Stanford Financial Group’s D&O insurer may advance the individual directors’ and officers’ defense expenses without violating the court’s receivership order, according to an October 9, 2009 ruling by Northern District of Texas Judge David Godbey. A copy of Judge Godbey’s ruling can be found here.

 

As detailed in a prior post (here), the insurer had been prepared to begin advancing defense expenses of Stanford Group’s former CFO, Laura Pendergest-Holt, subject to a reservation of its rights to later deny coverage under the policy if circumstances should warrant. However, before the insurer began advancing these amounts, the Stanford group receiver had notified the receiver that if the insurer advanced Pendergest-Holt’s defense expenses, the receiver would seek to have the insurer held in contempt of court for violating the court’s receivership and asset freeze orders.

 

The receiver asserted that the proceeds of the D&O insurance policies are "receivership assets" within the meaning of Judge Godbey’s prior receivership and asset freeze orders. The receiver also argued that his right to the proceeds "supersedes" the rights of insureds under the policy.

 

Pendergest-Holt filed a motion in the SEC enforcement proceeding (here) seeking a judicial clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeking authorization for the disbursement of the proceeds for payment of her defense expense.

 

The insurer itself had also inquired of the court whether it could advance the defense expenses without "running afoul" of the receivership order. However, the insurer, which has separately filed an action seeking a judicial declaration that the Stanford receivership is not entitled to payment of claims as a result of the operation of policy exclusions, did not request the court in the SEC enforcement proceeding to decide whether or to what extent any insured is entitled to coverage—it sought only to determine whether the receivership order barred it from advancing the individuals’ defense fees.

 

In his October 9 ruling, Judge Godbey concluded that he did not need to determine whether or not the proceeds were receivership assets, because he concluded that he would exercise "equitable discretion" to permit the payment of defense costs "even if the proceeds were part of the receivership estate."

 

In deciding to exercise his discretion to allow the proceeds to be advanced for defense expenses, he noted that "there is no argument that the insurance proceeds are potentially tainted by fraud" and therefore "the Court has not duty to preserve them as such." As for the possibility that the insurance premiums might have been paid with "stolen money," he noted that while this might be "unjust and regrettable," that fact "would not entitle victims to proceeds of policies intended to pay defense costs."

 

With respect to the receiver’s argument that allowing policy proceeds to fund the individuals’ defense expense would "decrease the coverage dollars eventually available for distribution," Judge Godbey found that "the possibility that the D&O proceeds might one day be paid into the receivership does not justify denying the directors’ and officers’ claims." The judge noted that the receiver "has not yet tendered any claims against the Stanford entities to [the insurer] for a defense," noting further that even if it had, "it is not at all clear" that the insurer would ever pay a claim into the receivership, owing to the insurer’s policy defenses.

 

Finally, Judge Godbey found that the "interests of fairness" justify allowing the individuals to access the insurance proceeds. The receivership’s potential claims are "speculative" while the individuals "expected that D&O proceeds would afford a defense" and the "potential harm to them if denied is not speculative but real and immediate: they might be unable to defense themselves."

 

Judge Godbey emphasized that in his ruling that his prior orders the insurer from disbursing policy proceeds to fund the individuals’ defense, he was not holding that any defendant "is entitled to have its defense costs paid by D&O proceeds." Moreover, Judge Godbey emphasized that his October 9 ruling does not authorize the insurer "to pay any claims other than defense costs."

 

Though Judge Godbey ruled only on Pendergest-Holt’s motion, his ruling expressly "extends to any covered officer or director whose claim is approved" by the insurer. Judge Godbey’s ruling seemingly applies to R. Allen Stanford himself, at least to the extent that the ruling represents a determination that the court’s prior receivership orders are no bar to the insurer advancing defense costs.

 

Whether the insurer will in fact advance Allen Stanford’s defense expenses may be yet to be determined, notwithstanding the October 9 ruling that the receivership order is no bar. An October 9, 2009 Bloomberg article (here) presumes that as a result of Judge Godbey’s ruling, Stanford is now entitled to have his attorneys’ fees advanced. Indeed, absent a judicial "determination" that Stanford in fact engaged in excluded misconduct, the basis on which the insurer might withhold advancement of Stanford’s defense expenses is not immediately apparent, notwithstanding the seriousness of the allegations against him.

 

The problem for everyone involved is the sheer number of persons who will seek to have their defense fees paid by the insurance and the extent of the collective defense expense. According to the Bloomberg article, as many as 60 Stanford officials are seeking to use the D&O insurance proceeds to pay their legal bills. Moreover, many of these individuals are involved in numerous civil and criminal proceedings.

 

The total amount of D&O insurance available is not entirely clear from the published reports. The Bloomberg article variously reports that the total insurance limits are "as much as $50 million" and "as much as $90 million" – kind of a big swing on a rather important detail. But the potential for defense expenses in catastrophic claims to substantial erode or even exhaust insurance programs of a similar magnitude has already been demonstrated in other claims (refer for example here).

 

Given the seriousness of the allegations and the multiplicity of proceeding involved, the various individuals’ collective defense expenses could quickly erode the available limits, particularly if, as seems possible, Stanford himself accesses the policy proceeds for his defense expenses.

 

It is worth noting that Judge Godbey exercised his discretion to allow the proceeds to be advanced toward the defense expenses, notwithstanding the Stanford entities’ potential claims, even though this policy reportedly lacked a "priority of payments" provision, which would have given the individual defendants priority to the policy proceeds over the entity, as a matter of policy language. As discussed in an October 4, 2009 Business Insurance article (here), this type of provision is now standard in most D&O insurance policies, and might have helped sort out this dispute, although in the end the outcome apparently would have been no different.

 

Special thanks to William Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of Judge Godbey’s October 9 ruling.

 

No D&O Policy Coverage Where Claim Made Only Against the Company: In an October 8, 2009 opinion (here), the First Circuit held that a D&O insurance policy does not cover the settlement of a disability discrimination claim that did not name any individual directors and officers as defendants.

 

The Medical Mutual Insurance Company of Maine had been sued in an administrative proceeding by a former company executive who claimed that the company had discriminated against him due to his stroke-related disability. The administrative proceeding resulted in a "right to sue" letter, pursuant to which the former executive initiated a federal court discrimination lawsuit. Both the administrative complaint and the federal complaint named only the company itself as a defendant.

 

The company settled the lawsuit and sought coverage under the D&O insurance policy for $325,000 of the settlement amount. The D&O insurer denied coverage under its policy, arguing that because there had been no claim made against an individual director or officer, there was no coverage for the settlement under the policy’s "corporate reimbursement" coverage. (The opinion explains in footnote 3 that while the policy also separately provided "entity coverage" for "securities claims," the discrimination complaint was not a securities claim and accordingly the policy’s separate entity coverage provisions were not implicated.)

 

In an October 8 opinion written by Judge Bruce Selya, the First Circuit held that the company’s argument that the policy’s coverage extended to claims in which directors and officers were not named as defendants "would if accepted transmogrify D&O policies into comprehensive corporate liability policies," and that "such a transmogrification is contrary to both the letter and the spirit of the D&O policy at issue."

 

The company had argued that the Policy’s claims made requirement had been satisfied because the underlying discrimination complaint consisted "largely of allegations of misconduct on the part of the directors and officers." The First Circuit held that "no matter what conduct the complaint describes, it is not a claim ‘made against’ any of the directors and officers."

 

The court went on to note that the policy’s separate requirements of both allegations of wrongful acts and for claims against insured persons "are complementary requirements and allegations of wrongful acts, without more, do not satisfy both."

 

The First Circuit’s opinion is arguably unremarkable, as D&O policies clearly and separately require both allegations of wrongful acts and claims to be made against insured persons.

 

The only puzzling thing to me about this case is why there was a D&O insurance dispute at all. The more natural place for the company to have looked for coverage for a claim like this is an Employment Practices Liability (EPL) insurance policy. EPL policies are designed to provide coverage for employment-related discrimination claims and generally provide coverage for claims against the insured organization.

 

Because I was curious, I ran down the parties’ appellate briefs on PACER. As it turns out, and as might have been predicted, the insured company did indeed also submit this claim to its EPL insurer.

 

As reflected in the D&O insurer’s appellate brief (here, at pages 4-6), not only did the EPL insurer provide the company with a defense for the underlying claim but it also paid $225,000 toward a total settlement amount of $500,000. The remaining $325,000 portion of the settlement amount for which the company sought coverage under the D&O policy represented the amount the company paid in resolution of the former executive’s unpaid contractual severance and benefits, for which the EPL carrier denied coverage under its policy.

 

So – that explains why this company was trying to stick what is rather obviously an EPL claim into the D&O policy, because there was a portion of the underlying EPL claim settlement for which the EPL policy did not provide coverage.

 

In any event, congratulations to my friend and former colleague Leslie Ahari, who represented the insurer in this action.

 

An October 12, 2009 Law.com article discussing the opinion can be found here. Special thanks to alert reader Marty Fox for providing me with a link to the Law.com article.

 

The Transmogrifier: For reasons unrelated to the merits or even the issues involved, the First Circuit’s opinion is one of my new favorites — it is the first judicial opinion of which I am aware using the words "transmogrify" and "transmogrification." (Judge Selya, the opinion’s author, has a well-established reputation for using flamboyant and occasionally obscure language in his opinions.)

 

The word "transmogrify" in its various formulations was forever immortalized in the Calvin and Hobbes comic strip, in which Calvin turned an empty cardboard box into a "transmogrifier," capable of changing a person into "whatever you’d like to be."

 

There is a truly wonderful website here dedicated exclusively to the Calvin and Hobbes transmogrifier comic strips. And the excuse to be able to link here to the Transmogrifier site is more than enough justification for discussing the First Circuit opinion above.

 

Please click through to the site and enjoy the comic strips. They will make you smile. You too could consider turning yourself into a "500-story gastropod, a slug the size of the Chrysler Building." However, do keep in mind, as Calvin reminded Hobbes, that "transmogrification is a new technology."

 

In the latest of the subprime and credit crisis cases to be dismissed, on September 30, 2009, District of Massachusetts Judge Richard G. Stearns dismissed the securities class action lawsuit that had been filed by purchasers of mortgage pass-through certificates against Nomura Asset Acceptance Corporation, certain of its directors and officers, the eight mortgage trusts that had issued the certificates, and the offering underwriters who had supported the 2005 and 2006 public offerings of the certificates. A copy of Judge Stearns’s opinion can be found here.

 

As discussed in my prior post about this case (here), the plaintiffs initially filed their complaint against Nomura in Massachusetts state court, but the defendants removed the case to federal court. After plaintiffs had amended their complaint, the defendants moved to dismiss. More detailed background regarding the case can be found here.

 

In their amended complaint (here), the plaintiffs alleged that in connection with each of the eight separate certificate offerings, the defendants had misled investors with respect to the loan underwriting by the originators of the mortgages in the trusts; with respect to the originators’ appraisal practices; with respect to level of delinquencies for the mortgages in the trusts; and with respect to the certificates’ investment ratings.

 

The court first addressed the standing of the plaintiffs to assert claims against the eight trusts, which, Judge Stearns noted, "are separate legal entities" that "each issued its own securities backed by different pools of mortgages." Judge Stearns found that because the named plaintiffs had only bought certificates from three of the eight defendant trusts, "the named plaintiffs are incompetent to allege an injury caused by purchase of Certificates that they themselves never purchased."

 

Judge Stearns held, based on the "overwhelming weight of authority," that the named plaintiffs lacked constitutional standing to assert claims against the five trusts from which they had not purchased certificates. Judge Stearns also held that the named plaintiffs lacked standing to assert claims against the offering underwriter defendants that had supported offerings only with respect to the five trusts from which the plaintiffs had not purchased securities. Judge Stearns dismissed the claims against the five trusts and the associated offering underwriter defendants.

 

Judge Stearns also granted the remaining defendants motions to dismiss the plaintiffs Section 12(a)(2) claims. He held that in order to state a claim under Section 12(a)(2), the plaintiffs must allege that they purchased securities from the defendants. However, the plaintiffs alleged only that they "acquired" the securities "pursuant and/or traceable to" the offerings. In granting the motion to dismiss the Section 12(a)(2) claims, Judge Stearns noted that "if plaintiffs did in fact purchase the Certificates directly from the defendants, they should have said so. An evasive circumlocution does not suffice as a substitute."

 

Finally, Judge Stearns granted the motion of the remaining defendants to dismiss the remaining claims under Sections 11 and 15 of the ’33 Act. He found with respect to the plaintiffs’ allegations concerning the mortgage originators’ underwriting standards that the offering documents contain a "fusillade of cautionary statements" that "abound with warnings about the potential perils." Judge Stearns noted that plaintiffs’ contention that they were not "on notice" of those perils "begs credulity."

 

With respect to the alleged misrepresentations regarding loan delinquency, Judge Stearns, noting that the allegedly delinquent loans represent 0.1 percent of the mortgages in the pool, stated that "there is no plausible question regarding materiality."

 

Finally, with respect to the allegations concerning the certificates’ ratings, Judge Stearns noted that while questions regarding the process by which mortgage-backed securities received ratings have arisen in recent months, none of those questions pertain specifically to the ratings of these certificates. Moreover, none of the later developments "support the inference that the ratings were compromised as of the dates" on which the offering documents became effective.

 

Because Judge Stearns found that the plaintiffs "have failed to allege a sufficient factual basis to support their claims for Securities Act violations," he granted the defendants’ motions to dismiss with prejudice.

 

The Nomura action is only one of many securities lawsuits that investors have brought against the securitizers that aggregated mortgages into pools that issued mortgage-backed securities. In many of these cases, as in the Nomura case, the plaintiffs have lumped together many different issuing trusts and many different offerings. In some of these cases, the plaintiffs will face the same "standing" hurdles that confounded the plaintiffs in the Nomura case.

 

And more to the point, the offering documents provided in connection with many of these mortgage-backed securities offerings, like the documents relating to the offerings at issue in the Nomura case, also contained a "fusillade of cautionary statements" that abound with warnings" about the perils.

 

During most of 2008 and into early 2009, Plaintiffs aggressively filed these types of Securities Act cases against the securitizers, perhaps on the theory that a Securities Act case (for which there are no scienter pleading requirements) might more easily survive a dismissal motion. However, Judge Stearns opinion in the Nomura suit suggests that these cases could face rigorous scrutiny and may also face substantial difficulty getting over the initial pleading hurdles.

 

I have in any event added the opinion in the Nomura case to my register of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here.

 

Special thanks to a loyal reader for providing a copy of Judge Stearns’s opinion.

 

Full Disclosure: On October 5, 2009, the Federal Trade Commission announced (here) that it had approved final revisions to the guidance it gives advertisers on how to keep their endorsements and testimonials in compliance with FTC requirements. The FTC’s formal Notice of Adoption of the guidelines can be found here.

 

These new guidelines have received a great deal of attention for the requirements they purport to impose on bloggers. For example, the Wall Street Journal seemed to think that the FTC’s requirements regarding bloggers is front page news (refer here). The guidelines do seek to impose certain requirements on bloggers. For example, in its press release, the FTC stated that "bloggers who made an endorsement must disclose material connections they share with the seller of a product or service."

 

Everyone here at The D&O Diary wants to reassure our readers that we have accepted no promotional considerations of any kind in connection with matters discussed on this blog. Of course, it is probably fair to note that no one has ever offered us any promotional considerations, darn it. But readers can be assured that if we ever did have the opportunity to accept any promotional consideration, we would fully disclose the consideration in compliance with FTC requirements.

 

Our "promotional consideration intake operators" are standing by …

 

Speakers’ Corner: On October 16, 2009, at 11 am EDT, I will be participating in a one hour webinar sponsored by Advisen, about securities litigation during the third quarter of 2009. Joining me on the panel will be 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.

 

This webinar will review securities cases filed and settled during the third quarter, include shareholder derivative suits, securities fraud suits, and other categories of securities-related litigation. The registration materials for the webinar can be found here.

 

In several prior posts (most recently here), I have noted that defendants seem to be faring particularly well at the dismissal motion stage in the subprime and credit crisis-related lawsuits. However, in recent dismissal motion rulings in two subprime-related cases, one in a securities class action lawsuit and one in an ERISA class action lawsuit, the plaintiffs substantially prevailed, though in each cases portions of the plaintiffs’ complaint were also dismissed. If nothing else, these rulings demonstrate that in at least some of the cases, plaintiffs are to some extent managing to overcome the initial pleading hurdles.

 

General Growth Properties: In a September 17, 2009 order (here), Northern District of Illinois Judge Milton Shadur denied in part and granted in part the defendants’ motion to dismiss the complaint that General Growth Properties shareholders had filed against the company and eleven of its directors and officers. My prior post about the General Growth action can be found here and detailed background about the case can be found here.

 

The plaintiffs’ amended complaint contained three separate counts. The first count alleged that in a series of statements during 2008, the defendants misrepresented the company’s ability to refinance debt that was to mature in November 2008. The complaint’s first count further alleged that the company’s COO and CFO had received loans from the CEO’s family trust in violation of company’s ethics policies. Count II of the complaint alleged that the defendants allegedly "rigged the system" by obtaining a short-selling ban from the SEC prior to disposing of extensive share holdings. Count II alleged control person liability.

 

Judge Shadur granted the motions to dismiss Counts II and III, but denied in substantial part the dismissal motion with respect to Count I.

 

The defendants had moved to dismiss the allegations in Count I on the grounds that the allegedly misleading statements on which plaintiffs sought to rely all came with the "safe harbor" for forward-looking statements.

 

Judge Shadur agreed with the defendants that, except as to one of the alleged misrepresentations, all of the statements on which plaintiffs’’ sought to rely were accompanied by "meaningful cautionary language," as required to come within the safe harbor. As Judge Shadur noted, "General Growth’s cautionary statements were in fact entirely anticipatory of Plaintiffs’ claims."

 

However, even if they were accompanied by meaningful cautionary language, the statements only qualify for safe harbor protection if they were also "forward looking." In a very detailed and painstaking analysis, Judge Shadur went through each of the alleged misrepresentations on which plaintiffs sought to rely and found that while some of the statements were indeed forward-looking and therefore are within the safe harbor, many others were not forward looking and there for outside of the safe harbor.

 

Judge Shadur found further that the plaintiffs had adequately pled scienter. The defendants had argued that the plaintiffs impermissibly attempted to rely on "group pleading." Judge Shadur noted that, in general, it is insufficient to attempt to infer scienter from individual defendants’ corporate positions and generalized responsibility for corporate actions. However, he found further that the group pleading doctrine "does not render each individual defendant’s position within a company irrelevant."

 

In this case, Judge Shadur found that "the insider Defendants either had to know about General Growth’s ability or inability to refinance its looming debt, or if they did not, such lack of knowledge would amount to reckless disregard." As a result, Judge Shadur concluded that the defendants’ argument regarding group pleading "is without merit."

 

Judge Shadur also rejected defendants’ argument that their insider sales could not support scienter, because their sales were "the result of margin calls over which they had no control." However, he noted that the defendants’ arguments in that regard "fail to acknowledge" plaintiffs’ contentions that the defendants "attempted to inflate the stock price in an attempt to avoid margin calls."

 

Judge Shadur did dismiss Count II of the plaintiffs’ complaint relating to defendants’ alleged scheme to ban short selling of the company’s stock. He noted that "without an explanation as to who played what role in the alleged scheme," Count II fails to meet the pleading requirements. Judge Shadur also rejected the plaintiffs’ control person liability allegations, finding that "without alleging facts other than defendants’ status to support their conclusion, a count for control person liability is improperly pleaded and must be dismissed."

 

Thus, though Judge Shadur did dismiss significant parts of the plaintiffs’ complaint, a substantial portion of the plaintiffs’ claims remain and those allegations will go forward.

 

First Horizon: On September 30, 2009, Western District of Tennessee Judge S. Thomas Anderson denied in part and granted in part the defendants’ motion to dismiss the plaintiffs’ ERISA class action complaint that had been filed against First Horizon National Corporation (the holding company for First Tennessee Bank) and its plan fiduciaries.

 

As reflected in the plaintiffs’ complaint (here), the plaintiffs allege that the company required plan participants to invest in the company’s stock in order to received matching contributions. As of the end of 2005, more than half of the plan’s assets were invested in company stock.

 

The plaintiffs contend that after January 1, 2006, the investment in company stock was "imprudent" because the bank was lowering its underwriting standards, becoming more heavily involved with subprime and Alt-A loans, and increasing its use of off-balance sheet transactions. The plaintiffs contend that the company’s share price declined when the company announced on April 28, 2008 that it needed to raise $600 million of additional capital.

 

Judge Anderson granted the motion to dismiss with respect to plaintiffs’ allegations that defendants’ breached their fiduciary duty by requiring participants to invest in the company stock fund in order to receive matching contributions from the company in the form of company stock. Judge Anderson held that because these requirements are part of the Plan itself, the plaintiffs allegations failed to state a claim for breach of fiduciary duty.

 

However, Judge Anderson denied the defendants’ motion to dismiss plaintiffs’ claims that the defendants breached their duty by failing to take steps to remove the stock from the plan. Judge Anderson noted that the plan gave the defendants discretion to invest plan assets. Thought the plan required the fiduciaries to invest in company stock, " a plan does not impose on a fiduciary an unquestioning duty to follow the terms of the plan when doing so would be imprudent," holding further that under ERISA a plan fiduciary may only follow plan terms to the extent that those terms are consistent with ERISA.

 

Judge Anderson did dismiss plaintiffs’ claims that the defendants had breached ERISA by failing to provide employees with complete and accurate information about First Horizon’s financial condition, finding that the plaintiffs "have pointed to no provision in ERISA requiring a fiduciary to disclose the specific kinds of risks and factors" the plaintiffs claim the defendants omitted to disclose.

 

Similarly to the outcome in the General Growth Properties securities case, a material portion of the First Horizon ERISA complaint survived the motion dismiss, even though significant parts of the complaint were also dismissed. In both cases, the claims that survived the dismissal motion will go forward.

 

I have in any event added both decisions to my register of subprime-related dismissal motion rulings, which can be accessed here.

 

Court Grants Renewed Dismissal in Fremont General Case: While the plaintiffs in the above cases managed to overcome the initial pleading hurdles at least in part, the plaintiffs in the Fremont General securities lawsuit have now twice failed to survive a dismissal motion, although the court has given them yet another opportunity to amend their complaint to try to cure the pleading defects.

 

As noted here, Central District of California Judge Florence-Marie Cooper had previously granted the defendants’ initial motion to dismiss, with leave to amend. The plaintiffs subsequently amended their complaint, and the defendants renewed their dismissal motion.

 

In a September 25, 2009 order (here), Judge Cooper granted the defendants’ renewed motion to dismiss, but with further leave to amend.

 

As an initial matter, Judge Cooper found that "despite an effort to add allegations that would address the problems identified in the Court’s October 28, 2008 order, the [amended complaint] still suffers from inadequate organization and insufficient specificity to adequately plead falsity and the requisite level of scienter." She noted further that plaintiffs’ "puzzle pleading" makes it "extremely difficult to identify or follow Plaintiffs’ reasoning and to determine – with specificity — which allegations are intended to establish the falsity and scienter requirements."

 

She concluded that

 

Lead Plaintiff’s factual allegations are neither sufficient, nor sufficiently particularized, to satisfy the pleading standard for the falsity requirements, nor they [sic] do they articulate facts sufficient to give rise to the requisite strong inference that one or more of the Defendants made the challenged statements with the requisite level of scienter.

 

Finally, Judge Cooper commented that the plaintiff’s allegations that "Fremont’s underwriting was woefully inadequate and that some or all of Defendants utterly failed to implement policies and procedures sufficient to halt the company’s downward spiral," even if take as true, are "less likely to support an inference of fraud than they are to support an inference of profoundly misguided corporate mismanagement."

 

Judge Cooper gave the plaintiff thirty days to amend the complaint, but directed further that certain specific statements, which she said were "so broad or vague as to not be actionable" should be "omitted from the amended pleading."

 

I have also added Judge Cooper’s September 25 order to my register of dismissal motion rulings.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for copies of the General Growth and Fremont General decisions.

 

Special thanks to Stephen Pincus of the Stember Feinstein Doyle & Payne law firm for providing a copy of the First Horizon decision. Pincus represents the plaintiffs in the First Horizon case.

 

In a rare case in which a securities suit is actually going to trial, on Monday a jury was empanelled in the Vivendi securities class action lawsuit pending in the Southern District of New York. An October 5, 2009 New York Times article summarizing the background of the case can be found here. A more detailed description of the case can be found here.

 

The Vivendi trial is unusual in another respect – it involves the claims of so-called "f-cubed" claimants, as detailed in an October 5, 2009 AmLaw Litigation Daily article by Andrew Longstreth (here). That is, the case involves claims by foreign shareholders of a foreign domiciled company who bought their shares on foreign exchanges.

 

However, because of March 22, 2007 class certification rulings by Southern District of New York Judge Richard Holwell, the class on whose behalf the claims are asserted does not include all potential f-cubed claimants. That is, though the class includes claimants from France, England and the Netherlands, it does not include investors from Austria and Germany.

 

As the AmLaw Litigation Daily article notes, plaintiffs’ lawyers, who are keenly interested in bringing claims in U.S. courts on behalf of foreign investors, will be watching this case closely.

 

As noted in a prior post (here), the question of the extraterritorial application of the U.S. securities laws is a current hot topic that could well wind up before the U.S. Supreme Court this term. In addition, as noted here, subject matter jurisdiction over the claims of f-cubed claimants is one of the issues addressed in financial reform legislation recently introduced in Congress.

 

The Vivendi case is actually the second securities class action lawsuit to go to trial this year. As detailed here, on May 7, 2009, a jury in the Northern District of Illinois entered a mixed verdict in the plaintiffs’ favor in the Household International securities suit.

 

As reported on the Securities Litigation Watch blog (here), only 21 cases (prior to Vivendi) have gone trial since the 1995 enactment of the PSLRA. Only seven of the 21 cases (including the Household International case) that have gone to a verdict involved conduct that occurred after the PSLRA was enacted. Accounting for post trial motions and appeals (and post-appeal trials), with respect to the seven cases, the current scoreboard standings show three wins for the plaintiffs and four for the defendants.

 

Credit Suisse Subprime Suit DIsmissed on Jurisdictional Grounds: In a topically related development that also took place in the Southern District of New York yesterday, on October 5, 2009, Judge Victor Marrero released his opinion (here) explaining his prior September 28, 2009 dismissal, on the grounds of lack of subject matter jurisdiction,  of the subpime securities class action lawsuit that had been filed against Credit Suisse and certain of its directors and officers.

 

As described in greater detail here, the plaintiffs had alleged that the defendants misrepresented the company’s financial condition by failing to disclose schemes to overstate assets, underestimate risk, hide subprime exposure, and ignore weaknesses in risk management and internal controls. The risk management and internal control allegations referred to the criminal prosecution of two former U.S.-based Credit Suisse employees, Julian Tzolov and Eric Butler, in connection with their sale of securities to customers of the bank, about which refer here.

 

In considering the sufficiency of the court’s subject matter jurisdiction over the case, Judge Marrero divided the question between the claims of foreign-domiciled claimants who bought their shares in the foreign-domiciled claimants on a foreign exchange (the "f-cubed" claimants) and the claims of claimants who had bought ADRs on the NYSE. Approximately 4.1% of investors had bought their investment through ADRs on the NYSE.

 

Judge Marrero concluded that the court did not have jurisdiction over the f-cubed claimants,  observing that the plaintiffs "have not adequately alleged or otherwise demonstrated that hte fraudulent schemes…were concocted or masterminded in the United States." He found further that the allegedly misleading statements had originated abroad, and the wrongful acts alleged in the United States (even the alleged criminal misconduct of the two former Credit Suisse employees) fail to satisfy the conduct test for the exercise of jurisdiction over the claims of foreign claimants.

 

Judge Marrero also held that the court lacked subject matter jurisdiction over the claims of investors who bought ADRs on the NYSE, holding that he could not conclude that the plaintiffs "have demonstrated the required effects on United States investors." This latter result appears largely to be due to "lack of information" and "lack of briefing" on the plaintiffs’ part. (Among other things, the amended complaint neglects to specify the domicile of the proposed lead plaintiffs who had bought ADRs on the NYSE.)

 

Judge Marrero allowed the plaintiffs 20 days to file a motion in which to attempt to show why allowing the plaintiffs to amend their complaint would not be futile.

 

The contrast between the events yesterday in the Southern District of New York courthouse involving these two cases could not be more stark. On the one hand, a jury is being empanelled with respect to the claims of the f-cubed claimants in the Vivendi case, which appears likely to head to a verdict. Yet in the same courthouse, Judge Marrero issued an opinion in whch he concluded that the court lacked subject matter over the claims of the f-cubed claimants. To be sure, this stark difference between the way the two cases have fared in the courthouse may simply be a reflection of underlying differences between the cases. Nevertheless, the contrast is stark.

 

Special thanks to a loyal reader for providing a copy of the October 5 opinion.

 

 

 

One consequence of the current economic crisis that has long seemed inevitable is some form of legislative overhaul of the financial regulatory system. This possibility may have taken one step toward realization with the October 1 release of a package of legislative proposals by Pennsylvania Democratic Congressman Paul E. Kanjorski, the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurnace and Government Sponsored Enterprises.

 

In his October 1, 2009 press release (here), Kanjorski released "discussion drafts" of three pieces of proposed legislation that, in the words of the press release, are "aimed at tracking key parts of reforming the regulatory structure of the U.S. financial services industry. The three bills include the Investor Protection Act (here), the Private Fund Investment Advisors Registration Act (here), and the Federal Insurance Office Act (here).

 

Most of the media coverage of these initiatives has focused on the second of these three proposals, the Private Fund Investment Advisors Act, as reflected for example in an October 2, 2009 New York Times article (here) about Kanjorski’s proposals. This proposed Act would for the first time require many financial providers, such as hedge funds and private equity funds, to register with the SEC. The proposed provisions specify recordkeeping and disclosure requirements and provide regulators with the authority to, as the press release states, "examine the records of these previously secretive investment advisors."

 

The Federal Insurance Office Act, as its name suggests, would create a national office of insurance. It does not appear that the proposed legislation would supplant state regulator of insurance or even provide for the so-called dual option that has been discussed for some time and which would allow insurers to choose whether to be regulated at the state or federal level, as banks do now.

 

The creation of a Federal Insurance Office would be intended to remedy a perceived "lack of expertise within the federal government" regarding the insurance industry. The new Insurance Office would "provide national policymakers with access to information" in order to allow them to respond to crises and to ensure a "well functioning financial system."

 

Though it has received less attention, the third piece of proposed legislation, the Investor Protection Act, also contains some potentially significant provisions, including some proposed revisions to the federal securities laws.

 

The Investor Protection Act contains a number of proposed legislative changed designed to strengthen the SEC and boost investor protection. Among other things, the Act would, according to the press release, double the SEC’s funding over five years and provide "dozens of new enforcement powers and regulatory authorities."

 

The Investor Protection Act also introduces a number of proposed innovations, including a proposed whistleblower "bounty" that is intended to "create incentives to identify wrongdoing in our securities market." These provisions allow for bounties of up to 30 percent of monetary sanctions imposed on wrongdoers to be paid to whistleblowers, and also provide protection for whistleblowers from retaliation. The proposed Act also includes a number of provisions designed to facilitate collaboration between the SEC and foreign securities regulators. Broc Romanek outlines a number of the other provisions of the proposed Act on his CorporateCounsel.net blog (here).

 

Among the changes proposed in the Investor Protection Act are the jurisdiction provisions proposed in Section 215 of the Act, relating to "Extraterritorial Jurisdiction."

 

It has long been noted that federal securities laws are silent about their extraterritorial reach. The courts have long struggled with jurisdictional issues in securities cases involving foreign-domiciled companies – as, for example, was extensively reviewed by the second circuit in its 2008 decision to Morrison v. National Australia Bank (about which refer here) and by the 11th Circuit in its recent decision in the CP Ships case (refer here).

 

Section 215 of the proposed Act would in effect legislatively mandate a jurisdictional standard for extraterritoriality. The jurisdictional reach proposed in the statute is very broad. By way of contrast, the defendants and amici in the Morrison case had urged the court to adopt a "bright line" test that would have held that mere conduct in the U.S. alone should not be enough for U.S. courts to exercise subject matter jurisdiction when the conduct had no effects in the U.S.

 

In its opinion in the Morrison case, the Second Circuit had rejected this proposed bright line test, holding that subject matter jurisdiction exists "if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused the losses abroad."

 

Section 215 would amend the ’33 Act, the ’34 Act and the Investment Advisors Act of 1940 to specify that U.S. courts could properly exercise jurisdiction in any action involving "conduct with the United States that constitutes significant steps in furtherance of violation, even if the securities transaction occurs outside the United States and involves only foreign investors," as well "conduct outside the United States that has a foreseeable substantial effect in the United States." Under the first of these two prongs, U.S. based conduct alone would be sufficient jurisdictional basis, even with respect to foreign purchasers of who purchased their shares of foreign-domiciled companies on foreign exchanges (so-called "f-cubed claimants").

 

This proposal may represent a legislative effort to head off the Supreme Court, which is currently considering whether to grant certiorari in the Morrison case. Of course, it remains to be seen whether or not this jurisdictional provision will survive the legislative process, or even whether regulator reform legislation in any form remotely resembling the proposal Congressman Kanjorski has put forward.

 

According to the Times, the House Financial Services Committee has scheduled an October 6, 2009 hearing to discuss this issue of hedge fund regulation, among other issues. Though there is a glut of items on the current Congressional agenda, reform of financial regulation in some form seems likely in the current political and economic environment. What will emerge of course will only be revealed in the fullness of time, but Congressman Kanjorski’s opening salvo suggest that the process could be interesting and that the final outcome could included significant innovations and alterations on a wide variety of topics.

 

Special thanks to a loyal reader for sending along links to Congressman Kanjorski’s press release.

 

PLUS Chapter Event: On Wednesday, October 7, 2009, I will be moderating a panel at a Professional Liability Underwriting Society Midwest Chapter event at the Hyatt Hotel in Cincinnati, Ohio. The title of the panel is "Bankruptcy and Barriers to Coverage." The panel, which will go from 3 pm to 5 pm, followed by a reception, will include several of the leading D&O coverage experts. Registration information is available here.

 

On September 30, 2009, in a decision that will be widely discussed both because of the high profile figures involved as well as because of the outcome, Southern District of New York Judge Loretta A. Preska ruled (here) that the statute of limitations bars the action brought by the Milberg law firm’s professional liability insurers to rescind the policies they had issued to the firm.

 

Background

During the period January 31, 2001 through January 31, 2004, the Milberg firm was insured under two professional liability insurance policies issued through the London insurance markets (the "Lead Policies") as well as under an Excess Policy.

 

In January 2002, Milberg and certain of its partners learned that they were the subject of a criminal investigation. The firm was served with investigative subpoenas. The law firm advised the insurers of the subpoenas and the investigation. The Lead Insurers provided defense expense funding in connection with the criminal investigation pursuant to an interim funding agreement.

 

The firm and several of its partners were indicted in May 2006. The firm provided a copy of the indictment to the insurers. During 2007 and 2008, four individual partners – Melvyn Weiss, David Bershad, William Lerach, and Steven Schulman – pleaded guilty to criminal charges for paying kickbacks to name plaintiffs in securities class action litigation. (Refer below for links regarding the guilty pleas.) On June 16, 2008, the prosecutor dropped the charges against the law firm itself under a non-prosecution agreement that required the firm to pay $75 million.

 

On August 26, 2009, the Lead Insurers filed an action seeking to rescind their policies, based on their allegation that they had been induced to provide the insurance by material misrepresentations in the policy application. The Excess Insurer intervened. The defendants moved to dismiss the action on the grounds that it is barred by the applicable statute of limitations.

 

The September 30, 2009 Decision

In granting the defendants’ motion to dismiss, Judge Preska rejected all of the Lead Insurers’ arguments that their action was not barred by the statute of limitations.

 

The Lead Insurers first argument was that the defendants should be "equitably estopped" from asserting the statute as a defense, because of the firm’s "emphatic denials" while the investigation was pending that the allegations had any basis. Judge Preska rejected this theory because the defendants failed to show or allege that they had reasonably relied on these denials of criminal guilt. Among other things, Judge Preska commented that:

 

This case … involves a contractual relationship between an insurer and an insured, both of who are sophisticated parties dealing at arm’s length. The London Insurers were not lulled into believing Milberg’s claims of innocence the same way a patient may be lulled into believing a doctor’s prognosis. And Plaintiffs do not contend that their contractual relationship with Milberg involved a fiduciary relationship such as that in a partnership, in which reliance on a party’s representations might be more justifiable. Therefore, the London insurers have failed to demonstrate that Defendants should be estopped from invoking the statute of limitations.

 

The court also rejected the Lead Insurers’ suggestion that the statute did not apply because the policy was void at its inception, holding that, notwithstanding the plaintiffs’ arguments, New York’s six year statute of limitations for fraud applied.

 

In that same vein, she rejected the plaintiffs’ argument that the running of the statute had been tolled because the insurers were providing a defense under a reservation of rights. Judge Preska noted that the plaintiffs "offer no authority holding that an insurer’s defense of its insured is inconsistent with investigating the validity of its contractual duty to defend." She went on to note that none of the cases on which the plaintiffs attempt to rely in support of their tolling argument "remotely suggest that an insurer’s duty to defend give it a special exception for the statute of limitations governing its own rescission claim."

 

Judge Preska further observed that "rather than awaiting the results of the government prosecution of Milberg, the London Insurers should have conducted their own inquiry into whether Milberg might have committed fraud in obtaining the London policies." The Court found that there was no record that the Lead Plaintiffs took any steps to determine whether the policies "were still valid."

 

Finally, Judge Preska rejected the Lead Insurers argument that their rescission claim was saved by the two-year discovery rule (that is, they argued that their action was brought within two years of the discovery of the fraud.) She found that because under New York law knowledge of a government investigation "clearly triggers a duty to inquire as to potential fraud," and because the Lead Insurers were aware of the government subpoenas soon after they were issued in 2002, they were put on notice of the alleged much longer than two years before they filed their action.

 

Judge Preska went commented further that "the most striking example of Plaintiffs’ willful ignorance of their potential rescission claim is their failure to have made any inquiry after Milberg was indicted." A "prudent insurer," she commented, "should have known in July 2006 that it may have a claim against Defendants for rescission." Yet, she noted, even then they undertook no inquiry, so that even if the two-year discover period runs from the time of the indictment, the rescission action "would still be time barred because Plaintiffs did not commence this action until August 2008."

 

Discussion

If nothing else, Judge Preska’s opinion serves as a vivid illustration of a point I have made many times, which is that courts are hostile to rescission claims. Let it be said, courts don’t like them, even apparently when asserted against convicted criminals.

 

Because the decision is particularly dependent on New York case law with which I am insufficiently familiar, I am in no position to assess this decision on its legal merits. I will stipulate that this decision could well be completely unremarkable given the governing principles.

 

But even allowing for these legal principles, I have to say I find this outcome somewhat, well, uncomfortable. I know statutes of limitations exist to encourage diligence and to eliminate stale claims, and therefore must be enforced. There is no doubt that a great deal of time elapsed while these events transpired. And I am well aware the insurers must act promptly in order to assert rescission.

 

What I am unsure about is exactly what it is that the court thinks the insurers should have done. I can only imagine what might have happened if the insurers had tried to launch their own investigation while the criminal investigation and prosecutions were pending. The criminal defendants undoubtedly would have raised holy hell if the insurers had, say, tried to interview witness or obtain copies of documents. The defendants and their lawyers almost certainly would have accused the insurers of quadruple bad faith for even trying to take those actions. I imagine that the defense attorneys would have argued that the insurers were interfering with or even prejudicing the criminal defense.

 

I can envision compelling arguments that under these circumstances it was entirely appropriate that the carriers showed forbearance until after the guilty pleas had been entered before taking action – had they acted earlier, they might well have been accused of acting precipitously or worse.

 

Finally, I am not sure I am entirely comfortable with what this decision implies about what a carrier should do in similar circumstances in the future – perhaps New York law may require insurers who wish to protect their interests to do so, but would it really be a good thing for insurers to interject their own investigation at a time when one of their insureds is accused of criminal misconduct? That strikes me highly undesirable for all concerned.

 

This is a very high profile case and it obviously will attract a lot of attention and perhaps significant debate as well—indeed, I can well imagine some readers taking vociferous objection to observations here. I am very curious to know readers’ reactions, either to Judge Preska’s opinion or to my observations. I strongly encourage readers to post their thoughts using this blog’s "comments" function.

 

An October 1, 2009 Business Insurance article discussing the opinion can be found here.

 

Special thanks to a loyal reader for supplying me with a copy of the court’s September 30 opinion.

 

Memory Lane: For those interested readers, my original post about the Milberg indictment and its possible effect on securities class action lawsuit filings can be found here. My post about Bill Lerach’s guilty plea can be found here. My post about Mel Weiss’s indictment and Steve Schulman’s guilty plea can be found here. My post about David Bershad’s guilty plea agreement can be found here.

 

After a brief lull during the second quarter, securities class action lawsuit filings during the third quarter were closer to historical norms, although the filings levels did drop again during September.

 

By my count, there were 49 new securities class action lawsuits during the third quarter. For reasons discussed below, my count could vary significantly from third quarter tallies that others may publish. But the 49 third quarter filings brings the year to date total through September 30, 2009 to which brings the year to date total of new securities class action lawsuit filings to 143.

 

The annualized equivalent of the filings for the first nine months of 2009 projects to a twelve-month filing rate of 191, which is slightly below but still well within range of the average of 197.7 annual filings during the 13-year period between 1996 and 2008.

 

After a decline in filings during April and May at the end of the second quarter, when there were monthly filing totals of 11 and six respectively, there were 20 new securities lawsuit filings in June. But the number dropped to 17 in July and only 12 in September. Clearly, the filing activity levels have fluctuated month to month so far during 2009.

 

There may be any number of reasons for this fluctuation, but I continue to believe that the fluctuations are largely due to the fact that the plaintiffs’ lawyers are jammed up with the mass of lawsuits they filed over the last three years. As I have detailed at length elsewhere (here), many of the third quarter filings have proposed class period cutoffs well in the past, in some cases more than a year in the past. These filings may suggest that the plaintiffs’ lawyers have been so preoccupied with the other cases and with the Madoff lawsuits that they developed a backlog, which they are now getting around to working off.

 

The filings during the third quarter were not nearly so concentrated in the financial sector as during the first half of the year. In the first six months of 2009, about two thirds of the target defendant companies were in the financial sector. However, in the third quarter, only 12 of the 49 new securities lawsuit involved companies with Standard Industrial Classification Codes in the 6000 series (Finance, Insurance and Real Estate). There were also nine new securities class actions involving firms without SIC codes, most of which were financially related companies.

 

Even if all nine of those companies lacking SIC Codes are counted as financial, that still makes only 21 out of the 48 third court suits in the financial sector. Thus less than half of the third quarter filings were against companies in the financial sector, as compared to over two-thirds in the first half of the year.

 

One contributing factor in the relative decline in the number of new securities suits against financial companies may be the declining number of new lawsuits relating to the subprime meltdown and credit crisis. Thus, while there have been nearly 200 securities lawsuits filed since February 2007 related to the subprime and credit crisis litigation wave, including as many as 58 total in 2009, only about seven of subprime and credit crisis related cases were filed in the third quarter (depending on how you count).

 

As I noted in my recent interim update of the subprime and credit crisis related litigation (here), this apparent decline in the cases related to these phenomena may be due to the changing financial circumstances. What started several years ago with the subprime meltdown has evolved into a global financial crisis, affecting all companies across the entire economy. As a result of these developments, it has become increasingly difficult to define precisely what constitutes a subprime and credit crisis-related lawsuit. It may not be so much that the subprime and credit crisis litigation wave has crested as it is that the wave has merged into a larger tidal movement and is no longer its own separately identifiable phenomenon.

　

The high incidence of lawsuits involving companies without SIC Codes is a reflection of the number of new cases involving unusual lawsuit targets. There were, for example, several filings during the third quarter involving ETF Funds (refer here, here and here, for example). There were also new lawsuits filed involving closed end investment funds (refer here) and mortgage trusts (refer here and here). These actions are a continuation of the filing activity we have seen for several quarters, as a wide variety of complex financial firms and investment vehicles have been and continue to be drawn into securities litigation.

 

But though the third quarter filings, as was the case with the filings in the first half of the year, involved a number of these unusual targets, many of the companies named in third quarter lawsuits are more representative both of the larger economy and of more traditional securities litigation targets. Overall the companies named as defendants represented over 30 different SIC Code categories. For example, six of the third quarter filings involved life sciences companies in the 2830 SIC Code category and three involved filings against medical device companies in the 3840 SIC Code category.

 

By contrast to the first six months of the year, relatively few of the third quarter filings involved foreign domiciled companies. Thus, while 18 of the first half lawsuits involved foreign companies, only two of the third quarter lawsuits involved foreign companies. Many of the foreign targets in the first half of the year were financial companies, so the relative decline in filings against foreign companies may simply be a reflection of overall reduction in lawsuits against financial firms.

 

The new securities lawsuit filings in the third quarter were not nearly so heavily concentrated in the Southern District of New York as in the first half of the year. Thus, while in the six months of 2009, 45 out of 94 (or nearly half) of the new securities lawsuits were filed in the Southern District, only 12 of the 48 third quarter filings (or only 25%) were initiated in the S.D.N.Y. Again, this relative decline may be a reflection of the reduced number of lawsuits involving financial companies.

 

About Counting: As has been the case in recent quarters, the process of "counting" new securities lawsuits continued to be quite challenging during the third quarter. As has been the case in the past, I have not counted breach of fiduciary duty/merger objection lawsuits. In addition, I have also excluded from my count the "failure to register securities" lawsuits when these suits have been filed in state court (refer for example here), or even if filed in federal court assert only state law claims (refer for example here). In addition, the recurring phenomenon of lawsuit involving nontraditional financial vehicles makes it extremely challenging, given the outward similarity of many of these vehicles and their names, to tell whether or new complaint represents a new or a duplicate lawsuit.

 

These kinds of sorting issues inevitably result in some line drawing and some marginal categorization issues. Reasonable minds clearly could differ on many of these sorting concerns.

 

The bottom line is that my lawsuit count for the third quarter and for the first nine months almost certainly will differ from similar tallies that other may publish – indeed, for the same reason, the various other tallies will also likely disagree with each other as well. Certainly, anyone trying to come up with their own count that were to include, for example, merger objection suits or failure to register claims, would reach a substantially different number than the one I came up with.

 

I emphasize these counting issues, as I have in the past, as a way to try to explain the differences that may appear in the various published accounts. No one should be surprised by the differences, although consumers of the counting data have every right to know what has been included and excluded from any given count in order to understand how and why the count differs from other published versions.

 

One of the recurring D&O insurance issues is the question of policy coverage for additional acquisition consideration paid to an acquired companies’ shareholders – so-called "bump up" claims. In an interesting and colorfully written September 28, 2009 opinion (here) that insurers undoubtedly will cite profusely in future disputes of this kind, District of Massachusetts Judge Nancy Gertner held that Genzyme Corporation’s D&O insurance policy did not cover amounts Genzyme paid to settle the claims of individuals who asserted they had received inadequate consideration in an exchange for their tracking shares of an internal Genzyme division.

 

Background

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

 

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

 

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

 

The September 28, 2009 Opinion

Judge Gertner opened her opinion with an assessment of the "plethora of cases" on which the D&O insurer sought to rely to argue that "an insured does not incur insurable loss when she is merely forced to disgorge money or other property to which she is not entitled." Judge Gertner noted that "this legal principle is undeniably correct and would almost certainly be adapted by a Massachusetts court."

 

Judge Gertner then made the first of the several vivid commentaries that characterize her opinion, when she noted that

 

A thief should not be able to claim the return of stolen property as an insurable loss. Similarly, an individual who breaches her contract and then is forced to pay damages should not be able to seek indemnification under an insurance policy. If I pay only $100for an item for which I promised to pay $200, and I am later ordered by a court to pay the additional $100, I should not be able to claim the additional $100 as an insurable loss. Had I paid the full $200 due up front, then clearly no part of the $200 would constitute loss covered by insurance. The dilatory nature of my obligatory payment should not transform it into an insurable event.

 

Genzyme sought to distinguish the referenced case law by arguing that it had received no benefit to which it was not entitled or that could be disgorged. Judge Gertner agreed, noting that the company had merely reorganized its capital and issued additional shares. But while Genzyme itself did not benefit, its shareholders "surely did" benefit from the reduced exchange ratio, and the class action was "meant to redress the imbalance."

 

As a result of these circumstances, Judge Gertner found, this case "does not fit comfortably within the existing case law holding that the mere return of an ill-gotten gain was uninsurable." She expressly rejected the insurer’s "attempt to force this case into the existing case law."

 

Having determined that the existing case law was inapposite, she proceeded to address defendants’ motion based her own analysis of the question presented, which she stated to be as follow: "When a corporate pays a settlement to resolve a claim that it benefitted one group of shareholders at the expense of another group of shareholders, is this settlement payment an insurable loss?" The answer to this question, she found, "must undoubtedly be ‘no.’"

 

To explain this conclusion, Judge Gertner resorted to a "somewhat strained – but one hopes enlightening – hypothetical." In her hypothetical, a father and his two sons, Daniel and Eli, are in a restaurant and have ordered a singled milkshake divided into two cups. The father redistributes the milkshake between the cups in a way that leaves Daniel with two-thirds of the milkshake and Eli with one third. The father, she noted, would be expected equalize the distribution, not "to turn to the restaurant owner and demand that he provide more milkshake to make up the difference."

 

Drawing upon this hypothetical, she found that the lawsuit settlement had merely "recalibrated the division" in the share exchange by giving the Biosurgery Division shareholders additional cash in place of the additional shares to which they claimed they were entitled. Genzyme should not, she said, be able to demand indemnification from the insurer for what is in effect a share redistribution.

 

If Genzyme’s interpretation of the policy were correct, she found, "a corporation merely need issue several classes of shares, cancel one class in an arguably unfair way, and then demand that the insurer pick up the tab." She rejected this possibility noting that the policy "should not be read in a way that produces absurd results."

 

Judge Gertner then turned to the insurer’s alternative argument that there was no coverage under the policy for the settlement because of the policy’s "inadequate consideration" or "bump up" exclusion, which provides that the carrier is not liable for "the actual or proposed payment by any Insured Organization of allegedly inadequate consideration in connection with its purchase of securities issued by any Insured Organization." Genzyme argued that the exclusion did not apply because the share exchange did not involve a "purchase" of securities, but rather the mere exchange of one class of securities for another.

 

After reviewing dictionary definitions, Judge Gertner concluded that the share exchange was "unambiguously a ‘purchase’ within the natural and ordinary meaning of the word." She also found that Genzyme sought coverage under a policy provision applicable only to a "securities claim," defined inter alia as the "purchase or sale of securities." Genzyme, she noted, was contending that the share exchange was a "purchase" for purposes of relying upon the policy’s definition of securities claim, yet did not explain why the same word should have a different meaning in a different policy provision.

 

Judge Gertner rejected Genzyme’s further argument that even if Genzyme itself no claim in its own right under the policy, there would still be coverage for the settlement under the policy’s separate insuring clause providing reimbursement for Genzyme’s indemnification of its directors and officers.

 

Judge Gertner found that "it makes little sense to allow a corporation to sidestep coverage limitations in its insurance policy through the simple expedient of claiming that a settlement payment was made to indemnify its directors and officers." She noted that a contrary holding could "encourage fraud" and "chicanery," as otherwise a corporation could use calculated indemnification resolutions to try to create coverage for otherwise noncovered claims.

 

Discussion

Judge Gertner’s opinion is not only highly readable and even entertaining, it is also potentially significant, for a number of reasons.

 

First, Judge Gertner made it clear that she was not relying on prior case law in reaching her decision. As a result, her opinion potentially represents a new line of analysis in connection with the perennial questions about coverage under the D&O policy for "additional consideration" claims. In particular, her analysis does not depend on whether or not the payment for which coverage was sought was "restitutionary." Rather her analysis turned on whether the insurer could fairly be asked to pay for what was effectively a redistribution or "recalibration."

 

At a minimum, this line of analysis could give insurers disputing coverage for "bump up" settlements an additional ground on which to base their position, arguably without even having to get into the question whether the payment in dispute was "restitutionary." Insurers instead (or perhaps alternatively) will strain to rely on Judge Gertner’s milkshake hypothetical.

 

Second, and perhaps more significantly, Judge Gertner did not base her decision on the bump up exclusion alone, although she did grant the motion in the alternative based on the exclusion. The significance of the fact that she separately and independently granted the motion to dismiss on the ground that the settlement is not an insurable "loss" is that even today many policies do not contain a bump up exclusion. Indeed, over the years, many of the "additional consideration" coverage disputes that have arisen have involved policies lacking such exclusions. Judge Gertner’s reasoning could be particularly influential in future "additional consideration" disputes involving policies without bump up exclusions.

 

Third, even though her opinion did not rely on the prior case law holding that restitutionary payments are uninsurable, her detailed elaboration of the intellectual basis for the principles behind the case law will undoubtedly add weight (and color) to legal arguments relying on these cases.

 

Fourth, the decision is also significant for its interpretation and application of the bump up exclusion. As I noted in a prior post (here), these exclusions are still relatively new, vary widely, and generally have not been subject to extensive judicial scrutiny. There is still relatively little case law interpreting bump up exclusions. Judge Gertner’s enforcement of the exclusion here, particularly her conclusion that the share exchange was a "purchase" within the exclusion’s meaning, helps illuminate how these exclusions operate and how they will apply.

 

Finally, Judge Gertner’s opinion may be particularly noteworthy because of her willingness to dispense with prior case law formulas and to base her decision instead on a careful consideration of the underlying transaction and facts. However, I expect that not everyone is going to be equally impressed with her milkshake hypothetical. Even those inclined to cheer Judge Gertner’s opinion here should reflect on the possibility that other judges, perhaps lacking Judge Gertner’s intellectual rigor, might unburden themselves of their own hypotheticals that may or may not have anything to do with the parties’ reasonable expectations of how the policy should operate.

 

In any event, insurers undoubtedly will find much to like in Judge Gertner’s opinion, which is not only highly literate but highly quotable. Her colorful phrases will undoubtedly be featured heavily in insurers’ future legal briefs both on bump up claims and with respect to questions regarding restitutionary payments. The only things that may undercut insurers’ attempts to rely on the Genzyme decision are the somewhat unusual facts involved in the case. Those seeking coverage will certainly try to argue that Judge Gertner’s "redistribution" or "recalibration" analysis is restricted to the specific and unusal circumstances of the Genzyme case.

 

A September 29, 2009 memo by the Wiley Rein law firm summarizing the opinion can be found here. Wiley Rein represented the D&O insurer in the Genzyme coverage dispute.

 

Special thanks to the several loyal readers who sent me copies of the Genzyme opinion.

 

All That, and She’s A Fellow Blogger, Too: Readers curious about Judge Gertner’s willingness to express herself so freely in a judicial opinion may be interested to know that in addition to being a federal judge, she is also a blogger. According to a Boston Globe profile (here), she began blogging because she determined with respect to blogs (correctly in my view), that "if this is where people are getting information, this is where to be." She also noted, in an observation to which every blogger and would-be blogger will relate, that the hardest part about blogging may be finding time to blog.

 

She apparently has had found little blogging time lately, because there have been relatively few recent entries by any of the contributing authors on the site for which she has been blogging, the Convictions blog on the Slate website (here). (Believe me, Judge Gernter, I know all about the way a pesky day job can interfere with important blogging activities.)

 

In my recent subprime and credit crisis lawsuit status update (here), I commented that the defendants seemed to be getting the upper hand at the dismissal stage in many of these cases. Two recent dismissal motion rulings tend to corroborate this view. In addition, the defendants in the auction rate securities cases continue to have their dismissal motions granted.

 

SunTrust Bank: The first of these two recent dismissal motion rulings is the September 24, 2009 opinion (here) by Northern District of Georgia Judge Thomas Thrash, Jr. in the SunTrust Banks auction rate securities lawsuit. As reflected in greater detail here, the plaintiffs alleged that SunTrust Bank’s broker-dealer subsidiary sold them auction rate securities. The plaintiffs allege that the defendants failed to disclose certain features about the securities and about the auction rate securities marketplace. The plaintiffs also allege that the defendants engaged in manipulative auction practices.

 

Judge Thrash granted the defendants’ motion to dismiss the disclosure related allegations because the allegations "about the Defendants state of mind do not meet the heightened pleading requirements applicable to securities fraud cases."

 

As an initial matter, Judge Thrash found that the plaintiffs’ allegations were "not stated with particularity." Though the plaintiffs contend that "high level corporate officials" issued certain management directives, the plaintiffs "do not identify any of these officials, by name, by title, or even by job description." With respect to the supposed directives, the Plaintiffs "do not describe what these documents may have said, who issued them, or when they were distributed."

 

Judge Thrash further found that the plaintiffs’ allegations "do not give rise to a strong inference that the Defendants’ acted with an intent to defraud or with severe recklessness." Thus, while the complaint refers to supposed management directives and uniform sales materials, the allegations are "not strongly supported" in the complaint. The confidential witnesses on whom plaintiffs rely do not reference the supposed directives or sales materials, and "none of the Plaintiffs’ allegations mention a single communication from any high level corporate officials, let alone any management directives or uniform sales materials."

 

Judge Thrash found that "the more plausible theory is that high level corporate officials carelessly or negligently provided training on how to sell auction rate securities, and because of the improper training, many SunTrust brokers exaggerated the benefits," noting further that the allegations overall were "more consistent with a negligent state of mind than a fraudulent or reckless one."

 

The court did noted that "the only allegation that might suggest otherwise" is the contention that the defendant entities were among the companies the SEC investigated in 2006 for auction rate securities practices, and therefore the defendants’ senior executives "must have been aware of manipulative auction practices." But Judge Thrash found that the inference that the plaintiffs seek to draw from this allegation is "simply too weak and convoluted," because it required the court to assume that the executives continued the manipulative practices after the SEC investigation and willfully trained brokers to sell the securities without changing the practices or disclosing the practices to the brokers. The court said "Plaintiffs do not provide sufficient allegations to make anything more than a weak and convoluted inference" about this contention.

 

Finally, Judge Thrash found that the plaintiffs’ market manipulation allegations "do not meet the heightened pleading requirements applicable to securities fraud cases." Because plaintiffs had previously amended their complaint, he denied plaintiffs further leave to amend.

 

The SunTrust Banks auction rate securities lawsuit is the latest of the auction rate cases to be dismissed. (Refer to my recent post here for an overview of prior dismissals.) The SunTrust Bank case also follows the recent dismissal in the Raymond James auction rate securities case, where the case was dismissed not on the basis of a prior regulatory settlement, but rather because of pleading deficiencies, without regard to whether or not the defendant company had entered a regulatory settlement.

 

While there are a number of other auction rate securities cases in which the dismissal motions are yet to be heard, at this point, the plaintiffs have not yet survived a dismissal motion in any of the auction rate securities cases in which dismissal motions have been heard.

 

There were almost two dozen separate auction rate securities lawsuits filed (some with multiple complaints) after the auction rate securities market froze up in February 2008. But though the plaintiffs’ lawyers rushed to file these cases, so far the suits are not faring well at all for the plaintiffs.

 

Huntington Bancshares: The second of the two recent dismissal motion rulings involves the shareholders’ derivative suit filed in the Southern District of Ohio against Huntington Bancshares, as nominal defendant, and certain of its directors and officers. The complaint relates to Huntington’s July 2007 acquisition of Sky Financial. At the time the deal was announced, Huntington officials stated that the acquisition would be "accretive to Huntington’s earnings.

 

The complaint alleges that in acquiring Sky, Huntington also acquired Sky’s long-standing relationship with Franklin, which included $1.8 billion debt in the form of high-risk residential mortgages. Just five months after the acquisition, Huntington took charges of $300 million for loan loss allowances on the Franklin debt, which was followed by a "restructuring" of the relationship with Franklin. In the weeks following the restructuring, Huntington’s share price declined.

 

In their February 2008 complaint, the plaintiff alleged that the defendants knowingly concealed material adverse facts about mortgage-related losses resulting from the Sky acquisition and that Huntington knowingly acquired and continued to hold high-risk financial instruments that could not properly be valued. The defendants moved to dismiss the complaint on the grounds that the plaintiff had failed to make a presuit demand on Huntington’s board.

 

In a September 23, 2009 order (here), Judge George C. Smith granted the defendants’ motion to dismiss, holding under Maryland law that the plaintiff had failed to sufficiently allege demand futility.

 

Judge Smith first held under the first prong of the demand futility analysis under Maryland law that "Plaintiff has failed to plead with particularity that a demand would have caused irreparable harm to Huntington."

 

Judge Smith found further that "because Plaintiff fails to establish that a single member of the Board is conflicted or committed for purposes of establishing demand futility," the plaintiff had failed to satisfy the second prong of the demand futility analysis under Maryland law.

 

While at this point, it is difficult to generalize with respect to the subprime and credit crisis related derivative suits, as there have been relatively few dismissal motion rulings either way, the plaintiffs do not seem to be faring particularly well in dismissal motion ruling so far (see for example my recent discussion of the dismissal in the Citigroup derivative suit, here).

 

I have in any event added these two dismissals to my list of subprime and credit crisis-related lawsuit resolutions, which can be accessed here.

 

Many thanks to a loyal reader for providing a copy of the SunTrust Bank opinion.

 

Among the many firms and entitles struggling with the effect of the global economic downturn are a host of municipalities, many of whom face diminished tax revenues, unfunded pension and health care liabilities and aging infrastructure. A number of these municipalities also labor under a burden of debt undertaken when times were flush. Financial woes have already forced credit rating downgrades on some issuers’ bonds and others are flirting with default. Among other things, these kinds of problems can lead to securities litigation, and recent developments in one securities suit involving a municipality raise the question whether there could be more suits to come.

 

Municipalities traditionally have various levels of exemptions from securities registration and reporting requirements, although these exemptions have evolved over time (about which refer here). But municipalities have always been subject to the antifraud provisions of the securities laws. Over the years the SEC has pursued a number of high profile enforcement actions in connection with municipal bond offerings. A lengthy list of the SEC’s enforcement actions against municipalities between 2003 and 2008 can be found here, including actions against issuers, public officials, and offering underwriters. Earlier cases can be found here and here.

 

Perhaps the most high-profile SEC enforcement action in recent months involving a municipality is the securities fraud complaint filed against five former San Diego city officials. As described in the SEC’s April 7, 2008 press release (here), the SEC alleged that the five officials, who allegedly played key roles in connection with inadequate municipal securities disclosures in 2002 and 2003, had "failed to disclose to the investing public buying the city’s municipal bonds that there were funding problems with its pension and health care obligations and these liabilities had placed the city in serious financial jeopardy."

 

As reflected in the SEC’s San Diego complaint (here), the five officials were the former City Manager, the former City Treasurer, the former City Auditor and Controller, the former Deputy City Manager, and the former Assistant Auditor and Controller. The complaint sought to enjoin the officials from further violations and to require the officials to pay a civil penalty.

 

The SEC’s actions clearly are designed to enforce the securities laws and to vindicate the principles they represent. However, the SEC’s actions in and of themselves will do little directly for the investors who were harmed by the alleged misrepresentations.

 

To be sure, investors are not precluded from initiating their own action to seek damages to redress their injuries. In at least one recent action involving the city of Alameda, California and related municipal entities, investors have filed a civil action seeking to recover damages for alleged violations of the securities laws.

 

As reflected in its Amended Complaint in the Alameda case (here), the plaintiff alleges that earlier in this decade with the City of Alameda issued certain municipal revenue anticipation notes, it knew the funding mechanism was never going to achieve the results needed, because the funding mechanism "was not economically feasible" for multiple reasons, "all of which were known to the City." The project was "not risky, but rather a surefire loser." The complaint is not filed as a class action, but a separate counterclaim brought by the Nuveen fund family raising substantially the same allegations against the City has also been filed in the same district.

 

The plaintiff in the Alameda case alleges violations of both the federal and California securities laws. The municipal defendants filed a motion to dismiss the California state securities law claims, based on statutory sovereign immunity.

 

In an August 11, 2009 order (here), Judge Susan Illston held that the statutory immunity provisions were not intended to provide local governments with immunity from securities fraud, and that the state securities law claims against the municipal entities may proceed.

 

As noted in a September 24, 2009 Daily Journal article entitled "The Newest Securities Litigators?" (here, subscription required), by Richard Gallagher of the Orrick, Harrington & Sutcliffe law firm, Judge Illston’s ruling is "a matter of first impression" under California law. As Gallagher further observes, Judge Illston’s ruling in the Alameda case is only one of several recent developments, including current SEC initiatives to provide greater regulatory oversight, that could further subject municipalities to litigation alleging securities law violations.

 

These developments, Gallagher comments, could not come at a worse time for municipalities, since many cities and counties around the country are dealing with record budget deficits and other financial difficulties. These public entities are in many instances struggling to meet debt obligations and are contending with problems arising from credit downgrades and even defaults.

 

These financial woes are producing significant bondholder losses, which could in turn lead to investor lawsuits like those filed against Alameda. Indeed, rulings such as that entered by Judge Illston, in which she held that municipal entities lacked statutory immunity from state securities laws claims, might embolden disappointed investors to pursue these kinds of claims.

 

The problem is that the financially troubled public entities can ill afford expensive, high-stakes securities litigation. Even if, as Gallagher notes, the municipalities would have substantial defenses for these kinds of claims, the defense costs alone could be staggering for financially strapped municipalities.

 

Readers of this blog may well wonder whether there are insurance products that could protect municipalities from these kinds of risks. Certainly, Public Official Liability Insurance includes liability protection not only for individual public officials but also for the public entities themselves. But many of these policies include an express exclusion precluding coverage for claims arising out of any debt financing. There may well be public entities that have procured insurance designed to provide protection for these kinds of claims, but the typical municipality has not, even if it otherwise purchases public official liability insurance.

 

The poor financial condition of defaulting public entities and the absence of insurance among other concerns do raise the question of what the investor plaintiffs’ litigation objectives may be – the beleaguered taxpayers of the troubled municipality hardly qualify as an attractive target, whatever wrongs the investors may allege.

 

Perhaps the motivation of investor plaintiffs in these kinds of cases may be understood from the lineup of the defendants in the Alameda case. The defendants named in that case include not only the various municipal entities, but also the offering underwriters that sponsored the city’s note offering, authored the offering documents, and sold the notes to the public.

 

The plaintiff’s complaint in the Alameda case alleges that the offering underwriter knew, "as the City did, that the project was not economically feasible," or in the alternative, that the underwriter "failed utterly in its duty to undertake due diligence to unearth the City’s misrepresentations and omissions of material fact." The plaintiff purchased $8.5 million of the city’s notes from the offering underwriter, which the plaintiff further alleged has been "an Advisor in which the Plaintiff reposed trust and confidence."

 

Thus, while Judge Illston’s ruling that municipalities lack statutory immunity from state securities law claims may be significant, the municipal defendants in the Alameda case may or may not even be the central targets.

 

Other aggrieved municipal bond investors may also seek to pursue similar claims against the outside professionals that advised the issuer municipalities. These gatekeeper kinds of claims could face substantial hurdles of their own, including with respect to the federal securities claims the U.S. Supreme Court’s 2008 ruling in the Stoneridge case that there is no private right of action for scheme liability or aiding and abetting under the federal securities laws.

 

These hurdles and the disincentives to pursuing financial trouble municipalities could discourage some prospective litigants from pursuing these kinds of claims. Nevertheless, the prospect of further municipal bond defaults and developments such as Judge Illston’s ruling in the Alameda case could encourage some claimants to proceed.

 

There may, in fact, be specific reasons why municipalities may be particularly vulnerable to securities suits, notwithstanding all of the contrary considerations noted above. That is, as Gallagher notes in his article, "municipal issuers may lack procedures for achieving consistent disclosure goals, leaving them vulnerable to securities suits." The provision of "incomplete financial information regarding the issuer’s financial affairs" could "present some serious litigation risks."

 

As Gallagher concludes, municipalities could find themselves for the first time in coming years defending themselves from securities fraud claims, particularly with respect to state law-based allegations.

 

Very special thanks to Richard Gallagher for providing a copy of his article and a copy of Judge Illston’s opinion.