In a move that recapitulates a classic dispute that has been brewing in bankruptcy court for years, the Stanford Financial Group receiver has asserted that the proceeds of Stanford’s D&O insurance policies are "receivership assets" and that his right to the proceeds "supersedes" the rights of insureds under the policy. Moreover, he has specifically threatened the insurer with "contempt" if it were to advance the individual insureds’ defense expenses. This sequence raises some fundamental issues about the D&O insurance structure and coverage and could highlight the importance of certain policy provisions that have recently become prevalent. It also raises some questions about some coverage structures.

 

Let me just say at the outset that I am not involved in this case and I do not intend in this post to express my opinions on the merits of the parties’ respective positions. Rather, the purpose of this post is simply to note the parties’ dispute and to make some observations.

 

According to a June 30, 2009 motion filed in the Stanford Financial SEC proceeding pending by former Stanford CEO Laura Pendergest-Holt (here), Stanford’s D&O insurance carrier had advised her that it would begin advancing her defense expense, subject to a reservation of its rights to deny coverage under the policy, on July 1, 2009. However, on June 25, 2009, the receiver sent the carrier a letter claiming that the D&O policy proceeds are "Receivership Assets" and that the receiver’s right to the proceeds "supersedes" the right of the other insureds under the policy. The carrier has withheld payment.

 

Pendergest-Holt’s motion seeks clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeks authorization for disbursement of the D&O policy proceeds for payment of her defense expense. A host of other individuals claiming also to be insureds under Stanford’s D&O policy have sought to join in Pendergest-Holt’s motion, as reflected, for example, in the August 6, 2009 motion (here) filed by two former Stanford brokers. UPDATE: The receiver’s response to Pendergest-Holt’s motion can be found here. Special thanks to a loyal reader for providing a copy of the response.

 

The question of ownership and entitlement to D&O policy insurance proceeds is a long-standing question in the bankruptcy context. This recurring question became even more troublesome after so-called "entity coverage" was added to most D&O policies in the mid-90s. This coverage extension provides liability protection for the company itself. In public company policy’s, the coverage is limited just to securities claims. However, for private companies, like Stanford, the entity coverage is usually more extensive.

 

As reflected in a memo (here) by my friend Kim Melvin of the Wiley Rein firm, courts have continued to struggle with these issues in bankruptcy, with some courts finding that the policy proceeds are not a part of the bankruptcy estate and therefore not subject to the stay in bankruptcy, and others reaching a contrary conclusion.

 

But these questions may take on a different light in the context of the question of the advancement of defense expenses subject to a carrier’s reservation of rights. In these circumstances, policy funds are advanced without a final determination of coverage (one that might, in fact, never come, if the claims are compromised). When it comes to the entitlement to advancement of defense expense, it could be argued that, all else equal, the various insureds’ rights — including the bankrupt company’s rights – under the policy could be regarded equivalent.

 

These issues could be even further complicated where, as here, the bankrupt company faces a likelihood of its own third-party liability claims, in which the company will likely incur its own defense expense.

 

One critical element of this dispute may be the question whether Stanford’s policy has a priority of payments provision, which predetermines the order of payment under the policy. This type of provision has become fairly standard in recent years. These provisions generally specify that payment of loss will first be made under the policy’s A Side coverage (which provides individual protection in the event the corporate entity is unable to indemnify them due to insolvency or legal prohibition). These provisions confirm the parties’ intent that the D&O policy serves primarily to protect the individual directors and officers.

 

Whether Stanford’s policy has this type of provision, and if so how the court will interpret and apply it here remains to be seen. The court’s interpretation of this provision (assuming it is in the policy) could be determinative of the parties’ dispute.

 

While the outcome of this dispute remains to be seen, the receiver’s position caused me to reflect on an auxiliary D&O insurance policy that many insureds have acquired in recent years, the so-called Excess Side A/DIC policy. The "difference in condition" coverage extension under this type of policy provides that the policy will "drop down" and provide first dollar coverage under certain circumstances.

 

Although these policies vary significantly, one of the relatively standard features of the DIC coverage is a provision specifying that the policy will "drop down" and provide first dollar coverage if the insured company is in bankruptcy and the proceeds of any traditional underlying insurance cannot be paid because the proceeds are subject to the automatic stay.

 

The circumstances of the dispute involving the Stanford D&O insurance policy present a situation where the individual insureds might well find themselves unable to access the protection of a traditional D&O insurance policy, at least if the receiver’s current efforts are successful. However, even if Stanford Financial D&O insurance program included a Side A/DIC policy, the typical Side A/DIC policy would not appear to provide drop down protection to the individual insureds in this circumstance, because their inability to access the policy proceeds is not as the result of the initiation of an action under the U.S Bankruptcy Code and not as a result of the automatic stay in bankruptcy.

 

The apparent nonapplicability of the drop down coverage to these circumstances under the typical Excess Side A/DIC policy made me reflect that there could be a need for an extension of the DIC coverage’s drop down protection to circumstances like this one where the proceeds of the traditional D&O insurance policy may be unavailable for the individual insureds’ protection for reasons other than the operation of the U.S. Bankruptcy Code. There may well be some DIC policies out there that might respond in this situation, but the typical Excess Side A/DIC policy likely would not.

 

The Stanford Financial insurance dispute will be interesting to watch, although it is an extremely unwelcome situation from the perspective of the individuals involved. In any event, the specifics of the situation suggest a possible (and arguably necessary) extension of the DIC coverage in the typical Excess Side A/DIC policy.

 

I know that many readers may have much more experience with the coverage issues involved in the receiver’s actions in the Stanford Financial case, and many readers may also have views about the extent and limitations of the typical Excess Side A/DIC policy. I encourage readers to share their views with others using the blog’s "Comment" feature.

 

Quelle Surprise: The Lawyers Want to Be Sure They Will Be Paid: Among other things, the receiver’s asset freeze together with the dispute of over the D&O policy proceeds may have left the various individuals’ lawyers wondering when and how they will be paid. R. Allen Stanford’s new criminal defense lawyers want assurance they will be paid before they will take any actions.

 

As reflected in an August 10, 2009 Texas Lawyer article entitled "Stanford’s Lawyers Want Assurance on Pay" (here), Stanford’s erstwhile new legal defense team has entered an appearance in the criminal proceeding against Stanford – solely for the limited purpose of determining "whether Mr. Stanford will be granted access to monies to pay for his legal fees and expenses."

 

"Private Companies Need D&O Insurance, Too": The Stanford Group case may represent an extreme example, but it does illustrate that private companies can become involved in serious claims for which D&O insurance is required. But many private company officials remain unconvinced of the need for D&O insurance, particularly when it comes to closely held companies.

 

A recent memo by Shannon Graving and Thomas H. Bentz, Jr. of the Holland & Knight law firm entitled "Private Companies Need D&O Insurance, Too" (here) takes a look at this recurring question about private companies and D&O insurance. As the article shows, private companies and their directors and officers may be susceptible to a wide variety of claims, as a result of which, the companies – even family owned businesses – would be well advised to secure D&O insurance protection.

 

More Madoff-Related Coverage Litigation: As I noted in a prior post (here), Madoff-related coverage litigation has started to arrive, and there undoubtedly will be more to come. Along those lines, Bloomberg reported today (here) that Madoff feeder fund Tremont Group Holdings and its related organizations have filed an action in Delaware Chancery Court against its insurers for denying coverage for Madoff-related claims.

 

According to the article, Tremont is owned by OppenheimerFunds, a unit of Mass Mutual Financial Group. The article reports that the complaint alleges that Mass Mutual’s D&O insurers and its bond insurers "have ignored repeated requests to pay defense costs." The complaint apparently contends that MassMutual’s D&O insurer has taken the position that the company’s bond insurer should pay a portion of the defense expense, but that "the primary bond underwriters have refused to pay any portion of the joint defense expense." The complaint seeks a judicial declaration of coverage under the applicable policies.

 

I don’t yet have a copy of this complaint, but I will post a link as soon as I get a copy. I would be grateful if any reader that has a copy of the complaint would forward a copy to me (anonymously, of course, if necessary), so that I can post the link. UPDATE: A copy of the complaint can be found here. Special thanks to a loyal reader for providing a copy of this complaint.

 

Special thanks to a loyal reader for sending me a copy of the Bloomberg article.

 

My suggestion (here) that the apparent second quarter securities lawsuit filing lull was due in part to the fact that plaintiffs’ lawyers have a backlog of cases outside the financial sector has proven controversial. All I can say that there is an increasing amount of evidence consistent with the backlog hypothesis. Specifically, a significant number of recently filed securities lawsuits propose class period ending dates that are well in the past, in many cases well over a year in the past. Three cases filed this past week reinforce this observation.

 

To cite the most recent example, on August 7, 2009, plaintiffs’ lawyers initiated a securities class action lawsuit in the Southern District of Texas against Flotek Industries and certain of its directors and officers. As reflected in the plaintiffs’ lawyers’ August 7 press release (here), the ending date of the proposed class period in their complaint (which can be found here) is January 23, 2008, well over a year and a half before the complaint was filed.

 

Similarly in the class action securities lawsuit filed in the Southern District of New York on August 6, 2009 against Conseco, Inc. and certain of its directors and officers, the proposed class period ending date is March 17, 2008, as reflected in the plaintiffs’ lawyers August 6 press release (here).

 

And, to cite another example just from among the complaints filed during this past week, the ending date for the class period proposed in the lawsuit filed on August 4, 2009 against Allscripts-Misys Healthcare Systems (refer here) is February 13, 2008.

 

These cases join a large number of other recently filed cases in which the proposed class period cutoff date is well in the past. Thus, the purported class period in the July 30, 2009 securities class action lawsuit filed against International Game Technology (refer here) ends on October 30, 2008. The proposed class period ending date in the lawsuit filed on July 22, 2009 against Accuray (refer here) is August 19, 2008.

 

An even more noteworthy example is the class period proposed in the securities class action filed on July 17, 2009 against Bare Escentuals (about which refer here), in which the proposed class period end date is November 26, 2007. Similarly, in the securities class action lawsuit filed on July 14, 2009 against Ambassadors Group and certain of its directors and officers, the proposed class period end date is October 23, 2007 (refer here).

 

Other recent cases in which the class period cutoff date is at least six months prior to the filing date include the lawsuit filed on July 10, 2009 against Tronox (refer here).

 

These cases were all filed during July and August, though every single one of them might have and could have been filed earlier. The seeming delayed timing of the filing of these cases might be due to any number of factors. But at a minimum, the seeming delay alone could account for the supposed class action lawsuit filing "lull" observed during 2Q09. The rapid accumulation of these cases during the third quarter suggests that the supposed lull is over. It also suggests that when all is said and done by year’s end, the 2009 securities lawsuit filings levels will likely be consistent with historical norms.

 

Another thing these lawsuits have in common is that, with the exception of the Conseco case, they all involve companies outside the financial sector. It is generally recognized that for some time going well into last year, securities lawsuit filings have been largely concentrated in the financial sector. This noteworthy recent accumulation of seemingly dated cases against companies outside the financial sector strongly suggests that while lawyers were racing to the courthouse over the past couple of years to file lawsuits against financial companies, they were also building up a backlog of cases against companies outside the financial sector, and that they are now actively working off that backlog. Indeed, this process may have started earlier this year (refer here), but it now appears to be picking up considerable momentum.

 

For D&O underwriters, the possibility of lawsuits over long past events may pose a particularly difficult underwriting challenge, as it makes it particularly tricky to determine when a company that has experienced problems is "out of the woods." Compounding the difficulty is the fact that while the D&O insurance market for financial sector companies has "hardened" as a result of economic and related litigation developments, the market for companies outside the financial sector remains competitive, and underwriters may face pressures to compete even for a company with past problems, not withstanding these underwriting uncertainties.

 

It would be all to easy, based on a review of the various recently released mid-year securities litigation reports, to conclude that securities class action lawsuit filing activity is both concentrated in the financial sector and declining. As I have suggested before (here), it is premature to conclude that overall securities litigation activity is in some sort of secular decline. By the same token, it would be incautious to conclude that the securities litigation threat is largely confined to the financial sector. The recent lawsuit filings in fact confirm that companies outside the financial sector continue to face considerable securities litigation exposure.

 

D&O Insurance in Troubled Times: An August 7, 2009 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation blog (here) incorporates a memorandum from the Wachtell, Lipton law firm summarizing the critical D&O insurance issues in the current era of "historically significant dislocation." The memo provides a good but brief summary of critical issues, emphasizing the importance of Side A excess insurance, as well as considerations relating to the financial condition of insurers.

 

Among other things, the memo notes that "it may make sense to spend more for coverage from insurers that appear well-capitalized and financially strong."

 

Apologies for Service Issues: In recent days, some readers may have experienced problems attempting to access some documents to which I have linked on this site. In a sequence of events characterized both by lack of foresight and poor communications, the web address for a server I was using to host some documents for this site was changed without my knowledge, breaking the link to the URLs I used to link to the documents. I have fixed the most important links, but it will take a while to fix all of them. Readers may experience broken links on some older pages on this site for the next week or ten days while I fix the problem.

 

I encourage anyone who needs a particular document that they are unable to access as a result of this problem to contact me directly and I will provide you with a .pdf of the document. I apologize for this service glitch. I also note that anyone who thinks it would be easy to maintain a blog isn’t reckoning, among other things,  with the infinite potential for other people to radically screw things up.

 

Another Subprime-Related Securities Lawsuit Dismissal: In yet another subprime-related securities class action lawsuit decision in defendants’ favor, on July 29, 2009, District of Connecticut Judge Stefan Underhill granted the defendants’ motion to dismiss in the securities lawsuit pending against CBRE Realty Finance and certain of its directors and officers. A copy of the opinion can be found here. Background regarding the case can be found here.

 

As reflected in Alison Frankel’s July 30, 2009 article about the decision in The American Lawyer Daily (here), the court’s order in the CBRE Realty case may be particularly noteworthy because the plaintiffs’ complaint asserts claims under the ’33 Act, in connection with which the plaintiffs would not have to plead scienter or even loss causation in order to survive a motion to dismiss — they only need to plead a material misrepresentation or omission.

 

In his July 29 order, Judge Underhill found that the plaintiffs had not adequately pled that the alleged misrepresentations or omissions were material. The plaintiffs had alleged that in connection with company’s IPO, the company’s offering documents had not adequately disclosed the risk of default in connection with two Maryland condominium conversion projects known as Triton. Judge Underhilll concluded that plaintiffs had failed to allege that there was not sufficient collateral to back the $51 million loan to Triton.

 

Judge Underhill’s ruling does not indicate whether or not it is with or without prejudice; however, he did order the court clerk to close the file.

 

I have added the CBRE decision to my register of subprime and credit crisis-related lawsuit dismissal motion outcomes, which can be accessed here.

 

Still More Bank Failures: In case you missed it, this past Friday night, the FDIC closed five more banks, bringing the year to date total number of bank failures to 69. The FDIC has taken control of 32 banks just since June 19, 2009. An August 1, 2009 Bloomberg article detailing the latest bank closures can be found here.

 

The most recent round of bank closures continues the trend concentration of recent bank closures within the community banks. Four of the five latest bank closures involved institutions that had assets of under $1 billion. Of the 69 banks that have closed this year, 59 have had assets under $1 billion.

 

The signs are that the bank closures will continue for some time to come. The July 31, 2009 Wall Street Journal reported (here) that banking regulators have already entered at least 285 memoranda of understanding with banking institutions this year, on pace for nearly 600 by year end, compared with 399 for the full year last year. While the MOUs are designed to try to direct the institutions away from closure, the sheer number of agreements is a reflection of the difficult circumstances that many banking institutions are facing.

 

The FDIC’s complete list of banking institutions that have failed since October 2000 can be found here.

 

Another Madoff-Related Insurance Coverage Action: In an earlier post (here), I noted the arrival of the Madoff-related insurance coverage litigation and suggested there would be much more similar coverage litigation ahead. Another Madoff-related coverage lawsuit has now arrived.

 

On July 20, 2009, Blezak Black filed an action (here) in New Jersey (Camden County) Superior Court against its crime insurers. The plaintiff alleges to have invested over $13 million with Madoff, which it lost. The plaintiffs’ crime insurers have denied coverage for the claim. The plaintiff’s complaint alleges breach of contract and seeks a judicial declaration of coverage.

 

I have added this lawsuit to my register of Madoff-related insurance coverage litigation, which can be found in Table V of my register of Madoff lawsuits. The register can be accessed here.

 

Special thanks to a loyal reader for providing a copy of the latest Madoff-related insurance coverage lawsuit complaint.

 

For some time, I have been asserting (refer here, for example) that increasing levels of Foreign Corrupt Practices Act enforcement activity represents an important development in the world of D&O insurance. During a conversation at the American Bar Association Annual Meeting in Chicago this past week, a senior claims executive from one of the leading D&O insurers expressed skepticism to me on this topic, essentially suggesting that D&O insurance doesn’t have anything to do with FCPA enforcement.

 

It is certainly true that fines and penalties imposed as a result of an FCPA violation would not be covered under the typical D&O insurance policy. But in many instances, defense costs incurred in defending against the enforcement action, which could be quite substantial, are likely to be covered under many D&O policies, so even just to that extent, increased FCPA enforcement activity could represent a significant D&O insurance development.

 

But perhaps even more significant for D&O insurance purposes than expenses incurred in defense of the enforcement activity itself is the exposure presented by the possibility of a follow-on civil lawsuit. As I have previously noted (most recently here), a separate civil action by shareholders or others is an increasingly frequent accompaniment of the FCPA enforcement activity. A recently filed case provides the latest example of this phenomenon.

 

On July 23, 2009, investors in Panalpina World Transport (Holding) Ltd. filed a securities lawsuit in the Southern District of Texas against the company, certain of its current and former directors and officers, and the foundation that owned the company prior to its September 2005 IPO. The investors’ complaint can be found here.

 

Panalpina is a Swiss company which the complaint alleges has "substantial operations in the Southern District of Texas." The complaint describes the company as "the market leader in freight forwarding services for the oil and gas industry." The complaint alleges that the company "concealed" that its Nigerian operations "depended on bribes to customs agents in Nigeria," in violation of the FCPA. The complaint further alleges that in its public reports the company "has essentially conceded its violations of the FCPA."

 

The complaint further alleges that when the illegal practices were revealed, the company "was forced to cease them," and its financial results and share price were "materially and negatively impacted." The complaint alleges that since disclosing its illegal activities in Nigeria on July 24, 2007, and subsequent disclosures regarding the material impact of the Nigerian business, the company’s common stock has lost over 78% of its value.

 

The complaint alleges violations of the Sections 10(b) and 20 of the Securities Act; Common Law Fraud; Aiding and Abetting Common Law Fraud; and Negligent Misrepresentation.

 

There are several interesting things about this new complaint. First, the case is an example of the ways in which FCPA-related activity can result in, for example, securities litigation against a company and its directors and officers. Subject to the terms and conditions of the applicable coverage, the expense of defending this kind of claim, as well as any subsequent settlement or judgment, would likely by covered by the typical D&O insurance policy. This case is just the latest example of how the growing FCPA enforcement activity represents a significant development from a D&O claims perspective.

 

But there are other interesting aspects of this suit, separate and apart form this primary consideration. Among other things, the complaint does not appear to be brought as a class action lawsuit. Rather, the action appears to have been brought solely on behalf of four apparently related investment partnerships, based in Connecticut and in the Cayman Islands.

 

The absence of class action allegations could be due to the fact that though Panalpina is a publicly traded company, its shares do not trade on any U.S. exchanges. (Its publicly traded shares trade only on the Swiss Exchange.) As a foreign domiciled company whose shares trade only on a foreign exchange, many of its shareholders likely are also domiciled outside the U.S., and so an action on behalf of a class of Panalpina shareholders could present a classic example of the f-cubed claimant problem (that is, foreign investors who bought their shares in a foreign company on a foreign exchange). Though the named plaintiffs include at least on foreign domiciled fund, several of the named plaintiffs are based in Connecticut and thus to that extent the f-cubed problem may be averted.

 

There may yet be some interesting jurisdictional questions in this case. Not only is the company foreign domiciled, and not only are its shares traded elsewhere, but the supposed bribery took place outside the U.S. And, without plumbing the depths of the factual allegations, it would seem that many of the alleged misrepresentations took place outside the U.S., notwithstanding the fact that the company may have substantial U.S. operations. The case seems to present circumstances quite analogous to the facts involved in the securities suit against National Australia Bank case (refer here), in which the Second Circuit ultimately concluded that the U.S. courts lacked subject jurisdiction over the matter.

 

Jurisdictional issues notwithstanding, this case in and of itself represents yet another example of a recurring phenomenon, one that I think will continue to gain importance in the months ahead, as a result of increasing FCPA enforcement activity.

 

The latest information regarding the increasing levels of FCPA enforcement can be found here.

 

In a July 31, 2009 report , Advisen became the latest group to confirm that securities litigation declined in the second quarter of 2009, noting in its report entitled "Securities Litigation Drops in Q2 2009" (here) that securities lawsuit filings "fell off in the second quarter from the frantic first quarter." Advisen’s July 31, 2009 press release describing its study can be found here.

 

But while the Advisen report is consistent with the report released earlier by Cornerstone Research (refer here), NERA Economic Consulting (refer here), as well as my own prior report (here), the Advisen report takes a slightly different approach to the topic and as a result contributes an important additional perspective.

 

It is absolutely critical to note at the outset that in using the term "securities lawsuit," the Advisen report is describing a category broader than just securities class action litigation. In addition to the securities class action litigation, the Advisen report uses the term "securities lawsuit" to include shareholder derivative litigation; breach of fiduciary duty litigation; "securities fraud" litigation, which includes regulatory actions brought by the SEC; as well as other kinds of litigation.

 

Using this broad definition, the Advisen reports that there were 121 "securities lawsuit" filings in the second quarter, down from 212 in the record-setting first quarter. Overall the first half "securities lawsuit" filings were within although slightly below historical norms.

 

The Advisen report notes that there were 37 new securities class action lawsuit filings in the second quarter, down from 70 in the first quarter. The 107 first half securities class action lawsuit filings would translate into 214 filings on an annualized basis, "in line with most recent years."

 

In speculating on the reasons for the first half decline, the Advisen report comments that the first half filings seem to have been "frontloaded" into the first quarter of the year. The report also states that "the second quarter could represent a lull in litigation activity while law firms worked on the flood of suits from the first quarter." The report does note (as I also observed, here) that "the first few weeks of the third quarter have seen a surge in securities suits once again."

 

The Advisen report also states that there were 41 settlements/awards in securities lawsuits in the second quarter of 2009, including the $2.9 billion jury award against Richard Scrushy in the HealthSouth shareholders’ derivative lawsuit. Taking the Scrushy award into account, the average settlement/award in the second quarter was $101.5 million, but if the Scrushy award is disregarded the average settlement/award drops to $60.0 million. The average securities class action settlement in the second quarter was $74.5 million, a quarterly average amount the report describes as "quite high."

 

The report has a number of other interesting observations, many of which have been noted in the previously released reports, including the concentration of the litigation activity in the financial sector; the increasing level of litigation involving foreign domiciled companies; and the elevated levels of activity involving the Ponzi scheme allegations.

 

Advisen Webinar: Advisen will be hosting a free webinar to discuss the findings in its second quarter report on August 3, 2009 at 11 am EDT. I will be participating in the call along with David Bradford and John Molka of Advisen, Randy Hein of Chubb and Tripp Sheehan of Marsh. For further information about the call and to register, refer here.

 

About Those July Securities Filings: The Advisen report mentions that in the first month of the third quarter, securities class action lawsuit filings seem to have ramped up again. Just to detail that point, by my count, there were at least 16 new securities class action lawsuits filed in July, which is a filing rate that is back at historical levels.

 

With respect to the new July filings, it is also interesting to note how few of these new lawsuits were in the financial sector. While five of the new lawsuits involve financial companies, the other eleven did not, which is sort of the exact opposite of the equivalent proportions for the first half of the year. Of the eleven new suits involving nonfinancial companies, as many as seven involved companies involved in the life sciences sector.

 

The other interesting thing about these July filings is how many of them involve purported class periods ending dates that are well in the past, as I previously noted here. To cite the most recent example, the purported class period in the July 30, 2009 securities class action lawsuit filing against International Game Technology (refer here) ends on October 30, 2008.

 

The July filings seem to me to be consistent with the hypothesis that the downturn in securities class action filings during the second quarter was just a temporary lull. In addition, the July filings are inconsistent with the hypothesis that the plaintiffs’ lawyers are running out of targets to sue. Rather, the July filings suggest to me, as I have speculated elsewhere, that the plaintiffs’ lawyers ran into a logjam during the second quarter and as they ran up a backlog of cases to be filed against nonfinancial companies. All of the evidence so far in the third quarter is entirely consistent with this final hypothesis.

 

One Thing the Plaintiffs’ Lawyers Were Up to During the First Half: As I also noted elsewhere, though the plaintiffs’ lawyers’ may not have been filing new securities class action lawsuits during the second quarter, they were by no means idle. A July 31, 2009 press release (here) by the Tramont Guerra & Nunez firm, issued in response to the various published reports regarding the decline in second quarter filings, provides some insight into at least one particular way the plaintiffs’ lawyers were otherwise occupied during the second quarter.

 

According to the press release, Finra’s dispute resolution statistics show an 82% increase in the arbitration claims for the first half of the year, with the majority of claims filed for breach of fiduciary duty and misrepresentation. Finra’s statistics can be found here. As I said, the plaintiffs’ lawyers were not idle.

 

On July 27, 2009, NERA Economic Consulting became the latest to publish a mid-year analysis of the year to date securities litigation developments. The NERA report, written by Stephanie Plancich and Svetlana Starykh, is entitled "Recent Trends in Securities Class Actions Litigation: 2009 Mid-Year Update," and can be found here. The NERA Report joins the earlier mid-year report of Cornerstone Research (refer here). My own mid-year review can be found here.

 

The NERA report seemingly reports a higher number of securities class action filings than the earlier reports, although the seeming difference requires some explanation; on closer review, the apparent difference arguably becomes more apparent than real. In addition to an analysis of the first half lawsuit filings, the NERA report also includes a review of the first half securities lawsuit settlements as well.

 

For the first six months of 2009, NERA reports that there were 127 new securities class action filings. This tally is quite a bit higher than the 87 first half filings that Cornerstone reported in its recent study of first half filings. However the difference may be attributable to a difference in counting methodology. As explained in footnote 2 of the NERA report, "unless cases are consolidated, we report all filings potentially related to the same alleged fraud, if the complaints are filed in different Circuits or if different securities are alleged to be affected by the fraud." Since many of the complaints filed in the first half involve duplicated allegations with multiple complaints filed in different circuits, NERA’s reported number of filings is quite a bit higher than other published reports. NERA notes that "if cases are ultimately consolidated, the data are adjusted." Hence, my statement that the seeming difference in the number of filings may be more apparent than real.

 

The NERA report notes that the first half filings are on an annualized pace of more than 250 filings, which would be more than in 2008. Consistent with earlier reports, the NERA report does note that the number of filings declined in the second quarter. The NERA report also notes that the first half filings were largely driven by the credit crisis cases and new lawsuits relating to the Ponzi schemes. Over 40% of first half filings were credit crisis related and over 20% were related to the Ponzi scheme allegations. About 67% of first half filings named at least one financial company as a primary co-defendant.

 

In addition, the NERA report notes that accounting firms have been named as co-defendants in 17.3% of filings, which represents a significant increase from prior years. Cases against foreign domiciled defendants have also increased, with 19 cases or 15% of all cases naming a foreign company as a primary defendant, the highest percentage since the passage of the PSLRA.

 

In terms of drivers affecting the pace of securities class action lawsuit filings, the report confirms that the filing rate is correlated to overall market volatility, but the relationship is "not tight" and in fact volatility accounts for only about 28% of the variability in quarterly filing levels.

 

In looking at case resolutions, the report attempts to determine how long on average it takes for these cases to be resolved. Looking back at the cases filed in 2000, the report finds that on average, the time to resolution is 2.9 year, with an average time for dismissals of 1.7 years and settlements it was 3.5 years. Most of the more recent cases, particularly those related to the subprime meltdown and the credit crisis still remain only in their earliest stages, and so it is too early to tell how these cases ultimately will be resolved.

 

In analyzing case outcomes overtime, the report finds that a higher fraction of cases have been dismissed since the U.S. Supreme Court’s 2005 ruling in Dura Pharmaceuticals, consistent with the hypothesis that defendants are more likely to prevail in a motion to dismiss as a result of that decision.

 

With respect to settlements so far this year, the NERA report finds that the median securities class action settlement is $8 million, which is about the same as in 2008. Median values have remained very consistent for the past five years.

 

The average securities class action settlement during the first half of the year has been $43 million, about even with last year’s average and slightly below the average of $49.6 million for the period 2003 to 2009. The high average relative to the median is driven by large outlier settlements. If the settlements above $1 billion are removed, the average for the period 2003 to 2009 drops to $27.6 million, although the year to date average for 2009 settlements remains at $43 million. A substantial number of settlements this year have been over $100 though less than $1 billion.

 

Median investor losses for cases filed in 2009 ($600 million) are much higher than for cases settled in 2009 ($289 million). Since settlement amounts traditionally have been "strongly correlated" to investor losses, this would seem to suggest that the 2009 cases would be much higher than more recently settled cases. However, given that the companies affected by the credit crisis "may no longer have …substantial resources to make …large settlement payouts" the traditional relationship of settlement amount to investor losses may or may not hold.

 

With the closure of a group of six interrelated Georgia banks this past Friday night, the state has now reclaimed the dubious distinction of as having the most failed banks of any state this year. With the addition of the most recent closures, there have now been 16 failed banks in Georgia this year, compared to 12 in Illinois, which had previously and for a brief period (refer here) led Georgia in the number of failed banks.

 

There were a total of seven bank closures on July 24, 2009, which brings the year to date total number of closures to 64. The pace of bank failures has definitely picked up in the last several weeks. There have been 27 bank closures just in the five-week period since June 19, which is more that the number of banks (25) that failed in all of 2008.

 

The six Georgia banks that filed Friday were all subsidiaries of Security Bank Corp., which had been Georgia’s fourth-largest lender. The six units were technically six separate banks, although according to the Atlanta Business Chronicle (here), "the banks essentially operated as the same institution."

 

The Atlanta Journal-Constitution described the rise and fall of the holding company (here) as "a stark symbol of the state’s banks woes." The bank made a "fatal push" into the Atlanta residential market in 2005 and 2006. The bank "tripled in size" between 2005 and 2009. The bank lost $243 million last year, and at the end of the first quarter of 2009 reported $277 in "severely delinquent loans that bank had given up hope of collecting on."

 

There have now been 22 different states that have had at least one bank failure this year. Beyond Georgia and Illinois, the other states with high numbers of bank failures include California (8) and Florida (3). Generally, the banks that have failed so far this year have been smaller banks; of the 64 banks that have failed so far this year, 55 have had assets under $1 billion. The FDIC’s complete list of all banks that have failed since October 2000 can be found here.

 

Relatively few of the bank failures involve publicly traded institutions. In its recent mid-year report on securities litigation (here), Cornerstone Research noted that of the 45 banks that had failed through June 30, 2009, only 21 involved publicly traded companies, and only one failed banks had been involved in securities class action lawsuits this year.

 

My earlier post analyzing the number of failed banks in Georgia can be found here.

 

Break in the Action: The D&O Diary will be on an intermittent publication schedule for the next few days. The "normal" publication schedule will resume the week of August 10.

 

In a July 15, 2009 motion (here), the plaintiff in the subprime-related securities class action lawsuit involving RAIT Financial Trust moved for preliminary approval of a proposed settlement of the case. According to the company’s May 27, 2009 filing on Form 8-K (here), the parties entered a preliminary agreement on May 26 2009 to settle the case for a cash payment of $32 million, to be funded entirely by the company’s D&O insurers.

As reflected in greater detail here, the company was first sued in August 2007 in a securities class action lawsuit alleging that in the offering materials accompanying the company’s January 2007 IPO as well as subsequent statements, the defendants made misrepresentations and omissions about the company’s credit underwriting, exposure to investments in debt securities, loan loss reserves and other financial items.

In a December 22, 2008 ruling, Eastern District of Pennsylvania Judge Legrome Davis substantially denied the defendants’ motions to dismiss. Among other things, Judge Davis’s ruling was noteworthy for its acceptance of the "core business operations" theory in concluding that the plaintiffs had adequately pled scienter, as discussed at greater length here.

The RAIT settlement joins the recent Accredited Home Lenders settlement (refer here) as subprime-related securities lawsuits in which the cases settled after the motions to dismiss were denied. The $22 million settlement in the Accredited case together with the $32 million settlement in this case suggest that companies (or at least their D&O insurers) may face significant financial consequences for losing the dismissal motion in these cases. These settlements and the recent $30.5 million settlement in the Beazer Homes case also start to create an impression that overall, the subprime and credit crisis cases might prove to be very expensive to resolve.

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

Very special thanks to a loyal reader for calling my attention to the RAIT settlement.

As I have shown (here) and has been detailed by others (here), the number of securities class action lawsuits declined during the first half of 2009 compared both to last year and to historical norms. There is a lot that might be said about the decline and its causes. However, the mainstream media (refer, for example, here) has latched onto the message that the number of securities suits is declining because the plaintiffs are "running out of people to sue."

 

Let’s be honest — fish gotta swim, birds gotta fly, and plaintiffs’ lawyers make their living filing lawsuits. The fish and the birds can be counted upon to continue their traditional activities, and so can the plaintiffs’ lawyers. The very idea that the plaintiffs have run out of targets is a flawed conclusion built on a faulty premise.

 

Before I get started on this topic, I think it would be useful to review why this question matters. Once before, the idea circulated that the securities class action plaintiffs’ lawyers were going out of business. This hypothesis turned out to be very wrong and it proved to be a very expensive mistake.

 

After the PSLRA was enacted at the end of 1995, some D&O insurers assumed the statute’s passage would mean that many fewer securities lawsuits would be filed, and so they slashed their insurance pricing. The marketplace followed. When securities litigation ramped back up, the D&O insurance industry suffered hundreds of millions of dollars in losses. The industry paid a lot of tuition to learn that what plaintiffs’ lawyers do is file lawsuits. Given how expensive the lesson was, it would seem unwise to start assuming now that anything has changed.

 

But with respect to the recent decline in securities lawsuits, let’s at least get the facts straight. The number of lawsuits did not decline during the entire first six months of the year. During the period January through April, the number of new securities lawsuit filings was more or less at normal levels. The drop took place in May and June. Now, looking at the ebb and flow of securities lawsuit filings during the last 14 years, there arguably is nothing noteworthy about a two-month decline. It could just be a blip. It may or may not continue; only time will tell. It does seem important (to me at least) that so far in July, there have already been at least twelve new securities lawsuits, more than were filed in either May or June.

 

The other thing about the first half of 2009 is that it was not as if the plaintiffs’ lawyers were idle — they were just otherwise occupied. Among other things, they were busy filing lawsuits related to Madoff, the Stanford Financial Group and other Ponzi schemes. Indeed, my list of Madoff-related lawsuits (which can be accessed here) now runs to some 23 pages, with more than 40 new cases filed during May and June.

 

This other extensive litigation activity is highly relevant, because of the similarity to what happened back in the period mid-2005 to mid-2007. That was the period when there was a sustained "lull" in new securities class action lawsuit filings. During that period as well, the plaintiffs’ lawyers were also otherwise engaged. Then, they were busy filing options backdating-related shareholders’ derivative lawsuits, eventually filing 168 of them (as shown here).

 

That prior "lull" in new securities lawsuit filings motivated some observers to speculate that the move to lower securities litigation levels might represent a "permanent" change. Subsequent history has shown that in fact there was no permanent change, and indeed the securities lawsuit activity returned with a vengeance.

 

Of course, it is possible that plaintiffs’ lawyers have indeed run out of targets and that lower level of new securities class action filings will persist going forward. Only time will tell. Just based on what history has shown, though, both after the passage of the PSLRA and after the so-called "lull," I think it would be unwise to bet that hereafter the plaintiffs lawyers will file fewer securities lawsuits.

 

My own theory about why the number of lawsuits has dipped is that the plaintiffs’ lawyers have been busy, not just with the Madoff lawsuits, but also dealing with the extraordinary number of lawsuits they previously filed in connection with the subprime meltdown and credit crisis. Many of these lawsuits are uncommonly complicated and they have in many cases entered procedurally demanding stages.

 

The main reason I believe that the plaintiffs’ lawyers have just been jammed up is that I think there is evidence that they are dealing with a backlog of cases, a point that I have made before (here). Recent filings even further reinforce the conclusion that the plaintiffs’ lawyers are now starting to work off a backlog.

 

Many of the recent filings have proposed class periods that are well in the past, sometimes years in the past. For example, the securities lawsuit filed on July 14, 2009 against Ambassador Group (refer here) has a proposed class period cutoff date of October 23, 2007. The securities lawsuit filed on July 17, 2009 against Bare Escentuals (refer here) has proposed class period cutoff date of November 26, 2007. The securities lawsuit filed on July 22, 2009 against Accuray (refer here) proposes a class period cutoff of August 19, 2008. Other recent filings though not quite as superannuated involve class period cutoff dates that well over six months past (refer, for example, here).

 

If you notice from the cases I have listed above and in my prior post, these cases not only involve a time gap, but they also are all outside the financial sector. It seems as if the plaintiffs lawyers have been so preoccupied with the race to the courthouse in lawsuits against the financial sector, they are just now getting around to filing the cases against the other kinds of companies.

 

The way I look at it, the plaintiffs’ lawyers have not had a shortage of targets, they have just had a shortage of time. But evidence suggests that they are getting caught up and they are now getting around to working off the backlog that has been accumulating. The one thing I know for certain is that they will continue to file lawsuits. Consider how reliable the birds and fishes are, and I think you will see what I mean.

 

One line of analysis that does give me pause is the suggestion that the lawsuit filings declined because of diminished stock market volatility. According to this theory, there is a correlation between overall market volatility and the level of securities lawsuit activity. This theory may have something to it; it is certainly the case that an individual lawsuit is directly related to the target company’s experience of volatility in its own share price. If this market volatility theory is true and if the lower volatility persists, then we could be in for a period of lower numbers of security lawsuits. We had a lull before, we could certainly have one again.

 

Because of the possibility that persistent lower market volatility might mean reduced lawsuit filings for awhile, I am not making any absolute predictions. I am just saying that I wouldn’t make any bets based on the assumption that the plaintiffs lawyers have run out of people to sue.

 

By the SEC’s own account, an enforcement action the SEC initiated on July 22, 2009 represents the first occasion on which it has used the Sarbanes-Oxley Act’s "clawback" provision to recover compensation from an individual not otherwise alleged to have violated the securities laws. While this type of action apparently was contemplated by the statute, it has never been pursued before and it raises some interesting questions.

 

As reflected in the SEC’s July 22, 2009 press release (here), the SEC enforcement action charges Maynard L. Jenkins, the former CEO of CSK Auto, with violation of Section 304 of the Sarbanes Oxley Act, the statute’s compensation clawback provision. The action seeks to compel Jenkins to reimburse CSK Auto for the more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." A copy of the SEC’s complaint can be found here. (Hat tip to the Courthouse News Service for the complaint.)

 

In May 2009, the SEC brought a settled enforcement action against CSK for filing false financial statements for fiscal years 2002 though 2004. The SEC has also brought a separate civil enforcement action against four CSK officials, but Jenkins is not among the officials that the SEC is pursuing.

 

Section 304 does provide that if a company restates its financials, then the company’s CEO and CFO "shall reimburse" the company any bonus compensation received during the 12 months following the restated period, as well as any stock sale profits earned during those twelve months.

 

There is no requirement in Section 304 that the CEO or the CFO from whom the reimbursement is sought have any involvement in the events that necessitated the restatement. Indeed, the statute doesn’t require any showing of wrongdoing or fault at all.

 

Professor Larry Ribstein criticizes the SEC’s use of the statute this way in a post on his Ideoblog (here), for "punishing business executives even when they are not accused of making a mistake." Jenkins undoubtedly will attempt to challenge the SEC’s attempt to use the statue this way. This provision has never been challenged on this basis before, so it will be interesting to see whether it withstands the legal challenge.

 

The SEC’s use of the statute in this way will undoubtedly add yet another item to the long list of criticisms of Section 304. As noted here, the statute previously has been criticized, among other reasons, because it lacks a private right of action; because it can only be used against the CEO and CFO, but not other corporate officials; and because it is only available in the event of a restatement, but not for other accounting discrepancies. Now it will be criticized as well because it can, if the SEC’s position withstands judicial scrutiny, effect a forfeiture without a requirement of fault, involvement or knowledge of the circumstances requiring the restatement.

 

To be sure, the logic of the statute is that since the financials were restated, the compensation was never earned in the first place. But litigation has its costs, and the burden an executive hit with a suit like this must endure goes beyond just the compensation he or she might be required to return. Among other things, defending against an SEC enforcement action can be extremely costly.

 

An executive facing an action like this might well seek to have his or her defense expenses paid by the company’s D&O insurer. But there could be problems with that as well. There would likely be no coverage under the typical D&O policy for any returned compensation, among other reasons because of the standard exclusion for claims for any "profit or advantage" to which the executive was "not legally entitled."

 

Many of these exclusions are written with a broad preamble (that is, precluding coverage for any loss "based upon, arising out of, or in any way relating to"), which some carriers might attempt to rely upon to preclude coverage not just for the returned compensation but for costs incurred in defending against the claim, even before a liability finding. While this interpretation of the policy would be highly suspect, the possibility of this interpretation highlights the need to try to revise the exclusion to require an actual judicial determination of the absence of "legal entitlement" to the profit or advantage before the exclusion’s preclusive effect is triggered. This revision may help to ensure that if an executive is hit with one of these suits that there is at least insurance coverage available for the executive to mount a defense.

 

An interesting July 22, 2009 Bloomberg article discussing the case can be found here. The article quotes a number of commentators with a variety of perspectives on the SEC’s action.