A lawsuit brought by investors who had purchased securities in three ING Group bond offerings in 2007 and 2008 was largely dismissed in a ruling issued Tuesday, although some allegations regarding the company’s June 2008 offering disclosures did survive.These rulings appeared in a September 14, 2010 order written by Southern District of New York Judge Lewis Kaplan. A copy of his ruling can be found here.

 

As discussed at greater length here, the ING bond investors first filed their action in February 2009. The allegations related to three ING bond offerings, in June 2007, September 2007, and June 2008, respectively, in which the company raised a total of $4.5 billion. The defendants include the company and two affiliated entities and certain of its directors and officers, as well as the offering underwriters.

 

The allegations in the plaintiffs’ complaint, as amended, relate to disclosures in the offering documents concerning ING’s own investments in Alt-A and subprime residential backed mortgages, which the plaintiffs allege were "extremely risky," because material portions of the loan pools on which they were based were comprised of lowest quality mortgages. The defendants moved to dismiss.

 

In his September 14 order, Judge Kaplan addressed each of the three offerings separately, dismissing all of the allegations regarding the June 2007 and September 2007 offerings, and many of the allegations with respect to the June 2008 offering. However, Judge Kaplan denied the motion to dismiss with respect to one part of the allegations concerning the June 2008 offering.

 

First, Judge Kaplan dismissed the allegations regarding the June 2007 offering on the grounds that they were untimely. Essentially, Judge Kaplan held that information contained in the September 2007 offering documents contained "storm warnings" that were sufficient to put the June 2007 bond offering investors on "inquiry notice," and since the plaintiffs first complaint was not filed until February 2009, more than a year later, the claims were untimely.

 

With respect to this ruling, Judge Kaplan added that "the facts placing one on inquiry notice need not detail every aspect of the fraudulent scheme, but only enough in the totality of circumstances to establish a probability of the alleged claim," adding that here, "these disclosures did so."

 

Second, with respect to the September 2007 offering, Judge Kaplan noted that the plaintiffs’ allegations largely relied on industry-wide or market-wide troubles, some of which post-dated the offering. Judge Kaplan said, quoting Twombley, that "absent some factual allegations suggesting that ING assets had been impacted by the general market conditions as the time allegedly misleading statements were made, [the complaint] stops short of the line between possibility and plausibility" that the offering documents were "misleading in a way that required additional disclosures."

 

Third, Judge Kaplan also granted the defendants’ motions to dismiss with regard to the June 2008 offering in many respects, in particular dismissing the allegations that the offering documents failed to disclose certain loan and loan-backed asset impairments, holding that the impairments themselves were immaterial.

 

However, Judge Kaplan denied the motion to dismiss with respect to the plaintiffs’ allegations that the offering documents misleadingly described the company’s mortgage-backed assets as "near prime and of high quality" and that the company was "well insulated from the worst effects of the market turmoil." Judge Kaplan found that the complaint’s allegations "sufficiently allege a connection between the general market conditions and ING’s assets" to "plausibly suggest" that "ING’s assets in June 2008 were ‘extremely risky’ and that could impact the company’s performance."
 

 

The defendants had argued that the statements were immaterial, a question Judge Kaplan described as a "close call." He observed that the offering documents disclosed "in some detail" the risks the assets posed, but he found that these disclosures were sufficiently "undercut" by other statements, as a result of which he could not conclude as a matter of law that a reasonable investor would find the omitted disclosure immaterial.

 

Discussion

Judge Kaplan’s ruling in the ING case is the latest in a series of recent decisions where plaintiffs have suffered full or substantial setbacks in their claims pertaining to the defendant company’s exposures to subprime-mortgage loans and mortgage loan backed assets. Judge Kaplan’s methodical opinion demonstrates that while it is not impossible for plaintiffs to survive dismissal motion in these cases, it is difficult.

 

The ING case is interesting in part because of the defendant company itself. Later in 2008, after the offerings that were the basis of this lawsuit, the Dutch government made a capital infusion into ING to the tune of 10 billion euros (about $13 billion). Judge Kaplan’s opinion references the bailout, although he ultimately concluded that the later events had not been alleged to have any connection with the earlier offering document disclosures.

 

Judge Kaplan’s analysis seems to suggest that even though a company may have received a bailout – even a massive bailout – does not mean that claims of securities fraud will not be scrutinized, and a later bailout by itself may mean little with respect to the question whether earlier statements were misleading.

 

It does seem that the dismissal motion rulings in the subprime and credit crisis-related cases are continuing to run against the plaintiffs. To be sure, a portion of the ING case will be going forward, and I know the name of the game for the plaintiffs is just to live for another day. But all but a small part of this case got knocked out, as seems to have been the case in many recent rulings.

 

I have in any event added the ING decision to my running tally of subprime and credit crisis dismissal motion rulings, which can be accessed here. Because the dismissal motion was denied at least in part, I added it to the motions denied table.

 

Special thanks to a loyal reader for providing a copy of the ING ruling.

 

Don’t Throw Stones: ING may have the oddest corporate headquarters of any company in the world. The building basically looks like a giant glass and steel baskeball shoe on stilts. It is hard enough to imagine any designer having the sheer audacity to present this thing to a client that presumably paid a lot of money for the design. It is even harder to imagine a room full of people saying,, "That’s it! That is exatly the image we were looking for." Perhaps the next project for the team that selected the design was to develop a strategy for getting the bank into U.S. residentail mortgage investments.  

 

In the latest ruling to address the pleading adequacy of a securities suit based on a financial institution’s loan loss reserve disclosures, a federal judge has found that the plaintiffs’ allegations in the SunTrust Trust Preferred Securities lawsuit were not sufficient to state a claim under the securities laws. Northern District of Georgia Judge William Duffey, Jr.’s September 10, 2010 decision (here) , which granted the defendants’ dismissal motions without prejudice, may be particularly noteworthy because it found that the plaintiffs’ allegations were not sufficient even to meet the ’33 Act’s pleading standard.

 

As discussed at greater length here, the complaint relates to SunTrust’s February 2008 offering of Trust Preferred Securities. The defendants include SunTrust and certain of its directors and officers, as well as the offering underwriters and SunTrust’s outside auditor.

 

 

The complaint alleges that the offering documents underestimated SunTrust’s allowance for loan and lease loss reserves (ALLL). The plaintiffs allege that the bank failed to disclose its mortgage-related exposures, and accurately account for losses in those assets and their impact on the bank’s liquidity and capital adequacy. The complaint alleges that as the housing market collapsed, SunTrust failed to increase its ALLL to account for the rise of non-performing loans from the fourth quarter of 2007 to through the end of 2008. The defendants moved to dismiss.

 

 

In his September 10 order, Judge Duffey noted that the plaintiff’s allegations depend on their assertion that after the offering, and after the housing market deteriorated further, SunTrust raised its ALLL. The plaintiff, Judge Duffey observed, “thus seeks to assert its Securities Act claims using a backward-looking assessment that interprets, in the context of later events, the statements that Plaintiff has identified” as misleading.

 

 

Moreover, whether SunTrust had adequate loan loss reserves “is not a matter of objective fact, but rather a statement of SunTrust’s opinion regarding what portion of its loan portfolio would be uncollectable.” Judge Duffey commented that “Plaintiff only asserts that Sun Trust’s opinion with respect to its loan reserves was ill-founded and proved so by a later course of events.”

 

 

Judge Duffey noted that the plaintiff does not allege that the defendants did not hold the opinion it expressed in the financial statements when they were issued, and that “absent an allegation that the Defendants did not believe the statements,” the plaintiff has not stated a claim for misstatements relating to the inadequacy of the loan reserves.

 

 

Judge Duffey added that while he would allow the plaintiff to attempt to replead its loan loss reserve allegations, it will have to meet the heightened pleading standards required if the amended complaint alleges that the defendants knowingly or recklessly cause material misstatements to be published. He added that in the current complaint the plaintiff “appears to be attempting to have it both ways, that is, disavowing a claim for fraud to avoid the need to meet the heightened pleading standard, at the same time suggesting that SunTrust’s stated opinion was false because SunTrust knew or should have known that it was undercapitalized.”

 

 

Judge Duffey also found that the allegations in the complaint “fails to provide minimal factual content” to meet the requirements of Twombly and Iqbal, noting that the complaint “offers, at most, conclusory assertions, including that SunTrust’s ALLL and loan loss provisions were understated, as evidenced by the fact that SunTrust subsequently raised these figures after the economic downturn.” This “hindsight assessment” does not support an inference that “SunTrust’s financial assessments were false or misleading at the time they were made.” (emphasis in original).

 

 

Judge Duffey also granted the underwriter defendants’ and auditor’s motions to dismiss.

 

 

Discussion

 

Prior decisions granting dismissal motion rulings in loan loss reserve cases have depended on the insufficiency of the complaint’s allegations relating to ’34 Act claims, particularly with respect to scienter. Refer, for example, to my recent post (here) discussing the dismissal of the loan loss reserve disclosure case involving Raymond James Financial.

 

 

The SunTrust Trust Preferred Securities case may be noteworthy because the loan loss reserve allegations were found to be insufficient event to satisfy the requirements for a ’33 Act claim, which do not have a scienter requirement. From Judge Duffey’s opinion, and his statement that the plaintiff may have been “trying to have it both ways,” the plaintiffs may have walked too fine of a line in trying avoid having their claims sound in fraud.

 

 

Judge Duffey’s firm rejection of what he interpreted as the plaintiff’s hindsight allegations is also interesting. The plaintiffs in many loan loss reserve cases will be fighting similar judicial impressions, especially to the extent that they plaintiffs cannot marshal facts suggesting that the defendants knew the loan loss reserves were insufficient.

 

 

Judge Duffey’s rejection of hindsight allegations may also be significant simply because of where his court is located. Georgia has been the leading state for bank failures since January 1, 2008, and many investors have filed actions alleging they were misled regarding the defendant bank’s financial conditions. To the extent Judge Duffey’s rejection of hindsight analysis reflects a larger sense of skepticism about alleged misrepresentations in the context of the subprime meltdown and global financial crisis, many of these investor actions could face an uphill battle.

 

 

In that regard, it is worth noting that Judge Duffey’s opinion follows the highly skeptical August 19, 2010 opinion of Judge Tom Thrash in the separate SunTrust subprime securities lawsuit, filed on behalf of SunTrust’s common shareholders. As discussed in a prior post, the opinion was particularly noteworthy for the harshness of the tone Judge Thrash used in dismissing the case. Though Judge Duffey’s opinion lacks the harsh tone, it seems to evince a similar level of skepticism.

 

 

Finally, it worth noting that the SunTrust Trust Preferred Securities case is one of numerous lawsuits filed amidst the subprime and credit crisis litigation wave that related to financial institutions’ trust preferred securities offerings, as discussed here. As noted in my prior post, many banks conducted these kinds of offerings in the years leading up to the financial crisis, and investors in these offerings have been active in seeking judicial relief following the meltdown.

 

 

I have in any event added Judge Duffey’s opinion to my running tally of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be found here.

 

Even though substantial parts of the case have been knocked out, at least one part of the auction rate securities case filed against Raymond James Financial and related entities has survived a renewed dismissal motion, making it the first of the auction rate securities cases to survive the preliminary motions – even if it only did so in limited part.

 

The ruling came in a September 2, 2010 order (here) from Southern District of New York Judge Lewis Kaplan. A September 8, 2010 Bloomberg article by Thom Weidlich about the ruling can be found here.

 

As detailed here, the plaintiffs sued Raymond James and two of its operating subsidiaries alleging that the defendants engaged in a scheme to defraud auction rate securities investors by knowingly misrepresenting the securities as highly liquid investments. The plaintiffs purport to represent investors who purchased the securities between April 8, 2003 and February 13, 2008.

　

As discussed at length in a prior post, in September 2009, Judge Kaplan granted the defendants’ motions to dismiss the plaintiffs’ initial complaint, holding that that the plaintiffs had failed specifically to attribute the allegedly actionable statements to any defendant and to plead with particularity any defendants’ scienter. The dismissal was without prejudice, and the plaintiffs subsequently filed an amended complaint. The defendants renewed their dismissal motions.

 

In his September 2 order, Judge Kaplan granted the defendants’ renewed motions as to all of the plaintiffs’ renewed claims, with one exception. That is, he found that the plaintiffs had adequately alleged both scienter and misrepresentation with respect to part of the Section 10(b) claims against one of Raymond James’ operating units, Raymond James & Associates (RJA). The claims against Raymond James itself and the other operating unit defendant, as well as the other claims against RJA, were otherwise all dismissed.

 

In attempting to allege that RJA had acted with scienter, the plaintiffs had argued that the unit was motivated, following turmoil in the auction rate securities market in 2007, to try to unload its own inventory of the securities, and that in fact it had provided its broker with financial incentives to sell those securities. Judge Kaplan found that these allegations were insufficient to establish scienter prior to November 2007, but "the period November 2007 through February 2008 stands differently."

 

Judge Kaplan said, with respect to that later period, that "given the deterioration of the ARS market that began in August 2007 and RJA’s wish to reduce its own position from November 2007 forward, it is quite reasonable to infer that RJA then had a motive to conceal the ARS liquidity risk from customers to whom it hoped to sell ARS from its own portfolio." Judge Kaplan held that the plaintiffs had adequately alleged scienter as to RJA for the period November 2007 through the end of the class period in February 2008.

 

Judge Kaplan also found that actionable misrepresentations had been made to one of the plaintiffs by an RJA broker. The amended complaint alleged that the broker had told the plaintiff that ARS were safe, liquid investments. However, the amended complaint further alleges that the broker did not tell the plaintiff that the appearance of a liquid market for the securities was only maintained by "extensive and sustained" interventions in the market place by various broker dealers.

 

Judge Kaplan said that "a trier of fact would be entitled to find that it would have been important to a reasonable investor, in deciding whether to buy or sell ARS, that the ARS – supposedly liquid investments – were liquid only because auction brokers routinely intervened in the auctions to ensure their success. Accordingly, RJA was under a duty to disclose this information."

 

Judge Kaplan rejected the plaintiffs’ allegations that the specific alleged misrepresentations made by individual brokers to the named plaintiffs were part of a larger scheme to defraud. As Judge Kaplan noted, other than with respect to the two brokers who interacted with the named plaintiffs, the amended complaint "does not allege any specific statement made to any investor."

 

In the absence of scheme allegations, the claims on behalf of an investor class may prove challenging, as the only supposed misrepresentations that survived the motion to dismiss were made only to one of the named plaintiffs and not to the class the plaintiffs are purporting to represent. Accordingly, the plaintiffs may yet face significant challenges even on the claims that survived, particularly at the class certification stage.

 

Nevertheless, even if narrow, Judge Kaplan’s ruling is noteworthy, as it represents the first occasion in an auction rate securities case in which a court has held that a plaintiff has adequately alleged misrepresentation and scienter.

 

The case against Raymond James may be somewhat distinct from the cases that had been pending against other large investment banks. In many of those cases, the defendant firms had separately entered regulatory settlements for the benefit of many of their auction rate securities investors. These regulatory settlements had served as the basis for dismissal of the auction rate securities cases pending against these banks, including for example the cases pending against UBS (refer here) and Northern Trust (refer here).

 

Raymond James, by contrast to these other firms, had not entered a regulatory settlement involving its investors. Indeed, the firm has been the target of certain high profile criticism (refer here) as a "holdout" for its resistance to entry into a regulatory settlement. Without a regulatory settlement, Raymond James was not able to move for dismissal on the same "absence of recoverable damages" theory as did the defendants in the Northern Trust and UBS cases.

 

I have in any event added the Raymond James decision to my running tally of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here.

 

In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the fourth in the series, I examine issues surrounding the application for D&O insurance and the surrounding application process. Although this might seem like a pretty straightforward topic, there are actually quite a few issues involving the D&O insurance application.

　

The Policy Definition of "Application"

As with most insurance, D&O insurers usually require insurance applicants to complete an insurance application as part of the insurance acquisition process. The D&O insurance application is of course a physical document – but it is not just a physical document. The term "application" is usually defined to comprise several categories of materials beyond just the physical document.

　

The term "application" is often defined broadly to include all prior applications the applicant previously submitted; all materials submitted with the application; and, in the case of public companies, all documents filed with the SEC or equivalent regulatory bodies. These policy definitions of the term "application" are sometimes unnecessarily overbroad and need to be narrowed to avoid sweeping in an entire universe of information that has no reasonable relationship to the actual application process. For example, many carriers will agree to revise the category of publicly filed documents to be included within the "application" to be narrowed to documents filed within the preceding twelve months.

 

The Application Form Itself

With respect to the physical application document itself, there is a further question of which application form an insured appropriately may be asked to complete and submit. Specifically, there is an important difference between the questions that appropriately may be asked when new coverage is being placed (or increased limits are being procured), compared to what appropriately may be asked when existing coverage is being renewed.

 

When new coverage or increased limits are being put in place, the insurer appropriately can ask the so-called "warranty question" – that is, whether the applicant is aware of any fact, situation or circumstances that might reasonably be expected to give rise to a claim. (The actual wording of the representation required varies among insurers and applications.) Any matters disclosed pursuant to the warranty statement will be excluded from coverage.

 

Because the policyholder is entitled to expect complete continuity of coverage in successive policy years, the warranty question emphatically is not appropriate in connection with the renewal of existing coverage.

 

Unfortunately, process participants sometimes use applications including the warranty question even in connection with renewals of existing coverage. The problem with providing an answer to the warranty question on renewal is that it potentially can provide the carrier with a basis on which to try to disclaim coverage, when the question should not even have been asked or answered in the first place. (In a previous post, here, I discussed a case in which a carrier successfully relied on this defense to disclaim coverage, in a situation where it fairly may be asked whether the policyholder should have answered the warranty question in the first place.)

 

Application Misrepresentations and the Consequences

This whole question of the carrier seeking to rely on application responses to disclaim coverage leads to the larger question of policy rescission – that is, the question of when the carrier may, on the basis of alleged material misrepresentations in the policy application, seek to have the policy declared void ab initio – that is, as if it had never been put in place. There are several components of this question, each one raising important considerations in connection with the wording of key policy terms and conditions.

 

The first issue of course is what the application consists of, as noted above. The second question is whose alleged misrepresentations may be relied on by the carrier and against whom may they be used.

 

The Representations Clause

Many policies will specify in a representations clause whose knowledge of the mispreresented facts will result in a vitiation of coverage. For example, the policy might specify that if certain top company executives are aware that application statements were untrue, then coverage will not apply to those executives or to the company. Because the operation of the representaitons clause could void coverage for the company, it is critical that the group of persons who knowledge will void coverage for the company be restricted and as narrow as possible, preferably just the CEO, CFO and General Counsel.

 

Nonimputation and Severability

Two related issues pertain to questions of imputation and severability. The question is basically whether one individual’s knowledge will be imputed to the company or to other individuals. As noted in the preceding paragraph, certain officials’ knowledge will be imputed to the company. But ideally, the policy terms will be structured so that no individual’s knowledge is imputed to another individual – or to put it another way, that each individual’s knowledge is severable from that of other individuals. (Please see the note below discussing the difference between this type of severability – that is, application severability – from a different type of severability that may arise under the D&O policy—that is, exclusion severability).

 

The inclusion within the policy of a provision of so-called "full severability" (that is, the specification that no individual’s knowledge will be imputed to another individual for purposes of determining the effect of an application misrepresentation) is critical in order to ensure that coverage for innocent insureds remains unimpaired.

 

Policy Rescission and Claim Exclusions

The final question that should be asked about policy provisions pertaining to application misrepresentations is the issue of what the consequences of an application misrepresentation will be. As noted above, absent policy provisions providing otherwise, the carrier may seek to rely on application misrepresentations as a basis on which to rescind the policy. From the policyholder’s perspective, policy rescission is highly undesirable on many levels, not least of which is that the voiding of the policy means not only that coverage will be unavailable for the specific matter at hand, but also for any and all future matters that might arise.

 

In light of this latter consideration, many carriers will agree to amend their policies so that in the event of an alleged application misrepresentation, policy coverage is unavailable only for persons aware of the misrepresentation and only with respect to claims pertaining to the allegedly misrepresented matter. This formulation allows for the possibility that coverage might be available for future matters that might arise, even if it is not available for certain persons in connection with the immediate matter at hand.

 

Non-rescindable Policies

In addition, in many instances, carriers are willing to incorporate provisions specifying that the policy is nonrescindable. In some cases, the policy may provide that it is nonrescindable only as to Side A coverage (that is, the coverage protecting the individuals in the event that corporate indemnification is unavailable due to insolvency or legal prohibition). In other cases, the policy may be fully nonrescindable.

 

Completing the Application and Polling the Board

As noted above, there are times when it is undeniably appropriate for the carrier to ask the warranty question. The issue for the applicant company is how to answer the question in a way that will need lead to problems down the road. The applicant obviously wants to make sure that all known circumstances are disclosed, so that coverage is not later impaired if it later turns out that there were known circumstances that were not disclosed.

 

In order to address this issue, the applicant company should poll its senior executives and board members, in a process that communicates the importance of the inquiry. The polling process and responses to the survey should also later serve to substantiate the fact that the applicant company took reasonable steps to determine whether or not any person was aware of any fact, circumstance or situation.

 

Two Different Kinds of Severability

As noted above, in an appropriately structured policy, no person’s knowledge will be imputed to any other person for purposes of determining the scope and effect of any alleged misrepresentations. This non-imputation is sometimes referred to as "full severability." This type of application severability is separate and distinct from another type of severability that operates in many D&O policies.

 

That is, many D&O policies contain provision, typically at the end of the exclusions section, in which it is provided that for purposes of determining the operation of the policy exclusions, no individual’s conduct will be imputed to any other individual. This "exclusion severability" is analytically separate and distinct from "application severability" but the similarity of the names can sometimes be confusing. Both types of severability are critically important but they are dealt with in separate parts of the policy and they must be addressed separately.

　

Readers who would like to read the prior posts in this series about the nuts and bolts of D&O insurance should refer here:

　

　

 

 

 

Executive Protection: Indemnification and D&O Insurance – The Basics

 

 

 

　

 

 

 

Executive Protection: D&O Insurance – The Insuring Agreement

　

Executive Protection: D&O Insurance—The Policyholder’s Obligations

 

 

 

　

　

　

Every fall since I first started writing this blog, I have assembled a list of the current hot topics in the world of directors’ and officers’ liability. This year’s list is set out below. As should be obvious, there is a lot going on right now in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. Here is what to watch now in the world of D&O:

　

1. What Impact Will Dodd-Frank Have on D&O Liability?: The massive Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which Congress enacted this past July, represents the most significant reform of financial regulation in decades. It will affect virtually every aspect of our financial system. However, exactly what the impact will be and how that might affect the liability of directors and officers remains to be seen.

　

Among the few things that are clear at this point is that some of the proposed reforms were not incorporated into the final version of the Act. Thus, for example, the law did not, as was proposed, legislatively overturn the U.S. Supreme Court’s decision in Stoneridge and enact a private right of action for aiding and abetting. The Act also did not incorporate a proposed legislative provision that would have extended the extraterritorial jurisdiction of the U.S. securities laws in cases brought by private litigants. (The Act did include a provision regarding the SECs extraterritorial jurisdiction, however).

　

One reason that the Act’s ultimate implications remain unclear is that much of the work still remains to be done. The Act calls for more than 240 rulemaking efforts and nearly 70 studies by 11 different regulatory authorities. Most of the details of the key provisions, and the ways those provisions will be implemented, remain to be spelled out by the various regulators in the months ahead.

　

But though much of the picture has yet to be fleshed out, there are certain provisions that clearly will impact directors and officers, even if the ultimate effect is uncertain. First, the Act provides rules regarding executive compensation and corporate governance generally applicable to U.S. public companies, including requirements on shareholder "say on pay;" broker discretionary voting; compensation committee independence; executive compensation disclosures; executive compensation "clawbacks;" disclosure regarding employee and director hedging; disclosures regarding Chairman and CEO structures; and shareholder proxy access.

　

These provisions do not expressly create new causes of action against directors and officers, but they do create a host of new obligations that undoubtedly will drive shareholder expectations. The probability of claims arising from these new requirements seems high, particularly with respect to the new disclosure requirements.

　

Among the specific parts of the Act that also seem particularly likely to lead to future claims are the new whistleblower provisions. The whistleblower provisions include the creation of a new whistleblower bounty pursuant to which individuals who bring violations of securities and commodities laws to the attention of the Securities and Exchange Commission or the Commodities Futures Trading Commission will receive between 10 percent and 30 percent of any recovery in excess of $1 million.

　

Many commentators have predicted that these incentives could lead to a dramatic increase in complaints of accounting misconduct, corrupt practices, and other violations. (The specific possibilities for increased reporting related to the Foreign Corrupt Practice Act are discussed below.) The likely increased enforcement activity also seems likely to generate a related upsurge in follow-on civil litigation, as the underlying violations are disclosed.

　

There are many ways that the impact of Dodd-Frank Act can be anticipated or at least conjectured, but the Act’s overall impact and significance wil only become apparent over the long haul. At 2,319 pages, the Act’s scope is so sweeping that many of its specific implications inevitably will reveal themselves only with the passage of time. Be prepared for years of commentaries about the Act that begin "Though the provision was little-noticed at the time that the Dodd-Frank Act was enacted, …" In the meantime, the laws of unintended consequences will be hard at work.

　

2. What Happens Next with the Subprime and Credit Crisis-Related Litigation Wave?: For several years beginning in 2007, corporate and securities litigation was largely driven by lawsuits arising out of the subprime meltdown and the global credit crisis. Beginning in the second half of 2009, the litigation wave began to lose steam, and the related lawsuits dwindled as we headed into 2010.

　

But while the pace of new lawsuit filings has dwindled, new filings have not entirely gone away. Even now, well into 2010, the credit crisis-related lawsuits continue to arrive (although as time goes by, it become harder and harder to maintain absolute definitional certainty around what makes a particular case "credit crisis-related."). By my count, there have been as many as 19 new subprime and credit crisis related lawsuits filed during 2010, out of approximately 104 new securities class action suits so far this year (as of September 3, 2010).

　

In the meantime, the vast amount of litigation that accumulated over the last four years continues to work its way through the system. There have been over 220 subprime and credit-crisis related securities class action lawsuits filed overall since the first was filed back in 2007. About two-thirds of the cases remain pending and many have yet to reach the motion to dismiss stage, though the dismissal motion rulings are starting to accumulate.

　

And while a number of courts have seemed skeptical about the fraud allegations in light of the magnitude of the global financial crisis, there have also been a number of decisions were the court have found the plaintiffs’ allegations sufficient. My running tally of the various subprime and credit crisis-related lawsuit dismissal motion rulings can be found here.

　

With the increasing number of dismissal motion rulings, the cases that survive are likely to head towards settlement. Just in the last few months, there have been several very high profile subprime-related lawsuit settlements, including the $624 million settlement in the Countrywide case, the roughly $124 million settlement in the New Century Financial case, and the $235 million total settlement in the Schwab Yield Plus case. (All settlement figures reflect aggregate settlement amounts) By my calculation, though there have been only 15 subprime and credit crisis related lawsuit settlements so far, those few settlements alone total over $1.8 billion.

　

The one thing that seems clear is that when all is said and done on the subprime and credit crisis-related litigation wave, the total costs will be staggering. The defense costs alone associated with this litigation will be enormous. (By way of illustration, the defense expenses associated just with the Lehman bankruptcy are running at about $ 5 million a month, and those costs are likely to accelerate in the event the SEC files an enforcement action or the DoJ files criminal charges.) Though not all of these costs will be insured, many of them will be.

　

In the aggregate the subprime meltdown and credit crisis represents an enormous event for the D&O insurance industry. Just how big of an event it is will continue to unfold in the weeks, months and years ahead.

　

3. Will the Wave of Bank Failures Lead to a New Wave of Failed Bank Litigation?: Since January 1, 2008 and through September 3, 2010, 283 banks have failed in the United States, and the total number of failed banks continues to grow. Indeed, in its most recent Quarterly Banking Profile, the FDIC reported that one out of ten banks in the United States is a "problem institution" (meaning rated a "4" or "5" on a scale of one-to-five on lineup of financial and operational criteria).

　

During the S&L crisis, the banking regulators pursued claims against the directors and officers of the failed institutions in connection with about a quarter of the bank failures. These efforts proved worthwhile for the FDIC, since its S&L crisis D&O claims led to recoveries of about $1.3 billion, out of total professional liability claims recoveries of about $3.25 billion. Given that history, it seems probable that the FDIC will pursue D&O litigation as part of the current bank wave.

　

Though the FDIC, as part of the current bank failure wave, has to date filed only one lawsuit against former directors and officers of a failed banks, there is every reason to expect that there will be more claims to come, perhaps many more. The FDIC has sent claims notice letters to the directors and officers of many failed banks, and otherwise taken steps to preserve its right to pursue claims and also to assert its priorities over other claimants.

　

During the S&L crisis, the lag between the peak of the failed banks and the timing of the FDIC’s peak recoveries was about three years. Since the current wave of bank failures did not really start to take off until late 2008 and did not really gain serious momentum until 2009, and in light of the lag in the FDIC’s recovery during the S&L crisis, it would seem that the FDIC’s failed bank lawsuit will begin to accumulate in earnest some time during 2011.

　

In the meantime, other claimants are also asserting claims against the failed banks’ former directors and officers . Unlike during the S&L crisis, when most of the failed institutions were privately held, many of the banks that have failed during the current wave were publicly traded. According to a recent NERA report, about 45 of the subprime and credit crisis related securities class action lawsuits have involved depositary institutions. Of the 20 failed banks that produced the largest losses prior to 2010, 13 involved publicly traded securities, of which eight had been named in securities class actions as of the end of 2009.

　

Even in privately held banks’ investors are pursuing claims, although they are crafting their claims very carefully to avoid running afoul of the FDIC’s priority rights to the claims of the failed institutions.

　

In some respects these investor lawsuit could be competing with the FDIC for the proceeds of the D&O insurance policies insuring the directors and officers of the failed institutions. However, while the FDIC generally has priority, the investors may be able to access the policies proceeds when the FDIC may not, if, for example, the relevant policies have exclusions precluding coverage for claims by regulatory bodies.

　

For now, the extent to which the FDIC will pursue litigation against former directors and officers of the failed institutions is uncertain, although the likelihood is that there will be extensive litigation ahead. In the meantime, numerous investors are pressing ahead with their own claims. In all likelihood, an extensive amount of litigation related to failed and troubled banks seems likely to accumulate as we head into next year.

　

4. Will the Mix of Litigation Involving Directors and Officers Continue to Shift Away from Securities Class Action Lawsuits?: One of the more interesting litigation phenomena of the last several years, at least as relates to the exposure of directors and officers, as been the material shift of litigation away from securities class action lawsuits and towards other types of lawsuits.

　

This shift was first discernable in the litigation that arose from the options backdating scandal, beginning in 2006. Though there were over 30 options backdating related securities class action lawsuit file, there were more than 160 options backdating related shareholders derivative lawsuits filed.

　

According to the mid-year 2010 corporate and securities litigation study by the insurance information firm Advisen, this shifting mix of litigation away from securities class action lawsuits has continued and securities class action lawsuits have represented a progressively smaller proportion of overall corporate and securities litigation for several years now. Thus, whereas prior to 2006, securities class action litigation represented over half of all corporate and securities litigation, through the middle of 2010 securities class action litigation represented less than 20% of all corporate and securities lawsuits.

　

What is making up the remainder of the corporate and securities lawsuits are a broad mix of kinds of claims including individual securities lawsuits, shareholder derivative lawsuits, and breach of fiduciary duty lawsuits.

　

This shifting mix has a number of important considerations. The first is that the dialog about litigation levels tends to focus on securities class action lawsuit filing patterns. Though class action lawsuit filings levels have always ebbed and flowed over time, it seems that every time the filing levels decline or climb (as they inevitably do), some commentator will make some sweeping generalizations about permanent changes in the filing levels.

　

The fact is, the dialog about shifting class action filing levels may be beside the point. The real story may be that the kinds of cases that are getting filed have changed.

 

In any event, the growing importance of lawsuits other than securities class action lawsuits does alter the issues that should be considered in the context of directors’ and officers’ liability exposures. The changing mix of litigation could have important implications for D&O insurance terms and conditions and limits of liability.

　

At a minimum, the changing litigation mix provides an important context within which to consider information relating to securities class action filing levels. Even if fewer class action lawsuits are being filed (at least lately, anyway), that does not mean the overall threat of litigation has declined. To the contrary, the Advisen report shows that the threat of corporate and securities litigation generally continues to increase. That is, the litigation threat is not declining, it is simply changing.

　

5. What Will Be the Impact of the Supreme Court’s Most Recent Securities Law Decisions?: Every year it seems, at least recently, the U.S. Supreme Court has issued important decisions affecting securities litigation. The Court’s most recent term, which was completed in June, proved to be no exception. The Court issued two cases of particular significance that potentially could have significant impact on future securities lawsuit cases and filings.

　

First, on June 24, 2010, the Supreme Court issued its long awaited ruling in the Morrison v. National Australia Bank case. The case was much anticipated because it was expected to provide much-needed guidance on the questions of the extraterritorial jurisdiction of the U.S. securities laws.

　

The Court threw everybody a bit of a curve ball, when it discarded many decades of jurisprudence analyzing when there was sufficient "conduct" in the U.S to support the application of the U.S. securities laws to a foreign company. The Court said that rather than a "conduct" based test, the securities laws required a "transaction" test, and effectively held that the U.S. securities laws do not apply to transactions that take place outside the U.S.

　

The Morrison case clearly rules out so-called "f-cubed" cases, which involve claims asserted against foreign-domiciled companies by foreign domiciled claimants who bought their shares on foreign exchanges.

　

Since the Morrison case came down, plaintiffs in other cases have tried to argue that Morrison does not preclude so-called "f-squared cases" – that is, cases in which U.S. investors bought a foreign company’s shares on a foreign exchange. So far, courts have not proven receptive to that argument but the issue is far from resolved.

　

In the meantime, the Morrison case seems likely to affect the many U.S. securities cases that have been filed in recent years against foreign domiciled companies. At a minimum, the cases in which the complaints have sought to assert claims on behalf of "f-cubed" claimants seem likely to be narrowed to exclude those claims. (I know many plaintiffs’ lawyers may contest the extent of this statement, and in recognition of their arguments I duly acknowledge their objections here.)

　

The larger impact of Morrison may be there will be fewer, or at least narrower, U.S. securities lawsuits filed against foreign domiciled companies. The many claimants who may now be unable to pursue claims in the U.S. may seek to resort to the courts and laws of their home countries, and perhaps, to the extent the home country laws fail to provide adequate relief, seek legislative change to allow greater investor protections.

　

The other significant decision this past term was the Court’s April 2010 ruling in the Merck case, in which the U.S. Supreme Court addressed the question of what is sufficient to trigger the running of the statute of limitations for securities claimants. The Supreme Court held that the running of the statute of limitations is not triggered until the plaintiffs have, or with reasonable diligence could have had, knowledge of facts constituting the violation, including facts constituting scienter.

　

The practical effect of the Court’s decision in Merck is that it could postpone the running of the statute of limitations, potentially lengthening the time within which plaintiffs might file their claim. This effect seems particularly significant in light of the relatively recent phenomenon that has developed in which plaintiffs have been filing securities lawsuits well after the proposed class period cutoff date.

　

Although so far there have been relatively few new filings that have reflected potential longer limitations periods, the possibility for an increase in belated filings remains. The challenge this presents for D&O insurance underwriters and companies alike is that it is harder to be sure when a company that has had adverse developments in the past may be "out of the woods" as far as possible securities lawsuits.

　

6. What Will Be the Impact of Securities Cases the Supreme Court Will be Considering in the Upcoming Term?: For whatever reason, the U.S. Supreme Court in recent years has seemed  particularly interested in taking up securities cases, and the Court’s docket for the upcoming October 2010 term is no exception. With Justice Kagan newly added to the Court’s lineup, the Court will be considering at least two potentially significant securities cases.

　

First, the Court has granted a writ of certiorari in the Matrixx Initiatives case. The question presented is whether plaintiffs must allege that adverse event information is "statistically significant" in order to establish that the defendants’ alleged failure to disclose the information was material. Though the issues involved appear narrow, the case potentially could address broader issues of securities claim pleading sufficiency.

　

Even if the Court confines itself just to the narrow question of statistical significance, the Court’s consideration of this issue has the potential to be important, since companies are regularly receiving customer complaints and must decide when the level of complaints are significant.

　

The larger possibility for this case is that the Court might take the occasion as an opportunity for a more comprehensive consideration of the issue of materiality. Were the Supreme Court to take up this larger question, the Court’s ruling potentially could have significant ramifications for many future securities class action lawsuits.

　

Second, the Court also granted certiorari in the Janus Capital Group case, which involved the question of who may be a "primary violator" under the securities laws. The defendants in the case are the holding company and the management company for a family of mutual funds. Investors claim they were misled by statements that the funds did not engage in market timing; the funds later entered a settlement for market timing.

　

As the Supreme Court recently affirmed in its Stoneridge case (about which refer here), there is no private action for aiding and abetting liability under the federal securities laws. Accordingly, the Janus entities can be liable if at all if they are "primary violators," that is, if they are directly responsible for the allegedly wrongful conduct. The Janus entities contend that as mere service entities for the actual funds, they cannot be held primarily liable.　

　

The Fourth Circuit ruled that "a service provider can be held primarily liable in a private securities fraud action for ‘helping’ or ‘participating’ in another company’s misstatements." The Fourth Circuit’s ruling is at odds with the decisions of other Circuit courts. Some courts hold that only someone that "makes" a statement and has it attributed to him can be held liable as a primary violator. Other courts, similarly to the Fourth Circuit, have held that someone that "substantially participates" in the activities that led to the creation of the allegedly misleading statement can be held liable as a primary violator, even if the statement is not attributed to him or her.

　

At some level, this "substantial participation" test starts to sound a lot like the "aiding and abetting liability" that the Supreme Court had rejected in connection with private lawsuits in the Stoneridge case. That may, in fact, be why the Supreme Court took up the case – not just to reconcile an apparent split in the Circuits, but to align the principles of primary violator liability with those of the secondary violator jurisprudence. In any event, and at a minimum, the case will draw greater clarity around what constitutes a primary violation of the securities laws.

　

7. What Will Happen to the Level of Business Bankruptcy Filings?: According to the latest report from the Administrative Office of the U.S. Courts, business bankruptcy filings rose 8.34% for the 12-month period ending June 30, 2010. Not only did the filing levels rise relative to the prior period, but they remain well above levels in recent years – for example, the filing rate during the twelve month period ending June 30, 2010 is 76% greater than the comparable period ending June 30, 2008, and 150% greater than the comparable period ending June 30, 2007.

　

The level of business bankruptcy filings directly affects the overall level of D&O claims activity, because so many bankruptcies involve claims against the former directors and officers of the failed entity. These claims are asserted by investors, creditors, the bankruptcy trustee and others. As long as the business bankruptcy filing rate remains at relatively elevated levels, D&O claims activity levels will also remain at higher levels.

　

The one positive note from the recent bankruptcy filing statistics is that the rate of business related filings may be slowing, albeit while remaining at relatively elevated levels. Thus, during the period ending June 30, the number of business-related filings declined during each of the three months periods during the twelve month stretch. During the first three months of the twelve month period, there were 15,303 business related filings; in the second three months, there were 15,156 business-related filings; in the third three-month period there were 14,697; and in the final three months, there were 14,452.

　

We can all hope that the continuing economic recovery will lead to fewer business-related bankruptcy filings in the months ahead. However, as long as the filing levels remain elevated compared to historical norms, D&O claims activity will also be elevated.

 

These issues are important because the interaction between the D&O insurance policy and the processes of the bankruptcy court are intricate and fraught with complexities. The ongoing heightened risk of business bankruptcy has important implications for D&O claims exposure as well as for issues surrounding the D&O insurance placement process.

　

8. What Will be the Next Sector to Get "Hot"?: One of the well-established patterns of securities class action lawsuit filings is that periodically some industrial sector will get "hot" and suddenly numerous companies in that sector will find themselves the targets of securities class action lawsuits.

　

Companies in the for-profit education sector saw that during August this year, when, following a government report suggesting the possibility of education loan fraud, nearly a half dozen companies in the sector were hit with securities suits within the space of just a few days. In just about the same way, late last year, a host of exchange traded funds were hit with securities class action lawsuits over a very short time period.

　

The recent industry-specific litigation outbreak in the for-profit education sector is a reminder of the many odd and circumstance-specific events that can drive securities class action lawsuit filings. Many things determine filing levels, many of which cannot be captured or predicted in historical filing data. As a result, it can be misleading to try to generalize from short term trends about future filing levels. Simply put, the numbers vary over time, because, for example, contagion events and industry epidemics happen.

　

　

9. Will Heightened FCPA Enforcement Activity Lead to Increased Follow-On Civil Litigation?: One of the relatively well-established trends in recent years has been that increasing Foreign Corrupt Practices Act enforcement activity has led to increasing levels of follow on civil litigation, in which the claimants assert that mismanagement and poor internal controls allowed the corrupt activity to occur. In addition shareholders also claim to have been misled about controls, as was alleged, for example, most recently in the securities class action lawsuit filed in August against SciClone Pharmaceuticals and certain of its directors and officers.

　

For at least a couple of reasons, the heightened level of anticorruption enforcement activity seems likely to accelerate in the months ahead.

 

First, as noted above, the recently enacted Dodd-Frank Act contains a whistleblower bounty provision that seems likely to produce heightened whistleblower activity in connection with FCPA violations. Under these whistleblower provisions, whistleblowers can receive rewards of up to 30 percent of recoveries over $1 million. These kinds of rewards could produce some enormous bounties in the FCPA enforcement context, where recent enforcement penalties have been in the range of tens and hundreds of millions of dollars.

　

Indeed, the top ten FCPA settlements collectively total $2.8 billion, but the top six, all of which took place just in the last 20 months, represent 95% of the total. Four of the top six settlements were reached just in 2010. Because of the massive scale of the settlements that the SEC has been achieving in this area, the potential rewards for whistleblowers are enormous.

　

Second, the UK Bribery Act received Royal Assent on April 8, 2010. On July 20, 2010, the U.K. Ministry of Justice released its timetable for the implementation of the Bribery Act, setting April 2011 as the effective date. The Act is widely viewed as in several important respects more "far-reaching" than the FCPA, and is likely to have significant impacts on business that either are based in the U.K. or have significant parts of their operations in the U.K.

　

Though the U.K. provisions may be somewhat delayed and though the impact of the new Dodd-Frank Act whistleblower provisions may be as yet undeveloped, there is no question that this is an area where many things are happening. Anti-corruption enforcement represents a significant and growing area of liability exposure for corporate officials, especially in light of the government’s apparent willingness to resort to sting tactics and other prosecutorial techniques as part of the heightened enforcement.

　

These developments also have significance for purposes of the structure and implementation of insurance calculated to protect corporate officials. The fines and penalties associated with these kinds of enforcement actions typically would not be covered under a D&O policy, but the defense fees, at least for the individuals might well be. However, the Dodd-Frank Act whistleblower provisions, for example, may raise concerns under the typical D&O policy’s insured vs. insured exclusion.

　

Finally, the increased levels of anticorruption enforcement may also represent a growing area of civil litigation exposure, as these kinds of enforcement actions frequently lead to follow-on civil lawsuits. Altogether, exposures arising from anticorruption laws represent an important and growing area of potential liability of corporate officials.

　

10. What Does All of This Mean for the D&O Insurance Marketplace?: The astonishing pace of legislative and judicial changes just over the last few months alone underscores how rapidly the liability exposures in the directors and officers arena can be transformed. Given the absolute whirlwind of recent changes, D&O insurers might be excused for taking a conservative approach to risk. Indeed, those outside the industry often assume that is what the carriers would be doing now.

　

But despite everything, the D&O insurance industry remains competitive, and all signs are that it will remain that way for the foreseeable future. Most insurance buyers, particularly those outside the financial sector and those with reasonably solid financials, can expect to obtain insurance with broad terms and conditions at relatively attractive prices. Though pricing is not declining at the pace we saw in recent years, pricing remains stable at relatively lower levels.

　

The iron laws of supply and demand are impervious to more trivial forces like legislative or judicial change. On the supply side, the insurance industry is operating with ample capacity, largely due to the absence of large-scale catastrophes. As a result, the D&O insurance marketplace is characterized by a large number of competitors all of whom are continuing to seek to write business. On the demand side, the number of businesses has been cut down by bankruptcies. Shrinking labor forces and diminished budgets have also reduced insurance demand.

　

In the absence of some large external event that substantially erodes insurance capacity, the likelihood is that insurance buyers (or at least those buyers outside the financial sector with relatively stable financials) will continue to enjoy a relatively favorable marketplace.

 

Nevertheless, the liability landscape for directors and officers is changing rapidly, and well-advised insurance buyers will want to make sure that their D&O insurance program is properly positioned to respond to these changing exposures.

　

Discount for Readers of The D&O Diary: On November 30 and December 1, 2010, I will be co-chairing the American Conference Institute’s 16th Annual Summit on D&O Liability. This conference is a great event every year, and once again the conference will feature an impressive array of the D&O insurance industry’s thought leaders. Background information about the conference, including the event brochure and registration information, can be found here.

　

The D&O Diary is a conference media partner for this event, and as a result the conference organizers are offering a $200 discount to readers of The D&O Diary. In order to obtain this discount, just use the code "D&O Diary" on the registration form. Hope to see everyone at the conference.

If the number of out of office messages sent back when I sent out new blog post email notifications during August are any indication, many readers have been away for some or all of the past few weeks. I hope you saved the little paper umbrella from the fruity drink that you and your spouse shared on the terrace of the outdoor café and that you are still finding sand in your tennis shoes.

 

Sadly, the summer eventually ends and everyone eventually has to go back to school.

 

 

Now that you are back at your desk, you will want to get caught up, especially because while you were away, the blogosphere continued to gyrate, and The D&O Diary continued to publish new posts. Here’s just some of what you missed:

 

 

The Nuts and Bolts of D&O: I have now published three installments in my ongoing series about the nuts and bolts of D&O insurance, the latest of which relates to the policyholder’s obligations under the D&O policy. The prior posts in the series related to the relationship of indemnification and insurance, and to the insuring agreement in the Policy. Additional installments will be forthcoming in the weeks ahead.

 

 

Guest Posts: I have been delighted to be able to publish a number of interesting guest posts over the past several weeks.

 

 

First, I published, in the form of two separate posts (here and here), an interesting exchange between Milberg partner Michael Spencer and Minnesota Law Professor Richard Painter, on the question of the impact of the Morrison v. National Australia Bank case.

 

 

Second, I published a post from Jones Day partner John Iole on the topic of conflicts in the insurance transaction.

 

 

And finally, I published a post (here) written by former plaintiffs’ securities attorney Bill Lerach, who had some spirited comments about my prior post discussing an article by three academics about whether corporate defendants that settle securities suits suffering continuing financial detriments. I published the academics’ response to Mr. Lerach over this past weekend.

 

 

Failed Banks: The number of banks that have been closed as a result of the current failed bank wave continues to grow.  Indeed, according to the FDIC’s most recently quarterly report, one out of ten banks in the U.S. is a “problem institution.” The FDIC has filed its first lawsuit, as part of the current failed bank wave, against former directors and officers of a failed bank. Meanwhile, investor litigation involving failed banks continues to move forward. For example, in the PFF Bancorp and Banco Popular cases the dismissal motions were denied, although in the Raymond James loan loss reserve case the dismissal motion was granted. In the meantime, at least one investor lawsuit involving a troubled bank appears headed to trial. NERA has published a comprehensive report on failed bank litigation.

 

 

Subprime Cases: There have been a number of significant dismissal motion rulings in subprime-related securities cases, including the partial dismissal in the BofA/Merrill merger case and the dismissal in the SunTrust case. In addition, the New Century Financial case settled for about $125 million. My updated list of subprime and credit crisis-related lawsuit dismissal motion ruling can be found here.

 

 

Coming Attractions: Now that everyone is caught up, tomorrow morning I will be publishing my annual survey of the D&O marketplace, “What to Watch Now in the World of D&O.” Watch this site.

 

 

Speakers’ Corner: On September 29, 2010, I will be speaking at C5’s 5th European Forum on D&O Liability Insurance in Cologne, Germany. I will be participating on a panel with Maurice Pesso of the White & Williams law firm on the topic “Why European Directors of U.S. Companies Should Worry About Their Exposure to U.S. Class Action Claims” – a topic that has changed pretty dramatically in the last few months. Information about the conference can be found here. I will look forward to seeing and greeting my European readers at this upcoming conference.

 

A recent article by three academics raising the question whether corporate securities lawsuit defendants underperform financially after their case settles has generated significant commentary on this site. In this post, the professors respond to the commentary.

 

The article in question is a March 18, 2010 paper entitled "Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms" (here) by Cincinnati Law Professor Lynn Bai, Duke Law Professor James Cox, and Vanderbilt Law Professor Randall S. Thomas.

 

 

The article describes the professors’ research in which they sought to discover whether getting hit with a securities a lawsuit and then subsequently entering into a settlement "weakens the defendant firm so that from the point of view of well-received financial metrics the firm is permanently worse off as a consequence of the settlement."

 

 

My initial post about the article provoked an unusual amount of reader commentary, including a comment about the academic’s research and analysis posted by former plaintiffs’ securities attorney, Bill Lerach. With Mr. Lerach’s consent, I republished his comment as a separate guest post, here.

 

 

The professors have prepared and submitted a response to the various comments about their paper.  Here is the professors’ response:

 

 

The comments seem to have concentrated on the possible alternative causation of the underperformance of defendant companies involved in securities class actions, i.e., these companies had financial problems prior to the lawsuit and it was likely that these pre-existing problems prompted the companies’ management to lie, and thus, it should not be surprising to see that these companies underperform their peers after settlement. We do not deny that this could be an alternative explanation to the underperformance that we have seen in the data, and indeed we have explicitly talked about this alternative explanation at a number of places in our paper. However, our study has also revealed empirical evidence that is inconsistent with this intuitive explanation, and we thought we should report such evidence in the paper so that people can think about them and perhaps follow up with more research.

 

 

First, we are not seeing deterioration (post-lawsuit and post-settlement compared to pre-class period) in the defendant firms’ sales numbers. This holds true both in terms of defendant firms’ absolute sales numbers and relative performance to their peers. We know that sales reflect the bottom line of the financial health of a company and the robust sales shown in the data are inconsistent with the story that these firms are deteriorating on their own independent of the lawsuit.

 

 

Second, we are seeing deterioration in liquidity in post-settlement period but not in the post-lawsuit-but-pre-settlement period. If the liquidity constraint is caused primarily by other factors such as banks’ withdrawal of credit as a result of revelation of fraud (as Bill Lerach suggested), why are we seeing significant constraints only in the post-settlement period?

 

 

Thirdly, although the average Altman Z-scores for defendant firms were lower in post-lawsuit and post-settlement periods compared to the pre-class period, the inferiority was more prominent in the post-settlement periods. The significantly lower Altman z-score in post-settlement periods seems consistent with the heightened liquidity constraint we observe in the post-settlement period. Again, we do not rule out the possibility that defendant firms are deteriorating on their own, but we want to point out that the data can also be consistently explained by an alternative hypothesis, i.e., lawsuit and settlement had an independently negative effect on the financial health of the defendant firms.

 

 

The comments are legitimate and we appreciate the interest that people have shown in this topic.  We have certainly thought about the causation issue in our research, but we could not explain completely what we were seeing in the data by the hypothesis that defendant firms were destined to underperform even if they were not dragged into a lawsuit. We have dutifully reported what we saw in the data.

 

 

I would like to thank the professors for taking the time to prepare a thoughtful response and for their willingness to have the comments posted on this site. My thanks to all of the readers who have engaged in this dialog. Further comments are still very much welcome.

 

Many observers have been waiting to see whether and to what extent the FDIC will pursue claims against former directors and officers of banks that have failed during the current bank failure wave. So far, the FDIC has filed just a single suit, against former officers of a subsidiary of IndyMac.

 

However, on August 31, 2010, federal regulators filed a complaint in the Central District of California against 16 officer and directors of a failed financial institution – but the agency filing the lawsuit was not the FDIC and the failed institution was not a bank. Rather, the agency filing suit was the National Credit Union Administration, and the failed institution was a credit union, Western Corporate Federal Credit Union (or WesCorp) of San Dimas, California.

 

A copy of the NCUA’s complaint can be found here. A copy of the NCUA’s August 31, 2010 press release can be found here.

 

Prior to its closure, WesCorp had operated as a wholesale or corporate credit union, providing back office services to other credit unions. As reflected in the agency’s press release at the time, on March 20, 2009, the NCUA placed WesCorp in conservatorship. At the time, WesCorp had $23 billion in assets and 1,100 retail credit union members.

 

As reported in the Agency’s August 31 press release, the former directors and officers were originally sued in November 2009 in Los Angeles County Superior Court in action brought by seven WesCorp member credit unions. The NCUA intervened in that suit and sought leave to substitute the NCUA as the proper party plaintiff. The court granted the NCUA’s motion and to file an amended complaint by August 31. The NCUA’s complaint supersedes the initial complaint filed by the member credit unions.

 

The NCUA’s complaint alleges beginning in 2002, after Robert Siravo became the institution’s CEO, WesCorp embarked “an aggressive campaign” to grow, which was successful due to the institution’s reliance on borrowed funds to make investments in mortgage backed securities. While WesCorp grew, so did its borrowings, which eventually equaled over 30% of the institution’s assets. As the firm grew, so too did its exposure to exotic mortgage backed assets, particularly securities backed by Option ARM mortgages.

 

In 2009, WesCorp was forced to record $6.9 billion in losses, rendering the institution insolvent. About two-thirds of the losses were from Option ARM securities WesCorp purchased in 2006 and 2007.

 

In addition to allegations against all defendants alleging negligence and breach of fiduciary duty, the NCUA complaint also allege that Siravo and the former head of Human Resources manipulated their retirement accounts to make them more lucrative, resulting in over $4.4 million in overpayments, including an extra $2.3 million to Siravo.

 

One of the defendants in the case is William Cheney, who was a member of WesCorp’s board from May 2002 to February 2006. Cheney is currently the President of the CUNA, which is the credit union industry’s national trade association.

 

At the time that the NCUA took control of WesCorp, the institution was the largest of the corporate credit union. The credit union industry, along with the rest of the financial sector, had been suffering some turbulence over the last several years. The NCUA has closed 14 retail credit unions in 2010, and closed 12 retail credit unions in 2009. There were 7,554 federally insured credit unions as of December 31, 2009.

　

The Wall Street Journal’s September 2, 2010 article about the NCUA’s lawsuit can be found here.

　

Be Excellent to Each Other: San Dimas is not only the pre-conservatorship home of WesCorp. It is also the home of San Dimas High School, which is of course where Bill and Ted went to school in the most excellent 1989 movie, Bill and Ted’s Excellent Adventure. (I wonder if Bill and Ted went on to work at WesCorp after their high school graduation. Perhaps in the investment division.) I am sure that when Bill and Ted learned that WesCorp had been put into conservatorship, they said something like “Bogus. Heinous. Most non-triumphant.”

 

In honor of San Dimas High School and the school’s two most famous alums, here’s a video tribute to Bill and Ted, showing their history report at a San Dimas high school assembly:　

　

https://youtube.com/watch?v=ijqnsRqSo2k%3Ffs%3D1%26hl%3Den_US%26rel%3D0

 

One of the most interesting aspects of the complicated sequence of events surrounding the Bank of America/Merrill Lynch merger is the suggestion that Treasury Secretary Henry Paulson instructed BofA’s CEO Ken Lewis not to disclose to BofA shareholders that the government, in order to keep BofA from backing out of the deal, was backstopping BofA to the tune of billions of dollars of additional TARP funds and asset guarantees.

 

As I recently pointed out in my discussion of the opinion, Southern District of New York Judge Kevin Castel, in his August 27, 2010 dismissal motion ruling in the BofA/Merrill securities suit, found that the plaintiffs had not sufficiently alleged scienter in connection with BofA’s alleged failure to disclose this federal backstop.

 

In support of this conclusion, Castel said the defendants were "acting at the instruction of the Treasury Secretary during a moment of acute economic and political uncertainty. There are no allegations of personal gain derived from the federal funds, or a violation of a statute or regulation in a ‘highly unreasonable’ manner."

 

Castel doesn’t say that BofA didn’t have a duty to disclose the existence of the federal backstop. But if BofA had a duty to disclose the information, what difference does it make under the federal securities laws that Paulson told Lewis not to disclose it? As CNN Money journalist Colin Barr noted on September 1, 2010 in his Street Sweep blog post entitled "Judge Embraces ‘Paulson Made Me’ Defense" (here), Castel’s ruling has "left some observers scratching their heads."

 

Is Castel suggesting that there is some kind of governmental instruction or national emergency exception to the disclosure requirements under the federal securities laws? On what basis? Whose instruction is sufficient? What level of exigency is sufficient and who decides?

 

I was glad to see Barr’s post focusing on this aspect of Judge Castel’s ruling. I think these issues are both interesting and important, but for whatever reason, this part of Castel’s opinion has largely gone without public comment.

 

I did explore these issues in my prior post about Judge Castel’s opinion. Because I think these issues are worthy of attention and further consideration, and at risk of appearing a little too self-referential, I am reproducing here my prior comments about this aspect of Judge Castel’s ruling, in order to try to highlight these issues and to try to encourage further discussion of these questions. Here are my thoughts on this issue:

　

The BofA/Merrill Lynch merger was one of highest profile events during the peak of the global financial crisis in late 2008 and early 2009. The disclosures in early 2009 about Merrill’s losses and about the bonus payments were highly controversial. As a result, Judge Castle’s opinion in the consolidated shareholder litigation undoubtedly will provoke extensive scrutiny and commentary. There are indeed a number of parts of the opinion that are worthy of discussion, but the part this is the most interesting to me is his conclusion regarding the inadequacy of the scienter allegations in connection with the alleged failure to disclose the federal bailout that Lewis negotiated with Paulson.

　

As alleged in the complaint, this massive federal package was negotiated after the shareholder vote but before the deal closed. Its existence was apparently critical to the BofA board’s vote to go forward with the deal rather than to invoke the MAC clause. Moreover, it was understood that Paulson’s verbal agreement would have to be disclosed if it were reduced to writing – and accordingly, it was not reduced to writing so it wouldn’t have to be disclosed.

　

In concluding that these actions, which seem to have been taken precisely so that something everyone recognized as important would not have to be disclosed prior to the merger closing, do not give rise to a strong inference of scienter, Judge Castel relied on two considerations: (1) Paulson "instructed" Lewis not to disclose the federal package; and (2) Lewis had nothing to gain personally from withholding disclosure.

　

Though these factors undoubtedly are relevant, it strikes me that these points do not necessarily answer the question whether or not Lewis consciously misled BofA shareholders of acted with reckless indifference to the truth.

　

It could be argued that the allegations strongly suggest that Lewis did not want the BofA shareholders to know that the only reason the BofA board was willing to go forward with the deal was the existence of massive federal support. A plausible inference is that he, like Paulson, feared the chaos that would have emerged if these facts were revealed before the deal closed. It is also plausible to infer that Lewis and others didn’t want to anger Paulson and risk losing the proffered federal support.

　

These might all have seemed like good and sufficient reasons to withhold the information, but whether or not the reasons might have seemed good and sufficient does not answer the question whether Lewis and others acted with awareness of or conscious disregard whether BofA shareholders would be misled.

　

The fact that Paulson "instructed" Lewis to withhold disclosure does not answer the question whether or not Lewis was aware BofA shareholders would be mislead; to the contrary, it might actually suggest a concern that BofA’s shareholders couldn’t be trusted with the truth. (Indeed, Paulson’s instruction arguably does nothing more than make him complicit in the alleged deception, which in Paulson’s case, encompassed not just BofA shareholders but also U.S. taxpayers.)

　

Why is Paulson’s "instruction" relevant at all to the question whether or not the securities laws were violated? Is Castel suggesting that there is some sort of immunity from securities liability if the actions were at the request of a government official? It seems to me that the supposed relevance of Paulson’s instruction is surprisingly unexamined in Castel’s opinion, and the entire discussion of the issue is disconnected from the question whether or not Lewis knew that the shareholders would be misled.

　

Judge Castel’s emphasis on Lewis’s lack of personal benefit, while not irrelevant, is also beside the point. Lewis’s lack of personal benefit certainly doesn’t answer the question whether Lewis and others were deliberately taking steps to avoid disclosing material information because they were afraid of what would happen if they did.

　

In the final analysis, I think Judge Castel’s ruling can perhaps only be understood by his observation that these events took place "during a moment of acute economic and political uncertainty." While this fact has nothing to do with whether or not Lewis was consciously withholding information from BofA shareholders, it does suggest Castel is simply unwilling to permit liability for actions taken at the direction of senior public officials at a time of national exigency. It is almost as if he is saying, with shrugging shoulders, "What else was BofA going to do?" I certainly understand this way of looking at these circumstances. The problem is that it doesn’t necessarily address the questions required by the securities laws.

　

Judge Castel does not actually say he is inferring either an official instruction or national emergency exception to the requirements of the securities laws. But by emphasizing those aspects of the situation, he seems to be suggesting that these exceptions exist and apply.

　

To be sure, Judge Castel did observe that the scienter allegations regarding the nondisclosure of the federal package, which he characterized as "thin," might have been sufficient if they were accompanied by adequate allegations of motive or recklessness. It could be argued that his ruling is simply a reflection of insufficient factual pleading, which may be the case. Nevertheless, his analysis raises many questions that in my view are insufficiently examined, whether or not the scienter allegations themselves were or were not sufficient.

　

Given the high profile nature of this case, I suspect there will be much discussion of Judge Castle’s opinion in the weeks and months ahead. Legal proceedings arising out of these circumstances do seem to attract controversy – as, with for example, Judge Rakoff’s high profile rejection of the SEC’s settlement of its enforcement action against BofA arising from these circumstances.

　

Back to School: Add one more company to the list of for-profit education companies that have recently been sued in securities class action lawsuits. As I discussed in a recent post, within the space of just a few days in August, plaintiffs’ lawyers filed a cluster of lawsuits against for-profit education companies. On August 31, 2010, plaintiffs’ lawyers added one more company to the list when they sued Corinthian Colleges and certain of its directors and offices, based on allegations similar to those raise against the other for-profit education companies. A copy of the plaintiffs’ lawyers’ press release can be found here.

　

Old School: I wonder if this for-profit education company’s schools cover their chairs with Soft Corinthian Leather. For those who miss the reference, and in respectful memory of Ricardo Montalban, here is the original Chrysler Cordoba advertisement to which I was referring :

　　

https://youtube.com/watch?v=vIL3fbGbU2o%3Ffs%3D1%26hl%3Den_US%26rel%3D0

According to the FDIC’s Second Quarter 2010 Quarterly Banking Profile, which the agency released on August 31, 2010, aggregate indicators of banking institutions’ financial health are improving, but at the same time the number of "problem institutions" also continues to increase. The FDIC’s August 31, 2010 press release about the Quarterly Banking Profile can be found here.

 

The positive news is that the industry’s 2Q10 earnings of $21.6 billion are the highest since the third quarter of 2008. Almost two-thirds of the banks reported higher year-over-year quarterly net income. However, 20 percent of institutions did report quarterly net losses (compared to 29 percent 2Q09).

 

The quarterly report also reflects that provisions for loan losses, while "still high by historic standards," represented the smallest total since the first quarter of 2008. Fewer borrowers are falling behind on their loan payments. With respect to just about every type of loan, troubled loans declined for the first time in more than four years. The only exception was commercial real estate loans, which continued to show increased weakness.

 

Despite this relatively good news, the number of problem institutions increased in the second quarter, to 829, up about 7% from the 775 problem institutions at the end of 1Q10, up 18% from the 702 problem institutions at the end of 2009, and up almost 100% from the 416 at June 30, 2009. (The FDIC defines a "problem institution" as those it rates as "4" or a "5" on its one-to-five scale of rating banks’ financial and operating criteria. The FDIC does not disclose the names of the problem institutions.)

 

The number of problem institutions is the highest since March 31, 1993, when there were 928.

 

To put the latest number of problem institutions into perspective, at the end of the second quarter, there were a total of 7,830 insured institutions. So the 829 problem banks represent about 10.6% of all insured institutions.

 

Or to put it a different way, one out of every ten banks in the United States is a problem institution. (And that’s after the 283 banks that have failed since January 1, 2008 have been taken out of the equation).

 

Though the number of problem institutions increased in the quarter, the assets associated with these banks did decrease. The 829 problem institutions at the end of the second quarter represented assets of about $403 billion, down slightly from the $431 billion that represented by the 775 problem institutions at the end of 1Q10.

 

To put the assets associated with the problem institutions into perspective, the collective assets of all insured institutions totals $13.2 trillion. The $403 billion in assets associated with the problem institutions represents about 3.1% of the industry’s total assets.

 

One other sign that the banking industry as a whole may not yet be in the clear, notwithstanding the relatively positive industry news overall, is that during the second quarter and for the first time in the 38 years for which data is available, there were no new insured institutions.

 

Since January 1, 2008, 283 banks have failed, 118 in 2010 alone. But even with the growing numbers of failures (each one of which presumably reduces the number of problem institutions by a count of one), the number of problem institutions continues to grow. The likelihood seems to be that the number of failed banks will continue to grow for some time to come.

 

Eric Dash’s August 31, 2010 New York Times article about the report can be found here.

 

Ain’t Too Proud to Beg: The D&O Diary has been selected as a nominee candidate for the LexisNexis Top 25 Business Law Blogs of 2010. The ultimate list of the Top 25 blogs will be chosen based on comment submited by members of either of two LexisNexis business law communities, the Corporate & Securities Law Community and the UCC, Commercial Contracts and Business Law Community. If you are a registered member of either of these communities, I would appreciate your comment in support. Members of the Corporate & Securities Law Community can submit comments here, and members of the UCC, Commercial Contracts and Business Law Community can submit comments here. The deadline for comments is October 8, 2010.