Janus Distinguished: In an interesting opinion that distinguishes the U.S. Supreme Court’s decision in Janus, on September 30, 2011 Southern District of New York Judge John Koetl granted in part and denied in part the defendants’ motion to dismiss in the EnergySolutions securities class action lawsuit. Judge Koetl’s opinion can be found here.

 

As discussed here, in October 2009, plaintiff shareholders filed a securities suit against the company, certain of its directors and officers, and its offering underwriters in connection with the company’s November 14, 2007 IPO and July 24, 2008 secondary offering. The plaintiffs also named as a defendant the parent company of Energysolutions (ES), ENV Holdings. The plaintiffs alleged that the company’s offering documents misrepresented the company’s financial opportunities in the nuclear energy decommissioning business, as well certain of its regulatory constraints.

 

ES had been formed by several sponsor institutional investors that had purchased several individual businesses through ENV Holdings. At the time of the IPO ENV owned 100% of the shares of ES. ENV was also a selling shareholder in the secondary offering.

 

The defendants moved to dismiss the plaintiffs’ complaint. Although the defendants’ motion was granted as to certain of the alleged misstatements, it was denied in other material respects.Among the more interesting aspects of Judge Koetl’s opinion is his analysis of the question whether the plaintiffs had stated a cognizable claim against ENV, which had been ES’s 100% owner prior to the IPO. ENV had moved to dismiss based on the U.S. Supreme Court’s holding in the Janus case, arguing that like the mutual fund management company in that case, it was a legally distinct entity lacking “ultimate authority” over the statement of its related entity, and therefore because it had not “made” the alleged misstatements, it could not be held liable under the securities laws.  

 

Despite the apparent parallels between the cases, Judge Koetl nevertheless held that the claim against ENV could go forward. Judge Koetl found that there are “significant differences” between EMV and the fund management company in the Janus case. Among the critical differences that Judge Koetl found were “ENV’s owndership of ES, its direct control over all corporate transactions, and its authority to determine when and whether to sell the shares beings sold.”

 

Judge Koetl went on to note that even though the individual directors and officers signed the registration statements in their capacities as directors and officers of ES, that did not “preclude attribution” to ENV as well. He added that Janus itself even said that attribution “could be implied from the surrounding circumstances.” A reasonable jury, Judge Koetl found, could conclude that ENV’s role went far beyond a “speechwriter drafting a speech,” because “ENV had control over the message, the underlying subject matter of the message, and the ultimate decision whether to communicate the message.”

 

Judge Koetl’s decision adds an interesting new layer to the evolving analysis of the question of when alleged misrepresentations made by one party can be attributed to another party. Under Judge Koetl’s analysis, there are times when the second party’s alleged control is so complete that notwithstanding the legal separation between the two parties, the controlling party can be said to have “made” the misstatement delivered by the other party – almost as if the controlling party were using the other party as its mouthpiece. The critical element in Judge Koetl’s analysis seems to have been ENV’s complete ownership and consequent complete ability to dictate its actions. (I would certainly be interested in hearing a panel of informed securities law specialists discuss the question of whether or not the differences Judge Koetl cites are or are not distinctions without a difference between this case and Janus.)

 

It is worth noting that the EnegySolutions case is one of the so-called “backlog" cases that were filed in late 2009 and early 2010 (the name refers to the fact that the cases were filed more than a year after the proposed class period cutoff date). As the time, some commentators speculated that the plaintiffs were filing the belated cases because they were out of fresh ideas and they were scraping the bottom of the barrel. But as this case’s dismissal motion survival shows, merely because the cases were belated does not necessarily mean they are not meritorious. Indeed, a number of the so-called belated cases have survived their initial dismissal motions (refer for example here).

 

Special thanks to a loyal reader for sending me a copy of Judge Koetl’s opinion.

 

Eleventh Circuit on Loss Causation: On September 30, 2011, the Eleventh Circuit affirmed in part and reversed in part the district court’s partial dismissal and later entry of summary judgment on the defendants’ behalf in the FindWhat.com securities class action lawsuit.   The opinion, which can be found here, has a number of interesting features.

 

Among the more interesting aspects of the Eleventh Circuit’s opinion is its reversal of the district’s summary judgment grant on loss causation issues. The Eleventh Circuit observed that the district court’s reasoning “misapprehends” the relation of misstatements, the company’s share price, and the plaintiffs’ allegations.

 

The district court had rejected the plaintiffs’ loss causation arguments because the plaintiffs’ expert had found that the stock price inflation predated the alleged misstatements, and that the subsequent alleged misrepresentations had not increased the amount of price inflation.  The district concluded that the misstatements could not have caused the price inflation and therefore the misstatements could not have caused the alleged financial harm.

 

The Eleventh Circuit, declining to follow prior Fifth Circuit case law, and looking at the nature of the plaintiffs’ allegations, reversed the district court’s loss causation ruling, holding that “fraudulent statements that prevent a stock price from falling can cause harm by prolonging the period during which the stock price traded at inflated prices,” adding that “confirmatory information that wrongfully prolongs a period of inflation – even without increasing the level of inflation—may be actionable.”

 

In an interesting footnote (fn.32), the Eleventh Circuit also observed that the district court had also improperly conflated the “loss causation” and “reliance” issues. The Eleventh Circuit directed the parties on remand to clarify their reliance and loss causation arguments, particularly with respect to the defendants’ reliance-related arguments that the alleged misstatements had not caused the price inflation (as opposed to the defendants’ loss causation-related arguments that the alleged inflation had not caused the plaintiffs’ financial loss).

 

Special thanks to a loyal reader for sending me a copy of this opinion.

The D&O Diary is on assignment in Europe this week. The first stop on the Continental itinerary was Amsterdam.I had never been to Amsterdam before, but I have traveled to Northern Europe quite a bit, so when I packed I made sure to load up on sweatshirts and a fleece. And an umbrella. As it turned out, I could have used some shorts and a tee shirt. The weather was absolutely gorgeous, with temperatures in the upper 70s and not a cloud in the sky. I don’t know what Amsterdam is like the rest of the year, but in early October it is spectacular.

 

Here’s the single most important thing about Amsterdam — bicycles rule. Bicycles outnumber people. Bicycles are  the prevailing physical force and predominant spirit. The bicyclists ride without regard for public order or their personal safety. The Dutch bicyclists seem to think that a bike ride is a good time to catch up with their friends, as almost every cyclist is talking on their cell phone. Or texting, using both hands. The prize-winning multitasking bicyclist I saw was a young mother, riding along with her kid straddling the back fender, talking on her cell phone and smoking. And wearing sun glasses. At night.

 

I saw a one-legged policeman riding a bike. I saw a guy cruising along on his Schwinn, with a beagle draped across his shoulders, its ears and tongue flapping in the breeze. I saw another woman, who apparently had never thought of wearing her dog, who was pedaling along with her terrier trotting, well, doggedly, along beside her. She was talking on her cell phone of course. (Her dog must have left his cell phone at home.) I also saw a very large black man riding a bike wearing only an orange wig and what looked like women’s panties. He lacked only a beagle to complete his ensemble.

 

It turns out, there actually is a dam in Amsterdam. Or there was, on the Amstel River. Now it is just a big public square adjacent to the Royal Palace, full of street musicians and American college kids on their semester abroad, learning about Dutch culture by smoking pot. (Legally! What a novelty!). Informed sources advise that the town originally was called Aemstelerdam, and somehow it became Amsterdam rather than Amsteldam. 

 

It also turns out that in Amsterdam, the natives speak Dutch, which sort of sounds like German and English being spoken simultaneously.  I don’t speak Dutch, but Ich spreche ein bisschen Deutsch, so I tried to a few words of my best Berlitz German. I got a look as if I were from Mars. (No, Cleveland actually).  The funniest thing I heard was when some young Dutch toughs tried to Talk American: “Yo, Joe, you bin kommen from da hoood?” (accompanied by gang member hand signs, performed with a Dutch accent).

 

I understand there are many fine museums in Amsterdam. I didn’t visit any of them. The weather was so glorious that I spent the better part of Saturday afternoon inVondelpark, which is sort of like Central Park but without the roads or the surrounding tall buildings. While I was in the park, I was exposed to something so unexpected that I will remember it even after I am dead. I was walking along admiring the fall foliage, when I was distracted by a young woman bending over and apparently looking for something on the ground. Though I was in Amsterdam, I immediately thought of the childhood rhyme, “I see England, I see France” – except she wasn’t wearing any underpants. I spontaneously blurted something improbably ascribing divine qualities to excrement. I wonder whether the guy with the wig misappropriated her panties?

 

(I wanted to insert a joke here about a “Dutch treat” but I couldn’t quite work it out. You get the point.)

 

On a warm fall evening, Amsterdam is a rocking place. Party Central is Leidseplein, which is an open area ringed with bars and cafes and full of American college kids learning about Dutch culture by studying the dynamic relationship between numbers of euros and liters of beer. (Turns out, they are directly proportionate, as is the case with dollars and ounces.) The kids were also texting, perhaps to their parents (“Please send money,” which translated from the vernacular means “Beer is expensive here.”) There was one street musician there who did a fantastic impression of Joe Cocker. While the faux Joe was singing, a man in a cow suit walked up and started dancing along to the music. He also performed a fairly impressive moonwalk.

 

A Moonwalking Man Cow – that was pretty special, but what happened next was truly awesome. Nine guys gathered in a semicircle and starting singing “Country Road,” a capella. When they reached the part about “West Virginia, Mountain Mama,” several hundred people gathered in the square spontaneously joined in. It was so cool it gave me goosebumps.  

 

The most distinctive feature of Amsterdam is its canals. The canals form a semicircle around the center city, and are lined with classic seventeenth century houses with their ornate four-story facades. The Canal District represents the distilled essence of civilized urban living. On a beautiful fall day, walking along the canals is a calm, peaceful, even sublime experience.

 

I found myself contemplating the vast Dutch trade armadas that gathered the wealth that built all of those beautiful houses. It is pretty amazing that a country about as big as Massachusetts became a global power for a time. But while the Dutch were clever enough to build an empire, they were not strong enough to keep it. So what is left now are a whole bunch on Indonesian restaurants and a museum city of beautiful houses. Sort of like Venice. Or when you come right down to it, sort of like Madrid. Or Paris. Or London, for that matter. Or, when you come right down to it, Rome. Or for that matter, Egypt.

 

There are innumerable cross streets spanning the canals on gently curving bridges. At many of the corners where the cross streets and the canals meet there are cafes and coffee shops.  If I could drop one moment in amber and have it with me always to warm my spirits when the January winds howl, it would be 4 o’clock on Saturday at a sidewalk café overlooking the Princengracht (Princes’ Canal). A nearby church rang the hour by chiming out the first few bars of Bach’s Passacaglia and Fugue in C Minor. It might have been the glass of Grolsch I was enjoying at that moment, but the warm sunlit glow – and the gentle voices of all of those cute Dutch people speaking German and English at the same time (perhaps discussing their underwear, or lack thereof) – will be something I will treasure for a long time.

 

On Sunday, I decided it was time to step off the sidelines and jump into the fray. I went out and rented a bicycle. Within the first minutes, I realized what an idiot I had been walking around the city the prior day. The only way to see Amsterdam is on a bicycle (sort of like the only way to see Los Angeles is in a car.) The other thing I quickly figured out is that Amsterdam is basically flat, so once you get rolling, you can just cruise, as long as you watch out for crazed people on motor scooters. After just a short time, I had an urge to make a cell phone call. Clearly I had tapped into the essential zeitgeist.

 

I biked along for more than six hours. I rode out in the suburbs. I pedaled along the Amstel River. I went out to the waterfront and rode along the docklands. What I found there was as deeply disturbing as the Canal District was uplifting. Over the past several years, developers have invested hundreds of millions of euros building a new residential area along the shipping canal. The area, called Oosterdokseiland, is as ugly and sterile and empty and dispiriting of a place as I have ever seen. Row upon row upon row of featureless, dead buildings. I have been in livelier cemeteries. The area is the exact urban opposite of the Canal District. I can understand the Dutch people wanting to move beyond their past, but how could they have completely forgotten everything they learned, especially when the best of it is so close at hand? Understand, this isn’t some urban renewal project for people with nowhere else to go, this is a very high end residential real estate development. I decided that the thousands of poor souls condemned by unforgivably poor judgment to live there are like the prisoners on Alcatraz, so close to paradise that you can see it and hear it, but living in hell just the same, with no one to blame but themselves.  

 

Fortunately for me, I could just turn around and head back to the warm, human, vibrant center of a real city – a city that is what a city was meant to be. After I returned my bike, I was thirsty and hungry, so I sat right down at the restaurant next to the bike shop. I had a plate of gnocchi in olive oil and a glass of wine. While I was eating, there was a sort of family reunion going on at the next tables. There was one group of six young men in their late 20s. At the next table, were several older men and women, obviously the parents of the men. Running between the tables were a bunch of little blond kids, flittering around like a flock of birds. It was obvious everyone knew and loved everyone else. (I have no idea where the children’s mothers were, but it didn’t seem to matter.) I thought to myself, this is what cities are for, for people to come together and to celebrate a warm sunny fall afternoon with a bottle of wine in the kindly glow of the brotherhood of man.

 

Amsterdam, I hereby apply for honorary citizenship. If I go back, I hope to see more of that attractive young woman in the park. Wait a minute, I already did. All the more reason to hurry back.

 

Disclaimer: For those readers whose only thoughts about Amsterdam are that pot and prostitution are legal there, let me just say that I did not visit the red light district or go in a smoke shop. Mrs. D&O Diary would staple my private parts to the back fence if I so much as thought of doing either of those things.

 

The Dutch, these are my people.

 

The Amstel River, still only 90 calories

 

The classic Amsterdam bicycle (rental version)

 

The essence of Amsterdam, bicycles and canals

 

In a case involving multiple ghosts of long lost companies, a judge in federal court in Manhattan has held that excess D&O insurers do not have a duty to “drop down” to fill the gaps in coverage caused by the insolvency of underlying insurers. The court also held, based on the language of the excess policies at issue, that the excess insurers’ coverage obligations were not triggered merely because the insureds’ losses exceeded the amount of the underlying insurance, where the underlying insurance has not been exhausted by actual payment.

 

A copy of the Southern District of New York Judge Richard Sullivan’s September 28, 2011 opinion can be found here.

 

Background

This insurance coverage case arises out of the bankruptcy of Commodore International Limited (the manufacturer of the classic Commodore 64 personal computer, pictured above). In connection with the bankruptcy proceedings, numerous lawsuits were filed against the company’s former directors and officers. Most of these actions have been resolved, save only one proceeding remaining in the Bahamas where the claimants seek to recover $100 million. The defendants have so far incurred a total of $14 million in losses as a result of the various actions.

 

At the time of the bankruptcy, Commodore carried a total of $51 million of D&O insurance arranged in eight layers and involving six insurers. Unfortunately for the company’s former directors and officers, the first and fourth excess layers were provided by Reliance Insurance Company, and the third and sixth level excess insurance was provided by The Home Insurance Company. In 2001, Reliance went into a regulatory liquidation, and in 2003 so did The Home.

 

The primary layer of insurance was exhausted by payment of losses. However, due to Reliance’s insolvency, the individuals were unable to obtain insurance for losses that went into the next layer of insurance. The individuals then turned to the solvent upper level excess insurers, seeking to have them provide coverage for the individuals’ continuing defense fees and other losses. The solvent excess insurer that provided the second and fifth level excess insurance agreed to advance defense fees pursuant to an interim funding agreement and later filed an action (in which the other solvent excess  insurers joined) seeking a judicial declaration that there was no coverage under its excess policies as a result of the insolvent underlying insurers’ unpaid gaps. The individual directors and officers sought to establish that there was coverage under the solvent excess insurers’ policies, claiming that the excess insurers’ payment obligations had been triggered because osses exceeded the amount of the underlying insurance.

 

The policies of the solvent excess insurers all contained a similar provision essentially providing that “the Underlying Policies shall be maintained during the Policy Period ….Failure to comply with the foregoing will not invalidate this policy but the [excess insurance carrier] shall not be liable to a greater extent that if this condition had been complied with.” In addition, the excess policies all have provisions essentially providing that their policies are triggered only “in the event of exhaustion of all of the limit(s) of liability of such Underlying Insurance solely as a result of payment of losses thereunder.”

 

The September 28 Opinion

In his September 28 opinion, Judge Sullivan agreed with the excess insurers that they had no obligation to “drop down” to fill the insolvent insurers’ gaps, and he also concluded that the excess insurers’ obligations under their policies had not been triggered merely because the individuals’ losses exceeded the amount of the underlying insurance.

 

Judge Sullivan found that the laws of New York and Pennsylvania “clearly provide” that “an excess insurer is not required to fill gaps in coverage created by the insolvency of the underlying insurer.” He went on to note that

 

The Insurance Contracts themselves make no mention whatsoever of such an obligation. To the contrary, the policies expressly state that, in the event that Defendants fail to maintain underlying insurance, the insurers “shall not be liable to a greater extent than if this condition had been complied with.” This language expressly demonstrates that the coverage provided by the Excess Insurers will not be enlarged to compensate for gaps in underlying coverage.

 

In rejecting the individuals’ argument that the excess insurers’ payment obligations were triggered because the amount of the individuals’ losses exceeded the amount of underlying insurance, Judge Sullivan found that the “express language” in the excess insurers’ policies requiring exhaustion of the underlying limits by actual payment of loss in order to trigger coverage “establishes a clear condition precedent to the attachment of the Excess Policies,” and therefore it is “clear from plain language of the Excess Policies…that the excess coverage will not be triggered solely by the aggregation of Defendants’ covered losses. Rather the Excess Policies expressly state that coverage does not attach until there is payment of the underlying losses.”

 

In reaching this latter conclusoin, Judge Sullivan rejected the applicability of the 1928 Zeig v. Massachusetts Bonding & Insuance Co. casae, and similar cases. Judge Sullivan said these cases "provide not guidance because they involved circumstances where the insured had accepted partial insurance from the underlying carriers while making up the shorfall themselves. In this case and unike in Zeig, the carriers "have a clear bargained for interest in assuring that the underlying policies are exhausted by actual payment." 

 

Discussion

This case provides a sharp reminder that though insurance carriers fail infrequently, when they do it is a real mess. This reminder highlights the all-too-often overlooked importance of carrier solvency – and not just when coverage is bound but also at the time when a claim must be paid.

 

The mess created by the carriers’ insolvency, compounded by the excess carriers’ ability to avoid dropping down to fill the gap, leaves these individuals uninsured for their continuing expenses and exposures. Which in turn provides a vivid illustration of the value of a so-called Excess Side A/DIC policy, which  by its terms would drop down and provide coverage in the event of the insolvency of an underlying carrier.

 

Excess Side A/DIC policies were available at the time that Commodore procured its D&O insurance, but they were not nearly as pervasive as they are now. (The policies that were available at that time were somewhat more restrictive than those available today.) If Commodore’s insurance program had included an Excess Side A/DIC policy, the individual defendants might have been able to rely on that policy to defend themselves notwithstanding the gaps caused by the insurers’ insolvency

 

Judge Sullivan’s holding that the excess insurers’ payment obligations were not triggered even though the individuals’ losses exceed the amount of the underlying insurance is consistent with other recent decisions in which the courts have interpreted the excess insurer’s trigger language to require exhaustion of the underlying insurance by the actual payment of loss (refer for example here and here).

 

This case may also represent the first occasion on which a court applying New York law expressly declined to follow Zeig. However, the court never conclusively stated whether it was applying New York law; rather, Judge Sullivan said only that the outcome was the same whether New York or Pennsylvania law applied. He also distinguished Zeig rather than overtly declining to follow it.

 

It is worth noting that in the current D&O insurance marketplace excess insurance policies are available with trigger language that allows the amount of the underlying limits of liability to be paid either by the insurer or the insured, in order for the excess insurer’s payment obligation to be triggered. How this language would have affected the outcome of this case is not entirely clear, because it does not appear from the record whether or not the individuals have actually funded the shortfall themselves. (My impression is they did not.)

 

It is astonishing to note that ten full years after Reliance failed, problems from its failure continue to arise. It somehow seems appropriate that all of these ghosts from an earlier era have all gathered in this one locale, presided over by the specter of the late lamented Commodore 64. Clearly, the former directors and officers continue to be haunted by their former company’s remarkably unlucky choice of carriers. (This company doubled down on its bad luck, by managing to slot both of the eventually insolvent carriers in two different layers each in Commodore’s insurance program.)

 

One final note. Commodore’s primary insurance carrier has a name that would have been completely unknown to all concerned at the time Commodore procured its coverage. The primary insurer is a company now known as “Chartis” – a company that in that bygone era was known by a different name altogether.

 

Yes, there are all kinds of ghosts roaming around on the set of this production.

 

Special thanks to a loyal reader for providing me with a copy of Judge Sullivan’s opinion.

 

“As of Now, I am in Control”: There is at least one more ghost to mention here. Among Commodore’s former directors and officers was the late Alexander Haig, Jr. who among other things served as Secretary of State under Ronald Regan. Haig had a distinguished career of public service, but he will be most remembered for his unfortunate statements shortly after Reagan had been shot: “Constitutionally gentlemen, you have the president, the vice president and the secretary of state, in that order, and should the president decide he wants to transfer the helm to the vice president, he will do so. As for now, I’m in control here, in the White House, pending the return of the vice president and in close touch with him. If something came up, I would check with him, of course.”

 

Unfortunate News for Former Directors and Officers in Failed Bank Litigation: There’s some bad news for former directors and officers of failed banks defending themselves in FDIC litigation. On September 27, 2011, in the case the FDIC filed in the Central District of California against four former officers of IndyMac bank (in what was the first lawsuit the FDIC filed in the current round of bank failures, as discussed here), Judge Dale Fischer granted in part the FDIC’s motion for judgment on the pleadings as to certain of the defendants’ affirmative defenses.  A copy of Judge Fischer’s opinion can be found here.

 

Judge Fischer held that because the FDIC as receiver stands in the shoes of the failed bank, the defendants could not assert defenses based on the FDIC’s pre-receivership actions or omissions. Accordingly, she granted the FDIC’s motion for judgment on the pleadings as to the individual defendants’ defenses of unclean hands, failure to mitigate and ratification. She did deny the FDIC’s motion as to other affirmative defenses, including the business judgment rule.

 

Special thanks to a loyal reader for sending me a copy of Judge Fischer’s opinion.

 

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.