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

 

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

 

 

Here is Anjali’s guest post:

 

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

 

 

Introduction

           

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

 

 

PCAOB’s Research Note on Chinese reverse mergers

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

NASDAQ’s proposed new listing requirements for reverse merger companies

SEC’s Investor Bulletin on reverse merger companies

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

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

 

 

 

PCAOB Issues a Report on China Reverse Mergers

 

 

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

 

 

 

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

 

 

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

 

 

           

SEC Launches Investigation of China-Based Issuers and Auditors

 

 

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

 

           

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

 

 

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

 

 

NASDAQ Proposes New Listing Requirements for Reverse Mergers

 

 

 

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

 

 

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

 

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

 

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

 

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

 

 

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

 

 

SEC Issues an Investor Bulletin on Reverse Mergers

 

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

 

Shorts-Sellers Creating Havoc

 

 

 

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

 

 

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

 

 

The Rise of Shareholder Litigation

 

 

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

 

 

D&O Insurance Coverage Issues

 

 

 

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

 

 

Reasonable and necessary defense costs

Coverage for parallel proceedings and investigations

Rescission

Known Claim exclusion

Fraud and personal profit exclusions

Severabiity of the policy exclusions and application

 

 

 

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

 

 

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

 

 

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

 

 

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

 

 

           

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

 

 

 

Conclusion

 

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The July 29 Opinion

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

 

Here is Rick and Micah’s guest post:

 

 

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

 

 

 

The Policies

 

 

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

 

 

 

The Agency Investigations and MBIA’s Claim

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

The Motions for Summary Judgment and Appeal

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

MBIA’s Affect on Future Claim Disputes

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

 

 

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

 

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.