With four more securities suits involving Chinese or China-linked companies this past Friday, the phenomenon of securities class action lawsuits against these firms has emerged as one of the most distinct securities litigation trends so far this year. The filing trend actually first emerged in the second half of 2010, but it has continued into 2011 and appears to have gained significant momentum in recent weeks following recent revelations of accounting irregularities involving Chinese companies.

 

The four latest suits involving Chinese-linked companies are as follows:

 

1. China Electric Motor, Inc.: According to their April 1, 2011 press release (here), plaintiffs’ lawyers have initiated a securities class action lawsuit in the Central District of California against China Electric Motor, a Delaware corporation with its principle place of business in China, as well as the certain of its directors and officers and the underwriters who underwrote the company’s January 29, 2010 IPO.

 

According to the Complaint (here), the lawsuit follows the company’s March 31, 2011 announcement that it is forming a special committee to investigate accounting discrepancies “concerning the Company’s banking statements” identified by the company’s auditors. The company has delayed release of its fourth quarter and year end financial statements and trading in the company’s securities has been halted.

 

2. Advanced Battery Technologies, Inc.: In their April 1, 2011 press release (here), the plaintiffs’ lawyers state that they have filed a securities class action lawsuit in the Southern District of New York against Advanced Battery and certain of its directors and officers. According to the complaint (here), the company is a Delaware corporation with offices in New York that, through subsidiaries, owns two Chinese operating companies.

 

The complaint alleges that the company made misleading statements about its ownership interests in certain Chinese operating companies and that it failed to disclose or fully disclose certain related party transactions involving the company’s CEO. The complaint also alleges, relying heavily on a securities analyst’s report , that the company made false statements about its supposed investment in a company that may not even exist.

 

3. China Intelligent Lighting and Electronics, Inc.: According to the their April 1, 2011 press release (here), plaintiffs’ attorneys have filed a complaint in the Central District of California against the company, certain of its directors and officer and the investment banks that underwrote the company’s June 18, 2010. (One of the investment banks, Westpark Capital, was also involved in the China Electric IPO described above.) The company is a Delaware Corporation with its principle place of business in China. A copy of the complaint can be found here.

 

The lawsuit follows the company’s March 29, 2011 press release in which it announced the termination of its auditor, MaloneBailey LLP; its auditor’s resignation and withdrawal of the audit opinion it issued in connection with the prior year end financial statement; and the formation of a special investigation committee. The press release also discloses that the SEC has launched a formal investigation of t he company.

 

In the press release, the company also discloses that MaloneBailey resigned “due to accounting fraud involving forging of the Company’s accounting records and forging bank records.” The auditors also allegedly stated that the “accounting records at the company have been falsified.” 

 

4. China Century Dragon Media: According to their April 1, 2011 press release (here), plaintiffs lawyers have filed a securities class action lawsuit against the company, certain of its directors and officers and against its offering underwriters. Among the offering underwriters named as defendant in the case is the Wespark Capital firm, which was involved in the China Electric Motor and China Advanced Lighting offerings described above. A copy of the complaint, which was filed in the Central District of California, can be found here.

 

The China Century Dragon Media lawsuit follows the company’s March 28, 2011 announcement of the resignation of its auditor, MaloneBailey LLP (the same firm as withdrew from auditing China Intelligent Lighting, as noted above), and the firm’s withdrawal of its prior audit opinions. The press release discloses that the auditor has resigned as a result of “irregularities” that may indicate that the company’s “accounting records have been falsified.” The discrepancies could also indicate material errors in the company’s prior financial statements. The company also disclosed that its shares have been delisted and the SEC has commenced a formal investigation.

 

These four new lawsuits join the seven suits that had previously been filed so far in 2011 against Chinese and China-linked companies. Of these eleven total lawsuits, six have been filed just since March 18, 2011. The eleven suits against Chinese-related firms already exceed the ten lawsuits that were filed against Chinese companies in 2010. Signs are that there may be further suits to follow shortly, as the law firm that filed all four of the above described lawsuits issued an April 1, 2011 press release (here) that it is investigating possible securities law violations involving Keyuan Petrochemicals (a Nevada corporation with its principal place of business in China), following the company’s April 1, 2011 announcement that it was delaying filing its year end financial statements and initiating an audit committee investigation of certain “concerns.” 

 

The rash of lawsuits has arisen at the same time that the Public Company Accounting Oversight Board raised concerns in a March 14, 2011 report (here) about accounting and auditing standards at Chinese companies that have conducted IPOs in the U.S. or that have become U.S. publicly traded companies through reverse mergers. The report identifies a number of factors that may undermine the ability of audit firms to complete their audit functions completely or effectively. In light of the concerns in the PCAOB report, it hardly comes as a surprise that accounting concerns are coming to light in connection with some of these Chinese firms.

 

The allegations raised in these cases, like the allegations in the four cases described in detail above, fall into two basic categories: Inadequate disclosures involved related-party transactions (see especially Tongxin [here], China Valves Technology [here], and China Integrated Energy [here]), and accounting irregularities or accounting improprieties (see especially China Media Express [here], China AgriTech [here], ShegndaTech [here] and NIVS Intellimedia Technology Group [here].

 

Another familiar theme running through at least a few of these cases is that the lawsuits followed the resignation of the MaloneBailey firm as the defendant company’s auditors. The audit firm’s resignation preceded the lawsuits filed against NVIS Intellimedia Technology Group, China Intelligent Lighting and Electronics, and China Century Dragon Media.  MaloneBailey is identified in Table 8 of the PCAOB report as the U.S.-based firm with the most Chinese reverse merger company clients. In addition, a number of the companies named as defendants in these suits conducted offerings with the investment bank Westpark Capital, Inc as one of their offering underwriters.

 

These firms’ involvement may well be purely coincidental. The larger pattern is that there seems to be a growing number of Chinese and China-linked companies that are announcing concerns related to the accounting and reported financial statements. Whether these issues will continue to emerge will remain to be seen. But for now, a securities litigation filing trend that first developed in the second half of 2008 seems to be going strong as we head into the second quarter of 2011. 

 

Largely as a result of a flood of M&A related lawsuits, there were a significant number of new securities class action lawsuits filed in the first quarter of 2011, and even factoring out the M&A lawsuits, the first three months of the year still represented an active period for securities lawsuit filings.

 

Taking the merger objection suits into account, there were a total of 55 new securities class action lawsuits filed in the first quarter. That would imply an annualized rate of 220 securities suits for the year, which would be well above both the 176 filed in 2010 and the 1996-2009 annual average of 195 filings. However, the rash of merger suits filed during the first quarter does complicate the numeric analysis, as the changing mix of cases may make the year to year measures somewhat of an apples- to-oranges comparison.

 

There were 20 federal court merger objection lawsuits in the first quarter. (There were even more state court merger objection lawsuits, as discussed further below.)  Subtracting the federal court merger objection lawsuits from the first quarter securities class action lawsuit filing tally would reduce the number of first quarter filings from 55 to 35, which would be idenitcal to the 35 new securities suits filed in the first quarter of 2010. Obviously, the process of determining what to include in the lawsuit count has a huge impact on the ultimate tally.  I have further observations about “counting” the securities suit filings below.

 

The 55 securities suits in the first quarter represent a surprisingly diverse range of kinds of companies. The companies targeted in the 55 suits represent 42 different Standard Industrial Classification (SIC  Code categories. Only two SIC Code categories had as many as three companies sued – SIC Code Category 2834 (Pharmaceutical Preparations) and SIC Code Category 3674 (Semiconductors and Related Devices.).

 

By interesting contrast to recent years’ filing patterns, the first quarter filings included relatively few companies in the 6000 SIC Code group (Finance, Insurance and Real Estate). While the credit crisis litigation wave was unfolding and lawsuits against financial companies flooded in, suits against companies in the 6000 SIC Code group predominated. The relative decline of litigation activity in this category provides even further proof that the credit crisis related litigation wave has largely played out. I count a total of only three cases in the first quarter that might even arguably be categorized as credit crisis related. Among these three were  two new securities suits in the first quarter involving failed or troubled banks, which is a filing phenomenon that seems likely to continue in the weeks and months ahead.

 

Among the 55 first quarter cases were nine suits filed against companies domiciled outside the United States. In addition to these nine, there were two additional companies sued that were incorporated in the United States but that have their principle place of business outside the U.S. These eleven total cases represent about 16.3% of all first quarter filings, a percentage that is above the approximately 12% of 2010 filings that involved non-U.S. companies. This relative increase in the incidence of filings against non-U.S. companies is frankly unexpected in light of the U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank (about which refer here).

 

The persistent elevated level of filings against non-U.S. companies is largely attributable to the surge in lawsuits involving Chinese companies. Four of the nine lawsuits filed in the first quarter against non-U.S. companies were filed against Chinese companies. Three additional lawsuits involved companies incorporated elsewhere but with their principle places of business in China. These seven suits together represent about 12.7% of all first quarter filings. Indications are that this phenomenon of suits involving Chinese companies is likely to continue, as in recent days, plaintiffs’ lawyers have issued numerous press releases (for example, here and here)  indicating that they  are “investigating” certain other Chinese companies (a development that usually presages a subsequent lawsuit filing.)

 

As the new filings have shifted away from financially related companies, the jurisdictions in which lawsuit filings have been concentrated have also shifted. During the credit crisis litigation wave, lawsuit filings were concentrated in the Southern District of New York. Indeed, there were nine new securities suit filings in the Southern District of New York during the first quarter 2011, but for the first time since 2007 there were more quarterly filings in a federal district other than the Southern District of New York. Specifically, there were ten new securities lawsuit filings in the Central District of California, and another five in the Northern District of California, a changing jurisdictional mix that reflects the shifting mix of companies that are getting sued.

 

More About the Merger Objection Lawsuits: As I noted above, there were twenty new federal court merger objection lawsuits filed during the first quarter of 2011. A total of at least 63 different M&A transactions produced merger objection litigation in the first quarter, but many of the lawsuits relating to these transactions were filed in state court rather than in federal court. In addition, some of the transactions provoked lawsuits in both state and federal court, and some provoked multiple different lawsuits in different states.

 

Breaking all of this M&A related litigation down, and counting both the state and federal merger objection lawsuits,  there were a total of at least 81 different lawsuits relating to at least 63 different transactions. OF these 81 lawsuits, 20 were filed in federal court and 61 were filed in state court. As indicated above, some transactions produced multiple lawsuits in different jurisdictions.

 

A Note About Counting: Some readers may note that my count of 55 first quarter securities lawsuits differs substantially that the 39 lawsuits reported as of today on the Stanford Law School Securities Class Action Clearinghouse website. There are two reasons for this difference. One is timing, as I have counted suits that have not yet made it onto the Stanford site’s list. The other is counting protocol, as I have included 11 federal merger objection suits on my list that are not included on the Stanford website list.

 

As I have noted numerous times in the past on this site, one of the most challenging parts about keeping a running tally of securities class action lawsuit filings is deciding what you are going to count. As part of my counting protocol used during the first quarter, I have chosen to “count” all federal court securities suits, including all merger objection suits. This has produced a count that differs in certain particulars from the Stanford website count. However, I should hasten to add that my count includes all of the cases noted on the Stanford site. It just includes a few more.

 

These differences underscored the importance of definitional consistency when making comparisons across time. The comparisons are only meaningful if the counting protocols are consistent over time.

 

Finally, and whatever else might be said about the increasing numbers of merger related lawsuits, it seems apparent that the mix of cases is decidedly shifting. While there may be fewer traditional securities class action lawsuits being filed than in some prior years, the amount of total litigation activity is at or above historical averages when the merger objection litigation is taken in to account. And it also seems to be the case that at least as a matter of percentages of all filings, the merger objection lawsuits now outweigh the tradtional securities class action lawsuits.

 

On March 30, 2011, the U.K. Ministry of Justice released its long-awaited Guidance with respect to The Bribery Act of 2010, detailing the Act’s scope and jurisdictional applicability. The Guidance, which can be found here,  has quickly been criticized in some quarters for “watering down” the Act, particularly with respect to the jurisdictional scope of the Act’s commercial bribery provisions. The Serious Fraud Office’s prosecution guidance, also released on March 30, 2011, can be found here.

 

From the time the Act received Royal Assent, one of its features that has been the focus of particular concern has been Section 7 of the Act. Section 7 creates a new offense which can be committed by commercial organizations that fail to prevent persons associated with them from committing bribery on their behalf. Commentators have been concerned that this provision seemingly would subject any firm –even non-U.K. companies that have operations in the U.K. – to liability under the Act for violative conduct taking place any where in the world.

 

The newly-issued Guidance proposes a “common sense” approach to the question of applicability of this provision to firms organized outside the United Kingdom. While noting that ultimately the courts will determine whether or not a firm has a sufficient U.K. presence to warrant the Act’s application, the document goes on to say that the Act would not apply to firms that “do not have a demonstrable business presence” in the U.K.

 

As an example of the kinds of activities that would not be sufficient to constitute the carrying on of business in the U.K., the document states that “the mere fact that a company’s securities have been admitted to the U.K. Listing Authority and therefore admitted to trading on the London Stock Exchange” is not sufficient “to qualify that company as carrying on a business or part of a business in the U.K.

 

The document further specifies that merely “having a U.K. subsidiary will not, in itself, mean that a parent company is carrying on a business in the U.K.,” as “a subsidiary may act independently of its parent or other group companies.”

 

The primary thrust of the Guidance document is to identify procedures that companies can put in place to take advantage of the defense available under the Act, which provides that a firm cannot be held liable under the Act if it has adequate procedures in place to prevent persons associate with it from bribing.

 

 The document describes a principles based rather than a rules based framework, built around six guiding principles. The six principles are: proportionate procedures; top-level commitment; risk assessment; due diligence; communication; and monitoring and review.

 

The document also provides clarification about hospitality, stating  that “bona fide hospitality and promotional expenditures” are an “an established and important part of doing business” adding that “it is not the intention of the Act to criminalize such behavior.” The document specifically cites as example of such payments that would not typically run afoul of the Act’s provisions as “the provision of airport to hotel transfer services to facilitate an on-site visit or dining and tickets to an event.”  Introductory comments in the document from the Secretary of the State for Justice Kenneth Clarke add that “no one wants to stop firms from getting to know their clients by taking them to events like Wimbledon or the Grand Prix.”

 

The Act will now come in to force on July 1, 2011. The provisions in the Guidance document have been welcomed by some commentators, who note that the proportionate approach reflect in the document should be “good for business.” At the same time other commentators have criticized the guidance as having introduced “loopholes.”  Others have criticized the government for “watering down” the Act’s provisions.  

 

My own view is that while the Guidance has provided some clarification, it has not provided absolute clarity either, and the lack of clarity remains a concern. The examples given about what kind of activity would not be sufficient to support liability under the Act are helpful as far as they go, particularly that merely having a U.K. listing or a U.K. sub is not enough to support liability against a listed firm or the sub’s parent. Those activities are not sufficient, but what level of activity is sufficient?

 

The clarification that the government will be pragmatic and that the government will be guided by principles of proportionality is reassuring. However, the government’s Guidance document does not by any means put to rest all concerns. The upcoming applicability of the Bribery Act should remain an issue of focus and concern for companies with a business presence in the U.K I worry about the first non-U.K. company whose activities will become the test case under the Act.

 

In a March 29, 2011 order (here), Southern District of New York Judge Jed Rakoff granted the defendants’ motions to dismiss a pair of subprime-related derivative lawsuits that had been brought against certain directors and officers of Merrill Lynch. Because the plaintiffs — former shareholders of Merrill Lynch who became BofA shareholders at the time of BofA’s January 2009 acquisition of Merrill—asserted their claims in the capacities as BofA shareholders, both lawsuits represented so-called double derivative suits. A copy of Judge Rakoff’s March 29 ruling can be found here.

 

Judge Rakoff granted the motions to dismiss because he concluded that the plaintiffs had failed to show that BofA’s board was” so involved in the underlying wrongdoing alleged in the derivative complaint that it could not impartially consider a demand to pursue claims against the Merrill officers and directors.”

 

Both lawsuits sought to assert claims against the defendants for the “unprecedented losses” Merrill had experienced “as a result of its aggressive investment in collateralized debt obligations.” A detailed review of the underlying facts can be found here. In an earlier ruling, Judge Rakoff had previously ruled that the plaintiffs lacked standing to assert derivative claims on Merrill’s behalf because they were no longer Merrill shareholders. His prior ruling was without prejudice to their refilling their claims in their capacities as BofA shareholders.

 

The plaintiffs refilled their complaints seeking to compel BofA’s board to force its Merrill subsidiary to bring claims against certain Merrill directors and officers in connection with Merrill’s reckless investments. The key difference in the two actions is that in the first action (referred to as the “Derivative Action”), the plaintiffs allege that they are not required to bring a demand that BofA’s board bring the action against the Merrill officials, whereas in the second action (the “Lambrecht Action”), the plaintiffs had presented a demand which the BofA board had refused.

 

Judge Rakoff concluded that both actions should be dismissed, noting that

 

The Court does not take this step lightly, for the allegations of the complaint, if true, describe the kind of risky behavior by high-ranking financiers that helped created the economic crisis from which so many Americans continue to suffer. But a derivative action is brought for the benefit of the company, and nothing here alleged in the complaints raises a reason to doubt that the board of the relevant company, BofA, was at all times fairly positioned to determine whether bringing an action against Merrill’s former directors and officers was in the company’s interests.

 

With respect to the Derivative Action, Judge Rakoff specifically concluded that the plaintiffs had “failed to make a legally adequate showing” that the BofA board was so involved in the underlying wrongdoing “that it could not impartially consider a demand to pursue claims against the Merrill officers and directors.”

 

With respect to the Lambrecht Action, Judger Rakoff concluded that the plaintiffs had “failed to carry the considerable burden of showing that the BofA’s Board’s decision not to bring a lawsuit against the Merrill officers and directors was made in bad faith or was based on an unreasonable investigation.”  

 

Discussion

Some time ago, as discussed here, Merrill Lynch settled for $475 million dollars the related securities class action lawsuit that had been filed on behalf of Merrill’s shareholder. Merrill also at the same time agreed to settle the related ERISA liability suit for an additional $75 million. In addition, Merrill agreed to settle the related securities suit that had been brought by its bondholders for $150 million, as discussed here. These settlements represent $700 million in aggregate.

 

However, Merrill and its successor in interest BofA declined to settle the related derivative litigation, and Judge Rakoff’s decision dismissing the derivative litigation appears to vindicate that decision.

 

Judge Rakoff’s ruling is interesting if for no other reason that the unusual posture of the double derivative suit, where the demand to pursue the claims against the former directors and officers of a subsidiary must be directed against the board of the parent company.

 

The ruling is also interesting because it illustrates just how difficult it is to overcome the initial pleading hurdles in a derivative suit. Judge Rakoff concluded that the initial pleading requirements had not been satisfied notwithstanding allegations that Judge Rakoff himself said “describe the kind of risky behavior by high-ranking financiers that helped create the economic crisis from which so many Americans continue to suffer. “ The clear implication is that even allegations of egregious behavior will not suffice if the demand requirements have not been satisfied or proved inapplicable.

 

Judge Rakoff’s analysis of the BofA board’s rejection of the Lambrecht plaintiffs’ suit demand is particularly interesting. In reviewing the substance of the reasons the BofA board gave for rejecting the demand, Judge Rakoff noted that the rejection letter the board had sent “belies plaintiff’s assertions” that the rejection was cursory and the letter itself mere boilerplate. In support of this conclusion, he noted that the board had reasoned that taking up the litigation as the Lambrecht plaintiffs demanded would have undermined Merrill’s defenses in the securities litigation and in the ERISA litigation. The letter also reflected the board’s conclusion that the cost of the urged litigation might well any benefit that might reasonably be expected. These types of considerations often are present when these types of demands are presented to boards, and Judge Rakoff’s analysis seems to confirm that it these kinds of considerations are appropriate for boards to take into account in rejecting litigation demands.

 

Finally, Judge Rakoff rejected the plaintiffs suggestions that the response letter irself showed that consideration of the litigation demand was cursory, noting that” there is no prescribed procedure a board must follow in responding to a demand letter.”

 

I have in any event added the ruling to my running tally of subprime-related dismissal motions rulings, which can be accessed here.

 

Nate Raymond’s March 29, 2011 Am Law Litigation Daily article about Judge Rakoff’s decision can be found here.

 

Special thanks to the securities litigation group at Skadden for forwarding me a copy of Judge Rakoff’s ruling. Skadden represented Bank of America and Merrill Lynch in the two derivative suits.

 

An International D&O Resource. I know from conversations with readers that one issue of recurring concern is finding resources on which to rely in connection with the non-U.S. exposures of directors and officers. With that concern in mind, I am pleased to link here to the recently completed paper by my friend Perry Granof. The paper, which is entitled “The Top 10 Non-US-Jurisdictions Based Upon Maturity and Activity” (here) analyzes the ten non-U.S. jurisdictions that Perry believes have the most evolved systems with respect to the liabilities of directors and officers. The list also includes three ‘up-and-coming” jurisdictions, as well.

 

I am pleased to reproduce below a guest post from my friend Maurice Pesso, who is a parner in the White & Williams law firm, and his colleagues Sarah Katz Downey. I welcome guest contributions from responsible commentators. This article first appeared as a White & Williams law firm memo. Please note that in an earlier post (here), I summarized a speech Judge Jed Rakoff gave last summer about the Bank of America case (mentioned below). Here is the guest post:

 

 

In a March 21, 2011 opinion by U.S. District Court Judge Jed Rakoff  in Securities and Exchange Commission v. Vitesse Semiconductor Corp., et al., Case No. 10cv9239 (S.D.N.Y. March 21, 2011) (the "Opinion"), Judge Rakoff, in approving the proposed consent judgments against Vitesse and two of its officers, questioned whether the SEC’s practice of allowing defendants to neither admit nor deny liability might render a proposed consent judgment “so unreasonable or contrary to the public interest as to warrant its disapproval.” Here are Judge Rakoff’s own words: “[h]ere an agency of the United States is saying, in effect, ‘although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.’”

 

 

This is at least the second time that Judge Rakoff has publicly called into question the SEC’s settlement practices. In September 2009, Judge Rakoff initially refused to approve a $33 million settlement between the SEC and Bank of America relating to shareholder communications by Bank of America prior to its takeover of Merrill Lynch. Although Judge Rakoff subsequently approved the settlement on revised terms, he chastised the SEC for the initial settlement terms, stating that the settlement "does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for that misconduct."

 

 

If Judge Rakoff’s reasoning gains traction in judicial or political quarters, the SEC may be placed in a position where it must refuse to enter into settlements with defendants unless the defendants admit liability. This would create a strong disincentive for defendants, and especially individual defendants, to settle with the SEC for at least two reasons: (1) if they admit liability, they will have limited future prospects as directors or officers of any registered company; and (2) the admission of liability will significantly raise the cost of resolving any related civil litigation, such as a securities class action.

 

In the wake of the Vitesse decision, D&O underwriters should be thinking about how the inability to settle SEC enforcement proceedings will affect the costs of defense for SEC enforcement proceedings and impact defense and settlement costs for related shareholder class actions and derivative litigation. On the one hand, if defendants cannot settle with the SEC without admitting liability, there likely will be fewer settlements and some defendants may decide to litigate until a final judgment — all resulting in increased costs of defense. On the otherhand, if a defendant chooses to litigate until a final judgment and a verdict is rendered against the defendant, the D&O insurer may be able to deny coverage in its entirety based on conduct exclusions in the D&O policy.

 

SEC v. Vitesse, et al.

 

On December 10, 2010, the SEC filed an enforcement proceeding against Vitesse Semiconductor Corporation and four Vitesse officers and directors. In its complaint, the SEC generally alleged that the defendants made numerous material misrepresentations in Vitesse’s SEC filings in an effort to conceal their fraudulent revenue recognition practices and stock options backdatings. Simultaneously with the filing of the complaint, the SEC filed proposed consent judgments against Vitesse and two of its officers, apparently anticipating that the court would simply approve the settlement as negotiated.

 

The consent judgments were presented to Judge Rakoff for court approval. According to the Opinion, the consent judgments lacked information explaining why they should be approved and how they met the requisite legal standards for court approval. In response to Judge Rakoff’s request for additional information, the SEC provided a December 21, 2010 letter brief. In addition, on December 22, 2010, a hearing was held before Judge Rakoff at which time the parties provided further information.

 

In the Opinion, Judge Rakoff acknowledged that, at first glance, the terms of the proposed consent judgments appeared inadequate based on the allegations of material misconduct by the defendants. However, despite the fact that the three defendants neither admitted nor denied liability, Judge Rakoff concluded that the terms of the settlement were “fair, reasonable, adequate, and in the public interest.” In finding that the terms of the proposed settlement were adequate, Judge Rakoff considered factors outside the terms of the settlement with the SEC, such as the fact that the two officers pled guilty to parallel criminal charges and that Vitesse had little money to pay based on its current troubled financial condition.

 

Despite having approved the settlement, Judge Rakoff raised concerns with the SEC’s longstanding practice of seeking court approval for settlements in which serious allegations of fraud are asserted against the defendants without requiring the defendants to expressly admit or deny the allegations.

 

As a practical matter, the SEC’s practice of settling with defendants who neither admit nor deny liability benefits both the SEC and the defendants. By entering into the consent judgments without admitting liability, the defendants are not collaterally estopped from asserting their innocence in parallel civil actions. Because the defendants do not have to admit liability, the SEC benefits because the defendants are more likely to enter into SEC settlements at an earlier time, and without requiring the SEC to devote substantial resources to taking enforcement actions to trial.

 

According to the Opinion, the SEC’s practice of entering into settlements where the defendants neither admit nor deny liability began decades ago and has developed through the years. Prior to 1972, after a court approved a settlement, the defendant would publicly deny his or her liability in connection with the SEC’s allegations. In response, in 1972, the SEC began to require all defendants who settled with the SEC without an admission of liability to refrain from publicly proclaiming their innocence. Nevertheless, SEC defendants still found ways in which to make it known that they never admitted liability — while being careful to refrain from denying liability at the same time.

 

In the Opinion, Judge Rakoff questioned whether the SEC’s practice of allowing defendants to neither admit nor deny liability might render a proposed consent judgment “so unreasonable or contrary to the public interest as to warrant its disapproval.” According to Judge Rakoff, the public suffers from the SEC’s practice of allowing the defendants to settle serious allegations without admitting liability, leaving the public with no way of knowing whether there was any truth behind the allegations.

 

D&O Coverage Implications

SEC settlements themselves are generally uninsurable under D&O policies because they are composed of either: (1) fines/penalties; (2) disgorgement; and/or (3) equitable relief. However, the costs associated with defending against SEC enforcement proceedings are generally covered under D&O policies.

 

As discussed, if Judge Rakoff’s reasoning is followed, the SEC may find itself pressured — or obligated — to enter into settlements only with defendants who will admit liability. If defendants cannot settle with SEC without admitting liability, there will be fewer settlements, and some defendants may decide to litigate until a final judgment — all resulting in increased costs of defense. In recent years, defense costs for even a single SEC defendant have run into the millions of dollars, and sometimes even more than $10 million. Because defense fees associated with SEC enforcement proceedings are generally covered under D&O policies, D&O insurers would feel the impact of increased defense costs in SEC actions.

 

At the same time, if a defendant chooses to litigate until a final judgment and a verdict is rendered against the defendant, the D&O insurer may be able to deny coverage for the defendant based on the conduct exclusions. In addition, the D&O insurer may be able to rely on the judgment to deny coverage for one or more D&O defendants in any related civil litigations. Depending upon the policy terms at issue, the D&O insurer may also be able to seek reimbursement of all of the defense costs that it previously advanced following an adverse verdict in an SEC trial.

 

The SEC’s reaction to Judge Rakoff’s criticism remains to be seen. Although intended to be an independent regulator, the SEC can be subjected to political pressure — especially from the U.S. Congress, which sets the SEC’s annual funding budget. It will be interesting to see if there is a slowdown in SEC settlements over the next few months and if other judges refuse to “rubber stamp” SEC settlements where the defendants neither admit nor deny liability. We will follow this issue and report any findings.

 

In a unanimous March 22, 2011 opinion by Justice Sonia Sotomayor, the U.S. Supreme Court rejected the argument of Matrixx Initiatives that adverse product reports must be "statistically significant" in order for a manufacturer to have an obligation to disclose the reports to investors. As a result of the Court’s decision, shareholders claims against the company for its alleged failure to disclose reports that its Zicam cold remedy caused loss of smell for some users will now be going forward. The Court’s opinion can be found here.

 

Background

Matrixx Initiatives manufactured an internasal cold remedy called Zicam. In April 2004, plaintiff shareholders filed a securities class action lawsuit against Matrixx and three of its directors and officers, alleging that the defendants were aware that numerous Zicam users experienced loss of the sense of smell. The complaint alleges that the defendants were aware of these problems because of calls to the company’s customer service line; because of academic research, which was communicated to the company; and because of product liability lawsuits that had been filed against the company.

　

The district court granted the defendants’ motion to dismiss, finding that the complaint failed to adequately allege that the alleged omissions were material, because the complaint did not allege that the number of customer complaints was "statistically significant."

　

As discussed at greater length here, on October 28, 2009, the Ninth Circuit reversed the district court, holding that the district court "erred in relying on the statistical significance standard" in concluding that the complaint did not meet the materiality requirement. The Ninth Circuit said that a court "cannot determine as a matter of law whether such links [between Zicam and loss of smell] was statistically significant, because statistical significance is a matter of fact." The defendants filed a petition for a writ of certiorari to the U.S. Supreme Court, and as discussed here, the Supreme Court granted the petition.

　

The Opinion

　

In their briefs before the U.S. Supreme Court, Matrixx urged the Court to adopt a "bright line" test that reports of adverse events with a pharmaceutical company’s produce cannot be material absent a sufficient number of reports to establish statistical significance. Matrixx argued that statistical significance is the only reasonable indicator of causation.

　

The Court declined to adopt the bright line test urged by Matrixx, reasoning that such a categorical rule would "artificially exclude evidence that would otherwise be considered significant to the trading decision of a reasonable investor."

　

The Court also rejected the notion that only statistical significance in the only reasonable indicator of causation, noting that medical professionals and the FDA regularly infer a causal event between a drug and adverse event. Justice Sotomayor wrote that "Given that medical professionals and regulators regularly act on the basis of evidence of causation that is not statistically significant, it stands to reason that in certain cases reasonable investors would as well."

　

This conclusion does not however mean that pharmaceutical companies have to disclose every adverse event. Rather, an adverse event is material and must be disclosed, the Court said citing its standing test for materiality, if it would "significantly alter the total mix of information." The "mere existence" of adverse reports "will not satisfy this standard." Rather, "something more is needed — but "something more" is "not limited to statistical significance." and "can from the source, context and context of the reports."

　

Justice Sotomayor reiterated, however, that absent a duty to speak, silence cannot be the basis of securities liability. Disclosure is only required when necessary to make previous statements not misleading; "Even with respect to information that a reasonable investor might consider material, companies can control what they have to disclose under these provisions by controlling what they say to the market."

　

Applying this total mix standard to this case, the Court concluded that the loss of smell reports of which the plaintiffs allege the defendants were aware, "the complaint alleges facts suggesting a significant risk to the commercial viability of Matrixx’s leading product." "This is not a case about a handful of anecdotal reports, as Matrixx suggests," Sotomayor wrote. She added the investors intend to prove that "Matrixx received information that plausibly indicated a reliable causal link between Zicam and anosmia," the medical term for a loss of smell.  At its most basic level, the Supreme Court’s decision in the Matrixx Initiatives case is essentially just a reaffirmation of its prior case authority dealing with the question of materiality. In particular the Court reiterated its prior statement of the standard for materiality in the   Basic, Inc. v. Levinson case and  TSC Industries v. Northway.  "companies can control what they have to disclose under these provisions by controlling what they say to the market "

　

The Court also found the plaintiffs’ allegations were sufficient to satisfy the requirements for pleading scienter. The Court noted that it has not yet determined whether recklessness along is sufficient to satisfy the scienter requirements, saving that question for another day.

　

Discussion 　  　

Viewed in that light, the decision may not be all that surprising. Just the same, there is something a little bit unexpected about this decision. The unanimous opinion represents a clean sweep for the plaintiffs, which given this Court’s track record arguably is an unexpected outcome. The Supreme Court has produced a number of decisions highly favorable to defendants in recent years, and while that has not been entirely uniform (there was the Merck decision last term for example), the Court has seemed to have a predisposition for the defense perspective.

　

By rejected the proposed "bright line" test , the Court has relieved plaintiffs of the burden of having to come up with sufficient facts to prove statistical significance. The lack of a bright line test may, however, represent something of a challenge for reporting companies going forward. Manufacturers receive "adverse event reports" in the form of customer complaints all the time. A bright line test would have clarified when the number of reports has reached a sufficient level that they must be disclosed. In the absence of such a clear standard, companies will face quite a struggle in trying to figure out what must be disclosed.

　

Once place companies may want to turn for guidance is the statement in Justice Sotomayor’s opinion that "companies can control what they disclosre under these provisions by controlling what they say tot he market."This statement suggests to me that the judicious use of precautionary disclosure may go a long way toward alleviating disclosure challenges.

　

Special thanks to my friends in the Securities Litigation group at Skadden Arps for alerting me to the Matrixx Initiative decision and for sending me a copy of their analysis of the decision (hewww.skadden.com/newsletters/Supreme_Court_Rejects_Bright_Line_Test_for_Materiality.htmlre)

I am pleased to reproduce below a guest post from my friend and colleague, David S. De Berry. Dave is an attorney and CEO of Concord Specialty Risk, a series of a Delaware limited liability companies owned by RSG Specialty Group, LLC. I want to emphasize that while Dave and I are now colleagues as a result of the common ownership of our two firms, I welcome guest post submissions from any responsible contributor. Dave’s topic is in an area not typically covered on this blog, but I still thought readers would find it of interest. Here is Dave’s post.

　

Companies could be facing a significant new exposure as a result of a new reporting requirement that goes into effect for tax returns that must be filed this year. The new reporting requirement expands beyond existing accounting requirements for tax uncertainty. The result is that tax liabilities not requiring a reserve for financial statement purposes may be directly disclosed to the IRS. This article discusses the new reporting requirements, the potential impact on securities litigation and the variety of insurance solutions available to address these issues.

 

The Requirement to "Confess & Rank"

The IRS now requires "large" corporations to "confess and rank" their uncertain tax positions when filing tax returns. Specifically, the IRS is now requiring corporations with (worldwide, gross) assets that exceed $100 million to provide the IRS with a "concise description" of all of their uncertain tax positions and to rank those positions by size of tax reserve, or by amount at issue (if not reserved), and to denote whether the position relates to transfer pricing. The information must be included in their 2010 U.S. income tax returns (generally filed on or before September 15, 2011 for calendar year taxpayers) under a new IRS form, Schedule UTP, which stands for "uncertain tax positions." The Schedule UTP form can be found here.

 

And the requirement to "confess and rank" to the IRS is slated to extend to all corporations as Schedule UTP phases in over the next five years. Corporations with total assets of $100 million or more must file Schedule UTP starting with 2010 tax years. Starting with 2012 tax years, the total asset threshold will be reduced to $50 million. Starting with 2014 tax years, it will be reduced to $10 million.　 The IRS stated that it will consider whether to extend the Schedule UTP reporting requirement to other taxpayers—such as pass-through entities or tax-exempt organizations—for 2011 or later tax years. The instructions for Schedule UTP can be found here.

 

The Dramatic Extension Beyond Current U.S. – GAAP

Companies reporting their financial statements in accordance with US-GAAP have recently had to follow a set of rules known as "FIN 48" when accounting for tax uncertainty. Essentially, FIN 48 requires that all tax positions be identified and evaluated in a two-step process: (1) the recognition step, which asks whether each tax position would more likely than not prevail under existing law – if not, then none of the tax benefits associated with the position are "recognized" (i.e., the entire amount at risk is charged or reserved and provisions for accruing interest and perhaps penalties must also be set forth in the financial statements); if the position is likely to prevail under existing precedent or authority, then the second (measurement) step is taken to determine how much of the tax benefits may be recognized for financial statement purposes and (2) the measurement step, which asks, as to each recognized position, how much of the position is more likely than not going to be allowed in a final resolution (via settlement or adjudication) with the taxing authority assuming the position were challenged and it would be settled on its own merits (no trading of positions for settlement purposes). The official publication of FIN 48 can be found here.

　

Schedule UTP is a dramatic divergence from the measurement step used in FIN 48 for accounting purposes. Under FIN 48, if a company believes (i.e., convinces its financial statement auditors) that it would never settle a tax position with the IRS and would more likely than not prevail in the adjudication of that position, no FIN 48 reserve is required. Under Schedule UTP, however, each such position must be disclosed and given a priority ranking as part of the corporate tax return filed with the IRS.

　

The Impact on Companies

The impact that Schedule UTP will have on securities class actions and derivative actions remains to be seen. The impact on corporate cash, balance sheets and income, however, is expected to be significant.For example, in a report by Credit Suisse dated May 18, 2007, entitled "Peeking Behind the Tax Curtain", Credit Suisse analyzed just 361 companies in the S&P 500 and found a total of $141 billion in unrecognized tax benefits for uncertain tax positions identified pursuant to FIN 48. A copy of an abstract of that repot can be found here.

 

To the extent that FIN 48 reserves relate to tax liabilities owed the IRS, Schedule UTP will almost certainly make the FIN 48 reserves a self-fulfilling prophecy. As discussed further below, however, there may be some relief for companies that posted large FIN 48 tax reserves of U.S. income tax liabilities. In cases where the tax position was not recognized, in part or in whole, because the company could not persuade its financial statement auditors with a tax opinion prior to the initial setting of FIN 48 reserves for the position, tax insurance may be available.

 

But regardless of the amount reserved for FIN 48 purposes, the amount not reserved but yet exposed by Schedule UTP will present a significant challenge to many companies. In certain instances, the discrepancy between tax liabilities reserved for FIN 48 purposes and tax liabilities disclosed to the IRS in Schedule UTP can be very significant. Many companies obtained tax opinions for certain tax positions and argued that they would never settle with (and would prevail over) the IRS to avoid FIN 48 reserves for those tax positions. As noted above, all such positions must now be disclosed in a concise narrative description and given a priority ranking as part of the corporate tax return.

 

When the discrepancy is material to the company’s financial condition and significant tax liabilities (and/or penalties) that were not reserved arise as a result of Schedule UTP, there may well be grounds for shareholder actions.

 

The Specter of Securities Class Actions & Derivative Suits

Absent rather extreme circumstances (e.g., Enron), it still seems fairly remote that an adverse, material, final determination of an uncertain tax position(s) not fully reserved in a company’s financial statements but reported on Schedule UTP could expose the company, its directors and officers and/or auditors to liability under securities laws or corporate law.

 

However, in instances in which the discrepancy between FIN 48 reserves and Schedule UTP exposure is both large (relative to liquidity) and protracted (not remedied over time by either increasing reserves or mitigating the tax risk, as discussed below), and/or if penalties are assessed, the plaintiff’s case becomes easier.

 

In Overton v. Todman & Co, 478 F.3d 479 (2d Cir. 2008), the Court vacated and remanded the trial court’s dismissal of a securities fraud claim against an accounting firm that purportedly failed to correct its certified opinion after learning that the company’s tax liability had not been correctly stated. (The appeal did not address the more difficult issue of loss causation because the trial judge had dismissed on the basis that the accounting firm had no "duty to speak.") The Court ruled:

 

Specifically, we hold that an accountant violates the "duty to correct" and becomes primarily liable under  Section  10(b) and Rule 10b-5 when it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that　potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied [i.e., materiality, transaction causation, loss causation and damages]. { Id at pages 486-487.} 

 

A copy of the decision can be found here.

 

It would seem that the reasoning in Overton as to an auditor’s duty to correct and speak about an inaccurately disclosed tax liability should extend to corporate "speakers" when any corporate tax directors, CFO’s and the members of an Audit Committee discover a material discrepancy between FIN 48 reserves for U.S. income tax liabilities and Schedule UTP. For purposes of establishing liability under Section 10(b) of the Securities Exchange Act of 1934, a significant discrepancy followed by silence (and no action to mitigate loss or increase reserves) may well be viewed as the basis for establishing corporate scienter (particularly in jurisdictions that follow either a weak or semi-strong theory of corporate scienter) and/or scienter on the part of the CFO and members of the Audit Committee. And the "failure to take reasonable steps" language of Overton could well be applied to a derivative action taken against the Audit Committee that fails to correct or mitigate these discrepancies and subsequently incurs large legal and expert fees and/or penalties.

 

In fact, transparency regarding tax liabilities has taken center stage in recent corporate governance gatherings. On October 19, 2009, IRS Commissioner Doug Shulman addressed the 2009 National Association of Corporate Directors Governance Conference and urged that companies establish an open dialogue and regular meetings between their Audit Committees and Tax Directors and that directors are legally charged with oversight of their company’s compliance with tax laws. Commissioner Shulman made a number of detailed inquiries that should be undertaken by Audit Committees. The IRS’s suggested inquiries could one day serve as the checklist for proper corporate tax governance by many corporations and/or plaintiff’s counsel prosecuting a derivative action (particularly where penalties have been assessed). A copy of the Commissioner’s remarks can be found here.

　

Loss Mitigation Techniques

So how does a company protect itself from the risk that it failed to adequately reserve for tax liabilities? As noted above, the traditional approach of obtaining a tax opinion may no longer suffice. There are two major concerns: (1) the opinion will not prevent disclosure under Schedule UTP and (2) the opinion may not, in practice, protect the company against penalties, much less un-accrued taxes and interest.

 

A "covered" tax opinion that satisfies the standards of Treasury Circular 230 (31 CFR 10.35) is often touted as the company’s defense against penalties. In practice, however, not many corporate taxpayers want to waive their attorney-client privilege and provide the IRS with a tax opinion that (in order to be a covered opinion) develops all relevant legal theories and considers all relevant authorities, support and arguments, both favorable and not favorable for the taxpayer.

 

Accordingly, tax practitioners may wish to consider advising their clients to consider tax insurance for their material uncertain tax positions. In fact, some tax practitioners already include such advice as a standard provision in any tax opinion. (E.g., "Of course, our opinion is not binding on the IRS and there is a reasonable basis by which the IRS could successfully challenge the tax position. If greater economic certainty around the tax position is desired, tax insurance may be available.")

　

Moreover, tax return preparers may wish to consider comparing the FIN 48 reserves (and work papers) with the Schedule UTP before filing the tax return and would be well advised to inform their clients that tax insurance may be available for discrepancies, if any, and/or for tax positions that have not been fully recognized.

 

Tax Insurance Protection: In fact, tax insurance may be available via several alternative (but not mutually exclusive) approaches:

 

1. Transactional Tax Insurance covering a particular uncertain tax positions (or set of related tax positions) taken in particular tax year(s) against claims made during the policy period (often co-extensive with the statutory period in which assessments can be made).

 

2. Schedule UTP/FIN 48 Tax Insurance covering the shortfall in FIN 48 reserves for those selected uncertain tax positions set forth on Schedule UTP. The policy period will often be co-extensive with the statutory period in which assessments can be made with respect to the U.S. (federal) corporate income tax return. The difference between Schedule UTP/FIN 48 Tax Insurance and Transactional Tax Insurance is that the scope of uncertain tax positions is expected to be far broader in Schedule UTP/FIN 48 Tax Insurance, with higher limits. Subsequently policies would cover subsequent returns on a non-cumulative basis with respect to tax positions covered under multiple policies (i.e., the full amount of tax exposure may be insured but not more than the full amount will be insured).

　

3. FIN 48 Tax Insurance – An annual claims-made policy with a one-year policy period covering the adequacy of the FIN 48 reserves with respect to the tax positions covered under the policy. A claim is made when an audit makes inquiry about a covered tax position. Each year, a new set of covered tax positions are covered (subject to underwriting approval) as new tax positions are reported and/or as former tax positions are no longer subject to challenge.

 

Variations of the above prototypes may also be available. Tax insurance almost always allows the insured to select its tax counsel (subject to consent) and typically contains no more than a few exclusions. It is not, however, available for "reportable transactions."

 

Because tax insurance provides cash when needed to pay a tax bill, and because its purchase reflects a prudent risk management approach to the inherent complexities of tax planning, reporting and reserving, as Schedule UTP becomes a corporate requirement, so too may tax insurance. The alternative may well be a new wave of shareholder suits.　

　

Any list of the most important and influential Americans of the 20th century would have to include William Brennan, whose 34-year tenure as an associate justice of the U.S. Supreme Court coincided with –and in many ways both reflected and influenced – a period of extraordinary change both in American society and in its jurisprudence. Liberal icon and lightening rod for conservative rancor, Brennan was at the center of many of the Court’s highest profile decisions.

 

In an authorized biography entitled "Justice Brennan: Liberal Champion," journalist Stephen Wermeil and attorney Seth Stern provide a balanced and thorough overview of Brennan’s long and extraordinary life. Because Wemiel had the opportunity to interview Brennan before his death in 1997 and because the authors had access to Brennan’s personal notes and files, the book provides significant insight into the Supreme Court’s inner workings.

 

The book explores Brennan’s early life, including his childhood and his years at Harvard Law School, where he took classes with Felix Frankfurter (with whom Brennan would later serve on the U.S. Supreme Court – Frankfurter did not remember Brennan, who had not been a particularly brilliant law student). The book also examines Brennan’s early career as a labor lawyer in Newark and then as a state court judge in New Jersey.

 

But the bulk of the book is devoted to Brennan’s years on the Supreme Court. Brennan was nominated for the Court by Republican President Dwight Eisenhower, though Brennan was a lifelong Democrat. With an eye on the 1956 presidential election, Eisenhower wanted to nominate a youthful Catholic, preferably one with state judicial experience. Few candidates met all of these criteria, so Brennan found himself on the Supreme Court at age 50, with only seven years of state trial and appellate court judicial experience. (Eisenhower is reported to have later regretted the nomination.)

 

Brennan would quickly become a key ally and working partner of Chief Justice Earl Warren, together exercising an expansive vision of judicial authority. The authors refer to Brennan’s collaborative relationship with Warren as "one of the most enduring friendships important alliances in the history of the Supreme Court," resulting, among other things in an historic and surprisingly enduring expansion of civil rights.

 

Brennan arrived after the Court’s landmark Brown v. Board of Education decision declaring "separate but equal" to be "inherently unequal." However, he soon became an indispensible part of the working majority on the court that operated with the view that for too long the Court had, in the name of judicial restraint, abdicated its responsibility to protect civil liberties.

 

Brennan himself developed an activist, results-oriented approach, first manifest in cases dealing with segregation and racial inequality, but soon extended to a host of other areas, including criminal procedure, privacy, voting rights and obscenity. Brennan would be in the majority in a wide range of controversial opinions, including those involving abortion, school prayer, busing and affirmative action.

 

As a result of these decisions, the Court attracted fierce criticisms that it was acting in the role of Platonic Guardian and operating as a "roving commission" to do justice as they conceived it, in the process trammeling majoritarian institutions.

 

The activist judicial approach of Brennan and his liberal colleagues on the Court triggered a strong political backlash. Barry Goldwater’s 1964 presidential campaign, as well as Richard Nixon’s campaign in 1968, was in many ways built around criticisms of the Court and its liberal agenda. As the Court’s membership changed in the 70’s and 80’s due to the conservatives political successes, Brennan found himself dissenting more frequently and sometimes isolated – but still able to influence colleagues and, to a certain extent, to protect decisions of the Warren Court era.

 

Though the biography is generally favorable, the portrait that emerges is relatively balanced. Brennan appears as a conscientious and effective jurist who, as a result of the strength of his personal charm, principles and intellect became, as the authors claim "one of the most influential justices of the 20th century."

 

Brennan’s life story is well told in this detailed account, which not only examines his judicial career, but also his life off the court, including his marriage, his friendships, his religious life and even his finances. The book is filled with interesting insights and anecdotes, such as Brennan’s passionate opposition to the death penalty, and, on a more personal note, his marriage to his long-time secretary, Mary Fowler, just three months after the death of his first wife, Marjorie, to whom had had been married for nearly all of his adult life.

 

Along the way, the authors provide deep insight into how the Court works and how it has had such an extraordinary influence on so many aspects of American life and society.

 

Despite the many years of conservative majorities that followed Brennan’s tenure on the Court, a surprisingly large part of Brennan’s legacy remains intact. In areas such as civil rights, privacy, voting rights and criminal procedure, decisions that when first made were highly controversial remain the law of the land. It is perhaps fitting that in his confirmation hearing, David Souter, Brennan’s replacement on the Court, referred to Brennan as "one of the most fearlessly principled guardians the Constitution ever had."

 

I enjoyed reading this book and I have no hesitation recommending it. I will say that reading the book occasioned much thought and even concern as I reflected on Brennan’s brand of judicial activism. Though the Warren Court’s civil rights decisions were essential to removing deep racial injustices, the activist approach the Court employed led to other decisions about which it is difficult for me to feel quite as comfortable, even if just from an analytical point of view.

 

Moreover, an activist approach that finds rights and legal requirements without an explicit textual basis in the Constitution can be used for conservative as well as liberal purposes, as it might be argues subsequent courts have proven.

 

Reflecting on this afforded me a new appreciation for the merits of judicial restraint. In reading this book, I found it striking that after the first few years of the civil rights cases, Justices Hugo Black and John Marshal Harlan II, who had been important participants in many of the Warren Court’s early civil rights decisions, began pulling back and increasingly began refusing to follow the liberal majority. The book suggests the two justices (particularly Black) may have just been getting old. Perhaps I am getting old too, because I found myself appreciating their perspective.

　

It has been a long road — one that included among other things, an amicus brief filed at the U.S. Supreme Court in connection with Morrison v. National Australia Bank – but the defendants in the Infineon Technologies securities suit have managed to have the court dismiss the claims of company shareholders who purchased their securities outside the U.S. Northern District of California Judge James Ware’s March 17, 2011 order granting the defendants’ motion can be found here.

 

The plaintiffs first initiated their suit in September 2004, as detailed here. The plaintiffs allege that the company had participated in an illegal conspiracy to fix the prices of Dynamic Random Access Memory (DRAM) and then misrepresented the company’s financial condition as a result of the artificially inflated DRAM prices. Infineon’s American Depositary Shares and ordinary shares are listed on the NYSE, but during the class period 92% of its securities were traded on the Frankfort Stock Exchange.

 

Following the U.S. Supreme Court’s June 2010 decision in the Morrison case, the defendants moved to dismiss from the case the shareholders who purchased their Infineon shares outside of the U.S. In opposing the motion, the plaintiffs – citing Morrison’s holding that Section 10(b) of the ’34 Act applies only to "transactions in securities listed on domestic exchanges" and "domestic transactions in other securities" – argued that because Infineon’s ordinary shares are "listed on" the NYSE, Section 10(b) applies to all ordinary shares, even those purchased on the Frankfurt Stock Exchange.

 

Consistent with Southern District of New York Judge Deborah Batts’ January 2011 opinion in the RBS securities suit (about which refer here), Judge Ware had little trouble rejecting the plaintiffs’ "listed on" argument. Judge Ware stated that under Morrison "a securities transaction must occur on a domestic exchange to trigger application of Section 10(b) of the Exchange Act."

 

Judge Ware said that the plaintiffs’ "listed on" argument was "misplaced," noting that in the Morrison case itself, National Australia Bank had ADRs listed on the NYSE, but the plaintiffs in Morrison were unable to state a Section 10(b) claim because "that Section of the Exchange Act focuses only on securities transactions that take place in the United States."

 

Accordingly, Judge Ware granted the motion to dismiss with respect to "all claims asserted on behalf of individuals who purchased Infineon ordinary shares on the Frankfurt Stock Exchange."

 

Judge Ware’s opinion in the Infineon case joins a growing list of decisions in which federal district courts have dismissed from securities suits the shareholder claimants who purchased their shares of the defendant company’s stock outside of the U.S. What makes Judge Ware’s opinion noteworthy is that it is one of the first such opinions outside of the Southern District of New York. As far as I know, it is the first in the Northern District of California.

 

(Central District of California Judge Dale Fischer interpreted and applied Morrison for purposes of a July 2010 lead plaintiff ruling in the Toyota securities suit, but did not reach the question whether Morrison precluded the claims of shareholders who purchased their shares outside the U.S.)

 

It is increasingly clear that the district courts are applying Morrison broadly and are refusing to be persuaded to trim the decision’s effect or to reduce its impact on the claims of securityholders who purchased shares on foreign exchanges.

 

Plaintiffs seeking to circumvent Morrison may be forced to proceed by other means – as for example, are claimants whose federal securities suit against Porsche was dismissed based on Morrison. As reflected in their March 15, 2011 complaint (here), these plaintiffs are now attempting to assert state law claims of common law fraud and unjust enrichment against Porsche. The plaintiffs will face numerous obstacles as they attempt to chart an alternative course. But claimants barred by Morrison from asserting securities claims under the federal securities laws will continue to search for ways to try to assert their claims, both inside and outside the U.S.

 

Susan Beck’ March 19, 2011 Am Law Litigation Daily article about Judge Ware’s decision in the Infineon case can be found here.

 

Transatlantic Cable: Writing about the Infineon decision seems fitting as I am now in London for this week’s C5’s 20th Forum on D&O Liability Insurance. I will be speaking on Thursday March 24, 2011 on a panel with my friend Rick Bortnick of the Cozen O’Connor firm on the topic "The Latest U.S. Judicial Decisions." If you are attending the conference, I hope you will take the time to say hello, particularly if we have not previously met.

 

As recently as this past Monday, commentators were grumbling that the FDIC is moving too slowly in pursue claims against former directors and officers of failed banks. The FDIC has responded in dramatic fashion with a March 16, 2011 lawsuit filing in the Western District of Washington against three former Washington Mutual executives, as well as two of the executives’ wives.

 

According to news reports (here), the lawsuit seeks damages of as much as $900 million. The media stories also suggest that there is an agreement by WaMu’s outside directors to pay $125 million to settle claims by the FDIC is pending approval. A copy of the FDIC’s recent complaint against the WaMu executives and their wives can be found here.

 

WaMu’s September 2008 failure (about which refer here), represents by far the largest bank failure in U.S. history. The events surrounding its failure have already been the subject of extensive litigation, not the least of which is a pending securities class action lawsuit filed on behalf of WaMu’s shareholders, which, as noted here, survived a renewed motion to dismiss after the lead plaintiffs amended their complaint.

 

The FDIC filed its recent lawsuit in its capacity as WaMu’s receiver. The lawsuit names as defendants WaMu’s former CEO, Kerry Killinger, its former President and COO, Stephen Rotella, and its chief of home lending, David Schneider. In a rather unusual twist that shows just how aggressively the FDIC may be prepared to get in pursuing these claims, the complaint also names Killinger’s wife, Linda Killinger, and Rotella’s wife, Esther as explained below.

 

The complaint asserts claims against the three executives for Gross Negligence, Ordinary Negligence and Breach of Fiduciary Duty.

 

The complaint alleges that the three defendants caused the bank to take "extreme and historically unprecedented risks with WaMu’s held-for-investment loan portfolio." The three allegedly focused on short term gains, to the disregard of the bank’s long term safety and soundness. The executives, lead by Killinger, allegedly developed an executed a strategy to make billions of dollars of risky residential mortgages, increasing the risk profile of the bank’s held for investment mortgage portfolio.

 

The bank’s business strategy dictated a lending approach for which few lenders were turned away. The bank also layered multiple levels of risk with particularly risk loan products such as option ARM mortgages, the riskiness of which was further compounded by allowing stated income lending and other questionable lending practices.

 

The complaint alleges further that these executives continued to pursue their aggressive growth strategy even at a point when housing prices "were unsustainably high" and while relying upon an aging infrastructure that was inadequate to keep up with the enormous loan volume. The complaint alleges that the three executives knew the strategy was risky, knew the process weaknesses, and even knew there was a housing price bubble. Yet, the complaint alleges, the three executives marginalized the company’s risk management department.

 

As a result, when the bubble collapsed, the bank "was in an extremely vulnerable position" and, as a result of the three executives "gross mismanagement" the bank suffered losses of "billions of dollars."

 

The complaint also includes fraudulent conveyance claims against Killinger and his wife Linda, and against Rotella and his wife Esther.

 

The complaint alleges that in August 2008, Killinger and his wife transferred two residential properties to qualified personal residence trusts and appointed themselves as trustees. The complaint alleges that these transfers were made with the intent to hinder, delay or defraud Killinger’s future creditors.

 

The complaint contains similar allegations against Rotella and his wife with respect to an April 2008 residential real estate transfer and a September 2008 transfer from Rotella to his wife of $1 million.

 

In statements to the Wall Street Journal, here, Killinger and Rotella said the FDIC’s allegations are "baseless" and "lack credibility" and that the lawsuit is "unworthy of the government." I recommend that readers take a few minutes and read these two individuals’ statements. Whatever may be the merits of this and similar cases brought by the FDIC, it is very clear from these statements that there will be a personal price to pay for the individuals involved. The personal pain these men are feeling is palpable, and there will be more of this kind of pain for other former bank officials as more of these kinds of lawsuits are filed.

 

With the filing of this complaint, the FDIC has unmistakably demonstrated that it will pursue claims against former directors and officer of failed banks when it chooses to do so. Indeed, the claims against the two executives’ wives clearly show that the FDIC will proceed aggressively.

 

Given that WaMu represented the largest bank failure in U.S. history, it may come as no surprise that the FDIC is pursuing these kinds of claims. What has been surprising to some, and what occasioned the criticism I mentioned in my opening paragraph, is how deliberate the FDIC has been in choosing to pursue claims. WaMu failed nearly two and one half years ago. If the FDIC were to act with similar deliberation in pursing other claims, it could well be some time before we know for sure how extensive the FDIC’s litigation activity ultimately will be in pursing claims as part of the current bank failure.

 

It is, however, quite clear that the FDIC will be pursuing more of these types of claims. The FDIC recently updated the Professional Liability Lawsuits page on its website (here) to show that the FDIC’s board has approved lawsuits against 158 individual directors and officers of failed banks. Since the six lawsuits the FDIC has filed to date only amount to about 40 individual defendants in total, there are many more lawsuits to come, just based on the actions that have been approved so far.

 

One particularly interesting detail about the news surrounding the FDIC’s recent lawsuit is the report that WaMu’s outside directors have agreed to pay $125 million to settle claims. It is interesting that the outside directors agreed to pay this amount without the intervening step of a lawsuit against them. One question that immediately occurs to me is whether and to what extent this $125 million payment is to be funded by D&O insurance.

 

WaMu’s D&O insurance program was undoubtedly already under pressure due to the significant presence of other claims already pending against its former directors and officers. One possibility that occurs to me is that the bank may have carried a significant layer of Side A DIC protection, which may well have been triggered by the bank holding company’s bankruptcy. Because of the bankruptcy, all of the claims represent potential Side A losses, suggesting that the bank’s Excess Side A/DIC program could well have been called in to contribute. All these are details that those of us on the outside can only wonder about; however, comments from knowledgeable persons who are closer to the situation are always welcome.

 

Whatever may be the case, it is clear that D&O insurance may be playing a role of some kind in all of this. At least Stephen Rotella thinks so. In his statement to the Wall Street Journal to which I linked above, he speculated that the lawsuit itself "may be a way for the FDIC to collect a payout from insurers who provided officers and directors liability coverage for the time they worked at WaMu."

 

As noted, with this lawsuit, the total number of lawsuits the FDIC has filed as part of the current wave of failed bank litigation is now up to six. A list of the six lawsuits can be found here.

 

A March 17, 2011 Bloomberg article about the FDIC’s lawsuit can be found here. A March 17, 2011 Seattle Post-Intelligencer article about the suit can be found here.