In a ruling with potential significance for the other remaining auction rate securities lawsuits, on September 17, 2009, Southern District of New York Judge Lewis A. Kaplan granted the defendants’ motion to dismiss, with leave to amend, in the auction rate securities lawsuit pending against Raymond James Financial and certain of its subsidiaries. A copy of Judge Kaplan’s opinion can be found here.

 

There have been prior dismissals granted in the many pending auction rate securities lawsuits. For example, dismissal motions have been granted in the auction rate securities lawsuits filed against UBS (refer here) and against Northern Trust (refer here), as well as in the auction rate securities lawsuit involving Citigroup (refer here, scroll down).

 

The Citigroup case had been based on a market manipulation theory rather than on a misrepresentation theory, and is noteworthy in that respect, but the dismissal of the Citigroup case based on the plaintiffs’ failure to adequately plead market manipulation is less relevant to the many other auction rate securities cases – including the one filed against Raymond James—that are based on misrepresentation theories.

 

Judge Kaplan’s September 17, 2009 dismissal in the Raymond James auction rate securities case is noteworthy in its own right and by contrast to the prior dismissals in the UBS and Northern Trust cases, because in the Raymond James, by contrast to UBS and Northern Trust, had not entered into regulatory settlements involving its investors. Indeed, Raymond James has been the target of certain high profile media criticism (refer here) as a "holdout" for its resistance to entry into a regulatory settlement.

 

Because Raymond James has not entered a regulatory settlement, the defendants in the Raymond James auction rate securities case were unable to seek dismissal on the same "absence of recoverable damages" theory as did the defendants in the Northern Trust and UBS cases. Thus, by contrast to the dismissals in those other two cases that turned on the existence of the regulatory settlements, the dismissal in the Raymond James case actually related to the sufficiency of plaintiffs’ allegations on the merits, and therefore may be of greater potential significance for other auction rate securities cases, particularly those relating to other defendant companies that have not entered regulatory settlements.

 

In granting the dismissal motions, Judge Kaplan very carefully distinguished the allegations that had been made against the various corporate defendants, and he carefully assessed the adequacy of the allegations as to each.

 

Judge Kaplan determined that many of the alleged misrepresentations were made by or on behalf of Raymond James Financial Services (RJFS), the parent company’s retail sales subsidiary that actually sold to investors the auction rate securities that other corporate subsidiaries had underwritten or managed the related auction processes. Judge Kaplan found that there were insufficient allegations concerning the alleged misrepresentations supposedly made to the plaintiff or as part of the overall scheme to be able to attribute misrepresentations as to defendants other than RJFS. He stated that the complaint "fails to allege how the remaining two defendant entities are responsible for the omissions."

 

Although this failure to attribute the alleged misrepresentations to the defendants other than RJFS alone would have been sufficient to dismiss the defendants other than RJFS, Judge Kaplan further considered the plaintiffs’ scienter allegations and concluded that the insufficiency of the scienter allegations provided an independent basis on which to dismiss the defendants other than RJFS, as well as for dismissing the complaint as a whole.

For reasons similar to those he expressed with respect to his ruling on the misrepresentation issue, Judge Kaplan concluded that the lack of particularized allegations of scienter were "fatal" to the claims against the defendants other than RJFS.

 

Judge Kaplan further found that plaintiffs’ scienter allegations in general were insufficient. First, he concluded that the plaintiff had not adequately pled "motive and opportunity." He first found that plaintiff’s allegations based on motivations to profit were insufficient. He allowed that plaintiff "comes closer" with her allegation that "defendants’ motive was to unload their excess and soon to be illiquid ARS inventory on unsuspecting customers."

 

Even these allegations, about the defendants’ supposed motive to unload excess inventory, were found to be insufficient because, Judge Kaplan held, they presumed that "there was a shared knowledge of the entire scheme" among all the defendants – yet the complaint failed, for example, to show that RJFS has knowledge of the issues surrounding the auctions or the securities inventory at the other subsidiaries.

 

Judge Kaplan noted that in effect the plaintiff sought to "aggregate the knowledge of two or more separate corporate entities on the basis that they share the same corporate parent and nothing more" – which Judge Kaplan found insufficient.

 

Finally, Judge Kaplan concluded that the plaintiff had not sufficiently alleged "conscious misbehavior or recklessness." Among other things, he found that:

 

The Court cannot infer that RJFS was aware it was marketing ARS to potential investors fraudulently because there is no showing that RJFS or insiders had access to the underwriters’ "unique" knowledge of the ARS market. Indeed, the complaint itself states that RJFS’s agents, the financial advisors who allegedly made the misrepresentations to investors, "lacked a rudimentary understanding about the auction rate securities and how the auction rate securities market functioned."

 

The September 17 dismissal is without prejudice. The plaintiff has until October 16, 2009, to submit an amended complaint. Whether or not the plaintiff in this case is successful in curing the pleading defects Judge Kaplan noted remains to be seen. But even if the plaintiff is able to overcome the pleading hurdle, Judge Kaplan’s analysis suggests that other auction rate securities plaintiffs may face significant challenges, even with respect to the defendant companies that have not entered regulatory settlements.

 

Many if not most of the auction rate securities lawsuits, like the one against Raymond James, involve multiple corporate subsidiaries as defendants, each of which touched a separate part of the auction rate securities process. Unless the plaintiffs in those cases are able to allege that the different subsidiaries had knowledge of the activities and operations of the other subsidiaries, the plaintiffs may, like the plaintiff in the Raymond James case, have difficulty establishing pleading sufficiency for their complaint’s allegations of misrepresentations and scienter against some or all corporate defendants.

 

To be sure, there may well be cases where plaintiffs can show – or at least allege—that, for example, the sales subsidiary was aware of the difficulties in the auction rate process or with excess inventory. But to the extent the plaintiffs failed to make or establish these connections in their complaint, their complaint may well be dismissed on the same grounds as in the Raymond James case.

 

One of the propositions on which most commentators seem to agree is that perverse compensation incentives helped fuel the global economic crisis. For example, last Wednesday, formed Fed Chairman Paul Volcker said in a speech that one of the causes of the financial crisis "was the ultimately explosive combination of compensation practices that provided enormous incentives to take risk." Other commentators have made similar assertions.

 

Given these sentiments, it comes as no surprise that among the first reform initiatives to emerge in the wake of the economic crisis are proposals to regulate compensation practices.

 

The most attention-grabbing example of this compensation-related reform agenda is last week’s news that the Federal Reserve is planning to issue bank compensation rules that would, according to the Wall Street Journal (here), "inject government regulators deep into compensation decisions traditionally reserved for the banks’ corporate boards and executives." Under this plan, the Fed would review – and could reject or amend – any compensation policies to make sure they "don’t create harmful incentives."

 

If these reforms are enacted, they could represent a significant potential expansion of bank board liability exposures. As reflected in a September 19, 2009 Wall Street Journal article entitled "Boards Face Expanded Responsibilities" (here), the proposed Fed rules "could increase time demands, recruitment challenges and legal exposures for boards."

 

Because the proposed Fed plan could lead to the Fed’s review of compensation for "many lower-level employees, such as big traders and groups of loan officers," the plan could "force directors to scrutinize pay practices for more employees," as "board members might have to keep tabs on pay arrangement for thousands of employees."

 

The Fed plan is not the only reform initiative that could impose increased compensation-related burdens on corporate boards. As detailed in a September 17, 2009 memorandum from the Pillsbury Winthrop Shaw Pittman law firm entitled "Executive Pay Reform Poses Complex Risks for Compensation Committees" (here), there are a variety of legislative proposals now working their way through Congress that could impose increased compensation-related burdens on corporate boards.

 

Of particular interest here is H.R. 3269, The Corporate and Financial Institution Compensation Fairness Act of 2009, which passed the House on July 31, 2009, and has now moved to the Senate for further review and possible amendment. According to the law firm memo, the Senate is likely to address the Act before the end of the year.

 

As described in the legal memo, the Act among other things embodies the principle that "the process of establishing executive compensation schemes should be transparent, protect against bias and provide enhanced accountability." The memo goes on to note that "notwithstanding passage of the Act, evolving corporate governance practices and pressures from shareholder advocates will ensure an enhanced role for compensation committees in fashioning the next generation of executive compensation policies and programs."

 

The bottom line is that as a result of regulatory, legislative and other initiatives, boards will face an increased array of compensation-related burdens and responsibilities. These burdens will not only increase the amount of time and effort that boards will be required to spend on compensation issues; they could also expand the board’s potential liability exposures regarding compensation issues.

 

In a prior post (here), I noted that Executive Compensation may be the "new front line in the litigation wars." The various regulatory and legislative initiatives now emerging seem likely to ensure that compensation issues will define the front line of the litigation wars for years to come.

 

Will Industry Get Out in Front on This Issue?: Many companies and their executives are well aware of the possibility of regulatory or legislative action regarding compensation issues, and at least some of them are working hard to get out in front of the issue. In that regard, on September 21, 2009, The Conference Board issued a report on the topic of executive compensation, containing proposals echoing the sentiments and even some of the specifics of the regulatory and legislative initiatives. A copy of the report can be found here.

 

As reflected in the September 21 press release, the recommendations are intended to try "to restore credibility and increase trust in pay practices and oversight." The recommendations include certain "Guiding Principles," including try to "establish a clear link between pay, strategy and performance." The Principles also recommend that public companies should "foster transparency with respect to compensation practices and appropriate dialogue between boards and shareholders."

 

A September 21, 2009 Bloomberg article about The Conference Board’s report and proposals can be found here.

 

Subprime Update: The Interview: On September 21, 2009, Bruce Carton of the Securities Docket interviewed me in connection with my recent interim update on the subprime and credit crisis class action securities litigation. The interview can be found on Securities Docket, here, and is also embedded below. My prior post with my detailed update about the subprime and credit crisis litigation can be found here.

 

 

 

 

 

 

 

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In January 2008, the U.S. Supreme Court in the Stoneridge case followed its prior decision in Central Bank of Denver and held that there is no private right of action for "scheme liability" or aiding and abetting under the federal securities laws, ruling that Congress had reserved to the SEC the right to enforce aiding and abetting liability.

 

But what Congress has decreed, Congress can also change, and change is what Senator Arlen Specter proposed on July 30, 2009 when he introduced Senate Bill 1551, "The Liability for Aiding and Abetting Securities Violations Act of 2009." If enacted, the bill would, in effect, legislatively overturn Stoneridge by amending the securities laws to allow private litigation against a person that provides "substantial assistance" in a violation of the securities laws.

 

On September 17, 2009, the bill had its first committee hearing at a session of the Subcommittee on Crime and Drugs of the United States Senate Committee on the Judiciary. A link to the Subcommittee proceedings site for the session, including links to the written witness testimony, can be found here. A September 18, 2009 memorandum (here) by Leslie Platt and Kimberly Melvin of the Wiley Rein law firm provides an excellent and detailed summary of the Subcommittee’s proceedings. (Thanks to Kim Melvin for providing a copy of the memorandum.)

 

Of particular interest among the witnesses’ written statements is the testimony of University of Michigan Law Professor Adam Pritchard opposing the bill (here), and the testimony of Columbia Law Professor John Coffee supporting the bill (here), subject to certain suggested amendments.

 

Professor Coffee suggests that "it is anomalous that one could be criminally liable of aiding and abetting by not civilly liable for the same conduct in a private suit." He also argues that allowing private suits for aiding and abetting would be "the most realistic means to prevent misconduct," because it would "deter those who have less to gain" from fraudulent misconduct, who also have "the ability to block the transaction."

 

Professor Pritchard by contrast argues that the bill would "tear down the safeguards" instituted in Central Bank and Stoneridge, "creating the potential for the securities laws to be injected in a wide range of ordinary commercial transactions." Enacting the bill would also, Professor Pritchard contends "undermine the United States’s international competitiveness and raise the cost of capital." The goal of the bill, he contends, is simply "to rope in more ‘deep pocket’ defendants to feed the plaintiff’s bar’s lucrative class action machine." The written testimony of Robert J. Giuffra, Jr., a partner at the Sullivan Cromwell law firm, is very much in the same vein as Pritchard’s.

 

In the Wiley Rein memo linked above, the authors advise that the bill will next likely be marked up for presentation to the full Senate. The current legislative calendar is remarkably full, and therefore the bill may not be considered before the end of 2009 – but, the authors note, "the 111th Congress does not end until 2010." The bill could also be "incorporated into a larger finance, banking or securities-related bill."

 

Could the Bill Pass?

Two years ago, a bill of this type would have stood little chance. The dynamic at the time was against further regulatory constraints and in favor of markets and the kind of "light touch" prevailing in the U.K. But the events of the past two years, both political and economic, have changed all that and the changed circumstances may substantially increase the likelihood of the bill’s passage. The sweeping Democratic victory in the 2008 elections and current popular need to assign blame for the global economic crisis will likely increase the collective willingness of Congress to remove barriers to the imposition of liability.

 

But separate and apart from these considerations that might suggest a Congressional inclination in favor of the bill, there are a variety of other factors that might further increase the possibility that the bill could pass.

 

First, the courts have presented Congress with an engraved invitation to implement these changes. The most prominent example of this is the March 17, 2009 opinion (here) by then-Southern District of New York Judge Gerald Lynch in the Refco case. (On September 17, 2009, the Senate confirmed Judge Lynch’s nomination to the Second Circuit.) In the opinion, Judge Lynch dismissed the securities claims filed against a lawyer that had advised the client later criminally convicted of securities fraud.

 

Judge Lynch commented that "it is perhaps dismaying that participants in a fraudulent scheme who may even have committed criminal acts are not answerable to the victims of the fraud." Judge Lynch stated that the Congressional decision to leave the enforcement of aiding and abetting liability solely to the SEC "may be ripe for re-examination." He noted that "while the impulse to protect professionals and other marginal actors who may too easily be drawn into securities litigation may well be sound, a bright line between principles and accomplices may not be approximate."

 

The sentiment expressed in the opinion of a judge as respected as Judge Lynch could provide intellectual cover, and perhaps even policy justification, for Congress to take steps to which it is likely already inclined.

 

Second, as a result of its fumbled opportunities to investigate Bernard Madoff and other developments, the SEC’s regulatory credentials are held in particularly low regard right now, which underscores the concern with leaving aiding and abetting enforcement exclusively with the SEC.

 

As Professor Coffee noted in his written testimony, "does anyone really believe today, in this post-Madoff world, that the SEC, by itself, can adequately deter most secondary participants in securities frauds?" He added that the SEC is "cost constrained, has limited personnel and a large backload of cases," noting that the SEC "sometimes missed for years frauds (such as Madoff and Stanford Ponzi schemes) that others had begun to suspect."

 

Third, in the wake of the global financial crisis, there is particularly strong public sentiment in favor of holding gatekeepers accountable. The gatekeepers most frequently cited are the rating agencies, but other gatekeeper scapegoats include auditors, lawyers and offering underwriters. Riding alongside this general public outrage is a parallel public perception that the SEC has so far at least has done relatively little in the wake of the subprime meltdown and global financial crisis to target and pursue wrongdoers, a perception that puts further stress on the SEC’s exclusive right to pursue aiding and abetting liability claims.

 

A final consideration that could increase the likelihood of the bill’s passage is a bill amendment Professor Coffee has proposed. He suggests placing a ceiling on liability for secondary defendants of $2 million for individuals and $50 million for corporations, subject to the further provision that the award should not in any event exceed the greater of ten percent of the defendant’s average income; net worth; or market capitalization. Professor Coffee’s proposed ceiling, if adopted, could further advance the likelihood of the bill’s passage.

 

What Happens if the Bill Passes?

Of course, it remains to be seen if the bill will in fact pass. Congress is extraordinarily preoccupied right now, and the bill’s opponents, who are legion, will be well-organized and active. The bill could yet wind up on the dust heap of failed legislative initiatives.

 

But what happens if it does pass? Well, at a minimum, the roster of defendants in securities class action lawsuits will be greatly expanded, and public companies’ outside professional advisors increasingly will find themselves named as co-defendants in securities suits along with their client companies. The likely costs of defense alone for these gatekeeper defendants will be enormous, which in turn will create significant pressure for these gatekeeper defendants to settle, at least for cases surviving initial dismissal motions. In short, if the bill passes, look for the cost of professional liability insurance to escalate. (Indeed, Coffee cited concerns about the availability of professional liability insurance as one reason to justify the adoption of a secondary liability ceiling.)

 

That said, plaintiffs seeking to pursue claims against the gatekeepers would still have to satisfy the PSLRA’s requirement that the complaint plead "with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind." This hurdle is hard enough for plaintiffs to satisfy with respect to primary actors; it will be that much more challenging in connection with allegations against secondary actors. Moreover, the PSLRA’s proportionate liability provisions at least theoretically should reduce the liability that would be imposed on less culpable defendants.

 

But while the potential exposure the bill might pose for gatekeepers is an interesting question, it is not the only question the bill’s passage would present. The potential liability of other companies and their directors and officers for aiding and abetting claims is a related and equally serious question that the bill’s passage would present.

 

In that regard, it is important to keep in mind that aiding and abetting defendants in the Stoneridge case were not Charter Communications’ outside professionals. Rather, the defendants against whom the plaintiffs sought to impose secondary liability were Scientific Atlanta and Motorola, who were acting as customers and suppliers that allegedly facilitated a "round trip" revenue scheme so that Charter could hit its revenue targets.

 

My point here is that the potential defendants who could find themselves drawn into securities class action lawsuits on aiding and abetting claims if the bill passes will include not just gatekeepers but also other companies whose business transactions with the alleged primary violator are alleged to have aided and abetted the securities fraud.

 

In other words, were Senator Specter’s bill to pass, it would not only greatly expand the potential securities liability exposure for companies’ outside professionals. It would also expand the potential securities liability exposure of all companies that transact business with public companies.

 

At a minimum, this possibility has significant implications for D&O insurance coverage. In particular, the way in which the term "securities claim" is defined in the D&O insurance policy could become even more important than it is now. Currently, there are two variations in the way the term is defined. Under one formulation, the term is defined solely with reference to violations alleged in connection with the purchase or sale of the insured company’s own securities. In the other formulation, the term is defined with respect to any alleged violation of the securities laws. (To be sure, there are some definitions that incorporate both formulations.)

 

The first formulation potentially might be too narrow to encompass a claim that the insured company aided and abetted a securities law violation by another company. Clearly in anticipation of the possibility that the Specter bill might pass, it is critically important to carefully review the D&O policy’s definition of the term "securities claim" to ensure that it is sufficiently broad to encompass aiding and abetting claims.

 

A more challenging issue may arise with respect to private companies. There is nothing about the kind of vendor wrongdoing alleged in the Stoneridge case that would restrict the possibility of a claim on that basis solely to public companies. These kinds of allegations clearly could also be alleged against private companies as well. But private company D&O insurance policies usually contain some form of securities claim exclusion. These exclusions typically are tied to the public offering of the insured company’s own securities. But in light of the possibility of aiding and abetting claims even against private companies, these private company D&O insurance policy exclusions should be carefully scrutinized to determine how they might affect coverage under the policy in the event of an aiding and abetting claim against the insured private company.

 

A final note about the possibility of private litigant aiding and abetting claims is that, were the bill to be enacted, it could enormously complicate the jobs of professional liability insurance underwriters. The potential liability exposures of both outside professionals and of companies that do business with public companies will be expanded, in ways that traditional underwriting tools may be ill-suited to test and measure. It seems probable that underwriters may attempt to raise rates as the only instrument available to protect insurers from the possibility of expanded aiding and abetting liability exposure.

 

Special thanks to the several loyal readers who have sent me links regarding the Specter bill.

 

And While You’re At It, Congress: Stoneridge is not the only Supreme Court decision that Senator Specter has targeted. In addition, on July 22, 2009, Senator Specter introduced Senate Bill 1504 , "Notice Pleading Restoration Act of 2009," the purpose of which is to legislatively overturn the Supreme Court’s decision in the Iqbal case. Iqbal, building on the Court’s previous holding in the Twombley case, held that in order to survive initial motions to dismiss, plaintiffs’ complaints must provide "facial plausibility" for the claims asserted.

 

Unlike his Stoneridge bill, Specter’s Iqbal bill has not yet made it to committee review. According to Tony Mauro’s September 21, 2009 Law.com article (here), civil rights and consumer groups and trial lawyers have been meeting and conferring on ways to advance the legislation or otherwise to try undo Iqbal. According to the article, Iqbal has already had a very significant impact – it has already "produced 1,500 district court and 100 appellate court decisions."

 

Whether or not these legislative efforts ultimately succeed, it is clear that the plaintiffs’ bar and their allies intend to try to circumvent the effects of a string of defense-friendly Supreme Court rulings. The current Congressional logjam will clearly be a factor in whether or not these bills even make it through the process. The more interesting question is whether the pendulum has swung enough as a result of the current economic crisis that these legislative initiatives will carry the day.

 

Former McAfee General Counsel Kent Roberts, accused of options backdating-related misconduct, was acquitted following a criminal jury trial and the SEC later dropped its separate enforcement action against him. But that apparently is not enough for Roberts – he wants vengeance.

 

On September 16, 2009, he filed a lawsuit in the Northern District of California (complaint here), in which he alleges that the company, certain of its officers and directors and its outside advisors conspired to scapegoat him for the company’s backdating problems, as part of a campaign supposedly dubbed "Project Shield," to shift attention and options backdating blame away from the company and its senior officials.

 

Background

The events leading up to the filing of this complaint do help explain Roberts’s anger. Among other things, the criminal trial against him on fraud charges got off to a startling beginning when literally on the eve first day of trial, the company for the first time produced to prosecutors and to the defense 16 pages of previously subpoenaed documents that allegedly corroborated Roberts’ contention that he had not initiated the backdating of the options grant he received and that was the basis of the criminal prosecution.

 

Roberts was not the only one infuriated by this belated production – according to press reports, Judge Marilyn Hall Patel said "somewhere or another, heads will have to roll, this is outrageous." Roberts’ criminal defense attorney said at the time that the belated production underscores the defense contention that the company had engaged in a pattern of selectively releasing information in order to scapegoat Roberts for the company’s options issues.

 

The criminal trial nevertheless went forward, and on October 3, 2008, the jury acquitted Roberts of all charges, except one on which the jury was unable to reach a verdict. Judge Patel was quoted as having said, "I would strongly recommend against pursuing this further. This was not a case where any money was lost as a result of this."

 

In March 2009, the SEC dropped its separate civil complaint against Roberts (although, interestingly in light of the reputational damage allegations in Roberts’ recently filed complaint, while the SEC’s complaint against Roberts and related litigation press release can be easily found on the SEC’s website, I was unable to find anything on the SEC’s website indicating that the SEC had withdrawn the complaint. It may be there, but I couldn’t find it, which seems seriously wrong to me.)

 

Roberts’ Complaint

So long the accused, Roberts is now the accuser. His long, detailed and fascinating complaint is written in a febrile and vehement tone.

 

Roberts alleges that the company’s then-CEO and members of the company’s board "instituted a campaign of diversion, manipulation, and falsehood aimed at shifting the attention of federal authorities away from [the CEO’s] and McAfee’s misdeeds." He further alleges that the company’s board "literally dubbed the campaign ‘Project Shield,’" which he alleges was designed to make him the "scapegoat."

 

Roberts not only contends that he was scapegoated, but he also alleges that he was offered up in order to divert attention from actual, and much more significant, options backdating allegedly connected to company officers and board members. Among other things, Roberts alleges that the company’s board "engaged in a deliberate effort to divert attention onto Roberts in order to protect more senior company officers and directors whose conduct with respect to stock options was extensive and potentially unlawful."

 

As part of this alleged process, Roberts alleges, the company, its senior officers and its outside advisors orchestrated a campaign to selectively provide information and documents to government investigators to cast blame on Roberts and draw attention away from other company option grant related activity. He alleges that this selective and slanted provision of information to the government resulted in his criminal prosecution and in the SEC enforcement action against him. He also alleges that the CEO and board members provided "false accounts" in SEC depositions about conversation that had with Roberts.

 

The complaint alleges that McAfee "employed delay, misinformation, and selective disclosure to slant the evidence" away from the company grants "to depict Roberts to federal investigators as the individual behind the wrongdoing." The complaint further alleges that the company’s dealings with the governmental authorities were "deliberately tainted with deception, misinformation and withheld information."

 

As further detailed in a September 17, 2009 article by Ross Todd on the AmLaw Daily (here), Roberts’ complaint also contains a number of very specific allegations against McAfee’s outside attorneys and against the counsel to the board’s special litigation committee.

 

Roberts alleges that the company’s "manipulation of evidence through Project Shield was a substantial factor in causing Roberts’ unwarranted prosecution" that "substantially and irreparably damaged Roberts’ career." Roberts accuses the company of malicious prosecution, defamation and false light invasion of privacy, and seeks to recover unspecified compensatory and punitive damages.

 

Discussion

Roberts’ complaint is a fascinating document. Regardless whether or not his lawsuit succeeds, he will always have the option of selling the movie rights to his story, which reads like a Grisham novel. I found particularly compelling his account of the series of separate meetings with the CEO and board members in which (he contends) he himself brought to their attention an incident in which the company’s comptroller changed the date of one of Roberts’ option grants, and the next thing he knew he was being terminated and escorted out of the building. The company’s conduct (at least as depicted in Roberts’ obviously self-serving account) comes off as hasty and ill-considered.

 

But it is important to put these events in context, particularly the pressure and scrutiny McAfee and other companies were under at the time. The companies were under enormous pressure to demonstrate (under the then-applicable McNulty Memo and its predecessor the Thompson memo, about which refer here, specifying the guidelines for corporate prosecution) that it was "cooperating fully" with government officials. One of the criticisms of these guidelines at the time was that they forced companies to offer up its employees in order to try to avoid its own potential criminal prosecution – not to say that that necessarily happened here, but the circumstances as portrayed in Roberts’ complaint certainly do suggest that possibility.

 

For all the feverish tone of Roberts’ complaint, it probably should be noted that, at a minimum, he was aware of and went along with the backdating of his options grant. According to the press reports linked above, the jury did conclude that Roberts had breached his fiduciary duty to the company, even if they also concluded that the government had not proved that he had set out to defraud the company. To me, this seems like important context within which to consider Roberts’ outrage.

 

The complaint does raise some interesting insurance questions. The only defendant named in the complaint is the company itself. Because the typical public company D&O insurance policy covers the company only for securities claims, and because Roberts has not filed a securities claim against the company, there likely would not be coverage under the typical D&O insurance policy for Roberts’ complaint as it currently stands (although Roberts does allege a variety of allegedly misleading statements in the company’s disclosure documents, which could raise some interesting issues). I express no views here whether or not the company’s Commercial General Liability policy would provide coverage.

 

Though no individuals are named as defendants, several individual directors and officers are expressly alleged to have engaged in a variety of supposedly wrongful actions. The possibility that the complaint could be amended to name the individuals as defendants does suggest that the complaint could at least represent a potential claim under the D&O policy.

 

The more interesting question is whether any claims against individual directors and officers based on the complaint’s allegations would be covered claims. Many (but not all) D&O policies contain omnibus exclusions, often within the policy exclusion for bodily injury and property damage, intended to preclude coverage for personal injury claims. These exclusions, when they appear, are not uniform. At a minimum, the kinds of claims asserted in the Roberts complaint underscore the need to consider the language of these personal injury exclusions carefully, if they cannot be removed altogether. Given the breadth and variety of Roberts’ allegations, at least some of his claims, if extended to individual defendants, might not be entirely excluded even by a D&O policy that had a personal injury exclusion. Obviously, the argument for coverage would be stronger if there were no personal injury exclusion.

 

But in the end, what makes the filing of this complaint so interesting is the way that Roberts’ tale manages to retrace the precise arc of the entire options backdating scandal – from the early, overwrought days when the scandal first emerged, to the long, slogging process that followed, with its by a proliferation of lawyers and prosecution of legal claims, to the empty void left when all was said and done, presenting a question of what the whole thing was really all about to begin with.

 

To be sure, there were some significant options backdating settlements, including the recent $118 million Broadcom settlement (about which refer here). But the fact that the Broadcom settlement was just about options backdating related attorneys’ fees merely serves to underscore the question of what the whole options backdating frenzy has accomplished in the end. (The options backdating derivative lawsuit filed with respect to McAfee settled for approximately $30 million, refer here.)

 

The one thing that the options backdating scandal unquestionably did was create an enormous amount of work for lawyers. As Roberts’ complaint itself illustrates, once these kinds of forces are unleashed, they continue to expand outward indefinitely like some fundamental force of physics. I guess Roberts’ complaint just represents the inevitable next phase of that process – litigation about litigation.

 

Hat tip to the Courthouse News Service for a copy of the complaint.

 

As the number of failed and troubled banks has surged, one recurring question has been whether the banks woes would lead to a new round of banking-related litigation. While a few lawsuits had emerged in connection with earlier bank failures (refer here), there really has been nowhere near the number of suits as might be expected from the number of trouble banks – until now, perhaps. The arrival of a couple of bank loan loss reserve lawsuits this past week, as well as other banking-related developments, raises the question whether the conjectured round of bank related lawsuits may now have begun.

 

First, on September 8, 2009, plaintiffs filed a securities class action lawsuit in the Central District of California against Pacific Capital Bancorp and certain of its directors and officers, as well as a stock analyst that follows the bank’s stock. According to the plaintiff’s counsel’s September 8, 2009 press release (here), the complaint alleges that the defendants misled investors by representing that:

 

that the Company was maintaining a strong allowance for loan losses which would enable it to absorb losses in its portfolio. As alleged in the complaint, defendants’ misstatements and omissions relating to Pacific Capital’s loan loss provision caused the Company’s common stock to trade at artificially inflated levels between April 30, 2009, when the Company reported that it maintained its loan loss provision at a very high level, through July 30, 2009, when the Company admitted that it had not adequately reserved for loan losses, had not applied a conservative reserve methodology, and needed to record an additional loan loss provision of $117 million. The "buy" rating issued by the analyst defendants on the Company’s common stock also contributed, as alleged, at certain times during the Class Period to the artificial inflation in the price of Pacific Capital stock.

 

Second, on September 11, 2009, plaintiffs filed a securities class action lawsuit in the Northern District of California against UCBH Holding and certain of its directors and officers. (UCBH Holding is a bank holding company for United Commercial Bank, a California-state chartered bank with its headquarters in San Francisco, refer here.) According to the plaintiffs’ lawyers’ September 11, 2009 press release (here), the complaint alleges:

 

UCBH knowingly falsified its financial statements by concealing the rising level of loan losses and non-performing loans through a series of improper accounting tricks and outright deception of regulators and auditors. On September 8, 2009, UCBH announced that its Chairman and CEO, Thomas Wu, and its Chief Credit Officer, Ebrahim Shabudin, were resigning following the results of an investigation of the improper loan accounting. As a result of the accounting improprieties, UCBH must restate its financial statements for each quarter and the full fiscal year of 2008. News of the accounting fraud and the pending restatement caused UCBH’s stock price to fall significantly, damaging investors.

 

The complaint can be found here.

 

The final related development this past week took place on Friday night after the close of business, when the FDIC closed Corus Bank, N.A. about which refer here. (The FDIC actually closed three banks on Friday, refer here, bringing the 2009 year to date total number of bank failures to 92.) Though Corus only just now failed, the bank’s holding company and certain of its directors and officers had already been sued earlier this year (refer here) in a securities class action lawsuits in the Northern District of Illinois alleging that:

 

(i) that Corus was failing to recognize losses on its condominium loans in accordance with generally accepted accounting principles ("GAAP"); (ii) that Corus and/or its affiliates was purchasing condominiums in developments Corus had financed in an attempt to: (a) inflate the appraised values of condominiums to delay having to recognize losses on financing for such condominiums; (b) inflate developers’ sales figures to increase the likelihood of successful future sales; and (c) create the illusion of successful sales histories in order to inflate appraisal values for the condominiums to ensure inflated future prices for the condominiums; and (iii) that Corus was involved in detailed and in-depth negotiations with the Federal Reserve Bank of Chicago and the Office of the Comptroller of Currency regarding its deteriorating pool of condominium loans.

 

The arrival of the new lawsuits and the development involving Corus all in this past week may well have been coincidental. It remains to be seen whether there will in fact be a significant number of additional lawsuits involving failed or troubled banks.

 

That said, there is definitely a familiar tone to these recent cases. The allegations regarding the various banks’ alleged loan loss reserve deficiencies and alleged failure to recognize failing loans will be quite familiar to anyone who was involving in any way in the wave of failed bank litigation that accompanied the last round of failed banks during the S&L crisis. Though the future is uncertain, it is difficult no to speculate that we will see many more of these kinds of loan loss reserve inadequacy cases in the months ahead.

 

Of course, even if the cases do arrive in significant numbers, that does not necessarily mean that they will succeed. Some cases previously filed in connection with banks that failed in 2008 have already been dismissed. For example, the Fremont General lawsuit (refer here) and the Downey Financial lawsuit (refer here) have both been dismissed, and in Downey Financial’s case, the dismissal is with prejudice.

 

Nevertheless, the most recent filings seem to suggest that plaintiffs’ lawyers are not deterred by the prior dismissals. Given the depth of the current difficulties in the banking sector (about which refer here), there may yet be more, perhaps much more, banking-related litigation to come.

 

Citigroup Auction Rate Securities Lawsuit Dismissed: On September 11, 2009, Southern District of New York Judge Laura Taylor Swain dismissed the auction rate securities lawsuit that had been filed Citigroup. A copy of the September 11 opinion can be found here.

 

This action follows the earlier dismissals of the auction rate securities lawsuits that had been filed against UBS (refer here) and Northern Trust (refer here). However, this dismissal represents its own separate development, because unlike many of the other auction rate securities lawsuits, which were based on alleged misrepresentations in connection with the sale of the securities, the Citigroup auction rate securities lawsuit was based on a market manipulation theory.

 

As reflected in greater detail here, the plaintiff in the Citigroup auction rate securities lawsuit had alleged "defendants manipulated the market for Citigroup ARS by fostering the illusion that a valid market existed where buyers and sellers came together, with supply and demand in balance, allowing for the successful completion of auctions of Citigroup ARS. In fact, no such balance existed." The defendants moved to dismiss.

 

In her September 11 order granting the defendants’ motion to dismiss, Judge Swain held with respect to the plaintiff’s market manipulation claim under Section 10(b) of the ’34 Act that the plaintiffs had insufficiently alleged fraud; scienter; reliance; and loss causation. She also dismissed the plaintiffs’ claims under the Investment Advisers Act for lack of subject matter jurisdiction and the plaintiffs’ state law claims because they were preempted by SLUSA.

 

With respect to the plaintiffs’ market manipulation claim, she found the plaintiff’s fraud allegations insufficient because the complaint "does not include specific allegations as to which Defendants performed what manipulative acts at what times and with what effect" but instead that the complaint "relies on general and conclusory allegations regarding Defendants’ practices" regarding the ARS auctions. She concluded that "absent particularized allegations regarding Defendants’ alleged manipulative conduct, Plaintiff cannot state a claim for market manipulation."

 

With regard the plaintiff’s scienter allegations, Judge Swain found that the plaintiff has not sufficiently alleged motive and opportunity, holding that "Plaintiff’s conclusory allegations regarding Defendants’ motive for the alleged manipulation focus principally on Defendants’ desire to sell Citigroup ARS to offset subprime losses and to obtain fees for services in connection with the auctions." She found these allegations "too generalized to meet the scienter pleading requirement."

 

She also found that plaintiff had failed to allege particularize facts giving rise to a strong inference of scienter based on circumstantial evidence of conscious misbehavior or recklessness. She found that "the very market conditions – specifically the ‘subprime crisis’ – that Plaintiffs cites in his Complaint…give rise to an opposing and compelling inference that Defendants engaged only in bad (in hindsight) business judgments in connection with the ARS, and did not engage in the alleged conduct with an intent to deceive."

 

Judge Swain found further that the plaintiff had not adequately alleged reliance. In reaching this conclusion, Judge Swain specifically reference an SEC report that preceded the class period in which many of the practices of which the plaintiff complains regarding the ARS market auction process. These materials "disclosed that the ARS market was not necessarily set by the ‘natural interplay of supply and demand’" and therefore Plaintiff has not identified any basis on which the class reasonably could have relied on "the market ‘integrity’ assumption."

 

Finally, Judge Swain found that the market manipulation claim also fails because the plaintiff’s loss causation allegations are insufficient. In reaching this conclusion, she observed that "Plaintiff does not specifically allege that he tried to sell his ARS, nor does he allege that the interest rates set through Defendants’ manipulative conduct were lower than they would have been absent such conduct."

 

The dismissal granted in Judge Swain’s September 11 ruling is without prejudice; the plaintiff has until October 1, 2009 to file an amended complaint.

 

I have in any event added the Citigroup auction rate securities dismissal to my table of subprime and credit crisis-related lawsuit dismissal motion ruling, which can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing me with a copy of Judge Swain’s ruling.

 

On September 9, 2009, Towers Perrin released its report of the firm’s 2008 Survey of Directors and Officers Liability Insurance Purchasing Trends, which can be accessed here. Towers Perrin’s anticipated annual report again this year will undoubtedly be widely read throughout the D&O insurance industry. The report is a good resource and it is full of useful and interesting information.

 

Because the Report is so widely read, I think it is very important to highlight some specific issues about  the report. As I noted in connection with the 2007 report (here), the survey report is subject to some very important limitations that may not always be fully appreciated or understood.

 

In my view, the most significant limitation is one that is duly noted in the final two sentences of the Report section headed "Statistical Terms Used in This Report." As the Report states, the Report is the product of a survey, which means that the data in the Report are drawn from a "non-probability sample." That is, participants "choose – or are selected" to participate, and therefore the sample "is not random." Most importantly, because "not all potential respondents are likely to participate, survey biases must be considered when interpreting results."

 

It is the danger that this last point – the possibility that the reported results reflect "survey biases" – that most concerns me. In particular, the reference to the possibility that the survey respondents were "selected" is particularly relevant.

 

Specifically, the broker rankings section of the Report reveals that fully 95.2% of all survey responses came from the clients of just four brokerage firms. The same four firms also dominated the 2007 survey results, but the 2008 results reflect an even greater concentration, as the four firm’s clients represented "only " 88% of the survey respondents in the 2007 survey. In the 2008 survey, only 4.8% of all respondents are clients of firms other than the four brokerages. Indeed, clients of the three global insurance carriers represented just 1.8% of the respondents.

 

These observations should not be taken as a criticism of these four survey-predominating brokerages. I will stipulate that they are in fact strong and significant industry participants. But no informed person actually thinks they are the four largest D&O brokers in the country. They are undeniably the leading firms in getting their clients to complete the Towers Perrin survey. Again, no criticism here; I salute their enterprising spirit in achieving this result. However, no one should confuse the survey "ranking" with an actual market share ranking, nor could anyone fairly attempt to use the survey results to try to create that impression.

 

I emphasize this aspect of the Report because the survey bias in the broker participation population has pervasive effects throughout the entire report. Indeed, given that the pool of actual survey respondents for all practical purposes represents the clientele of those four brokerage firms, the Report fairly might be characterized as a description of the purchasing patterns of the clients of those four firms, rather than of the marketplace as a whole.

 

However, the Report itself does not address whether or not this rather categorical "skew" in the survey response population affects the other reported results, although it pretty obviously could significantly affect many of the other observations in the report. For example, the Report’s attempt to rank carriers by policy count and premium could simply be a reflection of the predilections of the four firms. The same is true with respect to such issues as respondents’ decision whether to purchase Side A insurance or IDL insurance.

 

There are other limitations arising from the characteristics of the respondents. Many of the respondents are very small.—nearly 40% reported assets under $6 million. Nearly 70% of the respondents had under 100 employees.

 

Another perhaps more significant concern with the 2008 Report is that the survey participants completed the survey during the third quarter of 2008. Not only does that mean the data are a year old, but also the survey results may fail to reflect the enormous changes in both the global economy and in the insurance marketplace during the last twelve months. Thus, there is some risk that the survey results, to whatever extent they fully and accurately reflect marketplace conditions of a year ago, may not reflect current conditions, given the enormous changes since the survey was conducted.

 

In addition, the Report also makes numerous year over year comparisons, noting changes between the results of the 2007 survey and the results of the 2008 survey. The difficulty with these comparisons is that there is no way of knowing whether or not the differences in the survey results are simply the result of a different mix in survey respondents, rather than a change in the underlying circumstances. To be sure, the Report does several times work hard to provide comparisons showing the results reported by repeat survey respondents. But there are numerous comparisons throughout the Report that are not so limited.

 

With respect to the concern noted above about the concentration of survey respondents in the portfolios of just four brokerage firms, it is a fair observation that the survey is open to all. If survey participation were more widespread, many of the concerns noted above might be alleviated. However, the opposite appears be happening, as participation by other brokerage firms is clearly declining, for reasons that might well be surmised.

 

None of this is meant as a criticism of Towers Perrin, which should be saluted for performing the survey and distributing the survey report without charge. Moreover, Towers Perrin itself acknowledges that there may be biases arising from the survey population distribution. So I don’t mean to criticize Towers Perrin, or anyone else for that matter. Rather, my analysis here is presented as a petition to all industry participants that in using the survey data, they should explicitly recognize and acknowledge the sample bias limitations inherent in the report. In particular, no one should try to make the survey results represent anything more than they actually do, particularly with respect to the concentrations noted above.

 

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It is now over two and a half years since the first subprime-related securities class action lawsuit was filed in February 2007, yet many of the cases filed as part of the ensuing litigation wave are still only in their earliest stages. But there have been some important developments recently – for example, the Eighth Circuit’s recent decision affirming the dismissal of the NovaStar Financial subprime lawsuit – suggesting that the evolving litigation wave may have reached a passed a significant milestone. With that possibility in mind, it seems appropriate to check in for a status report on the subprime and credit crisis-related litigation wave.

 

Filing levels

There have now been a total of 199 subprime and credit crisis-related securities class action lawsuits, of which 57 have been filed so far in 2007. A compete list of the lawsuits can be accessed here. While the subprime and credit crisis securities suits continue to be filed, in recent months the pace has definitely slowed. Of the 2009 filings, the bulk of them were filed in the first quarter, and there have only been a handful since April. Of course, the pace of filling activity could return at any time, but at least at this point there seems to be some possibility that the subprime and credit crisis litigation wave may have already crested.

 

Another circumstance suggesting that the litigation wave may be ebbing is changing mix of companies that are the targets of the latest securities class action lawsuits. In the first half of the year, approximately two thirds of the new securities lawsuits involved companies in the financial sector. But of the 37 new securities lawsuits filed in July and August 2009, only 13, or slightly more than a third, involved companies in the financial sector. In other words, the proportion of lawsuits against financial companies versus nonfinancial companies seems to have completely reversed.

 

Of course, another possibility to explain the recent filing patterns is that the litigation has changed as the nature of the financial circumstances changed. 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.

 

A good illustration of this definitional challenge is the case recently filed against MGM Mirage as a result of construction delays and financing issues relating to the company’s CityCenter project in Las Vegas. Whether this case should be grouped with earlier subprime and credit crisis-related cases depends on whether or not the company’s difficulties relate to a categorically separate set of issues or are simply a reflection of the overall economic turndown. In other words, 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.

 

Dismissal Motion Rulings

Even after two and a half years, there have still only been a handful of dismissal motion rulings in the subprime and credit crisis related lawsuits. For that reason, and because among the few rulings so far there are some that have gone one way and some that have gone the other way, it is difficult to generalize. Just the same, there have been some recent rulings suggesting that, even though there are still dismissal motion rulings going in the plaintiffs’ favor, on balance the rulings seem to be favoring the defendants, and recent rulings could be particularly useful for defendants going forward. (A complete list of the subprime and credit crisis-related lawsuit dismissal motion rulings can be accessed here.)

 

The most prominent among these recent developments is the Eighth Circuit’s September 1, 2009 decision in the NovaStar Financial case affirming the district court’s dismissal of the plaintiffs’ complaint, about which refer here.

 

There have also been a series of recent rulings in which the courts have granted motions to dismiss in recognition that the defendant company’s difficulties were the result of economic downturn, not fraud. Thus for example, in both the lawsuit that Luminent Mortgage Corporation filed against Merrill Lynch (refer here) and in the First Marblehead subprime-related securities class action lawsuit (refer here), the courts quoted with approval language from a prior RICO case in which the Second Circuit said "when the plaintiff’s loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that plaintiffs’ loss was caused by fraud decreases."

 

This latter argument – that is, if the plaintiffs were harmed, it was due to the global financial downturn, not to defendants’ supposed misconduct – could prove useful to defendants in a wide variety of subprime related cases. Given the magnitude of the economic downturn, which was nearly universally unanticipated, this argument could well be extended to many if not most of the subprime and credit crisis-related lawsuits. The extent to which the defendants are able to exploit this argument in other cases remains to be seen, but for now defendants seem to have established a significant formula for dismissal motion success in these cases.

 

Another development that suggests the balance may be shifting in defendants’ favor is the number of recent cases were district courts granted renewed motions to dismiss after plaintiffs had filed amended complaints seeking to cure pleading defects noting in the initial dismissal rulings. Renewed dismissal motions were recently granted in both the Downey Financial and Centerline cases (about which dismissals refer here, scroll down)– although, to be sure, the renewed dismissal motion was denied in the BankAtlantic case, where the plaintiffs’ amended complaint survived the renewed motion to dismiss, as discussed here.

 

Another significant recent development suggesting that defendants may have developed an advantage at the dismissal stage is the dismissal granted in the CBRE Realty case. As discussed at greater length here, the district court granted the dismissal motion even though the plaintiff asserted only claims under the ’33 Act, and therefore did not have to satisfy the more rigorous initial pleading requirements that apply to ’34 Act claims (as for example the need to plead scienter). This development may be particularly significant because many of the subprime and credit crisis-related lawsuits, particularly many of those filed in 2009, assert only claims under the ’33 Act. Of course, it remains to be seen whether or not the complaints in these other cases will be found to be similarly deficient as the one in the CBRE Realty case, but for now (based on admittedly few data points) the balance seems to be in the defendants’ favor on these cases.

 

One final note is that the apparent pendulum swing in defendants’ favor at the motion to dismiss stage is that it is not limited just to the subprime and credit crisis-related securities cases. As shown by the recent dismissals in the Citigroup subprime related derivative lawsuit (refer here, scroll down) and in the Citigroup subprime related ERISA lawsuit (refer here, scroll down), the recent development suggest that defendants may be faring well at the dismissal motions stage in these other kinds of cases as well.

 

To be sure, there are also cases in which the motions to dismiss recently have been denied, as for example in the Levitt Corp. subprime related securities lawsuit (about which refer here, scroll down). The dismissal motion rulings are by no means all going in defendants’ favor and the outcome of the dismissal motions in any particular case is by no means predetermined. There are many more dismissal motions yet to be heard.

 

Settlements

If there are only a few dismissal motion rulings in these cases so far, there are even fewer settlements, and it is even more difficult to generalize.

 

By far the most attention-grabbing feature of the settlements so far is the series of eye-popping settlements in subprime lawsuits involving Merrill Lynch. The three Merrill Lynch settlements so far are the three largest subprime-related lawsuit settlements. The $475 million securities lawsuit settlement (refer here), the $150 million bond action settlement (refer here) and the $75 million ERISA action settlement (refer here) stand out among the few other, more modest settlements.

 

It is not just their size that may set these Merrill Lynch settlements apart. The fact that these enormous settlements were entered before the motions to dismiss were heard in each of these cases and also shortly after Bank of America acquired Merrill Lynch suggests that following its acquisition of Merrill, Bank of America moved quickly to clear the decks of Merrill litigation that predated the merger, even if substantial sums proved to be required to accomplish that goal. Because of the possibility that these settlements may represent the outcome of their own unique settlement dynamic, they may be of little guidance with regard to possible settlement ranges of other cases.

 

There have been other significant settlements in other cases, from which some generalizations may or not be able to be drawn. Thus, for example, the RAIT Financial subprime-relates securities lawsuit recently settled for $32 million (refer here) and the Accredited Home Lenders case recently settled for $22 million (refer here). Both of these cases had survived the defendants’ motions to dismiss, which suggests that while it may difficult for these cases to survive dismissal motions, when the cases do survive they can be quite costly to resolve.

 

Two other noteworthy recent settlements include the $37.25 million settlement in the American Home subprime-related lawsuit (refer here) and the $30.5 million settlement in the Beazer Homes subprime related lawsuit (refer here). These settlements are notable because in both instances the cases settled before the motions to dismiss had been ruled upon. While each of these cases had their own particular features and each was resolved for reasons particular to each case, they do suggest that resolving more serious cases can be prove costly to settle. These cases also suggest that when the claims are sufficiently serious the plaintiffs may be able to avoid the initial pleading hurdle altogether.

 

So while the defendants may have won some important recent victories in the courtroom at the motion to dismiss stage, the overall costs of defending and settling these cases taken in the aggregate nevertheless continues to look as if it will be enormous. By any measure, the subprime and credit crisis-related litigation wave continues to represent a tremendous loss exposure for D&O insurers.

 

In any event, a complete list of settlements in the subprime and credit crisis-related lawsuits can be accessed here.

 

Gatekeeper Liability

One of the characteristics of many of these subprime and credit crisis related lawsuits is the extent to which the plaintiffs are seeking to impose liability on the gatekeepers of the target companies. The gatekeepers named as defendants include not only the directors and officers of the target companies, but also the companies’ auditors and offering underwriters, as well as the rating agencies that provided rating on the companies’ securities offerings.

 

The plaintiffs have shown particular willingness to pursue claims against the auditors. Thus, for example, the trustee for New Century Financial Corp. has initiated a claim against KPMG, the company’s former auditor (refer here). KPMG is also named as a defendant in the New Century subprime securities lawsuit, and the district court in that case specifically denied KPMG’s motion to dismiss (refer here). In addition, in the Countrywide subprime-related securities lawsuit, the district court found denied KPMG’s renewed motion to dismiss the claims against KPMG in the plaintiffs’ amended complaint (refer here, scroll down).

 

The possibility that these gatekeeper claims could prove valuable for claimants was highlighted in the recent $37.25 million American Home settlement. As here, the total settlement fund included contributions of $8.5 million from the seven offering underwriter defendants and $4.75 million from the company’s auditor, Deloitte & Touche. While it is always dangerous to try to generalize from a single settlement, the American Home settlement does at least suggest the possibility that resolving gatekeeper liability could be an important and costly part of subprime and credit crisis litigation wave’s overall consequences.

 

Another significant development in terms of gatekeeper liability is Judge Schira Scheindlin’s September 2, 2009 ruling in the Cheyne Financial case denying the rating agency defendants’ motions to dismiss. Although, as discussed at length here, there could be limitations on the overall impact of Judge Scheindlin’s ruling, the ruling could influence the many other cases in which plaintiffs are seeking to impose gatekeeper liability on the rating agencies.

 

One final note about the gatekeeper liability developments is that at least so far the claimants seem to have shown little inclination to try to pursue claims against the attorneys that may have been involved in the underlying circumstances. There is precedent for plaintiffs to pursue these kinds of claims against the attorneys; in a case involving a commercial mortgage backed securities transaction that took place in the 90’s, certain claimants are now pursuing claims against the Cadwalader firm, which had been the law firm that created the transaction documents (refer here for more details about this case). Significantly, the claimants did not initiate that claim until many years after the fact and only after extensive litigation involving other parties. All of which suggests that the claims against the attorneys, even if not yet filed, could be yet to come.

 

Defense Expense

In addition to the potential costs of settlement, these cases are in most instances proving enormously expensive to defend. The most substantial illustration of this proposition is the State Street’s August 10, 2009 announcement (here) that the approximately $625 million subprime-related litigation expense reserve the company had established in January 2008 was as of June 30, 2009 already down to $193 million, and further that there could be no assurances that the remaining amount would be adequate for the company’s continuing litigation.

 

The potential cost of serious corporate litigation was also highlighted in the recent Broadcom options backdating derivative lawsuit settlement (about which refer here). Among other things, the settlement papers reflected recitals that the company’s litigation expense to date in connection with company’s various options backdating related legal proceedings was in excess of $130 million. Even though the Broadcom case related to options backdating and not to subprime litigation, the defense expenses accumulated in that case underscores how expensive serious corporate litigation can become.

 

Many of the subprime and credit crisis related cases are equally as complicated and equally serious. And while the $130 million in litigation expense in the Broadcom case may be an extreme case, it is not unusual any more for costs of litigation in complex corporate and securities cases to run into the tens of millions of dollars. The costs of litigation alone have become staggering.

 

All of which is a long way of saying that in addition to the costs associated with settling these cases, the overall cost of these lawsuit also will include massive amounts of defense expense. These enormous defense expenses will add to the overall aggregate burdens of this litigation for the D&O insurance industry, as well as for the company’s themselves. Though it has been a while since anyone has attempted to calculate the overall cost to the D&O insurance industry from the subprime and credit crisis litigation wave, by any measure the aggregate cost included defense and settlement amounts will be enormous.

 

Each fall for the last three years I have taken a look at the current trends and hot topics in the world of D&O. There are of course the perennial topics that always remain important. However, this overview is intended to address the most significant concerns of current interest for D&O insurance professionals and their clients. My list of the current issues to watch is set out below.

 

Will Rising Corporate Bankruptcies Produce Increased D&O Claims?

According to the Administrative Office of the U. S. Courts (refer here), the number of business-related bankruptcies increased 63% (to 55,021 from 33,822) during the year ended June 30, 2009. Although there are some encouraging signs that the overall economy may be beginning to recover, significant numbers of individual companies could continue to face the risk of bankruptcy for some time to come.

 

Among other problems associated with bankruptcy filings is the risk of increased claims against officials at the bankrupt firms. For example, in its 2008 year end report on securities litigation activity, Advisen noted that since 1995, roughly 35 percent of the large public companies (defined as having assets of over $250 million in 2008 dollars) that filed for bankruptcy also sustained securities class action lawsuits against their directors and officers. During 2007 and 2008, the percentage increased to 77 percent. The directors and officers of private companies also face a heightened claims exposure when their companies file for bankruptcy.

 

Bankruptcy associated-claims present a host of complications, not least of which is the intricate (and sometimes problematic) way that D&O insurance policies respond in the bankruptcy context. One recent development illustrating the difficulties that can arise in the bankruptcy context was the July 2009 decision in the Visitalk case (about which refer here), in which the Ninth Circuit upheld the carriers’ denial of coverage for a lawsuit brought by a company as debtor in possession against former directors and officers of the company, as a result of the policies’ insured vs. insured exclusion.

 

These kinds of complications underscore the need for D&O insurance policies to be closely scrutinized for their ability both to withstand and to respond to claims arising in the context of bankruptcy.

 

One final concern is that the rising tide of corporate bankruptcies could trigger increased losses under Excess Side A insurance that many companies now carry. This possibility is one of several factors, many of which that are discussed below, that could represent a changing environment for carriers offering Excess Side A insurance. The increased number of bankruptcies in any event further reinforces the proposition that Excess Side A insurance is an indispensible part of a complete D&O insurance program for any corporate insured, whether public or private.

 

Will the Growing Number of Bank Failures Produce a Wave of Failed Bank Litigation?

The number of 2009 year to date failed banks is now up to 89 (as of September 4, 2009, about which refer here), and the total number of bank failures since January 1, 2008, is up to 114. Alarmist commentators have made predictions that as many as 1,000 banks could fail by the end of 2010, as discussed here. Whether or not the number of bank closures will come anywhere near that level, it is clear that we are in the midst of the most significant wave of bank failures since the S&L crisis.

 

The question remains whether this time around we will see the same level of litigation activity as we saw during the last failed bank wave. Somewhat surprisingly, so far the FDIC has initiated relatively little litigation to try to recoup its losses from the directors and officers of the failed financial institutions. However, for now the FDIC is preoccupied dealing with further bank closures. And even during the S&L crisis, the FDIC and the other regulatory agencies usually did not act until statutes of limitations were just about to expire. There could yet be another round of failed bank litigation, in a 21st Century edition.

 

Private litigants might also be expected to get in the act — for example, investors who lost their entire investment when a bank closes might well be expected to pursue claims. There has been a certain amount of that (refer here). There has also been some securities class action litigation activity involving failed banks whose shares were publicly traded. Of the 25 banks that failed in 2008, six of them are involved in securities class action litigation, even though only 11 of them were publicly traded.

 

However, the securities class action litigation involving the failed banks has not fared particularly well so far. For example, in the Downey Financial securities class action lawsuit (about which refer here), the district court recently granted the renewed motion to dismiss following the plaintiffs’ attempt to amend their complaint to try to remedy the pleading defects noted in the initial dismissal without prejudice. In addition, in the Fremont General securities lawsuit (refer here), the court also granted the defendants’ motion to dismiss, albeit with leave to amend.

 

These early returns potentially could be discouraging some potential litigants. Nevertheless, if for no other reason than the fact that there was so much failed bank litigation last time around, it seems likely that when all is said and done, the growing number of bank failures will at some point lead to an extended round of failed bank litigation.

 

Whether or the failed bank litigation ultimately emerges, the D&O insurers have responded defensively to the wave of bank failures. Many financial institutions, including even smaller community banks, are facing significantly more challenging circumstances when trying to renew their D&O insurance. Many banks find that they can obtain coverage, if at all, at significantly greater cost for significantly restricted terms and conditions, and in many instances with significant new limitations such as reduced limits of liability or the addition of additional exclusions, such as a regulatory exclusion. The wave of failed banks has already had a significant impact in the D&O insurance marketplace.

 

Will the Rising Number of Derivative Lawsuit Mega Settlements Mean Significant Excess Side A Losses?

Within the last several years, there have been a rising number of unprecedented mega settlements in shareholders’ derivative lawsuits, particularly during the last 12 to 24 months. These massive derivative lawsuit settlements include the $900 million UnitedHealth Group options backdating settlement (refer here); the $118 Broadcom options backdating settlement (refer here); and the $115 AIG settlement (refer here).

 

One consequence of this outbreak of massive derivative lawsuit settlements is that now for the first time Excess Side A carriers are being called upon to contribute significantly toward settlement outside of the insolvency context. The recent Broadcom settlement, in which the Excess Side A insurers collectively contributed $40 million to settlement, appears to represent a milestone development in that regard. While there may well have been prior occasions on which Excess Side A insurance contributed toward settlement outside of insolvency, the Broadcom settlement is by far the most public example. Based on the reactions I have heard, the Broadcom settlement has been a wake up call of sorts for many players throughout the D&O industry.

 

Among other things, the Broadcom settlement underscores the value for companies and their directors and officers of the Excess Side A product, which, along with the insolvency related considerations noted above, should further encourage policyholder take up of this product. As also noted above, Excess Side A protection increasingly will become a standard part of any well designed D&O insurance program.

 

The Broadcom settlement also represents a significant development for D&O insurers as well, who until now have enjoyed the opportunity to offer Excess Side A insurance in a relatively low loss cost environment, particularly outside the insolvency context. The Broadcom settlement highlights the potential for Excess Side A insurers to sustain significant claims losses on this product, even outside of the insolvency context. The increasing incidence of mega derivative lawsuit settlements underscores the growing possibility of these kinds of losses.

 

Another significant side effect of the Broadcom settlement is that the plaintiffs’ lawyers clearly will now have developed an appreciation of the value of presenting claims that trigger the Excess Side A coverage. The question arises whether they might now attempt to craft claims for the express purposes of accessing the Excess Side A limits. The attempt to pursue this strategy would face considerable challenges – derivative lawsuits, for example, are subject to formidable defenses, including the demand requirement and the business judgment rule defense. Nevertheless, the possibility of claims targeted expressly at the Excess Side A limits is a consideration that should not simply be disregarded.

 

Will Securities Lawsuit Filings Return to Historical Levels?

As discussed in a prior post (here), securities class action lawsuit filings dropped during the second quarter of 2009. This decline was largely due to the low filing activity during May (when there were only 11 new securities class action lawsuits) and during June (when there were only six new securities lawsuits), compared to historical monthly filing levels in the range of 15 to 20 new lawsuits a month.

 

At least to this point in the third quarter, it seems as if the second quarter filing decline was just a temporary dip that has already ended. There were at least 20 new securities class action lawsuits in July, and at least 17 in August, both of which monthly filing levels are well within historical norms.

 

Another interesting attribute of the most recent lawsuit filings is that so far the third quarter filings are not nearly as concentrated in the financial sector. During the first half of the year, about two-thirds of the securities class action lawsuit filings involved financial companies. However, of the 37 securities lawsuits filed in July and August, only about 13 (or roughly a third) involved financial institutions. In other words the proportion of lawsuits filed against financial companies to lawsuits filed against nonfinancial companies seems to be completely reversed from the first half of the year.

 

The other interesting thing about the third quarter filings is the extent to which the cases involve proposed class period cutoff dates that are well in the past, sometimes by as much as a year or more prior to the actual filing date. As I have previously noted on this blog (most recently here), these belated filings suggest that while the plaintiffs lawyers were scrambling to file subprime and credit crisis-related lawsuit against financial companies in the first part of the year, they were also developing a backlog of other cases that they are now working off.

 

All signs indicate that by the end of this year, securities class action filing levels will likely have returned to historical levels after the brief and apparently temporary decline in the second quarter. The concentration of filings in the financial sector also seems to be abating, with distribution of filings by industry starting to look more like historical norms.

 

How are Plaintiffs Faring in the Subprime and Credit Crisis-Related Securities Lawsuit?

We are now more than two and a half years into the subprime and credit crisis-related litigation wave, yet in many respects the cases are still only in their earliest stages. But there have been a number of recent significant developments suggesting that the evolving subprime litigation wave recently may have passed a significant milestone, and that it could be an appropriate time to take a closer look at the status of the subprime and credit crisis cases. For that reason, I will be publishing a post within the next few days providing a detailed status report on the litigation wave. I will update this post with a link when the status report is available. UPDATE: My September 8, 2009 status report on the subprime and credit crisis related litgation can be found here.

 

In the meantime, though the wave is still in its early stages, it is possible to make a number of generalizations. First, it seems like the defendants again have the upper hand at the motion to dismiss stage. Among other things, the Eighth Circuit’s recent decision affirming the district court’s dismissal in the NovaStar Financial case (about which refer here) represents a significant victory for defendants. The Downey Financial dismissal, discussed above in connection with the failed banks is another example. The recent dismissals in the Citigroup subprime-related derivative lawsuit (refer here) and Citigroup ERISA lawsuit (refer here, scroll down) also suggest that plaintiffs may be faring poorly in those cases as well.

 

On the other hand, there have also been some significant recent settlements suggesting that if the plaintiffs can survive motions to dismiss in these cases, the cost of settlement can be significant. Along those lines, the recent $32 million settlement in the RAIT Financial case (refer here) and the $22 million settlement in the Accredited Home Builders case (refer here) illustrate how costly it can be to try to settle cases that survive motions to dismiss.

 

Two equally significant settlements in cases in which the dismissal motions had not yet even been heard – the $37.25 million settlement in the American Home case (refer here) and the $30.5 million settlement in the Beazer Homes case (refer here) – suggests that in cases that are sufficiently serious the plaintiffs may be able to avoid the initial pleading hurdle altogether.

 

The American Home settlement may be particularly noteworthy because in that case both the offering underwriter defendants and the company’s auditor contributed substantially toward the cost of settlement. That, together with the Judge Scheindler’s September 2, 20009 partial denial of the motion to dismiss the claims against the rating agencies in the Cheyne Finance lawsuit (about which refer here), could suggest that in at least some of these cases the possibility of gatekeeper liability could be an important part of the overall claims resolution.

 

The final point is that these cases are proving to be extremely costly to litigate. The most dramatic illustration of this point is State Street’s August 10, 2009 announcement (here) that the approximately $625 million subprime-related litigation expense reserve the company had established in January 2008 was as of June 30, 2009 already down to $193 million, and further that there could be no assurances that the remaining amount would be adequate for the company’s continuing litigation.

 

So while the defendants may have won some important victories in the courtroom, the overall costs of defending and settling these cases taken in the aggregate nevertheless continues to look as if it will be enormous. By any measure, the subprime and credit crisis-related litigation wave continues to represent a tremendous loss exposure for D&O insurers.

 

Will the SEC’s Renewed Aggressiveness Expand Individual Liability Exposures for Corporate Officials?

The SEC is under considerable pressure to reestablish its regulatory credentials and to try to restore its tarnished reputation. As a result, the SEC recently has shown a renewed aggressiveness and even an apparent willingness to try to expand the weapons in its arsenal, in ways that may pose increased threats to corporate officials.

 

Two recent enforcement actions underscore this pronounced new aggressiveness. First, in July 2009, the SEC launched an enforcement action against the CEO of CSK Auto. As discussed here, the SEC is seeking to clawback the compensation the CEO earned during the period for which the company later restated its financial statements. Significantly, the SEC is pursuing this claim even though the CEO is not alleged to have engaged in any wrongful misconduct or even to have had any role in or knowledge of the issues that triggered the company’s restatement.

 

The second example of the SEC’s recent aggressiveness is the July 2009 enforcement action filed against two corporate officials at Nature’s Sunshine Products. As discussed here, the SEC sought to impose control person liability on the two officials for the company’s activities that violated the Foreign Corrupt Practices Act, even though the two individuals were not themselves alleged to have been involved in or even aware of the corrupt activities.

 

Though the SEC’s apparently needs no further encouragement to pursue liability claims against individuals, the agency nevertheless is facing significant additional pressure to target individuals as part of its enforcement activities. Indeed, among other reasons that Judge Jed Rakoff has questioned the proposed settlement of the enforcement action involving the Merrill Lynch bonuses is that the settlement does not involve any specific allegations against or claims against the individuals who caused the alleged wrongdoing to take place. (Refer here for additional details regarding Judge Rakoff’s objections). Regardless of the outcome of the Merrill Lynch settlement, going forward the SEC likely will have to anticipate this objection and incorporate targeted allegations against individuals in an effort to forestall further objections of this kind.

 

The bottom line is that as a result of these developments, corporate officials could find themselves increasingly on the firing line. Of particular concern is that the CSK Auto and Nature’s Sunshine Products enforcement actions evidence an arguably disturbing willingness on the SEC’s part to try to impose liability on corporate officials even in the absence of culpable involvement in or even awareness of the alleged wrongdoing.

 

Will Claimants Increasingly Target Outside Directors?

The $61.55 million settlement earlier this year of the claims against the outside director defendants in the Peregrine Systems securities lawsuit is merely the latest example where outside directors have found themselves required to contribute toward a separate settlement of significant liability claims against them. As discussed at greater length here, at least some of the outside director defendants appear to have been required to contribute toward the Peregrine Systems settlement out of their own assets.

 

As was also shown in the now infamous Just for Feet settlement (about which refer here), the threat that outside directors will be targeted and could be called upon to contribute toward settlement out of their own assets is a growing concern, and one that is significantly increased in the bankruptcy context. Given the growing number of corporate bankruptcies, outside directors could find increasingly find themselves on the front lines of D&O claims.

 

These developments underscore yet again the need for alternative insurance structures such as Excess Side A insurance to be included as an important part of the corporate D&O insurance program. Indeed, among the defendants whose potential liabilities were settled by the Excess Side A insurers’ contribution in the Broadcom options backdating derivative lawsuit settlement were several of that company’s outside directors.

 

These cases also highlight the extent to which the outside directors’ liability exposures and interests should be separately considered as part of the construction of a company’s D&O insurance program. Simply put, the outside directors’ interests and the interests of the company’s officers may or may not be completely aligned. These developments and considerations suggest that the non-officer directors could be well advised to have their insurance interests independently reviewed, in order to ensure that their interests are appropriately addressed in the way the company’s insurance program is constructed, as I discuss at greater length here.

 

What Will be the Next Industry Event for the D&O Insurance Industry?

It is commonly understood that the D&O insurance industry’s historical experience is characterized by a sequence of industry events – for example, we went from the bursting of the Internet bubble to the era of corporate scandals, and we went from options backdating to the subprime litigation wave.

 

So what will be the next industry event? It might be one or more of the issues discussed above, like the failed bank litigation wave, or the rising number of derivative lawsuits. Or it could be a further extension of existing trends, like the rising numbers of FCPA follow-on civil lawsuits. Or it could be something entirely new, like lawsuits arising from climate change related disclosures.

 

Only time will tell for sure what the next industry event will be. The one thing that is for certain is that there will another event that will emerge and define the industry’s experience in the months and years that follow.

 

Is the D&O Insurance Marketplace Headed for a "Hard Market"?

Earlier this year, Advisen took the bold and provocative step of predicting that the D&O insurance marketplace is headed toward a "hard market" as early as late 2009 or early 2010, as discussed at greater length here. Whether or not we are actually headed to an overall harder insurance market remains to be seen, though as 2009 progresses, the possibility to that we will see a hard market earlier rather than later seems less and less likely.

 

To be sure, the D&O insurance marketplace for companies in the financial sector is definitely harder than for the rest of the marketplace, and some financial institutions are now "hard to place." The speed with which the D&O marketplace for community banks firmed up shows how quickly conditions can change.

 

Nevertheless, for most companies, particularly those that are financially stable, the D&O marketplace remains competitive, with ample capacity and coverage available on favorable terms and conditions. The pricing declines that have characterized the marketplace over the last several years have largely ended, but outside the financial sector significant pricing increases (at least for financial stable companies) remain the exception.

 

That is not to say that the possibility of a generalized harder market is completely out of the question. The losses and defense expense associated with the subprime and credit crisis related litigation wave, in combination with several years’ of pricing declines and coverage expansions, could start to affect carriers’ overall results and trigger pricing increases and marketplace restrictions. Whether and when these circumstances might arise remains to be seen.

 

Among the causes many cite for the subprime meltdown is the willingness of the rating agencies to assign investment grade rating to securities backed by subprime mortgages. For that reason, in many of the lawsuits filed as part of the subprime litigation wave, plaintiffs have named rating agencies as defendants, seeking to hold them responsible for their investment losses. However, as discussed here, whether the rating agencies could actually be held liable is unclear, because in the past courts have found the rating agencies’ rating opinions to be protected by the First Amendment.

 

However, in a September 2, 2009 opinion (here) in a lawsuit relating to investment notes issued by Cheyne Financial, Southern District of New York Judge Shira Scheindlin denied the rating agencies’ motions to dismiss. Most significantly, Judge Scheindlin rejected the rating agencies’ argument that their rating opinions were entitled to immunity under the First Amendment, and she also rejected their argument that their rating represented non-actionable opinion.

 

Background

Plaintiffs claims in the lawsuit related to their investment in certain notes that had been issued by Cheyne Financial, a $5.86 billion structured investment vehicle. The notes were collateralized by certain assets, included residential mortgage backed securities (RMBS). Cheyne collapsed amid the subprime meltdown in 2007. Cheyne was unable to pay the senior debt as it became due and Cheyne is now in bankruptcy. The investors lost substantially all of their investment.

 

The notes Cheyne issued received the highest possible ratings from the rating agencies. However, according to Judge Scheindlin’s factual recitation in her September 2 opinion, that rating agencies played a "more integral role" than merely providing ratings. The rating agencies were involved in "structuring and issuing" the notes. For example, the rating agencies "helped to determine how much equity was required at each level of the SIV."

 

For their efforts, the rating agencies were paid approximately $6 million, an amount the court noted was "three times their normal fees." Moreover, the rating agencies fees increased "in tandem with the Cheyne SIV’s growth." As Judge Scheindlin put it, "unbeknownst to investors, the Rating Agencies’ compensation was contingent upon the receipt of the desired ratings for the Cheyne SIV’s Rated Notes."

 

After Cheyne collapsed, the investors filed suit against Morgan Stanley, which had promoted and distributed the notes; Bank of New York Mellon, which had provided certain custodial and administrative services for Cheyne; and the rating agencies (including Moody’s and S&P and their corporate parents). The plaintiffs asserted thirty-two claims under twelve different legal theories. Essentially, the plaintiffs alleged common law fraud under New York law; common law tort claims alleging misrepresentation; and assertions based on alleged breach of contract. The defendants moved to dismiss.

 

Judge Scheindlin’s Opinion

The rating agencies moved to dismiss the plaintiffs’ fraud allegations, arguing that their ratings were protected by the First Amendment and represented non-actionable opinion.

 

Judge Scheindlin rejected the rating agencies’ attempt to rely on the First Amendment, noting that "where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large, the rating agency is note afforded the same protection." Judge Scheindlin held that here, because the Cheyne note ratings were provided only to "a select group of investors" as part of a private placement, the First Amendment defense is inapplicable.

 

Judge Scheindlin further rejected the rating agencies’ argument that their ratings were in any event non-actionable opinion, holding that the "plaintiffs have sufficiently pled that the Rating Agencies did not genuinely or reasonably believe that the ratings they assigned to the Rated Notes were accurate and had a basis in fact."

 

In finding that the plaintiffs had adequately alleged that the rating agencies did not reasonably believe the rating had a basis in fact, Judge Scheindlin among other things noted that the complaint alleged that the ratings "appeared to investors to equate the Rated Notes to other investments" such as investment grade bonds, though the notes "in reality and unbeknownst to investors, differed materially"; that, contrary to representations, the SIV’s portfolio consisted of more that 55% of RMBS, which "made the SIV a risky investment and certainly not deserving of high ratings."

 

The complaint further alleges that the rating agencies were subject to numerous conflicts of interest. Thus, even the rating agencies allegedly were aware that "the process used to derive ratings was deeply flawed and unreliable," but they nonetheless issued the ratings because they were compensated by a fee "substantially larger than normally received" and their fee was "directly connected to the success of the Cheyne SIV." These conflicts "compromised the objectivity of the ratings."

 

Judge Scheindlin further found that the plaintiffs had adequately pled scienter, based on the complaint’s allegations of motive and opportunity. She noted that the complaint alleged that the rating agencies knew Morgan Stanley would have "taken its business elsewhere" if the notes did not receive the desired rating, and in exchange for their "unreasonably high ratings" the rating agencies received "fees in excess of three times their normal fees."

 

With respect to motive and opportunity, the complaint further alleged that the rating agencies’ "remuneration was dependent on the successful sale of the Rated Notes," and that "they could sell successfully only if they were highly rated."

Judge Scheindlin also rejected the rating agencies’ argument that as sophisticated investors, the plaintiffs’ could not show actionable reliance on the ratings.

 

Finally, with respect to the plaintiffs’ other claims, Judge Scheindlin found that New York’s Martin Act precluded the plaintiffs’ common law tort claims, and that the plaintiffs’ had not alleged sufficient facts to support plaintiffs’ claims sounding in contract. She allowed the plaintiffs’ leave to amend their contract claims, but the dismissal with respect to the plaintiffs’ tort law claims was with prejudice.

 

Discussion

Judge Scheidlin’s rulings in the Cheyne Financial case are potentially of great significance in the many other lawsuits that have been filed against the rating agencies as part of the subprime litigation wave. In those many other cases, the rating agencies will also attempt to rely on the same threshold defenses on which they sought to rely in the Cheyne Financial case. The claimants in those other cases will cite Judge Scheindlin’s opinion in attempting to argue that the defenses should not be available to the rating agencies.

 

Several aspects of Judge Scheindlin’s opinion could be particularly helpful to other claimants. In particular, the significance she attached to the involved role of the rating agencies in structuring the investments they later rated could be particularly helpful, as claimants have asserted these same kinds of allegations in many of the other cases against the rating agencies. The same is also true with respect to her findings that the rating agencies’ compensation arrangement put them in a conflict of interest.

 

But while Judge Scheindlin’s opinion undoubtedly will be helpful to other claimants, the Cheyne Financial decision is far from conclusive of the issues surrounding the protections the rating agencies may be able to rely upon in connection with their ratings. Thus, even in the Southern District of New York, the opinion is at most of persuasive not precedential value. Though Judge Scheindlin is a highly respected Judge, other court nevertheless may decline to follow her analysis, particularly if the factual allegations are distinguishable.

 

A further way that Judge Scheindlin’s opinion could be of limited value is that her rulings were made under New York law with respect to allegations of common law fraud. Many of the other lawsuits that have been filed against the rating agencies allege violations of the federal securities laws, which other courts could view as being a critical distinction – although it does seem that shouldn’t make any particular difference with respect to the First Amendment issue.

 

Another consideration could further limit the impact of Judge Scheindlin’s rulings is that her analysis of the First Amendment issue may not persuade other courts. Indeed, a September 4, 2009 Wall Street Journal article (here) discussing the opinion quotes First Amendment scholar Martin Redish as saying that "the fact that [a rating] was just to a select audience should not disqualify it from First Amendment protection."

 

Even if other courts agree that the First Amendment protection does not apply to ratings that have only been disseminated to a small group, many of the claims that have asserted against the rating agencies in other cases do not involve the same kind of restricted offering involved in the Cheyne case. Many of the ratings that are now being challenged were issued in connection with public offerings, for securities that subsequently traded on the public securities exchanges. For ratings on those kinds of securities that were issued as part of those kinds of offerings, Judge Scheindlin’s analysis of the First Amendment issue, based on the fact that ratings of the Cheyne notes were not widely distributed, simply would not be applicable.

 

That does not necessarily mean that in those cases the rating agencies would be able to rely on the First Amendment defense, but it does mean that Judge Scheindlin’s First Amendment analysis would appear to be unavailing. Because so many of the cases in which the rating agencies have been named as defendants involve public securities offerings, Judge Scheindlin’s opinion could well have little impact at least on the First Amendment issue itself in many other cases against the rating agencies.

 

Nevertheless, as the Journal article puts it, Judge Scheindlin’s opinion is "one of the first to interpret the extent to which the [rating agencies] can expect First Amendment protection for their ratings of certain securities." The Journal quotes attorney David Grais as saying that Judge Scheindlin’s opinion "breaks new ground." Andrew Longstreath’s September 4, 2009 Law.com article about the opinion (here) quote Patrick Daniels of the Coughlin Stoia firm as saying "This is what we needed." Investors apparently believe that her ruling is a "landmark decision"

 

So, even though the Cheyne Financial decision is by no mean dispositive of the issue, it is nevertheless a highly significant development that could have a very significant impact in the many other subprime-related cases that have been filed against the rating agencies.

 

In the first appellate court decision related to the subprime and credit crisis litigation wave, the United States Court of Appeals for the Eighth Circuit on September 1, 2009 affirmed the dismissal of the NovaStar Financial subprime related securities class action lawsuit. A copy of the Eighth Circuit’s opinion can be found here. The Eighth Circuit’s action represents a milestone in the evolving litigation wave, but because the decision is focused on pleading deficiencies in the plaintiff’s complaint, the decision’s impact may be somewhat limited.

 

Background

The NovaStar lawsuit (described in greater detail here), was one of the first subprime-related securities lawsuits to emerge, with the initial complaint filed in February 2007. The lawsuit essentially alleged that NovaStar, a real estate investment trust, lacked adequate internal controls, as a result of which the company materially misstated its financial results and condition.

 

As discussed in a prior post (here), on June 4, 2008, Western District of Missouri Judge Ortrie Smith granted the defendants’ motion to dismiss the complaint, with prejudice. A copy of the dismissal opinion can be found here.

 

Judge Smith Held that the complaint did not satisfy the PSLRA’s pleading requirements, because it did not specify the statements the plaintiff alleged to be misleading, nor did it specify why any such statements are misleading. In addition, Judge Smith held that the complaint did not adequately plead scienter. The plaintiff appealed.

 

The Eighth Circuit’s Opinion

The Eighth Circuit’s Opinion, written by Judge Raymond Gruender, affirmed the dismissal, but because the Court found that the complaint’s deficiencies alone were sufficient to affirm the district court, the Court did not reach the scienter issue.

 

The plaintiff had argued that the district court erred in concluding that the complaint failed to specify the allegedly misleading statements, citing a thirty-six page section of the complaint that reproduced numerous public statements, press releases and SEC filings during the class period. The Eighth Circuit noted that "absent from this section (and from any other section of the complaint) however, is any indication as to what specific statements within these communications are alleged to be false and misleading."

 

In his appellate brief, the plaintiff had attempted to identify specific statements that allegedly were misleading. But the Eighth Circuit said that "identifying specifically false and misleading statements for the first time on appeal, however, doe not excuse a litigant’s failure to comply with the pleading requirements," concluding that the district court did not err in dismissing the complaint for failure to identify which statements were misleading.

 

The plaintiff also argued that the district court erred in concluding that the complaint failed adequately to allege that the statements were misleading, with respect to which the Eighth Circuit noted "absent an indication of precisely what statements [the plaintiff] alleged to be misleading, it is difficult, if not impossible, to determine whether the complaint adequately specified why each statement was misleading."

 

The Eighth Circuit went on to note that "even if we were able to identify specific statements that were alleged to be misleading," the complaint "does not provide any link between an alleged misleading statement and specific factual allegations demonstrating the reasons why the statement was false and misleading."

 

In his appellate brief, the plaintiff reference an omnibus paragraph in the complaint, with respect to which the Eighth Circuit noted "arguably attempts to boil down the complaint’s thirty-four pages of background material … into a generalized one-paragraph summary." The Eighth Circuit found the "broad allegations" in this summary "do not necessarily show that the defendants’ statements were misleading" or "provide the level of particularity required by the PSLRA."

 

Finally, the Eighth Circuit concluded that the district court did not err in decline to allow plaintiff leave to amend, finding as a procedural matter that the plaintiff had not preserved the right to seek amendment.

 

Discussion

Because the Eighth Circuit’s decision in the NovaStar case is the first substantive action by an appellate court in connection with the subprime and credit crisis-related litigation wave, the decision represents a noteworthy development that could hearten defendants in other cases. However, because the decision focuses exclusively on the pleading deficiencies in the plaintiff’s complaint, the decision is likely to be of limited impact in other cases, arguably even in the Eighth Circuit.

 

Certainly, defendants in other cases will try to show that the complaint in their case is as deficient as the complaint in the NovaStar case. As the Orrick law firm put it in their September 2, 2009 memo about the decision (here), "the court announced stringent standards making clear that plaintiffs cannot rely on a kitchen sink approach to pleading securities fraud that leaves judges to identify what statements were allegedly false and why." But the decision would have been much more valuable to defendants had the Eighth Circuit affirmed on the critical battleground issues of scienter and loss causation.

 

Moreover, the Eighth Circuit said nothing that would aid other arguments that defendants typically try to make in these cases, such as for example that their companies’ misfortunes were simply the result of the global financial downturn. Indeed, the Eighth Circuit’s opinion seems peculiarly detached in its omission of any detailed discussion of the controversy presented or what it might signify.

 

Even though the Eighth Circuit’s decision may not represent a breakthrough, it nevertheless is a victory for the defendants and serves as a prominent example of the difficulty plaintiffs continue to face in many of these cases. Though plaintiffs have indeed survived motions to dismiss in a number of subprime and credit crisis-related lawsuits, there is a large and growing number of cases where plaintiffs have not managed to survive the initial pleading motions. The Eighth Circuit’s decision represents a higher profile example of the problems that plaintiffs face.

 

I have in an event updated my table of subprime and credit crisis-related lawsuit resolutions to reflect the Eighth Circuit’s affirmance in the NovaStar case. The tablecan be accessed here.

 

Interestingly enough, though Judge Smith granted the defendants’ motion to dismiss in the NovaStar subprime securities lawsuit, a different judge in the same district court denied the motion to dismiss in the companion NovaStar ERISA class action suit, as discussed at greater length here.

 

More About Outside Director Exposures and D&O Insurance: In a prior post (here), I discussed the massive $55.95 million settlement involving the outside directors of Peregrine Systems and the implications it may have for D&O insurance protection of outside directors. An August 27, 2009 memorandum from the King & Spaulding law firm (here) takes a closer look at the settlement and review the specific D&O insurance issues that should be considered in light of the settlement.