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.

In a subprime-related lawsuit that highlights the advantages ERISA claimants may have over litigants seeking relief under the securities laws, a federal court has refused to dismiss the complaint filed under ERISA on behalf of benefits plan participants of NovaStar Financial.

 

In an opinion dated February 11, 2009 (here), Judge Nanette K. Laughrey of the Western District of Missouri denied the defendants’ motion to dismiss the action filed against the alleged fiduciaries of the NovaStar Financial 401(k) plan on behalf of plan participants. During the relevant time period, plan participants had the option to invest in a unitized stock fund that held NovaStar common stock.

 

The plaintiff’s complaint alleges that the defendants knew or should have known that investment in the company’s stock was imprudent, because of the company’s "serious mismanagement and improper business practices" The complaint alleges that the company was relying on subprime mortgage origination and servicing for revenue, while failing to maintain underwriting standards and appropriate risk management techniques. The complaint alleges that the company’s practices ultimately eliminated the company’s ability to elect to be taxed as a real estate investment trust, and that the company’s practices collectively caused the company’s financial statements to be misleading.

 

The plaintiff also alleges that the defendants knew about the company’s problems but did not disclose them to plan participants. The plaintiff also alleges that the defendants issued misleading statements to the plan participants, as a result of which the participants could not make informed decisions about their investments. Following revelations about NovaStar’s subprime-related difficulties, the company’s share price declined (approximately 99 percent from the beginning of the class period).

 

The complaint essentially alleges that the defendants breached their fiduciary duties in allowing plan participants to invest in company stock; by failing to monitor; and by issuing misleading communications.

 

The bulk of Judge Laughrey’s February 11 opinion relates to defendants’ arguments that the court should dismiss the complaint based on plaintiffs’ lack of standing. Suffice it to say here that the court concluded that the plaintiff alleged sufficient injury to support both statutory and constitutional standing, and the defendants’ motion to dismiss for lack of standing was denied.

 

Judge Laughrey also denied defendants’ motion to dismiss based on their argument that the defendants were not plan fiduciaries and in any event were entitled to a statutory presumption that they had acted with prudence. The court found plaintiffs’ allegations on which she contended that the defendants were fiduciaries to be sufficient. The court also found plaintiff’s allegation sufficient, at least at the pleading stage, to overcome the presumption of prudence, observing that the plaintiff has "pleaded facts indicating a precipitous decline in Novastar stock and that Defendants knew, or should have know, of NovaStar’s impending collapse."

 

Defendants further argued that the court should dismiss plaintiff’s allegations about the adequacy of communications to plan participants, contending that the allegations of insufficiency were inadequate and in any event that ERISA does not regulate the communications of which the plaintiff complaints. The defendants expressly cited the prior dismissal of the securities action concerning NovaStar stock (about which, more below).

 

In rejecting this argument, Judge Laughrey noted that the plaintiff had alleged "affirmative material misrepresentations to plan participants – as well as to the general public — regarding the soundness of the NovaStar investment." The court specifically noted that "the heightened pleading requirements of securities laws do not apply to [the plaintiff’s] ERISA action," commenting further that the plaintiff "need not identify the author or specific content of each misrepresentation in order to survive a motion to dismiss."

 

Judge Laughrey’s recognition that ERISA class actions are not subject to the pleading requirements and other procedural hurdles to which class action securities claimants are subject highlights the advantages, at least in the initial stages, that an ERISA claimant may have over a securities plaintiff in seeking to recover alleged investment losses.

 

The advantages available even on more or less the same set of facts is underscored by the fact that the securities class action filed on behalf of NovaStar’s shareholders was, as Judge Laughrey noted, previously dismissed, with prejudice. (Refer here for a detailed discussion of the prior securities lawsuit dismissal.). The contrast in outcomes is even more noteworthy given how curt the prior court was in dismissing the securities action (among other things, in granting the dismissal motion in the securities case, the court noted that companies "are not expected to be clairvoyant" and that "bad decisions do not constitute fraud.")

 

By my count (refer here), there have been at least 22 ERISA class action lawsuits filed in connection with the current wave of subprime and credit-crisis related litigation. Whether or not these cases, or any one of them, ultimately will be successful remains to be seen. But if Judge Laughrey’s opinion is any indication, these cases may at least survive a motion to dismiss – or, rather, they may have a better chance of surviving the initial dismiss motion than their parallel securities lawsuit.

 

In a recent post (here) discussing the New York state court lawsuit recently filed against Banco Santander and related entities on behalf of Madoff-related victims, I mentioned that among the claims asserted in the complaint is a cause of action under New York General Business Law Section 349. This item caught the attention of Albany Law School professor Christine Sgarlata Chung, who has a particular interest in the question whether Section 349 is applicable to securities claims.

 

At my invitation, Professor Chung has submitted the following brief guest post relating to the plaintiffs’ Section 349 claims:

 

I read with interest your recent post on the Madoff-related class action filed by the Coughlin Stoia firm.  As you note, the complaint asserts a variety of state law claims, including claims under §349 of the New York General Business Law.   This is an interesting approach, given the reluctance of some New York courts to apply §349 to securities transactions. 

 For example, in Gray v. Seaboard Securities, Inc., 788 N.Y.S 2d 471 (N.Y. App. Div. 2005), plaintiffs alleged that they opened accounts at Seaboard, purchased stock recommended by Seaboard, and paid full service brokerage commissions to Seaboard based on Seaboard’s promise to provide proprietary research.   Plaintiffs alleged that Seaboard engaged in a deceptive business practice within the meaning of §349 by failing to provide the promised investment advice.

The district court dismissed the plaintiffs’ claims on the grounds that §349 does not apply to securities transactions.  On appeal, plaintiffs argued that §349 does not contain a "wholesale exclusion" for securities transaction.  They also argued that their claims arose from Seaboard’s furnishing of services (i.e., investment advice) and not from securities transactions per se. 

The appellate court affirmed the dismissal of the plaintiffs’ claims, noting that the "vast majority of [New York] courts which have considered the issue have found general Business Law §349 inapplicable to securities transactions for essentially two reasons."   First, the court reasoned "individuals do not generally purchase securities in the same manner as traditional consumer products, such as vehicles, appliances or groceries, since securities are purchased as investments and not goods to be consumed or used."  Second, the court held that because the securities arena is highly regulated at the federal level, "it is questionable that the legislature intended to give securities investors an added measure of protection beyond that provided by securities acts." 

It is important to note that in 2001, a different department of the New York appellate court held that § 349 does not contain a blanket exception for securities transactions.   See Scalpe & Blade, Inc.  v. Advest, Inc., 722 N.Y.S. 2d (N.Y. App. Div. 2001).  Still, given Gray and its ilk, I am curious to see how the Coughlin Stoia plaintiffs fare with their § 349 claim.

 

Special thanks to Professor Chung for her interesting commentary on this issue. The D&O Diary welcomes guest posts from responsible commentators and we are always interested in submissions and contributions from readers.

 

Other Madoff-Related Notes: A February 18, 2009 Wall Street Journal article entitled "Accounting Firms that MIssed Fraud at Madoff May be Liable" (here) suggests that accounting firms for Madoff feeder funds could be "legally vulnerable to claims that they should have uncovered red flags, according to legal and accounting experts."

 

And a February 17, 2009 article in The (London) Times reports (here) that lawyers from firms in 21 different countries (including the U.S.) recently met in Madrid and formed a global alliance to represent claimants who lost money as a result of the Madoff scheme. Hat tip to the Securities Docket (here) for the linkl to the Times article.  

 

Deteriorating economic conditions threaten a massive wave of corporate defaults. Corporate borrowers’ inability to fulfill debt obligations not only could prompt a bankruptcy filing surge, but also could result in a flood of ensuing lawsuits and claims as creditors and shareholders seek to recoup their losses. These claims could present a host of challenging D&O coverage issues.

 

The Growing Default Threat

According to a February 13, 2009 Wall Street Journal article entitled "Wave of Bad Debt Swamps Companies" (here), "the U.S. is entering a period likely to feature the most corporate-debt defaults, by dollar amount, in history." The article reports estimates that "U.S. companies are poised to default on $450 billion to $500 billion in corporate bonds and bank loans over the next two years."

 

In percentage terms, the default rate could "approach levels last seen in 1933." High yield default rates peaked around 15% in 1930. The Journal reports that S&P estimates that default rates will hit 13.9% this year "but could go as high as 18.5% if the downturn is worse than expected."

 

The "growing wave of souring debt" has already resulting in rising numbers of bankruptcies, including, just in the last few days, Muzak Holdings LLC; Pliant Corp.; Aleris International; and Midway Games.

 

However, as the Journal article observes, corporate defaults do not always result in Chapter 11 filings. Borrowers are sometimes able to restructure their debt outside of bankruptcy, and sometimes give creditors ownership stakes in exchange for reducing or elimination debt.

 

The Risk of Increased Numbers of Claims

In addition to the possibility of a growing number of bankruptcies, the prospect of surging corporate defaults also raises the possibility of an upsurge in claims against the directors and officers of the struggling or bankrupt companies.

 

Companies whose financial stability is deteriorating may as one consequence of their struggles get hit with a "going concern" opinion from their auditor. As the securities lawsuit filed against NextWave Wireless illustrates, the question whether a company can continue as a going concern alone can become an allegation in a shareholders’ class action complaint.

 

Claims may arise even when companies attempt a work out to try to avoid bankruptcy. These claims can come from shareholders, who may content that the workout resulted in a dilution of their interests, or it can even come from other bondholders, who may claim that their interests have been harmed or improperly subordinated, as demonstrated in the recent Station Casino bondholder claim (complaint here). Bondholders also recently filed a similar lawsuit against Harrah’s Entertainment and certain of its directors and officers (refer here).

 

But a bankruptcy filing is particularly likely to be followed by claims against the bankrupt company’s directors and officers. These claims can come in the form of securities lawsuits brought against the individuals by the bankrupt company’s shareholders, as reflected for example in the recent cases filed against Pilgrim Pride’s corporate officials (refer here); against Britannia Bulk’s senior officers (here); or against the directors and officers of Charys Holding Company (here).

 

In addition, the Trustee in bankruptcy may also assert claims against the company’s directors and officers, as evidenced in the now infamous Just for Feet claim (about which refer here). As the Just for Feet bankruptcy also demonstrates, these various claims can arise simultaneously, which presents its own set of issues.

 

The Potential Coverage Issues

The advent of claims following bankruptcy presents a number of challenges in the context of any potentially applicable directors and officers’ liability insurance. Some of these challenges are a reflection of the size and structure of the insurance program; other challenges arise from the nature and extent of the coverage afforded.

 

With respect to the overall program, one critically important issue may simply be the amount of insurance available. The prospect for multiple simultaneous claims is increased dramatically when a company files for bankruptcy. The simultaneous prosecution of multiple claims presents the very real possibility that the insurance could be substantially depleted or even entirely exhausted. As demonstrated in the claims surrounding the Collins & Aikman bankruptcy (about which refer here), defense costs alone potentially could deplete the available limits.

 

And as demonstrated in connection with the multiple claims filed against the directors and officers of Just for Feet following that company’s bankruptcy, the proceeds of a traditional D&O insurance program alone may be insufficient to resolve all claims that can arise in the bankruptcy context. Both the Collins & Aikman and the Just for Feet examples have important implications for policy structure, as discussed below.

 

The interplay between the provisions of the Bankruptcy Code and the terms and conditions of the D&O policy may present certain specific challenges. As I discussed at greater length in a prior post (here), a recurring issue since so-called "entity coverage" has become a standard part of the D&O policy has been whether or not the D&O policy proceeds are property of the bankrupt estate under Bankruptcy Code Section 541(a) and subject to the automatic stay in bankruptcy under Bankruptcy Code Section 362.

 

A particularly good article discussing these questions regarding the D&O policy proceeds and the operation of the bankruptcy stay written by my good friend Kim Melvin of the Wiley Rein law firm can be found here.

 

Another frequently recurring D&O insurance coverage issue arising in the bankruptcy context is whether claims asserted by the Trustee or other receivers or liquidators against the company’s directors or officers funs afoul of the policy’s exclusion for claims brought by one insured against another insured. The "insured vs. insured" issue arises because of the concern that the Trustee or other claimant is "standing in the shoes" of a policy insured, the company itself.

 

Addressing the Insurance Concerns

A number of policy solutions to these recurring bankruptcy issues have developed in recent years. For example, a coverage carve-back to the insured vs. insured exclusion, now a standard provision in most policies, has continued to evolve over the years to address concerns about coverage for claims brought by Trustees and others.

 

In addition, many policies now contain "priority of payments" provisions as a way to try to address questions surrounding the availability of the D&O policy’s proceeds for the payment of defense expense or the resolution of claims notwithstanding the bankruptcy stay.

 

Perhaps even more importantly, to address concerns about the susceptibility of the policy proceeds to depletion or exhaustion from multiple simultaneous claims, particularly in the bankruptcy context, the D&O industry has developed a number of structural solutions designed to ensure that whatever may happen, a fund of money will remain available for specified individuals so they can defend and resolve claims against them. These structures might take any one of a number of forms, including a so-called Side A/DIC policy, or even an individual director liability (IDL) policy.

 

The complexity of these coverage and structural issues underscores the need to involve a skilled insurance professional in the D&O insurance acquisition process. Financial troubled companies in particular require the contributions of an informed and experienced advocate in structuring their coverage. The structure and the terms and conditions of a company’s insurance program could determine whether or not insurance coverage is available for individual directors and officers in the event of bankruptcy and related claims.

 

One final note about the likelihood of increasing corporate defaults. That is, the current deteriorating economic conditions not only present challenges for insurance buyers, they also present serious concerns for D&O underwriters. As the Journal article cited above notes, the defaults "will likely spread across many industries." Among the industries the article specifically mentions are "media, entertainment, casino and hotel companies, car makers and retailers."

 

Up to this point, the most significant consequences of the credit crisis have been concentrated in the financial sector. D&O underwriters have had the ability to segment risk arising from the credit crisis according to whether or not companies were financially related. However, with the growing threat of corporate defaults across many industry sectors, risk segmentation will be much more challenging. At a minimum, it will no longer be sufficient for underwriters to presume that risk is limited to the financial sector alone.

 

In a February 12, 2009 FINRA Dispute Resolution Award, a panel of three arbitrators ruled that Credit Suisse must pay ST Microelectronics more than $400 million based on the company’s claims that Credit Suisse misled the company into buying subprime-exposed auction rate securities. A copy of the award can be found here.

 

The FINRA Award

As I detailed in an earlier post (here), ST Microelectronics had filed the FINRA claim against Credit Suisse (USA) LLC, while also separately filing a civil lawsuit against Credit Suisse Group, the U.S. affiliate’s Switzerland-based parent. The separate lawsuit complaint can be found here.

 

According to the February 12 Award, the FINRA complaint against the U.S. affiliate asserted claims under Section 10 of the ’34 Act and Rule 10b-5, alleging that the claimant "requested investments in student loan securities backed by U.S. government guarantees" but that instead their funds were invested in what the civil lawsuit complaint described as "illiquid, risky and unsustainable auction rate securities consisting of collateralized debt obligations and credit linked notes, some of which were backed by subprime real estate loans." (The separate complaint alleged that Credit Suisse had an "intentional strategy" of "dumping into the accounts of unsuspecting clients some of the worst ARS on the market.")

 

The Award makes no specific findings of fact but instead simply species the amounts to be awarded to ST Microelectronics. Credit Suisse is ordered to pay the claimant "compensatory damages" of $400 million, which is to be "paid immediately in exchange for Claimant’s entire portfolio." The award also orders the payment of certain of fees and costs, interest, and $3 million attorney’s fees.

 

Discussion

The FINRA award has a number of significant implications, the most immediate of which may be those relating to Credit Suisse itself. The separate lawsuit complaint filed against the Credit Suisse parent company alleges that "at least a dozen other multinational corporations are victims of the same scheme," carried out by two Credit Suisse brokers who, in fact, are the subject of a current criminal prosecution (about which refer here). The complaint alleges that the supposed scheme involves "more than $2 billion of these clients’ money."

 

A July 31, 2009 Wall Street Journal article (here) listed ten overseas companies (including ST Microelectronics) that have initiated arbitration proceedings against Credit Suisse-affiliated companies based on auction rate securities. The February 12 FINRA Award may bode ill for Credit Suisse in these other proceedings.

 

In addition, the outcome, magnitude and prominence of the February 12 Award could also spur similar claims by other aggrieved parties against other broker-dealers, particularly other aggrieved institutional investors. By and large, institutional investors were excluded from the massive auction rate securities regulatory settlements that have been announced to great fanfare. These excluded investors may be encouraged by ST Microelectronics’ success, and seek to pursue their own claims. A February 13, 2009 Bloomberg article (here) discussing the Award quotes one observer as saying "this decision will likely lead to either more arbitrations or settlements between investors and broker-dealers."

 

To be sure, the circumstances relating to Credit Suisse’s involvement with auction rate securities may be distinct. As noted above, criminal proceedings have arisen from its brokers’ activities. Other prospective claimants’ claims may not be as sympathetic.

 

It is important to emphasize that while the Award itself describes the relief granted as "compensatory damages," what it actually accomplished is a rescission of the underlying securities transaction. Credit Suisse basically has to buy back the company’s securities at face value. (In that regard, the Award itself noted that what the claimant had requested was "relief equivalent to rescission" – which appears to what the claimant got.) Though the Award provides for the payment of other fees and costs, it does not award any other type of damages. The Award expressly denied the claimant’s request for punitive damages.

 

The absence of the award of other damages potentially could affect other prospective claimants. That is, while these cases may provide an avenue of relief, there is nothing about this Award to suggest that that a claim of this type is going to produce some kind of a bonanza. On the other hand, for many prospective institutional investor claimants, the opportunity to return their auction rate securities for face value at this point would be more than enough incentive for them to pursue a claim.

 

The Award does provide one very particular kind of encouragement for these kinds of claims. The panel’s award of $3 million in attorneys’ fees undoubtedly will capture the imagination of many would-be claimants’ attorneys. The prospect of this kind of fee recovery undoubtedly will encourage many attorneys to seek out and pursue these claims.

 

It is unclear from the Award what preclusive or superseding effect the Award might have on the separate federal court lawsuit ST Microelectronics filed against the Credit Suisse corporate parent. It seems that the company secured the relief it sought. What reason or even opportunity there might be to continue to prosecute the civil case is not immediately apparent.

 

Hat tip to the WSJ.com Law Blog (here) for the link to the FINRA Award.

 

Don’t Tell Me How to Fix It, Just Tell Me Who to Blame: If you missed it, you may want to take a look at the list of the "25 People to Blame" (here) in the February 23, 2009 issue of Time Magazine. The magazine’s attempt to identify the individuals responsible for the current financial mess is actually kind of interesting, even thought provoking.

 

The list includes the usual suspects: Dick Fuld, Jimmy Cayne Angelo Mozillo and Stan O’Neill.( I agree that Angelo Mozillo of Countrywide also belongs on the list, although I don’t think I would have put him first, as Time Magazine did.) Time also included, correctly in my view, Fred Goodwin of Royal Bank of Scotland, whose ill-fated and ill-time take over assault on ABN AMRO is record setting in a number of extremely negative ways.

 

The list also recognizes others who rightfully should shoulder some of the blame, but who sometimes elude the harsh spotlight. In this category I would put Marion and Herb Sandler, whose Golden West Savings bank initiated the Option ARM mortgage. Sandy Weill also (correctly, in my view) appears on the list for the mess he made of Citigroup.

 

A couple of U.S. Presidents make the list — Bill Clinton and George W. Bush. Alan Greenspan, Hank Paulson and Chris Cox are also there. There is also one former Prime Minister, Davíð Oddsson of Iceland, and one Premier, Wen Jiabao of China.

 

There are a several interesting names on the list. For example, John Devaney appears as a sort of a stand in for the whole hedge fund industry, and Lew Ranieri gets belated recognition for having fathered mortgage securitization. Kathleen Corbett, the former head of rating agency Standard & Poor’s also gets a nod for the plethora of triple-A rating on mortgage backed securities that encouraged so much misdirected investment. Joe Casano gets due recognition for basically taking down AIG.

 

There are others whom I think are misplaced on this list. For one thing, what is Bernie Madoff doing there? He may have been a big crook, but in the end he is just a crook.

 

There are also at least two very significant omissions from the list.

 

First and foremost, the U.S. Congress deserves to be recognized for its encouragement of housing policy that was misguided and disproportionate to the requirements and limitations of sound principles. Congress is great at holding hearings and making speeches when things go wrong. Their own abysmal record of implementing policies that prevent problems warrants its own set of hearings. I’d like to put some of them in the dock and subject them to the same kind of sneering cross-examination that they have been imposing on others in recent days. (To be fair to the list-makers, they did slot former Texas congressman Phil Gramm at No.2 on the list, which arguably is a Congressional designation by proxy.)

 

And finally, why isn’t the American Homebuyer on the list? Yes, the American Consumer is recognized, but I think we need to be specific here. Within the larger group of well-intentioned home buyers are those who were driven by some weird form of housing lust to buy gigantic houses they couldn’t afford. There also appear to have been some who were all too willing to hide or even misrepresent their true financial condition to secure credit. Sure, the lenders were complicit, but as long as we are assigning blame, let’s put some everywhere that it belongs.Of course, many homeowners who are now struggling had nothing to do with any of this kind of conduct, but there are also those who were involved.

 

When you come right down to it, there is no shortage of culprits. Sadly, there are many, many victims. Some of them are even the same people.

 

In a case demonstrating the range of both the potential legal theories and the prospective litigants that could become involved in Madoff-related litigation, a pension fund has filed an ERISA class action against an investment advisory firm for the advisory firm’s investment of the pension fund’s assets in a Madoff "feeder fund."

 

On February 12, 2009, the Pension Fund for Hospital and Health Care Employees – Philadelphia and Vicinity filed an ERISA lawsuit against Austin Capital Management Ltd. in the Eastern District of Pennsylvania, on its own behalf as well as on behalf of all employee benefit funds for whom Austin acted as investment manager and whose assets were invested in whole or in part by Austin in any Madoff-related investment during the period February 12, 2005 to the present.

 

A copy of the complaint can be found here. A copy of the plaintiffs’ lawyers February 13, 2009 press release can be found here. A February 17, 2009 Law.com article describing the lawsuit can be found here.

 

The complaint alleges that in June 2008, the plaintiff’s investment consultant retained Austin "for the purpose of managing a portion of the [plaintiff’s] assets, to be invested in hedge funds." At the time, Austin, which is a wholly-owned subsidiary of Cleveland-based KeyCorp, had approximately $2.3 billion of assets under management.

 

In July 2008, the plaintiff’s investment consultant placed $10 million of the plaintiff’s assets with Austin for investment with the Austin Capital Safe Harbor Dedicated ERISA Fund, Ltd., an exempt corporation operating under the laws of the Cayman Islands. Austin is the investment manager for Austin Safe Harbor.

 

The complaint alleges that Austin invested a portion of Austin Safe Harbor assets in "Madoff-related investments, specifically funds managed by Tremont Holdings." According to a February 3, 2009 Bloomberg article (here), Tremont in turn "placed money through its Rye Select Broad Market Prime Fund, L.P.," which in turn invested with Madoff’s firm.

 

The complaint alleges that Austin was a fiduciary to the class of benefit funds, but that Austin failed to conduct adequate due diligence prior to recommending and investing monies in Madoff-related funds. The complaint also alleges that Austin ignored "red flags."

 

The complaint identifies several other public pension funds for which Austin acted as investment manager. The complaint states that Austin managed $170 million for the Massachusetts Pension Reserves Investment Management Board, of which $12 million was exposed to Madoff-related investment, and also managed $170 million for the New Mexico Education Retirement Board, of which $8-10 million was in Madoff-related investments. According to news reports (here), the Massachusetts pension fund recently voted to fire Austin due to the Madoff-related losses.

 

There are a number of interesting things about this lawsuit. The first is that it seeks relief under ERISA. So far as I am aware, this is the first Madoff-related lawsuit asserting claims under ERISA. The interesting thing about an ERISA class action, as opposed to a securities class action, is that the ERISA action is not subject to the PSLRA’s discovery stay and other procedural requirements. So the ERISA plaintiff is free to conduct discovery even while the dismissal motion is pending.

 

The opportunity under ERISA to avoid some of the challenges of litigating under the federal securities laws clearly was one of the plaintiffs’ attorney’s motivations in bringing the action. The Law.com article linked above quote the attorney as saying that ERISA provides "an easier and quicker route in repairing the damage."

 

By was of comparison, the attorney cites as the shortcomings (from his perspective) of seeking relief under the securities laws, the "high burden of proving fraud" and the "limitations on showing third parties were at fault." The attorney said that while Madoff may have been involved in fraud, "it would be much more difficult to prove that third-party investment funds that invested with Madoff were also defrauding clients."

 

The other interesting thing about the fact that this lawsuit was filed under ERISA is that it at least potentially draws into the mix yet another type of insurance. Up to this point, the likeliest source of insurance funds in connection with the prior Madoff-related lawsuits has been the target defendants’ D&O insurance or errors and omissions (E&O) insurance. A claim under ERISA at least potentially triggers coverage under applicable fiduciary liability policies (if any). The spread of Madoff-related insurance exposure to include fiduciary liability coverage may not have been among the factors considered in earlier estimates about aggregate Madoff-related insurance losses.

 

The final interesting thing about this lawsuit is what it says about just how broad the pool of Madoff-related defendants has become. The plaintiff pension fund in this lawsuit did not invest with Madoff. It did not even invest with a Madoff feeder fund. Instead, it invested with an investment advisor that invested with a feeder fund that in turn invested with Madoff. (Got that?) The sheer span of these increasingly remote connections required to establish the Madoff-related link underscores just how widespread the Madoff litigation may yet become.

 

I have in any event added the new lawsuit to my running tally of all Madoff-related litigation, which can be accessed here.

 

The pace of bank failures is accelerating. This past Friday night the FDIC took control of four more banks, representing the largest number of bank closures yet on a single date and bringing the year to date total to 13 — including ten just in the last three weeks alone.

 

On February 13, 2008, the FDIC announced that it had taken control of Riverside Bank of the Gulf Coast, of Cape Coral, Florida, which previously had assets of $539 million (about which refer here); Sherman County Bank of Loup City, Nebraska, which previously had assets of $129.8 million (refer here); Corn Belt Bank and Trust Co. of Pittsfield, Illinois, which had assets of $271.8 million (refer here); and Pinnacle Bank of Beverly, Oregon, which had assets of $73 million (refer here).

 

The geographic distribution of these banks, including the presence of three banks outside the most challenged real estate markets in California and Florida, together with the fact that these are smaller community banks, are both particularly troublesome notes.

 

The FDIC has now taken control of 34 banks just since July 1, 2008. (The FDIC’s failed bank list can be found here.) The accumulated effect of these regulatory actions is starting to strain the agency, as detailed in a February 14, 2009 New York Times article entitled "Failed Banks Pose Test for Regulators" (here). The article states that the agency is in the midst of a "military-style buildup as it undertakes one of the greatest fire sales of all times." The FDIC is, according to the article, "struggling to deal with a miserable stew of failed real estate projects, vacant land, boarded-up houses and loans to defunct or bankrupt businesses."

 

In all likelihood, the situation will only get worse for some time to come. To be sure, we are a long way from the dark days of 1989, when regulators took control of 534 lenders (including 327 savings and loans). But we could be headed in that direction.

 

According to a February 9, 2009 Bloomberg article (here), an RBC Capital Markets analyst has predicted that as many as 1,000 U.S. banks may fail in the next three to five years. The analyst said that most of the failures will probably occur at banks with less than $2 billion in assets as their commercial loans default.

 

Both the analyst’s emphasis on smaller banks and on the banks’ exposure to commercial loans are particularly disturbing observations. By and large, the worst (or at least the most public) consequences from the credit crisis have been concentrated among the largest banks and have arisen from problems involving residential real estate lending. The expansion of the meltdown’s ill effects to a wider variety of financial institutions and other types of credit could have serious implications – and not just for the threatened banking institutions, but for the economy as a whole.

 

In any event, the four bank closures this past Friday night is the most yet on a single day as part of the current wave of bank failures. The seven banks closed so far in February already represent the highest monthly total yet. Unfortunately it appears that many of these kinds of records will be established and broken in the weeks and months ahead.

 

Motley Fool, commenting (here) on the FDIC’s practice of announcing bank closures on Friday evening, observed that "evidently the U.S. head-in-sand department has decreed that all such unpleasant announcements should be made when the least people will read them." The Fool might be right; the FDIC could in fact be worried about what might happen if people were to focus too closely on the accumulating number of bank failures. It may or may not be a real concern (yet) that depositors might lose confidence in the banking system, but the FDIC might well have that possibility in mind.

 

Conduct Unbecoming of a Gentleman: As described in a February 13, 2009 Las Vegas Sun article (here), Station Casino bondholders have sued the company and certain of its directors and officers, as well as certain related entities, alleging that the company’s debt-reduction plan is unfair to some of the company’s bondholders.

 

While the claims themselves may seem commonplace, the bondholders’ complaint (here) displays a rather unusual literary flair. Among other things, in what is effectively a prologue, the complaint quotes Count Leo Tolstoy as having said: "A gentlemen is a man who will pay his gambling debts even when he knows he has been cheated." Perhaps even more flamboyantly, the complaint then goes on to state that the defendants are "not acting Gentlemanly."

 

Shocking bevior, indeed.

 

Hat tip to Courthouse News Service for the Station Casino complaint.

 

Strangely, the Judge Couldn’t Be Found Inside the Mailbox at the UPS Store: According to the February 12, 2009 Atlanta Constitution (here), Fulton County deputies have yet to serve suit papers filed on December 12, 2008 against a Fulton County Superior Court Judge, even though the deputies and the Judge all work in the same courthouse building and even though the summons was addressed to the Judge at the courthouse. However, the deputies did attempt to serve the Judge at his campaign headquarters mailbox at a UPS store.  (Map courtesy of Fulton County deputies.)

 

Hell: According to a February 10, 2009 Minneapolis Star Tribune article (here), local police in Texas have seized 22 urine-soaked dogs found with their owner inside a locked station wagon. The ammonia level inside the car was measured as 23 parts per million. Humans reportedly start experiencing health issues at 12 parts per million. The article does not explain the simultaneous combination of owner, dogs, urine and locked station wagon.

 

Her Whole World Came to an End in an Instant: You might say, she broke a nail, big deal, right? However, Lee Redmond of Salt Lake City has not cut her nails since 1979. The total length of her nails in 2008 was over 28 feet, including a right thumbnail that measured nearly 3 feet long. She has appeared in the Guiness Book of World Records. The Associated Press reports (here) that she broke her nails after she was thrown from an SUV in a vehicle collision. She was hospitalized for serious injuries that are not considered life threatening – unless of course your life consists of being famous for having long fingernails. Everyone here at The D&O Diary hopes for the best for Ms. Redmond.

 

I Wonder, Did They Check Bernie Madoff’s Shoes?: According to a February 11, 2009 San Jose Mercury News article (here), a mortgage fraud suspect stopped at the Canadian border had $70,000 stuffed in his boots. (Don’t ask, of course they were cowboy boots.) He also had $1 million in Swiss bank certificates and four ounces of platinum valued at $1,420 an ounce. What an idiot. With the global economy in the tank, he probably could have written off the value of the certificates and gotten a tax loss carry forward for the next five years, and with commodities prices what they are, he was probably carrying the platinum at a loss too.

 

A Strange World, Indeed, Mr. Mum:  Ordinarily, I find material for my blog posts basically by roaming around the Internet and after a while someting worth writing about just kind of shows up. For whatever reason, last night, all I could find was a bunch of really weird stories. After a while, it occured to me, when life hands you lemons, or whatever, you basically just have to make a blog post out of it.

 

The hardest part was figuring out how to categorize this post. Categorization is a mandatory publication prerequisite within the blog software I use. I finally decided to put this post in the "SOX (Generally)"  category, because, after all, what is more absurd than the word "SOX"? 

 

All of this reminds me of the old comic strip, written by Irving Phillips, entitled "The Strange World of Mr. Mum." As shown in these examples, Mr. Mum was a silent but observant witness to all of the world’s absurdities. Many of the strips ended with Mr. Mum in a bar, contemplatively drinking a glass of carrot juice. (I just hope his dogs weren’t locked in the car outside.)

 

 When the Madoff scandal news first broke, I thought it would be like so many other fraud controversies, dominating the headlines briefly and then fading into the background – as seemingly has happened with the Marc Dreier debacle. But perhaps as a result of the scale and breadth of the harm caused, the Madoff scandal story just seems to keep escalating.

 

Today’s headline revelation is the widely reported news (refer here), that Ruth Madoff, Bernard Madoff’s wife, allegedly withdrew a total of $15.5 million from a brokerage account just prior to Mr. Madoff’s now-famous confession to his sons and subsequent arrest.

 

This allegation first arose in a footnote of a complaint filed on February 11, 2009 by Massachusetts Secretary of State William F. Galvin to revoke the broker-dealer registration of Cohmad Securities Corporation. The complaint and related exhibits can be found here.

 

The Enforcement Section of the Massachusetts Securities Division of the Officer of the Secretary of the Commonwealth had "sought to determine whether the businesses of Cohmad and Madoff Investments were so intertwined that they could be viewed as a common enterprise, and not as separate entities, for purposes of imputing liability and obtaining investor relief." The complaint alleges that Madoff was one of Cohmad’s co-founders and directors.

 

As detailed in the complaint, Galvan contends that Cohmad "categorically refuses to discuss its actions with regulators" and therefore "has no right to continue to engage in the securities business in the The Commonwealth of Massachusetts."

 

As part of the complaint’s contention that Cohmad and Madoff’s securities firm are "so intertwined that they could be viewed as a common enterprise," Galvin cites, among other things (in footnote 4, on page 25 of the complaint) wire transfer records showing the "flow of funds" between the two enterprises, referring specifically to documents showing that "Ruth Madoff withdrew [from Madoff-related accounts at Cohmad] $5,500,000 on November 25, 2008 and withdrew $10,000,0000 on December 10,2008." Madoff was arrested on December 11, 2008.

 

The documents reflecting these two wire transfers can be found on the last two pages of Exhibit 16 (refer to pages 51 and 52, here).

 

A news wire story (here) quotes a spokesman from Galvin’s office as saying "We’re not accusing her of anything wrong." The spokesman added "Now, what someone in New York or the feds may think of it may be entirely different."

 

A Painful Situation: And under the general heading of marital complications related to the Madoff scandal, I reference the difficulties facing Steven Simkin, formerly married to Laura Blank. On February 3, 2008, Simkin filed a complaint in New York State (New York County) Supreme Court (here) against his former wife in connection with the Madoff-related investment the couple had maintained prior to their divorce.

 

According to the complaint, the couple entered a June 27, 2006 agreement providing for the division of their marital assets. The couple "mistakenly believed" that their largest asset was their account with Madoff Investment Securities, which they believed to be valued at $5.4 million. As part of the agreement, Simkin agreed to pay Blank half of the assumed account value in cash. (Ouch.)

 

The account is now "worthless, literally not worth the paper on which the parties’ valuation rested." Simkin’s complaint alleges that

 

As a result of the parties’ clear mistake of fact, Steven paid Laura millions of dollars believing, as did Laura, that it represented her share in the "Account" (as the parties understood it to be) and retained the "Account" as a portion of his equitable share of the couple’s assets. As a result, Laura obtained a windfall and Steven did not receive an equitable share of the couple’s joint assets. Accordingly, by this action, Steven seeks to reform the Agreement, which is grounded upon a material and mutual mistake respecting the couple’s assets at the time …and recover from Laura so as to accomplish the goal the parties intended by executing the Agreement.

 

Mr. Simkin, you have my sympathy.

 

Special thanks to the several readers who send me links to the Massachusetts Secretary of State’s complaint and to Jon Jacobson for help in finding the Simkin complaint. I have added the two complaints to my register of Madoff-related litigation, which can be accessed here.

 

A Clawshank Redemption?: And under the general heading of trying to recover previously paid out amounts, one issue that has gained a great deal of attention is whether the trustee in the Madoff liquidation proceeding can recover ("clawback") amounts paid out to fund investors who cashed out before the scandal was revealed. The Securities Docket has a post on the topic (here), discussing efforts that some of the investors who redeemed their shares to change the claims bar date in the Madoff liquidation proceeding out of concern for anticipated clawback efforts. .

 

In a February 2009 memorandum entitled "How Long and Strong is Trustee Piccard’s Claw?" (here), the Seyfarth Shaw law firm takes a detailed look at the trustees’ powers, and reviews the similar clawback efforts undertake in the Bayou funds scandal.

 

The memo concludes that the trustee’s ability to clawback redemption payments is "not unbridled" and that there are "powerful defenses that can and will be advanced, including the good faith defense that protected many redeeming investors in the Bayou case." The memo also notes that "additional defenses also are likely to be developed as the facts surrounding what Madoff did come into sharper focus."

 

Meanwhile, in Europe:  According to press reports (here), European investor rights group Deminor has initiated a legal proceeding in a Luxembourg court in order to compel two Luxembourg units of UBS to provide informatoin and materials relating to the entities’ role in steering clients to Madoff-related investmens.

 

The action, which Deminor initiated on February 11, 2009, is filed against UBS S.A. and UBS Fund Services, as well as against the Luxalpha SICAV Fund, Luxembourg Third Party Management Company SA and Access Management Luxembourg SA.

 

According to the news reports, the action seeks information regarding contracts between the UBS units, Madoff, and Luxalpha, an investment fund that UBS allegedly promoted. Regulators closed Luxalpha last week for not complying with regulatory requirements. The action also seeks to obtain audit reports of the fund, prepared by Ernst & Young.

 

Deminor claims that it represents individual and institutional investors that had lost over $1.3 billion as a result of the Madoff scheme.

 

I would be very grateful to any reader who might be able to provide me with a copy of the new Luxembourg complaint.

 

Gender Issues: A February 11, 2009 Washington Post article entitled "In Banking Crisis, Guys Get the Blame" (here) raises the question whether the current global economic crisis is a result of the fact that the financial industry and its regulators are "overwhelmingly male-dominated."

 

The article quotes one commentator as saying that "you can argue that the men have made a right mess of it, and now the ladies should have a go." Another commentator observes that "maybe if we had some more women in the boardrooms, we may not have seen as much risk-taking behavior."

 

Finally, one commentator with an odd notion of human anatomy, commenting on London’s top financial sector officials, observed that "there are quite a lot of alpha males with testosterone steaming out their ears."

 

At least when it comes to relying on women to clean things up, Iceland "is leading the way," having appointed a female prime minister as well as two women to lead two of its major banks. The prime minister’s spokesperson is quoted as saying "Men, especially young men, made a mess of things. There is a strong discussion that women would have taken a more cautious approach in the financial sector."

 

And Finally: I have added a Twitter button in the right hand column. Readers interested in receiving Twitter updates (or "tweets" as they are known) between blog posts will want to click on the Twitter button and register to become a "follower" of my Twitter site. I also add "tweets" when I have added new blog posts. I have come to appreciate that there are many web denizens who prefer to receive their information as "tweets", so that is why this blog now has a Twitter button.

 

The New York Times has a nice February 11, 2009 article (here) with a good overview of what Twitter is all about.