The Supreme Court’s decision in the Iqbal case earlier this year has generated a great deal of controversy and comment and even a proposal to overturn the decision legislatively. Iqbal does seem to be having an impact on a number of cases. An interesting question, however, is whether the Iqbal case will have an impact on federal securities cases, given that the securities laws already have their own separate heightened pleading standards. But a recent Eighth Circuit decision, applying Iqbal to affirm a lower court dismissal, suggests that Iqbal could indeed have an impact in damages actions under the federal securities laws.

 

Background

First, some background. Fed. R .Civ. P. 8(a)(2) requires that a "claim for relief" must contain a "short plain statement of the claim showing that the pleader is entitled to relief." Historically, courts had come to use the shorthand phrase "notice pleading" to describe the requirements under this rule.

 

In the Supreme Court’s 2008 Twombley case (here), the Court said that in order to satisfy these pleading requirements, the complaint must contain sufficient factual matter, accepted as true, to "state a claim to relief that is plausible on its face."

 

In the 2009 Iqbal case, the claimant in a Bivens action had sought to argue that Twombley’s "facial plausibility" test should be limited to the pleadings made in the context of an antitrust dispute, as had been involved in Twombley. The Supreme Court held that the argument  that Twombley was limited to antitrust actions "is not supported by Twombley and is incompatible with the Federal Rules of Civil Procedure." Twombley, the Iqbal court said, "expounded the pleading standard for all civil actions."

 

The Iqbal decision that the "facial plausibility" pleading sufficiency test applies to all federal civil actions has been the subject of a great deal of heated discussion. It has been criticized in many quarters. For example, in a September 3, 2009 article entitled "Plausibility Pleading Revisited and Revised: A Comment on Ashcroft v. Iqbal" (here), Boston University Law School Professor Robert G. Bone argues that Iqbal "takes Twombley’s plausibility standard in a new and ultimately ill-advised direction." Seton Hall Law Professor Edward Hartnett, less critical of the decision, argues in his recent paper (here) that Twobley and Iqbal can and should be "tamed."

 

Twombley and Iqbal have thir supporters. Fellow bloggers Mark Herrmann and James Beck argue on their Drug and Device Law Blog (here) that:

  

There’s nothing radical about requiring a plaintiff to have sufficient facts to plead a prima facie case before the courts will entertain the lawsuit – and that goes for all forms of litigation. It’s simply a construction of the language of Rule 8 "short and plan statement" that emphasizes "statement" a little more and "short" a little less. It’s about time, we think, that courts adopt a construction of the Rules that favors reduced, rather than expanded, litigation.

 

Whether Twombley and Iqbal are generally viewed as good or bad developments largely seems to depend on where your starting point is. But regardless of whether they are good or bad, the cases are having an impact in the lower courts, as Beck and Herrmann underscored in their more recent Drug and Device Law Blog post (here) detailing developments, by way of illustration, in recent medical device cases applying Twombley and Iqbal.

 

These practical impacts have registered with the plaintiffs’ bar, and indeed a September 21, 2009 Law.com article (here) discussed how civil rights and consumer groups and trial lawyers have been meeting to discuss ways to undo Iqbal. According to the article, Iqbal has already had a very significant impact – it has "already produced 1,500 district court and 100 appellate court decisions."

 

These groups have already managed to get proposed legislation introduced in Congress seeking to have Iqbal overturned. On July 22, 2009, Senator Arlen Specter introduced Senate Bill 1504, "Notice Pleading Restoration Act of 2009," which basically provides that courts shall not dismiss a complaint except under the notice pleading standards applicable under Supreme Court precedent prior to Twombley.

 

Whether this legislative effort will go anywhere remains to be seen. Congress has rather a full plate these days, and a bid to adjust a narrow feature of civil pleading standards may not make the cut. On a related note, according to a Point of Law blog post (here), there will be a House hearing on October 27, 2009 on the topic of "Access to Justice Denied – Ashcroft v. Iqbal."

 

Impact on Securities Cases?

Whatever the impact of Iqbal may be in other contexts, it has seemed an uncertain question whether Iqbal will prove to have a substantial impact in damages actions under the federal securities laws, due to the fact that the securities laws already have their own particularized pleading standards. Indeed, under the PSLRA, there are very specific requirements regarding what must be pleaded with respect to misleading statements or omissions and with respect to the required state of mind. The Supreme Court’s 2008 decision in the Tellabs case even further underscored the degree of specificity required to satisfy the state of mind pleading requirements.

 

Given these very specific statutory requirements applicable to the federal securities laws, it could be argued that the more generalized pleading requirements expounded in Twombley and Iqbal might have relatively less impact in the context of a damages action under the federal securities laws. However, a recent decision from the Eighth Circuit suggests that Iqbal could have an impact in securities cases after all.

 

In an October 20, 2009 decision in McAdams v. McCord (here), the Eighth Circuit was reviewing an appeal of a district court’s dismissal of the securities class action lawsuit that have been filed against Moore Stephens Frost (MSF), the outside auditors of UCAP. The district court had held that the complaint "failed to plead with particularity the circumstances of MSF’s alleged fraud, as well as facts giving rise to a strong inference of scienter."

 

The Eighth Circuit held that it "need not decide whether the complaint adequately states with particularity facts giving rise to a strong inference that MSF acted with scienter," because, the court held applying Iqbal to the loss causation pleading requirement under the Dura Pharmaceuticals case, that "the complaint fails to sufficiently plead loss causation."

 

The court referenced what it called the complaint’s "threadbare, conclusory allegation" that as a "direct and proximate cause" of defendants’ fraud the plaintiffs had lost their investments. The court noted that this allegation failed to "specify" how MSF’s alleged statements "as compared to the complaint’s long list of alleged misrepresentations and omissions by the executives, proximately caused the investors’ losses." The court noted further that the complaint "does not state the value of UCAP’s stock when the investors made their investments, or its value right before, or right after, the need for restatement was announced."

 

The Court concluded that without these allegations "the complaint does not show that the investors’ losses were caused by MSF’s misstatements," which "defeats the plausibility of the investors’ claims that MSF’s audit opinions …caused their losses."

 

Discussion

The Eighth Circuit’s decision in the McAdams case, in which the Eighth Circuit held, applying Iqbal, that the claimants’ loss causation allegations lacked "plausibility," shows that Iqbal could indeed have an impact on securities cases.

 

It is particularly interesting that the Eighth Circuit affirmed the lower court’s dismissal on the grounds of insufficient loss causation plausibility, while observing that it did not even need to reach the question whether the plaintiffs had plead scienter with sufficient particularity under the PSLRA. The conclusion suggests that Iqbal’s generalized pleading requirements must be considered analytically prior to the PSLRA’s more particularized requirements. And whether or not the Iqbal standard is to be viewed as prior, its "facial plausibility test" apparently applies to the elements required to state a cause of action under the federal securities laws, even those elements for which the PSLRA does not itself specify particularized pleading requirements.

 

In any event, the basic holding of the McAdams case that the complaint’s loss causation allegations must meet the Iqbal "facial plausibility" standard in order survive an initial motion to dismiss could be a valuable tool for defendants’ to use at the initial pleading stage. (Of course, many plaintiffs will include allegations in the complaint of the kind that the plaintiffs in the McAdams case had omitted, so the extent to which the McAdams decision will affect other cases could be limited – with the inclusion of seemingly minimal additional information about their alleged investment loss, plaintiffs could likely defeat a motion raising similar arguments.)

 

One question that may be of more interest to civil procedure buffs is whether it matters that in McAdams the court was considering a complaint to which (as the McAdams court itself noted) Rule 9(b) applied, rather than (or perhaps, in addition to) Rule 8. Rule 9(b) requires that fraud must be plead with "particularity." To my mind, it does not and should not matter whether the applicable pleading standard is under Rule 9 rather than under Rule 8, either way it would seem (as the McAdams court noted) that the Iqbal "facial plausibility" test should apply, although I would be interested to know if readers disagree.

 

One final thought about Iqbal itself. I tend to agree with the school of thought in favor the decision. I recognize the argument that the "facial plausibility" test does not appear in the Fed. R. Civ. P., but then neither does the phrase "notice pleading." And I find myself puzzled by the critics of Iqbal – are they suggesting that complaints that are not facially plausible should be allowed to go forward? In any event, under Rule 15 (a)(2), courts are admonished to allow pleading amendments "freely when justice so requires," so plaintiffs will typically have at least a second crack at trying to present a "facially plausible" complaint.

 

In any event, based on the McAdams decision at least, Iqbal appears to represent yet another factor raising the hurdle that plaintiffs’ initial pleads must overcome in order to survive a motion to dismiss in a securities class action lawsuit. Clearly, the accumulating number of substantive and procedural developments increasingly favors the defendants in these cases.

 

Very special thanks to Tom Gorman of the SEC Actions Blog for his recent post (here) discussing the McAdams case.

 

More About Loss Causation: An October 21, 2009 memo entitled "Loss Causation Challenges in Securities Cases" (here) by Michael Smith and William Hutchinson of the King & Spaulding law firm surveys recent case law regarding loss causation issues under the federal securities laws.

 

 

It been a catastrophic week for Galleon Group and its founder, Raj Rajaratnam, with the firm reportedly about to wind itself up in the wake of the epic insider trading allegations raised against Rajaratnam. But the trading indictment is not the only recent stunning legal development involving Rajaratnam and his firm.

 

Among other things, on October 22, 2009, a group of survivors of alleged "terrorist" bombings sued Rajaratnam and his father claiming they knowingly provided financial support to the Tamil Tigers.

 

On a more positive note, Galleon was recently affirmed as lead plaintiff in a securities class action lawsuit pending in the Eastern District of Pennsylvania.

 

The terror victims filed their lawsuit on October 22, 2009 in the District of New Jersey. The seven-count complaint (copy here) was, according the plaintiffs’ lawyers press release (here), the result of "a year-long investigation." The complaint was filed under the Alien Tort Claims Act of 1789, which gives U.S. district court jurisdiction "of any civil action by an alien for tort only, committed in violation of the law of nations or a treaty of the United States."

 

The complaint alleges that Rajaratnam and the family foundation headed by his father provided millions of dollars in funds used for terrorist attacks by the group formerly known as the Liberation Tigers of Tamil Elam (LTTE). The complaint alleges that from 2004 to 2009 LTTE conducted hundreds of attacks and bombings, claiming over 4,000 victims. The complaint alleges that Rajaratnam and his family foundation provided millions in funding to a group that the Treasury Department has described as "a charitable organization that acts as a front to facilitate fundraising and procurement for the LTTE." The complaint alleges that Rajaratnam’s donations were given "with the intent of supporting specific LTTE attacks and operations."

 

The complaint alleges that the defendants aided and abetted terrorist acts "universally condemned as violations of the law of nations: aided and abetted, intentionally facilitated or recklessly disregarded "crimes against humanity in violation of international law," as well as, among other things, wrongful death, negligence and negligent or intentional infliction of emotion distress.

 

Things said about Rajaratnam and his firm in the September 30, 2009 ruling (here) by Eastern District of Pennsylvania Judge Juan R. Sanchez, in which Sanchez affirmed Galleon as lead plaintiff in the Herley Industries securities class action lawsuit, were decidedly more positive. The subsequent events (which the court obviously had no way of anticipating) do cast a very strange light on the opinion.

 

Even prior to events of the last week, Galleon’s selection as lead plaintiff in the case was notable. Investment advisors typically are regarded as lacking standing to pursue the claims of their clients’ funds, because they lack an "injury-in-fact" – that is, they suffered no direct injury. A long line of district court cases have declined to appoint investment advisers as lead plaintiffs for that very reason. In considering these issues, Judge Sanchez observed that Galleon, unlike the investment advisors in the other cases, was "closely connected" to the Galleon funds that held the company’s stock.

 

With respect to the connection between Galleon and the funds, Judge Sanchez noted that "the same people control both Galleon and the funds," adding that "Raj Rajaratnam serves as director of the two funds and as Galleon’s managing partner." There were, however, further standing issues involved because the funds had not assigned their claims to Galleon until after Galleon was initially appointed to serve as lead plaintiff.

 

Finding that Galleon now had standing in light of the assignment, and noting further that "Galleon has served as an adequate plaintiff for more than two years," and that it had a larger financial interest in the case than the competing pension fund, the court exercised its discretion to affirm Galleon as the lead plaintiff in the action.

 

In support of this conclusion, Judge Sanchez observed, among other things that "to appoint a new lead plaintiff at this late date would unduly disrupt the litigation process."

 

Certainly, no one wants the litigation process unduly disrupted, but I suspect that in light of events subsequent to Judge Sanchez’s September 30 order, the litigation process in the Herley Industries case is about to be duly disrupted.

 

Among other ironies is that in the court’s prior order initially appointing Galleon as lead plaintiff (here), the competing pension fund had argued that Galleon was an "unsuitable" lead plaintiff owing to the "unique defenses" to which Galleon was subject. Among other things, the competing pension fund had argued that Galleon was a hedge fund that had shorted Herley’s stock during the class period (and therefore allegedly profited from the fraud on the market), and further argued that the short sale activity violated the federal securities laws. Judge Sanchez found the securities law violation allegations to be speculative and selected Galleon as lead plaintiff in light of the PSLRA’s presumption in favor of the plaintiff that suffered the greatest financial.

 

The competitor pension fund presumably could be substituted in as lead plaintiff, but, as Judge Sanchez noted, the pension fund’s losses "pale by comparison" to Galleon’s.

 

As interesting as all of these things are, I suspect there will be more attention-grabbing legal developments about Galleon and Rajaratnam in the weeks and months ahead.

 

Special thanks to Adam Foulke of the Motley Rice firm for providing me with a copy of the plaintiffs’ complaint in the Tamil Tiger case. Special thanks to a loyal reader for providing copies of the opinions in the Herley Industries case.

 

In Case You Missed It: OakBridge Insurance Services announed yesterday that Mickey Estey and Lance Sunder, both previously of NASDAQ Carptenter Moore,  have joined OakBridge and will be opening offices for the company in the metro regions of San Francisco, CA and Minneapolis, MN, respectively.

 

On October 19, 2009, in a securities case from an earlier era involved allegedly misleading statements regarding asset-backed securities, Southern District of New York Judge Harold Baer substantially denied the defendants’ motions to dismiss the plaintiffs’ complaint as amended, following the long-running case’s trip through the Second Circuit on interlocutory appeal. A copy of the October 19 opinion can be found here.

 

Judge Baer’s decision in the Dynex Capital securities case is noteworthy not only because of the previous high profile appellate decision in the case, but also because Judge Baer found plaintiffs’ amended allegations sufficient to survive the renewed motion to dismiss, after prior pleadings had failed in whole or in part to withstand scrutiny.

 

Though the case is from a slightly earlier era (it was initially filed in 2005), it raises many allegations similar to those involved in the current round of subprime and credit crisis-related securities lawsuits, and therefore could be influential with respect to dismissal motions in the more recent cases.

 

Background

Dynex was in the business of packaging mortgage loans into securities. Between 1996 and 1999, Dynex originated or purchased 13,000 mobile home loans that served as collateral for bonds that a unit of the company issued. The underlying loans performed poorly and in 2003-04 the bonds were downgraded by the rating agencies. The bonds’ value dropped by as much as 85%.

 

The plaintiffs filed a securities class action lawsuit on behalf of investors who had purchased the bonds between February 7, 2000 and May 13, 2004. The plaintiffs allege that the defendants artificially inflated the bonds’ price by misrepresenting that the poor performance of the bond collateral was due to market conditions, concealing that the defendants’ "aggressive and reckless loan underwriting and origination practices generated a pool of collateral loans of poor credit quality and inherent defects."

 

In a February 2006 opinion (here), Judge Baer granted the defendants’ motion to dismiss the complaint as to the individual defendants for failure to adequately allege scienter, but he denied the motion as to the corporate defendants. In June 2006 he certified his opinion for interlocutory appeal on the question "whether scienter could be adequately alleged against a corporation without concomitant allegations that an employee or officer acted with the requisite scienter."

 

In 2008, the Second Circuit held (here) that corporate scienter may be sustained even "in the absence of successfully pleading scienter as to an expressly named officer." However, the Second Circuit held that the plaintiffs had not met the standard for corporate scienter, vacated Judge Baer’s prior ruling and remanded the case to allow the plaintiffs an opportunity to replead.

 

The plaintiff filed a second amended complaint (hereafter, the amended complaint) and the defendants’ renewed their motion to dismiss.

 

The October 19 Opinion

In their newly amended complaint, the plaintiffs added the statements of nine confidential witnesses and also identified and described for the first time four categories of reports that the plaintiffs alleged put the defendants on notice that their public statements were materially misleading.

 

Based on the confidential witnesses’ statements, which bolstered the plaintiffs’ allegations about how the defendants accessed and used the identified categories of reports, Judge Baer found that the plaintiffs had sufficiently alleged that several categories of the statements on which plaintiffs sought to rely were misleading and false. These categories included defendants’ statements regarding the adherence to underwriting standards; the defendants’ statements about the reasons for the deterioration in the collateral performance; and the defendants’ statements about the adequacy of the company’s loan loss reserves and internal controls.

 

More significantly in light of the case’s prior procedural history, Judge Baer found that the plaintiffs had adequately pled scienter. Judge Baer found that the plaintiffs’ allegations about the information available to defendants in the newly referenced documents represented strong circumstantial evidence of scienter. Judge Baer found that the amended complaint, by contrast to the plaintiffs’ prior complaint, "contains factual allegations about several forms of reports that collectively provided to Dynex’s senior management, including the Individual Defendants, information that contradicted their misleading statements."

 

The information in the documents was "available to and reviewed by the senior management responsible for the public statements at issue that either put them on notice of the falsity of these statements or clearly should have done so." Judge Baer found that the inference of scienter from these allegations was as least as compelling as the contrary inference that the defendants sought to draw.

 

Judge Baer found that when the amended complaint is viewed "holistically," a "cogent story of securities fraud is revealed":

 

The Defendants originated or purchased a large number of mobile home loans of generally low credit quality, a substantial number of which were "inherently defective," and packaged them into the Bonds failing to disclose that the stated underwriting guidelines were "systematically disregarded"; then, when adverse market conditions coincided with rising defaults and many loans were uncollectible as a consequence of inherent defects, Defendants publicly stated that market conditions were to blame in an attempt to forestall deeper drops in the value of the Bonds, many of which they held for their own account.

 

Accordingly, Judge Baer held that the amended complaint "alleges facts giving rise to a strong inference" that the statements he "found to be false and misleading were made with scienter."

 

Discussion

The Dynex Capital case arose in February 2005, two years before the current round of subprime and credit crisis litigation began, but the plaintiffs’ allegations are remarkably similar to many of the allegations raised in the more recent lawsuits. The fact that the amended complaint largely survived the most recent motions to dismiss is all the more significant given the plaintiffs’ early difficulties in the district and appellate courts in trying to get over the initial pleading hurdles.

 

The fact that the plaintiffs in the Dynex Capital case were ultimately able to overcome the initial pleading hurdles will obviously be of particular interest to the plaintiffs in the more recent cases. The plaintiffs were able to survive the renewed dismissal motion in this case because of the large number of well-placed confidential witnesses who were able to provide detailed descriptions of the company’s processes and of the key documents and their availability to senior management, as well as how the information in the documents allegedly contrasted with the defendants’ public statements.

 

Obviously not all plaintiffs in other cases will be able to muster the same number or caliber of confidential witnesses or success in being able to utilize confidential witnesses to show with such particularity what information was available to senior management and how the available information contrasted with public statements.

 

But the fact that the plaintiffs in this case were able to put those elements together, and were able to do so in a way sufficient to overcome the court’s original skepticism shows that plaintiffs in general can put together allegations to surmount even the heightened scienter pleading standards of the Tellabs case. The fact that these plaintiffs were able to do so after the initial pleading challenges also suggests that in other cases in which plaintiffs initial complaints failed to survive, the pleading defects still may be overcome with sufficiently particularized amended pleading, even on the critical issue of scienter.

 

In any event, because of the similarity of the allegations on this case to the allegations in many of the current cases, Judge Baer’s recent decision in the Dynex Capital case is likely to be important in the current cases similarly involving asset-backed securities allegedly misleading disclosures about underwriting standards, collateral quality, internal controls and adequacy of loan loss reserves.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing a copy of Judge Baer’s October 19 opinion.

 

Because private equity firms often place representatives on the boards of their portfolio companies, questions can sometimes arise about the interplay between the private equity firms’ and the portfolio companies’ D&O insurance when claims are asserted against portfolio companies’ boards. All too often, these questions are considered only after claims have emerged. However, the better approach is for these issues to be considered at the outset, when the coverages are first put in place.

 

An October 19, 2009 article entitled "Getting Your Portfolio D&O Insurance Right (The First Time Around)" (here) by Paul Ferrillo of the Weil Gotschal law firm takes a look at the factors to be considered in connection with structuring both the portfolio companies’ and the private equity firm’s insurance in order to ensure that the policies are appropriately coordinated.

 

The first question the memo addresses is the issue of how much insurance the portfolio company should carry to ensure that the insurance is sufficient "to insulate the sponsor’s own D&O coverage and more importantly the fund from liability." There are, the memo notes, a host of factors to be considered, including how large the portfolio company is and whether or not the portfolio company under consideration is private or public, but the memo correctly points out that the most important consideration is that the portfolio company’s insurance "should be adequate to insure the portfolio company and its directors and officers against risks related to that company."

 

As the memo notes, the question of the sufficiency of the portfolio company’s policy limits "is not an area to get caught short" because otherwise the private equity firm’s insurance might be looked to in order to "make up the difference."

 

The memo notes that in addition to the adequacy of the portfolio company’s limits of liability, the adequacy of the terms and conditions in the portfolio company’s policy must also be considered, since neither all D&O policies nor all D&O carriers "are created equal."

 

The memo lists a number of particularly important policy features to consider, including: making sure the policy is non-cancelable and that the Side A coverage is non-rescindable; confirming that the Insured vs. Insured exclusion has a broad coverage carve back for claims brought by the bankruptcy trustee, receivers or other bankruptcy constituencies; that the policy has a priority of payments clause; and ensuring that the conduct exclusions are fully severable so that no one’s conduct is imputed to another insured person for purposes of precluding coverage. (I have more to say below about the memo’s comments concerning the conduct exclusions.)

 

The memo also discusses indemnification issues that can arise when private equity firm’s representatives sit on portfolio companies boards. In a prior post (here), I discussed the potentially conflicting indemnification issues that can arise when private equity firm representatives serve on portfolio company boards, and I reviewed recommendations on how these conflicts may be addressed. The law firm memo also notes that the potentially conflicting indemnification obligations could lead to confusion over the applicability of the private equity firm’s and the portfolio company’s insurance. In particular, the memo raises the concern that if these indemnification issues are not addressed in advance, the portfolio company’s carrier might try to claim that the private equity firm’s insurance should "share" in settlement and litigation expense incurred in connection with a claim against the portfolio company’s board.

 

In order to prevent an outcome that is not a "result that anyone intended," the memo suggests that the private equity firm’s D&O insurance policy should incorporate wording in its "other insurance clause" stating that with respect to a portfolio company claim against a private equity firm representative on the portfolio company’s board, the portfolio company’s D&O policy is primary and the portfolio company’s policy is excess. The portfolio company’s policy should contain "similar clarifying language."

 

The memo also suggests that the private equity firm and the portfolio company should enter "separate letter agreements" confirming that the portfolio company is the primary indemnitor for advancement, indemnification and D&O insurance purposes.

 

Overall, the memo provides a good overview of the issues and raises some important considerations. However, I respectfully disagree with the memo on two points.

 

The first has to do with what the memo describes as important with respect to the conduct exclusions in the portfolio company’s policy. The memo states that the "fraud and personal profit exclusions should contain ‘in fact’ and/or ‘final adjudication" language.

 

I disagree with the memo’s suggestion that "in fact" and "final adjudication" wordings may be viewed as somehow equally acceptable, as they most definitely are not.

 

The "after adjudication" wording requires a judicial determination that the precluded conduct has occurred. The superiority of an adjudication requirement is in fact well-established (see for example my discussion here), as an "in fact" wording potentially could permit a carrier to try to deny coverage even though there has been no determination that the precluded conduct actually took place. Contrary to the suggestion in the memo, the "in fact" wording should be avoided. Indeed, in the current competitive insurance marketplace, there will rarely be a circumstance where any insured should have to accept "in fact" wording in the conduct exclusions.

 

The second point with which I respectfully disagree is the memo’s repeated suggestion that insurance brokers cannot be relied upon to guide firms with respect to the issues raised in the memo. I agree with the memo’s statement that the task of coordinating private equity firm’s insurance with that of their portfolio companies "is not a task for many ‘generalist’ brokers." However, I disagree with the memo’s later suggestions that brokers may not be a reliable source on the issue of carrier’s claims reputations, or that getting the portfolio company’s insurance right is "not a job to leave" to the insurance broker.

 

Generalist brokers may not be adequately equipped to address these issues, but there are specialized brokers who have the requisite experience and expertise to deal with these concerns. Of course many companies will also find it reassuring to have their outside counsel involved in the insurance transaction, but experienced insurance professionals with the requisite specialized expertise are eminently qualified to put together insurance programs that coordinate appropriately between private equity firms and their portfolio companies.

 

UPDATE: After this post’s publication, I spoke with Paul Ferrillo, the author of the law firm memo referenced above. To be clear, Paul’s comments on insurance brokers were only directed to the "generalist" broker without specific cross-training in Private Equity/Portfolio company D&O issues. Paul notes that he has a great many friends on the brokerage side who add tremendous value to complex D&O insurance transactions involving Private Equity firms and their portfolio companies. His practice pointer here was only that this area is a complex one involving both insurance and legal questions, which all must be melded into a wholistic solution for the client.

 

One of the questions insurance professionals have been asking with interest and anxiety since the financial crisis began is whether the economic recession will lead to a "hard market" for insurance (characterized by rising prices and tightening terms and conditions).

 

Earlier this year, Advisen, the insurance information firm, created a stir by predicting that a hard market for insurance would "begin to set in" as early as mid-2009, and in any event no later than 2010. The earlier Advisen report did, however, note that the current recession could reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition. My post about the prior Advisen report can be found here.

 

In an updated October20, 2009 study entitled "Planning for 2010: The Recession Will Keep Insurance Premiums Under Pressure" (here), Advisen now reports that "while rates are firming in a few isolated segments of the market," overall, due to falling demand resulting from the recession, insurance buyers "will continue to enjoy favorable pricing in 2010," and "materially higher rate levels most likely will have to wait until 2011."

 

The insurance cycle is basically a result of the shifting relationship between the demand for and supply of insurance. Prices fall when supply increases faster than demand. In order to track these shifting relationships, the Advisen report uses Gross Domestic Product (GDP) "as a proxy for demand," on the assumption that demand for insurance moves in relation to overall economic activity.

　

The study notes that historically, when the ratio of the supply of insurance (the insurers’ policyholder surplus) to GDP crosses the 3.2 percent mark, either up or down, "the market changes directions within the next 12 months or so." Part of the reason Advisen had earlier this year made its prediction of an approaching hard market is that the ratio fell to about 3.2 percent at the end of 2008 and continued to fall in the first quarter of 2009. However, the ratio crept back up to 3.27 percent at the end of the first half of 2009. Now, "the market remains unsettled with conflicting forces pushing and pulling on both sides of the tipping point."

 

The reason for this uneasy equipoise is that the recession is affecting both the supply and the demand sides of the equation. On the supply side, declining investment portfolio values has significantly reduced the insurers’ policyholder surplus. On the other hand, reduced economic activity has resulted in lower demand due to reduced numbers of "exposure units" (such as payroll levels, sales, vehicle units, etc.)

 

Other factors that have complicated the insurance cycle transition are: lower levels of catastrophe losses during 2009 compared to prior years; heightened competition from wounded market participants; the entry of new insurance capacity; and the insurers’ release of redundant loss reserves from prior years. Some of these factors could disappear (for example, catastrophe claims could emerge with little advance warning), or are less likely to be a factor going forward – in particular, loss reserve redundancies "now have been almost fully harvested," which eliminates insurers’ "cushion against adverse developments" and "could contribute to upward pressure on rates in 2010 and beyond."

 

Even if the recession may have ended as a matter of technical economic analysis, its effects are still being widely felt and the impacts from recovery "will be uneven, leading to further complexity and uncertainty" with respect to capacity and pricing. While these factors will continue to complicate the insurance cycle transition and "delayed the hard market," the shifting elements of the supply and demand equation "favor a modest increase in insurance demand by the end of 2010" – though "materially higher rate levels most likely will have to wait until 2011."

 

In the meantime, other than in certain areas, commercial insurance rates "on average continue to drift downward, though at a much reduced rate compared to a year ago." With respect to D&O insurance, financial sector premiums have "increased sharply" and financially stressed or highly leveraged companies "are likely to see higher premiums and some may have trouble finding adequate coverage." However other companies can expect to see premiums continue to fall into 2010, though "at a much slower pace."

 

Even at the time of Advisen’s earlier report, I had commented that "if there is going to be a hard market, its arrival could be more delayed than the report suggests." The more recent report seems consistent with my prior view that a hard insurance market could prove to be a long time coming. At this point, I don’t think I have any better sense of when it might arrive. I do agree that the uneven and gradual nature of the economic recovery could further delay the cycle transition. Unanticipated events (such as significant natural catastrophes) could intervene to accelerate the change, but absent those kinds of developments, the prospects for a market change anytime soon seem remote.

 

In any event, at 11 am EDT on October 22, 2009, Advisen will be hosting a free one-hour webinar on the State of the Insurance Market and the 2010. Registration for the webinar can be found here.

 

The worst of the global financial crisis may be past, and we may even be well on the road to economic recovery, but there still may be considerable pain yet to come, particularly in connection with commercial mortgages. Increased vacancies, declining property values and shortages of refinancing capital could mean increasing numbers of commercial mortgage defaults ahead.

 

These problems could spell trouble for banks holding commercial mortgage loans, as well as for those who invested in securities backed by commercial mortgages (CMBS). These problems likely will lead to commercial mortgage-related litigation, in what may be the final surge in the credit crisis-related litigation wave.

 

Background

The business pages recently have been full of tales of commercial mortgage defaults. For example, an October 6, 2009, Bloomberg article (here) reported that hotel foreclosures in California tripled in the first half of this year. An October 13, 2009 Wall Street Journal article (here) reports that declining hotel room demand in Hawaii "means a number of Hawaii’s resorts no longer generate enough revenue to pay the mortgage" and overall Hawaii’s distressed debt tied to hotels totals nearly $1.6 billion.

 

Similarly an October 15, 2009 Wall Street Journal article (here) detailed the danger of default on the massive mortgage debt of the Peter Cooper Village and Stuyvesant Town properties, which the article noted could "signal[] the beginning of what is expected to be a wave of commercial property failures." The lead article on the front page of the October 16, 2009 Cleveland Plain Dealer asks the question "Will Bad Commercial Loans Leave Cleveland Area Banks Targets" (here).

 

An August 31, 2009 Wall Street Journal article entitled "Commercial Real Estate Lurks as Next Potential Mortgage Crisis" (here) explores the sources of the problems in the commercial mortgage sector. Many of the mortgage-related problems "are simply the result of bad underwriting." The Wall Street "CMBS machine" lent owners money "on the assumption that occupancy and rents of their office buildings, hotels, stores or other commercial property would keep rising," but now "a growing number of properties aren’t generating enough cash to make principal and interest payments."

 

Another source of difficulty is that property owners are unable to refinance as mortgages come due. The August 31 Journal article reports that by the end of 2012, $153 billion in loans that make up CMBS are coming due, and as much as $100 billion will face difficulty in refinancing.

 

Declining property values are contributing to the problem. According to Bloomberg (here), commercial property prices have fallen 39 percent since their 2007 peak. As the Journal article notes, the property values have "fallen so far that borrowers won’t be able to extend existing mortgages or replace them with new debt."

 

All of this spells serious trouble for already struggling banks. Banks hold $1.8 trillion in commercial mortgages and construction loans, and as the Journal notes, "delinquencies on this debt already have played a role in the increase in bank failures this year."

 

Indeed, banks’ exposure to commercial mortgage losses is a serious concern for banking regulators, particularly since banks have been "slow to take losses on their commercial real estate loans," according to an October 7, 2009 Wall Street Journal article (here). According to one analysis quoted in the article, banks with heavy exposure to real estate loans have set aside just 38 cents in reserves during the second quarter for every $1 of bad loans. As the Journal article notes, "the recession combined with inadequate loan loss provisions when times were good have left banks dangerously vulnerable to the deteriorating commercial real estate market."

 

A significant amount of commercial mortgage debt is also held by the pools backing the CMBS. According to an October 2009 memorandum from the Robbins, Kaplan, Miller & Ciresi law firm entitled "Caught in the Credit Crunch: An Investigation into Commercial Mortgage Backed Securities" (here), there was nearly $650 billion in CMBS issuance during the period 2005 to 2007, at the same time as there was a "dramatic decrease in the underwriting standards for commercial mortgages." The recent problems in the commercial real estate sector have "resulted in more loan defaults and potentially significant losses for CMBS investors."

 

Potential Litigation

The commercial mortgage woes have already led to a certain amount of litigation. By far the most significant number of lawsuits growing out of commercial mortgage problems involves the handful of cases where companies and their directors and officers have been sued by the company’s own shareholders for alleged misrepresentations or omissions about the company’s ability to support its mortgage debt or commercial property acquisition debt obligations. Examples of the companies involved in these kinds of lawsuits include General Growth Properties (about which refer here); Station Casinos (refer here); Perini Corporation (refer here); and MGM Mirage (refer here).

 

There may well be more of this type of shareholder or investor driven "commercial mortgage disclosure" litigation ahead, as commercial mortgage defaults continue to emerge in the months ahead.

 

There also seems to be every prospect for litigation to emerge in the wake of bank failures caused by commercial mortgage defaults. There certainly has already been considerable litigation following in the wake of bank failures driven by residential mortgage losses. Example of this kind of residential mortgage-related failed bank litigation include the lawsuits filed by the shareholders of Corus Bank (refer here) and Pacific Capital Bancorp (refer here). At this point, it seems prudent to expect that as rising commercial mortgage defaults lead to further bank failures that there would be similar failed bank litigation pertaining to the banks’ commercial mortgage losses.

 

The more interesting question may be whether there will be investor litigation relating to the CMBS. The Robins Kaplan memo linked above notes that "while there hasn’t yet been much specific CMBS litigation yet," as the CMBS mature over the next few years, litigation could arise similar to the many lawsuits that have emerged involving residential mortgage backed securities (RMBS).

 

The law firm memo does go on to note that there could be some practical considerations that could forestall, or at least complicate, prospective CMBS-related litigation. For example, the memo notes, CMBS offering documents "generally have substantially more property specific information" than for example typically was found in RMBS offering documents, which "may eliminate" omission-based claims of the type that have been asserted in RMBS-related litigation.

 

In addition, as time passes, CMBS investors’ ability to bring ’33 Act claims based on alleged misrepresentations or omissions in the offering documents may face statute of limitations constraints. Indeed, given that the CMBS marketplace ground to a halt in after the financial crisis in September 2008, we may already be past the point where CMBS investors will even have the option to pursue ’33 Act claims alleging misrepresentations or omission in the offering documents, due to the operation of the applicable one-year statute of limitations.

 

Nevertheless, and despite these litigation impediments, as growing defaults mean mounting losses for CMBS investors, the aggrieved investors likely will seek alternative theories on which to pursue claims, including, for example, common law fraud or misrepresentation. A long-running CMBS lawsuit now being pursued against the Cadwalader law firm and related to a 1997 CMBS offering (about which refer here) dramatically underscores how far into the future the litigation threat may extend. Moreover, if the commercial mortgage-related losses prove to be anywhere near the current theoretical potential, investors will have substantial incentives to pursue claims, even if it means relying on a wider array of legal theories in order to assert their claims.

 

All of which suggests that there may yet be a further surge of credit crisis-related lawsuits before the credit crisis litigation wave has finally played itself out.

 

This past Friday night, San Joaquin Bank of Bakersfield, California became the 99th bank the FDIC closed this year (refer here) The growing wave of bank failures has been a troubling story all year, and one that unquestionably will get worse before it gets better. But now that the 100th bank failure of the year is approaching, the mainstream media have noticed and have taken up the story.

 

The approaching bank failure century mark certainly is noteworthy, but not all of the reporting is appropriately balanced. Some of the media reports have gotten a little overexcited about the whole thing.

 

Among the recent news reports observing the approaching 100th bank failure of the year are the October 11, 2009 New York Times article entitled "Failures of Small Banks Grow, Straining FDIC" (here) and Time Magazine’s article, in its October 26th issue, entitle "Spotlight: Bank Failures" (here). The Cleveland Plain Dealer’s lead article on Sunday October 18, 2009 was devoted to the topic, as well as to the threat that local banks face from souring commercial real estate loans.

 

The growing number of failed banks is unquestionably an important story and one that rightly deserves the media attention it is getting. But apparently not content with the presently available facts, some media sources have felt compelled to try and sensationalize the story.

 

Both the Time Magazine and New York Times article linked above repeat the alarmist (and as I detailed here, arguably suspect) forecast that as many as 1,000 banks – approximately one eighth of all the banks in the country – will fail by the end of next year. The Time Magazine article goes even further by reciting without question or comment an unsubstantiated projection that "soured commercial real estate loans may generate a fresh $600 billion of losses by 2013."

 

Not only is this projection out of proportion to other published commercial real estate loan loss projections – the highest number generally circulating is $100 billion – but it is self-evidently questionable. The total amount of commercial real estate and construction loans held by banks is $1.8 trillion (a figure recited, among other places, in the Times article linked above). How likely is it that one third of all of these loans will become total losses by the end of 2013? To put this question into context, the current commercial loan default rate that has everyone so alarmed is 3.8%.

 

In the current economy, we have more than enough real challenges to deal with without the media conjuring up projections to try to make things seem even scarier than they already are.

 

It is always useful to look at aggregate securities lawsuit filing data to try to determine what trends and themes can be discerned, but occasionally it is also useful to look at a single new filing whether it might suggest anything. To choose one example, a closer look at a new securities class action lawsuit filed on October 14, 2009 in the Eastern District of Pennsylvania against Advanta Corporation and certain of its directors and officers seems to reflect a variety of different securities litigation tendencies and motifs.

 

Advanta at one time was the country’s largest issuer of Visa and MasterCard credit cards, through its subsidiary, Advanta Bank Corp. As reflected in the plaintiffs’ lawyers’ October 14, 2009 press release (here), the lawsuit alleges that the defendants failed "to disclose the impact of the economic environment and the deteriorating credit trends on its business and that the Company failed to adequately and timely record losses for its impaired loans and customer delinquencies, causing its financial results to be materially false."

 

Specifially, the complaint (which can be found here) alleges that:

 

(a) Advanta’s assets contained tens of millions of dollars worth of impaired credit card receivables for which the Company had not accrued losses; (b) prior to and during the Class Period, Advanta had been extremely aggressive in granting credit to customers without verifying the customers’ ability to pay, to such a degree that by the summer of 2009, Advanta customers’ default rate would be almost six times worse than industry average; (c) Advanta’s manipulation of its cash rewards program angered customers and caused the Company to lose good, creditworthy customers; (d) Advanta’s credit receivables were unduly risky due to the Company’s practice of issuing credit cards to small business owners without, in many instances, verifying income; (e) defendants failed to properly account for Advanta’s continuing delinquent customers and the credit trends in the Company’s portfolio, resulting ultimately in large charges to reflect impairments; and (f) the Company was not on track to be profitable in 2008.

 

The complaint alleges that the company’s share price plunged after its October 2007 disclosure that it was experiencing a higher rate of delinquencies. The complaint alleges that thereafter the news only got worse, and in May 2009 the company announced in May 2009 the cancellation of "millions of cards held by small businesses." On June 30, 2009, the FDIC entered a cease and desist order (here) against Advanta Bank following allegations of unsafe and unsound banking practices.

 

Though the complaint references these more recent events, the putative class period proposed in the complaint runs from October 31, 2006 through November 27, 2007.

 

This complaint is of course a reflection of the specific circumstance alleged with respect to this one company and its banking subsidiary. Nevertheless, the complaint also reflects a number of different securities litigation themes and trends, some of which are well-established and some of which may only just be emerging.

 

First, this case is yet another example of the kinds of litigation that may emerge in connection with the growing numbers of troubled banks. As I have noted in numerous posts (most recently here), though the level of litigation involving failed and troubled banks is still well below what might be expected given the number of distressed institutions, a number of lawsuits have begun to emerge and there may yet be more in the future.

 

Second, while I have noted elsewhere that as 2009 has progressed the wave of subprime and credit crisis related litigation definitely seems to have slowed (or even just merged into larger litigation developments to the point that it may no longer be its own separately identifiable category of litigation), this case suggests that it is far too early to declare that the litigation wave has ended. Obviously, there may yet be other cases that raise similar credit related lawsuits in the months ahead.

 

This case also demonstrates with respect to the subprime and credit crisis-related litigation wave that the lawsuits encompass a wide variety of kinds and categories of credit, including, as shown here, credit card debt. As noted here with respect to the litigation involving American Express, there have been prior credit crisis securities lawsuits filed with respect to issues concerning credit card debt.

 

Third, the 23-month gap between the end of the proposed class period and the filing of this lawsuit is yet another example of the significant number of filings in the second and third quarter of 2009 that involve class period cutoff dates in the distant past. As noted in prior posts (most recently here), this phenomenon might suggest that while the plaintiffs’ lawyer were previously preoccupied filing numerous credit crisis and Madoff related lawsuits, they developed a backlog of cases that they have now started to work off.

 

Indeed, just in the past several days there have been several other cases with long past class period cutoff dates, including the lawsuit recent filed involving RHI Entertainment (filed on October 8, 2009, class period cutoff of June 19, 2008); Men’s Wearhouse (filed on October 8. 2009, class period cutoff date of January 9, 2008); and EnergySolutions (filed October 9, 2009, class period cutoff date of October 14, 2008).

 

Apparently, as the Advanta case suggests, the backlog may even include other credit crisis cases, which is yet another reason that, as noted above, there may be still other credit crisis cases yet to come.

 

In any event, I have added this case to my list of subprime and credit crisis-related securities lawsuits, which can be found here. If this case is any indication, there could be others credit crisis securities cases yet to come.

 

Courtroom Drama: While we all remain interested in the developments in the ongoing trial in the Vivendi securities class action lawsuit, there is certainly nothing new about courtroom drama, and some of the most compelling courtroom tales have an ancient and venerable pedigree.

 

A particularly engaging tale of courtroom drama is told in The Life and Times of Constantine the Great, a biography of the Roman emperor by D.G. Kousoulas. During Constantine’s reign, Athanasius, the bishop of Alexandria and one of the protagonists in the long-running Arian controversy, was accused by his foes of murder. An inquest of bishops and imperial officials was convened.

 

At the inquest, the accusers presented their case against Athanasius, and even produced a blackened hand, allegedly that of the victim, Arsenius. Kousoulas describes the scene:

 

After the accusers had enjoyed a moment of triumph as they passed the blackened hand around, Athanasius asked in a quiet voice if any of those present knew Arsenius personally. A number of bishops claimed to have known the murdered bishop well. Would they recognize him if they saw him, Athanasius asked. Certainly, they replied, "if he were alive." At that point Athanasius signaled to a man who was standing near the doorway, his face covered with his cloak. The man, his face still covered, moved to the front. "Lift your cloak," Athanasius said. The man removed the cloak and [as a contemporary account noted] "lo and behold it was Arsenius himself." Athanasius moved closer and drew first one and then the other sleeve. Aresenius had both of his hands. "Has God given a man more than two hands?" Athanasius asked with a sarcastic smile.

***

For a moment there was stunned silence. Then one of the accusers declared loudly that all this was sorcery and devil’s work. The man was not Arsenius although he had his face, he was not even human but an illusion produced by Athanasius with his knowledge of black magic. Athanasius asked the bishops to come and touch the man he was accused of having murdered. The meeting turned into a brawl, and Dionysius, the imperial officer attending the meeting on orders from Constantine, had to hurry Athanasius out to save his life.

 

Lawsuits alleging violations of the securities laws showed a strong comeback in the third quarter of 2009, according to an Advisen report released on October 14, 2009 (here). The report, the latest in a quarterly series from Advisen, reports that securities lawsuit filings were up "solidly" in the third quarter after a relative decline in the second quarter. Advisen’s report is directionally consistent with my own prior analysis of third quarter securities class action lawsuit filings, which can be found here.

 

One absolutely critical thing to understand about the Advisen report is that it uses its own unique terminology. As reflected on page 2 of the report, the report uses the term "securities suit" to describe a broad range of lawsuits beyond just securities class action lawsuits. As used in the report, the term "securities suits" includes, beyond the class actions, regulatory and enforcement actions; collective actions outside the United States; lawsuits alleging common law torts, contract law violations and breaches of fiduciary duty; derivative actions; and any other "securities-related suit" that impacts management liability insurance policies other than ERISA liability suits.

 

In addition, the report uses the phrase "securities fraud suits" to describe regulatory and enforcement actions brought by the SEC and other regulatory and enforcement agencies. Importantly this category of "securities fraud suits" also includes "cases brought by private parties alleging violations of securities laws that are not styled as class actions."

 

The report notes with respect to the broader category of "securities suits," as that term is used in the report, that there were 169 "securities suits" in the third quarter, which represents an 11 percent increase over the second quarter of 2009.

 

The report also notes that there were 55 new securities class action lawsuits in the third quarter of 2009, up from 38 cases in the second quarter, but down from 59 in the third quarter of 2008. The securities class action filing rate through the first three quarters of 2009 annualizes to 220 new lawsuits, which is "below the 230 filed in 2008 but well within its historical range."

 

The class action securities cases were, however, only the second largest subcategory among the larger group of "securities cases" (as that term is used in the report) filed in the third quarter. The largest subcategory among "securities cases" in the third quarter was "securities fraud cases" (which, again, is the term that the report uses to describe securities-related regulatory and enforcement actions, as well as private securities suits that are not filed as class actions), of which there were 70, up from 50 in 2Q09.

 

Overall, the securities class action lawsuits continue to represent an increasingly smaller proportion of all "securities suit" filings. The report notes that the proportion of securities class action lawsuit filings as a percentage of all "securities suits" has "been on a long downward trend." Whereas in the past, securities class action lawsuits have represented a majority of all "securities suits," in the third quarter, securities class action lawsuits represented just 33 percent of all "securities suits."

 

The report also notes that though filings against financial firms "remained strong" in the third quarter, new filings were more "widely dispersed" among other sectors than in the first half of the year. The report also notes that new Madoff and credit crisis-related suits "dropped substantially" in the third quarter compared to the first half of the year.

 

The report also notes the "long-term trend of growing numbers of suits against non-U.S. companies." Specifically, the report notes "the number of large securities suit filings against non-U.S. companies" are on a "long-term growth path."

 

With respect to potential insurance, the report notes that there is a growing number of "securities suits" that potentially trigger insurance coverage other than D&O insurance. The report notes that this trend "started in 2008 and continued in 2009," largely due to the filing of credit crisis and Madoff-related lawsuits. These cases may even be excluded by D&O policies but covered by E&O or fiduciary liability policies.

 

The Advisen report introduces a couple of nifty new features this quarter. First, the report includes a "Sector Impact Metric," which is designed to show the degree to which "securities suits" hit various industrial sectors over the past decade. The other new feature is the "Market Cap Impact Metric," which measures the market capitalization loss experienced by companies with securities class action lawsuits.

 

Speaker’s Corner: On Friday, October 16, 2009 at 11 am EDT, Advisen will be hosting a webinar to discuss the third quarter, in which I will be participating along with Arthur J. Gallagher’s Phil Norton, Zurich’s Paul Schiavone, and Advisen’s David Bradford. The session will be moderated by Advisen’s Jim Blinn. In addition to reviewing trends of securities litigation during the third quarter, the panel will discuss appropriate D&O limits.Registration for the webinar can be found here.

 

As noted in a prior post (here), trial in the Vivendi securities class action lawsuit began last week in the Southern District of New York. Thanks to the AmLaw Litigation Daily (here), the transcript of the opening arguments in the case are available here. The opening statements make for some interesting reading in and of themselves, and there are already a number of critical observations that may be made about this case.

 

Background

This case involves the financial impact on the company from the $46 billion December 2000 merger between Vivendi, Seagram’s entertainment businesses, and Canal Plus. The plaintiffs contend that as a result of this and other debt-financed transactions, Vivendi experienced growing liquidity problems throughout 2001 that culminated in a liquidity crisis in mid-2002, as a result of which, the plaintiffs contend, Vivendi’s CEO Jean-Marie Messier and CFO Guillaume Hannezo were sacked.

 

The defendants in the case include the company, Messier and Hannezo. The plaintiffs contend that the between October 2000 and July 2002, the individual defendants misled investors by causing the company to issue a series of public statements "falsely stating that Vivendi did not face an immediate and severe cash shortage that threatened the Company’s viability going forward absent an asset fire sale. It was only after Vivendi’s Board dislodged Mr. Messier that the Company’s new management disclosed the severity of the crisis and that the Company would have to secure immediately both bridge and long-term financing or default on its largest credit obligations."

 

Additional background regarding the case and the plaintiffs’ allegations can be found here.

 

A prior SEC enforcement proceeding against the company and the two former officers resulted, according to the SEC’s December 23, 2002 press release (here), in "Vivendi’s consent to pay a $50 million civil money penalty. The settlements also include Messier’s agreement to relinquish his claims to a €21 million severance package that he negotiated just before he resigned his positions at Vivendi, and payment of disgorgement and civil penalties by Messier and Hannezo that total over $1 million."

 

The Opening Statements

The lawyers making the opening statements on October 6, 2009 were: for the plaintiff class, Arthur Abbey of the Abbey, Spanier Rodd & Abrams firm; for Vivendi, Paul Saunders of Cravath, Swaine & Moore; for Messier, Micheal Malone of King & Spaulding; and for Hannezo, Martin Perschetz of Schulte, Roth & Zabel. The available transcript covers only the statements on the first day of trial, and does not include Perschutz’s opening argument, which took place the morning of the trial’s second day, so I have not discussed his opening argument below.

 

In his opening statement, Abbey tried to reduce the case to three points:

 

Number one, we are going to show you that Vivendi had growing problems during 2001 and the first half of 2002…and the problems that they had were with a thing called liquidity. Number two, they didn’t tell the truth about those problems….And the third thing that we will prove is that in the middle of 2002, the truth about Vivendi’s liquidity condition finally came out, and when that happened, unfortunately for my clients, the stock price fell and the investors that we represent suffered great losses. In a nutshell, that is why we are here today–a growing problem, failing to tell the truth, and then, like every lie, it finally comes out.

 

The overall theme of the plaintiffs’ case is that the defendants portrayed the company one way publicly, but another way internally:

 

Publicly, and I can’t stress this enough, defendants portrayed Vivendi as strong, healthy, and growing. They continuously downplayed the risks, the warnings, and they told the investing public how successful Vivendi was and would be in the future. But inside the company, behind the closed doors at Vivendi, the defendants were acknowledging a far different truth.

 

Among other things, Abbey referred to a "book of warnings" Hannezo supposedly compiled for the new CEO after Messier’s departure from Vivendi, which Abbey characterized as a collection of documents showing various forewarnings and admonitions Hannezo had send Messier and others about the company’s growing liquidity risks. Abbey read to the jury one note that Hannezo wrote to Messier at the end of 2001 following a meeting Hannezo had had with the rating agencies, in which Hannezo said "he felt like he was sitting in the death seat of a car that was accelerating in a sharp turn, and he didn’t want it to all end in shame." Abbey emphasized that while Hannezo had been communicating these warnings internally, they were not communicated to investors.

 

Abbey also argued in his opening that the company was under pressure to meet EBIDTA goals, and he further argued that the company was only able to report that it had met these goals by using, accounting adjustments (Abbey cited internal Vivendi documents referring to "accounting magic"), particularly "purchase accounting." Abbey told the jury that Vivendi never told investors the significant impact purchase accounting had on Vivendi’s reported results. He argued further that while use of accounting adjustments allowed the company to continue to report that it had met EBIDTA goals, the noncash adjustments did not help the company with its liquidity problems.

 

In support of the plaintiffs’ contentions, Abbey also referred to documents the company had filed in its severance dispute with Messier, in which the company supposedly said that Messier had driven the company "to the brink" yet had failed to disclose the problems to the company’s board.

 

Saunders, on behalf of Vivendi, argued that, contrary to the plaintiffs’ allegations about the company’s supposed liquidity problems, the company always had enough cash and credit to pay its bills, and in fact did pay all of its bills. He also argued that, contrary to the plaintiffs’ arguments that the defendants had misled investors, the company never had to restate its financials, even after new management came in. Saunders also emphasized that within days of his arrival, the new CEO completed a financing of over $1 billion, which, Saunders argued, demonstrated that even at the peak of the supposed crisis the company had sufficient resources (including credit) to pay its bills.

 

Saunders also argued that far from representing anything sinister, the company’s use of "purchase accounting" was only entirely appropriate, it was in fact required as a result of the three-way merger.

 

Saunders conceded that the company did have difficulties during the class period, but largely as a result of the September 11 tragedy and the following decline in economic activity (particularly at the company’s theme park properties). In that regard, he compared Vivendi’s stock price decline to the stock graphs of companies that the plaintiffs’ own expert had said were comparable, and that the stock graphs were virtually indistinguishable.

 

Finally, Saunders explained the two individuals’ departures from the company as a result of disagreements over the strategic steps the company should take in response to the business challenges it was facing, including a dispute between the board and Messier over whether Vivendi should sell its heirloom French water utility business.

 

Malone, arguing on behalf of Messier, contended that the plaintiffs’ case depended entirely on discrete "snippets" take out of context from a wide variety of documents, but that when the statements were put back in context, they show only the ordinary activities of business people struggling to deal with day to day business challenges. Malone emphasized the case is not about whether or not the company had problems or even about whether or not there were errors of judgment, but only about whether or not there had been an intentional effort to mislead investors.

 

Malone also emphasized that when Messier exercised stock options at the end of 2001, he invested all of the proceeds in Vivendi shares, and even took out a bank loan to buy additional shares. Messier also invested his entire April 2002 bonus in Vivendi shares, and indeed, within days of leaving Vivendi, Messier invested even more in Vivendi shares. Malone argued that Messier never sold a share, and that when Vivendi’s share price collapsed, no individual lost more than Messier.

 

Observations

Though the transcript only represents the arguments of counsel and not the actual presentation of evidence, a number of themes clearly emerge.

 

First, this case will be complex and will require the jury to grapple with a host of daunting technical terms and concepts. Just in his opening, Abbey referred to EBIDTA; purchase accounting; debt service; noncash earnings; nonoperational accounting entries; free cash flow; liquidity; and dividends. Saunders referred to negative cash flow; generally accepted accounting principles; and market capitalization. Malone referred to options exercises; hedging and hedging transactions; and tax advantages.

 

It is not that juries are incapable of figuring out these kinds of things. The problem is that these kinds of things put an enormous burden on the lawyers, the witnesses and the court to keep things clear; to avoid letting the trial get bogged down in technical minutiae; and making sure the jury it neither confused nor bored to death.

 

Second, much has been made (for example, here) of the fact that this Vivendi case is so unusual because it is the first "f-cubed" case to go to trial – that is, it involves claims against a foreign-domiciled company by foreign claimants who bought their shares on foreign exchanges. Whatever else might be said about whether or not f-cubed cases ought to be heard in U.S courts, it is clear just from the attorneys’ opening statements that there are serious challenges involved in attempting to put on one of these cases in a U.S. court. All of the lawyers wrestled with problems, for example, involving currency conversions and language translations. Abbey in particular seemed to experience embarrassment and discomfort using French names and phrases. The lawyers also warned that much of the testimony and many of the documents are in French for which the jury would be given English translations.

 

In addition, the opening statements also showed the complications that will arise from differing accounting systems, different account practices and standards, and different accounting conventions.

 

Third, all of the lawyers’ opening statements underscore the problems any plaintiff would face when large unrelated but material events – such as the 9/11 tragedy and the dot-com crash – happened at the same time as the supposed events of which the plaintiffs were complaining. Abbey tried to anticipate these issues and explain the plaintiffs’ theory of how these events should be understood in the context of the plaintiffs’ case. The defense counsel, for their part, showed that the defendants will argue that the challenges the company faced can only be understood within the context of these external events, which are, the defense counsel contend, among the root causes of the company problems involved in the case.

 

The parallel to the challenges facing the plaintiffs in the current round of subprime and credit crisis-related cases is unmistakable. The plaintiffs in these more recent cases will face the same challenge of attempting to explain how company-specific rather than marketplace-wide developments led to the defendant companies’ problems.

 

The final observation from a reading of the transcript is that the trial of a complex matter like a class action securities case is an elaborate, time-consuming, pain-staking exercise that could quickly become mind-numbingly tedious. Just judging from the opening statements, the jury could be in for a very long slog. One can only imagine how the jurors’ hearts sank when they heard Messier’s counsel tell them in his opening statement that "this trial will go on for months."

 

Nor will the verdict of this jury bring an end to this matter. Not only will there likely be further proceedings in this case, but as a result of the court’s class certification ruling in this case excluding Austrian and German investors from the plaintiff class, this case may only be the first of the trials in this matter. As reported in an October 7, 2009 article in the Telegraph (here), the defendants could face a "second trial" brought on behalf of European investors excluded from the plaintiff class in the Southern District of New York. (Hat tip to the 10b-5 Daily, here, for the Telegraph article link).

 

In my earlier post about the Vivendi trial, I noted how rare trials are in securities class action lawsuits. In an October 8, 2009 post (here) on his Enforcement Action blog, Bruce Carton (also the author of the Securities Docket blog), interviewed Adam Savett of the Securities Litigation Watch blog. In the brief interview, hosted on the Enforcement Docket site, Savett reviews statistical data regarding the prior securities cases that have gone to trial, and discusses why trials in these cases are so rare. He also discusses the significance of the presence of the f-cubed claimants.

 

They’re a Page Right Out of Hist-oh-Ree: Even allowing for the fact that The Flintstones show was set in the Stone Age, the program advertisement linked below still seems deeply primitive. Clearly, prehistoric peoples had a longer attention span, as the commercial seems almost movie-length compared to its more modern counterparts.

 

And even allowing for the time lapse since those long ago days, the advertisement’s politically incorrect premise and tobacco-related message seem vestiges of a culture completely unrelated to our own.

 

Finally, the way that Fred and Barney are sneaking around together and hiding from their wives, you do start to wonder whether the final line in the show’s theme song lyrics implied more than might originally have been suggested.

 

https://youtube.com/watch?v=oc1TBBp4dC8%26hl%3Den%26fs%3D1%26