A recent German legislative action creates some interesting requirements for and limitations upon insurance for German corporate director liability. These legislative changes are designed to try to ensure greater director exposure to personal liability, as a deterrent to corporate misconduct. However, the legislative changes are susceptible to circumventions that may limit their intended effects.

 

As reflected in a July 1, 2009 memo by Anthony Menzires and Dr. Gunbritt Kammerer-Galahn of the Taylor Wessing law firm entitled “D&O Insurance in Germany – The New Legislation Arrives” (here), on June 18, 2009, the Bundestag enacted the new Act on the Adequacy of Managerial Salaries.

 

 

Among other things, this new Act will impose a new requirement that German Stock Corporations (Aktiengesetz) purchasing D&O insurance for their executives must impose a personal deductible to be borne by the directors in an amount equivalent to at least 10% of the relevant loss, up to an annual cap. Comments accompanying the Act specify that the annual cap must be set at not less than one and one half the annual fixed remuneration of the director.

 

 

These requirements are applicable to all stock corporations, whether listed or publicly owned.

The requirements will to into effect immediately following the Act’s ratification by the Bundesrat on July 10, 2009, with immediate effect on all D&O insurance policies formed after that date and with a further requirement that all existing policies must be amended to bring them into compliance by July 1, 2010.

 

 

According to the law firm’s memo, these new statutory requirements codify long-standing German governance guidelines that had encouraged companies to structure their D&O insurance with a deductible to be borne personally by the directors as a way to “motivate them to avoid claims arising.” The memo observes that many German corporations “circumvented” these voluntary requirements.

 

 

The elevation of these provisions into statutory mandates represents an apparent legislative attempt to try to use the threat of personal liability to deter corporate misconduct. The German legislature’s action raises a couple of questions: Will the statutory requirement be effective? And will other countries follow?

 

 

As for whether the requirement will be effective in deterring corporate misconduct, there are certain aspects of the statutory requirement that are worth considering. The first is that that under the German two-tier system of board governance, the requirements apply only to D&O insurance for the management board (Vorstand) and not to the non-executive supervisory board (Aufsichtsrat). At a minimum, then, the deterrent effect, if any, is limited solely to the management board and would not reach the supervisory board.

 

 

The other aspect of the statute that may affect its effectiveness is the fact that the Act does not prohibit the acquisition of separate insurance for the individual director’s deductible exposure, which presents a rather obvious new product opportunity for German D&O insurers. And while the premium cost would have to be borne personally by the director, there is, as the memo notes, nothing to prevent each director from “seeking a commensurate uplift in their remuneration to cover the outlay.” Furthermore, there apparently is no existing requirement that would compel the corporation to disclose this type of compensation arrangement.

 

 

Whether other countries might follow the German legislation and enact similar statutory requirements may depend on whether the German requirement proves to be effective in deterring corporate misconduct. While the results from the statutory requirement remain to be seen, the apparent ease with which the personal exposure could be insured may well limit the deterrent effects.

 

 

The obvious logical step, then, might be to suggest that other countries considering the German requirement add further specifications that the director cannot acquire separate personal insurance to protect against the required liability exposure. My own view is that there are several critical considerations that should be taken into account before these kinds of prohibitions are imposed.

 

The first is that directors ought to be able to defend themselves, and so there should be no prohibition for the insurance providing defense expense protection. The second is that fundamental fairness requires that the barriers should apply only if an adjudication has determined that the director actually violated liability standards, and accordingly the statutory prohibition should only apply to judgments.

 

While the number of securities class action filings through the year’s first half still project to an annualized filing rate consistent with historical averages, there was a noticeable slackening in the number of new securities lawsuits filed as the second quarter of 2009 progressed. New filings in the second quarter were well below the number of filings in the first quarter as well as in last year’s second quarter. There were few new filings in May and even fewer in June.

 

Overall, the filings continue to be largely concentrated in the financial sector. In addition, as discussed below, a significant number of the securities lawsuit filings in the first half of 2009 did not involve publicly traded companies, but instead involved other types of entities, such as private investment partnerships and mutual funds.

 

 

Based on my review of the securities filings through June 30, 2009, there were 94 securities class action lawsuits filed in the first half of 2009. (Please see my comments below on the topic of “counting” the lawsuits during the year’s first half.) The 94 first half filings represent an annualized filing rate of 188, which is slightly below but within range of the average number of filings of 197.7 during the 13-year period between 1996 and 2008. The annualized rate of 2009 filings is also below the average filing level of 204.7 for the most recent seven year period of 2002 through 2008.

 

 

The filing level during the second quarter of 2009 was below both the first quarter of this year and last year’s second quarter. There were only 35 new securities lawsuit filed during the second quarter of 2009, compared to 59 during the first quarter of this year and 56 in the second quarter of 2008.

 

 

The lower filing level during the second quarter of 2009 reflects the low number of new securities class action lawsuit filings during the months of May and June. There were just eleven new securities lawsuit filings in May and only six in June. The June filings represent the lowest monthly number of new filings since December 1996, when there were just five new securities class action filings.

 

 

But though there were fewer new securities class action filings during the second quarter of 2009, the total number of filings for the twelve-month period ending June 30 remains within historical annual averages. There were 205 new filings during the twelve month period ending on June 30, 2009, which, though below the 219 new filings during the twelve month period ending on June 30, 2008, is consistent with the average annual number of filings noted above.  

 

 

In addition to the filing activity levels, the first half filings were characterized by the relatively unusual types of claimants involved. For example, as many as ten of the first half lawsuits were filed on behalf of holders of preferred or subordinated securities. As I noted at greater length here, these are relatively unusual claimants.

 

 

The securities class action litigation targets during the first half were also unusual. An uncharacteristically high number of the first half lawsuit defendants were entities other than public companies, including private investment partnerships, mutual funds, and other nonpublic entities. As many as sixteen of the new first half lawsuit filings involved primary defendant entities that lacked Standard Industrial Classification code (SIC) designations. As many as eight of the new filings in the first half involved mutual funds (many of them in the Oppenheimer mutual fund family).

 

 

One characteristic that the first half filings did have in common with the filings in immediately preceding periods is that the new filings continue to be concentrated in the financial sector. Though the first half filings represented 38 different SIC Code classes, fully 51 of the first half filings against entities with SIC Codes involved companies in the 6000 SIC Code series (Finance, Insurance and Real Estate). In addition, virtually all of the 16 actions involving entities that lacked SIC codes also involved enterprises in the financial sector, so that more than two-thirds of the new first half filings involved financial services entities of one kind or another.

 

 

The concentration of the filings in the financial sector is largely a result of the continuing subprime and credit crisis litigation wave. By my count, 51 of the first half filings involved subprime and credit crisis related allegations. My complete list of all subprime and credit crisis securities lawsuit filings can be accessed here.

 

 

Another factor contributing to the concentration of securities lawsuit filings in the financial sector is the number of new securities class action lawsuits that were filed in the first half related to the Madoff scandal. By my count there were 11 new Madoff-related securities lawsuit in the first half, although there were many more duplicate Madoff-related lawsuits filed during that same period as well. My complete list of the Madoff related lawsuit filings can be accessed here.

 

 

The first half securities lawsuit filings were filed in 26 different courts, but fully 45 of them, or nearly half, were filed in the Southern District of New York.

 

 

Eighteen of the first half lawsuit filings involved foreign domiciled companies, representing ten different countries. The country with the largest number of first half filings was the United Kingdom. However, a number of these lawsuits against foreign-domiciled companies involve multiple separate lawsuits against a single target. For example, the six lawsuits filed against U.K. companies actually involve just two different companies, Royal Bank of Scotland and Barclays.

 

 

Of the actions against U.S.-domiciled companies, the first half lawsuits involved companies from 22 different states, with the largest number in New York (28) and California (12).

 

 

Why the Apparent Slowdown?: There may be any number of possible reasons for the relative slowdown in the number of filings during the second quarter. My own theory is that the plaintiffs’ lawyers may have found themselves in a logjam, due to two factors. One factor is the onslaught of Madoff-related litigation (which is not fully reflected in the above numbers but has nevertheless been massive) Another factor is the sheer quantity of previously filed subprime and credit crisis-related litigation, which in many instances has reached critical procedural stages.

 

 

If I am correct about the reasons for the second quarter slowdown, then the downturn could proved to be temporary and filing levels could ramp back up as plaintiffs’ lawyers circle back and attempt to work off the backlog. (Indeed, I have previously noticed signs that plaintiffs lawyers could already have been working off backlogs from earlier periods, as noted here). My view is that we will soon see filing activity return to historical norms. Of course, only time will tell.

 

 

Some Comments on “Counting”: The various litigation statistical services will also be issuing their counts for the first half of 2009 and their counts almost certainly will vary from mine. Because the Stanford Law School Securities Class Action Clearinghouse publishes all of the actions that it includes in its running tally, it is easiest for me to compare my count with theirs, and so I already know that my count differs from theirs, as I have both omitted lawsuits Stanford Clearinghouse has counted and I have counted lawsuits that the Stanford Clearinghouse omitted.

 

 

I have set forth these differences below not because I think I am right and alternative version wrong, but simply so readers might be able to understand the differences. Reasonable minds might well reach different conclusion as to whether the items mentioned below should or should not be recognized in any count.

 

 

Thus, I have omitted at least a couple of cases from the Stanford Clearinghouse list that to me appear to represent double counting of lawsuits that were counted elsewhere in the Clearinghouse’s list. (Refer for example here and here for examples of cases previously counted in the Stanford Clearinghouse tally.) Also, because I only count class actions seeking damages for disclosure violations under the federal securities laws, I have omitted merger objection lawsuits (refer for example here).

 

 

By the same token, I have included federal securities class action lawsuits that were filed in state court (refer for example here), which the Stanford Clearinghouse did not. I have also included a number of other actions that do not appear on the Stanford Clearinghouse list, including lawsuits involving Metaldyne (here); Royal Bank of Scotland Series Q preferred shares (here), Deutsche Bank Alt-A Securities (here); Merrill Lynch Mortgage Pass-Through Certificates (here); FM Multi-Strategy Investment Fund (here); Citigroup 8.125% Non-Cumulative Preferred Stock, Series AA (here); Agape World (here); Wells Fargo Mortgage Pass-Through Certificates Series 2006 et seq. (here); Citigroup 8.50% Non-Cumulative Preferred Stock (here); and Thornburgh Mortgage Pass-Through Certificates (here).

 

 

During the first half of 2009 the seemingly simple process of counting new lawsuit filings was extraordinarily complicated. As the filings have continued to emerge involving different classes of securities, it is increasingly challenging to determine whether or not each additional complaint represents a duplicate lawsuit or a separate action. In addition, the flood of Madoff-related litigation has involved an enormous number of similar or overlapping lawsuits.

 

 

If you would like a particularly challenging example of the difficulties involved in “counting,” refer to this June 30, 2009 press release in which plaintiffs’ counsel describe the class complaint they filed in the Eastern District of California on behalf of holders of derivative interests in bonds issued by the California Infrastructure and Economic Development Bank. To greatly oversimplify the action, the lawsuit alleges that the bond documents misrepresented certain bond attributes, for which the plaintiffs seek to recover damages under the federal securities laws. It is an investor class action lawsuit seeking to recover damages under the federal securities laws, and for that reason I included it in my count. On the other hand, it involves public financing authority rather than a public company; others might not count it. Read the press release and I think you will see what I mean. This is not simple.

 

 

Whether or not to count any of these complaints as a new action or as a duplicate lawsuit, or at all, is enormously challenging and reasonable minds almost certainly would reach differing results. The various published versions of the number of lawsuits filed during the first half of 2009 almost certainly will vary, perhaps substantially.

 

 

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.

 

On Friday June 26, 2009, in the highest number of bank closures on a single day since 1992, the FDIC assumed control of five more banks, bringing the YTD total number of failed banks to 45, compared to 25 for all of 2008. In addition, at the same time as bank closures surge, there are growing signs that both private litigants and the FDIC intend to pursue claims against the former directors and officers of the failed institutions.

 

The five banks closed on Friday are Mirae Bank of Los Angeles, California, which prior to its closure had assets of $456 million (and about which refer here); MetroPacific Bank of Irvine, California, which prior to its closure had assets of $80 million (refer here); Horizon Bank of Pine City, Minnesota, which had assets of $87.6 million (refer here); Neighborhood Community Bank, of Newnan, Georgia, which had assets of $221,6 million (refer here); and Community Bank of West Georgia, Villa Rica, Georgia, which has assets of $199.4 million (refer here).

 

 

The closure of the two Georgia banks continues the pattern of a high concentration of bank failures in that state. With the addition of these two latest closures, the number of bank failures in Georgia since January 1, 2008 now stands at 14, the highest number of any state. There have been nine bank closures in Georgia already so far in 2009. My prior post discussing the Georgia bank failures at greater length can be found here.

 

 

The closure of the two California banks brings the total number of failed banks in California since January 1, 2008 to eleven. There have been seven bank failures in Illinois and four in Florida since the beginning of 2008. The FDIC’s complete list of all banks that have failed since October 2000 can be found here.

 

 

The relatively small size of all five of the banks closed this past Friday night continues the concentration of bank failures in the community banking sector. Of the 45 bank failures so far this year, 39 have involved institutions with assets under $1 billion. Only eleven of the 45 had assets over $500 million.

 

 

Some litigation against the directors and officers of these failed banks has already begun to emerge. As I previously noted (here), from among the six of the 25 banks that failed in 2008 have become involved in securities class action litigation, even though only eleven of the 25 were publicly traded.

 

 

Shareholders of failed banks are also starting to file shareholders’ derivative and individual litigation against the directors and officers of failed banks. For example, on May 28, 2009, a shareholder of Meridian Bank of Madison County, Illinois, which regulators closed on October 10, 2008 (refer here), filed a complaint (here) in Madison County (Illinois) Circuit Court against the former President of the bank and two former directors. The complaint combines derivative and individual claims. Among other things, the complaint alleges that the directors engaged in self-interested transactions and that the bank’s practices and procedures were detrimental, resulting in the bank’s closure by federal regulators and in damages to the bank’s shareholders.

 

 

In addition, according to a June 14, 2009 article in the FinCri Advisor (here, registration required), the FDIC is currently assessing whether to pursue claims against the former directors and officers of failed financial institutions. According to the article, the FDIC has begun the process of potentially suing directors and officers, by sending claims letters to ousted officials advising them of the FDIC’s intent to pursue claims.

 

 

Because the FDIC typically assumes control of failed banking institutions after the close of business on Friday evenings, it seems relatively unlikely that there were be any further bank closures in June 2009. However, the 45 closures in the first half of the year alone already represent an 80% increase over the total number of closures during all of 2008.

 

 

With the continued stress in the general economy, the deteriorating condition of the commercial real estate sector, and the elevated levels of unemployment, the likelihood is that the number of bank closures will continue to grow as the year progresses. Indeed, In the FDIC’s most recent Quarterly Banking Profile (as of March 31, 2009), the FDICcounted 305 institutions with assets of $220 billion on its Problem List. The Problem List is up from 252 institutions with $118 billion in assets at the end of the third quarter of 2008, which in turn was up from 117 institutions with $78.3 billion in assets as of the end of the second quarter. (The FDIC does not identify the problem banks by name.)

 

 

At the same time, there would appear to be a growing likelihood of claims against the former directors and officers of at least some of the failed banks. As I have previously noted (here), these developments have already registered in the D&O insurance marketplace for community banks, which has quickly become characterized by rising prices and narrowing terms and conditions.

 

 

Hat tip to the Courthouse News Service (here) for the Meridian Bank complaint.

 

 

Children’s Place Settles Securities Suit: In a June 26, 2009 filing on Form 8-K (here), The Children’s Place Retail Stores announced the settlement of the consolidated securities class action litigation that had first been filed against the company and certain of its directors and officers in the Southern District of New York in September 2007. Background regarding the securities lawsuit can be found here.

 

 

According to the 8-K, in the settlement, the company agreed to pay $12 million for a release of all claims. The cost of the settlement, according to the 8-K, “is covered by the Company’s insurance.”

 

 

Securities Suit Against FX Energy Dismissed: In an order dated June 25, 2009 (here), District of Utah Judge Clark Waddoups granted the defendants’ motion to dismiss the securities class action lawsuit that had been filed against FX Energy Corporation and certain of its directors and officers. Background regarding the case can be found here.

 

 

As summarized in the June 25 opinion, the plaintiffs alleged that the defendants had made two essential sets of misrepresentations. First, the plaintiffs alleged that in press releases and in a slide presentation the defendants had falsely represented that the decision to drill for gas at two sites was “based on well-established scientific and geological data,” while the defendants had in fact (the plaintiffs alleged) used only two-dimensional (2D) seismic data while suggesting that they had used three-dimensional (3D) data. Second, the plaintiffs alleged that the defendants had touted the proximity of the Sroda-5 and Lugi-1 sites to other successful wells as a significant factor indicating that gas could be located at one of the two sites, knowing that this representation was untrue.

 

 

With respect to the allegedly misleading statements regarding the type of seismic data used, the court found that reading all of the allegedly misleading statements, it “cannot find any statements that reasonably imply that FX Energy was using 3D seismic data.” To the contrary, the court found “the non-specific references to 2D and 3D in these documents give one the impression that FX Energy was generally using 2D but had plans to use 3D at some future time.” Accordingly, the court found with respect to the first set of allegations that the plaintiffs had not sufficiently pleaded fraudulent statements or omissions.

 

 

With the second set of alleged misrepresentations, the court found that the plaintiffs had adequately alleged that the defendants’ statements implied that the Lugi-1 and Sroda-5 wells would have a higher chance of success given the success of other wells in the vicinity. However, the court found plaintiffs allegations were still insufficient to establish a claim for securities fraud due to the complaint’s failure to properly plead scienter.

 

 

Specifically, the court found that there was a plausible opposing explanation for defendants’ statements, which is “that the Defendants actually believed that they were true.” The court found that it did not believe that a reasonable person would conclude that that the plaintiffs’ allegations that the defendants acted with scienter was at least as compelling as the opposing inference.

 

 

As the court said, “to accept Plaintiffs’ allegations, one would have to believe that Defendants knew that their information on Lugi-1 or Sroda-5 was unreliable and actually had strong information that those wells were dry, but nonetheless planned to drill there, repeatedly publicized those plans, and they expended significant resources to actually drill there, all on the chance that taking these actions might artificially inflated stock prices.” The court also found that the plaintiffs’ reliance on the testimony of confidential witnesses and on the defendants’ trading in their share in company stock were unavailing.

 

 

Accordingly the court granted the defendants’ motion to dismiss the plaintiffs’ complaint.

 

 

Hat tip to Adam Savett of the Securities Litigation Watch (here) for the link to the Children’s Place 8-K and to the June 25 opinion in the FX Energy case.

 

One of the most striking things I have found when talking to corporate officials about D&O insurance is how different the conversation can be when talking to non-officer directors compared to talking to corporate officers. Without meaning to over-generalize, the two groups sometimes have different questions and concerns. And indeed there are very good reasons why the insurance needs and interests of non-officer directors should be analyzed differently from those of the corporation and its officers.

 

By way of background, these issues arise in the context of the traditional D&O insurance policy, which may have potential conflicts of interest built right into its frame. By way of illustration, after I recently made a recent presentation about D&O insurance to a group of noninsurance professionals, one of the audience members (an economist) came up to me to express his astonishment that both a company’s inside officers and its non-officer directors would be insured under the same policy of insurance. When you think about it, it may not make much sense, but that is the way the insurance typically is structured.

 

 

Not only are there two potentially conflicting sets of individuals yoked together in the traditional D&O insurance policy, but since the mid-90s, the traditional D&O insurance policy has also incorporated so-called “entity coverage” for securities claims, providing the company with balance sheet protection and representing yet another potential conflict within the policy with respect to the interests of the non-officer defendants.

 

 

In recent years, the insurance marketplace has developed and materially improved a variety of alternative insurance vehicles designed to ensure a dedicated source of insurance protection for the individuals insured under the D&O insurance program. These alternative approaches include excess Side A insurance, which effectively provides catastrophe insurance for the protection of individual directors and officers, and individual director liability insurance (IDL), which protects a single individual. These products can be further customized to protect a specific group of individuals – for example, the non-officer directors.

 

 

Not every company wants, needs or can afford to acquire these alternative products in addition to their traditional D&O insurance. But every company should consider them. And these days, an increasing number of companies do purchase some form of these alternative products, typically Side A excess insurance. But both with respect to the companies declining to purchase these products and with respect to many of the companies that do, the assessment of these alternative or supplemental structures often is not taken from the perspective of the needs and interests of the non-officer directors.

 

 

It is this conversation topic – the one about the non-officer board members’ interests in the structure of the D&O insurance program – that represents the heart of the difference that arises between speaking about D&O insurance to outside board members compared to talking about these issues to corporate officers.

 

 

In my experience, outside board members are keenly interested in learning more about the protection afforded by these alternative products and the ways the D&O insurance program can be structured to maximize their protection. In particular, non-officer directors want to know about the ways the insurance program can be structured so that there is dedicated insurance set aside that cannot be eroded or exhausted by the defense expenses and indemnity obligations of the company or the company’s officers. They want as much reassurance as they can get that no matter what happens, they will not have to go out of pocket in any way.

 

 

Corporate officers, even those who recognize the theoretical value of these products, often are most concerned with considerations pertaining to cost. Even officials persuaded of the need for the company to acquire excess Side A insurance to protect the individual directors and officers may not be susceptible to persuasion of the need for separate limits set aside just for the outside board members, and frequently the stumbling block to further consideration of these issues is an unwillingness to incur additional D&O insurance expense.

 

 

These issues recur with sufficient frequency that it is my universal recommendation to non-officer board members that they request a separate presentation directly to the board about the company’s D&O insurance, to afford all of the board members a separate opportunity to inquire about their interest and the level of insurance protection available to them.

 

 

Another step I have found an increasing number of concerned board members requesting is a separate review of their company’s D&O insurance program by an outside and independent insurance professional, on behalf of the board. An independent review not only facilitates a separate determination whether or not the non-officer board members’ needs and interests are appropriately addressed, but it also facilitates a separate inquiry whether the terms, conditions, and structure of the program adequately addresses all of the interests insured.

 

 

This latter point bears emphasizing – that is, there is considerable value in having the D&O insurance program separately and independently reviewed. D&O insurance is of course only one part of the company’s overall insurance program, but from the outside board members’ perspective, the D&O insurance is the only insurance the company has that insures them directly, so they are highly motivated that the insurance program is the best available.

 

 

Though both the company’s officers and its board members are equally interested in ensuring the adequacy of the D&O insurance program, my own experience is that a separate insurance audit on behalf of the non-officer board members frequently discloses a variety of ways the overall D&O insurance program might be improved, sometimes materially.

 

 

Another constituency that may have an interest in having an independent insurance review is the board of a corporate subsidiary, particularly where the subsidiary’s board is separately constituted from the parent company’s board. Though the corporate parent’s D&O insurance typically will provide protection for the subsidiary’s directors and officers, there are occasions when the subsidiary board’s interests are sufficiently distinct that the subsidiary’s board would be well advised to at least consider whether or not to acquire a separate policy dedicated to their own protection. These interests are particularly noteworthy for subsidiaries of large financial services companies, when the subsidiary board may have its own distinct liability exposures as well as a separate interest in the availability of insurance limits dedicated to their protection.

 

 

As I noted above, the interests of a wide variety of insureds are yoked together in a single D&O insurance program. But that does not mean that the various constituencies’ interests cannot be considered separately. A separate consideration of competing and sometimes conflicting interests can sometimes result in the selection of different insurance structures. In addition, as noted above, an independent insurance audit can provide an opportunity for the separate review of the adequacy and appropriateness of the terms and conditions in the applicable policies.

 

On June 19, 2009, the Fifth Circuit, in a per curiam opinion (here) written by a panel that included retired Supreme Court Justice Sandra Day O’Connor sitting by designation, reversed and remanded the district court’s denial of class certification and entry of summary judgment in defendants’ favor in the Flowserve securities class action lawsuit.

 

CORRECTION: The original version of this post suggested that Justice O’Connor herself had written the June 18 opinion. In light of  reader comments (please see below) I have revised this post to reflect the fact that the Fifth Circui’s decision was in the form of a per curiam opinion that does not indicate which member of the panel authored the opinion. The entire staff here at The D&O Diary apologizes for any confusion our original post may have caused.

 

With respect to the class certification issue, the Fifth Circuit vacated the district court’s refusal to certify the class based on what the Fifth Circuit found was the district court’s application of an erroneous standard on the loss causation issue, and remanded the case for further proceedings. In addition, the Fifth Circuit reversed the district court’s entry of summary judgment, essentially on the ground that the district court’s analysis on the loss causation issue for class certification purposes was not in any event dispositive of the loss causation issue on the merits, and therefore was not the appropriate basis for entry of summary judgment.

 

 

The Fifth Circuit’s opinion is noteworthy for a number of reasons. First, it represents a rare occasion where securities class action plaintiffs have succeeded, even if only provisionally and for the time being, in a circuit that is generally perceived as heavily defense oriented. It should be noted that there is nothing in the Fifth Circuit’s opinion that precludes the district court from ruling against the plaintiffs on either issue on remand; even with application of what the Fifth Circuit described as the correct legal standard, the district court could nonetheless again rule in the defendants’ favor.

 

 

Second, the Flowserve case represents the latest example of the Fifth Circuit’s struggles with the question of the proper consideration of loss causation issues at the class certification stage. These same or similar issues are presented in both the Belo securities case (about which refer here) and the Halliburton securities case (here), both of which are now also pending before the Fifth Circuit. Given the continuing controversy on these issues, it seems increasingly likely that these issues could wind up before the U.S. Supreme Court.

 

 

Finally, the opinion is perhaps most interesting for the final commentary provided in the opinion’s concluding paragraph:  

 

To be successful, a securities class-action plaintiff must thread the eye of a needle made

smaller and smaller over the years by judicial decree and congressional action. Those ever higher hurdles are not, however, intended to prevent viable securities actions from being brought.

 

 

Whether or not these remarks perhaps represent an expression of concern with how far the pendulum had swung in the Fifth Circuit in these kinds of cases, these words undoubtedly will be repeated by plaintiffs’ counsel in future filings, both inside and outside the Fifth Circuit, in support of the claims.

 

 

Very special thanks to a loyal reader for providing a copy of the Fifth Circuit’s Flowserve opinion.

 

 

Speakers’ Corner: During the period June 21-23, 2009, I will be in Palo Alto, California, where I will be participating as a faculty member at the Stanford Law School Directors’ College. A summary agenda for the event can be found here.

 

Various blogs and news articles expressed surprise and astonishment at the $2.876 billion judgment entered against Richard Scrushy in the HealthSouth state court derivative lawsuit, but a review of the June 18, 2009 memorandum opinion (here) that accompanied the final judgment shows that Jefferson County (Alabama) Circuit Court Judge Alwin E. Horn III actually ruled that the total amount of the damages to be the even more eye-popping amount of $3.115 billion. It was only the application of $239 million credit for judgments entered against other defendants that brought the number down to the $2.876 billion figure ultimately entered against Scrushy and other individual defendants.

 

It may well be wondered how on earth the court could have come up with these astronomical figures, whether before or after the application of the judgment credit. Part of the answer is the fraud itself, with Judge Horn described as “remarkable and perhaps unique in its duration, size and scope.”

 

 

Judge Horn’s opinion details what he describes as HealthSouth’s fraudulently reported net income during the period 1996 through 2002. The annual figures stated in the opinion, when added up, suggest that HealthSouth’s fraudulently reported net income exceeded its actual net income by over $3.138 billion.

 

 

However, Judge Horn’s damage calculation was not directly related to the massive scale of the fraud. Rather, it was calculated based on a variety of separate categories of damages including: excess bonuses paid to Scrushy ($10.4 million); amounts Scrushy gained on inside trades ($147.4 million); amounts the company spent on remediation, reconstruction and restatement of its financial records ($457.6 million); amounts the company spent during the period 2004 to 2006 on excess debt, consent fees, bond and credit payments as a result of the fraud ($1.147 billion);salaries and bonuses paid to fraud participants ($26.5 million); excess payments and loans to Scrushy-related enterprises ($260 million) and HealthSouth’s overpayment of taxes ($169.6 million).

 

 

These amounts, as staggering as they are, add up “only” to $2.2 billion. The total damages Judge Horn calculated reached $3.115 billion by the application of nearly one billion dollars in prejudgment interest. In determining the amount of interest, Judge Horn calculated the applicable interest rate in varying amounts over time, applying Delaware law and using the standard of five percentage points above the Federal Discount Rate, resulting in interest rates applied in some cases of as much as 10%.

 

 

Judge Horn’s opinion does not state whether post-judgment interest will also accrue, but presumably there are provisions for this interest under applicable law.

 

 

Whether or not further proceedings or appeals ultimately will substantiate all of these damage amounts and interest assessments, Judge Horn’s analysis represents a fascinating catalog of the harm caused to the company as a result of the fraud, as well as the ways that Scrushy himself profited. It should probably be noted that the possibility of an appeal may be complicated by the rather interesting question of how Scrushy could post an acceptable and adequate appeal bond.

 

 

Judge Horn’s opinion makes for interesting reading in other respects as well, particularly the ways that Judge Horn went about reaching factual conclusions despite having to deal with competing and conflicting testimony from witnesses he described as “six testifying felons.”

 

 

Among other things, Judge Horn relied on Scrushy’s own testimony in a prior case (the MedPartners case), in which Scrushy testified about what financial information a CEO must receive. Judge Horn described Scrushy’s testimony as an “unwitting confession,” because it showed that “for a fraud of even a billion dollars to occur over a period of years, the CEO had to know of the fraud.”

 

Assuming for the sake of argument that the massive judgment against Scrushy withstands further review, if any, the question will then become what if anything can be recovered on the company’s behalf. Though at one time he was a wealthy man, years of litigation and the panoply of claims against him undoubtedly have greatly reduced his former wealth. He may have a multibillion dollar judgment against him, but that does not make him a multibillion dollar man. Nor does it seem likely that the company’s recovery will ever remotely approach the amount of the judgment.

 

A June 19, 2009 Law.com article by Ben Hallman providing the backstory on the state court derivative lawsuit can be found here.

 

 

From Those Incredibly Large Amounts to Some Incredibly Small Numbers: After working with figures in the billions, it is hard focus on a dispute involving only very small fractions of a dollar, but that is what is involved in the securities class action lawsuit filed on June 18, 2009 in the Eastern District of Arkansas against Shearson Financial Network and certain of its directors and officers.

 

 

As reflected in the their June 19, 2009 press release (here), the plaintiff’s purported class action complaint (which can be found here) alleges that the defendants

 

caused a press release to be issued on May 7, 2009, that stated the Company had emerged from bankruptcy. In the press release, the Company used the ticker symbol, SHSNQ to identify itself, which was the ticker symbol belonging to the Company’s old stock which would ultimately be cancelled. However, at the time the Company issued the press release the stock listed under the ticker symbol SHSNQ was still trading and had not been cancelled. As a result of defendants’ false and misleading statements, Shearson’s securities traded at artificially inflated prices during the Class Period, reaching a high of $.039 on May 8, 2009.

On May 11, 2009, the Company issued a press release stating among other things that the stock trading under the ticker symbol SHSNQ would be cancelled and that Shearson’s new stock would trade under a different ticker symbol.

 

The complaint alleges that following the issuance of the May 11 press release the share price fell to $.0097 on trading volume of over 27.6 million shares. (That is, the share price decline three cents per share). Later, all shares traded under the symbol SHSNQ were canceled, meaning holders of those shares “were left with nothing but losses.”

 

The plaintiff, who bought his shares at $.039 per share on May 8, 2009, purports to represent a class of purchasers who bought the SHSNQ shares during the five-day period between May 7, 2009 and May 12, 2009.

 

I know that there have been class periods shorter than five days. But I suspect there have been very few classes brought on behalf of share price declines as small as three cents a share. I was unable to determine how many of the SHSNQ shares actually traded on the open market, but even assuming a three cent per share loss on all of the 27.6 million SHSNQ shares that traded on May 11, the market cap decline was $810,000. Obviously, not everyone selling bought their shares at the peak and some sold before the entire three cent share decline accumulated, so the actual losses on those trades is almost certainly quite a bit below that amount.

 

 

The relatively small amount in dispute is of course no reason to forebear from filing the lawsuit; however, the absence of any allegations of scienter of any kind, in combination with the small amount in dispute, would have been enough to discourage most self-interested plaintiffs’ attorneys from enlisting in this case.

 

More Bank Closures: After the close of business on June 19, 2009, the FDIC announced the closure of three more banks, bringing the year to date total number of bank closures to 40. The FDIC’s complete list of failed banks, including the latest three to be added, can be found here. The three banks all had assets under $1 billion dollars, continuing the trend of closures in the community banking sectors.

 

One of the three banks was located in Georgia, bringing the total number of Georgia banks to fail during 2009 to seven, and the total since January 1, 2008 to 12.

 

My recent overview of the growing number of bank closures and the implications for the D&O insurance marketplace can be accessed here.

 

As the credit crisis litigation wave has evolved, an increasing number of related lawsuits have “targeted asset management firms and involved complex financial instruments,” according to a new study from NERA Economic Consulting. The June 15, 2009 study, written by Dr. Faten Sabry with her colleagues Anmol Sinha and Sungi Lee, is entitled “An Update on the Credit Crisis Litigation: A Turn Toward Structured Products and Asset Management Firms,” and can be found here.

 

The study provides an update of what the study describes as “credit crisis filings,” which category includes not only securities cases (i.e. those involving allegations pertaining to the purchase, ownership or sale of securities) but also includes ERISA claims, shareholder derivative actions, individual state and federal cases, and international cases. The category excludes predatory lending, mortgage loan repurchase disputes and actions involving consumer finance.

 

 

The study reports that this broad category of “credit crisis filings” increased by 172% in 2008 compared to 2007. The study, which reports data through March 17, 2009, notes that the filing activity shows no sign of slowing in 2009, with 46 “credit crisis filings” through March 17 of this year, compared with 188 in all of 2008 and 69 during 2007.

 

 

Though the study reports on a broad category of kinds of filings, even within this broad category, the study found that the percentage of filings that name individual directors and officers as defendants is high – 62% in 2008 and 72% in 2009.

 

 

The study found that within the broad category of “credit crisis filings” that while claims against shareholders involved 57% of filings in 2007, they represented only 37% in 2008 and 33% in 2009. The filings over time increasingly have involved other claimants, including auction rate securities investors, non-ARS investors, plan participants, and other plaintiffs. The non-ARS investors include those who invested in preferred securities, corporate bonds, mortgage-backed securities, mutual funds, and money-market funds.

 

 

Just as the type of claimants has shifted over time, so too has the type of claim target. The study reports that as the credit crisis has moved from the mortgage-related markets to the overall credit markets, “the focus of the related litigation has also shifted towards more complex financial instruments and different market participants.”

 

 

Among other things, the study reports that asset management firms and issuers/underwriters now represent the majority of the defendants named. The percentage of lawsuits involving asset managers more than doubled between 2007 and 2008.

 

 

The study includes a particular examination of lawsuits involving collateralized debt obligations (CDOs). As CDOs have experienced increasing numbers of “events of default,” the lawsuits have followed. The CDO-related lawsuits generally allege failures to disclose proper valuations and misrepresentations about the quality of the underlying collateral.

 

 

In addition, as the financial crisis has continued, the underlying debt and the indices that are used as reference entities for credit default swaps have declined in value and the providers of CDS protection have experienced significant losses, also resulting in litigation. A key allegation in the CDS lawsuits is the failure to pay the protection promised following the occurrence of certain credit events.

 

 

The study notes that though there have been some reported resolutions of the credit crisis cases, which the report describes generally, most cases remain in their earliest stages.

The report concludes by noting that “as the losses continue to mount, it is not clear that the litigation will slow down,” adding that the lawsuits remain in their early stages and the credit crisis story is far from over.”

 

 

The study’s update of the credit crisis litigation wave provides useful and interesting analysis of the evolving litigation. Indeed, perhaps as a result of the depth of interesting information and analysis in the study, a variety of additional interesting questions that the data might also answer follows from reading this study.

 

 

The study’s aggregation of a wide variety of kinds of claims into a larger category denominated “credit crisis filings” does raise the question of what portions within this larger category each of the included types of claims represents. It would be interesting to see a breakdown within the larger category of “credit crisis filings” how many and what percentage each of the constituent subcategories represents and how they have changed over time. By way of illustration, how many of the “international cases” have there been, and when were they filed?

 

 

Similarly, within the category of claims identified in the study as having been filed against directors and officers, it would be interesting to know how these claims break down by lawsuit type.

 

 

It would also be interesting if the study’s descriptive analysis of the claims involving CDOs and CDS, which included also descriptions of some representative cases, also included aggregate numerical analysis of claims involving these financial instruments – that is, over time, how many claims have there been involving these kinds of financial instruments, and how have the numbers changed?

 

 

The study also specifies that the authors identified a category of claims involving non-ARS investors. It would be interesting to know specifically how many of these claims by each of these kinds of investors have been filed over time. For example, with respect to claims involving investors in preferred or subordinated investors, which I have noted (here) is an increasingly important part of securities lawsuit filings, how many filings have there been? How have the filing numbers changed over time?

 

 

Finally, while the report intentionally and by its own terms intends to describe and analyze lawsuit filings trends broader than those just involving securities class action lawsuits, that filing subcategory is generally an area of widespread interest and it would be interesting to have the benefit of the authors’ analysis of this specific subcategory.

 

 

All of that said, the study provides an interesting and important overview of the way that the credit crisis litigation wave has evolved over time. We can all hope that the authors will continue to track the filings and to provide further updates as the credit crisis litigation wave continues to evolve.

 

 

A complete list of the credit crisis-related securities lawsuit filings is accessible here, and a table reflecting credit-crisis related securities lawsuit case resolutions is accessible here.

 

 

Speakers’ Corner: During the period June 21-23, 2009, I will be in Palo Alto, California, where I will be participating as a faculty member at the Stanford Law School Directors’ College. A summary agenda for the event can be found here.

 

In a June 17, 2009 opinion (here), the Eleventh Circuit upheld the district court’s entry, in connection with the $445 million partial settlement of the HealthSouth securities action, of a bar order that extinguished Richard Scrushy’s contractual claims both for indemnification of any settlement he may enter in the case as well as for advancement of his legal defense costs. The opinion raises interesting and important issues and arguably includes some troublesome analysis, particularly with respect to the advancement issues.

 

Background

In 1994, Scrushy and HealthSouth had entered an agreement requiring HealthSouth to indemnify Scrushy to the fullest extent permitted by law. The agreement also entitles Scrushy to receive advancement of attorneys’ fees as they become due, provided he agrees to repay the amount advanced if it is later determined that he is not entitled to be indemnified.

 

In 2003, HealthSouth, Scrushy and several other HealthSouth officials were sued in a series of securities class action lawsuits that were later consolidated. Refer here for background regarding the case. In 2006, HealthSouth and several of the officials reached a partial settlement agreement in which HealthSouth and its insurers agreed to pay the plaintiffs $445 million. (The insurance carriers paid $230 million of this settlement amount.) Scrushy was not a party to this settlement, and he has still not settled.

 

The parties’ stipulation of settlement proposed several bar orders for the court’s approval. Among other things, the proposed bar order extinguished any non-settling party’s claim for contribution against settling parties. The contribution bar order is reciprocal (that is, HealthSouth’s contribution claim against Scrushy is also barred), and is also balanced by a judgment credit, under which a future judgment against non-settling party is to be credited by the amount of the settlement.

 

The district court entered the bar order over Scrushy’s objections that the order extinguished his contractual indemnification and advancement rights. Scrushy appealed to the Eleventh Circuit.

 

The Opinion

Scrushy raised several arguments against the bar order, contending first that the mandatory contribution bar in the PSLRA was exclusive, and therefore the bar could extend only to his rights to contribution, but not to his separate contractual rights of indemnification and advancement. The Eleventh Circuit held that the PSLRA’s contribution bar was not exclusive, and in fact was enacted against a background of established case law which had approved bar orders precluding indemnification claims.

 

Scrushy also argued that under case law and the PSLRA if he were to be deprived of valuable rights in a contribution bar order, he is entitled to compensation. The Eleventh Circuit held that the judgment credit represented very valuable compensation, since if Scrushy were to take the case to trial, the plaintiffs "will recover nothing at all from Scrushy and other non-settling defendants unless the verdict exceeds $445 million." The court also noted that Scrushy should be able to use that fact as "a very significant bargaining chip" in settlement negotiations with plaintiffs.

 

Scrushy argued further that depriving him of his indemnification rights would be contrary to public policy under Delaware law designed "to encourage qualified individuals to serve as corporate officers." The court said that these considerations must be "balanced against countervailing policies in favor of settlement." The court also referenced extensive case law that indemnification of securities violations is inconsistent with policies underlying the securities laws. The court concluded that the bar order’s elimination of Scrushy’s indemnification right was not against public policy.

 

The court then turned to Scrushy’s argument that the bar order’s elimination of his advancement rights was inappropriate. Scrushy argued that his rights of advancement were independent of any liability he might have to plaintiffs, and therefore it inappropriate in a settlement involving plaintiffs’ liability claims to strip him of his independent contractual rights.

 

The court conceded that "no circuit court… has addressed this issue" and acknowledged that the injury to Scrushy with respect to his advancement rights is not measured with respect to amounts Scrushy might have to pay to the plaintiffs. However, the court said that "the attorneys’ fees are nonetheless paid on account of liability to the underlying plaintiffs or risk thereof." The court found that the claim for attorneys’ fees "clearly cannot be considered to be independent of his liability to the underlying plaintiffs" because it is "so close in nature of the claims which established case law holds are appropriately barred" that so holding is "a minimal and reasonable extension thereof."

 

Scrushy raised a separate public policy argument with respect to his advancement rights, arguing that Delaware law "supports advancement of litigation fees for officers and directors to ensure that they will resist unjustified claims, and to encourage qualified individuals to serve."

 

The court recognized that in the absence of fee advancement "an innocent officer might have difficulty proving his innocence, and thus might have difficulty realizing a prevailing status." But the court said these considerations have to be balanced by policies in favor of settlement. It noted that HealthSouth might well have been reluctant to settle if "it would continue to be liable for endless legal fees to fund Scrushy’s individual defense" as that would constitute "limited peace." The Eleventh Circuit also said (and I want to take care to quote this carefully here) "advancement of legal fees might be inconsistent with the policies underlying the securities laws."

 

The court rejected Scrushy’s argument that he was not compensated in the bar order for the elimination of his advancement rights; the court said the "overall compensation was adequate" given the judgment credit.

 

Accordingly the Eleventh Circuit held that the district court to not abuse its discretion in entering the bar order.

 

Discussion

At one level, the outcome of this dispute is hardly surprising, as it is particularly difficult to meet the "abuse of discretion" standard applicable to the Eleventh Circuit’s review of the district court’s entry of the bar order.

 

On the other hand, the Eleventh Circuit’s apparent commitment to upholding the settlement and to rejecting Scrushy’s claims seems to have driven their consideration of these issues, and whether or not the outcome ultimately is appropriate, there are parts of the court’s analysis that I find less than comfortable.

 

Although I also have issues with respect to the court’s analysis of indemnification issues, my real concerns relate to the court’s holding regarding Scrushy’s advancement rights.

 

In particular, the court gave very short shrift to Scrushy’s public policy arguments regarding advancement. True, the court did concede that an innocent officer "might" have difficulty proving his innocence if his advancement rights are eliminated, and (the court delicately added) "might have difficulty realizing a prevailing status."

 

A fair assessment of these points would not be written in the conditional sense — there is no "might" about it. The reality is that company official whose advancement rights are cut off is pretty much screwed unless he or she has individual resources to defend him or herself. (I am setting insurance issues to the side here, in order to concentrate on the advancement issues).

 

I also think the court strained very hard but not very convincingly to substantiate its conclusion that Scrushy’s advancement rights are not independent of the plaintiffs’ liability claims against him.

 

My overwhelming impression of this opinion is that the outcome was dictated by the identity of the appellant. The fact that it was the notorious and reviled Richard Scrushy before the court clearly seems to have had an impact, and in particular a presumption of Scrushy’s liability for the violation of which he is accused pervades the Eleventh Circuit’s opinion. For example, the Eleventh Circuit said that "Scrushy made no showing in the district court that he was merely an innocent bystander with respect to the violations at issue here."

 

The court also noted, approvingly, that "a party in HealthSouth’s shoes might well have been more willing to leave extant the contractual claims for advancement of fees on the part of an outside director who could adduce evidence of excusable ignorance of the violations."

 

The unmistakable message seems to be that it is OK for the bar order to extinguish Scrushy’s advancement rights because we all know that he is a bad guy. Indeed, the popular consensus is that Scrushy is a bad guy and even that he did all the stuff that plaintiffs allege. But in our system, we generally require these kinds of things to be proven before they can serve as the basis for depriving someone of their contractual rights. Scrushy was in fact acquitted in the criminal trial relating to these allegations, though later convicted on unrelated bribery and racketeering charges. The entry of the bar order did not follow a trial, it followed only a fairness hearing. (Readers who feel I am disregarding some important findings of fact in connection with these proceedings are invited to let me know if I am overlooking something.)

 

Several days ago I defended Bank of America’s advancement of Angelo Mozilo’s defense fees (see my prior post here), and many of the things I said there seem applicable here. In reflecting on these issues, I find myself wondering about the Eleventh Circuit’s consideration of public policy under Delaware law. I can’t help but find the contrast overwhelming between the outcome of the Eleventh Circuit’s analysis on the advancement issue here, and the ruling of the Delaware Chancery Court in the Sun-Times case (linked in my earlier post about Mozilo) that the company had to continue to advance defense costs even though the former officers had been convicted of crimes, had been sentenced and were in jail.

 

It seems to me that the right way to think about the advancement issue is to forget that the appellant here was Richard Scrushy and imagine instead that we are talking about some poor anonymous sucker that got cut out of a settlement and now faces a panoply of securities law allegations by himself. Imagine further that unlike Scrushy the poor sucker has no independent resources with which to defend himself. Perhaps the outcome on the question of the appropriateness of a bar order extinguishing advancement rights might be the same for the poor sucker as it was here. But I find the impression overwhelming that the outcome of this case had to do with the fact that it was about Scrushy and not some anonymous poor sucker.

 

My final concern about this opinion is that in its zeal to uphold the settlement against Scrushy’s challenge the court managed to say some things that simply don’t stand up. The worst example is the court’s statement (which I quoted carefully above) that "the advancement of legal fees might be inconsistent with the policies underlying the securities laws." I really cannot explain or understand this statement, but it seems to be a very radical suggestion to even pose the possibility that it is against public policy for companies to advance defense fees on behalf of corporate officials who have merely been accused of securities laws violations.

 

I feel confident that this is a proposition that would elicit no assent in any quarter, but if it were an accurate statement of the law, I think we would see a wave of mass resignations as no one would voluntarily undertake the kind of risks that this proposition implies.

 

I have said some strong things here. I hope readers who disagree with my view of this case will take the time to add their comments to this post.

 

Many thanks to a loyal reader for providing me with a copy of the Eleventh Circuit opinion.

 

UPDATE: On June 18, 2008, a Jefferson County (Alabama) Circuit Court judge entered a $2.8 billion judgment against Richard Scrushy following a bench trial in a derivative lawsuit filed against him. Although there are no findings of fact in the Final Judgment (copy here), the order clearly represent a finding that Scrushy engaged in the alleged misconduct. This ruling obviously puts the Eleventh Circuit’s decision in a different light. However, this ruling had not yet been issued at the time the Eleventh Circuit issued its decision, so I think many if not all of my questions raised above remain valid given the record before the Eleventh Circuit at the time it ruled.

 

A frequent securities class action lawsuit accompaniment is a companion ERISA stock drop lawsuit brought on behalf of employee participants in the defendant company’s benefit plan. These ERISA lawsuits have in recent years resulted in a string of impressive settlements, although the plaintiffs have not fared as well in the few cases that have actually gone to trial. In a ruling that could have significant implications for other cases, on June 1, 2009, the court in the latest of these cases to go to trial – the high-profile Tellabs ERISA case – entered a sweeping ruling (here) in defendants’ favor. 

 

Because the court in the Tellabs ERISA case ruled in defendants’ favor following trial both with respect to the “prudence” and the “disclosure” issues, and because the disclosures at issue involve many of the same alleged misrepresentation issues as are raised in the much-chronicled Tellabs securities class action (about which refer here and here), the defense ruling in the Tellabs ERISA case could proved to be particularly significant.

 

 

Background

 

The Tellabs ERISA case relates to issues raised by participants in Tellabs’ retirement and savings plan. During the class period of December 11, 2000 through July 1, 2003, the plan offered participants twelve different investment choices, including one fund that was invested exclusively in Tellabs stock. 

 

Tellabs itself had a record year in 2000, but beginning in the first quarter of 2001, Tellabs began to experience a downturn in product demand as well as increased costs. As the year progressed, senior company officials (many of whom were plan fiduciaries and who were subsequently defendants in both the securities lawsuit and the ERISA lawsuit) made a number of statements about the company’s business performance and business prospects. The company along with the rest of the telecommunications industry continued to face business challenges during 2002 and 2003. During the class period, Tellabs share price declined from $63.19 to $6.58 per share.

 

 

In their lawsuit, the plaintiffs contended that Tellabs and the individual plan fiduciaries breached their duties under ERISA. Among other things, the plaintiffs contended that the defendants breached their fiduciary duty of prudence by allowing and holding instruments in the Tellabs stock fund. The plaintiffs also alleged that the defendants breached their duty to honestly disclose material information.

 

 

The case was tried in an eight day bench trial in late April and early May 2009, and on June 1, 2009, Northern District of Illinois Judge Matthew Kennelly issued his findings of fact and conclusions of law, which can be found here.

 

 

The Court’s Rulings

 

Judge Kennelly found for the defendants on essentially all points. With respect to the issue whether the defendants violated the duty of prudence by allowing the plan to continue holding and investing in Tellabs stock, the court found that the defendants demonstrated “procedural prudence.” He found that “by virtue of their roles as high level executives,” they had extensive discussion of Tellabs’ business and future prospects “albeit outside the context of investment and administrative committee meetings.”

 

 

The court added that “though it would have been wise for defendants to conduct a more formal review of the Tellabs stock funds and to document that review, its absence does not mean they were imprudent in light of their intimate knowledge of Tellabs.”

 

 

Judge Kennelly further held, on the issue of so-called “substantive prudence,” that the “evidence shows that a reasonably prudent individual in similar circumstances who undertook such an examination would not have sold the Plan’s stock or removed it as an investment options,” notwithstanding the business challenges that the company was facing. Based on his review of how the business issues unfolded and how the defendants’ responded, Judge Kennelly concluded that “a reasonable fiduciary in similar circumstances would not have concluded that the Plan should have divested its Tellabs stock or ceased offering it to participants as an investment option.”

 

 

With respect to the plaintiffs’ allegations about the inadequacy of defendants’ disclosures about Tellabs and its financial results and prospects, the court concluded that the defendants did not make any material misrepresentations, adding that “Defendants certainly made a number of predictions about Tellabs and the communications industry that turned out to be wrong,” but the “evidence does not demonstrate that defendants misrepresented either the facts or their expectations when they made these statements.”

 

 

Finally, Judge Kennelly also ruled in the defendants’ favor on statute of limitations issues. The defendants had argued that the plaintiffs’ claims were barred by the three year statue of limitations. Plaintiffs had argued that due to defendants’ concealment of the fraud, a six-year statute of limitations should apply and therefore the claims were not time-barred. In a pretrial ruling, Judge Kennelly had found that there were disputed issues of fact on the question of concealment. But following trial, he concluded that there was no evidence of concealment and therefore that the three-year statute applied and accordingly the plaintiffs’ claims also failed because they are time-barred.

 

 

Discussion

 

It is not just that Judge Kennelly’s rulings represent a clean sweep for the defendants. It is that this is the latest of the high profile post-Enron ERISA stock drop cases in which the defendants have prevailed following trial. Other high profile examples include the DiFelice v. U.S. Airways case, in which the defendants’ trial court victory was affirmed in 2007 by the Fourth Circuit (refer here). In addition, in 2008, the Seventh Circuit affirmed (here) the defense verdict in the Nelson v. Hodowal ERISA stock drop case (albeit in a narrow ruling).  

 

 

Trials in these cases are rare, but the track record of defense verdicts at some point may begin to tell, both with respect to which cases get filed and with respect to how the cases settle. In particular with respect to settlement, a demonstrated defense willingness to take a case to trial could begin to have a downward effect on settlements.

 

Chuck Jackson of the Morgan Lewis firm, who successfully represented the defendants at trial in both the Tellabs ERISA case and in the earlier DiFelice case, wrote (here) with his colleague Christopher Wells following the DiFelice case that:

 

 

a plaintiff’s knowledge that an insured and insurer are willing to go through trial if necessary should have the effect of driving down settlements to more properly correspond to the merits of the particular claims, rather than simply fixing a price based on perceived trends, the limits of the insurance polices and a mushy ‘what if’ analysis based on Rule 12(b)(6) rules.

 

 

These points seem even more valid in light of the outcome of the Tellabs ERISA case.

 

 

The DiFelice case has rightly been viewed as significant because the court ruled in the defendants’ favor on the prudence issue, even thought the company wound up in bankruptcy. The Tellabs ERISA case may be even more significant because the court ruled in defendants’ favor on both the prudence issue and on the disclosure issue.

 

 

Plaintiffs are often attracted to ERISA stock drop cases because they can allege disclosure shortcomings without having to plead or prove scienter, as they would in trying to make a claim for securities fraud. Plaintiffs also try to insinuate in settlement negotiations that the court will be predisposed to favor their claims because the plan participants have seen their retirement funds substantially or entirely diminished.Judge Kennelly ruled in the defendants favor notwithstanding and seemingly without regard to these presumed plaintiffs’ advantages.

 

 

Judge Kennelly’s rulings on the disclosure issues may also be significant because of the prominence of the virtually identical disclosure allegations in the high profile Tellabs securities case. The Supreme Court opinion and the subsequent Seventh Circuit opinion in the Tellabs securities case were based solely on plaintiffs’ allegations, which were taken as true due to the procedural posture of the case.

 

 

However, Judge Kennelly made specific findings of fact based on an evidentiary record. . Judge Kennelly clearly credited he testimony of the Tellabs witnesses. His conclusion that the defendants did not make any material misrepresentations suggests that the securities plaintiffs’ allegations also ultimately may be unsustainable. Judge Kennelly’s conclusions that the defendants did not misrepresent either the facts or their assessments provide an important context for subsequent proceedings in the case.

 

 

Judge Kennelly’s final ruling on the statute of limitations issues may be significant in another way, as it seems to be one more basis on which the ruling could withstand appellate scrutiny. Adding the statute of limitations ruling at the end of his findings and conclusions seemingly another way for the appellate court to adopt the district court’s rulings.

 

 

Many of these ERISA stock drop cases contain very similar allegations to those in the Tellabs ERISA case. That is, as in the Tellabs case, the plaintiffs allege that the defendants were imprudent in allowing plan assets invested in company stock and that the defendants failed to disclose to plan participants what the defendants knew about the company’s business results and prospects. According to Jackson, Tellabs counsel in the ERISA trial, the detailed findings of fact and conclusions of law provide “a blueprint for how to try this kind of case.” The court’s findings and conclusions certainly show the challenges plaintiffs face in trying to substantiate these kinds of allegations and also show how defendants can go about refuting the allegations.

 

 

To be sure, there may not be a sudden rush of trials in these kinds of cases. These cases can be notoriously expensive to litigate, and costs and uncertainty of litigation will undoubtedly continue to motivate parties to these cases to seek settlement. But the outcome of the Tellabs ERISA case will hearten those who want to fight these kinds of allegations, and may increase the likelihood that the cases settle for reasons related to the merits.

 

 

Our congratulations to Tellabs’ trial counsel, Chuck Jackson of the Morgan Lewis firm, for his great victory in this case, as well as in the DiFelice case. Jackson has clearly staked out a very clear specialty in trying these kinds of cases. His track record certainly is solid. 

 

 

Special thanks to a loyal reader for providing a copy of the findings and conclusions.

 

 

Seinfeld on Risk Management: George Costanza has to read a risk management textbook, takes advice from a blind man, winds up lecturing (unintentionally) about Ovaltine. Hat tip to the Insurance Journal for the video link.

 

https://youtube.com/watch?v=laKprX-HP94%26hl%3Den%26fs%3D1%26

In the latest twist in the long-running options backdating saga, and in what appears to be a significant milestone in the options backdating-related gatekeeper claims, on June 15, 2009, Vitesse Semiconductor announced (here) that it had reached a settlement with its former auditor, KPMG LLP, in connection with the option backdating related allegations. In the settlement KPMG agreed to pay $22.5 million and to forgive past indebtedness.

 

As discussed at greater length here, in June 2007,Vitesse sued KPMG in Los Angeles County Superior Court alleging that KPMG had been negligent in auditing the company’s stock option grants and financial statements during the years 1994 to 2000. Vitesse later amended the complaint to include the years 2001 to 2004.

 

Vitesse itself had been the subject of an options backdating-related securities class action lawsuit in the Central District of California, as described here. Vitesse settled that lawsuit for a payment $10.2 million in cash, $8.75 million of which came from the company’s D&O insurance carrier, and the balance in payments from individual defendants. The settlement also included the transfer of shares of Vitesse stock from Vitesse and from the individual defendants.

 

The plaintiffs in the options backdating securities lawsuit had also sued KPMG and as reflected here, on June 16, 2008, the parties to the securities lawsuit filed a stipulation of settlement in which KPMG agreed to contribute $7.750 million toward the class settlement.

 

KPMG’s recent $22.5 million settlement of Vitesse’s own lawsuit is in addition to KPMG’s separate $7.750 million contribution to the settlement of the securities class action lawsuit.

 

As I recently noted (here), the options backdating securities class action lawsuits themselves appear to be winding down, but until word circulated of KPMG’s settlement with Vitesse, I had not heard of the resolution of any cases that companies themselves had filed against their outside professional advisors.

 

Even if there were prior outside gatekeeper settlements that I missed, the KPMG settlement with Vitesse has to be the most significant settlement between an outside gatekeeper and a company with respect to the options backdating scandal. It will be interesting to see whether the final stage of the options backdating saga includes further significant gatekeeper claim resolutions. Given the magnitude of the KPMG settlement, it would certainly seem that there could be other significant settlements and perhaps even the assertion of additional claims.

 

I would be very interested to know if readers are aware of the resolution of any other cases that companies have filed against their outside professionals in connection with the options backdating scandal.

 

As noted here, KPMG is also the subject of a trustee’s claim in connection with the New Century Financial Corp. bankruptcy proceeding. KPMG also remains a defendant in the New Century subprime-related securities class action lawsuit, after its motion to dismiss in that case was denied, as discussed here.

 

How Will GM Sell Cars Now?: General Motors certainly faces a daunting challenge trying to sell cars as a bankrupt company. I have posted a video link below of an irreverent but particularly funny take on what a bankrupt GM’s ads might look like. The spoof ad does a great job ripping conventional car ad clichés, which clearly won’t work now (if they ever did).

Hat tip to the Planet Money blog for the link to the video. Warning, the ad contains language some might consider offensive.

http://current.com/e/90184685/en_US