In a March 12, 2010 order (here) in a Madoff-related derivative suit, the New York (Nassau County) Supreme Court, applying New York law, substantially denied defendants’ motion to dismiss, holding among other things that demand was excused. As far as I am aware, this is the first Madoff-related derivative suit to survive a motion to dismiss. It is also the first Madoff-related lawsuit dismissal motion denial by a New York court of which I am aware.

 

The derivative suit was filed on April 1, 2009 by non-managing member of Andover LLC, on behalf of Andover LLC, as nominal defendant. Among the defendants are Andover’s investment manager (Andover Management), general partner, and investment consultant (Ivy Asset Management) and Andover’s auditor. The complaint, which can be found here, alleged that Andover should recover damages for the defendants’ negligence, gross negligence, breach of fiduciary duty, and for aiding and abetting breach of fiduciary duty.

 

The complaint alleges that the defendants committed these wrongs by permitting Andover to invest "approximately a quarter of its assets under the personal control of [Bernard Madoff] through his investment firm." The complaint alleges that as of December 31, 2007, Andover had assets of $57.7 million. The complaint further alleges that Andover’s auditors were negligent in conducting annual audits by failing to plan and perform appropriate audits and appropriate tests that would have identified Madoff’s fraud.

 

The plaintiff alleged that serving a demand on Andover’s management to prosecute these claims would have been futile because Andover and its principles were involved in wrongdoing constituting the basis of the claims. The plaintiff also asserted that it would have been futile to demand that Andover pursue claims against Ivy because Ivy’s agreement with Andover required Andover to indemnify Ivy. The plaintiff alleged it would have been futile to demand that Andover suit the auditor because Andover’s misconduct was "inextricably interconnected" with that of management.

 

The defendants moved to dismiss, arguing the plaintiff’s lack of capacity to sue; that the plaintiff’s claims are barred by New York’s Martin Act; that his derivative claims were barred by failure to make a demand on the managing member of the limited liability company and by the business judgment rule, and numerous other grounds. The auditor moved on lack of capacity and lack of proximate causation since the investment has been made before the current auditor was retained and the loss therefore could not have been avoided.

 

In its March 12, 2010 order, the court substantially denied the defendants’ motions in all material respects.

 

First, the court ruled that the plaintiff’s failure to make a demand was excused. The court reasoned that Andover Management and general partner had an interest in not being sued and an interest in protecting its principals, Ivy and its auditor from being sued, as claims against those persons "would tend to establish that Andover Management negligently breached its own fiduciary duty."

 

Second, the court ruled that the plaintiff’s claims were not barred by the Martin Act because the plaintiff’s claims do "not arise from alleged securities fraud and is not simply a securities fraud claim."

 

Third, the court also denied the defendants’ motion to dismiss plaintiffs’ gross negligence claim against Andover Management because "it may be inferred" that Andover Management "failed to exercise even slight care in failing to detect" Madoff’s fraud. It may also" be inferred" that Andover Management "showed complete disregard for Andover associates’ right and the safety of its investment."

 

In addition to its several other holdings, the court also denied the auditor’s motion to dismiss as well, observing that "the court must assume that an audit … conducted pursuant to generally accepted accounting procedure would have uncovered Madoff’s fraud" and that "a proper audit would have provided Andover with an opportunity to liquidate its investment."

 

The Andover case is not the first Madoff lawsuit to survive a motion to dismiss (see, for example, my recent post here about a dismissal motion denial in a Madoff-related case). However, it is as far as I am aware, the first dismissal motion denial in a Madoff-related derivative case and it is as far as I am aware the first dismissal motion denial in a court in New York, many of the Madoff-related cases are pending.

 

If the March 12 order is in any way indicative of the likely course of Madoff investors’ claims against feeder funds and investment gatekeepers, the investors’ litigation outlook appears favorable, at least at the dismissal motion stage. Indeed, the March 12 order fairly bristles with incredulity that the various defendants failed to take steps that, the court assumes, would have detected Madoff’s fraud.

 

But while a similar judicial predisposition might allow other claimants, like the plaintiff in this case, to survive a dismissal motion, it remains to be seen whether the claimants ultimately will be able to recover their losses or any substantial part thereof.

 

Of course, to even have any hope of any recovery, the aggrieved investors’ claims must first survive a motion to dismiss. The March 12 order in this case should be of keen interest to other Madoff claimants.

 

Special thanks to Daniel Tepper, one of the plaintiff’s counsel in the Andover case, for providing a copy of the March 12 order.

 

According to the March 11, 2010 bankruptcy examiner’s report, the collapse of Lehman Brothers was a result of the deteriorating economic climate, exacerbated by Lehman’s executives, whose conduct ranged from "serious but non-culpable errors of business judgment to actionable balance sheet manipulation."

 

The Report was prepared pursuant to a January 2009 bankruptcy court order directing the trustee to appoint an examiner to investigate the events leading up to Lehman’s collapse. The examiner appointed was Anton Valukas of the Jenner & Block law firm.

 

The full report is nine volumes long, consisting of 2,200 pages, and can be found here. The executive summary (which alone is 239 pages long) can be found here. According to news reports, Valukas spent $38 million conducting his examination. He and his team interviewed more than 100 people and scrutinized more than 10 million documents, plus 20 million pages of e-mails from Lehman.

 

The examiner’s report states that as conditions worsened during 2008 and in order to "buy itself time," Lehman "painted a misleading picture of its financial condition." For example, the report states, that while reporting a significant loss at the end of the second quarter 2008, Lehman "sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio," while failing to disclose that it had been using an "accounting device" – known as Repo 105 – that had "no substance" and whose sole purpose was to allow Lehman to "manage its balance sheet."

 

The report states that Lehman neither disclosed its use of nor "the significance of the use of the magnitude of its use of" Repo 105, to the Government, to rating agencies, to investors or even to its own Board. Its auditors were aware of but did not question the transaction. The Repo 105 balance sheet manipulation is summarized on the WSJ.com Deal Journal blog, here.

 

The examiner concluded that the business decisions that brought Lehman to a crisis "may have been in error but were largely within the business judgment rule." However, the "decision not to disclose the effects of these judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements," including CEO Richard Fuld and the company’s CFOs, Christopher O’Meara, Erin Callan and Ian Lowitt.

 

The examiner also found that there is a "colorable claim that the "sole function" of the Repo 105 transactions was "balance sheet manipulation" that "created a misleading picture of Lehman’s true financial health."

 

The examiner also concluded that there are "colorable claims" against the company’s auditor, Ernst & Young, on the grounds that it "did not meet professional standards" for its "failure to question and challenge improper or inadequate as disclosures."

 

The examiner’s report explains that the report uses the phrase a "colorable claim" to mean one for which "there is sufficient credible evidence to support a finding by a trier of fact," without presuming the finder of fact’s ultimate conclusion.

 

The examiner also reviewed the actions of Lehman’s lenders, JP Morgan and Citigroup. The report concludes that "The demands for collateral by Lehman’s lenders had direct impact on Lehman’s liquidity pool," adding that "Lehman’s available liquidity is central to the question of why Lehman failed." Citigroup, which handled currency trades for Lehman, received a new guarantee from Lehman when Lehman was already insolvent and didn’t give enough value in return, the report said. The report concludes that "a colorable claim exists to avoid the Amended Guaranty as constructively fraudulent."

　

The examiner also reviewed the acquisition of Lehman’s North American brokerage, concluding that "a limited amount of assets" belonging to Lehman were "improperly transferred to Barclays."

 

The examiner recites at the outset of the report that under the relevant bankruptcy code provisions one purpose of a bankruptcy examination is to determine the existence of "a cause of action for the estate." Given the bankruptcy examiner’s conclusion that there are colorable claims against Fuld and the other former Lehman’s officials, as well as against its outside auditor, it seems reasonable to anticipate that the next step with be the bankruptcy trustee’s initiation of claims against these individuals and the auditor.

 

By way of comparison, after the New Century Financial bankruptcy examiner issued a report issued a report critical of company officials and the company’s auditor (about which refer here), the bankruptcy trustee filed a lawsuit (refer here) seeking to hold New Century’s auditors liable. In addition, the claimants in the New Century securities class action lawsuit relied heavily on the Examiner’s findings in their amended complaint, which later suvived a motion to dismiss. I noted at the time of the dimissal that the bankruptcy examiner’s findings may have strongly influenced the court in its dismissal motion ruling.

　

General Growth Properties Settles Credit Crisis-Related Securities Suit: According to a February 23, 2010 filing in the Northern District of Illinois, the parties to the credit crisis-related securities suit arising out of the collapse of General Growth Properties has been settled for $15.5 million, subject to court approval. The parties’ stipulation of settlement can be found here.

 

The General Growth Properties suit was one of the cases first filed in late 2008 as the subprime meltdown morphed into a full blown credit crisis, as I discussed in a post at the time, here.

 

The lead complaint, which can be found here, was filed in January 2009. The plaintiffs alleged that General Growth’s survival depended on its ability to refinance in November 2008 approximately $1.5 billion of its $27 billion of outstanding debt. Ultimately the company was unable to refinance its debt and it filed for bankruptcy in April 2009. The plaintiffs essentially alleged that the eleven individual defendants misrepresented the company’s ability to refinance its debt.

 

The complaint also alleged that the company’s senior executives had improperly loaned money to certain executives so that the executives did not have to sell their company shares in a margin call. The companies also allege that the company’s officials improperly sought to have the company’s shares included in the SEC’s short selling ban, so that the officials could sell their share at inflated prices.

 

In a September 29, 2009 opinion (here), Northern District of Illinois Milton Shadur granted in part and denied in part the defendants’ motion to dismiss. According to the settlement stipulation, in January 2010, the parties submitted the case to mediation, from which the settlement ultimately resulted.

 

The General Growth suit is one of only a handful of cases filed in the wake of the subprime meltdown and the ensuing credit crisis that has reached the settlement stage, and one of only a smaller handful of cases that have been settled following a dismissal motion ruling. We undoubtedly will see more settlements ahead as more cases work their way through the system.

 

I have in any event added the General Growth Properties settlement to my list of subprime and credit crisis-related case resolutions, which can be accessed here. My recent status update on the subprime and credit crisis related securities litigation can be found here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing me with a copy of the stipulation of settlement.

 

Hello Polly: Many readers undoubtedly saw the article in yesterday’s Wall Street Journal (here) reporting that the Bank of America has apologized after its local contractor entered the home of a mortgage borrower, while she was away, and cutoff her utilities, padlocked the door and "confiscated her pet parrot, Luke." The homeowner, separated from her parrot for a week, filed a lawsuit against the bank for emotional distress.

 

This momentous story was deemed by the Journal’s editors to be worthy of a front page photograph of the homeowner, now fortunately reunited with her beloved parrot.

 

We mention this because, as was pointed out to us by a loyal reader, the Journal’s front page above- the- fold color photograph was headlined with the phrase "Hello, I Wish to Register a Complaint." We suspect that the Journal’s editors ran the picture on the front page for the sole reason that it gave them an excuse to use that headline.

 

If the topic is parrots, the only possible reference is to the immortal Monty Python dead parrot sketch, which believe it or not has its own Wikipedia page, here. The skit begins with John Cleese entering a pet shop and stating (as reflected in this script of the sketch) "Hello, I wish to register a complaint." Cleese’s problem in the sketch is not that his parrot has been confiscated; rather, his problem is that the parrot he had just purchased is dead. Deceased. It is no more. It has ceased to exist. It has joined the choir celestial. This is an ex-parrot

 

We are delighted to have this pretext to be able to embed a video of the sketch below. Because we think everyone should know a dead parrot when they see one.

 

https://youtube.com/watch?v=4vuW6tQ0218%26hl%3Den_US%26fs%3D1%26

 

For those of us who spend a lot of time looking at securities class action lawsuits, the cases often have a familiar pattern. Unfortunately, the familiarity may dull sensitivity to the allegations or even to the process itself. So it was interesting to read a layman’s reaction to a recently filed lawsuit, if for no other reason than it provided a look at the lawsuit and the process with a fresh set of eyes.

 

The lawsuit in question was filed in the Northern District of California on March 9, 2010 against Medivation and certain of its directors and offices. As is so often is the case in these kinds of lawsuits, Medivation is a life sciences company whose developmental stage product failed to meet certain clinical trial goals. Specifically, and as reflected in the plaintiffs’ lawyers March 9 press release (here), its product did not meet primary and secondary goals in a Phase 3 clinical trial for patients with mild to moderate Alzheimer’s disease. When the company announced this news, its stock price declined and the lawsuit followed. A copy of the complaint can be found here.

 

This lawsuit will work its way through the system. The lawyers involved, all of whom undoubtedly are (or when they are retained to defend will be) well versed in these things, and will raise familiar arguments that may or may not succeed. All very familiar to those of us who spend all of our time immersed in these kinds of things.

 

An interesting perspective about this lawsuit appeared on the Blogging Stocks site (here). The author, Gary E. Sattler, has a number of reactions to the plaintiffs’ complaint, summarizing his comments with the observation that "even when given my usually cynical nature, and my usual dislike for big pharmaceutical interests, I still take issue with this potential class action lawsuit."

 

After summarizing the plaintiffs’ allegations, the author notes that

 

The plaintiff class has to cross a significant threshold of proof in order to prevail in this case. Based on my reading of the original complaint, plaintiffs fail to establish intent, fail to reveal purposeful omission of fact, and fail to establish that the actions of the defendants were the true overt cause of any artificial inflation of Medivation’s stock value. Furthermore, the plaintiff’s complaint seems to disregard that Medivation has had broad yet cautious support from within the Alzheimer’s treatment community. Was it all wishful thinking? Perhaps it was, but that support came from many well-educated minds experienced in the field.

 

Sattler goes on to note that "to me, this potential class action smacks of sour grapes." He then reiterates his support for the company and for the company’s Alzheimer’s product.

 

Sattler seems to be reasonably objective (he states that he has no investment interest in the company). Of course, his rough and ready assessments have no direct relationship to how the lawsuit and its allegations might fare in court. But I have often found that the court of public opinion is an accurate sounding board. True, it might be argued that because of Sattler’s preexisting interest in the company and in its product he might be biased in its favor. But just the same it is interesting to look at the allegations through his eyes and see his reaction to the allegations.

 

When the U.S. Supreme Court first issued its opinion in Tellabs, I thought it would make little fundamental difference, because I thought that in the end and regardless of the formal standard, courts would give the green light to cases that raised a stink and would cut short the rest. Regardless of whether I am right about the Tellabs standard, I think trial courts fundamentally assess cases on a smell test, which is basically what Sattler has done in his post, albeit without specific reference to legal standards. Viewed in that light, his rough and ready assessment is interesting. And perhaps significant, at least with respect to the case’s prospects.

 

More About the FCPA: Regular readers know that I have a certain fixation about the Foreign Corrupt Practices Act. (Indeed, one reader has gone so far as to accuse me of being "obsessive" about it.) I continue to believe that the FCPA will be an increasingly important corporate exposure in the years ahead, if for no other reason than the relentless globalization of commerce.

 

For those who remain skeptical on the topic, I suggest a quick review of the March 10, 2010 post by Bruce Carton on his Securities Docket blog (here). In his post, Carton painstakingly compiles all of the recent comments by regulators corroborating that the FCPA is a top priority. He also reviews the significance of the recent Africa Sting enforcement action, as well as the implications of the Bribery Bill which may soon become law in the U.K. As Bruce’s emphasizes, there are a number of very significant implications to the Bribery Bill.

 

As Carton puts it, top FCPA lawyers agree that the anti-bribery activity has reached "a fever pitch." Whether or not I am obsessive, it is indisputably clear that FCPA related enforcement activity will be a significant area of corporate exposure in the months and years ahead.

 

A Picture is Worth a Thousand Words: Want to know what the financial crisis is all about? Check out this graphic depicting the escalating mortgage default rate during the current crisis. No interpretation required. As for myself, I am considering investing in gold. And stocking my basement with water, canned goods, matches, stout rope and a knife. You never know.

 

This Too Shall Pass: You are probably familiar with the OK Go video performed on an array of treadmills. If not, you should get out more. I’ve seen it and I have serious social issues. (See prior item). However, and in any event, everyone should watch the new video from OK Go for its new song, "This Too Shall Pass." Rube Goldberg would be impressed. Smashing pianos, crashing trash cans, smashing TV sets (showing the treadmill video, no less), the whole enchilada.

 

Though I have embedded the Rube Goldberg version below, there is an alternative spoof marching band version here that is also funny in a completely different way. (Don’t you love the Internet?) Please also see the Author’s Note below.

https://youtube.com/watch?v=qybUFnY7Y8w%26hl%3Den_US%26fs%3D1%26

　

Authors’ Note: This blog post was written in its entirety on a laptop computer while the author was sitting in Cladgagh Irish Pub in Lyndhurst, Ohio and watching Real Madrid play Lyon in a UEFA Champions League game on the television. (In an excellent game, the teams played to a 1-1 tie.)  I hope you enjoy reading this post as much as I enjoyed writing it. Gradus ad Parnassum.

 

　

It has now been over three years since the first subprime-related securities class action lawsuit was filed in February 2007, yet many of the cases filed in the ensuing litigation wave are still only in their earliest stages. While the vast majority of these cases are still unfolding, there have been some important recent developments, suggesting that the evolving litigation wave has passed some significant milestones. With that possibility in mind, it seems appropriate to check in for a status report on the subprime and credit crisis-related litigation wave.

 

 

In the latest issue of InSights (here), I take a look at the developments to date as the subprime and credit crisis-related cases have worked their way through the system, including trends in motion to dismiss rulings and settlements, as well as with respect to issues such as gatekeeper liability and defense expense costs.

Both the number of restatements and the number of companies reporting restatements are declining according to a new study. The number of restatements has been declining for three years now, and the number has declined materially since the figures peaked in 2006, both because of better controls and changing standards.

 

 

The study, by Audit Analytics, is not yet available online, but it has been widely reviewed, including in a March 4, 2010 CFO.com article (here) and a March 1, 2010 article by Matt Kelly of Compliance Week (here).

 

 

As reflected in this article, the study shows that there were just 630 companies reporting 674 accounting restatements in 2009. There were 24% fewer restatements in 2009 compared to the prior year, when there were 923. The 2009 figures represent the lowest number of restatements since 2001 (when accounting scandals dominated the headlines).

 

 

The number of restatements has actually declined for three years in a row since they reached their peak in 2006, when 1,564 companies filed 1,796 restatements. In other works, the number of restatements in 2009 was 62 percent less than the number in 2006.

 

 

In addition to the declining number of restatements, accounting errors requiring a restatement are now being caught sooner. The average restatement in 2009 covers a period of 476 days, compared to 716 days in 2006.

 

 

Restatements also reduced earnings by smaller amounts. 2009 restatements on average reduced earnings by $4.6 million, compared to $7.2 million in 2008 and $23.5 million in 2006.

 

 

The CFO.com article reports that the study’s authors attribute the decline to two factors: improved internal controls as a result of Section 404 of the Sarbanes Oxley Act, and a 2008 recommendation by the SEC’s Advisory Committee on Improvements to Financial Reporting that the SEC “relax its requirements on what types of errors should trigger restatements.”

 

 

One circumstance supporting the suggestion that SOX may be contributing to the reduced number of restatements is the fact that the majority of U.S.-based companies issuing 2009 restatements (374 out of 522) were “nonaccelerated filers,” meaning that Section 404’s requirements do not yet apply to them. Of course, there are, in fact, more nonaccelerated filers than accelerated filers in the first place, so the raw numbers alone may not tell the whole story. In addition, the smaller nonaccelerated filers simply may be more likely to have problems due to their small staffs and fewer tools.

 

 

On his Compliance Week blog, Kelly points out that the number of restatements by accelerated filers grew between 2002 and 2005, the year they had to comply with Section 404, but they have declined since that time. Kelly concludes that, despite all of the criticism of the provision, Section 404 may be working.

 

 

To those who say we had a crisis in 2008 notwithstanding Section 404, Kelly points out that the most recent crisis “has largely been a crisis of flawed assumptions and reckless risk management coming home to roost – not accounting fraud.” Kelly concludes that whatever financial reform Congress might conjure up in response to the current crisis, it is not time to “start rewriting Sarbanes-Oxley wholesale,” as “the law is working just fine.”

 

 

The suggestion that the declining number of restatements is due to SOX reforms brings to mind the long-standing question whether the changes in the number of securities class action filings are also attributable to improved company behavior as a result of SOX.

 

 

However, though the number of restatements has declined steadily, the number of lawsuits has fluctuated from year to year. Indeed, the most recent year with the highest numbers of restatements, 2006, when there were almost three times as many restatements as in 2009, there were fewer class action lawsuit filings (116) than in any year since 1996, and certainly significantly fewer filings than in 2009, when there were (depending on whose count you are using) at least 178 filings.

 

 

So there may well be fewer restatements as a result of Sarbanes Oxley, but that alone does not explain what has been happening with fluctuating securities class action lawsuit filings. Changed corporate behavior as a result of Sarbanes Oxley, even if it has occurred, is not a sufficient explanation for lawsuit filing levels. There may simply be too many other areas of corporate activity, beyond those addressed in Sarbanes Oxley, that continue to attract the unwanted attention of the plaintiff’ class action securities lawsuits.

 

 

The bottom line seems to be that as good as the news is that the number of restatements is declining, that does not necessarily mean as a general matter that companies are necessarily less likely to be sued.

 

 

An astonishing amount of litigation followed in the wake of the Madoff scandal revelations, as I have detailed here. But thought the litigation filings have surged, the question remains whether the plaintiffs’ desperate attempts to recover their losses from third parties have any chance of success.

 

This question was underscored by the March 4, 2010 ruling by a Luxembourg court that individual investors who lost money in Madoff’s scheme lack standing to sue UBS AG and its auditor Ernst & Young for losses in the bank’s LuxAlpha funds. According to news reports, the court said that the investor plaintiffs had failed to show they had suffered individual damage separate and apart from the funds themselves. They also failed to show any individual damage suffered by the alleged behavior of UBS or Ernst & Young.

 

But though the Luxembourg dismissal received widespread coverage, there was a largely overlooked earlier Madoff-related case ruling out of Florida, in which the investor plaintiffs’ claims largely survived the defendants’ motions to dismiss. (The Florida case is mentioned in a March 5, 2010 Wall Street Journal article, here, which otherwise is devoted to the Luxembourg court ruling.)

 

The Florida case arose on May 7, 2009, when seventeen plaintiffs filed a 62-page complaint in Palm Beach County Circuit Court against Madoff feeder funds Tremont Group Holdings and Tremont Partners, as well as three associated Rye Select funds. The complaint also names KPMG, which had serves as the Rye funds’ auditor, as a defendant.

 

The plaintiffs’ complaint alleges that the Tremont and Rye Select Fund defendants failed to perform their professional duties, but rather simply turned invested funds over to Madoff. The plaintiffs allege that the defendants "did not analyze Madoff, investigate his companies, conduct significant due diligence, or ensure that there were rudimentary safeguards." The plaintiffs further allege that the defendants took tens of millions of dollars in management and other fees from the funds.

 

The complaint alleges that the defendants violated Florida securities laws, committed common law fraud, negligent misrepresentation, professional malpractice and negligence. The complaint also alleges that defendants breached their contractual and fiduciary duties. The defendants moved to dismiss.

 

In a February 5, 2010 order (here), Circuit Court Judge David E. French granted in part and denied in part the defendants’ motions to dismiss.

 

With respect to the Tremont and Rye funds defendants, Judge French granted the motions to dismiss, without prejudice, as to plaintiffs’ claims of breach of fiduciary duty (Count VI), breach of statutory fiduciary duty (Count VII), breach of contract (Count XI), and adding and abetting breach of fiduciary duty (Count XII), all essentially on the grounds that the plaintiffs had failed to allege individualized injury, apart from the injuries to the funds themselves.

 

However, Judge French denied the Tremont and Rye funds defendants’ dismissal motions as to plaintiffs’ claims for violation of state securities laws (Count I), Negligence Per Se (Count II), Fraud in the Inducement (Count III), Negligent Misrepresentation (Count IV), and Deceptive and Unfair Practices (Count VIII), as these are claims where the investor plaintiffs suffered their own individual injuries.

 

Judge French also granted without prejudice KPMG’s dismissal motions as to plaintiffs’ claims for Negligent Misrepresentation (Count V), Professional Malpractice (Count X) and Aiding and Abetting Breach of Fiduciary Duty (Count XIII), but denied KPMG’s dismissal motion as to plaintiffs’ allegations against KPMG for deceptive or unfair practices (Count IX).

 

While the defendants’ dismissal motions were granted in part, substantial portions of the plaintiffs’ complaint survived and the case will now go forward, showing that at least some Madoff victims may be able to allege claims sufficient to survive initial dismissal motions.

 

The February 5 ruling seems significant because as far as I am aware it represents the first instance in which a private plaintiff against a Madoff feeder fund has survived a motion to dismiss.

 

To be sure, on February 8, 2010, New York Supreme Court Judge Richard B. Lowe III did enter an order (here), denying the defendants’ motions to dismiss in the New York Attorney General’s civil fraud lawsuit pending against Ezra Merkin and his Madoff-related feeder funds. But the Florida ruling is the only ruling of which I am aware in which a private plaintiff lawsuit against a Madoff feeder fund has survived a dismissal motion and will be going forward.

 

Obviously, the massive amount of Madoff-related litigation will continue to grind through the courts for years to come. The Florida decision shows that plaintiffs may be able to survive dismissal motions in at least some of these cases. Of course, whether the plaintiffs will ever recover even a very small part of their losses remains to be seen.

 

Special thanks to a loyal reader for calling my attention to the Florida decision and providing me with a copy of the opinion.

 

Class Act on the Danube: Here at The D&O Diary, we scour the globe looking of interest for our readers. By way of example, we refer readers to the article that appeared in the March 8, 2010 issue of the Budapest Business Journal (here), in which it is reported that "a revision to the standing civil code will shortly introduce class action lawsuits to the Hungarian legal system and already has a number of nongovernmental interest groups revving up to start the proceedings."

 

The prospects for class litigation outside the U.S. apparently continue to spread. Everyone here will remain vigilant.

 

If You Are Even Thinking about Starting a Blog: As we have pointed out before, a blog is a harsh mistress, as we know all too well. However, there may be those at this very moment who may be thinking about starting a blog. For all the aspiring bloggers, we recommend an essay by Mark Herrmann (now an ex-blogger since relinquishing his role as co-author of the essential Drug and Device Law Blog) in the Winter 2010 issue of the ABA Section of Litigation Journal entitled "Memoirs of a Blogger" (here, hat tip to the WSJ.com Law Blog).

 

Although much of the article is focused on the question whether a law blog is a good idea for a big firm attorney, there are many more universal truths as well. Among other indispensible pointers with which we concur, Herrmann states: "If you’re thinking of launching a legal blog, have your eyes open. Once you launch a blog, you will face the relentless, mind-numbing, never-ending task of finding worthwhile material to publish. That burden begins on the day of your first post, and ends only the day you call it quits."

 

Amen, brother.

 

And along those lines, everyone here at The D&O Diary is always grateful when readers send along blog ideas and suggestions. We get our best material from readers, so please let us know if you see anything interesting out there.

 

The SEC first acquired the right to impose civil penalties against corporations in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. Since the Remedies Act was enacted, the SEC has struggled with the question of when it is appropriate to obtain money penalties from corporate issuers.

 

In January 2006, in order to put some clarity around the issue of corporate penalties, the SEC issued its Statement of the Securities and Exchange Commission Concerning Financial Penalties (here). More recently, the sharp questions of a prominent federal judge have put a harsh spotlight on the SEC’s practices regarding corporate money penalties. In light of these questions, it is hardly surprising that the SEC might feel compelled to reexamine its practices for the imposition of penalties on corporations.

 

In a recent speech, current SEC Commissioner Luis Aguilar has proposed revising the guidelines in order to put the "appropriate focus" on the issue of deterrence. However, for reasons discussed below, I question whether Commissioner Aguilar’s position is necessarily the best approach to accomplish the desired goals.

 

Background

In the 2006 Statement, and after reviewing the legislative history of the Remedies Act, the SEC articulated a standard whereby the question of the appropriateness of a corporate penalty turns on two considerations: "the presence or absence of a direct benefit to the corporation as a result of the violation," and "the degree to which the penalty will recompense or further harm the insured shareholders." The Commission also identified seven additional factors that are also "properly considered," including "the need to deter the particular type of offense."

 

In a February 6, 2010 speech (here), SEC Commission Luis Aguilar characterized the 2006 Statement as a "misguided approach." The "serious flaw" in the Statement’s approach, he said, is that "the conduct itself becomes of secondary importance." Aguilar contends that the Commission "fails to appropriately focus on deterrence." He called the Commission to promptly revisit the 2006 guidelines go that penalties are refocused on their "purpose," which is to "deter and punish misconduct."

 

A March 6, 2010 Wall Street Journal article further discussing Aguilar’s views can be found here.

 

Discussion

In the current environment, Aguilar’s desire to focus the Commission’s enforcement efforts on the deterrence of future misconduct is both appropriate and commendable. However, that does not necessarily mean that the imposition of penalties on corporations is the appropriate means to that goal or even that the 2006 Statement needs to be revisited.

 

First, upon review of the 2006 Statement, it is clear that in devising the current guidelines, the Commission took significant pains to consider and to try to implement the considerations expressed in the legislative history of the Remedies Act, particularly the relevant Committee Report. Whatever Aguilar’s views may be, the current guidelines track the sentiments expressed in the Committee Report.

 

The second problem with Aguilar’s view is that, at least as expressed in his recent speech, it appears that his proposed approach simply disregards the fundamental problem with corporate penalties, which is that in many instances the penalties inappropriately harm the company’s current shareholders.

 

In that respect, the timing of Aguilar’s speech advocating the use of corporate penalties for deterrence purposes is more than a little odd, coming as it does so closely on the heels of Southern District of New York Judge Jed Rakoff’s highly publicized questions of the proposed settlement of the SEC’s enforcement action against the Bank of America.

 

Readers will recall that in his blistering September 14, 2009 opinion (here), Judge Rakoff rejected the SEC’s proposed $33 million settlement, on among other grounds that the proposed settlement "does not comport with the most elementary notions of justice and morality" because it "proposes that shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for the misconduct."

 

In response to the SEC’s argument that the proposed settlement "sends a strong signal" and "allows shareholders to better assess the quality and performance of management," Judge Rakoff said that

 

the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion dollar purchase of a huge, nearly bankrupt company, need to lose another $33 million of their money in order to "better assess the quality and performance of management" is absurd.

 

Judge Rakoff did subsequently approve a $150 settlement of the SEC enforcement action, but essentially as an act of judicial restraint and only while the Court was "shaking its head." Rakoff called the settlement "half-baked justice at best."

 

Judge Rakoff’s strong words seemingly challenge the very idea of corporate penalties, both because of the burden they impose on corporate shareholders and because the disconnect between penalties and the possibility of deterrence. In the immediate aftermath of the questions surrounding the BofA settlement, Aguilar’s advocacy of corporate penalties as a way to achieve deterrence seems both off-key and tone deaf.

 

We can all agree, as Aguilar proposes, that misconduct should be punished and deterred. However, it does not follow that the imposition of corporate cash penalties is the best or even a potentially well-calibrated means to try to achieve those goals. Indeed, as Judge Rakoff’s comments suggest, the problem with corporate penalties is that both the punishment and the putative deterrence are misdirected. Indeed, the notion that penalties paid out of the assets of one corporation will deter future misconduct by another corporation seems both abstract and unpersuasive.

 

Viewed in this light, the principles articulated in the Committee Report accompanying the Remedies Act, as implemented in the 2006 Statement, arguably represent an appropriate balancing of the considerations that should be taken into account in connection with the imposition of corporate penalties – including in particular the question whether the proposed corporate penalty "will recompense or further harm the injured shareholders."

 

My further concern about Aguilar’s initiative to try to ramp up corporate penalties is that his proposal arises at a time when the SEC is desperate to reestablish its regulatory credentials. One danger is that in its eagerness to look tough that SEC might try to extract enormous penalties from corporate treasuries while accomplishing little except the addition of unnecessary and unwarranted costs on beleaguered companies and their long-suffering shareholders (which is in fact the very thing that troubled Judge Rakoff).

 

The bottom line for me is that in the wake of the pointed questions that Judge Rakoff raised in the BofA enforcement action, this is a very odd time for any SEC Commissioner to be advocating increased corporate penalties as a likely or even promising way for the SEC to best accomplish its goals.

 

Just Visiting this Planet: In her latest email epistle, our globetrotting eldest daughter, now working in Quito for a nonprofit organization, passed along the following observation about a recent therapy session for refugee women she attended:

 

I was oddly reminded of the time at the neighborhood barbeque in Hokkaido with the inebriated  Japanese grandpas who wanted to sing Billy Joel. Totally unrelated to Spanish-speaking refugee women discussing how being a refugee increased their stress and messed up their female biorhythms. I think I drew the connection in my mind because of the "where on earth have I ended up" feeling I had both times.

　

Time-honored legal principles typically shield corporate officers and shareholders from direct personal liability for legal violations of the corporation itself, consistent with the notion that the corporation itself has a distinct and separate legal identity. However, as I noted in a prior post (here), courts have evolved a concept called "the responsible corporate officer doctrine," pursuant to which individuals can be held liable for corporate misconduct without involvement in or even awareness of the wrongdoing. Recent indications suggest that regulatory authorities may be planning a more aggressive use of this doctrine, a development that may have disturbing implications.

 

The responsible corporate officer doctrine was first articulated by the U.S. Supreme Court in the 1943 case of United States v. Dotterweich, in which corporate officers in positions of authority were held personally (and in that case, criminally liable) for violating strict liability statutes protecting the public welfare.

 

The Supreme Court approved the application of liability under the Food, Drug and Cosmetic Act (FDCA) in the 1975 case of United States v. Park holding that the FDCAs "requirements of foresight and vigilance" are "no more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and wellbeing of the public that supports them." The Supreme Court approved the imposition of liability in that case, though the defendant had no involvement in or personal knowledge of the violation.

 

The responsible corporate officer doctrine has been absorbed into environmental law as well, and, as discussed here, and has served as the basis of imposing liability in environmental enforcement actions.

 

According to a March 5, 2010 memo from the Skadden law firm entitled "FDA Announces New Push to Prosecute Corporate Officers and Executives for No-Intent Crimes" (here), the FDA, under fire for lack of active oversight of its office of criminal investigations, has advised Congress that it intends to "increase the appropriate use of misdemeanor prosecutions…to hold corporate officials accountable." The law firm memo suggests that this FDA statement to Congress is consistent with the "recent uptick" in prosecutions relying on the responsible corporate officer doctrine against pharmaceutical and medical device executives.

 

The responsible corporate doctrine unquestionably is a well-established tool for the imposition of liability on corporate officials in the context of public "health and wellbeing." But though well-recognized, it nevertheless has disturbing implications. The FDA’s apparent intention to use the responsible corporate officer doctrine more aggressively arguably is part of a larger and even more disturbing trend to try to hold corporate officers liable without regard to personal culpability.

 

First, the idea that liability can be imposed on an individual for corporate misconduct, in apparent disregard of the corporate form and without culpable involvement or even a requirement of a culpable state of mind, seems inconsistent with the most basic concepts surrounding the corporate form. The doctrine arguably imposes liability for nothing more than a person’s status. The word "responsible" in the doctrine’s name does not mean that the individual is responsible for the misconduct, but on that that the individual is responsible for the corporation.

 

Second, the application of the doctrine can have serious ramifications. The Skadden memo points out that in one recent FDCA prosecution, the individuals against whom liability was imposed on the basis of responsible corporate officer doctrine were required to pay criminal fines of $34.5 million (The imposition of liability is currently on appeal.) The imposition of criminal penalties of this extraordinary magnitude without any fault or even culpable state of mind seems fundamentally inconsistent with the fault-based framework of our criminal justice system.

 

But the most troubling thing about the responsible corporate office doctrine is that the apparently expanded willingness of regulators to use the doctrine to impose liability on corporate officials is entirely consistent with developments elsewhere that also suggest a willingness of government regulators to try to impose liability without regard to involvement of awareness of the alleged wrongdoing.

 

In that regard, there have been at least two instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged legal wrongdoing. Though these regulatory enforcement actions did not expressly rely on or even refer to the responsible corporate officer doctrine, the enforcement actions implicitly reflect a similar presumption, which is that in certain instances corporate officials can be held liable solely on the basis of their position without respect to the presence or absence of personal culpability.

 

First, as noted here, the SEC has initiated an enforcement action against the former CEO of CSK Auto, in which the SEC seeks to "clawback" compensation the CEO earned at a time with respect to which the company subsequently had to restate its financial statements. The SEC is pursuing this claim even though the former CEO is not only not charged with fraud, but is not even alleged to have had any involvement in or even awareness of the circumstances requiring the later restatement.

 

Similarly , the SEC more recently filed an enforcement action seeking impose control person liability on two officer of Nature’s Sunshine Products, in which the SEC sought to hold the individuals liable for the company’s Foreign Corrupt Practices Violation, though the individuals were not alleged to have had any involvement in or awareness of the wrongful conduct. The Nature’s Sunshine Products case is discussed here.

 

Though these recent SEC enforcement actions did not expressly rely on the responsible corporate officer doctrine, the SEC’s actions in these cases reflect a willingness – similar to that of the FDA and other regulatory authorities — to impose liability on corporate officials without regard to fault or culpability. These regulatory actions raise a very disturbing specter of strict liability for executives.

 

Even if there are circumstances where, as the U.S. Supreme Court has long recognized, that public health and welfare may justify the imposition of liability without culpability under certain circumstance, the enormous burden this possibility would impose on the civil rights and liberties of the affected individuals would seem to argue that these principles be used to impose liability on individuals only in the rarest and most extreme purposes.

 

But rather than restrict its use of these principles out of an appropriate respect for basic notions of fairness and individual liberty, regulators are moving in the exact opposite direction and apparently seeking new opportunities to use these principles to expand their regulatory reach.

 

The regulators may well feel this approach may be justified in order to accomplish regulatory goals and ensure that somebody pays the price for wrongdoing. The problem is that scapegoating individuals for misconduct in which they were not involved and of which they were not even aware is fundamentally unfair. In my view, this approach is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

 

If there are circumstances where public health and welfare might sometimes require the imposition of responsibility on a strict liability basis, the use of those circumstances should be infrequent and unusual. Regulators should be looking for ways to avoid relying on these powers rather than looking to expand their use. The imposition of penalties without regard to fault or culpability is a fundamentally unfair practice that should be discouraged at every possible opportunity.

 

During his long and provocative legal career, former class action securities litigator and convicted felon Bill Lerach was a self-selected lightening rod for controversy. He taunted his foes, stalked his enemies, challenged convention, and in the process transformed himself into a larger than life figure.

 

And so when his legal career collapsed among revelations that he and his colleagues had paid improper kickbacks, the post-mortems almost inevitably reflected much of the same mythmaking hyperbole that Lerach himself generated. Lerach became a stock figure in a morality tale, in which the angry, defiant mortal is struck down for his pride.

 

The reality is that Lerach’s tale is so much more interesting that this stock narrative frame. And is certainly a tale worth telling, as demonstrated in the marvelous new book entitled "Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to Its Knees," written by two Pulitzer-prize winning journalists, Patrick Dillon and Carl Cannon. (Full disclosure: Carl is an old family friend, but I feel comfortable in saying I would have liked the book every bit as much if Carl and I had never met.)

 

The authors explain in their Prologue that initially, Dillon had intended to co-author a book with Lerach, but that project got waylaid when it became clear that Lerach’s legal difficulties were serious. Though the project moved into an unanticipated direction as a result of these events, Lerach continued to cooperate with the authors, right up to making himself available for interviews from prison.

 

The authors ask themselves why Lerach cooperated with them, and they confess they are not entirely sure. I was initially concerned the book might shade in Lerach’s favor or even fall into myth-making trap. Make no mistake, however, the authors fully and damningly document all of Lerach’s most outrageous flaws and faults.

 

The authors open their book at the point where Lerach’s many shortcomings have finally caught up to him, at the court hearing in October 2007 when Lerach pled guilty to one count of obstruction of justice. Then, to discern how the career of one of the most influential lawyers of our time could have come to this, the authors then trace his career from its very beginning, including his childhood in Pittsburgh and his early legal career with the Reed Smith firm. A case in which Lerach was involved for Mellon Bank took both took Lerach to San Diego and also introduced him to Mel Weiss, his law partner whose fame, fortune and fate would follow its own parallel trajectory.

 

Lerach’s skill and his excesses emerged in his first successful case in San Diego, in which he represented a group of retirees against the Methodist Church. Lerach’s legal performance was by all accounts brilliant, and produced a great result for his clients. But, the authors note, "along with the good came the other things: the hubris, the taunting, the acrimony with the opposing side, the hyperpartisanship borne of the Manichean world view."

 

Following after this victory, Lerach sooned carved out a career for himself as the high-profile scourge of Corporate America, and at the same time becoming the poster child for class action excesses. This list of companies Lerach ultimately sued reads like a membership list for the U.S. economy. Lerach became feared and reviled. And he also became enormously rich.

 

Despite (or perhaps because of) his enormous success, the weaknesses Lerach had shown in the Methodist Church case clearly could at times consume him. This is perhaps nowhere as evident as in his mad, ill-fated bid to avenge himself on Daniel Fischel, who had testified as a witness for the defense in the Nucor case. Lerach blamed Fischel for his stinging defeat in that case. When Lerach later filed a suit against Charles Keating in connection with the Lincoln Federal scandal, Lerach named Fischel and his firm as defendants. Though the claim was later compromised (in a "disposition," not a "settlement") Fischel never forgot the many outrageous things Lerach said along the way (many of which cannot be reproduced in this family-oriented blog).

 

In the end, Fischel was the one to get revenge. His subsequent slander suit against Lerach and his firm resulted in a $45 million verdict in his favor, and while the unresolved punitive damages phase was pending, the law firm agreed to pay $50 million to resolve the whole thing, agreeing even to have the settlement funded, in cash, that same day. There is something about this whole sequence of events that encapsulates so much about Lerach — the excess, the outrageousness, and the way in which his own conduct caused him so much damage.

 

The book’s authors are not lawyers, but I think they deserve high marks for the way they deal with the legal topics. They also deserve credit for their appreciation of the atmosphere that Lerach’s excesses generated and how it influenced other participants in the process.

 

For example, the authors perceptively note that many of Lerach’s targets felt compelled to capitulate rather than confront a mad man – yet, the authors note, many of the companies who were unwilling to give in managed to walk away paying nothing. The lesson that the authors drew was that "if you really had done nothing wrong, it made sense to fight these class action securities cases in court. If more firms had done this successfully, there likely would have been fewer plaintiffs’ lawsuits."

 

The authors, unlike many other journalists that traverse this ground, also demonstrate an appreciation for the complex role that D&O insurance plays in the process, and indeed, that the actions and activities of class action attorneys have on the D&O insurance marketplace.

 

But what the authors do best, and what makes this book worth reading, is the way they weave the story of the criminal investigation through the massive corporate scandals, which were unfolding at the same time. The authors also methodically show how so much of Lerach’s crusading activities depending on his firm’s corrupt system for procuring plaintiffs on whose behalf to bring the suit, as well as on the testimony of a corrupt expert witness.

 

Many of the details of the criminal investigation may be familiar to many readers. The almost unbelievable way that a lover’s quarrel in Cleveland triggered a sequence of events that ultimate brought down Bill Lerach and Mel Weiss has been told elsewhere. The authors retell these tales particularly well. But what makes their version so compelling is the way the authors overlay events that were going on at the same time, particularly Lerach’s representation of the Enron litigants and his dispute with Weiss over the WorldCom case.

 

Frankly, Lerach’s contributions also help make the story compelling. His involvement provides a narrative tone and personal focus that bring the events to life. Lerach does not come off sympathetically, but he does come off as a real person – corrupt, deeply flawed, but real. As the authors say toward the end of their book, "Bill Lerach was no monster, but he had indeed gone after fraud by using fraud."

.

The much-anticipated annual letter to Berkshire Hathaway shareholders of its Chairman Warren Buffett has long been valued for its business insights and occasionally humorous tone. The 2009 version, which was released on Saturday February 27, 2010, and which can be accessed here, is no exception, though the expanding size of Berkshire’s business portfolio has reduced Buffett’s discussion of many company operations to just a few sentences and left relatively little space for his usual commentary.

 

Buffett does manage to work in some choice observations about the responsibilities of financial institutions’ senior officials for their companies’ collapses, and also about boards’ responsibilities in the M&A context.

 

For many readers, the 2009 version may be noteworthy for the things it does not discuss. For example, the 79-year old Buffett has nothing to say about leadership succession planning at the company (although the February 27, 2010 Wall Street Journal does fill the gap somewhat with an interesting article, here, about possible Buffett successor David Sokol, the Chairman of MidAmerican Energy)

 

Buffett also has nothing to say about recent events of keen interest to Berkshire’s shareholders, including the company’s addition to the S&P 500 and its loss of its triple-A financial rating (owing to the company’s deployment of cash for its largest-ever acquisition of Burlington Northern Santa Fe).

 

But despite the omissions, there is still much of interest in this year’s letter. Full disclosure: I hold BRK.B shares, although not nearly as many as I wish I did. (Actually, I do own more shares than I used to, due to the January 2010 50-for-1 split of the B shares.)

 

Buffett on Boards of Directors

For readers of this blog, the most interesting comments in this year’s letter are Buffett’s remarks about senior management of the financial institutions at the center of the global financial crisis. Buffett prefaces his comments by stating that he would never "delegate risk control," going on to contend that "in my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control."

 

Buffett not only suggests that corporate leaders should have full responsibility, but that there should be liability consequences for failure. Buffett says that if the CEO "fails" at risk control, "with the government thereupon required to step in with funds or guarantees," the "financial consequences for him and his board should be severe." Buffett notes that it has "not been shareholders who have botched the operations of some of our country’s largest financial institutions," yet they have had to "bear the burden" caused by the management errors. Despite shareholder losses, "the CEOs and directors of the failed companies … have largely been unscathed."

 

Buffett proposes that "the behavior of the CEOs and the directors needs to be changed," and they way to do that he suggests is to ensure that if "institutions and the country are harmed by their recklessness," then "they should pay a heavy price – one not reimbursable by the companies they’ve damaged or by insurance." Senior managers have long enjoyed "oversized financial carrots," now their employment arrangements should now include "meaningful sticks."

 

Buffett’s grumpy ruminations about board behavior don’t stop there; later in his letter, he returns to the boardroom context to discuss board functioning in the M&A context. He notes, based on his "more than fifty years of board membership," that directors often are "instructed" by "high-priced investment bankers (are there any other kind?)" on the value of a proposed acquisition target. But "never" has he heard investment bankers "or management!" discuss the "true value of what is being given" for the acquisition when company stock is being used to finance the acquisition.

 

Buffett proposes, as the only way to get "a rational and balanced discussion," that directors hire a "second advisor to make the case against the proposed acquisition," with the advisor’s fee "contingent on the deal not going through." He concludes with an observation about the way deal advisors typically function by the aphorism "Don’t ask the barber whether you need a haircut."

 

 

Buffett on Berkshire’s Investments

Overall, Buffett’s letter is upbeat, as might be expected in a year in which his company’s net worth rose $21.8 billion and income rose 61 percent to $8.06 billion. (This after the company reported in 2008 its worst results ever, due to the effects of the global financial crisis.)

 

Buffett is particularly chipper in talking about the performance of the company’s investments. He notes that the company has "put a lot of money to work during the chaos of the last two years," adding that its been an ideal period for investors" because "a climate of fear is their best friend."

 

The tale of Berkshire’s recent cash deployment is truly remarkable. The company entered 2008 with $44.3 billion in cash and cash equivalents, and during 2008 and 2009 the company retained an additional $17 billion in earnings. Nevertheless, by the end of 2009, the company’s cash pile was "down" to $30.6 billion (with $8 billion of that earmarked for the Burlington Northern acquisition) – implying a net cash outflow of $47.6 billion, or as much as $55.6 billion if the Burlington Northern obligation is taken into account.

 

Where has the cash gone? Well, in addition to the massive Burlington Northern deal and other items, the company invested an absolutely astonishing $22.1 billion in non-traded securities of just five companies: Dow Chemical, General Electric, Goldman Sachs, Swiss Re and Wrigley. Under the heading "that’s why he’s Buffett and you’re not," it should be noted that these investments (which cost $22.1 billion) have a carrying value of $26 billion and also deliver an aggregate $2.1 billion annually in dividends and interest (or roughly 10% of cost annually, meaning the investments will pay for themselves in about 7.2 years).

 

Moreover, these massive purchases are far from the only investment successes on Buffett’s scorecard. Berkshire’s $232 million investment in 2008 in Chinese battery maker BYD Company is now worth $1.9 billion. Buffett also accumulated corporate and municipal bonds in 2009, which he called "ridiculously cheap." But, he wrote "I should have done far more. Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble."

 

Not all of Buffett’s financial moves have been funded out of cash; the company also sold some investments, including in particular its holdings in Conoco Phillips, Proctor & Gamble and Moody’s. Each of these investment sales is interesting in its own way.

 

In his 2008 letter, Buffett cited his mid-2008 purchase of ConocoPhillips as one the "dumb things" he had done during the year, referring specifically to the purchase as a "major mistake of commission" because he bought the shares at their peak. Berkshire’s P&G holdings were the result of P&G’s acquisition of Gillette, which had been a major Berkshire holding for many years prior to that. Buffett seemingly was less interested in holding the shares of the more diversified company.

 

The sale of the Moody’s shares is perhaps the most interesting move, as the company’s Moody’s position had been a prominent part of its portfolio for many years. Moody’s share price has plunged during the last couple of years as a result of controversies surrounding the company’s ratings of subprime-related investments. Buffett has plenty to say in his 2008 letter about the excesses that cause the subprime meltdown, but even then he omitted any mention of Moody’s. Perhaps his sale of the company’s shares, even if accomplished without comment or observation, is the most eloquent statement he could make. (As an aside, in April 2009, Moody’s downgraded Berkshire from its highest investment rating.)

 

Buffett on Berkshire’s Balance Sheet

Though Buffett says nothing about the company’s loss of its triple-A financial rating, he has a great deal to say (perhaps defensively?) about the company’s financial strength. He emphasizes that "we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity."

 

He goes on to comment, somewhat triumphantly, that "when the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity to the system, not a supplicant." adding that "at the very peak of the crisis we poured $15.5 billion into a business world that could otherwise look only to the federal government for help."

 

Buffett on Berkshire Shareholders

As I have previously noted (here) about Buffett’s essays to Berkshire shareholders, one of the not so subtle goals of his missives is to try to ensure that the company has the right kind of shareholder – that is, investors willing to take a long-term view and patient enough to await long-term results. Due to the Burlington Northern acquisition (and the split of the company’s B shares), Berkshire now has many new shareholders, and in his 2009 letter, Buffett is trying to school these new owners on what he hopes for from them

 

Buffett is very explicit that he wants to "build a compatible shareholder population." On that topic, Buffett sounds some themes that will be familiar to regular readers of Buffett’s letters. He warns his new shareholders that "investors who buy and sell on media analyst commentary are not for us." Rather, Buffett wants "partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand."

 

Buffett on Berkshire’s Businesses

Much of the balance of Buffett’s letter is given over to a review of the operating companies’ performances. With a few exceptions (such as his lengthy exegesis of the systemic challenges facing mobile-home manufacturer Clayton Homes), most of his company-specific reviews are quite brief. Indeed, many Berkshire businesses are not even motioned in the letter. As Berkshire has enveloped more and more companies, the kind of meaningful review Buffett claims to want to provide investors has been increasingly more challenging.

 

Readers of this blog undoubtedly will be interested in Buffett’s review of Berkshire’s massive insurance businesses, which continue to perform magnificently, collectively producing over $1.5 billion in 2009 calendar year underwriting profit despite prevailing soft market pricing conditions. This continued underwriting profitability, even if not shared equally by all of Berkshire’s insurance competitors, virtually ensures that the soft market conditions will continue until either pricing collapses to the point where profit is simply no longer possible or some external event intervenes to overwhelm industry profitability.

　

Discussion

Some may find Buffett’s harsh words about CEOs and corporate boards alarming. His suggestion that company officials should be held liable for the harm they have caused, without benefit of indemnity or insurance, will strike fear into the hearts of company officials everywhere. It is particularly noteworthy that his prescription for individual liability is not limited just to CEOs but expressly extends also to members of the company boards.

 

However, a careful reading of suggests that these remarks may represent less of a threat to corporate officialdom that might appear at first blush. For example, it is clear that his remarks refer to officials at companies whose woes have required a government bailout. His suggestion of direct personal liability without benefit of indemnity or insurance is made with reference to misconduct that causes harm both to "institutions and the country." So, before anybody hits the panic button, Buffett is not necessarily suggesting that indemnification and insurance are never appropriate for corporate officials, but perhaps only when the officials’ misconduct has necessitated a government bailout.

 

But just the same, Buffett’s comments that corporate officials (including, apparently members of boards of directors) should not have recourse to insurance undoubtedly will make some board members uneasy – not to mention how uncomfortable it makes those of us who make our living in the D&O insurance industry.

 

Buffett’s plan for building a shareholder base built on owners who buy into Berkshire’s long term philosophy is commendable. However, as Berkshire has grown, this aspiration may be less realistic. Buffett may want partners invested "in a business they themselves understand" but the reality is that Berkshire may have grown beyond the point where the typical investor can fully appreciate and understand its business.

 

The fact is that much of this year’s letter seems a mile wide and an inch deep – indeed, at one point, he simply lists the names of companies, without any further gloss or detail.

 

Buffett’s description of the results of Berkshire’s insurance businesses is a good illustration of the challenge facing Berkshire’s new shareholders. Buffett is lavish in his praise of Ajit Jain and his thirty person operation. Indeed, Buffett adds the humorous aside that if he, Berkshire Vice Chair Charlie Munger and Ajit were in a sinking boat, "and you can save one of us, swim to Ajit."

 

But as for what Ajit’s 30 person team does to produce hundreds of millions of dollars of profit, shareholders are left with cryptic comments like this statement: "During 2009, he negotiated a life insurance contract that could produce $50 billion in premium for us over the next 50 or so years." Seems kind of important, but as for what kind of risks or uncertainties it involves, Buffett has little to say, because he has already moved on to the next topic.

 

The next topic, in fact, is another Berkshire insurance business, Gen Re, which prior to the Burlington Northern acquisition was Buffett’s largest ever acquisition and Berkshire’s largest operating division. Buffett spares only 125 words for Gen Re, 48 of which are actually about Gen Re’s European subsidiary Cologne Re.

 

Buffett also has relatively little to say about Berkshire’s derivatives exposures, other than to defend these complex transactions that cause Berkshire’s reported results to swing by billions from quarter to quarter. I hope that those of us who can recall that Buffett himself called derivative contracts "weapons of financial mass destruction" can be forgiven for feeling less than entirely comfortable with Buffett’s hasty sketch of Berkshire’s derivatives exposure.

　

Buffett says that "Charlie and I avoid businesses whose futures we can’t evaluate." Some of Buffett’s shareholders may wonder how in the world they are supposed to evaluate the future of a company that is entering massive, complex multi-decade financial commitments but whose leadership will be in place for only a few more years. Despite all of Buffett’s earnest attempts to educate Berkshire’s owners, current and prospective investors may simply have to take it on faith – which certainly does shine a harsh spotlight on that unanswered leadership succession issue.

 

But for all of that, the annual letter is not a disappointment. It continues to be worth waiting for. Buffett did manage to work in the zingers about corporate responsibility. And he even slipped in some of his signature humor. My personal favorite in this year’s letter is his remark, made as a demonstration of Prussian mathematician Jacobi’s inversion principles, that if you "sing a country song in reverse … you will quickly recover your car, house and wife." He ends his letter, with its extensive discussion of the Burlington Northern acquisition, with a postscript suggesting that visitors attending the May shareholders meeting should "come by rail."