Bankruptcy filings overall rose by 20 percent in the twelve-month period ending on June 30, 2010, according to information released on August 17, 2010 by the Administrative Office of the U.S. Courts. Though this filing surge was largely driven by non-business filings, business related filings also remained at elevated levels during the 12 months ended June 30.

 

According to the Administrative Office’s data, there were 59,608 business related bankruptcy filing in the 12 months ending on June 30 this year, compared to 55,021 in the 12 months ending on June 30, 2008, which represents an increase of 8.34%. The 59,608 for the twelve months ending on June 30, 2010 is the highest number of business-related filings for that 12 month period since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 took effect.

 

The number of business filings for the 12 months ended June 30, 2010, though only slightly greater than the comparable period in 2009, is also over 76% greater than the number during the comparable period in 2008, and almost 150% greater than during the comparable period in 2007.

 

Though the number of business-related filings remained at elevated levels during the 12 month period ended June 30, the number of business-related filings declined during each of the three month periods within that 12 month period. Thus, during the first three months of the 12-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.

 

As reflected in an August 17, 2010 analysis of the bankruptcy filing data by the American Bankruptcy Institute, business filings decreased 4 percent for the six-month period ending June 30, 2010, to 29,059 from the first-half 2009 total of 30,333.

 

Despite this quarter by quarter decrease in business-related bankruptcy filings, the overall number of filings (including non-business related filings) actually increased during the three months ending June 30, 2010, to 422,061, which is the highest for any quarter during fiscal 2010 (which runs October 1, 2009 to September 30, 2010), and the highest for any April-June quarter since the 2005 third quarter filings.

 

Though the news about bankruptcy filings overall is discouraging, the news related to business related bankruptcy filings may be slightly encouraging as there appears to be some suggestion that the worst may be past. However, that positive note should not obscure the fact that, even if the number of filings may be declining on a quarter to quarter basis, the number of business filings still remain at elevated levels compared to periods preceding the current economic crisis.

 

In a recent post, I discussed several recent decisions in which securities cases involving failed or troubled banking institutions survived dismissal motions. By contrast, however, in an August 16, 2010 ruling (here), Southern District of New York Judge Robert Patterson, Jr. granted the defendants’ motion to dismiss without prejudice in the securities class action lawsuit filed against Raymond James Financial and certain of its directors and officers alleging inadequate disclosures regarding the company’s banking subsidiary’s loan loss reserves.

 

As discussed in greater detail here, plaintiffs first filed their action against Raymond James Financial in June 2009. The plaintiffs’ allegations center on the loan portfolio and loan loss reserves at the company’s banking subsidiary, Raymond James Bank. Judge Patterson stated in his August 16 opinion that, despite the length of the complaint (which "extreme length," Judge Patterson noted, provides "an independent ground for dismissal"), the plaintiff’s allegations "boil down to one proposition: that the Defendants purposefully underfunded their loan loss reserves and then made material misrepresentations about het adequacy of those loan loss reserves during the class period."

 

With one small exception, Judge Patterson concluded that the misrepresentations and omissions on which plaintiff seeks to rely are not actionable. For example, he concluded that the alleged misrepresentations about the bank’s loan loss reserves "are, without exception, general statements of optimism" which "in and of itself renders these statements inactionable."

 

Similarly, Judge Patterson concluded that the statements about the quality of the bank’s loan portfolio "were, similarly, very general and not sufficiently detailed to have misled investors" and "for the most part" represent "classic puffery."

 

The one exception to his conclusion that the statements on which the plaintiff sought to rely are not actionable were two paragraphs in the Amended Complaint relating to the quality of the loan portfolio. These statements included representations that the bank "independently underwrote" all loans, including loans "sourced from agent or syndicate banks." The Amended Complaint reference the testimony of a confidential witness who avers that many loans that were later charged off were not independently underwritten.

 

However, Judge Patterson also concluded that the plaintiff had not sufficiently alleged scienter. He concluded with respect to the plaintiffs’ scienter allegations that:

 

None of the allegations of scienter are sufficiently specific that they allow the Court to determine whether the Defendants knew (or even likely knew) that their statements were false when made. For the most part, the scienter allegations are of the sort that could be made about nearly any company operating in the United States, namely that the executives were motivated to create profit, that the executives received a near-constant stream of information about economic trends, and that the executives made mistakes in some of their forward-looking projections.

 

These allegations, Judge Patterson concluded, were insufficient to give rise to a strong inference that the defendants acted with the requisite state of mind.

 

Accordingly, Judge Patterson granted the defendants’ motions to dismiss, but he did so without prejudice.

 

I have added Judge Patterson’s opinion to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

 

Among the very, very latest trends in securities class action lawsuit filings are suits against for-profit educational companies. Just since the middle of last week, at least five companies in this sector have been tagged with new lawsuits, four of which were securities class actions.

 

These lawsuits have been accumulating in the wake of an August 3, 2010 Government Accountability Office report (here) which alleged that several companies in the for-profit education industry encouraged fraud and engaged in deceptive advertising. The report was prepared in connection with the August 4, 2010 hearing before the Senate Committee on Health, Education, Labor and Pensions.

 

The GAO report said that undercover tests revealed that at least four schools encouraged fraudulent practices and all 15 tested made deceptive or questionable statements to the GAO’s undercover applicants. The fraud involved encouraging falsified financial aid applications. A summary of the report can be found here. A statement of the report’s highlights can be found here.

 

Though no specific companies are named in the report (or perhaps because no specific companies are named in the report), the share prices of many of the publicly traded for-profit education companies fell after the news about the GAO report circulated. And, perhaps inevitably, the lawsuits started coming in.

 

As far as I am aware, at least four for-profit education companies have been named in securities class action lawsuits just since the end of last week. These companies include the following:

 

Education Management Corp., against which the first suit was filed on August 11, 2010. A copy of the complaint filed in the Western District of Pennsylvania can be found here.

 

American Public Education, against which the first suit was filed on August 12, 2010. A copy of the complaint filed in the Northern District of West Virginia can be found here.

 

Lincoln Educational Services, against which the first suit apparently was filed on August 13, 2010. A copy of the complaint can be found here.

 

Apollo Group, Inc., against which the first suit apparently was filed on or about August 16, 2010. A copy of complaint can be found here.

 

In addition to these securities class action lawsuits, a separate class action lawsuit against Alta Colleges, Inc. (parent of Westwood College) and related entities and persons was filed on August 11, 2010 in the District of Colorado alleging violations of the Colorado Consumer Protection Act. A copy of the Alta/Westwood complaint can be found here.

 

With five suits in already, it seems safe to predict that other publicly-traded for-profit education companies could also get hit with one of these suits. This seems to be one of those classic contagion events that produces an epidemic of similar lawsuits that comes up every now and then. Last year it was ETFs (refer here); this year it seems to be for-profit educational companies.

 

The name Apollo Group may be familiar to many readers, as the company was the target of a prior securities class action lawsuit that has achieved a certain amount of notoriety because it is one of the few securities cases that has actually gone to trial. The trial resulted in a plaintiffs’ verdict, although the presiding judge later set the verdict aside in a response to a post-trial motion. More recently, the Ninth Circuit reversed the trial court’s ruling and remanded the case to the district court for further proceedings, a development that has sparked significant interest and discussion.

 

Unfortunately for Apollo Group, all of the long-running drama in the prior case was no shield against another case being filed.

 

It remains to be seen how these cases will fare. But this industry-specific litigation outbreak 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.

 

New Securities Suit Based on FCPA-Related Allegations: Regular readers know that I have frequently commented that one result of increased Foreign Corrupt Practices Act enforcement has been the growth in the number of follow-on private civil lawsuits based on the underlying corruption allegations.

 

The latest example of this phenomenon is the lawsuit filed against SciClone Pharmaceuticals and certain of its directors and officers. According to the plaintiffs’ lawyers’ August 16, 2010 press release (here), the complaint they filed in the Northern District of California alleges that:

 

defendants were engaged in illegal and improper sales and marketing activities in China and abroad regarding its products. This ultimately caused the Company to become the focus of a joint investigation by the Securities and Exchange Commission ("SEC") and the Department of Justice ("DOJ") for possible violations of the Foreign Corrupt Practices Act ("FCPA"). It was only at the end of the Class Period, however, that investors ultimately learned the truth about the Company’s operations after it was reported that the SEC and DOJ were investigating the Company for violations of the FCPA. At that time, shares of the Company declined almost 40% in the single trading day.

 

This case presents further support for the proposition that increased anticorruption enforcement activity represents a growing area of liability exposure for company executives.

 

Thought for the Day: "Time flies like an arrow. Fruit flies like a banana." (Often attributed to Groucho Marx, but although it seems as if he would have said it, he apparently did not.)

Though we are in the midst of the dog days of summer (at least in the northern hemisphere), the federal courts, at least, have been busy. In the last several days alone, several courts have issued dismissal motion rulings in lawsuits arising out of the subprime meltdown and the credit crisis.

 

As noted below, several of these decisions involve failed or troubled banks, and therefore may be of particular interest in relation to the many banks have failed in recent months or that are continuing to struggle now. Though investor plaintiffs in other cases involving failed or troubled banks have sometimes struggled to survive the initial pleading stages, in the cases discussed below, the plaintiffs managed to survive the dismissal motions, at least in part.

 

PFF Bancorp: In an August 9, 2010 opinion (here), Central District of California Judge Andrew Guilford denied the defendants’ motions to dismiss in the securities class action lawsuit against two former directors and officers of PFF Bancorp, the corporate parent for PFF Bank & Trust, which failed on November 21, 2008.

 

As reflected here, in January 2009, shareholders of the holding company filed a securities lawsuit alleging that the company’s President and CEO and its CFO contending that they concealed the Bank’s unsafe lending practices and made misleading statements about the bank’s loan loss reserves and capital levels.

 

In his August 9 order, Judge Guilford found that while the plaintiffs’ allegations that defendants made misleading statements about the banks’ "cautious" and "conservative" lending practices were insufficient to state a claim, the plaintiffs’ allegations that defendants had falsely characterized the bank’s loan loss reserves as "adequate" were sufficient to state a claim.

 

Judge Guilford also found that plaintiffs had adequately alleged scienter, finding that plaintiffs’ allegations "permit the inference that Defendants knew PFF’s loan practices were risky and that PFF had inadequate loan loss reserves, yet told investors that the loan loss reserves were adequate."

 

Interestingly, Judge Guilford found plaintiffs’ scienter allegations to be adequate despite the defendants’ contention that they had actually purchased PFF shares at the supposedly inflated prices. Judge Guilford declined, at the motion to dismiss state, to take judicial notice of the SEC forms on which defendants sought to rely in order to establish their share purchases.

 

Popular, Inc. (Securities Claim): In an August 2, 2010 order (here), District of Puerto Rico Judge Gustavo Gelpí granted in part and denied in part the defendants motion to dismiss the securities class action lawsuit that had been filed against Popular, Inc., certain of its directors and officers, its auditor and its offering underwriters.

 

The plaintiffs’ complaint focused on the company’s accounting for a deferred tax asset. In the three years preceding the beginning of the class period (which went from January 24, 2009 to February 2009), the company had recorded tax loss carry forwards that totaled over $1 billion, largely as a result of the company’s U.S. subprime and other lending operations. The benefit of these deferred tax assets could only be realized if the company experienced sufficient U.S.-based gains within 20 years.

 

To offset the possibility the company might not fully realize the value of the deferred tax assets, accounting rules required reporting companies to take a valuation allowance, but the company recorded no material valuation allowance of this asset until late 2008. The company ultimately recorded an allowance for the full value of the asset. Following the announcement of this action, the company’s share price fell substantially.

 

The plaintiffs allege that the increasing, multiyear U.S.-based operating losses prevented it from anticipating sufficient taxable income to realize the full value of the deferred tax asset prior to the expiration of the 20-year period, yet failed to take a valuation reserve because doing so would have lowered the bank’s risk-based capital ratio below regulatory requirements. The financial picture the company’s treatment of the asset portrayed allowed the company to raise over $300 million in a May 2008 offering.

 

The Court found that the plaintiffs allegations adequately alleged material misrepresentations, given that "Popular’s three-year cumulative loss position, combined with the Company’s significant downsizing of its U.S. mainland operations and the worsening market conditions, constituted strong evidence that at the beginning of the class period it was more likely than not that the Company would not be able to realize the benefit of its [deferred tax asset] in full."

 

The Court also concluded that the complaint adequately alleged scienter, concluding that the defendants’ decision "not to take an earlier valuation allowance was ‘highly unreasonable’ and an ‘extreme departure from the standards of ordinary care’ to the extend that the danger was either know to the defendants or so obvious that they must have been aware of it."

 

The Court also concluded that the ’33 Act allegations against the officer defendants were also sufficient. However, because the Court found that the amended complaint in which the plaintiffs added as defendants the outside directors, the company’s auditor and its offering underwriters had been filed more than a year after there were sufficient "storm warnings" to put the plaintiffs on inquiry notice, the ’33 Act claims against those defendants were untimely and were therefore dismissed.

 

Popular, Inc. (Derivative Suit): In an August 11, 2010 opinion (here), applying Puerto Rico law, in the shareholders’ derivative lawsuit filed against Popular, Inc, as nominal defendant, certain of its directors and officers, and its outside auditor, Judge Jay Garcia-Gregory denied in part and granted in part the defendants’ motions to dismiss. The allegations in the derivative suit largely mirror those alleged in the securities class action lawsuit.

 

The officer and director defendants had moved to dismiss on the ground that the plaintiff had not presented a demand to the company’s board to pursue the lawsuit. The plaintiff argued that demand was futile, and the Court agreed. The Court found that the plaintiffs’ allegations and of the requirements of SFAS 109 "provide ‘reason to doubt’ the legality of declining to record a valuation allowance until 2009" and therefore "demand is excused" because the presumption that the board took a valid business judgment had been rebutted by the alleged lack of "legal fidelity."

 

The Court did, however, dismiss the plaintiff’s gross mismanagement claim as duplicative of the breach of fiduciary duty claim. The Court also found that the plaintiff had not adequately alleged corporate waste. Finally, the Court found that the plaintiff’s claim against the company’s auditor should also be dismissed, on the grounds that the plaintiff had not made a demand on the company’s board to pursue the claim and had not established demand futility.

 

Discussion

Plaintiffs have had some difficult surviving initial dismissal motions in many of the securities class action lawsuits that have been filed against the directors and officers of banks that have failed during the current failed bank wave. For example, the securities class action lawsuit arising out the failure of Downey Financial Corp. (whose operating bank failed the same day as PFF Bank & Trust) was dismissed with prejudice.

 

Similarly, the motion to dismiss in the Fremont General case was also ultimately dismissed with prejudice. Similarly, the motion to dismiss was granted in the BankUnited securities case, albeit without prejudice.

 

More recently, however, the motion to dismiss was denied in the securities class action lawsuit arising out of the failure of Corus Bankshares. With the above decisions, it seems as if the plaintiffs in these cases have managed to overcome the initial pleading hurdle at least in several cases now.

　

To be sure, the reasoning the Popular case is based on circumstances that may be unique to that case. The allegations in the PFF Bancorp case, however, arguably are more typical. But while the PFF Bancorp case survived the dismissal motions, it remains to be seen whether the case will survive additional proceedings in the case, if defendants are able to establish that the purchased company shares at the allegedly inflated prices.

 

Ultimately, the fundamental question about the failed banks is whether the FDIC will lower the litigation boom on directors and officers of the failed banks. So far, the FDIC’s litigation activity has been limited to a single lawsuit it filed against officers of a subsidiary of IndyMac (about which refer here). Whether and to what extent the FDIC will pursue other claims will be revealed in the weeks and months ahead.

 

In any event, I have added these decisions to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

 

Very special thanks to the loyal readers who provided me with copies of these decisions.

　

Another Banking Institution Dismissal Motion Ruling: Though the financial institution involved has neither failed nor is seriously troubled, it should be noted here at least briefly that in an August 10, 2010 order (here), Southern District of Ohio Judge Sandra Beckwith denied in part and granted in part the defendants’ motion to dismiss in the securities class action lawsuit that had been filed against Fifth Third Bancorp and certain of its directors by former shareholders of First Charter, which Fifth Third acquired in a deal announced in August 2007.

 

As discussed here, the former First Charter shareholders alleged that in connection with the merger, Fifth Third and certain of its directors and officers had materially misrepresented Fifth Third’s exposure to poorly performing residential real estate markets, and had not fully represented how seriously its mortgage portfolio was deteriorating.

 

Judge Beckwith’s detailed and painstaking August 10 opinion denied the motion to dismiss as to the claims of certain classes of First Charter shareholders, but granted the motion to dismiss as to all other claims and claimants.

 

Another Credit-Crisis Related Securities Suit Dismissal Motion Ruling: In an August 13, 2010 order (here), District of Maryland Judge Catherine Blake denied in part and granted in part defendants’ motions to dismiss the securities class action lawsuit that had been filed against Constellation Energy.

 

As discussed here, Constellation Energy was one of the many nonfinancial companies that suffered credit crisis related financial reverses in late 2008 and early 2009 and attracted securities litigation arising out the companies’ financial woes.

 

In September 2008, Constellation shareholders and subordinated debenture holders filed a securities class action lawsuit against the company, certain of its directors and officers and offering underwriters. Their complaint asserts claims under Section 11, 12(a)(2) and 15 of the ’33 Act and under Section 10(b) of the ’34 Act.

 

Essentially, the plaintiffs alleged that the defendants had misrepresented the additional collateral the company would have to post in connection with its merchant energy business in the event of a company credit downgrade. (As the company itself later disclosed, the collateral requirements for a one-notch credit downgrade were less than had been disclosed; the collateral requirements for a two or three notch downgrade were significantly greater than disclosed.)

 

The plaintiffs also alleged that the defendants had not sufficiently disclosed the company’s exposure to Lehman Brothers. The plaintiffs also alleged that the defendants’ misrepresented the company’s future earnings, business outlook, risk management and internal controls.

 

In fall 2008, after the company suffered a several notch ratings downgrade and after Lehman collapsed, the company’s share price fell and investors’ sued. The company ultimately sold a substantial portion of its assets.

 

In her August 13 order, Judge Blake found that the plaintiffs’ ’33 Act allegations regarding the company’s downgrade collateral obligations were sufficient to state a claim. Interestingly, Judge Blake reached her conclusion even though the company’s debenture prices dropped only slightly immediately after the disclosure of the company’s revised collateral obligation and in fact rose thereafter for several weeks. These facts "ultimately may counsel against materiality" but are "not dispositive at this stage of the litigation.

 

Judge Blake found that the plaintiffs’ remaining ’33 Act allegations were insufficient to state a claim.

 

As for plaintiffs ’34 Act allegations, Judge Blake found that the plaintiffs had not adequately alleged scienter in connection with the downgrade collateral obligations. She noted that "without additional factual allegations that the defendants were somehow aware that the downgrade collateral requirements were miscalculated …neither Constellation nor its officers can be presumed to have known of a faulty computer calculation."

 

Judge Blake also found that the plaintiffs’ remaining ’34 Act allegations were inadequate.

 

I have also added the Fifth Third and Constellation Energy rulings to my running tally of credit crisis lawsuit dismissal motion rulings, which again can be accessed here.

 

Special thanks to a loyal reader for providing a copy of the Constellation Energy decision.

　

The September 2008 collapse of Lehman Brothers resulted in the largest bankruptcy filing in U.S. history, as well as an explosion of litigation and regulatory actions and investigations. In the pending bankruptcy proceedings a recent motion by the debtor’s counsel details the massive legal costs accumulating in the various legal proceedings and also raises some interesting D&O insurance implications.

 

Special thanks to Wayne State University Law Professor Peter Henning, who provided me with copies of the bankruptcy-related documents and who previously these issues on the Dealbook blog, here.

 

On July 27, 2010, counsel for the debtor filed a motion in the Lehman Brothers bankruptcy proceeding under Bankruptcy Code Section 362 for relief from the automatic stay in order to allow certain of Lehman’s excess D&O insurers to advance defense expenses.

 

According to the motion papers, for the policy period May 16, 2007 to May 16, 2008, Lehman carried an aggregate of $250 million in D&O insurance, consisting of a $20 million primary policy and sixteen layers of excess insurance. A copy of the Lehman primary policy, which is included in the bankruptcy pleadings, can be found here.

 

In March and November 2009, respectively, the bankruptcy court previously entered orders granting relief from the stay to allow defense fees to be paid first from the $20 million primary policy and then from the $15 million first excess policy.

 

However, the motion papers note, submitted defense fee statements already exceed the limits of liability of the first excess policy (i.e., the aggregate fees already exceed $35 million). The motion seeks relief from the stay to allow the second excess insurer, whose policy provides limits of $10 million in excess of $35 million, to advance defense expenses.

 

The motion goes on to state that the second excess policy’s $10 million excess of $35 million limits are likely to be exhausted "by August of this year." (That is, fees apparently already have or are about to top $45 million.) Accordingly the motion asks for relief from the stay for third excess policy, which provides limits of liability of $10 million excess of $45 million.

 

The third excess policy may also soon be exhausted. The motion suggests that the third excess policy may be exhausted by October. So the motion also asks for relief from the stay for the fourth excess policy, which provides limits of $15 million in excess of $55 million.

 

In answer to the obvious question of how so much defense expense could be accumulating so rapidly, the motion provides a brief recitation of the various proceedings in which the company’s former directors and officers are involved. First, there are the various securities class action lawsuit which have been brought by Lehman security holders. Then there are the various securities lawsuits which have been brought against former directors and officers in connection with the plaintiffs’ purchases of mortgage-backed securities. There are also additional actions or arbitrations which have been brought against certain individuals in connection with Lehman-issued securities, auction rate-securities and other alleged conduct.

 

In addition, the U.S. Department of Justice as well as the SEC and the New Jersey Bureau of Securities have "commenced formal grand jury and regulator investigations concerning the circumstances surrounding the collapse of the Lehman enterprise and have issued various requests and subpoenas," according to the motion papers.

 

All of these various proceedings undoubtedly took on a heightened sense of urgency after the March 11, 2010 release of the report of the bankruptcy examiner, Anthon Valukas, in which he referred, among many other things, to what he regarded as "actionable balance sheet manipulation."

 

In light of all of these various proceedings and given the fact that each of the individuals undoubtedly has their own counsel, it may be unsurprising that defense fees are accumulating so rapidly. Indeed, as Professor Henning notes in his Dealbook post, the fees seem to have been accumulating more rapidly in recent months, to the point that the fees now seem to be running at about $5 million a month. At that rate, even the fourth excess policy is likely to be exhausted before year’s end.

 

Given the size of Lehman’s insurance tower, there may be no immediate reason for the individual defendants to be alarmed. Even were the fourth excess policy to be soon exhausted, that would still leave $180 million in insurance available to cover the defense expenses.

 

But even if there may be no immediate cause for alarm for the individuals, the events so far and that likely lie ahead do present some noteworthy issues.

 

First, the sheer volume of defense expense so far dramatically underscores the enormous potential for a catastrophic claim to produce astonishing levels of defense expenses. To be sure, the Lehman collapse, as the largest bankruptcy in U.S. history, may represent an extreme case. But it is not as if the Lehman situation is the only case where enormous defense expenses have rapidly accumulated. To cite just two examples, in prior posts I have detailed the huge defense expenses that accumulated in the Broadcom options backdating lawsuit (refer here) and in connection with the Collins & Aikman bankruptcy (refer here).

 

In that regard, it should noted that not only has the pace of defense fee accumulation in the Lehman case accelerated in recent months, but the fees seem likely to accumulate even more quickly if the SEC were to file an enforcement action or the DoJ were to file criminal charges. As astonishing as are the fees that have accumulated already, it seems possible (arguably, probable) that even more astonishing fees could lie ahead. Professor Henning’s blog post, linked above, discusses these possibilities in greater detail.

 

While it is still only the catastrophic claims circumstances that produce these kinds of enormous fees, these cases do raise some very serious questions about traditional notions of limits adequacy. The fact is that the most important purpose of D&O insurance is to ensure that the individual directors and officers are protected in the event that the corporate entity is unable to indemnify them. These catastrophic claims scenarios demonstrate how challenging it may be to ensure that the D&O insurance can provide sufficient protection at the point where it is most needed.

 

One answer to this challenge may be the one that Lehman itself apparently followed, which is to buy very significant amounts of D&O insurance. Of course, not every company can afford to purchase anywhere near the amount of insurance that Lehman did. (To put the Lehman insurance program into perspective, the primary policy alone – which was written over a $10 million corporate reimbursement retention – cost Lehman more than $2 million. Clearly Lehman was willing to invest very substantial sums for its executives’ protection.)

 

For that matter, it remains to be seen if even the huge amount of insurance that Lehman put in place will be sufficient to protect the individuals from all of the defense expenses that may lie ahead. If the SEC were to file an enforcement action and the DoJ were to pursue criminal charges, it is not impossible that the accumulating defense expenses could test even the remaining limits

 

(And that is without even allowing for the possibility, raised by Professor Henning in his blog post, that one or more of the excess insurers might seek to disclaim coverage – "You know how insurance companies can be," he comments.)

 

There are no easy solutions to these kinds of concerns, although one consideration that should be taken into account is D&O insurance program structure. That is, in addition to considering the question of how much insurance is enough, the question of what structure of insurance should be put into place should also be considered. Among other things, one particular question is whether specific parts of the program should be designated solely for the protection of specific individuals (for example, outside directors) as one way to ensure that no matter what happens there is always a specific pot of money available for the protection of those individuals.

 

In any event, the consequences following the Lehman collapse are continuing to unfold and undoubtedly have much further to run. The astonishing accumulation of defense expense seems likely to continue if not accelerate. Whether or to what extent any of the D&O insurance might be available to pay settlements or judgments remains to be seen.

 

This last point, about possible funds for settlements or judgments, does underscore an issue that could well become critically important later on. That is, the D&O insurance tower that is responding to these various proceedings is the one that was in place for the period May 2007 to May 2008. However, Lehman filed for bankruptcy in September 2008. There is in fact, according to footnote 6 of the debtor’s memorandum in support of the motion for relief from the stay, a separate $250 million insurance tower that was in place for the period May 16, 2008 to May 16, 2009.

 

The 2007-2008 tower presumably is the one that is responding to these various proceedings because the first of the shareholder lawsuits apparently was filed in February 2008, during the policy period of the earlier tower, and later filed proceedings apparently have been treated as interrelated with the first filed claim, and therefore relate back to the date the first claim was made.

 

Given the huge amount of money at stake and in light of the fact that the 2007-2008 tower is being substantially eroded, it seems probable that someone will find it worthwhile to try to establish that one or more of the various claims triggered the 2008-2009 tower. (Indeed, it may well be that this type of effort is already well underway in one or more disputes or proceedings.) Before all is said and done in connection with the fallout from the Lehman collapse, there could be many twists and turns.

 

With as many as 17 different D&O insurers involved in this claim, there undoubtedly are quite a number of professionals in the D&O insurance industry involved in this matter. With a situation like this, there could be some pretty good scuttlebutt. I encourage anyone involved in this matter who is willing to share to post a comment using this blog’s comment function (anonymously if necessary). I am certain there is a lot more going on in this claim than can be discerned from the bare face of the pleadings.

 

Finally, for those practitioners who would appreciate insight into how the D&O insurance policy operates in the bankruptcy context, the debtor’s motion makes some pretty interesting reading. The motion not only shows how the the policy proceeds are administered and monitored in light of bankruptcy procedures, but it also illustrates how various key policy provisions (for example, the priority of payments clause) are intended to operate.

 

In the latest development in the long-running lawsuit that is among the very few securities cases to actually have gone to trial, the Ninth Circuit – in its second crack at the case – affirmed the district court’s dismissal. The Ninth Circuit’s August 9, 2010 opinion (here) in the Thane International securities class action lawsuit affirmed the district court’s entry of judgment for the defendants on the issue of loss causation.

 

Background

Reliant Interactive Media Corp. was acquired by Thane International in September 2001. Reliant shareholders received Thane shares in the merger. Thane’s shares had not been publicly traded, but the merger prospectus stated that Thane’s shares had been "approved for quotation and trading on the NASDAQ National Market" upon completion of the merger.

 

However, when the merger was consummated, Thane’s shares commenced trading not on the NASDAQ National Market System by on the NASDAQ Over-the-Counter Bulletin Board. For nineteen days, the shares traded above the merger price. However, when the company then reported disappointing earnings, the share price fell, and it continued to decline until Thane ultimately bought back the shares at a fraction of the merger price.

 

In September 2002, a class of former Reliant shareholders sue Thane and four of its directors and officers under Sections 12(a)(2) and 15 of the ’33 Act, alleging that the pre-merger prospectus had been misleading because it implied that Thane Shares would list on the NASDAQ National Market System.

 

Following a three-day bench trial, the district court concluded that Thane did not violate Section 12(a)(2), finding that the prospectus was not misleading, and that in any event the misrepresentations were not material because Thane’s share price did not depreciate below the merger price after the market became aware of the market on which the company’s shares were trading.

 

As discussed here, in a prior appeal, the Ninth Circuit reversed the district court’s trial ruling, holding that the statements in the prospectus, even if literally true, contained misleading statements regarding where Thane shares would be listed and trade, and that the information was material, because a reasonable investor would have wanted to know where the shares would trade. However, the Ninth Circuit recognized that the defendants could still prevail by establishing the affirmative defense of lack of causation.

 

On remand, the district court held that the defendants had carried their burden of establishing lack of loss causation, holding that there could be no loss as long as Thane’s share price remained above the merger price, and there could be no loss causation since the stock price didn’t fall below the merger price after "impounding" the information about the nonlisting on the National Market System. The plaintiffs’ appealed.

 

The August 9 Opinion

In its latest opinion, the Ninth Circuit quickly rejected the plaintiffs’ argument that the appellate court’s prior ruling that the prospectus misrepresentation "foreclosed" the defendants’ reliance on the loss causation defense. The Ninth Circuit found that materiality and loss causation are separate issues, and the question whether investors would find information important (materiality) is different than the question whether a particular misstatement actually resulted in a loss (loss causation). Even if the "two inquiries are related" that "does not mean they are the same."

 

The Ninth Circuit also rejected the plaintiffs’ argument that, due to the inefficiency of the market in which Thane’s shares traded, the share price could not be used in a loss causation assessment. The Court said the absence of efficiency "does not mean that prices are unreliable." The Court rejected the theory urged by the plaintiffs that it is inappropriate to rely on stock prices in an inefficient market to determine loss causation.

 

Finally, the Ninth Circuit held that the district court did not err when it found that Thane’s share price had "impounded" (absorbed) the failure to list on the National Market System before it fell below the merger price.

 

Discussion

The decision is likely to be of greatest interest to the parties involved, although it also has some value for its analysis of the relation between materiality the loss causation issue. The Court’s analysis of the role in the loss causation analysis of prices for shares that trade on an inefficient market is also interesting.

 

However, the thing that makes this decision most noteworthy is that it involves one of the very rare securities class action lawsuits that actually went to trial. Yes, the trial was a three-day bench trial, and yes the case’s lengthy post-trial procedural history essentially reduces the fact that there was a trial to just one event in the long history of the case.

 

Nevertheless, the process of tracking securities cases that have gone to trial has taken on an importance of its own, so for purposes of maintaining the running scorecard of securities cases that have gone to trial, this Ninth Circuit’s decision upholding the lower court’s dismissal is noteworthy.

 

According to data compiled by Adam Savett, the Director of Securities Class Actions at Claims Compensation Bureau, there have been nine securities class action lawsuits that have gone to trial post-PSLRA involving post-PSLRA conduct, including the Thane International case. Taking the Ninth Circuit’s recent ruling in the Thane case into account (as well as other recent developments, including the Ninth Circuit’s recent action in the Apollo Group case), the scoreboard in those nine post-PSLRA cases currently stands at five for the plaintiffs and four for the defendants.

 

I am pleased to present below an article submitted by John Iole, a partner in the Insurance Recovery Practice of the Jones Day law firm. John notes with respect to his guest post that “the views expressed in this post are those of the author and not necessarily those of the firm or any of its clients.”

 

I welcome proposed guest post submissions from responsible persons on topics relevant to this blog or its readership. Please contact me if you think you might be interested in submitting a guest post.

 

 

I note that John’s post addresses conflicts of interest that may arise in connection with the D&O insurance policy. In addition to the conflicts John discusses in his post, an additional conflict that can arise under the D&O policy is a conflict between the interests of the non-officer directors and other persons insured under the policy. I discussed these conflicts involving non-officer directors in a prior post, here.

 

 

Here is John’s post.

 

 

D&O insurance rightfully attracts the scrutiny of highly-placed personnel at purchasing companies. Likewise, the placing brokers are specialists with broad and deep experience in this line of cover. Nevertheless, a recurring issue that is infrequently addressed is the balance of interests that must be struck each year at the time of D&O renewal. This issue can arise again at the point of a claim.[1]

 

 

            Several characteristics combine to create divergent interests among the parties involved in D&O coverage. First, standard D&O insurance is sold on an aggregate limits basis, meaning that the program limits in any given policy period are available for any and all claims made against the policy. With exceptions that are essentially immaterial, any claim made against a D&O policy will, to the extent it is paid, result in an erosion of the limits available to pay all other claims that are made during (or allocated to) that same policy period. This means that a claim that is paid today necessarily reduces the insurance limits available to pay another claim tomorrow.[2]

 

 

            The second — and for present purposes the most significant — characteristic of D&O insurance is the fact that there are multiple insured persons who stand to receive the benefit of the insurance limits available. Each insured person has a separate interest in maximizing the limits available to pay a claim that might be asserted against that individual (or entity). Because insurance is protection purchased today against the financial consequences of events that might take place tomorrow, each insured person has an interest in guarding against erosion of limits – this holds true even when no claim has been asserted or is expected. Of course, if claims are known to be likely (known risks, not known losses, which would be excluded), then each insured person has an even greater interest in making sure that expenditures are kept to a minimum in order to protect the availability of funds. In addition, some individuals might have a particularly acute sensitivity to the potential for claims. For example, a member of the audit or compensation committee might expect a higher incidence of claims than non-member insureds. Although many insurance contexts represent the situation in which payment of claims results in a consumption of limits, the multiple insured persons that exist in the D&O context creates a potential for conflict.

 

 

            A third complicating consideration is the interest of the entity in the case of a company that has cover under Side-B (reimbursement of the entity for claims paid on behalf of directors and officers) or Side-C (which provides coverage to the entity itself, generally for securities claims). Take the case of a claim asserted against a director or officer that falls within the Side-B cover, and the entity not only is permitted to indemnify the individual, but also is required as a matter of corporate by-laws and/or indemnification agreement to do so. In such a case, the entity will pay the individual’s legal expenses as they become due, and these can be significant. In addition, the entity will stand ready to pay any judgment (or settlement) that results on the merits of the claim. In turn, the entity can expect to be reimbursed by the D&O insurance proceeds for the amount outlaid on behalf of the individual.[3] The individual’s interests are protected by the entity’s funds, and the individual has no direct concern as to whether the entity is reimbursed. Thus, a Side-B claim presents a conflict situation that is similar to the straightforward competition for limits (or preservation of limits) that exists between any two directors or officers. In a Side-B context, however, the competition is between the individuals (as a whole) and the entity.

 

 

            The conflict is essentially the same when a Side-C claim is asserted, in that the entity’s consumption of limits in the defense or resolution of a covered claim likewise reduces the limits available for other purposes (such as payment of Side-A claims). One significant difference in Side-C claims is that, unlike Side-B claims, a Side-C claim does not present any retirement of individual liability, but only pays for the elimination of corporate liability. In the case of a Side-B claim, the entity is reimbursed only after the individual claims already have been paid, whereas Side C claims potentially put the entity at the front of the claims line.

 

 

            Additional conflicts arise when a D&O program is laden with coverage “enhancements” that branch out from the core purpose of D&O cover. These enhancements sometimes are offered as a way to add value to an expensive line of insurance. In this respect, it can be an alluring prospect to equip the D&O program with optional coverages with the idea that the entity is saving premium dollars that otherwise would be spent on separate policies. For example, some D&O programs include special coverages (or combined limits) for employment-related claims or fiduciary claims. This type of cover might take the place of separate Employment Practices Liability or Fiduciary coverage.[4] Similarly, some D&O programs provide Employed Lawyers coverage for in-house counsel when acting as a lawyer (as opposed to coverage for counsel acting as an officer of the company).[5] As with securities claims against Side-C cover, these coverage grants can result in claims that compete for limits with “standard” D&O claims. Moreover, these coverages can extend the scope of insured persons to a broad swath of employees.

 

 

            These conflicts are not necessarily insurmountable problems, but should be adequately recognized and harmonized within the overall D&O program. There are many ways to deal with these issues, both at the point of policy placement, and also at the point of a claim. For example, a potential solution to invoke at the time of placement is to purchase substantial limits so that the risk of complete exhaustion is minimized, but of course this will bring extra cost. Another time-of-placement solution is to purchase Side-A only coverage (either excess, or excess difference in conditions) that sits above the Side A/B/C cover and comes into play if the A/B/C cover is exhausted (but of course this does not eliminate the potential for conflicts among insured persons). Another option is to purchase stand-alone individual Side-A-only cover for particular directors and officers.

 

 

            So long as the policy language provides sufficient flexibility, different solutions can be used at the point of a claim in order to reduce competition for limits. If it appears that the program limits could be compromised by pending and expected claims, the potentially competing demands can be harmonized by an automatic or discretionary deferral of payments to the entity through an order of payments clause.[6] A problem with an automatic order of payments clause (e.g., a clause stating that side A claims shall be paid before side-B or side-C claims), however, is that it can only operate with respect to known and ripe claims.  If the policy also combines a discretionary feature that allows the designated person to direct when and how payments will be made, then a deferral can be invoked to preserve limits for pending claims that are not yet ripe for payment, or for potential unasserted claims.[7] Because of the delicate interests that must be balanced in such a situation, the designated decision-maker will play a critical role.

 

 

            Given the inherent conflicts facing the directors and officers (both inter se and as between the entity), an additional consideration confronts each lawyer or other professional involved in policy placement and negotiation — namely, the interests that he or she is protecting, and the extent to which he or she is charged with representing conflicting interests. It is basic black-letter legal ethics law that a lawyer representing a corporation represents “the organization acting through its duly authorized constituents.”[8]

 

 

            In the context of D&O insurance, however, the representation analysis is complicated by the fact that the entity is providing coverage for the benefit of the individuals, and potentially also for its own benefit. In that setting, there are multiple potential clients – or at least acutely interested parties – who do not share identical interests. Furthermore, because the actual or potential conflicts of interest might not be fully appreciated by each of the affected persons, and the role of counsel might not be clearly understood, some statement of role clarification ordinarily will be prudent.[9] Nevertheless, a potential adversity of interests does not necessarily require separate legal representation. In the case of divergent interests among clients, the basic ethics rules still permit a multiple representation, so long as the lawyer reasonably believes that each client can be competently represented and each provides informed consent.[10] Although conflicts of interest at the time of placement have not generated reported disputes or case decisions, similar conflicts that arise at the point of a claim can produce major difficulties if the rules are not carefully observed.[11] 

 

 

            Therefore, when embarking on a representation involving D&O insurance that might affect multiple constituencies, the most prudent course to follow is to clearly define and limit (if necessary) the scope of the representation, and to obtain informed consent of each affected client if representation of more than one party is undertaken.[12] Another option is to make clear that some constituencies are being represented as clients and others are not being represented. In cases of particular risks or sensitivities, there is always the option to retain separate counsel to represent one or more constituents who are adverse to the others. Depending on the interests and jurisdiction involved, this potentially could be accomplished through separate lawyers from the same organization, or might require separate outside counsel.[13] In the end, there is no certain decision that is foolproof, but a consideration of these items, along with thoughtful guidance when appropriate, hopefully will yield the most prudent decisions that properly accommodate the different interests involved.

 

 

[1]This post does not address the obvious conflicts that occur when it becomes apparent that competing claims to limited insurance proceeds will eclipse the available limits, as discussed in Tittle v. Enron Corp., 463 F.3d 410 (5th Cir. 2006). In that situation, jurisdictions develop rules to determine whether claimants will be treated on a "first in time, first in right" basis or an equitable apportionment basis.

 

[2] There are some ancillary coverages that do not significantly affect the analysis, in that they either are subject to defined sub-limits or allowances, or are likely to be so small as to be an inconsequential impairment of limits. For example, a D&O policy might provide coverage for “crisis management” or “crisis communications,” or for responding to a subpoena for documents or testimony. Except in extraordinary situations, these claims will not seriously erode the limits, and these claims might be subject to a stated maximum amount. For example, the Chartis Executive Edge form provides: “This policy shall pay the Crisis Loss of an Organization, up to the $100,000 CrisisFund®. . . . .” A crisis under this form includes delisting events and events that cause or are reasonably likely to cause a material effect on stock price.

 

 

[3]Functionally, the insurance could pay instead of the entity in order to discharge the entity’s indemnity obligation, or alternatively could reimburse the entity after it has made payments on behalf of the individual. For example, the Chubb Asset Management Protector form pays on behalf of the entity: “The Company shall pay, on behalf of an Organization, Loss for which such Organization grants indemnification to an Insured Person, and which the Insured Person becomes legally obligated to pay on account of any Claim first made against the Insured Person, during the Policy Period . . . for a Wrongful Act by such Insured Person before or during the Policy Period.” The Chartis Executive Edge form provides reimbursement to the entity:  “This policy shall pay the Loss of an Organization that arises from any: . . . . Claim . . . made against any Insured Person . . . for any Wrongful Act of such Insured Person . . . but only to the extent that such Organization has indemnified such Loss of, or paid such Loss on behalf of, the Insured Person.”

 

 

[4]Towers Perrin reports that, for 2008 (the most recent year for which data is available), 57% of the surveyed companies purchased EPL coverage with their D&O insurance policy, whereas 33% purchased a stand-alone EPL policy (10% purchased no EPL coverage). Towers Perrin, Directors and Officers Liability: 2008 Survey of Insurance Purchasing Trends (Sept. 2009), at 7. Of those surveyed companies that purchased any fiduciary coverage, Towers Perrin reports that roughly half bought combined limits for D&O and fiduciary cover. Id.

 

 

[5]Additional coverages might include cover for shareholder derivative demand investigations or cover for participation as a member of the board of other organizations.

 

 

[6] The Chubb Asset Manager Protector form directs that Side-A claims, and covered loss to be paid on behalf of a benefits plan (if such coverage is purchased), be paid first before all other claims. The form specifically permits the insurance to pay claims without regard to whether there is a “potential for other future payment obligations” (i.e., future claims). The Chartis Executive Edge form provides:

 

In the event of Loss arising from a covered Claim(s) and/or Pre-Claim Inquiry(ies) for which payment is due under the provisions of this policy, the Insurer shall in all events:

 

(1) First, pay all Loss covered under Insuring Agreement A. Insured Person Coverage;

 

(2) Second, only after payment of Loss has been made pursuant to subparagraph (1) above and to the extent that any amount of the Limit of Liability shall remain available, at the written request of the chief executive officer of the Named Entity, either pay or withhold payment of Loss covered under Insuring Agreement B. Indemnification Of Insured Person Coverage; and

 

(3) Lastly, only after payment of Loss has been made pursuant to subparagraphs (1) and (2) above and to the extent that any amount of the Limit of Liability shall remain available, at the written request of the chief executive officer of the Named Entity, either pay or withhold payment of Loss covered under Insuring Agreement C. Organization Coverage and Insuring Agreement D. Crisisfund® Coverage.

 

In the event the Insurer withholds payment pursuant to subparagraphs (2) and/or (3) above, then the Insurer shall, at such time and in such manner as shall be set forth in instructions of the chief executive officer of the Named Entity, remit such payment to an Organization or directly to or on behalf of an Insured Person.

 

 

[7]Even though D&O insurance is sold on a claims-made basis (i.e., it pays covered claims made against the insureds during the policy period), it is not true that all payable claims will be made before the end of the policy period. For example, if a later claim (made after the policy period) is sufficiently related to a claim made during the policy period, then the limits of the first policy will respond to the claim and it will be excluded from later policies.

 

 

[8]See, e.g., ABA Model Rule 1.13, Organization as Client. This rule is emphasized by the Corporate Governance Recommendations adopted by ABA House of Delegates in 2003, which include the following statement: “A lawyer representing a public corporation shall serve the interests of the entity, independent of the personal interests of any particular director, officer, employee or shareholder.” Report of the American Bar Association Task Force on Corporate Responsibility, at p.32 (March 31, 2003).

 

9] For example, ABA Model Rule 1.13(f) provides: “In dealing with an organization’s directors, officers, employees, members, shareholders or other constituents, a lawyer shall explain the identity of the client when the lawyer knows or reasonably should know that the organization’s interests are adverse to those of the constituents with whom the lawyer is dealing.”

 

 

[10] ABA Model Rule 1.7(b) provides: “Notwithstanding the existence of a concurrent conflict of interest under paragraph (a), a lawyer may represent a client if: (1) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client; . . .and (4) each affected client gives informed consent, confirmed in writing." Each state has a different formulation of the rule, and some are dramatically different, so the relevant rule must be verified. For example, some states require consent to be confirmed in writing, whereas others do not. It is also clear that in-house counsel are treated essentially the same as outside counsel, and thus company counsel must be mindful of the conflicts presented by intra-corporate representations. See, e.g., ABA Model Rule 1.0(c) ("Firm" or "law firm" denotes . . . the legal department of a corporation or other organization.”); see also Association of the Bar of the City of New York, Committee On Professional And Judicial Ethics, Formal Opinion 2008-2, “Corporate Legal Departments And Conflicts Of Interest Between Represented Corporate Affiliates” (Sept. 2008) (discussing responsibilities of in-house counsel in the conflicts context).

 

[11] See, e.g., U.S. v. Ruehle, 606 F. Supp.2d 1109 (C.D. Cal.) (law firm referred for discipline for failure to properly advise and/or document warning to officer that firm represented corporate entity and not individual officer), rev’d on other grounds, 583 F.3d 600 (9th Cir., Sept. 30, 2009) (indictment dismissed on remand).

 

 

[12] See, e.g., ABA Model Rule 1.13(g) (“A lawyer representing an organization may also represent any of its directors, officers, employees, members, shareholders or other constituents, subject to the provisions of Rule 1.7.  If the organization’s consent to the dual representation is required by Rule 1.7, the consent shall be given by an appropriate official of the organization other than the individual who is to be represented, or by the shareholders.”).

 

 

[13] The lawyer ethics rules have not completely caught up with the realities of corporate law departments. The Model Rules define a “firm” to include a corporate legal department. The trouble arises when the imputation rule applicable to law firms is applied indiscriminately to corporate law departments. In that setting, no two lawyers in the law department are permitted to represent adverse interests unless two lawyers within a private firm would be permitted to do so. See, e.g., The Association of the Bar of the City of New York Committee on Professional and Judicial Ethics, Formal Opinion 2008-2, “Corporate Legal Departments And Conflicts Of Interest Between Represented Corporate Affiliates” (Sept. 2008). Some accommodation of corporate realities to permit ethical screens in this context to take the place of separate "firms" would appear to be appropriate in most cases.

 

The amount of damages awarded in 2009 Japanese securities cases exceeded "the aggregate amount of securities litigation damages determined by court decisions in Japan for the entire previous decade," according to a new study of Japanese securities litigation from NERA Economic Consulting. The report, dated August 2, 2010 and entitled "Trends in Japanese Securities Litigation: 2009 Update," and which can be found here, updates the NERA report released last year that surveyed Japanese securities litigation from 1998-2008.

 

According to the report, there were 39 total cases filed in 2009, of which 14 related to misstatements, the same number of misstatement cases as in 2008. The balance of the filings largely involve broker-dealer cases, of which there were 23 in 2009, 12 of which related to unlisted stock trading.

 

The most significant trend noted in the report has to do with damages awards. The total value of all 2009 securities lawsuit judgments was about 47.2 billion yen (just under $550 million), which is four times the 2008 total and the highest annual level ever. The average damage aware per judgment amount was also a record high of 1.9 billion yen, or about $22 million.

 

Both the 2009 filings and damage awards reflected matters involving two notable companies, Livedoor and Seibu Railway. Thus, of the 14 new disclosure cases filed in 2009, five each related to Seibu Railway and Livedoor. New cases "involving other companies and/or allegations were limited." Similarly, much of the damages awarded "were related to the Livedoor and Seibu Railway cases." The report specifically notes awards that approximately 25 billion yen in damages is attributable to just two awards involving those two companies in 2009.

 

The report acknowledges that as the Seibu Railway and Livedoor cases are resolved, there is like to be a decrease in the number of judgments and damages related to misstatements, but the report suggests that any such downturn will be "short-term."

 

The report attributes the historical trends of increased number of disclosure related lawsuits and increased damages to changes that were introduced in Japanese law in 2004. Among other things, these changes the plaintiffs’ burden for proving damages was decreased and the powers of the Japanese Securities and Exchange Surveillance Commission were increased. Increased disclosure burdens on companies and heightened institutional investor expectations "may lead to an increase in the number of misstatement cases in the [the] future."

 

Though the reasons for the phenomenon in Japan may have uniquely Japanese attributes, Japan is only one of several countries that has seen an increase in the number and severity of securities related lawsuits in recent years, largely as a result of relatively recent legal reforms. Prior NERA reports have detailed these trends in Australia (about which refer here) and Canada (about which refer here).

 

These trends, which are also emerging in other counties as well, seem likely to continue, both because of the evolving impact of legal reforms as well as because of increased expectations of institutional and other investors. Other factors, including the increasing availability of litigation funding, which has proved to be a significant factor in the growth of securities litigation in Australia and elsewhere, could also contribute to these developments.

 

Another factor that at least potentially could encourage these trends is legal developments in the United States, particularly the U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank (about which refer here and here). As a result of this decision aggrieved investors who purchased securities on non-U.S. exchanges will be unable to pursue remedies under the U.S. securities laws in U.S. courts. As a result, some foreign-domiciled investors who might have attempted to pursue claims in the U.S. may now seek to pursue claims in their own country – and even, to the extent they find the remedies or procedures in their own country to be unsatisfactory, to seek legislative.

 

In any event, as the authors of the recent study suggest, the developments in Japan seem to represent longer term trends, which seems to be true in other countries as well. Even though there are still many more securities lawsuits in the U.S. than elsewhere, the number and significance of the lawsuits outside the U.S. appear to be increasing.

 

In a prior post, I published the first in what I intend to be an occasional series of articles on the nuts and bolts of Directors’ and Officers’ Liability Insurance. I continue the series here with the second post in the series. In this post, I take a look at the most basic component of the D&O insurance policy – the insuring agreement. This basic policy clause contains the most critical terms, the definitions of which often determine whether or not a claim will be covered under the policy.

 

The Insuring Clause

Though the precise formulations may (and often do) vary from policy to policy, all D&O insurance policies more or less provide coverage for Loss arising from Claims first made during the policy period alleging Wrongful Acts against Insured Persons.

 

Each one of these nouns or noun clauses in the insuring agreement – Loss, Claims, Wrongful Acts, Insured Persons – are defined terms in the policy, and the specifics of the definitions of each of these terms may be among the most coverage-determinative provisions in a D&O insurance policy.

 

I briefly discuss below each of these terms and the claims issues that can arise in connection with each of the terms. I should emphasize at the outset that the precise contours of these terms have been the subject of extensive litigation over the years. Within the constraints of this blog format, I could not hope to summarize this litigation or all of the issues that have arisen. Moreover, it is important to note that the specific terms and definitions in any particular policy will determine the claims outcome in specific claims circumstances.

 

Here are the key insuring clause terms, addressed in a slightly different order than they typically appear in the D&O policy.

 

"Claims Made"

Many liability insurance policies are what are known as "occurrence" policies – that is, the policies provide coverage for accidents or mishaps that occur during the policy period, regardless of when the lawsuit is actually filed. However, D&O insurance policies are not "occurrence" policies, they are "claims made" policies. That is, D&O insurance policies provide coverage for claims made during the policy period, regardless of when the underlying conduct may have occurred.

 

(Actually, that last statement is not always literally true, as many D&O policies have "past acts" dates which specify the date after which the allegedly wrongful conduct must have occurred. In connection with policies that have past acts dates, claims based on conduct that occurred prior to the date would not be covered, even if the claim is made during the policy period.)

 

"Claim"

Obviously, in order to determine whether a claim was made during the policy period, one critical question is going to be, what is a "Claim"? Answering that question may be relatively straightforward in the context of civil litigation, as the service of the complaint is relatively easily recognizable as a claim.

 

The typical D&O policy’s definition of the term "Claim" extends much more broadly beyond civil litigation. Most policies’ definitions of the term encompass any type of demand for monetary or non-monetary relief, whether or not in the form of a complaint. A letter demand for redress of grievances, for example, though less formal than a civil complaint, typically constitutes a claim under a D&O policy.

 

In addition, the term "Claim" typically extends well beyond civil litigation to many other types of proceedings. For example, many policies extend the definition to include criminal proceedings, usually with a narrowing provision requiring the service of an indictment or an equivalent document. Many policies also extend to regulatory or administrative proceedings, although these clauses often include a requirement that these proceedings be "formal."

 

The term "Claim" also increasingly is defined to extend to arbitration and mediation and other types of alternative dispute resolution proceedings.

 

One of the perennial claims battlefields is the question whether investigative proceedings constitute a "Claim" within the meaning of a D&O policy. The question usually depends critically on the precise wording of the policy definition and the specifics of the investigation involved. Among other frequently recurring questions is whether grand jury subpoenas, informal document requests or other informal inquiries represent claims.

 

"Loss"

The term "Loss" specifies the things for which the policy will pay. The term usually encompasses specified indemnity amounts (settlements and judgments) as well as attorneys’ fees and other defense costs. (And, it should be noted, the policy’s payment of defense fees reduces the amount of insurance remaining under the policy, as payment of defense expenses erodes the limit of liability under the policy). The policy definition also typically excludes payment of certain items, including fines, penalties and matters deemed uninsurable under applicable law.

 

Among the recurring issues in relation to the definition of "Loss" are questions of coverage under the policy for amounts paid as disgorgement or restitution. These amounts generally are not regarded as "Loss," since they typically represent a defendant’s restoration of funds that were never his or hers in the first place. The battleground on these questions, though, is usually over whether or not a specific payment or kind of payment actually represents restitution or disgorgement.

 

Another recurring D&O insurance question arises in connection with lawsuits filed in the M&A context, particularly where the claim is that the transaction price is unfair to shareholders. These claims often are settled with an adjustment of the sales price. The question is whether the additional consideration paid is covered under the policy. These kinds of claims, often referred to as "bump up" claims, frequently recur and often depend on the specific circumstances presented and the policy wording involved. (Many policies today actually have specific "bump up" exclusions.)

 

"Wrongful Act"

The term "Wrongful Act" is usually defined as an actual or alleged act, error or omission, misleading statement or breach of duty. D&O policies are liability policies, so in order for coverage to attach, the insured person must have done something (or be alleged to have done something) for which they are liable to third parties. Although that might seem pretty straightforward, it can often become tricky in a variety of contexts.

 

One frequently recurring set of circumstances where the question whether or not a wrongful act has been alleged is in connection with the investigative proceedings. As noted above, the question whether or not subpoenas or informal document requests are claims often comes up. However, even if the specific investigative proceedings are claims under the definition of a specific policy, there may still be questions of coverage (again, depending on the specific circumstances and policy language involved) because the subpoena or informal document request does not allege a wrongful act. Or, if they allege a wrongful act, whether or not it is alleged against an insured person.

 

"Insured Person"

Many D&O policies provide coverage for both natural persons and for corporate entities. Whether or not a person or entity is or is not an insured person under the policy will often depend both on the person’s status and on the capacity in which they were acting.

 

For individuals, the status entitling them as insured persons under the policy is usually their service as a duly elected or appointed officer or director of the company. Whether or not a person is duly elected or appointed will often depend on the insured company’s own organizing documents or corporate charter. Questions can sometimes arise about whether or not middle or lower level personnel are insured; these questions are usually best addressed at the time the policy is formed, by endorsing the policy to specify that persons holding specific offices – or even specify particular named persons—are insured persons under the policy.

 

A frequent concern is whether individuals have coverage after they have completed their board service or officer duties. Most D&O policies include current, past and future director and officers within the definition of insured persons, so a former director or officer should continue to have protection for acts undertaken during their service, at least as long as the company continues to have D&O insurance in place.

 

Beyond the questions whether an individual’s status entitles him or her to be an insured person under the policy are questions concerning the capacity in which an individual was acting at the time of the alleged wrongful conduct. The individuals are insured only for actions in an insured capacity – that is, in connection with their service as a director or officer of the company.

 

These questions can be difficult when the individual has multiple connections with the insured company – as an investor, for example, or as a representative of a private equity or venture capital firm, or where the individual’s actions were in connection with a joint venture or other related but separate entity. The capacity in which the person was acting at the time may be a critical issue.

 

As for entities insured under the D&O policy, the typical policy provides coverage both for the insured entity (usually the first named insured) and its subsidiaries. Questions can arise whether or not an entity is a subsidiary (depending on the corporate parent’s ownership percentage). Questions can also arise about organizations formed or acquired after the policy’s inception. Most policies have very specific policy provisions addressing these subsequent formations or acquisitions.

 

More complex organizational structures can pose particular challenges. Organizational vehicles such as joint ventures or limited partnerships can pose particularly troublesome concerns if not addressed in the policy. Full exploration of these entity organizational issues are well beyond the scope of this blog post, but the critical issue is that these organizational questions should be addressed during the insurance acquisition process.

 

Future Posts in This Series: Based on the response I received to my initial post in the series, I intend to continue to write and publish posts on the nuts and bolts of D&O insurance in the weeks ahead. I am interested to hear from readers on topics they are particularly interested in seeing this series address. I can’t promise that I will address every issue – that are so many issues that I might possibly address, some of which are well beyond the "nuts and bolts" scope of this project.

 

However, with a better understanding of the issues in which readers are interested I can at least try to shape future posts to the issues that appear to be of greatest interest or concern. As always, I welcome readers’ thoughts and comments on the posts I publish as part of this series, as well as any other issues relating to this blog or its content.

　

Earlier this week, I hosted a guest post from the counsel for the plaintiffs in the Vivendi securities class action lawsuit, in which plaintiffs’ counsel summarized their position on the impact that the U.S. Supreme Court’s decision in Morrison v. National Australia Bank had on their case.

 

In response to their post, University of Minnesota Law Professor Richard Painter prepared the following commentary and submitted it to me for publication here. By way of background, Professor Painter’s opening reference is to George Conway of the Wachtell Lipton firm, who, as reported in the prior post on this topic, briefed and argued the Morrison case for National Australia Bank, and who has been quoted as characterizing the position of the Vivendi plaintiffs on this issue as “Completely nuts, N-U-T-S.” 

 

 

Here are Professor Painter’s comments:

 

 

Actually, Conway has to be right. The argument that Section 10(b) applies to foreign transactions in securities merely because those securities are listed in the United States is absurd.

 

 

First, a reading of the entire Morrison opinion leads to the conclusion that the Court did not extend the reach of Section 10(b) to foreign transactions in securities listed on an American exchange. The Court’s unequivocal holding is that Section 10(b) does not apply “extraterritorially.” The Court repeatedly emphasizes that the “focus” of American securities laws is on “domestic transactions” and on “purchases and sales of securities in the United States.”

 

 

An extremely large hole would be driven through that holding if the mere listing of a stock or an ADR on an American exchange were enough to justify application of U.S. law to a foreign purchase of the stock on a foreign exchange, as there are hundreds if not thousands of foreign issuers that list their home-country shares or ADRs on a U.S. exchange.

 

 

Second, the Court was well aware that NAB had ADRs listed in New York. In order for a foreign issuer to sponsor and list ADRs on a U.S. exchange, it must register the underlying, deposited shares with the SEC and, at least for the NYSE, actually list the underlying shares (though not for trading). NAB’s registration statement in the United States, for example, pertained to “ordinary shares” (At page 58 of the Supplemental Joint Appendix in Morrison v. NAB, the 20-F cover says NAB’s ordinary shares were “registered on the NYSE.” This cover looks exactly like the 20-F cover for Vivendi that the plaintiffs there are relying on.)

 

 

The Court nonetheless held that Section 10(b) did not apply to NAB’s ordinary shares traded in Australia. This holding is inconsistent with a theory that the Court would apply Section 10(b) to any security listed on a U.S. exchange even if the transaction in that security is outside the United States.

 

 

Many companies have ADRs trading in the United States. It cannot possibly be the case that the Court intended Section 10(b) to apply not only to the ADR itself but also to a foreign purchase of the underlying stock on a foreign exchange simply because the underlying shares are registered in the United States to enable the company to issue the ADR.

 

 

Indeed, if the Vivendi plaintiff’s counsel were correct, Section 10(b) after Morrison would have a broader extraterritorial reach than ever before. Think of the many foreign-cubed claims dismissed under the Second Circuit’s conduct test before the Supreme Court ruled: many – if not most – of the defendant issuers in those cases had sponsored ADRs that traded on American exchanges, just like NAB, and just like Vivendi. On plaintiffs’ reading of Morrison, those cases were wrongly dismissed. Section 10(b) – which the Supreme Court said did not have any extraterritorial application “at all” – according to Vivendi plaintiffs’ counsel would apply more extraterritorially than ever before.

 

 

This is the exact opposite of what the Court clearly intended. And it would mean that the Court got the result wrong in Morrison itself.

 

 

There are other points to make against the plaintiffs’ contention, such as the significance of Section 30 of the Exchange Act, whose territorial limitations would be rendered meaningless if plaintiffs’ reading of Morrison were correct. The bottom line is: it is quite clear that plaintiffs who transacted in securities outside the United States have no cause of action under Section 10(b) merely because these securities or related ADRs are listed on a U.S. securities exchange.

 

 

Nice try plaintiffs, but if you want a different rule, ask the SEC to recommend one in its study of extraterritorial private rights of action that Congress mandated in Dodd-Frank. Don’t waste your time with a meritless interpretation of Morrison.

 

 

I encourage reader to respond to Professor Painter’s commentary or to the Vivendi plaintiffs’ prior column using this blog’s comment function.

 

 

I welcome guest blog posts from responsible commentators on topics of interests to readers of this blog. Please contact me (using the Contact function in the right hand column) if you are interested in submitting a guest column.