against the directors and officers of failed banks. A number of these were filed in quick succession in August, raising the possibility that the apparent backlog of FDIC lawsuit filings may finally be starting to work out. There clearly are more cases to come. The FDIC’s website states that the agency has authorized suits in connection with 30 failed institutions against 266 individuals for D&O liability with damage claims of at least $6.8 billion. The eleven cases the FDIC has filed so far involve only 77 individuals. Even just taking account of the lawsuits that have already been authorized, there are many more suits to come, and undoubtedly even more lawsuits will be authorized.

 

The latest round of failed bank litigation has been very slow to develop. But at this point it seems likely that for the next several years there is going to be a very significant amount of FDIC litigation involving the directors and officers of failed banks. Moreover, the litigation will not be limited just to cases brought by the FDIC. Many of the failed banks were publicly trade or otherwise have broad and diverse ownership, and in many instances the bank failures have been followed by shareholder litigation. These shareholder suits represent competing claims for the D&O insurance policy proceeds. The competing claimants will be vying to secure the dwindling limits, adding a layer of complexity both for the defendants and for the FDIC.

 

3. Will the Failed Bank Litigation Be Accompanied by a Wave of Coverage Litigation?: During the S&L crisis, the FDIC was involved in extensive litigation to try to establish coverage under D&O insurance policies. Many of the leading cases on the Insured vs. Insured exclusion arose out of this litigation (about which refer here), and the Regulatory Exclusion was also extensively litigated (refer here).

 

The signs are that there could be extensive coverage litigation this time around too. Indeed, when the FDIC recently filed a lawsuit against the former directors and officers of the failed Silverton Bank, it included the bank’s D&O insurers as named defendants. As discussed here, the FDIC’s claims against the D&O insurers in the lawsuit involve the insurers’ attempt to deny coverage for the claim under the Regulatory Exclusion.

 

The FDIC may not be the only litigant involved in D&O insurance coverage litigation. As multiple defendants struggle with the problems associated with too many claims and too many insured persons, the various defendants will want to sort out their entitlement to the policy proceeds. For example, as discussed here, a subsidiary of the failed IndyMac Bank, which is a defendant in a number of lawsuits arising out of the bank’s failure, recently attempt to obtain a judicial declaration of coverage in order to sort out who was entitled to what under the bank’s D&O policies. Although the subsidiary’s claims were dismissed for lack of standing, the case does show that a variety of parties may be interested in using litigation as a way to establish their rights to the proceeds of D&O insurance.

 

The coverage litigation will hardly be limited just to D&O insurance. A recent coverage action in Alabama involved the coverage disputes involving a failed bank’s bond (refer here). There are also likely to be coverage disputes involving errors and omissions insurance. And as other outside professionals, such as accountants and lawyers, get dragged into these cases, there will likely be coverage litigation involving their professional liability policies.

 

For those of us who were involved in the failed bank coverage litigation during the S&L crisis, the return of these types of coverage cases has a very familiar feeling.

 

4. Will the Dodd-Frank Whistleblower Provisions Lead to More Claims? And How Will the D&O Insurers Respond?: Among the parts of the Dodd-Frank Act that may have a significant impact on claims is the Act’s whistleblower provisions. The whistleblower provisions include the creation of a new whistleblower bounty pursuant to which individuals who bring violations of securities and commodities laws to the attention of the Securities and Exchange Commission or the Commodities Futures Trading Commission will receive between 10 percent and 30 percent of any recovery in excess of $1 million. The SEC recently promulgated rules implementing these provisions.

 

While it is too early to tell what impact the bounty provisions will ultimately have, most observers expect that the substantial incentives provided by the whistleblower provisions will lead to an increased number of whistleblower reports and that these reports will lead to investigations and enforcement actions. In some instances, the revelations in the whistleblowers’ reports will also lead to follow-on civil litigation, as aggrieved shareholders or others pursue claims for misrepresentation or mismanagement. These follow on claims represent one type of potential increase claims exposure arising from the whistleblower provisions. But the possibility of increased numbers of investigations and enforcement actions present their own sets of issues.

 

One of the perennial issues in D&O coverage litigation is the question of policy coverage for regulatory investigations. Individual directors and officers typically covered (depending on policy wording) for both informal inquiries and requests for information, and civil, criminal, administrative or regulatory investigations commenced by either the issuance of a Target Letter or Wells Notice, or after the service of a subpoena. The company itself rarely has coverage for these types of investigations, except when it was named with an individual directors and officer in a “formal” SEC investigation. There typically is no coverage for the Company for responding to informal inquiries and requests for information from the SEC.

 

Many of these issues were discussed in the Second Circuit’s July 1, 2011 opinion in the MBIA case (about which refer here), which held that, under the specific policy language at issue and under the circumstances presented, MBIA’s D&O insurance policies covered the investigative and special litigation expense the company incurred during a regulatory investigation of its accounting practices.

 

Recently, one D&O insurance carrier introduced a new insurance product intended to provide entity coverage for these costs of investigation, as discussed here.  Due to problems of cost, as well as to the high deductibles and coinsurance that the carrier is requiring, this product is still looking for widespread acceptance. But the product’s introduction shows that the D&O insurance industry is working to try to find insurance solutions to the growing need for solutions addressing the regulatory investigation risk. To the extent the new whistleblower provisions mean increased numbers of investigations, companies will be increasingly interested in finding insurance products that address these risks.

 

5. What Will be the Next “Hot” Litigation Target?: From time to time, a sector or industry will find itself as the target of plaintiff securities class action attorneys. Last summer, for a brief period, the hot sector was the for-profit education section. Since then, the hot target has been U.S.-listed Chinese companies. This year alone, there have been 32 cases filed against U.S-listed Chinese companies (through September 2, 2011).

 

This surge of litigation involving Chinese companies has arisen out of accounting scandals, many of which were first revealed by online analysts, many of whom have short positions in the companies they are attacking. The Chinese companies have attempted to deflect the assertions of accounting improprieties by charging that the online attacks were merely rumors started by those with a financial incentive to drive down the companies’ share price. Fair or not, the online reports seem to be leading directly to shareholder litigation, as in many cases the shareholder plaintiffs are simply quoting the online analysts’ reports in their complaints.

 

For now, the phenomenon shows no sign of letting up, as the lawsuits involving the U.S.-listed Chinese companies have continued to accumulate as the year’s second half has progressed. Indeed, between July 1, 2011 and September 2, 2011, there were a total of 6 of these Chinese companies sued in new securities class action lawsuits in the U.S.

 

The recent litigation outbreak involving the U.S.-listed Chinese companies is a reminder of circumstance-specific events that can drive securities class action lawsuit filings. Many things determine filing levels, many of which cannot be captured or predicted in historical filing data. As a result, it can be misleading to try to generalize from short term trends about future filing levels. Simply put, the numbers vary over time, because, for example, contagion events and industry epidemics happen.

 

6. Will M&A Litigation Continue to Surge?: One of the more interesting phenomena in the world of corporate and securities litigation has been the changing mix of litigation. As recently as just a few years ago, securities class action lawsuits represented a significant percentage of all corporate and securities lawsuits. The insurance information firm Advisen has documented that in more recent years, class action securities litigation has represented an increasingly smaller percentage of all corporate and securities lawsuits. One area that has been growing as a percentage of all corporate and securities litigation has been M&A related litigation.

 

According to Advisen, in 2010, there were 353 lawsuits challenging corporate mergers filed in state and federal courts, which represents a 58% increase over 2009. As of August 27, 2011, 352 M&A related lawsuits had already been filed, putting this year’s filings to far exceed last year’s.

 

As discussed in an August 27, 2011 Wall Street Journal article entitled “Why Merger Lawsuits Don’t Pay” (here), these lawsuits rarely produce substantial damage awards. Often, the most they succeed in accomplishing is a delay in the merger or slightly improved disclosures about the deal’s terms. The reason these lawsuits continue to be filed, and indeed continue to be filed in increasing numbers, is that these cases are good business for the plaintiffs’ firms. These firms can collect fees that range from $400,000 for typical cases to millions of dollars for bigger cases.

 

In the past, these types of cases have not represented a significant claims exposure for D&O insurers. However, now that so many more of them are being filed, and now that individual merger deals are now attracting multiple claims, these cases are becoming a much bigger problem for the D&O insurers, particularly those that are the most active as primary insurers. A basic assumption of the D&O insurance industry is that D&O claims represent a low frequency, high severity threat. But these M&A claims are exactly the opposite – they represent a high frequency, low severity exposure, for which the D&O insurers likely did not price and almost certainly cannot underwrite. And even if the typical case settles for relatively modest amounts, the claims costs including defense fees are now in the aggregate becoming an issue for the D&O insurers.

 

In the current competitive marketplace (about which see more below), the D&O insurers may not be able to do much about this problem, but this might among the first areas to which D&O insures turn if the market does start to firm. Among other things, the D&O insurers might require higher self-insured retentions for these types of claims, on the theory that they really represent a cost of doing business rather than a true third-party liability exposure.

 

7. Will the U.S. Supreme Court Continue Its Inexplicable Willingness to Take Up Securities Cases?: Years from now, when the history of the Roberts Court is finally written, perhaps the historians will be able to explain why during the second half of the first dozen years of the 21st Century, the Court was so eager  to take up securities cases. The Supreme Court is just coming off a term in which the Court heard three different securities cases, and it has already agreed to take up one more case in the term that is about to begin.

 

The case that the Court has already agreed to hear next year is the Credit Suisse Securities case, and it involves statute of limitations issues arising in connection with Section 16(b) claims for short-swing profits. This narrow, technical issue is unlikely to have widespread significance. But what is significant is that yet again this Court has taken up a securities case. There doesn’t seem to be any particular member of the Court that is driving the Court’s interest in securities cases. But for whatever the reason, the Court’s docket increasingly includes these types of cases. Though there is only one case now on the Court’s docket in the upcoming term, the Court can always choose to hear others – which is something the Court seems inclined to do.

 

The current Court does not always rule in the favor of the defendants. For example, this last term, in the Matrixx Initiatives case (refer here), the court rejected the defense argument that plaintiffs must show “statistical significance” in order to establish materiality in a securities lawsuit. In an earlier term, in the Merck case, the court rejected the defendants’ statute of limitations arguments (refer here). But many of the Supreme Court’s recent securities law decisions  have been in the defendants’ favor, and the Court’s rulings in recent terms in such cases as Janus Capital (refer here), Morrison (refer here), and Tellabs (refer here) represent significant defense victories that have or will have a significant impact in many cases on the plaintiffs’ ability to pursue securities claims.

 

The overall cumulative impact of the Court’s interest in taking up securities cases has been favorable to companies and unfavorable to plaintiffs. There is some speculation that the increased difficulty of successfully maintaining a securities class action lawsuit through the motion to dismiss may be one reason for the shift in the mix of corporate and securities litigation away from securities class action lawsuits and toward other types of litigation (like the M&A litigation, discussed above).

 

8. Will the Implementation of the U.K Bribery Act Mean Increased Anti-Bribery Enforcement Activity?: On July 1, 2011, the U.K Bribery Act became effective, as discussed here. The Act has a broad reach, regulating prohibited conduct that takes place within the U.K. or that involves a company or person that carries on business in the U.K., regardless of where the prohibited activity takes place. The Bribery Act is broader than the U.S.’s Foreign Corrupt Practices Act, reaching a broader range of prohibited activities and providing for greater possible liabilities for those at companies involved in these activities, even if not directly involved in the prohibited conduct.

 

From the time the Act received Royal Assent, one of its features that has been the focus of particular concern has been Section 7 of the Act. Section 7 creates a new offense which can be committed by commercial organizations that fail to prevent persons associated with them from committing bribery on their behalf. Commentators have been concerned that this provision seemingly would subject any firm –even non-U.K. companies that have operations in the U.K. – to liability under the Act for violative conduct taking place any where in the world.

 

Because the Act has only just become effective, it is not yet known how aggressively it will be implemented or what its overall impact will be. At a minimum, it seems likely that the Act will lead to an increase in enforcement activity. It is also possible that as has proved to be the case with enforcement actions under the U.S. Foreign Corrupt Practices Act, follow-on civil litigation will follow in the wake of regulatory enforcement activity.

 

As companies confront these developments, among the issues that are likely to arise are questions concerning coverage for these proceedings under their D&O insurance policies, as discussed in a prior guest post on this blog.  The Act’s fines and penalties are not likely to be covered under typical policies. Whether investigative costs and defense fees will be covered will depend on a large variety of circumstances, including who is the target of the investigation. How serious these problems will turn out to be will depend a lot on the Act’s implementation, a development that will be worth watching.

 

9. What Impact Will the Changing Corporate Governance Requirements Have?: Largely due to the 2010 enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes now afoot have wrought a transformation in the relations between corporate boards and corporate shareholders. These changes have not only created additional burdens on affected companies but they have also resulted in some cases in a change in the corporate litigation environment as well.

 

Among the changes the Dodd-Frank Act implemented is the requirement for an advisory shareholder vote on executive compensation. As a result of Section 951 of the Dodd Frank Act and the requirements of SEC rules that went into effect January 25, 2011, all but the smallest public companies had to put their executive compensation practices to an advisory shareholder vote this past proxy season. As it turns out, about 40 companies experienced a negative shareholder vote. In some cases the negative “say on pay” vote have been followed by shareholder litigation, by activist investors seeking to reform executive compensation practices, as discussed here.

 

The requirement for a shareholder “say on pay” is only one of many current corporate governance reform under discussion. Other areas include the question of proxy access – that is, the question whether shareholders can have their board candidates listed on the annual proxy form. The D.C. Circuit recently struck down the SEC’s rules requiring proxy access, but the issue is not likely to go away.

 

As discussed at length here, other current corporate governance issues include reforms such as board declassification and majority voting. Other issues that loom ahead as other provisions of Dodd-Frank go into effect include requirements that companies disclose the ratio between total annual compensation of their CEO and the median annual compensation of their employees (rules implanting these provisions are required to be adopted before the end of 2011).

 

Another provision of the Dodd Frank Act requires to SEC to direct the national exchanges to impose new listing standards directing public companies to implement compensation clawback provisions. Under Section 954 of the Dodd Frank Act, companies making accounting restatements of prior financials must recover from any current or former officer all incentive-based compensation paid during the preceding three-year period above what would have been paid without the misstated financials. These provisions are to be implemented by this year-end.

 

These various provisions will affect different companies in different ways. But it is clear that these changes are here to stay and that as a result companies and their management are operating in a challenging environment. Companies that resist these governance developments may face heightened levels of scrutiny, both from shareholders and from the media. Moreover, as corporate governance standards change, boards will be held to standards of conduct reflecting the changed governance norms and expectations. And in an era of growing shareholder empowerment, that reality may translate into increased judicial expectation for boards to address shareholder initiatives.

 

Taken together, these changes in the corporate governance environment mean heightened scrutiny, changing shareholder expectations, and even an increased litigation risk. How extensive these changes ultimately will prove to be remains to be seen as the additional provisions of Dodd Frank are put into effect in the months ahead.

 

10. What Does All of This Mean for the D&O Insurance Marketplace?: Given all of these trends and developments, an outside observer might reasonably expect that the marketplace for D&O insurance would be becoming more restrictive. And certainly with respect to certain categories, such as U.S.-listed Chinese companies and commercial banks, the marketplace for D&O insurance is challenging. However, outside of those very particularized categories, the marketplace for D&O insurance remains generally competitive. Most financially stable companies continue to be able to obtain broad terms and conditions at relatively attractive prices.

 

There is nothing specific to suggest that the generally competitive environment is about to change, at least immediately. But there are a number of considerations that could lead to change. The first is the cumulative impact of the year’s catastrophic losses. The various natural disasters this year, from the earthquakes in New Zealand and Japan to Hurricane (and tropical storm) Irene, have had an impact on the insurance industry’s collective balance sheet. If there were to be another significant event in the four remaining months of the year, the accumulated losses could be enough to force a pricing increase or to cause carriers (or at least some of them) to pull back.

 

Given the catastrophe events that have already occurred this year, carriers are likely to be scrutinizing their books. Many of the developments discussed above will undoubtedly lead the various carriers to take a close look at their D&O portfolios. The mounting losses from the subprime meltdown and the credit crisis; the looming impact of the wave of failed banks; and the difficulties and uncertainties associated with a changing litigation and legal environment are all likely to raise concerns. These concerns inevitably lead to questions about pricing adequacy, risk selection, and scope of coverage.

 

In light of all of these considerations, it would be very rational for the D&O insurance marketplace to enter a more restrictive phase. In some sectors that may already be happening. For example, even relatively healthy commercial banks are seeing increased pricing and reduced limits. Several carriers are pulling back in that space.

 

At the same time, though, the overall marketplace remains competitive. As long as capacity remains ample and competition active, most companies outside of the most troubled sectors apparently will continue to enjoy the benefits of a competitive marketplace for D&O insurance. The question is how long these conditions will continue. Time will tell of course, but if the wind blows or the earth shakes again, among the consequences could be a harder market for insurance generally and for D&O insurance in particular.  

 

Labor Day has come and gone. The kids are back in school. The air is cooler and the nights are longer. There’s a definite autumnal feel in the air. It is time to get back to work. Fortunately, The D&O Diary kept its eye on things over the summer. So if you are feeling the need to get caught up on what happened while you were at the beach, don’t worry, we’ve got you covered. Here is a quick summary of what you missed on The D&O Diary while you were away.

 

Key Insurance Coverage Decisions: There have been several important D&O insurance coverage decisions in the last few months, two of them in the federal circuit courts. Probably the most significant decision of the summer is the Second Circuit’s July 1, 2011 ruling in the MBIA case, in which the Court held that the company’s D&O insurance policies cover the investigative and special litigation committee expense the company incurred during a regulatory investigation of its accounting practices.

 

The Fifth Circuit issued another important coverage ruling on August 5, 2011 when it held that where a policyholder has accepted a compromise payment from a primary carrier of less than the limit of liability of the primary policy, the excess carrier’s payment obligations were not triggered and the excess carriers has  no obligation to pay the policyholders‘ loss.

 

In another interesting coverage decision, the Judge William Q. Hayes of the Southern District of California held in an August 15, 2011 decision (refer here) that the D&O insurance policy at issue covered the attorneys’ fees of non-party employee witnesses.

 

Significant Developments in the Subprime and Credit Crisis-Related Litigation Wave: The subprime litigation wave began over four years ago but only a small number of the cases have been settled. As reflected in my running tally of subprime cases, even now only 29 of the cases have settled. But a number of these settlements were announced just in the past few weeks, and there is a definite sense that the movement of these cases toward settlement is gaining momentum.

 

The recent settlements in subprime and credit crisis-related cases included the largest subprime securities lawsuit settlement so far, the $627 million Wachovia bondholders settlement, about which refer here. Other subprime securities lawsuit settlements this summer included the following: Washington Mutual, $208.5 million (refer here); Wells Fargo Mortgage Backed Securities, $125 million (refer here); National City, $168 Million (refer here); Colonial Bank, $10.5 million (refer here); and Lehman Brothers executives, $90 million (refer here).

 

In other developments in the subprime and credit crisis cases, two appellate courts affirmed the lower courts’ dismissals of a couple of subprime cases. On May 24, 2011, the Eleventh Circuit affirmed the dismissal of the HomeBanc case (refer here), and on August 23, 2011, the Second Circuit affirmed the dismissal of the action that had been brought on behalf of the Regions Financial trust preferred securities holders (refer here).

 

There were also dismissal motion denials in two of the higher profile cases. First, on July 27, 2011, Southern District of New York Judge Lewis Kaplan denied the motion to dismiss in the Lehman Brothers case (about which refer here; as noted above, the Lehman Brothers executives settled the case against them shortly thereafter). And as discussed here, on July 29, 2011, Southern District of New York Judge Kevin Castel granted in part and denied in part the renewed motions to dismiss in the BofA/Merrill Lynch merger case.

 

FDIC Failed Bank Litigation Mounts: The current wave of bank failures is now several years old. Over 390 banks have failed since January 1, 2008. Yet the FDIC has filed lawsuits involving former directors and officers of failed banks in only a very small number of instances. In the past several weeks, however, the FDIC has launched several new lawsuits and there is a definite sense that the lull in FDIC lawsuit filings may be over.

 

Just in the last few weeks, the FDIC has filed lawsuits involving the former CEO of IndyMac bank (about which refer here); former directors and officers of Haven Trust bank (refer here); former directors and officers of Silverton bank (refer here); and First National Bank of Arizona (refer here). The Silverton bank case is particularly interesting because, as I discuss in my blog post about the lawsuit, the defendants that the FDIC named in the lawsuit include the bank’s D&O insurers.

 

With these latest filings, the FDIC has now filed a total of eleven cases involving former directors and officers of failed banks. But the likelihood is that there are more cases to come, perhaps many more. The FDIC’s own website states that the agency has authorized suits in connection with 30 failed institutions against 266 individuals for D&O liability with damage claims of at least $6.8 billion. The lawsuits the FDIC has filed so far involve only eleven failed institutions and 77 individuals. Even just taking account of the lawsuits that have already been authorized, there are many more suits to come, and undoubtedly even more lawsuits will be authorized.

 

Mid-Year Securities Litigation Studies Released: All of the leading statistical services issued their respective studies of securities class action lawsuit filings for the first six months of 2011. My post about the Cornerstone Research study can be found here; the NERA Economic Consulting study, here; and the Advisen study, here. My own analysis of the first half filings can be found here.

 

Supreme Court Issues Key Rulings: It already seems like a long time ago, but at the end of the Supreme Court’s term in June, the Court issued its opinions in several key cases. First, in a June 6, 2011 opinion (about which refer here), the Supreme Court held in the Halliburton case that proof of loss causation is not required at the class action certification stage. On June 13, 2011, the Court held in the Janus Capital case (refer here) that a mutual fund management company cannot be held liable for the alleged misstatements in the prospectuses of the mutual funds that the management company administered.

 

And finally, on June 20, 2011 the Court held in the Wal-Mart Stores v. Dukes case (refer here) that the gender discrimination claimants did not allege a companywide pattern of discriminatory practices and therefore their case could not proceed as a class action. (Earlier in the year, the Supreme Court also issued its opinion in the Matrixx Initiatives case, refer here, in which the Court rejected the “statistical significance” test for securities suit materiality.)

 

Consistent with the inexplicable interest the Court has shown in recent years in taking up securities cases, the Court has already granted a writ of certiorari for yet another securities case to be heard in the upcoming term. As discussed here, the Court has agreed to hear the Credit Suisse Securities case, which involves statute of limitations issues in Section 16(b) short-swing profits cases.

 

Litigation Against U.S.-Listed Chinese Companies Continues to Surge: As I have noted in several posts, most recently here, one of the most distinct securities litigation trends over the last twelve months or so has been the surge in litigation involving U.S.-listed Chinese companies. Signs are that this litigation surge is continuing, as the filings involving these companies have continued to accumulate so far in  the second half of the year, about which refer here. While some have questioned the merits or value of these cases, at least one of these cases recently survived a motion to dismiss, as discussed here.

 

These cases raise a number of important D&O insurance issues for these companies. A July 14, 2011 Client Advisory that I co-authored (about which refer here) examines the critical D&O insurance issues that these companies face and reviews the questions these companies should be asking about their D&O insurance.

 

Keynote Speeches at the Stanford Directors’ College: In June, I attended the Stanford Law School Directors’ college as a member of the event faculty. While there I was able to monitor the keynote speeches, about which I reported in a series of blog posts. The key note speakers included SEC Commissioner Troy Paredes, about whose presentation I wrote here; Delaware Supreme Court Chief Justice Myron Steele, whose speech I wrote about here; and SEC Enforcement Division head Robert Khuzami, about whose presentation I wrote here.

 

Debating Director Liabilities: As part of this blog’s continuing mission to explore the issues surrounding the liabilities of corporate directors and officers, I posted a couple of commentaries this summer discussing  whether and to what extent directors should be held responsible when problems occur at their companies.

 

First, on June 13, 2011, I published a post here examining the question of whether or not directors should be held liable more often. And on August 5, 2011 (here), I reviewed the question of whether or not directors at companies that have failed should be stigmatized for their association with the failed companies. Finally, on a related topic, in an August 15, 2011 post, I took a look here at issues surrounding the potential liabilities of former directors of failed banks.

 

Guest Posts: One of the great privileges of maintaining this site is that from time to time I am honored to be able to publish guest posts from leading commentators and observers. Over the course of this summer, I was fortunate to be able to publish several guest posts, including posts from the following authors and on the following topics: Anjali Das on the U.K. Bribery Act (here); Angelo Savino on the applicability of the Morrison decision to SEC enforcement actions (here); Rick Bortnick and Micha J.M. Knapp on the significance and implications of the Second Circuit’s decision in the MBIA case (here); Anjali Das again, on the issues surrounding the lawsuits against Chinese reverse merger companies (here); and Paul Ferrillo on the question of insurance coverage for investigative costs in light of the revisions of the Dodd-Frank Act (here).

 

Finally, just this past week, I published a post (here) by Mary Gill, Robert Long and Todd Chatham about the issues and concerns surrounding the defense of former directors and officers of failed banks in FDIC litigation.

 

I am very grateful to all of these authors for their willingness to publish their articles on this site. I am interesting in receiving guest post submissions from responsible commentators on topics of interest to readers of this blog. If you are interested in submitting a guest post, please contact me.

 

Coming Attractions: Tomorrow I hope to post my annual fall survey, “What to Watch Now in the World of D&O.” Obviously due to their significance, many of the items referenced above will also appear in tomorrow’s post, albeit discussed in greater depth, and there will be many additional topics as well.

 

ABA TIPS Commemorates 9/11: In recognition of the tenth anniversary of 9/11, the Tort, Trial and Insurance Practice Section (TIPS) of the American Bar Association is sponsoring a series of educational events. Among these events will be a teleconference sponsored by the TIPS Professionals, Officers and Directors Committee scheduled for September 16, 2011 from 12:00 to 1:30 Eastern Time, entitled “9/11 Attacks on the World Trade Center: Duties of Corporate Directors and Officers in the Preparation and Executive of Disaster Avoidance and Recovery,” which will be moderated by my friend Perry Granof. Complete information about this series can be found here. Registration for the September 16 teleconference can be found here. 

 

It’s a Long, Long While from May to December, But the Days Grow Short When You Reach September: Summer, it was great having you around. We are sorry to see you go. Please come back again next year. We will be thinking about you while you are gone. One thing, though. Next year we can do without the heat wave, hurricanes, earthquakes, tornadoes, and tropical storms, O.K.?

 

It is hard to believe that it is already September. There is something about heading into September and moving past Labor Day that always makes me feel blue. The feeling is captured in the classic soulful “September Song,” sung here by the incomparable Sarah Vaughn, with Teddy Wilson Quartet. Oh, the days dwindle down to a precious few. 

 

In the latest example of the SEC’s use of its compensation clawback authority under Section 304 of the Sarbanes-Oxley Act, the SEC reached a settlement with the former CFO of Beazer Homes to return more than $1.4 million in bonus compensation he earned during a period when the company was committing accounting fraud. As is contemplated under Section 304, the former CFO, James O’Leary, was obligated to return the bonus compensation even though he was himself not charged with any wrongdoing in connection with the accounting fraud. The SEC’s August 30, 2011 press release about the settlement can be found here.

 

The SEC has previously accused Beazer Homes and its former chief accounting officer, Michael Rand of accounting fraud. In September 2008, Beazer settled its SEC enforcement action. The SEC action against Rand is continuing. Last year, as reported here, Rand was separately indicted on charges including securities fraud and witness tampering. The SEC alleges that during various fiscal years including 2006  Rand and other employees misreported the company’s income by releasing redundant reserves to avoid missing analysts’ estimates.

 

O’Leary served as CFO from 2003 to 2007. However, in the SEC complaint against him, he was not charged with any involvement with or even any awareness of the accounting improprieties. Under Section 304, if any reporting company fails to comply with the financial reporting requirements of the federal securities laws, then the company’s CEO and CFO can be compelled to return bonus compensation or stock sale profits earned during the twelve months following the financial misreporting. Section 304 does not require that the CEO or CFO be personally charged with the misconduct or to have otherwise violated the securities laws.

 

Under the terms of his settlement with the SEC, which is subject to court approval, O’Leary agreed to reimburse Beazer more than $1.4 million in case, including his fiscal 2006 bonus of $1.02 million, plus $131,733 in stock compensation. He also agreed to reimburse the company $274,525 in stock sale profits.

 

O’Leary’s settlement follow the SEC’s similar March 2011 settlement with  Beazer’s CEO Ian McCarthy, who returned several millions of dollars in bonus compensation and stock compensation he had received.

 

These SOX Section 304 clawback actions against Beazer Homes CEO and CFO follow prior Section 304 clawback actions in which the SEC has sought reimbursement of compensation paid to corporate officials they had earned during periods in which their companies had made financial misstatements, as I discussed in an earlier post. As was the case in the actions against Beazer’s CFO and CEO, in the prior actions the officials involved were not alleged to have been involved in or aware of the financial misreporting. At least one court (refer here) has affirmed the SEC’s authority to pursue the compensation clawback under these circumstances, under SOX Section 304.

 

Though statutorily authorized, the implementation of a forfeiture without culpability or fault raises troubling questions, including even basic questions of fairness. On the other hand, it might also fairly be asked whether the CEO or CFO ought to be able to retain benefits accumulated at a time when the investing public was being misled, by financial statements that the CEO and CFO certified, about the company’s financial condition. As an SEC official was quoted as saying in the press release about the SEC’s settlement with O’Leary, “Section 304 of the Sarbanes-Oxley Act encourages senior management to take affirmative steps to prevent fraudulent accounting schemes from occurring on their watch.”

 

Regardless of where you come down on the propriety of the compensation clawback without culpability of any kind, the question is about to extend a much broader array of corporate officials. As discussed here and here, under Section 954 of the Dodd-Frank Act, the national securities exchanges are required to promulgate rules requiring reporting companies to adopt and disclose procedures providing for the recovery of any amount of incentive based compensation paid to any current or former executive that exceeds the amount which would have been paid under an accounting restatement in the three years prior to the date on which the company was required to prepare the restatement. The Dodd-Frank provision is quite a bit broader than Sox Section 304, as it extends to all executives and it reaches back three years and to all incentive based compensation.

 

As I have previously noted (here), these provisions allowing for the return of compensation without fault or culpability raise a host of potentially troublesome insurance coverage issues. The marketplace has responded, as many carriers are now willing in at least some cases to add a provision to their policy stating that the policy will cover defense expenses incurred in connection with a SOX 304 action.

 

With the advent of the Dodd-Frank Section 954 requirements, it may be worth asking whether the relatively new Section 304 policy provisions need to be further extended to clarify that the policies will also provide coverage for defense expenses incurred in a Section 954 action or any other compensation clawback provision.

 

Beazer Homes financial misreporting has led to a slew of litigation. As discussed here, Beazer previously settled for $30.5 million the subprime-related securities class action lawsuit that had been filed against the company and certain of its directors and officers. And as discussed here, the company also settled the separate subprime-related shareholders’ derivative suit that had been filed against the company, as nominal defendant, and certain company officials.

 

I am pleased to present below a guest post from Mary C. Gill, Robert R. Long and Todd F. Chatham of the Officers & Directors of Distressed Financial Institutions team at the Alston & Bird law firm, in which they discuss the critical issues surrounding the defense of former directors and officers of failed banks who find themselves the target of an FDIC lawsuit.

 

My thanks to Mary, Robert and Todd for their willingness to publish their article here. This article will also be published in the October edition of The Review of Banking and Financial Services. Mary will also be presenting on these same topics in a September 14, 2011 webinar entitled "Bank Executives Under Heightened Scrutiny by the FDIC," about which refer here. I welcome guest posts from responsible commentators on topics of relevance to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Here is Mary, Robert and Todd’s guest post.   

 

 

In the three years since the crush of the financial crisis, the number of banks that have been closed is roughly half the number of financial institutions that failed after the savings and loan crisis of the late 1980’s. [1] Although the number of problem institutions declined in the second quarter of 2011, there remain 865 institutions on the FDIC’s “problem bank list,” which indicates that bank closings will likely continue at a steady pace in the near term. [2] Whether the number of failed banks ultimately reaches the level of closings experienced in the post-savings and loan crisis remains to be seen.

 

 

The wave of litigation that has begun slowly and will continue in the wake of the bank closings also parallels the post-savings and loan crisis in many respects. [3] Significant developments in the law during the last decade, however, may yield strikingly different results in the claims that flow from the current financial crisis.

 

 

When a federally insured bank is closed, the Federal Deposit Insurance Corporation (“FDIC”) is appointed as conservator or receiver. The FDIC investigates every closed bank to determine whether there may be claims that can be pursued in an effort to recoup losses to the bank. [4] The investigation of a closed bank by the FDIC typically takes eighteen months with the focus on an array of professionals who provided services to the bank including accountants, lawyers, appraisers, and insurance brokers.  

 

 

The most intense scrutiny of the FDIC investigation, however, is on the former directors or officers of the failed financial institution. As a result, for an officer or director of a distressed financial institution, the risk of claims brought by the FDIC would appear to be high.    The FDIC has three years from the closing of a bank to bring claims against the former officers and directors. [5] At this point, the FDIC has authorized suits to be brought against 266 former directors and officers of 30 failed banks, seeking damages of $6.8 billion.   To date, however, only eleven lawsuits have been filed by the FDIC against former bank officers and directors. With the approach of the three year mark from the early bank closings, the pace of lawsuits filed against former bank officers and directors will undoubtedly increase.

 

 

FDIC Claims Against Bank Officers and Directors

 

According to its policy statement, the FDIC will only bring suit when there is a reasonable chance of establishing liability and the likelihood of recovery exceeds the cost of pursuing a claim. [6]   The current post-bank crisis litigation presents significant challenges to the FDIC in proving its case in court against the former officers and directors.   Under the federal statute that governs these claims, the FDIC must demonstrate that the officer or director conduct was grossly negligent, unless the applicable state law allows liability to be imposed based upon a stricter standard. [7] Simply stated, the FDIC must prove that the officers and directors made decisions that were in reckless disregard of the best interests of the bank.   In each case, the FDIC also must prove that the actions of the officers and directors caused actual losses to the bank.    In addition, the FDIC must rebut any affirmative defenses raised by the officers and directors to these claims. 

 

 

The first professional liability action brought by the FDIC in the current financial crisis was filed on July 2, 2010, against officers of the mortgage subsidiary of IndyMac, one of the earliest and largest bank failures. Since then, the FDIC has filed suit against the former officers and directors of ten other banks in Arizona, California, Illinois, Georgia and Washington. [8] The FDIC has asserted claims against these former officers and directors for negligence, gross negligence and breach of fiduciary duty. [9] In most of these cases, the claims relate to loans that were made by the bank. The FDIC also generally claims that the business plan executed by the officers and directors of the bank involved undue risk, overly aggressive growth strategy or unwarranted concentration in real estate based lending, particularly acquisition, development and construction. 

 

 

The FDIC has espoused the policy of pursuing claims against outside bank directors only for conduct that rises to the level of gross negligence or worse. [10] And, indeed, not all of the directors of these banks have been caught in the net of litigation. In many cases, only the outside directors who served on the loan committee and bore some responsibility for approving the particular loans were joined as defendants. In one instance, the FDIC sued outside directors for failure to supervise an allegedly faulty loan approval process.   Notwithstanding its stated policy, however, the FDIC has asserted claims of negligence against these outside directors.

 

 

In each of the pending lawsuits, the former officers and defendants have moved to dismiss the negligence claims on the grounds that FIRREA requires, at a minimum, a showing of gross negligence. [11] Thus, the threshold issue in these cases is whether claims of ordinary negligence will lie against the former officers and directors under the applicable state law.    Based upon well-established state law principles and decisions from the post-savings and loan litigation, courts should readily determine that the FDIC claims for negligence should be dismissed. In most states, directors are not subject to liability for negligence, either by statute or the application of the business judgment rule, which is generally viewed as protecting directors and officers from personal liability for ordinary negligence. Accordingly, in cases arising from the savings and loan crisis, courts rejected claims of negligence brought by the FDIC against bank officers and directors. For example, in a 1999 decision applying California law, the Ninth Circuit Court of Appeals held that directors are immune from claims of ordinary negligence brought by the FDIC when they have acted in good faith and on an informed basis. [12] Similarly, in the first court decision rendered in the recent wave of litigation, a federal court in California followed the same reasoning and held that the former directors of a credit union could not be held liable for negligence, which allegedly caused the failure of the financial institution. [13]

 

 

    

Although each case will be governed by the applicable state law governing the particular bank, the similarities in state law should lead to comparable results in most cases. Unless the state law governing the bank permits officers and directors to be held liable for ordinary negligence, the courts should dismiss the FDIC’s negligence claims.   The rulings in these initial cases will have a profound effect on the director and officer litigation that will continue in the years to come.

 

 

The Availability of Affirmative Defenses to FDIC Claims

 

The FDIC will also confront a variety of affirmative defenses raised by the former officers and directors in these cases. Many of these defenses were rejected by courts in the post-savings and loan crisis litigation.    The most common ground for striking affirmative defenses was the so-called “no duty” rule. A ruling by the United States Supreme Court near the end of the savings and loan litigation, however, has reopened the door to these defenses. As a result, there is a renewed viability to many of these affirmative defenses, which will level the playing field for officers and directors defending against FDIC claims.

 

 

The “no duty” rule was based upon “federal common law” and precluded former officers and directors from asserting certain defenses against the federally appointed receiver. The policy behind the “no duty” rule was “that any affirmative defense calling into question the pre-or post-bank closing action of the FDIC are [sic] insufficient as a matter of law because the FDIC owes no duty to the O&Ds of a failed bank either in its pre-failure regulation of a bank or in its post-failure liquidation of the same." FDIC v. Schreiner, 892 F. Supp. 848, 853 (W.D. Tex. 1985). Based upon this reasoning, the Resolution Trust Corporation (“RTC”), which served as receiver for many closed savings and loans, and the FDIC consistently relied on the “no duty” argument to block former officers and directors from asserting a variety of affirmative defenses to the receiver’s claims, including failure to mitigate damages, contributory or comparative negligence, estoppel and waiver. Prior to 1994, the RTC and the FDIC were generally successful in striking these defenses. As a result of the widespread acceptance by the courts of the “no duty” rule, bank officers and directors were handicapped in defending these lawsuits in the late 1980s and early 1990s.  

 

 

The litigation landscape was significantly altered near the end of the savings and loan litigation through a decision by the United States Supreme Court. As a result, former officers and directors of failed banks who face FDIC claims today may have an array of defenses that were not previously available. 

 

 

In the 1994 landmark decision, O’Melveny & Myers v. FDIC, 512 U.S. 79 (1994), the Supreme Court rejected the premise of “federal common law,” which afforded the FDIC unique protection from defenses. In doing so, the Supreme Court ruling swept away the basis for the “no duty” argument that had been applied by courts to reject an array of affirmative defenses raised by bank officers and directors to the FDIC claims.   In O’Melveny & Myers, the FDIC sued the former lawyers of a failed savings and loan institution. In their defense, the lawyers relied upon a defense that imputed the fraud of the former officers of the savings and loan to the institution itself and, as a result, to the FDIC, which as receiver stepped into the shoes of the institution.   The FDIC argued that public policy and federal common law barred the application of this defense against the FDIC.   Calling the FDIC’s premise “plainly wrong,” the Supreme Court unequivocally rejected the principle that there was a federal body of common law that afforded special defenses to the receiver. The Court held that neither federal policy, nor FIRREA itself, created a federal rule to protect the FDIC. Instead, “any defense good against the original party is good against the receiver.” [14]

 

 

 Thus, the FDIC’s previously successful argument that a federal “no duty” rule trumps otherwise available state law defenses is no longer available.   Moreover, because O’Melveny & Myers undermines the rationale upon which the prior pro-FDIC case law was based, these earlier decisions are no longer binding, nor should they be persuasive to courts in the current litigation environment.   In a number of decisions, courts have relied upon O’Melveny & Myers to reject the FDIC’s “no duty” argument and afford the director defendants state-law defenses that would have been denied them previously. [15] These decisions should pave the way for courts to allow the officer and director’s affirmative defenses to proceed on the merits, rather than stripping them of these arguments as a matter of federal policy. 

 

 

Conclusion

 

The wave of FDIC litigation against former officers and directors of banks will continue to build over the next few years. Not all officers and directors will face claims by the FDIC. For those who do, the burden of proof on the FDIC to establish liability is high.   Moreover, as a result of significant court decisions from the earlier savings and loan litigation, former bank officers and directors who face FDIC claims today have access to affirmative defenses that may bar or otherwise limit the receiver’s claims against them.   Bank directors and officers of distressed financial institutions may wish to seek counsel who can advise them and take steps now to prepare for potential FDIC claims.

 

__________________________________

 

[1]Between 1988 and 1992, there were 794 bank failures and 1,019 savings and loan failures. Recent Bank Failures and Regulatory Initiatives, Before The Committee on Banking and Financial Services, U.S. House Of Representatives (Testimony of Donna Tanoue, FDIC Chairman), February 8, 2000, available here.

 

[2] FDIC Quarterly Banking Profile, Second Quarter 2011, available here.

 

 

[3] The FDIC asserted professional liability claims against the former officers and directors of 24% of the banks that failed as a result of the savings and loan crisis from the late 1980s. Many of these claims were resolved, however, without litigation being filed by the FDIC.

 

[4] In an earlier article, the authors provided a full discussion of the FDIC investigation process, see Claims Against Bank Officers and Directors Arising from the Financial Crisis, The Review of Banking & Financial Services, Vol. 26 2010, available here.

 

[5] In some instances, the FDIC will seek to enter into tolling agreements with the former directors and officers in an effort to resolve the claims without filing a lawsuit and to afford the parties more time to do so.

 

[6} Fed. Deposit Ins. Corp., The FDIC and RTC Experience, Managing the Crisis, 266 (1998), available here.

 

[7] Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), 12 U.S.C. § 1821(k), refer here.

 

[8] FDIC v. Van Dellen, No. 2:10-cv-04915-DSF-SH (C.D. Ca.), July 2, 2010; FDIC v. Saphir, No. 1:10-cv-07009 (N.D. Ill.), Nov. 1, 2010; FDIC v. Appleton, No. 2:11-cv-00476-DDP-PLA (C.D. Ca.), Jan. 14, 2011; FDIC v. Skow, No. 1:11-cv-0111 (N.D. Ga.), Jan. 14, 2011; FDIC v. Stark, No. 3:11-cv-03060-JBM-BGC (C.D. Ill.), Mar. 1, 2011; FDIC v. Killinger, No. 2:11-cv-000459 (W.D. Wash.), Mar. 16, 2011; FDIC v. Spangler, No. 10-cv-4288 (N.D. Ill.), May 5, 2011; FDIC v. Perry, No. 11-cv-5561-ODW-MRWx (C.D. Cal.), July 6, 2011; FDIC v. Briscoe, No. 1:2011-cv-002303 (N.D. Ga.), July 14, 2011; FDIC v. Bryan, et al., No. 11-mi-99999-UNA (N.D. Ga.), August 22, 2011; FDIC v. Gary A. Dorris and Phillip A. Lamb, No. 11-cv-01652-GMS (D. Ariz.), August 23, 2011.

 

 

[9] In one of the cases, the spouses of the former officers were also sued for alleged fraudulent conveyance of assets.  FDIC v. Killinger, No. 2:11-cv-000459 (W.D. Wash.), Mar. 16, 2011.

 

[10] Managing the Crisis, supra, note 6, at 275.

 

[11] The difference between negligence and gross negligence is significant. Gross negligence requires a showing of reckless conduct in disregard of the best interests of the bank. Ordinary negligence may be established by showing a failure to act with ordinary care.

 

[12] FDIC v. Castetter, 184 F.3d 1040 (9th Cir. 1999).

 

[13] National Credit Union Administration v. Siravo, No. 2:10-cv-01597-GW-MAN (C.D. Cal.), Mar. 3, 2010.

 

[14] O’Melveny & Myers, 512 U.S. at 86.

 

[15] See, e.g., RTC v. Mass. Mut. Life Ins. Co., 93 F. Supp. 2d 300, 306 (W.D.N.Y. 2000) (permitting the defense to assert the affirmative defenses of contributory negligence and failure to mitigate damages against the FDIC/RTC); FDIC v. Ornstein, 73 F. Supp. 2d 277, 282 (E.D.N.Y. 1999) (concluding that O’Melveny & Myers completely undermined the “no duty” rule and freed defendants to assert state law affirmative defenses, such as failure to mitigate damages, against the FDIC); FDIC v. Gladstone, 44 F. Supp. 2d 81, 89 (D. Mass. 1999); FDIC v. Haines, 3 F. Supp. 2d 155 (D. Conn. 1997); RTC v. Liebert, 871 F. Supp. 370 (C.D. Cal. 1994).   A few courts have reached contrary results and held that O’Melveny & Myers should be limited to its facts. See, e.g., FDIC v. Healey, 991 F. Supp. 53 (D. Conn. 1998); see also Grant Thornton, LLP v. FDIC, 535 F. Supp. 2d 676 (S.D. W. Va. 2007); FDIC v. Raffa, 935 F. Supp. 119 (D. Conn. 1995). These decisions are based upon the rationale that it is inappropriate to second-guess the conduct of federal banking agencies. See generally, Healey, 991 F. Supp. at 58-63. This reasoning, however, directly contradicts O’Melveny & Myers, which rejects the notion of federal common law used as a shield for affirmative defenses that would otherwise be available. O’Melveny & Myers, 512 U.S. at 86.

 

In an opinion that provides an interesting glimpse of a complex D&O insurance program, on August 24, 2011, Central District of California Judge R. Gary Klausner granted the motions to dismiss of the insurance company defendants in an action that had been brought by a subsidiary of IndyMac bank, which was trying to establish its rights to coverage under the failed bank’s D&O insurance policies. A copy of the August 24 opinion can be found here.

 

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.  According to Judge Klausner’s August 24 opinion, there are a total of twelve separate lawsuits pending (referred to in the opinion as the “underlying actions”). Judge Klausner describes the litigation generally as alleging “various improprieties, mostly centering around mortgage backed securities.”

 

IndyMac MBS was a subsidiary of IndyMac Bank, and is now wholly owned by the IndyMac federal receivership. IndyMac MBS is a defendant in a number of the lawsuits that have been filed in the wake of the bank’s collapse. Earlier this year, IndyMac MBS filed an action seeking a judicial declaration of coverage on its behalf under the bank’s D&O insurance policies.

 

The insurance policies at issue represent a total of $160 million of insurance coverage spread across two policy years. (Judge Klausner’s opinion does not explain why two policy year’s policies are potentially implicated, rather than only one.) The coverage in the 2007-2008 policy year, providing coverage during the year from March 1, 2007 to March 1, 2008, 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 coverage for the policy year March 1, 2008 to March 1, 2009 is arranged similarly, except that the lineup of insurer involved changed slightly in the 2008-2009 program. Judge Klausner’s opinion names all of the carriers involved and their respective roles in the two programs.

 

In its declaratory judgment action, IndyMac MBS sought to have the court determine that each of the underlying actions is covered under one or the other of the two insurance coverage towers. Moreover, because the two programs are each subject to a “priority of payments” provision giving the individual defendants in the underlying actions priority to coverage under the policies, IndyMac MBS sought to have the court make a determination of coverage for the individual defendants in the underlying actions, so as to allow the court to ascertain whether IndyMac MBS  may be eligible to receive coverage under the policies. The defendant insurance companies moved to dismiss.

 

In his August 24 order, Judge Klausner granted the insurance companies’ motions to dismiss, holding that IndyMac MBS’s request for declaratory relief is “too remote to constitute a case or controversy” because any insurance coverage that may ultimately be owed “can only be determined after the underlying actions involving the Individual Defendants have been concluded.” Accordingly, IndyMac MBS “does not yet have an adequate injury that would make this case justiciable.”

 

In addition, Judge Klausner found with respect to the excess layers of insurance had not even been triggered because the underlying insurance has not yet been exhausted, and whether the excess layers “will ever be triggered in the underlying action is too speculative to give rise to a valid request for standing in the current case.” Indeed, even under the primary policy, IndyMac’s alleged injury is “too speculative” as IndyMac MBS has not yet met the $2.5 million deductible.

 

Finally, Judge Klausner separately granted the Excess Side A insurers’ motion to dismiss. Because the insurance coverage under the Excess Side A policies is only available, if at all, for the benefit of the individual defendants, IndyMac “lacks standing to request declaratory relief” because it “cannot adequately allege that it has a legal interest” in the Excess Side A policies, given that the Excess Side A policies “provide coverage only for the Individual Insured Defendants.”

 

Discussion

There is nothing surprising about the outcome of this ruling. It clearly is too early for the court or anyone else to try to sort out who is going to be entitled to what under the various policies. Nevertheless, it certainly is understandable that IndyMac MBS would want to know how much insurance it is going to have as it faces the various lawsuits in which it is involved.

 

This is a classic situation of too many claims, too many defendants and possibly not enough insurance. Even though IndyMac carried annual limits of liability of $80 million (and I note as an aside, there is nothing that says that both of the two $80 million towers of insurance will actually be available; it is entirely possible that all claims will relate back to the date of the initial filing of the first claim, in which case only a single $80 million tower would actually be available to pay the various insured persons’ losses), that may prove to be an insufficient amount to pay the defense fees and to pay settlements and judgments in order to resolve all of the various underlying actions.

 

The larger concern for IndyMac MBS is that owing to the priority of payments provision in the traditional ABC policies, and owing to the limitation of coverage in the Excess Side A policies to the individuals only, it is entirely possible that payment of the individual insureds’ defense expenses and settlement amounts will entirely exhaust all insurance. The Excess Side A insurance of course is not available at all for IndyMac MBS. IndyMac’s declaratory judgment action seems like an attempt to try to do something before all of the insurance is gone.

 

Of course, I am assuming for the sake of argument that there actually is coverage available under these policies for the benefit of the individual insured persons. Whether or to what extent there are policy terms and conditions that preclude coverage in whole or in part for the individual insureds is another question. That is of course one of the questions that IndyMac MBS wanted answered in the declaratory judgment action, because knowing the answer to the question of how much insurance is available to the individuals is a necessary predicate to knowing the answer to how much insurance might be available to IndyMac MBS.

 

The structure of IndyMac’s insurance was somewhat unusual, as it is not common for companies to carry equal amounts of traditional ABC insurance and of Excess Side A insurance, or to carry $40 million of Excess Side A, as IndyMac did here. However, from the perspective of the individuals, the unusually large amount of Excess Side A insurance that the bank carried is turning out to be a good thing from there perspective, as it is looking like they are going to need it, and it is only going to be available to them and for their benefit, without having to share with other entities.

 

Anyway, while I don’t think the outcome of this decision is particularly surprising, it is still an interesting situation. The circumstances provide insight into the ways that the various parts of a D&O insurance program operate, particularly the priority of payments provision and the Excess Side A insurance structure.

 

One final observation has to do with the fact that a lot of insureds, like IndyMac MBS, become frustrated when they are unable to find out with clarity at the outset of a claim how much insurance is going to be available. The problem is, as this case demonstrates, until the underlying litigation has played itself out, it is not possible to know how all of the various rights and interests under the policy are going to be addressed. When this type of frustration arises in the course of a claim, the insured persons often translate their frustration into anger at the carriers involved. But as this case also shows, even taking as active a step as suing the carriers to try to force a determination of coverage cannot eliminate the unavoidable constraint that requires the underlying claim to be resolved (or at least sufficiently advanced) before coverage can finally be determined.

 

I do wonder sometimes whether it is a sad commentary that I find all of this interesting.

 

Special thanks to a dedicated reader for sending me a copy of the IndyMac order.

 

Las Vegas Sands Credit Crisis-Related Securities Suit Survives Dismissal Motion: Like a lot of companies during the economic turmoil in late 2008, the Las Vegas Sands Corp. experienced serious liquidity problems that put it in breach of various covenants it has with its lenders. These disruptions affected the company’s ability to proceed with expansion plans in Las Vegas and Macao. As these events unfolded the company’s share price lost much of its value.

 

As I discussed in an earlier post, somewhat belatedly, in May 2010, a plaintiff shareholder filed a securities class action lawsuit in the District of Nevada, alleging that the company and certain of its directors and officers had made misleading statements about the company, its development plans, its liquidity and its financial condition. The defendants moved to dismiss.

 

In an August 24, 2011 order (here), District of Nevada Judge Kent Dawson denied the defendants’ motion to dismiss. He concluded that the plaintiffs “have adequately pled facts asserting that investors were misled by statements that liquidity was not an issue and that development was steadily progressing.” He also concluded that the plaintiffs have “adequately pled that Defendants knew that the statements they were making were false.”  He also found that the allegations in the complaint “show a series of public statements on material issues that were inconsistent with what was known internally.” He did conclude that certain forward-looking statements were not actionable, because they came within the safe harbor for forward looking statements.

 

I have added the Las Vegas Sands case to my running tally of credit crisis-related dismissal motion rulings, which can be accessed here.

 

Here’s A Real Shocker: Merger Objection Lawsuits Are Worthless: If the hurricane blew away your Saturday newspapers, you may not have seen the August 27, 2011 article in the Wall Street Journal entitled “Why Merger Lawsuits Don’t Pay” (here). According to the article, “legal experts” warn prospective claimants with respect to merger objection lawsuits that “the chances that you will succeed in stopping a deal or receiving a payday are minimal.”

 

The article reports data from Advisen that in 2010, there were 353 merger objection lawsuits, which represents a 58% increase from 2009. There have already been 352 merger objection lawsuits so far this year. The number of these lawsuits keeps increasing even though these suits “rarely result in a tangible award,” and the best outcomes are usually limited to “a delay in the merger or slightly improved disclosures about the deal’s terms.”

 

The answer to the question about why these cases are filed if they produce so little is that they make money for the lawyers. As the article puts it, “in many cases the biggest beneficiaries are the law firms,” which collect fees “from roughly $400,000 for typical cases to several million for bigger cases.” The article quotes a statement from Delaware Chancellor J. Travis Laster that the specific merger objection case before him was “a bunch of movement for nothing.”

 

Yes, it’s a great country, isn’t it?

 

Video Tribute: As a parting salute to Irene as she heads north and back out to sea, here’s a video tribute — The Scorpions "Rock You Like A Hurricane." (sorry about the commercial at the beginning, it is short).

 

https://youtube.com/watch?v=sxdmw4tJJ1Y

In a development that undoubtedly will attract comment and controversy, fourteen former Lehman Brothers executives – including former Lehman Chairman and CEO Dick Fuld (pictured) –have reached an agreement to settle the consolidated securities class action litigation that has been filed against them for $90 million. In a separate development, seventeen former Lehman executives have agreed to settle the separate lawsuit brought against them by the New Jersey Treasury Department Investment Division for $8.25 million.

 

The entire amount of both settlements is to be funded by D&O insurance. The settlements are subject to the consent of the bankruptcy court to lift the stay in bankruptcy to allow the D&O insurers to fund the settlement, as well as to the approval of the respective courts in which the respective settled actions are pending. The executives’ motion for relief from the bankruptcy stay in connection with the equity and debtholders’ action can be found here. The executives’ motion for relief from the bankruptcy stay in connection with the New Jersey action can be found here.

 

Peter Lattman’s August 25, 2011 article on August 25, 2011 article on The New York Times Dealbook blog  describing the motions and the settlements can be found here. Nate Raymond’s August 25, 2011 article on The Am Law Litigation Daily about the settlements can be found here.

 

Securities lawsuits had been filed against Lehman and certain of its directors and officers both before and after its dramatic collapse in September 2008. The cases ultimately were consolidated. On July 27, 2011, Judge Lewis Kaplan largely denied the motions to dismiss in the consolidated securities class action lawsuit, as discussed here.

 

At the time the first of these actions was filed against Lehman in early 2008, Lehman carried an aggregate of $250 million in D&O insurance, consisting of a $20 million primary policy and sixteen layers of excess insurance. A copy of the Lehman primary policy, which is included in the bankruptcy pleadings, can be found here. Further discussion of the details of the Lehman D&O insurance program can be found here.

 

Following Lehman’s bankruptcy filing, and  as the securities cases and other litigated matters went forward, from time to time the parties would appear in bankruptcy court to seek relief from the stay to allow the D&O insurers to fund ongoing defense expenses. As I noted in a prior post (here) anallyzing one of the prior requests from the relief from the stay, the defense costs have been accumulating extraordinarily rapidly.

 

The executives’ motions for relief from the bankruptcy stay for purposes of these settlements show just how rapidly the defense expenses and other items have been eroding the limits. In their motion with respect the $90 million securities class action settlement, the executives explain that they are seeking relief from the stay with respect to the sixth through twelfth level excess insurers in Lehman’s insurance program.

 

Footnote 4 of the motion identifies the excess insurers involved (their policies are also attached to the motion) and also explains that the sixth level excess insurer provide coverage of $25 million in excess of $85 million, and the twelfth level excess insurer provides coverage of $20 million in excess of $180 million. (The equivalent motion with respect to the New Jersey action seeks relief with respect to the sixth and if necessary the seventh level excess insurers, so the $8.25 million New Jersey settlement is assumed to have already eroded the limit for purposes of calculating the limits available for the consolidated securities lawsuit settlement).

 

Taking all of this information into account, and assuming the various stays and approvals are granted, the settlements, together with prior defense expenses and other payments, will erode up to $200 million of the $250 million tower. The two settlements together total $98.25 million.

 

There is nothing in any of the settlement papers to suggest that the individual defendants will contribute to either of these settlements out of their own assets. The settlements do not include the other defendants in the cases; in the securities class action lawsuit, the remaining defendants include Lehman’s offering underwriters, as well as its auditor, E&Y.

 

Discussion

Not only was the Lehman bankruptcy the largest in U.S. history, but the company’s collapse very nearly triggered a global economic catastrophe. The circumstances of its collapse have been the subject of extensive investigation and commentary. The company’s accounting prior to its collapse has also been the subject of intense scrutiny, most notably in the report of the bankruptcy examiner, who, among other things, he called the company’s quarter-end Repo 105 transactions “balance sheet manipulations,” about which refer here. Dick Fuld has become something of a poster child (or at least one of the poster children) for problems on Wall Street that contributed to the economic crisis.

 

Given that context, the fact that the individual defendants apparently are not going to contribute to this settlement is likely to be controversial. Many commentators have already bewailed the fact that cases of this type are settled exclusively with D&O insurance, and without any personal contribution by the alleged wrongdoers. These kinds of concerns will be even more exacerbated here, given the high profile nature of this case and the vilification that has heaped on Fuld and other Lehman executives. 

 

I have no insight into why the settlements were structured the way they were. But I can speculate at least that a major factor driving the timing, size and structure of these settlements was the alarming erosion of the policy limits as defense expense reduced the amount of insurance available with which to try to settle these cases.

 

The problem the plaintiffs’ lawyers faced, which is the one that claimants always face in the insolvency context, is that the plaintiffs can always hang tough and hold out for the optimal settlement, but in the meantime the policy proceeds out of which any settlement would have to be funded are rapidly disappearing. These concerns were particularly abrupt here because of the astonishing speed at which the policy limits were disappearing. An added concern for the plaintiffs here is that if they held out too long, they ran the risk that the SEC might suddenly file an enforcement complaint against one or more Lehman executive, or the DoJ might file a criminal action. If either of those things were to have happened, the rapid depletion of policy limits would have leapt into hyperspeed.

 

So to those who say that the plaintiffs’ lawyer here should have demanded a settlement in which the individuals contributed out of their own assets, I say that while that type of settlement might theoretically have been more satisfying at some level, it might not have produced a better result for the class members and other aggrieved parties. Indeed, if the settlement talks had dragged on too much longer, there might soon have been no insurance left at all out of which to settle the case.

 

I am realistic enough to know that not everyone will find this appeal to practicality to be satisfying. There is a lot of emotion associated with the Lehman collapse, and there undoubtedly will be those who will be outraged that Fuld and others are “getting off” here without having to contribute out of their own assets. This notion precedes from a basic sentiment that these executives should be punished. From my perspective, it is the job of the SEC and the DoJ to determine who needs to be punished. If the SEC and the DoJ believe these individuals should be punished in some way, they will pursue the appropriate sort of action. The types of private civil actions that are under discussion here are meant to provide a way to compensate aggrieved parties. That is the purpose of these settlements. Whether or not they are the optimal settlements, they may have been the most economically beneficial and viable settlements available given the rapid depletion of the policy limits.

 

I have in any event added these settlements to my running tally of credit crisis related case resolutions, which can be accessed here.

 

On August 23, 2011, a three-judge panel of the Second Circuit in an opinion by Judge Barrington D. Parker affirmed the dismissal of the subprime-related securities lawsuit that had been brought against Regional Financial Corporation and certain of its directors and officers. A copy of the Second Circuit’s opinion can be found here.

 

Background

As reflected in greater detail here, the plaintiffs first filed a securities class action lawsuit in the Southern District of New York against Regions on April 1, 2009. The plaintiffs represented investors that had purchased securities in the company’s $345 million April 2008 trust preferred securities offering. The defendants included the company, certain of its directors and officers, its offering underwriters, and its auditor.

 

The plaintiffs alleged that the April 2008 offering documents were false and misleading because they incorporated by reference financial statements that overstated goodwill associated with Regions Financial’s 2006 acquisition of AmSouth and underestimated loan loss reserves associated with the AmSouth’s declining mortgage lending porfolio. Among the financial statements incorporated into the offering documents was the company’s 2007 Form 10-K.

 

The complaint alleged that the company "did not write down any of the massive goodwill" it recorded in its 2007 10-K "despite growing evidence indicating that serious problems existed at the time of the acquisition." The complaint also alleges that Regions "only marginally increased its loan loss reserves" despite "the high risk of loss inherent in its mortgage loan portfolio." The defendants moved to dismiss on the grounds that the plaintiffs had failed to allege any actionable misstatements or omissions.

 

As discussed here, in a May 10, 2010 opinion, Southern District of New York Judge Lewis Kaplan granted the defendants’ motions to dismiss, holding that the statement about goodwill and the loan loss reserves represented opinions that were not actionable because the complaint failed to allege that defendants did not honestly hold those opinions at the time they were expressed. The plaintiffs appealed.

 

The Second Circuit’s Opinion

The Second Circuit affirmed Judge Kaplan’s dismissal of the trust preferred securities investors’ securities lawsuit. With respect to the allegations regarding the statement concerning goodwill, the Second Circuit observed that “as Judge Kaplan correctly recognized, plaintiffs’ allegations regarding goodwill do not involve misstatements or omissions of material fact, but rather a misstatement regarding Regions’ opinions.”

 

In concluding that the plaintiffs had not adequately alleged actionable misstatements regarding misstatements or omissions regarding goodwill, the court said that

 

Plaintiff relies mainly on allegations about adverse market conditions to support the contention that defendants should have reached different conclusions about the amount of and the need to test for goodwill. The complaint does not, however, plausibly allege that defendants did not believe that statements regarding goodwill at the time they made them.

 

The Second Circuit went on to conclude that the plaintiffs’ allegations regarding loan loss reserves “suffer from the same deficiencies as those regarding goodwill.” The court approvingly cited Judge Kaplan’s statement that “determining the adequacy of loan loss reserves is not a matter of objective fact”; rather, loan loss reserves “reflect management’s opinion or judgment about what, if any, portion of amounts due on the loans ultimately might not be collectible.” Because the plaintiff failed to allege that the defendants’ opinions were “both false and not honestly believed when they were made,” the loan loss reserve allegations also fail to state a claim.

 

Discussion

The Second Circuit’s opinion in the Regions case is the latest in a series of decisions in which the appellate courts have affirmed the district court’s dismissals of subprime or credit crisis-related securities class action lawsuits. Earlier example include the NovaStar Financial case (about which refer here), the Centerline Holdings case (refer here),  the Impac Mortgage Holdings case (refer here) and the HomeBanc case (refer here).  At this point, it seems clear the appellate courts are reluctant to setting aside the dismissal motion rulings of the district courts in these cases.

 

What makes the Regions Financial trust preferred securities case noteworthy and even interesting is that the case was dismissed, and the dismissal was affirmed, while related complaints involving many of the same facts have actually survived dismissal motions. In particular and as noted here, in June 2011, Northern District of Alabama Judge Inge Prytz Johnson denied the motions to dismiss in the securities class action lawsuit filed on behalf of Regions Financial’s shareholders.

 

The Northern District of Alabama lawsuit also alleges that the company had failed to recognize the impairment of the goodwill associated with the AmSouth merger. As I discussed in my prior post about Judge Johnson’s ruling, she expressly recognized that Judge Kaplan had previously dismissed the Southern District of New York lawsuit filed on behalf of the trust preferred securities investors. However, she differentiated the allegations in the case in her court based on the plaintiffs’ allegations made based on the statements of confidential witnesses.

 

Judge Johnson concluded that the plaintiffs in the case before her have “pled many facts showing that the defendants had information that did not support defendants’ opinions.” Among other things, she cited the statements of the confidential witnesses “showing how defendants improperly handled and classified loans, defendants were aware of the collapsing commercial real estate in Florida yet continued to push for more growth there, and continued to ignore [internal] reports signaling a negative risk-adjusted bottom line.

 

Judge Johnson concluded that the plaintiffs has sufficiently alleged that the company’s loan loss reserves were false and misleading, citing the testimony of several confidential witnesses that “defendants mishandled loans in order to manipulate their financial reporting numbers.” Because the loan loss reserves impacted the company’s reported income (which was the measure by which the company tested its goodwill), Judge Johnson concluded that the plaintiffs had adequately alleged that the company’s goodwill was “overstated, false and misleading.”

 

On August 23, 2011, Judge Johnson denied the defendants’ motion for reconsideration, rejecting the defendants’ argument that the Supreme Court’s recent decision in the Janus Capital case required a different result. Judge Johnson’s August 23 order can be found here.

 

In addition, and as noted here, the plaintiffs in the separate shareholders’ derivative lawsuit filed in Alabama Circuit Court against Regions Financial, as nominal defendant, and certain of its directors and officers, also survived a motion to dismiss. However, it should be noted that the Alabama court was determining only whether or not the requirement for pre-suit demand was excused based on the circumstances alleged.

 

Finally, and just to complete the picture, in March 2010, the motions to dismiss was also denied in the Regions Financial ERISA action, about which refer here.

 

While the differences in the outcome between the New York lawsuit and the other lawsuits can be accounted for based on differences in the claims asserted and the specific matters alleged, there is also a sense in reading through all of these opinions that the outcomes may also be understood based on the respective court’s starting points. As I noted in my prior posts discussing the prior dismissal motions denials, for the other judges, the context matters, but for Judge Kaplan (and now for the Second Circuit) the context is irrelevant. There is also a sense that the more geographically proximate the decisions maker to the locus of the corporate defendant and its woes, the less sympathetic the courts are to the defendants’ position.

 

In any event, I have adjusted my tally of the dismissal motion rulings in subprime-related securities suits to reflect the Second Circuit’s opinion. The tally can be accessed here.

 

Special thanks to Douglas Henkin of the Milbank law firm for providing me with a copy of the Second Circuit’s opinion. Milbank represented the Underwriter defendants before the Second Circuit.

 

Deutsche Bank Subprime-Related Securities Suit Survives Dismissal Motion Ruling: In an August 19, 2011 opinion, here, Southern District of New York Judge Deborah Batts largely denied the motion to dismiss in the subprime-related securities suit filed against Deutsche Bank and certain of its directors and officers.

 

As discussed here, several groups of investors, who had purchased Deutsche shares in a series of offerings during the period 2005 to 2007, filed lawsuits asserting claims that the offering materials contained material misrepresentations and omissions in the associated offering documents. The plaintiffs basically alleged that the bank had misrepresented its exposure to residential mortgage backed securities and collateralized debt obligations. The various cases were later consolidated before Judge Batts and the defendants moved to dismiss.

 

In her August 19 order, Judge Batts granted the motion to dismiss as to stock offering from October 2006. However, Batts left intact claims relating to five other offerings, or gave the plaintiffs a chance to replead their allegations.

 

I have also added the Deutsche Bank decision to my tally of subprime related dismissal motion rulings.

 

On August 22, 2011, when the FDIC filed a lawsuit related to the collapse of Silverton Bank, which is Georgia’s largest failed bank, the named defendants included not only bank officers that the regulators allege are responsible for the bank’s failure, but also the bank’s former outside directors and even the bank’s D&O insurers. A copy of the FDIC’s complaint, which was filed in the Northern District of Georgia, can be found here. Scott Trubey’s August 22, 2011 Atlanta Journal Constitution article about the lawsuit can be found here.

 

In addition, and as discussed further below, on August 23, 2011, the FDIC separate filed an action in the District of Arizona against certain directors and officers of the failed First National Bank of Nevada.

 

When Silverton failed on May 1, 2009, it had assets of over $4 billion. Prior to its collapse, Silverton had done business as a “banker’s bank” and had been chartered to do serve the needs of community financial institutions, by providing correspondent and clearinghouse services. The bank eventually expanded into residential and commercial real estate acquisition and development loans, which it accomplished through “participations” in which the Bank shared funding and risk with other banks.

 

The FDIC’s complaint alleged that its case represents “a text book example of officer and directors of a financial institution being asleep at the wheel and robotically voting for approval of transactions without exercising any business judgment in doing go.” The complaint, which seeks recovery of damages of $71 million, asserts claims against the individual defendants for negligence, gross negligence, breaches of fiduciary duty and waste.

 

The individual defendants named in the lawsuit include not only the bank’s former President and CEO and two other former bank officers, but also 14 additional former outside board members. In naming the outside directors, the FDIC stressed that what makes this case “so unique and troubling” is that the bank’s board was not composed of “ordinary businessmen” but, rather, in view of the bank’s business as a banker’s bank, of individuals who were all CEOs or presidents of other community banks. These outside board members “by virtue of their elevated positions within their own banks, were more skillful and possessed superior attributes in relation to fulfilling their duties” than “others who may serve in this capacity.

 

The complaint alleges that the individual defendants allowed the bank to pursue a strategy of rapid expansion, particularly with respect to commercial real estate lending, just as the economy started to head south, and allowed the bank to continue to pursue this strategy even after the signs of economic problems began to mount. The complaint alleges that the bank’s “aggressive banking plan” was accompanied by weaknesses in loan underwriting, credit administration and a complete disregard of a declining economy, which “led to the failure of the Bank.”

 

The complaint also alleged that the individual defendants “directed the Bank on a course of expansive and extravagant spending on unnecessary items for the Bank after the economy began to decline.” The individual defendants are alleged to have “authorized the purchase of two new aircrafts, a new airplane hanger to house three large and expensive airplanes, and a large and lavish new office building.”

 

In addition to naming the former officials of the failed bank as defendants, the complaint somewhat unconventionally also names as defendants the bank’s two D&O insurers.

 

At the time the bank failed, it carried a total of $10 million of D&O insurance, arranged in two layers consisting of a primary layer of $5 million and an additional $5 million layer excess of the primary. The complaint relates that when the binder for the relevant primary policy was issued on March 3, 2009 (that is, less than two months before the bank failed), the binder listed ten endorsements, including an endorsement containing the so-called regulatory exclusion (for background about the regulatory exclusion, refer here). However, when the primary carrier issued the policy on April 1, 2009, only seven of the ten endorsements that had been listed on the binder were included on the D&O policy. Among the endorsements that were listed on the binder that were not included on the issued policy was the endorsement with the regulatory exclusion.

 

On the afternoon of May 1, 2009 (that is, the day Silverton was closed), a representative of the primary carrier sent an email message that he “had noticed that the Regulatory Endorsement was on the Binder but left off the policy in error,” and attached to the email an endorsement with the Regulatory Endorsement dated May 1, 2009 but with an effective date of March 9, 2009. The complaint characterizes this as a “last minute attempt to unilaterally change the terms of the Policy.” The complaint further alleges that policy issuance terminated the binder.

 

The FDIC’s complaint seeks a judicial declaration that the regulatory exclusion is not a part of the primary or excess policy, and that the Insured vs. Insured exclusion, on which the carriers also purport to rely to deny coverage, does not preclude coverage for the claim. (Refer here for a discussion of the issues surrounding the applicability of the Insured vs. Insured exclusion in connection with a claim involving the FDIC as receiver.)

 

Discussion

The FDIC’s lawsuit against the former Silverton directors and officers is not the first lawsuit filed as part of the current round of bank failures in which the FDIC has included outside directors as defendants. For example, the lawsuit the FDIC recently filed in connection with the collapse of Haven Trust included the failed bank’s former outside directors as defendants, as discussed here.  The FDIC seems to have particularly targeted the outside directors of this failed bank, owing to the unusual circumstance that former directors were all themselves also senior executives of other banking institutions. The FDIC clearly intends to try to bootstrap this fact in order to argue that these specific directors should be held to a higher standard of care. (My recent post on issues surrounding questions of bank director liability can be found here.)

 

Upon reflection of the unique circumstances by which these directors came to be on the Silverton board, it occurs to me that the FDIC may have certain additional motivations in pursuing claims against the former outside directors of the bank. The parrticular circumstance I have in mind is the fact that each of these outside directors of Silverton was also an officer of another banking institution. To the extent these individuals were serving on the Silverton board at the direction of the sponsoring institution, these individuals potentially could have coverge for claims in connection with their Silverton board service under the outside director liability provisions of their sponsoring bank’s D&O insurance policies. I am expressing no views on whether or to what extent such coverage actually would be available, nor could I without further information about their sponsoring banks’ D&O insurance policies and about the circustances by which they came to be on the Silverton board. My purpose in noting the observations here is simply to suggest this possible additional motivation that the FDIC might have in pursuing claims against these particular outside directors. In any event, the outside director liability coverage, if any, under the sponsoring company’s D&O insurance may be limited to outside director service on nonprofit boards.

 

The FDIC’s inclusion of the D&O insurers as parties defendant in the liability lawsuit is unorthodox to say the least. One the one hand, as the complaint recites, the D&O insurers have denied liability for the FDIC’s claim, which might set the predicate for a more conventional (and separate) declaratory judgment action against the carrier. From reading the complaint, it seems that the primary carrier’s belated attempt to correct the omission of the regulatory exclusion from primary policy may explain the FDIC’s more aggressive approach here.

 

Whatever else may be said about the FDIC’s inclusion of the insurers as defendants in this lawsuit, the alleged facts provide a veritable parable about the importance of making sure that the issued policy matches the terms of the binder. It will be interested to see how the Court addresses what allegedly appears to be a policy issuance error, as the insurance arrangement to which the parties had agreed unquestionably was intended at the time of contract formation to include a regulatory exclusion.  For that matter, it will be interested to see whether the Court permits the coverage action to remain joined with the underlying liability action, and whether or not the Court will permit the two related actions to go forward at the same time.

 

FDIC Also Files Lawsuit Against Former Officials of First National Bank of Arizona: In addition to its new lawsuit against the Silverton officials, the FDIC also filed a separate lawsuit in August 23, 2011 in the District of Arizona  against two former directors and officers of First National Bank of Arizona,  which had been one of the sister banks of First National Bank of  Nevada until they merged shortly before FNB Nevada failed. FNB Nevada was among the first banks to fail as part of the current round of bank falures when it failed on July 25, 2008. A copy of the FDIC’s complaint in the case can be found here.  

 

The complaint alleges breach of fiduciary duty, negligence and gross negligence against the former officers, asserting that they cause the bank to sustain "losses from the unsustainable business model they promoted for FNB Arizona’s loan portfolio — a model that depended on real estate values rising indefinitely and low defaule rate." The complaint alleges that "when the real estate market collapsed and default rates skyrocketed, FNB Arizona was left holding millions of dollars of bad loans it could not sell." The FDIC alleges that as a result of the defendants’ conduct, the FDIC has sustained losses in excess of $193 million.

 

 

The Current FDIC Failed Bank Lawsuit Count: These complaints represent the tenth and eleventh that the FDIC has filed against former directors and officers of a failed bank as part of the current round of bank failures. The Silverton lawsuit represents the third so far in Georgia. There undoubtedly will be more lawsuits to come, as the FDIC has indicated on its website that as of August 4, 2011, it has authorized suits in connection with 30 failed institutions against 266 individuals for D&O liability with damage claims of at least $6.8 billion. With the Silverton Bank and FNB Nevada lawsuits, the FDIC has now filed suits in connection with eleven failed institutions against 77 individuals. Even just taking account of the lawsuits that have already been authorized, there are many more suits to come, and undoubtedly even more lawsuits will be authorized.

 

But with the back to back arrival of these two lawsuits in the space of two days, both involving banks the failed early on the the bank failure wave, there is a sense that the long lagtime associated with the FDIC’s lawsuit filings may be over. For what it is worth, both of these new complaints both involve the same lawfirm on behalf of the FDIC, the Mullin Hoard & Brown law firm of Amarillo, Texas.

 

It is probably worth noting that the FDIC’s lawsuit is not the first to be filed against the former directors and officers of Silverton. As reflected here, the bank’s defunct parent company earlier this year filed suit against the bank’s former CEO and its former accountant and accounting firm, seeking about $65 million in damages.

 

Special thanks to the several readers who sent me copies of the Silverton complaint and related links. Special thanks also to the loyal reader who sent me a copy of the FNB Nevada lawsuit as well.

 

Number of Problem Banks Declines: According to the FDIC’s latest Quarterly Banking Profile, released on August 23, 2011 (refer here), the number of problem institutions during the second quarter of 2011 declined to 865, from 888 at the end of the first quarter of 2011. This reduction represents the first quarterly decline in the number of problem institutions in 19 quarters. (The FDIC identifies banks as problem institutions as those that are graded a 4 or a 5 on a 1-to-5 scale as a result of “financial, operational, or managerial weaknesses that threat their continued financial viability.” The FDIC does not release the names of the individual problem institutions.)

 

While the quarterly decline in the number of problem institutions is good news, the latest quarterly figure still represents a significant number and percentage of all banks. The 865 problem institutions represents about 11.5% of the 7513 of all reporting institutions. This is slightly lower than the 11.7% of all banks that were rated as problem institutions at the end of the first quarter.

 

With the continued weakness in the sector, the number of failed and troubled banks will continue to remain a concern for some time to come.

 

The FDIC’s August 23, 2011 press release regarding the latest Quarterly Banking Profile can be found here.