In the latest eye-popping subprime-related securities class action lawsuit settlement, the parties to the National City Corporation securities class action lawsuit have agreed to settle the case for $168 million. The proposed settlement is subject to court approval. The August 8, 2011 press release of the New York Comptroller, acting on behalf of the New York State pension funds as lead plaintiff, can be found here.

 

The settlement papers are not yet available on PACER (indeed, that is the reason I waited for a day to publish a post about this settlement, in the hope that I might be able to run down copies of the papers. No luck so far – should I get my hands on them, I will post them to this site.) Jan Wolfe’s August 9, 2011 Am Law Litigation Daily article describing the settlement can be found here.

 

As detailed here, this case arises out of the financial woes that beset Cleveland-based National City as its portfolio of subprime related mortgages nearly dragged the bank down. In their 249-page consolidated amended complaint (here), the plaintiffs alleged that as the residential real estate market began to collapse in 2007, the bank’s residential mortgage and construction loan portfolio – which allegedly was of much lower quality than the bank had disclosed — began to deteriorate much more rapidly than the company acknowledged publicly. The plaintiffs alleged further that the bank’s failure to recognize this deterioration rendered the bank’s financial statements and other disclosures materially misleading.

 

National City’s financial difficulties proved so severe that in October 2008, it was acquired at fire sale prices by PNC. The transaction was highly controversial at the time, and not just because it involved a takeover of a landmark Cleveland institution by a bank based in Pittsburgh. As discussed at greater length here, because PNC moved to acquire National City using TARP funds that PNC had only just received and only after TARP funds were withhold from National City.  The PNC acquisition was itself the subject of separate litigation, which was later voluntarily dismissed. PNC’s acquisition of National City means that the likely source of funds for this settlement was PNC itself, to the extent not otherwise funded by D&O insurance – hence my interest in seeing the settlement papers.

 

The parties to the related-ERISA class action previously settled that action for $43 million, as discussed at greater length here.

 

The $168 million National City securities class action lawsuit settlement follows close on the heels of the announcement of the $627 million Wachovia bondholders’ settlement. I have long wondered when the overhang of subprime-related securities class action lawsuit would finally start to work itself off. With these settlements, it seems increasingly likely that the time may now be here.

 

There have been larger settlements announced in connection with the subprime-related securities class action litigation wave, but the National City settlement is still attention-grabbing. Among other things, the National City settlement, if approved, would be the 53rd largest all-time securities class action lawsuit settlement. As was the case with the Wachovia settlement, the National City settlement was not (prior to the settlement) one of the highest profile subprime-related cases. But while these two cases may not have been at the center of the radar screen, these two nine-figure settlements in quick succession undoubtedly have gotten everyone’s attention.

 

The problem for the parties in the remaining subprime cases is that these settlements — and the recent $125 million settlement in the Wells Fargo mortgage-backed securities cases – create an even more challenging environment in which to try to work out a settlement. The plaintiffs in these other cases undoubtedly will by try to rely on these settlements as a way to try to argue that the price of poker is going up.

 

Here We Are Now, Entertain Us: It may not be quite the same thing without Kurt Cobain, but still this is pretty awesome.

A recurring insurance coverage issue is the question of excess insurers’ obligations when the underlying insurers have paid less than their full policy limits as a result of a compromise between the underlying insurers and the policyholder.

 

In the latest of a growing list of recent cases examining these issues, on August 5, 2011, the Fifth Circuit, applying Texas law held, based on the language of the excess policies at issue, 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 they have no obligation to pay the policyholders ‘ loss. The Fifth Circuit’s August 5 opinion can be found here.

 

Background

In July 1999, Associates First Capital Corporation purchased $200 million of integrated risk insurance coverage, arranged in three layers. The primary $50 million was provided by Lloyd’s. In addition, there was a layer of $50 excess of the primary $50 million in the “Secondary Layer,” and a third layer, called the “Quota Share Layer,” provided $100 million excess of the primary and Secondary layers.

 

In November 2000, Citigroup purchased Associates and later sought insurance coverage from the insurers in connection with its settlement of two matters that had been pending against Associates. The settlement in the actions totaled $240 million plus $23 million in class counsels’ fees and costs. The Fifth Circuit opinion states that Citigroup entered the settlement “without the consent of the carriers.”

 

Each of the insurers initially denied coverage, but Citigroup ultimately entered a settlement with Lloyd’s by which Lloyd’s paid $15 million of its $50 million layer. The excess carriers continued to refuse coverage, and Citigroup filed suit. Citigroup later settled with the insurers in the Secondary layer, but the coverage litigation continued as to the insurers in the Quota Share Layer. The remaining parties moved for summary judgment.

 

The District Court granted summary judgment in favor of the excess insurers, holding that under each of the excess insurers’ respective policies, their liability did not attach until the primary insurer had paid its full $50 million limit of liability. Citigroup appealed.

 

The August 5 Opinion

On appeal, Citigroup attempted to rely on the holding of Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 225 (2d Cir. 1928), arguing that where an excess insurance policy ambiguously defines “exhaustion,” settlement with an underlying insurer constitutes exhaustion of the underlying policy, for purposes of determining when the excess coverage attaches.

 

The Fifth Circuit, applying Texas law, declined to follow the “Zeig rule,” stating that “we conclude that the plain language of the policies dictate that primary insurer pays the full amount of its limits of liability before the excess coverage is triggered.”

 

The Fifth Circuit examined the exhaustion trigger language of each of the excess policies and concluded that the “plain language” of each of them “requires that Lloyd’s pay Citigroup the total limits of Lloyd’s liability before excess coverage attaches,” adding that “Citigroup’s settlement with Lloyd’s for $15 million of its $50 million limits of liability in exchange for a release from coverage for [the underlying claims], did not satisfy the requirements necessary to trigger the excess insurers’ coverage.” 

 

The Fifth Circuit affirmed the District Court’s entry of summary judgment in favor of the excess insurers.

 

Discussion

The Fifth Circuit’s decision in the Citigroup case joins a growing list of recent judicial decisions rejecting the Zeig rule and requiring as a trigger of coverage for excess insurance coverage that the limit of liability of the underlying insurance be exhausted by payment of loss. Indeed, the Fifth Circuit cited with approval the March 2008 California Intermediate appellate court opinion in the  Qualcomm case (about which refer here) and also cited the July 2007 Eastern District of Michigan opinion in the Comerica case (about which refer here), noting that “while not binding,” the Comerica case is “persuasive.” Another recent case reaching the same conclusion was the Bally case (about which refer here), although the Fifth Circuit did not refer to the Bally decision.  As first federal circuit court decision, the Citigroup case could prove to be the most significant in this line of cases.

 

While this list of case authority is growing longer, it is important to keep in mind that the outcome of each of these cases was a direct reflection of the specific language of the exhaustion trigger in the excess policies at issue. In each case, the courts concluded that the excess policies required complete exhaustion of the underlying limit of liability by payment of loss.

 

These cases underscore the critical importance of the language describing the payment trigger in the excess policy. In recent months, and in large part as a reaction to these cases, excess carriers increasingly have been willing to provide language that allows the excess carriers’ payment obligations to be triggered regardless whether the underlying amounts were paid by the underlying insurer or by the insured. This language was not generally available in 1999 when Associates First purchased its integrated risk insurance.

 

Increasingly larger settlement amounts and increasingly higher defense expenses are increasingly driving claims losses into the excess layers, and as a result these issues pertaining to the excess policies’ coverage triggers are also increasingly important. These cases underscore the critical importance of the specific wording used in the excess policies, which in turn highlights the need to have an experienced, knowledgeable insurance professional involved in the insurance placement process.

 

One interesting final note about the Fifth Circuit’s opinion is that it represents the unusual resolution of a case “by quorum.” Due to the July 14, 2011 death of Judge William Garwood, the opinion was issued by the remaining two judges of the three judge panel that heard the case.

 

What Makes a Marine Biologist Scream?: This is seriously cool. Warch very closely…

 

http://www.sciencefriday.com/embed/video/10397.swf

According to Cornerstone Research’s recently released mid-year 2011 securities litigation report (here), during the 18 months ending on June 30, 2011, there were a total of 37 securities class action lawsuit filings involving U.S. listed Chinese companies, 33 of which obtained their U.S. listing by way of a “reverse merger” a publicly traded shell company. While some have questioned how these cases will fare, at least one of these cases recently survived a motion to dismiss, a development that an August 4, 2011 memo from the O’Melveny & Myers law firm (here) suggested “could signal the willingness of courts to her reverse merger securities fraud actions.”

 

As discussed here, plaintiffs first filed their complaint against Orient Paper, certain of its directors and officers, and its auditor in the Central District of California in August 2010. Orient Paper had obtained its U.S. listing by way of a reverse merger transaction. The plaintiffs allegations were largely based on an online report by Muddy Waters, a securities analysis firm and known short seller of shares of Chinese companies. The plaintiffs alleged that the company had failed to disclose related-party transactions with its main supplier, and that company misstated its financials in its annual reports in 2008 and 2009. The allegations financial statements were based on alleged differences between its SEC filings and its Chinese regulatory filings. The plaintiffs also alleged that the allegedly misleading financial statements had audited by a disbarred and unlicensed auditor.

 

The defendants moved to dismiss, contending that plaintiffs had not adequately alleged material misrepresentation, arguing that the company’s auditor had not been disbarred and that an internal company investigation conducted by the company’s audit committee determined that there was no evidentiary basis to substantiate the financial misrepresentation allegations. The defendants also alleged that the plaintiffs had not adequately pled scienter.

 

In a July 20, 2011 order (here), Central District of California Judge Valerie Baker Fairbanks denied the defendants’ motions to dismiss. The plaintiffs had provided PCAOB documentation substantiating that the company’s auditor had been disbarred. Judge Fairbanks also found with respect to the company’s internal investigation that it had been conducted by the company’s own audit committee “with no public or signed statements by any of the outside firms” the company had hired for the effort.” She added that “the truth of the Muddy Waters report and the audit committee’s conclusions is a factual dispute not appropriate for resolution at this stage.”

 

With respect to the issue of scienter, she found that “viewed holisitically … the inference of scienter advanced by the Plaintiffs is “at least as compelling as any opposing inference one could draw from the facts alleged.” Her find in this respect was based in part on the related-party transactions which indirectly benefited the company’s CEO. She also found the internal investigation on which defendants’ sought to rely in order to rebut the inference of scienter to be “questionable.”

 

According to the law firm memo, Judge Fairbanks’ ruling in the Orient Paper case is the first opinion involving a corporate defendant in a Chinese reverse merger company securities case. A prior ruling in the China Experts Technology case, discussed here, involved only the company’s auditors and also involved a case filed in 2007, prior to the current round of Chinese reverse merger litigation. The ruling in the China Expert Technology case did not relate to the company, which never responded to the complaint. The Orient Paper decision, by contrast, does not relate to the company’s auditor, who has not yet been served in the case.

 

With respect to Orient Paper decision, the law firm memo noted that Judge Fairbanks denied the motion to dismiss even though the plaintiffs had based “nearly all of their allegations on an Internet report authored by an admitted short seller.” The memo goes on to note that many of the cases filed against the Chinese reverse merger companies were, like that against Orient Paper, “preceded by disparaging reports from self-interested and often anonymous short sellers.”

 

In its assessment of the significance of the Orient Paper decision, the law firm memo says that “if this first motion to dismiss opinion is any view into the future, and defendants are unable to challenge the truth of the short seller reports at the pleading stage, most of these cases appear poised to proceed past the pleading stage, and instead, their issues will most likely be decided on motions for summary judgment.”

 

One obvious concern for these companies if they become involved in protracted U.S. securities litigation is the expense involved. This prospect may be particularly daunting for many of these companies because in many instances with which I am aware, the companies carry very low and in same cases minimal levels of directors and officers liability insurance. (My more detailed view of the D&O liability insurance issues involving the securities litigation exposures of U.S. listed Chinese companies can be found here.)

 

Alison Frankel’s June 21, 2011 report about the Orient Paper decision in Thomson Reuters News & Insight can be found here. My prior discussion about the role of the Muddy Waters firm in raising the allegations asserted in may of these Chinese reverse merger companies can be found here, in a post that also discusses the litigation hurdles that the plaintiffs in many of these cases will face.

 

Many thanks to the loyal reader who forwarded me a copy of Judge Fairbanks’ decision.

 

Securities Litigation in Japan: In a July 2011 publication entitled “Trends in Securities Litigation in Japan: 2010 Update” (here), NERA Economic Consulting provides a status report on the current state of securities litigation in Japan. Among other things the study reports that “the number of judgments related to damages litigation over misstatements has decreased substantially to seven in 2010 from 14 in 2009.”

 

The study also notes that the number of regulatory actions by the Japanese Securities and Exchange Surveillance Commission regarding monetary penalties for misstatement has “increased to a record high of 12 in 2010 from nine in 2009.” In light of the number of enforcement actions “the potential for future misstatement cases is expected to continue to rise.” The study also notes the increase in the number of shareholder petitions “for appraisal of stock purchase price in company reorganizations.”

 

In what is the largest settlements so far to arise out of the subprime meltdown-related securities class action litigation wave, and apparently the largest settlement ever of a securities suit filed solely under the Securities Act of 1933, the parties to the consolidated Wachovia Preferred Securities and Bond/Note Litigation have collectively agreed to settle the suit for a total of $627 million. The settlement is subject to court approval. The lead plaintiffs’ August 5, 2011 memorandum in support of the motion to approve the settlement can be found here, and the parties’ settlement stipulation can be found here.

 

The settlement amount of $627 million represents two different settlement funds: $590 million on behalf of the Wachovia defendants, including 25 former directors and officers of Wachovia, as well as 72 different financial firms that underwrote bond offerings for Wachovia between 2006 and 2008; and $37 million on behalf of Wachovia’s auditor, KPMG. According to data from Institutional Investor Services, the collective $629 million settlement, if approved, would represent the fourteenth largest securities class action settlement of all times.

 

As impressive as these aggregate numbers are, one ratio may be the most impressive number of all. According to the plaintiffs’ motion for settlement approval, the settlement recoveries “collectively represent roughly 30% to 50% of the reasonably recoverable total damages that Lead Bond/Notes Counsel would have been able to credibly present to a jury.” This percentage recovery represents a far higher figure than is usually the case in securities class action lawsuit settlements. (According to NERA Economic Consulting’s Mid-Year 2011 Securities Litigation Report, the average percentage of investor losses recovered in 2010 securities class action settlements was 2.4%, and only 1% for 2011 settlements through June 30, 2011.)

 

The plaintiffs’ claims related to the financial disintegration that Wachovia experience between its 2006 purchase of Golden West Financial Corporation and Wells Fargo’s 2008 acquisition of Wachovia. Folloing Wachovia’s collapse, securities litigation ensured, filed, on the one hand on behalf of Wachovia’s shareholders (about which refer here) and on the other hand on  behalf of Wachovia’s bond and note holders (about which refer here).

 

In their May 2010 amended consolidated complaint, the lead bond/note plaintiffs alleged that in offering materials related to various Wachovia bond and note offerings, the defendants misrepresented the nature and quality of Wachovia’s mortgage loan portfolio and made  material misstatements regarding the risk profile and quality of the $120 billion pick-a-pay adjustable rate residential mortgage portfolio that Wachovia acquired in the Golden West acquisition.

 

In a lengthy and detailed March 31, 2011 order (about which refer here), Southern District  of New York Judge Richard Sullivan granted the defendants’ motions to dismiss the equity securities actions, but he denied the motions to dismiss the bondholders’ action, other than with respect to certain bond offerings in which the plaintiffs had not actually purchased any securities.

 

In granting the motions to dismiss the equity securities plaintiffs’ ’34 Act claims, Judge Sullivan held that the plaintiffs had not sufficiently alleged scienter. Judge Sullivan concluded that the “more compelling inference” is that “Defendants simply did not anticipate the full extent of the mortgage crisis and the resulting implications for the Pick-A-Pay loan portfolio. Although a colossal blunder with grave consequences for many, such a failure is simply not enough to support a claim for securities fraud.” He added that “bad judgment and poor management are not fraud, even when they lead to the demise of a once venerable financial institution.”

 

In concluding that the bondholders’ allegations were sufficient when the equity securities plaintiffs’ allegations were not, Judge Sullivan found that the bondholder plaintiffs had adequately alleged misrepresentation in the relevant offering documents with respect to loan to value ratios maintained in the mortgage portfolio and with respect to the alleged manipulation of the appraisal process to produce inflated appraisal values.

 

As I noted at the outset, the Wachovia bondholders’ settlement is the largest securities class action lawsuit settlement so far as part of the subprime and credit crisis-related litigation wave. The $627 collective million settlement amount is slightly larger than the $624 million settlement in the Countrywide case. Interestingly, both the Countrywide and Wachovia settlements included substantial settlement contributions from KPMG — $37 million in the Wachovia case and $24 million in the Countrywide case. My running tally of the subprime and credit crisis-related settlements can be accessed here.

 

The settlement will now go before Judge Sullivan for approval. The settlement itself does not include any agreement or understanding with respect to the plaintiffs’ attorneys fees, but the settlement papers indicate that the lead plaintiffs’ counsel intends to seek court approval of a fee recovery representing 17.5% of the collective settlement amount – that is, roughly $110 million. (By way of comparison, the fee award approved for lead plaintiffs in the Countywide case was $46.4 million, although I am sure the Wachovia bondholders’ counsel could explain important differences that would make this comparison irrelevant).

 

The settlement papers do not reveal whether or not any portion of the Wachovia bondholders’ settlement is to be funded by insurance, although the released Wachovia parties and the released KPMG parties identified in the settlement stipulation in both cases include the respective entities’ “insurers.” In addition the settlement stipulation funding provisions specify that the Wachovia defendants and the KPMG defendants respectively are obliged to pay “or to cause to be paid” the specified amounts into the escrow account within the specified time.

 

With the addition of the massive Wachovia bondholders’ settlement, the now 26 securities class action lawsuit settlements so far arising out of the subprime and credit crisis-related litigation wave total over $3.1 billion. With scores of cases still pending, the implications for aggregate amount for which all of these cases ultimately will be settled are truly staggering. The interesting thing is that the Wachovia bondholders’ case was not really on the radar screen as one of the big ones out there (compared, say, to the Citigroup,  Lehman Brothers or BofA/Merrill Lynch merger cases). The fact that a below the radar case can result in a settlement of this magnitude is an arresting development, particularly in view of the fact that many of the cases that remain pending are, like this one, filed under the Securities Act of 1933.

 

As impressive as the amount of the Wachovia bondholders’ settlement is, the most ominous aspects of the settlement for other defendants and their insurers is the percentage of investor loss that the settlement represents. If this settlement percentage winds up becoming a point of reference, it could have very serious consequences in connection with attempts to settle the remaining cases.

 

One thing about this settlement is that it does seem to suggest that Wachovia’s purchase of Golden West is a serious candidate for the title of worst deal leading into or as part of the credit crisis-related financial transactions. There is a lot of competition in the worst transaction category, including Bank of America’s purchase of Countrywide. But there is no doubt that the Golden West dealis one of the real stinkers.

 

Speaking of Wells Fargo, the litigation consequences for the bank of the mortgage meltdown are becoming rather breathtaking. The Wachovia defendants’ $590 contribution to this settlement, which presumably is being funded in substantial part if not in whole by Wells Fargo, comes closely on the heels of the recently announced $125 million Wells Fargo mortgage backed securities case (about which refer here)

 

There were a number of interesting items about this settlement out in the blogosphere. Alison Frankel has a nice August 5, 2011 piece on Thomson Reuters News & Insight (here) about the Bernstein LItowitz firm, which is one of the co-lead plaintiffs’ firms in the Wachovia bondholders’ case. Susan Beck’s August 5, 2011 write-up about settlement for the AmLaw Litigation Daily can be found here, and Luke Green’s August 5, 2011 post about the settlement on the ISS Securities Litigation Insight blog can be found here.

 

Special thanks to the Bernstein Litowitz firm for providing me with links to the settlement papers.

 

Dismissal Denied in State Street Subprime Securities Suit: In an August 3, 2011 order (here) in a securities suit against State Street Corporation and involving in part subprime mortgage-related allegations, District of Massachusetts Judge Nancy Gertner denied the defendants’ motion to dismiss.

 

The case, which involves consolidated securities and ERISA class actions, involves allegations that the investors deceived investors in two ways: first that State Street impermissibly charged its clients different exchange rates than the one the bank actually used to execute foreign exchange (“FX”) trades for clients; and that State Street misled investors in the fall of 2008 with statements that debt securities in its investment portfolio and in four specific off-balance sheet commercial paper conduits – collateralized in part by mortgage-backed securities – were of “high quality.”

 

In ruling that the plaintiffs’ allegations about the company’s statements regarding its debt securities were sufficient, Judge Gertner said "it is clear that some of the State Street disclosures simply failed to provide sufficient warning or detail, while others actually obscured as much as they revealed."

 

Nate Raymond’s August 4, 2011 article in the Am Law Litigation Daily about Judge Gertner’s ruling in the State Street case can be found here.

 

I have added the State Street ruling to my running tally of dismissal motion rulings in the subprime related securities cases, which can be accessed here.

 

In an August 2, 2011 post on the New York Times  Dealbook blog entitled “Ex-Directors of Failed Firms Have Little to Fear”(here), Ohio State University Law Professor  Steven Davidoff voices his consternation that the former directors of Bear Stearns and Lehman Brothers seemingly will be able to “continue their prominent careers.” Davidoff seems miffed that the former board members of these failed firms have not only been able to get on with their lives but many of them have continued to serve as board directors. Others maintain roles of prominence in academia or business. (Bear Stearns of course did not actually fail but for simplicity of expression in this post I have referred to it using that term.)

 

Davidoff acknowledges that the financial crisis that accompanied these companies’ failures was an “enormously complex event” and that officials at these failed firms can argue that “it was the crisis itself – not poor management or inadequate board supervision – that caused their firm’s demise.” Given that, Davidoff is “not arguing that these directors be tarred and feathered or that they should not be able to earn a living.” He is just suggesting that “at a minimum…other public companies might be more hesitant to keep these failed directors on their boards.”

 

Davidoff’s column does strain to maintain a balanced point of view, but there is nevertheless an unmistakable underlying assumption that these former board members should be shunned or otherwise punished as a result of their former firms’ failures. Davidoff’s apparent thesis is consistent with a prior post of his, in which  he argued that directors should be held liable more often, a point of view with which I disagreed here. I also have some concerns about Davidoff’s latest post, which I have outline below. I acknowledge that I have certain biases, which I outlined in my response to Davidoff’s prior post. My concerns with the latest post are as folllows.

 

First, the SEC has the authority to bring enforcement actions and, among other things, to impose lifetime bans on individuals from future service as board members of public companies. The SEC has not brought any such action against these individuals, presumably because it does not believe it could bring a meritorious claim against them. Indeed, these individuals have not been found blameworthy or culpable in any way by any legal authority in connection with the demise of these two firms

 

Second, there is a peculiarly American notion that is something has gone wrong, then somebody must be punished – even if the designated scapegoat is not directly to blame for what has gone wrong. But it seems to me that little purpose would be served by forcing these persons onto the shelf and out of productive contributions to corporate life. Stigmatizing them would accomplish nothing, except perhaps satisfaction of some tribal atavistic urge for retribution.

 

It bothers Davidoff that these individuals have been getting on with their lives and in particular that there these individuals apparently have not taken a permanent and disqualifying hit to their reputations. Davidoff ascribes this to the alleged “decline in importance of reputation on Wall Street.”

 

I suspect strongly that these individuals would have a far different view of whether or not their have been consequences for them as a result of the firms’ failures, and in particular I suspect they would have a lot to say on the specific topic of reputation.

 

Even though these individuals have not been found to have done anything wrong, I am quite certain that these individuals’ lives have been quite disrupted as a result of these firms’ collapses. Not only has there been the harsh scrutiny they have all had to face, but there has also been a seemingly endless procession of legal events and proceedings. These individuals are undoubtedly spending more time than is healthy in the company of lawyers.

 

I simply cannot agree that reputation has declined in importance, on Wall Street or anywhere else. For several years I have participated in the Stanford Law School Directors College, in connection with which an attendee survey is conducted in which, among other things, the attendees express their concerns about governance issues. An overwhelming majority of attendees indicate that their biggest concern with respect to problems at the companies with which they are associated is not the risk of liability as such, but the risk to their reputations.

 

Most corporate directors have spent their entire lives building their professional reputations and they take them very seriously. None of the former directors affiliated with Bear Stearns and Lehman Brothers can escape their association with those firms’ demises.

 

The fact that these individuals have been able to get on with their lives despite these failure of their former firms can be interpreted in a number of ways. One way is to conclude that in the “the old boy network of Wall Street,” as Davidoff calls it,  the corrupt fat cats complacently overlook each others’ peccadillos while lighting cigars with $100 bills. Another way to look at is that the kinds of individuals who serve on public company boards often are highly accomplished individuals whose talents and skills are sufficient that their services are still valued in other contexts despite the tarnish that comes even with association with an event like the collapses of Bear Stearns and Lehman Brothers.

 

It seems to me that Davidoff’s real gripe is not really with the individuals themselves but rather is with the rest of the corporate, academic and business world, which just doesn’t think, as he does, that these individuals really ought to be more seriously stigmatized for their association with the failed firms. Perhaps these other organizations can see that these individuals have not been found culpable in any way for what happened at Bear Stearns and at Lehman. Perhaps these other organizations, motivated to act in their own best interests, value the service of the individuals for all of their skill, knowledge and experience,  notwithstanding their association with Bear Stearns and Lehman.

 

The bottom line for me is that I see no value in demonizing individuals who have not been found to have done anything wrong. To me, allowing on the one hand that these individuals shouldn’t be tarred and feathered and should be able to earn a living, but on other hand suggesting that their should be some things they shouldn’t be allowed to do is like arguing that they should be allowed to continue their lives, but should just have to wear some type of scarlet letter for which they are universally shunned. I just can’t get on board with that.

 

There are plenty of legal mechanisms in our country for determining culpability and imposing penalties. I am very wary of any suggestion that there should be social penalties outside of those processes.

 

One of the many distinctive traits of the litigation that surrounded the S&L crisis in the late 80s and early 90s was the plethora of lawsuits  between the FDIC (and other federal banking regulators), on the one hand,  and the failed banks’ insurers, on the other hand,  over the interpretation of the banks’ management liability insurance policies. Among the questions surrounding the current bank failure wave has been whether or not we will see a similar round of insurance coverage litigation. If a lawsuit filed last week in the Middle District of Alabama is any indication, the anticipated insurance coverage litigation may be on its way.

 

The coverage lawsuit arises out of the massive failure of Colonial Bancorp, which closed its doors on August 14, 2009. The bank’s holding company filed for bankruptcy on August 25, 2009. Among the factors contributing to Colonial’s failure was the criminal conspiracy relating to the failed mortgage lender, Taylor Bean & Whitaker. In April 2011, Lee Farkas, Taylor Bean’s ex-Chairman, was convicted of wire fraud and securities fraud.

 

Prior to Farkas’s conviction, two Colonial Bank employees pled guilty in connection with the Taylor Bean scheme. As reflected here, on March 2, 2011, Catherine Kissick, a former senior vice president of Colonial Bank and head of its Mortgage Warehouse Lending Division, pleaded guilty to conspiracy to commit bank, wire and securities fraud for participating in the Taylor Bean scheme. As reflected here, on March 16, 2011, Teresa Kelly, the bank’s Operations Supervisor and Collateral Analyst, pled guilty on similar charges.

 

The two bank employees allegedly caused the bank to purchase from Taylor Bean and hold $400 million in mortgage assets that had no value. The employees also allegedly engaged in fraudulent actions to cover up overdrafts of Taylor Bean at the bank. The employees are also alleged to have had the bank engage in the fictitious trades with Taylor Bean that had no value.

 

At the time of the bank’s failure, the bank carried three financial institution bonds. At or about the time that Colonial failed, the bank submitted notices of claim under the financial institutions bonds in connection with the activities and actions that ultimately were the topic of the criminal guilty pleas of the bank employees.

 

In a complaint filed on July 29 in the Southern District of Alabama (a copy of which can be found here), the FDIC as receiver for Colonial Bank, as well as the bankrupt bank holding company on its own behalf, filed an action against the bank’s bond insurer. Among other things, the complaint alleges that the losses caused by the misconduct “constitute recoverable losses under the Bonds up to the full aggregate limits of liability of the Bonds.” 

 

The complaint states that the bond insurer “has neither accepted nor denied the Plaintiffs’ claims under the Bonds.” The complaint alleges  that the insurer “has failed to investigate the claims and losses in a reasonable and appropriate manner.” After cataloging the back and forth between the FDIC and the insurer on their respective efforts to enter a confidentiality agreement, the complaint alleges that the insurer “has declined to enter into any of the proposed confidentiality agreements or offer appropriate confidentiality agreements of its own,” and “hence” the FDIC is unable to produce the confidential information that the insurer has requested. The complaint asserts a single claim for breach of contract.

 

Interestingly, the complaint does not specify whether or not the FDIC or the bankrupt holding company is entitled to recover under the bonds, but rather says that the amount of any recovery under the bonds is to be deposited in a bankruptcy court escrow account, where the issue of entitlement to the proceeds will be determined.

 

There are a number of arguably unusual features of this dispute. First, it is filed in connection with the failed bank’s financial institutions bonds, rather than in connection with the failed bank’s D&O insurance policy. To be sure, given the circumstances surrounding the bank employees’ guilty pleas, the implication of the bonds is hardly surprising. But the typical bank closure during the current round of bank failures will not implicate the failed bank’s financial institution bonds. The relevant insurance issues will more likely arise, if at all, under the failed bank’s D&O policy.

 

Another interesting thing about this dispute is that the parties are in coverage litigation even though the carrier has not even denied coverage. It looks as if the parties’ so-far unsuccessful attempts to hammer out a confidentiality agreement have gotten a little bit out of hand. It is mercifully uncommon for parties in similar circumstances to be unable to come up with a mutually acceptable confidentiality agreement. It may be that once the parties in this circumstance can finally manage to come up with a confidentiality agreement that this whole dispute will resolve itself without the need for further litigation (whether or not there was ever really any need for litigation in the first place.)

 

But the fact that the FDIC has not hesitated to file this suit in the first place certainly does evince a willingness to use the court to pursue its claims, as receiver, in connection with failed banks’ insurance policies. And while this case may not on its face present any significant coverage issues of more general significance, the likelihood is that as the FDIC presses claims for insurance recovery, that some of these claims will find their way into court with significant implications for questions of coverage under the applicable policies.

 

As I have said before, so many aspects of the current bank failure wave provide a feeling of déjà vu for those of us who lived through the S&L crisis. If the feeling is not necessarily one of nostalgia, it at least has a certain familiarity. Of course, it remains to be seen whether or not there will be any where near the amount of coverage litigation this time around. It just looks to me from this recent lawsuit that just like last time, the FDIC is not messing around, and it is not going to hesitate to use the courts to pursue claims against failed banks’ insurers.

 

As numerous commentators have noted, one of the most distinctive litigation developments over the last twelve months has been the emergence of U.S. securities litigation against Chinese companies that obtained their listings on U.S. exchanges that a “reverse merger” with a publicly traded U.S. shell company.

 

Given the prominence of these issues, I am very happy to publish the following guest post from Anjali C. Das, who is a partner in the Chicago office of the Wilson Elser law firm. Many thanks to Anjali for her willingness to publish her article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

 

Here is Anjali’s guest post:

 

D&O Spotlight on China: Claims Against China-Based Reverse Merger Companies: A Tempest in a Teapot of Gunpowder Green Tea?

 

 

Introduction

           

These days, nearly everything to do with China has grabbed the spotlight – not least of all the country’s extraordinary and seemingly unstoppable economic growth. Not surprisingly, many U.S. investors have been pouring millions of dollars into Chinese companies with the hopes of gaining super-sized returns. However, naysayers have long predicted a bursting of the China bubble. At least for investors in China-based issuers, perhaps that time is now. Not unlike the bursting of the internet bubble in the 1990s fueled by explosive growth and investment in “dot.com” companies, investors and regulators may now have reason to fear the rapid rise and fall of Chinese companies that have accessed U.S. capital markets through reverse mergers. While short-sellers are publicly denouncing the purported fraud at these companies (and making big bucks shorting the stock), U.S. regulators are investigating the rash of accounting scandals at these companies which have caused some auditors to abruptly resign. Meanwhile, D&O insurers have to contend with the collateral damage resulting from the multitude of claims against China-based issuers and their directors and officers. This article highlights the following topics involving Chinese reverse merger companies: 

 

 

PCAOB’s Research Note on Chinese reverse mergers

SEC’s investigation of China-based issuers and their auditors

NASDAQ’s proposed new listing requirements for reverse merger companies

SEC’s Investor Bulletin on reverse merger companies

Moody’s "Red Flags" report on China-based companies

D&O insurance coverage issues for claims against China-based issuers

 

 

 

PCAOB Issues a Report on China Reverse Mergers

 

 

On March 14, 2011, the Public Company Accounting Oversight Board ("PCAOB") issued a report examining the audit implications for reverse mergers involving China-based companies. A copy of the report can be found here. As explained in the PCAOB report, a reverse merger is an acquisition of a private operating company by a public company shell company. While the public shell company is the surviving entity, the  private company’s shareholders typically control the surviving company or hold publicly traded shares in the company.  A perceived benefit of a reverse merger is that it enables a company to become an SEC reporting company with registered securities without having to file a registration statement under U.S. federal securities laws.

 

 

 

The PCAOB report identified 159 companies from China that accessed the U.S. capital markets in a reverse merger transaction from 2007 through March 2010, representing 26% of all reverse mergers during the period. Reportedly, the market capitalization of these companies was $12.8 billion as compared to a $27.2 billion market cap of the 56 Chinese companies that completed initial public offerings in the U.S. during that same period. 

 

 

Reverse merger entities listed on U.S. exchanges are required to file audited financial statements with the SEC, and the auditors of the financial statements are required to be registered with the PCAOB. According to the PCAOB, U.S. firms audited 116 or 74% of the China-based reverse merger companies, while Chinese registered accounting firms audited 38 or 25 of companies. The PCAOB report raises concerns that some U.S. firms are not conducting proper audits of China-based companies, including handing off the audit work to a local Chinese accounting firm without verifying the accuracy of the results. The PCAOB has identified various "key considerations" to determine the appropriate level of oversight of firms that performs audits of foreign companies with the aid of assistants outside the firm, including:  the ability to supervise outside assistants; whether the outside assistants have appropriate language skills, and whether the auditor would have the ability to comply with the PCAOB’s documentation requirements.

 

 

           

SEC Launches Investigation of China-Based Issuers and Auditors

 

 

In response to a congressional inquiry by House Representative Patrick T. McHenry, Chairman of the Committee on Oversight and Government Reform, SEC Chairman Mary L. Schapiro issued a letter on April 27, 2011 seeking to assure Congress and the public that the SEC "has moved aggressively to protect investors from the risks that may be posed by certain foreign-based companies listed on U.S. exchanges" — particularly those companies based in China.  As SEC Chairman Schapiro noted in her letter, there has been a recent marked increase in China-based companies listed on U.S. exchanges through the process of a reverse merger.

 

           

Last summer, the SEC reportedly launched a "proactive risk-based inquiry into U.S. audit firms" which have a significant number of issuer clients based outside the U.S.  Among other things, the SEC has requested auditors to provide information concerning the firms’ compliance with U.S. audit standards for foreign-based reverse merger companies based in China.  Since the SEC launched its investigation, dozens of China-based companies have disclosed auditor resignations and accounting problems.  Since February 2011, Big Four accounting firms have resigned or been dismissed from at least seven Chinese companies listed in the U.S., as reported here. These auditors have reportedly experienced difficulty obtaining independent bank confirmations of a company’s bank accounts, balances, and transactions, as reported here.   In at least one case, the auditor purportedly received false information directly from the bank itself, prompting the auditor to resign. 

 

 

In an effort to protect U.S. investors, the SEC has reportedly suspended trading in several China-based reverse merger entities.  In addition, the SEC has revoked the securities registration of many other China-based reverse merger companies.  In some instances, the SEC is also pursuing these companies’ auditors for improper audits.   As the SEC Chairman observed, the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank") has enhanced the SEC’s ability to obtain audit documentation in connection with its investigations of issuers based in China and other countries. 

 

 

NASDAQ Proposes New Listing Requirements for Reverse Mergers

 

 

 

On June 8, 2011, the NASDAQ filed proposed rules with the SEC to adopt additional listing requirements for companies that become public through a reverse merger. Under the proposed rules, which can be found here, a company that is formed by a reverse merger shall only be eligible to submit an application for initial listing if the combined entity can satisfy the following conditions: 

 

 

traded for at least 6 months in the U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange following the filing of all audited financial statements;

 

maintained a bid price of $4 or more per share for at least 30 of the most recent 60 trading days;

 

in the case of a U.S. domestic issuer, the company has timely filed its two most recent financial statements (i.e., Form 10-Q or 10-K);

 

in the case of a foreign based issuer, the company timely files comparable financial statements (i.e., Form 6-K, 20-F or 40-F) that includes an interim balance sheet and income statement presented "in English"

 

 

In support of its proposed enhanced listing requirements, the NASDAQ cited the "extraordinary level of public attention to listed companies that went public via a reverse merger," and "allegations of widespread fraudulent behavior by these companies, leading to concerns that their financial statements cannot be relied upon." The NASDAQ believes that these new listing requirements will protect investors and "discourage inappropriate behavior" by companies. 

 

 

SEC Issues an Investor Bulletin on Reverse Mergers

 

 

 

On June 9, 2011, the SEC issued a bulletin cautioning investors of the potential pitfalls of investing in reverse merger companies. The bulletin can be found here. Among other things, the SEC observed that many reverse merger companies ("RMCs") "either fail or struggle to remain viable following a reverse merger"; there have been instances of fraud and other abuses involving RMCs; and some RMCs have been using smaller U.S. auditing firms that may not have sufficient resources to conduct adequate overseas audits. The SEC bulletin also cited recent examples where it suspended trading of RMCs due to accounting irregularities and/or revoked the securities registrations of RMCs due to the companies’ failure to timely file required periodic financial statements.

 

 

Moody’s Issues its "Red Flags" Report on China-Based Companies

 

 

To address investors’ increasing concerns with the quality of financial reporting from publicly listed Chinese companies, on July 11, 2011 Moody’s credit rating agency issued a "Red Flags" report for China-based companies. The report examines 20 red flags grouped into five categories that identify possible governance or accounting risks for China-based companies, including:

 

 

            Weaknesses in corporate governance: short track record of operations and listing history,         murky shareholders’ background, large and frequent related-party transactions;

 

            Riskier or more opaque business models: unusually high margins compared to peers,     concentration of customers, complicated business structures;

 

            Fast-growing-business strategies: very rapid expansion, big capital investments resulting         in large negative free cash flow and intangible assets;

 

            Poorer quality of earnings or cash flow: discrepancy between cash flows and accounting             profits, disjointed relationship between growth in assets and revenues, large swings in working capital, insufficient tax paid compared to reported profits;

 

 

            Concerns over auditors and quality of financial statements: a switch in auditing firm or    legal jurisdiction of auditor’s office, delay in reporting, or adverse comments from      auditors.

 

 

Moody’s applied its red flags analytical framework to 61 rated Chinese companies. According to Moody’s report, due to the rapid growth of Chinese companies, nearly all Chinese high-yield issuers tripped red flags related to aggressive business and financial strategies and quality of earnings. Moody’s observed that fast-growing companies put pressure on managerial and financial resources. Additionally, these companies may make large capital investments that could negatively impact cash flow for a prolonged period of time. Also, due to the prevalence of strong founding families, many Chinese companies tripped the red flag for concentration of family ownership which may reflect weaknesses in corporate governance.  Moody’s also noted the so-called arms-length related-party transactions were not always transparent. Interestingly, according to Moody’s report, concerns over auditors arose less frequently compared to other red flags. 

 

 

 

Shorts-Sellers Creating Havoc

 

 

 

Meanwhile, short-sellers are wreaking havoc on China-based issuers’ stock and publicly accusing these companies of fraud. In several instances, detailed reports issued by short-sellers have triggered a wave of internal investigations, investigations by regulators, and shareholder litigation against companies. While some companies have gone to lengths to deny short seller’s often unsubstantiated accusations, the damage is done when the investors get spooked and the company’s stock price spirals downward. 

 

 

All of the negative publicity has impacted Chinese companies across the board, regardless of whether specific allegations of fraud have been asserted. Where investors were once rushing to dump huge sums of money into any business with ties to China, they are now rushing to liquidate their stock holdings at the slightest sign of any trouble. The fallout has had a devastating impact on the number of reverse merger transactions of Chinese companies. Not surprisingly, some Chinese companies have postponed plans to sell shares in the U.S., either through reverse mergers or initial public offerings ("IPOs"). As reported here, compared to 47 reverse merger transactions in the first half of 2010, there have been only 29 for the first half of 2011.  At least for now, Chinese companies are no longer the darling of Wall Street.

 

 

The Rise of Shareholder Litigation

 

 

Approximately 30 shareholder suits were filed in the first half of 2011 against China-based companies listed on U.S. exchanges and the companies’ directors and officers. On the surface, many of these suits are classic securities class actions alleging securities fraud and violations of Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act") for materially false and misleading financial statements and related derivative actions.  However, suits against China-based companies may pose unique hurdles and added expense to the defense of shareholder claims in the U.S. For one thing, many or most of the individual defendants, corporate documents, and key witnesses may reside in China. Moreover, testimony and documents may need to be translated from Chinese to English. As such, defense costs can escalate rapidly. Also, given the current regulatory climate and increased suspicion of China-based issuers, the company may also be the subject of parallel proceedings or investigations by the SEC and other regulators. In some situations, the company’s Board may simultaneously launch an internal investigation – particularly if the company’s outside auditor abruptly resigns without issuing a clean audit opinion. That could also trigger a wave of management departures, putting added strain on the company’s already stretched resources. 

 

 

D&O Insurance Coverage Issues

 

 

 

Claims against China-based issuers and their directors and officers may raise a host of coverage issues under traditional Directors and Officers (“D&O”) liability insurance policies including, but not limited to: 

 

 

Reasonable and necessary defense costs

Coverage for parallel proceedings and investigations

Rescission

Known Claim exclusion

Fraud and personal profit exclusions

Severabiity of the policy exclusions and application

 

 

 

D&O policy limits for public companies are typically eroded by defense costs. This may occur more rapidly in suits against Chinese companies in light of the complexities of transnational discovery. As such, it is in the interests of D&O insurers and insureds alike to ensure that these claims are being defended with maximum efficiency to minimize the possibility that the D&O insurance is significantly impaired or even exhausted by defense costs alone. While many large defense firms now have outposts in China, it is still imperative to gain an understanding of the anticipated division of labor between the U.S. based lead defense attorneys and their colleagues in China with respect to discovery, document collection, witness interviews, and other matters. Additionally, there should be an objective assessment to determine whether it is cheaper and more efficient to outsource certain discovery-related tasks such as collection and translation of documents.

 

 

Shareholder litigation against Chinese companies may spawn multiple parallel proceedings and investigations by the government, regulators, the Board, a Special Litigation Committee, and others. A key issue is whether such investigations constitute covered Claims or Securities Claims under the D&O policy. Historically, many D&O policies narrowly limited the availability of coverage for investigations, such as formal investigations by the Securities and Exchange Commission (“SEC”) commenced by service of a subpoena on a director or officer. However, in the past few years, some D&O policies began to offer enhanced coverage, including coverage for both formal and informal investigations by regulators. Nowadays, the definition of a Securities Claim is less standard and may contain many subtle, yet critical nuances impacting coverage. Not surprisingly, there has been a significant amount of litigation and reported decisions with respect to coverage for investigations under D&O policies. However, many of these decisions are fact-specific and driven by now obsolete D&O policy language and definitions which continue to evolve. 

 

 

Recently, on July 1, 2011, the Second Circuit Court of Appeals issued an opinion in MBIA, Inc. v. Federal Ins. Co., 2011 U.S. App. LEXIS 13402 (2d Cir.), that sets forth a comprehensive analysis of coverage for various investigations under a D&O policy. In that case, the policy definition of a covered Securities Claim included “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document.” First, the Second Circuit held that investigations commenced by the SEC and the New York Attorney General (“NYAG”) were covered under the policy definition of a Securities Claim. The court observed that the issuance of a subpoena by NYAG was, at a minimum, a “similar document” related to a “formal or informal investigative order”. The court also opined that requests for information by the SEC pursuant to oral requests and subpoenas were covered because they were connected to the SEC’s formal order of investigation. The court also concluded that fees incurred by an independent consultant retained by MBIA in the context of negotiating a settlement with the SEC and NYAG were also covered.

 

 

Second, the Second Circuit concluded that legal fees incurred by MBIA’s Special Litigation Committee (“SLC”) to determine whether to pursue or terminate pending shareholder derivative actions were covered and did not clearly fall within the policy’s sub-limit of liability for shareholder derivative demands. Prior to the filing of the derivative actions, a shareholder demand on MBIA’s Board had been made and ultimately rejected. After the shareholder derivative suits were filed, the SLC sought and obtained dismissal of the lawsuits. The Second Circuit determined that the legal fees incurred by the SLC arguably fell within the policy’s coverage for “costs ‘incurred in . . . investigating’ ‘Claims’ or ‘Securities Claims,’ respectively, each of which is defined to expressly include lawsuits.” The Second Circuit also determined that that the insurer had failed to carry its burden of proving that the SLC’s legal fees were not covered under the policy definition of Loss which excluded “any amount incurred by [MBIA] (including its board of directors or any committee of the board of directors) in connection with the investigation or evaluation of any Claim or potential Claim by or on behalf of [MBIA]”. 

 

 

           

To the extent claims against China-based issuers and their directors and officers allege accounting improprieties and false and misleading financial statements, D&O insurers might have a potential rescission argument if the policy was issued in reliance on these false financials. In some instances, D&O policies and/or applications contain a Known Claim Exclusion which might serve as a basis for denying coverage if an insured knew and/or failed to disclose a fact, circumstance, act, error, or omission that might give rise to a Claim under the policy. Also, standard D&O policies contain fraud and personal profit exclusions that might apply; however, these exclusions are usually restricted to a finding “in fact” or “final adjudication” that the insured committed fraud or unlawfully profited. In addition, both the application and the exclusions might be “severable,” such that the knowledge or wrongful acts of one insured cannot be automatically imputed to other insureds except in limited situations.

 

 

 

Conclusion

 

 

 

Some might conclude that the spotlight on China-based reverse merger companies is merely a tempest in a teapot, as compared to the global financial crisis precipitated by the subprime market meltdown and collapse of numerous financial institutions at home and abroad. Nonetheless, the reality is that many China-based issuers have been targeted by regulators and investors alike for purported securities and accounting fraud that could ultimately cost D&O insurers millions in losses. At least for now, this trend seems to be gaining traction. Until the pot is done brewing and the tea leaves are read, D&O insurers should tread carefully in handling claims against their China-based issuers.

 

Settlement opt-outs have been always been a feature of securities class action litigation. However, as part of the settlements of the huge cases filed during the era of corporate scandals at the beginning of the last decade, opt outs became more prevalent and they represented an increasingly significant part of the case resolution. Many of the opt out recoveries during that period were substantial, both in absolute dollars and in terms of recovery percentages, a phenomenon that occasioned much commentary and even some discussion about whether the rise in class action opt outs represented a fundamental change in the securities class action lawsuit paradigm.

 

But after a seeming cascade of opt out settlements as the securities cases associated with the corporate scandals were resolved, the phenomenon seemed to die down, or at least fade into the background. However, it seems that in connection with the larger cases associated with the credit crisis, the phenomenon of significant opt out cases may be back, at least if recent developments in one case are representative.

 

The securities lawsuit in question is the case filed by shareholders of Countrywide, which previously settled for $624 million. One of the questions I asked at the time was whether or not the class settlement, as large as it was, would be “enough” to keep the class intact. As it turned out, a number of large institutional investors opted out of that settlement and on July 28, 2011, they filed their own collective action against Countrywide and certain of its directors and officers in the Central District of California. (A copy of their massive 425-page complaint can be found here.)

 

The lengthy list of plaintiffs is interesting. The list includes the California Public Employees Retirement System (CalPERS). There are pension funds from Guam and Montana; Dutch pension funds; and investment funds from the Nuveen, American Century, T.Rowe Price, BlackRock and TIAA-CREF fund families; and many others. The list of plaintiffs alone is seven pages long. So if this isn’t a class action, then it is a group action of sorts, for sure.

 

In earlier interview (summarized here), counsel for the opt out plaintiffs was quoted as saying that the opt out litigants losses were “far greater than what they would have received in the proposed settlement” and that they were unwilling to settle for just "pennies on the dollar. " The attorney said that his clients, "are fully committed to recovering the substantial damages caused by the fraudulent conduct at Countrywide,” adding that "the conduct by the former officers of Countrywide was particularly egregious. And prominent institutional investors were completely blind-sided by [its] pervasiveness."

 

It certainly was the case with respect to many of the opt out cases filed in the wake of the class settlements associated the corporate scandals that many of the opt out litigants claimed to have recovered substantially more than they would have if they had remained in the class. It remains to be seen whether the Countrywide opt outs will fare as well.

 

But while the value of opting out of the Countrywide settlement for these institutional claimants remains to be seen, the spectacle of all of these institutional investors leaving the class and heading out on their own has to be truly daunting for both plaintiff and defense counsel in the other large unresolved credit crisis cases. At least in the large credit crisis cases where there is either a solvent or successor entity, the challenge that counsel on both sides will face is trying to come up with a settlement that is practically feasible yet  also “large enough” to keep the institutional investors in. And meanwhile, while the counsel struggle to complete a settlement, legal costs mount on both sides.

 

 If large institutional investors conclude that their interests are served by proceeding outside the class, the class action could quickly become a sideshow. Indeed opt outs get to a critical level, it could trigger the “blow up” provision that is a part of many settlement agreements. Even if the class action litigants can pull a class settlement together, the defendants may not achieve the finality and repose that are among the usual reasons for settling cases in the first place. Instead, the defendants may face the possibility of continuing litigation with a well-financed subset of the original class.

 

To be sure, the actions of the Countrywide opt outs may or may not be representative of the actions that institutional investors in the other large credit crisis cases will take. Nevertheless, with the apparent reemergence of the institutional investor class lawsuit opt out action, it seems  hard to disagree with the words of Columbia Law Professor John Coffee who called the emergence of the large class action opt-outs “probably the most significant new trend in class action litigation.”

 

Victor Li’s July 29, 2011 Am Law Litigation Daily article discussing the institutional investors Countrywide action can be found here.

 

The facts and circumstances surrounding Bank of America’s credit crisis-induced acquisition of Merrill Lynch remain among the highest profile and most controversial events during the global financial crisis. In a July 29, 2011 opinion (here), Southern District of New York Judge Kevin Castel granted in part and denied in part the defendants’ renewed motions to dismiss in the consolidated Bank of America securities litigation arising out of BofA’s acquisition of Merrill.

 

Judge Castel’s opinion deals with two of the most controversial aspects of the events surrounding the deal – BofA’s alleged failure during the fourth quarter of 2008 to disclose Merrill’s deteriorating financial condition after the deal was announced but prior to the shareholder vote; and BofA’s alleged  failure to disclose the commitments of key government officials of financial inducements offered to BofA to complete the deal.

 

Background

In mid-September 2008, at the height of the global financial crisis, BofA agreed to acquire Merrill Lynch. In October and November 2008, while shareholder approval of the transaction was pending, Merrill suffered losses of over $15 billion and also took a $2 billion goodwill impairment charge. The Complaint alleges that BofA’s senior officials were aware of these losses as they occurred. The Complaint alleges that the losses were so significant that BofA management discussed terminating the transaction, prior to the December 5, 2008 shareholder vote on the merger, in which BofA shareholders approved the merger.

 

On December 17, 2008, BofA Chariman and CEO Kenneth Lewis called Treasury Secretary Henry Paulson to advise him that BofA was "strongly considering" invoking the “material adverse change” clause in the merger agreement, in order to terminate the deal prior to its scheduled January 1, 2009 close date.  At Paulson’s invitation, Lewis flew to Washington for a face-to-face meeting, at which Paulson and Federal Reserve Board Chair Ben Bernanke urged Lewis not to invoke the MAC clause.

 

In subsequent conversations, Lewis again advised the government officials that BofA intended to invoke the MAC clause. According to the plaintiffs’ allegations, BofA’s board voted on December 21, 2008 to invoke the MAC clause, but on the following day, the Board voted to approve the merger, apparently in part based on Lewis’s statement that he had received verbal assurances from Paulson that BofA would received a capital infusion and a guarantee against losses from risky assets if the merger concluded.

 

On January 16, 2010, BofA disclosed the fourth quarter losses of both BofA and Merrill and also revealed the federal funding package, which included $20 billion in capital and protection against further losses on $118 billion in assets. In following days, news reports revealed that in the days prior to the deal’s close, Merrill employees had been paid massive bonuses. 

 

In response to this news, BofA’s share price declined, and shareholder litigation ensued. The plaintiffs alleged that the defendants misstated and concealed matters related to the Merrill bonuses, the losses that accrued in the Fourth Quarter of 2008 after the merger was announced, and the pressure to consummate the deal from government officials. After the securities and derivative lawsuits were consolidated, the defendants moved to dismiss.

 

In a lengthy August 27, 2010 opinion (about which refer here), Judge Castel denied in part and granted in part the defendants’ motions to dismiss. First, he denied the defendants’ dismissal motions with regard to the plaintiffs’ allegations concerning the disclosures of the Merrill bonuses. Next, he concluded that while the plaintiffs had also alleged that there were materially misleading misrepresentations or omissions about Merrill Lynch’s deteriorating 4Q08 financial condition and about the promised government financial inducements, the plaintiffs had not adequately alleged scienter as to these topics, and so he denied the defendants’ motion to dismiss as to these allegations.

 

Thereafter, the plaintiffs filed a Consolidated Second Amended Class Action Complaint (hereafter, the “complaint”). The amendments in the complaint were primarily intended to address the court’s concerns regarding the scienter allegations. The defendants renewed their motions to dismiss.

 

The July 29 Opinion

In his July 29 ruling, Judge Castel denied the defendant’s dismissal motion as to the allegations surrounding Merrill’s declining 4Q08 financial condition, but granted the dismissal motion as to the allegations about the government bailout. He held that the plaintiffs’ amended complaint adequately alleged scienter as to the Merrill’s financial condition in the fourth quarter of 2008, but did not adequately allege a duty to update prior disclosures  as to the financial support the government officials offered in order to facilitate the deal.

 

In considering the plaintiffs’ amended allegations concerning Merrill’s 4Q08 losses, Judge Castel first found that the plaintiffs’ had not adequately alleged   that the defendants had a “motive” to mislead. The plaintiffs had alleged that BofA CEO Kenneth Lewis wanted to complete the deal to realize a “long-time business goal.” Lewis, the plaintiffs had alleged, was also motivated to complete the deal to keep his position, after Paulson had “bluntly told Lewis that the Federal Reserve would remove BofA’s senior management if it tried to terminate the transaction.” Judge Castel said neither of these “raised a strong inference of scienter” as there is no allegation that Lewis or BofA’s CFO Joe Price “could personally have profited from either the delay or the closure of the Merrill transaction.”

 

However, Judge Castel concluded that, with respect to the BofA’s alleged omissions regarding Merrill’s deteriorating 4Q08 financial condition, that the plaintiffs had adequately alleged “recklessness” as to both Lewis and Price.

 

With respect to Price, Castel concluded based on the plaintiffs’ allegations that the CFO, upon receiving the initial recommendation of the company’s General Counsel that Merrill’s deteriorating results should be disclosed, kept the GC “out of the loop” which “impeded counsel from making a fully informed analysis.’ These allegations are sufficient to infer that upon receiving the GC’s initial discourse recommendation, Price “engaged in ‘conscious recklessness’ amounting to ‘an extreme departure from the standards of ordinary care.’”

 

Castel concluded, based on the plaintiff allegations that Lewis had full information regarding Merrill’s declining results and that, in light of the transaction’s importance and the magnitude of Merrill’s losses, and that Lewis was reckless in failing to seek guidance of BofA’s disclosure obligations, that  the complaint adequately alleges that “Lewis’s inaction on the disclosure issue raises a strong inference of recklessness.”

 

In granting the defendants’ motion to dismiss with plaintiffs’ allegations concerning the financial benefits the government officials had offered, Judge Castel said that the plaintiffs had to show that the defendants had a duty to update prior disclosures when subsequent events rendered prior statements misleading. Judge Castel said that the plaintiffs’ complaint “does not, however, allege which statements were rendered misleading by the non-disclosure of federal financial assistance.” Because the complaint “does not allege which statements were allegedly rendered fraudulent by the defendants’ omissions,” the plaintiffs failed to satisfy the PSLRA’s pleading requirements.

 

Discussion

One of the reasons the BofA/Merrill merger remains so controversial is that, only after the deal closed, the information came out about Merrill’s losses, the governmental financial inducements, and the payment of the Merrill bonuses. The shocked reaction of the financial marketplace reflected in part an expectation that this information should have been disclosed previously to BofA’s shareholders and to the investing public. While the actual facts and circumstances remain a matter of proof, the plaintiffs portray a set of circumstances in which BofA officials were straining to avoid disclosing potentially disruptive information in order to try to preserve the deal – in part because of threats and inducements from senior government officials.

 

But no matter how compelling this version of the events may be, they still have to fit within the analytic framework required in order to state a claim under the federal securities laws. Judge Castel’s careful consideration tests the allegations against this analytic framework. Nevertheless, plaintiffs’ suggestion that it was misleading not to tell BofA shareholders that the deal was competed only because of massive government financial inducements, as well as threats to senior BofA officials, does present its own kind of narrative plausibility.

 

It is probable worth noting that by concluding that the defendants’ had no duty to update prior statements in order to disclose the government financial inducements, Judge Castel avoided the need to get into the questions, which he had addressed in his prior opinion, whether or not the defendants acted with scienter in withholding this information. Indeed, one of the more controversial aspects of Judge Castel’s prior opinion was his conclusion that, in part because the BofA officials had been ordered by the government officials not to disclose the government bailout, they had not acted with scienter in withholding the information. 

 

In any event, plaintiffs have now succeeded in at least two respects in fitting their plausible narrative into the analytic framework required in order to pursue a securities class action lawsuit. The case will now go forward with respect to the claims relating to the alleged failure to disclose the Merrill bonuses and the alleged failure to disclose Merrill’s massive 4Q08 losses. Even without the provocative allegations regarding the actions of the government officials, this will remain an interesting and high-profile case.

 

In its sweeping July 1, 2011 opinion in the MBIA case, the Second Circuit addressed many of the D&O insurance coverage issues that are currently the most contentious. The opinion has occasioned much discussion and commentary in the D&O insurance industry. My blog post about the case can be found here.

 

In view of the ongoing discussion about the case, I am very pleased to be able to publish here as a guest post an article analyzing and commenting on the Second Circuit’s decision written by Richard Bortnick and Micah J. M. Knapp of the Cozen O’Connor law firm. Rick is also the co-author of the Cyberinquirer blog. Many thanks to Rick and Micah for their willingness to publish their article here.  I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

 

Here is Rick and Micah’s guest post:

 

 

In its July 1, 2011 opinion MBIA, Inc. v. Federal Ins. Co. and ACE American Ins. Co., 10-0355-cv (2d Cir. July 1, 2011), the U.S. Court of Appeals for the Second Circuit rejected Insurers Federal Insurance Company’s (Federal) and ACE American Insurance Company’s (ACE) (collectively, the Insurers) appeals seeking to reverse a Finding of coverage for (1) expenses associated with federal and state government investigations into the insured’s accounting practices, and (2) a special litigation committee formed to investigate the shareholder derivative suits that followed the agency scrutiny. In an analysis heavily influenced by the facts, the Second Circuit swept aside the Insurers’ arguments that their D&O policies did not cover expenses associated with what they argued were informal agency inquiries and investigations only loosely associated with written agency orders and subpoenas. The court also concluded that expenses incurred by the special litigation committee formed by the insured, MBIA, Inc. (MBIA), to investigate two derivative suits were “Defense Costs” covered under the Insurers’ D&O policies. On close scrutiny, however, the impact of the decision may be limited based on the particular policy language at issue and the facts of the case.

 

 

 

The Policies

 

 

MBIA provides financial guarantee insurance for government bonds or structured finance obligations – essentially guaranteeing that bond holders would be paid with respect to MBIA’s clients’ bonds. MBIA purchased $15 million in primary D&O insurance from Federal covering the period of February 15, 2004 through August 15, 2004. ACE issued $15 million in excess coverage that followed form to the Federal policy in all respects relevant to the lawsuit (collectively, the Policies). The Policies’ entity coverage section provided: “The Company shall pay on behalf of any Organization all Securities Loss for which it becomes legally obligated to pay on account of any Securities Claim first made against it during the Policy Period ….” The Policies further covered “Defense Costs” for “Securities Claims.” “Securities Claim” was defined as “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document” that “in whole or in part, is based upon, arises from or is in consequence of the purchase or sale of, or over to purchase or sell any securities issued by [MBIA].”

 

 

 

The Agency Investigations and MBIA’s Claim

 

 

In 2001, the SEC issued an Order Directing Private Investigation and initiated an investigation into potentially unlawful accounting practices in the insurance industry. The SEC targeted MBIA in November 2004 as part of that larger investigation, issuing subpoenas compelling the company to produce documents concerning transactions involving “non-traditional products” – products that could be used to “affect the timing or amount of revenue or expense recognized.” The New York attorney general (NYAG) followed suit, serving MBIA with similar subpoenas requesting similar documents in November and December 2004.

 

 

 

The federal and state investigations eventually focused on three separate MBIA transactions. In the first transaction, MBIA purchased reinsurance for its guarantee of bonds issued by a group of hospitals owned by the Allegheny Health, Education and Research Foundation (AHERF) after AHERF declared bankruptcy. The investigations sought to determine whether MBIA endeavored to disguise the impact of a $170 million loss from the transaction with AHERF.

 

 

 

In the summer of 2005, the SEC and NYAG began investigating two additional transactions. In the second such transaction, MBIA purchased an interest in Capital Asset Holdings GP, Inc. (Capital Asset), but soon found it necessary to provide additional, unanticipated funds to Capital Asset. MBIA made the payment through a subsidiary, thereby transferring the risk of the investment loss to the subsidiary and allegedly disguising a potential loss to the parent company. The third transaction involved MBIA’s guarantee of securities used to purchase airplanes for US Airways. MBIA foreclosed on the airplanes after US Airways declared bankruptcy and treated the transaction as an investment in airplanes rather than a loss. 

 

 

 

MBIA forwarded the agency subpoenas to the Insurers in May 2005, informing them that it was the target of state and federal investigations. MBIA asked for the Insurers’ consent to retain counsel. The Insurers denied that the subpoenas triggered coverage, but accepted the subpoenas as notice of a potential claim. MBIA hired counsel and responded to the agency inquiries.

 

 

 

The SEC and NYAG considered issuing additional subpoenas concerning the Capital Asset and US Airways transactions in the summer of 2005. Concerned about additional adverse publicity, MBIA requested that the agencies hold on issuing more subpoenas, and instead accept MBIA’s voluntary compliance with the agencies’ demands. The SEC and NYAG agreed and, thereafter, MBIA complied with the agencies’ informal, often oral, requests.

 

 

 

In October 2005, MBIA forwarded the agencies an over of settlement concerning the AHERF transaction investigation. That over included a payment of penalties and MBIA’s proposal to retain an independent consultant to analyze the Capital Asset and US Airways matters. MBIA notified the Insurers of the settlement discussions in September 2005 and met with Federal in October 2005. At the time, however, MBIA did not advise the Insurers of its proposal to hire an independent consultant. The SEC and NYAG finalized settlements with MBIA in January 2007 in accords substantially similar to MBIA’s October 2005 over. The independent consultant later exonerated MBIA of any wrongdoing in the Capital Asset and US Airways transactions.

 

 

 

MBIA’s shareholders followed the state and federal agency investigations with two derivative lawsuits. Upon receiving the shareholder plaintiffs’ presuit demand letters, MBIA formed a Demand Investigative Committee (DIC) – a committee of independent directors tasked with investigating the shareholders’ demand letter. The DIC retained an outside law firm, Dickstein Shapiro (Dickstein), to assist in the investigation. When the DIC failed to act on the shareholders’ derivative demand within the time allotted by Connecticut law, the shareholders filed suit. MBIA reconstituted the DIC as a Special Litigation Committee (SLC), which again employed Dickstein to aid in the investigation of the derivative suit allegations. The SLC concluded that the suits were not in the best interests of the company and, consistent with Connecticut law, moved to dismiss the complaints.

 

 

 

MBIA submitted a claim with the Insurers seeking costs associated with the agencies’ investigations of the three transactions, the cost of the independent consultant retained to investigate the Capital Asset and US Airways transactions, and expenses associated with the DIC and the SLC. Federal paid MBIA approximately $6.4 million out of its $15 million limit to cover losses from the SEC investigation of the AHERF transaction and related lawsuits. The payment included $200,000 for the DIC’s investigation of the shareholder plaintiffs’ presuit demand pursuant to the Federal policy’s derivative investigation coverage sublimit. Federal denied MBIA’s claim for losses associated with the NYAG investigation of the AHERF transaction, the SEC and NYAG investigations of the Capital Asset and US Airways transactions, the independent consultant, and the SLC. ACE denied that it had any obligation to pay for any of the losses based upon MBIA’s non-exhaustion of the primary policy.

 

 

 

The Motions for Summary Judgment and Appeal

 

 

MBIA filed suit against the Insurers on May 7, 2008, asserting three claims for breach of contract and seeking a declaratory judgment. MBIA and the Insurers cross-moved for summary judgment on MBIA’s claim for losses associated with the NYAG investigation of the AHERF transaction, the SEC and NYAG investigations of the Capital Asset and US Airways transactions, the independent consultant, and the SLC.

 

 

 

Judge Berman of the Southern District of New York granted in part and denied in part the parties’ cross-motions for summary judgment. On balance, however, the Southern District found in MBIA’s favor, holding that the Insurers owed coverage for the SEC and NYAG investigations of all three transactions, as well as for the expenses incurred by the SLC. The District Court determined that MBIA was not entitled to coverage for the costs associated with the independent consultant’s review of the Capital Asset and US Airways transactions because MBIA had not provided the Insurers with adequate notice of its intent to retain the consultant. The Insurers appealed and MBIA cross-appealed. 

 

 

 

The Insurers’ appeal challenged the District Court’s holdings that the Policies obligated the Insurers to cover losses associated with (1) the NYAG investigation of the AHERF transaction, (2) the SEC and NYAG investigations of the Capital Asset and US Airways transactions, and (3) the SLC. 

 

 

 

On the first issue, the Insurers argued that the NYAG subpoena was a “mere discovery device” that did not meet the Policies’ definition of “Securities Claim.” The Second Circuit disagreed, pointing out that a subpoena is the “primary investigative implement in the NYAG’s tool shed,” and that, at a minimum, it constituted a document similar to a “formal or informal investigative order,” which was within the definition of “Securities Claim.”

 

 

 

On the second issue, the Second Circuit rejected the Insurers’ argument that the SEC and NYAG investigations into the Capital Asset and US Airways transactions were not within the scope of the SEC’s formal order and the NYAG’s similar AHERF investigation. The court found that the language of the SEC order and NYAG subpoenas evidenced a “broad but definitive investigatory scope” that included all three of the questionable transactions. It further observed that the SEC and NYAG investigations of the Capital Asset and US Airways transactions were connected to the SEC’s formal order and the NYAG’s AHERF investigation, and rejected the Insurers’ argument that they were not obligated to cover MBIA’s expenses associated with its voluntary compliance with informal requests made in the course of those related investigations.

 

 

 

The Insurers’ main argument in support of its third issue on appeal was that the SLC costs were incurred solely by the SLC, and that the SLC was not an “insured person” under the Policies. The District Court found coverage for the SLC expenses primarily because the expenses at issue were owed to Dickstein, and Dickstein had entered its appearance on behalf of MBIA, a nominal defendant in the derivative suits. The District Court reasoned that because Dickstein represented MBIA in the derivative suits, Dickstein’s fees were covered “Defense Costs.” The District Court then suggested that the SLC expenses would have been covered even if the outside firm had not represented MBIA, because the SLC was not an entity independent of MBIA.

 

 

 

The Second Circuit broadened the District Court’s reasoning and concluded that the SLC expenses were covered “Defense Costs” because the SLC was part of MBIA. After a brief analysis of Connecticut law on how and through whom corporations operate, the Second Circuit proclaimed that MBIA directed or acted through the SLC when the latter moved to dismiss the derivative suits and, as a result, the SLC was an “insured person” under the Policies. Unlike the District Court, the Second Circuit did not mention, much less rely upon the fact that Dickstein represented both the SLC and MBIA in the derivative suit. The Second Circuit further rejected the Insurers’ arguments that coverage for the SLC would render superfluous the Policies’ sublimit for investigation costs, and that the SLC expenses were excluded from coverage by operation of exclusions within the Policies’ definition of “Loss.” The court found that the investigation sublimit only applied to presuit investigations, not costs related to derivative suits, and that the Insurers had failed to establish that any exclusions applied to MBIA’s claim for SLC expenses. 

 

 

 

Turning to MBIA’s cross-appeal, the court reversed the District Court’s ruling in the Insurers’ favor on the issue of coverage for costs associated with the independent consultant’s investigation of the Capital Asset and US Airways transactions. In a lengthy analysis reciting what and when MBIA reported to the Insurers, the court concluded that MBIA did not breach the Policies’ “right to associate” clause, because MBIA provided the insurers with sufficient notice of the settlement discussions with the SEC and NYAG “early enough in the process to allow the insurers to exercise their option to associate effectively.”

 

 

 

MBIA’s Affect on Future Claim Disputes

 

 

The Second Circuit’s opinion touches on two types of expenses commonly disputed in D&O claims, expenses incurred in responding to state or federal subpoenas and special litigation committee expenses associated with the investigation of allegations in derivative suits. The court accepted the policyholder’s arguments in support of coverage for both types of expenses. 

 

 

 

With respect to the first category of expenses, MBIA interprets “Securities Claims” broadly, supporting the assertion that coverage extends to expenses associated with an insured’s voluntary compliance with certain types of informal or quasi-formal agency investigations. Insureds undoubtedly will cite MBIA for the proposition that a company does not forfeit its D&O coverage when it volunteers to cooperate with investigative agency requests rather than await formal, legal proceedings and risk suffering potentially damaging publicity and harsher penalties. 

 

 

 

The court’s ruling on coverage for MBIA’s voluntary cooperation with investigators, however, cannot be universally applied without regard to the court’s view of the breadth of the investigations and the expansive language of the primary policy’s insuring agreement. Both factors may provide bases for distinguishing MBIA from other cases. In MBIA, the policy at issue broadly defined “Securities Claim” to include any “formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document.” A formal order of investigation and regulatory subpoenas already had been issued by both agencies before any voluntary compliance was offered or undertaken. Given the Federal policy’s expansive definition of “Securities Claim,” the Second Circuit had little difficulty concluding that coverage existed. This should be distinguished from situations involving voluntary disclosure in the absence of formal agency process or where a policy contains more limited language. 

 

 

 

The most significant aspect of the Second Circuit’s MBIA opinion is the seemingly blanket pronouncement that special litigation committee investigative costs incurred in response to a derivative suit are covered “Defense Costs.” That holding, however, relies on two questionable propositions: (1) that the SLC was an agent of, and acted at the behest of, MBIA, and (2) that the SLC’s actions were related to the defense of MBIA or insured directors.

 

 

 

On summary judgment, the District Court strained to find coverage for SLC expenses by noting that outside counsel retained by the SLC to investigate the shareholders’ claims also represented MBIA as a nominal defendant in the derivative lawsuits. After linking the SLC’s expenses to Dickstein’s representation of MBIA in the derivative suits, the District Court decreed that the SLC costs were, in fact, “Defense Costs.” 

 

 

 

The Second Circuit abandoned the District Court’s reliance on Dickstein’s representation of both the SLC and MBIA, determining instead that the SLC was not a separate entity from MBIA and was, therefore, an “insured person” under the Policy. The court’s analysis notwithstanding, there is no support for the proposition that MBIA directed the SLC. Rather, the SLC was comprised of independent directors uninvolved in wrongdoing alleged by the shareholder plaintiffs. Indeed, under Connecticut law, the SLC was required to operate independent of MBIA and its board in the SLC’s investigation of the derivative suits. The decision to dismiss the derivative suits was the SLC’s alone. MBIA did not, and legally could not, instruct the SLC to conclude that the derivative suit was not in the company’s best interest.

 

 

 

More importantly, the SLC did not act in the defense of MBIA or the insured directors and its expenses should not have been categorized as “Defense Costs.” The Second Circuit’s opinion provides no analysis on this point, concluding simply that “the costs incurred by the SLC in terminating the derivative litigation were covered ‘Defense Costs.’” But the very purpose of special litigation committees – to investigate allegations in shareholder derivative suits and determine whether the company should prosecute those claims against the defendant directors – is a corporate governance function. The board, through the SLC, has a fiduciary duty to investigate whether wrongdoing has occurred and whether to seek relief on behalf of the corporation. Thus, the SLC’s investigative costs should be covered here only to the extent of the Federal policy’s investigations sublimit. 

 

 

 

Moreover, costs for appearing in a lawsuit are not necessarily defense expenses. The SLC, after all, was not defending itself or the corporation. It was, in this case, seeking the termination of claims against other directors on grounds that it was not in the company’s interest to pursue those claims. This is the company’s right as the true owner of the claims being prosecuted. Simply because targeted directors avoided adverse claims as a result of the SLC’s investigation does not transform the SLC into a tool to defend target directors or defeat shareholder derivative claims. Had the SLC decided to take over the prosecution of the claims, also its right, no colorable argument for coverage could have been made. The Second Circuit overlooked this crucial analytical distinction.

 

 

 

MBIA is likely to be cited by policyholders both within and outside the Second Circuit in support of arguments for broad coverage with respect to agency investigations and Special Litigation Committee costs. Insurers need to be aware of the limitations of the Second Circuit’s reasoning and the factual idiosyncrasies of the case.