As a result of legislative reforms and a changing enforcement environment, the number of disclosure related securities cases in Japan has increased in recent years and is likely to continue to grow in the years ahead, according to a July 15, 2009 report from NERA Economic Consulting. The report, which was written by Makoto Ikeya and Satoru Kishitani, is entitled "Trends in Securities Litigation in Japan: 1998-2008" and be found here.

 

The report examines 249 criminal and civil actions alleging violation of the Japanese securities from 1998 through 2008. Because very few Japanese cases settle, the report analyzes cases that have resulted in a judgment following trial.

 

The 249 cases studied encompass a wide variety of kinds of matters. The vast majority of the 249 cases (79%) represent broker-dealer cases (reflecting, for example, suitability allegations as well as a variety of other issues). The list also contains other kinds of cases included "market manipulation" and "insider trading" cases. But a large and growing number of the cases involve allegations of "misstatement" – indeed, by 2008, the misstatement cases represented half of all of the cases.

 

The growth in the number of misstatement cases in recent years is attributable to changes in the liability provisions in the Japanese securities laws. One set of revisions lessened the plaintiff’s burden for proving damages. In addition, for fiscal years beginning April 1, 2008, misstatements in internal control reports are subject to civil liability. The introduction of new accounting standards, more rigorous audits and disclosure of quarterly reports has added disclosure responsibilities, "increasing the risk that companies may make misstatements and face suits." Finally, Japan’s Securities and Exchange Surveillance Commission has been strengthened and expanded.

 

The report’s data show that cases related to misstatements have increased significantly since 2005, although the numbers in part reflect that certain high profile scandals have attracted multiple suits in the absence of any provision in Japan for class action litigation. For example, there have been eleven cases filed against Seibu Railway and four against Livedoor.

 

The report also notes that cases alleging that auditors alleged failed to detect misstatements have been on the rise since 2006, with ten such cases from 2006 through 2008, compared to only two from 1998 through 2005.

 

The report also notes that the type and number of plaintiffs involved is changing. Institutional investors have been more involved in recent years; for example, pension funds and trust banks are the main plaintiffs in the cases against Livedoor and Seibu Railway. Plaintiffs attorneys have also started forming large groups of plaintiffs to file for damages; the Livedoor case involved 3.310 individual investors and similarly large plaintiff groups have formed in other cases.

 

The increased number of misstatement cases has also affected the damages trends. The 9.5 billion yen award in the Live Door case raised the average award in 2008 to 450 million yen. However, of the 25 civil cases alleging misstatements between 1996 and 2008, a high number resulted in no damages award, although eight of those sixteen involved audit firm defendants and four involved Seibu Railway litigation.

 

Excluding litigation against the audit firms, 44% of the civil misstatement cases resulted in damage awards that were more than half of the amount sought and the average judgment was 1.5 billion yen.

 

The report concludes by noting that given the changes in disclosure requirements and the current litigation environment, securities litigation in Japan is expected to gradually increase going forward. However, in light of the "fundamental differences" between the U.S. and Japan (for example, "the absence of class actions, fewer attorneys, and other social factors") it is "unlikely that the number of securities litigation cases in Japan will be comparable to the U.S."

 

An interesting January 2009 legal memorandum by the Anderson Mori & Tomotsune law firm on the topic of civil liability under Japanese law for false statements in securities filings can be found here.

 

In what may be the largest ever outside director securities lawsuit case settlement, on July 13, 2009, Southern District of California Judge Roger R. Benitez preliminarily approved the six settling outside directors’ $55.95 million settlement of the claims pending against them in the Peregrine Systems securities class action lawsuit. The July 13 order can be found here. As discussed further below, the directors’ settlement is the latest of a multiple settlements in the case, as a result of all of which former Peregrine outside directors have now agreed to pay a total of $61.55 million in settlements.

 

Background

As reflected in greater length here, in May 2002 plaintiffs filed securities class action lawsuits against Peregrine and other defendants, including certain directors and officers of Peregrine. Peregrine itself filed for bankruptcy in September 2002 and was dropped from the lawsuit. On April 5, 2004, following an initial round of motions, the plaintiffs filed their first amended consolidated complaint.

 

The complaint alleges that Peregrine materially overstated its revenues and earnings during the class period due to the company’s failure to recognize revenue properly. Peregrine ultimately issued restatements of its financial statements for fiscal years 2000 and 2001. The restatement reduced previously reported revenue of $1.34 billion by $509 million, of which, according to the SEC’s separate civil enforcement complaint against Peregrine (here), "at least $259 million was reversed because the underlying transactions lacked substance." Several Peregrine officers, including the company’s CEO and CFO, entered guilty pleas in connection with the criminal investigations of Peregrine.

 

In July 29 2006, the parties to the class action lawsuit announced a partial settlement in the amount of $56.3 million on behalf of certain settling defendants. As part of the July 2006 settlement, and as reflected further here, Arthur Anderson agreed to pay $30 million; former officer Douglas Powanda agreed to pay $4.675 million; former director William D. Savoy agreed to pay $5.1 million; and former director Thomas Watrous agreed to pay $500,000. The July 2006 settlement also included certain amounts received in bankruptcy from the company. In November 2006, Judge Benitez approved the July 2006 settlement. The case proceeded against the non-settling defendants.

 

On February 9, 2009, the plaintiffs filed a motion (here) for approval additional settlements with the remaining individual defendants, six former outside directors (John J, Moores, Charles E. Noell III, Norris vandenBerg, Richard A. Horshey II, Christopher Cole, and Rodney Dammeyer), and four former officers (Stephen P Garner, Mattew C. Gless, Frederic B. Luddy, and Richard T. Nelson).

 

One of the settling directors, John Moores, was Peregrine’s chairman from 1990 to July 2000 and from May 2002 through March 2003. For a time, Moores owned the San Diego Padres major league baseball team. According to Wikipedia, here, during his years on Peregrine’s Board, Moores sold over $600 million worth of Peregrine stock.

 

Accompanying the February 9 motion were two settlement stipulations, one each with respect to the two groups of defendants. The settlement stipulation with respect to the outside director defendants, a copy of which can be found here, is dated December 2008 and reflects the six outside director defendants’ agreement to pay a total of $55.95 million toward settlement.

 

The settlement stipulation with respect to the four officer defendants can be found here and provides that defendant Luddy will pay $100,000 and defendant Nelson will pay $25,000. The stipulation provides further that defendants Gardner and Gless "shall note be required to pay any cash in light of their current financial condition and, as to Gardner, the fact that the forfeitures obtained from him in the criminal case … may be distributed" to claimants.

 

In Judge Benitez’s July 13 order, he preliminarily approved these two proposed settlement, subject to a final determination at a hearing scheduled for October 16, 2009.

 

I should emphasize that the foregoing description as well as the analysis below is based solely on the information available in the public record. If I have mischaracterized anything or misunderstood any of the events discussed above, I encourage readers to let me know so that I can correct any errors.

 

UPDATE: Andrew Longstreth’s July 16, 2009 American Lawyer article about this settlement (here)  includes a statement from counsel for one of the outside directrros that insurers did contribute toward the outside directors’ settlement and the outside directors are pursuing payments from excess insurers. Counsel for the outside directrors also disputes that this is the largest ever settlement on behalf of outside directors, which could be true — but this is still a very large settlement.

 

The Outside Directors’ Settlement

The outside directors’ settlement stipulation does not disclose the source of funds for the outside directors’ payments in the settlement. Given Peregrine’s bankruptcy, the payments obviously will not be funded by indemnification from the company. And in light of the extensive, years-long litigation, as well as the 2006 settlement, it seems probable that any potentially available D&O insurance was long ago exhausted; the stipulation itself does not indicate whether any portion of the outside directors’ settlement is to be funded by insurance.

 

There are however, certain indications in the stipulation suggesting that at least part of the outside directors’ settlement will be funded out of one or more of the directors’ personal assets. For example, of the directors’ total $55.75 million settlement contribution, $27.5 million is to be paid in the form of a note signed and payable by John J. Moores and Rebecca Ann Mores as individuals and as trustees of the John and Rebecca Ann Moores Family Trust. The stipulation also provides that the security for the note will be provided either by a letter of credit or by a security interest in JMI Holdings LLC’s economic interest in a San Diego hotel. These and other terms strongly suggest that at least a portion of the settlement will be funded out of one or more directors’ personal assets.

 

The six outside directors’ settlement, taken together with the $5.6 million in settlement amounts to which the two directors agreed as part of the July 2006 settlement, brings the total amount paid in settlement of claims against former Peregrine directors to $61.55 million, which exceeds any prior securities lawsuit solely on behalf of outside directors of which I am aware.

 

Discussion

When I spoke as a panelist at the 2009 Stanford Law School Directors’ College last month, the number one concern of the directors attending the D&O insurance session was the possibility that their personal assets might be exposed in the event of a lawsuit against them arising out of their service as directors. Although relatively rare, there is in fact some danger that directors might have to pay settlement of claims against them out of their own assets, as the Peregrine settlement strongly suggests.

 

As I noted in a prior post (here) concerning the now infamous Just for Feet case, the possibility that directors might have to contribute personally toward settlement is materially increased in the bankruptcy context, when the defunct company is unable to fulfill its indemnification obligations. In the event of complex and serious claims following bankruptcy, there is danger that the available D&O insurance could be exhausted before all claims are resolved, potentially leaving directors exposed to additional claims without insurance, which is what happened in the Just for Feet case.

 

The threat of possible exposure of personal assets of outside directors raises the question whether there are insurance solutions that can be used to try to insure against these possibilities.

 

Many companies in recent years have secured so-called Side A/DIC coverage, which in effect provides catastrophic claim protection for company officials, particularly in the event of corporate bankruptcy. However, the typical Side A/DIC policy insures all company officials, including officers, raising the risk that even the Side A/DIC policy could be exhausted by defense expense or settlement payments on behalf of the officers, potentially leaving directors exposed without adequate insurance.

 

As discussed at greater length here, the best way for an individual director or a group of directors to ensure that a pool of insurance will be available to protect them regardless of what happens is to secure a policy solely for the protection of those individual(s). One possible solution is a separate Side A policy just for nonofficer directors. An alternative solution is an individual director liability policy (IDL) designed to provide insurance protection exclusively to a named individual or group of individuals.

 

The nightmare scenario suggested in the Peregrine Systems settlement, where outside directors may have been required to contribute massive amounts out of personal assets to extricate themselves from litigation arising from their service as directors, together with the availability of alternative insurance products that could address their exposure, are the reasons why I contend that outside board members should retain and consult an independent insurance advisor in connection with the company’s D&O insurance acquisition.

 

As I noted recently (here), in my experience outside directors are keenly interested in learning more about the protection afforded by these alternative products. A separate consideration of competing and sometime conflicting interests can sometimes result in the selection of different D&O insurance structures.

 

Given the massive amount of litigation arising out of the Madoff scandal as well as the enormous sums of money involved it is perhaps inevitable that the scandal would also generate its own category of insurance coverage litigation. As the two cases described below demonstrate, the Madoff-related coverage litigation has now arrived. There undoubtedly will be much more to come in the weeks and months ahead.

 

The first of the two recently filed coverage complaints was filed on July 14, 2009 in Hennepin County (Minn.) District Court by Upsher-Smith Laboratories, a pharmaceutical company. A copy of the complaint can be found here. Since 1995, Upsher-Smith had invested all of its funds in its profit sharing plan with Bernard L. Madoff Securities LLC. As of December 2008, the company had invested $12 million in plan assets with Madoff. The company had also invested millions of its own with Madoff.

 

As a result of the plan losses, the U.S. Department of Labor launched an investigation, and by letter dated June 30, 2009, the DOL has demanded that the company "restore losses" to the plan, or the DOL may file a lawsuit.

 

Upsher-Smith filed a claim with its "Employee Benefits Plan Administrative Liability" insurer in connection with the plan losses and the DOL’s actions. The company has also filed an action with its crime insurer in connection with its own separate losses. Both carriers have denied coverage. In its July 14, 2009 complaint, Upsher-Smith seeks a judicial declaration of coverage under both policies, and also alleges breach of contract against both insurers.

 

The second of the two complaints was filed on July 15, 2009 in the Southern District of New York by Ann & Hope, Inc., which operates retail stores, as well as by an affiliated entity and affiliated persons. The complaint, which can be found here, was filed against the company’s crime insurers. The complaint alleges that on August 14, 2008, Madoff’s firm "caused $5 million to be transferred" from the affiliated company to Madoff’s account with JP Morgan. As a result of Madoff’s fraud, the funds have been lost. The company submitted a claim to its crime insurer, which has denied the claim. The complaint seeks a judicial declaration of coverage and also alleges breach of contract.

 

Merely because these complaints have been filed does not, of course, mean that they are meritorious. In that regard, I note that both complaints neglect to mention the specific grounds on which the respective carriers have denied coverage, an omission that may be telling. The stilted wording on the Ann & Hope complaint alleging that Madoff "caused the funds to be transferred" may suggest the kind of coverage problems that the companies seeking coverage under their crime policies for Madoff losses will have to solve.

 

There may well have been other Madoff-related insurance coverage litigation before these two cases, although I have been keeping track of all Madoff-related litigation fairly attentively and I have not seen any other coverage lawsuits before. The one thing I know for sure is that these lawsuits won’t be the last.

 

Madoff may be in prison for the next 150 years, but while he does his time outside the prison walls, the litigation his crimes have engendered will grind on for many years. I predict that the litigation will live on long after his obituary appears.

 

I have in any event added the two insurance coverage cases to my register of Madoff-related litigation, which can be accessed here. In recognition of the distinction that these two new coverage cases represent, I have created a new table on my litigation chart (Table V) for Madoff-related coverage litigation. I hope readers will help me to maintain the table by supplying me with copies of complaints of which they may become aware.

 

Special thanks to loyal reader Bill Sweeney for providing me with copies of the two coverage complaints.

 

In a July 1, 2009 opinion (here), Northern District of California Judge Susan Illston denied in part and granted in part the defendants’ motion to dismiss the plaintiffs’ consolidated complaint in the subprime-related securities class action lawsuit pending against the The PMI Group and certain of its directors and officers. Among other things, Judge Illston specifically found that insider trades pursuant to a Rule 10b5-1 trading plan cannot serve as the basis of a finding of scienter. Background regarding the case can be found here.

 

Judge Illston denied the defendants’ motion in part, finding that the plaintiffs’ consolidated complaint had sufficiently alleged material misrepresentations with respect to the adequacy of PMI’s risk management practices and its reporting of its loss reserves. She also found that the complaint adequately alleged loss causation. However, she nevertheless granted the defendants’ motion to dismiss with leave to amend on the grounds that the consolidated complaint did not adequately allege scienter.

 

With respect to scienter, Judge Illston found that the complaint "falls short of showing that the defendants were aware that the statements were false or misleading when made."

 

Judge Illston specifically found that the confidential witness testimony on which the plaintiffs sought to rely was insufficient. Judge Illston noted with respect to the internal reports that one confidential witness referenced that "the complaint does not describe these reports in any detail, and thus there is no information in the complaint as to whether the reports should have alerted the defendants" as to the falsity of the disclosures.

 

With respect to the other confidential witnesses’ testimony, she said that the complaint does not disclose how the witnesses would have had "personal knowledge" of the items they reference or that that the individual defendants were aware of this information.

 

Judge Illston also rejected as insufficient the plaintiffs’ attempt to satisfy the scienter requirements by arguing that the individual defendants are company officers who may be presumed to have knowledge of the company’s "core operations." She found that the "plaintiffs have not shown that this case fits within the unusual circumstances" to which the "core operations" theory might apply, noting that in addition to alleging the defendants’ corporate positions, the complaint must detail the defendants’ actual exposure to information. She noted that the plaintiffs can attempt to amend their complaint if they can to show that the defendants "actually had information showing the problems."

 

In addition, Judge Illston rejected as insufficient the plaintiffs’ attempt to rely on the existence of a bonus plan and of insider trading to establish scienter. She noted that "the simple fact that PMI had a bonus compensation plan, without more does not support scienter."

 

She rejected the alleged insider trading allegations as insufficient both because the complaint does not contain any allegations regarding the defendants’ prior trading histories and because she found that three of the defendants had actually increased their holdings during the class period, "which is inconsistent with the intent to defraud."

 

Finally, Judge Illston noted on the issue of scienter that 98% of on individual defendant’s sales were pursuant to Rule 10b5-1 trading plans, with respect to which she further noted that "sales according to pre-determined plans may rebut an inference of scienter." (Refer here for discussion of another recent case where trades pursuant to a Rule 10b5-1 plan were also found sufficient to rebut the inference of scienter.)

 

Because she concluded that plaintiffs had not adequately alleged scienter she granted defendants’ motion to dismiss with leave to amend. The plaintiffs have until July 24, 2009 to file their amended complaint.

 

I have in any event added Judge Illston’s opinion to my running register of subprime and credit crisis-related securities lawsuit dismissal motion rulings, which can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of Judge Illston’s opinion.

 

Bloomberg Podcast on Directors’ Accountability Now Available: On June 24, 2009, I participated in a Bloomberg-sponsored roundtable discussion on the topic of "Corporate Directors’ Accountability During and After the Economic Crisis." Also participating on the panel were Professor Charles Elson, Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, Michael Barry of Grant & Eisenhofer, and Michael Forman of Dorsey & Whitney. The hour-long panel discussion can now be accessed or downloaded from Bloomberg’s website, here.

 

The Latest Stanford Financial Group Lawsuit: According to a July 13, 2009 Bloomberg article (here), Stanford Group investors have filed a class actoin lawsuit in the Southern District of Texas against The Commonwealth of Antigua and Barbuda, alleging that the Caribbean nation helped the financier engineer a massive fraud. The complaint (here) , purports to be filed on behalf of all individuals and investors who were customers of Stanford International Bank as of February 16, 2009, alleges violations of and seeks to recover damages under RICO.

 

I have added this latest lawsuit to my running register of all Stanford Group-related litigation, which can be accessed here.

 

From time to time on this blog I try to draw generalizations from a variety of disparate claims as a way to identify emerging themes. However, a single recently filed securities class action manages to embody in a single complaint several themes I have previously tried to describe.

 

The case in question is the action filed on July 10, 2009 in the Southern District of New York on behalf of those who purchased common shares of Tronox, Inc. between November 28, 2005 and January 12, 2009. The complaint names as defendants certain former directors and officers of Tronox, as well as Kerr-McGee Corporation, Andarko Petroleum Corporation and certain Kerr-McGee executives.

 

According to the plaintiffs’ lawyers’ July 10, 2009 press release (here), the complaint alleges that:

 

Tronox was spun-off from Kerr-McGee in a two-step transaction. In November 2005, Kerr-McGee sold 17.5 million shares of Tronox Class A shares in an initial public offering for $14.00 per share (the "IPO") generating proceeds for Kerr-McGee of $225 million. After the IPO, Kerr-McGee continued to hold 56.7% of Tronox’s outstanding common stock. In March 2006, Kerr-McGee distributed the balance of the shares that it owned as Class B shares to its shareholders as a dividend (the "Spin-Off").

The Complaint alleges that, throughout the Class Period, Defendants failed to disclose material adverse facts about the Company’s true financial condition, business and prospects. Specifically, the Complaint alleges that Defendants failed to disclose the true scope and extent of Tronox’s environmental and tort liabilities. When the market learned of the true facts about the Company, the price of Tronox stock declined precipitously.

 

The complaint itself (which can be found here) alleges that the alleged misrepresentations and omissions

 

(i) deceived the investing public regarding the true nature and extent of the Company’s environmental and tort liabilities, Tronox’s business, operations, management, and the intrinsic value of Tronox’s stock; (ii) enabled Kerr-McGee to sell $225 million of Tronox stock to the unsuspecting public at artificially inflated prices; (iii) enabled Kerr-McGee to successfully rid itself of hundreds of millions of dollars of liabilities, thereby clearing the way for Kerr-McGee to sell itself to Andarko; and (iv) cause Plaintiff and other members of the Class to purchase Tronox common stock at artificial prices.

 

There are a number of interesting things to me about this complaint, all of which sound themes that will be familiar to readers of this blog.

 

First, this case represents yet another example of the way in which the spreading wave of corporate bankruptcies is extending the litigation consequences of the financial crisis beyond just the financial sector. (My prior post on this topic can be found here.) Tronox, the bankrupt company at the cent of this case, is engaged in the business of producing and marketing titanium dioxide, a white pigment used in a variety of products. Tronox, which definitely is not a financial services company, was not named as a defendant in the case owing to its bankrupt status.

 

Second, the complaint is based on alleged misrepresentations and omissions regarding Tronox’s environmental and tort liabilities. Among other things, the complaint alleges that the defendants ignored known information in setting Tronox’s reserves for environmental liabilities, and in particular that the reserves did not include any allowance for special sites (supposedly known as "secret sites") Kerr-McGee had identified as part of an investigation. The complaint also alleges that the defendants knew that independent third parties had reviewed the company’ s non-public information regarding its environmental liabilities and concluded that the company’s liabilities could be substantially larger.

 

These allegations may be noteworthy in and of themselves, but they are also noteworthy because they represent specific examples of what I have previously identified (most recently here) as the growing disclosure risks public companies face regarding their environmental liabilities. Although more recently I have emphasized the growing risks surrounding climate change related issues, as this case demonstrates, the disclosure risks also include the risks associated with more conventional environmental liability exposures.

 

Third, the roster of defendants involved in this case demonstrates a potential problem that can arise under D&O insurance policies in certain situations. Under the typical D&O insurance policy, coverage for the corporate entity is provided solely for "securities claim," which is a policy term that is typically defined in one of two ways. The first way is with respect to the securities involved, and the second way is with respect to the specific legal violations alleged.

 

In the first of these formulations, the policy includes within its definition of the term "securities claim" for which entity coverage is provided any claim based upon the purchase or sale of the securities of the Insured Entity itself. The alternative formulation pertains to claims alleging violation of any federal, state, local, or foreign securities law. (It should be noted that some current policies incorporate both formulations within the definition of the term "securities claim.")

 

The interesting thing about the Tronox lawsuit in connection with these alternative definitions of the term "securities claim" is that the Tronox complaint alleges violations of the securities laws against Kerr-McGee and Andarko, but not in connection with the purchase or sale of those companies’ own securities, but rather in connection with the securities of Tronox. Thus, to the extent these companies’ D&O insurance policies contain only the first of the two alternative formulations for the term "securities claim," their respective insurers might take the position that the Tronox complaint is not a "securities claim" with the meaning of their policies.

 

I should emphasize here that I have no familiarity with the specific terms or conditions of the D&O insurance policies of any party involved in this case and I am expressing no opinions one way or the other about the availability of coverage under any policies that may be applicable.

 

As I noted above, many policies available in the D&O insurance marketplace today actually incorporate both alternative formulations with the definition of the term "securities claim." But the Tronox complaint provides an example of how problems might arise in connection with D&O insurance policies containing more restrictive definitions of the term.

 

As for my first two observations noted above, I suspect that there will be many other securities lawsuits yet to come arising out of bankruptcies outside the financial sector. And I suspect strongly that in the months and years ahead we will see an increasing number of securities lawsuits raising allegations based on supposed misrepresentations or omissions relating to environmental liabilities and exposures, including but not limited to climate change issues.

 

And Speaking of Climate Change-Related Disclosure Issues: Just the other day I added a post (here) in which I raised the possibility that companies may soon find themselves facing the need to incorporate climate change-related disclosures in their periodic filings. A recent news article suggests that these changes may be even closer than I anticipated.

 

According to a July 13, 2009 New York Times article entitled "SEC Turnaround Sparks Sudden Look at Climate Disclosure" (here) federal regulators are preparing to launch a "very serious look" at requiring corporations "to assess and reveal the effects of climate change on their financial health."

 

According to the article, the SEC is following up on the landmark disclosure requirements enacted by the National Association of Insurance Commissioners this spring (and about which refer here). SEC representatives have also met with CERES, which submitted a petition in 2007 asking the SEC to clarify and strengthen requirements for climate change disclosure (and about which refer here).

 

Although the article hints strongly that formal disclosure requirements might be ahead, the article also acknowledges that nothing specific is actually underway now, and that a variety of practical and policy concerns would complicate any initiative that is launched.

 

Nevertheless, the message is that the SEC’s new leadership is more receptive to these possibilities and interested in pursing them further.

 

Hat tip to the Securities Docket for the link to the New York Times article.

 

Claims arising out of corporate bankruptcy represent a significant stress test for directors’ and officers’ liability insurance coverage. Among other frequently recurring issues are questions whether post-bankruptcy claims against the bankrupt company’s directors and officers run afoul of the Insured vs. Insured (I v. I) exclusion found in most D&O insurance policies.

 

In a July 10, 2009 opinion (here) that highlights many of these perennial bankruptcy-related D&O insurance coverage issues, the Ninth Circuit held that a D&O policy’s Insured vs. Insured exclusion bars coverage for claims that were brought against former directors and officers of a bankrupt company by the post-bankruptcy debtor in possession and later assigned to a creditors’ trust. The decision may have important implications for the prospective wording of coverage “carve backs” from the  I v. I exclusion.

 

  

Background

 

Visitalk, which had filed a Chapter 11 bankruptcy petition, and while acting as “debtor and debtor in possession,” sued four of its recently discharged directors and officers for breaches of their fiduciary duties. Visitalk’s D&O insurers refused coverage for the claim, in reliance on the I v. I exclusion.

 

 

Visitalk’s primary D&O insurance policy’s I v. I exclusion provided as follows:

 

 

V. EXCLUSIONS

 

The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against the Directors and Officers . . .:

 

(D) brought or maintained by or on behalf of an Insured in any capacity or by any

security holder of the company except:

 

(1) a Claim, including, but not limited to, a security holder class or derivative action that is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of an Insured;

 

(2) an Employment Practice Claim3 by a former Director or a present or former Officer;

 

(3) a claim for contribution or indemnity if the Claim directly results from another Claim that is otherwise covered under this Policy; or

 

(4) a claim by any employee(s) of the Company described in IV.(D)(2) of the Policy.

 

 

Visitalk filed a Chapter 11 reorganization plan that assigned its claims against the directors and officers to a trust created by the creditors. The trustee for the creditors trust (Biltmore) and the four director and officer defendants agreed to settle Visitalk’s claims for about $175 million. The four directors and officers assigned to the creditors’ trust their rights against the D&O insurers. (The record does not disclose whether or not the settlement with Biltmore also included a provision typical of these kinds of arrangements, which is a covenant by the settling claimant not to execute any judgment entered pursuant to the settlement on the assets of the settling defendants.)

 

 

Biltmore, as trustee for the creditors’ trust, then sued the D&O insurers in reliance on the individuals’ assignment to Biltmore of their rights under the D&O policies. The District Court dismissed Biltmore’s complaint on narrow grounds relating to the relation between Visitalk’s primary D&O insurer and the primary insurer’s successor in interest. The Ninth Circuit did not reach the successor in interest issue but nevertheless affirmed the District Court’s dismissal of the case on the grounds that the I v. I exclusion applies.

 

 

The Ninth Circuit’s Opinion

 

The Ninth Circuit’s July 10, 2009 opinion (here) written by Judge Andrew J. Kleinfeld opens with a review of the reasons for the inclusion of an insured vs. insured exclusion in D&O insurance policies, noting that “because risks such as collusion and moral hazard are much greater for claims by one insured against another insured … than for claims by strangers, liability policies typically exclude them from coverage.”

 

 

The Court then noted that because none of the exceptions to the policy’s I v. I exclusion apply, the only question was whether the underlying suit was “brought or maintained on behalf of an Insured in any capacity.”

 

 

The Court found that the underlying claim had been “instigated and continued” by Visitalk as Chapter 11 “debtor and debtor in possession.” Though coverage was now being sought by the trustee of the creditor’s trust, it was doing so merely as an assignee. The court noted that “an assignee of a claim against an insurance company can have no stronger claim than the assignor who assigned the claim.”

 

 

The question then is whether Visitalk’s status as debtor in possession at the time it initiated the claim triggered the I v I exclusion.

 

 

Biltmore argued that Visitalk, the chapter 11 debtor in possession that brought the underlying suit, is not the same entity as Visitalk, the insured corporation. However, the Ninth Circuit concluded after a review of authorities that “for purposes of the insured versus insured exclusion, the prefiling company and the company as debtor in possession in chapter 11 are the same entity.”

 

 

The Ninth Circuit acknowledged that “it is certainly true that interests differ once a debtor goes into bankruptcy.” Among other things, due to the bankruptcy “ownership of the cause of action fell into the bankruptcy estate” and Visitalk as debtor in possession of the bankrupt estate was “empowered to act as fiduciary for its creditors and shareholders.”

 

 

Biltmore argued that because Visitalk as debtor in possession was acting as representative for the estate’s creditors in bringing the suit, the I v. I exclusion does not apply. The Ninth Circuit reasoned that while suit might be brought for the benefit of creditors, it was not brought “on behalf of” the creditors. The Ninth Circuit said that the suit is “for the benefit of the creditors, but on behalf of the pre-bankruptcy corporation.”

 

 

The Court said that the question was not whether the creditors might benefit from any recovery. The court said that the insurance “cannot be turned into an available pot for the corporation’s creditors by enforcing the insurance obligations while disregarding the parties’ agreement to limit those obligations to exclude insured versus insured claims.”

 

 

The Ninth Circuit concluded its analysis of the I v. I exclusion issues by noting that a contrary holding would

 

 

create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D & O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

 

 

Discussion

 

As I have previously noted (here), the insured vs. insured exclusion is heavily litigated and continues to be at the heart of many D&O coverage disputes, particularly in the bankruptcy context, as this case demonstrates. In response to these many continuing disputes, the exclusion itself has continued to evolve, and the I v. I exclusion in the typical D&O policy in today’s marketplace is quite a bit different than the exclusion at issue in the Visitalk case.

 

 

Among other things, the I v. I exclusion in most D&O policies today contain additional exceptions to the exclusion, or coverage “carve banks” as they are usually called. Among other provisions now more or less standard is a carve back to the I v. I exclusion specifically relating to the bankruptcy context. A typical carve back of this type would specify that the I v. I exclusion would not apply “in any bankruptcy proceeding by or against an Organization” to “any claim brought by an examiner, trustee, receiver, liquidator or rehabilitator (or any assignee thereof) of such Organization.”

 

 

It would have been interesting to see how the Ninth Circuit would have addressed the issues in the Visitalk case if the policy as issue had contained these now fairly standard provisions. However, even if Visitalk’s policy had contained a carve back of this kind, it likely would not have altered the outcome, because the underlying action in the Visitalk claim had not been brought by any of the creditors’ representatives referenced in the carve back, but rather had been brought by Visitalk as debtor in possession.

 

 

The solution to this coverage problem would seem to be simply to include the debtor-in-possession in the list of bankruptcy-related claimants for whose claims coverage is carved back as an exception to the exclusion. Indeed, parts of the Ninth Circuit’s opinion in the Visitalk case suggest that this would be appropriate, particularly the Court’s comments about how a debtor’s status changes upon becoming a debtor in possession, and how an action by a debtor in possession as representative of the estate is for the benefit of creditors.

 

 

However, throughout the Ninth Circuit’s opinion is a pervasive concern with the possibility of collusive litigation. The Court clearly was concerned that if there were coverage, a debtor in possession action might represent a collusive attempt by a debtor company to use the cover of a bankruptcy filing and the ruse of a supposed claim as a way to access insurance proceeds to pay off the company’s debts.

 

 

Without minimizing the collusive possibilities to which the Ninth Circuit refers, I believe there is also a legitimate concern that without policy recognition in some way for debtor in possession claims, individuals could be left without insurance for claims of a kind for which D&O policies are intended to provide coverage.A debtor in possession claim is not inevitably collusive, and in that regard I note that the individuals named as defendants in the underlying suit in the Visitalk claim were former directors and officers, targeted post-bankruptcy on behalf of the bankrupt estate.

 

 

There are, in fact, D&O insurance policies available in the current marketplace that attempt to address the problem of debtor in possession claims. For example, one policy’s list of the bankruptcy-related claimants for whose claims coverage is carved back include “a Claim by the Entity as Debtor-in-Possession after such Examiner, Trustee, Receiver has been appointed.” The prerequisite for the availability of coverage under this carve back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.

 

 

Whether or not this particular formulation is sufficient to preclude the possibility of collusive claims, it strikes me as a step in the right direction toward protecting against the possibility that individuals could otherwise be left without coverage for claims of a kind for which these policies were intended to provide protection.

 

 

To be sure, the individual defendants in the Visitalk claim were not left to defend themselves without coverage; they entered into the settlement and assignment of rights with the trustee to the creditors’ trust. The parties’ entry into this settlement arrangement clearly troubled the Ninth Circuit, and the Court’s concerns about these kinds of settlement and assignment of rights deals clearly affected the court’s analysis. However, it should be noted that there is nothing about the debtor in possession claim context that uniquely encourages this kind of settlement, and litigants in many other contexts enter similar arrangements. Indeed, if the individuals were clearly covered and thus able to defend themselves, they would have far less incentive to enter these kinds of arrangements.

 

 

While I don’t mean to trivialize concerns about the possibility of collusive claims, for me the most important message from the Ninth Circuit’s decision in the Visitalk case is not necessarily the threat of collusive claims but rather then need to address in the policy the possibility of debtor in possession claims against individual directors and officers. The clear implication seems to be that the now fairly typical bankruptcy-related coverage carve back to the I v I exclusion should be modified to preserve coverage for debtor in possession claims.

 

 

One final observation about this particular coverage problem is that whether or not the primary D&O insurer will agree to provide a coverage carve back in the I v I exclusion for debtor in possession claims, an insured company may be able to purchase an excess Side A policy providing “difference in condition” protection and that either does not contain an I v. I exclusion or has one that is very narrowly circumscribed.

 

 

Because of the issues raised in the Ninth Circuit’s opinion, particularly the court’s concerns about the possibility of collusive claims, I would like to hear readers’ views about these issues, and I encourage everyone to post their thoughts for others using this blog’s “Comment” feature.

 

 

Very special thanks to Mike Early of the Chicago Underwriting Group for providing me with a copy of the Visitalk opinion. I hasten to add that the views expressed in the blog post are exclusively my own.

 

 

2009 Failed Banks – The Slideshow: This past Friday night, the Bank of Wyoming of Thermopolis, Wyoming, became the fifty-third bank to fail this year (refer here for more details). Regular readers know that the FDIC maintains a detailed list of failed banks (here). But who needs a list when you can see a slideshow, including pictures of all of the banks that failed this year? Check out Clusterstock’s failed bank slideshow, which is complete prior to the closure of the Bank of Wyoming, and can be accessed here.

 

 

Mid-Year Review: Securities Litigation and Enforcement: On July 9, 2009, I participated in a Securities Docket webinar entitled “Mid-Year Review: Securities Litigation and Enforcement” that included as panelists Lyle Roberts of the 10b5-Daily blog, Francine McKenna of the Re: The Auditors blog, Tom Gorman of the SEC Actions blog, as well as Bruce Carton of Securities Docket. Carton has posted a brief summary of the topics discussed in the webinar in a July 10, 2009 Compliance Week column entitled “Bloggers Offer 2009 Mid-Year Review” (here).

 

 

The webinar itself is available to be viewed online and can be accessed below:

 

http://www.brighttalk.com/dc/swf/dotcom_base.swf?234

 On June 26, 2009, when the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009, it set the stage for changes that could have a direct effect on corporate financial results. The Act has now moved to the Senate, where it could face significant hurdles. But strong White House support for the initiative and pressures from looming regulatory changes suggest that some form of climate related requirements will ultimately be enacted, with significant implications for companies’ carbon-related risk disclosures.

 

As reflected in a July 8, 2009 CFO.com article entitled "Clearing the Air on Carbon Disclosures" (here), the cap and trade system currently under Congressional consideration "contains the makings of a new asset class for affected companies" in the form of carbon emissions allowances. The likely corporate trading in these allowances could have a material effect on reported financial results – the CFO.com article cites analyses suggesting that carbon costs "could depress earnings before interest, taxes, depreciation and amortization by 5.5% for the S&P 500."

 

These potential financial impacts will, as the article comments, "likely cause investors to demand more information about carbon-related risk."

 

According to a June 2009 report from PricewaterhouseCoopers Transaction Services Division entitled "Capitalizing on a Climate of Change" (here), as the financial impacts of climate change issues rise, "investors, stakeholders and regulators will demand greater transparency and comparability of companies’ financial information."

 

As reflected in M&A examples cited in the PwC report, this process is already well underway. The report refers to Porsche’s recent bid to acquire a majority stake in Volkswagen, which, the report claims, was motivated in part by Porsche’s desire to "offset its fleet’s high emissions with the more efficient and low emissions VW line."

 

The PwC report suggests that "climate change considerations will likely be a key consideration in M&A activity" and that in more and more deals, "the potential impacts of climate change on earnings, cash flow, and target valuation, as well as any opportunities for cost reduction through synergies, will have to be thoroughly evaluated."

 

The likelihood that these kinds of considerations will become increasingly critical does not depend alone on whether or not Congress ultimately enacts a climate change bill; regulatory developments at the EPA and elsewhere could drive climate change related mandates, as disclosed at greater length in a prior post, here. Indeed, the likelihood that regulators will act if Congress does not is one of the strongest motivations for Congress to find a way to put something together rather than to cede field to regulators.

 

According to the PwC report, in light of these considerations, "companies should begin planning today for the elevated status this issue now commands." Climate change issues are likely to become increasingly material, and companies that fail to adapt could risk "penalties, less profitability and damaged reputations." as well as "missed opportunities for growth."

 

The disclosure-centered nature of many of these potential risks creates a context within which litigation could well arise. To cite one example from the PwC report, investors may become increasingly attentive to M&A-related climate change exposures, the presence or absence of which could significantly affect deal valuations. Whenever there is an opportunity for investors to later contend they were misled or not fully informed, there is a danger of possible litigation.

 

The current predominance of issues relating to the global financial crisis may make these climate change related issues seem relatively remote and unimportant. But the possibility of claims based on carbon-related disclosures is only a matter of when, not if.

 

For that reason, in my view, the constituencies that will be scrutinizing carbon-related disclosures includes not only investors and regulators, but will also include D&O underwriters. As best practices in this area develop, D&O underwriters will necessarily develop their own sense of what disclosure practices suffice. Just as there are risks for companies that fail to adapt to the climate change related issues, there will be risks for D&O underwriters as well.

 

In prior posts, I have frequently noted the rising tide of Foreign Corrupt Practices Act (FCPA) enforcement activity as well as the increasing level of FCPA follow-on civil litigation. If the trends noted in a recent law firm memo are any indication, we are likely to continue to see both heightened enforcement activity and ensuing civil litigation for some time to come.

 

In a July 7, 2009 memo entitled "2009 Mid-Year FCPA Update" (here), the Gibson Dunn law firm takes a comprehensive look at FCPA enforcement trends. The memo notes that during the first six months of 2009, the regulatory authorities have "continued the recent explosion of FCPA enforcement activity, and the number of ongoing investigations suggest that this trend will not soon subside."

 

In substantiating the observation that there is a "continuing explosion of FCPA prosecutions," the memo notes that "in just the first six months of 2009, more FCPA prosecutions were brought than in any other full year prior to 2007" and that "the nineteen enforcement actions initiated to date in 2009 exceeds the enforcement activity undertaken during the first half of any prior year."

 

The memo also observes that the heightened enforcement activity trend is likely to continue for the foreseeable future. The memo cites key regulators as having "confirmed" that "at least 120 companies are the subject of ongoing investigations."

 

The memo also addresses a theme frequently raised on this blog, which is the threat of civil litigation following in the wake of FCPA enforcement action. As the memo notes, even though the FCPA does not provide a private right of action, "enterprising plaintiffs’ lawyers have not been deterred from shoehorning alleged FCPA violations into a variety of civil actions," including securities fraud actions, shareholder derivative suits, contract claims and tort claims. At the same time, the memo notes, some corporate enforcement action defendants "have brought suit against the individuals responsible for these violations."

 

Among other things, the memo discusses the continuous threat of FCPA-related securities litigation, mentioning specifically the UTStarcom securities litigation (background here) in which the plaintiff shareholders allege that the company knowingly violated the FCPA by bribing officials in China, Mongolia, and India in order to secure contracts.

 

The growing significance of FCPA-related securities litigation was underscored in the January 2009 NERA Economic Consulting report discussing, among other things, the growing size and number of FCPA securities class action lawsuit settlements. As discussed here, the NERA report notes that a total of $84.4 million was paid in securities class action settlements between 2002 and 2008.

 

In addition to FCPA-related securities lawsuits, plaintiffs have also filed FCPA-related shareholders derivative lawsuits. The Gibson Dunn memo specifically mentions the April 2009 settlement in which FARO Technologies agreed to implement certain corporate governance changes and to pay $400,000 in plaintiffs’ attorneys’ fees to settle a derivative suit alleging that the directors and officers breached their fiduciary duties by failed to properly oversee the company’s internal activities. The FARO Technologies derivative settlement follows FARO’s earlier settlement of an FCPA-related securities lawsuit in which its D&O insurers paid $6.785 million to settle the suit.

 

During the first half of this year, plaintiffs also filed a shareholders derivative lawsuit against Halliburton and KBR as nominal defendants and against the companies’ current and former directors and officers to recover as civil damages amounts the companies paid in connection with their recent high profile FCPA settlements, as discussed here.

 

The Gibson Dunn memo emphasizes that the follow-on lawsuits are not always successful, and the memo specifically cites as examples of unsuccessful cases the shareholders’ derivative suits involving Baker Hughes and Chevron Corporation, where motions to dismiss were granted earlier this year.

 

The memo also describes civil litigation that companies themselves are pursuing to try to recoup amounts the companies paid to settle FCPA enforcement actions. Among other cases the memo specifically mentions is an action brought by Willbros International against several former officials and consultants. Willbros pled guilty to violating the FCPA in 2008 and now alleges that the defendants were responsible for the unlawful conduct.

 

The Gibson Dunn memo concludes that "the number of recent enforcement actions and ongoing investigations suggests that the FCPA enforcement environment that we have observed over the past several years is here to stay." As the FCPA enforcement activity continues to grow, an increasing number of companies will find themselves involved in FCPA-related civil litigation.

 

Even though the FCPA enforcement fines and penalties generally would not be covered under a D&O insurance policy, the policy could be called upon to respond to the costs of defending against an FCPA enforcement action, and any follow-on civil litigation could also trigger the company’s D&O coverage, subject to all of the policy’s terms and conditions.

 

On a final note, the SEC Actions blog had an interesting recent post (here) emphasizing the high priority that FCPA enforcement actions are being given, both here and abroad. I would be remiss if I did not also note that The FCPA Blog (here) is a continuing source of excellent information on FCPA related developments that I follow regularly.

 

Pay to Play?: According to a July 7, 2009 article in the Deseret (Salt Lake City) News (here), U.S. Senator Bob Bennett (R. Utah) has asked the SEC to investigate whether plaintiffs’ law firms are making campaign contributions to public officials that oversee government pension funds in the hope of later being able to represent the funds in securities class action litigation.

According to the article, Bennett wrote that "state officials with control over pension fund decisions…receive very substantial campaign contributions from out-of-state law firms with no apparent interest in the election – other than the possibility of being chosen as the pension fund’s lawyer in a class action."

Bennett noted that these practices are of particular concern at a time when pension funds "are reeling from the decline the financial markets."

You Can’t Make This Stuff Up: As part of the eternal vigilance required in order to maintain this blog, I am constantly scouring the media for important developments. Sometimes I run across items that are noteworthy, even if they are not particularly important. Just to make sure that my readers are not deprived of these vital items, I share the following:

"Drunk Badger Disrupts Traffic in Germany" (here)

"France Faces EU Lawsuit for Failing to Protect Endangered Hamster" (here)

"Iowa State Fair Rethinks Jackson Butter Sculpture" (here)

 

Non, Je Ne Regrette Rien: With apologies to Edith Piaf and with a hat tip to Francine McKenna on whose blog, Re: The Auditors (here) I first saw this video, here is a musical tribute to a funny and odd assortment of Internet regrets.

 

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

Though Rule 10b5-1 trading plan abuses have figured in recent high profile cases (refer here), predetermined trading plans remain a good idea. A July 1, 2009 dismissal of a securities class action lawsuit pending in the Southern District of New York underscores the potential protective benefit that a trading plan can provide.

 

Gildan Activewear is a Canadian sportswear company based in Montreal. Its shares trade on both the NYSE and the Toronto Stock Exchange. Following the company’s April 2008 press release in which it announced a reduction in its earning guidance, its share price declined and litigation ensured. Background regarding the case can be found here.

 

 

 

On November 17, 2008, the lead plaintiff filed a Consolidated Amended Class Action Complaint (here), and on December 19, 2008, the defendants moved to dismiss.

 

 

 

In a July 1, 2009 opinion (here), Southern District of New York Judge Harold Baer, Jr., granted the defendants’ motion to dismiss, apparently with prejudice. Judge Baer granted the motion among other reasons on the grounds that plaintiff’s scienter allegations were insufficient to meet the PSLRA’s pleading requirements.

 

 

In attempting to establish scienter, the lead plaintiff had sought to rely on alleged insider trading by Gildan’s CEO, Glenn J. Chamandy, and by its CFO, Laurence G. Sellyn. Judge Baer noted that Chamandy’s sales, which comprised “over 99% of the total insider trading” alleged, were made pursuant to a non-discretionary Rule 10b5-1 trading plan, which, Judge Baer said, “undermines any allegation that the timing or amounts of the trades was [sic] unusual or suspicious.”

 

 

Judge Baer noted several other shortcomings regarding the plaintiff’s insider trading allegations. Among other things, he noted that though the plaintiff alleges that the defendants’ sales produced gross proceeds of $96 million, it fails to “allege any facts relating to the amount of profit” the defendants garnered by their sales. Judge Baer also found that the relatively low percentage of the sales compared to the defendants’ overall holdings, as well as the timing of the sales, in addition to the fact that the other officers and directors did not sell their shares, also militated against a finding of scienter.

 

 

Although Judge Baer’s discussion of Chamandy’s Rule 10b5-1 plan is relatively brief, it appears that the critical components of the plan were that Charmandy entered the plan in advance of his trades, the plan was non-discretionary, and the sales were pursuant to the plan. Judge Baer’s holding is yet another reminder that a well-constructed Rule 10b5-1 trading plan can provide substantial protection.

 

 

Judge Baer’s opinion cites the Eighth Circuit’s 2008 opinion in Elam v. Niedorff, which also found sales pursuant to a Rule 10b5-1 plan sufficient to rebut scienter allegations, and which is discussed in an earlier post, here.

 

 

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

 

 

Best Boards in America?: When Eric Jackson at TheStreet.com set out to identify the best boards in America as part of his July 7, 2009 article (here), he found that it was easier to list companies with poor governance practice than the best. Part of the problem is that there is no universally accepted definition of good governance. In addition, past attempts to identify exemplary boards look dubious in retrospect, as the performance of many companies cited later slumped.

 

 

Jackson quotes University of Delaware Professor Charles Elson to the effect that board governance alone is no guarantee of success, but “good governance give you protection when things to wrong. It the long run, that will play out.”

 

 

In creating his best boards list, Jackson ultimately relied on two factors Elson identified: equity ownership of directors and independence of directors. Jackson added his at third criterion, which is that directors must actually have enough time to serve.

 

 

Based on these criteria, Jackson identified three companies as having the best boards: Berkshire Hathaway, Johnson & Johnson, and Amazon.com. Of the three, Jackson judged Amazon.com as the best, saying it has “done things right on the important governance factors of equity ownership, independence and time,” as a result of which Jackson says Amazon is “far less likely to suffer a Lehman-like shock that could destabilize or kill the company.”

 

 

Securities Docket Mid-Year Litigation Update Webcast: On July 9, 2009, at 2:00 P.M. EDT, I will be participating in a Securities Docket webcast entitled “2009 Mid-Year Review: Securities Litigation and Enforcement.” The webcast will be moderated by Bruce Carton of Securities Docket and the panelists will also include Francine McKenna of the Re: The Auditors blog; Lyle Roberts of The 10b-5 Daily blog; and Tom Gorman of the SEC Actions blog. Further information and registration instructions can be found here.

 

This past Thursday night, the FDIC closed seven additional banks, including six in Illinois alone. These latest closures bring the number of year to day bank failures to 52, already double the 26 bank closures during all of 2008. The FDIC has closed twelve banks in just the last two weeks. The FDIC’s complete list of all bank failures since October 2000 can be found here.

 

The 2009 bank failures have been spread across 18 different states, but certain states have experienced a high bank closure concentration. Up until now, Georgia had the dubious distinction of leading the way, having been dubbed the “bank failure capital of the world” earlier this year (refer here).

 

 

But with the latest closures, the state with the highest number of bank failures this year is now Illinois, where twelve banks have now failed, compared to nine so far this year in Georgia. California has had six and Florida just three.

 

 

There are a number of reasons for the surge of Illinois bank failures, as discussed at length in a July 2, 2009 American Banker article entitled “The Next Georgia? Failures Spike in Illinois” (here). It is probably worth noting that this American Banker appeared before the six bank closures were announced after the close of business on Thursday evening.

 

 

Among other things, the number of Illinois bank closures may simply be the “law of numbers.” According to the American Banker article, Illinois, which was one of the last states to allow branch banking, has more banks than any other state, with 652 institutions headquartered there, compared to Georgia, which has only half as many.

 

 

The real estate downturn is also part of the explanation, as it is in other states,

But another reason for the particular problems in Illinois is challenge many of these banks are having with their investment portfolios. According to the American Banker article, because these banks had fewer lending opportunities in the slow-growing Midwest, some banks bought heavily into mortgage-backed securities.

 

 

According to a July 3, 2009 Bloomberg article (here), the six Illinois banks closed on July 2 were all controlled by a single family and all followed a similar business model, and all suffered losses on collateralized debt obligations (CDOs), as well as on soured loans.

 

 

The National Bank of Commerce, an Illinois bank that closed earlier this year, was forced to close after writing down its investments in the securities of Fannie Mae and Freddie Mac, which left the bank in a negative capital position.

 

 

The likelihood is that these problems will continue. Data in the American Banker article suggest that Illinois and Georgia led the country in the number of undercapitalized banks at the end of the first quarter, with 17 each. Of the 371 banks nationally judged undercapitalized or in danger of becoming so, 42 are in Illinois compared with 55 each in Georgia and Florida and 20 in California.

 

 

But with respect to banks having problems with their investments, Illinois leads the way. At least 17 Illinois banks took hits on their investments during the fourth quarter of 2008 and 11 did so in the first quarter of 2009. No other state came close. Florida, which had the next highest number of banks reporting securities write downs, had seven in the fourth quarter and three in the first quarter. 

 

 

The latest bank closures once again involved smaller institutions, continuing the trend of the involvement of community banks in the current bank failure wave. All of the seven banks closed on July 2 had assets under $500 million. Of the 52 bank failures this year, 46 have involved institutions with assets under $1 billion. Only twelve banks had assets over $500 million.

 

 

In a recent post (here), I noted that with the latest bank failure surge, D&O claims have started to emerge. And as a result, the D&O marketplace has begun to react, as I discuss at greater length here.

 

 

Over the last few weeks, I have written frequently about failed banks, perhaps too frequently for some readers’ tastes, but the fact is that something remarkable is happening in the banking sector. In the last 18 months, 78 banks have failed, 64 in just the twelve months since July 1, 2008. The twelve banks that have closed in just the last two weeks alone suggest that his is a problem that is going to get worse, perhaps a lot worse, before it starts getting better.

 

 

Anything Called “Hot Money” Can’t Be Good: In case you missed it over the weekend, the New York Times had a front page article on July 4, 2009 entitled “For Banks, Wads of Cash and Loads of Trouble” (here) that describes the complicated role that brokered deposits have played for many banking institutions. The article suggests that many struggling banks are particularly dependent on these deposits, which also may have played a role in many of the recent bank failures.

 

 

These deposits are made by out-of-state brokers who deliver billions of dollars in bulk deposits. These funds are often referred to as “hot money” because they arrive in search of the highest interest rates, and leave when better rates are available elsewhere. According to the Times article, hot money comes at a cost. In order to lure the money, “banks typically had to offer unusually high rates” which in turn “often led them to make ever riskier loans, leaving them vulnerable when the economy collapsed.”

 

 

The article focuses on banks in Georgia that sought to capture the brokered deposits, but the Georgia banks were hardly alone. Indeed, the article notes the banks that have failed since January 1, 2008 “had an average load of brokered deposits four times the national norm.” In addition, a third of the failed banks had both an unusually high level of brokered deposits and an extremely high growth rate “often a disastrous recipe for banks.”

 

 

The article shows that the 371 banking institutions on an independent bank rating firm’s “Watch List” as of March 31, 2009 “held brokered deposits that were twice the norm.”

 

 

 Securities Docket Mid-Year Litigation Update Webcast: On July 9, 2009, at 2:00 P.M. EDT, I will be participating in a Securities Docket webcast entitled “2009 Mid-Year Review: Securities Litigation and Enforcement.” The webcast will be moderated by Bruce Carton of Securities Docket and the panelists will also include Francine McKenna of the Re: The Auditors blog; Lyle Roberts of The 10b-5 Daily blog; and Tom Gorman of the SEC Actions blog. Further information and registration instructions can be found here.