Three minutes. That’s how long it was between the dramatic moment that clutch Baltimore Oriole hitter Robert Andino drove in Nolan Reimold from second base, bringing about the victory of the Baltimore Orioles over the hapless Boston Red Sox, and the dramatic moment just seconds later that Evan Longorio hit a home run to push the Tampa Bay Rays to victory over the New York Yankees. In that small interval, the Red Sox were knocked out of the playoffs and Tampa Bay secured their spot in the post season.

 

Let’s recap. On September 3, the Rays were down nine games in the wild card chase to the Red Sox. The Red Sox then proceeded to plumb previously unexplored depths of futility during the month of September.  And Tampa Bay found ways to win, to bring their wild card chase with the Red Sox to an absolute dead heat going into last night’s games.

 

As if that were not enough, the Rays were down by seven runs in the eighth inning last night in their last game of the regular season, in a must-win game against the Yankees. The Rays scored six runs in the eighth inning, to bring the game to 7-6. But in the bottom of the ninth, when the Rays were down to their absolute last strike, pinch hitter Dan Johnson smacked a game-tying home run, sending the games into extra innings. And then in the bottom of the 12h inning, Evan Longoria (who had hit a three-run home run in the eighth inning) pulled a fastball over the short porch in left field to win the game for the Rays.

 

The Red Sox, at least theoretically, should have been in position to force an extra playoff game, despite the Rays’ victory. After all, the Red Sox were winning their game against the Orioles last night by a score of 3-2 with two outs in the bottom of the Ninth Inning. Even if Tampa Bay won their game against the Yanks, Boston should have been in a position to live to see another day, as long as they held on to their 3-2 lead. Alas, it was not meant to be. Moments before Longoria’s dramatic walk-off home run, and when the Baltimore Orioles were down to their last out in the bottom of the Ninth inning and were trailing 3-2  and facing Boston closer extraordinaire Jonathan Papelbon, the Orioles came back to tie and then to win the game.

 

With all due apologies to my friends in the Red Sox Nation, if you are a baseball fan with a pulse, this was one of the most exciting baseball evenings of all times. The ESPN Sportscenter guys were at a loss for words, and that is saying something. I should have gone to bed hours ago, and here I am blogging about absolutely astonishing post-Midnight baseball that I absolutely should not have been awake to see. After all, I have a blog, I have a job, I have responsibilities – why in the world did I keep watching? Because It was great, it was great, it was awesome, that’s why, and I suspect squadrons of (baseball fan) readers did too. Wasn’t it awesome? Well, yes, it was awesome.

 

I mean no disrespect to anyone, but for those of us who root for small market teams, this is about as good as it possibly can get. A massive payroll team goes down in flames, while a small market team overcomes adversity (and beats the Yankees! How great is that!) to knock an arrogant, smug big market team (again, all due apologies to Boston fans) out of the post-season. (Just as an aside, how did Boston, of all teams, with all of the Curse of the Bambino stuff, become so arrogant? I don’t know, but they managed to do it.) Hooray for the Rays, Hooray for the Orioles.

 

The vast majority of baseball fans, owing to the fact that there are so freaking many of them living in big cities on the Eastern Seaboard, thought last year’s World Series was an abomination. Too bad for all of the East Coast elitists—if what you care about is baseball it was a GREAT World Series.  I love baseball, and I loved every game of last year’s World Series. And I have a feeling I am going to love this year’s World Series too.

 

So with all due respect to all of those people that think it isn’t real baseball unless one of the Big Market East Coast teams makes it into the World Series, I just want to go on record by saying that a Detroit Tigers/ Milwaukee Brewers series would be an awesome contest between two very well matched teams. Small market teams rule, Big Market teams drool (and Big Market teams are so obnoxiously arrogant that every right- thinking person everywhere is rooting strenuously against them.) 

 

And by the way, the single greatest artistic creation of the Twentieth Century was the musical, “Damn Yankees,” based as it was on the premise that the Washington Senators should win the World Series – and the Yankees should not.

 

One of the most basic notions in our legal system is that liability attaches only to those who act with intent or knowledge. But as detailed in a front-page September 27, 2011 Wall Street Journal article (here), Congress has in recent decades enacted numerous provisions imposing criminal liability regardless of intent. Among the many troubling aspects of this trend are the implications for corporate directors and officers, who often are the target of these strict liability provisions and who increasingly have liability imposed on them for matters in which they were not involved and of which they were not even aware.

 

As the Journal article explains, a “bedrock principle” of our legal system is that criminal liability cannot be imposed without “mens rea,” or a guilty mind. But as the article details, Congress has “repeatedly crafted laws that weaken or disregard the notion of criminal intent.” As a result, things that “once might have been considered simply a mistake” are “now sometimes punishable by jail time.”

 

The article cites a number of recently enacted criminal provisions, particularly certain enactments regarding wildlife issues and firearms violations. One example cited refers to the imposition of a 15-year criminal sentence for possession of a single bullet (in violation of firearms restrictions for convicted felons).

 

Among the areas the article references that have seen the enactment of these types of provisions is white collar crime. The article specifically cites the provisions of the Sarbanes Oxley Act that make it “easier for prosecutors to bring obstruction of justice cases related to the destruction of evidence.” The article explains how these provisions passed as part of the larger bill without full or appropriate consideration of the implications.

 

The Sarbanes Oxley Act provision cited is far from the only recent statutory enactment or judicial development that potentially imposes liability on corporate officials without culpability. Indeed, just a few days ago, on September 13, 2011, another Wall Street Journal article entitled “U.S. Targets Drug Executives” (here) described how federal regulators have increasingly been using the judicially developed “responsible corporate officer doctrine” to pursue criminal prosecutions against corporate executives for federal food and drug law violations.

 

As I discussed in my own earlier look at the “responsible corporate officer doctrine” (here), courts have the doctrine to impose criminal liability on corporate officials who were not involved in or even aware of the violations. (The word “responsible” in the name of the doctrine references responsibility for the corporation not for the conduct.) As the September 13 Journal article details, the use of this doctrine can not only result in the imposition of criminal fines and penalties, but the convictions obtained in reliance on the doctrine can then be used to exclude convicted executives from Medicare and Medicaid, in effect turning their conviction into “career-ending punishment.”

 

As discussed here, the doctrine’s application has not been limited just to food and drug violations but has also been extended to violations of environmental law as well, and also has been used as the basis for the imposition of civil liability as well as criminal liability.

 

Nor do these instances represent the only examples of imposition of liability without culpability – to the contrary, they are consistent with a growing willingness of government regulators and prosecutors to try to impose liability without regard to involvement in or awareness of the alleged wrongdoing. For example, there have been multiple instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged wrongdoing.

 

First, as described here, the SEC has now on several occasions used its authority under Section 304 of the Sarbanes-Oxley Act to “clawback” compensation corporate executives earned a time when their companies were committing accounting fraud. For example, most recently former Beazer Homes CFO James O’Leary was compelled to return $1.4 million in bonus compensation even though he was himself not charged with any wrongdoing in connection with the company’s accounting fraud. As I noted in my prior post, though the SEC’s implementation of the compensation clawback is statutorily authorized, the imposition of a forfeiture without culpability or fault raises troubling questions, including basic questions of fairness.

 

In a separate development discussed here, the SEC recently filed an enforcement action seeking to impose control person liability on two officers of Nature’s Sunshine Products for the company’s Foreign Corrupt Practices Act violations – even though the two officials were not alleged to have any involvement in or awareness of the wrongful conduct.

 

Unfortunately, this trend toward the expansion of liability without culpability seems to be growing. Indeed, the Dodd-Frank Act greatly expands the compensation clawback ,  by requiring the major exchanges to adopt requirements for all listed companies to adopt provisions for the recovery in the event of a restatement of bonus compensation from any current or former executive officer who earned bonus compensation during the three years preceding the restatement.

 

The September 27 Journal article suggests that Congress is creating these types of exposures simply because it is neglecting to consider traditional intent requirements. I am not so sure, particularly when it comes to liability for corporate officials, as there seems to be this pervasive notion that corporate officials deserve liability and are getting off “scot free” and this in turn is leading to an increasing willingness to impose liability because of the position rather than because of their culpability.  

 

In recent months, I have taken on several commentators who have tried to argue that corporate officials need to be held liable more often (here), or that there is something wrong with our legal system when corporate officials cannot be held liable more frequently (here). I am concerned that general presumption that corporate executives are somehow blameworthy and deserving of liability are behind this trend toward imposing liability on corporate executives without actual culpability.

 

There is an unfortunate trend in our society to assume that when something has gone wrong that somebody has to be punished. This general proclivity to look for someone to blame is exacerbated by a general willingness to demonize corporate “fat cats,” which in turn leads some to conclude that corporate executives deserve liability because of their position, without regard of whether they actually did anything culpable.

 

I appreciate that many believe corporate executives need to be held accountable. Nevertheless, I am concerned that as a result of the increased tendency to impost liability on corporate executives without culpability, there is a contrary danger that corporate executives could be held liable too frequently, or at least in instances when they have done nothing themselves to deserve it. Scapegoating any individual – even a corporate executive – for circumstances in which they were not involved and of which they were not even aware is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

 

Along with all the other concerns, these types of proceedings may also raise D&O insurance coverage issues. Corporate officials in most instances would not have insurance coverage for the various fines and penalties imposed in these actions or for disgorged compensation. But the executives might well seek insurance coverage of their legal fees incurred in defending themselves in these actions. One question that might be asked in many of these types of cases is whether or not the proceedings involve an alleged “Wrongful Act” as is required to trigger coverage. Should these questions arise, these executives will want to be able to argue that the applicable D&O policy in any event covers them for allegations against them in their capacities as directors and officers “and in their status as such.”

 

Bank Director and Officer Defenses: As I have noted in prior posts (most recently here), there are now a growing number of actions against the directors and officers of failed banks brought by the FDIC as the failed bank’s receiver. The defenses available for these individuals and related considerations (including indemnification and insurance) are discussed in a brief, useful (date) memo from the Dechert law firm, entitled “Bank D&O Defense Manual” (here). The memo provides background on the FDIC’s approach to director and officer liability, the well as on the legal theories on which the FDIC will proceed and the defenses available to the directors and officers.

 

Speakers’ Corner: On October 5 and 6, 2011, I will be in Cologne, Germany participating in C5’s Sixth European Forum on D&O Liability Insurance. I will be participating in a panel on the first day discussing the evolution of class actions in the U.S. and Europe. Joining me on the panel will be Rick Bortnick of the Cozen O’Connor law firm; Guillaume Deschamps of Marsh, S.A. (France) and Prof. Dr. Roderich Thümmel of the Thümmel Schültze law firm.  Background regarding the event, including the complete agenda and registration information, can be found here.

 

If you will be attending the conference, I hope you will take time to greet me, particularly if we have not previously met.

 

In a lawsuit suggesting a new area of potential liability for corporate directors and officers, a shareholder of J.P. Morgan Chase has filed a derivative lawsuit against the company, as nominal defendant, and certain of its directors and officers alleging breaches of fiduciary duty in connection with the company’s recent $88.3 settlement with the U.S. Department of Treasury’s Office of Foreign Assets Control (OFAC). A copy of the derivative lawsuit complaint, filed September 6, 2011 in the Southern District of New York, can be found here.

 

OFAC is responsible for the administration of various trade sanctions regulations. In an August 25, 2011 press release, OFAC announced (here) that J.P. Morgan had agreed to pay $88.3 million to settle alleged violations of U.S. trade sanction regulations. Among other things, the OFAC press release described three alleged violations it characterized as “egregious.” Among the programs that OFAC alleged that the company had violated are those involving sanctions against Cuba, Iran and Sudan. The OFAC press release described the settlement as the largest settlement to date obtained by OFAC.

On September 6, 2011, the Louisiana Municipal Police Employee Retirement System filed a derivative lawsuit in the Southern District of New York, naming eleven directors and officers of J.P. Morgan as defendants. The complaint alleges that the defendants “knowingly allowed and rewarded the Company’s violations of The U.S. Department of Treasury’s multiple sanctions programs.” The lawsuit alleges that “the misconduct occurred, unchecked, under the Defendants’ watch because of their complicity in the improprieties alleged herein.” The lawsuit seeks to “recover damages caused by the Individual Defendants’ unlawful course of conduct and breaches of fiduciary duty.” Among other damages alleged are “the costs to the Company associated with the settlement, remedial measures, damage to goodwill and increased regulatory scrutiny.”

As reflected in a September 23, 2011 memo from the Fried Frank law firm entitled “State Pension Plan Files Claim Seeking $88.3 Million OFAC Penalty” (here), among the implications of these developments is that “OFAC violations can have significant follow-on consequences for not only the company — but officers and directors as well.” The payment of a settlement “sometimes is just the beginning,” as a settlement “can spark the attention of shareholders and result in the filing of a derivative lawsuit to hold officers and directors liable for repayment of any amounts paid in settlement.”

The prospect of a follow-on civil lawsuit following a civil settlement for OFAC violations raises a number of interesting challenges, particularly from an insurance standpoint. The settlement amount itself would not be covered under the typical D&O policy. The defense costs the defendants incur in a follow-on civil lawsuit would likely be covered. The interesting question comes in with respect to the damages alleged in the follow-on lawsuit. The question of the coverage for the alleged damages is analogous to the damages claimed in the follow-on civil actions filed following companies’ payment of Foreign Corrupt Practices settlements (about which refer here).

The complaint itself in this action actually has some things to say about D&O insurance. In arguing that its failure to make a pre-litigation demand on the J.P. Morgan board ought to be excused as futile, the plaintiff argues among other things that if the board were to sue themselves or other officers in connection with the OFAC violations, the claim would run afoul of the D&O policy’s Insured vs. Insured exclusion and therefore “there would be no directors’ and officers’ insurance protection” which is a “reason why they will not bring a suit.” The complaint notes that the Insured vs. Insured exclusion will not apply if the suit is brought derivatively.

Although the Insured vs. Insured exclusion would not apply to the plaintiff’s derivative suit, it remains an interesting question of what position the carrier would take with respect to the damages that the plaintiff seeks to recover. In any event, the lawsuit raises the possibility of a potentially significant new liability exposure for directors and officers of company’s engaging in transactions subject to OFAC’s oversight.

Yahoo’s board members may or may not be “doofuses” as departed Yahoo CEO Carol Bartz declared after they sacked her, but the one thing for sure is that the events surrounding her firing, and the more recent CEO turnover at H-P, sure have folks riled up. Whatever else you want to say about these events, they certainly have provoked an interesting dialogue about the role and function of corporate boards.

 

A particularly interesting discussion of these issues appears in Alison Frankel’s September 23, 2011 article on Thomson Reuters News & Insights entitled “Want More Board Accountability? It Won’t Come Through Litigation” (here). Her opening salvo in her call for board reform is that shareholders have “precious little power over corporate directors.” She notes that while derivative lawsuits “give investors an opportunity to blame boards for breaching their duties, “ all the suits really do is to provide shareholders “an opportunity to air allegations without a lot of hope they’ll make difference.”

 

Frankel is particularly concerned that when derivative suits are filed, board members are able to rely on the business judgment rule and also on the procedural requirement that shareholders first make a demand on the board to take up the claim before pursuing the lawsuit. She also is concerned that derivative litigation defense expenses and rare settlement amounts are often paid by insurance. As a result she says, “there’s really little consequence for board members from even the rare derivative suit that ends with a sizeable payment to shareholders.”  She concludes by questioning how boards can be reformed “when board members have so little incentive to change.”

 

Frankel makes a number of interesting points, and as usually is the case for her, she makes her points well. Nevertheless, I have a number of comments about her article. I want to emphasize at the outset that by offering these comments I mean no disrespect — I am in fact a huge fan of Frankel’s.  I offer these thoughts here purely in the interests of the exchange of ideas.

 

I should also acknowledge my biases. I have basically spent my entire career involved one way or the other with the interests of corporate boards. I tend to look at things from the perspective of corporate officials, which undoubtedly affects my view – although I do not think that disqualifies my opinions. What it means is that when some people think of corporate board members, they can only think of fat cats in fancy suits lighting cigars with hundred dollar bills. Whereas I think of the conscientious, hard-working, well-intentioned men and women I have known over the years who try hard to do what is best for their companies.

 

There is some irony that this debate is arising in the context of two recent board actions to fire their companies’ CEOs. It used to be that boards were criticized for being too cozy with the CEOs they were supposed to be supervising. Now Yahoo’s and H-P’s board are being criticized for the actions they took in throwing their CEOs out. I think a fair case could be made that these events played out the way they did not because the boards lack “incentives” to change as Frankel asserts, but rather because the boards are under excruciating pressure and feel a tremendous urgency to act forcefully. We may or many not agree with their actions or the way they went about it, but no one can question their willingness to act aggressively to try to make changes they think are necessary.

 

I think it is important to keep the extraordinary pressure facing board members today in mind when thinking about the desirability of trying to hold directors more accountable through shareholder derivative litigation. My own view is that it would be highly detrimental to the general aims and purposes of the corporate business enterprise if the defensive safeguards to derivative litigation were significantly reduced.

 

The expression of the need to “hold boards accountable” represents fine sentiment. But does anyone think that the economic purpose of the corporate business enterprise would be advanced if corporate officials could more easily be hauled into court and more frequently forced to defend their business decisions in court? In particular, does anyone really think that the increased threat of litigation would produce better business results and outcomes? And what would this omnipresent threat of litigation do to corporate decision-making if at the same time these corporate officials could not resort to insurance to protect themselves?

 

Personally, I have an experienced-based bias against anything that would encourage more litigation. I began my career litigating business cases. It is very hard to come in contact with our civil litigation system without concluding that the litigation process in our country is a colossal waste of time, energy and resources. All too often, the only ones who benefit from the system are the lawyers, and even they hate it. While I will concede that there are meritorious cases, it is the rare case indeed that produces benefits even remotely commensurate with the hideous waste of resources the process entails. It is impossible for me to believe that removing barriers to litigation will do anything to improve corporate performance or board functioning.  

 

It is far likelier that increased litigation threats and liability exposures will undermine the kind of decision-making our companies need to be able to compete in the global economy. It could also exacerbate the enormous pressures that directors already face and magnify the kinds of pressures that arguably caused the Yahoo and H-P boards to act precipitously in their recent actions.

 

The fundamental issue here is the question of what it means to “hold boards accountable.” I start with the proposition that the corporate enterprise is a financial venture pursuing a business purpose and run by a group of individuals. Investors’ participation in this venture is purely voluntary and entirely optional, and based on the investors’ own assessment of the venture and the individuals trying to run it.  Whether to invest, to stay invested or to stay away altogether are the tools investors have – and they are powerful tools, as in the end access to investment capital could be determinative of whether or to what extent the venture succeeds. Investment selection is the truest and most effective form of shareholder democracy.

 

One valuable thing that has emerged from the recent events and the ensuing discussion is a renewed appreciation for the importance of board functioning. An effective board is an important part of any successful corporate enterprise. But rather than producing bigger cudgels with which to chastise boards of lagging enterprises, what we need are better tools to understand how to identify companies with effective boards. In the long run, picking winners rather than punishing losers will be better for individual business enterprise and for our general economic well-being.

 

I would like to see improved board functioning as much as anyone else. In a highly competitive global economy it is going to be increasingly important for companies to have wise and visionary leadership. But subjecting corporate stewards to increased hindsight second-guessing in a courtroom will do little to bring that type of leadership about.  

 

My earlier post discussing the question of whether directors should be held liable more often can be found here.

 

Looking in the Hermit Kingdom:  According to a September 17, 2011 article in The Economist magazine (here), North Korea is once again facing a severe food shortage. The article examines the question of how a regime that so persistently leaves its population in hunger and misery remains so entrenched. The article speculates that population distribution and transportation shortcomings have internally isolated the country’s underclass and minimized the risk that they might act collectively.

 

A question worth asking is what the country’s leadership is doing to address the current crisis. The answer is that, well, they are looking at things. Indeed, based on pictures published in North Korean newspapers, looking at things is the country’s leader’s principal occupation – so much so that there is a website descriptively and accurately entitled “Kim Jong-il Looking at Things.” The site, which notes that “the dear leader likes to look at things,” consists of pictures of, well, Kim Jong-il looking at things. What kinds of things? A fish, umbrellas, doner kabab, scientists, glass bottles, corn, chemicals, bread…I guess there are a lot things to look at when you a “Supreme Leader.”

 

According to Wikipedia (here), Kim Jong-il’s official biography claims that his birth “was foretold by a swallow, and heralded by the appearance of a double rainbow over the mountain and a new star in the heavens.”   Many North Koreans believe that he has the "magical" ability to "control the weather" based on his mood.  In 2010, the North Korean media reported that Kim’s distinctive clothing had set worldwide fashion trends.

 

The whole bizarre situation would be funny if it weren’t so tragic.

 

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Only small a small number of companies experienced a negative “say on pay” vote this past proxy season, but many of the companies that did found themselves hit with a shareholder lawsuit in the wake of the negative vote. Cincinnati Bell is one of the companies that with both a negative vote and subsequent shareholder lawsuit.  Now, in a September 20, 2011 opinion (here) that expressly references and even relies on the negative vote, Southern District of Ohio Judge Timothy S. Black denied the defendants’ ‘motion to dismiss the shareholder suit, finding that whether the defendants would be entitled to rely on the business judgment rule is a question for trial, and also finding hat the shareholders’ pre-lawsuit demand was excused.

 

Under Section 951 of the Dodd-Frank Act, reporting companies must seek a non-binding shareholder vote in the form of a resolution to approve the company’s executive compensation plan at least every three years. Cincinnati Bell’s 2011 proxy included a resolution seeking shareholder approval of its 2010 executive compensation plan. On May 3, 2011, 66% of the company’s voting shareholders voted against the resolution.

 

Thereafter, a shareholder plaintiff filed a derivative lawsuit alleging that the company’s board breached its fiduciary duty of loyalty when it approved large pay raises and bonuses to its top three executives in a year that, according to the plaintiff, the company performed poorly. The plaintiff’s complaint specifically referenced the negative say of pay vote.

 

The defendant board members moved to dismiss, arguing that their actions with respect to executive compensation were protected by the business judgment rule, and arguing further that the plaintiff had failed to make the requisite pre-lawsuit demand that the board consider the claims that he asserted in his lawsuit.

 

In his September 20 opinion, Judge Black found that that the plaintiff had adequately alleged that the Cincinnati Bell board was not entitled to rely on the business judgment rule, and that while the defendants may attempt to rely on the business judgment rule at trial, they were entitled to rely on the rule as a basis for dismissal.

 

In making this ruling, Judge Black noted that the plaintiff’s factual allegations “raise a plausible claim that the multi-million dollar bonuses approved by the directors at a time of the company’s declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and were not in the best interests of Cincinnati Bell’s shareholders and therefore constituted an abuse of discretion and/or bad faith.”

 

Judge Black also rejected the defendants’ argument that the plaintiff’s lawsuit must be dismissed due to the plaintiff’s failure to make a pre-lawsuit demand on the company’s board. In reaching the conclusion that the demand was excused as futile, Judge Black said that:

 

Given that the director defendants devised the challenged compensation, and suffered a negative shareholder vote on the compensation, plaintiff has demonstrated sufficient fact to show that there is reason to doubt these same directors could exercise their independent judgment over whether to bring suit against themselves.

 

In reaching both of these conclusions, Judge Black specifically referenced and even relied on the fact of the negative say on pay vote. In reaching the conclusion that the defendants were not entitled to rely on the business judgment rule at the dismissal motion stage, and in concluding in particular that the plaintiff had adequately alleged that the board’s actions were “not in the best interests of Cincinnati Bell’s shareholders,” Judge Black specifically cited the plaintiff’s allegation that the negative say on pay vote “provides direct and probative evidence that the 2010 executive compensation was not in the best interests of the Cincinnati Bell shareholders.” As noted in the preceding paragraph, Judge Black also specifically referenced the negative say on pay vote in concluding that demand was excused as futile.

 

Discussion

As I have noted before, it is hardly surprising that there is shareholder litigation over executive compensation. Executive pay is a hot button issue that generates a great deal of interest and emotion. Indeed, in a footnote, Judge Black expressly cited a media commentary that “excessive executive compensation is the No. 1 problem in corporate governance.” This perspective clearly influenced Judge Black’s consideration of the dismissal motion.

 

But though the litigation itself may not be surprising, it is somewhat surprising that Judge Black in effect conceded the shareholder’s entitlement to rely on the negative say on pay vote. The Dodd-Frank Act is quite clear that the required vote is not binding on the company or its board. Moreover, Section 951(c) of the Act expressly states, among other things that the shareholder vote “may not be construed” to “create or imply any change to the fiduciary duties of such issuer or board of directors” or to “create or imply any additional fiduciary duties for such issuer or board of directors.”

 

Judge Black acknowledged these statutory limitations on the vote’s significance. He even acknowledged the concerns of Dodd-Frank critics that the say on pay requirement will lead to “extensive, frivolous litigation.” He nevertheless quoted with approval from other sources that “a negative say on pay vote give the court evidence that there’s been a breach of duty. It doesn’t mean there’s been a breach of duty, but it can support a finding of breach.”

 

On the one hand, all that has happened here is that the complaint has survived a dismissal motion. That is far from a finding that the defendants have actually violated any duties. On the other hand, it is highly unlikely that the defendants will context these claims all the way through trial. Most corporate and securities cases settle and their will be pressure on the defendants here to settle as well.

 

There is something very ironic about the fact that on the one hand the say on pay vote is nonbinding but was also expressly built to leave existing legal standard unchanged, and on the other hand the outcome of the say on pay vote can be used as a basis for denying a motion to dismiss an excessive compensation lawsuit – which in turn will create pressures for the corporate defendants to settle.

 

It is true that for companies whose executive compensation practices receive a positive shareholder vote, the say on pay requirement will not encourage litigation. But nevertheless, those who question whether the say on pay requirement will encourage litigation need to take a look at this case. The company’s negative say on pay vote was followed by litigation, and the outcome of the say on pay vote was used as a basis for denying the motion to dismiss. The vote created the context for the claim and also provided the plaintiffs a tool with which to maintain the claim.

 

As UCLA Law Professor Stephen Bainbridge said in an April 26, 2011 post on his blog (here), he knew these kinds of problems were coming when Congress incorporated the advisory say on pay provision in the Dodd-Frank legislation, having warned that the process “would be abused and turned from a supposed non-binding voting exercise into a club to beat directors with.”

 

The saving grace, perhaps, is that the vast majority of companies did not have a negative say on pay. However, for the companies that did, and who thereafter got caught up in shareholder litigation, these cases will be costly to defend and could be costly to resolve. These costs are a concern not only to the companies themselves but to their D&O insurers, who may wind up having to foot the bill at least for the defense expenses. All of this because of a non-binding vote that wasn’t supposed to change the legal standards in any way….

 

Alison Frankel notes in her post on Thomson Reuters News & Insight (here) that Judge Black’s ruling in the Cincinnati Bell case is contrary to the ruling of the Georgia state court in the Beazer Homes say on pay case.

 

Many thanks to Dan Gilman of SCN Strategies for providing me with a copy of Judge Black’s decision.

 

Ain’t Too Proud to Beg: The LexisNexis Insurance Law Community has now begun the process to select the Top 50 Insurance Law Blogs of 2011. I am pleased to note that The D&O Diary is among the blogs nominated for this list. The editors at LexisNexis are now soliciting comments from legal practitioners and others as part of the process to select the Top 50 blogs. The comments will serve as a part of the information the editors use to select the Top 50 blogs.

 

The initial list of nominees includes a number of fine blogs. I encourage readers to visit the site and post a comment about their favorite insurance law blog. I would be humbled if any reader would consider posting a comment about my site on the LexisNexis Insurance Law Community. To submit a comment, visitors need to log on to their free LexisNexis Communities account.  More detailed instructions about how to post a comment can be found here. If you haven’t previously registered, you can do so at the Insurance Law Community for free. The comment box is at the very bottom of the blog nomination page. The comment period for nominations ends on October 7, 2011. 

 

The typical D&O insurance policy precludes coverage for loss arising from fraudulent misconduct. But when an insured has been convicted of fraud, whose coverage is precluded? In the second case in recent days to address the consequences for the insured entity of the criminal conviction of one of the entity’s principals, Judge James L. Graham of the Southern District of Ohio held on September 16, 2011 that the criminal convictions of several principals of National Century Financial Enterprises preluded D&O insurance coverage not only for those individuals but for the insured entity’s successor in interest as well. Judge Graham’s opinion, which addresses a number of recovering issues, can be found here.

 

National Century had been in the business of purchasing accounts receivable at a discount from healthcare providers and then raising capital by issuing investment grade notes backed by the receivables. It later emerged that many of the accounts receivable were worthless or nonexistent, and the funds raised through the notes offerings were paid to healthcare companies in which principals of National Century held undisclosed ownership interest. The principals of the company caused National Century to issue financial reports that were entirely fabricated.

 

Eventually the multibillion dollar scheme collapsed and National Century filed for bankruptcy. Several of the principals of National Century were ultimately convicted of a variety of criminal charges. The principals appealed their criminal convictions and while their convictions on certain of the charges were overturned, their convictions were otherwise affirmed.

 

During the period March 28, 2002 to March 28, 2003, National Century had a $10 million D&O insurance program in place, arranged with a $5 million primary policy and an additional $5 million follow form policy excess of the primary $5 million. Though these policies were to expire on March 28, 2003, National Century exercised an option under both policies to purchase an additional one year of discovery coverage for claims that arose during the original policy period.

 

The Unencumbered Asset Trust (UAT), which was created by the bankruptcy court to pursue claims belonging to National Century and its subsidiaries, filed an adversary action against the company’s D&O insurance carriers seeking a judicial declaration that the policies were enforceable and requesting an equitable apportionment of the policies’ proceeds among the insureds. The primary carrier filed a motion to deposit its policy limits in the registry of the court and to obtain a discharge of its liability. The bankruptcy court granted this motion and later apportioned the $5 million primary policy among UAT (which received $1.5 million) and seven individuals (who received $500,000 each).

 

Contrary to the actions of the primary carrier, the excess carrier disputed coverage and filed a counterclaim seeking rescission of its policy and seeking a declaratory judgment that the excess policy was void. After additional proceedings, the parties to the insurance coverage action filed cross motions for summary judgment. UAT argued that the excess carrier was not entitled to rescission and in any event had waived its right to rescind. UAT also argued that the principals’ criminal conviction cannot be imputed to the entity, and therefore the fraud exclusion did not preclude coverage for the entity (and its successor in interest, UAT).

 

In his September 16, 2011 opinion, Judge Graham held, based on the misrepresentations in the company’s financial statements, which statements were incorporated by reference into the application and therefore into the policy, that the excess insurer had a substantial basis on which to rescind the policy. However, he found there was a genuine issue of material fact on the questions of whether the excess carrier had waived its right to rescission by agreeing to issue the discovery coverage and by accepting the premium for the discovery coverage. (By the time the discovery coverage was acquired, National Century had already filed for bankruptcy and allegations of misconduct had already come to light.)

 

Judge Graham had little difficulty concluding that, as a result of their criminal convictions, coverage under the excess policy for the convicted individuals’ loss was precluded by the policy’s fraud exclusion. Lance Poulson, the company’s founder and former President and Chairman, had tried to argue that the exclusion could not be applied to him because he still has the option of filing a petition for a writ of certiorari to the U.S. Supreme Court, and therefore the “adjudication” of his criminal misconduct was not yet “final.” 

 

Judge Graham rejected this argument holding that the “type of finality” that Poulson “espoused” is “not required to trigger the fraud exclusion.” Rather the exclusion requires only “a judgment or other final adjudication adverse to such Insured.” Judge Graham found that this provision “speaks nothing of exhaustion of appellate review.” Poulson’s criminal conviction alone was held sufficient to establish the applicability of the exclusion.

 

Judge Graham then turned to the question of whether or not these individuals’ fraudulent misconduct could be imputed to UAT, the entity’s successor in interest. Many policies have specific provisions designed to address to whom and how insured persons’ conduct will be imputed, but Judge Graham’s opinion does not reference any policy language in connection with the question whether or not the individuals’ fraudulent misconduct could be imputed to the entity. Instead, his analysis turned on various aspects of agency law addressing the question of whether and when the conduct an agent acting on his or her own account can be imputed to their principal. Judge Graham held that because the individuals so dominated the principal the principal itself had no separate existence or identity, and therefore their financial fraud must be imputed to the entity.

 

Discussion

Judge Graham’s conclusion here that the individuals’ fraudulent misconduct could be imputed to the entity (and its successor in interest) stands in interesting contrast to Southern District of New York Judge Naomi Reice Buchwald’s September 9, 2011 decision in the SafeNet coverage case (about which refer here), in which Judge Buchwald held that the criminal guilty plea of SafeNet’s CFO could not be imputed to SafeNet itself for purposes of determining the applicability to SafeNet of its excess D&O insurance policy’s fraud exclusion.

 

The difference in outcome between the two cases may be due in part to the fact that in the SafeNet case, Judge Buchwald was interpreting the imputation language in the policies at issue, whereas here Judge Graham was applying general agency law principles. In the SafeNet case, even though the relevant policy language provided that knowledge and facts could be imputed to company, the adjudication of the CFO’s criminal misconduct could not be imputed to SafeNet. That is, the imputation to the company under the policy’s language was limited to “facts” and “knowledge,” whereas here, Judge Graham found that the individuals’ fraudulent misconduct could be imputed to the company and its successor in interest.

 

I do wonder whether or not this apparent distinction really does explain the difference in outcome, though. The relevant exclusionary language at issue here precludes coverage for loss in connection with any claim against any insured “brought about or contributed to by any deliberately fraudulent or deliberately dishonest act or omission. by such Insured” but only “if a judgment or final adjudication adverse to such Insured establishes such a deliberately fraudulent or deliberately fraudulent dishonest act or omission.” (Emphasis added)

 

I don’t know whether the entity’s successor in interest raised this argument but it seems like it could have been argued that there had been no adjudication adverse to the entity as required in order for the exclusion to preclude coverage for the entity.  Even if as Judge Graham found that the individuals’ misconduct can be imputed to the entity and its successor as a result of the application of agency law principles, there does not seem to be anything that would impute the adjudication of those individuals’ misconduct to the entity. That was certainly the reasoning of Judge Buchwald in the SafeNet case.

 

It may be purely coincidental, but I do think it is noteworthy that in both the SafeNet case and this case the coverage issues were being raised not by the primary insurers but rather by the excess insurers. This is yet another example of a phenomenon I have noted before on this site, which is that so many of the litigated coverage disputes seem to involve excess carriers.

 

The procedural step taken by the primary carrier here may be particularly of interest in light of the issues recently raised in the Lehman Brothers case (about which refer here). The individual officers and directors of the Lehman subsidiary are trying to contend in the Lehman bankruptcy that they are entitled to some type of equitable apportionment of the remaining D&O insurance. The difference between that proceeding and what occurred here with respect to the primary carrier’s policy proceeds  is that here the primary insurer here  deposited its policy proceeds with the court (presumably through some type of interpleader). The Lehman bankruptcy court may lack an equivalent procedural context for the type of apportionment that the Lehman subsidiary executives seek. But it is nevertheless interesting to seen an example of a situation where a court provided for the equitable apportionment of insurance proceeds along the lines that the Lehman subsidiary executives are seeking in the Lehman bankruptcy.

 

In any event, it is probably worth noting that even though Judge Graham concluded that the fraud exclusion precludes coverage for the convicted individuals and for the entity’s successor in interest, that is not the end of this matter. There are other insured persons seeking the benefit of the policy proceeds. These persons include the company’s former outside directors and Poulson’s wife., who was also an officer of the company. These persons were not criminally convicted. So as a result of Judge Graham’s conclusion that the are genuine issues of material fact on the question of whether or not the excess insurer waived its right to policy rescission, this case must go forward in order to determine whether or not those individuals do or do not have coverage under the excess policy.

 

Hartford Financial Subprime-Related Securities Suit Dismissed: Speaking of Judge Buchwald, on September 19, 2011, she granted with prejudice the motion to dismiss of the defendants in The Hartford Financial Services subprime-related securities class action lawsuit.  A copy of Judge Buchwald’s opinion can be found here.

 

As discussed here, the plaintiffs filed suit against the company and certain of its directors and officers in March 2010, alleging that the company had failed to disclose its growing exposure to derivatives and hedging contracts, the deterioration of which had caused the company’s public statements about its financial condition to become inaccurate. The plaintiffs also alleged that the company used inflated valuations for mortgage-backed assets on the company’s balance sheet, which resulted in an overstatement of the company’s capital position.

 

In granting the defendants’ motion dismiss, Judge Buchwald noted that the plaintiffs’ allegations were “unusual” because they did not allege that the company had violated GAAP or even that the company’s regulatory filings contained a misrepresentation or omission. Instead, she noted, “plaintiffs base their entire complaint on a unilateral, and ultimately unsupported, interpretation of The Hartford’s insurance filing, and their belief about what this document reveals about defendants’ state of mind and valuation of assets.” The plaintiffs, she said, have made “an unfounded assumption about the year-end insurance filings and follow that with a series of equally unfounded extrapolations based on this flawed assumption.”

 

I have in any event added Judge Buchwald’s ruling in The Hartford case to my running tally of subprime-related lawsuit dismissal motion rulings, which can be accessed here. Nate Raymond’s September 19, 2011 Am Law Litigation Daily article about the dismissal in The Hartford case can be found here.

 

FDIC Failed Bank Lawsuits Will Peak in 2012?: In yesterday’s post, I noted that the FDIC’s lawsuit filing activity picked up momentum in August. I also suggested that in light of the timing of bank closures and the seeming lag time between prior closures and later lawsuits, it appears that there will be many more lawsuits in the months ahead, particularly as we head into 2012.

 

In a September 19, 2011 post on the blog of the Joseph & Cohen law firm, Jon Joseph presents his analysis which he believes shows that the FDIC’s failed bank litigation filings are likely to peak in 2012. Joseph has a number of interesting observations about the cases the FDIC has filed so far as part of the current wave of bank failures and has some interesting speculations about what may lie ahead, in particular about how many lawsuits are yet to come and when they are likely to be filed. Among other things he speculates based on the current number of bank failures that there will be lawsuits in connection with about 80 additional failed banks, beyond the 14 lawsuits that have been filed so far.

 

A wave of litigation followed in the wake of the April 2010 Deepwater Horizon oil spill. Among this litigation were several shareholder derivative suits filed against certain directors and officers of BP and of its U.S. subsidiary. At the time these cases first arose, I asked whether or not these suits involving (and ultimately for the benefit of) an English corporation and even asserting claims under English law would be permitted to go forward in U.S. courts.  

 

A September 15, 2011 ruling from Judge Keith Ellison of the Southern District of Texas determined that, notwithstanding the fact that the Deepwater Horizon disaster took place in the U.S. and caused extensive environmental damage here, “the English High Court is a far more appropriate forum for this litigation,” and accordingly he granted the defendants’ motion to dismiss the cases.  Judge Ellison’s September 15 decision can be found here.

 

As discussed here, plaintiffs filed the first of several derivative lawsuits in connection with the Deepwater Horizon oil spill in May 2010. Though many of the lawsuits were first filed in the Eastern District of Louisiana, the cases were ultimately consolidated through the multidistrict litigation process in the Southern District of Texas. However, while the lawsuits were filed in U.S. courts, they asserted claims under the English Companies Act of 2006 (about which refer here). The defendants moved to dismiss the consolidated derivative litigation in the grounds of forum non conveniens.

 

In his September 15 ruling, Judge Ellison granted the defendants’ motion to dismiss. He summarized his ruling by saying that “this case is a shareholder derivative action brought under a recently enacted U.K. statute on behalf of an English Company against numerous English defendants and other foreign nationals.” The Court, he said, is “persuaded that the Complaint should be dismissed under the doctrine of foreign non conveniens, as the English High Court is the more appropriate forum for this case.”

 

Judge Ellison found that considerations of public interest “most strongly favor England as the appropriate forum in which to proceed with this case.” He noted that the focus would not be the events in the Gulf that led up to the oil spill, but rather the actions of the company’s board, which took place in England. He commented that “this lawsuit is not intended to redress the devastating impact of the Deepwater Horizon disaster in the Unites States. Instead the lawsuit is intended to compensate BP for the financial and reputational harm the company suffered as a result of its high level management’s alleged disregard for the safety of its operations.”

 

Judge Ellison noted that “the primary concern of this derivative litigation is the internal affairs of an English corporation, and the suit seeks to recover damages for the benefit of BP only.” He concluded that England “has a far greater interest in the resolution of this dispute.”

 

Judge Ellison was particularly concerned that were the case to remain in a U.S. court, the court would have to interpret and apply the recently enacted Companies Act. If the case were to go forward in a U.S. court, “the Court would be faced with the formidable exercise of interpreting and applying a still nascent and evolving body of law.”

 

Judge Ellison did condition his dismissal on the defendants proferring adequate proof that they are amenable to service of process in England or submitting a stipulation that the will submit to the jurisdiction of the appropriate English court.

 

Although the claimants clearly would have preferred to pursue their mismanagement claims against the BP officials in the U.S., where the disastrous oil spill occurred, Judge Ellison found that the allegations in this case involve alleged actions or inactions that took place in England. The fact is that though the shareholders chose to file their action here in preference to England, with full awareness that English courts presented an alternative forum. The decision to file here rather than there undoubtedly had something to with a perception that a court in closer proximity to the damages cause by the spill might prove to be a more receptive forum. The selection of a U.S. court over an English one also reflects the more general advantages a plaintiff enjoys here by comparison to English courts – for example, the absence in the U.S. of a “loser pays” model, among other things.

 

These kinds of advantages often encourage plaintiffs with claims involving non-U.S. companies to try to pursue their claims in U.S. courts. But the outcome of the dismissal motion in the BP derivative suit represents just one more example of the many ways prospective litigants are finding it increasingly more difficult to pursue corporate and securities claims against non-U.S. companies in U.S. courts. Courts interpreting the U.S. Supreme Court’s Morrison decision have significantly narrowed the circumstances in which securities claims involving foreign companies can go forward in U.S. courts. Judge Ellison’s decision in the BP case underscores the difficulties prospective claimants may fact in pursuing derivative suits involving non-U.S. companies here as well.

 

Alison Frankel’s September 16, 2011 Thomson Reuters News & Insight article about Judge Ellison’s decision can be found here. Victor Li’s September 16, 2011 Am Law Litigation Article about the decision can be found here.

 

For Whom the Statute Tolls: Under Section 13 of the ’33 Act, liability actions alleging a violation of the statue must be brought within one year of “discovery of the untrue statute or omission.” Section 13 provides further that in no event shall the action be brought more than three years after the security was first offered to the public. The one year provision represents a statute of limitation and the three year provision represents a so-called “statute of repose.”

 

Questions of statutes of limitation and repose might seem obscure, but they can often be critical in determining whether or not a case will go forward. A September 15, 2011 decision by Southern District of New York Judge Laura Taylor Swain in the Morgan Stanley Mortgage Pass-Through Certificates Litigation (here) presents interesting and potentially significant rulings on both the statute of limitations and statute of repose issues.

 

The case involves claims asserted by investors who purchased certain mortgage-backed securities issued by various Morgan Stanley related entities. The plaintiffs allege that the offering documents related to these securities misrepresented and omitted material facts regarding the underwriting standards applied by the loan originators. As detailed in Alison Frankel’s September 16, 2011 article in Thompson Reuters News & Insight (here), this lawsuit has a convoluted procedural history, in part due to the plaintiffs’ efforts to assemble a group of prospective class representatives whose claims were not time-barred. This latest dismissal motion round involved amended allegations and additional named plaintiffs. The defendants again moved to dismiss based on the statute of limitations and the statute of repose.

 

Judge Swain’s 40- page opinion reflects a number of interesting rulings, particularly with respect to the timeliness questions. First, she rejected the defendants’ arguments, based on information that was publicly available more than a year before the initial complaint was filed, that the claims of the Public Employees’ Retirement System of Mississippi (MissPERS) were untimely. Judge Swain said that though there was ample publicity on issues pertaining to circumstances relevant to the securities, none of the various items of publicity “addresses, even at a speculative level, the disregard of underwriting practices, neglect of appraisal standards, or consequent LTV ration misrepresentations alleged in the [amended complaint]”

 

Nevertheless, though she found that the early warnings were not sufficient to trigger inquiry notice, she also found that the plaintiffs had not alleged with sufficient specificity the time and circumstances of their discovery of the conduct alleged in their claims. Accordingly she allowed the plaintiffs leave to replead to establish the circumstances of their discovery in order to establish compliance with the one year statute of limitations.

 

Perhaps even more interesting is Judge Swain’s ruling on the question of the three-year statute of repose, and in particular her application of what is known as the American Pipe tolling doctrine. Under this doctrine, which derives from a 1974 U.S. Supreme Court opinion, the initiation of an earlier class action suit tolls the running of the statute of limitations for other purported class members who may later seek to intervene and represent the class. The application of the American Pipe tolling doctrine to the running of the statute of limitations is well established. A long standing question has been whether American Pipe tolling also applies to the statute of repose. Judge Swain held that American Pipe tolling does apply to the statue of repose, and denied defendants’ argument that the claims of certain new plaintiffs were barred by the statue of repose in the ’33 Act.

 

In holding that American Pipe tolling applies even to the three-year statute of repose, Judge Swain declined to follow two recent decisions by other Southern District of New York judges. She reasoned that the tolling doctrine is equitable in nature and “permits a court – after weighing the equities in the discrete case before it – to authorize plaintiffs to bring actions outside the limitations period.”

 

Judge Swain’s ruling about the statute of repose represents a potentially big deal. If followed by other courts, it could potentially be very significant in cases where an initial plaintiff’s purported class action is dismissed for the plaintiff’s lack of standing. Other prospective claimants who might want to come forward at that point might find their claims blocked by the statute of repose, if the initial filing did not toll the statute’s running.

 

This possibility is not merely theoretical, particularly with respect to the many mortgage-backed securities class action claims that have been asserted in the wake of the financial crisis. In many of these cases, the claimants have had some of their initial claims dismissed because the named plaintiff did not actually buy securities in all of the offerings in which the securities were sold. Judge Swain’s ruling, if followed, would remove one potentially significant impediment that might other wise exist for other prospective claimants who did buy securities in the other offerings and who might want to come forward and assert class claims on behalf of other investors who bought those securities.

 

The question is whether other courts will follow Judge Swain on these issues, or will follow the other two Southern District of New York decisions that recently went the other way and held that American Pipe tolling does not apply to the statute of repose.  In her September 16, 2011 Am Law Litigation Daily article about Judge Swain’s ruling in the Morgan Stanley case (here), Susan Beck identifies and links to the two other recent Southern District of New York rulings that Judge Swain declined to follow. She also speculates that the Second Circuit will likely weigh in on these issues, given that the two prior cases (which resulted in dismissals) are on appeal to the Second Circuit and have been consolidated for one hearing before that court.

 

Special thanks to a loyal reader for sending me a copy of Judge Swain’s decision in the Morgan Stanley case.

 

When Words Fail: Here in the blogosphere, the deadline is always right now. Because of the need for speed and the fact that I work alone (often late at night or very early in the morning), mistakes sometimes make their way into my blog posts. Because I don’t the benefit of an editor’s surveillance, I am always grateful when readers point out the errors to me, so that I at least have the opportunity to make a correction.

 

Massive media organizations publishing on a regular weekly basis with the benefit of a large editorial staff have fewer excuses for errors. For that reason, I am always appalled at the slips that make their way into print in some traditional print publications.

 

This week’s candidate for the boo-boo that someone really should have caught appears in the current issue of Time Magazine (cover date September 26, 2011). In an article entitled “After Three Years and Trillions of Dollars, Our Banks Still Don’t Work” (here, subscription required), Stephen Gandel writes, with reference to comments by analyst Meredith Whitney about the banking sector, “Eventually, Whitney says, growing litigation issues and a continued drop in housing market were bound to burst the levy.” I am pretty sure Whitney meant that eventually the “levee” was bound to burst, as a "levy" might be on a ballot or be imposed but I have never heard of one bursting. In addition, I feel pretty confident that if this were pointed out to Gandel, a “damn” would burst out as well.

 

Turns out that while some of us were wondering when the lawsuits arising out of the current bank wave would really start to accumulate, the FDIC itself was busy filing lawsuits — they just didn’t tell anybody about it, at least not until now. Specifically, the FDIC filed three more lawsuits in August than had previously come to light. At a minimum, these lawsuits suggest the FDIC has been more active in pursuing its litigation strategy than may have been perceived. The suits also suggest that the FDIC’s declarations about its planned litigation strategy are very much in earnest.

 

The three newly publicized lawsuits, each of which were filed by the FDIC in its capacity as receiver of a failed bank, are as follows:

 

First, on August 8, 2011, the FDIC filed a lawsuit in the Eastern District of Michigan against a single former loan officer at Michigan Heritage Bank, of Farmington Hills, Michigan, which failed on April 24, 2009 (about which refer here). A copy of the complaint in this lawsuit can be found here. The complaint alleges that the individual, whom the complaint alleges had been CEO of a different Michigan bank that failed in 2002, caused the bank to incur losses in excess of $8.2 million. The complaint, which asserts claims of negligence, gross negligence and breach of fiduciary duty, alleges among other things that the lending officer “failed to conduct due diligence and analysis prior to originating and recommending approval of 11 commercial loans that resulted in losses” and “failed to adequately inform [the Bank’s] board of directors and senior management of deficiencies with respect to those loans.”

 

Second, on August 9, 2011, ,the FDIC filed a lawsuit in the District of Kansas against six former officers and directors of the Columbian Bank and Trust Company, of Topeka, Kansas, which failed on August 22, 2009 (about which refer here). The FDIC’s complaint in this lawsuit can be found here. The FDIC seeks to recover losses of at least $52 million the bank allegedly suffered because the defendants allegedly “negligently, grossly negligently, and in breach of their fiduciary duties originated and/or approved poorly underwritten large commercial and commercial real estate loans … and failed to properly supervise the Bank’s lending function.” The FDIC also alleges that the defendants (one of whom owned or controlled the bank’s holding company) “failed to heed the warnings of bank supervisory authorities.”

 

Third, on August 10, 2011, the FDIC filed a lawsuit in the Eastern District of North Carolina against nine former directors and officers of the Cooperative Bank, of Wilmington, North Carolina, which failed on June 19, 2009 (about which refer here). The FDIC’s complaint in this action can be found here. The complaint alleges that defendants “failed to manage the inherent risks associated with their aggressive growth strategy” and “permitted a lax loan approval process.” The complaint further alleges that through out the period 2005 through the bank’s failure, state and federal regulators “repeatedly warned” the bank’s management and board “about the risks associated with its high concentrations in speculative loans and weaknesses in lending functions,” yet the bank’s board “permitted and approved” the bank’s continued lending practices. The FDIC alleges that the defendants’ negligence, gross negligence and reckless conduct “ultimately led to the bank’s failure.”

 

There are a number of interesting things about these three new lawsuits, beyond the fact that they were filed on three successive days in August. For one thing, all three involved banks that failed more than two years before the complaints were filed. The timing of the filings relative to the earlier closures says something about the FDIC’s internal timetable for working up potential lawsuits. Another thing about these lawsuits are that the involve banks in states that have not been particularly hard hit during the current bank failure. By and large the bank failures have involved banks in just a few states, particularly Georgia, Illinois, California and Florida. Hard to know for sure what it signifies, but it is interesting that none of these suits involve banks from those hard hit states.

 

Another interesting thing about these suits is that all three involve relatively small banks. The Michigan Heritage bank lawsuit  involves a single mid-level lending officer and relatively modest losses on a relatively small number of loans. The implication seems to be that the FDIC intends to be very thorough and that there are not going to be cases that are too small to bother with. This is a salvage operation, pure and simple, and the FDIC is going to recover everything it can, no matter how small.

 

In any event, when these three additional lawsuits are taken into account, the total number of lawsuits that the FDIC has filed against former directors and officers of failed banks as part of the current bank failure wave is now up to fourteen, five of which were filed in August, and half of which were filed since June 30, 2011. The fact that these suits were filed in August and are just coming to light now suggests the possibility that there could be other FDIC lawsuits that have been filed but that have not yet surfaced.

 

Whether or not there are other filed but not yet publicized suits out there, it is clear there are many more lawsuits to come. On its website, the FDIC has said that as of September 13, 2011, the agency has approved lawsuits involving suits in connection with 32 failed institutions against 294 individuals with damage claims of at least $7.2 billion. The FDIC’s fourteen lawsuits to date involve only 103 directors and officers. The implication is that there are at least 18 more lawsuits yet to be filed – and that is only taking into account the lawsuits that have been approved as of September 13, 2011. There undoubtedly will be many lawsuits approved in the months ahead, with additional filings to follow after that.

 

Given the two year lag time between failure date and filing date that these three lawsuits described above demonstrate, and given the fact that the pace of bank failures only really accelerated during late 2009 and early 2010, it seems likely that the failed bank filings will not only continue well into at least 2012, but that over the next few months the pace of failed bank lawsuits could really take off. 

 

Indeed, one of the clear implications of the FDIC’s lawsuit filings during August of this year is that the agency’s declared litigation strategy is for real. The FDIC clearly does intend to pursue the active litigation strategy it has laid out on its website. And in light of these latest filings, the FDIC’s litigation approach clearly will not be limited just to the largest banks, but could well involve many smaller failures as well.

 

To be sure, the FDIC’s approach does not necessarily require an actual lawsuit in every case. Early on in connection with many of the bank failures, the FDIC has submitted notices of claim to the failed banks’ former directors and officers and to the failed bank’s D&O insurance carriers. In many cases, the FDIC may attempt to try to negotiate a settlement with the former directors and officers and the D&O carriers, without the actual filing of a civil action.

 

Reliable sources advise me that that is in fact exactly what happened in connection with one large failed bank in Florida. Apparently, the FDIC was able to negotiate a settlement in connection with the failed bank without actually filing a lawsuit against the failed bank’s former directors and officers. To the extent the FDIC pursues this approach in other cases and succeeds in negotiating settlements, there could ultimately be fewer complaints. In view of the fact that this approach would avert the erosion of the D&O insurance limits of liability by the payment of defense expenses, this approach could actually result in improved recoveries.

 

But though there may be cases where actual lawsuit filings are averted, the likelier scenario in many cases is that there will be an FDIC lawsuit. With the revelation of the FDIC’s August lawsuit filings, and the suggestion that the FDIC is now actively pursuing its litigation strategy, it is clear that the game is on. For months to come, one of the predominant stories on the directors and officers’ liability scene will be the FDIC’s pursuit of growing numbers of failed bank lawsuits against the former directors and offices of the failed institutions

.

One final note. The FDIC’s website makes it clear that its litigation strategy is not limited just to suits against former directors and officers. The site says that the agency has “also has authorized 20 fidelity bond, attorney malpractice, and appraiser malpractice lawsuits. In addition, 175 residential malpractice and mortgage fraud lawsuits are pending, consisting of lawsuits filed and inherited.”

 

Active Self-Defense: As discussed in prior posts (refer for example here), the individuals dragged into the failed bank lawsuits will rely on a number of theories in order to try to defend themselves. Former Indy Mac Chairman and CEO Michael Perry is taking a different approach. He has launched a website called “Not Too Big to Fail” (here) on which he is attempting to defend himself against charges the FDIC has asserted against him and other former IndyMac executives.

 

As discussed here, in July 2011, the FDIC filed a lawsuit in the Central District of California against Perry. The FDIC alleges that Perry acted negligently when he allowed IndyMac to generate and purchase $10 billion in loans when the secondary mortgage market was becoming illiquid. When IndyMac was later unable to sell the loans, the bank transferred them to its own investment portfolio, which then caused over $600 million in losses. Perry has also been named as a defendant in other lawsuits arising out of IndyMac’s July 2008 failure.

 

On his website, Perry asserts that “not one of the lawsuits against me has merit.” He says that “I and the management team and directors of IndyMac Bank made prudent and appropriate business decisions based on the facts available to us at the time and always with the primary goal being to keep IndyMac bank safe and sound.”

 

The name of the site is taken from Perry’s complaint that IndyMac did not receive government bailout funds that were made available to other banks. He asserts that this occurred because IndyMac was “not too big to fail.”

 

Though Perry’s website represents a rather impressive display of self-justification, it seems unlikely that his Internet-based public relations campaign will accomplish much. I suppose though for someone in Perry’s position there is some satisfaction involved with telling off the regulators, even if it is unlikely to change the outcome of any of the claims against him. The one thing that is clear is that Perry is both unrepentant and defiant.

 

Well, Maybe Next Year: For those who missed the allusion in the title of this blog post, the reference was to the lyrics of the song “Send in the Clowns,” from Stephen Sondheim’s Broadway musical A Little Night Music. The lyrics include these lines: “Sorry my dear/ But where are the clowns?/Quick, send in the clowns/Don’t Bother, they’re here.”  

 

Although many have sung this tune, it is has perhaps become most closely associated with Judy Collins. There are actually a surprising number of verions on You Tube of Judy Collings singing this song. Here’s an audio only version:

 

https://youtube.com/watch?v=0a2QGDFHTv0

I am pleased to present below a guest post by Mike Hogan, Executive Vice President at U.S. Risk Financial Services. I would like to thank Mike for his willingness to publish his article on this site. I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

 

Here is Mike’s guest post:

 

The banking crisis of the 1980’s, resulted in the passage of the Financial Institutions Reform, Recovery and Endorsement Act by Congress, (FIRREA) that significantly increased the penalties for both banks, and individuals and broadened the applicability of Civil Money Penalties. These penalties may be assessed for the violation of any law, regulation, as well as for a violation of any condition imposed in writing by the appropriate Federal banking agency in connection with any written agreement between a depository institution and the agency.

 

Clearly, the banking industry has suffered through some of its most difficult times during the last three years as indicated by the 25 bank failures in 2008, 140 bank failures in 2009 and 157 failures in 2010. This year, thru September 2, 70 banks have failed with the expectation of considerably more before year end.  This year, on June 24, 2011, the FDIC announced  57 enforcement actions against problem banks that included 11 Civil Money Penalties, the majority of which were issued to individuals. 

 

As a result of these failures and the fact that over 800 banks are currently on the FDIC “Problem Bank List”, the agency has initiated a new trend to review directors and officer’s liability policies during their examinations. The intent of this review is to determine if there is a “regulatory exclusion” on the policy and to identify the potential limits of liability that might be available for recovery of losses the FDIC sustains when taking a bank into receivership.  

 

In the last few months the FDIC has also begun to review bank D&O Insurance  policies to determine if a “Civil Money Penalty” endorsement attached to the policy. If they find a Civil Money Penalty endorsement is attached to the policy, the agency is issuing citations to the bank along with a requirement that the endorsement be immediately deleted from the policy.

 

According to this author’s interview of an attorney in the FDIC’s legal division, the governing bank regulation is the Deposit Insurance Act (12 U.S.C. 1828(k)) Part 359.1(1)(2)  – Golden Parachute and Indemnification Payments. This regulation provides that a depository institution may not purchase an insurance policy that would be used “to pay or reimburse an IAP (institution affiliated party a.k.a Directors and Officers) for the cost of any judgment or Civil Money Penalty assessed against such person in an administrative proceeding or civil action commenced by any federal banking agency…”. Section 18(k) of the statute includes the same prohibitions. (See 12 U.S.C. 1828( k) (5)-(6) ). (Both Part 359 and Section 18 prohibit the bank from purchasing an insurance policy that includes Civil Money Penalties insurance coverage. 

 

The FDIC’s position with respect to insurance for Civil Money Penalties is made even more difficult by the period of time such coverage has been made available.  Over the last twenty years, most if not all of the principal insurers that offer directors and officers liability insurance to banks have also provided Civil Money Penalties coverage for bank officers and directors as long as the bank is performing well and have no current regulatory concerns. During this period, banks have been advised to retain photocopies of the Directors and Officers personal checks in the event the bank has to prove that these individuals had paid for the coverage personally. This was based on the assumption that if the bank could prove that the directors and officers paid for the coverage personally, that the FDIC wouldn’t object to the coverage. 

 

Insurance agents and brokers that have placed directors and officers liability insurance that include Civil Money Penalties coverage are potentially exposed to criticism for offering coverage that is contrary to FDIC rules and regulations,  and putting their client bank in a situation where the FDIC  cites the bank for violation of the FDIC regulations.   Equally, agents could be faced with competition from agents and other Insurers who are willing to offer the coverage in spite of these regulations.  Interestingly, many of the bank directors and officers liability insurers are continuing to offer bank management the choice of whether they want to purchase the coverage or not. 

 

These issues would lead most agents to believe that the most appropriate approach is to be proactive by advising their client bank management of the regulation and its intent so the directors and officers can make their own decision on whether to retain the current endorsements on the directors and officers liability policy or to remove it prior to the next FDIC exam. 

 

The FDIC attorney this author consulted further advised that the FDIC has no concerns or interest in policies where the bank is not named as an Insured on the policy. This could lead insurers to consider other options for providing Civil Money Penalties coverage. For example, the coverage could be offered through a stand alone policy where the bank is not named as an Insured. Alternatively, insurers may consider offering the coverage on a Side A Policy naming the Board and officers as Named Insureds or on an Individual D&O policy by endorsement. In either event,   directors and officers will have to pay for the coverage personally, as opposed to the bank purchasing it on their behalf. 

 

My New All-Time Favorite Headline: Our sincerest condolences to the family of the late Percy Foster. We mean no disrespect. But you have to admit, it is pretty hard to beat this headline from the September 14, 2011 issue of Perth Now: "Gordon Ramsay’s Dwarf Porn Double Dies in Badger Den." (here)

The options backdating scandal may now be ancient history, but questions surrounding insurance coverage for the scandal’s consequences apparently continue to live on. In a September 9, 2011 opinion applying Maryland law, Southern District of New York Judge Naomi Reice Buchwald ruled in a coverage action brought by SafeNet’s excess D&O insurer that, among many things, there is no coverage under the policy for SafeNet’s $25 million options backdating-related securities lawsuit settlement.

 

The opinion addresses a number of recurring policy issues, including questions of claim interrelatedness and relation back; imputation of fraudulent misconduct; application of the consent to settlement provision; and imputation of application misrepresentations for purposes of policy rescission.  

 

Beginning in early 2006, SafeNet experienced a series of legal problems. These problems began with the company’s February 2006 announcement that it was restating prior financial statements. On May 18, 2006, the company announced it had received a subpoena from the U.S. Attorney as well as an informal inquiry from the SEC. Shortly thereafter, the company announced that it was forming a special committee to investigate its stock option granting practice. In September 2006 the company announced that the committee concluded that certain prior stock options had been accounting for using incorrect measurement dates and as a result its financial statements for the relevant periods would have to be restated.

 

These developments led to a variety of legal proceedings, including a securities class action lawsuits (about which refer here). There was also an SEC enforcement proceeding and a criminal investigation. The SEC proceeding resulted in the entry of a permanent injunction against the company’s former CFO, Carole Argo. Argo also pled guilty to a single count of securities fraud. The consolidated  securities class action litigation was later settled for $25 million.

 

For the period March 12, 2005 to March 12, 2006, the company carried $15 million of D&O insurance, arranged with a primary $10 million layer, and a $5 million layer of insurance excess of the primary. For the period March 12, 2006 to March 12, 2007, the company also carried $15 million of D&O insurance, arranged in the same way as the prior year.

 

On February 28, 2006, the company sent its primary carrier a copy of the initial financial restatement disclosure. Both the primary carrier and the excess carrier accepted this letter as a notice of circumstances that might give rise to a claim. The company advised the carriers of the various legal matters as they later arose. The carriers took the position that all of the subsequent notices and claims related back to the initial notice of circumstances and therefore the various matters implicated only the 2005-06 policies, regardless of when the later claims may have been made.

 

Later, after Argo entered her guilty plea, the primary carrier advised the company that it was no longer entitled to coverage under its policy. The excess carrier advised the company that due to the guilty plea, “a declination of coverage is in order in certain respects” under the excess policy, and that “rescission of the policy may be appropriate.” The excess carrier asked the company to enter a tolling agreement.

 

SafeNet later settled the securities class action lawsuit and paid the settlement amount. In the later coverage action, the parties stipulated that the company did not notify the excess carrier of the settlement negotiations and did not seek the excess carrier’s consent to settlement. In the later coverage action, the company contended that it spent more than $20 million in defense costs for itself and the directors and officers, including more than $10 million in defense costs for directors and officers other than Argo.

 

The excess carrier filed an action against Safeguard, Argo and the company’s former CEO, Anthony Caputo., seeking a judicial declaration of its coverage obligations and seeking a rescission of the renewal excess insurance policy. The defendants filed a motion to dismiss arguing amount other things that the case could not proceed without the primary carrier as a party and arguing further that the case was premature because the primary policy had not been exhausted. In a December 7, 2010 order (discussed here, scroll down), Judge Buchwald denied the defendants’ motions to dismiss. The parties then filed cross-motions for summary judgment.

 

In her September 9 opinion, Judge Buchwald denied the defendants’ summary judgment motion and granted the excess carriers’ motion in part and denied the excess carrier’s motion in part. Among other things, Judge Buchwald agreed that all of the claims relate back to the 2005-06 policy and that only the 2005-06 policy was implicated; that any loss incurred by Argo was precluded from coverage by the policy’s fraudulent conduct exclusion, but that coverage for the company’s loss was not precluded by that exclusion; that because the company had failed to obtain the excess carrier’s  settlement approval, there was no coverage under the excess policy for the $25 million securities class action settlement; and that to the extent that there is coverage under the renewal excess policy, the excess carrier was entitled to rescind the policy as to Argo and the company based on Argo’s application misrepresentations.

 

In contending that they were entitled to coverage under the 2006-07 renewal excess policy, the defendants had argued that the various option backdating problems were not even discovered until the middle of 2006 and therefore could not relate  back to the February 2006 notification sent to the carriers. In rejecting these arguments, Judge Buchwald found that in the class action lawsuit, the financial irregularities disclosed in February 2006 and the stock options backdating were “part of an interrelated course of conduct.” 

 

With respect to the policy’s relation back language, Judge Buchwald said that “these provisions make clear that the relation back of a claim turns upon the nature of the allegations in a subsequent Claim, not simply on the relationship in fact between an earlier notice of circumstances and a later Claim.” Because of the interrelationship between the two types of conduct and the “broad-relation back language” in the policies, she concluded that the subsequent matters relate back to the original notification and therefore only the 2005-06 policy was implicated.

 

Although she concluded that the fraudulent conduct exclusion precluded coverage for Argo, she concluded that the exclusion did not preclude coverage for the company. Even though policy language imputed “facts” and “knowledge” possessed by Argo to the company for purposes of determining the applicability of the exclusion to the company, the exclusion still does not apply to the company unless there has been an adverse judgment against the company. There was no adverse judgment against the company, and the judgment against Argo cannot be imputed to the company. Accordingly, notwithstanding Argo’s guilty plea and the imputation to the company of the facts and knowledge possessed by her, the exclusion does not operation to preclude coverage for the company.

 

However, the fact that the exclusion did not apply to the company does not mean that the company is entitled to coverage under the policy. Judge Buchwald concluded that the company was not entitled to coverage under the policy for the $25 million settlement because it had failed to get the carrier’s prior consent to settle. She said further that the she “could not conclude that the company was excused” from complying with the consent to settlement provisions. 

 

As for the question of whether or not there was coverage under the policy for the more than $10 million the company incurred defending the directors and officers other than Argo, Judge Buchwald concluded that because there was no record evidence that the company had actually indemnified any particular director and officer and the state of the record is “undeveloped” she could not decide the question of coverage for the defense fees.

 

Finally, although she had concluded that SafeNet’s claims did not implicate the renewal excess policy, Judge Buchwald concluded that to the extent the renewal policy does apply, the excess carrier was entitled to rescission as to Argo and as to the company. She found that because Argo admitted to knowingly and with intent to defraud causing the company to file inaccurate public filing, the carrier was entitled to rescission was to her. Moreover, Argo’s knowledge was imputable to other insureds. And while the policy allows individual insureds to establish lack of actual knowledge, it does not allow the company to establish that it lacked knowledge.

 

Discussion

This case is a veritable textbook of D&O Insurance coverage issues and Judge Buchwald’s opinion contains a number of rulings that could be important in many other cases.

 

Her ruling that the subsequent legal proceedings all relate back to the date of the initial notice, and therefore that only the 2005-06 policy is triggered, is likely to be of particular interest in many of the credit crisis related cases, in connection with many of which the insurance carriers are arguing that all of the various lawsuits filed against a particular company all relate back to a single, earlier policy year. Indeed that is the position that the carriers are taking in connection the Lehman Brothers lawsuits, as discussed in a recent post. The broad reading Judge Buchwald gave to the interrelated claim and relation back language here could prove to be very helpful for the carriers in many of these cases.

 

On the other hand, Judge Buchwald’s interpretation of the fraudulent conduct exclusion, and the limitations on what she was willing to impute to the company, will likely motivate carriers to quickly review  their policy language to see whether the imputation provisions in their fraud exclusion require an adjudication of the fraudulent misconduct even when the fraud has been  imputed. I suspect it came as a surprise here that if there was an adjudication of fraud as to Argo and that fraud was imputed to the company that the company could still retain coverage under the policy if the adjudication itself was not imputed to the company or there was otherwise no adjudication of the company’s fraudulent misconduct. I suspect many carriers are going to want to hold up their fraud exclusion and compare them to the fraud exclusion applicable here to see whether their fraud exclusion might operate as the fraud exclusion did here

 

As an aside, it is probably worth noting that Judge Buchwald was satisfied that a guilty plea represented an “adjudication” sufficient to trigger the exclusion. Perhaps that is a common sense interpretation, but I can certainly imagine the argument that a guilty plea is different from an adjudication, since there was no separate determination by a finder of fact, but merely an admission. Judge Buchwald’s conclusion that the guilty plea was sufficient would seem to undercut the argument that the exclusion could have said that an admission was sufficient to trigger the exclusion, but instead it required an adjudicated determination, which is different from an admission.

 

On the other hand, with respect to the topic of imputation, in her analysis of the rescission issues, Judge Buchwald found that Argo’s knowledge was imputable to the company under the applicable policy language. Thus Argo’s knowledge of application misrepresentations was sufficient to rescind coverage not only for herself but for the company as well. What observers may find most noteworthy about this is not just the imputation to the company but the fact that the application misrepresentations to which the imputation applied were in the form of misstatements in the company’s financial filings. In other words, the very financial misrepresentations that might attract a lawsuit might also wind up removing the company’s insurance coverage – at least where as here a senior corporate official has pled guilty to knowing fraudulent misrepresentation.

 

The final determination of significance in Judge Buchwald’s opinion is her conclusion that the company’s failure to obtain prior consent to settlement precludes coverage under the policy for the settlement. While a number of court have recently reiterated the enforceability of the consent to settlement clause (refer, for example, here), what is noteworthy here is that she found that the failure to obtain consent was not waived even where the carrier has said it has grounds to deny coverage, is contemplating rescission and has asked for a tolling agreement. The company undoubtedly felt like it had been left by the carrier to do the best it could to look after its interests, yet Judge Buchwald had found that the consent requirement had not been waive.

 

Judge Buchwald’s willingness to enforce the consent requirement even in these circumstances is yet another reminder of the critical importance of communicating with the carrier even under these types of strained circumstances. One protective step the company might have been able to take to avoid triggering a consent problem would be to obtain the carrier’s agreement that it would not raise the consent issue as an additional defense to coverage beyond those the carrier had said it believed it had grounds to assert.

 

Ad Nauseum: I was flipping channels earlier this week and I stopped to watch part of a major league soccer game. The field on which the game was being played had a billboard that said “Infinitum.” I idly wondered what product or service  the billboard might be referring to, and then it hit me – the billboard is nothing less than an “ad infinitum.”