From this week’s news, it almost appears as if there had been some kind of an unannounced competition for most outrageously fraudulent or corrupt scheme. First, there was Marc Dreier’s incredibly brazen plot to peddle bogus notes to hedge funds using assumed identities. Then there was Illinois Governor Rod Blagojevich’s apparent attempt to flog Barrack Obama’s vacant Senate seat for personal enrichment. And finally there was New York financier Bernard Madoff’s massive Ponzi scheme, which may have taken investors for as much as $50 billion.  

 

The scale of the corruption and deception involved in these schemes is almost incomprehensible. It could be said of the three perpetrators of each of these scandals, as Time Magazine said (here) of Blagojevich, he is “either delusional, stupid or some combination of both.” But as astonishing as these developments may all be, they really don’t represent anything new.

 

 

Buried underneath the week’s headlines were the latest developments in an older but equally unsavory tale, which may serve as a reminder that there is, regrettably, nothing new about massive schemes of deception and corruption.

 

 

According to a December 12, 2008 Bloomberg article entitled “Siemens Agrees to Pay Fine to Settle Bribery Charges” (here), Siemens AG has agreed to plead guilty to Foreign Corrupt Practices Act violations and pay $800 million to settle U.S. charges that it paid $1.36 billion in bribes to government officials in at least a dozen countries.

 

 

The FCPA Blog (here) has an extensive review of the charges against Siemens, as well as links to the supporting documents, including the criminal information filed against Siemens and the DoJ’s sentencing memorandum. As the FCPA Blog puts it, the criminal charging documents detail “years of systematic and intentional violations of the internal controls and books and records provisions. It’s a story of fraud, deceit and concealment — filled with phony contracts, fake invoices, slush funds, and a boardroom feigning ignorance. “

 

 

A hearing on the deal under which Siemens would pay a $450 million fine and forfeit $350 million in profits will take place on December 15. If accepted, the penalty would be by far the largest FCPA penalty ever, far eclipsing the prior record payment of $44 million in the Baker Hughes case (about which refer here).

 

 

The Siemens case is a reminder that, as startling as this past week’s revelations have been, there is nothing new about fraudulent schemes or deceptive behavior. In the timeless words of the Book of Ecclesiastes (here), “What has been will be again, what has been done will be done again; there is nothing new under the sun.”

 

 

Next Up: The Litigation: One inevitable byproduct of the developments like those of the past week is litigation, and so it comes as no surprise that a lawsuit against Bernard Madoff and his firm has already emerged.

 

On December 12, 2008, an investor initiated a purported securities class action lawsuit in the Eastern District of New York against Madoff and his firm (BMIS), on behalf of “all persons and entities who purchased securities sold by or through” Madoff and his firm, “from the early formation of BMIS in the 1960s until December 12, 2008.” Refer here for news coverage of the lawsuit.

 

The complaint (reproduced below) alleges that its claims arise “from one of the most damaging Ponzi schemes in the history of Wall Street and the United States,” and that the defendants “swindled investors out of monies estimated to exceed $50 billion.” The complaint alleges breaches of the federal securities laws, civil RICO violations, and related state and common law violations.

 

Meanwhile, other plaintiffs’ firms have announced (for example, here) that they are investigating the alleged “massive fraud.” UPDATE: Please refer here to access my regularly updated list of all Madoff investor litigation, including in particular "feeder fund" lawsuits.

 

The filing of this lawsuit may not be surprising, and there may be further litigation yet to come. As detailed in the lead story in the December 13, 2008 Wall Street Journal (here), the victims of Madoff’s scheme include a host of institutional investors, hedge funds, and funds of funds. It may well be that these entities’ investors, eager to recoup losses as well as to assign blame, will also file lawsuits in a daisy-chain of litigation based on the Madoff firm’s collapse.

 

Hat tip to the Dealbook blog (here) for the text of the Madoff class action complaint, which can be viewed here:

 

Class Action Lawsuit Against Madoff

http://documents.scribd.com/ScribdViewer.swf?document_id=8925572&access_key=key-e0601l6vbyo6x4hv63z&page=1&version=1&viewMode=

 

 

Another Friday Night Special: December 12, 2008 was a Friday, and that can only mean one thing – after the close of business, the FDIC announced another round of bank closures.

 

First, the FDIC announced (here) that state banking regulators had closed, and the FDIC had been appointed receiver of, Haven Trust Bank of Duluth, Georgia. Next, the FDIC announced (here) that state regulators had closed, and the FDIC had been appointed receiver of, Sanderson State Bank of Sanderson, Texas.

 

These two closures represent, respectively, the twenty-fourth and twenty-fifth bank failures so far this year. The FDIC’s complete list of failed banks during the period October 2000 to the present can be found here. Haven Trust is the fifth Georgia bank to close this year, which represents the highest total for any one state. The Sanderson bank’s closure is the second in Texas this year.

 

As I have noted before (here), the pace of bank closures has accelerated as the year has progressed. Of the 25 bank closures in 2008, 21 have taken place since July 1, eight of them just since November 1. The trend certainly suggests that there will be further bank closures in the weeks and months to come. And, pertinent to the preceding discussion, there likely will also be further bank-related litigation (refer here).

 

As the year end approaches, various commentators will be issuing their retrospectives on the year’s securities litigation activity. The lead story undoubtedly will be that the wave of subprime and credit crisis-related lawsuits continued to flood in during the year. With some 94 new subprime and credit crisis related securities lawsuits so far in 2008 (by my count, which can be accessed here), the litigation wave undoubtedly is an important part of the story. But it is not the whole story. The danger is that the wave of credit crisis-related litigation has become so predominant that other important developments may be overlooked.

This past week illustrates my point. There were seven new securities class action lawsuits filed during the week of December 8, which is noteworthy in and of itself, as December historically is a slow month for securities class action lawsuit filings.

 

Among this past week’s seven new securities lawsuits was one new credit-crisis related filing. On December 11, 2008, plaintiffs’ lawyers filed a class action lawsuit against GS Mortgage and certain of its directors and officers, on behalf of purchasers of mortgage pass-through certificates and asset-backed securities the company issued. (GS Mortgage is an affiliate of Goldman Sachs, which is also named as a defendant.)

 

According to the plaintiffs’ press release (here), the GS Mortgage complaint alleges a variety of misrepresentations in the instruments’ offering documents, including with respect to the underwriting standards and appraisals used in the origination of the underlying mortgages.

 

But while the seven lawsuits filed last week did include this one subprime-related lawsuit, the other six lawsuits appear completely unrelated to the subprime or credit crisis-related events.

 

The remaining six companies named include a Canadian mining company, Crystallex International, allegedly facing regulatory issues in Venezuela (about which refer here); two medical device companies, Medtronix and Atricure (refer here and here); a media conglomerate, CBS Corporation, that announced non-cash impairment charges to intangible assets and goodwill (refer here); a laser and technology manufacturer, GSI Corp., that restated its financials due to revenue recognition issues (refer here), and a Chinese agricultural company, China Organic Agriculture, facing allegations regarding its development of organic products (refer here).

 

These six lawsuits represent a diverse mix of companies and allegations. The point here is that none of these six lawsuits is related to the subprime meltdown or credit crisis. Similarly, during the past year, while there have been a host of credit crisis-related lawsuits filed, there have also been many other lawsuits that are totally unrelated to the credit crisis.

 

Given the nature and magnitude of the financial developments this year, it is hardly surprising that there has been significant litigation activity involving the financial sector. What may be even more noteworthy is that notwithstanding the predominance of the financial events, there have been a significant number of lawsuits having nothing to do with the credit crisis or the financial sector.

 

I will detail these observations in my own forthcoming year-end analysis of securities litigation activity. In the interim, particularly as the various year-end reports emerge, it is important to keep in mind that 2008 securities litigation activity was not just about the credit crisis alone, nor was it confined just to the financial sector.

 

Does This Sounds Familiar?: Our age is not the first to have to contend with the consequences from cultural excess fueled by speculation, debt and deficit spending enabled by “financial wizardry.” A similar pattern also appeared in the events leading up to the French Revolution. In his book, Revolutionary France, 1770-1880 (here), historian François Furet details the country’s astonishing accumulation of indebtedness, and the consequences that followed.

 

In particular, Furet explores the way the French monarchy, led by Finance Minister Jacques Necker, financed its participation in the American war of independence by increasing state-guaranteed life annuities, fueling a speculative bubble and enabling borrowing backed by inflated values. Furet writes:

 

In total, between 1776 and 1781, 530 million in loans of all kinds fed the Treasury and financed a war that was all the more popular because it was painless. Money continued to flow in, and the resale of annuities enriched Parisian speculation. Even if the state was seriously compromising its future, Necker retained his popularity. In 1781, to counter-attack court intrigues … he published the Compte rendu, a statement of accounts which concealed the expenditure of the extraordinary budget and revealed an apparent surplus revenue of ten million livres.

 

As Furet observed, “after three years of war and no new taxes, that was truly  financial wizardry!” The problem is that, contrary to Necker’s assurances, “the real deficit lay in the region of eighty million.”

 

Similar deficit financing by Necker’s successors furthered the French government’s financial challenges. A successor minister, Charles Alexandre de Calonne, “found, out of 600 million livres in annual revenue, 176 million committed in advance, 250 million absorbed by debt service, and 390 million in accounts in arrears to be settled.” What was Calonne’s response? “He borrowed money on all sides, even more and at a higher rate than his predecessors.”

 

Among other things, this massive indebtedness enabled the illusion of prosperity; “one would need to reconstruct the entire circuit of money borrowed by Calonne to understand how these years were without doubt the most dazzling in court civilization.” But, as Furst notes, “sinking borrowed money into the parasitic round of court life proved eventually to be the downfall of this aristocratic sleight of hand.” This “artifice” unleashed “one of the most gigantic crashes in history.”

 

As we face the consequence of the collapse of our own era of debt-fueled prosperity, with its accompanying speculation, asset-valuation bubbles and financial wizardry, there is something sobering in realizing that once again the response consists of “borrowing money on all sides.” The ever-cumulating deficits have reached the point where figures of billions and trillions have lost all meaning. I am sure I am not the only one with the uneasy  feeling that we may be sinking borrowed money into parasitic hands and that we could be “seriously compromising our future.”

 

PLUS D&O Symposium: The Professional Liability Underwriting Society (PLUS) will be holding its annual D&O Symposium on February 25 and 26, 2009, at the Marriott Marquis in New York City. I will be co-Chairing the event again this year, along with my good friends, Tony Galban of Chubb and Chris Duca of Navigators Pro. There will be a terrific line up of speakers, including the keynote speakers Madeline Albright and New York Insurance Commissioner Eric Dinallo .

 

The panels will include all of the familiar favorites, such as the securities litigation update panel, to be chaired again by Boris Feldman of the Wilson Sonsini firm, and View from the Top panel, featuring the heads of the leading D&O underwriting facilities. Other panels will also address issues surrounding the governmental bailouts and increased business failures. An added bonus is that the fascinating video The Rise and Fall of Bill Lerach will be shown during the conference. (View a trailer of the video here).

 

Further information about the 2009 PLUS D&O Symposium, including registration information, can be found here. This event sells out every year, so early registration is advised.

 

As I have previously noted (here), one of the significant procedural developments in the subprime securities litigation wave has been the plaintiffs’ apparent interest in pursuing ’33 Act subprime-related lawsuits in state court. Section 22(a) of the ’33 Act expressly provides that the federal court’s jurisdiction for ’33 Act lawsuits is "concurrent with State and Territorial courts," which presents an immediate forum selection issue for any prospective ’33 Act plaintiff.

A recent ’33 Act lawsuit filing suggests that the forum selection issue involves not only electing between federal and state courts, but also deciding in which state to file, if a state court forum is to be preferred. The case also suggests that the forum selection may also entail forum shopping.

The Lawsuit

On December 2, 2008, the Public Employees’ Retirement System of Mississippi filed a ’33 Act class action complaint in Orange County (California) Superior Court against Morgan Stanley and several Morgan Stanley affiliates, several individuals associated with the Morgan Stanley affiliates and fourteen issuing trusts that sold certain mortgage pass-through certificates. The complaint also names as defendants McGraw Hill Companies, the corporate parent of S&P, and Moody’s. A copy of the complaint can be found here.

The complaint alleges that the offering documents associated with the securities "misstated and omitted material information regarding the quality of the loans underlying the Certificates," and failed to disclose" that the loan originators had "systematically ignored their stated and pre-established underwriting and appraisal standards." The complaint also alleges that Morgan Stanley entities "overpaid for underlying mortgages without regard to the quality of the loans for the sole purpose of increasing its position in the mortgage lending and securitization industry."

The complaint further alleges that the rating agency defendants "directly participated in structuring the securitization transaction" and that the rating agencies’ ratings "did not represent the true risk of the Certificates."

The complaint asserts claims under Sections 11, 12 and 15 of the ’33 Act and seeks relief on behalf of the class of investors who purchased securities pursuant to or traceable to the March 16, 2006 Registration Statement and accompanying prospectus.

Jurisdiction and Venue

The plaintiff is a Mississippi public employee pension fund. Morgan Stanley has its headquarters in midtown Manhattan. The complaint does not allege that any of the other defendants are domiciled in California. Apparently none of the parties are from California. So what exactly is this case doing in California?

As to why it is in state court rather than federal court, the state court has concurrent jurisdiction as I noted at the outset. But the mere availability of a state court forum does not explain why a state court was chosen in preference to a federal court. In my earlier posts (here), I have speculated that the plaintiffs are hoping to make an end run around the PSLRA’s procedural requirements, although no one has ever confirmed that.

But even if the preference of state court over federal court can be explained, why a state court in California?

The complaint itself purports to allege a variety of California connections: a "substantial portion of the wrongs complained of" are alleged to have occurred in Orange County. The defendants are alleged to have "availed themselves of the benefits of conducting business" in Orange County. Moreover, the complaint alleges that "a great percentage of the underlying mortgages pooled in the Certificates…were securitized by properties located in California."

All of these supposed connections to California are superficially plausible. But the fact is that all the parties are from outside California. The transaction that is at the heart of the lawsuit took place outside California. The supposedly misleading documents were created outside California.

I have my own theory why the case has been filed in California. That is, the plaintiffs really want the case to be in state rather than federal court. They anticipate that the defendants will seek to remove the case to federal court. The case law on which the plaintiffs would seek to rely in trying to have the case remanded back to state court is more favorable in California and less favorable in New York.

Specifically, as discussed here, in New York, in the HarborView mortgage case (about which refer here), the plaintiffs’ motion to remand the subprime-related securities case to state court was denied. However, in the Luther v Countrywide case, a subprime-related Section 11 lawsuit originally filed in California state court but removed by the defendants to federal court, the motion to remand the case to state court was granted, and the remand was specifically affirmed by the Ninth Circuit. For a detailed discussion of the Luther case including the Ninth Circuit’s opinion, refer here.

So did the plaintiffs choose a California state court because of the Ninth Circuit’s opinion in the Luther v. Countrywide case — that is, because the chances of being able to proceed in state court in California was perceived to be greater than the chances of being able to proceed in state court in New York? If I am right, the plaintiffs selected the forum in order to increase the likelihood of a state court venue. Call it forum shopping to the second power.

Anyone who questions my theory should know that the complaint in the Morgan Stanley case explicitly references the Luther case, complete with case citation to the Ninth Circuit opinion. .

Of course, it may also be fairly observed that Orange County is ground zero for the mortgage meltdown, and as result the plaintiffs may expect a more sympathetic court and jury in that forum . This possible explanation is not inconsistent with my theory. Call it fourm shopping to the third power.

In any event, as I have previously noted, it appears likely that in connection with the subprime litigation wave, a significant amount of high stakes class action securities litigation will be going forward in state court. The plaintiffs’ lawyers ’33 Act forum selection preference is now well-established. Now we must wait and see what it all portends.

Rating Agency Defendants

The Morgan Stanley case is not the first subprime securities lawsuit naming the rating agencies as co-defendants. Indeed, the HarborView case referenced above also named rating agencies as defendants. However, in the HarborView case, the complaint alleged that the rating agency defendants were liable under Section 11 as "appraisers" as defined in Section 11(a)(4) of the ’33 Act. (Refer here for a detailed discussion of the allegations in the HarborView complaint.)

The Morgan Stanley complaint takes a different approach. Because it alleges that the rating agencies were directly involved in the creation of the securitized assets, the Morgan Stanley complaint alleges that the rating agencies are liable under Section 11(a)(5) as "underwriters" of the mortgage pass-through certificates. (The text of Section 11 can be found here.)

It will be interesting to see in any event whether these various liability lawsuits against the rating agencies succeed under any theory. As I have previously noted here, the rating agencies may have constitutional defenses protecting their rating activities. It remains to be seen whether the rating agencies involvement in the securitization process transformed them into "underwriters" sufficiently to subject them to Section 11 underwriter liability.

Run the Numbers

In any event, I have added the Morgan Stanley Pass-Through Certificates lawsuit to my running tally of subprime related securities litigation, which can be accessed here. With the addition of the new Morgan Stanley case, the current tally of subprime and credit crisis-related securities lawsuits now stands at 133, of which 93 have been filed in 2008.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for a copy of Morgan Stanley mortgage pass-through certificates lawsuit complaint.

Subprime Loans, Predatory Lending?: One of the recurring allegations on behalf of subprime borrowers is that the subprime loans in which the borrowers became ensnared represented "predatory lending." A November 20, 2008 article by three NERA Economic Consulting economists – Denise Neumann Martin, Faten Sabry and Stephanie Plancich – reviews "the definition of predatory lending and describe the recent litigation history. The authors then examine alleged discriminatory lending in detail, reviewing key economic theory and evidence, as well as relevant statistical techniques."

The paper also reviews predatory lending allegations and takes a look at recent predatory lending lawsuit filings. The article categorizes the lawsuits according to the specific allegations, and also examines predatory lending lawsuit settlements.

The report contends that proper statistical analysis is required to establish whether or not discriminatory or other improper lending activity has taken place. The report states that:

A proper assessment of alleged predatory lending, then, must control for characteristics including but not limited to the credit history, employment status, income level, and education of the borrower, as well as the borrower’s preference for risk (or discount rate). The competitiveness of the market in which the loan was arranged and other relevant macroeconomic factors may also need to be considered. Such analysis is essential to distinguish behavior that is predatory from that which is explainable by these other factors and would not be evidence of discrimination.

The paper, entitled "The Use of Economic Analysis in Predatory Lending Cases: Application to Subprime Loans," can be found here.

In a deeply troublesome decision, the New York Department of Insurance has issued an October 16, 2008 opinion (here) stating that "a D&O policy may not include a provision that places the duty to defend upon the insured, rather than the insurer." A December 5, 2008 memo (here) written by Carrie Cope, a partner in the Tressler, Soderstrom Maloney & Preiss law firm, diplomatically but accurately summarizes just how far off base the opinion is.

By way of background, public company D&O insurance as it is uniformly distributed and purchased throughout the entire U.S. marketplace today is written on a duty to indemnify rather than a duty to defend basis. Under this arrangement, the insured persons, rather than the insurer, select their defense counsel, subject to the insurer’s consent, and the insured persons control their defense. The insurer reimburses reasonable defense expense.

Not only is this arrangement the uniform marketplace standard for public company D&O insurance, but it is the clear and unambiguous preference of public company D&O insurance buyers, who want to be able to use their own counsel in matters affecting their personal liability.

This arrangement has also has been approved by state court insurance regulators throughout the country. As Cope’s memo succinctly points out, the New York Insurance Department’s opinion is directly contrary to this well established regulatory record.

Cope also notes that the opinion "fails to address the needs and desires of the Insureds that it seeks to protect." She correctly points out that public company D&O insurance policies are purchased by sophisticated parties represented by risk managers and other specialized insurance professionals who seek to procure the best insurance available for their clients. The terms and conditions are highly negotiated. While virtually every word in the policy is subject to intense scrutiny, no one is trying to insert a duty to defend into their public company D&O insurance policy.

The D&O insurance industry’s uniform adoption of a duty to indemnify approach rather than a duty to defend approach is not the result of some insidious insurance company conspiracy. It is instead exactly what sophisticated and well-advised insurance buyers want.

Cope also correctly points out the opinion’s flawed logic. The opinion seeks to criticize the specific insurance policy addressed in the opinion because it transfers to the insured the burdens of litigation "such as managing, controlling or otherwise overseeing the litigation." As Cope notes, the opinion "fails to recognize that the ability to oversee the litigation is exactly what the typical insured purchasing a public company D&O policy wants." (Emphasis added).

The opinion also criticizes the policy because it does not pay the compensation costs of in-house counsel. Cope correctly notes that even if the policy were a duty to defend policy, it would not cover these costs.

Cope concludes her memo by noting that the opinion, "if not further modified, may well have a chilling effect upon the D&O insurance industry in New York and unduly cause applicants to seek means to obtain coverage they need and want outside the State of New York."

Cope is correct. This opinion is not in anyone’s interests, and in particular it absolutely is not in the interests of any person to be insured under a public company D&O insurance policy. Cope’s memo should be a rallying cry for all industry participants to have this erroneous opinion modified or set aside as soon as possible.

Special thanks to the several readers who sent me copies of Cope’s memo.

All litigants face the challenge of managing lawsuit expenses and exposures. The Reserve Primary Fund investor litigation defendants have crafted a novel approach to addressing these challenges – they apparently intend to finance their defense as well as any indemnity out of funds due to investors — that is, the funds of the very people on whose behalf the claims are being asserted.

 

Background

In September, the Reserve Primary Fund ("the fund") gained notoriety when the money market fund "broke the buck," as massive redemptions and the fund’s exposure to Lehman Brothers’ securities drove the fund’s per share net asset value below one dollar. Due to the magnitude of the redemption requests, the fund’s trustees voted to liquidate the fund and distribute the assets to investors.On December 8, 2008, the Wall Street Journal ran a front page article (here) detailing the events behind the fund’s woes.

 

Meanwhile, investors initiated a number of securities lawsuits against the fund, its directors and officers, its investment advisor and related parties. (Refer here for background regarding the lawsuits.) The lawsuits allege, among other things, that the defendants’ selective or inaccurate disclosure regarding the fund’s troubled assets enabled certain institutional investors to avoid losses to the detriment of other investors. The lawsuits also alleged that the fund failed to disclose its vulnerability due to its alleged overexposure to Lehman. The lawsuits also allege that the Lehman Brothers investments were inappropriate for a money market fund, and that the fund deviated from its stated investment approach.

 

The Liquidation Plan

On December 3, 2008, the fund’s trustees issued a "Plan of Liquidation and Distribution of Assets" (here). Among other things, the Liquidation Plan provides a plan for distribution of fund assets through "interim payments." The interim payments are to include distribution amounts "up to the amount of a special reserve, which would include amounts that would be required to satisfy disputed claims."

 

As the Liquidation Plan explains, this special reserve will be used to finance "costs and expenses of the Fund, its officers and Trustees"; "pending and threatened claims against the Fund"; and claims, "including but not limited to claims of indemnification that could be made against plan assets." Were the fund to distribute its assets without the special reserve, investors could expect about 98.5 cents per share. However, the special reserve, the amount of which has yet to be determined, will reduce this per share distribution.

 

As a December 5, 2008 New York Times article entitled "Embattled, Fund Shifts Costs to Investors" (here), put it, investors might hope to get 98.5 cents on the dollar, but "if they continue to wage legal battles against the fund managers, the company will use investors’ own money to defend itself against allegations or mismanagement and deception." Moreover, the Liquidation Plan makes it clear that the special reserve is not just for litigation expense, but also to "satisfy disputed claims." The December 8 Journal article cited above states that the fund has told investors "the fund will use some if its assets to fight suits investors have filed, which could reduce the money available to return to them."

 

Insurance and Indemnification

Readers who like me wonder whether there isn’t D&O liability insurance available to pay these amounts will be interested to learn that there is insurance, just not very much. According to the Liquidation Plan, the fund has a directors’ and officers’ liability insurance policy with a $10 million aggregate limit of liability.

 

Not only does the fund only have a $10 million D&O policy, but it is a "joint" policy, insuring not just the fund and its directors, officers and trustees, but also its investment advisor, its corporate parent, and other affiliated parties and person, many of whom are co-defendants with the fund and its directors and officers in the mass of investor lawsuits that have been filed.

 

In other words, though the fund has D&O insurance, its limits are, well, limited, and are also subject to erosion or depletion due to competing interests of multiple parties in the policy proceeds. It should be emphasized that under most D&O policies, defense expense reduces the amount of insurance remaining under the policy, meaning that there could be little or no insurance available to satisfy investors’ claims if the various cases are actively litigated.

 

The rights of the fund’s individual officers, directors and trustees to indemnification are not eliminated merely because of the allegations raised in the lawsuits (indeed, the outbreak of litigation is precisely the circumstances that trigger the operation of indemnification rights). Angered investors who may want to contend that the individual’s supposed misconduct should forfeit their rights to indemnification can try to argue based on Section 17(h) of the Investment Company Act that the fund cannot indemnify the individuals for "willful malfeasance, bad faith, gross negligence, or reckless disregard."

 

The problem for any investor inclined to make that argument is that the only way to establish that the statutory indemnification prohibitions have been triggered is to litigate the issue – which, as the Times article notes, is "the very act that could reduce the return to investors." In order to establish that the disqualifying conduct occurred, investors would have to pursue their case all the way to verdict, and arguably through appeal as well, a process that would be as uncertain as it would be costly and protracted.

 

Discussion

So basically the message seems to be, you want to litigate, investors? Fine, knock yourselves out. It’s your money. As the Times article puts it, the choice offered investors under the Liquidation Plan "struck some legal experts as brazen."

 

The fund’s insurance limits are also worthy of comment. The fund had assets of approximately $64 billion. In that light, some may find the fund’s $10 million D&O insurance limits, well, surprising, particularly given that the limits insure not just the fund and its directors, officers and trustees, but also the fund’s investment advisor and other affiliated parties and person. Reasonable minds might well question the fund’s limits selection.

 

These circumstances also highlight the risks associated with widely shared limits. The number and diversity of entities and person who will be depending on the limits, along with the apparent seriousness and extent of the litigation involved, raises the probability that the litigation expense will quickly erode if not altogether deplete the available limits. The risk of limits erosion associated with these kinds of shared limits further underscores the fact that reasonable minds might well question the fund’s insurance limits selection.

 

In any event, the circumstances, particularly the Liquidation Plan, present investors with some difficult decisions. It will be interesting to see their next move, and whether they try to challenge the Liquidation Plan.

 

Special thanks to Kelly Rehyer for the link to the Times article.

 

And Speaking of Threats to Litigating Investors: As I noted in a prior post (here), investors have sued the Bank of America, challenging the loan modifications to which the bank agreed in connection with mortgages issued by Countrywide. The litigation has apparently caught the attention of FDIC chairman Sheila Bair.

 

As reported in a December 4, 2008 Los Angeles Times article (here), Bair told a consumer group gathering that "there is an obligation to modify mortgages," and that "investors should take a hard look at what they are advocating." She also said that "the harder investors push, the more there’s going to be a backlash here." She suggested that Congress may step in and change the legal obligations of mortgage services toward investors.

 

Interestingly, Bair did not state that the investors’ opposition to the mortgage makeovers is illegitimate or unmeritorious, only that their assertion of their interests represents an obstruction to policy goals she advocates. It certainly can be inconvenient when concerned parties insist on asserting their rights, but the threat of a Congressional backlash could strike some as heavy-handed.

 

Call it a hunch, but Bair’s remarks seem likelier to embolden rather than to discourage investors, as her remarks suggest that she recognizes the potential significance of their claims. In any event, whether or not Congress has the power or political will to set aside the agreements on which the investors are relying, if Congress were to take such a step it would do little to restore investor confidence in mortgage marketplace mechanisms, which would seem to be an indispensible part to restoring stability to the mortgage lending industry.

 

And Speaking of the FDIC: In yet another Friday-night special, on December 5, 2008, First Georgia Community Bank of Jackson, Georgia became the twenty third U.S. bank failure this year, after state regulators closed the bank and the FDIC was named receiver. The closure is Georgia’s fourth bank failure this year.

 

The FDIC’s December 5, 2008 press release can be found here. The FDIC’s updated list of bank failures can be found here. My prior post about the significance of the accumulating bank failures can be found here, and my prior post about the prospects for a new wave of "dead bank" litigation can be found here.

 

In a recent post (here), I described the "new wave" of credit crisis lawsuits, in which the companies involved were damaged by their exposures to other companies experiencing credit crisis losses. The latest of these new wave lawsuits to be filed involves the Federal Agricultural Mortgage Corporation, or "Farmer Mac" as it is more familiarly known.

 

Freddie Mac is a government sponsored entity that was established to support a secondary market for agricultural real estate and rural housing mortgage loans. According to their December 5, 2008 press release (here), plaintiffs’ lawyers have initiated a securities lawsuit against Farmer Mac and certain of its directors and officers in federal court in the District of Columbia. According to the press release,

 

a) defendants were inflating Farmer Mac’s results through manipulations relating to the characterization of impairment costs and/or depreciation expenses which inflated the Company’s reported cash flows, gross margins and Core and GAAP-earnings; (b) the Company’s financial results were inflated by defendants’ use of overly optimistic assumptions of asset valuations and investments, which were also reflected in defendants’ misuse of mark-to-market accounting; (c) the Company’s exposure to investment losses and credit problems of trading partners such as Lehman Bros. and Fannie Mae was much greater than represented; and (d) the Company was not on track to meet or exceed guidance sponsored or endorsed by defendants.

 

Investors only first learned the truth about Farmer Mac on September 12, 2008, when its shares closed at $16.56, from an open of $23.78, losing over 30% of their value in one day after the Company filed documents with the SEC saying it would incur significant charges due to its exposure to Fannie Mae securities. Further, shares of the Company continued to trade down thereafter to close to $2.00 per share following announcements concerning the resignation of its Chairman of the Board and losses related to debt issued by Lehman Brothers.

 

The involvement of the allegations relating to the company’s Fannie Mae and Lehman Brothers investments is the reason I have characterized this case as a new wave credit crisis lawsuit. That is, it was its exposure to these other companies that caused Farmer Mac’s problems, at least in part.

 

However, because of the allegations relating to Farmer Mac’s own asset valuations, including its alleged misuse of mark-to-market accounting, the lawsuit also has characteristics of the more conventional subprime and credit-crisis related type of litigation that has accumulated over the last two years.

 

In any event, I have added the Farmer Mac lawsuit to my running tally of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of the Farmer Mac lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands at 132, of which 92 have been filed in 2008.

 

And Speaking of Credit Crisis Litigation: One of the more noteworthy events during the current credit crisis was the collapse of Bear Stearns in March 2008 (which already seems like a long time ago, doesn’t it?) and its acquisition by JP Morgan Chase.

 

Following JP Morgan’s March 16, 2008 agreement to acquire Bear Stearns, shareholders of Bear Stearns filed a New York (New York County) Supreme Court lawsuit against both Bear Stearns and JP Morgan, alleging that the $10 per share consideration JP Morgan paid for Bear Stearns was inadequate. The plaintiffs sought damages from Bear Stearns’ directors for claimed violations of their fiduciary duties and from JP Morgan for its allegedly tortious conduct in effecting the merger.

 

In a December 4, 2008 opinion (here), Judge Herman Cahn granted the defendants’ motion for summary judgment. The court rejected the plaintiffs’ challenges to the deal, holding that the business judgment rule applied, and that under the rule, the court could not second guess the board:

 

In response to a sudden and rapidly-escalating liquidity crisis, Bear Stearns’ directors acted expeditiously to consider the company’s limited options. They attempted to salvage some $1.5 billion in shareholder value and averted a bankruptcy that may have returned nothing to the Bear Stearns’ shareholders, while wreaking havoc on the financial markets. The Court should not, and will not, second guess their decision.

 

In a December 5, 2008 post on the Harvard Law School Corporate Governance Blog (here), the attorneys that represented JP Morgan in the Bear Stearns case discuss the decision in greater detail, noting that "as the credit crisis continues and evolves, boards will continue to face serious challenges. The Bear Stearns opinion confirms, however, that the directors that act diligently and in good faith should not have exposure for their actions."

 

The suggestion that the Bear Stearns opinion represents a precedent in support of the protection of directors arguably has already been borne out in a North Carolina court.. As Francis Pileggi discusses on his Delaware Corporate and Commercial Litigation Blog (here), the North Carolina court considering shareholders’ challenges to the merger of Wachovia and Wells Fargo has dismissed the action, with reference to  the New York court’s decision in the Bear Stearns case. The Wachovia and Wells Fargo merger was arranged in similarly unusual circumstances in light of the economic turmoil that in very short order saw some of the countries largest financial institutions "go under" or need "bailouts."

 

A December 6, 2008 Charlotte Observer article describing the ruling in the Wachovia case can be found here.

 

Fake ID: In a recent post (here), I analyzed the problems associated with credential inflation and reviewed famous examples of identity misrepresentation. However, a recent episode involving prominent attorney Marc S. Dreier, the name partner of Drier LLP, may represent a whole new level of identity misrepresentation.

 

As reported on December 5, 2008 on the City Room blog (here), earlier last week Toronto police arrested Drier for "fraudulent impersonation." A December 8. 2008 Law.com article (here) reports that at a meeting in the offices of the Ontario Teachers’ Pension Plan with representatives of Fortress Investment Group and involving a multimillion dollar deal between the two organizations, Drier "pretended to be Michael Padfield, senior legal counsel for investments at Ontario Teachers." The Wall Street Journal reports (here) that Dreier passed out Padfield’s business card and signed documents as Padfield. When Padfield himself arrived at the meeting, police were called.

 

As if that were not enough, three attorneys from the Wilson Sonsini firm have been retained "to examine firm operations and finances, including escrow accounts." Whether or not these concerns are related to Drier’s arrest is not specified. However, the Above the Law blog reports here that as much as $38 million is missing from the Dreier firm’s client escrow account.

 

The Journal also reports that federal prosecutors are looking into concerns raised by Solow Realty, a former client of the firm, "that Mr. Dreier allegedly was selling to hedge funds fraudulent documents falsely purporting to be debt instruments of Solow without Solow’s authority."

 

The firm’s holiday party, planned to take place last Thursday night at the Waldorf Astoria, was cancelled. I guess it is hard to party when your name partner is (or was) in jail and your client escrow account is missing tens of millions of dollars.

 

I doubt even John Grisham could have made this one up.

 

UPDATE: The Marc Dreier story just keeps getting weirder and weirder. In a totaly bizarre development, on December 8, 2008, the SEC filed a complaint against Dreier in which it accused him of "fraud in connection with an elaborate scheme that raised at least $113 million from the sale of bogus promissory notes." Read the SEC’s press release here. The press release that Dreier has already admitted his involvement with the phony note sale. The WSJ.com Law Blog reports (here), that the DoJ has also filed a criminal complaint against Dreier and that he was arrested upon his return to the U.S. on Sunday. The firm’s lender has also sued the law firm because the firm is in default on its line of credit.

Following closely on the heels of the denial of the motion to dismiss in the Countrywide case earlier this week (about which refer here), on December 3, 2008, Judge Dean Pregerson of the Central District of California issued an opinion (here) denying the defendants’ motions to dismiss in the New Century Financial Corporation securities class action lawsuit.

 

Background

New Century was at one time the largest subprime mortgage lender. However, on April 2, 2007, the company filed for Chapter 11 bankruptcy protection. In a development with significance for the securities lawsuit, in March 2008, the New Century bankruptcy examiner filed a report (refer here) finding, among other things, that the company had "engaged in a number of significant improper and imprudent practices related to its loan originations" that "created a ticking time bomb that detonated in 2007."

 

The lead plaintiff in the New Century securities lawsuit is the New York State Teachers’ Retirement System. The plaintiff filed a consolidated class action complaint on September 14, 2007, and the defendants moved to dismiss. On January 31, 2008, as discussed here, Judge Pregerson granted the motions dismiss without prejudice, but the dismissal focused entirely on the organization and complexity complaint and the court’s difficulty in evaluating the basis of the plaintiff’s claims. Thereafter, the plaintiff’s filed a second consolidated amended complaint (refer here, referred to below as the amended complaint) and the defendants again moved to dismiss.

 

The amended complaint names as defendants certain officers and directors of New Century; its former auditor, KPMG; and the investment banks that underwrote certain New Century securities offerings. The complaint alleges that the defendants

 

misrepresented New Century’s ability to repurchase defaulted loans; overvalued its residual interests in securitizations; falsely certified the adequacy of its internal controls, loan origination standards, and the quality of its loans; and failed to identify these problems in public statements, registration documents, audits, or elsewhere.

 

Further background regarding the case can be found here.

 

Judge Pregerson’s Opinion

In his December 3 opinion, Judge Pregerson first considered whether the amended complaint remedied the organization and clarity issues for which he had previously granted the defendants’ motions to dismiss. While noting that the amended complaint is "truly massive" and commenting that he "questions whether the Complaint provides a manageable road map for litigation," he nevertheless concluded that the amended complaint was "responsive to the concerns" and that he was "now able to evaluate whether the allegations sufficiently state a claim." He also recognized that the PSLRA’s "stringent pleading requirements appear to invite both parties to throw everything and the kitchen sink into their respective pleading."

 

In turning to the merits, Judge Pregerson examined whether the plaintiffs could rely on the "group pleading doctrine," under which "group published documents" (e.g, press releases) for which there is not identified author can be considered the collective work of those with direct involvement in the company’s day-to-day affairs.

 

After reviewing the relevant case law, and noting that the Ninth Circuit had not expressly rejected the doctrine, Judge Pregerson joined the "majority of other courts in the Circuit" and held that "group pleading" is not longer viable under the PSLRA. He dismissed the plaintiff’s allegations that were made in reliance on the group pleading doctrine. However, he also noted that because the amended complaint alleges attributed misrepresentations that do not rest on the doctrine as to each of the officer defendants, his holding regarding group pleading "does not preclude any of the Officer Defendants from liability."

 

Judge Pregerson then addressed the 10b-5 allegations in the amended complaint. He concluded that the amended complaint adequately alleged falsity as to loan quality and underwriting and as to financial reporting and internal controls. Interestingly, in concluded that the allegations concerning loan quality and underwriting standards adequately alleged that the statements were false and misleading when made, Judge Pregerson expressly noted that other district courts in the Ninth Circuit had "found similar statements regarding loan quality and underwriting to provide a basis for actionable securities law violations," citing the Countrywide and Accredited Home Lenders decisions. (Refer here regarding the Accredited Home Lenders decision.)

 

On the issue of scienter, Judge Pregerson found that the amended complaint

 

sufficiently alleged facts giving rise to a strong inference that the Officer Defendants were at least deliberately reckless in making misrepresentations as to loan quality, internal controls and various financial statements.

 

Judge Pregerson noted that "the confidential witness statements describe a staggering race-to-the-bottom of loan quality and underwriting standards," noting that "the witnesses catalog an explosive increase in risky loan product." The allegations

 

are sufficient to infer a deliberately reckless set of statements telling the public one thing when New Century was doing something quite different – the loans were poor, not great quality; the underwriting was all but absent, not strict; and the internal controls were slack rather than searching.

 

Judge Pregerson also found that the insider trading allegations supported his finding of the adequacy of the scienter allegations, as did the allegations regarding the defendants’ bonus and other compensation. In that regard, it is interesting to note that Judge Pregerson specifically observed with respect to the defendants’ trading plans that "the timing of the 10b5-1 plans, several years after they became available, at least raises the question precisely why there was a delay in creating these plans, and why they were formed during the Class Period."

 

Judge Pregerson also denied KPMG’s motion to dismiss. The firm had issued an audit opinion on the company’s 2005 financial statements. He found that the amended complaint adequately alleged that KPMG was aware of accounting and internal control deficiencies but nevertheless issued its audit opinion. He found that the allegations against KPMG adequately alleged scienter and loss causation.

 

Finally, Judge Pregerson concluded that the amended complaint adequately pled claims under Section 11 in connection with New Century’s securities offerings, including as to the Underwriter Defendants.

 

Discussion

Judge Pregerson’s opinion is another subprime-related securities lawsuit pleading-stage victory in favor of plaintiffs. The New Century opinion, together with the recent decision in the Countrywide case,  undermine the suggestion (refer here) that plaintiffs may not be faring well in the subprime related litigation. These cases establish that in at least some instances, plaintiffs can satisfy the pleading requirements, notwithstanding the fact that the current financial crisis has affected virtually every company and every segment of the economy.

 

Moreover, both the New Century and the Countrywide opinions are sweeping and strongly worded. The potential for these cases to take on a collective power may be seen in Judge Pregerson’s own reference, in connection with the loan quality and underwriting standards allegations, to the conclusions in prior rulings in other cases. A developing body of judicial decisions potentially could take on a collective and persuasive weight that could affect other cases.

 

Judge Pregerson’s ruling with respect to KPMG is also noteworthy. His decision may have been influenced by the strongly worded findings in the New Century bankruptcy examiner’s report. But in any event, his willingness to permit the allegations as to KPMG to go forward may suggest the possibility that auditors could be targeted in at least some other subprime and credit crisis related cases.

 

One interesting note in the opinion is Judge Pregerson’s reference to the defendants’ trading pursuant to Rule 10b5-1 plans. As in the Countrywide case, Judge Pregerson found that the defendants’ use of the trading plans raised suspicions. Rule 10b5-1 was intended to provide a way for insiders to trade without liability concerns, yet, ironically perhaps, the defendants’ implementation of trading plans was in and of itself found in these cases to be grounds for suspicion. As I have noted elsewhere (here), Rule 10b5-1 plans can still be a good idea if properly implemented, but they clearly can be dangerous is not used properly.

 

A final observation about Judge Pregerson’s comments on the trading plans. There is an odd note in his consideration of the defendants’ plans. He referred, with suspicion, to the timing of the defendants’ adoption of plans "several years after they became available." This is a curious statement, as if he is suggesting that the very fact that the defendants decided to adopt a plan later is itself suspicious. These seems to me to be the very kind of circumstances in which there a host of alternative innocent inferences, including even the possibility that the defendant just didn’t get around to doing it for awhile. The suggestion that a belated adoption is suspicious would potentially bar anyone who has not already adopted a plan from doing so now, which obviously would undermine the Rule’s purposes of attempting to allow corporate officials to trade in company shares without liability concerns.

 

In any event, I have added the New Century decision to my table of subprime and credit crisis-related lawsuit dismissals and denials, which can be accessed here.

 

D&O Indemnification and Insurance: As the credit crisis litigation wave gains momentum, issues surrounding indemnification and insurance for directors and officers are becoming increasingly important. A December 3, 2008 memo by the Gibson, Dunn & Crutcher law firm entitled "Director and Officer Indemnification and Insurance in Turbulent Times" (here) takes a look at recent case law developments regarding indemnification and review the key issues concerning D&O insurance.

 

The memo provides a good summary overview of these issues. I note parenthetically that readers who may be interested in more detail regarding the specific items in the memo can refer back to this blog, where I have discussed at greater length each of the items discussed in the memo.

 

One particularly noteworthy observation in the memo is the statement with respect to D&O insurance that:

 

Due to the complexity of policy language and the issues involved, expert advice from qualified insurance and legal professionals can be important in obtaining a thorough understanding of the coverage available under a company’s D&O insurance program. A growing number of boards of directors are seeking comprehensive analyses of their companies’ D&O insurance programs, undertaken with the assistance of experts, in connection with the purchase or renewal of D&O insurance coverage.

 

As suggested in the memo, I have also noted that more boards are now seeking outside reviews of their insurance, and that an increasing number of boards (and, in particular, independent directors) are interested in a review of their insurance independent from the company’s broker or regular outside counsel, whom boards apparently are concerned have their first loyalties to company management. I have in recent months taken on a number of assignments along these lines, and I am available to discuss these services for others who may be interested.

 

In an earlier post (here), I suggested that the credit crisis litigation wave had reached an inflection point, and in subsequent posts, I identified additional "new wave" credit crisis lawsuits.

 

The exact contours of this "new wave" is admittedly amorphous, but the basic concept is that it involves, first, companies that were not themselves undermined by the credit crunch but rather as result of their exposure to companies that were. The most prominent examples are companies that suffered losses due to their exposure to Lehman Brothers. One specific example is Constellation Energy, which, as noted here, is the target of a securities lawsuit alleging among other things that the company insufficiently disclosed its exposure to Lehman Brothers securities.

 

That there will be other lawsuits in the "exposed to others’ misfortunes" category is demonstrated by the lawsuit initiated on December 3, 2008 in the Southern District of New York against Chinese solar cell manufacturer JA Solar Holdings and certain of its directors and officers. According to the plaintiffs’ counsel’s December 3 press release (here), the Complaint alleges that the defendants failed to disclose that:

 

JA Solar purchased from a subsidiary of Lehman Brothers Inc. ("Lehman Brothers") a three month, $100 million note (the "Lehman note") on or about July 9, 2008. At the time of this purchase, Lehman Brothers, which guaranteed the Lehman note, was under severe financial distress. According to the complaint, defendants failed to disclose: (i) that JA Solar had made a material, highly speculative investment in a subsidiary of Lehman Brothers, an entity that was then undergoing a credit crisis and under significant financial distress; (ii) that the value of JA Solar’s investment in the Lehman note had diminished considerably; and (iii) that, as a result of the foregoing, defendants’ positive statements concerning JA Solar’s financial performance, outlook and earnings guidance were materially false and misleading and without reasonable basis.

Ultimately, at the end of the Class Period, JA Solar wrote off its $100 million investment in the Lehman note. After JA Solar fully disclosed and recorded an impairment in the value of its investment in the Lehman note, on November 12, 2008, JA Solar’s stock closed at $2.38 per share, a price that represented a decline of more than 87% from the high during the three month Class Period.

 

A copy of the JA Solar complaint can be found here.

 

Constellation Energy and JA Solar are far from the only companies experiencing losses as a result of the onslaught of bankruptcies and bailouts. Many companies have experienced huge losses as a result of the collapse of Lehman Brothers, Fannie Mae and Freddie Mac, AIG, Washington Mutual, and the other recent massive failures. There undoubtedly will be further lawsuits like the ones filed Constellation Energy and JA Solar.

 

Another category of "new wave" credit crisis litigation relates to companies that made wrong way bets on commodities and currencies, as I noted in a prior post (here). These companies have experienced significant losses as commodities prices and currency exchange rates suddenly and unexpectedly reversed direction this fall. Some of these companies have also been hit with securities lawsuits, as I noted in my prior post, and as also illustrated in the lawsuit recently filed against Aracruz Cellulose (about which refer here).

 

As discussed in a December 3, 2008 Wall Street Journal article entitled "Rapid Price Decline in Commodities Turns Some Offsets into Big Losses" (here), a number of companies "have taken hedging-related losses in the third quarter as a result of the rapid decline in commodities costs." But, the article emphasizes, "it isn’t over, either." Companies hedge their costs a few quarters in advance, so hedges taken more recently "are going to hurt profits for many in the fourth quarter and beyond." The article specifically mentions Campbell Soup, Kraft Foods, Pilgrim’s Pride, and Southwest Airlines.

 

The reference to Pilgrim’s Pride is particularly noteworthy as part of this discussion, because as I previously noted (here), the company has already been hit with a securities lawsuit based among other things on the company’s wrong way bet on corn prices. As the Journal notes, there will be other companies reporting losses after the end of the fourth quarter and even beyond on wrong way commodities and currency bets. Some of these companies likely will also face securities lawsuits.

 

The final category (or at least final until a new category emerges) involves auction rate securities. I refer here not to the mass of litigation filed earlier this year by auction rate investors against the broker-dealers that sold them the auction rate securities. Rather, I am referring to the cases where investors have sued companies because of losses the companies suffered as a result of the companies’ investment in auction rate securities.

 

An example of this auction rate case is the one involving NextWave Wireless (about which refer here) in which it is alleged, among other things, that the company "failed to timely disclose that it had invested all of its marketable securities in extremely illiquid auction rate securities."

 

There are a host of other companies facing distress due to their exposure to illiquid auction rate securities. For example, a December 3, 2008 Wall Street Journal article entitled "LandAmerica’s Collapse Leaves Investors Looking for Cash" (here) describes the failure of title insurance company LandAmerica Financial Group, which came about because one of the company’s subsidiaries had put funds held for real-estate investors in auction rate securities. Land America filed for bankruptcy last week.

 

There undoubtedly will be other companies facing liquidity crises as a result of their exposure to auction rate securities, and some of these companies, like NextWave Wireless, will face securities litigation as a result.

 

One final point about the evolution of the credit crisis litigation wave is that many of the companies involved in these various "new wave" categories identified above are outside the financial services sector. To the extent these new wave lawsuits continue to accumulate, this evolutionary process could be the means by which the credit crisis litigation wave spreads outside the financial sector to the larger economy.

Premonition of War Foretold: As we wonder how we got into the mess, one of the things that is becoming obvious is that the sober voices were silenced and mocked, and the dialog was dominated by the voices of those who had spent far too much time at the punch bowl.

 

The following video compiles of series of clips from the period 2006 through 2007, showing both how many foolish things were said, and also showing the prescience of Peter Schiff of Euro Pacific Capital. I don’t know what is more amazing about this video, that Schiff’s predictions were so uncanny or that the others, who mocked and even laughed at him, so badly misperceived what was happening, especially with respect to housing prices. I guarantee you will shake your head in disbelief at some of the things that are said in this video. Schiff in the meantime sounds like a man who had access to a crystal ball.

 

Hat tip to Joe Nocera of the New York Times in his Executive Suite blog (here) for the link to the video.

https://youtube.com/watch?v=2I0QN-FYkpw%26hl%3Den%26fs%3D1

Has the "due diligence" standard articulated in the WorldCom securities litigation produced an increase in the Section 11 litigation? That is the question addressed in David J. Michaels’s November 29, 2008 paper entitled "An Empirical Study of Securities Litigation After World Com" (here).

 

In this post, I review the analysis based upon which Michaels contends that, due to the WorldCom due diligence decision, Section 11 filings have increased as a percentage of all securities lawsuits, followed by my own discussion of the data on which Michaels relies.

 

The Author’s Analysis

Outside directors historically have had little Section 11 liability exposure, owing to their ability to rely on Section 11’s due diligence defense. Michaels notes that courts generally have found outside directors’ due diligence obligations to be minimal. However, Michaels contends, the Southern District of New York’s Section 11 due diligence decision in In re WorldCom Securities Litigation, 2005 WL 638268 (S.D.N.Y. 2005) (refer here) "significantly changed the landscape for outside directors" by holding them to a "stringent standard of liability."

 

A more detailed review of the impact of the WorldCom litigation on the due diligence defense can be found here.

 

Michaels hypothesized that because the WorldCom decision represents a change in the due diligence standard, making it easier for plaintiffs to pursue Section 11 claims (particularly against outside directors), securities cases under Section 11 would increase. In order to test this hypothesis, Michaels examined the ratio of securities filings asserting Section 11 claims to Section 10b-5 filings during the period 2002 through 2007, using data from the Stanford Law School Class Action Clearinghouse website. Because the court issued the WorldCom opinion in March 2005, the period selected included both years preceding and following the decision.

 

Michaels reported the following ratios of Section 11 filings to Section 10b-5 filings for the years 2002 through 2007:

 

2002 13%

2003 11%

2004 6%

2005 10%

2006 13%

2007 23%

 

Michaels concludes that these data suggest an "abnormal rise in Section 11 filings." Michaels concedes that "it is difficult [to] prove a causal relationship between WorldCom and the rise in Section 11 filings," he nevertheless asserts that it "is reasonable to attribute causation of the rise in Section 11 filings to WorldCom." In support of this conclusion, Michaels states:

Consider the following series of events. Prior to WorldCom, Section 11 filings were relatively constant; WorldCom comes along and greatly alters 35 years of precedent by making it easier for plaintiffs to survive a motion for summary judgment; Section 11 filings increase.

Michaels ends his paper by arguing that the upward trend in Section 11 cases will continue, but also that WorldCom’s holding applying a stringent standard to outside directors’ "due diligence" defenses is contrary to the ’33 Act’s purposes. He proposes a safe harbor for outside directors that "would exclude from liability outside directors who follow certain procedures designed to inform them of all material information surrounding a given offering."

 

Discussion

Michaels may be correct that the WorldCom decision will result in an increase in Section 11 filings. Reasonable minds may differ on whether the data support his conclusion that there already has been a demonstrable increase in Section 11 filings. Those same reasonable minds might hesitate before jumping to any conclusions about the causes of any increase that arguably may have taken place. A more conservative view is that it is at best premature to reach any conclusions in that regard.

 

First, the data on which Michaels relies represents only a brief time period. Since the WorldCom opinion was issued in 2005, that data from calendar year 2005 represent only a partial year. Michaels’s analysis places an enormous weight on data from just two years, 2006 and 2007. Michaels does not explain why he believes a data set that small is sufficient to support his conclusions.

 

Second, Michaels does not consider whether or not there were external factors that may have affected securities filings during the period after the WorldCom decision. In fact, it has been well documented (refer, for example, here) that there was a filing "lull" during the period from mid-2005 through mid-2007, in which there were an historically low number of securities filings overall. Michaels does not even mention this fact, nor does he consider whether the filing levels during that period may suggest that other factors may have been at work during this period.

 

Third, although Michaels is convinced that there was an "abnormal rise" in the Section 11 filings after WorldCom, the only thing I can conclude from looking at the data is that something was going on during 2007, as the 2005 and 2006 data are consistent with the prior years’ data. Michaels is essentially arguing the filing activity in a single year supports his hypothesis. Again, Michaels does not consider whether or not there may have been some anomalous factor behind the 2007 data.

 

My own prior review of the 2007 filing data (refer here) concluded that a significant number of the overall 2007 filings involved companies that conducted IPOs during the 12 months prior to getting sued. Many of these IPO cases involved foreign domiciled companies. Perhaps it may be concluded that the 2007 uptick in Section 11 litigation was due to a wave of IPOs involving foreign companies that were not ready to go public. At a minimum, there are certainly other plausible explanations for the 2007 uptick in Section 11 litigation other than the WorldCom decision alone.

 

Not only does Michaels fail to consider other possible explanations for the anomalies in the data, but the basis on which he nevertheless argues that WorldCom decision alone explains the supposed increase is also suspect.

 

In effect, he urges us to conclude that because the supposed increase in Section 11 filings came after the WorldCom decision, the decision must have been the cause of the supposed increase. This analysis arguably represents an example of the logical fallacy post hoc ergo propter hoc (after this, therefore because of this). Essentially, Michaels is trying to substitute chronological sequence for causation. However, the mere order of events does not rule out other factors that might explain the data, as the preceding paragraph shows.

 

From my perspective, given the anomalousness of the 2007 data, it is premature to reach any conclusions without the opportunity to consider subsequent years’ data, to see, for example, whether the 2007 uptick represented a trend or (as I strongly suspect) is merely a statistical outlier. I can say from my own informal review of the 2008 year to date filing data, a much smaller percentage of 2008 cases involve IPOs (14 out of 195 year to date in 2008, compared to 29 out of 172 in 2007), which suggests that the number of Section 11 filings will prove to have been down substantially in 2008 compared to 2007.

 

The decline in 2008 IPO-related lawsuits is hardly surprising given the downturn in the number of IPOs in recent months. Given the low level of IPO activity during 2008, and indeed the low level of securities offerings of any kind, it seems probable that Section 11 litigation could well taper off in the months ahead. All of which suggests to me the inadvisability of trying to make a few months of filing data support sweeping conclusions.

 

It may well be, as Michaels argues, that WorldCom’s articulation of the Section 11 due diligence standard arguably is inconsistent with the ’33 Act’s goals, particularly to the extent it may result in the imposition of greater Section 11 liability on outside directors. I simply disagree with Michaels’s conclusion that WorldCom decision has demonstrably caused an increase in Section 11 filings. Michaels’s hypothesis may or may not eventually prove to be correct, but it will be a significantly longer period of time than he has allowed before we can reach any conclusions.

 

Special thanks to Werner Kranenburg of the With Vigour and Zeal blog for the link to Michaels’s article.

 

In order to remedy the faulty link in the email distribution notice for today’s post about the Countrywide subprime-related securities class action lawsuit, I have republished the post, which can be found here.

I apologize for any inconvenience that the faulty link in the prior email may have caused.