On August 23, 2011, a three-judge panel of the Second Circuit in an opinion by Judge Barrington D. Parker affirmed the dismissal of the subprime-related securities lawsuit that had been brought against Regional Financial Corporation and certain of its directors and officers. A copy of the Second Circuit’s opinion can be found here.

 

Background

As reflected in greater detail here, the plaintiffs first filed a securities class action lawsuit in the Southern District of New York against Regions on April 1, 2009. The plaintiffs represented investors that had purchased securities in the company’s $345 million April 2008 trust preferred securities offering. The defendants included the company, certain of its directors and officers, its offering underwriters, and its auditor.

 

The plaintiffs alleged that the April 2008 offering documents were false and misleading because they incorporated by reference financial statements that overstated goodwill associated with Regions Financial’s 2006 acquisition of AmSouth and underestimated loan loss reserves associated with the AmSouth’s declining mortgage lending porfolio. Among the financial statements incorporated into the offering documents was the company’s 2007 Form 10-K.

 

The complaint alleged that the company "did not write down any of the massive goodwill" it recorded in its 2007 10-K "despite growing evidence indicating that serious problems existed at the time of the acquisition." The complaint also alleges that Regions "only marginally increased its loan loss reserves" despite "the high risk of loss inherent in its mortgage loan portfolio." The defendants moved to dismiss on the grounds that the plaintiffs had failed to allege any actionable misstatements or omissions.

 

As discussed here, in a May 10, 2010 opinion, Southern District of New York Judge Lewis Kaplan granted the defendants’ motions to dismiss, holding that the statement about goodwill and the loan loss reserves represented opinions that were not actionable because the complaint failed to allege that defendants did not honestly hold those opinions at the time they were expressed. The plaintiffs appealed.

 

The Second Circuit’s Opinion

The Second Circuit affirmed Judge Kaplan’s dismissal of the trust preferred securities investors’ securities lawsuit. With respect to the allegations regarding the statement concerning goodwill, the Second Circuit observed that “as Judge Kaplan correctly recognized, plaintiffs’ allegations regarding goodwill do not involve misstatements or omissions of material fact, but rather a misstatement regarding Regions’ opinions.”

 

In concluding that the plaintiffs had not adequately alleged actionable misstatements regarding misstatements or omissions regarding goodwill, the court said that

 

Plaintiff relies mainly on allegations about adverse market conditions to support the contention that defendants should have reached different conclusions about the amount of and the need to test for goodwill. The complaint does not, however, plausibly allege that defendants did not believe that statements regarding goodwill at the time they made them.

 

The Second Circuit went on to conclude that the plaintiffs’ allegations regarding loan loss reserves “suffer from the same deficiencies as those regarding goodwill.” The court approvingly cited Judge Kaplan’s statement that “determining the adequacy of loan loss reserves is not a matter of objective fact”; rather, loan loss reserves “reflect management’s opinion or judgment about what, if any, portion of amounts due on the loans ultimately might not be collectible.” Because the plaintiff failed to allege that the defendants’ opinions were “both false and not honestly believed when they were made,” the loan loss reserve allegations also fail to state a claim.

 

Discussion

The Second Circuit’s opinion in the Regions case is the latest in a series of decisions in which the appellate courts have affirmed the district court’s dismissals of subprime or credit crisis-related securities class action lawsuits. Earlier example include the NovaStar Financial case (about which refer here), the Centerline Holdings case (refer here),  the Impac Mortgage Holdings case (refer here) and the HomeBanc case (refer here).  At this point, it seems clear the appellate courts are reluctant to setting aside the dismissal motion rulings of the district courts in these cases.

 

What makes the Regions Financial trust preferred securities case noteworthy and even interesting is that the case was dismissed, and the dismissal was affirmed, while related complaints involving many of the same facts have actually survived dismissal motions. In particular and as noted here, in June 2011, Northern District of Alabama Judge Inge Prytz Johnson denied the motions to dismiss in the securities class action lawsuit filed on behalf of Regions Financial’s shareholders.

 

The Northern District of Alabama lawsuit also alleges that the company had failed to recognize the impairment of the goodwill associated with the AmSouth merger. As I discussed in my prior post about Judge Johnson’s ruling, she expressly recognized that Judge Kaplan had previously dismissed the Southern District of New York lawsuit filed on behalf of the trust preferred securities investors. However, she differentiated the allegations in the case in her court based on the plaintiffs’ allegations made based on the statements of confidential witnesses.

 

Judge Johnson concluded that the plaintiffs in the case before her have “pled many facts showing that the defendants had information that did not support defendants’ opinions.” Among other things, she cited the statements of the confidential witnesses “showing how defendants improperly handled and classified loans, defendants were aware of the collapsing commercial real estate in Florida yet continued to push for more growth there, and continued to ignore [internal] reports signaling a negative risk-adjusted bottom line.

 

Judge Johnson concluded that the plaintiffs has sufficiently alleged that the company’s loan loss reserves were false and misleading, citing the testimony of several confidential witnesses that “defendants mishandled loans in order to manipulate their financial reporting numbers.” Because the loan loss reserves impacted the company’s reported income (which was the measure by which the company tested its goodwill), Judge Johnson concluded that the plaintiffs had adequately alleged that the company’s goodwill was “overstated, false and misleading.”

 

On August 23, 2011, Judge Johnson denied the defendants’ motion for reconsideration, rejecting the defendants’ argument that the Supreme Court’s recent decision in the Janus Capital case required a different result. Judge Johnson’s August 23 order can be found here.

 

In addition, and as noted here, the plaintiffs in the separate shareholders’ derivative lawsuit filed in Alabama Circuit Court against Regions Financial, as nominal defendant, and certain of its directors and officers, also survived a motion to dismiss. However, it should be noted that the Alabama court was determining only whether or not the requirement for pre-suit demand was excused based on the circumstances alleged.

 

Finally, and just to complete the picture, in March 2010, the motions to dismiss was also denied in the Regions Financial ERISA action, about which refer here.

 

While the differences in the outcome between the New York lawsuit and the other lawsuits can be accounted for based on differences in the claims asserted and the specific matters alleged, there is also a sense in reading through all of these opinions that the outcomes may also be understood based on the respective court’s starting points. As I noted in my prior posts discussing the prior dismissal motions denials, for the other judges, the context matters, but for Judge Kaplan (and now for the Second Circuit) the context is irrelevant. There is also a sense that the more geographically proximate the decisions maker to the locus of the corporate defendant and its woes, the less sympathetic the courts are to the defendants’ position.

 

In any event, I have adjusted my tally of the dismissal motion rulings in subprime-related securities suits to reflect the Second Circuit’s opinion. The tally can be accessed here.

 

Special thanks to Douglas Henkin of the Milbank law firm for providing me with a copy of the Second Circuit’s opinion. Milbank represented the Underwriter defendants before the Second Circuit.

 

Deutsche Bank Subprime-Related Securities Suit Survives Dismissal Motion Ruling: In an August 19, 2011 opinion, here, Southern District of New York Judge Deborah Batts largely denied the motion to dismiss in the subprime-related securities suit filed against Deutsche Bank and certain of its directors and officers.

 

As discussed here, several groups of investors, who had purchased Deutsche shares in a series of offerings during the period 2005 to 2007, filed lawsuits asserting claims that the offering materials contained material misrepresentations and omissions in the associated offering documents. The plaintiffs basically alleged that the bank had misrepresented its exposure to residential mortgage backed securities and collateralized debt obligations. The various cases were later consolidated before Judge Batts and the defendants moved to dismiss.

 

In her August 19 order, Judge Batts granted the motion to dismiss as to stock offering from October 2006. However, Batts left intact claims relating to five other offerings, or gave the plaintiffs a chance to replead their allegations.

 

I have also added the Deutsche Bank decision to my tally of subprime related dismissal motion rulings.

 

On August 22, 2011, when the FDIC filed a lawsuit related to the collapse of Silverton Bank, which is Georgia’s largest failed bank, the named defendants included not only bank officers that the regulators allege are responsible for the bank’s failure, but also the bank’s former outside directors and even the bank’s D&O insurers. A copy of the FDIC’s complaint, which was filed in the Northern District of Georgia, can be found here. Scott Trubey’s August 22, 2011 Atlanta Journal Constitution article about the lawsuit can be found here.

 

In addition, and as discussed further below, on August 23, 2011, the FDIC separate filed an action in the District of Arizona against certain directors and officers of the failed First National Bank of Nevada.

 

When Silverton failed on May 1, 2009, it had assets of over $4 billion. Prior to its collapse, Silverton had done business as a “banker’s bank” and had been chartered to do serve the needs of community financial institutions, by providing correspondent and clearinghouse services. The bank eventually expanded into residential and commercial real estate acquisition and development loans, which it accomplished through “participations” in which the Bank shared funding and risk with other banks.

 

The FDIC’s complaint alleged that its case represents “a text book example of officer and directors of a financial institution being asleep at the wheel and robotically voting for approval of transactions without exercising any business judgment in doing go.” The complaint, which seeks recovery of damages of $71 million, asserts claims against the individual defendants for negligence, gross negligence, breaches of fiduciary duty and waste.

 

The individual defendants named in the lawsuit include not only the bank’s former President and CEO and two other former bank officers, but also 14 additional former outside board members. In naming the outside directors, the FDIC stressed that what makes this case “so unique and troubling” is that the bank’s board was not composed of “ordinary businessmen” but, rather, in view of the bank’s business as a banker’s bank, of individuals who were all CEOs or presidents of other community banks. These outside board members “by virtue of their elevated positions within their own banks, were more skillful and possessed superior attributes in relation to fulfilling their duties” than “others who may serve in this capacity.

 

The complaint alleges that the individual defendants allowed the bank to pursue a strategy of rapid expansion, particularly with respect to commercial real estate lending, just as the economy started to head south, and allowed the bank to continue to pursue this strategy even after the signs of economic problems began to mount. The complaint alleges that the bank’s “aggressive banking plan” was accompanied by weaknesses in loan underwriting, credit administration and a complete disregard of a declining economy, which “led to the failure of the Bank.”

 

The complaint also alleged that the individual defendants “directed the Bank on a course of expansive and extravagant spending on unnecessary items for the Bank after the economy began to decline.” The individual defendants are alleged to have “authorized the purchase of two new aircrafts, a new airplane hanger to house three large and expensive airplanes, and a large and lavish new office building.”

 

In addition to naming the former officials of the failed bank as defendants, the complaint somewhat unconventionally also names as defendants the bank’s two D&O insurers.

 

At the time the bank failed, it carried a total of $10 million of D&O insurance, arranged in two layers consisting of a primary layer of $5 million and an additional $5 million layer excess of the primary. The complaint relates that when the binder for the relevant primary policy was issued on March 3, 2009 (that is, less than two months before the bank failed), the binder listed ten endorsements, including an endorsement containing the so-called regulatory exclusion (for background about the regulatory exclusion, refer here). However, when the primary carrier issued the policy on April 1, 2009, only seven of the ten endorsements that had been listed on the binder were included on the D&O policy. Among the endorsements that were listed on the binder that were not included on the issued policy was the endorsement with the regulatory exclusion.

 

On the afternoon of May 1, 2009 (that is, the day Silverton was closed), a representative of the primary carrier sent an email message that he “had noticed that the Regulatory Endorsement was on the Binder but left off the policy in error,” and attached to the email an endorsement with the Regulatory Endorsement dated May 1, 2009 but with an effective date of March 9, 2009. The complaint characterizes this as a “last minute attempt to unilaterally change the terms of the Policy.” The complaint further alleges that policy issuance terminated the binder.

 

The FDIC’s complaint seeks a judicial declaration that the regulatory exclusion is not a part of the primary or excess policy, and that the Insured vs. Insured exclusion, on which the carriers also purport to rely to deny coverage, does not preclude coverage for the claim. (Refer here for a discussion of the issues surrounding the applicability of the Insured vs. Insured exclusion in connection with a claim involving the FDIC as receiver.)

 

Discussion

The FDIC’s lawsuit against the former Silverton directors and officers is not the first lawsuit filed as part of the current round of bank failures in which the FDIC has included outside directors as defendants. For example, the lawsuit the FDIC recently filed in connection with the collapse of Haven Trust included the failed bank’s former outside directors as defendants, as discussed here.  The FDIC seems to have particularly targeted the outside directors of this failed bank, owing to the unusual circumstance that former directors were all themselves also senior executives of other banking institutions. The FDIC clearly intends to try to bootstrap this fact in order to argue that these specific directors should be held to a higher standard of care. (My recent post on issues surrounding questions of bank director liability can be found here.)

 

Upon reflection of the unique circumstances by which these directors came to be on the Silverton board, it occurs to me that the FDIC may have certain additional motivations in pursuing claims against the former outside directors of the bank. The parrticular circumstance I have in mind is the fact that each of these outside directors of Silverton was also an officer of another banking institution. To the extent these individuals were serving on the Silverton board at the direction of the sponsoring institution, these individuals potentially could have coverge for claims in connection with their Silverton board service under the outside director liability provisions of their sponsoring bank’s D&O insurance policies. I am expressing no views on whether or to what extent such coverage actually would be available, nor could I without further information about their sponsoring banks’ D&O insurance policies and about the circustances by which they came to be on the Silverton board. My purpose in noting the observations here is simply to suggest this possible additional motivation that the FDIC might have in pursuing claims against these particular outside directors. In any event, the outside director liability coverage, if any, under the sponsoring company’s D&O insurance may be limited to outside director service on nonprofit boards.

 

The FDIC’s inclusion of the D&O insurers as parties defendant in the liability lawsuit is unorthodox to say the least. One the one hand, as the complaint recites, the D&O insurers have denied liability for the FDIC’s claim, which might set the predicate for a more conventional (and separate) declaratory judgment action against the carrier. From reading the complaint, it seems that the primary carrier’s belated attempt to correct the omission of the regulatory exclusion from primary policy may explain the FDIC’s more aggressive approach here.

 

Whatever else may be said about the FDIC’s inclusion of the insurers as defendants in this lawsuit, the alleged facts provide a veritable parable about the importance of making sure that the issued policy matches the terms of the binder. It will be interested to see how the Court addresses what allegedly appears to be a policy issuance error, as the insurance arrangement to which the parties had agreed unquestionably was intended at the time of contract formation to include a regulatory exclusion.  For that matter, it will be interested to see whether the Court permits the coverage action to remain joined with the underlying liability action, and whether or not the Court will permit the two related actions to go forward at the same time.

 

FDIC Also Files Lawsuit Against Former Officials of First National Bank of Arizona: In addition to its new lawsuit against the Silverton officials, the FDIC also filed a separate lawsuit in August 23, 2011 in the District of Arizona  against two former directors and officers of First National Bank of Arizona,  which had been one of the sister banks of First National Bank of  Nevada until they merged shortly before FNB Nevada failed. FNB Nevada was among the first banks to fail as part of the current round of bank falures when it failed on July 25, 2008. A copy of the FDIC’s complaint in the case can be found here.  

 

The complaint alleges breach of fiduciary duty, negligence and gross negligence against the former officers, asserting that they cause the bank to sustain "losses from the unsustainable business model they promoted for FNB Arizona’s loan portfolio — a model that depended on real estate values rising indefinitely and low defaule rate." The complaint alleges that "when the real estate market collapsed and default rates skyrocketed, FNB Arizona was left holding millions of dollars of bad loans it could not sell." The FDIC alleges that as a result of the defendants’ conduct, the FDIC has sustained losses in excess of $193 million.

 

 

The Current FDIC Failed Bank Lawsuit Count: These complaints represent the tenth and eleventh that the FDIC has filed against former directors and officers of a failed bank as part of the current round of bank failures. The Silverton lawsuit represents the third so far in Georgia. There undoubtedly will be more lawsuits to come, as the FDIC has indicated on its website that as of August 4, 2011, it has authorized suits in connection with 30 failed institutions against 266 individuals for D&O liability with damage claims of at least $6.8 billion. With the Silverton Bank and FNB Nevada lawsuits, the FDIC has now filed suits in connection with eleven failed institutions against 77 individuals. Even just taking account of the lawsuits that have already been authorized, there are many more suits to come, and undoubtedly even more lawsuits will be authorized.

 

But with the back to back arrival of these two lawsuits in the space of two days, both involving banks the failed early on the the bank failure wave, there is a sense that the long lagtime associated with the FDIC’s lawsuit filings may be over. For what it is worth, both of these new complaints both involve the same lawfirm on behalf of the FDIC, the Mullin Hoard & Brown law firm of Amarillo, Texas.

 

It is probably worth noting that the FDIC’s lawsuit is not the first to be filed against the former directors and officers of Silverton. As reflected here, the bank’s defunct parent company earlier this year filed suit against the bank’s former CEO and its former accountant and accounting firm, seeking about $65 million in damages.

 

Special thanks to the several readers who sent me copies of the Silverton complaint and related links. Special thanks also to the loyal reader who sent me a copy of the FNB Nevada lawsuit as well.

 

Number of Problem Banks Declines: According to the FDIC’s latest Quarterly Banking Profile, released on August 23, 2011 (refer here), the number of problem institutions during the second quarter of 2011 declined to 865, from 888 at the end of the first quarter of 2011. This reduction represents the first quarterly decline in the number of problem institutions in 19 quarters. (The FDIC identifies banks as problem institutions as those that are graded a 4 or a 5 on a 1-to-5 scale as a result of “financial, operational, or managerial weaknesses that threat their continued financial viability.” The FDIC does not release the names of the individual problem institutions.)

 

While the quarterly decline in the number of problem institutions is good news, the latest quarterly figure still represents a significant number and percentage of all banks. The 865 problem institutions represents about 11.5% of the 7513 of all reporting institutions. This is slightly lower than the 11.7% of all banks that were rated as problem institutions at the end of the first quarter.

 

With the continued weakness in the sector, the number of failed and troubled banks will continue to remain a concern for some time to come.

 

The FDIC’s August 23, 2011 press release regarding the latest Quarterly Banking Profile can be found here.

               

One of the hottest current topics in the field of D&O insurance is the question of coverage for costs incurred in connection with regulatory investigations. As discussed in the following guest post from Paul Ferrillo, who is Of Counsel and a senior litigator in the Securities Litigation/Corporate Governance Group of Weil Gotshal & Manges, LLP, these issues are likelier to become even more important as the Dodd-Frank whistleblower rules go into effect.

 

I would like to thank Paul for his willingness to publish his article on this site. (Paul’s article previsously appeared in Propery & Casualty 360.) I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

 

 

Here is Paul’s guest post:

 

 

            Though most in-house risk professionals and in –house corporate lawyers do not exactly relish the opportunity to review their company’s directors and officers (“D&O”) liability insurance policy, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), coupled with an increasingly active regulatory environment, should cause all companies (especially smaller ones) to consider the scope and breath of their D&O policies. Particularly important under Dodd-Frank is whether and how their policies will cover internal corporate investigations caused by whistleblowers out to recover a bounty (10 to 30 percent) on potential penalties collected by the SEC in excess of $1 million. Should these sorts of complex internal investigations be covered under the Company’s pre-existing directors and officers liability insurance coverage? Here are the considerations, and here are some potential answers.

 

 

            Scope of D&O Coverage for Corporate Investigations – Then and Now

 

 

            Before we begin, its probably important to re-emphasize why this question is important. Simply put, corporate investigations set in motion by a whistleblower or regulatory authorities (SEC, DOJ, and/or the states attorney generals), can lead to a whole host of problems for a company and its directors and officers, including: (1) potential fines and penalties, (2) potential criminal repercussions for individuals who are accused of potential wrongdoing, and (3) follow-on civil litigation commenced by the plaintiff’s bar seeking to take advantage of potentially damaging facts that came to light as a result of the investigation.  It also goes without saying that internal corporate investigations are expensive to conduct, including not only the associated legal expenses, but also IT expenses as well, which are occasioned by the need to review email and other soft-copy documents that might be relevant to the investigation. A competently handled investigation where no wrongdoing is found may cause regulators to walk away satisfied that the company “did the right thing.” and will many times will add no fodder to the follow on civil litigation A poorly handled investigation can lead to disastrous consequences for all involved, especially the company who has to ultimately “foot the bill.”

 

 

            Prior to 2011, D&O coverage for certain categories of internal corporate investigations was relatively standard in most primary D&O policies. Individual directors and officers were generally covered (depending, of course, upon the primary carrier and policy form in question) for both informal inquiries and requests for information, and civil, criminal, administrative or regulatory investigations commenced by either the issuance of a Target Letter or Wells Notice, or after the service of a subpoena. The company was almost never covered, except when it was named (along with an individual directors and officer) in a “formal”[1] SEC investigation (and then only when the D&O policy at issue specifically allowed for such coverage). No coverage, at all, existed for the Company for responding to “informal” inquiries and requests for information from the SEC.

 

 

            The New Threat – More Investigations – More Risk – More Expense

 

 

            On May 25, 2011, the SEC adopted final rules implementing the whistleblower provisions of Dodd-Frank. Though these rules are somewhat complex, for the corporate risk professional they can be broken down as follows. Dodd-Frank provides that (1) an eligible individual (e.g. an employee of a company), (2) who “voluntarily” provides the SEC (3) with “original information” about a potential violation about a violation of the federal securities laws, (4) that ultimately leads to a “successful” enforcement action, (5) may be entitled to receive a cash award ranging from 10% to 30% of the total monetary sanctions, in excess of $1 million, recovered by the SEC in a civil or judicial action.[2]

 

 

            Importantly, despite the fact that the potential whistleblower might just have easily reported the potential wrongdoing through the company’s own internal reporting and compliance program, the whistleblower provisions of Dodd-Frank do not require him or her to first do so. Instead, the whistleblower may go directly to the SEC in order to be “first in line” to receive the potential bounty. The new rules enacted by the SEC do give the whistleblower an “incentive” to first report internally by (1) allowing him up to 120 days to report such information to the Commission after he or she first reports internally (and still retain her or her place in line to receive the bounty), and (2) allowing for the attribution to the whistleblower who first reports internally all subsequently reported information reported by the Company following its own internal investigation.

 

 

            These reporting provisions, along with the monetary incentives of Dodd-Frank present the company at issue with a number of potential challenges: (1) more internal investigations as a result of the clear financial incentives of employees and others to “blow the whistle” (in fact, there are reports already that the SEC has received an increased number of tips (often made with supporting documentation) since the passage of Dodd-Frank[3], (2) the potential need to quickly perform an internal investigation should the whistleblower report to the Company first (knowing that he or she has 120 days to report to the SEC). Indeed it may be in a company’s interest to self-report to the SEC before the SEC contacts it first, and/or (3) in any event, be ready to perform the investigation upon first contact with the SEC should the whistleblower choose to bypass internally reporting procedures.

 

 

            Corporate Investigations D&O Coverage Today

 

 

            Prior to 2011, companies generally had no insurance mechanism to cover a costly internal investigation triggered by a regulatory inquiry. Today that is not the case. One large insurer has created a stand-alone product that potentially covers a company for a wide variety of potential corporate investigations., whether triggered by internal reporting through a company’s internal compliance program (with subsequent self reporting of a potential securities law violation), or triggered by a direct formal or informal written or telephonic communication with the SEC requesting information, documents or interviews.[4] There are rumors that other companies will soon follow suit and provide similar, if not alternative products or solutions, to cover the costs of internal corporate investigations triggered by regulatory inquiries.

 

 

            A stand-alone corporate investigations D&O policy has a clear advantage for many companies seeking to insure for corporate investigations, and a compelling advantage from the stand-point of a director or officer of a public company. Since it is “stand-alone,” monies spent under an “investigations”  policy will not reduce the limits of the company’s pre-existing directors and officers insurance coverage. Simply put, separate dedicated limits for a corporate investigation is the best solution.

 

 

            If for cost reasons, a stand-alone product is not affordable, but a carrier agrees to attach or “blend” corporate investigations coverage directly into the primary directors and officers policy, the directors and officers should insist either (1) that company only purchase such coverage with a significant “sublimit,” (meaning that only a portion of the primary policy can be used for a corporate investigation), or (2) purchase much higher D&O limits from a “tower of insurance” perspective, knowing that “on any given Sunday” a complex investigation could eat up millions of dollars of the tower. For many companies, it may be a good idea to consult with an insurance broker or advisor that has a high degree of experience in insuring public companies, as they can often help inform and effectuate some of the corporate investigations D&O insurance strategies laid out above.

 

[1] A “formal” SEC investigation is one commenced by the issuance of a Formal Order of Investigation by the SEC. Formal orders of investigation can now be issued by the Director of Enforcement of the SEC, or by certain senior officials of the SEC to whom he has delegated such authority. The SEC can also make “informal” inquiries of company’s, seeking both documents and information on specific issues which they are interested in investigating.

[2] For a thorough review of the whistleblower provisions of Dodd-Frank, see June 3, 2011 Weil Alert: “SEC Disclosure and Corporate Governance: Dodd Frank Update: SEC Adopts Whistleblower Rules.

[3] In fact, SEC Chairman Mary Shapiro noted publicly on May 25, 2011 in an SEC Open Meeting that “Already, the whistleblower provision of the Dodd-Frank Act is having an impact. While the SEC has a history of receiving a high volume of tips and complaints, the quality of tips we have received has been better since [Dodd-Frank] became law. And we expect this trend to continue.” Refer here.

[4] This product is called the Chartis Investigation Edge, refer here.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

Background

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

 

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

 

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

 

Relevant Policy Language and the Parties’ Respective Positions

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

 

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

 

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

 

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

 

The Court’s Decision

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

Background

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

 

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

 

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

 

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

 

The August 5 Opinion

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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