News reports about the September 22, 2010 Senate Banking Committee hearing regarding the SEC have focused on the provocative statements by SEC Inspector General H. David Katz. Among other things, Katz suggested that a Texas-based SEC official quashed the investigation of allegations regarding Stanford Financial Group, allowing the Stanford-related Ponzi scheme to continue. Katz also suggested that the SEC times its initiation of its enforcement action against Goldman Sachs to draw attention away from the Inspector General’s report critical of its Stanford-related failures. (Katz’s written testimony, which focuses primarily on the Stanford-related issues, can be found here.)

 

But along with the headline-grabbing commentary on the SEC’s processes, there was also other commentary and information at the Hearing suggesting the possibility of future regulatory and enforcement actions against corporate and banking figures in response to the global financial crisis.

 

First, at least according to press reports, the hearing seemed to reflect political expectations, in the wake of the financial crisis, for regulators to pursue actions against corporate officials. For example, the September 23, 2010 Wall Street Journal quotes Delaware Senator Edward Kaufman as having observed at the hearing that "we have seen very little in the way of senior officers or boardroom-level prosecutions of the people on Wall Street who brought this country to the brink of financial ruin. Why is that?"

 

Second, the same Journal article quotes the deputy inspector general of the FDIC as saying that the FDIC is investigating 227 banks.

 

There undoubtedly will be further fallout from the SEC Inspector General’s report about the SEC’s handling of the Stanford investigation. But amid those details, the larger picture should not be overlooked. That is, we remain in an atmosphere of recrimination that includes a political expectation that government officials should pursue action against corporate executives in connection with the financial crisis. In this atmosphere, because of the political pressures, it seems probable that government officials will feel obliged to bring claims and pursue actions.

 

And while these government actions might take any number of forms, one area where regulatory and enforcement action seems probably is in the banking arena. Just as during the S&L crisis, the FDIC pursued numerous claims in response to political pressure, the FDIC may well feel the same kind of pressure in the current circumstances, and may pursue claims as a result.

 

All of which is a reminder that larger forces may drive claims against corporate and banking officials, possibly for years to come.

 

In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the fifth in the series, I examine D&O insurance issues of particular concern to private companies. Both the potential liability exposures and the available insurance solutions for private companies and their directors and officers are quite a bit different than for public companies.

 

Why Should Private Companies Buy D&O Insurance?

Most public companies don’t need to be persuaded that their company needs D&O insurance. Public company executives generally understand that D&O insurance is an indispensible prerequisite for a company whose securities are publicly traded.

 

However, the view among at least some private company managers is different. These officials, particularly those at very closely held companies, feel they are unlikely to need the insurance because, they believe, they are unlikely to ever have a D&O lawsuit. In my experience, just about every company that has ever had a claim was quite sure, before the claim arrived, that they would never have a claim. Executives who have survived a claim know better; too many company officials find out the hard way that when they recognize they need the insurance after all, it is too late. The fact is, the right time to buy the insurance is when you think you don’t need it.

 

Many of those who resist the need for D&O insurance are affiliated with companies that have only a very small number of shareholders. These company executives look at the ownership structure and conclude their company could never have a D&O claim. This perspective overlooks the fact that the plaintiffs in D&O claim include a much broader array of claimants than just shareholders. D&O claims plaintiffs also include customers, vendors, competitors, suppliers, regulators, creditors and a host of others. In our litigious age, just about anybody is a prospective claimant.

 

And when a company has claim, expenses mount quickly. Even frivolous suits can be expensive to defend and resolve. At the same time, the cost of insurance to protect private companies against D&O claims is relatively low. Indeed, the incremental costs of private company D&O insurance, on top of the company’s employment practices liability insurance (and no entity should do business in this country without EPL insurance) is relatively slight.

 

For the relatively low cost, private company D&O insurance buyers obtain coverage that is quite broad. Private company D&O insurance policies are materially broader than D&O insurance for public companies. In particular, the entity coverage under a private company D&O policy is significantly broader than the entity coverage under public company D&O insurance policies. The entity coverage in public company D&O insurance policies is generally limited just to securities claims. However, private company D&O policies contain no such limitation, so the private company D&O insurance policy provides significant balance sheet protection for the insured entities.

 

Because the private company D&O insurance policies provide broad coverage at relatively low cost it should be a part of every private company’s risk management portfolio – not just private companies with a broad ownership base.

 

Combined or Separate Limits?

A recent D&O insurance innovation is the development of modular management liability policies. These permit various management liability coverages to be combined in a single policy. The typical modular policy consists of a declarations page (identifying the limits of liability and the policy period, and so on), a general terms and conditions section applicable to all of the separate coverage parts, and then separate coverage parts for each of the various management liability coverages (such as D&O, EPL, Fiduciary, Crime, etc).

 

These modular policies have become quite popular. They do have certain advantages. The first is that the policies simplify the management liability insurance acquisition process by reducing what would otherwise be a series of discrete transactions into a single insurance transaction. The modular structure also ensures that the various coverages are coordinated, which could be important in the event of a claim the straddles several coverages.

 

The modular structure does present questions with respect to the limits of liability. Many buyers, attracted by the convenience of multiple coverages combined in a single policy are also attracted by the possibility of combining the limits of liability for the various coverages into a single, combines aggregate limit, under which a claim payment under any of the various coverages would reduce the amount of insurance remaining for a separate claim under any of the coverages.

 

There is no doubt that combining the limits of liability into a single aggregate limit affords costs savings for the buyer. For some insurance buyers, particularly very small enterprises, the cost saving consideration justifies the decision to structure the insurance into a single aggregate limit.

 

For most other enterprises, however, the combination of all of the coverages into a single limit may be a poor choice. A combined limit presents the possibility that a prior claim might reduce the amount of insurance available for a later, more serious claim. The fact is that when things go wrong, multiple problems can arise at once.

 

My greatest concern is that a prior unrelated claim against the company might leave company executives with insufficient remaining insurance to protect them if a separate claim later arises against them as individuals. This concern is particularly applicable in the bankruptcy context, in which company indemnification is unavailable. The executives could be left without insurance or with insufficient insurance at the time when they need it most.

 

I am Old School on this issue. I have a bias in favor of separate limits for the separate coverages, because I believe that there should be a fund of insurance available to protect the individual executives, without a concern that entity claims might drain the insurance away. Of course, as noted above, cost considerations may nevertheless dictate that some small enterprises will purchase combined limits. But most insurance buyers should not allow relatively small premium differences to drive important insurance decisions, potentially leaving the company with insurance that might not afford sufficient protection with the hour of need arises.

 

Duty to Defend or Duty to Indemnify?

Public company D&O insurance is written on reimbursement basis, based on the insurer’s duty to indemnify the insured company for its defense expenses and claim resolution costs. Under this duty to indemnify type of coverage, the insureds select their defense counsel, subject to the insurer’s consent, and the insureds control the claim. The insurer reimburses the insureds for these costs.

 

Private Company D&O insurance is also often written on a duty to indemnify basis. In addition, however, private company D&O insurance is also sometimes written on a duty to defend basis, under which the insurer selects the defense counsel and controls the defense. Many private company D&O insurance carriers offer their prospective insureds the choice of whether or not the coverage will be written on a duty to indemnify or a duty to defend basis.

 

There are certain advantages to the duty to defend structure. The first is ease of administration. Under the duty to defend coverage, the carrier appoints defense counsel and takes care of managing the claim. The policyholder doesn’t have to deal with legal bills and so on. This can be particularly helpful for smaller and more routine claims. In addition, the counsel the carrier selects often are experienced with these kinds of claims, which can also contribute to smoother claims resolution.

 

Another advantage of duty to defend coverage is that, in general, if any part of the claim is covered, the insurer must defend the entire claim, even those parts of the claim that are not covered. This unified defense avoids what can be a recurring problem under a duty to indemnify policy when a claim encompasses both covered and uncovered matters; in that circumstance under a duty to indemnify policy, the defense costs must be allocated between the covered and uncovered matters and the insurer reimburses only the defense expenses associated with the covered matters (often only a percentage of total defense expenses). The process of determining the allocation can be contentious and disruptive at a time when the insured and the insurer ought to be trying to work together to resolve the claim.

　

But despite these advantages of the duty to defend coverage, there may be times when duty to defend coverage is not the best choice. In particular, many policyholders are not comfortable having the insurer’s counsel defending a claim. This may be particularly true with more serious and more sophisticated litigation, which some insureds feel are outside the capabilities of some insurer-selected defense counsel. Also, although the topic involves issues far beyond the scope of this blog post, a host of issues arise when the insurer is defending a claim subject to a reservation of rights to deny coverage for any settlements or judgments.

 

There are no absolute answers to the question whether the D&O coverage should be written on a duty to defend or a duty to indemnify basis. It is a question each insurance buyer must decide in consultation with their insurance adviser.

 

One innovation the D&O insurance industry has introduced in recent years is an optional duty to defend policy, which gives the policyholder the option of tendering the claim defense to the carrier at the outset of the claim. The advantage of this arrangement is that it allows the policyholder to let the carrier handle the smaller or more routine matters, while allowing the company to select its own counsel and manage its defense on more significant matters or matters of greater concern to the company.

 

Public Offering Exclusion

The critical distinction between private and public companies is that public companies have publicly traded securities and private companies do not. Private company D&O insurers do not intend to cover exposures arising from the issuance or subsequent trading of publicly traded securities, and so private company policies typically have a public offering exclusion.

 

One particular concern with this exclusion is that it should not be written so broadly that it would preclude coverage for claims arising from pre-IPO activities. If a company is preparing to go public, the company and its senior executives undertake a variety of activities that may create potential liability exposures. If the company ultimately goes public, the public company D&O insurance policy, put in place on the offering date, should pick up coverage for all claims arising from the offering related activities. However, if the company does not complete the offering and claims result, or if offering activity claims arise prior to the offering date, then private company policy is the one that will respond to the claims.

 

Because of the heightened claims exposure associated with pre-offering activities, it is critically important that the public offering exclusion is worded in a way to afford coverage for these kinds of claims. Unfortunately, this is an area where there is a significant and serious lack of uniformity in available wordings, and many of the wordings available are not well-designed to provide the full extent of coverage needed. For example, many carriers, in an attempt to address this concern, will include a so-called "roadshow carve back" from the securities offering exclusion. These wordings, while helpful, are not sufficient to address all of the potential pre-IPO exposures, because pre-offering problems might arise that have nothing to do with the roadshow.

 

The concerns arising in connection with coverage for pre-IPO activities is a good illustration of the unavoidable fact that even with respect just to private company D&O, it is critically important for insurance buyers to associate knowledgeable and experienced insurance advisors in the insurance acquisition process. Otherwise the insured could wind up with D&O insurance coverage that is not well suited to the company’s needs and exposures, and that does not reflect the best coverage available in the marketplace.

　

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

　

 

 

When the U.S. Supreme Court issued its ruling earlier this year in the Merck case pertaining to the question of what triggers the running of the statute of limitations in securities cases, there was some speculation that the decision might encourage an influx of cases involving events from the distant past. There really have not been that many cases that seemed to have been filed in reliance on Merck — at least not until now.

 

A case filed late last week, in which the class period cutoff date is over three years past, seems to represent a pretty clear example of a filing made in reliance on Merck, and may suggest both the kinds of filings that Merck may encourage and also the problems these cases may present.

 

Just to review, in its April 2010 decision in Merck, the U.S. Supreme Court held that the statute of limitations for cases under Section 10(b) is not triggered until the claimants have, or with reasonable diligence could have had, knowledge of the facts constituting the violation, including in particular facts constituting scienter.

 

According to their September 17, 2010 press release (here), plaintiffs’ lawyers’ have filed an action in the District of Idaho against PCS Eduventures!.com, its CEO and its former CFO. Though the complaint (a copy of which can be found here) was only just filed last week, the lawsuit purports to be filed on behalf of investors who purchased the companies’ shares between March 28, 2007 and August 5, 2007 – a period that ends more than three years before the complaint was filed.

 

The gist of the complaint is that on March 28, 2007, the company announced that it had entered a license agreement with its Mideast distributor, PCS Middle East, for a fixed license fee of $7.15 million. However, the complaint alleges that PCS Middle East did not have the ability to pay the fee without first entering a contract with the Saudi Arabian government. PCS did not have a contract with Saudi Arabia, and the complaint alleges that "PCS officers knew there was no contract."

 

The reason that the class period cuts off in August 2007 is that on August 15, 2007, after several months worth of disclosures about the Saudi arrangement or reflecting the revenue from the arrangement, the company issued an "update" clarifying that while the company had relied on their Mideast distributor’s assurances that a contract was "imminent," in fact, the company was "unable to confirm a timeframe or other specifics regarding any such contract" and the company’s managers "do not know when our Company will be called upon to participate in the initiative through our independent licensee."

 

The complaint anticipates the statute of limitations issue by alleging that "it was not until August 26, 2010, when the SEC instituted a civil action against PCS and others, did [sic] any reasonable investor could have reasonably suspected that Defendants’ misstatements about its purported $7.5 million sales contract were made with scienter."

 

The SEC’s August 30, 2010 press release regarding its enforcement action can be found here and the SEC’s amended enforcement complaint against PCS and its CEO and former CFO can be found here.

 

According to the SEC’s complaint, in March 2007, the company’s Mideast representative had been promising the Saudi contract for months, at a time when the company also faced the looming possibility of missing its EBIDTA requirements in one of its loan covenants. The SEC alleges that the company concocted the license fee arrangement with its Mideast distributor as a way to come up with revenue to satisfy the EBITDA requirement.

 

The company booked the fee as revenue in March 2007, even though the distributor could not pay the fee until there was a Saudi contract. The SEC alleges that the company’s officers "knew there was no contract with Saudi Arabia." The SEC also alleges that in the absence of the contract, the company lacked an appropriate basis to recognize the fee as revenue, a fact of which the SEC also alleges company management was aware.

 

Discussion

Because the investor complaint was filed more that three years after the August 2007 "update," the complaint would appear to be untimely, unless the plaintiffs succeed in persuading the court that the statute of limitations was not triggered until the SEC filed its complaint more than three years later, in August 2010.

 

The U.S. Supreme Court held in Merck that the statute of limitations is not triggered until the claimant has knowledge of the facts constituting the violation, including the facts constituting scienter. The plaintiffs expressly allege in their complaint that until the SEC initiated its enforcement action, they were unaware of the facts constituting scienter – that is, that the PCS officials knew all along there was no Saudi contract.

 

The defendants undoubtedly will argue that the plaintiffs could have with reasonable diligence uncovered the facts constituting the violation, and indeed the company’s mealy-mouthed August 2007 "update," which uses a lot of words to explain the simple facts that there was no Saudi contract and there never had been a Saudi contract, should have set off some alarm bells.

 

The defendants will argue in particular that the August 2007 update specifically noted that the company had only been told that the Saudi contract was "imminent" and had been "unable to confirm the timeframe or other specifics regarding any such contract" – meaning that even back in March, when the company booked the fee revenue, the company lacked specifics regarding the contract, which suggests that the company lacked the minimum necessary to recognize the fee as revenue, and that the company clearly was as aware in March as it was in August that it lacked sufficient specifics to support recognition of the revenue.

 

It will be interesting to see how this case unfolds. At a minimum, the lawsuit’s filing does demonstrate the troublesome potential of the Merck decisions to encourage the pursuit of litigation over long-distant events.

 

The problem is that this possibility creates significant uncertainty about when events in the past so long gone that companies can be sure that they are "out of the woods" about past problems. This is also a serious problem for D&O insurance underwriters trying to assess the risk associated with companies that have had problems in the past. If cases like this one go forward, underwriters will be compelled to extend their scrutiny of a particular company far into the past, with no sure way of knowing how far back is far enough. This uncertainty poses a challenge for companies and underwriters alike.

 

One final question has to do with the SEC’s action. I am not sure of theory on which the SEC will show that its action was timely, a question that presents its own separate set of issues and that will have to be worked out as the enforcement action goes forward. I welcome readers thoughts on the statute of limitations issues.

 

More Bank Failures: In case you missed it, the past Friday evening after the close of business, the FDIC took control of six more banks, bringing the 2010 year to date total number of bank failures to 125. The 2010 pace of bank closures continues to run well ahead of the pace in 2009, when the FDIC closed 140 banks. Bank closure number 125 in 2009 did not occur until December.

 

Among the six banks closed this past Friday night were three more Georgia banks. Since January 1, 2008, there have been 44 bank failures in Georgia, the highest total for any state during that period. However, the 14 bank failures in Georgia so far in 2010 represent only the third highest state total this year, behind Florida (23) and Illinois (15).

 

The Coolest Time-Waster Website Ever: Check out the Global Genie. When you click on the "Shuffle" button, the site displays a Google Earth view of some random location somewhere on five continents (Antarctica and for some reason South America are not included). Each location is helpfully identified by an accompanying Google Map. The "Shuffle" button quickly becomes addictive.

 

On September 14, 2010, in another ruling that the U.S. Supreme Court’s decision in Morrison v. National Australia Bank precludes claim by "f-squared" claimants – that is, U.S. residents who purchased shares of a Non-U.S. company on a foreign exchange – Southern District of New York Judge Victor Marrero dismissed the claims of investors who purchased their Alstom shares on the Euronext exchange from the long-running Alstom securities class action lawsuit. A copy of Judge Marrero’s opinion can be found here.

 

In reaching his conclusion, Judge Marrero rejected an argument that plaintiffs in Vivendi and other cases have raised to try to salvage claims of those who purchased their shares on foreign exchanges – that when non-U.S. companies have "listed" their shares on U.S. exchanges, investors who purchased their shares outside the U.S. can still assert securities claims under U.S. law in U.S. courts.

 

Background and Decision

Investors first sued Alstom and certain of its directors and officers in the U.S. in 2003. Discovery in the case in now complete and the parties face a November 12, 2010 deadline for filing summary judgment motions.

 

On July 29, 2010, two days after he issued his opinion precluding f-squared claimants’ claims in the Credit Suisse case (about which refer here), Judge Marrero directed the plaintiffs in the Alstom case to show cause why the "claims of plaintiffs who purchased their shares on foreign exchanges should not be dismissed."

 

The plaintiffs’ response, Judge Marrero noted, "went far beyond the limited direction of scope the court’s direction." In any event, Judge Marrero rejected both of the arguments on which the plaintiffs sought to rely.

 

First, Judge Marrero rejected the plaintiffs’ argument that because the Euronext purchases of Alstom shares had been "initiated" in the United States, they represented "domestic transactions" as required by Morrison. In rejecting this argument, Judge Marrero cited his own prior opinion in the Credit Suisse case.

 

Second, Judge Marrero also rejected the plaintiffs’ argument that because Alstom shares are "listed" on the NYSE, the claims of purchasers who acquired their shares anywhere in the world are cognizable under the U.S. securities laws. Judge Marrero described this argument as a "selective and overly-technical reading of Morrison that ignores the larger point of the decision."

 

With respect to the specific portions of Morrison on which the plaintiffs sought to rely in making this argument, Judge Marrero said these excerpts "read in total context" compel a result contrary to that urged by plaintiffs. The Morrison opinion, Judge Marrero said, taken as a whole, "reveals a focus on where the securities transaction actually occurs," adding that the Morrison court was "concerned with the territorial location where the purchase or sale was executed."

 

Judge Marrero added that the conclusion "that the transactions themselves must occur on a domestic exchange to trigger application of Section 10(b) reflects the most natural and elementary reading of Morrison."

 

Finally, Judge Marrero rejected the plaintiffs’ suggestion that he should retain "supplemental jurisdiction" over the claims of the foreign purchasers and apply French law to their claims, noting that the case has been pending for seven years exclusively under U.S. law and "plaintiffs have not given any indication that the French claims were unavailable when they began this action and the Court is not now persuaded they should be allowed to press the reset button here."

 

Discussion

The second argument the plaintiffs raised – that is, because Alstom’s shares are "listed" on a U.S. exchange, the U.S. securities laws extend to transactions in the company’s shares taking place outside the U.S. – has been raised by plaintiffs in a number of pending securities cases involving non-U.S. companies. For example, and as detailed at length in a guest post on this blog (refer here), the Vivendi plaintiffs are relying on this argument to try to preserve their claims against foreign purchasers in that lawsuit.

 

According to Andrew Longstreth’s September 16, 2010 article in the Am Law Litigation Daily (here), Judge Marrero’s order in the Alstom case "appears to be the first decision to address the various plaintiffs’ "controversial interpretation" of Morrison.

 

Judge Marrero’s rejection of the plaintiffs’ listing argument is categorical. However, his ruling binds no other judges, not even other Southern District judges. Whether his interpretation of Morrison prevails in other cases before other judges remains to be seen.

 

In that regard, it is worth noting that though there are now two high-profile decisions holding that Morrison precludes the claims of "f-squared" claimants, both of the opinions were written by Judge Marrero – indeed, he even quoted his first opinion in the second one.

 

But though the plaintiffs’ lawyers in many other pending cases involving claimants who purchased their shares outside the U.S. may continue to limit Morrison’s effects in order to preserve those claims, the arguments look increasingly challenging.

 

The stakes involved in many of these cases are enormous. Indeed, the Am Law Litigation Daily article linked above quotes defense counsel in the Alstom case as saying that Judge Marrero’s decision "cuts the potential damages by 95 percent."

 

Looking retrospectively, some of the largest U.S. securities lawsuit settlements involving foreign companies likely would have worked out substantially differently were all claims based on overseas purchases precluded. For example, as reported in NERA’s Mid-Year 2010 securities litigation study, in the $1.1 billion Royal Ahold settlement (the seventh largest settlement of all time), 97.6% of all trading volume during the class period took place on foreign exchanges.

 

The elimination of these claims from U.S. securities suits not only potentially narrows the putative aggregate class damages dramatically in cases involving non-U.S. companies, but it also could make future cases against some non-U.S. companies substantially less attractive to plaintiffs’ counsel than they might have been in the past.

 

 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.