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

 

Preliminary Notes

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

 

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

 

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

 

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

 

The Report’s Findings

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The Client Advisory can be found here.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

“Other”?

 

The U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank looked like the end of securities claims in U.S. courts on behalf so-called “f-cubed” claimants – that is, foreign shareholders of foreign-domiciled companies who bought their shares on foreign exchanges. In the aftermath of Morrison, these foreign claimants have pursued a number of avenues to pursue their claims, including, for example, initiating litigation in the defendant company’s home jurisdiction.

 

Among the more creative approaches was the attempt to pursue – in U.S. courts – claims on behalf of non-U.S. claimants under the laws of the claimants’ home country. The highest-profile attempt along these lines emerged in the Toyota shareholder litigation pending in the Central District of California, where the plaintiffs had amended their complaint in shareholder arising from the company’s sudden acceleration problems to assert claims under the Japanese Financial Instruments and Exchange Act.  The plaintiffs had substantial incentive to pursue this approach since only a small fraction of the company’s shares (less than 10 percent) trade in the U.S. as American Depositary Shares.

 

However, in a July 7, 2011 opinion (here), Central District of California Dale Fischer made short work of this attempt to circumvent the impact of the Morrison decision. In her July 7 ruling, Judge Fischer rejected the plaintiffs’ argument that the court had original jurisdiction over plaintiffs’ Japanese law claims under the Class Action Fairness Act (CAFA). She further declined to exercise the court’s supplemental jurisdiction over the claimants’ Japanese law claims. He dismissed the plaintiffs’ Japanese law claims with prejudice.

 

In seeking to argue that the court had original jurisdiction over their Japanese law claims, the plaintiffs’ had contended that because Toyota shares were listed but did not trade on the New York Stock Exchange, they were not a “covered” security to which CAFA applied, and, because CAFA did not apply, they could assert claims in U.S. court under Japanese law even though they could not otherwise assert claims under U.S. law. (I have attempted to summarize the plaintiffs’ CAFA arguments as best I could; Alison Frankel has a more thorough discussion of these issues in her July 11, 2011 Thomson Reuters News & Insight article entitled “Morrison End Run Hits Brick Wall in Toyota Case” (here)). Judge Fischer declined to read into CAFA the requirements that plaintiffs urged, as “to do so would ignore the plain language of the statute.”

 

Judge Fischer’s refusal to exercise supplemental jurisdiction over the Japanese law claims is even more interesting, and is likely to spell the end of most future attempts by f-cubed claimants to try to assert claims in U.S. under foreign law. Among other things, because of the vast predominance of Japanese holders, “the damages analysis would focus overwhelmingly on these claims” and the Japanese law claims “unquestionably would dominate the litigation.”

 

Judge Fischer also found that the requirement of comity to Japanese courts “strongly argues against the exercise of supplemental jurisdiction.” He added that the respect for the rights of other countries to regulate their own securities markets “would be subverted if foreign claims were allowed to be piggybacked into virtually every American securities fraud case,” which would result in “imposing American procedures, requirements and interpretations likely never contemplated by the drafters of the foreign law.”

 

Judge Fischer did not say that there would never be an occasion when a U.S. court could properly exercise supplemental jurisdiction over foreign securities fraud claims. However, he specifically noted that “any reasonable reading of Morrison suggests that those instances will be rare.”

 

Whether or not any readers consider this outcome unexpected, the one thing that is clear is that the U.S. District Courts continue to take an expansive reading of Morrison. As Frankel put it in her article to which I linked above, the Toyota plaintiffs “fared no better than everyone else who’s tried to find any vulnerability in the Supreme Court’s ruling.”

 

M&A Litigation Soaring, For Sure: In my first half 2011 securities litigation analysis (here) one of the most distinctive trends I noted was the rise of M&A related litigation. Fox Business News has a July 12, 2011 article entitled “M&A Lawsuit Skyrocket as Fee-Hungry Law Firms Smell Easy Money” (here) which takes a closer look at the subject.

 

The article sounds themes that will be familiar to readers of this blog. However, the article is accompanied by a startling graphic that dramatically illustrates how massively the M&A-related litigation has ramped up since 2008. The article graphics also show how the M&A-related litigation has grown relative to M&A-related activity. In addition, the article provides numerical substantiation for the generalizations about the rising levels of M&A litigation.

 

I continue to believe that in the aggregate, these cases represent a serious problem for the D&O insurance industry, or at least for the carriers that are most active as primary carriers. I expect the increasing frequency of M&A –related litigation will be of increasing focus in the months ahead.

 

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

 

Parting Thought: Am I the only one that finds the new nickels, with Thomas Jefferson’s oversized and distorted face looming off to one side, weird and creepy?

 

Largely due to last summer’s enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes already underway have transformed the relations between corporate boards and corporate shareholders. Even further changes loom. In a July 2011 article entitled “Corporate Governance Perspective: Current Bearings, Future Directions”  in the latest issue of InSights (here),  I  take a look at where we are now with respect to the current round of corporate governance reforms , what lies ahead, and what it all means.

The short week after the July 4th holiday is usually quiet. There certainly did seem to be less traffic on the roads. But nevertheless, there was news of note this past week on several stories we have been following, as discussed below. The traffic on the roads may have slowed but the circulation on the information superhighway continued unabated.

 

Pace of Bank Failures Slows – But More Closures Loom: Earlier this year (refer here), I had noted that it seemed as if the pace of bank failures had finally started to decline. As discussed in a July 9, 2011 Wall Street Journal article (here), the pace of bank failures did indeed slow  in the first half of 2011, compared both to the equivalent period a year ago as well as to the second half of last year. There were 48 bank failures in the first half of 2011, compared to 74 in the second half of 2010 and 86 in the first half of 2010.

 

This slowdown is consistent with the FDIC’s projections. The agency had previously indicated that it believed 2010 would represent a high water mark for bank failures. But while the pace of bank closures has finally started to slow, the wave of bank failures is far from finished. As I noted here, the FDIC’s most recent Quarterly Banking Profile, released in May, showed that the number of “problem institutions” was a record levels, a situation that the Journal article characterized as representing a “backlog” of troubled banks. The FDIC reported that as of the end of March 31, 2011 there were 888 “problem institutions.”

 

And while the 48 bank failures in the year’s first half represents a decrease compared to recent periods, that figure still represents a sizeable number. By way of comparison, in 2008, when the financial crisis reached its crescendo, there were only 25 bank failures. Moreover, it is clear that bank failures will continue for the foreseeable future, even if at reduced levels from a year ago. Indeed, on Friday evening – the first Friday of the year’s second half – the FDIC took control of three more institutions.

 

The Journal article quotes one commentator as saying that historically about 19% of the banks on the FDIC’s problem list wind up failing, which implies about 169 bank failures after March 31, 2011. Since 22 banks failed in the second quarter of 2011, that would suggest that there may be about 147 bank failures yet to go. The completion of the current  bank closure process could, according to a source cited in the Journal article, take about two more years. As another commentator quoted in the article put it, the process is about in “the seventh inning” of the cycle of failures.

 

Though the bank closure process may now be slowing and will run its course in time, the mopping up process may only have just begun. Allowing for the extensive post-mortem that follows each failure, and the attendant lag time before the FDIC initiates litigation against the directors and officers of failed banks, the era of failed bank litigation may just be getting started. If the wave of bank failures is in the seventh inning, we are much earlier in the bank litigation wave ball game. Refer here for my recent review of the details surrounding the failed bank litigation.

 

U.S. Investors Are Not the Only Ones Concerned About Chinese Company Accounting Scandals: As various accounting scandals involving U.S.-listed Chinese companies have emerged, shareholders have launched a series of lawsuits in the U.S. against the companies and their senior officials, as I have previously noted on this blog. It turns out that U.S. investors are not the only ones upset about the problem involving Chinese companies.

 

A July 8, 2011 Bloomberg article (here) examines the concern that investors in Singapore have about Chinese companies, based on the various accounting issues that have come to light. Among other things, the article states that since 2008, more than ten percent of the Chinese companies listed on the Singapore stock exchange have been delisted or had trading in their shares suspended. The article also reviews investor concerns that executives of Chinese companies are outside the reach of Singapore enforcement authorities.

 

The crescendo of voices raising concerns about the Chinese companies may be being heard in China itself. News reports this past week (refer here) suggest that officials from the SEC and the PCAOB will be meeting with their Chinese counterparts this upcoming week to discuss the possibility of allowing the U.S. regulators to investigate Chinese companies and Chinese audit firms for the first time.

 

In the meantime, however, the wave of lawsuits in the U.S. involving U.S.-listed Chinese companies continues to mount. The latest lawsuit involves A-Power Energy Generation Company, which obtained its U.S. listing by way of a reverse merger with a U.S. listed publicly traded shell company. According to their July 5, 2011 press release (here), plaintiffs’ counsel have filed a securities class action lawsuit in the District of Nevada against the company and certain of its officers. The complaint (which can be found here), refers to published reports describing the company’s auditors concerns about weaknesses in the company’s internal controls and differences between financial figures the company reported to Chinese regulatory source compared to those reported in the company’s SEC filings. On June 28, 2011, the company announced (here) that its auditor had resigned because of the company’s failure to hire an independent forensic accountant to investigate certain business transactions.

 

With the arrival of this latest lawsuit, there have now been a total of 27 securities class action lawsuits filed against U.S. listed Chinese companies so far in 2011, representing about one-quarter of all 2011 securities lawsuit filings in the U.S.

 

One variation on this litigation theme has arisen in a separately filed securities suit that has been brought as an individual action rather than as a class action. As discussed in Jan Wolfe’s July 5, 2011 Am Law Litigation Daily article (here). Starr International has amended its securities suit against China MediaExpress Holdings and certain of its directors and officers to include as defendants three American businessmen who helped the company obtain its U.S. listing by way of reverse merger.

 

While there have been calls to reform the reverse merger process, particularly for foreign companies, if the functionaries that make the process possible are going to find themselves hauled into litigation involving the companies they help to go public, the reverse merger process may cease to exist as a means for non-U.S. companies to use in order to process the more conventional method of going public. In any event, in the current climate, it seems likely that there would be much investor interest in shares of foreign domiciled companies that obtained their U.S. listings by way of a reverse merger.

 

Variation on the Auction Rate Securities Concerns: There have been extensive developments recently involving financial companies involved with marketing or selling auction rate securities, as Tom Gorman summarized in a July 5, 2011 post on his SEC Actions blog. But a new adversary action filed in the Land American Financial Group bankruptcy proceeding shows an interesting variation on the usual auction rate securities litigation theme.

 

As discussed at length in the bankruptcy trustee’s June 24, 2011 complaint (here), Land America had a division (“LES”) whose purpose was to facilitate tax-advantaged land swaps. In essence, a property seller could “park” the proceeds of a land sale with LES until an appropriate land swap counterparty emerged, allowing the “exchange” to take place. The property sales proceeds were invested during the holding period. According to the complaint, beginning in about 2003, LES invested a substantial portion of the proceeds in auction rate securities. When the auction rate securities market froze up in 2008, 41% of LES’s assets were tied up in auction rate securities. The failure of the auction rate securities market eventually created a liquidity crisis for LES and for its parent company. The liquidity crisis, according to the complaint, was a substantial cause in the demise of the parent company.

 

According to the complaint, the parent company (LFG) “met its demise because the LFG and LES directors and officers failed to properly inform themselves and failed to consider and implement any timely action to mitigate the effects of the LES liquidity crisis. These failures caused LFG and its stakeholders to incur hundreds of millions of dollars in damages.”

 

As discussed in this July 8, 2011 Richmond Biz Sense article (here), the bankruptcy trustee is seeking damages of $365 million in the action , which names 21 former Land America directors and officers as defendants. The article quotes sources as saying that “the purpose of the suit is to trigger insurance policies that protect executives and directors in such instances.” 

 

Though the lawsuit itself may be an unremarkable bankruptcy-related effort to snare D&O insurance proceeds for the benefit of the bankruptcy estate, the allegations themselves represent an interesting variation from the usual action rate securities allegations. The typical auction rate securities lawsuit involves allegations by the securities buyer against the firm that sold the securities. Here the allegations are brought against the buyer’s own company officials in connection with the purchases.

 

These kinds of auction rate securities allegations are not unprecedented – as I have previously noted (for example, here), there have been prior lawsuits brought against the auction rate securities buyers rather than the sellers. The fact that these kinds of complaints are continuing to arise even critical events of the financial crisis continue to recede into the past suggests that while time may have passed, the critical effects of the crisis remain. And the lawsuits continue to mount.

 

Special thanks to a loyal reader for forwarding the news article about the Land America case.  

 

Second Circuit Rules out RICO Claims Against Securities Fraud Aiders and Abettors: One of the interesting questions is whether private claimants, foreclosed from pursuing claims against third parties for aiding and abetting securities law violation, could pursue their aiding and abetting claims against the third parties under RICO. In a July 7 decision (here), in a case captioned MLSMK Investment Company v. J.P. Morgan, the Second Circuit held that the aggrieved investors cannot pursue the aiding and abetting claims under RICO.

 

Alison Frankel has an excellent summary of the legal issues and of the holding in her July 8, 2011 article on Thompson Reuters News & Insight (here). As Frankel’s article discusses, the case has mostly drawn attention for its connection to the Madoff scandal and for its implications for the Madoff trustee’s pending claims against certain litigation targets. However, as she notes, the case does “far more” – it “forecloses the only possible route to recovery through federal court for securities investors suing defendants who help a company engage in securities fraud.” Frankel’s interesting article details the larger significance of the decision.

 

Special thanks to the several loyal readers who called this decision to my attention and for sending me a link to Frankel’s article.

 

Apologies: I would like to extend my regrets that on two occasions this part week there were duplicative email distributions in connection with a single new blog post publication. I am very sorry to have burdened anyone’s email box with duplicative email distributions. The duplicate emails were an unfortunate byproduct of an error I made in putting content up on my site for publication. It really was a rookie mistake, and even worse, I made the same mistake twice in the same week. Some readers may have found that they were unable to access the links in the initial email distributions.

 

The good news is that I know what caused the duplicate email distributions and I will take steps to try to ensure that the duplicate distributions do not recur.

 

I really feel bad about the duplicate email distributions. I really want to make it up to everyone. So what I have decided to do is to send everyone a bunch of roses. Wild roses. Please accept these flowers with my sincerest apologies.

 

 

Wild Roses

Shaker Heights, OH, Bicycle Path

July 6, 2011

In what is as far as I know the first settlement of a securities class action lawsuit brought by mortgage-backed securities investors as part of the subprime and credit crisis-related litigation wave, the parties to the Wells Fargo Mortgage-Backed Certificates securities litigation have agreed to settle the case for $125 million. The lead plaintiffs’ July 6, 2011 motion for preliminary approval can be found here, and the stipulation of settlement can be found here. A July 7, 2011 Bloomberg article describing the settlement can be found here.

 

Bank of America last week announced an $8.5 billion settlement with Countrywide mortgage-backed securities investors, but as discussed here, that settlement involved only the investors’ repurchase claims under the documents governing the securities and expressly did not  resolve investors’ separate claims with respect to the Countrywide mortgage-backed securities under the federal securities laws.

 

As detailed here, purchasers of the mortgage pass-through certificates filed their initial lawsuit in March 2009, asserting claims under Sections 11, 12 and 15 of the Securities Act of 1933 and alleging that the Certificates’ offering documents contained misrepresentations and omissions. The plaintiffs alleged that the documents misstated Wells Fargo’s underwriting processes and loan standards; falsely stated the appraisal value of the underlying mortgaged properties; and misstated the investment quality of the securities, which had been assigned the highest ratings regardless of the lower quality of the underlying mortgages.

 

In an April 22, 2010 order (here), Northern District of California Judge Susan Illston granted in part and denied in part the defendants’ motions to dismiss. She dismissed, for lack of standing, plaintiffs’ claims based relating to 37 out of the 54 referenced offerings in which the named plaintiffs had not purchased securities. She denied the motion to dismiss as to the 17 remaining offerings at issue, holding that the plaintiffs, in reliance on confidential witness testimony, had adequately alleged misrepresentations in connection with the defendants’ underwriting practices, improper appraisal practices, and the process by which the securities obtained their investment ratings. Further discussion of the dismissal motion ruling can be found here.

 

In an October 5, 2010 order (here), Northern District of California Judge Lucy Koh (to whom the case was reassigned) granted the defendants’ motion to dismiss the plaintiffs’ amended Section 12(a)(2) allegations as well as certain other factual allegations. In a separate order (here), Judge Koh granted the motion to dismiss of certain underwriter defendants. The same order also dismissed as untimely the claims pursued by additional plaintiffs as to a total of eleven additional offerings.

 

The final settlement relates to a total of 28 different offerings. The settlement has been reached on behalf of not only Wells Fargo itself and related Wells Fargo entities, but also nine offering underwriters and four individual defendants. The settlement stipulation does not indicate whether or to what extent any of the other defendants are contributing toward the settlement amount. Indeed paragraph 6 of the settlement stipulation expressly states that “other than the obligation of Wells Fargo to cause to be paid [the settlement amount] to the Escrow Agent, no Defendant shall have any obligation to make any payment into the Escrow Account.”

 

There is nothing in the settlement stipulation to suggest, one way or the other, whether or not there is  any to insurance payment or reimbursement for any portion of the settlement amounts. The operative release provisions in the stipulation recites that the release parties shall include the defendants’ “related parties” which are defined to include “insurers and reinsurers,” but there is otherwise no reference in the stipulation to any insurance payment.

 

The Wells Fargo settlement comes close on the heels of the $208.5 million settlement in the WaMu securities suit (about which refer here). But there still have been only 24 settlements out of the over 230 credit crisis-related securities lawsuits filed between 2007 and now. I have long thought that the apparent settlement logjam in the credit crisis securities litigation would eventually break and that the settlements would then quickly start to accumulate. With these two recent substantial settlements, it may be the settlements will now start to quickly pile up.

 

As I mentioned at the outset, this settlement is as far as I know the first settlement of a subprime meltdown or credit crisis-related securities class action lawsuit brought on behalf of investors in mortgage backed securities. There were squadrons of other securities lawsuits filed on behalf of various mortgage backed securities investors, many of which have survived dismissal motions in whole or in part. It may be that we will start to see settlements in the other various mortgage backed securities cases shortly.

 

I have in any event added the $125 million Wells Fargo settlement to my running list of subprime meltdown and credit crisis-related lawsuit resolutions, which can be accessed here.

 

Special thanks to a loyal reader for alerting me to this settlement.

 

Quick Hits: A number of interesting law firm memos have come across our desk in recent days here at The D&O Diary. Here’s a quick list.

 

First, the Lowenstein law firm has issued an interesting July 1, 2011 memorandum discussing the perennial issues involving D&O insurance in the bankruptcy context. The memo, entitled “Navigating the Intersection of Bankruptcy and Insurance,” can be found here.

 

Second, I have had several posts on this site discussing the U.K Bribery Act (most recently here), which became effective July 1, 2011. With respect to possible D&O insurance issues arising in connection with the Act, the Pillsbury law firm published a July 5, 2011 memo entitled “U.K. Bribery Act: Consider Your Directors and Officers Insurance?” (here).

 

Third, readers may recall my recent post discussing the phenomenon of shareholder litigation arising after a negative “say on pay” vote. The Drinker Biddle law firm has a June 2011 memo about these lawsuits, entitled “Lawsuits in the Wake of Say on Pay” (here). The Bingham McCutchen law firm also has a July 7,2011 memo on the same topic, entitled "’Say on Pay’: Shareholder ‘No’ Votes Now Leading to Derivative Actions Challenging Executive Compensation," (here).

 

In the eighth lawsuit that the FDIC has filed so far as part of the current round of bank failures, on July 6, 2011, the FDIC filed suit in the Central District of California against former IndyMac CEO, Michael Perry. The FDIC’s complaint can be found here.  

IndyMac failed nearly three years ago, on July 11, 2008, as discussed here. The FDIC’s complaint against Perry alleges that he caused over $600 million in losses by causing the bank to purchase mortgage loans in 2007, just as the mortgage marketplace was destabilizing. The complaint alleges that Perry acted negligently when he allowed IndyMac to generate and purchase $10 billion in loans when the secondary mortgage market was becoming illiquid. When IndyMac was later unable to sell the loans, the bank transferred them to its own investment portfolio, which then caused over $600 million in losses.

 

The news articles report that the Complaint alleges the “instead of enforcing credit standards, Perry chose to roll the dice in an aggressive gamble to increase market share while sacrificing credit standards.”

 

Even though its complaint against Perry is only the eighth so far during the current banking crisis, the lawsuit is the second that the FDIC has filed against former IndyMac executives. As discussed at length here, the first lawsuit the FDIC filed during the current round was filed in July 2010 against four former officers of IndyMac’s Homebuilder Division.

 

The FDIC’s concentration on IndyMac likely has something to do with the fact that the bank’s closure represented the second largest bank failure as part of the current banking crisis, following only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure). IndyMac was also one of the earliest banks to fail – it was just the fifth bank to fail during 2008, while there have been well over 300 bank failures since then. So the FDIC’s post-mortem processes may be further along on IndyMac than with respect to the many other bank failures that have followed.

 

The FDIC’s lawsuit is far from the first legal imbroglio in which Perry has become involved. As discussed here, on February 11, 2011, the SEC filed a lawsuit against Perry and two other former IndyMac officers, accusing them of “misleading investors about the mortgage lender’s deteriorating financial condition.”

 

Perry is also one of the defendants named in the consolidated securities class action lawsuit first brought in the Central District of California in 2007 by IndyMac shareholders. The shareholder suit has a long and involved history, as discussed here. On March 29, 2010, Central District of California Judge George Wu denied the defendants’ motion to dismiss the plaintiffs’ sixth amended complaint, while at the same time certifying the case for interlocutory appeal to the Ninth Circuit. Judge Wu’s order can be found here.

 

In any event, a list of the eight lawsuits that the FDIC has filed can be found on the FDIC’s website, here. As noted on the same page, as of July 7, 2011, the FDIC “has authorized suits in connection with 28 failed institutions against 248 individuals for D&O liability with damage claims of at least $6.8 billion.” Since the eight lawsuits filed so far involve only seven institutions and only 53 former directors and officers, there clearly are many more lawsuits (perhaps as many as 21 or more) the FDIC is preparing to file. In all likelihood, even further lawsuits will be approved in the future as well. All of which means that we could be heading into a period of very significant failed bank litigation.

 

Readers who scan the FDIC’s website closely will undoubtedly notice that one of the eight lawsuits has already settled. The settled case  is the lawsuit the agency filed in March 2011 in connection with Corn Belt Bank and Trust Company (about which here). As reflected in the FDIC’s May 10, 2011 motion (here), the parties settled the case. However, the court records do not reveal any of the details of the settlement.

 

The Name Game:  As far as I am aware, Michael Perry, the former Indy Mac CEO, is not related to Michael Dean Perry, who played football in the NFL, for the Cleveland Browns among others, during the 80s and 90s. According to Wikipedia (here), Michael Dean Perry had a McDonald’s hamburger sandwich named after him – the “MDP,” which was only served in Cleveland-area McDonald’s while Perry played for the Browns. As far as I am aware, the former IndyMac CEO did not have a sandwich named after him.

 

In a sweeping July 1, 2011 opinion in MBIA’s favor, the Second Circuit held that the company’s D&O insurance policies cover the investigative and special litigation expense the company incurred during a regulatory investigation of its accounting practices. This case had been closely watched in the D&O insurance community because of widespread carrier concerns over the district court’s coverage findings. The insurers had hoped for relief on appeal. But the Second Circuit’s decision, if anything, is even more expansive in favor of coverage than was the district court.  

 

Background

For the policy period February 15, 2004 to August 15, 2005, MBIA carried $30 million of D&O insurance, arranged in a primary layer of $15 million and an additional $15 million layer of excess insurance.

 

In 2001, prior to the policy period, the SEC had issued an Order Directing Private Investigation in connection with certain of insurance industry accounting practices. In November and December 2004, the SEC issued subpoenas to MBIA concerning "nontraditional products." The New York Attorney General also issued subpoenas in November and December 2004 regarding nontraditional products. Both the SEC and the NYAG issues additional subpoenas in March 2005. In spring 2005, MBIA, because of concerns about the cumulative impact in the marketplace, asked regulators to forbear from issuing additional subpoenas and agreed to comply voluntarily with informal document requests.

 

The investigation ultimately narrowed to three MBIA transactions. The first involved MBIA’s retroactive purchase of reinsurance on it guarantee of bonds issued by an Allegheny Health hospital group (knows as “AHERF”). The regulators latter contended that MBIA’s retroactive reinsurance purchase allowed MBIA to avoid recognizing a large ($170 mm) one-time loss. In the second transaction involving General Asset Holdings GP, the allegation was that MBIA transferred its risk of an investment loss to an MBIA subsidiary, allowing the parent company to avoid reporting the loss. The third transaction involved MBIA’s guarantee of securities US Airways issued to purchase aircraft. When US Airways went bankrupt, MBIA foreclosed on the aircraft, and treated the transaction as an “investment” rather than a “loss.”

 

In October 2005, MBIA submitted an offer of settlement to SEC. In the offer of settlement, MBIA undertook to retain an independent consultant to review MBIA’s accounting for the transactions. In January 2007, the SEC entered a Cease and Desist Order and the NYAG entered an Assurance of Discontinuance, both of which documents largely incorporated the company’s prior offer of settlement. Thereafter the company hired a consultant to undertake the proposed review. The independent consultant found no wrongdoing in connection with the Capital Asset and US Airways transactions.

 

In addition to the regulatory investigations, the company, as nominal defendant, was also sued in two derivative lawsuits. Prior to filing the suits, the shareholder plaintiffs had sent demand letters to MBIA asking the board to file suit against the directors and officers for the alleged wrongdoing. The company organized a demand investigative committee (“DIC”) to investigate the demands, but the DIC failed to act within the statutory time limit. The shareholders then filed suit, as a result of which the company organized a Special Litigation Committee (“the SLC”). The SLC hired an outside law firm, which investigated the derivative lawsuit allegations. Following its investigation, the SLC determined that maintaining the lawsuits was not in the company’s interest and recommended that the derivative lawsuits be dismissed. The derivative suits ultimately were dismissed.

 

MBIA claimed that it has spent $29.5 million in defending or responding to the regulatory investigations and the follow-on litigation. The primary insurer had agreed it was obligated to pay the costs associated with the SEC’s AHERF investigation and also its $200,000 sublimit for the DIC investigation. The primary insurer disputed that it was obliged to reimburse other amounts incurred. Specifically the primary insurer disputed that it was obligated to reimburse the costs associated with NYAG’s AHERF subpoena; the Capital Asset and US Airways transaction investigations; the SLC expenses; and the independent consultant’s expenses. The primary carrier reimbursed MBIA $6.4 million.

 

MBIA filed an action against the two insurers alleging breach of contract and seeking a judicial declaration that the insurers were obligated to reimburse the company for legal fees and other costs associated with the regulatory investigations and the derivative actions. The parties filed cross motions for summary judgment.

 

In December 30, 2009 opinion (discussed here), District Judge Richard M. Berman held that the policies covered all of the investigative costs and the special litigation committee counsel’s expenses, but that they did not cover the independent consultant’s post-settlement investigation. The parties cross appealed.

 

The July 1 Second Circuit Opinion

In a 43-page July 1, 2011 opinion for a three-judge panel of the Second Circuit, Southern District of New York Chief Judge Loretta Preska (sitting by designation) affirmed the district court’s holdings finding coverage for the investigative expenses and for the special litigation committed expenses. However, the Second Circuit reversed the district court with respect to the independent consultant’s expenses, holding that the policies covered this category of expense as well. In short, the Second Circuit found for MBIA with respect to all items in dispute.

 

The insurers argued that NYAG’s AHERF subpoena did not represent a covered “Securities Claim” within the meaning of the primary policy. The primary policy defined a “Securities Claim,” inter alia, 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.”

 

The Second Circuit agreed with the district court’s “sensible intuition that a businessperson would view a subpoena as a ‘formal or informal investigative order’ based on the common understanding of these words,” adding that in any event a “subpoena is a ‘similar document’ to those listed the definition of a ‘Securities Claim’ because it is similar to other forms of investigative demands made by the regulators.” The Court rejected the insurer’s “crabbed view” that a subpoena is a “mere discovery device” that is “not even ‘similar’ to an investigative order.”  Rather, it is the “primary investigative implement in the NYAG’s toolshed.”

 

The coverage debate with respect to the Capital Asset and US Airways transactions was whether or not the transactions fell within scope of the SEC’s formal order and the NYAG’s AHERF subpoena. The insurers had argued that descriptive limitations in the formal order’s caption put these matters outside the scope of the SEC’s order and NYAG subpoena. The Second Circuit rejected this argument holding that the order “announced a broad but definite investigative scope that includes these transactions.” It reached a similar conclusion with respect to the NYAG subpoena.

 

In addition, the Second Circuit rejected the insurers’ arguments that because the investigative documents connected with these matters were produced voluntarily by oral request rather than by subpoena or other formal process, there was no coverage in connection with the related investigation. The Second Circuit found this argument “meritless” since the investigations were connected with the formal order. The Second Circuit added that “insurers cannot require that as an investigation proceeds, a company must suffer extra public relations damage to avail itself of overage.”

 

The Second Circuit also rejected the insurers’ argument that the SLC expenses were not covered. The insurers had argued that the SLC was “independent” of MBIA and therefore was not an insured person under the policy. The Second Circuit observed that “MBIA formed the SLC to determine MBIA’s response to this litigation, and the SLC decided to terminate the litigation. The SLC entered appearances for MBIA and filed motions to dismiss on it behalf in both the state and federal cases.” Because “the dismissal of the suits was MBIA’s decision, undertaken pursuant to the powers granted to MBIA under Connecticut law,” the Second Circuit rejected the insurers’ argument that the SLC was not an “Insured Person” under the policy.

 

The Second Circuit further  rejected the insurers’ argument that because the SLC was required by law to operate “independently” of MBIA, it took on a separate identity and operated separately from MBIA. The Second Circuit characterized this as “sleight of hand,” because “independent” in this context means “independence of judgment,” a “lack of conflict of interest.” The Court noted that “independence of judgment does not generate a new source of authority to terminate derivative litigation; that authority is still exercised by the corporation, which can only act through its agents.”

 

Similarly, the Second Circuit rejected the insurers’ attempt to rely on the $200,000 sublimited coverage for investigative costs. The Court found that this sublimit related solely to pre-litigation demands. However the SLC’s activities were, consistent with Connecticut law, post-litigation, as a result of which the operative policy provisions were the general policy provisions relating to litigated matters, rather than the narrow sublimit relating to pre-litigation demands.

 

Finally, the Second Circuit rejected the insurers’ argument that against coverage for the post-settlement consultant’s investigation expenses. In a highly fact-based analysis, the Court determined that the insurers had been given adequate notice of these expenses and that MBIA’s provision of information relating to these expenses had not violated any of its notice or settlement consent obligations under the policy.

 

Discussion

The Second Circuit’s MBIA opinion is an important decision addressing many recurring D&O insurance coverage issues, Because of the Second Circuit’s reasoning and the breadth of its language, policyholders will undoubtedly seek to rely heavily on this opinion in connection with the perennial issues such as coverage for costs associated with responding to a subpoena and special litigation committee expenses.

 

The Second Circuit’s opinion largely mirrored the district court with respect to the issue of the policy’s coverage for costs associated with responding to the NYAG’s subpoena – although even there, policyholders may find the Second Circuit’s language useful.

 

But the Second Circuit’s reasoning on the question of coverage for the SLC expenses goes further than the district court did. Judge Berman had found coverage for the SLC’s outside counsel’s expenses largely because of his specific factual determination that the SLC’s counsel had appeared on behalf of MBIA to have the derivative suits dismissed. The Second Circuit’s logic was more basic, having to do with the fundamental character of the SLC and its relation to the company under Connecticut law. The Court’s rejection of the insurers’ argument that the SLC was “independent” of the company seems particularly critical.

 

Another aspect of the opinion that many policyholders may find helpful is the section where the Second Circuit found coverage for the company’s expenses incurred in voluntarily providing investigative material to the regulators. Companies are often fighting with carriers over whether there is coverage for voluntary or cooperative efforts, which are often undertaken in an effort to fend off more formal regulatory action. Insurers can expect to have quoted back to them frequently the Second Circuit’s words that “the insurers cannot require that as an investigation proceeds, a company must suffer public relations damage to avail itself of coverage a reasonable person would think was triggered by the initial investigation.”

 

From the carrier’s perspective, this is a very fact-specific opinion that in many ways is largely a reflection of the unusual circumstance that all of the investigation followed the SEC’s issuance of its very broad formal investigative order. Much of the coverage analysis, including for example the court’s discussion of coverage for the voluntarily produced information, is merely  a reflection of the fact that the disputed expenses arose  after the formal order of investigation.

 

The much more frequent dispute involves costs incurred before the issuance of a formal order of investigation, a circumstance that was not involved here.  In that respect, it is critical to note that as broad as the Second Circuit’s opinion is, the decision has nothing to say concerning the recurring question of policy coverage for expenses incurred in connection with an informal investigation.

 

In addition to being fact-specific, the Second Circuit’s analysis, particularly in connection with the SLC expenses, is very law-specific too, depending narrowly on the details of Connecticut corporate law. Carriers can be expected to argue when the laws of other jurisdictions are applicable, the Second Circuit’s determination in the MBIA case is inapplicable.

 

While there are ways that the carriers can try to narrow the application of the Second Circuit’s MBIA decision, the fact is that this decision is a strong one for policyholders. This may be one of those instances where the carriers, if they really didn’t intend to cover these things and really don’t want to cover these things, may have to go back and look at their policy language. But since the general marketplace trend recently has been toward increased investigative cost coverage, the carriers may find that they lack sufficient marketplace room to maneuver on these issues from a policy language standpoint.

 

UPDATE: Joe Monteleone has an interesting July 6, 2011 post about the SLC portion of the Second Circuit’s MBIA opinion on his The D&O E&O Monitor blog, here.

 

Same Name, Different Reference: I may be the only one that cares, but there is a Camaroonian soccer player named Stephane Mbia, who plays in the French top flight soccer league, League 1, for the Olympique de Marseille club.