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.

 

I found myself talking about options backdating for the first time in months yesterday, and it wasn’t just because of the Ninth Circuit’s blockbuster August 18, 2009 opinion (here) reversing and remanding for retrial the conviction of former Brocade CEO Gregory Reyes – although that certainly is a highly noteworthy development.

 

What triggered much the discussion was the publication in the yesterday’s Wall Street Journal of an article entitled "Backdating Likely More Widespread" (here), which caused several callers  to ask me whether I thought we might see a new wave of options backdating litigation. But while the academic research on which the Journal article was based is certainly interesting, I am skeptical that the new "revelations" will result in a renewed wave of options backdating lawsuits.

 

The Journal article is based on the August 16, 2009 study by University of Houston professors Rick Edelson and Scott Whisenant, entitled "A Study of Abnormally Favorable Patterns of Executive Stock Option Grant Timing" (here). The authors conducted the study because previously "no attempt" had been made "to first isolate a sample of specific companies that committed backdating and then to study the characteristics of such sample." The authors claim that their paper "demonstrates" that a "reliable sample of companies, with both disclosed and undisclosed backdating activities, can indeed be constructed," based on publicly available information.

 

The authors applied a complex probability technique to 4,008 companies with respect to which they had sufficient data, from which they were able to "extract" a sample of 141 companies that had "abnormally favorable patterns of stock option grants at a very stringent confidence level," many more than the two or so companies that would be expected to have this luck by chance.

 

The authors divided the 141 companies into the 49 companies that disclosed backdating and the 92 that have not. While prior research had shown that companies that disclose backdating suffered negative stock returns, the authors conclude that the companies that failed to disclose backdating suffered a higher rate of unfavorable stock market results, from which the authors further conclude that it was not public disclosure of the backdating that "drove the destruction of wealth associated with options backdating"; to the contrary, they conclude that "vigorous enforcement and disclosure" may "ameliorate backdating related losses."

 

The authors also conclude that higher market capitalization companies were substantially more likely to have disclosed backdating, which the authors suspect reflects regulators’ or other discovery mechanisms to be biased toward larger companies.

 

The authors’ conclusions are striking, which explains the Journal’s prominent discussion of the academics research (that and the fact that it is August and the new cycle is a little slow right now). As the Journal put it, the research suggests that "the majority of companies that improperly backdated stock options never were caught by regulators or confessed to the practice." The practice, the Journal observed, "might have been more widespread than thought at the time."

 

But while the authors’ research may be noteworthy, I strongly doubt that it will result in a wave of new backdating lawsuits. First and foremost, the authors’ report doesn’t name any names. Even though the Journal identified four of the companies, the other companies the authors identified as having undisclosed backdated stock options are not identified.

 

Second, as the Journal article mentions, the statute of limitations is highly relevant here. Much of the backdating took place before the Sarbanes-Oxley Act was passed, now over seven years ago. This temporal consideration underscores another important point, that this is really old news by now, and even the academics’ spin on the topic can’t change that. (More on this point below.)

 

Third, I can’t see the plaintiffs’ lawyers getting excited now to file a new round of options backdating cases. While there were some notable exceptions, by and large, many of the plethora of options backdating cases the plaintiffs’ lawyers scrambled to file between 2006 and 2008 didn’t turn out all that great for the plaintiffs.

 

Fourth, the kind of case that turned out particularly poorly for the plaintiffs was the purely statistically based "must have been backdating" kind of case. The courts proved skeptical of these kinds of allegations, but that is the very kind of case (and the only kind of case) the authors’ research would support. Indeed, the authors themselves are quoted as saying that their analysis is "purely statistical" and that the authors don’t claim "to provide categorical or absolute legal proof that any specific company engaged in backdating."

 

Would you want to take that case now if you were a plaintiffs’ lawyer – particularly if you knew that the case almost certainly would involve a smaller company and would have to be one other than the nearly 170 companies that were already sued. (Seriously, what would make anyone think the good cases are the ones that haven’t been discovered yet?)

 

My own view is that the whole backdating story has long since been exhausted, which is a factor that undoubtedly will have to be weighed in the prosecutorial decision of whether or not to retry Gregory Reyes. The backdating scandal had its time, but that time is long past. Indeed, the authors themselves acknowledge that based on their research, "backdating appears to have been substantially eliminated."

 

What’s the point of continuing to beat on this ancient topic now? In the words of the old Joan Baez song entitled Winds of the Old Days, "the 60s are over now, set him free." (A little anachronism there, but you get my point.)

 

And so, while I could be proven wrong, I don’t expect to see a bunch of new options backdating cases. Time will tell of course, but basically, the plaintiffs’ bar (and the rest of the world) has moved on to other things. As I have noted recently (here), the recent data strongly suggest that the plaintiffs’ bar already appears to be working off a backlog. I doubt they will rally to rake over the coals of a long dead scandal.

 

Two recent dismissal motion rulings in cases arising out of the subprime and credit crisis litigation wave involve two companies from outside the original core of the subprime lending sector – student lender First Marblehead and residential home builder Levitt Corporation. When these cases were filed early in 2008, I cited each of them as examples of how the subprime litigation wave was expanding to encompass a broader range of companies.

 

Both of the recent opinions in these two cases are quite detailed and allegation-specific, but in many respects they point in divergent directions. The First Marblehead decision is a sweeping defense victory, but the Levitt Corp. opinion, while a split decision, is generally more favorable to the plaintiff in that case.

 

First Marblehead: In an August 5, 2009 opinion (here), District of Massachusetts Judge Joseph L. Tauro granted defendants’ motion to dismiss. Judge Tauro’s opinion essentially rejects all of plaintiffs’ allegations. (Background regarding the case can be found here; my prior post about the lawsuit’s filing can be found here).

 

Judge Tauro found that the plaintiffs had not sufficiently pled misrepresentation, because, he concluded, "First Marblehead disclosed what the Complaint alleges it concealed" with respect to the company’s supposedly changed lending criteria and loan standards; default rates; relationship with its insurer affiliate; and changes in the various factors that could undermine its financial projections.

 

Because he found that the company had disclosed what the plaintiffs alleged was withheld, Judge Tauro also found that the plaintiffs had failed to plead sufficient facts to give rise to a strong inference of scienter. He also found that the complaint’s insider trading allegations were not sufficient to establish a strong inference of scienter, because the individual defendants who traded were not alleged to have particularized knowledge of the alleged fraudulent scheme, and because one individual’s trades were distant in time from the alleged corrective disclosure while the other individual’s trades were pursuant to trading plans whose existence had been publicly disclosed.

 

Finally Judge Tauro rejected plaintiffs’ loss causation allegations, finding that the company’s "drop in share price coincided with a significant downturn in the credit markets and its own preexisting patter of stock declines." He also quoted with approval from a Second Circuit opinion in a RICO case, which stated that "when the plaintiff’s loss coincides with marketwide phenomena causing comparable losses to other investors, the prospect that the plaintiff’s loss was caused by fraud decreases."

 

Judge Tauro’s opinion does not state whether or not the dismissal is with prejudice, but the opinion does not offer the plaintiffs’ leave to amend.

 

Levitt Corp.: Southern District of Florida Judge Donald L. Graham’s August 10, 2009 opinion in the Levitt Corp case (here) grants in part and denies in part the defendants’ motions to dismiss. (Background regarding the case can be found here. My prior post about the lawsuit’s filing can be found here.)

 

With respect to many of the factual allegations in the plaintiffs’ complaint, Judge Graham found that the plaintiff had sufficiently alleged misrepresentation, except as to a few with respect to which he found the allegations were insufficient, and several others he found came within the safe harbor for forward looking statements. Other than with respect to the statements he found to be within the safe harbor, he allowed plaintiff leave to amend his allegations to attempt to correct the pleading deficiencies noted.

 

Judge Graham also found that the plaintiff had adequately alleged scienter as to the company’s CEO Alan Levan, based on the plaintiffs’ allegations that Levan had knowledge of the need for updated pro forma financial analyses of the company’s home building subsidiary and was aware of circumstances that necessitated an impairment analysis.

 

However, Judge Graham concluded the plaintiff’s scienter allegations were insufficient as to the company’s CFO George Scanlon, finding that the plaintiff had "insufficiently alleged his knowledge of the failure to update pro formas and, as a result, to conduct the impairment analysis." He did allow plaintiff leave to amend the scienter allegations as to Scanlon.

 

Finally Judge Graham found based on the complaint’s allegations of the company’s share price declines following the alleged disclosure revelations that the plaintiff had adequately pled scienter.

 

Judge Tauro’s opinion in the First Marblehead case appears tough and skeptical by comparison to Judge Graham’s, particularly with respect to loss causation issues. In those respects the two cases may well appear at odds, although the difference may largely be due to Judge Tauro’s initial conclusion that the defendants had disclosed what the plaintiffs alleged had been withheld. With that as a starting point, he seemed clearly inclined against the plaintiffs’ allegations.

 

Whatever else may be said about the opinions, the two decisions do illustrate how the outcome of the dismissal motions in these cases have shown a broad range of approaches and outcomes. While a fair number of these cases are being dismissed, a number are surviving as well, notwithstanding such considerations as the overall market decline in which so many of these companies participated.

 

In any event, I have added these cases to my register of subprime and credit crisis-related securities lawsuit dismissal motion resolutions, which can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing me with copies of the opinions.

 

As D&O maven Dan Bailey noted in a recent memo (here), ERISA class action litigation represents a significant and growing liability exposure for benefit plan fiduciaries. With the recent addition of the $70.5 million settlement in the Tyco ERISA class action lawsuit (about which refer here) and the $55 million settlement in the Countrywide ERISA class action lawsuit (refer here) to the long and growing list of significant ERISA class action settlements, it is clear that the these ERISA class action lawsuit represent an increasingly important area of potential liability exposure.

 

In light of the increasing prevalence of these significant ERISA class action lawsuits, it seems to me that the time has arrived for a more systematic tracking of significant settlements.

 

Accordingly, I have prepared a list of the largest ERISA class action settlements of which I am aware. The list, in the form of a Word document, can be found here.

 

This list is comprehensive, but it likely is incomplete. I suspect strongly that there may be other similarly significant ERISA class action settlements of which I am unaware that should be included in order for the list to be complete. I would be very grateful if any readers who are aware of any specific settlements that I omitted from the list but that should have included would please let know so that I can incorporate them into the list and make the information available to all readers.

 

In any event, as new ERISA class action settlements arise in the future, I will add them to the list, and I will indicate on the top of the Word document the most recent date on which the list was updated. I encourage readers to let me know about any significant ERISA class action settlements of which they become aware.

 

On July 30, 2009, Eastern District of New York Judge Thomas C. Platt entered an order (here) preliminarily approving the settlement of the securities class action lawsuit that had been filed certain directors and officers of American Home Mortgage Investment Corporation. The total value of the settlement is $37.25 million, which alone makes the settlement significant. However, the settlement is also significant because it appears to be the first subprime-related securities lawsuit settlement to which the target company’s auditors and offering underwriters contributed toward settlement.

 

As reflected in greater detail here, plaintiffs first initiated the lawsuits in July 2007. Because American Home itself had filed a voluntary petition for bankruptcy under Chapter 11, the company itself was not named as a defendant. In addition to the individual directors and officers, the defendants named in the case included the company’s outside auditor, Deloitte & Touche LLP, as well the investment banks that had acted as offering underwriters in connection with the company’s August 9, 2005 and April 30, 2007 public offering of its securities. Deloitte issued reports as to the company’s financial statements that were incorporated into the offering documents.

 

American Home had been a real estate investment trust that engaged in the investment in and origination of residential mortgage loans. The complaint (which can be found here) essentially alleged that the company was experiencing an increasing level of loan delinquencies. The complaint alleged that this was due to the company’s shift from higher quality loans to higher risk subprime loans, though the company allegedly continued to represent that it was not a subprime lender. As a result of the decline in loan quality, the company allegedly was experiencing increasing difficulties selling its loans, which compelled the company to reduce prices, reducing profits and margins. The company allegedly was also failing to write-down the value of certain loans and mortgage-backed assets in its portfolio. As a result of these developments, the plaintiffs alleged, the company was overstating its financial results.

 

The plaintiff filed a motion for preliminary approval of the settlement (here) on July 7, 2009. According to the document, the settlement was reached while the motions to dismiss were still pending and as the result of formal mediation as well as settlement discussions. As reflected in the document and its attachments, the $37.25 settlement is actually a reflection of three separate settlement stipulations: a settlement of $24 million with ten individual defendants; a settlement of $4.75 million with Deloitte; and a settlement of $8.5 million with the seven underwriter defendants. (The details of the settlement are summarized here, see paragraph 8.)

 

According to the individual defendants’ stipulation of settlement, the company’s D&O insurers (who are named in the stipulation) "agreed to pay the Settlement Amount on behalf of the Settling Defendants."

 

While the settlement is noteworthy in and of itself, it is significant because the settlement includes significant monetary contributions from the offering underwriters and the company’s outside auditors. So far as I am aware, this is the first subprime-related securities class action lawsuit settlement in which either offering underwriter or audit firm defendants have made a monetary contribution toward settlement. These defendants’ settlement contributions are all the more noteworthy given that the motions to dismiss in the case had not even been heard in the case.

 

Many of the subprime and credit crisis related securities suits name offering underwriters or audit firms as defendants. Whether or to what extent these parties will find themselves contributing toward settlement in these other cases remains to be seen. But if they are required to participate in settlements in significant amounts as was the case in the American Home suit, the overall costs of litigation for these firms could quickly mount to some truly impressive aggregate figures.

 

The D&O insurers’ contribution toward the individuals’ settlement is also a reminder that these cases could wind up being collectively very expensive for the D&O insurance industry. There are still only a handful of settlements but the ones have been entered so far include some sizeable settlements, and if the settlements so far are representative, there could be some huge claims payments ahead.

 

Even the few settlements that have been entered so far would seem to be starting to have their impact on the insurers – for example, the recent $32 million settlement in the RAIT Financial subprime-related securities case (refer here) and the recent $22 million settlement in the American Home Lenders subprime-related securities case (here) were also entirely funded by the D&O insurers. If these settlements are any indication, the industry’s overall claim loss exposure from the subprime and credit crisis-related litigation wave could be enormous.

 

I have in any event added the American Home settlement to my list of subprime and credit crisis-related lawsuit resolutions, which can be accessed here.

 

While we wait to see whether the U.S. Supreme Court will grant the pending petition for a writ of certiorari in connection with the Second Circuit’s recent landmark opinion in the Morrison v, National Australia Bank case, the lower courts must continue to wrestle with questions regarding the extraterritorial application of the U.S. securities laws, particularly with respect to the claims of so-called "f-cubed" or "foreign-cubed claimants" – that is, foreign domiciled investors who bought their shares in foreign companies on foreign exchanges.

 

In an interesting August 13, 2009 decision in the C.P. Ships Ltd. class action securities lawsuit (here), the Eleventh Circuit distinguished the Second Circuit’s holding in Morrison and concluded that in that case the district court had properly exercised jurisdiction over the claims of the f-cubed claimants under the circumstances presented. The decision illustrates how these jurisdictional issues can arise in a surprisingly broad variety of procedural contexts and also shows how the cases continue to raise complex jurisdictional and policy concerns as well.

 

Background

C.P. Ships Ltd. is a Canadian company with its headquarters in the United Kingdom that also conducts "crucial headquarters activities" (that were central to the alleged fraud) in Tampa, Florida. The company’s shares trade on the New York and Toronto Stock Exchanges.

 

In 2004, the company transitioned to a single accounting platform. Later, the company disclosed that the transition had caused it to understate its operational costs. The company’s share price declined and investors initiated lawsuits in the both U.S. and Canadian courts. Background regarding the U.S. action can be found here.

 

On April 5, 2007, the district court dismissed the U.S. securities lawsuit (refer here), and the plaintiffs appealed. While the appeal was pending, the parties agreed to settle for $1.3 million. The settlement class included claims of some foreigners but, the Eleventh Circuit stated, it "specifically excludes the claims of Canadian citizens who purchased CP stock" on the Toronto exchange.

 

A Canadian investor who bought his shares on the NYSE, Allen Germain, objected to the settlement on behalf of Canadian investors who, like himself, bought their shares on the NYSE, as well as on behalf of other foreign investors who purchased their shares on the Toronto exchange. Among other things, Germain asserted that the district court lacked subject matter jurisdiction over these investors’ claims. The district court overruled Germain’s objections and approved the settlement. Germain appealed.

 

The Eleventh Circuit’s Opinion

Even though Germain bought his shares on the NYSE and therefore lacked standing to represent the interests of foreign investors who bought their shares on the Toronto exchange, the Eleventh Circuit addressed the jurisdictional issues of both groups of foreign claimants, "because of our obligation to examine our jurisdiction sua sponte,"noting that there do not in any event appear to be many of the latter group of investors.

 

After observing that the ’34 Act is "silent as to its extraterritorial application," the court reviewed the two jurisdictional tests for transnational securities frauds, the "conduct" test and the "effects" test, the court concluded that the Complaint "alleges ample facts sufficient to establish subject matter jurisdiction under the ‘conduct text’ over unnamed foreign class members who purchased" their shares on the Toronto exchange, and therefore it did not need to address the "effects" test.

 

In arguing that the district court lacked subject matter jurisdiction over the foreign investors’ claims, Germain sought to rely on the Second Circuit’s holding in Morrison, in which the court there had found that because the principal activities supporting the alleged fraud had taken place in Australia, rather than at the company’s Florida-based subsidiary, the district court in that case lacked jurisdiction. Germain argued that the U.S.-based activities alleged in the C.P. Ships case were merely preparatory, and that the alleged misrepresentations appeared in connection with the company’s overseas release of its financial statements that were prepared overseas.

 

The Eleventh Circuit concluded that the Morrison case was "distinguishable," because in Morrison case, "all of the executives bearing responsibility to present accurate information to the investing public, and all the actions in supervising and verifying the information, occurred in Australia."

 

By contrast, in the CP Ships case, where the company’s CEO was based in Tampa, the Eleventh Circuit said "not only did the manipulation and falsification of numbers occur in Florida, the executives with responsibility for ensuring the accuracy of the accounting data operated from Florida." The court also found that the chain of causation in the CP Ships case between the conduct in the U.S. and the alleged fraud "was direct and immediate," by contrast to the Morrison case.

 

Based on its conclusion that the Morrison case was distinguishable due to the difference in factual allegations, the Eleventh Circuit found that the district court properly exercised subject matter jurisdiction. The court further concluded that the district court had properly overruled Germain’s objections to the settlement, and accordingly the Eleventh Circuit affirmed the district court’s approval of the settlement.

 

Discussion

Even though the Second Circuit held there was no subject matter jurisdiction in the Morrison case itself, its holding (and in particular its rejection of the "bright line" test urged by some parties and amici) expressly recognized the possibility that under certain circumstances it would be appropriate for U.S. courts to exercise subject matter jurisdiction over the claims of "f-cubed" claimants. The CP Ships case provides an example where a court concluded that such a jurisdictional exercise is held to be appropriate.

 

The implication of these cases is that these jurisdictional issues are very fact dependent and must be decided on a case by case basis. By the same token, the Eleventh Circuit’s careful analysis of the difference in the allegations between the CP Ships case and the Morrison case in effect provides a road map for plaintiffs seeking to establish U.S. court jurisdiction for the claims of f-cubed claimants.

 

This analysis is all very pragmatic and measured, but still it arguably disregards the larger policy question of whether or to what extent U.S. courts should be implementing what is in effect the extraterritorial application of U.S. securities laws. It is worth reflecting that in addition to the U.S. court action involving CP Ships, a separate action involving the same issues was pending in Canadian courts. The Eleventh Circuit’s decision says remarkably little about the significance of this parallel proceeding and how its existence ought to affect the U.S. court’s exercise of jurisdiction over the claims of foreign claimants.

 

These questions about the extraterritorial application of U.S. securities laws matter, because, as analyses of the 2008 securities class action lawsuit filings all show (refer for example, here), foreign-domiciled companies increasingly are the targets of U.S. securities class action lawsuits.

 

Moreover, while most of these cases involve companies whose shares trade on U.S. securities exchanges, some do not. For example, EADS, whose shares do not trade on the U.S. exchanges, is the target of a U.S. securities lawsuit (about which refer here)

 

Indeed concerns about these extraterritoriality issues clearly have influenced at least some courts to decline to exercise jurisdiction over the claims of foreign domiciled investors (refer for example here, with regard to the case involving AstraZeneca).

 

Perhaps if the U.S. Supreme Court grants the writ of certiorari in the Morrison case, these larger policy concerns will be addressed.

 

But in the meantime the Eleventh Circuit’s opinion in the CP Ships case demonstrates that even after the Second Circuit’s ruling in Morrison, there are circumstances where courts will conclude that their exercise of subject matter jurisdiction – even with respect to the claims of f-cubed claimants – is appropriate.

 

This possibility creates an obvious liability concern for potentially affected companies outside the U.S. It also presents a challenge for D&O underwriters, who must factor into their risk analysis of companies outside the U.S. the possibility of those companies facing securities liability exposure under the U.S. securities laws. And as the EADS case shows, this exposure may not even be limited to companies whose shares trade on the U.S. securities exchanges – the exposure potentially could extend even to companies whose shares trade only on exchanges outside the U.S.

 

One thing that is clear is that in an increasingly global economy, the question of the cross-border application of domestic securities laws is a serious and growing concern.

 

The "Ultimate Solution" to Securities Fraud?: According to an August 6, 2009 Associated Press article entitled "China Executes Two for Defrauding Investors" (here), China executed two business people for defrauding hundreds of investors out of about $127 million, calling the scam "a serious blow to social stability."

 

The article reports that Du Yimin, a beauty parlor owner, collected more than $102.5 million from hundreds of investors promising them monthly returns up to ten percent, from investments in beauty parlors, real estate and mining businesses. She spent most of the money on houses, cars and luxury items. The second defendant collected $24 million from 300 investors in a separate scam by saying they could received interest up to 108 percent.

 

Bernard Madoff’s 150-year prison sentence looks positively restrained by comparison.

 

Special thanks to a loyal reader for the link to the AP story.

 

I hate to sound like a broken record a broken record, but as the third quarter securities lawsuit filings continue to come in, certain definite trends are clearly emerging. As I previously noted (here), the most recent filings are characterized by a high number of new lawsuits against companies outside the financial sector and by proposed class period cutoff dates in the distant past. Last week’s new filings reflect these previously noted trends, which I think both explain the second quarter filing "lull" and suggest what we might expect for the balance of the year.

 

The following table shows the filing date for four of the new class action securities lawsuits filed last week (each of the company names in the table below is hyperlinked to a web page providing further information about the respective lawsuit):

 

 

 

Recently Filed Securities Class Action Lawsuits
Company Filing Date Class Period End Date
Flotek Industries 8/10/09 1/23/08
Align Technlogy 8/11/09 10/24/07
MIND C.T.I., Ltd. 8/13/09 2/27/08
Sturm, Roger & Company 8/13/09 10/29/07

 

 

As shown in the table, each of these new lawsuits has been filed against companies outside the financial sector and each of them has a proposed class period cutoff date well over a year and a half ago.

 

These latest filings, taken together with the filings noted in my prior post on this topic (here), represent growing data supporting my theory that during the run-up in securities lawsuits against financial companies in connection with the subprime and credit crisis litigation wave, the plaintiffs’ lawyer accumulated a backlog of cases against companies outside the financial sector, and they are now starting to work off that backlog.

 

Indeed, even with respect to recent filings that have a more recent proposed class period cutoff date, the filings are largely with respect to companies outside the financial sector, as reflected in the new lawsuit recently filed, for example, against Huron Consulting (refer here); Repros Technology (here); Textron (here); and Allscripts-Misys Healthcare Solutions (here).

 

All of which leads me to a number of conclusions: the filing "lull" noted in the second quarter is over; part of the reason for the lull was that plaintiffs’ lawyers hit a logjam because of credit crisis and Madoff-related litigation activity, as a result of which they accumulated a backlog of cases against companies outside the financial sector, that they are now starting to work off; and as a result we are seeing a rush of new lawsuits against companies outside the financial sector.

 

Furthermore, I strongly suspect that this observed third quarter trend of new lawsuit filings against companies outside the financial sector will continue for the balance of the year, and many of these new lawsuits will be characterized by proposed cut-off dates approaching the two-year period of the statute of limitations. Notwithstanding the second quarter filing lull, by year end the annual rate of new filings for 2009 will be consistent with, if not slightly above historical norms.

 

In support of this final point about likely year end filing levels, I note not only the conjectured lawsuit backlog discussed above, but also the recent heightened level of SEC enforcement activity and the marketwide run-up in share prices since March, which could position some individual companies for the kind of sudden and conspicuous share price decline that attracts the unwanted attention of the securities class action plaintiffs’ attorneys.

 

Another Trend Noted: The lawsuit noted above that was filed last week against MIND C.T.I. Ltd. also represents another securities lawsuit filing trend I have described previously (refer for example here) – that is, the investor lawsuit regarding a company’s balance sheet exposure to auction rate securities.

 

The typical ARS-related lawsuit is brought by an ARS purchaser against the firm that created or sold the security. However, in contrast to this more typical ARS lawsuit, the suit filed against MIND alleges that the company misrepresented or failed to fully disclose the company’s balance sheet exposure to ARS investments. That is, rather than suing the ARS seller, the type of suit filed against MIND is brought against the ARS buyer.

 

As I noted in my most recent post (here) about auction rate securities litigation, numerous public companies continue to face surprisingly large balance sheet exposures to ARS, and some of them may be potentially vulnerable to this type of investor over the companies’ ARS-related disclosures.

 

It is interesting to note that MIND’s auction rate securities investments included investments in the infamous Mantoloking CDO, about which I previously wrote here. As I noted in my prior post, this single CDO has spawned an enormous amount of litigation, including even (as I noted in the prior post) a FINRA arbitration initiated by MIND against the creators and sellers of the Mantoloking CDO.

 

Insolent Sprat: When I told my then 15-year old son that he sounded like a broken record, he said "What does a broken record sound like?"

 

In prior posts (refer here), I have observed that the D&O insurer’s consent to settlement really is required. An August 10, 2009 decision by the Delaware Supreme Court (here) confirms that not only is the insurer’s consent required, but the D&O insurer may under certain circumstances reasonably withhold its consent to settlement. The Court, applying Missouri law and observing that the excess carrier in the case had been "cut out" of the settlement process, affirmed the jury’s verdict that the excess carrier had not unreasonably withheld its consent.

 

Special thanks to Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog (here) for providing me with a link to the opinion. Pileggi’s blog post on the opinion can be found here.

 

Background

Payless Cashways was insured under three different layers of insurance from three different carriers, a primary carrier and two excess carriers. The first level excess insurer is referred to in this post as the excess insurer.

 

In 2003, Hilco Capital and another entity sued Payless’s directors and officers alleging that in connection with certain loans Hilco made to Payless the defendants had misrepresented the value of Payless’s inventory.

 

Prior to trial, the parties scheduled a mediation session. The primary carrier’s representative attended the mediation, but because the defense counsel (Shay) and the primary carrier valued the case within the primary insurer’s $10 million limit, and because Shay told the excess carrier’s representative that he would rather try the case than settle for more than the the primary limit, all parties agreed that the excess carrier’s representative should not attend the mediation, but rather  be available by telephone.

 

After the mediation’s first day, the mediator proposed mediation of a single issue – whether the defendants were aware that a Payless employee had falsified the company’s inventory numbers. He further proposed a "high-low" outcome, whereby the primary insurer would pay Hilco $5 million immediately, and then if Hilco lost the single issue mediation, it would keep the $5 million, but if it won the mediation, it was also get the remaining limits of the primary policy (about $3.7 million) — and in addition approximately $7 million under the excess insurer’s policy.

 

Unfortunately, it was 10:00 P.M. by the time the mediation parties agreed to this proposal, and they couldn’t get the excess insurer’s representative on the phone. As the Delaware Supreme Court later put it, "rather than wait until the next morning," the parties finished the deal that night by agreeing that the individual defendants would not be liable for the settlement and would assign their rights under the excess policy to Hilco.

 

Upon reviewing the memorandum of understanding (MOU), the excess insurer’s representative rejected the proposed settlement, among other grounds on that a "straight" settlement would be lower than the high-end number in the high-low settlement.

 

The excess carrier asked the mediation parties to withhold finalizing the MOU until after a January 5, 2005 settlement conference, but they did not. The mediation parties later mediated the single issue, and Hilco prevailed. The primary insurer paid its remaining limit. The excess insurer denied coverage for the settlement, asserting a breach of the policy’s consent to settlement requirement.

 

Coverage litigation ensued. The trial court granted summary judgment for the excess insurer on certain legal issues, and the coverage action then went to trial. The jury found for the excess insurer on three issues: that the individual insureds had breached the policy before the excess insurer withheld consent; that the excess insurer did not unreasonably withhold its consent; and that the excess insurer was not permitted to reasonably associate in the negotiation. Hilco appealed.

 

The Delware Supreme Court’s Opinion

One of the issues on which the trial court had granted summary judgment was whether or not the excess insurer had breached the covenant of good faith and fair dealing under Missouri law. The Court affirmed the trial court’s ruling but on alternative grounds, holding that even viewing the record in the light most favorable to Hilco, the excess insurer was entitled to judgment as a matter of law.

 

In reaching this conclusion, the Court noted that "all agreed" that the excess carrier’s representative should not attend the mediation because it would "send the wrong message," so, the Court concluded, there was no breach in the excess carriers’ failure to attend the mediation. And, the Court noted, it was the mediation participants "who refused to wait until the next day to discuss the proposal" but instead "effectively cut [the excess carrier] out of the process by agreeing that the Insureds would assign their rights to Hilco."

 

Hilco argued that while the MOU was being negotiated, the excess insurer "was willing to negotiate" but that the "straight settlement" it sought required the primary insurer to tender its limits. The Supreme Court noted that the primary insurer refused to tender its limits "because the MOU gave it a better deal," under which, at worst it would pay its limits, but "at best "it would save approximately $3.5 million.

 

The excess insurer’s "only recourse" under the circumstances was to object to the settlement at the January 5 settlement hearing, but the "mediation participants mooted that effort by executing a definitive settlement agreement the day before the conference." Thus, the Court said based on these circumstances, "in sum, there is no record of a breach of good faith claim against [the excess insurer]."

 

The Court also ruled in the excess carrier’s favor on other legal grounds and held as well that even if the trial court erred in excluding certain evidence at trial, it "did not deny Hilco a fair trial."

 

Among Hilco’s evidentiary objections was that the trial court had allowed Shay to testify that the excess carrier "had a reasonable basis to withhold settlement." The Court noted that Shay testified that "he believed it was more likely than not that the Insured would win if the case went to trial and that Hilco had grossly overstated its damages." Shay also testified that he "believed a ‘straight’ settlement could have been negotiated for less than the ‘high’ end …of the high-low agreement."

 

The Court found that given his testimony "it was obvious" that Shay thought the excess insurer "had a reasonable basis to withhold its consent," so his testimony on that question "did not deny Hilco a fair trial."

 

The Court reached similar conclusions regarding Hilco’s other evidentiary objections and concluded that because the jury found the excess carrier had "a reasonable basis to withhold its consent," it did not need to reach the jury’s other rulings, and affirmed the jury’s verdict.

 

Discussion

There are two sides to every story, and there may well be a side to this story that does not appear from the face of the Court’s opinion. Perhaps the information in the excluded evidence paints a different picture.

 

All of that said, though, the only surprising thing to me about this case is that it went all the way to the Delaware Supreme Court. Pretty clearly, the settlement looked like a set up deal to the jury, and that seems to be the way the Supreme Court saw it too.

 

Whatever else might be said in defense of the settlement process, it is undeniable that the mediation participants’ actions managed to eliminate any possibility that the process would later appear to have been fair to the excess insurer. Their repeated actions to, as the Supreme Court put it, to "cut out" the excess insurer, make it appear as if their goal was to keep the excess insurer from upsetting a settlement that they clearly found advantageous for themselves, even if objectionable – for obvious reasons – to the excess insurer.

 

The details of the settlement that the Supreme Court chose to emphasize in its opinion are telling. The Supreme Court twice noted that at the mediation (a mediation "all agreed" the excess carrier’s representative should not attend to avoid "sending the wrong message"), the mediation participants decided not to wait until the following morning to discuss the proposed settlement. Instead, the Court observed, they cut the excess insurer out of the deal, with the assignment of rights and the agreement that the inidividuals would not be liable.

 

The Court also noted that the mediation participants, having refused even to wait until the next morning to discuss the deal with the excess insurer,  refused to forebear from finalizing the settlement until after the January 5 hearing, depriving the excess insurer of its only means of objecting to the settlement.

 

In addition to the obvious question of fairness of a process that appears to have been calculated to cut out the excess insurer but that nonetheless exposed its interests, there are the further questions of the fairness of the amount of the settlement and the burden it imposed on the excess insurer, given Shay’s trial testimony about the trial prospects of the underlying case and the appropriate settlement valuations at the high end.

 

The interesting thing about the outcome of this case is its suggestion that absent a reasonable opportunity to consider a settlement, a D&O insurer may reasonably withhold its settlement consent. The further implication is that a set up deal that deprives a D&O insurer of a reasonable opportunity to consider a proposed settlement may represent a sufficient basis for the insurer to withhold its consent. Perhaps with an awareness of this possibility, other settlement participants might think twice about taking steps that later could be portrayed as cutting an insurer out of the process.

 

About Those Late Night Settlement Demands: 10 P.M. seems to be a popular time to send D&O insurers unexpected settlement demands. As I noted in a prior post (here), former Globalstar CEO Bernard Schwarz sought his company’s D&O carriers’ consent to a $20 million at 10 P.M. on a Sunday night before his Monday morning trial testimony.

 

In that case, by contrast to the one discussed above, the Second Circuit held that the insurers’ did not reasonably withhold consent to Schwarz’s settlement. However, the critical difference between that case and the case discussed above is that in connection with his settlement, Schwarz accepted personal liability and in fact funded the settlement out of his own assets while seeking coverage from the carriers. This willingness to assume responsibility for the settlement deprived the carriers of the ability to argue that the amount of the settlement was unreasonable and by extension that their action in withholding consent reasonable.

 

In other words, the difference between the two cases is that in the case discussed above the deal looked like a set up. That seems to be how the jury saw it and how the Delaware Supreme Court saw it. That is why I say I am surprised the case went all the way to the Supreme Court. It is hard to argue that someone else wasn’t reasonable when your own conduct can be portrayed as unreasonable.

 

Earlier this year, when the auction rate securities lawsuit against UBS was dismissed (refer here), the obvious question was whether the dismissal signaled the end of the auction rate securities litigation. Certainly, the growing number of companies that, like UBS, had entered regulatory settlements (the basis of the UBS dismissal) or otherwise agreed to redeem the ARS seemed to suggest that the auction rate securities lawsuits pending against other financial companies would suffer the same fate as the UBS suit.

 

But while this anticipated effect is now being realized in some cases, the end of at least a major chunk of the auction rate securities litigation may be nowhere near.

 

There are recent significant developments regarding the possibility that the ARS regulatory settlements and repurchase agreements may mean further auction rate securities lawsuits dismissals. Along those lines, on August 6, 2009, Southern District of New York Judge Victor Marrero granted the defendants’ motion to dismiss in the Northern Trust auction rate securities lawsuit. Judge Marrero’s opinion can be found here. Background regarding the case can be found here.

 

In granting the motions to dismiss, Judge Marrero ruled, citing the decision in the UBS auction rate securities lawsuit dismissal, that the plaintiff had "not alleged recoverable damages," owing to the fact that the plaintiff had "already received compensation for losses suffered as a result of the alleged misstatement or omissions." (In December 2008, the plaintiff had "received par value" for his ARS investments under Northern Trust’s ARS repurchase program.)

 

The UBS and Northern Trust dismissals do seem to suggest that the auction rate securities litigation could be coming to an end — at least for companies that have entered regulatory settlements or repurchase agreements.

 

But not all of the targeted firms have agreed to repurchase the ARS.

 

For example, as reflected in an August 1, 2009 New York Times article (here), Raymond James Financial is "among the holdouts." According to the article, the firm’s clients currently hold approximately $800 million (presumably, par value) of illiquid securities that the first sold them. The firm is working to try to reduce these investor holdings, primarily through issuer redemptions. However, the article, reports that the firm has stated in its disclosure documents that it does not "at present" have the "capacity" to redeem all of the securities.

 

As reflected here, Raymond James is the subject of a pending auction rate securities lawsuit in the Southern District of New York. However, without having made a redemption offer, Raymond James will not be in a position to seek dismissal on the same basis as did UBS and Northern Trust.

 

In addition to the firms that have not redeemed securities, there are the investors whose securities have not yet been redeemed.

 

For example, many of the regulatory settlements either do not extend to institutional investors or only provide for the redemption of institutional investors securities at a later date (in some cases, a much later date.) As a result of the continuing illiquidity of these investors’ securities, many of these investors have filed and are continuing to file lawsuits against the firms that sold them the securities.

 

A very recent example of this type of suit is the lawsuit filed on August 5, 2009 – the day before the Northern Trust dismissal – in the Southern District of New York, by Teva Pharmaceutical Industries and affiliated companies against Merrill Lynch and related entities. The complaint, which can be found here, alleges that Teva purchased CDO action rate notes and other auction rate securities that Merrill Lynch structured and underwrote. The complaint alleges that as a result of the failure of the ARS market, the plaintiffs now holds ARS for which it paid $273 million that now have a market value of less than $10 milllion. (Among the CDO auction rate notes in which Teva invested is the infamous Mantoloking CDO, about which I wrote here.)

 

Nor is Teva alone in its predicament. Teva is just one of several public companies cited in a July 15, 2009 CFO Magazine article entitled "Buyer’s Remorse" (here), which describes the continuing woes of many companies that invested in auction rate securities. Among other things, the article cites a source as saying that nonfinancial public companies still have $24 billion (par value) of ARS on their books. Many of these companies, like Teva, have sued the firms that sold them the securities. A prior post in which I discuss other recent examples of institutional investor auction rate securities litigation can be found here.

 

But a lawsuit by the company against the firm that sold them the securities is not the only litigation possibility involved here. As I previously noted (here), some public companies have been hit with lawsuits by their own investors who claim they were misled about the companies’ exposure to auction rate securities in which the companies had invested.

 

If nothing else, the recently filed Teva lawsuit signals that we may be nowhere near the end of the auction rate securities litigation, even if some of the cases (like those against UBS and Northern Trust) are dismissed. The continuing illiquidity of the securities, the complexity of the transactions and the sheer quantity of dollars involved suggest that at least some of the auction rate securities litigation could and probably will go on for some time to come.

 

I have in any event added the Northern Trust dismissal to my running register of credit crisis-related lawsuit resolutions, which can be accessed here.

 

An Interesting Note: According to his official biography, Judge Marrero filed the seat on the Southern District of New York previously occupied by the newly confirmed Supreme Court Justice, Sonia Sotomayor, prior to her appointment to the Second Circuit.

 

In a noteworthy subprime-related litigation development, on August 5, 2009, the parties to the Countrywide ERISA action filed a stipulation of settlement (here), together with a request for preliminary court approval. Under the stipulation, the case is to be settled by a payment of $55 million, to be funded entirely by Countrywide’s fiduciary liability insurers.

 

The plaintiffs first filed their complaint in September 2007. As reflected in the plaintiffs’ Corrected Second Amended Complaint (here), the case was brought on behalf of participants in the Countrywide benefits plan who made contributions to the plan between January 31, 2006 and July 1, 2008, and whose individual plan accounts were invested in Countrywide stock.

 

The plaintiffs’ complaint alleges that the plan fiduciaries "allowed the imprudent investment of the Plan’s assets in Countrywide’s equity," even though they knew or should have known that such investment was unduly risky," because of the company’s "serious mismanagement, highly improper and potentially unlawful business practices," particularly with respect to subprime loans. The plaintiffs alleged that the defendants breached their fiduciary duties to plan participants.

 

The Countrywide ERISA action joins the Merrill Lynch ERISA case as high profile subprime-related ERISA lawsuits that have resulted in significant settlements – as noted here, the Merrill Lynch ERISA action settled for $75 million. The Countrywide settlement may be particularly noteworthy given that the entire $55 million settlement amount is to be funded by the company’s fiduciary liability insurers. While the Countywide case may be particularly notorious, the ERISA action settlement size may represent an ominous sign for fiduciary liability insurers whose policyholders are involved in subprime-related ERISA litigation.

 

There have been a variety of estimates of the insurance industry’s overall prospective loss exposure due to the subprime meltdown and the credit crisis. Though the magnitude of many estimates is impressive, most of these estimates have largely been based on a series of conjectures about likely D&O and E&O losses. Potential fiduciary liability losses were not a prominent part of the calculation. But if the Countrywide ERISA action settlement is any indication, fiduciary liability insurance losses could prove to be a significant factor in the overall insurance industry exposure from the subprime and credit crisis events.

 

In any event, I have added the Countrywide ERISA action settlement to my roster of subprime and credit crisis-related lawsuit resolutions, which can be accessed here. The ERISA cases can be found in Section III of the roster.

 

State Street’s Subprime Litigation Contingency Reserve Too Small?: In a development that underscore both the massive scale of the subprime litigation exposure and the extent to which that exposure may largely be uninsured, on August 10, 2009 State Street Corporation filed its Form 10-Q (here), in which among other things the company reported that the approximately $625 million reserve it established in January 2008 (for the fourth quarter of 2007 reporting period) may not be sufficient in the event that regulators currently investigating the events were to bring an enforcement action. Details about the initial reserve can be found in a prior post, here.

 

State Street reports that as of June 30, 2009, $193 million of this initial reserve remains. But the filing goes on to note that on June 25, 2009, the SEC has served the company with a "Wells notice" and the SEC staff has recommended the initiation of enforcement proceedings. If the SEC or other regulators were to pursue enforcement actions, the report states, then, "depending upon the resolution of these governmental proceedings, the remainder of the reserve established in 2007 may not be sufficient to address ongoing litigation, as well as any such penalties or remedies."

 

The astonishing erosion of this massive reserve certainly highlights the expense involved in this type of litigation, and the company’s warning that the remaining reserve may not be sufficient, stresses the seeming boundlessness of the exposure. The fact that it is the company’s own reserve that is being eroded suggests that this exposure is largely or entirely uninsured, which shows that no matter how great the insurance industry’s exposure may be from the subprime and credit crisis-related litigation wave, the overall exposure, including uninsured liabilities and amounts, may be many multiples greater.