As reflected in a recently released and detailed analysis of audit firms’ current litigation and prior lawsuit settlements, the audit firs’ litigation challenges are a serious and growing problem. The July 2009 presentation by Mark Cheffers, the CEO of Audit Analytics, is entitled "Accounting Professional Liability: Scorecards and Commentary" and can be found here. According to a July 22, 2009 Compliance Week article (here), Cheffers presented the slides at a recent litigation conference cosponsored by the American Bar Association and the American Law Institute.

 

The presentation materials reflect very detailed information about the major accounting firms’ litigation. Among other things, the presentation aggregates the top 50 accounting malpractice settlements since 1999. The data show that Ernst & Young has paid the largest amount in malpractice settlements during that period, totaling $1.92 billion. KPMG follows with settlements totaling $1.42 billion, followed by PricewaterhouseCoopers at $1.27 billion and Delotte & Touche at $1.25 billion.

 

As detailed in the presentation, the audit firms now face huge potential exposure from the growing numbers of lawsuits that have been filed against them in connection with the credit crisis and the Madoff scandal. Cheffers’ presentation lists the current litigation scorecard of cases that have been filed against the audit firms. According to the Compliance Week article, Cheffers said at the conference that these lawsuits filed so far are "likely just the beginning."

 

The presentation also shows the prevalence of going concern audit opinions, both in terms of percentage of all audit opinions and in absolute numerical terms. The presentation shows that in 2008 going concern opinions, both in percentage terms and in absolute numbers were at their highest level in the past decade

 

There may well be other places where this kind of information about audit firm liability exposure has previously been compiled, but this is the first time I have seen the information presented this comprehensively. The information presented in the slides is fascinating and one can only hope that Cheffers will continue to update the information and continue to make it publicly available.

 

 The 2009 securities lawsuit filings have been characterized by an overall decline in filing activity, particularly in the second quarter, as well as the continued prevalence of lawsuits against financial sector issuer-defendants, according to a July 20, 2009 study by the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research. The study, which is entitled "Securities Class Action Filings: 2009 Mid-Year Assessment" can be found here. A July 20 press release describing the study can be found here. My own prior study of the first half securities lawsuit filings can be found here.

 

According to the Cornerstone study, there were 87 securities class action lawsuits filed in the first half of 2009, which represents a 22.3 percent decline from the 112 securities suits that were filed in both the first half and the second half of 2008. The first half filings project to an annual filing rate of 174 securities class action, which would represent a 22.3 percent decrease from 2008 and an 11.7 percent decrease from the annual average for the 12 years ending in December 2008.

 

The drop in new filings was particularly pronounced in the second quarter of 2009, as only 35 of the 87 new filings occurred during the second quarter. The Cornerstone Report notes that over the same period, there was "a similarly dramatic decline" in the stock market volatility measured by the Chicago Board Options Exchange Volatility Index. The report also suggests that the "decline in market volatility raises the possibility of a return to the subdued levels of filing activity observed from the third quarter of 2005 to the second quarter of 2007."

 

Filings against companies in the financial sector predominated in the first half of 2009, as financial companies were named as defendants in 66.7 % of the first half filings. Slightly less than 50% of the first half filings were related to the credit crisis, as 42 of the 87 first half filings contained allegations related to the credit crisis.

 

The 2009 mid-year report contains a couple of new metrics. The first measures the number of unique issuers whose exchange-traded securities were involved in class action lawsuits. The metric shows that the number of lawsuits against unique exchange traded issuers has declined even more rapidly than the overall number of new lawsuits. The decrease is "driven by a large number of filings related to non-exchange trade securities and private companies" in the first half of 2009. These suits relate to Ponzi scheme allegations as well as other filings "related to mortgage-backed securities, preferred stock and open-ended mutual funds."

 

The other new metric in the mid-year report measures the number of filings against defendant corporations headquartered outside the United States. The metric shows that the number of suits against non-U.S. companies has been gradually increasing over the years, from only 6.8 percent of all filings during the period 1997 through 2003 to 13.8 percent in 2008. This upward trend continued in the first half of 2009, with 20.7 of all filings against non-U.S. companies, largely due to cases against foreign domiciled companies in the financial sector. Interestingly, this increase in litigation activity has coincided with a decrease in the share of foreign companies listed on the major U.S. exchanges.

 

In terms of the potential damages involved in the first half filings, the report’s detailed analysis shows that the 2009 filings are characterized by a decrease in losses associated with announcements at the ends of class periods and an increase in overall market capitalization losses for the entire class periods.

 

The report notes that since the end of 2008, there has been an "unprecedented" concentration of new Ponzi-scheme related filings. The Madoff scandal has resulted in five filings in the second half of 2008 and 15 in the first half of 2009, and there were four additional Ponzi scheme-related filings unrelated to Madoff in the first half of 2009.

 

The report concludes with an observation of the heightened number of bank failures during 2009, adding the observation that only 21 of the 45 banks that had failed through June 30, 2009 were publicly traded, and only one of the bank failures has resulted in a securities class action lawsuit.

 

The report’s new metric related to number of lawsuits against unique exchange-traded issuers is particularly useful for observers of public company litigation trends. Though the numerous lawsuits against private firms and mutual fund companies are interesting and important, those developments are less likely to affect the overall market for public company directors and officers liability insurance. In that respect, the Cornerstone report’s observation that the decline in lawsuits against unique publicly traded companies is even more pronounced than the overall decline in lawsuit filings is a particularly significant observation. The addition of this new metric is a particularly useful and welcome addition to Cornerstone’s reporting on litigation activity.

 

The report’s suggestion that the decline in lawsuits is linked to a decline in market volatility is also particularly interesting, as is the observation that lower volatility may mean a return to the low filing activity of the period mid-2005 through mid-2007. My own view, expressed in my prior post (here), is that the decline in lawsuit filing activity during the second quarter arose because plaintiffs’ lawyers found themselves in a logjam, due to the onslaught of Madoff-related litigation and the fact that many of the previously filed credit crisis cases had reached critical procedural stages.

 

The filings so far in July have in fact been characterized by the number of lawsuits outside the financial sector, many with class period ending dates considerably before the filing dates, which does suggest that plaintiffs’ lawyers are to a certain extent working off a backlog. Of course, the pace and nature of the second half filing activity overall remains to be seen.

 

ABA TIPS Panel: The Financial Collapse — What Caused It and How Will It Continue To Impact Corporations and Their Boards?: The American Bar Association Tort Trial & Insurance Practice Section (TIPS) Task Force on Corporate Governance will hold this meeting at the ABA Building in Chicago on July 30, 2009 as part of the ABA Annual Meeting, to discuss the 2008 financial collapse and how corporations can manage risk throughout the remainder of the ongoing crisis.

 

I will be participating in this free session, which will be chaired by my good friend Kim Hogrefe from Chubb. The panel will also include Fiona Phillip of Howrey LLP and Dr. Faten Sabry of NERA Economic Consulting. The event will be followed by a reception. More information about the event, including event registration can be found here.

 

In the latest subprime-related securities lawsuit to be settled, on July 15, 2009, the parties to the Accredited Home Lenders Holding Company securities fraud lawsuit filed a motion for preliminary approval of their proposed $22 million settlement of the case. A copy of the parties’ stipulation of settlement can be found here. Background regarding the case can be found here.

 

The Accredited Home Lenders case was one of the earliest subprime-related securities lawsuits to be filed – the first filed complaint in the case was filed in March 2007. And as reflected here, it was also one of the early subprime-related cases to survive a motion to dismiss.

 

In her January 4, 2008 order denying the motion to dismiss, Central District of California Judge Marilyn Huff found that the plaintiffs’ complaint adequately pled that the alleged misrepresentations were false and misleading. In making this finding Judge Huff relied on the "group pleading doctrine" which she found properly applied to the officer defendants because they had "direct involvement with the company’s day to day affairs and financial statements." She also found that the complaint adequately pled scienter, based on confidential witness information that the defendants directed "deviations" from company policy.

 

Accredited itself filed for bankruptcy protection in May 2009. According to the settlement stipulation, the settlement is conditioned upon receiving bankruptcy court approval for the company’s participation in the settlement.

 

According to the stipulation, the settlement was the result of "extensive settlement discussions" in April 2009, following mediation.

 

The $22 million settlement apparently is to be entirely funded by a transfer of funds from the company’s directors’ and officers’ liability insurers, who are identified in the definitions section of the stipulation. The stipulation recites that settlement is also conditional on bankruptcy court approval of the use of the insurance proceeds to fund the settlement.

 

The Accredited settlement joins the recent $30.5 million settlement announced in the subprime-related securities lawsuit involving Beazer Homes (about which refer here). Because the Accredited case was one of the first subprime lawsuits to be filed and because it had already progressed past the motion to dismiss, it may or may not immediately prefigure coming events in other subprime cases, as so many of the cases are still just in their earliest stages. Nevertheless, as settlements like those in the Beazer and Accredited cases accumulate, a better sense of the range of possible settlements may begin to emerge.

 

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

 

ABA TIPS Panel: "The Financial Collapse — What Caused It and How Will It Continue To Impact Corporations and Their Boards?": The American Bar Association Tort Trial & Insurance Practice Section (TIPS) Task Force on Corporate Governance will hold this meeting at the ABA Building in Chicago on July 30, 2009 as part of the ABA Annual Meeting, to discuss the 2008 financial collapse and how corporations can manage risk throughout the remainder of the ongoing crisis.

 

I will be participating in this free session, which will be chaired by my good friend Kim Hogrefe from Chubb. The panel will also include Fiona Phillip of Howrey LLP and Dr. Faten Sabry of NERA Economic Consulting. The event will be followed by a reception. More information about the event, including event registration can be found here.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The Outside Directors’ Settlement

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

  

Background

 

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

 

 

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

 

 

V. EXCLUSIONS

 

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

 

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

security holder of the company except:

 

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

 

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

 

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

 

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

 

 

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

 

 

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

 

 

The Ninth Circuit’s Opinion

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

Discussion

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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