In a detailed 106-page opinion dated July 27, 2011 (here), Southern District of New York Judge Lewis Kaplan granted in part and denied in part the defendants’ motions to dismiss in the consolidated Lehman Brothers Securities Litigation. Though Judge Kaplan knocked out certain of the plaintiffs’ allegations, what Judge Kaplan called the “core” of plaintiffs’ allegations remain, particularly with respect the company’s quarter-end Repo 105 transactions.

 

As detailed here, the plaintiffs allege that the defendants made false and misleading statements about Lehman Brothers prior to the company’s September 2008 collapse. The defendants include certain former officers and directors of the company; the company’s auditor; and the company’s offering underwriter. The plaintiffs amended their consolidated complaint following the March 2010 release of the report of the Lehman Brothers bankruptcy examiner (about which refer here), which, described the company’s alleged “balance sheet manipulation,” among other things by using a quarter end accounting device know as “Repo 105.” The defendants moved to dismiss.

 

In his July 27 opinion, Judge Kaplan granted the defendants motion to dismiss s to certain of the plaintiffs’ allegations, finding that the plaintiffs had not adequately alleged misleading falsity, for example, with respect to statements about the company’s use of risk mitigants and with respect to certain aspects of the company’s liquidity.

 

However, Judge Kaplan found that the allegations were sufficient with respect to a number of the plaintiffs’ other allegations, particularly with respect to the company’s use of the Repo 105 transactions; its statements about its net leverage; its statements about its use of stress testing; its statements about risk management; its statements about value at risk; and its statements about concentrations of credit risk.

 

With respect to the Repo 105 transactions, Judge Kaplan said that “repetitive, temporary, and undisclosed reduction of net leverage at the end of each quarter is sufficient to make out a claim.”

 

With respect to the statements that the plaintiffs had sufficiently alleged to be false and misleading, Judge Kaplan found that the plaintiffs had also sufficiently alleged scienter. In finding that the plaintiffs had adequately alleged scienter against the officer defendants in connection with the statements concerning the Repo 105 transactions, Judge Kaplan said:

 

The suggestions that defendants believed that the Repo 105 transactions were permissible in and of themselves and that the financial reporting for them, in and of itself, complied with GAAP does not address the core of plaintiffs’ claims  – that they were used to reduce temporarily and artificially Lehman’s net leverage and paint a misleading picture of the company’s financial position at the end of each quarter. The allegations of that these transactions were used at the end of each reporting period, in amounts that increased as the economic crisis intensified, to affect a financial metric that allegedly was material to investors, credit rating agencies, and analysts supports a strong inference that the Insider Defendants knew or were reckless in not knowing that use of the Repo 105 transactions and the manner in which they were accounted for painted a misleading picture of the company’s finances.

 

Although Judge Kaplan also knocked out many of the allegations against E&Y, the company auditor, Judge Kaplan also found that the amended complaint “adequately alleges that D&Y misrepresented in the 2Q08 that it was ‘not aware of any material modification that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.’”

 

Judge Kaplan’s conclusions as to the sufficiency of the Exchange Act allegations against the individual defendants also extended to the sufficiency of the Securities Act allegations against the Underwriter Defendant.

 

As a result of Judge Kaplan’s rulings, one of the highest profile securities suits filed in the wake of the credit crisis will now go forward. Unsurprisingly, the allegations concerning the Repo 105 transaction had a significant impact on Judge Kaplan’s consideration of the plaintiffs’ claims. While any resolution of this case would be challenging, the difficulty for all concerned is that due to the multiplicity and complexity of the various legal matters arising out of the company’s collapse, the amount of D&O insurance remaining is rapidly declining. Even if the defendants feel strongly that they are wrongly accused, they will have to think hard about whether it is better to try to work a deal while insurance funds remain, or to fight on in the hope of ultimate vindication – preferably before the insurance funds are gone.

 

Nate Raymond’s July 27, 2011 Am Law Litigation Daily article discussing the decision can be found here.

 

I have in any event added the Lehman brothers ruling to my running tally of the subprime meltdown and credit crisis related dismissal motion rulings, which can be accessed here.

 

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

 

Second Circuit Affirms Dismissal in CBRE Realty Subprime-Related Securities Suit: In another ruling in a subprime-related securities class action lawsuit, on July 26, 2011, the Second Circuit affirmed the district court’s dismissal of the subprime-related securities suit that had been filed against CBRE Realty Finance. The Second Circuit’s opinion can be found here.

 

As discussed here, the plaintiffs had alleged that in connection with company’s September 2006 IPO, the company’s offering documents had not adequately disclosed the risk of default in connection with two Maryland condominium conversion projects known as Triton. In July 2009, the District of Connecticut dismissed the plaintiffs’ claims because the loans were fully collateralized at the time of the IPO. The plaintiffs appealed.

 

In its July 26 opinion, a three-judge panel of the Second Circuit affirmed the district court, but on different grounds. The Second Circuit held that “the alleged misstatements were not material because the value of the transactions composed an immaterial portion of the issuer’s total assets.”

 

I have also added the Second Circuit’s opinion in the CBRE case to my table of credit crisis lawsuit dismissal motion rulings.

 

In the most recent of the securities litigation analyses, on July 26, 2011, NERA Economic Consulting issued its report on the securities class action lawsuit filing during the first six months of 2011. In a report entitled “Recent Trends in Securities Class Action Litigation: 2011 Mid-Review” (here), NERA  suggests, perhaps contrary to other recently published reports, that securities suit  filings during the first half of the year were  “on the rise” and “indeed unusually high.” As I discuss below, the seeming variance among the various published reports is a reflection of different counting methodology. I have comments about that below.

 

According to NERA (and by rather stark contrast to the conclusions of the analyses of the recently released Cornerstone Research report), during the first half of 2011 “securities class action lawsuits were filed at the second highest semi-annual rate in the last eight years.” According to NERA, there were 130 filings in the first half of the year. If the filing rate were to continue at the same pace for the rest of the year, “there would be 260 filings in 2011, the highest level since 2002, and the fourth highest in the 16 years since the passage of the Private Securities Litigation Reform Act.”

 

According to NERA, a decline in the year’s first six months was offset by a “surge in suits targeting Chinese companies.” Over a third of the lawsuits during 2011’s first half were filed against foreign domiciled issuers, a rate which is “extraordinary by historical standards,” and “more than double the prior peak of 2004.”

 

The filings themselves has “continued to migrate from the Second Circuit to the Ninth Circuit,” as the mix of companies targeted has shifted away from financial companies and toward technology companies. Filings against companies in the financial sector has declined from a 2008 peak of 49 percent to just under 20 percent in the first half of 2011. Filings in against companies in the electric technology and technology services sector represented 22 percent of filings in the year’s first six months.

 

The NERA report notes that filings activity continues to be positively correlated with market volatility. Controlling for market returns, volatility is positively and statistically significantly correlated with quarterly filings from the second quarter of 1996 through the second quarter of 2011. However, the correlation is “not one-for-one.” Indeed, market volatility and market returns together explain only about 20 percent of the variance in quarterly filings. In other words, volatility is important but it does not come close to telling you everything you need to know.

 

In looking at the status of cases from the 2000 filing year, the NERA report shows that about 63% of all cases from that year have settled and about 37% percent have settled.

 

With respect to the 245 credit crisis cases filed as of June 30, 2011, 79 have produced “current dismissals” and “only 23 settlements. “

 

With respect to first half 2011 settlements, the average settlement was $23 million, which is sharply down from the 2010 average settlement of $108 million. The median settlement during the year’s first six months was only $6.3 million, down sharply from the all time high median settlement of $11 million in 2011. The proportion of cases settling for less than $10 million reached a post-2006 high during the first half of 2011, when 58 percent of cases settled below $10 million , up from 41 percent in 2010.

 

The report speculates that one reason for the lower settlement levels may be that during the first half of 2011 “cases may have been more apt to settle within insurance limits, possibly due to defendants’ reduced ability to pay.” Of the 15 out of the 48 first half settlements for which NERA was able to determine the insurance contribution, insurance paid all of the settlement in eight cases, between 71 and 81 percent in three and an unspecified rate in the remaining four.

 

The full report, which has a wide variety of other interesting and useful information, warrant reading at length and in full.

 

Discussion

It is  purely coincidental that the NERA report’s publication came in such close conjunction with the publication of the Cornerstone Research report. But because they appeared so close in time, it is impossible not to compare the two reports’ findings. The contrast between the reports’ conclusions is striking. The Cornerstone Report suggested that securities class action laws filings are in decline and trending toward historically lower levels. The NERA Report, by contrast, suggests that filings “are on the rise” and “unusually high.”

 

What in the world is going on? Aren’t these two reports supposed to be analyzing the same thing?

 

The casual reader will be forgiven for assuming that the two reports are analyzing the same thing. But careful reading of the small print and footnotes will disclose that the two reports are not analyzing the same thing. Or to put it more accurately, they are not counting the same things in the same ways. I suspect there are even more differences in what is counted and how it is counted than can be discerned from the reports themselves. But even just based on what can be gleaned from the reports,, the NERA Report (as described in its footnote 1), counts separate filings against a company in separate circuits as separate lawsuits, at least until they are consolidated. Cornerstone, by contrast, counts each target defendant company only once. Cornerstone also counts separate lawsuits brought by separate classes of securityholders separately, at least until consolidated.

 

I know from my own experience that another very difficult category has to do with the lawsuits arising from M&A-related transactions. Whether or not to include these cases can only be decided on a case by case basis, and reasonable people almost certainly might reach different conclusions , which could produce significantly different lawsuit counts.

 

My point here is that how you count affects what you count. And what you count affects the ultimate outcome of your count. The net effect is that we have two very reputable analytic firms reaching quite different conclusions about the level of securities class action lawsuit filing activity during the first six months of 2011. Truthfully, that is the reason I keep my own count, because I find it too confusing trying to make sense out of the conflicting conclusions of the reporting firms.

 

The problem for everyone is that these conflicting conclusions get picked up in the mass media and reported as if they representing absolute conclusions rather than alternative analyses based on mixed data. These conflicting reports create a great deal of confusion among the general public.

 

I think part of the problem here as the respective commentators act as if they are publishing their data in a vacuum. Nothing could be further from the truth. I suspect to a very high degree of moral certainty that every single reader that reads any one of these report reads them all. Not only that, but the authors of these reports read each others reports and they know that everyone that reads their reports reads all the reports.

 

 It would be extraordinarily helpful if the authors would acknowledge this reality up front (not in footnotes, not in reduced text, not in text buried deep within the document) in a simple cover page statement that declares the counting methodology used and that explains how that contrasts with counting methodologies used in other published reports. It would be even more helpful if this initial disclosure explained how the methodology selected affects the ultimate count.

 

By making these remarks here, I hope that no one concludes that I am being critical of anyone. To the contrary, I am one of many people who are very grateful that these high-powered analytic firms are willing to publish their reports and make their analyses available for free. These reports are extraordinarily valuable and helpful. My point is simply that these reports would be even more useful if the reports were to recognize the context within which they are read.

 

Finally, I want to be sure to acknowledge the incredibly fine work that the folks at these firms produce. On behalf of myself and everyone else that devours these reports as soon as they are published. I would like thank everyone associated with the production of these reports. And since this particular post is about the NERA report, I would like to salute all my friends at NERA and to thank them for another fine report. I hope no one interprets my curmudgeonly remarks as anything other than a friendly suggestion.

 

Among other things, Cornerstone Research’s mid-year 2011 analysis of securities class action lawsuit filings reported that during the year’s first half lawsuits were filed more quickly. The report said that in the first six months of 2011 “the median lag between the end of the class periods and the filing dates dropped to the lowest recorded semiannual level since 1997.” But while securities suits in general may be being filed with alacrity, there are still suits that are being filed only after considerable delay. At least one recent suit filing qualifies as belated, while yet another recent filing looks positively ancient.

 

First, on July 20, 2011, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York against Lockheed Martin and certain of its directors and officers. According to the plaintiffs’ lawyers’ July 20, 2011 press release (here), the complaint (which can be found here) purports to represent a class of Lockheed shareholders who purchased their shares between April 21, 2009 and July 21, 2009. 

 

In other words, the plaintiffs appear to have filed their complaint in the Lockheed Martin action on the last day of the two year statute of limitations period applicable to most private securities lawsuits. Given the lag between the class period cutoff date and the date the complaint was filed, the Lockheed Martin lawsuit filing would seem to qualify at least as “belated.”

 

But the lag time in the Lockheed Martin case is nothing compared to the time gap in the case recently filed involving Fairfax Financial Holdings Limited.

 

As reflected in their press release (here), on July 25, 2011, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York against Fairfax Financial Holdings, its auditor, and certain of its affiliated entities and certain of its directors and officers. In their complaint, the plaintiffs purport to represent a class of Fairfax shareholders who purchased their shares between May 21, 2003 and March 22, 2006. In other words, the plaintiffs filed their complaint in this case more than five years after the end of the purported class period.

 

Doesn’t this apparently tardy filing violate the statute of limitation? The plaintiffs knew you were going to ask that question, and so in their complaint they expressly address the statute of limitations issue. As reflected in the complaint’s preamble, on page 2 of the complaint, it is going to be the plaintiffs’ position in the case that the statute of limitations was tolled on April 14, 2006, with the filing of a prior action – Parks v. Fairfax Financial Holdings, et al. (about which refer here) — in the Southern District of New York, against many of the same defendants and involving many of the same allegations.

 

In other words, as you might expect with an ancient set of circumstances, history is important. In particular, the history of the Parks case could be determinative of the statute of limitations issues in the recently filed action.

 

The Parks case, it turns out, was dismissed on March 29, 2010 on the grounds of lack of subject matter jurisdiction. Fairfax Financial Holdings is a Canadian company. In his March 2010 opinion, Southern District of New York Judge George B. Daniels, citing the Second Circuit’s opinion in Morrison v. National Australia Bank, held that the plaintiffs in the Parks case had not alleged sufficient “conduct and effects” in the United States in order to establish subject matter jurisdiction. The plaintiffs’ subsequent appeal to the Second Circuit was dismissed.

 

However, after that, in June 2010, the U.S. Supreme Court entered its opinion in the Morrison case, rejecting the “conduct and effects” text and substituting the “transaction” test. Moreover, the Supreme Court said that the questions of U.S. courts’ authority to hear securities cases involving foreign companies was not jurisdictional, but rather was simply a question of whether or not a claim was within the ambit of the securities laws.

 

The plaintiffs in the recently filed action involving Fairfax Financial Holdings, cognizant of the U.S. Supreme Court’s “transaction” test in the Morrison case, purport to represent only shareholders who purchased their company shares on U.S. exchanges. As a matter of pleading, the presentation of their claims in U.S. court should satisfy the Morrison standard, now that the “conduct and effects” test has been discarded.

 

While the plaintiffs in the recently filed case may avoid the jurisdictional problems that waylaid the prior plaintiffs in the Parks case, there are still those pesky statute of limitations issues. The most recent filing is not only well beyond the two-year statute of limitations, but it is even beyond the five year statute of repose. The question the parties will have to hammer out (and I expect they will) is whether or not the 2006 filing the Parks case not only tolled the statute of limitations but also stays the running of the statute of repose. There is a point where a claim or claims are not just old, but stale. The question is whether or not these claims are past their sell-by date. It will be interesting to see how these issues are resolved in this case.

 

An unrelated issue that comes to mind is whether or not the dismissal in the Parks case is determinative of the claims. That is, as lawyers would say, is the prior dismissal res judiciata? The question there will be whether a dismissal for lack of subject matter jurisdiction has a res judiciata effect, since it does not represent a determination of the merits of any of the claims asserted. Attorneys who have access to associates to research interesting question like that will know the answer to this question (or they will when their associates have completed their legal research).

 

But in the end, what is clear is that while securities lawsuits generally may be being filed more quickly, there are some of these older cases still kicking around out there. And they raise some potentially very interesting issues.

 

Summary Judgment Denied: Securities class action litigation observers know that very few securities suits actually go to trial. Most cases are either dismissed or settled. From time to time, a securities suit will make it all the way to the summary judgment stage. The securities suit pending against Motorola and certain of its directors and officers in the Northern District of Illinois is one of those cases where the case reached the summary judgment stage. In a July 25, 2011 order (here), Northern District of Ilinois Judge Amy St. Eve denied the defendants’ motion for summary judgment, holding inter alia that there are genuine issues of material fact on the issues of falsity, materiality and scienter. As a procedural matter, the case is now headed toward trial, depending on whether or not a settlement intervenes.

Decreased credit crisis-related filings partially offset by an influx of new filings related to M&A transactions or involving Chinese companies resulted in slightly decreased overall levels of securities class action litigation filings during the first half of 2011, according to a recent report entitled “Securities Class Action Filings: 2011 Mid-Year Assessment,” jointly published by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse. The report can be foundhere and the accompanying July 26, 2011 press release can be found here. My own analysis of the first half filings can be found here.

 

According to the report, there were 94 securities class action lawsuit filings during the first half of 2011, compared to 104 in the second half of 2010. The 94 first half filings annualizes (using calendar days rather than months) to 190 filings, which is slightly below the 1997-2010 annual filing average of 194. (Cornerstone’s lawsuit count may differ slightly from other published tallies because, among other things, it counts multiple complaints against the same defendants only once and because it does not count state court filings.)

 

The report notes that the quarterly number of filings has generally declined during the past twelve months. Quarterly filings decreased from 56 in the third quarter of 2010 to 48 in the fourth quarter of 2011, 46 in the first quarter of 2010 and 48 in the second quarter of 2011.

 

One factor driving the first half 2011 filings was the upsurge in lawsuits against Chinese companies. There were 24 securities class action lawsuits against Chinese companies in the first half of 2011, with 23 of those actions involving reverse merger companies, up from 12 filings against Chinese companies, nine involving reverse merger companies, in all of 2010. By the same token there were 21 M&A-related filings in the first six months of 2011, “continuing a new pattern” that emerged in the second half of 2010, when there were 27 M&A-related lawsuits.

 

The lawsuits involving Chinese companies and M&A-related activity collectively represent a very substantial part of all securities class action lawsuit filings in the first six months of 2011. These two groups of lawsuits together represented 46.8 percent of all filings in 2011’s first half, up from 32.7 percent in the second half of 2010. Excluding these two categories, there were otherwise only 50 securities class action lawsuits in the first half of 2011, 70 in the second half of 2010 and 57 in the first half of 2010. These figures, the report notes, are “similar to the low number of filings seen in 2006 and 2007.”

 

The report notes that the its own annualized projection for the 2011 year-end number of securities class action lawsuit filings assumes that the pace of new filings against Chinese companies seen in the year’s first half will continue in the second half. However, the report notes, the number of U.S.-listed Chinese reverse merger companies is finite, and the current level of new filings involving Chinese companies is unlikely to continue indefinitely. The report reckons, “at one extreme,” that if there were no new lawsuits involving Chinese companies in 2011’s second half and other filings continue at the same pace as in the year’s first half, there would be only a total of 166 filings this year, “making 2011 the second lowest year in filings activity during 2006.”

 

The report contains some interesting analysis of the frequency of new lawsuit filings involving S&P 500 companies. The report notes that only 8.5 percent of the first half of 2011 filings named companies in the S&P 500 index, down from 15.4 percent in the second half of 2010. Overall, eight companies, or about one out of every 63 companies in the S&P 500 Index, were defendants in a class action filed in the first half of 2011, compared with about one out of every 19 S&P 500 companies during the full year of 2010. Only one out of 81 companies in the S&P 500 Financials sector was named as a defendant in the first half of 2011, compared to an average of 11.7 percent of Financials sector firms named in class actions between 2000 and 2010.

 

The losses in market capitalization associated with adverse disclosures at the end of the class periods remains low compared to historical levels. The total disclosure loss during the first half of 2011 of $48 billion is well below the historical average of $64 billion occurring between 1997 and 2010. The market cap declines during the class periods also remained low during 2011.

 

Discussion

The report clearly substantiates that the number of lawsuits against Chinese companies and involving M&A transactions were a significant factor driving securities class action litigation activity during the first half of 2011. The report’s exploration of the counterfactual question of what the litigation levels might have looked like without these two categories of litigation activity is interesting. But the report’s implicit suggestion that – but for the anomalous Chinese company and M&A transaction lawsuits –  securities litigation filings are actually trending toward the lower levels that prevailed during the “lull” years of 2006 and early 2007 warrants scrutiny.

 

The lawsuits involving Chinese companies and M&A-related transactions may reflect short term filing patterns. But it has long been the case with securities class action lawsuit filings that they are substantially driven by short term filing patterns. For years, class action lawsuit filings have been reflected sector slides, contagion patterns, or industry events. The Internet bubble was followed by the telecom industry crash and that was filed by the era of the corporate scandals, which was followed by the mutual fund industry market timing scandal, and then came options backdating scandal and after that the subprime meltdown and then the credit crisis. Each one of these events involved an associated influx of securities class action lawsuits.

 

So while it is true that the current litigation activity is largely being driven by short-term trends, there is nothing unusual about that. There always seems to be something driving securities class action litigation activity and it seems likely that even after the current round of securities lawsuits involving Chinese companies winds down, the plaintiffs lawyers will find something else to agitate about. (And as for whether the pattern of lawsuits against Chinese companies is going to wind down soon, I note that there have already been four new securities class action lawsuits filed against U.S.-listed Chinese companies already this month, so there is no current suggestion that the filing phenomenon has started to slow down.)

 

The other thing about the “lull” period, from about mid-2005 to mid-2007, is that while securities class action lawsuit filings may have declined compared to historical norms during that period, overall litigation levels did not decline. The options backdating scandal unfolded during that period, and many more of the options backdating lawsuits that were filed during that period were filed as shareholder derivative suits (over 160) than were filed as securities class action lawsuits (only about 40). So while there may have been a decline in new securities lawsuits during that period, overall litigation levels remained at or near historical norms. It is important to keep this fact in mind when attempting to discern filing patterns over time, especially when considering the possibility that filing levels are or are not actually trending toward a putative lower level.

 

My own view, which is substantially dependent upon the assumption that the plaintiffs’ lawyers will always find the next new category of lawsuits to pursue, is that securities class action lawsuit filings are not trending toward some lower level. More specifically, I do not think that the mid-2005 to mid-2007 filing levels represent some sort of “new normal” to which filings levels are generally trending but for short-term anomalies that obscure the overall pattern. To the contrary, I think the lower securities class action filing levels during the 2005 to 2007 period represent the anomaly, and it is an anomaly that is entirely explainable by the plaintiffs’ bar’s temporary diversion into shareholders derivative lawsuit filings during the options backdating scandal.

 

As I have said before, fish gotta swim, birds gotta fly, and plaintiffs’ lawyers have to file lawsuits. The fish and the birds can be counted upon to continue their traditional activities, and so can the plaintiffs’ lawyers.

 

An important consideration to keep in mind along those lines is that going forward the lawsuit filings driving corporate and securities litigation may or may not involve securities class action lawsuits. As the insurance advisory firm Advisen has well documented in its periodic reports on corporate and securities litigation (refer for example here), securities class action lawsuits increasingly represent a declining percentage of all corporate and securities litigation. So it may happen, as was the case during the so-called “lull” period, that securities class action lawsuit filings may decline while overall litigation levels remain unchanged or even continue to increase.

 

Responding to Negative Say on Pay Vote: Although only a very small companies experienced a negative say on pay vote during this past proxy season (as detailed here), a number of the companies that did sustain negative votes wound up in litigation. For companies that find themselves in this position, the question arises of how the company and its board should respond.

 

In an interesting July 24, 2011 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation blog (here), Paul Rowe of the Wachtell Lipton law firm examines the question of the how companies that have experienced a negative say on pay vote should respond.

 

For many years, one of the fundamental goals of shareholder rights activists has “proxy access,” which would require corporations to include shareholder nominated board candidates on the company’s proxy ballots. Last year, in the wake of the Dodd-Frank Act, the SEC promulgated rules facilitating shareholder director nominations under certain circumstances. However, on July 22, 2011, in an opinion that called the SEC’s rulemaking “arbitrary and capricious” and reflected sharp criticism of the agency, a three-judge panel of the District of Columbia Court of Appeals struck down the SEC’s rule. The opinion, which can be found here, makes for some interesting reading and raises some potentially significant implications.

 

Background

Shareholder activists have been lobbying for proxy access for years. As part of the sweeping financial reform encompassed in the Dodd-Frank Act, Congress provided the SEC in Section 971 of the Act with authority to promulgate proxy access rules. On August 25, 2011, the SEC adopted rules implementing this provision. Rule 14a-11 would have provided shareholders holding at least three percent of the voting power of a company’s securities who have held their shares at least three years with the right to have their director nominees included in the company’s proxy materials.

 

However, on September 29, 2010, the Business Roundtable and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules. On October 4, 2010, the SEC issued a stay of the rule’s effectiveness pending the court’s review. 

 

The July 22 Opinion

In an opinion written by Judge Douglas Ginsberg for a three-judge panel, the D.C. Circuit held that the SEC has acted “arbitrarily and capriciously” in adopting the proxy access rules. In language that was presented a particularly harsh rebuke to the SEC, the court said that:

 

We agree with petitioners and hold the Commission acted arbitrarily and capriciously for having failed once again …adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commentators.

 

The court seemed particularly concerned with the costs companies would incur as incumbent directors sought to defeat the shareholders’ electoral challenge, and with the SEC’s supposed failure to take those costs into account. The court said “although it might be possible that a board, consistent with its fiduciary duties, might forego expending resources to oppose a shareholder nominee – for example, if it believes the cost of opposition would exceed the cost to the company of the board’s preferred candidate losing the election, discounted by the probability of that happening – the Commission has presented no evidence that such forbearance is ever seen in practice. “

 

The court was also critical of the SEC for failing to take into account the likelihood that the proxy access process might be used by shareholders with special interests to pursue their own agendas, at the expense of other shareholders. The court said that “the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause the companies to incur costs even when their nominee is unlikely to be elected.”

 

The court granted the business groups’ petition and vacated the SEC rules.

 

Discussion

Both the court’s holding and the language it used have important implications for proxy access and for the SEC’s future rulemaking efforts.

 

With respect to the SEC’s proposed rule, the agency now has to decide whether to appeal the D.C. Circuit’s ruling or to try remedial efforts to try to address the D.C. Circuit’s  concern. The prospects for addressing all of the court’s concerns seem daunting. As a former SEC general counsel quoted in the July 23, 2011 Wall Street Journal article about the decision (here) put it, “given the number of objections the court had, the amount of work would be very substantial and it may just be impossible.”  It may be that at least this latest effort to implement proxy access has hit an insurmountable obstacle.

 

But beyond the proxy access question, the D.C. Circuit’s decision has important implications for SEC rulemaking generally. The court went out of its way to rebuke the SEC for its repeated failure to address legal requirements for the agency’s rulemaking. According to the Journal article, the July 22 opinion represents “the fourth time in recent years the same appeals court has invalidated an agency rule on similar grounds.”

 

The D.C. Circuit’s criticism of the agency’s rulemaking and its insistence on a high bar for rulemaking compliance comes at a time when the SEC is laboring under a significant rulemaking burden due to the requirements of the Dodd-Frank Act and at a time when the agency is also coming under significant budgetary constraints. The SEC will have to move forward to try to meet the Dodd-Frank rulemaking requirements with awareness of the harsh scrutiny its rules will face in the appellate courts.

 

Shareholder activists quoted in the various news articles commenting on the D.C. Circuit’s opinion suggest they will continue to try to press ahead on proxy access. It remains to be seen how the SEC will respond. But for now, proxy access has been tabled, and it may be some time before this or another initiative resuscitates the initiative.  

 

The Morrison & Foerster law firm’s July 22, 2011 memo discussing the D.C. Circuit’s opinion can be found here. The statement of the U.S. Chamber and the Business Roundtable about the opinion can be found here. Special thanks to the several loyal readers who sent me links about the Court’s opinion.

 

Meanwhile, Back at the FDIC: Although the standard current line on the continuing wave of bank failures is that the FDIC is winding down its bank closure efforts, the FDIC does not seem to have gotten the memo. This past Friday evening, the FDIC closed three more banks, bringing the July 2011 month to date total number of closures to 10, after the agency had closed only nine banks in the months of May and June combined. The latest closures brings the year-to-date total number of bank failures to 58, and with the latest closures signs area that the number of bank failures could continue to mount for some time to come.

 

Another thing that is striking about the YTD bank closures is how many of the closures still involve Georgia banks. So far this year, 16 Georgia banks have failed. This is after several years of massive numbers of bank failures in the state. You do start to wonder how there could be any banks left in Georgia at this point.

 

Morrison: Where is the Place of the Transaction?: As explained in the U.S. Supreme Court’s opinion in Morrison v. National Australia Bank, Section 10 of the ’34 Act and Rule 10b-5 apply  to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” The second of the two prongs in this standard requires courts to determine whether or not the disputed transaction is or is not “domestic,” which leave courts to try to determine where the transaction took place.

 

In the Quail Cruise ship case (refer here, second item), the Eleventh Circuit recently held that because the share transaction allegedly “closed” in Miami, the plaintiffs had adequately alleged that the transaction was a domestic transaction. In a more elaborate opinion, discussed here, Southern District of New York Judge Barbara Jones held in the SEC enforcement action against Goldman Sachs associate Fabrice Toure that the place of the transaction is to be determined based on the place where the transaction counterparties incurred “irrevocable liability” to take or sell the securities in question.

 

As discussed in Nate Raymond’s July 21, 2011 Am Law Litigation Daily article (here), last Thursday, Judge Jones quoted her own prior opinion in holding that the plaintiff in the civil action against Goldman Sachs in connection with the infamous Timberwolf CDO (to which an unfortunate Goldman associate referred in an email as “one shitty deal”)  had not adequately alleged that the security sale involved a domestic transaction. A copy of Judge Jones’ opinion can be found here.

 

In holding that the plaintiffs had not adequately alleged that the transaction in question took place in the U.S., Judge Jones said that in order to meet the requirements of Morrison’s second prong and establish that a transaction took place in the U.S., the plaintiff “must allege that the parties incurred irrevocable liability to purchase or sell the security in the United States.” Judge Jones dismissed the plaintiff’s complaint but with leave to attempt to replead the transactional allegations in order to establish that their transaction was cognizable under the federal securities laws.

 

Through sheer repetition, Judge Jones’s “irrevocable liability” test may become the de facto standard for determining whether or not a transaction has taken place in the United States.  On the other hand, the Eleventh Circuit’s recent (albeit somewhat unexplained) pronouncement that the place of the transaction closing is sufficient may present an alternative test on which parties may seek to rely. 

 

Choice of Law: In a prior post, I noted that choice of law may be one of the sleeper issues for determining insurance coverage. I specifically discussed the potential merits of the incorporation of a choice of law clause within the D&O insurance policy.

 

In a July 20, 2011 post on the Delaware Business Litigation Report blog, Edward M. McNally of the Morris James law firm takes a look at the question of choice of law in the context of breach of contract disputes, and he reviews the advantages of the incorporation into business contracts of choice of law provisions. His article specifically raises the questions that can arise in the D&O insurance context in the absence of a choice of law provision in the policy.

 

The Plot Thickens: When discussing the allegations many Chinese companies are raising that the assertions of accounting impropriety against the companies are the product of the fevered and self-interested imaginings of short sellers, I compared the situation to the Spy vs. Spy feature in  Mad Magazine. It turns out that I had no idea of how much skullduggery might be involved.

 

In a July 22, 2011 Thomson Reuters News & Insight article (here), Alison Frankel details the allegations and counter allegations that are flying in connection with online securities analyst and short-seller Muddy Waters, which has been at the center of a number of the assertions of financial impropriety involving Chinese companies. Apparently an anonymous online source has posted phony content purporting to show that Muddy Waters was the target of an SEC enforcement action for fraud and was forced to pay over $240 million for improper profits on stock manipulation. Another individual (who called himself “Shaun Coffey” in possible reference to famous former plaintiffs’ securities attorney Sean Coffey) is out trying to present himself as a Muddy Waters employee and attempting to use threats to try to blackmail Chinese companies.

 

Meanwhile, the July 24, 2011 New York Times had an article entitled "China to Wall Street: The Side-Door Shuffle" (here) that tells the story of how Rino International, a Chinese company, obtained its U.S. listing through a reverse merger. The article also describes how a research report from the Muddy Waters firm first raised questions about the company, following which the company’s share price collapsed and lawsuits ensued. You can certainly see how there might be some people who don’t like the Muddy Waters firm.

 

I will say that since she moved over to Thomson Reuters, Frankel has consistently been cranking out top quality articles and at an impressive rate. I marvel both at how she continues to come up with interesting story topics and how she cranks out an astonishing number of interesting and entertaining articles. Alison, everyone here at The D&O Diary salutes you.

 

With the temperatures reaching mind-bending levels, we considered it advisable to stay inside, drink plenty of fluids, and limit our exertions. So in lieu of a more elaborate post, we have simply noted some mid-summer quick hits below.

 

Action against U.S.-Listed Chinese Companies Auditors Allowed to Proceed: A recurring question during the current wave of lawsuit filings involving U.S.-listed Chinese companies has been how the plaintiffs will pursue their claims and enforce any judgments against the Chinese defendants. One likely counter to these problems has been for plaintiffs to pursue the claims against the Chinese defendant company’s more accessible outside professionals. A number of recent suits have named outside auditors and other professionals as defendants (refer for example here). Given recent U.S. Supreme Court case law, making these claims against the outside professionals stick could be tough.

 

But in a July 18, 2011 decision in a case filed prior to the current wave of lawsuit filings against Chinese companies, a judge had held that the plaintiffs’ allegations were sufficient for the claims against the auditor to proceed. As reflected here, the plaintiff first filed its lawsuit against China Expert Technology in 2007. The original complaint included among the defendants the company’s outside auditors including affiliates of BDO Seidman and affiliates of PKF.

 

The case had been through several rounds of pleading. The defendants’ motions to dismiss were initially granted, but the dismissal as to the PKF parties was without prejudice. The plaintiff twice attempted to amend his complaint in an attempt to overcome the pleading concerns, but each time the motion as to the PKF parties was granted, without prejudice.

 

In the July 18 order, which is handwritten, Southern District of New York Judge Alvin Hellerstein concluded with respect to the plaintiff’s fourth amended complaint that “enough has been alleged to make out a plausible claim for relief.” Unfortunately for other litigants who might want to try and rely on or cite Judge Hellerstein’s ruling, his brief order does not provide any elaboration.

 

But despite the brevity of the ruling and the fact that it took four amended complaints for the China Expert technology plaintiff to overcome the pleading hurdle, the fact is that the plaintiff was ultimately able to present allegations sufficient to meet the pleading hurdles. That fact alone may provide comfort for the plaintiffs in pursuing claims against the Chinese companies’ outside professionals in other cases.

 

Success in overcoming the hurdles in pleading claims against the auditor in this particular case is for this plaintiff critical. As Nate Raymond pointed out in his July 20, 2011 Am Law Litigation Daily article about the case (here), China Expert Technology has never appeared in the case and a default was previously entered against the company. Plaintiffs in other cases may face similar challenges, and so the ability to pursue claims against the outside professionals may prove to be critical in other cases as well. Whether or not those claimants will be able to make their claims stick remains to be seen. But in at least one case, the plaintiff’s claims against a Chinese firm’s outside auditor are going forward.

 

A July 21, 2011 Reuters article about the decision can be found here

 

Who’s Paying for News Corp.’s Legal Costs?: The media frenzy over News Corp.’s phone hacking scandal has led to a host of actual and potential legal proceedings involving News Corp. and its senior managers. The legal bills no doubt are starting to mount, which inevitable leads to the question of who will be paying the lawyers. A July 20, 2011 Reuters article (here) speculates that the company’s D&O insurance may be paying for the the legal expenses.

 

The article appropriately notes some of the questions surrounding the availability of D&O insurance coverage for the legal fees. Among other things, depending on its terms and conditions, the D&O policy may not cover substantial amounts of the expense, even if there is coverage under the policy for some of the company’s expense. The fees the company and its senior officials incur in defending the various civil suits are likely to be most likely to be covered. The various investigations and criminal proceedings may or may not be covered depending on the nature of the proceedings and the specific wordings of the company’s policy.

 

And Speaking of D&O Insurance: As suggested in the prior item, the specific wording in a D&O insurance policy is critically important. Subtle wording differences can make a significant difference in whether or to what extent insurance is available for claims related expenses, settlements and judgments. In a competitive insurance marketplace , the more advantageous wordings often are available and are often available at little or no additional cost.

 

A July 2011 memo from the Lowenstein Sandler law firm describes the availability of more favorable coverage terms as “D&O Coverage at Little or No Additional Cost.” The memo explores some of the policy alternations that can increase the scope of coverage available under the D&O insurance policy.

 

They’re Getting Litigation Weary North of the Border, Too: In changes that went into effect in 2005, Ontario modified its securities laws to provide a different liability regime for holding corporate officials accountable to shareholders for material misrepresentations and omissions. One of the new law’s features was the inclusion of a procedural requirement that prospective litigants obtain judicial leave to proceed. The leave requirement was introduced at companies’ insistence as a way to try to ensure that only meritorious cases proceed.

 

But as discussed in a July 20, 2011 Reuters article (here), the leave requirement itself is proving to be burdensome, as the process of determining whether or not the case should be allowed to go forward is proving to be protracted and expensive. The article also reports that there are concerns in some circles that the courts have set the bar for granting leave too low.

 

It was perhaps inevitable that there would be grumbling in the wake of claims under the new regime. From that perspective, the complaints are hardly surprising. But it does seem as if the actual process under the new rules is turning out differently than at least some had envisioned.

 

Overall levels of corporate and securities litigation during the second quarter and first half of 2011 remained at elevated levels despite a decline in regulatory and enforcement activity during the quarter, according to the latest Advisen quarterly litigation report. A copy of the report can be found here. My own survey of the second quarter and first half securities class action litigation activity can be found here.

 

Preliminary Notes

It is critically important to recognize that the Advisen report uses its own unique vocabulary to describe certain of the corporate and securities litigation categories.

 

The “securities litigation” and “securities suits” analyzed in the Advisen report include not only securities class action lawsuits, but a broad collection of other types of suits as well, including regulatory and enforcement actions, individual actions, derivative actions, collective actions filed outside the U.S. and allegations of breach of fiduciary duty. All of these various kinds of lawsuits, whether or not involving alleged violations of the securities laws, are referred to in the aggregate in the Advisen report as "securities suits."

 

One subset of the overall collection of "securities suits" is a category denominated as "securities fraud" lawsuits, which includes a combination of both regulatory and enforcement actions, on the one hand, and private securities lawsuits brought as individual actions, on the other hand. However, the category of "securities fraud" lawsuits does NOT include private securities class action lawsuits, which are in their own separate category ("SCAS").

 

Due to these unfamiliar usages and the confusing similarity of category names, considerable care is required in reading the Advisen report.

 

The Report’s Findings

According to the report, the annualized level of all corporate and securities litigation activity during the first half of 2011 remained “on par with the record-setting year of 2010,” notwithstanding a decline in the number of new regulatory actions against financial services firms, as enforcement activity in the wake of the global financial crisis waned.

 

Advisen tracked a total of 332 new actions across all categories of corporate and securities lawsuits during the second quarter, compared to 398 during 1Q11. Despite the falloff, the second quarter activity remained as a “high level” and the first half activity annualizes to a record level of corporate and securities litigation activity.

 

One category of litigation activity driving these numbers is the group of lawsuits alleging breach of fiduciary duties. Many of these breach of fiduciary duty lawsuits are merger objection lawsuits, the filing of which has been “mushrooming” in recent years. The number of merger objection suits has grown from only 21 in 2001 to 353 in 2010, and with 176 merger objection suits in the first half of 2011, the pace of merger objection litigation remains in line with 2010 levels. The report includes a chart on page 6 illustrating the dramatic growth in merger objection litigation activity.

 

According to the Advisen report, there were 63 new securities class action lawsuit filings during the second quarter, which is flat with the previous quarter, but above the 2010 quarterly average of 48 per quarter and in line with the 60 suits per quarter during 2009. Securities class action lawsuit filings as a percentage of all corporate and securities lawsuit filings remains down from historical levels although up slightly from 2010 levels. Class action securities lawsuits represented as much as a third of all corporate and securities litigation activity as recently as 2006, but during the second quarter, securities class action lawsuits represented only 19 percent of all corporate and securities lawsuits, which while below historical levels is up slightly from the 14 percent such suits represented in 2010. Three industrial sectors accounted for over 60 percent of all securities class action lawsuit during the first half: information technology, consumer discretionary, and industrial.

 

Actions involving companies in the financial services industry accounted for a smaller percentage of all corporate and securities litigation activity during the second quarter compared to recent periods. Financial firms counted for 45 percent of all corporate and securities litigation in 2008 and 45 percent in 2009. The number fell to 34 percent in 2010 and during the second quarter of 2011, the number fell to 25 percent. Despite the decline, the financial services industry still remains the “leading sector” for attracting corporate and securities litigation activity.

 

One prominent trend has been the growth in corporate and securities litigation activity involving non-U.S. companies. A certain amount of this litigation involving non-U.S. companies involves proceedings outside the U.S. The Advisen study reports that during the first half of 2011, there were 38 corporate and securities lawsuits filed outside the U.S., 18 of which were filed during the second quarter. Corporate and securities lawsuits involving non-U.S. companies, whether filed in the U.S. or elsewhere, have accounted for about ten percent of all corporate and securities litigation activity since 2005. But in the first half of 2011, corporate and securities lawsuit activity against non-U.S. companies accounted for 17 percent of all corporate and securities litigation activity, and during the second quarter of 2011, the figure for non-U.S. companies was up to 20 percent.

 

A substantial part of this rise in activity involving non-U.S. companies has been the rise in the number of corporate and securities lawsuits involving Chinese companies, of which there were 44 during the first half of 2011.

 

Discussion

Advisen’s report takes a broader view of corporate and securities litigation, because its scope reaches beyond just securities class action lawsuits to include all corporate and securities litigation, and not just in the U.S, but outside the U.S. as well. But even with this broader scope, it is apparent that a couple of identifiable factors are currently driving corporate and securities litigation activity, as is also the case with securities class action litigation – that is, the high levels of litigation largely  is a factor of the suits connected to merger and acquisition activity  and by lawsuits involving Chinese companies.

 

The table in the report depicting merger objection litigation filings dramatically illustrates the growth in this type of litigation activity in recent years. This development has a number of implications, including for the D&O insurance carriers that often wind up picking a significant part of the defense expenses and settlement amounts associated with these kinds of lawsuits. Even though these cases taken individually do not present a significant severity risk, taken collectively that represent a significant claims loss burden for the carriers, particularly those that are the most active in the primary layers.

 

As the mix of litigation has shifted away from higher severity claims such as securities class action lawsuits and toward higher frequency claims such as merger objection suits, the D&O carriers’ claims experience has shifted as well. As I noted in my own report on second quarter litigation activity, this is an under-discussed issue.

 

The burden these costs represent may be all the more painful for the carriers because the exposures involved with these kinds of suits likely are not priced into the risk premium. In addition, it is tough to underwrite the likelihood that any one company will be acquired. But because the discussion of carriers’ loss exposures tends to focus on the higher severity risk of securities class action litigation, there is relatively little consideration given to the higher frequency exposure that these merger objection lawsuits represent. This is one of those issues that just doesn’t get the airtime it deserves – at least not so far.

 

One interesting development involving these kinds of merger objection lawsuits is that the judges in the Delaware Chancery Court have started to show some resistence to the fee awards to plantiffs’ counsel in cases that do not produce a material benefit for shareholders. The Wall Street Journal has a July 19, 2011 article (here) discussing these developments. The flip side of this judicial resistence is that in some instances the Delaware courts have proven more willing to approve larger fee awards where the court concludes the plaintiffs have produced substantial benefit for shareholders.

 

The surge in litigation involving U.S.-listed Chinese companies also has important D&O insurance implications, as noted in a recent Client Advisory I co-authored with Pillsbury Winthrop’s Peter Gillon, about which refer here. Alison Frankel has a July 18, 2011 post on the same topic on her Thomson Reuters News & Insight blog, here.

 

Second Quarter Litigation Update Webinar: And speaking of first half 2011 litigation filing trends, on Tuesday July 19, 2011 at 11 a.m. EDT, I will be participating in the Advisen’s "Q2 Securities Litigation Webinar."  My fellow panelists will include Anderson Kill’s Bill Passanante, Navigators’ Scott Misson, and Willis’ John Connolly. The panel will be moderated by Advisen’s Jim Blinn. Information about this event, which is free, can be found here.

 

Outside Directors and SEC Enforcement Actions: A July 16, 2011 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “SEC Enforcement Actions Against Outside Directors Offer Reminder for Boards” (here) takes a look at recent SEC Enforcement actions targeting outside directors. The article concludes with respect to the recent SEC enforcement actions that “when taken together, the cases signal the commission’s continued interest in bringing enforcement actions against directors of publicly traded companies who personally violate securities laws or egregiously disregard their duties.”

 

Among other implications, the article notes the importance for board members of considering the coverage available through their company’s D&O insurance program for regulatory investigations and enforcement actions.

 

Cordray for Consumers? : Many readers may have seen the news that President Obama has nominated former Ohio Attorney General Richard Cordray to head the new Consumer Financial Protection Bureau. Cordray will be a familiar figure to readers of this blog, as I have commented in the past on Corday’s actions while Ohio Attorney General in pursuing securities class action lawsuits on behalf of Ohio’s pension funds.

 

Reactions to Cordray’s nomination to head the new consumer agency include concerns regarding Cordray’s connections to the securities class action bar. In a July 18, 2011 post on his Full Disclosure blog on the Forbes website, Daniel Fisher takes a look at the campaign contributions Cordray received in the past from prominent members of the securities class action litigation bar and comments that Cordray’s “record of taking money from lawyers who profit from private litigation that often follows closely on the heels of government investigations could provide fodder for his enemies.”

 

Ross Todd has a July 18, 2011 post on the Am Law Litigation Daily on the same questions about Cordray.

 

When an ex- Chairman, CEO and Director sues his former company, are the company’s defense expenses covered under its D&O insurance policy? According to the June 24, 2011 report and recommendation of Middle District of Tennessee Magistrate Judge John S. Bryant, applying Tennessee law, they are not. A copy of Magistrate Bryant’s report and recommendation can be found here.

 

In October 2009, David Resha, a current shareholder and former Chairman, CEO and director of American Security Bank & Trust Company, sued the company in Tennessee state court for alleged violations of law and fiduciary duty. Resha alleged that the company had violated its bylaws and asserted the right to inspect the company’s books and records. American Security is the sole named defendant in the action.

 

The company submitted the action as a claim to its D&O insurer, seeking reimbursement for its defense expenses. The carrier denied coverage for the claim and American Security filed an action against the carrier alleging breach of contract and bad faith and seeking a judicial declaration that all past and future expenses incurred in defending against Resha’s claim are covered.

 

The policy contained the standard D&O insurance agreements for nonindemnifiable loss (Side A coverage) protecting the individual directors and officers in the event indemnification is not available to them due to insolvency or legal prohibition, and for corporate reimbursement (Side B coverage), reimbursing  the company to the extent it does indemnify the individual directors and officers. At least as presented in the Magistrate Judge’s report and recommendation, the policy did not contain a separate insuring agreement providing coverage for the entity’s own losses (Side C coverage).

 

The policy defined the term “Claim” to mean a “civil proceeding commenced by the service of the complaint … instituted against an Insured Person or against the Company, coverage is granted to the Company.” 

 

Resha’s lawsuit named only American Security as defendant in the lawsuit. Due to the absence of an entity coverage insuring provision, there is no separate coverage for the company under American Security’s D&O insurance policy. The company nevertheless argued that the insurer should reimburse the company’s defense costs because the complaint asserts bad faith actions and breaches of fiduciary duty by American Security directors, and therefore “impliedly” asserts claims against the directors.

 

The Magistrate Judge rejected American Security’s arguments, holding that because Resha’s complaint did not name the directors as defendants, the action has not been “instituted against” them. He said that to find under these circumstances that Resha’s action was “instituted against” the directors, the court “would be required to find the words ‘instituted against’ to be ambiguous.” He said that ‘after considering the usual, natural, and ordinary meaning of these words, there is no ambiguity to be found and any premise to the contrary must be rejected.” He added that “to find otherwise would violate the intent of this D&O policy and effectively change it into a comprehensive corporate liability policy.”

 

The Magistrate Judge went on to hold that “to the extent that a claim has been made against the directors and officers of American Security in substance, though not in form,” the claim would be barred by the policy’s Insured vs. Insured exclusion, since Resha, as the company’s former CEO is an insured person under the policy.

 

American Security had tried to argue that because Resha was also a shareholder, his claim was in the nature of a derivative claim, and therefore his action fell within the exception to the Insured vs. Insured exclusion for derivative claims. Without deciding whether or not Resha’s action was a derivative claim, the Magistrate Judge concluded that the derivative claim exception to the Insured vs. Insured exclusion did not apply, because Resha’s action was not maintained “independently of, and totally without the participation of any Insured” as would be required in order for the derivative claim exception to the Insured vs. Insured exclusion to apply.

 

The Magistrate Judge recommended that the insurer’s motion to dismiss be granted and the complaint against it dismissed.

 

Discussion

Assuming that the description of American Security’s D&O insurance policy in Magistrate Judge Bryant’s report and recommendation is complete, its policy is somewhat unusual as most current D&O insurance policies include a so-called entity coverage insuring provision (Side C coverage) providing insurance for the entity’s own separate liability exposures. Subject to all of the typical policy’s terms and conditions, entity coverage does provide a form of corporate liability protection.

 

However, even if American Security’s D&O insurance policy had carried the typical entity coverage insuring provision, Resha’s claim would still have run afoul of the policy’s Insured vs. Insured exclusion, and indeed if anything the exclusion’s applicability would have been even more clear.

 

The inclusion of the Insured vs. Insured exclusion in the D&O insurance policy is usually explained as a way to avoid the provision of insurance coverage for “collusive” claims. But that is not the only reason the exclusion is there. It is also a means to avoid insurance for corporate “infighting” where company officials attempt to pursue their disputes and rivalries in Court. The requirement that a derivative claim must be independent and without the participation of an insured person in order for the exclusion’s coverage carve back for derivative claims to apply is just an illustration as the ways the typical exclusions seeks to avoid coverage for infighting type claims.

 

Although Magistrate Judge Bryant’s report and recommendation does not say, it seems possible that Resha’s action represents just such an example of corporate infighting. The report and recommendation does not explain why Resha no longer is Chairman, CEO and a director of the company, but his action alleging by law violations and seeking access to the company’s books and records sounds like part of an ongoing dispute after his departure from office. In any event, Resha’s claim is the kind for which most D&O insurance policy’s typically would not provide coverage.

 

For a more detailed discussion of the Insured v. Insured exclusion generally, refer here.

 

Morrison: Domestic Transaction in Other Securities?: In its June 2010 decision in the Morrison v. National Australia Bank case, the U.S. Supreme Court said that the Exchange Act applies only to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” Among other issues with which the lower courts have struggled in the wake of Morrison has been the reach of Morrison’s second-prong; that is, what are “domestic transactions in other securities?”

 

A July 8, 2011 decision by the Eleventh Circuit may shed at least a little bit of light on this question. The case, styled as Quail Cruise Ship Management Ltd. V. Agencia de Viagens CVC Tur Limitada, which can be found here, involved the sale of M/V Pacific, a boat once featured in The Love Boat television series. The sale was effected by a transfer of shares.  The buyer alleged that it had been induced to purchase the shares through a series of misrepresentations, in violation of the U.S. securities laws.

 

The district court had concluded that it did not have jurisdiction over the dispute because the shares were not listed on a U.S. exchange (the Eleventh Circuit correctly noted that the issue was not jurisdictional at all, but was rather under Morrison a question as to whether or not the U.S. securities laws applied).

 

The Eleventh Circuit held that because the complaint alleged that "the acquisition of the Templeton stock closed in Miami, Florida, on June 10, 2008, by means of the parties submitting the stock transfer documents by express courier into this District," the Complaint at least alleged that the final act to effect the share transfer took place in the U.S. Of course, whether or not the share transfer actually took place in the United States and whether the transfer actually effected the sale of the ship are questions of fact for later determination. 

 

Accordingly, the Eleventh Circuit held that it “cannot say at this stage in the proceedings that the alleged transfer of title to the shares in the United States lies beyond § 10(b)’s territorial reach.” the Eleventh Circuit vacated the district court’s dismissal and remanded the case for further proceedings. 

 

A further discussion of this case can be found in a July 15, 2011 post on the Corporate and Financial Weekly Digest blog, here.

 

The Message is Getting Through in China, Too — At Least to a Certain Extent: In numerous posts on this blog, most recently here, I have noted the increasingly challenging D&O insurance market for U.S.-listed Chinese companies. The word about the challenging insurance market for these firms apparently is getting heard in China, too, at least based on one recent article. On June 24, 2011, the People’s Daily Online (English edition) carried an article entitled “D&O Premiums Skyrocket After U.S. Lawsuits” (here).

 

Although it is good that this message is getting communicated in China, the article soft-pedals the problem. D&O insurance premiums for U.S.-listed Chinese companies have gone up much more than the 20% increase cited in the article – that is, if you can find coverage at all. The article does at least go on to note, with greater (but not yet complete) accuracy, that in some cases the premiums have doubled. The premium increases have in fact been even more dramatic than that.

 

“Starring Your Love Boat Crew”: Those of you interested in having a look at the M/V Pacific or who just want a short trip down memory lane will want to view this video clip of the opening credits from The Love Boat, which according to Wikipedia, aired on television from 1977 to 1986.

 

During the twelve months ending June 30, 2011, at least 32 Chinese companies were hit with U.S. securities suits. In addition, the U.S. Securities and Exchange Commission has initiated a number of enforcement actions and other proceedings against U.S.-listed Chinese companies, issued a formal bulletin warning investors about the risks of investing in Chinese companies that have gone public through reverse merger transactions, and launched a task force to investigate U.S.-listed Chinese companies that have sold stock to investors in the U.S.

 

These developments have significant D&O insurance implications for the directors and officers of these firms. In a July 14, 2011 Client Advisory from the Pillsbury Winthrop law firm, Pillsbury partner Peter M. Gillon and I review the current litigation exposure facing U.S.-listed Chinese companies and examine the questions that officials at these firms should be asking about their D&O insurance.

 

The Client Advisory can be found here.

 

On July 14, 2011, the FDIC filed a lawsuit in the Northern District of Georgia against 15 former directors and officers of Haven Trust Bank of Duluth, Georgia. This suit is the ninth the FDIC has filed as part of the current bank failure wave and the second that the FDIC has filed in Georgia. A copy of the FDIC’s complaint can be found here. Scott Trubey’s July 14, 2011 Atlanta Journal-Constitution article describing the lawsuit can be found here.  

 

Haven Trust was one of the earliest bank closures of the current wave when it failed on December 18, 2008. The bank’s failure has already been the subject of extensive litigation. In late December 2008, the bank’s investors filed a securities class action lawsuit against the former directors and officers of the bank. But as discussed here, on January 14, 2011, Northern District of Georgia Judge Charles A. Pannell, Jr. granted the defendants’ motion to dismiss the securities suit.

 

The FDIC’s suit filing against the Haven Trust officials may come as little surprise; indeed, as discussed here, the FDIC had previously sought to intervene in the investors’ securities suit. Among other considerations the FDIC cited as part of its bid to intervene was the FDIC’s own intention to assert claims against the individual defendants and the FDIC’s concomitant “interest” in the bank’s D&O insurance. On December 29, 2010, Judge Pannell denied the FDIC’s motion to intervene, as discussed here. He specifically rejected the argument that the FDIC has a “legally protectable interest” in the D&O insurance, as a mere prospective claimant.

 

In its lawsuit, the FDIC accuses the former directors and officers of gross negligence and alleges that they breached other duties. The complaint specifically alleges improper lending practices and seeks to recover over $40 million. Among other things, the FDIC alleges that the bank suffered losses of over $7 million on improper loans to family members of two bank insiders.

 

While this lawsuit is only the second that the FDIC has filed against former directors and officers of a failed Georgia bank as part of the current round of bank failures, there undoubtedly will be many more to come. Georgia, with 65 bank failures since mid-2008, has had more bank failures than any other state during that period. The prior FDIC lawsuit involving a Georgia bank failure was the lawsuit filed in January 2011 against former directors and officers of Integrity Bank, about which refer here. 

 

Though the FDIC has so far filed only nine lawsuits against failed bank officials, many more lawsuits will be coming. According to the professional liability lawsuit page on the FDIC’s website (which can be found here), the FDIC had as of July 7, 2011 authorized lawsuits against 248 individuals at 28 failed institutions. Even with the Haven Trust lawsuit, the FDIC has sued only 68 individuals in connection with nine failed institutions. Many more suits have been authorized, and it seems likely that even as the suits already authorized are filed, even more with be authorized in the months ahead.

 

Haven Trust was one of the first banks to fail back in late 2008, and the FDIC is just getting around to filling suit now. Since Haven Trust failed, well over 300 other banks have failed, and further bank failures seem likely. Given the lag time on the Haven Trust lawsuit, the FDIC lawsuits could continue to accumulate for at least another three years or more.

 

A Final Observation: The online registration form for Google+ provides the following choices for the registrant’s gender on a drop-down menu: “Male,” “Female,” and “Other.”

 

“Other”?