In its comments about the elevated level of filings against U.S.-listed Chinese companies during the first months of 2011 in its mid-year report on securities class action litigation (here), Cornerstone Research noted both that the total  number of such companies is relatively small and even made second-half projections based on the assumption that there would be no further litigation in the year’s final six months involving Chinese companies that had obtained their U.S. listings by way of a reverse merger. But as the year’s second half has progressed, lawsuits involving U.S.-listed Chinese companies have continued to be filed. Signs are that there will be even more filings ahead.

 

The latest U.S- listed Chinese company to be targeted is SinoTech Energy Ltd. According to news reports, on August 19, 2011, plaintiffs’ filed a securities class action lawsuit in the Southern District of New York against the company, its directors and officers, and its offering underwriters.  The company was the subject of an August 16, 2011 Internet post by the online research firm (and short seller) Alfred Little. Among other things, the report claimed that the company, its largest customers and suppliers “are likely nothing more than empty shells with little or no sales or income.”

 

In an August 17, 2011 response, the company said that its board of directors is “not aware of inaccuracy with respect to material facts or material omission contained in its previous public reports and filings with the United States Securities and Exchange Commission,” and called the Alfred Little report “inaccurate and defamatory.” The company also noted that as a short seller, Alfred Little stands to profit by driving down the company’s share price.

 

In its August 19, 2011 press release (here), the plaintiffs’ firm that filed the lawsuit said that the complaint references assertions in the Alfred Little report that:

 

(a) SinoTech Energy’s  five largest subcontracting customers appear to be shell companies with unverifiable operations and minimal revenues; (b) SinoTech Energy’s sole chemical supplier appears to be an empty shell, with little or no revenues, a deserted office and no signs of production activity; (c) SinoTech’s audited financial statements filed with Chinese authorities confirm the Company’s negligible business operations; and (d) other facts showing that Company’s business operations are smaller than it represents in SEC filings.

 

Many of the U.S.-listed Chinese companies have been hit with U.S. securities class action lawsuits obtained their U.S. listings through a reverse merger with a publicly traded shell company. Indeed, the Cornerstone Research mid-year litigation study reports that 24 of the 25 securities class actions filed during the first half of 2011 against U.S.-listed Chinese companies involved companies that obtained their listings through a reverse merger. However, as the Alfred Little report notes, SinoTech is not a reverse merger company. Rather, SinoTech (like Longtop Finanical, which is also caught up in allegations of financial misstatements and in securities litigation, as discussed here) obtained its U.S. listing through a standard IPO, underwritten by UBS and Lazard Capital Markets. SinoTech also has a big 4 auditor, E&Y. If nothing else, it is clear that the online analysts are not going to limit their Internet commentary about Chinese companies to reverse merger companies.

 

Moreover, it is clear that the various online commentators that are targeting U.S.-listed Chinese companies are going to be continuing to keep the plaintiffs’ law firms supplied with material for still more lawsuits. Indeed, press releases from the plaintiffs’ firm that filed the SinoTech lawsuit indicate that the firm is “investigating” other U.S.-listed Chinese companies, and in each case, the company involved has been the subject of a negative online report.

 

For example, in an August 4, 2011 press release, the law firm has said that it is investigating allegations that L & L Energy, a coal company with its principal operations in China, “may have issued materially inaccurate financial statements to the investing public.” The press release cites an August 2, 2011 online report about the company issued by Glaucus Research questioning whether the company actually owns some of its most important assets and claiming that corporate funds were used to procure assets on behalf of company principals. L & L apparently obtained its U.S. listing by way of a reverse merger.

 

In a separate August 4, 2011 press release the law firm has also said that it is investigating Lihua International. The press release cites an August 1, 2011 report by Absaroka Capital and an August 4, 2011 report from Karrisdale Capital to the effect that “had engaged in a series of undisclosed self-dealing and related party transactions that diminished the value of the Company.”

 

It should be noted that many of the companies targeted in the online reports contend, as SinoTech contends, that the reports are nothing more than financially motivated attacks lacking any basis, as I discussed in an earlier post, here.

 

With the arrival of the lawsuit against SinoTech Energy, there have now been five securities class action lawsuits filed against U.S. listed Chinese companies so far in the year’s second half,  bringing the year to date total to 29. The law firm’s “investigation” press releases suggest that there may well be more suits yet to come. It appears that as long as the online commentators continue their barrage of negative reports about the Chinese companies, the plaintiffs’ lawyers will have a steady supply of lawsuit fodder.  To be sure, eventually the wave of lawsuits against U.S.-listed Chinese companies will play itself out. It just seems that for now the lawsuit filing phenomenon still has further to run.

 

An August 21, 2011 Business Insurance article (here) discusses the current challenging D&O insurance market for Chinese reverse merger companies. A recent Client Advisory that I co-authored and that can be accessed here discusses the critical D&O insurance issues facing these U.S.-listed Chinese companies.

 

Who Would Talk to the Fisherman If He Could Talk to the Fish?: Because  the fish and the other animals have quite a bit to say, and it turns out they are pretty entertaining to listen to.

 

https://youtube.com/watch?v=f-Kt_kuYVtU

When corporate officials face an SEC enforcement action, the testimony of non-party corporate employees is sometimes required. The insurance question that may arise when this happens is whether the attorneys’ fees incurred in connection with these witnesses’ testimony is covered under the company’s D&O policy. According to an interesting August 15, 2011 decision from the Southern District of California and applying California law (here), the employee witnesses’ attorneys’ fees are covered under the specific language of the D&O policies  involved.

 

Background

Three individual officers of Gateway, Inc. were the subject of an SEC enforcement action. During the course of the SEC action, certain of Gateway’s current and former employees who were not parties to the SEC lawsuit were compelled by subpoena to give deposition testimony in the SEC lawsuits as fact witnesses. Ultimately, the SEC lawsuit was resolved by way of a settlement.

 

At the time of the SEC action, Gateway carried a total of $35 million in D&O insurance, arranged in three layers: a primary layer of $10 million; an excess layer of $10 million; and a second excess layer of $15 million. The primary and first excess layers were exhausted through payment of loss. The second excess layer advanced a total of about $12.18 million in payment of defense expenses, leaving about $2.82 million.

 

In connection with the testimony of the witness employees, attorneys’ fees of about $553, 875 were incurred. The second excess carrier denied coverage for this amount (referred to as the amount in dispute). Gateway sued the second level excess carrier to recover the amount in dispute. The parties filed cross motions for summary judgment on a stipulated record.

 

Relevant Policy Language and the Parties’ Respective Positions

The second excess policy incorporated the terms of the primary policy. Insuring Clause B of the primary policy provided that the insures shall pay loss “which the Company is required or permitted to pay as indemnification to any of the Directors and Officers resulting from any Claim firm made against the Directors and Officers during the Policy Period.”

 

Policy Section II.H.2 defined the term “Directors and Officers” to mean “to the extent any Claim is for …a Securities Law Violation, all persons who were, now are, or shall be employees of the Company.” Policy Endorsement No. 7 amended the definition of “Directors and Officers,” inter alia, by adding Policy Section II.H.5, to include within the definition “employees of the Company. However coverage for employees who are not directors or officers shall only apply when an employee is named as a co-defendant with a director or officer of the Company.”

 

Gateway argued Policy Sections II.H.2 and II.H.5 were independent clauses and that the attorneys’ fees incurred in connection with the employee witnesses were covered under Section II.H.2, because the SEC lawsuit was a Claim for “Securities Law Violation” against” Directors and Officers” (the three officer defendants in the SEC action), and the company incurred loss in connection with indemnifying the employees, who are “Directors and Offices” within policy section II.H.2. 

 

The second excess carrier argued first that as mere witnesses, the testifying employees were not parties to the civil action, and therefore no claim had been made against them. The second level excess carrier argued further that Endorsement No. 7 had modified the policy language to provide that “However, coverage for employees who are not directors shall only apply when an employee is named as a co-defendant with a director or officer of the Company.” The second level excess carrier argued that because none of the employee witnesses had been named as co-defendants, they were not “Directors and Officers” for whom reimbursement coverage was available under the policy.

 

The Court’s Decision

The fundamental question for the Court to decide was whether or not the “However” clause in Policy Section II.H.5 applied only to the preceding sentence in Policy Section II.H.5 or also applied to Policy Section II.H.2. (“However coverage for employees who are not directors or officers shall only apply when an employee is named as a co-defendant with a director or officer of the Company.”)

 

In his August 15, 2011 opinion in the case ruling in favor of Gateway, Southern District of California Judge William Q. Hayes found that the “clear and explicit reading” of the policy showed that Policy Sections II.H.2 and II.H.5 “are independent provisions” and the Gateway employees on whose behalf the disputed fees were incurred “constitute ‘Directors and Officers’ pursuant to sub-paragraph II.H.2.” The court said that “alternatively” the two “competing interpretations” of the definitional sections “highlight an ambiguity” in the policy language, which the Court construes in favor of Gateway.

 

Judge Hayes also rejected the second level excess carrier’s position that the employee witnesses attorneys’ fees did not come within Insuring Clause B of the policy because as mere witnesses no claim had been made against them. Gateway argued that Insuring Clause B required only that a claim have been made against Directors and Officers, which was the case in connection with the SEC action against the three Gateway officers, and in any event, the subpoenas directed to the employee witnesses constituted a claim against them as well. Judge Hayes said that the two parties “have advanced a reasonable interpretation of the Insuring Clause,” and accordingly the policy is ambiguous on this issue, and therefore the policy is interpreted in Gateway’s favor.

 

Judge Hayes granted summary judgment in favor of Gateway and against the second level excess carrier.

 

Discussion

At one level, this decision is just a reflection of the interaction between the specific policy language and the circumstances presented. In the end, rather than choose between two alternative views, Judge Hayes found that the alternatives reflected an ambiguity and therefore ruled in favor of the insured on a more or less “tie goes to the runner” basis.

 

I am sure that at least some carrier-side observers may find it a surprising outcome that there was found to be coverage in connection with fees incurred for  non-party employee witnesses who were not defendants in the SEC action. In that regard, it is possible to look at the policy language as amended and to conclude that the Endorsement No7 had not been intended simply to add an alternative and independent provision bringing employees within the definition of covered “Directors and Officers,” but instead to fundamentally alter the policy’s coverage for employees.

 

Thus, in the base form, Policy Section II.H.2 afforded coverage for employees by bringing them within the definition of Directors and Officers, but only in connection with Claims for Securities Law Violations. The Endorsement amended the policy to remove the limitation restricting the coverage for employees only to Claims for Securities Law Violations, extending the policy’s coverage afforded to employees even for claims that did not involve Securities Law Violations, but specifying further that this broader employee coverage is only available when the employees are co-defendants with officers and directors of the company.

 

I think there is a good case to be made that that was what was intended at the time the changes were made. Unfortunately for the second level excess carrier, the amendments were accomplished through additional provisions rather than through delete and replace alterations. Because the Endorsement No. 7 amended by adding, the policy provisions necessarily had to be read together, thus creating the possibility that two different provisions could potentially apply to the same circumstance.

 

There is a practical lesson here for everyone who is involved in the process of modifying policy language through endorsement. That is, it is not enough that the language in the endorsement accomplishes what is intended to be accomplished. In addition, the endorsement language must also interact as intended with the language in the base policy form. Because I know how hard these issues are to manage, I am reluctant to postulate how these changes should have been done, as I may establish nothing but to show that in hindsight this language could have been structured differently. (My reluctance here is underscored by the fact that the second excess carrier that was forced to argue these issues here was forced to make these arguments based on language negotiated by the primary carrier, not by the excess carrier itself.) But all of that said, the disputes here could have been avoided if rather than simply adding an additional policy provision about coverage for employees, the endorsement had deleted and replaced the base form’s provision for employee coverage.

 

Because of his findings of ambiguity, Judge Hayes managed to sidestep a number of interesting issues, including, for example, whether or not the deposition subpoenas served on the employee witnesses constituted “Claims” within the meaning of the policy. As I have discussed in prior posts (most recently here), the question of whether or not a subpoena is a claim is one of the perennial D&O insurance coverage issues. It would have been particularly interesting for the Court to have explored in particular whether or not a deposition subpoena is or is not a claim under the applicable policy language. But Judge Hayes managed to make a decision without issuing rulings on many of the parties’ disputed issues, and so we will have to await another case and another day on many of these issues.

 

An Alternate List of Top Colleges: If for no other reason than its sheer perversity, the recently released Forbes Magazine list of theTop 100 U.S. colleges makes for some fascinating reading. What can you say about a list where West Point outranks Stanford, Harvard, MIT and Yale? (For that matter, Yale is not even in the top 10, coming in at number 14). Or where Haverford outranks Swarthmore, Claremont-McKenna outranks Pomona (that one was particularly unpopular in our house), Washington & Lee outranks Dartmouth, Colby and Bates are ranked ahead of Bowdoin, and Penn is ranked 52nd? And Michigan is ranked 93rd, just above Transyvania University? (The methodology used in compiling the Forbes list can be found here.)

 

One thing you can say is that the Forbes listmaker has a bias against public universities. The highest ranked public college on the list is UVa, coming in at 46th (another ranking particularly unpopular in our house).

 

If nothing else, the Forbes list is reminder not to get too hung up on the U.S. News and World Reports college list — it does not represent scripture, and there are many ways of looking at the many fine colleges in the U.S. As the excellent guidance counselor at my daughters’ school says, "College admission is a match to be made, not a prize to be won." 

 

In a settlement that apparently will be funded entirely by D&O insurance, the plaintiffs and 23 former executives of the failed Colonial Bank of Montgomery, Alabama have agreed to the settle the class action securities lawsuit that investors filed in connection with the bank’s 2009 collapse,  for $10.5 million. The settlement does not resolve the plaintiffs’ claims against the offering underwriter defendants nor does the settlement include the bank’s former auditor. The settlement is subject to court approval. A copy of the parties’ August 12, 2011 stipulation of settlement can be found here. The plaintiff’s August 12, 2011 motion for settlement approval can be found here.

 

When Colonial Bank failed in August 2009, it was the sixth largest U.S. bank failure of all time (as discussed here). The bank, which had assets of $26 billion, was brought down in part due to its involvement in the mortgage securities fraud scheme involving mortgage originator Taylor Bean, as discussed in a recent post. The bank’s holding company filed for bankruptcy shortly after the bank’s closure.

 

As discussed here, the plaintiffs had actually filed their securities lawsuit in February 2009, prior to the bank’s demise. The plaintiffs initially alleged that the defendants failed to disclose that "Colonial would be required to raise additional outside capital of $300 million before it could receive the $550 million in TARP funding." The complaint further alleges that Colonial "belatedly disclosed" this requirement, its share price plunged. The plaintiffs’ 334-page consolidated amended complaint (here) contains significantly broader allegations and contends that the defendants engaged in a broad, multipart fraudulent scheme that led to the bank’s collapse.

 

Given the bank’s size prior to its failure, and the high-profile nature of the allegations, including the bank’s association with the Taylor Bean fraud, the relatively modest $10.5 million settlement may seem low, especially by comparison to the string of nine-figure securities class action lawsuit settlements that recently have been announced (refer for example here). However, the dollar figure may also be reflective of the particularly challenging circumstances claimants may face when trying to pursue claims against the former officials of a defunct organization.

 

Without a solvent entity to fund claims settlements, the claimants may be left to try to salvage what they can from the remaining D&O insurance, which represents at best a declining fund that will only become smaller the longer the case continues and the more vigorously the parties contest the case, as defense expenses erode the limit of liability. The vulnerability of the insurance funds to claims cost erosion is a particular problem in a situation like this, where there are multiple proceedings and multiple parties.

 

Indeed, in their memorandum in support of their request for preliminary court approval of the settlement, the plaintiffs argue that the settlement represents n “outstanding result” given that they were facing a “significant risk of no or a much smaller recovery after protracted litigation.” The motion papers attribute this risk to the holding company’s bankruptcy and to “the limited resources of the primary Director and Officer defendants and the limited insurance policy proceed available.”

 

With respect to Colonial’s insurance, the plaintiff’s motion papers report that the bank had “a total of $35 million in liability insurance,” which were in the form of “wasting insurance policies.” At the time of the mediation “less that $32 million in funds remained available to satisfy all claims,” including not only the securities class action lawsuit but also a separate shareholder derivative suit filed on behalf of the company and the “claims of the FDIC-Receiver” as well as other matters.

 

In any event, this settlement is to be entirely funded by D&O insurance. Paragraph 6 of the settlement stipulation says that the Settling Defendants’ Insurance Carriers “shall pay the sum of $10,500,000 in cash into the Escrow Account.” (The carriers involved are identified in the definitions section, on page 13 of the stipulation.) The absence of any contribution to the settlement from the individual defendants is explained in the motion papers, which report that “during the mediation process, the plaintiffs acquired certain confidential financial information from certain selling Defendants that reflected an inability to contribute in any meaningful way to the settlement.”

 

Though this settlement may appear relatively modest, it may be worth noting that the settlement does not include the offering underwriter defendants or the bank’s former auditor, against whom the case will continue. Whether the plaintiffs ultimately will be able improve their overall recovery with settlements with these other defendants remains to be seen, but there is at least that possibility.

 

This settlement certainly reduces the insurance funds out of which the FDIC might have hoped to extract a recovery by pursuing claims against the bank’s former directors and officers. The reduction of the amount of insurance does underscore one problem the FDIC may face in pursuing claims against former directors and officers of some failed banks, which is that the FDIC may be a competition – or even in a race – with shareholder plaintiffs to try to capture remaining D&O insurance policy proceeds, before they are eroded by defense expense. That said, it does seem like an attempt was made as part of this settlement to preserve some remaining portions of the bank’s D&O insurance in order for them to defend or resolve the FDIC’s claims.

 

I have in any event added the Colonial Bank settlement to my running tally of subprime and credit crisis-related case resolutions, which can be accessed here.

 

Among the individual defendants party to this settlement is Colonial’s colorful and controversial former Chairman and CEO, Bobby Lowder. In addition to Colonial, Lowder has long been associated with Auburn University. I discussed Lowder’s Auburn connection in a prior post, which can be found here.

 

In the wake of the current round of bank failures, the FDIC has filed a number of lawsuits against former directors and officers of failed banks, and has indicated that it intends to file more. Among the issues this litigation raises is the question of when the former directors of a failed bank can be held liable. As discussed in an August 10, 2011 memo from the Manatt, Phelps & Phillips law firm (here), a recent decision a case in the Central District of California involving a failed credit union may provide some insight into this question.

 

First, some background. Section 11(k) of the Federal Deposit Insurance Act provides that directors and officers of failed institutions can be held liable “for gross negligence.” in an action brought by the FDIC in its role as receiver.  As explained in the FDIC’s online materials about professional liability claims, case law interpreting this statute has established that “state law, not federal common law provides the liability standard for directors and officers, and that section 11(k) provided a gross negligence floor for the FDIC claims in states with insulating statutes.” (State insulating statutes allow corporations to amend their bylaws to limit the civil liability of the corporations’ directors.) As a result, even in states with insulating statutes, directors cannot protect themselves from FDIC claims based on gross negligence. 

 

The recent decision in the Central District of California involved a case brought by the National Credit Union Administration (NCUA) against 16 former directors and officers of Western Corporate Federal Credit Union (WesCorp). As discussed at greater length here, the NCUA alleged that the defendants had allowed WesCorp to purchase vast amounts of securities backed by Option ARM mortgages without appropriate analysis of the creditworthiness of the underlying securities or appropriate regard for the limits on concentrations in the company’ s portfolio.

 

In an August 1, 2011 order (here), Central District of California Judge George Wu granted the director defendants’ motion to dismiss the NCUA’s most recently amended complaint, for reasons discussed in the court’s July 7, 2011 minute order (here). In the July 7 minute order, Judge Wu noted that “the business judgment rule protects the director defendants,” adding that the director defendants “may have made choices—or not made choices – with which the NCUA disagrees, but that does not mean they failed in their responsibilities so severely that they lose the protection of the business judgment rule.”

 

Judge Wu drew a distinction between the officer defendants (whose dismissal motion he denied) and the director defendants, observing that “the question in assessing the director defendants’ liability vis a vis the Option ARMs and concentration levels is what the director defendants knew at the time that should have dictated to them that they do something more or different from all that they did do.” He concluded that the NCUA has “failed to present sufficient allegations in this regard, so as to fit within the exceptions to the business judgment rule.”

 

The law firm memo linked above observes that the holding in the WesCorp case is “equally applicable to actions brought by the FDIC against former directors of a failed bank.” In that regard, it is worth noting that the FDIC itself has said, in its online materials describing its approach to professional liability claims, that it is the FDIC’s “long-standing internal policy” of pursuing claims against outside directors only where “the facts show that the culpable conduct rises to the level of gross negligence or worse.” In other words, the FDIC itself has said that it is not its policy to pursue claims against directors based on mere negligence.  The law firm memo suggests, by reference to the WesCorp case, that conduct within the protection of the business judgment rule by definition is not grossly negligent, and therefore cannot serve as a basis for director liability.

 

In the law firm memo, the author notes that the misconduct that the FDIC has alleged in many of the cases it has filed as part of the current wave of bank failures arise in the context of the collapse of the residential real estate market and against the background of the global economic crisis. In light of those circumstances, the FDIC’s allegations may be susceptible to the argument that it is “attempting to substitute its after-the –fact judgment for that of the board made in real time.” The business judgment rule exists to “prevent a court from second guessing honest, if inept, business decisions.”

 

Directors’ protections under the business judgment rule may, however, be overcome where, for example, there is evidence that the directors’ “improper motives or undue influence, conflict of interest” or where the directors failed to be “fully informed before making decisions.”

 

The possibility of being drawn into an FDIC lawsuit is a recurring source of anxiety for outside directors of failed or troubled banks. Indeed, the FDIC has filed a number of these suits and clearly intends to file more. But directors concerned about the possibility of this type of litigation can be reassured, first, that it is the FDIC’s own policy only to pursue claims against outside directors where it believes there is evidence of gross negligence, and, second, that as a result of the protections of the business judgment rule, the directors cannot be held liable for actions that merely prove to have been mistaken or even inept. Judge Wu’s ruling in the Wescorp provides directors reassurance that defendant directors may even be able to get the claims against them dismissed — even if claims against the officer defendants are not — where the allegations presented are insufficient to meet these requirements.

 

The law firm memo concludes with a number of lessons for current bank directors from the current environment and from the FDIC’s allegations in the cases that it has filed so far. Among other things, the memo’s author notes the following: that board membership is a serious responsibility for which the individual directors must be willing to devote “substantial amounts of time” in order to perform their duties in accordance with the FDIC’s expectations;  that board members are “charged with holding management’s feet to the fire in addressing strategic challenges and operational problems”; that directors must act independently and must not “turn a blind eye to unsafe or unsound practices; and that directors “must be very sensitive to the appearance of a conflict of interest.”

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

In the latest of a growing list of recent cases examining these issues, on August 5, 2011, the Fifth Circuit, applying Texas law held, based on the language of the excess policies at issue, that where a policyholder has accepted a compromise payment from a primary carrier of less than the limit of liability of the primary policy, the excess carrier’s payment obligations were not triggered and they have no obligation to pay the policyholders ‘ loss. The Fifth Circuit’s August 5 opinion can be found here.

 

Background

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

 

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

 

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

 

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

 

The August 5 Opinion

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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