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.

 

After a year of heightened securities litigation activity during 2008, the number of securities lawsuit filings declined in the first-half of 2009, largely due to a drop in filings during the second quarter. In this latest issue of InSights (here), I take a detailed look at the 2009 securities lawsuit filings and explain the possible reasons for the decline in the number of second quarter filings. The article concludes with a discussion of early third quarter developments and what we expect in the months ahead.

In what is one of the largest ever shareholders’ derivative lawsuit settlements, the parties to the consolidated federal options backdating related derivative lawsuit involving Broadcom Corp. have agreed to settle the case for $118 million, to be funded entirely by the company’s D&O insurance carriers. The settlement does not include the company’s co-founders, Henry Samuels and Henry T. Nichols, III, against whom the suit will continue. As discussed below, the settlement has a number of interesting features, including certain details surrounding the insurers’ settlement participation, particularly the substantial participation in the settlement of Broadcom’s Excess Side A insurance carriers.

 

As reflected in Broadcom’s August 28, 2009 filing on Form 8-K (here), and the accompanying stipulation of settlement (here), the $118 million settlement, which is subject to court approval, is to be funded by the company’s D&O insurers and includes $43.3 million that "Broadcom had already recovered in connection with prior reimbursements from its insurers (subject to a reservation of rights that will be released upon settlement approval."

 

The stipulation also provides that in connection with the settlement Broadcom will pay plaintiffs’ attorneys’ fees and costs of $11.5 million.

 

There are a number of interesting things about this settlement. The first is its size. The settlement’s total value of $118 million would make this the second largest options backdating related derivative lawsuit settlement, exceeded only by the $900 million UnitedHealth Group options backdating derivative settlement (about which refer here and here).

 

Indeed, the $118 million settlement may be among the largest shareholders’ derivative settlements of any kind, exceeded or equaled only by a small handful of prior derivative settlements (including, in addition to the UHG settlement noted above, the $115 million AIG derivative settlement and the $122 million Oracle derivative lawsuit settlement).

 

These settlements are of course all dwarfed by the  $2.876 billion judgment entered against Richard Scrushy in the HealthSouth shareholders’ derivative lawsuit, but that astronomical judment represents its own peculiar point of reference, like some odd parallel universe. 

 

But notwithstanding the settlement’s size, the net overall benefit to the corporation on whose behalf the lawsuit nominally was filed is an interesting issue. Not only is $43.3 million of the total settlement amount in the form of previously reimbursed defense expense, and not only is the settlement amount further reduced by the plaintiffs’ attorneys’ fees of $11.5 million, but the roughly $63.2 million remainder from the $118 million total is more than offset by litigation expenses the company has incurred in connection with the options backdating scandal.

 

As stated in the recitals in the separate Insurance Agreement (here) filed as an exhibit to the settlement stipulation, Broadcom has "advised the Insurers that it has claims for reimbursement exceeding $130 million in respect of the Broadcom Stock Option Matters, of which approximately $85 million remains outstanding."

 

Broadcom and its directors and officers were and are involved in a diverse range of lawsuits and claims as a result of the options backdating scandal, not just the shareholders derivative lawsuit. But the fact is that the remainder of the forthcoming cash settlement payment (after payment of plaintiffs’ attorneys’ fees) effectively represents only a partial offset of the company’s enormous options backdating related litigation expenses.

 

The corporation’s recovery of disputed legal expenses is unquestionably a benefit to the corporation, but how much additional litigation expense was generated along the way? It does seem to raise certain questions about the efficiency of the process. Indeed, in an August 31, 2009 American Lawyer article about the settlement (here), Susan Beck commented that "we’re still scratching our heads over this one."

 

The answer to the question of why the derivative lawsuit was a necessary vehicle to secure this extent of defense expense reimbursement from the carriers lies in the way Broadcom’s D&O insurance was structured

 

The Insurance Agreement accompanying the settlement shows that Broadcom had a total of $200 million of D&O insurance, arranged in various layers, with $100 million of "traditional" D&O insurance, and an additional $100 million of Excess Side A insurance. Excess Side A insurance  only provides protection to individual directors and officers (and not to the company itself) and only against loss that is nonindemnifiable, whether due to insolvency or legal prohibition. This element of insurance for nonindemnifiable loss is critical to understanding this settlement.

 

The Insurance Agreement recites that the insurance carriers believed they had certain defenses to coverage, but that in connection with the settlement, these coverage issues were being compromised. In exchange for relinquishing these potential coverage defenses, the carriers each paid amounts less than their full policy limits, with each successive carrier contributing a correspondingly smaller amount.

 

The Insurance Agreement specifies the dollar amount each carrier is to contribute to the settlement. Among other things, the Insurance Agreement shows that the Excess Side A insurers will contribute a total of $40 million, with each of the successive Excess Side A carriers contributing a correspondingly smaller amount.

 

Given the number of carriers involved, the complexity of the coverage issues and the sheer quantity of dollars involved, the completion of this settlement is an extraordinary accomplishment. I tip my hat to all of the lawyers involved in putting this together.

 

The key to understanding the inner logic of this deal is to recognize that without the existence of a shareholders’ derivative lawsuit against the individual directors and officers creating the type of nonindemnifiable loss that is the sole type of loss for which the Excess Side A policies provide coverage, the Excess Side A policies would not have been triggered.

 

The defense expenses incurred in connection with the other options backdating related litigation matters are presumptively indemnifiable. The company’s payment of these indemnifiable amounts, in and of itself, would not have triggered the Excess Side A policies.

 

However, the derivative lawsuit’s claim against the individual defendants for the harm to the corporation caused by the backdating includes claims on the corporation’s behalf for the enormous litigation expense the company incurred due to the alleged misconduct. The settlement of the claims in the derivative lawsuit against the individual defendants to recoup the harm to the corporation was not indemnifiable, triggering a potential payment obligation for the Excess Side A carriers.

 

So if, for example, there had been no derivative lawsuit, and the company had, say, tried to recoup its defense expense from the carriers directly in a declaratory judgment action, the Excess Side A carriers would have taken the position that because there was no nonindemnifiable loss, their policies were not implicated. The derivative lawsuit, asserting nonindemnifiable claims against the individual defendants, triggered the Excess Side A policies, which ultimately contributed a total of $40 million toward the settlement.

 

The fact that the Excess Side A carriers are contributing so significantly to this settlement is particularly noteworthy. When the options backdating scandal first arose and the wave of derivative lawsuits began to flood in, it was a topic of discussion in the industry whether the options backdating scandal might be the event that would break through and produce significant aggregate losses for the Excess Side A insurers. Whether or not other options backdating claims have hit Excess Side A insurers, the Broadcom options backdating derivative lawsuit settlement certainly did, and the Excess Side A insurers’ $40 million contribution toward the settlement in and of itself makes this settlement a noteworthy event.

 

With jumbo derivative settlements now a more frequent occurence, Excess Side A insurers could begin to accumulate substantial claims losses. The rising tide of corporate bankruptcies as a result of the global financial meltdown could also produce significant Excess Side A claims losses ahead. Both developments underscore the value to policyholders of the inclusion of this kind of insurance within their D&O insurance program.

 

I have in any event added the Broadcom options backdating-related derivative settlement to my chart of options backdating related case resolutions, which can be accessed here.

 

Citigroup Subprime ERISA Class Action Dismissed: Following close on the heels of his dismissal of the Citigroup subprime-related derivative lawsuit (about which refer here), on August 31, 2009, Southern District of New York Judge Sidney Stein granted the defendants’ motion to dismiss the Citigroup subprime-related ERISA class action as well. A copy of Judge Stein’s August 31 opinion can be found here.

 

The plaintiffs had alleged that the defendants had breached their fiduciary duties under ERISA in a number of ways, most significantly by offering Citigroup stock as an investment option even though defendants knew or should have known that Citigroup was an imprudent investment. Among other things, Judge Stein held that the Plan itself required the Citigroup stock to be offered as an investment option and therefore the defendants had no discretion in that regard.

 

With respect to the plaintiffs’ allegations that the defendants had failed to give complete and accurate information, Judge Stein held that the defendants did not have an affirmative duty to disclose financial information about Citigroup because ERISA fiduciaries are not required to provide investment advice, and to the extent the defendants did provide information about Citigroup it was not in their capacities as ERISA fiduciaries, and, in any event, "plaintiffs have failed to allege facts showing that the defendants knew the statements were misleading."

 

I have in any event added the Citigroup ERISA class action dismissal to my register of subprime and credit crisis-related case resolutions, which can be accessed here.

 

Special thanks to Courtney Scott at the Tressler, Soderstrom law firm for providing me with a copy of Judge Stein’s opinion in the ERISA class action suit.

 

Finacial Downturn, Not Fraud, Caused Plaintiffs’ Losses: In a ruling that is interesting for what it says about the relevance of the overall economic downturn to the wave of subprime lawsuits, on August 20, 2009, Eastern District of Pennsylvania Judge R. Barclay Surrick, Jr. granted the motion to dismiss the securities fraud lawsuit that Luminent Mortgage Corporate had filed against Merrill Lynch and related entities. A copy of the August 20 opinion in the case, which was filed solely on behalf of the named plaintiffs and not as a class action, can be found here.

 

In August 2005, Luminent had acquired $26 million worth of the most junior tiers of Mortgage Loan Asset-Backed Certificates that were backed by nearly $1 billion of underlying mortgage loans. Merrill and the related defendant entities underwrote, issued and sold the securities. Luminent acquired the securities as part of a complex transaction whereby Merrill had financed Luminent’s purchase and then held the securities as collateral, while Luminent retained the rights to the income stream from the certificates. As the court later noted, Luminent’ purchase of securities from the most junior layers represented a riskier investment, a consideration that clearly affected the court’s analysis.

 

In April 2007, Luminent reviewed a sampling of some of the underlying mortgages and found that several of the mortgages deviated from information about the mortgages Luminent had been given prior to the purchase transaction. Luminent contended that a result of these deviations, which allegedly showed the mortgages to be less secure than had been represented prior to the purchase transaction, the underlying mortgages were experiencing an unexpectedly harsh rate of default and delinquencies.

 

The investment performance on the certificates was so poor that in September 2007, Luminent demanded rescission of its purchase. After the defendants refused to rescind, Luminent filed suit under a variety of legal theories, among other things alleging that the defendants, in violation of the federal securities laws, had misrepresented the composition of the pool of mortgages and had misrepresented their due diligence in scrutinizing and selecting the mortgages. The defendants moved to dismiss.

 

Judge Surrick granted the defendants’ motion on several grounds. First, he held that the complaint did not adequately plead scienter, finding that the plaintiffs had not alleged facts sufficient to show that the discrepancies in the loan sample Luminent reviewed were the result of anything more than negligence. He also found that the plaintiffs’ theory of fraud was inconsistent with the fact that Merrill retained Luminent’s securities as collateral for the purchase loan, as a result of which any purported fraud would have harmed Merrill as well as Luminent.

 

Judge Surrick also granted the defendants’ motion to dismiss on the grounds that the plaintiffs had not adequately pled economic loss or loss causation. With respect to the economic loss issue, Judge Surrick found that Luminent did not hold the securities themselves and did not and could not have sold them at a loss, and he found further that the plaintiffs had failed to allege how their diminished income stream "can be distinguished from the market-wide losses in mortgage-backed securities generally."

 

This latter point, about the indistinguishability of the plaintiffs’ losses from market-wide losses is the most interesting aspect of Judge Surrick’s opinion. In similarly holding that the plaintiffs had not adequately alleged loss causation, Judge Surrick cited Second Circuit case law to the effect that "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."

 

Though the Second Circuit case from this cited language is drawn is a RICO case, Judge Surrick’s opinion is the second recent decision in which a district court granted a motion to dismiss in a subprime-related securities class action lawsuit on loss causation ground in reliance on this language. As noted here, on August 5, 2009, District of Massachusetts Judge Joseph L. Tauro also granted a motion to dismiss in the subprime-related securities class action lawsuit pending against First Marblehead, citing the identical language from the Second Circuit.

 

In convincing courts to grant their securities lawsuit dismissal motions on loss causation ground in reliance on the language drawn from a RICO case, defendants seem to have hit on a formula that appears to be drawing a sympathetic judicial response – that is, the argument is that if the plaintiffs were harmed at all, it was due only to the global financial crisis, not to the defendants’ alleged misconduct. 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.

 

Luminent’s directors and officers were themselves a target of a subprime-related securities class action lawsuit. (Luminent itself filed for bankruptcy in September 2008.) As noted in detail here, the Luminent securities lawsuit settled in December 2008 based on defendants’ agreement to pay $8 million.

 

An August 28, 2009 article in the Legal Intelligencer about Judge Surrick’s opinion can be found here.

 

Citigroup Shareholders’ Derivate Lawsuit Dismissed: In an August 25, 2009 order (here) that largely tracks the earlier dismissal of the related Citigroup derivate lawsuit that had been pending on Delaware, Southern District of New York Judge Sidney Stein, applying Delaware law, granted the defendants’ motion to dismiss the consolidated Citigroup derivative lawsuit, holding that "the complaint fails to allege with specificity facts showing that plaintiffs are excused from pre-suit demand."

 

The plaintiffs had filed their complaints, later consolidated, against certain directors and officers of Citigroup, in connection with the billions of dollars Citigroup had lost from its investments in mortgages and mortgage-related securities. The consolidated complaint alleged that the defendants should be liable for allowing Citigroup to invest in subprime mortgages; failing to disclose the extent of Citigroup’s exposure to subprime mortgages; approving a stock repurchase plan despite Citigroup’s subprime exposure; committing securities fraud for failed to adequately disclose the company’s subprime exposure; and engaging in or allowing others to engage in insider trading.

 

The allegations were similar to but not identical to the allegations in the separate Delaware derivate lawsuit. The Delaware action, for example and by contrast to the New York action, also contained a claim for waste based on the severance package awarded former CEO Charles Prince. The New York action, by contrast, contained claims not alleged in the Delaware suit based on securities fraud and insider trading allegations.

 

In concluding that the plaintiffs in the New York action had failed to establish that the pre-suit demand was excused, Judge Stein, applying Delaware law, largely followed (and expressly quoted from) Chancellor Chandler’s prior dismissal ruling in the Delaware case

 

The interesting part about Judge Stein’s opinion is with respect to the claims that were raised in the New York action but not in the Delaware lawsuit, and therefore with respect to which Chancellor Chandler did not rule in his earlier opinion.

 

Specifically, in concluding that the plaintiffs had failed to establish that demand was excused with respect to their derivative claim for securities fraud, among other things, Judge Stein concluded that the plaintiffs had not established that the defendants "face a substantial likelihood of liability of securities fraud." (If the faced such liability, then the plaintiffs’ pre-suit demand would be excused as futile.)

 

Judge Stein found that the plaintiffs’ complaint "fails to allege with specificity which statements plaintiffs contend are fraudulent," and that it does not "allege with specificity why any alleged misstatement is fraudulent." In addition, Judge Stein held, citing Tellabs, that the complaint "does not state with particularity facts giving rise to a strong inference that the defendants acted with the required state of mind."

 

While Judge Stein found that the plaintiffs had failed to show a substantial likelihood of liability for securities fraud, he was careful to note that his ruling related only to the allegations in the consolidated derivative complaint in this case, and not to the securities fraud allegations that may have been raised in other lawsuits involving Citigroup and the same or related circumstances.

 

Judge Stein expressed skepticism that the plaintiffs could cure their pleading defects, and therefore rather than simply allowing the plaintiffs leave to file an amended complaint, he required them to file a motion seeking leave. The plaintiffs’ motions are due September 14, 2009.

 

I have in any event added Judge Stein’s ruling to my register of subprime-related lawsuit dismissal motion grants and denials, which can be accessed here.

 

My prior post discussed the corporate waste allegations in connection with Charles Prince’s severance package in the Citigroup derivative lawsuit in Delaware, which allegations survived the initial motion to dismiss in that case, can be found here.

Plaintiffs Target Stanford Financial’s Outside Counsel: On August 27, 2008, former Stanford Financial investors claiming damages of over $7 billion filed a purported class action lawsuit in the Northern District of Texas against former Stanford Financial outside counsel Thomas Sjoblum and his law firm, Proskauer Rose. A copy of the plaintiffs’ complaint can be found here.

 

In an apparent attempt to circumvent the limitations of the Stoneridge case, the plaintiffs filed their aiding and abetting claims against Sjoblum and his firm under the Texas securities laws rather than under the federal securities laws. The plaintiffs also assert alternative legal theories under Texas law, including civil conspiracy, aiding and abetting civil conspiracy and respondeat superior.

 

Given the revelations of former Stanford CFO James Davis at his August 27, 2009 guilty plea, it may not be surprising that Sjoblum has now gotten drawn into the case. (In an August 27, 2009 post, here, the WSJ.com Law Blog details Davis’s revelations.) Among other things, Davis, in the factual recitations in his plea agreement, suggested that Sjoblum, in concert with Stanford officials, made representations to the SEC that were contrary to information he had been given about the company and its operations, including problematic characterizations of the company’s portfolio.

 

The extent to which the plaintiffs will succeed in imposing gatekeeper responsibility on Sjoblum remains to be seen. The interesting thing to me about the lawsuit is how unusual it is for the lawyers to have gotten dragged into the litigation. There have been very few instances (if any) where lawyers have become targets in the litigation arising out of the various other Ponzi scheme scandals or any of the collapses associated with the subprime meltdown and credit crisis. To my knowledge neither the Madoff scandal nor the subprime litigation wave drawn in gatekeeper claims against the lawyers involved in the underlying transactions, even though gatekeeper claims have been an important part of both related categories of litigation (primarily with respect to auditors, offering underwriters and rating agencies).

 

I have in any event added the lawsuit against Sjoblum to my running register of the Stanford-related lawsuits, which can be accessed here.

 

An August 31, 2009 National Law Journal article about the Sjoblum lawsuit can be found here.

 

Upcoming Directors and Officers Liability Conference: On November 30, 2009 and December 1, 2009, I will be co-Chairing the American Conference Institute’s Fifteenth Annual Advanced Forum on D&O Liability, in New York City. The program features an all-star cast of experts in the field on a wide variety of critical topics in the area. A copy of the agenda and registration information can be found here.

 

The FDIC’s August 27, 2009 announcement in its latest Quarterly Banking Profile (here) that during the second quarter of 2009 it had increased the number of financial institutions on its "Problem List" from 305 to 416 (a 36% increase) caused quite a stir. The Wall Street Journal’s lead article the next day referred to the FDIC’s "sick list" and other media sources also buzzed with the news.

 

And well they might. As I noted in the prior issue of InSights (here), the number of banks on the FDIC’s "Problem List" and the assets they represent have both grown rapidly. The 416 institutions on the list at the end of the second quarter of 2009, representing assets of $299.8 billion, contrasts dramatically with the end of the second quarter of 2008, when there were "only" 117 institutions on the list representing $78.3 billion in assets. This nearly 300 percent increase in the number of problem banks in just one year, along with the nearly 400 percent increase in the assets the problem banks represent, are both deeply troublesome developments.

 

The FDIC itself noted in its Quarterly Banking Profile that the current number of problem banks is the highest such count since June 30, 1994, and the assets they represent are at the highest level since December 31, 1993.

 

It is hardly surprising that these disturbing developments and the trends they represent have triggered some daunting projections about what the future may hold. Among the most alarmist, and the one that has garnered the most media attention, is the statement on CNBC by banking veteran and investor John Kanas that the number of failed banks could reach 1,000 by the end of next year. Other commentators have made other pessimistic albeit less dire projections (refer for example here.)

 

It may not be possible simply to write off the question whether 1,000 bank failures over the next year and a half is a possibility. Certainly, banks failed at a tremendous rate during the S&L crisis. During the dark days of 1989, banking regulators took control of 534 banking institutions. Overall, during the S&L crisis, over 1,000 financial institutions failed.

 

In addition, other details in the FDIC’s latest Quarterly Banking Profile certainly underscore the deteriorating conditions facing many banks. Among other things, the banks’ loan portfolios are weakening faster than the banks can set aside loss reserves. At the end of the second quarter, the industry’s ratio of reserves to bad loans stood at just 63.5%, its lowest level since 1991.

 

The data in the FDIC’s report also highlights how problems are spreading beyond just the real-estate sector where the problems in the current economic crisis first emerged. Credit card losses are increasing and the banks find themselves collectively holding billions of dollars worth repossessed real estate. Persistent high levels of unemployment raise the risk that even low-risk borrowers could fall behind or default on their loan payments. For further details about reasons why banks are failing now, refer to my recent post here.

 

Though we are still a very long way from 1,000 failed banks, the number of failed banks has continued to surge. With the addition of three more bank closures this past Friday night, the number of 2009 year to date bank failures now stands at 84. Since January 1, 2008, 109 banks in 29 states have failed. These bank failures have ranged from the smallest banks with assets under $15 million, to Washington Mutual’s failure, which with assets of $307 billion was the largest bank falure in U.S history. The FDIC’s complete list of failed banks since October 2000 can be found here.

 

All of that said, it is still a very long way from 84 bank failures – in and of itself a significant number – to 1,000 bank failures by the end of 2010. This truly pessimistic prediction presumes that more than double the number of current problem banks will fail in the next 14 months. This despite the fact that while both the number of problem banks and the number of failed banks have climbed dramatically in the past year, the number of failed banks has remained well below the number of problems banks.

 

Because of the historical example of the S&L crisis, it is hard to say that 1,000 bank failures couldn’t happen. It happened before and it could happen again. However, in the range of possible outcomes, the likelihood of 1,000 bank failures has to rank among the remote possibilities. Among other things, the prediction of 1,000 bank failures seems to reckon without the possibility that eventually the effects of the economic recovery might start to alleviate the harsher trends of the economic downturn.

 

Unfortunately, the current trends do seem to suggest that things will continue to get worse before they get better. But one of the lessons we were all supposed to have learned from the events that preceded the credit crisis is the fallacy of projecting from current conditions and presuming current conditions will continue indefinitely into the future.

 

Just as it was a mistake in the late stages of the housing bubble to assume, for example, that housing prices would continue to rise indefinitely, so too it could be a mistake to presume that current adverse banking conditions will continue unabated into the future. Yes, circumstances are difficult and there undoubtedly will be further bank failures, perhaps many more bank failures. The possibility of as many as 1,000 bank failures seems remote and unlikely, even given current adverse and deteriorating conditions. Securities Analyst Meredith Whitney’s projection of 300 bank failures (refer here), although also arguably pessimistic, by comparison seems less radical.

 

Among other questions raised when discussing these issues on recent days is whether the rising tide of bank failures, no matter how large it ultimately proves to be, will lead to a wave of lawsuits against the former directors and officers of the failed institutions, as happened during and following the S&L crisis.

 

As I have noted previously, most recently here, there have been some lawsuits filed by shareholders of failed banks, who claim that their investment losses were the fault of the banks’ former directors and officers. There have also been a number of securities class action lawsuits filed by shareholders of publicly traded failed banks. Indeed, of the 25 banks that failed in 2008, six were sued in securities class action lawsuits, even though just eleven of the 25 were publicly traded.

 

These seems to have been less of this shareholder litigation in connection with the 2009 bank failures so far, perhaps in part due to the fact that fewer of the 2009 bank closures involve publicly traded financial institutions.

 

Prospective litigants are not likely to be encouraged by the recent developments in one of the 2008 securities class action lawsuits involving a failed bank. That is, on August 21, 2009, the court granted with prejudice the defendants’ renewed motion to dismiss the amended complaint plaintiffs had filed to try to cure the defects noted in the earlier dismissal motion rulings in the subprime-related securities class action lawsuit involving Downey Financial. A copy of the court’s ruling can be found here. This development underscores the pleading obstacles plaintiffs may face in trying to survive dismissal motions in any case involving a failed bank, particularly against the larger background of the global economic crisis and wave of bank failures.

 

One recurring question I am asked is whether the FDIC will, as it did during the S&L crisis, pursue liability claims against the former directors and officers of failed financial institutions. These kinds of lawsuits were a major part of the FDIC’s efforts to try to recoup its losses during the last banking crisis. There would seem to be every reason to expect the FDIC to attempt to do the same thing this time around as well.

 

However, at least so far, the FDIC does not seem to have actually filed these kinds of claims, at least as far as I am aware. I have been informed by reliable sources that the FDIC has presented written notices of potential claims in certain instances (perhaps in an effort to preserve a possible later recovery from D&O insurance policy proceeds before the policy’s lapse). However, so far, the FDIC does not seem to have actually pursued these claims.

 

One thing that seems certain is that if there really were to be as many as 1,000 failed banks, or any number remotely in that neighborhood, the latent prospect for litigation involving the former directors and officers of the failed banks would potentially be enormous.

 

Special thanks to the many readers who sent me links, comments and questions about the FDIC’s latest Quarterly Banking Profile and related media developments.

 

In the wake of numerous corporate scandals in recent years, many factors have been suggested as possible indicators of fraud, including outsized compensation, questionable accounting and failed oversight. But a recent paper by three Canadian academics proposes a surprising alternative indicator of fraudulent misconduct they suggest is more reliable – the size of the CEO’s ego.

 

The authors suggest that egotistical managers, stoked by media attention and analyst praise, gain a "feeling of invincibility" that leads them to "take more risks in fraudulent activities," akin to the "moths attracted to the flames that ultimately kill them."

 

In their paper, "Like Moths Attracted to Flames: Managerial Hubris and Financial Reporting Frauds" (here), Michel Magnan of Concordia University in Montreal, Denis Cormier of UQAM and Pascale Lapointe-Antunes of Brock University report on their analysis of financial reporting frauds or improprieties committed at Canadian publicly traded firms between 1995 and 2005 and that led to the imposition of penalties or fines by securities regulators.

 

At the outset, the authors observed that while the "fraud triangle" of incentives, opportunity and rationalization are "red flags" indicating possible fraud, the fact is that many companies exhibit one or more of these characteristics but very few of them are actually engaged in fraud. Because these "red flags" may not actually indicate fraud, the "red flags morph into red herrings, that may lead to numerous and unfruitful wild investigation chases."

 

The authors contend, based on their review of the 15 companies in their sample, that the missing element in the analysis is the factor that explains why some companies become involved in fraud. The missing element, they contend, is "managerial hubris", which they say "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud." The authors define "managerial hubris" as "exaggerated pride or self-confidence often resulting in retribution," deriving the meaning from the concept in Greek tragedy for "man’s fatal flaw."

 

The authors propose that:

 

Hubris actually ignites and accelerates the sequence of incentives, opportunities and attitudes (rationalization) that bring CEOs to engage in financial reporting frauds or to be oblivious to such frauds being committed in their own entourage.

 

Interestingly, the authors noted that many of the firms studied were not completely unrestricted; to the contrary, many seemed to exhibit governance mechanisms that appeared to be functioning. Thus, for example, 12 of the 15 firms had a majority of independent directors, and "at least 7 out of the 15 had ‘star’ directors who brought considerable credibility." In addition, "most of the sample firms were supposedly screened or watched by some of Canada’s leading intermediaries."

 

The authors noted that the firms "were subjected to what would appear to be appropriate oversight and scrutiny." The authors’ view is that "for fraud or impropriety to be committed, governance and markets monitoring conditions need to be present, as they provide additional cover."

 

The authors’ most striking observation is that all of the sample firms or their top executives "were the objects of glowing media, society or stock market reports," which "may have either enhanced the willingness of perpetrators of fraudulent activities to pursue their actions or removed successful CEOs from carefully monitoring their executive team." The authors observed that "hubris can be fed and magnified when there is too much self-reflection of success and achievements." This managerial hubris, stoked by the fawning attention of the media and analysts "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud."

 

The authors suggest that awareness of these factors can aid fraud detection, because this element of hubris is "more likely to be transparent" when executives are asked about "plans realizations, future strategies." The authors suggest that "inconsistencies between executives’ statements and observable facts or realities, outlandish claims, and a lack of concern for operational detail can be signals that managerial hubris has set in."

 

Thought the authors’ study is limited to Canadian companies, the authors note that "it is highly likely that managerial hubris is present in U.S. cases of fraudulent financial reporting as well" (citing the example of Scott Sullivan, the former CFO of WorldCom).

 

But while the authors refer to the possible applicability of their analysis to financial fraud in the U.S., they also acknowledge the potential limitations of their analysis as well. Among other things, they note the small size of their sample, which they acknowledge represents a "limitation" even though it also afforded them the opportunity for a more detailed study of each case.

 

The authors note that there may be factors unique to Canada at work as well. For example, they note that due to the relatively small size of Canada’s business environment and the relatively fewer number of media outlets there, "it is probably easier for someone to attain ‘star" status in Canada."

 

The authors also note that many Canadian firms have a CEO who is also a controlling shareholder or member of a control group, which may both give the CEO a stronger personal incentive to commit fraud and great opportunities to overcome internal controls. This fact may explain much about the cases the authors studied; in 13 of the 15 cases, the firm’s CEO was "an important shareholder, if not the controlling shareholder."

 

These somewhat distinctly Canadian factors may limit the extent to which the authors’ analysis may be applicable outside Canada, particularly in the U.S. where very few public companies are as controlled as were these Canadian firms. The characteristics of those Canadian firms may have given the hubristic CEOs more opportunity to indulge their egotistical goals, in ways that might not be available to many CEOs in the U.S., even to highly egotistical American CEOs.

 

Of course, there are countless examples of egotistical CEOs of U.S companies that led their companies in fraudulent misconduct –it is just that the presence of a hubristic CEO may or may not be as indicative of fraudulent misconduct in the U.S. as in Canada. Perhaps it is a topic for further study.

 

There is the problem about what to do with the authors’ conclusions, even if we accept them as valid and applicable both in Canada and outside as well. It is not as if analysts, auditors or D&O insurance underwriters can administer personality tests to measure the size of CEOs egos. And favorable press, even highly favorable press, is not always an indicator of problems looming – to the contrary, the media reports might be lavishing praise not because they are duped by fraud, but because the company’s performance actually is praiseworthy. Moreover, many CEOs have enormous egos. Arguably, only someone with a massive ego would even attempt to do their jobs.

 

In the end, the authors are suggesting only that signs of hubris should be watched for, and where found in the presence of more typical red flags, uses as a trigger for further investigation – an observation that is undeniably sound.

 

One final observation is that at some level, the authors’ research conclusions are consistent with the research I discussed in a prior blog post (here) that suggested an inverse correlation between the size of CEO’s houses and their company’s performance. Both studies suggest that if a company becomes an instrument in a CEO’s self-aggrandizement, shareholders better watch out.

 

Very special thanks to Professor Michel Magnan for providing me with a copy of the research paper. Hat tip to the Securities Docket (here), for linking to an August 26, 2009 Toronto Globe and Mail article (here) discussing the research paper.

 

And Speaking of Hubris: One of the more astonishing parts of the global financial crisis is the outsized role that banks based in Iceland played, particularly in the early stages of the crisis. The question of how several banks from a very small county in the North Atlantic created such havoc is one of the great puzzles of the crisis.

 

Picking up on the Canadian authors’ research, I would suggest that one of the ways Icelandic banks came to assume such an outsized, and ultimately dangerous role, was hubris. If you have any doubt, watch the following (pre-collapse) video from Kaupthing Bank, which, before it was seized by Iceland’s banking regulators, had transformed itself into Iceland’s largest bank. You don’t think there were some massive egos involving in this operation? (Fatal last words: "We can if we think we can… We think we can continue to grow the same way we always have.") 

 

Hat tip to Clusterstock (here) for the link to the video.

 

https://youtube.com/watch?v=31U54cgf_OQ%26color1%3D0xb1b1b1%26color2%3D0xcfcfcf%26hl%3Den%26feature%3Dplayer_embedded%26fs%3D1

It seems that Southern District of New York Judge Jed Rakoff has been busy lately reviewing proposed settlements related to Merrill Lynch. But unlike his recent well-publicized refusal to accept the SEC’s proposed settlement of its enforcement action regarding the Merrill Lynch bonus disclosures, he did agree on August 21, 2009 to preliminarily approve the proposed $150 million settlement in the securities class action lawsuit brought on behalf of purchasers of certain Merrill Lynch bonds and preferred securities. A copy of Judge Rakoff’s August 21 order can be found here.

 

This settlement relates to what has come to be known as the "Bond Action," to differentiate it from the "Securities Action." As reflected here, the parties to the securities action had previously agreed to a $475 million settlement in that case (as well as a $75 million settlement of a related class action under ERISA).

 

As reflected at greater length here, the Bond Action was brought on behalf of those who invested in the more than $24 billion in preferred and debt securities that Merrill had issued to the public between October 2006 and May 2008.

 

As reflected in the plaintiffs’ Corrected Amended Complaint (here), the lead plaintiffs asserted claims on behalf of the class under Sections 11, 12 and 15 of the Securities Act. The defendants included not only Merrill itself and certain of its directors and officers, but also the offering underwriters as well.

 

The complaint alleged that the offering documents issued in connection with the specified securities offerings failed to "accurately disclose the existence and the value of tens of billions of dollar of complex derivative securities linked to subprime mortgages" that Merrill was carrying on its balance sheet. The complaint further alleges that these exposures "nearly wiped Merrill out by September 2008" and also "nearly toppled Merrill’s white knight acquirer," the Bank of America, and only a massive federal bailout rescued the banks’ merger.

 

There are several interesting things about this settlement, beyond just its size alone. The first is that the defendants entered the settlement while the motions to dismiss the amended complaint were still pending. While there may be any number of reasons for the timing of this development, it does (together with the timing of the prior Securities Action settlement) suggest 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.

 

The substantial sums of cash raises another interesting question, which is the omnipresent question for all bailed out financial institutions – is this being financed with federal bailout money? Or, to put it another way, are taxpayer funds going to pay off the plaintiffs and their lawyers in this case? (For an earlier discussion of the question whether TARP money would go to settle securities lawsuits, refer here.)

 

The bare face of Judge Rakoff’s order preliminarily approving the settlement does not broach any of these subjects. However, he did take a parting shot at the end of the order, by adding a handwritten paragraph just above his signature, stating that "notwithstanding any provision anywhere in this case that could otherwise be interpreted, no attorneys’ fees shall be paid or otherwise distributed until after all other authorized distributions of funds have occurred."

 

I have in any event added the Merrill Lynch Bond Action settlement to my register of subprime and credit crisis case resolutions, which can be accessed here.

Andrew Longstreth’s August 26, 2009 article in the American Lawyer about the settlement can be found here.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for providing a copy of Judge Rakoff’s order.

 

And Speaking of Subprime-Related Securities Lawsuit Case Resolutions: In recent orders in separate subprime-related securities lawsuits, two separate courts granted renewed motions to dismiss after the plaintiffs had filed amended complaints seeking to address concerns noted in prior orders dismissing the plaintiffs’ initial complaints.

 

First, on August 4, 2009, in the Centerline Holding Company case (about which refer here), Judge Schira Scheindlin entered an order (here) granting defendants’ motion to dismiss the plaintiffs’ amended complaint. Judge Scheindlin had previously granted the defendants’ motion to dismiss plaintiffs’ initial complaint (as discussed here), but she had previously also allowed plaintiffs leave to amend. In her August 4 order, she denied plaintiffs leave to amend.

 

Second on August 21, 2009, Central District of California Judge John F. Walter granted the defendants’ motion to dismiss the plaintiffs’ second amended complaint in the Downey Financial case. A copy of Judge Walter’s opinion may be found here. As reflected here, Judge Walter had previously dismissed plaintiffs’ initial complaint with leave to amend. However, the dismissal entered on August 21 was with prejudice.

 

The Downey Financial case may be of particular interest, because Downey Financial represents one of the relatively few bank failures out of the recent wave of closures that has resulted in shareholder litigation. The plaintiffs’ lack of success in that case may suggest why plaintiffs’ lawyers’ have at least so far pursued relatively few lawsuits in connection with the bank failures. The dismissal could discourage others as well.

 

I have in any event added the two dismissals to my running tally of subprime and credit crisis-related securities lawsuits case dismissals and dismissal motion denials, which can be accessed here.

 

It might well be asked why anyone should bother reading both the Wall Street Journal and the New York Times business pages. After all, both usually cover the same stories. Indeed, on Friday, both ran stories discussing the fact that year-to-date bank failures are at the highest level since 1992.

 

However these same-day articles about the number of bank failures in fact were a great illustration of the value of reading both publications, because the two newspapers presented very different explanations for the run of failed banks, particularly with respect to the latest round of bank closures. Each article has its points, though, and both raise interesting questions.

 

First, the context for the two articles. With the addition of four bank closures this past Friday night, there have now been 81 bank failures this year, compared to 25 during all of 2008, and just three in 2007. Not since June 12 has there been a Friday without a bank closure (Friday being the FDIC’s preferred day to take control of banks.) The FDIC’s complete list of banks that have failed since October 2000 can be found here.

 

The addition of two more failed banks in Georgia among this Friday’s round of bank closures brings that state’s nation-leading year to date total number of failed banks to 18. Friday’s closures also included Austin, Texas-based Guaranty Bank, the tenth largest bank failure in U.S. history. For more about Guaranty’s closure, refer here.

 

Though this year’s round of bank failures includes behemoths like Guaranty, and Colonial Bank of Birmingham, Alabama which closed last Friday, the bank failures generally involve much smaller banks, many of them so-called community banks having assets of less than $1 billion. Of the 81 year-to-date bank failures, 68 of them have involved community banks.

 

Now – why are the banks failing? The Journal and the Times disagree on that point, particularly with respect to the most recent closures.

 

In an August 21, 2009 article written by Floyd Norris, the Times reported (here) that "banks are now losing money and going broke the old-fashioned way: They made loans that will never be repaid." The Times article notes further with respect to the bank failures that "it has become clear that most of them had nothing to do with the strange financial products that seemed to dominate the news when the big banks were nearing collapse and being bailed out by the government."

 

There were, Norris writes, "no C.D.O’s or S.I.V.’s or AAA-rated ‘super-senior tranches.’" He added that "certainly, there were not ‘C.D.O.’s-squared.’"

 

The WSJ sees things quite differently. In a front-page article (published the same day as the Times article) entitled "In New Phase of Crisis, Securities Sink Banks" (here), the Journal asserts that "the banking crisis is entering a new stage, as lenders succumb to large amounts of toxic loans and securities they bought from other banks." Guaranty’s woes and ultimate failure were, for example, due to its "investment portfolio, stuffed with deteriorating securities created from pools of mortgages originated by some of the nation’s worse lenders."

 

The Journal article notes that Guaranty "is one of the thousands of banks that invested in such securities, which were often highly rated but ultimately hinged on the health of the mortgage industry." The securities fell into two categories, those "carved out of loans originated by mortgage companies, packaged by Wall Street firms, and then sold to investors," and "trust preferred securities" which are hybrid securities banks issue through special purpose trusts and that have certain advantages for purposes of measuring regulatory capital (for further background regarding trust preferred securities and the problems they are causing banks, refer here).

 

Banks themselves issued trust preferred securities, which "Wall Street brokerage firms bought" and packaged into "so-called collateralized-debt obligations" for which "many of the buyers were small and regional banks." The outcome of what one commentator called "this wonderful chain of stupidity" is that the "consequences are cascading down on the banks that bought these securities." Indeed, trust preferred securities holdings "doomed six family-controlled Illinois banks that collapsed last month." (My post about these six banks’ failure can be found here.)

 

It hardly seems as if the two newspapers were discussing the same topic, with the Times saying the bank failures had nothing to do with these exotic investment securities, and the Journal directly pinning the blame for numerous recent bank failures on the banks’ investment in precisely these kinds of investment instruments. Certainly, the examples the Journal cites suggest that the structured investments has had a lot more to do with at least some of the most recent banks failures than the Times article implies.

 

But as different as the two articles’ analyses may appear, the articles do agree that the fundamental problem for banks is that too many loans are not performing. The Journal article specifically notes that "delinquency rates and losses are at all-time highs," and the investment portfolio problems are hitting banks "already weakened by losses on home mortgages, credit cards, commercial real-estate and other assets imperiled by the recession."

 

The one topic on which the two articles unquestionably agree is that the banks’ problems are likely to continue to get worse for some time to come. The Times article specifically notes that "the losses on current failures stem mostly from construction loans," but that commercial real estate could be "the next problem area." Commercial real estate loans typically must be refinanced every few years, and with rents down and vacancies up, "some owners are just walking away from their buildings."

 

Finally, an August 23, 2009 New York Times article entitled "What the Stress Tests Didn’t Predict" (here) confirms, based on a comprehensive review of over 7,000 banks (but excluding the 19 money center banks), that there was "more stress in the banking industry in the second quarter of 2009 than in the immediately preceding periods" and that "even the best run banks are having trouble escaping the impact of a sluggish economy and high unemployment."

 

A recent SEC enforcement action alleging Foreign Corrupt Practices Act violations against Nature’s Sunshine Products and two of its officers may represent a new and disturbing liability threat to corporate officials. The SEC asserted claims directly against the two individuals even though they were not alleged to have either involvement in or knowledge of the alleged misconduct, based solely on their "control person" responsibilities. These allegations, which experts say may represent the first of its kind to be alleged, could represent a troublesome new liability exposure for officers and directors.

 

The SEC’s Enforcement Action

As reflected in the SEC’s July 31, 2009 litigation release (here), the SEC filed a complaint (copy here) in the Central District of Utah against the company, alleging that in 2000 and 2001, the company had made $1 million in payments to Brazilian customs officials in order to facilitate the company’s importation of certain of its products. The complaint alleged that the company had violated the FCPA’s antibribery, books and records, and internal control provisions.

 

The complaint also alleges claims against Douglas Faggioli, the company’s CEO who at the time had been the company’s COO and a member of its board of directors, and against Craig D. Huff, who is no longer with the company but who served as the company’s CFO at the time.

 

With regard to Faggioli, the SEC alleged that his position gave him supervisory responsibility for the senior management of and policies regarding the worldwide distribution of the company’s products. The SEC alleged that Huff had supervisory responsibility for the senior management of and policies regarding the company’s books and records. Both were alleged to have failed to adequately supervise the company’s personnel in 2000 and 2001 to keep the company’s book and records accurately and to devise and maintain a system of books and records sufficient to adequately monitor company activities.

 

Neither the company nor the individuals admitted wrongdoing, but the company agreed to pay a civil penalty of $60,000 and the individuals each agreed to pay a civil penalty of $25,000

 

Discussion

According to an August 11, 2009 memorandum from the Shearman and Sterling law firm (here), the significance of the case is that control person liability allegations have "rarely (if ever) been used by the SEC in FCPA cases."

 

The memo also notes that the SEC did not allege that Fagiolli or Huff were involved the payments or even aware of the improper accounting for the payments. As the memo states, "the SEC’s decision to charge Faggioli and Huff with control person liability without alleging that either of them participated in or had personal knowledge of the FCPA violations raises the disturbing spectre [sic] of strict liability for executives."

 

In a separate interview published in the National Law Journal on August 20, 2009 (here), Philip Urofsky of Shearman and Sterling noted that at least in the civil context, control person liability "has been used against a much wider variety of corporate officers and even directors," so there is even a potential for control person allegations for FCPA violations to be raised against directors, "at least where the directors are very active and involved in the operations of the company."

 

The possibility that directors and officers could be held liable for FCPA violations without any culpable involvement or even knowledge of the misconduct represents a disturbing new potential liability threat to corporate officials. This threat is all the more troublesome because the SEC, under pressure to reestablish its regulatory credentials, has made it clear that FCPA enforcement will be a high priority.

 

Indeed, in an August 5, 2007 speech (here), Robert Khuzami, the SEC’s new Division of Enforcement head, among other things announced the formation of a new FCPA unit, saying that "more needs to be done" to enforce the FCPA. He described the unit’s goals as "being more proactive in investigations, working more closely with our foreign counterparts, and taking a more global approach to these violations."

 

There is no private right of action under the FCPA itself. However, civil litigants have long relied control person liability allegations in claims against corporate officials. Whether these civil litigants can use these theories of control person liability for FCPA violations remains to be seen, although that seems unlikely give the absence of private right of action for FCPA violations.

 

However, as I have frequently noted (most recently here), one of the exposures facing corporate officials related to FCPA enforcement activity is the possibility of follow-on civil litigation – indeed, Nature’s Sunshine Products is itself the subject of a securities class action lawsuit in which investors have alleged that the company and certain of its directors and officers made misrepresentations about the company’s internal controls and financial statements as a result of the overseas FCPA violations. As discussed here, the case previously survived the defendants’ motion to dismiss.

 

To the extent corporate officials are held liable by the SEC for FCPA violations on control person liability theories, they could also potentially be susceptible to claims by private litigants based on alleged fiduciary duty breaches. In addition, other civil claims, including claims based on alleged violations of disclosure duties under the securities laws, could be bolstered by an SEC enforcement action alleging control person liability claims.

 

In short, these developments may represent a significant new area of D&O liability exposure, or at least a significant extension of previously existing exposures. The typical D&O liability insurance policy would not likely cover any fines or penalties imposed on corporate officials for their control person liability, but their expenses incurred in defending against the claims likely would be covered under the typical policy, as would their defense expenses and any settlements or judgments against them in any follow-on civil litigation. Because of these possibilities, these developments potentially could represent a significant new loss exposure for the D&O insurers, too – or at least an expansion of a previously existing exposure.

 

One final note is that there seems to be a disturbing new trend where the SEC is seeking to use its authority to impose liability on or to effect recoveries upon corporate officials even where the individuals themselves are not alleged to have engaged in culpable misconduct. As I noted here, the SEC recently took steps to try to clawback executive compensation form the CEO of CSK Auto even though he was not alleged to have any knowledge or involvement in the events that required the company to restate its previously issued financial statements. In the Nature’s Sunshine Products case, the SEC sought to impose control person liability on the two individual defendants despite their lack of culpable participation in or awareness of the FCPA violations.

 

I recognize that the SEC is under pressure to show that it is tough and that it is a trustworthy regulatory guardian, but I find this new willingness to try to impose liability on individuals who are not themselves alleged to have engaged in culpable misconduct troubling. I recognize the theoretical appeal of a "captain of the ship" type approach to corporate misconduct, but I still think individuals without culpable participation in or even awareness of misconduct ought not to be subject to the burden, humiliation and expense of governmental enforcement activity. The pursuit of persons lacking culpability seems to me like the essence of overzealous regulatory action.

 

That said, I note that the law firm memo linked about does recite certain background features of the Nature’s Sunshine Product case that may go a long way toward explaining why the SEC sought to impose control person liability in this particular case. It is entirely possible that the claims asserted are simply a reflection of the facts involved, and nothing more.

 

Special thanks to the several readers who sent me links regarding the Nature’s Sunshine Products case.

 

Has Global Financial Turmoil Increased FCPA Risks?: The FCPA prohibits corruptly offering or providing anything of value to "foreign officials." As a result of the global financial crisis, government ownership in a wide variety of enterprises has proliferated. According to an August 10, 2009 New York Law Journal article by Stephanie Melzer and Christopher Tierney of the Cadwalader law firm entitled "Has Economic Uncertainty Expanded the Reach of the Foreign Corrupt Practices Act?" (here), the number of "foreign officials" may have dramatically increased, in ways that could have transformed long-established business practices into conduct violative of the FCPA.

 

The authors show that the published guidance and case law resources do not really establish conclusively what level of governmental involvement or ownership in an enterprise is required in order for an entity’s representative to be a "foreign official." Various settlements do show that U.S. authorities have been willing to extend the FCPA to "conduct involving payments to employees of entities that are less than majority-owned or controlled by foreign governments."

 

Accordingly, the authors conclude that given the massive amounts that governments have injected in a wide variety of enterprises, "a legitimate question arises whether employees of previously private enterprises will be viewed as ‘foreign officials’ under the FCPA." In short, "the current financial crisis may have turned some previously private employees into ‘foreign officials.’" – creating the unsettling possibility that previously acceptable and appropriate business entertainment or other ordinary business activities could now be alleged to constitute conduct violative of the FCPA.

 

Does FCPA Enforcement Encourage Corruption?: It may sound counterintuitive, but a recent paper (here) by attorney and scholar Andy Spaulding suggests that among the "unintended consequences" of aggressive FCPA enforcement may be that it could cause corruption to proliferate unimpeded in emerging markets.

 

As reflected in an August 5, 2009 Wall Street Journal article discussing Spaulding’s paper (here), Spaulding contends that FCPA enforcement might be deterring corporations from investing in developing countries where corruption is rampant. But if U.S. corporations stop investing in emerging markets, entities from other nations that are not as committed to fighting corruption will step in. As Spaulding puts it, "’black knights’ will move in to fill the void," as a result of which "the world economy could slowly begin to bifurcate into two economies: one in which bribery is tolerated and one in which it is not."

 

Spaulding concludes that "the FCPA is thus revealed to be a large-scale study in the law of unintended consequences."

 

Portrait of a Corrupt Society: An August 22, 2003 Wall Street Journal article entitled "Pride and Power" (here), about the current political and economic conditions in Russia, reported the following about the culture of corruption in that country:

 

One of the major obstacles to conducting business in Russia is the all-pervasive corruption. Because the government plays such an immense role in the country’s economy, controlling some of its most important sectors, little can be done without bribing officials. A recent survey by Russia’s Ministry of the Interior revealed, without any apparent embarrassment, that the average amount of a bribe this year has nearly tripled compared to the previous year, amounting to more than 27,000 rubles or nearly $1,000.

 

And Finally: For those readers who like me are fascinated with these emerging FCPA-related issues, The FCPA Blog is an absolutely essential daily read. The blog’s author, Richard Cassin, regularly updates the key developments in anticorruption activities around the globe. For example, Cassin’s take on Spaulding’s provocative paper about the FCPA’s unintended consequences can be found here.

 

Could Madoff-related losses be insured under a homowners’ insurance policy? That is what is claimed in a class action complaint filed on August 19, 2009 in the Southern District of New York by Robert and Harlene Horowitz against their homeowners’ insurer and related entities. Their complaint (which can be found here) alleges that the insurer denied coverage under its policy for the more than $8 million that the Horowitzes claim to have lost in the Madoff scandal.

 

The plaintiffs claim that their homeowners’ policy contains a so-called Fraud SafeGuard provision, which insures against the "loss of money, securities or other property … resulting from fraud, embezzlement or forgery perpetrated against [policyholders] or [policyholders’] family member[s] during the Policy Period."

 

The Horowitzes claim that they had a family trust account, of which Robert Horowitz was trustee, with Bernard Madoff Investment Securities. They claim that their final balance on the BMIS account was over $8.5 million.

 

The complaint alleges that when they submitted their claim seeking payment for their claimed losses (which they assert is the full $8.5 million amount), the insurer denied coverage "on several grounds, all of which are erroneous."

 

The complaint is filed as a class action on behalf of all the policyholders under the defendants’ homeowners’ insurance policies with coverage for Fraud SafeGuard events and that lost money in the Madoff scheme.

 

The complaint asserts claims for breach of contract; breach of the implied covenant of good faith and fair dealing; and unjust enrichment. The class action seeks compensatory damages as well as "declaratory and injunctive relief to end the Defendants’ improper practices."

 

Though the complaint alleges that the defendants’ have denied coverage entirely for the plaintiffs’ claimed loss, a significant portion of the complaint is devoted to the plaintiffs’ contention that they are entitled to recover the full amount of their claimed $8.5 million loss, and not just the (unspecified) amount of the initial investment. They claim entitlement to the supposed investment gains that the plaintiffs’ believed they had earned on the BMIS account.

 

The plaintiffs argue that their loss is "the amount shown on their last account statement," and that their loss "cannot be erased by Defendants’ ad-hoc, after the fact definition of covered loss." The plaintiffs argue that in any event, they are at least entitled to implied interest on the initial investment as well as non-recoverable tax payments that had been made based on the Madoff statements.

 

The complaint also recites and refutes the applicability of the long list of policy exclusions on which the insurer relied in denying coverage, including, for example, that the policy does not cover loss caused by "the confiscation, destruction or seizure of property by any government or public entity or their authorized representative"; and that the policy does not cover "indirect loss resulting from any fraud guard event, including, but not limited to, an inability to realize income that would have been realized had there been no loss or damage to money, securities or other property."

 

It is interesting that the complaint was filed by the Milberg law firm, which may not be the first firm you think of when you think of insurance coverage litigation — but on the other hand over the years, the firm has been in the forefront of class action litigation (albeit usually in the securities context), which may explain in part the fact that the complaint was filed as a class action.

 

When I noted recently (here) the arrival of the Madoff coverage litigation, I predicted that there would be a great deal more litigation to come. But I never expected that the first class action coverage lawsuit would be based on homeowners’ coverage. For that matter, I have to confess that I didn’t foresee the involvement of homeowners’ coverage at all. But if the Horowitzes get any traction with their lawsuit, I suspect that we could see a whole lot more litigation raising similar allegations. There may be many more claims to come under other kinds of first-party coverages, as well.

 

The one thing I know for sure is that earlier this year, when various commentators were putting out their estimates on the likely aggregate insurance losses from the Madoff scandal, they did not factor in the possibility of losses under homeowners’ insurance policies.

 

In any event, I have added the new class action complaint to my register of Madoff-related litigation, which can be accessed here. The insurance coverage litigation of which I am aware so far is listed in Table V of the Madoff lawsuit register.

 

I continue to believe that there will be a great deal more Madoff-related insurance coverage litigation, and as I become aware of any new cases I will add them to the register. I hope readers who become aware of Madoff-related insurance coverage lawsuits will please let me know (anonymity protected upon request, of course).

 

Special thanks to a loyal reader for bringing the Howowitz lawsuit to my attention.