As the current Supreme Court term gets ready to draw to a close, many court observers are awaiting the Court’s decision in the Janus Capital case (background here). With the opinion due to be released any day now, I am pleased to be able to publish here a guest post from Brian Lehman, who is an associate at the Bernstein Liebhard law firm, in which Brian presents his prediction of how the Court will decide the Janus Capital case. Because the release of the Court’s decision may be imminent, I am presenting this guest post in the form of a special Friday afternoon edition.

 

I would like to add by way of introduction that I am always happy to accept proposed guest blog posts from responsible commentators. Please let me know if you think you would like to publish a guest post on this site.

 

 

Here is Brian’s guest post:

 

 

 

Predicting how the Supreme Court will decide a particular case can be a fool’s errand, but that’s also what makes it fun. So, as the securities litigation bar awaits the Court’s decision in Janus Capital v. First Derivative Traders, I offer a doozy: In Janus, Justice Thomas will defer to the position taken by the Securities and Exchange Commission (SEC) in its amicus brief and author a majority opinion holding that a person or company “makes” a false statement under Rule 10b-5 when “writing or speaking it, providing false or misleading information for another to put into it [e.g., a prospectus] or allowing it to be attributed to him.” Only Justice Scalia will dissent. And the decision will be heralded as the third opinion this term favoring securities class action plaintiffs (Matrixx and Halliburton are the other two).

 

 

By way of background, Janus Capital Group, Inc. is a publicly traded asset management firm that sponsors a family of mutual funds. The investment advisor to the funds is Janus Capital Management LLC. Investors sued the firm and the advisor on the ground that they knowingly or recklessly made false statements about how the funds would be operated. 

 

 

According to the complaint, the funds’ prospectuses created the misleading impression that the firm and advisor would implement measures to curb market timing in the fund when in fact, “secret arrangements with several hedge funds” allowed market timing transactions. The lead plaintiff seeks to represent a class of investors who purchased shares of the firm’s stock at inflated prices starting in 2000 and ending in 2003, when the market timing agreements were publicly revealed and the stock’s price dropped significantly. 

 

 

Rule 10b-5 states that it is unlawful for “any person, directly or indirectly” to “make any untrue statement of a material fact . . . in connection with the purchase or sale of any security.” In the lower courts, the advisor argued, among other things, that it did not make any of the false statements because they were not attributed to the advisor in the prospectus.

 

 

 In Janus, there are two questions that must be answered. First, what does it mean to “make” a statement? Second, once that standard has been established, is it plausible that the advisor made the statements based on the factual allegations in the complaint? 

 

 

My prediction only addresses the first question, and here is my reasoning. As Tom Goldstein at SCOTUSblog wrote last Thursday: “For the December sitting, only the Janus securities fraud case is outstanding. Justice Thomas is almost certainly the author, because he is the only Justice who does not yet have an opinion from that sitting.” Goldstein has explained before: “By tradition, the Court attempts to evenly distribute majority opinions, both within individual ‘sittings’ and across the entire Term.” (A “stat pack” that shows the distribution of decisions is available here.)

 

 

The length of time that it has taken for the Court to issue its decision indicates that there will be a dissent. The other cases argued in December had opinions issued in 109 days on average. Janus is now at 186 days and counting.

 

 

Many lawyers might think if Justice Thomas is writing the opinion and there is a dissent, then the defendants are going to win – perhaps a classic 5-4 split with Justice Kennedy in the majority? But yesterday, Justice Thomas issued a decision signaling that something else could be afoot.

 

 

The issue in Talk America, Inc. v. Michigan Bell Telephone Company was whether a regulation passed by the Federal Communications Commission (FCC) required local exchange carriers to make their existing entrance facilities available to competitors at cost-based rates in certain circumstances. In holding that the regulation did require this, Justice Thomas wrote: “As we reaffirmed earlier this Term, we defer to an agency’s interpretation of its regulations, even in a legal brief, unless the interpretation is plainly erroneous or inconsistent with the regulations or there is any other reason to suspect that the interpretation does not reflect the agency’s fair and considered judgment on the matter in question” (quotations marks and alterations omitted).

 

 

Justice Thomas quoted and relied upon Chase Bank USA, N. A. v. McCoy, which was issued on January 24, 2011, and Auer v. Robbins, a Supreme Court decision from 1997 and the reason why deferring to an agency’s interpretation is called “Auer deference.”

 

 

Rule 10b-5 is, of course, a regulation passed by an agency – the SEC. And the SEC set forth its position on how to interpret Rule 10b-5 in its amicus brief: “The Commission has construed the term ‘make’ as providing for primary liability when a person ‘creates’ a misrepresentation either by writing or speaking it, providing false or misleading information for another to put into it, or allowing it to be attributed to him. Under Auer v. Robbins, 519 U.S. 452, 461 (1997), the Commission’s construction of its own rule is entitled to controlling weight.”

 

 

If the Justices are going to be consistent, they will either need to defer to the SEC’s interpretation of Rule 10b-5 or explain why Auer deference doesn’t apply to the SEC’s interpretation of its own rule while distinguishing Talk America and Chase Bank from Janus. Deferring to the SEC seems far more likely.

 

 

If that’s correct, then we can expect Justice Thomas to issue an opinion in Janus that will be joined by all of the Justices but one: Justice Scalia. Yesterday, Justice Scalia stated that he agreed with the result in Talk America on the ground that “the FCC’s interpretation is the fairest reading of the orders in question,” but then stated “[i]t is comforting to know that I would reach the Court’s result even without Auer.  For while I have in the past uncritically accepted that rule, I have become increasingly doubtful of its validity.” After outlining some of his concerns, Justice Scalia concluded: “We have not been asked to reconsider Auer in the present case. When we are, I will be receptive to doing so.” In contrast, the other Justices joined Justice Thomas’s opinion.

 

 

Janus looks to be the case where Justice Scalia will provide his reasons why Auer should be reconsidered. At oral argument in Janus, Justice Scalia argued against the SEC’s interpretation: “If someone writes a speech for me, one can say he drafted the speech, but I make the speech.” Counsel for the respondent (the plaintiff’s lawyer) answered, “Justice Scalia, we address the definition of ‘make’ under the SEC’s interpretation, which is entitled to deference, as being to create or to compose or to accept as one’s own.”

 

 

Justice Scalia didn’t have an immediate response to counsel’s argument that the Court should defer to the agency, but instead answered: “That – that’s not what – it depends on the context of ‘make.’ If you’re talking about making heaven and earth, yes, that means to create, but if you’re talking about making a representation, that means presenting the representation to someone, not – not drafting it for someone else to make.”

 

 

Reporters who closely follow the Supreme Court know that “Scalia doesn’t come into oral argument all secretive and sphinxlike, feigning indecision on the nuances of the case before him. He comes in like a medieval knight, girded for battle. He knows what the law is. He knows what the opinion should say.” Justice Scalia wasn’t playing devil’s advocate when he argued over what “makes” means; Justice Scalia just doesn’t agree with the SEC’s interpretation. But Justice Scalia also didn’t have an answer to the argument that the Auer deference should apply, and it is fairly uncharacteristic of Scalia not to have a response.

 

 

There is one last thing to note. At the end of January, Scalia joined the unanimous opinion in Chase Bank authored by Justice Sotomayor that held: “Under Auer v. Robbins, 519 U. S. 452 (1997), we defer to an agency’s interpretation of its own regulation, advanced in a legal brief, unless that interpretation is ‘plainly erroneous or inconsistent with the regulation.’” If Scalia is now changing his mind about Auer deference, it must be because something happened in the last four months. 

 

 

To review: Janus has taken an extraordinary amount of time to be issued, which indicates a dissent. But interpreting the word “make” is not particularly difficult regardless of whether one is in the majority or dissenting. The briefs and decisions by the lower courts have fully covered this ground.

 

 

Nor is it difficult to determine whether the allegations in the complaint give rise to a plausible claim after the word “make” is interpreted. For example, in Matrixx, the Justices unanimously determined that the allegations gave rise to a plausible claim in an opinion that was issued in a mere 71 days. 

The Justices must be disagreeing about something else. Given the amount of time that has elapsed, the issue is probably significant and perhaps something that was not fully briefed or considered by the parties. 

 

 

A disagreement over Auer deference fits perfectly. Although the press hasn’t covered it, few, if any, issues decided this term can compare to the Court’s repeated holding that courts should defer to an agency’s interpretation of its own regulation. Anyone who thinks otherwise should consider this fact: the Dodd-Frank Act alone requires 243 rulemakings by eleven agencies. 

 

 

A year ago, I had either not heard of Auer or I had forgotten about it. Within a few years, every lawyer who works for a corporation will know this case. If an environmental regulation is ambiguous, defer to the agency. If an agricultural regulation is ambiguous, defer to the agency. If an energy regulation is ambiguous, defer to the agency. Defer, defer, defer. Here is the federal government’s A-Z Index of U.S. Government Departments and Agencies –  there are a lot of them.

 

 

But, despite the importance of Auer, the argument over whether the Court should defer to the SEC has not been well-developed. The Petitioners’ merits brief on behalf of the defendants does not mention Auer; the Respondent’s merits brief mentions it three times but does not dwell on it; and the Petitioners’ reply brief responds to the case with a single footnote on page 10 of its brief. 

 

 

Moreover, the Justices were not focused on this issue at oral argument. The word “deference” was only mentioned one time at oral argument – when Justice Scalia disagreed with counsel on how to interpret the word “make.” When Curtis Gannon argued on behalf of the government, he was immediately asked by Justice Sotomayor to distill his brief into “three sentences.” He responded by arguing the merits, rather than arguing that the Court should defer to the SEC’s interpretation.

 

 

When I put all of the pieces of the puzzle together here is what I get: Justice Thomas will write the majority opinion and defer to the SEC’s interpretation of Rule 10b-5; everyone but Justice Scalia will join. 

 

 

Justice Scalia disagrees with the SEC’s interpretation of the word “make” and has begun to question why courts should defer to agencies when interpreting their regulations. 

 

 

But the issue is not well-developed, so it is taking more time than usual for Justice Scalia to make his arguments. Justice Scalia has also realized how significant this issue is and, if Justice Scalia stays true to form, he is putting together quite the dissent.

 

 

— Brian Lehman is an associate with the New York law firm of Bernstein Liebhard LLP. He concentrates his practice on complex and class action litigation. He may be contacted at lehman@bernlieb.com.

 

One of the most distinct securities litigation filing trends during the last twelve months has been the filing of securities class action law suits against U.S.-listed companies based or operating in China. With a phenomenon this well-established, it is only natural that the trend should begin to evolve, which seems to be what has happened in connection with a couple of new filings during this past week.

 

Yahoo: First, according to their June 6, 2011 press release (here), plaintiffs’ attorneys have filed a securities class action lawsuit in the Northern District of California against Yahoo , its CEO Carol Bartz, and director and co-founder Jerry Yang. Yahoo is of course a well-established U.S.-based company. But the lawsuit relates to Yahoo’s investment in its Chinese-based strategic partner, Alibaba Group Holdings Limited, which is China’s largest e-commerce company. (Yahoo owns about 40% of Alibaba Group.)

 

The lawsuit arises out of the well-publicized dispute between Yahoo and Alibaba over the March 31, 2011 restructuring of a unit of Alibaba (Alipay) that resulted in Alibaba’s CEO’s ownership of 100% of Alipay. The complaint alleges that Alibaba and Yahoo received only about $45 million for Alipay, which allegedly is worth more than $5 billion. The complaint further alleges that Yahoo failed to disclose this information to investors until May 10, 2011. When Yahoo released the information in a periodic SEC filing, its share price declined. The complaint alleges that the delay in releasing the information misled investors.

 

The fact that the defendant in this case is a mainstream U.S. company makes this new lawsuit different from the many cases that have been filed recently against Chinese companies. But the case has certain features in common with those other suits, other than the obvious China connection. For example, both the alleged lack of transparency surrounding a critical corporate transaction and the allegations of self-dealing involving senior Chinese management are the kinds of allegations that have appeared in many of the prior suits against Chinese-linked companies. Alison Frankel’s June 8, 2011 article on Thompson Reuters News & Insight has further comments on the Chinese litigation connection of the new Yahoo lawsuit.

 

Sino-Forest Corporation:  The second of the two recent lawsuits involves Sino-Forest Corporation. Sino-Forest’s name has been in the news recently after the publication of analyst reports that the company has significantly overstated its forestry assets and revenues. The company’s share price declined sharply and the company announced that is has formed a special committee to investigate the allegation.

 

Inevitably, a securities class action lawsuit filed. In certain respects, this new lawsuit filing is similar to many of the prior suits involving Chinese companies, based as it is on allegations of accounting and reporting misrepresentations. What makes this suit different is that it has been filed in Canada, by a Canadian law firm, as reflected in the law firm’s June 8, 2011 press release ( here). Sino-Forest’s shares are listed on the Toronto stock exchange and the lawsuit has been filed in the Ontario Superior Court of Justice.

 

Sino-Forest, meanwhile, has struck back at the analyst, whom the company claims is a short-seller spreading misinformation about the company in order to profit by driving down the company’s share price. Sino-Forest has threatened litigation. Indeed, several of the Chinese companies that have suffered share price declines (and securities class action lawsuits) following negative analysts’ reports have taken a similar approach. A June 6, 2011 Bloomberg article (here) reports that several of these companies have even initiated litigation against the analysts.

 

So with the filing of these two new lawsuits, it appears that the securities litigation filing trend involving China-linked companies is developing. These latest filings involve, in the case of the Yahoo lawsuit, a company’s whose connection to China is indirect and unrelated to the basic public identity of the company. In the case of the Sino-Forest filing, the trend has expanded to reach beyond just the Chinese companies whose shares are traded in the U.S.

 

There undoubtedly will be even further variations as this latest securities litigation filing trend continues to develop. Up until this point, I have been keeping a pretty careful tally of the filings against the Chinese and China-linked companies. Not counting the two lawsuits described above, there have been 24 lawsuits filed in 2011 against Chinese and China-linked companies, out of about 102 new lawsuit total so far this year. But as the types of lawsuits become increasingly diverse, it clearly is going to be increasingly challenging to maintain definitional clarity about exactly what I am counting. I suppose I will have to start deploying Roger Maris type asterisks in presenting my tallies.

 

In a decision that largely turned on detailed confidential witness statements, on June 7, 2011, Northern District of Alabama Judge Inge Prytz Johnson denied the motions to dismiss in the Regions Financial Corporation subprime-related securities lawsuit. This ruling is the latest of a series of decisions involving the company. The June7 ruling can be found here.

 

Background

As detailed here, this case arose following the company’s January 20, 2009 announcement that it was taking a goodwill impairment of nearly $6 billion related to the company’s November 2006 purchase of AmSouth Bancorporation. As the plaintiffs later alleged, even though Regions acquired AmSouth, with a year former AmSouth executives were running the combined company. The AmSouth loan portfolio was heavily weighted toward Florida real estate.

 

The plaintiffs allege that the company and its senior officials were well aware of the deteriorating conditions in the Florida real estate market, but they failed to recognize the non-performing loans in the company’s portfolio. As a result, the defendants “repeatedly, yet falsely, claimed that the $6 billion in goodwill associated with the AmSouth acquisition was unimpaired. “

 

But by January 2009, “the collapsing real estate market proved more devastating than even defendants’ fraud could conceal,” and on January 20, 2009, “defendants were forced to finally announce a huge increase in loan loss reserves , and a colossal $6 billion writedown of goodwill.” The company’s share price declined and litigation ensured. The defendants moved to dismiss.

 

The June 7 Opinion

Judge Johnson’s June 7 Opinion denying the defendants’ motions to dismiss relied heavily on the statements of confidential witnesses cited in the amended complaint. Her opinion recites this testimony at length. Among other things, one confidential witness reports that senor bank officials changed the status of nonaccrual loans at month or quarter end, but that following the month or quarter end, the numbers would be switched back, the delay done with the purpose of “making the numbers.” Another confidential witness stated  that the company did not properly classify nonperforming loans as nonaccruing assets in a timely manner.

 

The plaintiffs also relied on confidential witness statements to establish that “defendants were kept aware of this process through both the reporting structure and periodic reports.” The confidential witness cited specific detailed reports senior managers were regularly given.

 

Another confidential witness statedthat the Federal Reserve has opened an investigation into the company’s classification of loans as “non-accrual,” and that the Company’s Audit Committee is now in the process of conducting its own investigation, and has hired an outside law firm to investigate.

 

In denying the denying the defendants’ motions to dismiss, Judge Johnson differentiated the plaintiffs’ allegations from those involved in a separate case relating to Regions’ alleged delay in recognizing the impairment of the AmSouth transaction goodwill, in which Southern District of New York Judge Lewis Kaplan had granted the motion of the defendants in that case to dismiss the complaint.

 

By contrast to the allegations in that case, Judge Johnson said, the plaintiffs in this case 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 “overstate, false and misleading.”

 

Judge Johnson also relied on the confidential witnesses’ statements in concluding that the plaintiffs had adequately alleged scienter. Taking the fact that the defendants had compensation tied to company performance as one possible motive to be considered, Judge Johnson also noted that the defendants “had access to reports showing the true state of affairs regarding Regions’ loans and the deteriorating markets, particularly in Florida.”

 

Judge Johnson also found that the defendants’ “significant and sudden increase in loan loss reserves along with its $6 million goodwill write-down, considered collectively with all allegations, supports a strong inference of scienter.”  Judge Johnson added that “coupled with allegations of defendants’ knowledge of the scheme to manipulate classifications of loans, it was apparent to defendants that the financials were inaccurate long before their adjustment in January 2009.”

 

Discussion

Securities plaintiffs have been uniformly successful in attempting to rely on confidential witness statements  in order to try to meet the PSLRA’s pleading requirements This case is a notable example where use of confidential witness statements was successful. The success depended on a number of factors. The witnesses’ statements was detailed and specific. More importantly, Judge Johnson found that the witnesses’ statements  showed that the defendants were aware of the information about which the witnesses testified, in particular about alleged differences between the information cited by the witnesses and what the company was saying publicly.

 

At the same time it seems that the witnesses’ statements  reinforced Judge Johnsons’ predispositions. She clearly found the magnitude of the $6 billion write-down and the January 2009 increase in loan loss reserves to be disturbing, and even suspicious. These factors came together to support her conclusions.

 

The confidential witness statements were  clearly important and  help explain the difference in outcome between her ruling and that of Judge Kaplan in the separate ’33 Act claim that had been brought on behalf of class of investors who had purchased Regions trust preferred securities in a separate securities offering. As noted above, in that case, Judge Kaplan had granted the motion to dismiss. The difference seems to be the allegations based on the statements  of the confidential witnesses.

 

There have been a number of other credit crisis-related lawsuits in which the presence of statements from confidential witnesses seemed to have made a difference in enabling plaintiffs’ claims to survive the initial pleading hurdles. Among these cases are: the Sallie Mae case (refer here); and  the Wells Fargo Mortgage-Backed Securities case (refer here). Indeed, in the Credit Suisse case, which later settled for $70 million dollars, the court found that the information in confidential witness statements cited in the amended complaint was sufficient to permit the plaintiffs’ amended complaint to survive the renewed dismissal motions, after the motion to dismiss the initial complaint had been granted, as discussed here.

 

As I noted in a prior post, here, here have been a number of cases filed against this company in the wake of the AmSouth merger and in light of the problems Regions encountered during the financial crisis. A number of these cases are proceeding, including, as discussed in a prior post, the state court derivative complaint.

 

These cases are part of the huge number of cases that continue to work their way through the system following the financial crisis. I have in any event added the June 7 ruling to my running tally of credit crisis-related dismissal motion rulings, which can be accessed here.

 

Special thanks to a loyal reader for sending along a copy of the June 7 order.

 

As many observers had expected, the U.S. Supreme Court has reversed the Fifth Circuit’s opinion in the Halliburton case. In a brief June 6, 2011 opinion from Chief Justice John Roberts, writing for a unanimous court, the Court held that securities class action lawsuit plaintiffs do not need to prove loss causation in order to obtain class certification. A copy of the opinion can be found here.

 

Background

As detailed here, in 2002, shareholders had filed a securities class action lawsuit against Halliburton and certain of its directors and officers, alleging that the company has misrepresented certain aspects of its financial condition, including the company’s exposure to potential liability from asbestos litigation and the company’s expected revenue from certain construction contracts. The plaintiffs alleged that Halliburton’s share price declined following a corrective disclosure.

 

The plaintiffs purported to represent a class of Halliburton investors and filed a motion for class certification. The district court found that the case could proceed as a class action, except for the fact that the plaintiffs had not satisfied the Fifth Circuit requirement that securities fraud plaintiffs proved “loss causation” in order to obtain class certification .The district court concluded that the plaintiff “had failed to establish loss causation with respect to the any of its claims” and therefore denied the motion for class certification.

 

The Fifth Circuit affirmed the denial of the motion for class certification, holding that in order to obtain class certification a securities plaintiff is required “to prove loss causation, i.e.., that the corrected truth of the corrected falsehoods actually caused the stock price to fall and resulted in losses.” Owing to the conflict among the circuit courts on the question whether loss causation must be proved at the class certification stage, the U.S. Supreme Court granted the plaintiff’s petition for writ of certiorari.

 

The June 6 Opinion

Chief Justice Roberts’s June 6 opinion reversed the Fifth Circuit, and expressly rejected the Fifth Circuit’s interpretation of the Supreme Court’s prior opinion in Basic v. Levinon and Basic’s holding that to establish reliance using the fraud on the market presumption. The Fifth Circuit had held that in order to invoke the rebuttable presumption of reliance under the fraud on the market theory, the plaintiff had to prove that the decline in Halliburton’s stock price had occurred because of the corrective disclosure and that the decline could not be explained by other factors.

 

In his opinion for the Court, Chief Justice Roberts said that this “requirement” is “not justified by Basic or its logic,” adding

 

To begin, we have never before mentioned loss causation as a precondition for invoking Basic’s rebuttable presumption of reliance. The term “loss causation” does not even appear in our Basic opinion. And for good reason: Loss causation addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.

 

Roberts went on to draw a distinction between “transaction causation” (that is, whether the plaintiff relied on the alleged misrepresentation in deciding whether or not to engage in the transaction) and “loss causation” which “by contrast” required a plaintiff to show “that a misrepresentation that affected the integrity of the market price also cause a subsequent economic loss.”

 

Roberts said to require proof of loss causation in order to invoke the rebuttable presumption of reliance under the fraud-on-the market theory

 

contravenes Basic’s fundamental premise – that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.

 

Discussion

In many ways this decision is not a surprise. Indeed, as Justice Roberts notes in his opinion, Halliburton’s counsel was forced to concede that the Fifth Circuit had erred in trying to require loss causation at the class certification stage. (Defense counsel tried to salvage things by trying to argue that in using the phrase “loss causation” the Fifth Circuit had really meant “price impact” – but Justice Roberts was having none of that. The Fifth Circuit had said “loss causation” and that was what Justice Roberts interpreted them to have meant.)

 

On the other hand, while the outcome itself may come as little surprise, it is nonetheless less than expected that this particular court would come out so clearly in a ruling that favors the plaintiffs. This Court has not exactly been plaintiff-friendly over the years.  To be sure, except in the Fifth Circuit, this ruling really does not change anything, as the courts in the other circuits had not been requiring proof of loss causation at the class certification stage. Nevertheless, if this case had come out the other way and the Supreme Court had found that proof of loss causation is required at the class certification stage,  that would have represented a significant hurdle for plaintiffs at a critical preliminary stage. So, from the plaintiffs’ perspective, the outcome at the Supreme Court is more of a potential serious problem avoided than a significant new advantage gained.

 

The brevity of the Court’s opinion may disappoint some observers. There has been some hope that the U.S. Supreme Court would provide further elaboration on what elements plaintiffs must prove in order to trigger the presumption of reliance at the class certification stage, and perhaps provide further guidance on the plaintiffs’ burdens of production and persuasion. There may be some takeaways on these topics from the comments in the opinion about Basic and the fraud on the market presumption. But a detailed analysis of these issues will have to await another day.

 

If a verdict form contains the jury’s specific finding that the insured engaged in “fraudulent, malicious, oppressive, wanton, willful, or reckless conduct,” you might think that would trigger the exclusion for fraudulent misconduct in the applicable D&O insurance policy. But apparently not, at least according to a May 12, 2011 Southern District of West Virginia ruling (here) in a case involving the Charleston Area Medical Center (CAMC). The case makes for some interesting reading and interesting analysis.

 

Background       

In September 2004, CAMC determined that Dr. R.E. Hamrick’s plan to self-fund his medical professional liability was inadequate and not actuarially sound. Based on this determination and the fact that Dr. Hamrick’s insurance coverage had lapsed, CMAC revoked his clinical privileges. Dr. Hamrick went to court seeking injunctive relief and three days later succeed in having his clinical privileges restored. He then pursued a damages claim against CAMC. Dr. Hamrick’s amended complaint contained a claim for defamation and a claim for invasion of privacy/false light. Dr. Hamrick also sought punitive damages.

 

In February 2008, Dr. Hamrick’s damages claim went to the jury. In Section 1 of the jury Verdict form, entitled “Liability,” the jury indicated that they found in favor of Dr. Hamrick. In Section 2 of the Verdict form, entitled “Damages,” the jury awarded Dr. Hamrick $5 million in compensatory damages. In Section 3, labeled “Punitive Damages,” the jury found that CAMC had engaged in “fraudulent, malicious, oppressive, wanton, willful, or reckless conduct with respect to Dr. Hamrick,” and awarded $20 million in punitive damages. In Section 4 of the form, labeled “Other,” the jury found that CAMC had acted in “bad faith, vexatiously, wantonly or for oppressive reasons with respect to Dr. Hamrick.”

 

In July 2008, the court granted CAMC’s motion for remittitur, and reduced the damages award to $2 million in compensatory and $8 million in punitive damages. The case ultimately settled for $11.5 million, representing the remittitur award of $10 million, post-judgment interest of $476,917 and attorneys’ fees of $1.023,083.

 

The Insurance Coverage Dispute

CAMC was insured, inter alia, by a  D&O insurance policy with a primary limit of liability of $10 million., including a punitive damages limit of $5 million (the punitive damages limits is part of not in addition to the primary $10 million limit.) The policy contains an exclusion stating that the insurer will “not pay Loss for Claims brought about or contributed to in fact (1) by any dishonest or fraudulent act or omission or any willful violation of any statute, rule or law by any Insured.”

 

The D&O insurer filed a coverage action seeking a judicial declaration that at least some portion of the settlement falls under the dishonest/fraudulent acts exclusion and therefore is not covered, maintaining further that the jury’s findings necessitate an allocation between covered and non-covered conduct. CAMC filed a counterclaim, and the parties filed cross motions for summary judgment.

 

The May 12 Opinion

In his May 12, 2011 opinion (here), Southern District of West Virginia Chief Judge Joseph R. Goodwin held that the insurer had not carried its burden under West Virginia law to prove the facts necessary to support an exclusion to coverage.

 

In attempting to carry its burden, the insurer had sought to rely on the jury’s determinations in Sections 3 and 4 of the verdict form. Judge Goodwin found that these portions of the verdict form “quite clearly related to damages and attorney’s fees, as the jury assessed liability only in Section 1 of the jury form,” adding that the insurer’s arguments that “the jury’s findings in Section 3 and 4 related to something other than damages and attorney’s fees is somewhat hard to fathom.”

 

Judge Goodwin noted that the standards in Sections 3 and 4 “are not elements of any of the causes of action on which the jury’s liability finding in Section 1 could have been predicated, nor are those standards relevant to compensatory damages.” As a result “the only reason for the jury to have made such findings would have been in relation to punitive damages and attorney’s fees.”

 

Judge Goodwin went on to state that the insurer

 

has lost sight of the simple fact that the claims presented to the Hamrick jury were for defamation and invasion of privacy, not fraud. Because Dr. Hamrick never pressed a cause of action that was predicated on fraudulent or dishonest conduct, the jury could not possibly have found for him on such a claim. Moreover, [the insurer] cannot identify any particular dishonest or fraudulent act or omission on the part of CAMC.

 

Instead, [the insurer’s] entire position boils down to the argument that the last two sections of the jury verdict form somehow transformed the claim into one involving dishonest or fraudulent conduct. …CAMC was alleged to have wronged Dr. Hamrick by communicating to others his lack of insurance coverage, the actuarial deficiencies of his self-insurance program, and his revoked clinical privileges. There is no fraudulent or dishonest conduct in those acts or omissions, however, and the mere fact that the jury made predicate findings with regard to punitive damages and attorney’s fees does not alter the nature of the conduct giving rise to the claim.

 

Judge Goodwin further stated that “there were only two claims in this case – for defamation and invasion of privacy – and no colorable argument that the conduct giving rise to them fit within the Dishonest/Fraudulent Act Exclusion,” adding that the insurer’s “argument for denying coverage stems not from the nature of the claims or the conduct giving rise to them, but from specific findings made by the jury as part of the damages award.”

 

Judge Goodwin entered summary judgment against the insurer and in favor of CAMC.

 

Discussion

This coverage dispute is different than the usual clash over the fraudulent misconduct exclusion. Disputes about the fraudulent misconduct exclusion are usually over the fact that there are all kinds of allegations but unless there has been a finding that the precluded conduct actually occurred, then the exclusion doesn’t apply. Here the usual debate has been completely turned on its head. The assertion is that regardless of the jury’s specific finding of precluded misconduct, the exclusion doesn’t apply because the precluded misconduct was never alleged.

 

Judge Goodwin emphasizes that the specific legal theories on which Hamrick proceeded did not allege or depend upon precluded acts or omissions. Perhaps Judge Goodwin reads the phrase precluding coverage for “Loss for Claims brought about or contributed to in fact” by the excluded conduct to mean (1) that it is not sufficient if the Loss is brought about or contributed to by the precluded act or omission; (2)  the exclusion applies only if the Loss arises from Claims brought about or contributed to precluded act or omission. Because the Claims on which Hamrick relied and which he asserted did not depend on or even allege precluded conduct, then the exclusion would not apply, regardless of whether or not Loss was brought about or contributed to by precluded conduct.

 

The arguable problem with this analysis is that it  exalts mere pleading over proof – regardless of what Hamrick’s pleadings might have alleged , the fact is that the  jury specifically found that CAMC had engaged in “fraudulent, malicious, oppressive, wanton, willful or reckless conduct” with respect to Dr. Hamrick. (Moreover, Judge Goodwin doesn’t seem to have considered the jury finding’s use of the disjunctive “or” to be inconsistent with a finding of “fraudulent “conduct. He seems to accept that the jury finding represents a finding of “fraudulent” conduct.)

 

Judge Goodwin emphasizes that the jury made its fraudulent misconduct determination in the portion of the verdict form that relates to damages rather than the portion of the form relating to liability. It may well be that this distinction is as determinative as he believes it to be. But he never explains why that is so, particularly with reference to the operative policy language. In the absence of this explanation, we are left to wonder why he finds that distinction determinative of the issue.

 

All of this analysis disregards what seems to be the real problem here –there doesn’t seem to have been any fraudulent misconduct pleaded or proven.  As Judge Goodwin states, the insurer “cannot identify any particular dishonest or fraudulent omission on the part of CAMC.” In other words, Judge Goodwin seems to to be saying, the fraudulent misconduct exclusion doesn’t apply because there wasn’t any fraudulent misconduct – notwithstanding the jury’s specific finding in the jury verdict form that there was fraudulent misconduct. Judge Goodwin eludes this problem with this statement: “The mere fact that the jury made predicate findings with regard to punitive damages and attorney’s fees does not alter the nature of the conduct giving rise to the claim.” Well,  what could “predicate findings” be based upon other than conduct?

 

Judge Goodwin doesn’t say anything about it expressly , but there really does seem to be something wrong with a result in which punitive damages have been awarded based on a jury finding for which there appears to be  no basis in the record. And that’s not all. For a few days loss of clinical privileges, Hamrick was awarded millions of dollars of damages for reputational harm. Even without the punitive damages, Hamrick seem immensely better off than he would have been if his privileges had not been briefly interrupted.  

 

I will leave it to others to assess what the result in the underlying case might imply about the process involved.  But given the apparent proclivity of West Virginia juries, Dr. Hamrick’s plan to self-insure really does not look like a great idea.

 

Special thanks to a loyal reader for sending along the opinion.

 

According to news reports, on June 1, 2011, Alpha Natural Resources completed its $7.1 billion acquisition of Massey Energy Company. The deal went forward despite last minute efforts by groups of Massey shareholders proceeding in West Virginia and Delaware courts to try to enjoin the transaction on the grounds that the merger did not properly value the pending derivative claims against the company’s board, resulting in Alpha being able to acquire Massey without taking into account the fair economic value of the derivative claims.

 

The courts in both West Virginia and Delaware rejected the preliminary injunction motions. Delaware Vice Chancellor Leo E. Strine Jr.’s  81-page May 31, 2011 opinion (here) refusing to enjoin the merger makes for some extraordinarily interesting reading, as Susan Beck notes in her June 1, 2011 Am Law Litigation Daily article about the decision (here).

 

All of these events relate back to the April 5, 2010 disaster in Massey’s Upper Big Branch Mine in Montcoal, West Virginia, in which 29 miners were killed. In the wake of the disaster, the company’s share price declined, and the company struggled to deal with the fallout and scrutiny from the tragedy. These events set up a lengthy process that resulted in Alpha’s agreement to acquire Massey. During this process, Massey forced out its long-standing CEO, Don Blankenship.

 

Another thing that happened in the wake of the disaster (“inevitably,” Vice Chancellor Strine noted) is that Massey shareholders filed derivative suits seeking to ensure that to the extent Massey was harmed by the obligation to pay fines, judgments to the deceased miners’ families and lost cash flow from the damaged mine, the companies directors and officers should be held responsible for failing to make sure that Massey complied with mine safety regulations.

 

In addition to damages, the derivative plaintiffs sought a preliminary injunction against the merger, arguing among other things that the merger was an attempt by the board to evade its responsibilities for the harm to the company by means of a sale to Alpha.

 

In his May 31 opinion, Vice Chancellor Strine denied the plaintiffs’ motion for a preliminary injunction, holding that it is “highly doubtful” that the shareholders would be able to show that Massey’s board had sought to sell the company “solely, or even in a material way” to escape liability for the shareholder claims. He also said that to delay the deal would “threaten more harm to Massey shareholders than its potential benefits to them,” reasoning that Massey’s shareholders ought to be able to vote for against the merger on their own.

 

There are a host of interesting things about Vice Chancellor Strine’s highly readable 81-page opinion. Among them, in no particular order, are the following.

 

First, Vice Chancellor notes that it is “undisputed” “regrettable” “concerning” and “might even be characterized as a breach of the duty of care” that in connection with its consideration of the proposed Alpha merger the Massey board “failed to address the value” of the derivative claims, as the duties of a board in negotiating the sale of company are to consider and get full consideration for “all of the corporation’s material assets.” However, he added, that “does not much help the plaintiffs obtain an injunction,” as the record “does not support the inference that the Derivative Claims are material in comparison to the overall value of Massey as an entity.”

 

Second, as part of reaching the preceding conclusion, Vice Chancellor Strine noted that “the record does not persuade me that the Merger would, after trial, likely prove to be economically unfair to the Massey shareholders,” citing a number of considerations. In particular, with respect to the question whether or not the failure to separately negotiate value for the derivative claims harmed Massey shareholders, Strine noted numerous difficulties the claims face,  including the difficulty of showing that the defendants “acted with a wrongful state of mind, particularly given the exculpatory provision in Massey’s charter”; the possibility that “insurance proceeds may not be available to pay any judgment”; the questionable ability of even the wealthy board members to satisfy any judgment; and the fact that most of the individual defendants are independent directors whose “motivation to tolerate unsafe practices for the sake of profits would be tempered.” The value of the derivative claims might represent at most an opportunity for the company to recoup some of the costs for the disaster – and for that reason “it is unlikely that Alpha viewed these Claims as an asset at all, but merely as having some potential to reduce the gravity of the Disaster Fall-Out Alpha was inheriting.”

 

Third, though the Massey board itself might have been unclear on what the merger’s completion would mean for the derivative claims, Stine himself is very clear that the claims survive the merger (given his determination that the merger was not motivated primarily to avert the derivative suit liability). But with the merger’s completion, Alpha, as Massey’s successor in interest, controls the claims, putting the derivative plaintiffs in the position of having to prove demand excusal, and thus “receive leave to proceed in a double derivative action on behalf of Alpha” – an outcome Strine says “is not one an objective mind ought to consider probable” given that Alpha’s board has no exposure to the claims but “myriad of rational business reasons why Alpha may later decide that prosecuting these Claims does or does not make sense for Alpha.”

 

Nevertheless, Strine also notes that it is not a foregone conclusion that Alpha would not itself decide to pursue claims against the former fiduciaries of Massey. The fact is, as Strine notes, “Alpha will have to make a difficult business calculation about the extent to which it goes after Massey’s former management,” and its board will have to answer to Alpha’s own shareholders on their decision whether or not to pursue such claims. As Strine notes, “it is not clear why Alpha would not seek to offset the costs to itself of those violations by suing previous management if by doing so it had a realistic chance of obtaining some meaningful recovery.” That does not necessarily mean that Alpha will be able to effect a recovery commensurate with this costs (See the “second” item above and the “seventh” item below).

 

Fourth, Strine has some choice words to say about the Cravath law firm, which is not only acting as the board’s counsel in the derivative lawsuit, but also counseled the board on how it ought to consider the derivative suit in connection with the proposed merger. Strine characterized the law firm as being an “awkward source for advice” on this issue, and given the Cravath firm’s recommendation that the board not consider the existence of the derivative claims at all, “one cannot conclude that the Massey Board was presented with a reasoned analysis of the ‘value’ of the Derivative Claims." Strine also faulted Cravath for insufficiently explaining to the board what a survival of derivative claims means in the context of a merger. (Susan Beck’s Am Law Litigation Daily article linked above has more on this particular topic.)

 

Fifth, using language that is both noteworthy and striking, Strine went out of his way to excoriate former Massey CEO Don Blankenship, quoting descriptions of him as “autocratic” and describing him as having an “adversarial relationship” with the UAW and a “combative approach” to the federal mining regulator. He noted that Massey’s managers and employees understood that “if you wished to stay or get ahead at Massey under Blankenship, then the priority of profits over safety is one not to be questioned.” He also noted that in 2009, after President Obama’s election and a change in leadership at the mining regulator, and after Massey had sustained a number of losses in legal proceedings, Blankenship’s attitude toward regulators “deteriorated very sharply.”

 

Sixth, Strine makes it clear that he believes the real victims here are the deceased coal miners and their families – and in that regard, Strine is not prepared to let the shareholders off the hook. As he points out in a biting 1,071-word footnote (number 185), Massey’s shareholders not only had an annual opportunity to elect directors, but they “continued to invest in a company they say was well known to treat its workers and the environment poorly.” Indeed, “to the extent Massey kept costs lower and exposed miners to excess dangers, Massey’s stockholders enjoyed the short-term benefits in the form of higher profits.” The very practices of which the plaintiff shareholders now complain might rationally have been expected to act as a “goad” to shareholders to “give more weight to legal compliance and risk management in making investment decisions.” In the end, Strine notes, the “most sympathetic victims here were not shareholders, they were Massey’s workers and the families” and other constituencies who suffered while the company prospered and shareholders benefitted.

 

Seventh, readers of this blog will be interested in some parenthetical comments Strine has to make about D&O insurance. In noting the difficulties Alpha would have in collecting on any judgment entered in the derivative case, he notes that even if the derivative claims were to settle for the full amount of the D&O insurance, the total amount of coverage available is $95 million – not a “trifle,” but also not material in the context a merger valued over $ 7 billion. Also, Strine notes, showing that he has a keen appreciation for the D&O insurance market’s dark reality, “anyone who has dealt with coverage questions and insurance carriers would also tell you that a scenario in which the D&O insurers in the ‘tower’ would easily pay out anywhere near the full amount of the policy in a quick and low-cost way to Alpha is more the stuff of dreams than of real life.”

 

Eighth , it may not be entirely relevant to Vice Chancellor Strine’s decision or to the fact that the Alpha acquisition went forward as planned, but it is probably worth noting that among Massey’s former independent directors is another individual whose name has been in the news for entirely different reasons this week – that is, among the independent Massey directors named as defendants in the derivative litigation is Ohio State University President E. Gordon Gee. According to Wikipedia, Gee served on Massey’s board from 2000 until 2009 (that is, he resigned before the Big Branch Mines disaster, but during many of the prior safety and environmental problems the company faced.)

 

Now that the merger has been completed, the ball shifts to Alpha’s board to consider whether or not to pursue direct claims against the former Massey directors and officers. While Alpha might as Strine notes have substantial business reasons for wanting to close the book on the past and moving forward, the fact is that Alpha also inherited the wrongful death and regulatory claims that were pending against Massey. As much as Alpha might want to move on for business reasons, that may not be an available option.

 

To the extent Alpha must pay settlements, fines, and judgments, it will have to consider whether or not to pursue claims against the former Massey fiduciaries to try to recoup these costs. And in making that determination, the Alpha board will also have to consider its fiduciary duties to its own shareholders (some of whom now are former Massey shareholders.) I don’t know where any of this ultimately will lead, but the insurers in that $95 million insurance tower (whoever they may be, I have no idea) may find it prudent to wait a while before deciding whether or not to take down their reserves on this particular claim.

 

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

 

Yeah, I Really Hate it When the Guy in Front of Me Reclines His Seat Back, Too: On a May 29, 2011 United Airlines flight from Washington Dulles Airport to Ghana, one of the passengers decided to lower his seat back – which set in process a sequence of events that started with a scuffle on the plane and ended with Air Force F-16 fighter jets being scrambled. Because no one could make this up, you really have to read the Washington Post story (here) for yourself.

 

Just something to think about next time before reclining your seat back, O.K.?

 

On May 25, 2011, In the latest example of shareholders suing a company’s board following a negative “say on pay” vote, two union pension funds filed a shareholders’ derivative action claiming that Umpqua Holdings Corporation’s board violated its duties to investor by approving the2010 compensation plan despite the negative shareholder vote.. The lawsuit follows the April 19 annual meeting of the bank holding company, in which about 62% of shareholders voted “no” in the advisory shareholder vote on the company’s 2010 executive compensation plan. The claims asserted in the lawsuit rely directly on the negative note.

 

Background

As I discussed in a recent post (here), Section 951 of the Dodd-Frank Act expressly requires all but the smallest publicly traded companies to hold an advisory shareholder vote on executive compensation. This requirement has already started to have an impact on executive compensation practices, as many companies are adjusting certain compensation practices to avoid a negative vote. However, while the vast majority of companies have received shareholder support for their compensation practices, there are still some companieswhose shareholders have voted “no” on the shareholder resolution regarding executive compensation. (At last count, according to The CorporateCounsel.net,  there were over thirty companies whose “say on pay” resolutions had received a negative vote from a majority of their shareholders).

 

Umpqua’s “Say on Pay” Vote

As reflected in the company’s April 22, 2011 filing on Form 8-K, Umpqua is among those companies receiving a negative say on pay vote. The 8-K reflects that about 62% of shareholders voted against the company’s executive compensation shareholder resolution.

 

The 8-K explains that the negative vote followed a recommendation from Institutional Shareholder Services (ISS) that Umpqua’s shareholders vote against the resolution. The 8-K states that ISS found a “disconnect” between the company’s 2010 executive compensation and the company’s pay-for-performance standards. The 8-K states that the company takes the vote “seriously” and that it is committed to pay-for-performance principles. Nevertheless, the company takes exception to the ISS’s “formulaic” approach which, the company contends, inappropriately viewed 2010 compensation only by comparison to 2009 compensation, when the company’s executive compensation declined 29%. The company contended that the 2010 compensation plan is reasonable in light of prior compensation and in light of the company’s overall performance, particularly relative to its peers.

 

The Lawsuit

On May 25, 2011, two union pension funds filed a shareholder derivative lawsuit in the District of Oregon against the company, as nominal defendant; against the company’s individual board members; against four company executives; and against the company’s compensation consultant, PricewaterhouseCoopers. The complaint alleges that the Board’s “decisions to increase CEO and top executive pay in 2010, despite the Company’s severely impaired financial results, were disloyal, irrational, and unreasonable, and not the product of a valid exercise of business judgment.”

 

The complaint further asserts that the board’s approval of the 2010 pay hikes “violated its own pay-for-performance policy and, as intended, favored the interests of Umpqua’s CEO and top executives at the expense of the corporation and its shareholders.”

 

The complaint attempts to use the negative say on pay vote to try  to avert  the defendants’ reliance on the business judgment rule. The complaint states that the “adverse shareholder vote on the 2010 executive compensation is evidence which rebutted” the usual business judgment presumption. The complaint further states with reference to the negative shareholder vote that the company’s shareholders “concluded, in their independent business judgment, that the Umpqua Boar’s 2010 CEO and top executive pay hikes were not in the best interest of Umpqua and its shareholders.”

 

The complaint asserts a claim against the directors for breach of the duty of loyalty; against the compensation consultant for aiding and abetting breach of fiduciary duties and breach of contract; and against the four executive officers for unjust enrichment. The complaint seeks an award to Umpqua for damages; a declaration that the shareholder vote “rebutted the presumption of business judgment”; disgorgement of the allegedly excess compensation and implementation and administration of internal controls and systems to prevent excess executive compensation.

 

Discussion

At this point, it seems clear that plaintiffs’ bar intends to try to utilize a negative “say on pay” vote, in at least some instances, to try to bootstrap claims for allegedly excess executive compensation. At one level, this is hardly surprising, because the negative vote does create the possibility of the board appearing to be acting contrary to shareholders’ views. And executive pay unquestionably is a hot button issue right now.

 

But on the other hand, the vote required under the Dodd Frank is expressly and explicitly an “advisory” vote. Congress could have made the say on pay vote binding. The fact that Congress did not make it controlling but rather left the vote as advisory clearly allows for the possibility that the company and its board retained discretion and might elect to act contrary to the shareholder vote without acting improperly. Indeed, Section 951 (c) of the Dodd Frank Act expressly states that the say on pay requirement should not be interpreted to alter any existing fiduciary duties or to create any new fiduciary duties. Congress seemed to be going out of its way to try to avoid having the say on pay process to add compulsion or  to the legal exposures of directors and officers.

 

Indeed, given the express statutory provisions to make the vote advisory and to try to prevent against having the vote add to directors’ legal exposures, it seems clear that Congress was hoping that the vote, and the threat of the vote, would cause companies voluntarily to adjust their compensation practices, — not out of fear of liability but out of a desire to maintain the affirmative support of shareholders. Indeed, that in fact seems to be happening, as many companies have adjusted their practices in order to try to avoid a negative shareholder vote.

 

Despite Dodd-Frank’s express provisions designed to eliminate the possibility that the say on pay vote should alter the legal responsibilities of directors and officers, the plaintiffs in this case are seeking to rely on the negative say on pay vote to argue that the defendants are not entitled to the usual protections of the business judgment rule. The plaintiffs do not explain why a purely advisory vote, which by its own enacting provisions is not intended to alter or create additional legal duties, should nevertheless deprive the board of the usual protections to which they are entitled.

 

The lawsuit has only just been filed and it remains to be seen how it will progress. But it will be interesting to see if the plaintiffs are successful in having the defendants’ rights to rely on the business judgment rule suppressed.  

 

The company itself seems to think that the best defense is a good offense, as the company’s spokesperson is quoted in a May 27, 2011 Portland Business Journal article as saying with respect to the plaintiffs’ firm that brought the suit, “our understanding of this firm is they create fees by dragging the names of reputable companies through the mud.”

 

Our Solar System’s Family Album: A wide variety of probes and vessels have been cruising the planets, taking some amazing pictures in the process. The truly stunning highlights are compiled in a May 27, 2011 post (here), on the InFocus blog on the Atlantic Monthly’s website.

 

In a May 27, 2011 post on the FCPA Compliance and Ethics Blog (here), Tom Fox has some interesting observations about the ongoing FCPA gun sting trial. (Readers will recall that this prosecution involves numerous individuals from the armaments industry who were caught up in a government sting operation that included extensive wiretaps and an FBI agent posing as a representative of an African government.)

 

Among other things, Fox comments that this prosecution is a “game changer” because of the government’s use of “organized crime fighting techniques in very mundane white collar crime.”

 

Fox’s point is a serious one, particularly in view of the government’s use of wiretaps in several other recent high-profile prosecutions. The insider trading conviction of Raj Rajaratnam depended critically on extensive government wiretaps. The prosecution of the former big law associate who had passed along inside information gained from the law firms where he worked also relied on use of wiretaps.

 

The government’s use of these aggressive crime-fighting techniques underscores how seriously the government is taking its responsibility to enforce these laws. The government’s willingness to use these techniques also has important implications for anyone concerned about the potential exposures for companies and their executives. The most obvious lesson is that the government is vigilant and will actively pursue criminal activity. For that reason, corporate compliance efforts are critically important.

 

Another, perhaps more chilling implication is that presuming confidentiality for even the most private conversations and communications could be dangerous. There is probably a larger essay for another day here. Suffice it to say that the line between necessary vigilance and intrusive surveillance is a fine one, and the government’s involvement in monitoring its citizen’s activities is fraught with difficulties. Some might say it is only those involved in criminal activities that have any thing to fear.  I note that we only hear about the wiretaps that result in criminal prosecutions. One can only wonder about the extent of governmental intrusion into purely lawful communications.

 

Independent Director Liability Insurance: Do independent directors need a separate liability insurance policy? The IDL insurance product has been around for years, though relatively few companies buy it. The problem is that sometimes when things go wrong, things go catastrophically wrong. Though IDL continues to attract relatively few buyers, there are occasions when it could be critically important. A May 26, 2011 article from Corporate Secretary magazine (reprinted here) takes a closer look at the IDL product. (Full disclosure, I was interviewed for the article).

 

Take Two: Perhaps there are no panaceas, but there may be one thing Americans could do to solve many of their problems — everything “from stuck zippers to the national debt” — according to a recent report you might have missed.

 

The American Scene: A series of recent trips has reminded me that there are a multitude of beautiful places in this big country. Among other delightful places I have visited are several that are well worth the journey, including Davidson, North Carolina; Lake Tahoe, California; Denver, Colorado; and Lexington, Virginia.

 

My most recent sojourn, a Memorial Day weekend  trip to South Carolina for a wedding, introduced me to Greenville, which is yet another delightful surprise. The cluster of restored buildings and pedestrian bridges surrounding the waterfalls on the Reedy River and the blocks of shops and restaurants along the tree-lined Main Street make the town a pleasant and enjoyable place to explore. Greenville is only one of several U.S. cities that recently have made big investments in reorienting themselves toward their riverine setting, including Dubuque, Iowa and Jacksonville, Florida.

 

Travel has its stresses and headaches, but it also occasionally affords agreeable discoveries that reward the exertion. Truly, you could explore this country endlessly and never exhaust its aesthetic possibilities.    

 

 

Greenville, South Carolina  May 28, 2011

 

According to FDIC’s Quarterly Banking Profile, released on May 24, 2011 (refer here), the pace of bank failures slowed during the first quarter. However, both the absolute and relative number of problem institutions continued to increase, albeit at a reduced pace compared to recent quarters. The FDIC’s May 24, 2011 press release about the Quarterly Banking Profile can be found here.

 

During the first quarter of 2011, 26 banking institutions failed, compared to 41 in the first quarter of 2010. The total of 26 bank failures in the first quarter is the smallest quarterly number of bank failures in seven quarters.  (My prior post on the declining pace of bank closures can be found here.) A total of 43 banks have failed year to date in 2011 as of May 25, 2011.

 

As of the end of the first quarter 2011, there were 888 “problem institutions,” compared to 884 at the end of 2010 and 775 at the end of the first quarter 2010. The increase in the number of problem institutions during the twelve month period ending March 31, 2011 is 113, or about 14.5%. (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.)

 

 The increase of only four additional problem institutions since year-end 2010 represents only a slight increase in the number of problem institutions. In its press release, the FDIC noted that this increase is “the smallest increase in three and a half years.” However, the 888 problem institutions as of March 31, 2011 represent the larges number of problem institutions since March 31, 1993, when there were 928.

 

The number of problem institutions as a percentage of all reporting institutions has continued to increase. This is not only due to the increase in the absolute number of problem institutions but also because of the declining number of reporting institutions. The decline in the number of reporting institutions is not only due to bank failures, but also due to mergers and acquisitions.

 

The 888 problem institutions as of March 31, 2011 represent about 11.7% of all 7574 reporting institutions. By way of comparison, the 775 problem institutions as the end of the first quarter 2010 represented only about 9.7% of all 7,934 reporting institutions as of that date. So both the absolute and relative numbers of problem institutions has increased substantially during the 12 months ending March 31, 2011.

 

Though the number of problem institutions has continued to increase, the aggregate assets those problem institutions represent has decreased. Thus the 775 problem institutions as of March 31, 2010 represented assets of $431 billion, whereas the 888 problem institutions as of March 31, 2011 represented assets of $387 billion.

 

With all of the remaining numbers of problem institutions, there are still a lot of challenges in the banking industry. There may yet be more bank failures yet to come, perhaps many more. However, the overall message of the Quarterly Banking Profile is guardedly upbeat. The press release quotes the FDIC Chairman Sheila Bair as saying that “the industry shows signs of improvement, “ and adding that “the process of repairing bank balance sheets is well along, but is not yet complete.”

 

As I have noted elsewhere, the numbers of bank failures overall may be slowing, but the lawsuits involving directors and officers of failed institutions may just be ramping up – slowly

 

On May 25, 2011, the SEC adopted the final rules implementing the whistleblower provisions of the Dodd-Frank Act. The SEC declined to propose a rule that would have required whistleblowers to report first through internal corporate compliance programs. However, the SEC adopted changes that are intended to “incentivize whistleblowers to utilize their companies’ internal compliance and reporting systems when appropriate.”

 

The SEC’s May 25, 2011 press release about the final whistleblower rules can be found here. The SEC’s 305-page document describing the final rules can be found here. The SEC’s rules will be effective 60 days after they are submitted to Congress or published in the Federal Register.

 

Section 922 of the Dodd-Frank Act created certain new whistleblower incentives and protections. The section directs the SEC to pay awards to whistleblowers that provide the Commission with original information about a securities law violation that lead to the successful SEC enforcement action resulting in monetary sanctions over $1 million. The section also prohibits retaliation against whistleblowers.

 

The SEC released proposed rules to implement the whistleblower provisions in November 2010. The SEC received hundreds of comments on the proposed rules. The final rules document released yesterday describes many of the comments as well as the way that the SEC took the comments in to account in promulgating the final rules.

 

One of the most significant issues raise in the comments related to the impact of the whistleblower program on internal corporate compliance processes (refer here for a discussion of this issue). The gist of the concern is that the SEC whistleblower provisions would encourage the whistleblowers to bypass internal reporting mechanism (many of which have only recently been implemented pursuant to the requirements of Sarbanes Oxley). Though some commentators urged the Commission to require whistleblowers to report violations first internally, the SEC decided not to include this requirement. Rather, the SEC included in the final rules elements it hopes will encourage potential whistleblowers to use internal compliance processes.

 

Specifically, the rules make the whistleblower eligible for an award if the whistleblower reports the violation internally and the company informs the SEC about the violation. The SEC will also treat the informant as a whistleblower as of the date of an internal report of the employees provides the same information to the SEC within 120 days (this allows whistleblowers to save their “place in line” for a possible award). Finally, the informant’s voluntary participation in the company’s internal reporting program will be a factor the SEC will use to increase the amount of an award.

 

The SEC’s final rules also identify a number of categories of persons who will not be eligible for an award, including those with a preexisting legal or contractual duty to report their information; those who obtain their information either by privileged or illegal means; officers and directors who are informed by another person of the violations; compliance and audit personnel. (There are defined circumstances when compliance and audit personnel can be eligible.

 

The rules also clarify the whistleblowing procedures, and provide clarification of what constitutes a voluntary report; what constitutes original information; what constitutes a successful enforcement action and so on.

 

These rules will be effective shortly, most likely later in the summer. The ultimate practical effect of these new rules depends on how forthcoming prospective informants are; the quality of the information; and what the SEC does with the information.

 

The sheer scale of the prospective awards (from 10 to 30 percent of awards in excess of $1 million) is clearly designed to encourage whistleblowing, as indeed is the SEC’s final rule. For its part, the SEC has a huge incentive in the post-Madoff era to heed whistleblower’s warnings and to pursue the reported information. Just looking at the way the incentives and motivations line up, the most probable outcome here seems to be that there will be significant numbers of whistleblower reports and that these reports will trigger significant numbers of investigations and enforcement actions. These enforcement actions could well be followed by follow-on civil litigation, which could increase the potential exposure that companies and their senior officials could face as a result of the implementation of these rules.

 

It certainly appears that a portion of the plaintiffs’ bar things there is an opportunity here supporting prospective whistleblowers and perhaps using their reported information as the basis for separate civil suits – refer for example to this advertisement for the “SEC Whistleblower Claims Center.” The quick emergence of an opportunistic plaintiffs’ bar eager to try to turn these new rules to their advantage is hardly surprising. Enterprising plaintiffs’ lawyers have been profiting from the whistleblower incentives in the False Claims Act for years (refer, for example, here)

 

However these incentives may appear now, they will all be augmented exponentially once a whistleblower or two has garnered a significant award. Given the magnitude of some of the recent SEC enforcement actions (as for example in connection with SEC enforcement action under the FCPA, refer here) the likelihood that we might see some large awards seems high. Refer here for further discussion of the particular concerns surrounding the prospects for whistleblowing activity in the FCPA context.

 

The bottom line is that for those of us who worry about the potential exposures of directors and officers of public companies, there is a whole new category of concerns.

 

Special thanks to a loyal reader for the link to the whistleblower advertisement.