When the FDIC released its Quarterly Banking Profile for the fourth quarter 2010, it included a statement from FDIC Chairman Sheila Bair that the agency believes “the number of failures peaked in 2010.” However, at least through the end of February 2011, the evidence was to the contrary, as the number of bank failures during the first two months of 2011 (23), exceed the number through the end of February 2010 (22).

 

However, since the end of February 2011, the number of bank failures has declined sharply. The FDIC closed only three banks during March 2011, and only one since March 11, 2011. As of April 1, 2011, there have been a total of 26 bank failures this year. By the same point in 2010, there had been a total of 41 failed banks.

 

The difference between the two year-to-date tallies is that during March 2010, the FDIC took control of 19 banks, compared to only three in March 2011. In addition, the first Friday in April 2011 also passed without any additional bank failures.

 

The 26 bank failures through the end of March would if annualized project to about 104 bank failures by year end 2001, which would be the lowest annual number of bank failures since 2008 (when there were 25). But if the bank failure pace that prevailed in March 2011 were to continue, the number of bank failures by year end could be well below that projected number.

 

One of the signs that will be interesting to watch is the number of problem institutions reported when the FDIC releases its next Quarterly Banking Profile for the quarter ended March 31, 2011. The Profile is due to be issued sometime later in May. The number of problem institutions has been increasing every quarter for several years now, although the rate of increase has slowed. In its last profile, the FDIC stated that 2010 was a “turnaround” year for the banking industry. If last year truly was a turnaround year, the reported number of problem institutions should finally start to decline — which, if it were to happen, would tend to support the probability that the slower rate of bank failures could well continue as the year progresses.

 

With the 23 bank failures so far this year, the total number of bank failures since January 1, 2008 stands at 348. Even with this significant number of failed institutions and the amount of time that has passed since the beginning of the current bank failure wave, the FDIC has so far filed lawsuits against the directors and officers of only six failed banks. (Refer here to access a list of the FDIC lawsuits.)

 

On its website, the FDIC reports that as of March 15, 2011, it has authorized lawsuits against a total of 158 individuals. However, the six FDIC lawsuits so far collectively include only about  43 individual defendants, which suggest that there are a number of additional lawsuits being readied and likely to be filed in the near future. In addition, the number of individuals against whom lawsuits have been authorized has grown over recent months to its current level of 158, and since banks have continued to fail in the interim, it seems likely that the authorized number will continue to grow, which would imply an even greater number of lawsuits yet to come.

 

The number of lawsuits that ultimately will be filed remains to be seen. But while that part of the story unfolds, it is noteworthy that for the first time in quite a while, the story appears to be that the number of bank failures is declining. And that sure seems like a good thing to me.

 

Over the last few days, there have been a series of rulings in high-profile lawsuits arising out of the subprime meltdown and credit crisis. As discussed below, just in the past week there were dismissal motion rulings in cases involving Freddie Mac, Wachovia/Wells Fargo, and AIG. Though some or all of the claims in these cases were dismissed in whole or in part, the plaintiffs have managed to live at least for another day (if only just barely in the Freddie Mac case). At the same time,  in the AIG ERISA case, the case largely survived the dismissal motion.

 

Freddie Mac: On March 30, 2011, Southern District of New York Judge John Keenan granted without prejudice the defendants’ motion to dismiss in the Federal Home Loan Mortgage Corp. (Freddie Mac) subprime-related securities class action lawsuit. A copy of the March 30 order can be found here.

 

Freddie Mac is of course one of the government sponsored entities that was at the center of the residential mortgage crisis in 2008. On September 7, 2008, it was placed in the hands of a conservator. In August 2008, shortly before the company entered conservatorship, the company’s public shareholders filed a securities class action lawsuit against the company and certain of its directors and officers, as discussed in greater detail here.

 

The plaintiffs alleged that in various public statements the defendants had made three types of misrepresentations or omissions: (1) about the company’s exposure to “non-prime mortgage loans”; (2) about its capital adequacy; and (3) about the strength of its due diligence and quality control mechanisms. The defendants moved to dismiss.

 

In finding that the alleged misrepresentations about the company’s exposure to subprime mortgages were insufficient, Judge Keenan found that “the Amended Complaint does not explain why Freddie Mac’s disclosures in its November 2007 Financial Reports … were insufficient to convey the truth that Freddie Mac was dealing in non-conforming mortgages to the public.” He added that “Plaintiffs present no theory at all about why Freddie Mac’s disclosures would not be understood by the reasonable investor and thus part of the ‘total mix’ of information that determined its share price.”  

 

Judge Keenan also found that the alleged misrepresentations regarding the company’s capital adequacy were also insufficient. He observed that “in a volatile economic, political and regulatory environment like the one that existed in the summer and early fall of 2008, with even Freddie Mac’s primary regulator being replaced, Plaintiffs must show more to plausibly claim that Freddie Mac’s statements were made without any basis in fact. “ However, he concluded that “Plaintiff has not adequately pleaded sufficient facts giving rise to a strong inference that Freddie Mac’s statements about its capital adequacy or its hope that it would continue to function were made with intent to defraud or without factual basis.”

 

With respect to the alleged misrepresentations regarding the company’s internal controls and processes, Judge Keenan found that “there are simply no facts in the Amended Complaint from which one could reasonably infer a causal link between Freddie Mac’s statements about its underwriting standards and internal controls and any loss suffered by purchasers of its equity securities during the Class Period.” He added that “considering that the price of Freddie Mac’s stock was clearly linked to the ‘marketwide phenomenon’ of the housing price collapse, there is decreased probability that Plaintiffs’ losses were caused by fraud.”

 

Judge Keenan granted the motions to dismiss without prejudice and allowed the plaintiffs’ 60 days in which to file a Second Amended Complaint.

 

An April 1, 2011 Bloomberg article about Judge Keenan’s decision in the Freddie Mac case can be found here.

 

Wachovia/Wells Fargo: On March 31, 2011, Southern District of New York Judge Richard Sullivan issued his rulings on the motions to dismiss in the consolidated securities litigation that had been filed on behalf former equity shareholders and bondholders of Wachovia Corporation. In a lengthy and detailed opinion (here), Judge Sullivan granted the defendants’ motions to dismiss the equity securities litigation, but he denied the motion to dismiss the bondholders’ action, other than with respect to certain bond offerings in which the plaintiffs had not actually purchased any securities.

 

As Judge Sullivan wrote in summarizing the various plaintiffs’ allegations, “all claims arise from the financial disintegration Wachovia experienced between its 2006 purchase of Golden West Financial Corporation and its 2008 merger with Wells Fargo & Company.” In essence, the complaint is based on the difficulties Wachovia experienced as a result of the Golden West “Pick-A-Pay” mortgage portfolio. Further background regarding the equity securities litigation can be found here and background regarding the bondholders’ litigation can be found here.

 

Judge Sullivan granted the defendants’ motions to dismiss the equity securities plaintiffs’ ’34 Act claims, finding that the plaintiffs had not sufficiently alleged scienter. Judge Sullivan concluded that the “more compelling inference” is that “Defendants simply did not anticipate the full extent of the mortgage crisis and the resulting implications for the Pick-A-Pay loan portfolio. Although a colossal blunder with grave consequences for many, such a failure is simply not enough to support a claim for securities fraud.” He added that “bad judgment and poor management are not fraud, even when they lead to the demise of a once venerable financial institution.”

 

Judge Sullivan also granted the defendants’ motion to dismiss the equity securities plaintiffs’ ’33 Act claims, finding that their “scattershot pleadings” failed to “afford proper notice, much less provide facially plausible factual allegations.” He added that he could not conclude “that the relevant offering documents contained material omissions in violation of affirmative disclosure obligations.”

 

However, Judge Sullivan denied the defendants’ motions to dismiss the bondholders’ ’33 Act claims (other than with respect to the offerings in which the plaintiffs had not purchased shares, with respect to which the motion was granted). In concluding that the bondholders’ allegations were sufficient when the equity securities plaintiffs’ allegations were not, Judge Sullivan found that the bondholder plaintiffs had adequately alleged misrepresentation in the relevant offering documents with respect to loan to value rations maintained in the mortgage portfolio and with respect to the alleged manipulation of the appraisal process to produce inflated appraisal values.

 

On the strength of these alleged misrepresentations in the offering documents, Judge Sullivan also denied defendant KPMG’s motion to dismiss the bondholders’ 33 Act claims.

 

Susan Beck’s April 1, 2011 Am Law Litigation Daily detailed article about Judge Sullivan’s ruling can be found here.

 

AIG ERISA Action: In a March 31, 2011 order (here) in the AIG subprime-related ERISA action, Southern District of New York Judge Laura Taylor Swain, denied the defendants’ motion to dismiss, other than with respect to plan organized on behalf of Puerto Rico employees with respect to which the motion was granted on the ground that because none of the name plaintiffs participated in that plan, they lacked standing to pursue those claims.

 

The plaintiffs are participants or beneficiaries in I two AIG plans, the AIG Incentive Savings Plan and the American General Agents’ & Managers’ Thrift Plan between June 15, 2007 and the present. Each plan offered participants a menu of investment options, one of which was the AIG Stock Fund, which invested in AIG stock.

 

The plaintiffs alleged that the defendant plan fiduciaries breached the duty of prudence by continuing to offer the AIG Stock Fund as an investment option, even when they knew or should have known that AIG stock was no longer a suitable and appropriate investment. The plaintiffs further alleged that the defendants failed to disclose to fellow fiduciaries nonpublic information that was need to protect the interests of the Plans. The plaintiffs also alleged that the defendant fiduciaries failed to monitor the investments and failed to provide complete and accurate information regarding AIG’s mismanagement and improper business practices.

 

Judge Swain rejected all of the grounds on which the defendants’ sought to dismiss the allegations asserted on behalf of participants and beneficiaries of the AIG Incentive Saving Plan and the American Genera Agents’ and Managers’ Thrift Plan. Judge Swain held that Plaintiffs had sufficiently alleged that had there been an investigation triggered by  the “warning signs” regarding problems in AIG’s Financial Products Unit, “it would have demonstrated that AIG stock had become an imprudent investment.”

 

Judge Swain also found that the Plaintiffs “have adequately alleged that Defendants failed to disclose the true extent of the risk facing AIG as a result of its financial decisions and the decline of the residential housing market, and that Defendants affirmatively misrepresented the strength and extent of the processes AIG had in place to mitigate this risk.”

 

Finally, she found that the plaintiffs “have sufficiently alleged that AIG and the director defendants were aware of the increasingly risky financial position maintained by AIG, material weaknesses in AIG’s financial health and the potential impending erosion of the value of AIG’s stock.”

 

An April 1, 2011 Bloomberg article about Judge Swain’s rulings can be found here.

 

I have in any event added these  rulings to my running tally of subprime-related lawsuit dismissal motion rulings, which can be found here.

 

Discussion

It has been quite a while since the subprime and credit crisis litigation wave first started in early 2007. Yet many of the cases are still working their way through the system. The cases discussed above involve some of the highest profile participants in many of the events surrounding the credit crisis. One thing that is striking, at least about the Freddie Mac and the Wachovia cases, is the extent to which the courts seemed influenced by the comprehensiveness of the credit crisis. It seems that in the context of a global economic crisis – particularly one that caught so many by surprise – the courts continue to be skeptical of fraud claims, absent concrete support for the allegations.

 

These rulings suggest that the barrier to overcome the initial judicial skepticism may be substantial. Indeed, the plaintiffs in the Wachovia case failed to overcome the court’s concerns despite having assembled 50 confidential witnesses, and despite the fact that the aggregate market cap drop on which the equity shareholders was approximately $109 billion.

 

On the other hand, the hurdle the plaintiffs must overcome is not insurmountable. The Wachovia bondholders’ Section 11 claims are going  forward. And even the plaintiffs in the Freddie Mac case will have at least another chance to replead to try to overcome the initial pleading hurdles.

 

Judge Swain’s ruling in the AIG ERISA case seemed more receptive. But it is worth keeping in mind that ERISA plaintiffs do not face the same heightened pleading standards that securities lawsuit plaintiffs face under the PSLRA. Perhaps even more significantly, the ERISA plaintiffs do not have to plead scienter.

 

In any event, all three of these cases will be worth watching as they continue to work their way through the system.

 

Special thanks to the loyal readers who provided me with copies of these rulings.

 

In my year-end securities litigation survey, I noted that while a number of new trends emerged during 2010, one securities lawsuit filing trend had remained constant during the year – that is, life sciences companies remained a favored securities class action lawsuit target. The heightened exposure that life sciences companies face is fully detailed in a March 2011 memo from David Kotler and Kathleen O”Connor  of the Dechert law firm entitled “Survey of Securities Fraud Class Actions Brought Against Life Sciences Companies.” A copy of the memo can be found here.

 

According to the memo, 29 different life sciences companies and their directors and officers were the subject of class action securities lawsuit filings in 2010, representing about 16.5% of all2010 securities lawsuit filings. Both the absolute filing numbers and the relative percentages of all filings are up from recent years. The 29 life sciences securities suits were up substantially from the 19 filed in 2009 (representing 10% of all securities suits that year) and from the 23% filed in 2008 (representing 10% of all securities suits).

 

It is worth noting that the count of 29 suits involving life sciences companies  does not include lawsuits involving allegations relating to mergers and acquisitions. If the merger objections suits were included, at least seven more suits would be added to the count.

 

The 2010 life sciences securities suits as a group do reflect certain distinctive characteristics. First, the 2010 lawsuits were more heavily weighted towards life sciences companies with larger market capitalizations. 28% of the 2010 lawsuits were brought against life sciences companies with market capitalizations over $10 billion, by contrast to only 5% in 2009.

 

The 2010 life sciences securities suits  also involved a significant number of lawsuits based not on such industry specific issues as FDA approvals or safety recalls. Consistent with the patterns of securities suit filings against life sciences companies in recent years, more than half of the filings involved allegations of financial improprieties, such as misstated or misleading financial reports or accounting mistakes or mismanagement.

 

To be sure, many of the 2010 did involve more industry specific allegations such as prospects or timing of FDA approval (9 of the 29 2010 lawsuits); allegations involving product efficacy (8); product safety (7); marketing practices (4); and manufacturing processes (2). Another five involved insider trading allegations.

 

The memo’s authors have been tracking the life sciences cases since 2007, and while the filings from those earlier years have not yet fully developed, there is some growing evidence to suggest that though life sciences companies may be sued more frequently than other cases, the cases may be dismissed more frequently than are cases in the larger universe of securities class action lawsuits.

 

The authors note that the SEC and the DoJ have made a priority of Foreign Corrupt Practices Act (FCPA) enforcement regarding life sciences companies and in at least one case (involving SciClone Pharmaceuticals), the FCPA enforcement has resulted in a follow-on securities class action lawsuit.

 

The authors also include a discussion of the U.S. Supreme Court’s recent decision in the Matrixx Initiatives case (about which refer here). They note that “by rejecting statistical significance as setting a minimal threshold for disclosure, Matrixx will require life sciences companies to assess … disclosures and investor impact more holistically, and on a case by case basis.” The authors also note that “life sciences companies are now faced with heavily fact-specific questions of where to draw the disclosure line in the absence of a bright-line standard.”

 

The authors conclude with a number of practical suggestions for life sciences companies to take to minimize the risk of, and impact from, securities fraud class actions.

 

Share the Road: The April 2, 2011 Wall Street Journal carried a rant entitled “Dear Urban Cyclists: Go Play in the Traffic” (here), written by alleged humorist P.J. O’Rourke. O’Rourke apparently is incensed by what he perceives as the increasing preference of traffic planners for urban bicycle lanes. His essay contains a lot of statements like “ bike lanes violate fundamental principles of democracy.” Some might say that Mr. O’Rourke’s comments want proportionality.

 

My own perspective on urban cycling took a completely unexpected turn during a recent visit to London. Owing to historically unprecedented weather conditions – it was sunny and pleasant six straight days in a row while I was there – I had occasion to try out the new Barclays Bicycle Hire arrangement. The way this arrangement works is that you pay a fee for bicycle access (one pound for a single day, five pounds for a week), and then you pay a one pound an hour usage fee. (There are other arrangements for longer term users.) The best part of the arrangement is that once you have paid the access fee, you can pick up or drop off a bike at any of the numerous bike racks around the city.

 

What this means is that you can rent a bike and tool around the city without having to cycle all the way back to the place where you first rented it. You can also drop the bike off at a rack if you just want to stop and get a snack or go in a store. The first day I tried the system, I picked up a bike in Green Park and cycled all the way around Hyde Park; dropped the bike off and took the tube to Trafalgar Square  and then biked down Whitehall, past Parliament, across Lambeth Bridge to Lambeth Park; then I dropped the bike off in Vauxhall and took the tube to Regent’s Park, picked up another bike at the tennis courts there and cycled around the Park.

 

The second time I tried it, I ran a relay of bicycles all across the west end into Kensington, Notting Hill and Bayswater, stopping and starting for meals and shopping, all the while traveling through and exploring parts of the city I have never seen before.

 

According to Wikipedia (here) , there are over 5,000 bicycles and 317 docking stations available in central London. The docking stations were first installed in London in July 2010, but the heavy, three-speed bicycles themselves are already ubiquitous (particularly on kind of bright, sunshiny days I enjoyed there last week).

 

There are downsides. Among other things, the rental does not include a helmet. In addition, the left hand lane rule of the road that prevails in London led to intermittent tense moments for me, particularly with respect to other cyclists whose behavior was not always predictable. Also, it takes a certain kind of courage to try to ride a bike through, say, Piccadilly Circus.

 

All of those concerns notwithstanding, I have to say that I found this bicycle hire scheme absolutely marvelous. One of the docking stations is located just outside the hotel I favor when I visit London, and now that I am comfortable with the scheme, I intend to take advantage of the arrangement on future visits. It is a convenient and enjoyable way to get around the city.

 

As for Mr. O’Rourke and his dyspeptic vision of urban bicycling, I can only surmise that he had not given the new London bicycle hire arrangement a chance. I think a cruise around Hyde Park on a sunny afternoon would do him a world of good, and might entirely alter his views about urban bicycling and democracy.

 

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.