The numbers are unambiguous – there were more securities lawsuits filed in the second half of 2008 than there were in the first half. Nevertheless commentators and observers continue to repeat the mistaken conclusion that there were fewer lawsuits filed in the second half, and even to try to discern some significance from a decline that never, in fact, occurred.

 

Here are the facts. As reflected on the Stanford Law School Clearinghouse Securities Class Action Clearinghouse website, which helpfully indexes the securities class action filings by quarter (here), there were 112 securities lawsuits filed in the first half of 2008 and 114 in the second half.

Not only were there more lawsuits filed in the second half of the year, but there were more lawsuits filed in the fourth quarter (65) than any other quarter during the year. Indeed, there were more lawsuits filed in December (30) than any other month during the year.

 

 

Clearly, the fact that securities lawsuit filings in fact accelerated at the end of 2008 potentially has far different implications for the future than the mistaken impression that lawsuit filings were declining.

 

 

The source of the impression that there were fewer lawsuits in the second half of 2008 is the year-end securities lawsuit filing Report jointly published by the Stanford Law School Clearinghouse and Cornerstone Research. The Report, which can be found here, considered only lawsuit filings through December 15, 2008. As I noted at the time the Report was first published (here), by omitting the last two weeks’ lawsuit filings, the Report not only excluded at least 12 lawsuit filings from its analysis, but it also reached a conclusion, inconsistent with the actual aggregate year-end data, that lawsuit filings had declined in the year’s second half. When lawsuit filing data through December 31 are considered, it is clear that the number of filings did not decline in the year’s second half.

 

 

What difference does it make whether or not lawsuit filings declined in the second half? Well, a discussion of the reasons for a lawsuit filing decline is a far different conversation that a debate over the reasons why lawsuit filings accelerated in the year’s final quarter and month. The repetition of the impression that lawsuit filings were declining when in fact they were accelerating not only perpetuates a misunderstanding of what actually happened, but it also allows the possibility that decisions could be made or conclusions reached based on a faulty premise.

 

 

Unfortunately the conclusion that securities lawsuit filings declined in the second half of 2008 continues to be repeated. As reflected in a February 9, 2009 Business Insurance article (here), industry observers continue to distract themselves and perhaps others as well debating the reasons for a lawsuit filing decline that never happened, when in fact the actual discussion ought to be the reason why lawsuit filings actually accelerated at the end of the year.

 

 

The danger from this mistaken conclusion is apparent in the remarks of one leading industry observer at a recent conference. As quoted in the Business Insurance article, the observer noted, in apparent reliance on the Cornerstone report, that “in this last quarter, there were actually fewer cases filed. It got better, not worse at the end of the year.” The world certainly looks a lot different if you think things recently “got better”; unfortunately, they didn’t get better, they got worse.

 

 

The D&O insurance industry has a hard enough time behaving rationally and making sense of what has actually happened. It would be extremely unfortunate if the industry were to become even further confused by a conclusion that unsupported by full-year data.

 

 

I entreat readers to do everything they can to make sure that the misimpression about securities lawsuit filing activity levels is not perpetuated. The industry faces too many other challenges to have to deal with the added burden of laboring under misimpressions.

 

 

The credit-crisis securities litigation wave, which began with the filing of the first subprime mortgage-related lawsuits in early February 2007, is about to enter its third year. Though the wave has evolved during the intervening period, it shows no sign of slowing down. The more interesting question going forward will be whether the litigation, which up until now has largely been concentrated in the financial sector, will spread to encompass companies in the wider economy.

The Wave’s History – So Far

The current subprime and credit crisis-related securities litigation wave began on February 8, 2007, with the filing of a securities lawsuit against New Century Financial Corporation and certain of its directors and officers. (Refer here for my most recent post on the New Century case.) Two years later, there have been 152 separate subprime or credit crisis-related lawsuits filed against companies and other entities, as reflected in my running tally of the suit, which can be accessed here.

The initial cases during 2007 were largely filed against subprime loan originators, banks, mortgages companies, home builders and residential real estate investment trusts. However, by year end 2007, a number of lawsuits had also been filed against investment banks, investment advisors, and rating agencies.

During 2007, there were a total of 40 subprime-related securities lawsuits filed.

In 2008, the lawsuits against banks and other mortgage originators continued to mount, but the litigation activity spread beyond just residential mortgage and real estate issues. The litigation also involved student lenders, commercial construction companies, commercial real estate investment trusts, bond insurers, and mortgage guaranty insurers. As I noted at the time (refer here), by early 2008, the litigation activity was no longer just about the subprime meltdown but had by that time become a credit crisis litigation wave.

The litigation wave also picked up considerable momentum during 2008, driven in part by the onslaught of cases involving auction rate securities. A total of 21 separate auction rate securities lawsuits were filed in 2008, against broker dealers, security issuers and mutual funds, among others. There were also a significant number of separate securities lawsuits filed on behalf of preferred shareholders and subordinated debtholders, which represents a relatively unusual securities litigation development, as discussed here.

The crisis in the global financial markets during fall 2008 also significantly affected the litigation wave. As I noted here, as a result of the financial market turmoil, the litigation wave reached an "inflection point" during the third quarter of 2008, where companies began to find themselves exposed to litigation not because of their own direct vulnerability to the credit crisis, but because of the companies’ exposure to other companies that were experiencing credit crisis-related issues.

During 2008, a total of 101 subprime and credit crisis-related securities lawsuits were filed.

As 2009 has begun, the litigation wave has shown no sign of slowing down. Indeed, during January 2009 alone, there were eleven new credit crisis-related securities lawsuits. A spreadsheet of the 2009 cases can be found here.

One important consequence of the litigation wave’s evolution over time is that it has become increasingly difficult to maintain absolute definitional clarity about what should be included in the category. This challenge has become even more difficult now that the financial crisis basically encompasses the entire global economy. It has become progressively tricky to determine whether or not newly filed lawsuits logically ought to be group together with the earlier suits, or whether they represent something entirely different. This categorization challenge has made simply "counting" the subprime and credit crisis-related lawsuits increasingly more difficult over time.

Financial Sector Concentration

Though the litigation has evolved and become more diverse, the litigation activity has largely been concentrated in the financial sector. Of the 152 subprime and credit crisis-related securities lawsuits that have been filed as of February 4, 2009 and that involved companies or other entities that have assigned standard industrial classification codes (SIC Codes), fully 117 of them have involved companies or other entities with SIC Codes in the 6000 series (Finance, Insurance and Real Estate).

Moreover, the 18 entities that have been sued but that have no SIC Code designated are also almost exclusive concentrated in the financial sector. These entities include mutual funds, private equity firms, hedge funds, and foreign firms whose shares do not trade on U.S. exchanges (e.g., Fortis and Société Générale).

Of the financial companies, the SIC Code categories with the largest number of lawsuits were SIC Code 6021 (National Commercial Banks) and SIC Code 6798 (Real Estate Investment Trusts), both of which had 16 lawsuits. Other categories with a significant number of securities lawsuits include SIC Code 6211 (Security Broker Dealers), which had 13 lawsuits; SIC Code 6189 (Asset Backed Securities), which had 12 lawsuits; and SIC Code 6035 (Savings Institutions, Federally Chartered), which had 11 lawsuits.

Has the Wave Entered a New Phase?

But while the litigation activity has largely been concentrated in the financial sector, there has more recently been a "new wave" of credit crisis lawsuits, as discussed at greater length here. These new wave lawsuits involved companies exposed to some of the credit crisis casualties (Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual, American International Group, etc); that made wrong-way bets on commodities or currencies; and companies outside the financial sector whose balance sheets are laden with auction rate securities or other troubled assets.

The interesting question these new wave cases present is how far outside the financial sector these kinds of cases will spread as we go forward.

How are the Cases Faring?

Even though the subprime and credit crisis-securities litigation wave is about to enter its third year, most of the cases are still only in their earliest stages. There has really been only one significant settlement, the recent massive $550 million settlement involving Merrill Lynch (about which refer here). The few other settlements have been considerably more modest (refer here).

Only a handful of these cases have even reached the motion to dismiss stage. Among the cases where dismissal motions actually have been addressed, there have been several notable cases in which the dismissal motions were denied – for example, the New Century case (refer here) and the Countrywide case (refer here).

On the other hand, there have also been a handful of cases in which the motions to dismiss have been granted, and at least some courts have seemed skeptical that the target companies financial woes were the result of fraud (about which refer here).

My complete list of subprime and credit crisis-related securities lawsuit settlements, dismissals and dismissal denials can be found here.

Looking Ahead

Even though the litigation wave is about to enter its third year, it is clear that we have still only just begun. With the cases already filed only in their earliest stages and with new lawsuits continuing to pour in, the subprime and credit crisis-related litigation wave is likely to continue to remain an important feature of the litigation landscape for years and years to come.

 

The 2008 securities lawsuit filings were dominated by new lawsuits filed against companies in the financial sector, as has been well-documented elsewhere (refer here). But while lawsuits against financial companies were the most prominent feature of the 2008 securities filings, there were also a significant number of lawsuits filed against companies outside the financial sector. In particular, life sciences companies, which historically have experienced a heightened level of securities litigation exposure, suffered a significant level of litigation activity once again in 2008.

 

For purposes of this post, I am including under the heading "life sciences" companies any company either in SIC Code series 283 (Drugs) or in SIC Code series 384 (Surgical, Medical and Dental Instruments and Supplies). Reasonable minds could differ about whether additional categories should also be included within life sciences companies, but the interests of simplicity and consistency with my own prior analyses support this categorical definition.

 

A review of the 2008 securities lawsuit filings shows that, notwithstanding the primacy of litigation involving financial companies during the year, heightened securities litigation activity involving life sciences companies continued in 2008.

 

According to my analyses, during 2008, there were 15 new securities lawsuits filed against companies in the 283 SIC Code series, including nine in the 2834 SIC Code category (Pharmaceutical Preparations). There were also eight securities lawsuits filed against companies in the 384 SIC Code category, including five in the 3845 SIC Code category (Electromedical Apparatus).

 

The fact that there were 23 new securities lawsuits filed against life sciences companies in 2008 is quite remarkable given the predominance of the credit crisis litigation wave.

 

The total number of life sciences lawsuits is significant in relative terms as well. By way of comparison to the 23 new securities lawsuits filed against life sciences companies in 2008, there were 21 securities lawsuits filed against life sciences companies in 2007. (My detailed analysis of the 2007 life sciences securities lawsuits can be found here.)

 

The fact that the number of lawsuits filed against life sciences companies actually increased in 2008 is extraordinary in light of the extent of the surging credit crisis litigation wave.

 

The 23 securities lawsuits filed against life sciences companies in 2008 represents approximately 10% of the total of 226 new securities lawsuits overall that were filed in 2008, which is comparable to the 12% that life sciences lawsuits represented of 2007 securities lawsuit filings.

 

That this significant of a percentage of securities litigation activity is unrelated to the credit crisis litigation wave underscores a point I have previously emphasized (for example, here), that while the subprime and credit crisis-related litigation wave is a significant factor driving securities lawsuits filing activity, it is by no means the sole factor.

 

The lawsuits filed against life sciences companies in 2008 involved a wide variety of allegations. The most common allegation, asserted in five of the lawsuits, is that the defendant company misrepresented the results or progress of one or more of its clinical trials. Lawsuits filed against four companies alleged financial misstatements or improper revenue recognition.

 

Other lawsuits involved allegations relating to disclosures about product efficacy; manufacturing deficiencies or controls; merger integration issues; misrepresentations about an officer’s credentials; intellectual property concerns; and product commercial viability.

 

The attributes of these companies that most frequently attract litigation is the combination of their susceptibility to disruptive events and the vulnerability of their share prices. These kinds of setbacks are an almost inevitable attribute of the regulatory and scientific environment in which these companies operate. However, these kinds of risks are also often comprehensively disclosed.

 

As a result, though life sciences companies are frequently sued, they have not proven to be easy targets. As I noted here and here, lawsuits filed against life sciences companies are frequently dismissed. Nevertheless, life sciences companies continue to attract the unwanted attention of the plaintiffs’ lawyers.

 

Securities Litigation Survey: Readers interested in securities litigation topics under the year-in- review heading will want to take a look at  the January 2009 memorandum by the Skadden law firm entitled "Securities Litigation 2008 – Noteworthy Decisions" (here). The memorandum does a particularly good job briefly summarizing the eleven decisions discussed as well as identifying the significance of the decisions.

 

Early Registration Deadline Approaching: The early registration deadline for the C5 D&O Liability Insurance Conference is approaching. The Conference is scheduled to take place March 24 and 25, 2009 in London. As reflected in the program brochure, which can be accessed here, the program has a number of interesting speakers and will be addressing many of the current hot topics in D&O insurance. I will be participating in a panel entitled "Current Litigation Trends in Europe and the US: Are Class Actions on the Horizon?"

 

The early registration deadline for this conference is February 9, 2009, after which the registration fee becomes considerably more expense.

 

The growing problems surrounding option adjustable-rate mortgages (Option ARMs) are a concern I have previously noted (here). But it now appears that the problems may be far worse even than previously feared. These problems not only represent a growing threat to borrowers and lenders alike, but the also present the increasing likelihood for further shareholder litigation.

According to a January 30, 2009 Wall Street Journal article entitled “Option ARMs See Rising Defaults” (here), nearly $750 billion in Option ARMs were issued from 2004 to 2007. Unfortunately, as of December 2008, 28% of Option ARMs were in default or foreclosure, and an additional 7% involved properties that have already been take back by lenders. A chart accompanying the Journal article shows that the Option ARM default rate is already far greater now than was the subprime default rate at the beginning of 2008.

Borrowers holding Option ARM mortgages now find themselves having to play a particularly unattractive hand. In particular, as a result of the way these loans are structured, borrowers that have been paying only the minimum have likely seen their principal amount due increase as a result of so-called “negative amortization.”

At the same time, housing values around the country have declined. The Journal article reports that more than 55% of borrowers with Option ARMs owe more than the current value of their homes.

Think that sounds bad? Things are about to get worse. A lot worse.

As detailed in a lengthy January 4, 2009 post on the Seeking Alpha blog (here), the interest rates on billions of dollars are due to reset in 2009 and 2010. The problems that likely will ensue “are expected to be more pronounced than the subprime crisis since the economy is already nearing its trough, the consumer confidence has slumped to an all time recent history low and financial markets are in a gridlock.”

In explaining why the problems associated with the Option ARM resets could be so bad, the Seeking Alpha blog post goes through a detailed analysis of the timing and likely magnitude of the resets. In explaining the problems that could follow, the author notes:

The potential average payment increase on the loans recast is 63%, representing an additional $1,053 due each month on top of the current average payment of $1,672. These large payment increases could cause delinquencies to increase, and increase dramatically, after the recast. The fact that only 65% of borrowers have elected (or are able) to make only minimum payments underscores the magnitude of the potential problem. The potential payment shock combined with the continuous deteriorating outlook for home prices and lack of refinancing opportunities could be a negative cause of concern for investors in Option ARM securities. Even more ominous, is pall cast upon the banks that hold these assets and are additionally exposed to other forms of consumer credit, ie. HELOCs, credit card debt and other unsecured loans.

As a result of these problems and possibilities, sources quoted in the Journal article estimate that more than half of all option ARMs outstanding will default, and that nearly 61% of options ARMs originated in 2007 will eventually default.

These looming problems not only represent a threat to borrowers, investors and lenders, but they also present the possibility for even further litigation.

Problems arising from Option ARM mortgages have already been the source of considerable securities litigation. The most recent lawsuit involves Triad Guaranty, which provides private mortgage insurance products to residential mortgage lenders and investors in the United States.

As reflected in their January 29, 2009 press release (here), plaintiffs’ attorneys have filed a securities class action lawsuit in the Middle District of North Carolina against Triad and certain of its directors and officers. According to the press release, the complaint (which can be found here), alleges that

beginning in late August 2007 and continuing throughout 2008, Triad began to acknowledge serious issues surrounding its exposure to anticipated losses and defaults related to its book of business for its Alt-A and pay-option adjustable rate mortgage (“ARM”) products written in 2006 and 2007 due to a failure to engage in proper underwriting practices, resulting in a decline in Triad’s stock price. Then, on November 10, 2008, Triad issued its financial results for the third quarter of 2008, reporting a net loss for the quarter ended September 30, 2008 of $160.1 million. On this news, Triad’s stock price dropped $0.11 per share to close at $0.70 per share on November 11, 2008.

The complaint further alleges that the defendants concealed from the investing public that:

(a) the Company was not adequately accounting for its loss reserves in violation of Generally Accepted Accounting Principles, causing its financial results to be materially misstated; (b) the Company failed to engage in proper underwriting practices for its book of business related to insurance written in 2006 and 2007, including the insurance related to its Alt-A and pay-option ARM products; (c) the Company had far greater exposure to anticipated losses and defaults related to its book of business related to insurance written in 2006 and 2007, including its Alt-A and pay-option ARM portfolios, than it had previously disclosed; (d) the Company lacked effective internal controls to detect fraud and misrepresentations in the underwriting process; and (e) the Company failed to disclose the true risks associated with its ability to continue to write new business and, given rating downgrades and capital limitations, the Company would be forced to liquidate its Canadian subsidiary and stop writing new insurance policies and transition the business to run-off.

Even before this recent lawsuit was filed against Triad, there had already been a number of securities lawsuits raising allegations concerning Option ARMs, including for example cases filed against Wachovia (refer here), Washington Mutual (refer here) and Downey Financial (refer here).

All of those prior lawsuits involved either companies that issued the Option ARMs or the issuers’ successors in interest. Triad, by contrast, is not an issuer but rather is a mortgage insurer. Triad’s involvement in a securities lawsuit raising Option ARM-related allegations highlights the potential for extensive further litigation, involving not just the issuers themselves but other types of companies as well.

I have in any event added Triad to my running tally of subprime and credit crisis-related securities litigation, which can be accessed here. With the addition of the Triad lawsuit, the current tally of subprime and credit crisis related securities litigation filed during the period 2007 through 2009 now stands at 150, of which eight have been filed in 2009. A spreadsheet reflecting the 2009 lawsuits can be found here.

As detailed in a recent post (here), one of the more worrisome trends in an economic environment full of thing to worry about is the increasing number of bank failures involving community banks. This trend continued this past Friday night when the FDIC closed three more banks, brining the 2009 bank closure tally up to six.

 

The three banks closed on Friday were MagnetBank of Salt Lake City, Utah, which has assets of $292.9 million (and the details about which can be found here); the Suburban Federal Savings Bank of Crofton, Maryland, with assets of $360 million (refer here); and Ocala National Bank of Ocala, Florida, with assets of $223.5 million (refer here).

 

 

A particularly troublesome note regarding the Utah bank’s closure is that the FDIC was unable to find a buyer for the bank’s assets or deposits, which the Wall Street Journal described (here) as a “rare event and an ominous sign for regulators.” According to news reports (here), this is the first time in over five years that the FDIC has been unable to find a buyer for a failed bank’s assets. In the absence of a buyer, the FDIC will issue checks to the bank’s depositors, increasing the impact on the FDIC insurance fund.

 

 

The failure of the Suburban Federal Savings Bank was the first bank failure in Maryland since 1992. As detailed in the Washington Post (here), the bank’s failure was precipitated by mounting losses in the bank’s mortgage loan portfolio.

 

 

Perhaps even more noteworthy than the fact that the total number of bank failures in 2009 is already up to six banks is the fact that the total number of bank failures in the seven month period between July 1, 2008 and January 31, 2009 is 27. (The FDIC’s complete list of failed banks for the period October 2000 through the present can be found here.) That is a huge number and all signs are that these numbers will continue to grow as 2009 progresses. The Journal article specifically observed that regulators are “bracing for dozens of more lenders to collapse in the coming months.”

 

 

Along those lines, it is worth noting that in the FDIC’s Quarterly Banking Profile for the Third Quarter of 2008 (here), which is the FDIC’s most recent quarterly profile, the number of institutions on the FDIC’s problem list increased from 117 to 171, and the assets of the “problem institutions” rose from $78.3 billion to $115.6 billion. This is the first time since 1994 that assets from problem institutions have exceeded $100 billion.

 

 

The FDIC’s next quarterly banking profile, for the quarter ending December 31, 2008, will not be released until later in February (the reports are issued 55 days after each quarter end). It will be interesting to see how significant the deterioration was in the fourth quarter.

 

 

As I detailed in my prior post, both historically and more recently, an increase in the number of failed banks has meant an increase in failed bank litigation. As the bank failures continue to mount, the threat of increased bank related litigation will also continue to grow.

 

The recent news about the eleventh hour award of nearly $4 billion in bonuses to Merrill Lynch employees is only the latest in a series of events exciting enthusiasm for "clawbacks" of allegedly excessive or undeserved Wall Street bonuses. Reports that New York City financial firms disbursed $18.4 billion in cash bonuses is 2008 added further fuel to the fire.

 

Senator Chris Dodd stated, with particular reference to executives receiving bonuses from financial institutions benefiting from government bailouts, "I’m going to look at every possible legal means to get that money back," adding "I’m going to be urging – in fact not urging, demanding—that the Treasury Department figures some way to get the money back."

 

President Obama, for his part, referred to the award of bonuses during a recession and while financial companies are seeking financial help to be "shameful" and the "height of irresponsibility."

 

The idea of compelling executives to disgorge compensation has been a recurring part of the public discussion surrounding the current economic crisis. The suggestion that the government should clawback financiers’ prior compensation has been a rallying cry for academics (here) and commentators (here) alike.

 

Indeed, the Dealbook blog reports (here) from Davos that a discussion of the topic of executive compensation turned a conference session into " a bit of a lynch mob, Davos-style" in response to a proposal to force those financiers who benefitted from the boom to "disgorge some of the money they ‘earned’ in bonuses based on profits that have since vanished."

 

This lynch mob mentality is familiar to those who recall the public outcry that accompanied the last era of corporate scandals. In fact, the perceived compensation excesses at Enron and Tyco, among others, resulted in a statutory provision specifically designed for the purpose of clawing back unwarranted compensation, Section 304 of the Sarbanes Oxley Act.

 

Section 304 has in fact been used to recover executive compensation, in the noteworthy options backdating settlement involving UnitedHealth Group (about which refer here). However, the fact that over six years’ after the enactment of the statutory clawback provision that there is only one noteworthy example of its utilization underscores the provision’s limited usefulness.

 

Simply put, and as discussed in detail here, Section 304 has several critical limitations: the provision lacks a private right of action; the provision’s language is poorly written; and it can only be used against the CEO and the CFO, limiting its use against other executives.

 

Moreover, as discussed in a December 24, 2008 CFO.com article (here), a federal district court recently ruled that the provision cannot be enforced against a company’s CEO or CFO if the company did not restate its financial results, even if the company had accounting discrepancies. The restriction clearly could further limit the provision’s usefulness and could constrain the government’s attempt to use the provision to recover the recent controversial bonus payments.

 

There are, however, other legal avenues that litigants might pursue to try to recover executive compensation, as discussed in the January 29, 2009 New York Law Journal article entitled "Limiting, Clawing Back Executive Pay in the Wake of the Financial Bailout" (here) by David Pitofsky and Matthew Tulchin of the Goodwin Proctor law firm.

 

The authors note that while the business judgment rule traditionally has shielded compensation decisions "shareholders seeking equitable rescission and restitution via derivative suits have been successful in recovering ill-gotten gains, even in the absence of compelling proof of personal impropriety." The authors cite as an example the recovery of $40 million in bonuses from HealthSouth CEO Richard Scrushy.

 

The authors also reference the mixed results presented in recent attempts to use state corporate governance laws to recoup executive compensation. On the one hand, they note the unsuccessful regulatory efforts to recoup a $187 million compensation package from former NYSE Chairman Richard Grasso (about which refer here).

 

On the other hand, the authors also note the more recent and successful use of New York’s fraudulent conveyance laws by current New York Attorney General Andrew Cuomo, who obtained AIG’s agreement, in response to the Attorney General’s demand letter, to freeze salaries and eliminate bonuses for certain former top AIG executives. (An October 15, 2008 New York Times article discussing Cuomo’s letter can be found here.)

 

University of California law professor Jesse Fried, among others, suggests (here) that the New York fraudulent conveyance laws, upon which Cuomo relied in his efforts involving AIG, might be used to recover unwarranted bonuses. Fried points out that the statute applies to all firms in New York, even those that have not applied for bankruptcy, and gives creditors the right to recover payments made to insiders under certain circumstances.

 

Provisions regarding executive pay were in fact a part of the federal bailout bill enacted by Congress last fall. However, amendments specify that the provision only applies to firms that receive government bailout funds by selling assets to the government in an auction. Because the bailout funds have not been deployed as originally intended to buy assets, the compensation recoupment provision may prove "toothless," as discussed in a December 18, 2008 Washington Post article (here).

 

Nevertheless, the lynch mob mentality in evidence at Davos is likely to continue to arise elsewhere, and in all likelihood, popular interest in recouping executive compensation will continue as a prominent topic while Congress continues to grapple with the current economic crisis.

 

Among other things, we can also expect continued discussion on whether or not Congress should enact a legislative limit on executive pay, as discussed in Robert Frank’s January 3, 3009 New York Times column (here).

 

In addition we can expect increasing pressure on companies to adopt their own clawback provisions, either as part of their incentive compensation plan, as governance policy, or as a statement of intent. My prior post discussing corporate clawback policies can be found here.

 

Whenever the issue of possible litigation against corporate officials comes up, the question arises concerning who will bear the costs. Obviously, the amounts of any compensation clawed back or disgorged would not be covered by the typical D&O policy. However, under the wording of the typical policy, a corporate official that is the target of a compensation clawback lawsuit would have substantial grounds on which to argue that his or her costs of defending against the suit should be covered.

 

To the extent that current popular sentiment for compensation recoupment translates into litigation, the resulting defense expense could become yet another area of growing claims expense for increasingly beleaguered insurers.

 

The Heat is On: Banco Santander started it, with its offer to make good on its clients’ Madoff related losses. The word is out now, and at least some other banks have gotten the message.

 

As reported in the January 29, 2009 Financial Times (here), the National Bank of Kuwait has fully reimbursed all of its clients that lost money on the Madoff-related Ponzi scheme — full reimbursement meaning both the clients initial investment as well as "the gains, thought to be ficticious, that they thought they had made."

 

As the Financial TImes article notes, the NBK move "puts pressure on other banks and fund managers whose clients lost money in Mr. Madoff’s alleged fraud." (I wonder why the FT found it necessary to add the work "alleged.") The article goes on to note that NBK had the advantage of relatiively small losses to cover

 

Proud to Be a ‘KM Pick’: Knowledge Mosaic, the online subscription information service for attorneys, regulators, journalists and academics, offers a number of excellent services, including a weekly newsletter entitled Wired Mosaic. A feature of the newsletter is the KM Pick, in which the newsletter highlights a legal-oriented blog.

 

I am proud to report that in the January 29, 2009 issue of the newsletter (here), The D&O Diary is featured as the KM Pick. Modesty prevents me from reciting here the blush-inducing words of the newsletter’s glowing encomium, but suffice it to say that I sure hope everyone will take a look at the item (right hand column, scroll down).

 

 

A recurring theme on this blog has been the growing threat of civil litigation following in the wake of increased Foreign Corrupt Practices Act enforcement activity. (Refer for example, here.) A recent study both establishes both the overall scale of FCPA enforcement activity and quantifies the magnitude of the FCPA follow-on securities litigation.

 

The January 28, 2009 NERA Economic Consulting study, entitled "FCPA Settlements: It’s a Small World After All" (here) reports that since 2002, SEC and DOJ litigation and class actions involving the FCPA have "increased steadily," with over "$1.2 billion in settlements and penalties involving more than 30 countries during that period."

 

While this impressive number is inflated by the $800 million penalty and disgorgement recently imposed on Siemens, it also apparently does not include the pending $559 million settlement to which Halliburton recently agreed.

 

The Report, which draws on a database of all FCPA settlements between 2002 and 2008, includes a list of the ten largest regulatory settlements (again, not including the pending Halliburton settlement), which range between $16 million and $800 million. These figures include settlements with both the SEC and the DOJ.

 

What makes this Report really interesting is its analysis of settlements of securities class action lawsuits based on FCPA-related allegations.

 

The Report states that in securities fraud class action lawsuits arising from alleged FCPA violations a total of $84.4 million has been paid in settlements between 2002 and 2008. The Report further notes that if the outsized Siemens settlement is removed from the analysis, the settlements related to securities class action lawsuits represent 21% of all of the total FCPA-related civil and regulatory settlement by public companies during the period 2002 through 2008.

 

Based on the author’s review of several recently settled FCPA-related class action settlements, the Report concludes that "the behavior connected to the alleged FCPA violation can sometimes have a lasting impact on the company’s business." The class action settlements demonstrate "the link between alleged FCPA violations, ongoing revenue and the potentially large impact on firm value."

 

The Report also contains a table reflecting the market-adjusted price reactions to FCPA-related news and announcements. Analysis of the data shows that "the majority of companies that exhibited statistically significant price reactions at the 5% level to FCPA-related news had resulting 10b-5 actions filed against them."

 

The Report concludes by stating that as a result of globalization trends, coordinated regulatory activity and record-keeping requirements, FCPA enforcement is a growing priority around the world, and states that "as FCPA-enforcement against domestic and foreign issuers increases, it is likely that related securities litigation will be an issue in many of these cases."

 

The NERA Report’s detailed analysis is very interesting and is also quite consistent with my own analysis of the growing liability threat that FCPA enforcement activity represents. The Report also provides statistical support for my view, expressed here, that "the proliferation of this type of litigation activity and the significant involvement of the leading plaintiffs’ firms suggests that this category of emerging litigation may represent an increasingly important area of potential liability to directors and officers."

 

This growing liability exposure also raises a number of potentially significant D&O insurance coverage issues, which I discussed at length in the June/July 2008 issue of InSights, which can be found here.

 

My  recent post analyzing the opinion in the InVision case, in which the Ninth Circuit affirmed the dismissal of a securities class action lawsuit that had been based on FCPA-related allegations, can be found here.

 

A recent post with a year-end 2008 FCPA update can be found here.

 

2008 was a remarkably eventful year, from the dramatic developments during the fall that rocked the financial markets to the changing of the guard in the Presidential election.  Many of the events had a profound impact in the world of D&O insurance.  In all likelihood, significant developments will continue to emerge during 2009 that will have implications for the D&O insurance marketplace.

In the latest issue of InSights (here), I review the past year’s most noteworthy events in the context of the D&O insurance marketplace.  The article’s first section reviews the top ten developments in the world of D&O insurance during 2008.  The article concludes with a perspective on what may lie ahead in 2009, including, in particular, a consideration of the impact that last year’s events could have on D&O pricing and coverage. 

 

A separate addendum to the InSights article takes a closer look at the 2008 securities class action lawsuit filings.As the addendum details, the pace of shareholder lawsuit filings increased significantly in 2008. There were 224 new securities lawsuits filed in 2008 , which represents a 30% increase over the 172 securities lawsuits filed in 2007, and an 88% increase over the 119 filed in 2006.

 

The 2008 filing total also represents the highest annual filing total since 2004. Further, all signs seem to indicate that the heightened filing levels will continue into 2009.

 

Banco Santander, the Spanish bank whose customers may have suffered as much as $3.1 billion in Madoff-related losses, is reportedly offering some clients compensation for their losses. Reports of this compensation proposal follow one day after investors filed a securities class action lawsuit against Banco Santander and related entities in federal court in Miami.

 

According to a January 27, 2009 Wall Street Journal article (here), Banco Santander is offering its private banking clients up to $1.79 billion in compensation for losses from the Madoff scheme. The offer would not apply to institutional investors.

 

According to the Journal, the bank has approached its Latin American clients, offering them preferred stock with a 2% coupon in exchange for an agreement not to sue and an agreement to keep their deposits with the bank. (The great majority of Santander customers who suffered Madoff losses were Latin American, perhaps as many as 70%.) UPDATE: Banco Santander’s January 27, 2009 statement regarding the proposed compromise can be found here.

 

Meanwhile, according to their January 27, 2009 press release (here), on January 26, 2009 plaintiffs’ lawyers initiated a Madoff-victim securities class action lawsuit in the Southern District of Florida.

 

The class action complaint (which can be found here) was filed by a Chilean company and an Argentinean individual. Both named plaintiffs claim they lost money through their investment in the Optimal Strategies U.S. Equity Fund, a subfund managed by Optimal Investment Services ("Optimal SUS") and marketed by Banco Santander S.A. in the United States. The complaint alleges that substantially all of the Optimal SUS fund was invested with Madoff’s firm.

 

The complaint is filed on behalf of persons who owned Optimal SUS shares on December 10, 2008 or who purchased shares of Optimal SUS between January 23, 2004 and December 10, 2008.

 

The complaint names as defendants Banco Santander S.A., Banco Santander International, Optimal Investment Services S.A. (Santander’s Geneva-based hedge fund unit) and certain individuals related to Optimal.

 

In addition, the complaint also names as defendants PricewaterhouseCoopers, whose Dublin office serves as the Optimal Fund’s auditors. The complaint also names as defendants two related HSBC entities, HSBC Securities Services (Ireland) Ltd. and HSBC Institutional Trust Services (Ireland) Ltd., which acted as administrator, registrar, transfer agent and custodian for the Optimal Funds.

 

According to the press release, the complaint alleges that the defendants violated the U.S. securities laws by

 

issuing materially false and misleading statements about their due diligence and oversight of Madoff and BMIS. Among the allegedly false statements made in the Explanatory Memorandum dated January 7, 2008, that was distributed to investors, was the assurance that Optimal "bases its investment decisions on a careful analysis of many investment managers." The complaint further asserts that had the Defendants conducted a reasonably "careful analysis" of Madoff and BMIS, Defendants would not have lost billions of dollars belonging to the investors.

 

In addition to the securities claims, the complaint also alleges common law causes of action including breach of fiduciary duty, negligence, negligent misrepresentation, and unjust enrichment. The complaint also alleges professional negligence against PricewaterhouseCoopers.

 

The new Banco Santander lawsuit is similar in many respects to the other securities class action lawsuits that have been filed against Madoff "feeder funds." What makes the case interesting is that both the named plaintiffs and the defendants are foreign domiciled (or at least owned by a foreign parent company). To be sure, one of the named plaintiffs, the Chilean company, specifically alleges that it invested in the Optimal SUS subfund through a Banco Santander International bank account in Miami, Florida.

 

Notwithstanding the lawsuit’s international flavor, the class action against Banco Santander may be unsurprising, as the bank has disclosed that its clients’ exposure to Madoff through the Optimal SUS fund was as much as $3.1 billion, which the Journal reports is the largest loss by any single bank. (Only investment companies Fairfield Greenwich and Tremont, both of which already face securities litigation, had larger losses).

 

It remains to be seen where Santander’s proposed compromise leaves the newly filed lawsuit. At least according to the Journal’s account, the proposed compromise does not apply to institutional investors. The Journal also reports that "some of those who have privately received the offer were unhappy with its terms and vowed to hold out for a better deal."

 

The Journal does report that the Spanish law firm that joined in bringing the suit is scheduled to meet with bank officials on February 6, 2009. Bloomberg quotes the Spanish attorney (here) as saying that the Santander offer is " a step in the right direction"; he added, however, that "at first sight, it looks insuficient."

 

In any event, I have added the Banco Santander suit to my list of Madoff-related securities class action lawsuits, which can be accessed here. According to my tally, there have now been eleven Madoff-related securities class action lawsuits filed.

 

Special thanks to the several readers who forwarded me copies of the Banco Santander complaint.

 

Among the many lawsuits that have flooded in as part of the subprime and credit crisis litigation wave has been a profusion of lawsuits against the mortgage-backed securities issuers and their securities offering underwriters. These lawsuits, typically filed under the ’33 Act and alleging misrepresentations in the offering documents, claim that investors who purchased securities in the offering have been harmed due to the deterioration in the performance of the underlying mortgages.

 

As discussed below, questions about the damages claimed in these lawsuits could present serious hurdles as the cases go forward.

 

Background

A recent example of the class action securities litigation filed on behalf on investors in these mortgage-backed securities investments may be found in the January 26, 2009 press release (here) in which the plaintiffs’ lawyers described the lawsuit they filed in the Eastern District of New York against Deutsche Alt-A, Inc., and certain other defendants in connection with the offering of mortgage-backed pass-through securities by 32 mortgage loan trusts.

 

As described in the press release, the complaint (here) alleges that the offering documents failed to disclose that:

 

sellers of the underlying mortgages to Deutsche Alt-A were issuing many of the mortgage loans to borrowers who: (i) did not meet the prudent or maximum debt-to-income ratio purportedly required by the lender; (ii) did not provide adequate documentation to support the income and assets required to issue the loans pursuant to the lenders’ own guidelines; (iii) were steered to stated income/asset and low documentation mortgage loans by lenders, lenders’ correspondents or lenders’ agents, such as mortgage brokers, because the borrowers could not qualify for mortgage loans that required full documentation; and (iv) did not have the income or assets required by the lenders’ own guidelines necessary to afford the required mortgage loan payments, which resulted in loans that borrowers could not afford to pay.

 

The complaint alleges as the underlying mortgages have deteriorated, "the Certificates are no longer marketable at prices anywhere near the price paid by plaintiff and the Class and the holders of the Certificates are exposed to much more risk with respect to both the timing and absolute cash flow to be received than the Registration Statement/Prospectus Supplements represented."

 

 

This case is only one of several recent lawsuits in which the same or similar allegations have been raised. Plaintiffs’ lawyers have raised similar allegations against, for example, mortgage-backed pass through certificates sponsored by JP Morgan Acceptance Corporation (refer here); mortgage backed securities sponsored by GS Mortgage Securities Corp. (refer here); mortgage pass-through certificates sponsored by Washington Mutual (refer here); and mortgage-pass through certificates sponsored by Residential Asset Securitzation Trust (refer here). By my count, there have been more than a dozen of these types of lawsuits filed in connection with the current subprime and credit crisis-related litigation wave.

 

Like many of these cases, the Deutsche Alt-A case was originally filed in state court, and removed by defendants to federal court. (The removal petition, which accompanies the complaint, can be found here.) The federal court subsequently denied the plaintiffs’ motion to have the case remanded to state court, in this case on the relatively narrow and specific ground that that one of the entities that originated the underlying mortgages, American Home Mortgage Corporation, is in bankruptcy in the federal court in Delaware, and the securities case is related to the bankruptcy proceeding. A copy of the January 8, 2009 opinion denying the remand motion can be found here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the removal petition and complaint in the Deutsche Alt-A case.

 

Damages Analysis

In each of these cases, the harm claimed is similar to that alleged in the Deutsche Alt-A case; that is, that as a result of problems associated with the underlying mortgages, the securities are "no longer marketable at prices near the price paid" and the holders are exposed to much more risk with respect to the timing and absolute cash flow."

 

These allegations raise some interesting and perhaps novel questions, as discussed in a January 2009 article from the Milbank Tweed law firm entitled "Subprime Litigation Against Issuers and Underwriters of Mortgage-Backed Securities—Where are the Actual Losses?" (here).

 

As the memo notes, these lawsuits embody "the relatively untested assumption" that the current paper value of these securities is "the appropriate reference point" for determining whether the investors have "suffered a loss that is ripe for litigation (and the extent of any such loss)."

 

The authors note that these securities are not listed on any public exchanges, but rather all trades are privately negotiated. The securities themselves are essentially contracts that entitle the owner to certain portions of principal and interest from the pools of mortgages that serve as collateral for the securities. The securities also have various forms of credit enhancement, such as overcollateralization, subordination and excess spreads, so that defaults on the underlying mortgages will not necessarily trigger a default on the payment obligations on the securities themselves.

 

As a result, an investor could continue to receive payments under the securities as scheduled, even if GAAP accounting might require the carrying value of the securities to be reduced.

 

These circumstances lead the authors to ask

 

Is the fear that certain tranches of the [mortgage backed securites] might not be paid in full a sufficient basis for brining a claim under the ’33 Act? Is such a claim a ripe case or controversy for the courts? And is the fact that some "paper measure of price" for the [mortgage backed securities] tranche has declined since the time of purchase enough to overcome these hurdles?

 

In considering these questions, the authors note that the typical offering documents for these kinds of securities expressly warn that a secondary market for the securities may not exist and that investors may not be able to sell the securities at the price they hope to obtain. For most investors in these types of securities, this consideration is generally of less concern, because the investors "expect to make money by holding the bond through maturity and receiving the income stream they bargained for, not by trading on a secondary market."

 

Nevertheless, the lawsuits relating to these securities claim damages based on the decline in their valuation and the fears that payments may be at "risk" in the future. The memo reviews the well-publicized difficulties associated with valuing these securities, and notes the probable lack of valuation uniformity among holders of these securities, given the flexibility of the relevant accounting standards. As a result, the securities holders may face challenges in establishing with sufficient certainty that they have suffered an "economic loss," as the securities laws arguably require. These difficulties are particularly where, as is the case with many of these securities, the investors continue to receive all payments due to them.

 

The authors suggest that generally there is no basis in law for seeking damages where the damages cannot be quantified and may never come to pass. They suggest that defendants in these cases will attempt to argue based on these principles that investors "who continue to be paid the full amount of any principal and interest payments due to them may have little choice but to ‘wait and see’ whether feared, modeled, or projected losses…come to fruition (i.e., become ‘clear and definite’) before being able to state claims under the securities laws."

 

The authors add that this argument may be particularly compelling where "intervening events such as legislative or executive action….could drastically alter the future payment outlook for many mortgage-backed securities."

 

These lawsuits against the issuers of mortgage-backed securities represent a significant number of the subprime securities lawsuits. Plaintiffs’ lawyers seem inclined to file these lawsuits, undoubtedly in part due to the degree of investor concern about their investments. Whether and to what extent these cases ultimately will succeed remains to be seen. As the law firm memo demonstrates there may be a host of questions surrounding these lawsuits. At a minimum it will be interesting to see what the courts make of these cases, and in particular the alleged damages, as the lawsuits proceed.

 

A more academic overview of many of these issues may be found in the paper Harvard Law School professor Allen Ferrell and Babson Business School Professors Jennifer Bethel and Gang Hu entitled "Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis" (here).

 

Largest FCPA Penalty Ever Against U.S. Company: Fast on the heels of Siemens recent agreement to pay $800 million to settle bribery allegations (about which refer here), Halliburton has now agreed to pay $559 million to settle charges that one of its former units bribed Nigerian officials during the construction of a gas plant.

 

According to Halliburton’s January 26, 2009 press release (here), Halliburton has agreed to pay $382 million to the U.S. Department of Justice in eight installments over the next two years. In addition, Halliburton agreed to pay the SEC $177 million in disgorgement. Both settlements are subject to final approval by the relevant authorities.

 

As reported on the WSJ.com Law Blog (here), the Halliburton penalty is by far the largest ever for a U.S. company, far surpassing the prior record of $44 million by Baker Hughes in 2007. More detail about the Halliburton agreement can be found on The FCPA Blog (here).

 

The Halliburton settlement is further evidence of a point I have made numerous times on this blog, that FCPA enforcement activity represents a growing area of concern. As I discussed most recently here, an important part of this exposure is the threat of civil litigation that frequently follows on after the enforcement proceeding. The sheer magnitude of the Siemens and Halliburton settlements suggest that potential FCPA liability could represent a significant exposure for corporations and their directors and offices.

 

Blast from the Past: Another Options Backdating Settlement: The options backdating cases are a vestige from another time and place, yet they remain, like so much cosmic dust, reminders of a distant catastrophe. In a recent development in one prominent case, the Delaware Chancery Court has approved a settlement that is noteworthy in at least a couple of respects.

 

As reflected in a January 2, 2009 opinion by Chancellor William Chandler in the Ryan v. Gifford case (here), the court has approved the settlement of the options backdating case involving Maxim Integrated Products, over shareholder objections. Under the settlement, which is detailed in the opinion, the defendants agreed to pay a total of $28,505,473 in cash. In addition, the defendants agreed to cancel, reprice or surrender claims with respect to certain options they continued to hold. The company also agreed to certain corporate governance reforms.

 

The settlement is noteworthy in a couple of respects. The first is simply that it involves the Ryan v. Gifford case, in which Chandler had written an influential and important February 2007 opinion denying the defendants’ motion to dismiss (as discussed here). Because of this opinion, the case is among the more prominent of the options backdating cases.

 

The other noteworthy aspect of the settlement is the individual defendants’ significant contribution toward settlement. Of the $28.5 million settlement amount, $21 million was paid by insurance. The balance of the cash was paid by the individual defendants. John Gifford, the company’s former CEO, agreed to make his own cash payment of $6 million to Maxim, even though, as the Court noted, he was "covered by insurance." The court’s statement in this respect seems to suggest that there were additional insurance funds available to fund this amount, but that as part of the settlement Gifford nevertheless agreed to pay this amount out of his own assets. Other individuals agreed to pay lesser amounts.

 

It is not entirely clear whether the insurance would in fact have covered the amounts of these individual payments. For example, in connection with the payments by the individuals other than Gifford, the court noted that the amounts paid "represent the entire amount that they were alleged to have benefitted from the exercise of backdated stock options." To the extent these amounts represent disgorgement or return of ill-gotten gains, the policy’s coverage would not apply. The court’s opinion is not as specific with respect to Gifford’s payment, but to the extent his contribution also represents his return of benefits from the exercise of backdated options, the insurance coverage similarly would not likely apply.

 

In any event, the size of the settlement, the prominence of the case and the significance of the individuals’ contributions make this a noteworthy settlement. I have added the settlement to my list of options backdating lawsuit settlements, dismissals and dismissal motion denials, which can be accessed here.