In our era, the burgeoning BRIC countries represent the developing economies forcing their way onto the global stage and arguably even threatening to dominate the financial arena in the decades ahead. It is hard to remember now, but in the late 19th century, the developing economy that was pushing its way into the global financial stage was that of the United States.

 

The captivating story of how our country became a global economic powerhouse is entertainingly told in H.W. Brands’ fascinating new book, "American Colossus: The Triumph of Capitalism 1865-1900." Brands portrays the transformation as part of a struggle between the principles of democracy and the exigencies of capitalism.

 

In Brands’ account, though the forces of democracy predominated in the early nineteenth century, in the late nineteenth century, the animal spirits of capitalism emerged triumphant. While the country was transformed, the results included some rather unsavory side-effects, many of which suggest some rather sober reflections on our present circumstances.

 

The picture of the United States in the late 19th century, as the country emerged from a devastating civil war and struggled to overcome challenges imposed by immense geographic distances, is one of stark contrasts, between the seemingly unlimited opportunities available and the astonishing excesses perpetrated in pursuit of those opportunities.

 

If the country’s transformation produced unprecedented economic expansion and vast wealth, it also entailed  environmental devastation, rampant corruption, labor exploitation, a deliberate policy of ethnic cleansing targeting a vulnerable indigenous population, and a destructive cycle of boom and bust.

 

The story of the United States transformation into a global powerhouse involves some familiar details, such as the almost incredible accumulation of immense wealth by Rockefeller, Carnegie, Vanderbilt and others. But in Brands’ account, the transformation also involves a host of other important but sometimes overlooked developments and processes, such as the conversion of the vast central plains from untamed grasslands full of roaming buffalo herds into industrial cattle ranches and monoculture farms encompassing wheat fields of previously unimaginable size and scale.

 

As the American economy was transformed it also was forced to adapt to or perhaps even invent the processes and practices required by modern capitalist economies. Among other things, the development of a transcontinental rail system was a project of such enormous size that it simply outstripped the existing accounting and management tools and controls, a situation that almost inevitably led to waste and corruption. The unexpected part is not that the waste and corruption took place but that the railroad nevertheless was completed, opening the country’s virtually unexplored interior both to settlement and development.

 

The country’s growth into a global powerhouse involved more than just an increased exploitation of geographic and material assets. It also meant the adaptation to new requirements and the elimination of old structures.

 

For example, the transformation of the South’s failed slavery economy to a functioning labor economy was an evolution required for the Southern states to advance. Though the transformation was only partially completed during the nineteenth century, the region’s movement from a feudal slave economy based on compulsion and exploitation to a capitalist labor economy built on supply and demand was an indispensible part of the country’s overall conversion into a modern economy.

 

Perhaps the most compelling aspect of Brands’ book is the way the earlier era suggestively prefigures our own. As events associated with the development of industrial scale agriculture demonstrate, the world was "flat" long before Tom Friedman declared it to be so:

 

Even in the best years, the Red River farmers were at the mercy of occurrences half a world away. Price tickets in managers’ offices recorded fluctuations in the grain markets in Minneapolis and Duluth and Buffalo, which in turn responded to developments in the world market. "A rainfall in India or a hot wind in South America is felt upon the Dakota farm in a few hours. The nerves of trade thrill around the globe, and the wages of the harvester in the Red River Valley are fixed by conditions in the fields of Russia , or in Argentina, or in India. The distance between the fields has been lost. The world’s wheat crop might as well lie in one great field, for the scattered acres are wired together in the markets, and those markets are brought to the farmer’s door."

 

In our own time, we struggle to understand the weaknesses and systemic failures that allowed the recent global financial crisis to occur. We might do better to understand that these kinds of weaknesses have been around for a long time; indeed many of the same questions we are now asking ourselves were being asked following the periodic crises and busts that occurred with devastating regularity during the late nineteenth century.

 

For example, in the aftermath of the Jay Gould’s and James Fisk’s audacious attempt to corner the gold market, then-Congressman (and future President) James Garfield wrote that "however strongly we may condemn the conspirators themselves, we cannot lose sight of those causes which lie behind the actors and spring from our financial condition. The conspiracy and its baneful consequences must be set down as one of the items in the great bill of costs which the nation is paying for the support of its present financial machinery."

 

Brands’ book is full of fascinating anecdote and telling detail. He ranges across a multitude of topics and issues, including immigration, politics, racial integration, technological innovation and change, as well as all of the attendant social and economic consequences involved. If the book has one fault, it is perhaps in its very range. Brands’ framework sweeps so broadly that at times he leave the impression of simply moving from topic heading to topic heading, with less connective tissue than many readers might desire.

 

Despite the overall celebratory tone of his book – it is, after all, subtitled as "The Triumph of Capitalism" — Brands also seems ambivalent about capitalism itself. At different times (and occasionally, at the same time) he is exhilarated by the irresistible force of unbridled capitalism or appalled by its exploitative and corrupt excesses. Perhaps in the end however, that is the moral of his book, that capitalism encompasses both, and that what is required most is a watchful and wary eye.

 

Time Marches On: During Back-to-School Night this fall, I asked my son’s high school U.S. history teacher where the semester break would fall chronologically in the curriculum. When the teacher said they aimed to get through the nineteenth century by the semester break, I expressed surprise, noting that when I studied U.S. history, the Civil War had been dividing point. The teacher eyed me carefully and then commented that there is quite a bit more U.S. history to be studied now than there was when I was in school. (I did not tell my son later that I think his history teacher is a wiseass.)

 　

　

In a series of posts, I have been exploring the “nuts and bolts” of D&O insurance. In this post, the seventh in the series, I examine the perennial questions of limits selection and program structure – that is, how much insurance is enough, and how should the insurance be structured? As explained below, these two questions are inextricably linked.

Limits Selection

One of the most challenging questions for anyone that advises D&O insurance buyers is the question of what is the right amount of insurance. The question inevitably involves a mixture of art and science, particularly because the analysis is affected by basic considerations of cost and risk tolerance. While there are certain objective benchmarks that can help to inform the process, the benchmarks must be considered in conjunction with relevant considerations that should also influence the analysis.

The question of D&O insurance limits selection is, of course, different depending on whether the buyer is a publicly traded company or is privately held. The difference in analysis between the two is not just in the total quantity of insurance purchased but also in how the limits selection question is analyzed. I discuss the question of limits selection for public and privately held companies separately below.

For publicly traded companies, there are some basic benchmark reference points and some additional considerations that every insurance buyer should asses.

Publicly traded companies will first want to approach questions surrounding limits selection from the perspective of basic limits adequacy, taking into account the company’s likely securities class action litigation settlement exposure. The securities suit settlement exposure is the appropriate starting place because for most companies in most circumstances, a securities suit represents the company’s largest management liability exposure. The company should be provided with information sufficient to allow it to assess the range and distribution of settlements for companies of its size and other characteristics.

A second benchmark publicly traded companies may want to consider are peer purchasing patterns – that is, how much D&O insurance do other companies like ours buy? Some buyers find this information reassuring, although care should always be taken to make sure that peculiar purchasing patterns, which sometimes can be industry-wide, do not inappropriately drive an important decision like limits adequacy.

In addition to these basic, relatively objective guidelines like settlement trends and peer purchasing patterns, there are additional considerations that should also be taken into account.

The first is that information about securities class action settlements, discussed above, does not take into account defense expense. Defense costs must be considered, because under most D&O insurance policies, defense costs erode the limits of liability. Every dollar of defense cost means one less dollar available for settlements or judgments. For a company to be sure that it has adequate limits of liability both to defend and to settle serious claims, appropriate consideration must be given to likely defense expenses as well as to settlement amounts. Along those lines, it is critical to note that both settlements and defense expenses have been escalating in recent years, much faster than the rate of economic inflation.

The other consideration that should be taken into account is that the most important value of D&O insurance is the protection it affords individual insureds in the event of a catastrophic claim. When things go seriously wrong, the D&O insurance may be the individuals’ last line of defense.

When these catastrophic type events occur, the company and the individual directors and officers may find themselves battling multiple legal proceedings simultaneously. In addition, the interests of the various defendants in the various proceedings may conflict dramatically, particularly when ousted former management is faulted for the company’s woes. Often when this occurs, each defendant will retain separate counsel. Under these circumstances, defense expenses can mount astonishingly quickly, causing the rapid depletion or even the complete exhaustion of the available insurance (for more about which, refer here).

The possibility of a catastrophic claim that could consume available limits underscores the importance of careful consideration of limits selection issues. Simply put, what other cases might have settled for in the past or how much insurance other companies buy may provide little guidance for the question of how much insurance a particular company might need in the future, particularly since the settlement and purchasing pattern data tend to be backward looking and incorporate historical patterns that may not be relevant to future requirements.

On the other hand, the difficulty of using a catastrophic claim scenario is that it may quickly lead to the rather unhelpful conclusion that no amount of insurance is enough to address the top end exposures. At some point, the analysis must shift from the quantity of insurance to the structure of the insurance, a question I address further below.

With respect to private companies, the issues are different, primarily because privately held companies do not typically face class action securities litigation risks. However, merely because private companies have no class action securities litigation exposure does not mean that private companies and their directors and officers do not face serious liability risks. I have in fact seen numerous private company D&O claims that have settled for millions of dollars. For that reason, an appropriate awareness of the possibilities should also inform private company D&O limits selection issues.

For private companies, the objective reference standards are peer purchasing patterns by company asset size. These peer data have the same benefits and limitations as they do for public companies, but many buyers find this data useful and reassuring in the insurance acquisition process.

The limits of liability for private company D&O insurance is, like public company D&O insurance, in most instances subject to erosion by defense expenses. so many of the same considerations concerning defense expenses should also be taken into account for questions of private company D&O limits selection.

One added consideration particular to private company D&O insurance is that the entity coverage available under a private company policy is quite a bit broader in the private company policy than is the entity coverage in a public company policy. (The public company policy is limited to securities claims; the private company policy is not so limited.)

The broader entity coverage available in the private company policy creates the possibility that the limits of liability could be eroded by the defense expenses and settlements of the entity, potentially leaving the individuals with less (or no) insurance remaining to defend themselves or settle claims. The broader entity coverage in the entity policy could influence some buyers to increase the D&O insurance limits of liability, as one way to protect against erosion or exhaustion of the limits by entity claims.

Program Structure

In light of the escalating average claims severity and of the catastrophic potential for defense expense to deplete policy limits, it may be necessary to reconsider commonplace concepts of limits adequacy. Increased limits alone, however, may not solve all of the problems.

Part of the solution has to be program structure. Clearly, one of the factors that can contribute to limits depletion or exhaustion is that so many different people are accessing the insurance, particularly when there are multiple simultaneous claims. One way that well-advised corporate officials can ensure they are not left without insurance to protect them as individuals is through supplemental D&O insurance structures dedicated solely to their own protection.

These supplemental structures might take any one of a number of different forms, including for example, excess Side A coverage for a specified group of individuals, or even through an individual D&O insurance policy (so-called IDL coverage). While there are a variety of ways this supplemental insurance might be structured, the possibility of catastrophic claims underscores the importance of addressing these issues as part of the insurance acquisition process.

The point of these supplemental insurance structures is to ensure that no matter what happens, the individuals (or some subset of them, for example, the non-officer directors) will have a pot of money with their name on it, as reassurance that the individuals will not be left with unresolved claims but no insurance remaining with which to defend themselves. For more about structuring D&O insurance to protect non-officer directors, refer here.

Moreover these alternative structures often have broader coverage than the “traditional” D&O insurance; for example, they often contain fewer exclusions. They also provide so-called “drop down” protection when they provide first dollar coverage, in the event, for example, that the underlying traditional D&O insurers have become insolvent or seek to rescind coverage. In addition, because these alternative insurance structures protect only specified individuals, the insurance cannot be siphoned off for the payment of entity claims or the claims of other individuals who are not insured under the structure.

The complexity of these limits selection and program structure issues underscore how indispensible it is that insurance buyers enlist knowledgeable and experienced advisors in their D&O insurance acquisition process. In particular, it is important that buyers ensure not only that their advisors have access to the data described above that is relevant to the limits selection process but also have the ability to explain the limitations of the data as we well as the additional considerations that should be taken into account. In addition the insurance advisor should be able to guide the company through the process of selecting the right insurance structure to ensure that the company and its directors and officers are adequately protected even in the event of a catastrophic claim.

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

D&O Insurance: Executive Protection – The Policy Application

Executive Protection: Private Company D&O Insurance

Executive Protection: D&O Insurance Policy Exclusions

The LexisNexis Top 25 Business Law Blogs of 2010, as selected by the members of the LexisNexis business law communities, have been announced, and I am pleased and honored to discover that The D&O Diary is among this year’s designees. The LexisNexis announcement, including the list of the 2010 Top 25 Business Law blogs, can be found here.

 

I am particularly happy to find my blog among the honorees because the list includes so many blogs that I follow and bloggers whose work I respect. I encourage everyone not only to take a look at the list, but also to visit the other sites, particularly those with which you might be unfamiliar.

 

Readers may note in the LexisNexis announcement that though the Top 25 blogs have been chosen, the voting is not yet finished. The voting for the Top Business Law Blog of 2010 will continue and the winner will be announced on November 5, 2010. I encourage all readers who are also members of a LexisNexis business law community to cast a vote for their favorite business law blog. I would be honored and humbled if anyone should choose to cast a vote for The D&O Diary.

 

Interested readers who are not familiar with the site may also want to take a look at the LexisNexis Corporate & Securities Law Community, which can be found here. The community site contains a wealth of resources, including links to blog posts and articles, case law and commentary, and podcasts.

 

My thanks to the members of the LexisNexis business law communities for voting for my site as a Top 25 Business Law Blog, and my congratulations to all of the honorees.

 

Among the many cases filed as part of the subprime litigation wave are the numerous cases filed on behalf of holders of mortgage-backed securities against the firms that issued the securities. In many of these cases, the plaintiffs have not alleged that they have failed to receive payments due under the securities, but rather they have alleged that their investments have declined in value or are now riskier than when purchased.

 

As these cases accumulated in 2008 and 2009, observers questioned whether these investors’ claimed harms represented injuries cognizable under the federal securities laws, as I discussed in an earlier post.

 

In an October 14, 2010 decision (here), Southern District of New York Judge Miriam Goldman Cedarbaum held in a case filed on behalf of holders of certain asset-backed certificates issued by Goldman Sachs-related entities that, where the holders had not alleged that they had failed to receive payments due under the certificates, they had failed to allege injuries cognizable under the federal securities laws.

 

The investors had purchased the asset-backed certificates in 2007 offerings. The certificates entitled the holders to monthly distributions of interest, principal or both. The offering documents for the certificates warned investors that the offering underwriters "cannot assure you that a secondary market" for the securities will exist, and "consequently, you may not be able to sell your certificates readily or at prices that will enable you to realize your desired yield."

 

In its amended complaint, the plaintiff did not allege that it had failed to receive the monthly distributions. The harm the plaintiff claimed is that a hypothetical sale in the secondary market at the time of the suit "would have netted, at most, between 35 and 45 cents on the dollar." The plaintiff also claimed that it is exposed to "much more risk than the Offering Documents represented with respect to both the timing and absolute cash flow to be received."

 

In her October 14 ruling, Judge Cedarbaum noted that at a prior hearing she had previously denied the defendants’ motion to dismiss the plaintiffs’ claims based on Section 12 (a) (2) of the ’33 Act. However, she granted the defendants’ motion to dismiss plaintiffs’ Section 11 claims, holding that the plaintiffs alleged injuries were insufficient to state a claim.

 

In rejecting the sufficiency of plaintiff’s argument that that their certificates would have a diminished value in a hypothetical sale, Judge Cedarbaum noted that "the Certificates were issued with the express warning that they might be resalable." She concluded that because the plaintiff "made an investment that it knew might not be liquid, it may not allege injury based upon the hypothetical price of the Certificates on a secondary market at the time of the suit." She noted further that the complaint failed to allege that a secondary market for the certificates "actually exists" and also failed to allege "any facts regarding the actual market price" for the certificates at the time of the suit.

 

Judge Cedarbaum also rejected the sufficiency of the plaintiff’s allegations about the increased risk of diminished cash flow in the future, not that "Section 11 does not permit recovery for increased risk." She said that "to allege an injury cognizable under Section 11," the plaintiff must "allege the actual failure to receive payments due under the Certificates," adding that though the plaintiff has "had three opportunities to amend its complaint, it has never made the allegation."

 

Discussion

As far as I am aware, Judge Cederbaum’s ruling is the first in which mortgage-backed investors’ Section 11 claims have been dismissed for lack of cognizable injury based on a failure to allege that payments due under the securities had been terminated or interrupted. There were quite a few of these mortgage-backed securities lawsuits filed during 2008 and 2009, and Judge Cedarbaum’s decision potentially could be quite significant in these other cases, at least where the investors have not alleged that payments due under the instruments have failed.

 

One aspect of this decision is the presence in these instruments’ offering documents of precautionary language warning about the potential unavailability of a secondary market for the instruments. Investors in instruments with offering documents that lacked this precautionary language may still be able to try to argue establish a cognizable injury based on the diminished resale value of the securities. However, those other claimants would also have to be able to allege that there actually is a secondary market for their securities and will have to allege what the resale price would be in order to allege injury sufficiently.

 

In any event, Judge Cedarbaum’s ruling potentially could be sufficient in many of the other securities suits that mortgage-backed asset investors filed in 2008 and 2009.

 

Special thanks to Doug Henkin of the Milbank Tweed law firm for providing a copy of Judge Cedarbaum’s opinion. Doug is the co-author of a paper I cited in my earlier post raising the question of whether mortgage-backed asset investors would be able to satisfy the requirements under Section 11 to allege a cognizable injury. An updated version of the paper can be found here.

 

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

 

A Securities Litigator’s Guide to D&O Insurance: Readers of this blog may be interested to know about two articles written by Jack Cinquegrana and John R. Barankiak Jr. of the Choate Hall law firm. The articles, which can be found here, are entitled "A Securities Litigator’s Guide to D&O Insurance," provide a brief overview of D&O insurance basics and also discusses issues that frequently arise concerning payment of defense costs and settlements. The articles are relatively short but contain some interesting observations and comments.

 

Sorry: My blog hosting service experienced a variety of service outages and problems on Monday. Readers may have experienced delays in receiving email notifications and difficulty in accessing the most recently added content. I am assured the problems have been addressed. I apologize for the inconveniences yesterday.

　

　

　

　

As has now become a familiar routine, this past Friday night the FDIC took control of several more commercial banks. The seven additional banks seized on Friday bring the year to date total number of failed banks to 139, and the total since January 1, 2008 to 304. At the same time, lawsuits involving failed and troubled banks are also accumulating, and on Friday, investors filed two more banking-related securities class action lawsuits. And as noted below, the jury trial in another banking related-securities class action lawsuit continues to go forward in federal court in Florida.

 

Recent Banking-Related Securities Suits

The first of the new lawsuits was filed on October 22, 2010 in the Northern District of Illinois against PrivateBancorp and certain of its directors and officers. As reflected in the plaintiffs’ lawyers’ October 22 press release (here), the Complaint alleges material misrepresentations in connection with the company’s June 4, 2008 and May 11, 2009 securities offerings. The complaint (which can be found here) alleges that the company’s share price fell over 37% in October 2009 after it announced that it held nearly $400 million in nonperforming loans.

 

The other recently filed banking-related suit was filed on October 22, 2010 in the Northern District of Iowa against Meta Financial Group and certain of its directors and offices. According to their October 22, 2010 press release (here), the Complaint (which can be found here) relates to the company’s October 12, 2010 announcement that the Office of Thrift Supervision was investigating the company in connection with its iAdvance credit origination program. The complaint alleges that the company’s shares declined over 40% on the news.

 

Statistical Review of Recent Banking-Related Litigation

Securities class action activity involving commercial banks represents a significant part of 2010 securities class action lawsuit filings. By my count, there have been at least ten securities class action lawsuits so far this year involving banking institutions, representing about seven percent of the approximately 143 securities suits filed year to date.

 

As noted in NERA’s August 2010 report on failed bank litigation, investor lawsuits involving failed and troubled banks have been a significant accompaniment of the current round of banking problems. According to the NERA report, private investor litigation "was not a notable feature of the S&L crisis litigation," but this time around "private litigation against D&Os has been widespread."

 

Among other statistics, the NERA report notes that of the 240 securities class action lawsuits filed against financial sector firms in 2008 and 2009, there were 45 against depositary firms. The report further notes that of the 20 largest failed banks prior to 2010, 13 involved publicly traded institutions, and eight were involved in securities class action litigation through the end of 2009.

 

Updated Overview of Bank Failures

Meanwhile the number of failed banks continues to mount. The 139 banks closed in 2010 through October 22 is nearly equal to the 140 banks closed in all of 2009. The seven banks closed this past Friday night includes two more failed banks in Georgia and Florida, respectively, as well as one more in Illinois. There three states – Georgia, Florida and Illinois – are the states with the highest numbers of failed banks, both this year and since January 1, 2008.

 

So far this year, Florida has the highest number of failed banks, with 27, followed by Georgia (16), Illinois (16) and California (10). These four states alone have combined for 69 bank failures this year, or just under 50% of all 2010 bank failures.

 

Though 39 states and Puerto Rico have each had at least on bank failure since January 1, 2010, the bank failures have predominately been concentrated in just a handful of states, again led by the same four states – with Georgia leading the way with 46 failed banks, followed by Florida (43), Illinois (38) and California (32). These four states together have had 159 bank failures, or about 52% of all failed banks since January 1, 2008. Other states with high numbers of failed banks during that period include Minnesota (14), Washington (13), Missouri (11) and Nevada (10).

 

The 2010 bank failures have largely been concentrated among smaller banks. 116 of the 139 bank failures, or about 83%, have involved institutions with less than $1 billion in assets. 32 (or about 29%) of the 2010 bank failures have involved banks with less than $100 million in assets. Of course, given that there are many more smaller banking institutions in the U.S. than there are larger banks, it may be unsurprising that there are so many bank closures involving smaller banks.

 

Discussion

While the bank closure statistics are striking, it is worth noting that the lawsuits described above, as well as much of the banking-related securities litigation, involves banks that remain in operation. In other words, the current level of banking-related securities litigation represents more than just the direct fallout from the high level of bank failures. Rather the litigation reflects the pressures and stresses more widely distributed throughout the entire U.S. banking industry in the wake of the credit crisis.

 

Even though we are well past the depths of the financial crisis (at least temporally), many banks remain under pressure, as reflected in the FDIC’s most recent quarterly banking profile (about which refer here). In many instances, this pressure has, among other things, led to litigation.

 

So while we continue to wait and see the extent to which the FDIC will, as a result of the current round of bank failures, become an active claimant against former directors and officers of failed bank, investors have pressed ahead with their own claims. Many of these investor claims have come in the form of securities class action lawsuits, the targets of which include a range of banking-related defendants, beyond just the failed institutions. The most recent filings suggest that we may continue to see more commercial banking-related securities litigation in the months ahead.

　

Meanwhile, BankAtlantic Securities Trial Continues: Among the banking-related securities cases filed in recent years is the securities class action lawsuit filed against BankAtlantic Bancorp and certain of its directors and officers, which recently became one of the very rare securities class action lawsuits to actually go to trial (about which refer here). The jury trial in the case is going forward in federal court in Miami, and as reflected in the October 22, 2010 post in the Southern Florida Business Journal Blog (here), the trial has among other things involved the plaintiffs’ introduction of inflammatory internal emails highly critical of the bank’s lending practices and processes.

 

According to informed sources, the plaintiffs are likely to conclude the presentation of their case some time during the upcoming week, and it will then be the defendants’ turn to present evidence and to introduce testimony.

 

Plaintiffs in the case are represented by Matthew Mustokoff and Andrew Zivitz of the Barroway Topaz firm and Mark Arisohn of Labaton Sucharow. The defendants are represented by Eugene Stearns of the Stearns Weaver Miller law firm.

 

Anatomy of a Failure: Those readers wondering how in the world we got into this current banking mess may want to take a look at the article entitled "Death of a Small Town Bank" in November 1, 2010 issue of Time Magazine (link currently unavailable) The article tells the story of Community Bank & Trust (CBT) of Cornelia, Georgia, which the FDIC closed on January 29, 2010.

 

Though CBT is just one of the 139 banks that have failed this year, its tale encompasses so many of the problems underlying the current crisis. All of the usual details are present, as a small town institution got caught up in the speculative fever caused by rapidly escalating real estate prices, compounded by administrative and procedural shortcomings (and possibly worse) that led to faulty and some improper loans. The sudden collapse of prices that accompanied the financial crisis left lenders unable to repay and the bank saddled with a portfolio of bad loans that ultimately caused the bank’s failure and left the town with a challenging future. The article makes for interesting, if sobering, reading.

 

For Those Looking for Something to Feel Good About: Those readers who have had just about enough of depressing stories about failed banks may want to take a look at the cover article from the October 24, 2010 issue of The New York Times Magazine entitled "The D.I.Y. Foreign-Aid Revolution." The article reports the stories of several individuals who have made it their personal responsibility to try to make the world a better place, and who actually have each found a way to actually do things that can make a difference. A really inspirational article about some really interesting and impressive people.

 

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. In the latest issue of InSights (here), I take a look at the current hot topics in the world of directors’ and officers’ liability. There is much to discuss in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. The latest InSights article reviews what to watch now in the world of D&O.

 

The Latest Bulletin From Our San Francisco Bureau:  Our SF correspondent filed this report before last night’s game (names removed to protect privacy, swear words modified to conform with the family-oriented approach of this blog):

 

So living with a wacko Giants fan is actually really fun right now. Yesterday {name removed} and her mom and godmother went kayaking outside the stadium and it sounds like SO MUCH FUN. I have added it to my to-do list of things while I live in the Bay.

 

Anyway, aside from kayaking (and drinking, and eating, and singing while kayaking) Giants fans wear these ugly fake beards to mimic the "rally beards" that the pitchers have (well, all the pitchers except Lincecum). And they have t-shirts that say "Fear the Beard." I have seem some television footage of very small children and very blonde women in beards. Very strange.

 

Also, just to prove that Tim Lincecum really could never play on any team except the Giants or the A’s, everyone knows he smokes pot like it’s his job, and the fans wear shirts that say "Let Timmy Smoke." I very much doubt that would be the public reaction ANNNYwhere else. Also he doesn’t cover his mouth when he swears, so "F*ck Yeah" t-shirts are also very popular.

 

Unfortunately, I’m still not overly interested in the BASEBALL…just the funny things that San Franciscans do while they WATCH baseball.

 

Among the most frequently recurring and arguably most vexatious D&O insurance coverage issues are the questions of the carrier’s obligation under the policy for defense expenses incurred either in connection with an informal SEC investigation or an internal investigation.

 

In an October 15, 2010 summary judgment ruling in insurance coverage litigation involving Office Depot, Southern District of Florida Judge Kenneth Marra, applying Florida law, denied coverage for both of these categories of defense expense. Though the decision is a direct reflection of the specific facts involved and the particular policy language at issue, the ruling provides an interesting insight into these recurring issues.

 

Background

In June 2007, Office Depot was the subject of news report suggesting the company had improperly disclosed material information to securities analysts in violation of Sec. Regulation FD. In a July 17, 2007 letter, the SEC advised Office Depot it was "conducting an inquiry" to determine whether the securities laws had been violated, and requested certain information from Office Depot "on a voluntary basis." Office Depot opted to voluntarily cooperate by providing documents and making its employees and officers available for sworn testimony. On July 31, 2007, the SEC requested that Office Depot preserve the records of numerous employees and offices, which it identified by job title.

 

Office Depot forwarded the letter to its insurers. Office Depot’s primary insurer accepted the letter as a "Notice of Circumstances" that may give rise to a claim.

 

In addition, in July 2007, before it received the SEC’s informal inquiry, Office Depot received an internal whistleblower letter raising concerns relating to the timing of recognition of Office Depot’s vendor rebate funds. Office Depot self-reported the whistleblower allegations to the SEC, which expanded its inquiry to include the whistleblower allegations. The company’s audit committee conducted its own investigation of the allegations, retaining lawyers, accountants and consultants for those purposes. The internal investigation resulted in Office Depot’s restatement of its 2006 financial statements.

 

In November 2007, two shareholder derivative lawsuits and two securities class action lawsuits were filed against the company. The shareholder suits alleged misrepresentations in connection with the company’s financial reporting of vendor rebates. In January 2010, the defendants’ motions to dismiss the securities class action lawsuit were granted. The dismissal is now on appeal. The plaintiffs in the derivative lawsuits voluntarily dismissed those cases.

 

In January 2008, the SEC issued a formal "order directing private investigation" and during the course of 2008 subpoened the company and at least eight current and former Office Depot officers and directors, including several who previously voluntarily testified. The notice did not name any individuals as wrongdoers. In November and December 2009, the SEC issued Wells notices to three Office Depot officers. In December 2009, the company reached an undisclosed settlement with the SEC staff.

 

Office Depot requested reimbursement from its D&O insurers of the over $23 million the company had incurred in responding to the SEC, indemnifying individuals against defense expenses, and conducting an internal investigation of the whistleblower allegations.

 

The primary carrier acknowledged its obligation to reimburse Office Depot for defense costs incurred by officers and directors after having been served with SEC subpoenas and Wells notices, and for the costs incurred in the four securities lawsuits. However, the approximately $1.1 million of acknowledged expenses did not exceed the policy’s $2.5 million retention. The primary insurer denied coverage for the other expenses, and Office Depot filed an action alleging breach of contract and seeking a judicial declaration of coverage. Office Depot’s excess D&O insurer intervened the action.

 

The parties filed cross motions for summary judgment.

 

The October 15 Ruling

The insurers argued that there is no coverage for Office Depot’s costs incurred in voluntarily responding to the SEC’s investigation and for the costs of Office Depot’s internal investigation of the whistleblower allegations because the costs did not arise either because of a "Securities Claim" against Office Depot or a "Claim" against an insured director or officer. All policy references below refer to the language of the primary policy.

 

The policy’s definition of Securities Claim contains threshold language that excludes from the term "an administrative or regulatory proceeding against, or investigation of, an Organization." However, the definition contains a "carve back" which specifies that the term Securities Claim "shall include an administrative or regulatory proceeding against an Organization, but only if and only during the time that such proceeding is also commenced and continuously maintained against an Insured Person."

 

Judge Marra found it significant that the threshold language excluded coverage for "an administrative or regulatory proceeding against, or investigation of" an Organization, but the carve back preserving coverage refers only to "an administrative or regulatory proceeding" – and thus the carve back does not refer to "an investigation" as does the threshold language. Judge Marra concluded that "the carve-back clause does not restore coverage for ‘an investigation of’ the Organization"

 

Judge Marra also found the policy’s definition of "Claim" distinguishes between "a proceeding for relief" and an "investigation of an insured person," specifying that an investigation constitutes a "Claim" only once the insured person has been notified in writing that he or she may be a target or after service of a subpoena.

 

In addition, Judge Marra rejected Office Depot’s argument that the term "proceeding" was broad enough to encompass the SEC’s informal and formal investigation of Office Depot. In reaching this conclusion, Judge Marra referenced the policy’s distinction between "proceedings against" and "investigations of" insured persons and organizations. Judge Marra said this distinction can only be given "any meaning" by giving the term "proceeding" its "plan meaning," which he defined as "a formal legal action or hearing conducted in a court of law or some official tribunal."

 

Judge Marra concluded therefore that the company’s costs of voluntarily responding to the SEC do not represent "loss of the Organization arising from a Securities Claim."

 

Judge Marra also concluded that the voluntary, pre-subpoena costs incurred on behalf of the individual directors and officers were not incurred in connection with a "Claim." In reaching this conclusion he specifically referenced the trigger required to bring an "investigation" within the definition of "Claim."

 

Office Depot had argued further that the policy’s "relation back" language brought all of the pre-claim costs within coverage when the claims finally did emerge. Office Depot made this argument in reference to the language in the policy’s notice provisions which provide that when a policyholder provides a notice of circumstances that could give rise to a claim, and a claim subsequently arises, the claim relates back to the time of the original notice.

 

Judge Marra ruled that the "relation back" language pertained solely to the question of when a "Claim" is first made for purposes of determining the appropriate claims made policy period. The relation back language, Judge Marra said, "simply serves to identify the policy period in which the ‘subsequent Claim’ was made; it does not operate to expand the Policy definition of ‘Claim’ to absorb any allegations of wrongdoing which happen to be related or similar to the wrongdoing described in the insured’s original Notice of Circumstances."

 

Judge Marra also rejected Office Depot’s related argument that the November 2007 securities lawsuit "relate back" to provide coverage for the company’s internal investigation. The company had argued that because the subsequent lawsuits were "subsequent claim," the Policy’s "relation back" language brought under the Policy’s coverage all defenses expenses incurred from the date of the Notice of Circumstances.

 

Judge Marra said that even if the securities suits were "subsequent claims" that relate back for notice purposes to the date of the original notice of circumstances, "it does not follow that any pre-suit investigation costs which may have related to and benefitted the defense of those suits…are transformed into a covered ‘loss’ which ‘arises from’ that securities litigation."

 

Finally, Judge Marra held that the Policy’s definition of covered Loss does not include the costs of investigating potential or anticipated claims, rejecting Office Depot’s argument that those costs are "arising from" the defense of a claim. He found that the "arising from" phrase "connotes a sequential relationship" between the Claim and the Loss that "arises from it" – that is, Loss that "follow sequentially in time." He said that covered loss "does not include related pre-suit or pre-claim investigation costs, regardless of how ‘related’ or ‘beneficial’ those costs may have ultimately proved to be in defending against the claim which ultimately materialized." He added that "while these costs may well have reasonably been incurred in contemplation of anticipated or potential litigation, that is not enough to meet the Policy’s requirement that the ‘resulted solely from’ the investigation or defense of a Claim."

 

UPDATE: In a subsequent October 27, 2010 order (here), Judge Marra rejected Office Depot’s further assertion, based on the prior order, that the company was entitled to insurnace payment for all costs the company incurred in responding to the SEC after November 5, 2007, the date on which the first of the shareholder lawsuits was filed.

In his October 27 order, Judge Marra said that volunarary SEC response costs the company incrred after the shareholder suit was filed "may have followed the securities lawsuit sequentially in time, they did not ‘grow out of’ or ‘flow from’ the subject lawsuits, and therefore did not ‘arise from’" those suits. Judge Marra added that even though the comany incurred SEC response costs after the shareholder suit was filed, that "does not transform the post-suit SEC response costs into covered ‘Loss" … even though some of those response costs may have been related to or had utility in Office Depot’s defense of the securities lawsuit."

 

Discussion

Judge Marra’s analysis and conclusions are a direct reflection of the specific language at issue in the Office Depot case, and his analysis might or might not produce the same or similar outcome under different policy language. He seemed particularly persuaded that Office Depot’s primary D&O policy draws a clear distinction in how the policy responds to "investigations" on the one hand and "proceedings" in the other.

 

That said, Judge Marra’s analysis is quite detailed and represents a very thorough examination of what policyholders are entitled to under the policy before an investigation ripens into a formal administrative or regulatory proceeding. The opinion also represents a detailed examination of what insurers are responsible for before a claim has been made under the Policy.

 

Insurers will undoubtedly welcome this decision and will attempt to rely on it in other cases. As a district court opinion, the decision has limited precedential value, but the insurers will seek to rely on the decision for its persuasive value. The extent to which other courts will follow Judge Marra necessarily will depend on the policy language at issue in the other cases. Indeed, Judge Marra himself rejected Office Depot’s attempt to rely on prior decisions in which courts had held that an "investigation" is a "proceeding," stating that the policies involved in those other cases involve different language.

 

Notwithstanding Judge Marra’s decision, policyholders will continue seek coverage for defense costs incurred in informal investigations and for internal investigation, particularly where distinctions in policy language would seem to justify a different outcome. The sheer dollar costs involved alone (see, e.g., Office Depot’s $23 million in expenditures) ensure that policyholders will continue to agitate on these issues.

 

Given the perennial nature of these issues, the question arises of what are the practical lessons of Judge Marra’s opinion. The most important lesson seems to be that the policy’s wordings of "Securities Claim" and "Claim" are very important and the specific wording used with relation both to "investigations" and "proceedings" can be critically important. A particularly important issue for insurance buyers and their advisors to keep in mind is that a court may differentiate "regulatory and administrative proceedings" on the one hand and "investigations" on the other hand, and it is critically important to analyze coverage with respect to these two sets of considerations separately.

 

One final note relates to Judge Marra’s analysis of whether pre-claim defense expenses may be said to be "arising from" a subsequent claim. Judge Marra reduced this analysis to a question of temporal relation, in effect concluding that any particular item of defense expense can only "arise from" a claim if it comes later in time. I am not sure this analysis takes into account all of the possibilities, In particular, there are occasions when defense expenses are incurred earlier that would inevitably have been incurred later, the argument being the expenses "would have been incurred in any event" and the fact that they were incurred prior is an accident of timing. Arguably, Judge Marra’s analysis is not (or perhaps fairly ought not to be) preclusive of this argument. (Please refer to the Update above for further on this point).

 

It is probably worth noting that there have been recent innovations introduced into the D&O insurance marketplace designed to try to provide coverage for certain preclaim expenses incurred by or on behalf of individual directors and officers. The most recent formulations would not address the pre-claim expenses or internal investigative expenses of the insured entity itself, but it would at least provide direct or reimbursement coverage for costs incurred by or on behalf of individuals before a "Claim" has emerged.

 

　

These issues surrounding informal inquiries and internal investigations raise many points of contention, and policyholders and their insurers will continue to struggle with these issues. It seems probable that insurers facing these disputes will attempt to rely on Judge Marra’s opinion.

 

Special thanks to Steve Brodie of the Carlton Fields law firm for providing me with a copy of Judge Marr’s opinion. The Carlton Fields firm represented the primary insurer in the coverage litigation.

 

For discussion of a recent decision in which a court held that there was coverage under a D&O insurance policy for investigative expenses of a special litigation committee, refer here.

 

In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the sixth in the series, I examine the range of D&O insurance policy exclusions. Though some exclusions are found in most D&O insurance policies, others appear only occasionally , while yet other particular exclusions may only appear in specific policies or specific kinds of policies. For purposes of analysis, I have tried to group the various kinds of exclusions in separate categories below.

　

As a preliminary matter, it is important to note that while generalizations are possible about the kinds of exclusions that may appear in "most" or "many" policies, there are always exceptions. For example, one type of D&O policy, the so-called Excess Side A/DIC policy, often has fewer exclusions than the traditional D&O policies. In addition, more recently introduced D&O insurance policies may have different or narrower exclusions that are found in the typical policy. D&O insurance policies for financial institutions often have exclusions relating specifically to the type of financial activity in which the institution is engaged.

 

Any attempt to try to identify all of these exclusions and exceptions would be far beyond the scope of this post. For purposes of this introductory overview, I have limited my observations to what generally is the case, and in most cases, my observations relate to traditional D&O insurance policies.

　

Exclusions to Define the Policy’s Relation to Other Policies: In order to avoid overlapping policies or duplicate coverages, most D&O policies contain exclusions providing that coverage is precluded for matters that have been reported or the subject of notice under other policies. Consistent with the claims made nature of D&O policies, many policies also include exclusions precluding coverage for litigation that was pending prior to the policies inception.

　

Exclusions to Fit the Policy with Coverage Afforded by Other Types of Insurance: D&O insurance policies are built with the presumption that it is just a part of the policyholder’s overall program of insurance. With that in mind, most D&O policies contain exclusions to preclude coverage for claims that are typically covered by other types of insurance. Thus, most policies contain exclusions for loss arising from claims arising from bodily injury or property damage, as those hazards are typically insured under Commercial General Liability Insurance (CGL) policies. Similarly, most D&O policies exclude coverage for claims under ERISA and similar laws, as those claims typically would be covered under Fiduciary Liability Insurance policies.

　

Catastrophic Hazards: Many policies include separate exclusions for loss arising from catastrophic hazards, such as nuclear events, environmental damage and war. Some of these exclusions, particularly the environmental damage exclusion, will often have coverage coverage carve backs for shareholder claims or for loss for which the company is unable to indemnify individual directors and officers. In addition, in the wake of the events of September 11, 2001, and in compliance with the Terrorism Risk Insurance Act (TRIA), many policies will also contain specific provisions relating to acts of terrorism.

 

Refer here for an example of a coverage dispute arising in connection with the question whether or not a D&O policy’s pollution exclusion precluded coverage for a shareholder claim alleging pollution related misrepresentations and omissions.

　

Conduct Exclusions: Most D&O policies contain one or more exclusions precluding coverage for certain types of conduct. The conduct exclusions typically preclude coverage for two categories of conduct: first, for loss relating to fraudulent or criminal misconduct; and second, for loss relating to illegal profits or remuneration to which the insured was not legally entitled.

　

These exclusions can often have subtle wording differences that can significantly affect the availability of coverage. The most important wording variant is with respect what is required in order for the exclusion to be triggered. In recent times, these provisions usually require a prior "adjudication" that the precluded conduct has actually occurred in order for the exclusion to be triggered. Different variations of the adjudication requirement may require the adjudication to take place in the underlying claim, while other exclusions may allow the determination to be made in a separate proceeding (such as a declaratory judgment proceeding).

 

Another important aspect of these exclusions are the accompanying provisions defining when one insured person’s conduct may be attributed to another person or to the insured entity. In more recent times, many policies restrict the imputation of conduct among insurerds – policies with these provisions are said to have "full severability of conduct."

 

An example of a recent case illustrating the importance of the precise wording of the adjudication trigger in the fraud exclusion can be found here.

 

Insured vs. Insured Exclusion: Most D&O policies have exclusions precluding claims brought by one insured against another insured, in order to preclude coverage for collusive claims and for infighting among senior corporate officials. The Insured vs. Insured exclusion typically includes numerous exceptions (or "carve backs" as they are usually called). The exceptions preserve coverage for derivative claims, cross claims, certain employment practices claims, and claims brought by bankruptcy trustees.

　

The Insured vs. Insured exclusion (often referred to as the I v. I exclusion) has evolved over time, and so there are many variants both to the exclusion and to the carve backs. As others have noted (refer here), the Insured vs. Insured exclusion continues to be heavily litigated and is often at the heart of many coverage disputes. Insured vs. Insured disputes can often arise in the context of corporate bankruptcy, as noted here. More recently, whistleblower provisions in the Sarbanes Oxley Act and the Dodd-Frank Act have also potentially raise Insured vs. Insured concerns, if the whistleblower is also an insured person. Many insurers will agree to Insured vs. Insured exclusion carve backs designed to preserve coverage for whistleblower claims.

　

Particular Circumstances: In the course of insurance acquisition process, it sometimes happens that the insurance underwriter will identify a specific circumstance or event that represents a risk the underwriter is unwilling to accept. In that event, the underwriter will sometimes insist on an exclusion precluding coverage for the event or circumstance. While these kinds of specific event (or "laser" exclusions as they are sometimes called) are not uncommon, the typical insurance buyer that has an alternative will try to acquire a policy without the event exclusion.

　

Private Company D&O Insurance Policy Exclusions: As discussed in the preceding post in this series, the entity coverage available in a private company D&O insurance policy is quite a bit broader than the entity coverage in a public company D&O policy. In a public company policy, the entity coverage extends only to securities claims. The entity coverage available under a private company policy is not so restrictive, and in fact is quite comprehensive.

 

In order to protect themselves from the breadth of claims that otherwise might come within the entity coverage, many private company D&O insurers will include a number of exclusions applicable solely to the entity coverage. Some examples of entity coverage exclusions of this type include the contract exclusion (about which refer here), an exclusion precluding coverage for intellectual property claims, and an exclusion for antitrust and other competition related claims.

 

The antitrust or competition exclusion is not found in all private company D&O policies, and many insurers will remove or at least modify the exclusion upon request. There are a very limited number of insurers who insist on retaining this exclusion or at most allowing only defense cost coverage. In the current competitive insurance environment there are usually private company D&O insurance alternatives available that do not include the antitrust exclusion.

 

Since private company D&O insurers do not want to include the risks associated with public securities trading, most private company policies contain exclusions relating to public securities offerings and trading. It is important for these exclusions to be worded appropriately so that they do not preclude coverage for activities that might take place in advance of a planned public offering. If the planned offering does not go forward, the private company policy will have to respond to any claims, so it is important that the wording of the exclusion contemplates that possibility.

 

Miscellaneous and Anachronistic Exclusions: As the exclusion involved in the Stanford Financial coverage dispute demonstrates, there a many other kinds of exclusions out there in the insurance marketplace, some of them quite unusual. Among other exclusions that sometimes appears is the so-called "bump up" exclusion, precluding coverage for additional amounts paid to investors claiming inadequate consideration in a corporate buy out situation (about which refer here).

 

There are a host of other exclusions that have been around for a long time but that you just don’t see that much any more. An example of this kind of exclusion is the "failure to maintain insurance" exclusion (or FTMI exclusion, as it sometimes is called), precluding coverage for claims against corporate officials based on their negligent failure to obtain or maintain insurance.

 

Another example of this type of exclusion is the old "Commissions" exclusion The commissions exclusion, as typically worded, precludes coverage for loss incurred in connection with any claim "alleging, arising out of, based upon or attributable to payments, commissions, gratuities, benefits or any other factors to or for the benefit of" an agent or employee of any foreign government.

 

This exclusion was instituted after the Foreign Corrupt Practices Act was enacted in the late 70s. The exclusoin has largely fallen into disuse since that time, although you still see it on some policies from time to time. As discussed at greater length here, in an era of heighted FCPA enforcement activity, the Commissions exclusion is highly undesirable from the policyholder’s perspective.

 

As I noted at the outset, D&O insurance policies for companies in the financial sector sometimes contain exclusions particularly relevant to claims and exposures associated with the companies’ specific activities. An example of this kind of exclusion is the so-called regulatory exclusion sometimes found on policies issued to commercial banks. This exclusion became relative rare in the mid-90s and until recently, but as the number of failed banks began to rise a couple of years ago, the exclusion began to reappear in at least some commercial banks’ D&O insurance policies. Refer here for a brief overview of the regulatory exclusion.

　

A Final Note about Policy Wording: One final note is that language accompanying the exclusions can often be critically important. As discussed here, some exclusions are preceded by all-encompassing omnibus language, precluding all loss "based upon, arising out of, or any way relating to" the excluded conduct or matter. In other instances, the exclusion is preceded only by the more limited "for" preamble. The broader preamble can substantially expand an exclusion’s preclusive effect, and accordingly it is critically important to consider not only what exclusions a policy contains, but also how the exclusions are worded and what terms and conditions accompany the exclusions.

 

Towers Watson Survey 2010: The 2010 version of the Towers Watson survey is underway, but the window is closing soon. This survey, which so many of us in the industry depend upon, queries companies about liabitliy issues and D&O insurance questions. Because we all depend on the survey results, and because the more survey responses the more complete the survey results will be, we all have an interest in as many respondents as possible completing the survey.

 

The survey, the questionnaire which can be accessed here, will close Friday October 22, 2010, so please have your clients and companies complete the survey form.

　

Prior Installments in the D&O Nuts and Bolts Series: 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

　

D&O Insurance: Executive Protection – The Policy Application

　

Executive Protection: Private Company D&O Insurance

 

 

 

 

 

 

　

In a public report that makes for some interesting reading, UBS on October 14, 2010 released a statement disclosing that though its own investigation had concluded that "what happened should not have been allowed to happen," the company will take no legal action against its former directors and offices for losses the company suffered during the U.S subprime meltdown that forced a government bailout of the company. The company’s write-down of mortgage related assets exceeded $50 billion.

 

The company’s October 14 statement can be found here and the report itself, which was undertaken pursuant to the May 2010 recommendation of the Swiss Federal Assembly, can be found here.

 

The report includes a number of critical findings, including an assessment that the company’s "growth strategy" was "not planned in a sufficiently systematic manner," which contributed to the bank’s losses. The management incentives at the time encouraged company officials to seek revenue "without taking appropriate consideration of the risks."

 

The report also concludes that there company lacked a "uniform approach" to risk and that risk control was "based too heavily on statistical models." As a result, and "despite warning," the company "falsely believed" that is U.S. real estate investments were both valuable and sufficiently hedged, though there was "no comprehensive or continuous assessment" of the overall risk profile of the cross-border wealth management business.

 

The report also concluded that there were "failures with regard to the training and instruction" of some employees, and that the company "did not implement an effective system of supervisory and compliance controls necessary to convey a clear and consistent expectation that full compliance with applicable internal controls and U.S. legal requirements."

 

Despite these shortcomings, the company’s Board concluded, as part of the reporting process, that it is not in the company’s interests to pursue legal claims against the former directors and officers.

 

In its October 14 statement, the company explains that among the reasons the Board decided not to pursue claims is that "the chances of any such proceedings being successful" is "more than uncertain." The Board also took into account that these kinds of actions "last many years, generate high costs, lead to negative informational publicity and thus hamper UBS’s efforts to restore its good name.’

 

The statement also notes that pursuing claims against "could weaken UBS’s legal position in pending cases, regardless of whether the former management is ever found to be liable." The report itself goes on to note that UBS is the subject of class action proceedings in the U.S. and that "by litigating against its former directors and officers inSwitzerland, UBS would negatively impact its position in these class action proceedings in the US, in particular because, under US rules, the US plaintiffs could claim that thisis an admission that they had in fact acted improperly."

 

The report emphasizes that there had been no findings of criminal misconduct. The report states finally that "the Board of Directors is opposed to any attempt by third parties to file actions against former directors and officers or to pursue actions at the company’s expense. In the event that individual shareholders were to propose a vote at the general meeting for a resolution in favor of filing a claim at the company’s expense, the Board would consider it its duty to recommend that such a proposal be rejected."

 

Finally, the report is accompanied by an external report prepared by University of Zurich Law Professor Peter Forstmoser, who concluded that though there is "a sufficient basis to initiate legal proceedings against former individual directors or officers," the Board’s decision not to pursue legal claims is not only "appropriate," but it is also "necessary," taking into account the overall interests of the company and its shareholders.

 

The Dow Jones Newswire October 14, 2010 article about the UBS report notes that two UBS executives have returned pay from the 2007 to 2009 time frame totaling $73.7 million. The article also quotes a representative of one shareholder group as "disappointed" that the UBS Board decided not to pursue a civil lawsuit against the former directors.

 

Discussion

I can imagine a school of thought amongst a certain type of investor who might be outraged that the company is doing nothing to pursue claims against the individual former directors and officers who were responsible for the operational shortcomings identified in the report as having caused the bank’s enormous losses. I can also imagine this same type of investor complaining that this is the type of cozy, protect-your-old-buddies mentality that allow problems to arise the first place.

 

But at the same time, there is something quite instructive and perhaps even refreshing in the report’s consideration whether the postulated claim would actually help or hurt the company. There is something to the idea that this type of litigation, which can drag on for years and can be enormously expensive, does more harm than good. Indeed, if all prospective corporate and securities litigation were forced to endure this same type of scrutiny, and had to withstand the question whether the lawsuit would help or hurt the company and its investors on whose behalf it supposedly is filed, there would almost certainly be significantly less corporate and securities litigation.

 

The report’s justification for taking no action against the former company officials is of course pertinent to the company and to investors who remain invested in the company and interested in the company’s future. Investors who lost money as a result of the events analyzed in the report and who are no longer invested in the company may continue to feel aggrieved, but they can hardly complain that the company has refused to pursue any claims since those investors would not have benefited either.

 

Where investors may be most concerned is the Board’s statement that the Board will oppose any shareholder proposals seeking claims against the former officials. That is really the point where this report and the Board’s conclusions do seem defensive. On the other hand, if the Board really believes it is not in the company’s interest for those kinds of claims to be pursued, then the Board’s statement on this issue is simply consistent with the overall conclusion about where the company’s interests lie.

 

The Hits Just Keep on Coming: One of the most distinct trends to emerge in connection with recent securities lawsuit filings was the sudden surge during 3Q10 in securities class action lawsuits filed against for-profit education companies. On Friday, October 15, 2010, plaintiffs; lawyers announced the filing of yet another securities suit involving a for-profit education company, in this case Strayer Education.

 

According to the press release, the Complaint, which was filed in the Middle District of Florida against the company and certain of its directors and officers, alleges that the defendants:

 

failed to disclose that: (i) the Company had engaged in improper and deceptive recruiting and financial aid lending practices and, due to the government’s scrutiny into the for-profit education sector, the Company would be unable to continue these practices in the future; (ii) the Company failed to maintain proper internal controls; (iii) many of the Company’s programs were in jeopardy of losing their eligibility for federal financial aid; and (iv) as a result of the foregoing, defendants’ statements regarding the Company’s financial performance and expected earnings were false and misleading and lacked a reasonable basis when made.

 

The allegations in the Strayer lawsuit are similar to the allegations in the actions previously filed against other for-profit educational institutions in recent months. As detailed further here, these cases all relate back to a congressionally-initiated investigation involving federally backed student loans.

 

By my count, a total of seven different for-profit education companies have been sued in securities class action lawsuits since mid-August. These seven securities suits represent about five percent of the roughly 136 securities class action lawsuits that have been filed so far in 2010.

 

Yet Another Mortgage Mess: The headlines on the business pages have been dominated recently with tales of the mortgage documentation mess that is choking the mortgage foreclosure process. But according to Felix Salmon’s October 13, 2010 post on his Shedding No Tiers blog, there is yet another mortgage-related mess, relating to disclosures surrounding the mortgage-backed securities that the investment banks sold to investors at the peak of the housing bubble.

 

According to Salmon, it "turns out that there’s a pretty strong case" that the investment banks "lied to investors in many if not most of these deals."

 

Salmon comments relate to a process the investment banks followed as they assembled the pools of mortgages for securitization. As the banks acquired mortgages, they relied on outside service providers to test the mortgages in effect reunderwriting the mortgages according to the standards the origination entities were supposed to have used in creating the mortgages.

 

In reviewing documents submitted to the Financial Crisis Inquiry Commission, what Salmon determined is that in reunderwriting the mortgages, the outside service providers sometimes rejected the mortgages at an astonishingly high rate – in the specific example Salmon cites, the reviewer rejected 45% of the mortgages reviewed.

 

It is what happened next that really troubled Salmon. According to Salmon, rather than telling the originator that the pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool. And, Salmon adds dramatically, "this is where things get positively evil."

 

Salmon contends that because the investment banks knew they would be selling the mortgages rather than keeping them, they "had an incentive to buy loans they knew were bad," because the banks could go back to the originator and get a discount. The advantage afforded the investment banks is that "the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors."

 

The "scandal," according to Salmon, is that "the investors were never informed of the results" of the outside service providers’ tests. The banks didn’t pass the discounts along to the investors, who were "kept in the dark" about the tests, about the poor results, and about the discounts. The banks, according to Salmon, were "essentially trading on inside information about the loan pool: buying it low (negotiating a discount from the originator) and then selling it high to people who didn’t have that crucial information."

 

Salmon followed up his initial provocative post with some an interesting follow-up post as well.

　

More Failed Banks: This past Friday night, the FDIC took control of three more banks, bringing the 2010 year-to-date number of failed banks to 132. The latest three were not in any of the real estate disaster areas like Georgia, Florida, Illinois or California, but rather involved banks in America’s heartland. Two of the three were in Missouri and the third was in Kansas.

 

Since January 1, 2008, there have been a total of 297 failed banks. During that period, there have been six bank failures in Kansas and ten in Missouri. The states that lead with the highest number of failed banks during that period are Georgia (44), Florida (41), Illinois (37) and California (32).

 

The First Circuit has overturned a lower court’s decision holding that Genzyme’s D&O insurance policy did not provide coverage for additional amounts paid to claimants who asserted they had not received enough in a share exchange. Though the First Circuit reversed and remanded the case, the First Circuit did not invalidate the so-called bump up exclusion and indeed agreed that the exclusion precluded entity coverage for bump up amounts.

 

The First Circuit’s October 13, 2010 opinion can be found here.

 

Background

From 1993 to 2003, Genzyme’s capital structure included "tracking stock" to track the performance of three separate business units within the company. In May 2003, Genzyme’s board decided to eliminate the tracking stocks, and the company announced that it would exchange the business units’ tracking stock for a certain number of the company’s General Division’s shares.　

 

The ensuing exchange was unpopular among many Biosurgery Division shareholders, who subsequently initiated a securities class action lawsuit against Genzyme and certain of its directors and officers. The Biosurgery Division shareholders alleged that the defendants had schemed to depress the Division’s tracking stock so that Genzyme could fold the Biosurgery Division into the General Division at an exchange rate favorable to General Division shareholders. In August 2007, Genzyme agreed to settle the Biosurgery Division shareholders’ claim for $64 million. More detailed background regarding the lawsuit can be found here.

 

Genzyme sought to recover part of this settlement amount from its D&O insurer. The insurer denied coverage on two grounds: (1) that the settlement did not represent insurable "loss" under the policy; and (2) that coverage was precluded by the policy’s "bump up" exclusion. Genzyme initiated coverage litigation. The D&O insurer moved to dismiss.

 

As detailed here, in a colorfully written September 2009 opinion, District of Massachusetts Judge Nancy Gertner granted the insurer’s motion to dismiss. Judge Gertner based her decision on two separate grounds.

 

She concluded first that the settlement amount did not represent insurable loss as a matter of Massachusetts public policy because the settlement benefitted one group of shareholders at the expense of another. She also concluded that coverage for the settlement amount was precluded by the policy’s "bump up" exclusion, which provides that the carrier is not liable for "the actual or proposed payment by any Insured Organization of allegedly inadequate consideration in connection with its purchase of securities issued by any Insured Organization."

 

　

In her opinion, Judge Gertner expressly considered and rejected Genzyme’s argument that the "bump up" exclusion was limited by its own terms to the policy’s entity coverage and therefore did not apply to claims against individual directors and officers.

 

The First Circuit’s opinion

In an October 13, 2010 opinion written by Judge Timothy Dyk, a three judge panel of the First Circuit reversed in part Judge Gertner’s ruling, and remanded the case to the District Court for further proceedings.

 

As an initial matter, the First Circuit rejected Judge Gertner’s conclusion that coverage for the settlement would violate Massachusetts public policy, noting both that "the public policy rationale articulated by the district court finds no support in Massachusetts statutory or case law." Massachusetts recognizes "only a limited public policy exception" and applicable principles weigh against "creating amorphous public policy limitations on insurance policies."

 

The First Circuit concluded that not only does it "see no basis in Massachusetts legislation or precedent for concluding that the settlement payment is uninsurable as a matter of public policy," but also that "there are significant reasons why such an exception should not be created as a matter of public policy," noting that such an exception "have the effect of making it impossible to secure coverage for damages awards in routine securities litigation that charges the corporation with unfair or unlawful treatment of a class of securities holders."

 

The First Circuit then went on to agree with Judge Gertner’s conclusion that the bump up exclusion precluded coverage for the settlement. However, the Court noted that the exclusion by its own terms expressly limited its preclusive effect only to policy’s entity coverage clause. The court held that there was no basis in the policy language or under Massachusetts public policy for applying the bump-up exclusion to the policy’s other insuring clauses.

 

The First Circuit also referenced the policy’s allocation provisions, which the court found expressly recognized that there might be occasions on which the bump up exclusion operated to bar coverage under the policy’s entity insuring provision but in which the other insuring provisions would still provide coverage.

 

The court concluded that "we must remand the district court to consider the allocation question," adding that "if part of the Genzyme payment represented indemnification provided to officers and directors," then the payment would fall under the policy’s corporate reimbursement coverage provisions (as opposed to the entity insuring provisions) "and allocation of the total settlement is required under the policy."

 

　

With a final wink and a nod, the First Circuit acknowledged that because "the problems involved in allocation may be difficult," this might be a case "where settlement, rather than lengthy and costly litigation, might be worth consideration by the parties."

 

Discussion

On the one hand, we might assume that because the First Circuit reversed and remanded this case that insurers would score this as a loss. No doubt, the ruling arguably represents something of a setback for the specific carrier involved in this case. But the news for insurance carriers generally is not all bad here, and looked at from a certain angle, the overall news for the insurers may be relatively good, or at least acceptable.

 

First of all, the First Circuit affirmed that the bump up exclusion applied to the Genzyme settlement. Sure, the court also concluded that the exclusion only applied to preclude coverage under the Policy’s entity insuring provision, but that limitation is expressly stated in the exclusion itself. It was pretty slick for the insurer to have convinced Judge Gernter that the exclusion applied to other insuring provisions notwithstanding the express limitations in the exclusion, but insurers in general can hardly grumble that exclusions are to be applied according to their express terms.

 

And though the First Circuit may have taken away Judge Gertner’s public policy determination, I think the circuit court’s conclusion here may not be all bad from the insurer’s perspective.

 

In thinking about this public policy issue, it is worth drawing a contrast between the colorful prose of Judge Gertner’s district court opinion, which was full of humorous analogies and heavily freighted language, and the straightforward, workmanlike approach of the First Circuit’s opinion.

 

I noted at the time that not everyone was going to be equally impressed with Judge Gernter’s elaborate hypotheticals and her willingness to dispense with conventional case law formulas. I also noted the problems that that her judicial approach might prsent in the event other less intellectually agile judges were to try reasoning by analogy or from first principles rather than established case law formulas.

 

Back in the day when I was regularly representing D&O carriers in coverage disputes, I know which way I would have come down on the question whether I would have prefered a judicial decision maker that writes flamboyantly and dispenses with case law formulas, or a judicial decision maker that is unwilling to infer case decisive principles. Over the long haul, this latter approach to the decision making process is likelier to be preferable – in fact, preferable for all litigants, not just insurers.

 

All of that said, the parties must now go back to this district court to try to sort out the allocation issues, which the First Circuit correctly stated are likely to be difficult. The insurer probably did not appreciate the First Circuit’s friendly suggestion that perhaps settlement is the best approach. As someone who once represented carriers, I know that when a court suggests settlement, what they are really saying is – insurance company, get out your checkbook. I never considered that particularly helpful, actually.

 

But as I said, though Genzyme’s D&O insurer may not be happy with the way the First Circuit’s opinion impacts this specific case, I don’t think this is necessarily a bad decision overall for the insurers. As was said to me back when I was representing carriers, some days the bear eats you, some days you eat the bear.

 

I fully recognize that some readers may take strong exception to my interpretation of this decision, and those readers are strongly encourage to post their views to this blog using the site’s comment feature. (I really do wish people would post their thoughts and reactions more often.)

 

Special thanks to the several loyal readers who send me copies of the First Circuit’s opinion, including Peter Welsh of the Ropes & Grey law firm. The Ropes & Grey law firm represented Genzyme before the First Circuit.