In the first securities class action jury verdict to arise out the credit crisis, on Thursday November 18, 2010, the jury in the BankAtlantic securities lawsuit in federal court in Miami returned a verdict in the plaintiffs’ favor, finding seven of the statements at issue to have been false, and awarding damages of $2.41 per share. According to sources, this damage measure translates to total damages of as much as $42 million.

 

The case went to the jury last week after more than four weeks of trial, testimony from 13 fact witnesses and one expert witness. The verdict form the jury was required to complete ran to some 53 pages. At the outset of the trial, the lead defense counsel had characterized the claim as a "completely made-up, frivolous claim."

 

In their completed verdict form, the jury found the company and two of the five individual defendants to be liable for seven of the 19 statements at issue. The two defendants held liable are the company’s CEO, James Lavan, and its CFO, Valerie Toalson. All of the statements for which the defendants were found liable had been made in 2007. The completed jury verdict form can be found here.

 

As reflected here, the plaintiffs’ complaint had alleged that the defendants had made misleading statements about the bank’s loan portfolio from October 2006 through October 2007 and had "materially understated reserves for real estate loan losses on its financial statements, and thus materially overstated net income." The plaintiffs alleged that the defendants (the bank holding company and five of its individual directors and officers) had made misleading statements about the quality of the bank’s loan portfolio, the bank’s exposure to loan losses and the bank’s loan loss reserves.

 

As noted here, the plaintiff’s initial complaint had failed to survive the defendants’ motion to dismiss, but the amended complaint survived the defendants’ renewed dismissal motion.

　

According to information compiled by Adam Savett, the Director of Securities Class Actions at the Claims Compensation Bureau, since the enactment of the PSLRA, there had previously been only nine securities class action lawsuits based on post-PSLRA conduct that have actually been tried to a jury verdict. (Another seven cases alleging post-PSLRA conduct went to trial but were compromised or otherwise resolved prior to verdict. An additional eleven securities cases have gone to trial post-PSLRA but involved pre-PSLRA conduct.)

 

In other words, the verdict in the BankAtlantic case represents only the tenth securities class action lawsuit verdict since the enactment of the PLSRA based on post-PSLRA conduct.

　

The current tally (taking into account post-verdict proceedings and reflecting only the current status of post-verdict proceedings) is as follows: Plaintiffs 6, Defendants 4. (The scoreboard is subject to revision pending the outcome of additional proceedings in several of the cases.)

　

With the plaintiffs’ verdict in the BankAtlantic case, the securities class action jury verdict scoreboard (taking into account post-verdict proceedings and reflecting only the current status of post-verdict proceedings) is as follows: Plaintiffs 6, Defendants 4. (The scoreboard is subject to revision pending the outcome of additional proceedings in several of the cases.)

　

The BankAtlantic case will now undoubtedly head into post trial motions, and perhaps even later appeals. As has been shown in the Apollo Group securities class action case (about which refer here), in which there the plaintiffs’ jury’s verdict has been set aside in post trial motions only to have the verdict reinstated on appeal, the verdict itself can effectively wind up as only one stop in a very long procedural grind. Stay tuned for further proceedings.

 

In a statement to The D&O Diary, Matthew Mustokoff, a partner in the Barroway Topaz law firm said "The jury’s verdict vindicates our position from the outset that this was a case with merits and it delivers a message that a financial institution can’t mislead their shareholders about the riskiness of its loans." The Barroway Topaz firm was co-lead counsel for the plaintiff on the case. The other lead attorneys were Andrew Zivitz of the Barroway Topaz firm and Mark Arisohn of the Labaton Sucharow firm.

 

A November 18, 2010 South Florida Business Journal article describing the verdict can be found here.

　

　

From time to time, readers suggest blog topics to me. I am always interested in the range of topics suggested. Very late at night (or perhaps early in the morning) in the bar at the recent PLUS International Conference in San Antonio, a loyal reader whom I had only just met for the first time suggested that I write a blog post about my favorite business books. Unsurprisingly, it seemed like a good idea then. Surprisingly, it still seemed like a good idea later.

 

My notion of the books worth recommending may diverge from what the reader had in mind when he made the suggestion. I figure that no one really needs me to suggest the usual fare from the business section at the book store, like, for example, The Smartest Guys in the Room or Liar’s Poker. If those books interest you, by all means, read them.

 

The problem with the vast run of business books is that they rarely aim for anything higher. To find anything of more lasting value, you must look elsewhere. So my suggested "business" books won’t be found in the business section, and in fact may not necessarily meet anybody’s idea of what constitutes a business book. But these books have more to say about the business of life and the life of business than the more conventional fare. Here are a half- dozen essential books I suggest to anyone looking for something a little more substantial:

 

The Way We Live Now: Regrettably, the books of Anthony Trollope are not much read these days, perhaps because he was such a prolific writer and not all of his works were equally good. But he wrote several very fine books, including Orley Farm and Doctor Thorne. By far his best novel is The Way We Live Now, a scathing and bitter satire of late 19th Century English society and morals.

 

The central character is this vast book is Augustus Melmotte, a foreign financier with an uncertain past who sets all of London society ablaze with his seemingly immense wealth. He schemes to procure actual wealth through an American railroad development project, intending drive up the share prices so he can extract gains at others’ expense.

 

Melmotte is surrounded by a crowd of witting and unwitting accomplices whose greed, vanity or self-deception allow them to be carried along in the plot, which becomes increasingly complex as the story unfolds. The catalog of characters and sub-plots is rich, thick and entertaining.

 

No one can turn back time, but there are squadrons of heartbroken investors who might have spared themselves financial tragedy if they had only been first introduced to Melmotte before they met Madoff.

 

The House of Rothschild: One of the great financial historians of our time is Niall Ferguson, whose book The Ascent of Money makes a compelling case that the development of currency and banking was the indispensible prerequisite for the emergence of modern civilization. But I think Ferguson’s most valuable work is his two-volume history of the rise of the Rothschild banking family. Anyone who wants to understand the rise of modern finance, and also to appreciate the interplay of historical forces and familial ambitions, will be amply rewarded for reading these books.

 

The story of how the five sons of Meyer Amschel Rothschild went on to establish themselves as the premier bankers in Europe and to become the financiers to the sovereigns across the continent is well-told and instructive. The firm’s inviolable founding principles kept the family establishment together across borders and across generations, as well as through wars and economic crises, and allowed the family to ride the changing tides of history and survive the ever-present anti-Semitism to establish a dynasty more durable (and vastly better financed) than all of the royal houses.

 

Dombey and Son: The novels of Charles Dickens vividly capture the life of so many late 19th century British institutions. Given that Dickens wrote in and of a country that has been derided as "a nation of shopkeepers," it is perhaps indispensible that Dickens also captured the life of street level commerce and it is entirely fitting that one of Dickens’ finest novels revolves around a trader and his ambitions for himself and for his firm and family.

 

Dombey’s huge (and ultimately thwarted) ambitions for his son set the frame for a narrative that races on even as it races away from Dombey’s own ability to trace and track his own interests. His frustrated ambitions leave him aged and bitter, but his ultimate reunion with his estranged daughter, Florence, provide a measure of redemption at the end.

 

The House of Medici: Before the Rothschilds, before the processes of institutions of finance evolved all of their modern forms, the Medici were the premier banking family in Europe. In later generations, they went on to wed kings and to serve as Popes, but they began as textile traders. Only later, Cosimo de’Medici, transformed the family’s growing banking influence into the foundation of a political dynasty that lasted for generations.

 

Although the family has a modern reputation for ambition and ruthlessness, their success, at least in its origins, was more mundane. As retold in Christopher Hibbert’s book, The House of Medici, a notable contribution to the family’s success was their early adoption of the double-entry bookkeeping system for keeping track of debits and credits.

 

And although they amassed great wealth, they were among the most important benefactors of the Italian Renaissance. Among the many artists the family sponsored were Brunelleschi, Michelangelo, Donatello and Fra Angelico. The family’s collection serves as the core of the Uffizi Gallery in Florence.

 

While the family’s glory and wealth is well remembered, the family’s fortunes ebbed and flowed. Hibbert’s one-volume account captures the travails and misfortunes, which included exile, assassination attempts, and financial declines, as well as the periods of the family’s astonishing ascendancy.

 

Buddenbrooks: This novel is one of my favorite books, even though it is, admittedly, a total downer. Thomas Mann’s novel, Buddenbrooks, tells the story of four generations of the Buddenbrooks family and its merchant trading business in 19th century Lubeck. The story  begins at what only later becomes apparent is the family’s high water mark, when old Johann and Frau Counsel Buddenbrooks are enjoying the simple fruits of prosperity while still living over the trading house.

 

At the book’s center are the struggles and ambitions of the next generation, Thomas Buddenbrooks and his sister Antonie. Thomas takes over the family business, which prospers at first. But then due to the pressure of maintaining the business and living up to society’s and his own expectations, he is ultimately consumed with self-doubt. He finally puts all of his hopes and ambitions in his son, who is more interested in art than business. Antonie, who marries badly in order to serve the family interests, also finds herself unable to find her way and assist her brother.

 

Although the family’s decline seems preordained, there are many choices along the way that were not inevitable and that could have avoided later disasters. Antonie’s unsustainable devotion to luxury is but one of the weaknesses that leads to her own poor decisions. Thomas’s ill-fated decision to possess a grand house similarly undermines his self-confidence, as the house comes to possess him. The turning away of the subsequent generations from the simplicity and thrifty frugality of the family business’s founder seems to underlie the family’s ultimate decline.

 

In recommending this book once, I said that "what this book is about is life." It is an epic story of the ebb and flow of family fortunes, the blessings and burdens of prosperity, and the difficult challenges that face all of us as we navigate across the years.

 

The Meditations of Marcus Aurelius: According to tradition and at least some evidence, the Roman Emperor Marcus Aurelius wrote his Meditations while campaigning against the empire’s many foreign enemies. Marcus composed these brief statements of Stoic philosophy and self-discipline to exhort himself to be a better version of himself.

 

Marcus recorded his thoughts as a way to examine his own strengths and weaknesses, in order to determine how best he should live. He articulates a strong personal philosophy based on his own responsibility for his own actions as well as the need to maintain equanimity for the things he cannot control, including both the actions of others and (ultimately) death.

 

The Mediations are fully of many good, noble and thought-provoking statements and ideas that are all the more powerful given that at the time Marcus recorded these thoughts, he was probably the most powerful person on the planet. He writes with simplicity and clarity, and repeatedly calls himself simply to achieve a good life well lived.

 

In the business of life, we all encounter periods when we too find ourselves compelled to battle enemies who threaten all that we have worked to achieve. To persevere under these circumstances are among life’s great challenges. The thoughts Marcus recorded during his own times of crises are a substantial help and guide. As Marcus wrote, the important thing is to be the best and most noble person you can be: ‘The best revenge is not to be like your enemy.’

　****

Though I have assembled here a list of half-dozen essential books, there undoubtedly are many more books that might be added to this list. I encourage readers to suggest their own candidates by using this blog’s Comment feature. Please take the time to share your own thoughts and suggestions with me and with other readers.

　

For reasons I am sure they find good and sufficient, Chinese companies have been seeking listings on the U.S. securities exchanges. The Chinese companies (or at least some of them) have also been discovering an added side-effect of a U.S. listing – that is, exposure to a class action lawsuit under the U.S. securities laws.

 

The latest Chinese company to be sued is RINO International Corporation, which has its headquarters in Dalian, in China’s Liaoning province. As reflected in their November 15, 2010 press release (here), plaintiffs’ lawyers have filed a complaint against the company and certain of its directors and officers in the Central District of California.

 

The complaint (which can be found here) alleges that in RINO’s SEC filed annual report for fiscal 2009, RINO reported $193 million of revenue, but in the annual report RINO filed for 2009 with the China State Administration for Industry and Commerce, it reported only $11 million of revenue. This discrepancy, "along with other accounting inconsistencies and questionable transactions between RINO and its management, has raised red flags and prompted an internal review."

 

RINO joins a growing list of Chinese companies that have been named as defendants in securities class action lawsuits in the U.S. in 2010. There have been as many as 14 new securities class action lawsuits filed against foreign domiciled in 2010 (out of a total of about 154 new lawsuits filed this year), but seven of the 14 (including the new lawsuit against RINO) involve Chinese companies.

 

The other six Chinese companies to be sued are Fuqi International (about which refer here), China Natural Gas (here), China-Biotics (here), Duoyuan Printing (here), Duoyuan Global Water (here), and China Green Agriculture (here). Interestingly six of the seven have been filed just since the last week of August 2010, all of which of course were filed after the U.S. Supreme Court’s decision in the Morrison case (about which refer here), which seemingly narrowed the range of foreign-domiciled companies U.S. private securities litigation exposure.

 

Taken collectively, these lawsuits could be interpreted to suggest that at least some Chinese companies have experienced some difficulties adapting to the burdens and responsibilities involved with a U.S. listing.

 

But there seems to be more going on here that just that. A review of the basic allegations in these cases suggests a common thread among at least some of the cases. In three of the cases – the ones involving China-Biotics, China Green Agriculture, and RINO – the allegation is that the companies reported different revenue and other financial information to the Chinese authorities than they reported in the SEC filings.

 

One might conjecture on the possible reasons why these companies might have reported different figures to their domestic authorities than they did in their SEC filings. For example, the companies might have been seeking to avoid domestic tax liabilities. (Of course, there is always the possibility that the differences in the reports are attributable to differing reporting conventions, but you would think that it that were the explanation, that would be disclosed in their SEC filings.) These companies’ reporting discrepancies are more than a little bit puzzling, as it seems probable that the differences would be detected, given the public availability of the SEC filings.

 

It probably should be added that while the recent upsurge in new lawsuit filings against Chinese companies is unquestionably noteworthy, this observation should also be put in context. According to news reports, 226 Chinese companies are currently listed on the NYSE, AMEX and NASDAQ. In the context of these 226 Chinese companies whose securities trade in the U.S., the seven securities lawsuits this year involving Chinese companies may appear less significant.

 

Nevertheless, when you have multiple companies domiciled in a single country outside the U.S. being sued in securities class action lawsuits over the course of just a few weeks, the phenomenon seems worthy of note.

 

Indeed, though the number of Chinese listings has continued to surge, questions about the listed companies have also followed, as for example in the August 26, 2010 Barron’s article "Beware This Chinese Export" (here). The Barron’s article particularly warns about Chinese companies that achieve their U.S. listing through a reverse merger with a domestic shell company. Among other things the article notes that:

 

The group has been a minefield of revenue disappointments and earnings restatements. Financial filings the companies make with the Securities and Exchange Commission often diverge from those filed with the Chinese government—by drastic amounts. Investor and analyst visits to corporate facilities in China reveal operations smaller and less impressive than shown in U.S. presentations. The companies too often select auditors who have previously signed off on the financials of companies that turned out to be busts. Some companies’ securities filings don’t disclose the involvement of promoters in China or the U.S., who …have disquieting track records in the stock market.

 

Similar concerns prompted the PCAOB to issue a July 12, 2010 warning about accounting practices associated with these Chinese companies, particularly those whose U.S. listing originated with a reverse merger. Securities analysts have expressed a certain wariness of these U.S. listed Chinese companies as well.

 

Given these concerns, it probably comes as no surprise that litigation has arisen. The likelihood seems to be that more securities suits involving Chinese companies will follow.

 

I am pleased to reproduce below the latest guest post submission. This post has been submitted by John Iole, a partner in the Pittsburgh office of the Jones Day law firm. In submitted this post, John emphasized that "comments expressed are those of the author and do not necessarily represent the views of Jones Day or its clients." In addition, John has expressly retained the copyright to the content. John previous guest post submission to this blog can be found here.

 

I would like to thank John for his willingness to post his submission on this site. The D&O Diary welcomes guest submissions from responsible persons on differnent points of view. Readers who may be interested in submitting a guest post should please feel free to contact me. John’s guest post follows below:

 

 

            Large insureds often purchase substantial D&O coverage limits in layers that comprise a tower, with each D&O insurer occupying one or more layers and attachment points.[1] The excess policies commonly contain provisions that dictate how the overall program will respond to claims that implicate multiple layers. Ideally, the policy responses will be harmonious, because all participants are interested in efficiency of administration as well as a satisfactory level of coverage predictability. This guest post addresses the “narrowing clause” found in many such excess D&O policies, and how this feature can raise extremely difficult issues of policy interpretation and coverage that are not always obvious — or even knowable — at the time of policy placement.

 

 

            Assume that each excess policy in a layered program contains a “follow form” endorsement providing that the excess policy will follow the terms, conditions and exclusions of a designated underlying policy. A standard explanation of a follow form policy is that it provides coverage that is neither more broad nor more narrow than the followed policy.[2]

 

 

            If all of the policies in a tower are written on a “pure” follow form basis, then it is likely (but not inevitable) that coverage issues will be determined in essentially the same way at each layer of coverage. However, many D&O excess policies are not pure follow form, but instead contain terms and conditions specific to particular insurers. This is where the “no broader than underlying” provision (called a “narrowing clause” for the purposes of this post) comes in.

 

 

            A sample narrowing clause from an “Underlying Insurance” section in a Bermuda D&O excess form provides:

 

 

In no event shall this policy grant broader coverage than would be provided by any of the Underlying Policies.[3]

 

This provision clarifies that the excess policy does not to provide coverage if the underlying policies do not provide coverage.[4]  The excess policy might impose additional restrictions on coverage, but it is a one-way ratchet. Coverage can only get more narrow as a claim rides up the coverage tower.[5]  The following sections discuss the potential coverage impact presented by narrowing clauses.

 

 

 

            What Are The Mechanics Of Applying A Narrowing Clause?

 

 

            In the most basic situation, a narrowing clause can be interpreted to allow an excess insurer to incorporate a selected, “more narrow” provision from an underlying policy. In many cases, the effect of incorporation will be to erase a contrary term that otherwise would be applicable through the followed policy, or to erase such a term in the (incorporating) excess policy itself. As a consequence, the upper-level policy might, in operation, provide drastically different coverage than is implied by the direct terms of the upper-level policy (but for the narrowing clause).

 

 

            Narrowing clauses do not actually provide that they permit “incorporation” of provisions in underlying policies, nor do they provide any guidance on how incorporation is to be achieved. Nevertheless, it is likely that courts will permit incorporation as the method for executing such a clause. A good example of this in the D&O context is Fed. Ins. Co. v. Raytheon Co., 426 F.3d 491 (1st Cir. 2005). In Raytheon, the court held that a prior and pending litigation exclusion in the primary policy negated coverage under the excess policy, even though the excess policy had its own, differently-worded PPL exclusion that might not have excluded the claim.[6] The narrowing clause therefore deleted the excess policy’s stated PPL provision.

 

 

            Assuming that the narrowing clause permits incorporation by reference, a more difficult question is how much leeway it gives the excess insurer to pick and choose amongst underlying provisions. For example, assume that two excess policies each have an arbitration clause. Further assume that each clause has two provisions, one that deals with selection of arbitrators, and another that deals with the conduct of the arbitration itself. Further assume that the lower-layer policy is more limited in respect of arbitrator selection, and the upper-layer policy is more limited in respect of the arbitration proceedings. Can the upper-layer excess insurer invoke the narrowing clause to incorporate the selection provision from the lower-layer policy, but retain the proceedings provision from the upper-layer policy, thereby stitching together the most narrow, combined arbitration clause applicable to the upper-layer policy? If this is possible in practice, then a high-level excess insurer would be able to pick and choose from amongst numerous underlying provisions. One can easily envision a situation in which this exercise could lead to a bewildering patchwork of coverage arguments in a multi-issue case.[7]

 

 

            One can say with almost certain confidence that an “unlimited incorporation” approach, resulting in a hodgepodge policy, is likely to be rejected as unfair. Accordingly, it is likely that an insurer will have to incorporate underlying provisions in full (“jot for jot”), or not at all. Even this rule of thumb could be difficult to apply in practice. If the upper- and lower-layer policies are structured in ways that do not allow provisions to be easily matched up (or are endorsed so as to make a match-up confusing), then an incorporation exercise can lead to difficult questions about the scope of coverage.

 

 

            Can A Narrowing Clause Be Applied To All Underlying Provisions?

 

 

            Again assuming that a narrowing clause permits incorporation of underlying policy provisions, one must ask whether all underlying provisions are candidates for incorporation.  A policyholder would contend that the excess policy is not restricted in all instances to what is provided by the underlying insurance. A trivial example is the limit of liability provision of the excess policy, which is unaffected by “narrower” underlying provisions.

 

 

            Another seemingly obvious example is the notice provision. That is, if an underlying policy requires notice “immediately” and the excess policy requires notice “as soon as practicable”, it would seem to be absurd to import the more rigid standard into the excess policy, even if doing so would potentially affect the timeliness of a claim under the excess policy. Nevertheless, it is perhaps not completely free from doubt as to whether incorporation in this setting would be refused by a court.

 

 

            There are additional provisions that, one could argue, are not candidates for incorporation because they do not directly pertain to coverage, such as forum selection, choice of law, and claims participation clauses. However, these provisions can have an important impact on the effective coverage available, and therefore an insurer might well contend that they are subject to incorporation as “more narrow” provisions. An insurer would likely contend that the purpose of the narrowing clause is to limit the net effective coverage under the excess policy to what is available from the underlying coverage. Therefore, it would contend, any term in the underlying coverage that has the practical effect of limiting coverage also should apply to the excess policy. These arguments are left to the courts or other tribunals to determine without guidance from the narrowing clause itself.[8]

 

 

            If Incorporated, Should Policy Provisions Be Interpreted Uniformly?

 

 

            Once the incorporation of underlying text is settled, there is another problem awaiting the parties – interpretation of the text. Is the text to be incorporated “bag and baggage”, such that a 2nd-layer excess insurer is bound by a reading of the text that satisfies the 1st-layer excess insurer? The answer to this is perhaps “No”, at least in those jurisdictions that follow reasoning similar to the Supreme Judicial Court of Massachusetts in the Allmerica case.[9] If the policyholder and the 1st-layer excess insurer obtain a court or arbitral declaration on the meaning of the text, does this bind the 2nd-layer excess insurer in its own use of the text? The answer here is “Yes, perhaps,” but I am not aware of any authority for this outcome.[10]

 

 

            A related question can arise in the case of policy mistakes. It is not unknown for a mistake to be made in an insurance policy, perhaps through misunderstanding or inattention on the part of the underwriter, broker or policyholder. Assume that an underlying policy is reformed on the basis of mistake, where does that leave the excess policy? An excess insurer can probably make a strong case for leaving the underlying policy intact (as to the excess insurer) insofar as the unreformed policy provides narrower coverage than the as-reformed policy. The excess insurer probably would contend that its excess policy was placed in actual or presumed reliance on the terms of underlying coverage, and therefore no change via reformation is effective as to the excess policy.[11] Moreover, if reformation of the underlying policy has the opposite effect – i.e., reformation results in a narrowing of coverage, that change might well trickle up to the excess policies, narrowing them as well. These dynamics greatly magnify the potential consequences of any mistake that occurs at the time of placement.

 

 

            What Does it Mean to be “Broader Than” Underlying Coverage?

 

 

            The previous three issues are somewhat mechanical. A more fundamental question provoked by narrowing clauses is what it means to be “broader than” the underlying coverage. In some respects, such a characterization is not far different from asking whether one restaurant is “better than” another – the distinction works perfectly well for extreme (or at least reasonably clear) examples, but breaks down when a more precise differentiation is required.

 

 

            An example helps to illustrate the problem. Let’s assume that a 1st-layer excess policy in a coverage tower selects New York substantive law for all matters of policy interpretation, including insurability of punitive damages, and that such damages are uninsurable as a matter of New York law. Then assume that the 2nd-layer excess policy specifically selects Wisconsin law, under which punitive damages are insurable. Is coverage afforded by the 1st-layer policy “less broad” than that afforded by the 2nd-layer policy? If the answer to that question is “Yes”, is the New York choice of law swept into the 2nd-layer excess policy so as to supplant Wisconsin law? The 2nd-layer (and above) excess insurers might well contend that this is what should happen.

 

 

            Well, if the 2nd-layer excess insurer is correct (New York law supplants Wisconsin for purposes of punitive damages), then what happens if the dispute involves multiple issues? Let’s assume in our same example that the parties also dispute how a prior and pending litigation exclusion in the excess policy should be interpreted. In our hypothetical, let’s say that Wisconsin has a much more expansive (favoring insurers) application of PPL exclusions, which has the ultimate affect of narrowing coverage. Does Wisconsin law retain its place in the dispute for this purpose, via some type of party-dictated depecage (New York law applies so as to preclude coverage for punitive damages and Wisconsin law applies so as to favor application of the PPL exclusion)?[12] The excess insurer(s) might again say that this is an available outcome.

 

 

            When Is The True Scope Of Excess Coverage “Knowable”?

 

 

            There is a major consequence of the “no broader than underlying” exercise that should be apparent from the foregoing discussion. If one stops to think about it, the implications of a narrowing clause are potentially ominous. The content, meaning and coverage of the excess policies – as determined only after the incorporated provisions have been selected – cannot be known until the point of a claim, or even a good bit thereafter. It is impossible to say, on an a priori or categorical basis, whether a lower-level policy is more or less broad than an upper-level policy. First, one needs to know: (a) exactly the claim for which coverage is being requested and, potentially, (b) how the claim has been resolved in each of the underlying layers. Although a party and its counsel can hypothesize examples and anticipate how the coverage would respond, it is not possible to know exactly what issues the next claim will bring.  This raises the prospect of inefficient and contentious claims resolution.

 

 

            One might counter that all insurance policies are somewhat indeterminate until a claim has crystallized to the point at which coverage can be analyzed, rendering trivial this observation. In a standard insurance situation, however, the wording is static, and all that is left to do is apply the policy wording to the claim as presented. The major difference with “no broader than underlying” provisions is that the actual wording of the policy is not fixed until a claim is asserted. The excess policy is “inchoate” until the point of a claim and the wording floats and metamorphoses until determinations are made under each of the underlying layers. The text of the excess policy cannot truly be determined until each of the underlying policies has responded.

 

 

            Potential Solutions to Ponder

 

 

            Perhaps the most simple and comprehensive solution to the “problem” of narrowing clauses is to negotiate “pure” follow-form coverage if possible. This solves the problem through identity of wording and avoids the prospect of vertical discontinuity. Obviously, this alternative will not always be available. Another potential solution is to implement quota-share insurance.[13] In that event, the problem of layered coverage is eliminated through a change in program structure. Again, however, knowledgeable observers have identified problems with this approach, including the difficulty in arranging for claims control, and the potential for losing horizontal continuity on a long-standing program. Notwithstanding these potential solutions, it appears likely that layered, non-uniform programs are going to continue into the foreseeable future. Therefore, a solution that directly meets the terms of narrowing clauses could be useful.

 

 

            When seeking to determine the field over which a narrowing clause operates, and the clause states that the excess policy provides coverage no broader than underlying, it is reasonable to interpret the provision as applying to the coverage grant, and terms that specifically pertain to the scope of coverage. Under this interpretation, the narrowing clause would not incorporate “non-coverage” elements of the underlying policies, perhaps those dealing with notice, choice of law, forum selection or cooperation and settlement.[14]  In the context of reservation of rights letters, and for the purpose of crafting rules dealing with waiver of defenses and avoiding “coverage by estoppel”, some courts already distinguish between “coverage defenses” and “policy defenses” available under the policies at issue.

 

 

            Under these cases, a “coverage defense” is one asserting that a claim simply does not fall within the scope of insurance for which a premium was charged. For example, a claim seeking coverage under a D&O policy when no “wrongful act” has been alleged, or seeking Side-C coverage for something other than a securities claim, would be deemed to fall outside the scope of coverage, and therefore would be subject to a coverage defense.

 

 

            A “policy defense” is one in which the insurer acknowledges that the claim comes within the scope of coverage, but contests the claim based on the policyholder’s failure to comply with some other provision in the policy, such as a requirement of cooperation. See, e.g., Ideal Mut. Ins. Co. v. Myers, 789 F.2d 1196 (5th Cir. 1986) (Texas law); Continental Ins. Co. v. Bayless & Roberts, 608 P.2d 281 (Alaska 1980).

 

 

            This distinction obviously cannot be applied woodenly, and it is beyond the scope of this post to engage in a full-blown discussion of the merits, deficiencies and complexities it poses in a particular situation. Nevertheless, there is no simple way to craft a rule that can be applied in all instances, and this approach can form a basis for striking a fair balance between the interests of insurers and policyholders.

[1]The use of pure follow-form and/or quota share insurance to ameliorate the problems addressed herein is mentioned briefly below, but this post assumes a continuation of the practice of placing layered coverage with less than full vertical continuity.

 

[2] E.g., Travelers Cas. & Sur. Co. v. Constitution Reinsurance Corp., 2004 U.S. Dist. LEXIS 21829 (E.D. Mich. Aug. 16, 2004) ("A typical ‘follow the form’ provision ‘expressly limits the reinsurance to the terms and conditions of the underlying policy and provides that the reinsurance certificate will cover only the kinds of liability covered in the original policy issued to the insured.’ . . . [A] ‘follow the form’ emphasizes ab initio that the scope of the reinsurer’s undertaking is not broader (or narrower) than that of the ceding insurer.") (quoting 14 Appleman on Insurance Law & Practice § 106.2 (2d ed. 2004)).

 

[3] Some other formulations of this concept are as follows:

“Provided always that this policy shall, in no event and notwithstanding any other provision, provide coverage broader than that provided by the Followed Policy unless such broader coverage is specifically agreed to by the Insurer in a written endorsement attached hereto.”

"In no event shall this Policy grant broader coverage than would be provided by the most restrictive policy constituting part of the applicable Underlying Insurance."

“The Insurer shall pay the Insured . . . in accordance with the terms and conditions of the Followed Form . . . as amended by any more restrictive terms, conditions and limitations of any other Underlying Policies excess of the Followed Form . . . .”

 

[4]Simply because an insurer occupies an excess position above more narrowly-drawn underlying policies does not preordain that its coverage is limited to the scope of underlying coverage. E.g., Smith v. Hughes Aircraft Co., 783 F. Supp. 1222 (D. Ariz. 1991) (in a CGL context, court held that follow form excess policy covered pollution loss whereas underlying policy did not, based on difference in relevant endorsements, and the presence of phrase “except as otherwise provided herein”).

 

[5]This post does not address the separate question of whether an excess policy should pay if the claim is “covered” but one or more of the underlying policies has not fully paid its limits. In those cases, an “exhaustion of underlying insurance” provision might provide that the excess policy will pay if – and only if – the underlying insurance pays in full. This is a different method for achieving essentially the same result as the narrowing clause. Although outcomes differ depending on jurisdiction and policy wording, recent cases have resulted in particularly strict applications of such exhaustion requirements. E.g., Great American Ins. Co. v. Bally Total Fitness Holding Corp., 2010 U.S. Dist. LEXIS 61553 (N.D. Ill., June 22, 2010)(less than limits settlement with primary and first- and second-layer excess carriers means that third- and fourth-layer excess policies are not liable);Citigroup, Inc. v. National Union Fire Ins. Co., 2010 WL 2179710 (S.D. Tex., May 28, 2010)(settlement with primary insurer for less than full limits means that excess policies are not liable). A reasonable (although perhaps not always feasible) solution to this problem is to settle on a global or top-down basis as opposed to a bottom-up basis. Because of their potentially chilling effect on settlements, one might conclude that these provisions are even less favorable to policyholders than narrowing clauses. Practically speaking, both provisions are apt to appear in the excess policies.

 

[6] See also HLTH Corp. v. Clarendon Nat’l Ins. Co., 2009 Del. Super. LEXIS 437 (Del. Super. Ct., July 15, 2009), in which a D&O excess insurer at the $10mm xs of $90mm layer effectively incorporated a run-off endorsement from the $10mm xs of $80mm policy instead of a provision in the “followed” primary policy.

 

[7] As another (more substantive) example, can an upper-level policy incorporate a “more narrow” PPL date from below, but retain its own “more narrow” PPL trigger wording?

 

[8] When policy language does not provide clear guidance for incorporation, courts sometimes can reach results that are quite different from what the parties appear to have intended. For an example of incorporation by reference of a defense obligation into an excess follow form policy in the CGL context, see Johnson Controls Inc. v. London Market, 325 Wis.2d 176, 784 N.W.2d 579 (2010).

 

[9] Allmerica Fin. Corp. v. Certain Underwriters at Lloyd’s, 449 Mass. 621, 871 N.E.2d 418 (Mass. 2007)(excess insurer who issued follow-form policy was not bound by settlement entered into by primary insurer). It is important not to overstate the holding of Allmerica. That was a case in which the primary carrier paid its full limits, but did so by way of a “no admission of coverage” settlement on a claim as to which it had already raised coverage questions. The primary insurer also expressly provided that the settlement had no effect on excess coverage.

 

[10]Assuming that at least one of the policies involved has a private arbitration provision, there is no functional way in which all of the parties can be haled into a court or arbitral forum for the purpose of forcing a declaration that is binding on them all. The most logical solution, however, is to bind any higher-layer excess insurer to an interpretation of lower-level policies so long as it was reached in an arms-length proceeding otherwise worthy of recognition. Some insurers may be more likely agree to be informally bound by underlying determinations than others, and the assistance of a knowledgeable broker can be extremely important.

 

[11] The excess follow-form insurer made this argument, unsuccessfully, in L.E. Myers Co. v. Harbor Ins. Co., 77 Ill. 2d 4, 394 N.E.2d 1200, 31 Ill. Dec. 823 (1979). In that case, however, the evidence showed that the excess insurer did not bother to review the underlying policy before issuing its excess policy.

 

[12] The concept of depecage (French for “dismemberment”) allows a court to apply different states’ laws to different parts of a single contract. Schwartz v. Twin City Fire Ins. Co., 492 F. Supp. 2d 308 (S.D.N.Y. 2007) (applying law of two states to D&O policy interpretation and to handling of claim under policy), aff’d, 539 F.3d 135 (2d Cir. 2008). Although not really an issue of depecage so much as party choice, a policy can specify the application of more than one state’s law. The Bermuda form choice of law clauses are a familiar example of this in D&O policies, in that they apply a modified version of New York law in some circumstances, and potentially call for the application of other law (such as the law of England and Wales) in other circumstances, which easily can result in the application of both.

 

[13]Some participants in the Bermuda market have been particularly active in advocating a simplification of coverage terms and basic vertical continuity, although others remain uncertain. E.g., P&C National Underwriter, Top Bermuda Players Split Over Wisdom Of Adopting Single Excess Policy Form (June 16, 2008); see also Insurance Journal, Aon: Bermuda Markets Introduce Single Excess Follow Form (October 13, 2008). Other commentators have advocated the quota-share solution. For example, in 2008 and again this past August, Joseph Monteleone pointed out the inefficiencies of multiple wordings in the same tower, suggesting that quota share insurance might be the best response. E.g., J. Monteleone, D&O E&O Monitor, Quota Share Insurance – An Idea Whose Time Has Come Again (Aug. 18, 2010).

 

[14]However, as can be seen by the third example in note 4, supra, not all narrowing clauses will specifically reference “coverage”, but might limit themselves to the “most restrictive” terms in the underlying policies. Moreover, some provisions that might be identified as “non-coverage” are nevertheless classified as conditions precedent to coverage in some wordings.

 

In a November 9, 2010 order (here) in the Citigroup subprime-related securities suit, Southern District of New York Judge Sidney Stein dismissed a host of allegations and a number of individual defendants. However, Judge Stein denied the motion to dismiss as to plaintiffs’ claims regarding Citigroup’s exposure to its CDO portfolio, which Judge Stein described as the plaintiffs’ "principal" allegations.

 

Among the defendants who must answer these allegations are seven individual defendants, including former Citigroup CEO Charles Prince and former Citigroup board member (and former Treasury Secretary) Robert Rubin.

 

As reflected here, plaintiffs first sued Citigroup and certain of its directors and officers in November 2007. In their February 20, 2009 consolidated amended complaint, which named as defendants the company and 14 of its directors and offices, the plaintiffs alleged that the defendants had mislead investors about the company’s financial health and caused them to suffer damages when the truth about Citigroup’s assets were later revealed.

 

Judge Stein emphasized the length and weight of the amended complaint, noting that it is "536 pages long, contains 1,265 paragraphs, and weights six pounds." The amended complaint alleges that defendants misled investors about its exposure to what Judge Stein described as a "gallimaufry of financial instruments." However, as Judge Stein noted, the plaintiffs’ "principal grievance" is that Citigroup "did not disclose that it held tens of billions of dollars of super-senior tranche CDOs until November 4, 2007," and that even after that date, until April 2008, the company did not disclose the full extent of its exposure.

　

The basic thrust of the plaintiffs’ CDO-related allegations is that though the company disclosed that it was deeply involved in underwriting CDOs, the company did not disclose that billions of dollars of the CDOs had not been purchased at all but instead had been retained by Citigroup. In November 2007, the company disclosed that it was exposed to super-senior CDO tranches in the amount of $43 billion and that it estimated a write down of $8 to $11 billion of those assets. The plaintiff alleged that this disclosure omitted an additional $10.5 billion worth of holdings that the company had hedged in swap transactions.

 

In his November 9 order, Judge Stein found that the plaintiffs had adequately alleged that Citigroup’s CDO valuations were false between February 2007 and October 2007. In concluding that these statements were made with scienter, Judge Stein noted that the plaintiffs’ claims "concern a series of statements denying or diminishing Citigroup’s CDO exposure and the risks associated with it." These statements, Judge Stein found were "inconsistent with the actions Citigroup was allegedly undertaking between February 2007 and October 2007."

 

Citigroup was, Judge Stein found, "taking significant steps internally to address increasing risk in its CDO exposure but at the same time it was continuing to mislead investors about the significant risk those assets posed. This incongruity between word and deed establishes a strong inference of scienter."

 

Judge Stein then went on to hold that the plaintiffs allegations of scienter against seven of the individual defendants was insufficiently particularized, but that the allegations against the remaining defendants were sufficient, in part because these individuals attended meetings concerning the company’s CDO exposure during the period in question and in part because they were responsible for the company’s SEC filings, and therefore bear responsibility for the statements under the "group pleading doctrine."

 

Judge Stein also found that even the company’s disclosures in November 2007 were materially misleading because they omitted to disclose the additional $10.5 of CDO exposure that the company had hedged. However, Judge Stein concluded that the allegations of individual scienter were only sufficient against the company’s CFO at the time, Gary Crittenden.

 

Judge Stein the concluded that the plaintiffs’ allegations regarding the other financial instruments in the "gallimaufry" of financial assets were insufficient. Judge Stein granted the motion to dismiss the plaintiffs allegations as to all of the financial assets other than the company’s CDO assets.

 

Discussion

Though Judge Stein significantly narrowed the plaintiffs allegations and though he dismissed out seven of the 14 individual defendants, substantial portions of plaintiffs’ complaint survived – and more importantly from the plaintiffs’ perspective, what Judge Stein himself described as the plaintiffs’ "principal" allegations substantially survived dismissal, and the plaintiffs managed to keep some of the higher profile defendants in the case as well.

 

I am sure the plaintiffs in this case would have preferred to keep their other allegations in this case, but with the remaining allegations, the plaintiffs still have a substantial basis on which to proceed. As I have often noted on this blog, the name of the game for the plaintiffs is to survive dismissal and to try to move on to the settlement phase. Of course the defendants may well take a different view, and where this case may ultimate wind up remains to be seen.

 

In the meantime, I do think it is interesting to note that pretty much all of the mega subprime cases – AIG, Countrywide, Fannie Mae, Washington Mutual, New Century Financial – seem to have survived the initial pleading stage, in whole or in part. Thus while there has been considerable discussion (among other places, on this blog) about whether or not the plaintiffs are fairing poorly in the subprime lawsuit dismissal motions, it definitely seems that in the high profile cases, the plaintiffs claims are managing to survive.

 

As noted here, Judge Stein has previously denied in part the motions to dismiss in the separate subprime-related Citigroup bondholders’ action.

 

I have in any event added the Judge Stein’s ruling in the Citigroup case to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

 

Special thanks to a loyal reader for providing me with a copy of the Citigroup ruling.

 

The Latest on the BankAtlantic Securities Class Action Trial: While the rest of us have been going about our daily business, the BankAtlantic Securities Class Action trial has been going forward in federal court in Miami. Now, according to a reliable source, after four weeks of trial, 13 fact witnesses and a damages expert, the lawyers are going to begin delivering their summations today. The case could be going to the jury shortly. The verdict form weighs in at a hefty 53 pages. Stay tuned, we could have a rare securities class action jury trial verdict just ahead.

 

The News from San Antonio: I have arrived in San Antonio for the PLUS International Conference, where I have noticed among other things that the winner of the PLUS1 Award at this year’s conferfence will be my good friend and former law partner Gary Dixon of the Troutman Sanders firm. The PLUS1 award is given annually to the person "whose efforts have contributed to the advancement and image of the professional liability industry." No one deserves this award more than Gary, who is one of the lions of our industry. My congratulations to Gary. If you are at the conference this week, I hope you will plan on attending the award ceremony at lunch on Thursday to help congratulate Gary for this honor.

There is a reason that when class action settlements are announced, they are described as preliminary and subject to final approval – sometimes the settlements fall apart before the case is finally put to rest. That appears be what has happened with the Schwab YieldPlus subprime-related securities class action lawsuit.

 

As discussed here, in April 2010, the parties to the Schwab YieldPlus securities suit announced a preliminary settlement of the plaintiffs’ securities claims. At the time, the settlement did not include plaintiffs’ separate state law claims. In May 2010, Schwab announced the separate settlement of the state law claims. The total value of the agreed settlements was about $235 million.

 

However, in a November 8, 2010 press release (here), Charles Schwab Corporation announced that it had notified the plaintiffs in the case that it was invoking the termination provisions of the settlement agreement and withdrawing from the case.

 

As reflected in the November 8, 2010 notice of withdrawal that Schwab filed with the court, a copy of which can be found here, after the parties initially reached their settlements, the plaintiffs contended that the remained free to pursue certain state law claims on behalf of non-California residents. The specific claims at issue are asserted under the California Business & Professions Code Section 17200.

 

Schwab had contended that the form of judgment agreed upon as part of the settlement had been designed to release all claims. However, in an October 14, 2010 order (here), Northern District of California William Alsup, referring to the Section 17200 claims as "the governance claim," said that "at no time was the governance claim certified for class treatment for anyone residing out of California" and he cited language in the settlement notice that the Section 17200 claims were "not released in the settlement." He concluded that, as a result, the non-California residents’ claims "were never extinguished by the settlement," and "federal securities class members residing outside of California are free to sue under Section 17200."

 

In its motion to withdraw, Schwab commented that it had "agreed to a generous settlement," but only in exchange for "an end to all litigation," adding that "now that Plaintiffs have reneged on the primary consideration Schwab was to receive…Schwab has no choice but to withdraw from the joint motions for final approval."

 

It is hard to tell from the outside exactly what happened here – that is, whether there was some problem or misunderstanding about the way the release was put together, whether the plaintiffs somehow sandbagged the defendants, or if there was just some massive misunderstanding with respect to whether or not all of the Section 17200 claims had been settled.

 

The conclusion that there is no way to tell from the outside what is going on is reinforced by Judge Alsup’s October 14 order. My initial instinct was to be sympathetic with Schwab’s complaint that it had thought it was buying complete repose for its millions, but that clearly is not the conclusion that Judge Alsup reached. All in all, this is a little bit of a head-scratcher.

 

The one thing is clear is that as a result of Judge Alsup’s order, Schwab concluded that it had no choice except to blow up the settlement. Perhaps that will mean the case will now go forward, but of course there is always the possibility that the motion to withdraw was a form of negotiation carried out by other means.

 

I recently noted that it seemed as if not many of the subprime related cases were settling, even though scores of the subprime cases have survived dismissal motions. Well, now there is one fewer subprime cases. Perhaps the Schwab settlement debacle explains why so few other cases have settled – these cases are complex and the settlement efforts are tricky.

 

I have modified my list of subprime and credit crisis related case resolutions, which can be accessed here, to reflect Schwab’s motion to withdraw from the settlement.

 

Pretty Soon You’re Talking About Real Money: It just in August that the lawyers in the Lehman Brother proceedings had approached the bankruptcy court to request the release an additional $35 million from the company’s D&O insurance policies. (My post about the prior request can be found here.) The total amount of insurance that the court has now authorized, including the $35 million, is $70 million.

 

Now the lawyers are back. Only this time the lawyers want more. A lot more.

 

On October 27, 2010, the lawyers for the debtors request a fresh $90 million, which Wayne State Law Professor Peter Henning, writing on the New York Times Dealbook blog (here), interprets to mean that "the government could be closer to ending its civil and criminal investigations and moving ahead with some type of enforcement." A copy of the latest motion can be found here.

 

As Henning explains, Lehman had one $250 million D&O insurance tower for the period May 2007 to May 2008, and a second $250 million insurance tower for the period May 2008 to May 2009. The prior payments were made under the first of these two towers. The prior $35 million was exhausted in part by the settlement of a securities arbitration against Lehman’s former CEO, Richard Fuld. The remainder has gone to defense fees.

 

In their latest motion for relief from the automatic bankruptcy stay, in order to permit the payment of the $90 million, the debtors are requesting the authorization of payments from the fifth, sixth and seventh excess D&O insurers in the 2007-08 tower in the total amount of $55 million, and payments of $35 million from the primary and first level excess insurers in the D&O 2008-09 tower. According to the motion, the primary and first level excess insurers in the 2008-09 towers have "recognized coverage" for certain legal proceedings.

 

Assuming this request will be granted, a total of $135 million out of the $250 million total in the 2007-08 tower will have been released, and now the erosion of the second tower has begun as well. The motion does not explain why the requested amount has ramped up so rapidly from the prior request, but the implications are, as Professor Henning notes, serious. At the time of the prior request I suggested that the lawyers just might succeed in depleting the entire $250 million of the 2007-08 tower. At this rate they may get there even sooner than I previously supposed. And now they are working on the second tower as well. The fees clearly are accumulating more rapidly than the $5 million a month previously supposed.

 

My prior post has an detailed review of the implications of these massive costs.

 

Special thanks to Professor Henning for providing me with a link to his blog post.

　

All too often, the securities class action litigation process seems like a complicated and costly mechanism for transferring large amounts of money to the lawyers involved but only small amounts to the aggrieved investors, all at the expense of the D&O insurers. It is hard not to wonder sometimes what the whole process accomplishes, other than making D&O insurance indispensible and expensive.

 

Even worse, the deterrent effect that securities litigation is supposed to have is undermined because the presence of insurance insulates companies and their managers from any consequences for their alleged misconduct, at least according to a new book by Penn law professor Tom Baker (pictured, left) and Fordham law professor Sean Griffith (pictured, right).

 

The irony is that D&O insurers are in a position from which, at least in theory, they could positively influence corporate conduct and advance the regulatory goals of the securities laws. In their book, "Ensuring Corporate Misconduct: How Liability Insurance Undermines Shareholder Litigation," Baker and Griffith explore the ways D&O insurers might provide a "constraining influence" on their policyholders. The authors conclude that as a result of actual practices and processes insurers do not in fact perform that role.

 

Rather, the authors conclude, D&O insurance "significantly erodes the deterrent effect of shareholder litigation, thereby undermining its effectiveness as a form of regulation." In order to try to "rehabilitate the deterrent effect of shareholder litigation, notwithstanding the presence of liability insurance," the authors propose three regulatory reforms, as discussed in detail below.

 

To understand how D&O insurance works and how it affect securities litigation, the authors interviewed over 100 professionals from across the D&O insurance industry, as well securities litigators from both the plaintiffs and defense side. (Full disclosure: I was one of the people interviewed.) The authors previously published interim assessments of their research in three separate law review articles, about which I previously commented here, here and here. This new book pulls their prior publications together in a single volume comprehensively presenting their research and the bases for their reform proposals.

 

D&O Insurers’ Three Opportunities to Advance Securities Litigation Deterrence Goals

The authors postulate that there are three ways D&O insurers might, in theory, preserve the deterrence function of shareholder litigation.

 

First, insurers might use insurance pricing as a way to motivate corporate behavior, by forcing companies engaging in riskier behavior to pay more for insurance.

 

Second, the insurers might monitor their policyholders and force them to avoid risky conduct or adopt governance reforms.

 

Third, the insurers could control claim defense and settlement to insure that settlements reflect the merits of the claim and force defendants to pay more toward the defense and settlement when there is evidence of actual wrongdoing.

 

 

The D&O Insurers Failure to Pursue Opportunities to Advance the Deterrence Goals

The authors found from the interviews, however, that D&O insurers do not take advantage of these opportunities, despite the seeming financial incentives to do so.

 

What they found is that the pricing mechanism does not affect policyholder conduct, in part because the insurance cost is a very small part of most companies’ overall cost structure, and in part because the difference between the premiums riskier companies pay and the premiums less risky companies pay is relatively slight.

 

The authors also found that D&O insurers do almost nothing to monitor their policyholders or to try to influence their conduct. The authors puzzled over this issue at length, because insurers not only have an incentive to try to improve conduct but also because insurers effectively and positively influence their policyholders’ behavior with respect to other hazards and other lines of insurance.

 

Ultimately the authors concluded that monitoring and loss prevention services related to D&O insurance are not valued by corporate managers, and that in a competitive insurance environment it is hard to charge a price that supports the costs associated with delivering these services. (When the authors previously published their research pertaining to this particular topic, I wrote a lengthy blog post, here, discussing my views on why D&O insurers do not offer monitoring and loss prevention services.)

 

Finally, the authors found that, as a result of the way that D&O policies are structured, D&O insurers have little control over defense costs, and that insurers’ authority over settlements is constrained by the dynamics of the claims process – in particular, by the fact that the plaintiffs’ theoretical damages usually so far exceed the policy limits. The authors also found that insurers have some ability to use coverage defenses to insist on greater contributions to defense and settlements from defendants when there is greater evidence of actual wrongdoing, but that insurers’ ability to deploy these influences is limited.

 

The Authors’ Three Proposed Reforms

The authors concluded that each of these problems "increases the likelihood that insurance substantially mutes the deterrence effect of shareholder litigation." But rather than jumping to the extreme position of suggesting the abolition of D&O insurance, the authors suggest three reforms they contend would reinvigorate the deterrence function.

 

First, the authors suggest that the SEC require reporting companies to disclose their D&O insurance information (premium, limits, retentions, and the identity and attachment point of various insurers). The authors contend that these details "will convey an important signal concerning the quality of the firm’s governance," and that changes in premiums will alert investors to changes in the risk. The limit selected, the authors contend, would signal the managers’ belief about their companies’ relative risk of serious securities litigation, and the identity of carriers (and in particular whether the carrier is "a market leader" or a "cut-rate insurer") could "signal governance quality."

 

Second, in order to ensure that corporate defendants have "skin in the game" and therefore become more deeply invested in avoiding litigation and more deeply involved in managing defense costs and settlement amounts, the authors propose the mandatory requirement of coinsurance. By ensuring that the settlement of a securities lawsuit would produce a loss for the company, coinsurance would reduce the "moral hazard" of D&O insurance.

 

Third, in order to "provide capital market participants a window onto the merits of claims," the authors propose that the SEC require the disclosure of information about settlements, including the extent to which insurance funded the settlement and defense costs.

 

Discussion

Baker and Griffith have written a readable, interesting and important book. Their discussion of the actual role of D&O insurance in the securities litigation process is enhanced by their research methodology. All too often, theoreticians postulating about D&O insurance lack any understanding of the way things actually work. Because the authors took the time to interview the marketplace participants, their analysis is grounded in the practical realities of the real world.

 

As a result, the authors bring an informed outsider perspective to their discussion of the D&O insurance industry. The authors are painfully successful in highlighting the peculiar pathologies of the D&O insurance industry and the ways that D&O insurers and other marketplace participants systematically undermine both the insurers’ financial interests and the regulatory goals of the securities litigation system.

 

I am grateful to the authors for not just coming right out and advocating the abolition of D&O insurance – the career change I would face would be rather unwelcome at this point in my work life.

 

The authors do propose some regulatory alternatives. Some of the authors’ proposed reforms have substantial merit. In particular, I agree with the authors’ suggestion that the entire process would be improved if corporate defendants were required to have "skin in the game" in some form. The threat that companies would have to contribute to defense and settlement would encourage companies to try to avoid risky behavior. It would also provide a healthy influence both on the defense and settlement of securities lawsuits.

 

I know that many companies and their advocates will object to the idea of requiring  companies to participate financially in the lawsuit. Companies clearly would prefer to avoid that cost. But the benefits that would follow from greater company participation will ultimately inure to the benefit of everyone, and ultimately lead to a more disciplined, more rational and less costly system.

 

There might be ways other than coinsurance to bring about this reform. One possibility has already been implemented in Germany, where D&O insurance is now required to include a self-insured retention for individual liability. This is a more extreme version of the solution Baker and Griffith have proposed, but it undeniably has the potential to motivate corporate officials to avoid misconduct and risky behavior. My lengthy discussion of the new German requirement can be found here. (I am not advocating the German alternative, merely pointing out there there are alternatives to coinsurance.)

 

The authors’ proposal to require the disclosure of settlement and defense cost information also has some merit. At a minimum, investors are entitled to know the actual financial impact the litigation has had on the company. Investors would be astonished to learn how much these cases cost to defend, and the extent of insurance contribution to the defense and settlement is also highly relevant in order to understand the financial impact of the litigation on the company.

 

The availability of defense cost and settlement information would also be enormously helpful to companies themselves when deciding how much insurance to buy. As it stands, the settlement information that companies rely on to decide how much insurance to buy lacks any connection to insurance contribution toward settlements, and also lacks the vital detail regarding the costs of defending these cases. This kind of information would be valuable for everyone.

 

I am less persuaded by the authors’ proposal that reporting companies should have to disclose their D&O insurance information. I do not believe the publication of insurance information would provide the marketplace "signal" the authors think it would. I also think that requiring this disclosure could also could distort corporate behavior in ways that would be harmful to shareholders.

 

The analytic flaw with the authors’ proposal is that it treats D&O insurance as if it were a fungible commodity, like wheat. The fact is that these days, every single public company D&O policy is heavily negotiated. In the process of negotiation, it frequently happens that buyers will have to make a choice of whether or not to incur the cost required in order to obtain a particular term — say, for example, adding increased limits with or without full past acts coverage. The insurance the company winds up with is the product of a host of these kinds of decisions.

 

As a result, every policy is different and those differences have important pricing implications. If you were to go down your street and find out how much each one of your neighbors paid for their car, you still wouldn’t know everything you need to know. I drive a small compact, my neighbor across the street has a squadron of kids and so he drives a Yukon. If you didn’t know about the differences between the vehicles, and also the reason for these differences, you wouldn’t understand the meaning of the differences in what we paid for our vehicles. The same goes for D&O insurance.

 

The authors give a nod to the notion that D&O policies are not standardized by suggesting that public companies should be required to publish their policies on their website. (As a person who makes his living off of policy wording expertise, I find this suggestion absolutely loathsome.) But even this extreme step would not supply the necessary information to explain the tradeoffs and choices the company went through in order to make its insurance purchase. The bare policy alone would not, for example, reveal what selections the company did not make or how those choices affected the final policy and the policy’s ultimate price.

　

The bottom line is that companies that make prudent, conservative choices sometimes pay more for D&O insurance that provides better protection. Moreover, there are other important considerations that would distort the author’s postulated signal. For example, many buyers attach value to stability in their insurance relationship. These buyers bypass opportunities to reduce their insurance costs in exchange for stability and continuity. Other buyers who have had positive claims experiences feel loyalty to their carrier (yes, that really does happen) and even recognize the carrier’s need to try to recoup claims costs in higher premiums.

 

In other words, premium levels reflect a host of considerations that have nothing to do with the governance signaling assumptions underlying the authors’ proposal. But on the other hand, if companies nevertheless had to confront the possibility that investors and analysts might downgrade them because of the amount they pay for D&O insurance, the companies inevitably would cut corners to bring costs down, for example by buying less or narrower coverage. This could leave both executives and the company’s balance sheet exposed to losses that could financially harm the company and thereby harm investors’ interests.

　

In the end, whatever else might be said, Baker and Griffith have certainly raised a host of issues meriting further discussion. Indeed, Professor Baker will be participating in a panel to discuss the impact of D&O insurance on securities litigation this upcoming Thursday, November 11, 2010, at the PLUS International Conference in San Antonio. I suspect this will be the first of many industry discussions about the authors’ book.

 

Professor Griffith’s prior guest post on this blog in which he defended the authors’ suggestion of requiring companies to disclose their insurance information can be found here. My apologies to Professor Griffith for my not being able to figure out how to make his picture the same width as that of Professor Baker.

 

 

See You in San Antonio: I will also be in San Antonio for the PLUS Conference, and I look forward to seeing and greeting readers of The D&O Diary while I am there. I hope readers who see me will say hello, particularly if we have never met before.

 

Although the world of electoral politics may seem distant from the directors’ and officers’ liability arena, there was one development in Tuesday’s elections that potentially could affect the D&O claims environment, and it happened right here in The D&O Diary’s home state of Ohio. It has not drawn much national attention, but Ohio’s activist Attorney General Richard Cordray (pictured) lost his reelection bid to his Republican challenger, former U.S. Senator Michael DeWine.

 

Regular readers of this blog know that during his time in office, Cordray has been both highly active and highly visible in leading securities class action lawsuits on behalf of the Ohio public pension funds. Cordray was prominently involved in the recently announced $725 million AIG securities class action lawsuit settlement (about which refer here). Cordray put himself forward in connection with the $400 million Marsh contingent commission securities class action lawsuit (about which refer here).

 

In addition, in November 2009, Cordray led the way on behalf of the Ohio pension funds in filing a securities class action lawsuit against the rating agencies, in which he accused the rating agencies of "wreaking havoc on U.S. financial markets by providing unjustified and inflated ratings of mortgage-backed securities in exchanged for lucrative fees from securities issuers." The rating agency lawsuit is discussed here.

 

Cordray’s office has also sought lead plaintiff status in the securities class action lawsuit filed against BP, as discussed in his July 21, 2010 press release.

 

While Cordray was Ohio Attorney General, his office regularly issued reports on the status of the various securities class action lawsuits his offices was leading. The reports were titled "Holding Wall Street Accountable." The most recent report, dated August 31, 2010, can be found here. His office’s webpage detailing the various securities class action lawsuits in which Cordray was involved can be found here

 

In Tuesday’s election, the Republicans made a clean sweep of the Ohio statewide offices, but the Attorney General contest was by far the closest of any of state level race and. Cordray lost to challenger Mike DeWine by a narrow margin.

 

It remains to be seen whether or not DeWine will try to take up his predecessor’s mantle of "Holding Wall Street Accountable." DeWine’s campaign advertisements emphasized his background as a former prosecutor, and (in light of various scandals in Cuyahoga County), his promises to pursue corruption, an approach that potentally could lend itself to a scourge of Wall Street kind of approach.

 

However, one of the key planks of DeWine’s campaign platform was his commitment to "creating jobs through a business-friendly environment." Given DeWine’s overall conservative background and his commitment to maintaining a "business-friendly environment," I suspect the securities class action litigation agenda will be deemphasized once DeWine takes office.

 

To be sure, even if (as seems likely) DeWine steps back from his predecessor’s securities class action leadership role, others elsewhere might step forward. But the absence of an aggressive attorney general whose agenda includes using securities class action litigation as a policy and political tool could impact the frequency and magnitude of future securities litigation, at least to a certain extent.

 

Reuters reporter Dan Levine’s November 4, 2010 article (here) also speculates that Cordray’s defeat, along with the losses of numerous other activist attorneys general nationally, could help speed resolution of the current foreclosure mess, as well, as the defeated candidates seek to advance measures before they leave office. Among other things, Levine describes Cordray as one of the "spiritual leaders" among the activist AG’s who were agitating on the foreclosure issues.

 

Some Data About Follow-On FCPA Lawsuits: I have written frequently on this blog about the possibility of follow-on civil litigation brought by investors against companies that have been the target of an FCPA enforcement action. A November 1, 2010 Reuters article by Brian Grow entitled "Bribery Investigations Spark Shareholder Suits" (here) provides some quantification for this observation.

 

The article reports that according to Westlaw data, since the beginning of 2010 alone, plaintiffs’ lawyers have filed 24 shareholder suits against companies that have disclosed FCPA investigations. (The cases are a mix of class actions and derivative suits). The past average has been about eight such suits a year. The article also reports that though some cases have been dismissed, plaintiffs generally have been successful in these cases. Of the 37 cases in the preceding four years, 26 resulted in settlements.

 

The November 2010 issue of Metropolitan Corporate Counsel published (here) a roundtable discussion entitled "Compliance and Litigation Issues As Foreign Corrupt Practices Act Enforcement is on the Rise." The article includes a discussion of some of the challenges involved with FCPA compliance issues.

 

I will be participating in a panel at the upcoming PLUS International Conference in San Antonio. The panel, which is entitled "Foreign Corrupt Practices Act: Unexpected Liabilities for D&O Insurers, will be moderated by my friend Joe Monteleone, and is scheduled as the first session on Thursday, November 11, 2010. More information about the Conference and the FCPA panel can be found here.

 

The Nuts and Bolts of D&O: I hope readers have noticed that I have added a reference in the right hand column of this blog to my multipart series on the nuts and bolts of D&O. The reference, which can be found right below the "Subscribe" dialog box,  includes a link to the series index.

　

In a resolution of one of the longest running subprime-related securities class action lawsuits, the parties to the Toll Brothers subprime securities suit have agreed to settle the case for $25 million. The parties’ stipulation of settlement filed on October 28, 2010 can be found here.

 

The Toll Brothers case was among the first of the subprime-related securities suits when it was first filed in April 2007. As reflected in greater detail here, the plaintiffs allege that between December 9, 2004 and November 8, 2005, the defendants made several misrepresentations relating to the company’s "ability to open new active selling communities at the rate necessary to support its financial projections, traffic in its existing communities, demand for Toll Brothers homes, and the ability to continue its historically strong earnings growth." The Amended Complaint further alleges that despite "adverse developments" the company raised its earning projections, which allegedly inflated the company’s share price, facilitating the defendants’ sale of 14 million of company shares for proceeds of over $617 million.

　

The Amended Complaint also alleges that "within days" of the completion of the insider sales, defendants "shocked investors" in a series of disclosures between August and November 2005 revealing that traffic and sales were declining, as a result of which the company’s share price declined 43% from its class period high.

 

As reflected in greater detail here, in August 2008, the district court denied the defendants’ motion to dismiss. After extensive additional procedural wrangling that included a trip to the Third Circuit, the parties agreed to settle the case during mediation.

 

　

A November 2, Reuters article discussing the settlement can be found here.

 

The interesting thing to me about this development is the simple fact that this case has settled. For whatever reason, there have been very few settlements of the subprime-related securities class action lawsuits, even though we are now will into the fourth year of the subprime litigation wave.

 

By my count, there have still only been 16 settlements of subprime and credit crisis related securities class action lawsuits, even though there have been over 220 subprime related securities class action lawsuits filed since the beginning of the subprime litigation wave in early 2007 and even though scores of cases have survived the initial dismissal motion. I would be very curious to know if any readers out there have any suggestions on why so few of these cases have settled.

 

It is probably worth noting that even though there have been only sixteen settlements of subprime and credit crisis-related securities class action lawsuits, those sixteen settlements total over $1.85 billion dollars (including the $624 million settlement in the Countrywide case).

 

It is also interesting to note that, because the Toll Brothers lawsuit was filed in early 2007, after the beginning of the subprime litigation wave, the lawsuit is counted among the subprime related cases, the class period for the case goes from December 9, 2004 and November 8, 2005 and relates to events and circumstances that allegedly took place well before the subprime meltdown really gained momentum. The lawsuit’s relation back to the earlier time period is reminder that the later problems were in many ways foreshadowed by earlier events.

 

In any event, I have added the Toll Brothers settlement to my running tally of subprime and credit crisis-related settlements and other case resolutions, which can be found here.

 

The Subprime and Credit Crisis-Related Cases Are Still Coming In: While the earliest cases are now finally being resolved, there are still subprime and credit crisis-related cases being filed. The latest case is the lawsuit filed on November 3, 2010 in the Northern District of Florida against The St. Joe Company and certain of its directors and officers.

According to the plaintiffs’ lawyers November 3 press release, the Complaint (a copy of which can be found here) alleges that the defendants failed to disclose that:

 

(1) as the Florida real estate market was in decline, St. Joe was failing to take adequate and required impairments and accounting write-downs on many of its Florida based property developments; (2) as a result, St. Joe’s financial statements materially overvalued the Company’s Florida based property developments; (3) the Company’s financial statements were not prepared in accordance with Generally Accepted Accounting Principles; (4) the Company lacked adequate internal and financial controls; and (5) as a result of the foregoing, the Company’s financial statements were materially false and misleading at all relevant times.

 

The lawsuit follows on the heels of an October 13, 2010 report critical of the company written by hedge fund manager David Einhorn, the President of Greenlight Capital. Einhorn is perhaps best known for his very public bet against Lehman Brothers prior to the firm’s collapse. Einhorn’s report about St. Joe was the subject of a November 3, 2010 Wall Street Journal article (here).

 

My list of all 222 subprime and credit crisis related lawsuits that have been filed since February 2007 can be found here.

 

The Nuts and Bolts of D&O Insurance: I hope all readers have noticed that I have added a reference (with a hyperlink) in the right hand side bar to a single-page index for my multipart series on D&O insurance. Tell a friend.

 

If the lawsuit filed on Monday is any indication, the long-anticipated FDIC litigation against failed banks may have arrived. On November 1, 2010, the FDIC filed a lawsuit in the Northern District of Illinois against eleven former directors and officers of Heritage Community Bank, a lending institution in Glenwood, Illinois that failed in February 2009. A copy of the FDIC’s complaint can be found here.

 

Because 304 banks have failed since January 1, 2008, there has been widespread speculation that the FDIC might pursue claims against the former directors and officers of the failed institutions. Until now, the FDIC has filed just one lawsuit against former executives of a failed bank, involving former officers of IndyMac bank (about which refer here). More recently, there had been reports that the FDIC’s board had authorized numerous lawsuits to proceed – and now the lawsuits apparently have begun.

 

The Heritage Community Bank lawsuit, filed by the FDIC in its capacity as the bank’s receiver, seeks to "recover losses of at least $20 million" that the FDIC alleges the bank suffered because the defendants "failed to properly manage and supervise Heritage and its commercial real estate lending program." The complaint alleges claims of negligence, gross negligence and breach of fiduciary duty.

 

Essentially, the complaint alleges that the defendants made imprudent or improper commercial loans while "making millions of dollars of dividend payments to Heritage’s holding company and paying generous incentive awards to senior management." The complaint also alleges that by December 2006, the defendants knew the bank was in trouble, but instead of curtailing lending, the defendants "tried to mask the Bank’s mounting problems" by lending troubled borrowers more to pay down earlier loans.

 

The defendants in the case include not only the bank’s CEO, CFO and various lending officers, but also five outside directors.

 

The defendants are alleged to have extended or approved commercial real estate without appropriate expertise, processes or supervision, allowing loans in excess of prudent loan to value rations. The bank allegedly also lacked appropriate loan monitoring processes. The bank allegedly failed to post appropriate loan loss reserves, and even inappropriately recognized income as subsequent loans were used to pay off interest on prior loans.

 

The inappropriately recognized income allowed the allegedly improper holding company dividends and incentive compensation payments. (The allegedly improper incentive compensation payments in 2007 totaled $825,000.) The FDIC alleges that the total amounts of the improper dividends and inventive compensation payments were over $11 million.

 

Counsel for the defendants issued a press release on the defendants’ behalf that stated among other things:

 

The FDIC has now filed a lawsuit against the Bank’s former officers and directors for failing to foresee the recent unprecedented collapse in real estate values. The FDIC’s action is both regrettable and wrong. With the advantage of 20-20 hindsight, the FDIC blames the former officers and directors of a small community bank for not anticipating the same market forces that also caught central bankers, national banks, economists, major Wall Street firms, and the regulators themselves by surprise.

 

From my perspective, this case seems like an unexpected place for the FDIC to have started. The allegedly improper compensation seems relatively modest and there are otherwise no allegations of self-dealing or other egregious conduct. Similarly, there are no allegations that the bank operated in violation of any regulatory orders or consents.

 

Even taking the FDIC’s complaint on its own terms, it looks as if this bank (like so many others) got caught up in the real estate bubble and then failed to recognize the collapse until it was too late. In the aftermath, it seems easy to say the bank should have been more prudent than it was. The bank has a lot of company in that regard, starting with the Federal Reserve and going from there.

 

I will say this (in quotation of a comment from one of my readers) this complaint is a hell of a lot more compact than the 300-page behemoth the FDIC filed in the Indy Mac case.

 

It is perhaps not much of a surprise that this suit involves an Illinois failed bank. There have been 38 bank failures in Illinois since January 1, 2008, the third highest number of any state, behind only Georgia (46) and Floriday (43).

 

Earlier news reports had suggested that the FDIC had authorized lawsuits against as many as 50 former directors and officers of failed banks, but news reports concerning the new Heritage Community Bank lawsuit report that the FDIC has now authorized lawsuits against "more than 70" former directors and officers. Reliable sources tell me that the FDIC has also filed a lawsuit against the former directors and officers of a specific failed bank in a Western state although I have been unable to independently verify that.

 

But in any event, it appears the FDIC failed bank D&O litigation has now begun. It seems probable that may more lawsuits will follow. Stay tuned.

 

Special thanks to John M. George, Jr. of the Katten & Temple law firm for providing copies of the complaint and of the defense counsel press release. George’s firm is of counsel in connection with the defense of one of the indidivudal defendants.