On March 2, 2009, in an opinion with important implications for the availability of coverage when a company official has inculpatory knowledge at the time of policy formation, Judge Gerald Lynch of the Southern District of New York granted the motions for summary judgment of two of Refco’s excess D&O insurers, but denied the summary judgment motion of a third excess insurer. The reasons both for the grants and the denial are instructive, particularly with respect to the interplay between varying excess forms and the language of the primary policy. A copy of the March 2 opinion can be found here.

 

Background

As reflected in prior posts regarding this case (here and here), this coverage dispute relates to the D&O insurance Refco procured in connection with its ill-fated August 2005 IPO. Refco’s $70 million insurance program was arranged in multiple layers, with a primary carrier and several excess carriers.

 

The $70 million program was arranged as follows: A primary $10 million layer; a first level excess layer of $7.5 million excess of the primary $10 million; a second excess layer of $10 million excess of the underlying $17.5 million; a third excess layer of $12.5 million excess of the underlying $27.5 million; a fourth excess layer of $10 million excess of the underlying $40 million; and a fifth excess layer of $20 million excess of $50 million. UPDATE: According to the remarks posted by an anonymous commentator, the fifth level excess policy is a Side A/DIC policy.

 

In October 2005, two months after Refco’s IPO, it was revealed that at the time of the IPO, Refco had an undisclosed $430 million receivable due from an entity controlled by Refco’s CEO, Phillip Bennett. Following this revelation, the company collapsed. Bennett, among others, has pled guilty to an array of criminal offenses.

 

Following Refco’s collapse, the company’s directors and officers were the target of extensive litigation. The primary and first level excess carriers advanced their entire combined limits of $17.5 million in payment of defense expense, subject to repayment if it is determined that there is no coverage. The four remaining excess carriers initiated litigation seeking a judicial determination of no coverage under their policies. In a June 18, 2008 opinion (here), Judge Lynch denied the second level excess carrier’s motion for summary judgment and in a subsequent opinion (here) determined that the second level excess carrier had an obligation to advance the payment of defense expense while the coverage issues were pending.

 

The March 2 Opinion

Judge Lynch’s March 2 Opinion relates to the motions for summary judgment of the third, fourth and fifth level excess carriers. Judge Lynch granted the motions of the third and fourth level excess carriers but denied the motion of the fifth level excess carrier.

 

The difference in outcome turned significantly on important differences between and among the excess policies each of the three carriers had issued to Refco. The third and fourth level excess policies were so-called "follow form" policies, meaning they followed the terms and conditions of the primary policy, except to the extent that their excess policies expressly adopted additional or different terms and conditions. The fifth level excess policy was not a follow form policy, a distinction that proved to be outcome determinative, at least for purposes of the summary judgment motions.

 

Each of the three policies had their own exclusionary provisions (not found in the primary policy) precluding coverage for claims arising from any facts or circumstances of which any insured had knowledge at policy inception and that might reasonably be expected to give rise to a claim. (The relevant exclusions were described in the third and fourth level excess policies as "prior knowledge exclusions" and as an "inverted representation endorsement" in the fifth level excess policy.)

 

Although he took some time getting there, in the end Judge Lynch had little trouble concluding that Bennett’s knowledge of the undisclosed receivable at the time of policy formation triggered these knowledge exclusions. The critical question was whether or not Bennett’s knowledge and the operation of the exclusions precluded coverage for all of the other insureds in light of the applicable policy terms and conditions.

 

The availability of coverage for the other insureds in turn depended on the operation of the applicable "severability language." This language determines whether or not the knowledge of one insured can be imputed to another.

 

Because the third and fourth level excess insurers’ policies are "follow form," the severability language on which the insureds relied to argue that Bennett’s knowledge was not imputable to them was from the primary policy. By contrast, because the top level excess policy was not a follow form policy, but instead had its own severability language, the insureds relied on the top level policy’s language in arguing for coverage under that policy.

 

After a lengthy discussion whether or not the primary policy’s application severability provision applied to the excess insurer’s exclusions, the court concluded that in the end the question didn’t matter. (See the following section for the distinction between application severability and exclusion severability.) Judge Lynch concluded that, under the policies’ terms, the addition of the knowledge exclusions to the third and fourth level excess policies "superseded" any contrary language in the primary policy, including the primary policy’s severability provisions.

 

Since the knowledge exclusions the third and fourth level excess policies precluded coverage where any insured has knowledge of the existence of facts giving rise to the claim, Judge Lynch concluded that Bennett’s knowledge of the receivables scheme precluded coverage for all of the insureds under the third and fourth level excess policies.

 

By contrast, however, Judge Lynch concluded that "a number of facts unique to [the top level excess insurer] preclude granting summary judgment to the insurer." The critical distinction is that the top level excess policy had its own severability provision, which, because it was in the same policy, was not superseded by the presence of the knowledge exclusion.

 

In addition, the top level excess insurer’s severability language lacked a critical sentence that the primary policy’s severability language included. The severability provision in the primary policy contained, but the top level insurer’s severability provision lacked, the following final sentence: "If any particulars or statement in the Application is untrue, the Policy will be void as to any Insured who know of such untruth." Because the top level excess insurer’s policy had no such provision, which specifically linked the severability language to the application, Judge Lynch concluded that the top level insurer "had not met its burden of showing" that its severability provision applied only to the application and not also to exclusions.

 

The Distinction Between Application and Exclusion Severabiltiy

A critical point to try to understand what is going on in this opinion is the distinction between application severability (that is, whether or not one person’s knowledge of application misrepresentations will be imputed to other persons) and exclusion severability (that is, whether or not one person’s knowledge or actions can be imputed to another for purposes of an exclusion).

 

Many practitioners will likely share my puzzlement that the decision almost entirely involves the question of the arguably more general operation of application severability provisions, even though the insurers were not relying on application misrepresentations to deny coverage, but rather upon the operation of the knowledge exclusion.

 

The explanation is that the excess policies apparently had no exclusion severability language of their own. Since the top level excess policy was not follow form and the excess policy has no exclusion severability language, the insureds relied on the arguably generalized operation of the application severability language to contend that Bennett’s knowledge could not be imputed to them for purposes of the exclusion.

 

The primary policy did, in fact, have its own exclusion severability language. However, Judge Lynch concluded (in a footnote) that because of the way the primary policy’s exclusion severability provision was worded, it applied only to the exclusions in the primary policy, and not to the distinct exclusion in the excess policy. Judge Lynch found that because the primary policy’s exclusion severability language applied only to the "above exclusions," it applied only to those found (that is, literally appearing "above") in the primary policy.

 

Discussion

If nothing else, this case provides an object lesson of the complicated way that the various components of a single D&O insurance program can operate to produce disparate results.

 

The so-called "follow form" policies wound up following neither the application severability nor the exclusion severability language of the primary policy, not because the excess policies expressly disclaimed those provisions, but simply because of the way the various policies interacted with each other. This opinion certainly highlights the truly limited extent to which "follow form" excess may actually follow form.

 

The extension of the excess policies’ knowledge exclusions to persons without knowledge is likely to trouble at least some observers. For most of the last decade, the D&O insurance industry has struggled to try to ensure that "innocent insureds" do not lose their insurance protection due to the misconduct or misrepresentations of others . The efforts to avoid these problems have concentrated on developing application and exclusion severability language limiting the consequences from the bad actors’ misconduct to the bad actors themselves.

 

This opinion illustrates an issue that may not have been a part of these industry efforts to create policy mechanisms to protect innocent insureds —  that is,  the importance of clarity of the purpose and design of application and exclusion severability provisions not just at the primary level, but all the way up the tower.

 

Another factor in this opinion not touched on above was the uncertainty whether or not the knowledge exclusions were even part of the excess policies. In addressing this issue, Judge Lynch reviewed the communications surrounding the placement of the insurance coverage. In my view, there was nothing unusual about these communications, which reflect nothing so much as the short time frame within which these kinds of insurance programs often are put together. But while the communications themselves are not out of the ordinary, the questions that subsequently have arisen do highlight the pitfalls of the policy procurement process.

 

Among other things, the process (at least to the extent reflected in Judge Lynch’s opinion) seems to suggest that in connection with the placement of the excess policies, the company’s representatives accepted the knowledge exclusion in lieu of an increased limits application. The practitioners’ pointer from this case is that severability is an equally important issue with respect to the exclusion as it would be to the increased limits application. This case suggests that in order to determine whether or not the severability issue is appropriately addressed entails consideration not only of the specific exclusionary language but also consideration of the interaction of all of the pieces in the tower.

 

The other specific practitioners’ pointer is that the exclusion severability language in a primary policy can be (and in this case, was) worded so as to restrict exclusion severability solely to the primary policy, without effect on any exclusions that may be added in any excess policies and regardless whether or not the excess policies otherwise are follow form policies. This observation suggests the need to specifically consider the question of exclusion severability in the context of any exclusions added to excess policies.

 

I wish to emphasize that nothing in these observations should be taken in any way as a criticism of anyone involved in the Refco coverage placement. This case demonstrates how complicated the interaction of the various program components can be, and that the interaction of the components can even, as this case demonstrates, produce results that might not be anticipated at the time of policy placement.

 

One final thought has to do with the fact that the court granted summary judgment for the third and fourth level excess insurers but not for the top level insurer. There has not at this point been any determination that there is coverage under the top level insurer’s policy. But if there were, I wonder whether the court’s entry of summary judgment on behalf of the third and fourth level excess insurer would create a gap in coverage that would relieve the fifth level excess insurer from its payment obligations – or rather, because the coverage underlying the fifth level of coverage will not be exhausted by payment of loss, could the fifth level excess carrier’s policy even be triggered? Obviously, the specific trigger language in the fifth level excess policy could be critical on this issue, but I suspect that before all is said and done the argument that there is a coverage gap will come up.

 

A March 3, 2009 memo from the Wiley Rein law firm discussing the Refco opinion can be found here. The Wiley Rein memo discusses a number of other important aspects of this opinion that I have not addressed above. Special thanks to the several loyal readers who sent me a copy of the opinion.

 

The Marc Dreier Scandal: The subsequent and much larger Madoff and Stanford Financial scandals have driven the Marc Drier scandal into the background, but the Dreier scandal is in some ways even more astonishing than those larger cases. A truly fascinating account of Marc Drier’s manic passage from hyper-aggressive lawyer to identity-misrepresenting fraud is set out in a March 3, 2009 American Lawyer article entitled "Anatomy of a Crack-Up: The Marc Dreier Case" (here). Alison Frankel’s comprehensive retelling of Drier’s disturbing tale makes for compelling reading.

 

We Don’t Need No Stinking TARP Money: According to a March 3, 2009 CFO.com article (here), a number of regional banks have concluded they are better off without TARP money. The article cites, for example, TCF Financial Corp, a Minnesota-based bank holding company with $16.7 billion in assets which claims that it only took the money ($361.2 million) under government pressure.

 

The article quotes the company’s CEO as saying that "the rules have definitely changed," and that whereas at the outset the message had been that only healthy banks would be granted the funds, subsequent Treasury actions and congressional mandates have created a "public perception" that banks that took TARP money "did so out of weakness." The CEO says that this perception puts the bank at a "competitive disadvantage."

 

The government recovery program is in trouble if bankers become convinced there is a stigma associated with accepting government aid. Part of the problem for the banks undoubtedly is the grandstanding politicians who insist on attempting to aggrandize themselves by flaying anyone receiving government aid. Even if some (but definitely not all) bankers made a hash of it in recent years, do we really want Congress trying to tell banks what to do?

 

On February 23, 2009, Advisen released its Report of 2008 securities litigation entitled "Securities Litigation in 2008: Implications for the D&O Market in 2009 and Beyond" (here, $ required). The Advisen Report’s numerical securities litigation analysis is directionally consistent with prior reports of the 2008 lawsuits, although the Report also contributes its own unique observations to the dialog. The Report also provides a number of specific comments about the lawsuits themselves as well as about likely future trends, including in particular reflections on the implications for D&O insurers.

 

Advisen’s February 26, 2009 press release describing the Report can be found here.

 

Largely as a result of the way it counted the lawsuits, the Advisen report concludes that securities class action lawsuits as such did not substantially increase in 2008 compared to 2007, although both years’ activity did increase compared to 2006. Pertinent to these conclusions, the Advisen Report provides a lengthy explanation of its "counting" methodology, which is helpful in understanding how Advisen’s numbers differ from those reflected in prior reports. The Advisen Report correctly notes that the phrase "securities class actions" is "increasingly inadequate for categorizing and explaining securities suits."

 

The Advisen Report is consistent with previous released studies in its conclusion that during 2008 securities litigation was concentrated in the financial sector. The Report notes that "fully half of securities lawsuits filed in 2008 named financial firms and their directors and officers as defendants." Specifically, the Report finds that banking, finance and insurance companies accounted for half of the securities lawsuits in 2008.

 

The Report stresses that the nature of many of the suits filed in 2008 differs from what may have been standard form in prior years. Many of the suits were not filed against public companies for their financial disclosures, but rather were filed against companies that structured or sold securities, and were being sued for representations about the securities themselves. The auction rate securities lawsuits are one illustration of this new category.

 

In addition, Advisen reports that during 2008, many of the suits were filed not as securities class action lawsuits as such, but rather in the form of lawsuits for breach of fiduciary duty, breach of contract, or common law torts. Many of these lawsuits were filed in state court.

 

The Report notes that as the economy continues to deteriorate, "at some point in 2009, the idea of ‘subprime and credit crisis’ as a category of suits will fade away as the credit crisis simply becomes ‘the economy’." Among other things, the Report speculates that the spreading economic woe could cause the growing litigation wave to spread outside the financial sector.

 

The deteriorating economic conditions could also lead to increased bankruptcies, a development the Advisen Report notes "almost certainly will be accompanied by an increase in securities lawsuits." The Report notes that since 1995, roughly 35 percent of large public companies (defined as having more than $250 million in assets, measured in 2008 dollars) that filed for bankruptcy were also named in securities class action lawsuits. However, in 2007 and 2008, the percentage increased to 77 percent.

 

The Report also notes a number of factors contributing toward escalating costs of defense, including the complexity of the cases being filed, the novelty of many of the legal theories, and the coincidence of multiple, simultaneous proceedings.

 

The Report reviews the implications of these developments and trends for D&O carriers. The Report also contains interesting comments from several D&O mavens, including John McCarrick, Rick Bortnick and Joe Monteleone. The Report is interesting, well-written and well-documented, and well worth reading in its entirety.

 

My own overview of the 2008 securities lawsuit filings can be found here.

 

Remember Options Backdating?: The cases from the last wave of corporate scandals still remain, although fewer and fewer or them all the time. On February 27, 2009, the parties to the Sunrise Senior Living securities lawsuit, one of the remaining options backdating related securities class actions, agreed to settle the case for $13.5 million. A copy of the stipulation of settlement can be found here.

 

I have added the Sunrise settlement to my running table of the options backdating related lawsuit settlements, dismissal and dismissal motion denials. The table can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch for providing me with a copy of the Sunrise settlement stipulation.

 

Now I Have Seen Everything: According to a March 2, 2009 story on Bloomberg (here), former AIG Chairman and CEO Maurice "Hank" Greenberg has sued AIG alleging that "material misrepresentations and omissions" caused him to acquire AIG shares in his deferred compensation profit participation plan at an inflated value, and later to lose nearly his entire investment after AIG’s losses became known.

 

A March 2, 2009 Reuters story about the lawsuit (here) says that Greenberg acquired the shares on January 30, 2008, when AIG shares traded at $54.37. The company’s shares closed today at 42 cents. Greenberg seeks the difference between what he paid for the shares and what he said the shares were worth, as well as reimbursement of more than $70 million of taxes.

 

The defendants in the lawsuit include, in addition to the company, Greenberg’s successor as CEO, Martin Sullivan, as well Joseph Cassano, who headed AIG’s Financial Product (AIGFP) division. Both men worked for Greenberg prior to Greenberg’s departure.

 

I wonder if his lawsuit would be barred from coverage under AIG’s D&O insurance program (assuming for the sake of argument that it is not otherwise exhausted by prior claims)? As a former officer and director of the company, he still qualifies as an "insured" and so his lawsuit potentially at least could trigger the "insured vs. insured" exclusion typically found in most D&O policies. On the other hand, he left the company in March 2005, and so his claim might come within a coverage carve back in the exclusion, depending on how the applicable provision is worded.

 

If one were to assume that insurance would not be available, then defense expenses (both for the company and for the individuals, who would be indemnified by the company) would come from AIG itself, which owes the U.S. government approximately a gazillion dollars. The same would go for any uninsured settlements or judgments. I leave to others to comment on whether or not taxpayers ought to have to incur the costs associated with this lawsuit.

 

Perhaps pertinent to the question whether or not taxpayers should have to bear the cost of Greenberg’s lawsuit, in comments published today (here), the current AIG CEO, Edward Liddy, said that Greenberg is partially responsible for AIG’s current woes. Among other things, Liddy said "The formation of the AIGFP unit, which has literally brought us to our knees, that happened on his watch. The compensation systems that have gone astray, happened on his watch. I don’t think it’s as clean and simple as sometimes Hank would like to portray."

 

And Finally: This week’s Time Magazine has several interesting article about the current economic crisis, including an article highly critical of former SEC Chairman Christopher Cox, entitled "The Inside Story on the Breakdown at the SEC" (here).

 

In addition, this week’s issue also has a fascinating story entitled "One Bad Bond" (here), which explains how losses have compounded exponentially in connection with a CDO-cubed created in March 2007 and called Jupiter High-Grade CDO V. This poster-child of financial engineering excess was originally rated AAA, but now nearly 59% of the instrument’s investments are worthless. Among Jupiter’s investments is an interest in the Mantoloking CDO, a toxic investment vehicle about which I blogged a year ago, here.

 

The article is worth tracking down in its original print version, because the print version is more detailed and is accompanied by graphics that are not available online but that do a particular good job in showing how the complexity of these instruments compounded the losses as the underlying mortgages have faltered.

 

Even though I was not even away a full week for the recent PLUS D&O Symposium, there was a flood of noteworthy developments while I was gone. Here is a roundup of last week’s news and notes.

 

Subprime-Related Derivative Lawsuit Largely Dismissed: In a detailed and painstaking February 24, 2009 opinion (here), Chancellor William Chandler dismissed the bulk of the consolidated subprime-related derivative suit pending against Citigroup, as nominal defendant, and certain of the company’s directors and officers, in Delaware Chancery Court. A very thorough review of the opinion can be found on the Delaware Corporate and Commercial Litigation Blog, here.

 

Chancellor Chandler dismissed all but one of plaintiffs’ claims for failure to adequately plead demand futility. He did, however, allow plaintiffs’ claims of waste concerning the compensation and benefits package for Citigroup’s CEO to continue.

 

The most interesting part of Chancellor Chandler’s opinion relates to the plaintiffs’ allegations that the defendants failed to monitor the company’s business risk with respect to Citigroup’s exposure to the subprime mortgage market. Chandler characterized this claim as an assertion that "the director defendants should be personally liable to the Company because they failed to fully recognize the risk posed by subprime securities."

 

Chandler noted that Delaware case and statutory law places "an extremely high burden on a plaintiff to state a claim for personal director liability for failure to see the extent of a company’s business risk." Chandler concluded that in light of this burden, plaintiffs’ conclusory allegations (and thus their failure to plead particularized facts) were insufficient to excuse demand.

 

Among other things, Chandler noted that the "oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk."

 

Chandler did take pains to distinguish the recent Chancery Court decision in which the "failure to monitor" claim against the directors and officers of AIG survived a motion to dismiss. (The February 10, 2009 opinion in the AIG case can be found here.) In that case, unlike the Citigroup action, the defendants "allegedly failed to exercise reasonable oversight over pervasive fraudulent and criminal conduct." The Citigroup case, by contrast, involved only alleged failure to recognize the extent of the company’s business risk.

 

Both because of the high-profile nature of the Citigroup case as well as Chancellor Chandler’s detailed review of the applicable provisions of Delaware law, his opinion could prove to be particularly influential in other pending subprime and credit crisis-related derivative suits. The basis on which he distinguished the AIG case could also prove to be an important distinguishing characteristic in the determination of which derivative suits will survive and which may be dismissed.

 

I have in any event added the Citigroup opinion to my table of subprime and credit crisis-related lawsuit settlements, dismissal and dismissal denials. The table can be accessed here. A list of the subprime and credit crisis-related derivative suits themselves can be found here.

 

One final observation about the Delaware Corporate and Commercial Litigation Blog, which I referenced above. If you have any inclination or desire to follow the important legal trends affecting the potential legal liabilities and responsibilities of corporate directors and officers, you will find the Delaware litigation blog absolutely indispensible. I would rank the blog among the few truly must-read resources in this area on the Internet. The blog’s post on the Citigroup case is just one example why.

 

More Stanford Financial Developments and Litigation: In addition to the initiation of criminal charges against former Stanford Financial Group investment officer Laura Pendergast-Holt for obstructing the SEC’s investigation (about which refer here), last week’s developments regarding the Stanford scandal included the SEC’s filing late Friday night of an amended enforcement complaint in the matter.

 

According to the SEC’s amended complaint (which can be found here), R. Allen Stanford and his firm’s CFO, James M. Davis, operated a massive Ponzi scheme and misappropriated at least $1.6 billion of investor money in bogus personal loans to Stanford. An unspecified additional amount was also put into speculative investments, which by the end of 2008 made up the bulk of the Stanford Financial Group’s investments, though the company marketed its portfolio as a "well-diversified portfolio of highly marketable securities."

 

The amended complaint also alleged that Stanford and Davis fabricated portfolio’s investment performance, deciding each month on the return to be reported and "reverse engineering" the financial statements to reflect investment income that was never earned.

 

A February 28, 2009 New York Times article describing the criminal charges and the amended SEC complaint can be found here.

 

In addition to these criminal and regulatory developments, the Stanford Group was also hit with an additional civil lawsuit, this time involving a case filed in a Canadian Court. According to a February 27, 2009 article in the Financial Post (here), on February 25, 2009, Calgary-based furniture manufacturer has initiated a class action lawsuit in the Alberta Court of Queen’s Bench against Allen Stanford, Stanford International Bank, Stanford Group Company, Stanford Capital Management LLC, James M. Davis and Laura Pendergast-Holt.

 

The company alleges that it invested $1 million in certificates of deposit issued by the bank. The complaint, which seeks class action status, seeks damages for misrepresentation, unjust enrichment, conversion, fraudulent conveyance and breach of trust. The complaint also asserts fraud in connection with other Stanford investments.

 

I have added the new Canadian lawsuit to my running tally of the Stanford related litigation, which can be accessed here.

 

More Madoff Litigation, Too: During the past week, additional litigation related to the Madoff scandal also continued to flow in. I have added multiple new cases to my running tally of the Madoff-related litigation, which can be accessed here. Special thanks to the several readers who have alerted me to new Madoff cases, particularly to loyal reader Jon Jacobson.

 

One of the more interesting new cases is the one filed on February 24, 2009 in the District of New Jersey. Though this case raises allegations similar to those asserted in prior cases, the complaint asserts claims neither against Madoff and firm nor against the Madoff feeder funds. Rather, the sole defendant in the case is Peter Madoff, Bernard Madoff’s brother.

 

According to the complaint in the case (which can be found here), Peter Madoff and his brother "have worked side by side" for "nearly 40 years," and their offices "were only a few feet from each other." The complaint alleges, among other things, that Peter Madoff was responsible for "regularly verifying and accurately reporting the financial condition" of the Madoff firm, as well as establishing and monitoring internal controls and detecting and reporting any legal violations. The complaint asserts claims under Sections 10(b) and 20 of the ’34 Act, for breach of fiduciary duty, aiding and abetting, negligence, and negligent misrepresentation.

 

Hat tip to the Courthouse News Service for the Peter Madoff complaint.

 

Auction Rate Securities Litigation Continues to Amass: As I have previously noted (here), the various massive auction rate securities settlements do not seem to have stemmed the tide of auction rate securities litigation, and cases involving institutional and entity investors, who are not part of the regulatory settlements, continue to file new lawsuits.

 

The latest example of this phenomenon is the complaint filed on February 25, 2009 in the Eastern District of Missouri by KV Pharmaceutical Company against Citigroup Global Markets. A copy of the complaint can be found here.

 

The complaint alleges that between May 2005 and February 2008, Citigroup counseled KV into investing $72 million in auction rate securities that are now illiquid. Among other things, the complaint alleges that the securities can now be sold, if at all, at substantial discounts to par value. The complaint alleges that "holding $72 million of illiquid ARS exacerbates KV’s current cash crisis, which is requiring KV to seek borrowed capital and engage in overall cost-cutting by, among other things, eliminating approximately 700 jobs."

 

Clearly the auction rate securities market’s continued failure to function is causing enormous stress for the persons and entities unfortunate enough to have been stuck holding these instruments when the music stopped last February.

 

Hat tip to the Courthouse News Service for the KV Pharmaceutical complaint.

 

More Failed Banks: Add two more banks to the growing list of 2009 bank failures. On Friday, February 27, 2009, the FDIC took control of the Heritage Community, Glenwood, Illinois (about which refer here), and of the Security Savings Bank of Henderson, Nevada (refer here). Prior to its closure, the Heritage Community Bank had assets of $232.9 million, and Security Savings Bank had assets of $238.3 million.

 

The closure of these two banks brings the total number of  banks closed during February 2009 to ten, and the 2009 year to date total to 16 (compared to 25 during all of 2008). The FDIC’s complete list of failed banks can be found here.

 

As I recently noted (here), a significant number of the 2009 bank failures, including the two most recent examples, involve smaller community banks. These troubling developments raise serious concerns both for the banking community and for the larger economy. The rash of bank closures also raises the likelihood that there will be increased litigation involving the failed banks and their former directors and officers.

 

Did the Milberg Kickback Scheme Hurt Class Members?: Those readers who were fortunate enough to have attended the PLUS D&O Symposium among other things heard interesting comments from St. John’s University law professor Michael Perino about the fascinating video, "The Rise and Fall of Bill Lerach" (to see the video trailer for which, refer here). Perino mentioned in his discussion the research he had completed about the impact on shareholder class members from the kickback payments the Milberg firm made to the paid plaintiffs.

 

In light of Professor Perino’s remarks, I thought readers might appreciate having a link to the Professor’s research paper, which can be found here. As reflected in the paper’s abstract, Perino concluded that not only were the firm’s fee requests and awards overall higher in the cases identified in the indictment, but that these findings are consistent with the hypothesis that class members were harmed.

 

An interesting commentary on the paper can be found on Professor Ribstein’s Ideoblog, here.

 

Insurance Persons of the Year: The LexisNexis Insurance Law Center is receiving nominations for the "Insurance Law Persons of the Year." The Center will be making four awards: the Policyholder Attorney of the Year; the Insurer Attorney of the Year; the Insurance Regulator of the Year; and the Insurance Jurist of the Year. In each case, the award will go to the person in each area that had the most impact in insurance law during 2008.

 

The deadline for nominations is March 6, 2009. Nominations can be sent to Karen Yotis the following address: karen.yotis@lexisnexis.com.

 

My New All-Time Favorite Headline: The table I have assembled regarding the Stanford Financial Group litigation, which I mentioned above, has proven to be a popular addition to this blog. I am grateful that a number of other blogs and sites have linked to the post in which the table can be accessed.

 

But as nice as it is for other blogs to recognize my post, nothing can top the article posted on February 24, 2009 on the American Lawyer website (here), entitled "D&O Diary Launches Stanford Financial Litigation Tally; Kevin LaCroix is Our Hero." That one even impressed my wife (I think), which is really saying something.

 

My thanks to AmLaw reporter Alison Frankel for this nice but undeserved accolade.

 

And Finally: Just a reminder to all my readers that I continue to report additional items between blog posts on Twitter. Among other things, I am increasingly active in retweeting interesting items from other Twitterers. Readers interested in monitoring my "tweets" are encouraged to click on the Twitter button in the right-hand column above to follow my Twitter posts.

 

In addition, I remain interested in connecting with readers on LinkedIn. I have recently become much more active in various LinkedIn groups and I would like to draw other readers into the dialog. I encourage readers interested in connecting with me on LinkedIn to click on the button in the right hand column above and join my network.

 

On February 28, 2009, Berkshire Hathaway released (here) the annual letter of its Chairman Warren Buffett, to the company’s shareholders. Like prior editions, this year’s letter contains homey and often humorous aphorisms and thought-provoking observations both about Berkshire and about the business economy as a whole. But, consistent with the fact that 2008 was Berkshire’s worst year ever, this year’s letter is much denser than prior years’ and — along with Buffett’s usual tone of self-deprecation – reflects some occasional and uncharacteristic notes of defensiveness. There is at least one rather noteworthy omission from the letter as well. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

 

The Letter’s Major Themes

The Global Economy: The letter opens with a sober appraisal of the "debilitating spiral" into which the global economy slipped during 2008. Buffett observes that these dire circumstances produced unprecedented governmental action, steps that were "essential" if the "financial system was to avoid total breakdown." But these "massive actions," while necessary, will "almost certainly bring on unwelcome aftereffects," including an "onslaught of inflation."

 

Buffett also expressed his concern that "the economy will be in shambles throughout 2009, and, for that matter, probably well beyond." However, in contrast to this gloomy shorter term view, Buffett’s long view is optimistic. He notes that "our country has faced far worse travails in the past," but that "without fail we’ve overcome them." Buffett asserts that "America’s best days lie ahead."

 

Berkshire’s Investment Performance: But even if the longer term view is bright, the immediate picture isn’t pretty. Berkshire’s 2008 results were its worst ever. On the other hand, the company’s results were considerably better than those of the S&P 500 companies. For example, Berkshire’s book value per share declined by 9.6% in 2008, while the S&P stock index fell 37% last year, including dividends.

 

The overall value of Berkshire’s investment portfolio fell 13.89%, form $90,343 per share to $77,793 per share. Nineteen of top 20 stakes in Berkshire’s U.S. stock portfolio declined last year.

 

Contributing to this investment decline were some "dumb things" Buffett did in managing Berkshire’s investments, including a "major mistake of commission" involving a major acquisition of ConocoPhillips stock when oil prices were near their peak. Buffett comments in the letter that "the terrible timing of my purchase has cost Berkshire several billion dollars." Buffett also noted his poor timing in spending $244 million to invest in two Irish banks that have since declined 89% in value.

 

Berkshire’s Derivatives Portfolio: Nearly a quarter of the shareholders’ letter is given over to Buffett’s defense of Berkshire’s derivatives portfolio. Greater detail regarding the portfolio was not only requested by regulators, but it was perhaps obligatory in any event, in part because of Buffett’s own long standing criticism of derivatives as "financial weapons of mass destruction," but also because of what the derivative investments did to Berkshire’s reported 2008 financial results.

 

The company’s share price has declined over 40% in the past year largely due to concerns about the company’s exposures to derivatives. The company’s fourth quarter net income fell 96 percent to $117 million from $2.95 billion in the prior year’s final quarter. The decline is primarily the result of mark to market losses on long-term derivative investments in Berkshire’s portfolio.

 

But while detailed disclosure of Berkshire’s derivative portfolio may have been mandatory, Buffett seems rather grumpy about it. Indeed, at virtually the same time Buffett lays out the company’s derivative investments, he mutters some rather disparaging remarks about the futility of increased "transparency" requirements for "describing and measuring the risk of a huge and complex portfolio of derivatives."

 

In case some readers might conclude that Berkshire itself has a huge and complex portfolio of derivatives (and, in my view, that is the only conclusion that anyone acquainted with the facts, even as presented by Buffett, reasonably could reach), Buffett strains to try to differentiate Berkshire’s portfolio. Not only were Berkshire’s derivative contracts "mispriced at inception," but also, by contrast to many similar arrangements, Berkshire "always holds the money." Moreover, only "a small percentage of our contracts call for posting of collateral," and even under last year’s chaotic conditions," Berkshire had to post less than 1% of its securities portfolio."

 

So, I guess the message is, don’t be alarmed by those massive, multi-billion dollar "mark to market" write-downs — everything is fine. My own view is that Buffett was much more persuasive before when he was decrying derivaties as "financial weapons of mass destruction." 

 

The Subprime Debacle: Buffett’s letter also contains a separate homily about the experience of Berkshire’s mobile home subsidiary, Clayton Homes, whose recent performance is, in Buffett’s retelling, a sort of morality tale against which to compare the events that up to the subprime meltdown.

 

Though they are people of "modest incomes and far-from-great credit scores," Clayton’s mobile home buyers have much lower default and foreclosure rates that those of many similar residential borrowers because "they took a mortgage with the intention of paying it off, whatever the course of home prices." The mobile home buyers didn’t "count on making loan payments by refinancing" and they weren’t seduced by "teaser rates."

 

Buffett observes that foreclosures don’t happen because housing prices decline, but because borrowers "can’t pay the monthly payment they agreed to pay." The home purchased "ought to fit the income of the purchaser." And, Buffett adds, homeowners who have "made a meaningful down payment – derived from savings and not from other borrowing – seldom walk away from a primary residence."

 

Buffett concludes with the observation that "putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective." However, keeping them in their homes "should be the ambition."

 

Tax- Exempt Bond Insurance: Buffett also takes considerable pains to describe Berkshire’s move into tax-exempt bond insurance, and how the financial troubles of the traditional monoline bond insurers allowed Berkshire an opportunity to reap outsized premiums for "second-to-pay" insurance (triggered if the primary monoline carrier defaults).

 

Though unabashedly gleeful in describing this opportunity and how it came about, Buffett also gravely notes that it is "far from a sure thing that this insurance ultimately will be profitable for us." He notes that while municipal debt historically has enjoyed an essentially default free record, the future could be far different, and indeed, the very presence of Berkshire insurance could itself trigger a higher rate of defaults. Buffett also notes that defaults could be correlated. In short, insuring tax exempts "has the look today of a dangerous business."

 

Some Interesting Sub-topics

In addition to the major themes, there are also of narrower message salted throughout the letter. Some of these, although barely mentioned, are among the letter’s more interesting details.

 

For example, I was interested to note that as a result of Berkshire’s unsuccessful bid to acquire Constellation Energy, Berkshire not only received a break-up fee of $175 million but also reaped an investment gain on the Constellation shares it did acquire of $ 917 million. I supposed Berkshire could hardly be described under these circumstances as a "disappointed bidder." (The details of the transaction are briefly summarized here.)

 

Buffett also tucks into the letter a brief commentary of how the swing of the risk-tolerance pendulum had resulted in the "U.S. Treasury bond bubble of late 2008," which could be regarded as "almost equally extraordinary" as the "Internet bubble of the late 1990s and the housing bubble of the early 2000s." Buffett predicts that clinging to cash equivalents or government bonds will almost certainly be "a terrible policy of continued too long," if for no other reason that inflation alone will "erode purchasing power."

 

There are also a couple of separate notes in the letter about Berkshire’s apparent growing commitment to green energy. In his description of Berkshire’s utilities businesses, Buffett describes the utilities businesses’ growing wind power output. And in his description of the upcoming Berkshire shareholders’ meeting, he notes that among the exhibits at the meeting will be a "new plug-in car developed by BYD, an amazing Chinese company in which we own a 10% interest."

 

Commentary

While this year’s letter rewards careful reading just as much as prior years’ letters, and though this year’s letter arguably contains even more that customary detail, there are nonetheless some critical omissions.

 

First and foremost, the letter is silent about the criminal fraud convictions during the past year of the former CEO and former CFO of the Berkshire’s largest subsidiary, General Re, for misconduct committed while General Re was a part of the Berkshire group. For details regarding the convictions, refer here and here. (Full disclosure: for several years, I was employed by a General Re subsidiary.)

 

At one level, this omission may be understandable given questions some have asked about Buffett’s own possible involvement in the events at the heart of the prosecution. But given these criminal convictions, the letter’s happy talk about General RE’s 2008 annual results – including Buffett’s euphemistic reference to the fact that the subsidiary’s successor CEO also "stepped down" during the past year, without any reference to the reasons for the successor CEO’s other than purely voluntary departure – rings hollow, or at least lacking in context.

 

There is an ironic contrast between this rather obvious omission and the withering tone Buffett employs later in his letter to describe the June 15, 2003 OFHEO letter and report that "were delivered nine days after the CEO and CFO of Freddie had resigned in disgrace and the COO had been fired." Some might call it hypocritical on the one hand for Buffett to disparage OFHEO’s letter for its failure to mention the Freddie Mac officials’ departures while at the same time himself omitting even to acknowledge the criminal convictions of the two most senior officials of his company’s largest subsidiary.

 

In addition, while Buffett was characteristically direct in acknowledging the mistaken timing of his ConocoPhillips investment, I think it is worth noting that the ConocoPhillips and Irish Bank investments were far from the only recent Berkshire investments that may have been ill-timed.

 

Looking at Berkshire’s largest stock holdings, it appears that many of Berkshire’s most recent investments are faring poorly. In particular, the recent investments in Swiss Re (down 85% the past year), on which Buffett recently doubled down, raises certain questions.

 

For that matter, some of Buffett’s longer term investments have also declined beyond market wide averages, including in particular American Express (down 71% in the past year) and Moody’s (down 53% in the past year).

 

Of course, times are tough throughout the financial arena, and not even Berkshire is immune from the current overwhelming financial downdraft. Among many interesting points Buffett makes in his letter is his observation that 75% of the time during Berkshire’s 44-year history, the S&P 500 has recorded an annual gain, adding that he guesses "a roughly similar percentage of years will be positive in the next 44."

 

We can all, even those who may not own Berkshire shares, hope that Buffett is right about the prospects for future positive results.

 

A Final Note: My review of Alice Schroeder’s recent biography of Buffett, "The Snowball," can be found here.

 

LAST UPDATED ON February 24, 2010. With the arrival today of two more lawsuits against R. Allen Stanford and the Stanford Financial Group of companies, it may now be time to start keeping a table of the Stanford Group-related litigation. Given the magnitude of the losses and the publicity surrounding the Stanford scheme, there could well be a great deal more of litigation ahead.

 

My running tally of Stanford Group lawsuits can be found here. The document categorizes the suits into several tables, including a final table in which I have listed related proceedings. I will update the table as new cases arrive, and I will indicate the date of the most recent update at the top of this post.

 

The first of the two lawsuits to be added (that is, latest as of the time this post was originally created) today is the securities class action lawsuit filed on February 20, 2009 in the Middle District of Louisiana, in Baton Rouge. A copy of the complaint can be found here. This latest securities lawsuit joins two separate securities class action complaints previously filed in the Southern District of Texas, as well as the SEC enforcement proceeding filed in the Northern District of Texas. UPDATE: In addition to these cases, the plaintiffs in the first filed Southern District of Texas case have also filed a substantially identical complaint in the Nothern District of Texas as well, refer here.

 

The second of the two Stanford-related lawsuits to be added today is a lawsuit filed in Texas (Harris County) District Court by a trustee for the Rocky Mountain Trust. A copy of the trustee’s Original Petition can be found here. According to the Petition, the trust used its income to fund a foundation for "medical, dental and nutritional programs in Mexico and Central America." The Petition states that thousands of poor, including hundreds of Mexican orphans, have received assistance through the foundation. The defendants in the case include Stanford Group Company and related Stanford entities, as well as R. Allen Stanford and other individual Stanford directors and officers.

 

According to the Petition, the trustee was introduced to the Stanford group by acquaintances in Mexico. The trustee was persuaded to invest all of the trust’s assets in Stanford certificates of deposit. The trust is currently invested in three CDs, two of which total approximately $475,000 in face value and a third of which has a face value of about €202,000. Upon hearing of issues involving the Stanford CDs, the trustee unsuccessfully demanded return of the trust’s investment. The complaint asserts claims for common law fraud, violation of the Texas Securities Act, negligent misrepresentation, breach of fiduciary duty, aiding and abetting, conspiracy, and breach of contract. The complaint also seeks a temporary restraining order, and exemplary damages.

 

One common problem all of these cases will face is trying to get service of process on the elusive Mr. Stanford.

 

Hat tip to the Courthouse News Service (here) for the Louisiana and Texas state court complaints. Thanks to Adam Savett of the Securities Litigation Watch for the new Northern District of Texas complaint.

 

Other Stanford-Related Notes: The FCPA Blog has an interesting post today (here) questioning whether Stanford’s interactions with the Antiguan authorities could subject him to enforcement action under the Foreign Corrupt Practices Act.

 

Meanwhile, the February 24, 2009 Wall Street Journal is reporting (here) that a hedge fund run by Vice President Biden’s son and brother was exclusively marketed by companies controlled by R. Allen Stanford.

 

Finally, if you need a steady stream of news about the Stanford scandal, you will want to check out the Houston Chronicle’s Stanford Watch blog (here). Hat tip to the Daily Caveat for the link to the blog site.

 

For those readers who may not previously have seen it, I am also separately maintaining a list of litigation related to the Madoff scandal, which can be accessed here.

 

In the lists of those supposedly responsible for the current financial mess, the rating agencies are among those usually featured prominently. Numerous investors have in fact sued the rating agencies claiming the ratings misled them into making their investment (about which refer, for example, here). Whether these investor actions will succeed remains to be seen, but in a recent ruling, at least one court has held that much of the subprime-related securities lawsuit brought against Moody’s by its own shareholders can go forward.

 

Background

In 2007, Moody’s shareholders sued the company and several of its directors and officers in a series of lawsuits that ultimately were consolidated in the Southern District of New York. (For the background of the case, refer here.)

 

The consolidated amended complaint alleged that the defendants had falsely claimed that the company was an independent and impartial body, while in fact the company’s arrangements for rating asset-backed securities and other structured investments put it in a conflict of interest and compromised its independence. The amended complaint also alleged that the company falsely claimed to have verified the quality of the underwriting practices at the loan originators whose mortgages were consolidated into the securities being rated.

 

The amended complaint further alleged that the company misrepresented that the rating scale used for the structured investments was equivalent, and reflected the same risk of default, as the company’s rating scale for traditional financial instruments. Finally, the amended complaint alleged that the defendants had falsely represented that the company derived its revenue from legitimate business practices.

 

The defendants moved to dismiss the amended complaint, arguing that the plaintiffs’ initial complaint had been filed after the statute of limitations had expired; that the amended complaint failed to adequately allege misrepresentations and materiality; and also that the amended complaint failed adequately to allege loss causation and scienter.

 

The Court’s February 18, 2009 Order

In a February 18, 2009 order (here), Judge Shirley Wohl Kram denied the motion in part and granted the motion in part, with leave to amend. The practical consequence of the court’s order is that a significant portion of the plaintiffs’ case will now be going forward.

 

The court first reached the defendants’ argument that the plaintiffs’ claims were barred by the statute of limitations. The defendants had argued that the plaintiffs were put on "inquiry notice" about the supposed fraud due to "storm warnings" as early as 2003. However, the court found that the statements on which the defendants sought to rely "refer to the credit rating industry in general terms and make no specific reference to Moody’s" and there is in any event "no mention of fraud." The court also found that Moody’s management’s "words of comfort preclude a finding of inquiry notice."

 

The court next determined that the amended complaint adequately alleged material misrepresentations in connection with Moody’s assertions of independence and also with respect to its statements about its assessment of the quality of loan originator underwriting as part of its ratings process.

 

However, the court found that the plaintiffs had not adequately alleged material misrepresentations in connection with the company’s statements about the equivalence of its structure finance rating system to its corporate finance rating system, and about the company’s statements concerning the sources of its revenue.

 

Even though the court found that the amended complaint’s "poor organization…dilutes Plaintiffs’ allegation of loss causation," the court found that the complaint alleges "sufficient corrective disclosure" to survive a motion to dismiss on the loss causation issue. The court also held that because the defendants failed to establish that Moody’s share price had declined as part of an industry-wide downturn, the defendants had failed to establish a "direct intervening cause" for the share price decline.

 

Finally, the court held that the amended complaint adequately pled scienter on the part of the company’s CEO as well as the company itself, finding that the CEO’s statements in a confidential slideshow were "revealing" of the CEO’s knowledge that the company "was not truly independent." With respect to the company itself, the court found that the plaintiffs had "alleged specific statements indicating that various top officials knew that Moody’s independence, ratings and methodology had been compromise," and that "consequently" the allegations of the amended complaint "sufficiently plead" the company’s scienter.

 

The court did however find that the amended complaint had not adequately pled scienter as to the other two individual defendants, the company’s COO and the Managing Director of the Asset Finance Group.

 

Regarding the claims and defendants with respect to which the motion to dismiss was granted, the court allowed plaintiffs leave to amend, directing them to file their amended complaint by March 18, 2009.

 

Discussion

The court’s opinion in the Moody’s case is significant in and of itself, as yet another subprime-related securities lawsuit that has survived the motion to dismiss, if only in part. Though the nature of the allegations against Moody’s may be somewhat distinct from those raised in many of the other subprime and credit crisis-related securities lawsuit, and though the dismissal motion was in fact granted in part, the outcome of the dismissal motion ruling nevertheless underscores that some of the many pending subprime and credit crisis-related securities lawsuits will be going forward.

 

The ruling, even if based on factual circumstances that arguably are specific to Moody’s, may be of particular significance to the separate securities lawsuits brought by the shareholders of McGraw-Hill (corporate parent of S&P) and by the shareholders of Fimalac (corporate parent of Fitch’s).

 

The more interesting question is what significance any of the court’s order in the Moody’s case may have for the many lawsuits brought against the rating agencies not by the agencies’ own shareholders but rather by investors who claim to have made their investments in reliance on the integrity and quality of the agencies’ ratings. These other investor lawsuits raise categorically different factual and legal issues that the suits brought by the agencies’ own shareholders.

 

Nevertheless, even given the differences between the two sets of claimants and the two categories of cases against the rating agencies, the ruling in the Moody’s case may at least provide some context for the investor lawsuits, particularly with respect to the court’s holdings that the shareholder plaintiffs adequately alleged that Moody’s had made material misrepresentations about its independence and processes, and had sufficiently alleged scienter as to the company’s CEO and the company itself. These particular holdings could be relevant in the separate investor lawsuits, at least on those issues.

 

I have in any event added the court’s February 18 ruling in the Moody’s case to my table of subprime and credit crisis-related securities lawsuit settlements, dismissals and dismissal motion denials, which can be accessed here.

 

A February 23, 2009 Reuters article regarding the court’s ruling in the Moody’s case can be found here.

 

By now it is not news that the current credit crisis and related litigation wave have both spread far beyond the residential real estate sector in which they both first began. But the details surrounding the extension remain interesting and may even contain hints about what may lie ahead, as suggested by a recent lawsuit.

 

As reflected in their February 20, 2009 press release (here), plaintiffs’ attorneys have filed a securities class action lawsuit in the Southern District of New York against American Express and its CEO and CFO. The complaint (which can be found here) is filed on behalf of those persons who purchased the company’s securities between March 1, 2007 and November 12, 2008.

 

According to the complaint, American Express is the world’s largest issuer of charge cards. The complaint alleges that during the class period, the company "deviated from its historical strategy" of targeting the "premium market sector" and instead "engaged in riskier lending," while it "reassured investors and analysts that it did not engage in such riskier transactions."

 

The complaint alleges that the defendants "mislead investors by falsely representing American Express’s exposure to the riskiest credit card holders." The complaint alleges that the defendants repeated these reassurances to "artificially support" the company’s share price "as the building credit crisis in the market punished most companies that dealt with risky customers."

 

The complaint further alleges that as a result of the company’s "shift to risky card business," its brand has been "cheapened" and its stock has dropped over 65%. The complaint also alleges that the company won approval to convert to a bank holding company in order to qualify for TARP money – "a capital infusion required to save the Company from its risky endeavors."

 

On the one hand, it is hardly surprising in this environment that any credit lending facility should be experiencing difficulties or that those difficulties might result in litigation. But on the other hand, this new lawsuit does demonstrate both how far afield from the original subprime-related problems that triggered the current crisis, and how diverse the credit problems are that are now driving the related credit crisis litigation wave.

 

For some time now, the spreading subprime and credit crisis-related litigation wave has spread to encompass sectors of the credit marketplace beyond just subprime lending. Some time ago, for example, student lenders were drawn in (refer here), as were commercial construction companies (refer here). The involvement of a credit card company represents just another category of the credit marketplace to be drawn into the litigation wave.

 

But even though this new lawsuit may be just an extension of previously existing trends, it still has some ominous overtones. For one thing, American Express may be one of the largest providers of consumer credit, but it is far from the only one. Many businesses, other than just credit card companies, depend at some level upon the extension of consumer credit as part of their business model. The financial troubles these companies are now facing could also mean vulnerability to possible future litigation.

 

Another troubling note suggested by American Express’s woes is that a great deal of consumer debt, like the residential real estate debt, was packed into securities backed by the debt. The challenges facing the mortgage-backed securities market are at this point well known. Deteriorating conditions in the consumer credit arena could have significant implications for securities backed by the consumer debt.

 

In the meantime, American Express seems to be taking matters into its own hands to try to avoid further defaults as the recession deepens. According to February 23, 2008 news reports (here), American Express has offered to pay some cardholders $300 to pay off their outstanding balances and close their accounts by April 30, 2009. According to the news reports, analysts are concerned that credit card defaults could reach 11 percent by year end. One commentator is quoted as saying that what the company is trying to do is to "move to the front of the line in terms of getting paid back."

 

In any event, I have added the American Express complaint to my running tally of the subprime and credit crisis related securities litigation, which can be accessed here. With the addition of the American Express complaint, the current litigation tally now stands at 162, of which 19 have been filed so far in 2009. A spreadsheet reflecting the 2009 cases can be found here.

 

Special thanks to Adam Savett at the Securities Litigation Watch for the link to the American Express Complaint.

 

As the difficulties and challenges from the global economic crisis continue to mount, one recurring question has been – how could things possibly have gone so wrong?

 

One way to try to answer this question is to look at the root causes – that is, the financial and economic conditions that produced the current circumstances. A February 19, 2009 memorandum by my friend Faten Sabry of NERA Economic Consulting and her colleague Chudozie Okongwu and entitled "How Did We Get Here?: The Story of the Credit Crisis" (here) does an excellent job explaining how "problems that first manifested in a relatively small part of the mortgage market" have "led to a contagion" that has "quickly spread to threaten the liquidity and possible solvency of may financial institutions around the world."

 

As alternative to looking for root economic causes is to try to determine who, rather than what, is responsible for the current mess. It is perhaps inevitable given the magnitude of the current crisis that attempts would arise to assign blame. Time Magazine’s recently published gallery (here) of the 25 persons most responsible for the financial crisis is just one manifestation of this inevitable fault finding process.

 

The supposed regulatory shortcomings of the SEC are among the contributing factors cited by some commentators.Indeed, former SEC Chairman Christopher Cox is among those whose names appeared on the Time Magazine list.

 

With the SEC under scrutiny and facing questions, the incoming agency leadership faces pressure to burnish the agencies’ supervisory credentials. It appears that this rehabilitative exercise may include in part the assignment of responsibility for the financial crisis, a process that apparently may target corporate boards.

 

According to a February 20, 2009 Washington Post article entitled "SEC to Examine Boards’ Role in Financial Crisis" (here), one of new SEC Chairman Mary Schapiro’s "first tasks" will be looking into "whether the boards of banks and other financial institutions conducted effective oversight leading up to the financial crisis," as part of an SEC effort to "intensify scrutiny at the top levels of management."

 

This process, described as an "inquiry into what went wrong at the board level," will examine boards that "signed off on the risks the companies took." The Post article quotes observers who note that "the boards of top financial firms had characteristics that promoted risky business practices and harmed shareholders." Among the characteristics the article cites are: board members overloaded with commitments to multiple boards; failure to separate the CEO and Chairman functions; and insufficient oversight of compensation issues.

 

To a certain extent, the Post article, and perhaps even the reported SEC initiative to scrutinize boards, reflects something of a faulty premise. The article states that "with few exceptions, boards have received little media attention as the country has sought explanations for financial firms’ taking on such perilous risks. Whether or not boards have received "media attention," they certainly have not escaped scrutiny, as the boards of numerous companies already have been subjected to extensive private securities class action litigation by shareholders. Were there to be an SEC initiative targeting boards, plaintiffs’ attorneys’ undoubtedly would be emboldened to bring even further litigation in the SEC’s wake.

 

To be sure, the Post article also cites comments by other observers who question whether boards should be "held culpable for a financial crisis that just about everyone missed." One commentator observes that the "universe of people who misread the risks…is very broad" and "could extend to rating agencies, managements and regulators." (The mention of regulators’ own potential culpability adds a certain ironic note here.) Regrettably, in the current environment, this observation about the broad dispersion of culpability may represent less of a statement of exculpation that a justification for enlarging the list of persons on whom blame might be cast for the present predicament.

 

The causes of the current situation may be myriad and the responsibilities widely dispersed. Nevertheless, for cultural reasons buried deep in the American psyche, particularized blame apparently must be assigned. The prospect of the SEC deliberately targeting financial institutions’ boards unquestionably elevates directors’ potential liability exposures. This heightened exposure extends not only to the boards of the high profile companies that have already failed, been bailed out or been merged out of existence. It also extends to the boards of the many other banks, insurance companies and other financial institutions, and even companies outside the financial sector, that are currently struggling.

 

The prospect of heightened board scrutiny inevitably leads to questions concerning the adequacy of the potentially targeted board members’ D&O insurance. Now more than ever, board members will want to ensure that they have appropriate insurance structures in place to protect themselves should they attract the unwanted attention either of regulators or plaintiffs’ attorneys.

 

Potential Liability of Other Professionals: Consistent with the suggestion cited above that a wide range of persons potentially culpable for misreading the risks, investors seeking to recover their massive losses are targeting numerous other "gatekeepers," in addition to the directors and offices of the troubled companies. These gatekeepers include companies’ outside professionals, many of whom have been named as defendants in the subprime and credit crisis-related securities lawsuits.

 

On February 24, 2009 at 2:00 p.m. EST, the Securities Docket will be hosting a webcast on the "Liability of Professionals in the Financial Crisis." In this free webcast, Stuart Grant of Grant & Eisenhofer and Michael Young of Wilkie Farr and Gallagher will be addressing questions surrounding the potential liability of professionals such as auditors, investment bankers, rating agencies, lawyers and others.

 

For further information about the webcast and to register, refer here.

 

Did the Media Fail Their Gatekeeper Function, Too?: Add the media to the list of gatekeepers that arguably failed in their gatekeeper responsibilities. In a February 21, 2009 interview in the Wall Street Journal (here), NYU Professor Nouriel Roubini observes that

 

in the bubble years, everyone becomes a cheerleader, including the media. This is the time when journalists should be asking tough questions, and I think there was a failure there. The Masters of the Universe were always on the cover, or the front page — the hedge-fund guys, the imperial CEO, private equity. I wish there had been more financial and business journalists, in the good years, who’d said, ‘Wait a moment, if this man, or this firm, is making a 100% return a year, how do they do it? Is it because they’re smarter than everybody else . . . or because they’re taking so much risk they’ll be bankrupt two years down the line?"

And I think, in the bubble years, no one asked the hard questions. A good journalist has to be one who, in good times, challenges the conventional wisdom. If you don’t do that, you fail in one of your duties.

 

There is, it seems, no shortage of blame to spread around. The question remains whether anyone in particular can or should be held directly responsible for failing to see what no one else saw – and if so, whom.

 

The Week Ahead: The PLUS D&O Symposium: This week, I will be in NYC to help co-Chair the annual Professional Liability Underwriting Society (PLUS) D&O Symposium, which will take place on Wednesday, February 25, 2009 and Thursday 26, 2009, at the Marriott Marquis hotel in Times Square. Details about the Symposium, including the agenda and registration information, can be found here.

 

I know that many readers will be attending the Symposium, and I hope readers at the conference will make a point of greeting me, particularly if we have not previously met. I look forward to seeing everyone in New York.

 

Because of the Symposium and related PLUS duties and functions, The D&O Diary will not be appearing according to its usual schedule. Regular publication activities will resume next week.

 

Even after Merrill Lynch’s recent $550 million settlement of the subprime-related securities and ERISA lawsuits pending against the company (about which refer here), the consolidated subprime-related derivative lawsuit against the company’s directors and officers remained pending. By contrast to the massive settlements in those other lawsuits, the derivative litigation was recently dismissed, because of the company’s January 2009 acquisition by Bank of America.

 

In a February 17, 2009 opinion (here), Judge Jed Rakoff of the Southern District of New York granted the defendants’ motion to dismiss the derivative action. The defendants had argued that as a result of the Bank of America’s acquisition of Merrill in a stock-for-stock transaction, the plaintiffs are no longer Merrill shareholders and therefore lack standing to pursue the derivative actions as filed. Judge Rakoff granted the motion in light of the requirement under Delaware law for a derivative plaintiff to show "continuing ownership."

 

In his opinion, Judge Rakoff expressly noted that the dismissal "is without prejudice to plaintiffs’ filing with this Court, if and when they have standing, a renewed action, recast as a derivative action against Bank of America, or as a so-called ‘double derivative action, or otherwise, but based on the same underlying allegations as the actions here dismissed." (As reflected here, a "double derivative action" is a lawsuit in which a shareholder of a parent corporation brings an action on behalf of a wholly owned subsidiary for alleged wrongs to a subsidiary.)

 

The subprime-related derivative litigation involving Countrywide was also dismissed, following Bank of America’s acquisition of Countrywide, based on the requirement that derivative plaintiffs must demonstrated continuing ownership in order to have standing to assert the derivative claim, as reflected here and here.

 

Bank of America’s acquisition of Merrill is itself now the subject of extensive securities litigation, as discussed here.

 

A February 20, 2009 Law.com article discussing the dismissal in the Merrill subprime-related derivative litigation can be found here.

 

Second Stanford Financial Lawsuit Alleges Madoff Connection: As noted in a prior post (here), the same day as the SEC announced that it had launched a civil enforcement proceeding against R. Allen Stanford, the Stanford Financial Group and related entities and individuals, aggrieved investors also launched a securities lawsuit against many of the same entities and individuals in the Southern District of Texas.

 

A second lawsuit has now been commenced in the Southern District of Texas against the Stanford International Bank and related Stanford entities. Among other things, the second complaint expressly alleges a connection between the Madoff scandal and the new Stanford Financial scandal.

 

As reflected in the plaintiff’ lawyers February 19, 2009 press release (here), the action is brought "on behalf of purchasers of Stanford International Bank Ltd. ("SIB") certificates of deposit ("CDs") or shares in SIB’s Stanford Allocation Strategy proprietary mutual fund wrap program ("SAS") between February 19, 2004 and February 17, 2009."

 

According to the press release, the Complaint (which can be found here), alleges that the defendants

 

fraudulently peddled CDs that promised rates of return far above those available from other banks. Defendants claimed that these superior returns were possible because SIB invested its deposits rather than loaning them. To ensure that depositors could redeem their CDs, defendants assured them that SIB’s investments were liquid and diversified. In fact, nearly 80% of SIB’s investments were concentrated in just two high-risk, illiquid categories: private equity and real estate. Now that the real estate and private equity markets are in free fall, many of those who purchased SIB’s CDs have recently been informed that they cannot redeem them.

 

The complaint also alleges with respect to the defendants mislead investors about the SAS program. The complaint alleges that the defendants

 

picked a handful of mutual funds that had performed extremely well in 1999-2004 and claimed the returns of those high-performing funds as the historical returns of the SAS program. Defendants also inflated the claimed returns of the SAS program in 2006 and 2007. Investors, misled by defendants’ claims of historic returns, have fared very poorly in the SAS program.

 

The complaint also alleges that the defendants misled investors about SIB’s exposure to the Madoff scandal. The complaint alleges that the bank sent investors a letter

 

unequivocally stating that "Stanford International Bank did not have any exposure to the Madoff Fund." Just two days before this letter was sent, an SIB analyst informed all three of the individual defendants, including R. Allen Stanford ("Stanford"), that SIB had invested in Meridian, a New York-based hedge fund that used Tremont Partners as its asset manager. Tremont, in turn, had invested a portion of Meridian’s – and SIB’s – money with Madoff.

 

The two fraud schemes seem to have come together as if they were subatomic particles drawn by some unwritten law of physics.

 

The Sox First blog has an interesting post here on the parallels between the Madoff and Stanford scandal.

 

Yet Another Bank Closure: By contrast to the last several Friday nights in a row, the FDIC did not assume control of multiple banks following their closure by regulatory authorities. Rather than multiple banks, this Friday the FDIC announced that it had assumed control of just a single bank.

 

As reflected in its February 20, 2009 press release (here), the FDIC assumed control of Silver Falls Bank of Silverton, Oregon. Prior to its closure, the bank had assets of approximately $131.4 million.

 

The closure of the Oregon bank already brings the 2009 year to date total of bank failures to 14 (by contrast to the 25 banks that failed during all of 2008). As I have recently noted (here), the surging bank failure levels has some very troublesome implications, and the now standard Friday bank closure announcement is one more reflection of the current challenging financial circumstances.

 

Auction Rate Securities: Balance Sheet Valuation Concerns: With all the long-standing publicity surrounding the difficulties in the auction rate securities markets, and the extensive related litigation, you might expect that companies with balance sheet exposure to auction rate securities had long since adjusted the securities’ carrying values to reflect the current market conditions. But according to a recent study, many companies with auction rate securities exposure have yet to make any accounting adjustments.

 

As reported in a February 20, 2009 CFO.com article (here), a recent study of 625 corporate auction rate securities holders found that 186 of them, or nearly 30 percent, continue to report them at par value. The study’s author is quoted as saying that "there’s still an awful lot of companies out there that are not properly accounting for [the auction rate securities]."

 

These companies failure to recognize their balance sheet exposure to auction rate securities could represent a significant litigaton risk factor. There have already been at least one securities lawsuits against a nonfinancial company that included allegations based on the company’s alleged failure to disclose its exposure to auction rate securities (refer, for example here). Companies delaying their recognition of this exposure could be exacerbating an already serious concern. The delay potentially could represent a heightened litigation risk.

 

In case you were wondering how long it would take, you should know that investors have already filed the first securities class action lawsuit in connection with the fraud allegations surrounding R. Allen Stanford and his Stanford Financial Group.

 

On February 17, 2009 — the same day as the SEC announced its charges that Stanford had engaged in a "multi-billion dollar investment scheme" — plainiff investors filed a securities class action lawsuit against Stanford and his related entites, as well as several other individual directors and  offficers, in the Southern District of Texas. The complaint, which can be found here, is filed on behalf of all persons who purchased securities and CDs from Stanford and affiliated selling agents from January 1, 2000 through February 17, 2009.

 

Though many of the Stanford investors reportedly are domiciled abroad (particularly in Latin America), the named plaintiffs in this initial lawsuit are all residents of the Houston area. The defendants include not only Stanford and his Houston-based firm but the affilated bank, based in Antigua.

 

The complaint describes the allegedly aggressive sales efforts undertaken to sell the affilated bank’s CDs. The complaint alleges that the sales efforts misrepresented the safety and security of the CDs. The complaint also alleges that the Stanford affilated entitles misrepresented their performance and investment returns. The returns are alleged to have been "misleading and inflated."

 

Call it a hunch, but I suspect this complaint is only the first of many that will be filed in the days, weeks and months ahead.