On December 1, 2008, in a massive, detailed 112-page opinion (in three parts, here, here and here), Central District of California District Judge Mariana R. Pfaelzer substantially denied the defendants’ motions to dismiss the Countrywide subprime-related securities class action lawsuit.

 

Background regarding the case can be found here. The consolidated amended complaint can be found here.

 

Judge Pfaelzer’s ruling did dismiss with prejudice the plaintiffs’ claims against Grant Thornton, and also dismissed with prejudice allegations concerning certain alleged 2003 accounting misstatements as well as other specific alleged misstatements. Judge Pfaelzer also dismissed with leave to amend certain allegations as to certain defendants, but otherwise, and in substantial part, the motions were denied.

 

In certain respects, Judge Pfaelzer’s opinion may come as little surprise, as she wrote the lengthy May 2008 opinion denying the motion to dismiss in the separate California-based Countrywide subprime-related derivative lawsuit (about which refer here). Indeed, in her December 1 opinion in the securities lawsuit, Judge Pfaelzer even quotes her prior opinion in the derivative lawsuit.

 

If Judge Pfaelzer did not tip her hand about her views of the securities case in her prior opinion in the derivative case, she certainly did in the opening overview section of the December 1 opinion, in which she stated that the amended complaint’s allegations.

 

present the extraordinary case where a company’s essential operations were so at odds with the company’s public statements that many statements that would not be actionable in the vast majority of cases are rendered cognizable to the securities laws.

 

As an illustration, she notes that "descriptions such as ‘high quality’ are generally not actionable"; however, in this case, the amended complaint "adequately alleges that Countrywide’s practices so departed from its public statements that even ‘high quality’ became materially false and misleading" and "to apply the puffery rule to such allegations would deny that ‘high quality’ has any meaning."

 

Judge Pfaelzer’s view of the case may also be seen from her response to defendants’ arguments that allegations of falsity after the third quarter of 2007 should be barred because by that time the company was "forced to admit the poor quality of the mortgage loans." Judge Pfaelzer states that this argument "borders on the frivolous" because the 3Q07 disclosures "failed to correct all misrepresentations" but instead "the truth only gradually leaked."

 

That is not to say that Judge Pfaelzer is complimentary of the plaintiff’s pleading; to the contrary, she states that she "would have appreciated a complaint that is more concise, less redundant and better organized." She also noted that she "has little patience for excess – and 416 pages is excessive."

 

Having set the stage, Judge Pfaelzer then proceeded to undertake a painstaking review of each of the defendants’ dismissal grounds, substantially rejecting most of them.

 

Among her other noteworthy observations, and one that may reverberate in other subprime cases, is one she makes in connection with the defendants’ arguments based on market forces. Defendants in this case, as in many of the subprime cases, sought to argue that the company’s woes were largely due to marketwide forces. As Judge Pfaelzer put it, "for the past year, almost all defendants have recited…that an ‘unprecedented’ external ‘liquidity crisis’ caused all (or most) of Countrywide’s decline."

 

Judge Pfaelzer noted that Countrywide’s shares declined only as the company’s deteriorating underwriting standards came to light, though "Countrywide held itself out for a long while as situated differently than from other subprime lenders" and "concurrently with corrective disclosures" made "continued misrepresentations and omissions" into early 2008.

 

It is true, Judge Pfaelzer notes, that "the domestic market shifts will raise complicated questions on damages." But, she also notes by the same token, the amended complaint raises the "inference" that the company’s deteriorating lending standards "were causally linked to at least some of the macroeconomic shifts of the past year." In any event, she concludes that at this stage the issue is whether the alleged violations caused a loss, not how much of the loss the violations proximately caused.

 

With respect to the amended complaints Rule 10b-5 allegations, Judge Pfaelzer’s opinion concludes that the plaintiffs "have created a cogent and compelling inference of a company obsessed with loan production and market share with little regard for the attendant risks, despite the company’s repeated assurances to the market."

 

In concluding that the amended complaint adequately alleges scienter, Judge Pfaelzer relies in large part on the allegations of insider trading as well as allegations concerning the individual defendants’ respective positions of responsibility combined with their access to detailed underwriting information. Her analysis of the scienter issues relies heavily on her prior analysis of scienter in her May 2008 opinion in the Countrywide subprime-related derivative suit, and indeed, she repeatedly cites and even quotes her prior opinion.

 

In connection with the insider trading allegations, Judge Pfaelzer placed particular emphasis on the coincidence of the insiders’ sales with the company’s initiation of a share repurchase program financed with outside capital. The inference is that the company was raising funds to buy shares to keep the share price up so that the insiders could sell profitably.

 

She also specifically noted (as she did in her prior opinion in the derivative case) that former CEO Angelo Mozillo was increasing his sales, and even modifying his Rule 10b5-1 trading plan to facilitate further sales, as the company increased its share repurchases. She repeated her conclusion from the derivative suit that these actions defeat the very purpose of Rule 10b5-1 plans.

 

Based on the stock sales and the individuals’ positions within the company she concluded that there were no plausible innocent inferences (except to the extent that some of the chronologically earlier allegations involve periods prior to which certain individuals could have learned particularized information).

 

Finally, with respect to the loss causation issue, Judge Pfaelzer concluded that the amended complaint did not fail to establish loss causation merely because the corrective disclosures and the resulting stock declines were piecemeal. Citing the Ninth Circuit’s decision from earlier this year in the Gilead case (about which refer here), Judge Pfaelzer concluded that "loss causation is not precluded by a series of disclosures; serial disclosures just make it more difficult for plaintiffs as a practical matter."

 

In its overall effect, Judge Pfaelzer’s December 1 opinion is a substantial rebuttal to the suggestion I raised in an earlier post (here) that plaintiffs may not be faring well in the subprime cases. At a minimum, the opinion establishes that certain cases will survive preliminary motions and that the overall economic decline is, in and of itself, not a barrier to the assertion of securities violations, at least in certain cases.

 

The December 1 opinion may also be of in connection with attempts to hold companies’ auditors responsible for subprime problems. Though Judge Pfaelzer did allow the plaintiffs leave to amend their allegations against KPMG, her analysis in this opinion suggests that plaintiffs could well have difficulty presenting allegations that withstand scrutiny. Her analysis of the allegations against KPMG could have significance in connection with attempts in other subprime cases to hold auditors responsible. (Her dismissal of Grant Thornton is less relevant, as the dismissal largely relates to the firm’s early and limited involvement in the events described in the complaint.)

 

In any event, I have added Judge Pfaelzer’s opinion to my table of subprime case dispositions, which can be found here.

 

One final note, as I discussed here, in October 2008, the Delaware federal court dismissed the Delaware-based Countrywide subprime-related derivative lawsuit, due to the plaintiff’s lack of standing to pursue the case following Bank of America’s acquisition of Countrywide. It appears that the Delaware court’s decision had no impact of any kind on Judge Pfaelzer’s consideration of the motions to dismiss in the Countrywide securities suit.

 

Special thanks to a loyal reader for alerting me to the December 1 opinion.

 

The subprime scapegoating process has resulted in a round up of the usual suspects, including directors and officers of publicly traded companies. But among other targets many aggrieved parties seem particularly keen to blame in the subprime debacle are the rating agencies.

 

In prior posts (most recently here), I have noted the securities claims that some investors are trying to assert against the rating agencies, notwithstanding the substantial legal barriers (about which refer here) that may exist to the rating agencies’ liability.

 

The urge to try to hold the rating agencies responsible has reached a creative new level in the action filed on November 17, 2008 by the National Community Reinvestment Coalition, a national coalition of over 600 community-based housing advocacy organizations, against Fitch’s and Moody’s. The complaint was filed with the Department of Housing and Urban Development’s (HUD) fair housing and equal opportunity unit.

 

The complaint, which can be found here, purports to be brought under the Fair Housing Act of 1968 and alleges that the defendants "facilitated, encouraged and profited from subprime loans that were designed to fail, due to unfair payment terms and borrower income levels that could not sustain home ownership based on those payment terms."

 

The complaint further alleges that the defendants "unlawful actions caused a disproportionate adverse impact on African Americans and Latinos." The defendants are alleged to have "facilitated…predatory real-estate transactions" through their "unwarranted ratings, which fueled and sustained subprime lending."

 

The defendants are also alleged to have "facilitated discriminatory conduct" because their "inflated ratings…allowed discriminatory securitized subprime loans to be originated, brokered and serviced." The defendants’ alleged role was "central" because "investors purchased securities based on their ratings," as a result of which the defendants "profited significantly." Further, the defendants "knew or should have known that the predatory practices permeated the subprime securitization market."

 

The complaint seeks a declaratory judgment that the rating agencies violated the FHAA, a permanent injunction requiring the agencies to "take all affirmative steps necessary to remedy the effect of the illegal, discriminatory conduct"; and to award NCRC compensatory damages "for the frustration of mission and diversion of resources" the defendants’ conduct allegedly caused.

 

In its November 18, 2008 press release announcing the complaint (here), NCRC states that if HUD "does not adequately address the issues in the complaint," then the NCRC "will consider civil litigation."

 

According to a November 29, 2008 Washington Post article describing the complaint (here), the complaint did not name S&P as a third defendant, because the NCRC is "in discussions" with S&P. However, the article also quotes an NCRC source as saying that if discussions with S&P are "unsatisfactory," the NCRC could institute a separate proceeding against S&P.

 

The NCRC complaint belongs in a category with the nuisance lawsuit the City of Cleveland filed against the major investment banks (about which refer here). Both actions involve novel legal theories, and both attempt to scapegoat downstream deep pockets for the consequences of upstream transactions. Both depend entirely on simplistic causation analyses that disregard the multitude of causes that contributed to the subprime mess.

 

These blame casting exercises may gratify claimants or even provide catharsis, but these exercises in creative lawyering (and I do not mean that as a compliment) will do little, other than contributing friction costs, to affect the current deplorable conditions in the housing market. To be sure, there are no easy solutions in these circumstances, but simplistic litigation definitely does not help.

 

Where Were the Auditors?:  A December 1, 2008 CFO.com article entitled "Subprime Suspects" (here) takes a look at the likelihood that litigants will seek to blame auditors for the financial meltdown. The article notes that while claimants undoubtedly will pursue the auditors, "it’s far from clear what burden they will bear – or even what they did wrong."

 

One school of thought claims the auditors "are at fault for overlooking inflated asset valuations during the mortgage bubble." The other camp says that the "auditors were doing fine until they forced banks to take overly severe write-downs on assets, based on fears that they would face punishment from regulators."

 

The article suggests that the audit firms "may yet prove bulletproof" because of the difficulty even proving misconduct at their financial institution clients. The firms, however, are likely to face further litigation and are in any event facing their own challenges as a result of the disruptions in the financial and economic marketplace.

 

Investors Sue Over Mortgage Loan Workouts: In an earlier post (here), I noted the objections investors have raised to the various mortgage modification proposals designed to provide relief to distressed homeowners. I specifically noted concerns investors had raised about the Bank of America’s regulatory settlement in which the bank proposed to restructure over 400,000 mortgages the Countrywide Financial Corporation had originated prior to being acquired by BoA.

 

As discussed in a December 1, 2008 Business Week article (here), mortgage investors have now initiated a purported class action lawsuit alleging that the proposed modification of the Countrywide mortgages is illegal. The article quotes the lawsuit plaintiff as saying "while these loan adjustments may help to keep struggling borrowers in their homes," the alterations "run the risk of permanently damaging the secondary market for housing finance."

 

The investor ‘s lawsuit in New York (New York County) Supreme Court seeks a judicial declaration that under the terms governing the mortgage trust holding the securitized mortgages, "Countrywide is required to purchase any loans on which it agrees to reduce the payments." A copy of the state court complaint can be found here.

 

Special thanks to David Grais of the Grais & Ellsworth firm (which represents the plaintiff in the declaratory judgment action) for providing a copy of the state court complaint.

 

The investors clearly are committed to having their concerns about the mortgage modifications heard. The political pressure to provide mortgage relief is substantial. However, there does seem to be reason to be concerned whether future investors will be interested in investing in this class of assets if the investment agreements can be unilaterally altered.

 

Lehman Excavation: The November 30, 2008 issue of New York Magazine has a cover article entitled "Burning Down His House" (here) about the fall of Lehman Brothers and the role of Lehman CEO Richard Fuld in the firm’s collapse. The article raises the question whether Fuld is a dupe or a victim; the article says:

 

He held on to 10 million shares of Lehman stock until the end and lost almost $1 billion – "He drank the Kool Aid," said one executive. And consensus grows that the Lehman fall was one of Treasury Secretary Henry Paulson’s and Fed chairman Ben Bernanke’s biggest mistakes.

 

Professor Ribstein, on his Ideoblog (here), citing the article’s statement that Lehman was "in a financial condition that was even worse than critics suspected," interprets the article as suggesting that Fuld may be the "next loser in the corporate crime lottery."

 

Hat tip to the Securities Docket blog (here) for the link to the New York Magazine article.

 

In a November 26, 2008 opinion (here), the Ninth Circuit affirmed the lower court’s dismissal of a lawsuit asserting securities law violations against InVision and certain of its directors and officers based on FCPA-related disclosures. The case is noteworthy not only for its involvement of FCPA-related allegations, but also for the appellate court’s consideration of "collective scienter" issues, as well as of the significance of Sarbanes-Oxley certification issues.

 

Background

On March 15, 2004, InVision announced it would be acquired by GE in a cash-for-stock transaction. That same day, the company filed its annual filing on Form 10-K to which the merger agreement was attached. On July 30, 2004, InVision announced that an internal investigation had revealed possible violations of the Foreign Corrupt Practices Act (FCPA). The company voluntarily reported the activities to the SEC and the DOJ. The company later entered negotiated arrangements with the DOJ and the SEC (refer here). GE later consummated the pending merger.

 

Shortly after InVision announced the FCPA concerns, shareholders initiated a securities class action lawsuit against the company and certain of its directors and officers. (Refer here for further background regarding the case). The plaintiffs based their claims on three alleged misstatements in the merger agreements, which InVision had attached to its 10-K.

 

The plaintiffs alleged that the merger agreement misleadingly stated that the company was "in compliance … with all applicable law"; in compliance with the "books and records" provision of the FCPA; and that that neither the company nor any of its officers, directors or employees had knowledge that the company had violated the FCPA’s antibribery provisions.

 

The district court dismissed the complaint and the plaintiffs appealed.

 

The Ninth Circuit’s Decision

The appellate court essentially assumed that the plaintiff had satisfied the requirement to plead falsity with respect to the three alleged misrepresentations stating that "even if [the plaintiff, Glazer] properly pled falsity, the district court’s dismissal would still be appropriate if Glazer failed to plead scienter adequately with respect to the three statements."

 

In order to satisfy the scienter requirement, the plaintiff urged the Ninth Circuit to adopt the "collective scienter" theory, following the Second Circuit’s recent decision in the Dynex Capital case (refer here) and the Seventh Circuit’s recent decision in the Tellabs case (refer here). Under this theory, as articulated by the Seventh Circuit, "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud."

 

After reviewing the case law concerning corporate securities liability, including its own prior decision in the Nordstrom v. Chubb case (a decision that will be familiar to many of this blog’s readers), the Ninth Circuit ultimately concluded that this case did not require the court to decide whether or not to adopt the theory of collective scienter.

 

The court concluded that because of "the limited nature and unique context of the alleged misstatements" involved in the case, the "collective scienter" issue was not before the court. In reaching this conclusion, the court noted that

 

Glazer rests its securities fraud claim on three statements, all of which appear in a sixty-page legal document. If the doctrine of collective scienter excuses Glazer from pleading individual scienter with respect to these legal warranties, then it is difficult to imagine what statements would not qualify for an exception to individualized scienter pleadings. In fact, because the merger agreement warranted that the company was in compliance "with all laws," then under the collective scienter theory urged by Glazer, so long as any employee at InVision had knowledge of the violation of any law, scienter could be imputed to the company as a whole. This result would be plainly inconsistent with the pleading requirements of the PSLRA.

 

Accordingly, the Ninth Circuit held that in order to succeed on his claim, the plaintiff had to establish that individual defendants acted with scienter in making the statements in the merger agreement. The court said that "we see no way that [the defendant] could show that the corporation, but not any individual [director or officer] had the requisite intent to defraud." Only the company’s CEO and CFO had signed the merger agreement, and the plaintiff alleged scienter only with respect to the CEO, Magistri.

 

The court found with respect to Magistri, however, that Glazer had not pled any facts to demonstrate that "Magistri was personally aware of the illegal payments or that he was actively involved in the details of the details of InVision’s Asian sales."

 

The Ninth Circuit also refused to infer scienter from the CEO’s and the CFO’s signature of the Sarbanes-Oxley certifications, holding that the mere signature, without more, is insufficient to raise a strong inference of scienter.The Ninth Circuit followed prior decisions of the Eleventh and Fifth Circuits, concluding that there was no evidence that the SOX certification requirements were intended to alter the PSLRA’s pleading requirements. The Court said that "the Sarbanes-Oxley certification is only probative of scienter if the person signing the certification was severely reckless in certifying the accuracy of the financial statements.

 

Discussion

The Ninth Circuit’s decision is noteworthy for its discussion of the "collective scienter" issue, although in the end it is of limited significance on this point given the court’s conclusion that it did not need to reach that issue. The decision is also noteworthy for its discussion of the Sarbanes-Oxley certification issue, but in that respect it also merely followed existing precedent.

 

But perhaps the greatest significance about the Ninth Circuit’s opinion may be what it suggests about securities cases based on FCPA-related disclosures. The Ninth Circuit’s refusal to allow the claim to proceed in the absence of allegations that senior officials were aware of the improper conduct could present a significant hurdle for FCPA-related securities claims, at least in the circuits that have not adopted the "collective scienter" theory.

 

As the Ninth Circuit noted in the InVision case, "the surreptitious nature of the transactions creates an equally strong inference that the payments would have deliberately kept secret – even within the company." Obviously, payments of this kind invariably are of a surreptitious nature and of a kind that would be kept secret, even within the company. The implication is that in order for a securities claim alleging FCPA-related disclosures to survive the initial pleadings stage, the claimants may have to plead that the company officials who prepared the company’s public disclosures were aware of the improper activities.

 

In prior posts (most recently here), I have noted the increasing prevalence of follow-on civil litigation accompanying FCPA investigations, including the increasing frequency of follow-on securities litigation alleging misrepresentations in the FCPA-related disclosures. The Ninth Circuit’s decision in the InVision case suggests that, at least in jurisdictions that have not recognized the collective scienter theory, the ability of these follow-on securities lawsuits to get past the pleading stage may depend on the existence of allegations that senior company officials were aware of the improper payments. Given the invariably "surreptitious nature" of these payments, claimants may find this a challenging requirement to satisfy.

 

The SEC Actions blog has a thorough analysis of the Ninth Circuit’s discussion of the pleading issues in the InVision case, here. The FCPA Blog also has a good discussion of the case, here.

 

Special thanks to Neil McCarthy of Lawyerlinks.com for providing me with a copy of the Ninth Circuit’s opinion.

 

Another New Wave Securities Lawsuit: In a recent post (here), I noted that there have been several recent securities class action lawsuits in which the companies involved have been hit with significant losses due to wrong way bets on commodities or currencies.

 

The latest example of this type of securities litigation involves a case filed on November 26, 2008 in the Southern District of Florida against Brazilian forest products manufacturer Aracruz Cellulose S.A. and certain of its directors and officers on behalf of investors who purchased the company’s American Depositary Receipts on the NYSE., as well as purchasers of the company’s common stock, which trades on the Sao Paulo Bovespa.

 

According to the plaintiffs’ lawyer November 26 press release (here), the complaint alleges that

 

During the Class Period, Aracruz entered into undisclosed currency derivative contracts to purportedly hedge against the Company’s U.S. dollar exposure. The Company characterized the use of these contracts as protection against foreign interest rate volatility and assured investors that this type of trading did not represent "a risk from an economic and financial standpoint." However, these contracts violated Company policy in that they were far larger than necessary to hedge normal business operations. As a result of Aracruz’s clandestine and speculative currency wagers, credit rating agencies downgraded Aracruz, the Company’s CFO resigned, and Aracruz’s stock suffered a severe decline, plummeting to the lowest levels in 14 years.

 

As I noted in my prior post, many companies were also exposed to sudden and unexpected losses by dramatic changes in the commodities and currencies markets earlier this year. For example, the November 29, 2008 Wall Street Journal reported (here) on several airlines that have recently reported the negative impact from fuel cost hedges that generated huge losses. These kinds of developments and other unexpected fallout from the crisis roiling global financial markets are likely to affect a wide variety of companies, some of which may be subject to securities litigation.

 

It is interesting to note that the plaintiffs’ lawyers in the Aracruz case appear to have made a conscious decision to include within the class the Brazilian company’s common shareholders. Within this group are likely to be a number of shareholders domiciled outside the U.S. that bought their shares against the foreign company on a foreign exchange. The presence of these so-called "foreign-cubed" litigants could pose subject matter jurisdiction issues, at least as to those claimants.

 

My recent post discussing the Second Circuit’s recent "foreign-cubed" litigant ruling in the National Australia Bank case can be found here. The November 24, 2008 Southern District of New York decision granting the motion to dismiss the securities class action lawsuit that had been filed against Vodafone for lack of subject matter jurisdiction, in reliance upon the National Australia Bank decision, can be found here. (Note: Special thanks to the reader who pointed out that I had incorrectly referred to the Vodafone case as the Vivendi case. My apologies for any confusion.)

 

A recent appellate court opinion interpreting a D&O liability insurance policy securities exclusion carries some important reminders both about policy wording precision and about exclusionary language, and also raises some critical questions about the scope of coverage for securities claims generally.

 

In an October 27, 2008 opinion (here), the Eighth Circuit, applying Minnesota law, held in the In re SRC Holding Corp. case that there is no coverage under a D&O liability insurance policy containing a securities claims exclusion for claims made against a financial services company and certain of its directors and officer for alleged wrongful acts in connection with the company’s underwriting and sale of certain municipal bonds.

 

Following a description below of the case’s background and the appellate court’s holding, I discuss the implications of the Eighth Circuit’s decision.

 

Background

Between 1996 and 1999, Miller & Schroeder (M&S), a securities underwriter and broker, underwrote and sold $140 million of municipal bonds. The bonds later defaulted and the bond investors initiated lawsuits and arbitration proceedings against M&S and certain of its directors and officers, alleging breaches of federal securities laws and other violations. M&S ultimately went into bankruptcy.

 

M&S’s D&O insurance carrier denied coverage for the claims. The bankruptcy trustee initiated a lawsuit against the D&O insurer alleging breach of contract and seeking a judicial declaration of coverage. The individual M&S directors and officers intervened in the trustee’s action.

 

The bankruptcy court held that the policy exclusion on which the insurer relied to deny coverage did not preclude coverage for all of the claims and that the carrier must defend the individuals against all claims. The district court affirmed the bankruptcy court’s ruling and the carrier appealed.

 

The Eighth Circuit’s Decision

On appeal, the carrier argued that the district court erred in finding that the policy required the carrier to provide the directors and officers with defense cost coverage and indemnification for the bond investors’ claims.

 

The carrier relied on Endorsement No. 3 to the policy, which provides that:

 

In consideration of the premium charged, this Policy does not apply to any Claim based on, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving any actual or alleged violation of:

(1) the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, any other federal law, rule or regulation with respect to the regulation of securities, any rules or regulations of the United States Securities and Exchange Commission, or any amendment of such laws, rules or regulations; or

(2) any state securities or "Blue Sky" laws or rules or regulations or any amendment of such laws, rules or regulations; or

(3) any provision of the common law imposing liability in connection with the offer, sale or purchase of securities.

 

The district court held that this exclusion precluded coverage only for M&S’s sale of its own securities, but not otherwise. In reaching this conclusion, the district court relied in part on the testimony of the insurance broker who sold the policy, who testified, according to the appeals court, that "this standard-form securities exclusion is typically intended to exclude coverage for liability resulting from the insured’s sale of its own stock."

 

As the appeals court paraphrased the district court’s logic, because the provision had a "typical effect," the meaning of the provision "must accord with that typical effect." The district court said that this was the only interpretation that "makes sense."

 

The appeals court held, however, that the district court erred in relying the broker’s testimony. Because the district court held (correctly in the appellate court’s view) that the provision is unambiguous, it was erroneous as a matter of Minnesota law for the court to rely on extrinsic evidence in interpreting the provision.

 

The Eighth Circuit said that "the effect of [the securities exclusion] as it may be generally applied in practice is not the legal authority that governs our coverage inquiry here; it is the mutually agreed-upon policy’s plain language that binds [the parties] in the first instance." The appeals court noted that

 

Sophisticated business entities who rely on experts to advise them are best suited to determine what makes the most economic sense and the language they have mutually negotiated and agree to is the best evidence of what those parties intended.

 

The appeals court held that the endorsement is "not limited to claims arising out of M&S’s sale of its own securities," as such a limitation "is nowhere to be found in its language."

 

The appeals court also rejected the suggestion that this interpretation was inconsistent with other provisions in the policy.

 

The insureds argued further that in any event coverage for claims against them for alleged violations of NASD rules were not precluded, and therefore that the carrier was obliged to fund the defense, even as to non-NASD proceedings.

 

The appeals court rejected this argument as well, in reliance on the Endorsement No. 3’s broad preamble ("based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving…"), as well as the policy’s provisions broadly treating interrelated matters as a single claim.

 

Because the alleged NASD violations "arise out of, flow from and have their origins in the same set of operative facts" as the claims alleging violations of the securities laws, for which coverage is broadly excluded under the policy, they fall "well within the ‘arising out of’ exclusionary language of Endorsement No. 3."

 

The Wiley Rein law firm, which represented the carrier before the appellate court, has a detailed memorandum here summarizing the Eighth Circuit’s decision is greater detail.

 

Discussion

The Eighth Circuit’s ruling is noteworthy in and of itself, as a federal appellate court decision vigorously holding that insurance policies negotiated between sophisticated parties must be interpreted strictly according to their terms.

 

The opinion also represents a cautionary tale for practitioners in this area, and it is well worth considering more fully in that light.

 

None of my remarks are meant in any way as a criticism of the broker involved. Clearly, the broker’s view of how this policy should operate had a substantial basis, as both the bankruptcy court and the district court adopted the broker’s interpretation.

 

However, the Eighth Circuit’s opinion is a harsh reminder that, notwithstanding what the common understanding may be about the meaning or operation of policy provisions, ultimately courts will look at a policy‘s actual language. As the Eighth Circuit’s opinion demonstrates, a court’s policy interpretation may or may not coincide with common understandings or expectations. For practitioners in this area, the appellate court’s ruling underscores that what matters is wording not intent.

 

In addition, the court’s reliance on the breadth of Endorsement No.3’s exclusionary preamble is a reminder of the inclusive nature of this type of omnibus language. The Eighth Circuit found that the use of this broad preamble substantially extended the reach of the provision’s exclusionary effect, which represents its own reminder to practitioners of the critical importance of the way in which policy provisions are framed, particularly policy exclusions.

 

A critical part of the coverage dispute here relates to the fact that the securities violations alleged arose not in connection transactions involving the insured company’s own securities. This aspect of the dispute raises a more general question about how, in the absence of a securities claim exclusion, D&O insurance policies should respond to claims of securities law violations asserted by persons other than the insured company’s own shareholders.

 

There have been some high profile 2008 examples of securities lawsuits filed by persons other than the defendant company’s own shareholders. The numerous auction rate securities claims represent one example. Another example is the securities class action lawsuits filed against, among others, Hexion Specialty Chemical and certain of its directors and officers by shareholders of Huntsman Corporation. The Huntsman shareholders alleged that the Hexion defendants "deceived the investing public regarding Hexion’s efforts and intentions with respect to the merger with Huntsman." (Refer here for further background about the Hexion claim).

 

These recent examples, as well as the M&S case discussed above, underscore the possibility of securities allegations by persons other than a company’s own shareholders. These kinds of claims can arise not only in connection with financial companies, like M&S and the companies involved in the auction rate securities cases, but can also involve non-financial companies, like Hexion.

 

Questions of policy coverage for these types of securities lawsuits potentially could be significant not only in connection with the type of exclusionary language in the M&S case, but also in connection with the definition of "securities claim" found in the typical D&O insurance policy.

 

There are standard formulations for the definition of the term "securities claim." One formulation is oriented toward claims arising under the securities laws and the other is oriented toward claims involving the issuer’s securities or the issuer’s securities holders.

 

Definitions of the term "securities claim" oriented toward the securities laws themselves will extend more broadly without respect to who has asserted a claim and are more likely to encompass securities lawsuits filed by persons other than a company’s own shareholders.

 

Definitions of the term "securities claim" tied to claims involving the company’s own securities, rather than more broadly to claims involving the securities laws generally, could be interpreted more narrowly with respect to securities lawsuits brought by persons other than the company’s own shareholders.

 

All of which begs the question: how should the policies respond to securities lawsuits against insured persons filed by claimants other than the company’s own shareholders? In my view, because these claims allege wrongful acts by persons insured under the policies, they represent precisely the kind of litigation for which the policy should provide coverage. Of course, whether any particular policy will respond to this kind of claim depends on the actual policy language.

 

Financial Collapse: The Board Game: According to a November 28, 2008 Financial Times article entitled "Icelanders Collapse in Laughter" (here), some Icelanders, tapping into their typically "darkly ironic sense of humor" have developed a board game "that takes a grimly comical swipe at the financial crisis that has devastated the economy."

 

Players roll dice and move around the game board while drawing cards that, for example, allow them to buy a private jet or obtain a foreign loan, or perhaps go bust. Icelanders have been suggesting additional content for the cards via the Internet. Among other cards suggested is one reading "Go to demonstrate at parliament, stop to buy some eggs to throw, only to realize that prices have gone up so much you can’t afford them."

 

FDIC Report: More Bank Failures Coming?: The FDIC’s Quarterly Banking Profile for the third quarter 2008 (here), released on November 25, 2008, paints a dismal picture of the banking industry.

 

Among other things, the Report notes that during the third quarter the number of insured institutions on the FDIC’s "Problem List" increased from 117 to 171, and the net assets of "problem" institutions rose from $78.3 billion to $115.6 billion. This represents the first time since the middle of 1994 that assets of "problem" institutions have exceeded $100 billion.

 

These grim statistics suggest further bank failures ahead. A November 25, 2008 CFO.com article discussing the FDIC’s report (here) quotes FDIC chairperson Sheila Bair as saying "we expect more banks to fail."

 

In its November 25 press release (here), the FDIC also notes that "community banks – those with total assets of under $1 billion – are beginning to exhibit stresses similar to those facing the industry as a whole." However, the press release also comments that "capital levels and reliance on retail deposits remain higher at those banks than the industry average."

 

My recent post detailing the latest bank failures and possible implications can be found here. My earlier post addressing the possibility of a new wave of "dead bank" litigation can be found here.

 

Big FCPA Penalties Ahead: According to statements reported in a November 25, 2008 Law.com article (here), the SEC’s deputy enforcement division director expects the imposition in the next two to six months of Foreign Corrupt Practices Act (FCPA) penalties that will "dwarf the disgorgement and penalty amounts that have been obtained in prior cases."

 

The biggest FCPA penalty to date is the $44.1 million settlement Baker Hughes paid last year to settle charges of bribery and other improper conduct in six countries (about which refer here).

 

One probe attracting particularly attention is the investigation involving Siemens, which in 2006 disclosed that it had uncovered more than $1 billion in bribes paid in over a dozen countries in order to win contracts. The potential magnitude of this fines and penalties Siemens could be facing may be inferred from Siemens’ recent 1 billion euro provision for the expected settlement with U.S. and German authorities of bribery allegations (about which refer here).

 

A "twist" noted with respect to the forthcoming cases is that a "significant" number involve violations that were not self-reported by the companies. In the recent past, many of the FCPA enforcement cases have arisen when companies themselves discovered and reported violations. However, many of the newer cases "were generated by other leads," such as the SEC’s own investigatory work or whisteblowers.

 

As I have noted in prior posts (most recently here), one of the risks increasingly associated with FCPA enforcement actions is the threat of follow-on civil litigation. For example, Siemens itself is the subject of a purported shareholders’ derivative suit in the U.S. related to its ongoing bribery investigations. As the scale of FCPA enforcement activity grows, the threat of FCPA-related civil litigation will also increase.

 

Litigation Funding Developments: In a November 2008 report on Transatlantic Trends in Business and Litigation (here), the Lloyd’s insurance market, among other things, examines the growing prevalence of third-party litigation funding, whereby investors financially support a claimant in return for a share of the damages. (My recent post discussing the role of litigation funding in the Australian class action against Centro Properties can be found here.)

 

The Lloyd’s report concludes that businesses on both sides of the Atlantic "should expect third party litigation funding to rise," and that "current economic conditions may actually accelerate the growth."

 

Meanwhile, a start-up venture is planning to try to launch an IPO in what may be one of the more creative attempts to try to fund litigation. According to a November 18, 2008 Pensions & Investments article (here), VR Holdings, Inc. is planning the offering to try to "provide liquidity" for the suit’s 2,500 claimants, 2,000 of whom are older than 65 and concerned that they may not live to see the suit settled. (For reasons specified below, these concerns may be well founded.)

 

According to the company’s President, the IPO will "give the claimants a vehicle to hopefully generate some funds for themselves." The offering is a "way to sell stakes in the eventual payout," in that the shares will be "like an option that sells for around $1 but has a potential upside of $12 or $14." (I guess this fellow believes the company is not yet in the quiet period.)

 

The suit, which has been filed against several investment firms, alleges that the defendants conspired to "take over, liquidate, and bankrupt" (I presume not necessarily in that order) a concert T-shirt maker.

 

In addition to possible legal objections to this litigation funding arrangement, the prospective IPO may face a more immediate practical obstacle. That is, the case, which was pending in the Northern District of Illinois, has already been dismissed with prejudice. It is unclear from the article whether a timely notice of appeal was filed. (No, I am not making any of this up.)

 

The prospective IPO sponsors may want to reconcile themselves to the possibility that investors may not exactly fall all over themselves to get a piece of this action.

 

And Finally: The Securities Docket blog has an interesting interview (here) with trailblazing blogger Mike O’Sullivan of the Munger, Tolles & Olson law firm, whose trendsetting Corp Law Blog showed the way for many blogs that followed, including The D&O Diary. After running his blog for some time, O’Sullivan ultimately stopped adding new posts in 2004.

 

In discussing the reasons why he discontinued the blog, O’Sullivan notes that he was facing "existential doubts" of the kind that will be familiar to any blogger, including yours truly: "Why am I doing this? What do I really have to say? Why are you reading this?"

 

In commenting on the current crop of corporate and securities blogs, O’Sullivan mentions that one blog he "slavishly" follows is Broc Romanek’s (and now Dave Lynn’s) Corporate Counsel blog (here), which I mention here because it is a blog that I read every day as well.

 

Hats off to Bruce Carton for the interview and for his new Securities Docket site (here) which has quickly also become a daily (or even several times daily) must-read.

 

Blogging Off: The D&O Diary likely not be adding any new posts for the next few days. We will resume our "normal" publication schedule after December 1.

 

The closure of three more banks this past Friday night underscores the difficult environment now facing many banks and also suggests that the pace of bank failures is accelerating. These developments may also have important implications for the D&O insurance placement market banks may have to confront in the months ahead.

 

On November 21, 2008, the FDIC announced (here) that state bank regulators had closed The Community Bank of Loganville, Georgia and that the FDIC has been named as a receiver.

 

The FDIC also announced on November 21, 2008 (here) that as part of an FDIC-brokered deal, U.S. Bank had acquired the banking operations of Downey Savings and Loan Association of Newport Beach, California and PFF Bank and Trust of Pomona, California.

 

With the addition of these three banks, the total number of 2008 bank closures now stands at 22. The FDIC’s complete list of all bank failures since October 2000 can be found here. The 2008 year-to-date total represents the highest annual total since 1993 and is already double the highest annual number of bank failures for any year reflected on the FDIC table. (There were 11 bank failures in 2002).

 

Moreover, the pace of bank failures has accelerated as the year has progressed. 18 of the 22 bank failures in 2008 have taken place since July 1, 2008, and nine have occurred just since October 1, 2008. The November 2008 month-to-date total of five bank failures is already the highest number of failures for any month reflected on the FDIC table.

 

In addition, as noted in a November 22, 2008 Washington Post article (here), the most recent bank failures expanded "what is by far the most expensive crop of bank failures in modern American history." Downey, which had $12.6 billion in assets is the third largest bank failure this year (after Washington Mutual and IndyMac). The FDIC projects that it will spend $2.3 billion as a result of the three most recent closures. The FDIC also projects that it will spend almost $15 billion total on the year-to-date 2008 closures. The Post article notes that this 2008 annual amount is "more than twice the total of any previous year."

 

The states with the highest number of 2008 closures so far are California (4), Georgia (3), Nevada (3), and Florida (2), which may be expected due to the well-chronicled trouble in the housing markets in those regions. But banks in states outside these more notoriously troubled areas are also failing, including, for example, banks in Missouri, Minnesota, Kansas and Illinois. In other words, while the banks in the states with the most significant housing trouble are faring poorly, banks in other states may also face challenges.

 

At this point, the reasonable presumption is that there will be further bank failures to come. It seems unlikely that there will be hundreds of failures as occurred during the S&L crisis, but the number of failures yet to come could be substantial. The slowing economy and the likelihood of continued deterioration in the residential and commercial real estate sectors suggest that the pace of bank failures could continue well into 2009 and even beyond.

 

One of the possible consequences from a wave of bank failures could be surge of related claims. I have previously noted (here) the possibility that we could be headed toward a new era of "dead bank" litigation. It is hardly surprising then that D&O underwriters’ concerns regarding banks and other traditional lending institutions are increasing, even with respect to those, such as community banks, that have seemingly avoided many of the problems of the current financial crisis.

 

Very recently, it has become apparent that the D&O underwriting industry has taken a much more defensive approach to banking institutions, again even including in some instances institutions such as community banks. To be sure, financial institutions in general have faced greater underwriting scrutiny for some months now as the credit crisis has unfolded. Recently, the level of scrutiny has increased and the scope of the scrutiny has widened. The carriers that are active in this space are taking a much harder line, and have shown an unaccustomed willingness to walk away even from long-standing relationships.

 

These carriers’ apparently altered underwriting stance has changed the insurance environment for many banking institutions. Some smaller banks that have for years enjoyed significant competition among D&O underwriters may now find that they face a changed situation. Banks that are facing operational or financial challenges may now find insurance placement difficult.

 

The changed insurance underwriting environment for banks and other financial institutions is part of the evidence some commentators have cited to support their view that a harder D&O insurance market may be approaching (refer, for example, here). Whether the overall D&O insurance market will harden remains to be seen. But it seems likely that the D&O insurance market for financial institutions, at least, could become challenging as we head into 2009.

 

Court Rejects Starr Foundation Lawsuit Against Former AIG CEO, CFO: According to a Bloomberg article (here), on November 17, 2008, New York Supreme Court Justice Charles Ramos dismissed a lawsuit that the Starr Foundation had filed against former AIG Chairman and CEO Martin Sullivan and former AIG CFO Steven Bensinger, calling the case a "waste of time."

 

Starr’s May 2008 lawsuit contended that the defendants had "fraudulently reassured" Starr in August 2007 that AIG’s "risk of loss from its credit-default swap portfolio was remote." Starr alleged that it would have sold its entire portfolio of AIG stock if it had known the extent of the company’s subprime exposure.

 

Starr’s President, Florence Davis, testified that the foundation had been "reassured" by the defendants’ August 2007 remarks. However, in an affidavit, Davis acknowledged that the foundation sold more than 12 million AIG shares, worth almost $1 billion, between August and October 2007, and only stopped because the company’s share price fell below $65 a share.

 

Judge Ramos questioned Davis at the November 17 hearing, seeking to clarify this seeming inconsistency in Davis’s comments. Judge Ramos apparently found Davis’s answers less than satisfying. The Bloomberg article reports that Judge Ramos told Davis "You are being more than difficult. You are being contemptuous, and you are very, very close to contempt of court and I’m talking criminal contempt. Now answer my question."

 

According to the Bloomberg article, following this barrage, Davis asked for a break to get an asthma inhaler.

 

Under questioning from the defendants’ counsel, Davis also testified that the foundation did not sell its remaining shares in February 2008, even after AIG had disclosed its subprime woes, because the price was "too low." Defense counsel argued that this showed that the foundation based its decisions to sell or to hold on its own criteria, and not based on the defendants’ disclosures.

 

Just an aside, but do you suppose that the Starr Foundation’s Chairman, Hank Greenberg, who was also Sullivan’s predecessor as AIG’s Chairman and CEO, had anything to do with the foundation’s pursuit of this litigation against the defendants? Nah….

 

And Finally: Speaking of AIG, the Delaware Corporate and Commercial Litigation Blog (here) has posted links to video clips of portions of the recent Delaware Chancery Court hearing regarding the AIG derivative litigation about the government’s bailout of the company. The footage is a reminder that the expression "courtroom drama" does not apply to everything that happens in a courtroom.

 

Though multi-billion dollar auction rate securities settlements were announced to great fanfare some months ago, litigation involving auction rate securities continues to mount (as I previously noted, here). Two recently filed proceedings highlight the fact that notwithstanding the settlements, many investors’ grievances are yet to be addressed.

 

As a result, while regulatory authorities continue to press for additional settlements, other investors may feel that the settlements do not remedy their particular claimed harm, and may seek to pursue individual litigation, in effect opting out of the regulatory settlements already reached.

 

 

I note that I raised the possibitliies for these further disputes when the settlements first emerged, here.

 

 

The Hutchinson Auction Rate Securities Lawsuit

 

First, on November 14, 20008, Hutchinson Technology filed a securities lawsuit in Minnesota federal court against UBS and related entities, accusing the defendants of fraud in connection with their purchase on Hutchinson’s behalf of approximately $70 million in illiquid auction rate securities under a discretionary cash management agreement.

 

 

Hutchinson’s complaint, which can be found here, alleges that UBS sought to protect its own balance sheet by seeking “secretly to shift the risk from its swelling inventory of ARS onto clients like Hutchinson by pitching ARS as safe, liquid, ‘cash equivalent’ investments while knowing that, in fact, the purported liquidity of the ARS had become an illusion.”

 

 

The complaint quotes extensively from UBS e-mails and other internal documents allegedly showing that the defendants had conflicts of interest with their own clients to whom they sold the securities, as well as a growing awareness of the dangers associated with a failing ARS marketplace. The complaint alleges that the defendants violated federal and state securities laws as well as other state statutory and common law duties.

 

 

What makes the Hutchinson complaint of particular interest is that it expressly acknowledges UBS’s August 2008 auction rate securities settlement, which the complaint also implicitly acknowledges applies by its terms to Hutchinson. However, the complaint alleges that the settlement “does not resolve the dispute between Hutchinson and UBS” in that the settlement’s terms “do not return Hutchinson to the position it would otherwise be in but for UBS’s fraud.”

 

 

Though the settlement contains UBS’s commitment to redeem the securities as par, “the purchases will take place over several years, and corporations with positions of more than $10 million (like Hutchinson) will not be able to start selling their position to UBS until June 30, 2010.” And thought the settlement required UBS to provide “liquidity loans,” any borrowing client would “remain obligated to repay the loan on demand even if the value of the ARS declines.”

 

 

Hutchinson’s complaint cites several alleged deficiencies with these arrangements. First, “it is uncertain whether UBS will have the means to satisfy its obligations or indeed survive as a firm.” (Ouch.) Second, Hutchinson “has needs for liquidity well in advance of that date,” including, for example, the need to redeem $150 million in convertible notes due in March 2010. Third, the value of Hutchinson’s ARS has “dropped considerably,” causing the company to mark down the securities on its balance sheet, with further writedowns potentially ahead, which in turn could have the effect of “potentially negatively impacting the price of its stock.”

 

 

Hutchinson is basically attempting to opt out of UBS’s regulatory settlement regarding the auction rate securities. Though the settlement promises eventually to make Hutchison whole, it is the word “eventually” that is giving Hutchinson concern. Hutchinson’s litigation objective may be discerned from its offer in its complaint to tender its auction rate securities investments “at par value plus all interest accrued.” Hutchinson wants its own deal, without having to wait, in effect contending that the delay itself constitutes an additional form of harm.

 

 

Hutchison may or may not succeed. Many of the harms it claims have not yet occurred, but merely threaten. But to the extent other investors perceive, like Hutchinson, that their interests are better served or will be advanced by separately litigating their claims rather than participating in the settlements, the utility of the regulatory settlements could be substantially undermined.

 

 

Because of this risk, UBS may have to vigorously contest Hutchison’s claim (and other claims like it) or face the prospect of a multitude in individual disputes and pressure to enter a multitude of individual deals that could bleed the company on a timetable accelerated from the more leisurely scheme contemplated in the regulatory settlements.

 

 

This potentially could become a process for the administration of a thousand cuts – and it potentially affects not just UBS, but Citicorp, Wachovia, Merrill Lynch and the other large institutions (or their successors in interest) that tried to effect a comprehensive solution to the auction rate securities debacle.

 

 

The Massachusetts Regulatory Action Against Oppenheimer

 

While the financial firms that have reached regulatory settlements could face continued litigation notwithstanding the settlements, other firms that have not yet reached settlements could face continued regulatory pressure to do so.

 

 

For example, on November 18, 2008, the Massachusetts Securities Division filed a complaint (here) to initiate an adjudicatory proceeding against Oppenheimer for alleged violations of state securities laws in connection with the company’s sales of auction rate securities to the firm’s clients in the state.

 

 

The complaint alleges that Oppenheimer “significantly misrepresented not only the nature of the ARS, but also the overall stability and health of the market when marketing the product to clients.” The complaint further alleges that “Oppenheimer executives and ARS Department personnel sold their own ARS as they learned that the market was in danger of imploding.”

 

 

The complaint, which was filed with the Office of the Secretary of the Commonwealth, seeks an order among other things, “requiring Oppenheimer to offer rescission of sales of ARS at par” and “requiring Oppenheimer to make full restitution to investors who already sold these instruments at less than par.” Basically, the complaint seeks to compel Oppenheimer to provide substantially the same relief as other firms previously have agreed as part of their regulatory settlements.

 

 

The one thing that is clear from these two new proceedings is that, despite the high profile settlements earlier this year, litigation surrounding the auction rate securities continues to mount. First, there are firms like Oppenheimer that have not yet reached regulatory settlements that will face pressure to do so. But second, there are continuing disputes, like those raised by Hutchinson, that continue even with respect to the firms that have already reached regulatory settlements.

 

 

If nothing else, it seems likely that the auction rate securities litigation will churn on for some time to come, with no end yet in sight.

 

 

There no longer seems to be a question whether European countries will adopt some form of collective action procedures. The questions now are what form the collective action mechanisms will take and to what extent will the processes will adapt or reject features of the U.S. class action model.

 

A November 6, 2008 article by NYU law professors Samuel Issacharoff and Geoffrey Miller entitled "Will Aggregate Litigation Come to Europe?" (here) takes a look at these questions and examines whether current European reforms are, in light of the extent of the aversion to the U.S. model, "likely to be effective in realizing their stated aims."

 

The authors begin their analysis by noting that while class actions were long "decried as the perversity of rapacious Americans," class actions are now "the focus of significant reforms in many European countries and even at the level of the European Union." Indeed, a "consensus" has emerged that "aggregate litigation will soon be the norm" in Europe. But by the same token, there is also a consensus that the European model of aggregate litigation "will not replicate American class action litigation with its domination of entrepreneurial plaintiffs’ attorneys."

 

The European movement toward aggregate litigation models has advanced because of the "need to create ex post accountability mechanisms" and the create mechanisms for the "efficient resolution of numerous intertwined claims." Aggregate litigation also mobilizes "efforts to foster prevention through the prospect of civil litigation."

 

The authors note that the criticisms of the U.S. model in many ways correspond with concerns raised inside the U.S. But the authors also ask whether or not the categorical aversion to the U.S. model may leave European reform efforts without the means to achieve desired results.

 

In order to assess whether the European rejection of the U.S. model sweeps too broadly, the authors examine the recurring criticisms of U.S. class action litigation. Among other things, the authors suggest that by framing the debate this way, the discussion will reflect both the weaknesses and the strengths of the U.S. approach and allow the reform process to benefit from the beneficial aspects of the U.S. approach.

 

The four criticisms of U.S. class action litigation on which the authors focus are:

 

(1) the danger that mass settlements may overgeneralize, by treating differently situated claimants as if they were similar, particularly where "an unsolicited and effectively unsupervised" agent resolves the case on behalf of absent class members;

(2) the most significant recovery is "often by successful class counsel, not by any class member;

(3) the uneasy relation between entrepreneurialism and avarice (as evidenced most recently by the criminal pleas of leading plaintiff securities attorneys); and

(4) the manipulation of the judicial forum for litigation gain (particularly through serial exploitation of "judicial hellholes").

 

The authors observe that what unifies these four controversies is "the role of private entrepreneurial lawyers" – which, the authors note, is "precisely what troubles Europeans about American class action practice." Nevertheless, motivated lawyer action is the "engine that fuels American aggregate practice." The authors ask whether the comprehensive rejection of the U.S. model "throws the baby out with the bath water" and whether "the controversies that arise in a system build on self-interest can be mitigated without disabling the entire undertaking."

 

In order to examine these questions, the authors look at the common features of European collective action reform efforts. While the legal reforms represent a broad spectrum of initiatives, there are three common features: (1) the tendency to allow only organizations to represent consumers in class actions; (2) the interaction between rules on litigation funding and class action procedures; and (3) the preference for "opt-in" rather than "opt-out" systems.

 

The authors find that there are potentially significant limitations to each of these unifying features. The authors also note that the evolving European efforts attempt to realize the benefits of collective action, but are "limited in their conception of how these processes will be realized."

 

The threshold issue that current European reform efforts must address is who will "organize, fund and lead the collective efforts." Both the strength and weakness of the American collective approach has been the "willingness to entrust a great deal of social regulation to private initiative and common law forms of adjudication." The authors express their concern that the European "cultural revulsion" to "accepting the reality of legal enforcement as entrepreneurial activity may leave the reforms without the necessary agents of implementation."

 

Discussion

The excesses of the U.S. class action system are a familiar hobby horse for social critics, both in the U.S. and abroad. Nevertheless aggrieved parties continue to pursue relief and redress through class litigation — and not just consumers whose interests critics contend are hijacked by self-interested lawyers, but also well-financed institutional investors that are fully informed about their interests and fully able to act independently.

 

While Europeans disdain the excesses of the U.S. model, there have been periodic outbursts over the past several years where the need for collective action mechanisms has been so obvious that the local legal systems had to respond. Among the various corporate scandals that came to light earlier this decade were several instances where large group of aggrieved European investors were adversely affected and collectively sought redress. The current credit crisis underscores these issues. The further European development of collective action mechanisms does, as the authors note, seem to be inevitable.

 

On the other hand, the limitations of the U.S. model have been painfully apparent lately. The criminal sentencing of the leading plaintiff securities attorneys certainly highlights the corrupting potential of class litigation where the agent controls or even selects the principal.

 

There is also recent evidence that aggrieved parties involved in U.S-based litigation increasingly may perceive their interests to be best served outside of class litigation. Significant securities class action opt-out actions, in which would-be class members proceed independently to maximize their recovery and even to reduce counsel fees (about which refer here), suggest deep concerns about the utility of class litigation.

 

The authors may be correct that class litigation is most effective if it is driven by motivated entrepreneurs who can drive the process and maximize class results. Nevertheless, the lessons of the recent past in the U.S. highlight clearly how important it is for strict controls over class counsel.

 

The recent lessons also suggest the need for some modesty in advocating the U.S. class counsel model to Europeans. Indeed, rather than expecting the success of the European reforms to depend on European’s willingness to adopt aspects of the U.S model (such as the involvement of entrepreneurial counsel), perhaps it will be the case that the improvement of the current flawed U.S. model will depend on the adoption in the U.S. of existing or yet-to-emerge European innovations that develop as part of current European reform efforts.

 

Hat tip to the Point of Law blog (here) for the link to the article.

 

In a recent post (here), I raised concerns about the possibility of U.S.-domiciled companies becoming subject to securities litigation under the Ontario Securities Act. Now, a recent decision by an Ontario Superior Court judge interpreting the Act’s provisions suggests the possibility of litigants using a parallel Ontario proceeding to circumvent the PSLRA’s discovery stay.

 

The decision arose in connection with the prospective securities action that claimants seek to pursue in Ontario court against IMAX and certain of its directors and officers. Under the provisions of Bill 198, enacted in 2005 and codified in Section XXIII.1 of the Ontario Securities Act (which can be found here), a preliminary procedure is required to determine whether a liability action under the Act can proceed.

 

Section 138.8 (1) of the statute, a liability action cannot be commenced "without leave of court granted upon motion with notice to each defendant." The court is to grant leave only "where it is satisfied" that the action "is being brought in good faith" and there is a "possibility" the plaintiff will prevail at trial.

 

The procedure specified for this determination is that the plaintiff and each defendant are to serve affidavits "setting forth the material facts upon which each intends to rely." The affiant may be "examined" on the affidavit "in accordance with the rules of the court."

 

The issue addressed in the recent decision in the IMAX case is the breadth of the examination that is to take place in connection with this authorization proceeding. In addressing this question, Madame Justice Katherine van Rensberg issued a ruling that potentially could compel defendants to answer questions under oath about a broad range of issues, even issues the claimants have not initially raised. A November 18, 2008 Globe and Mail article regarding the decision can be found here.

 

Justice van Rensberg wrote that the Act itself "provides no guidance as to the interpretation of the threshold test and what type, quality and quantity of evidence the court is to consider." IMAX had urged her to restrict examination to publicly available information. However, she found that shareholders seeking leave to proceed under the Act have "special powers" generally not available otherwise and she held that anyone being examined must answer questions that have a "semblance of relevance" even if it "might also reveal some other potential issues or wrongdoing not currently contemplated by the statutory claim."

 

The "semblance of relevance" test Judge Van Rensberg used is the threshold used in connection with discovery, the procedures with respect to which ordinarily apply once a case is underway. In effect, the Judge’s ruling permits discovery in the precertification stage, before the case has even been authorized to proceed. As comments quoted in the article note, defense advocates had militated in favor of inclusion of the precertification procedure in the Act as a way to bar frivolous claims, but now it appears that procedure can be used to compel defendants "to disclose evidence relevant to the merits."

 

This development, if it stands, not only seems to authorize plaintiffs to use the procedure to conduct a fishing expedition, it also could be used as a way to aid a parallel proceeding filed in U.S. courts, by allowing shareholders to examine company officials, even as to matters not raised either case.

 

As Adam Savett points out on his Securities Litigation Watch blog (here), this procedure, pursued in parallel with a U.S. filed lawsuit, could permit claimants to use the Ontario procedure to circumvent the PSLRA’s stay of discovery. Savett points out that IMAX itself is not only subject to the Ontario action but also to a separate action under the U.S. securities laws in the Southern District of New York, in which a motion to dismiss is pending. Savett observes that the Ontario court’s IMAX ruling "raises the specter of cases being filed cooperatively in Canadian and U.S. courts, with discovery in the Canadian action possibly being allowed to be used in the U.S. action."

 

This possible PSLRA discovery stay end-around takes on even greater potential significance in combination with the possibility of U.S.-domiciled companies and their directors and officers getting hauled into securities litigation in the Ontario courts. As I noted in my prior post (here), discussing the Ontario securities lawsuit recently filed against AIG, the prospect for U.S. companies of securities litigation outside the U.S. is unattractive. But perhaps even more unwelcome is the possibility of litigants using a parallel Ontario case against a U.S. company as a way to try to get material to be used to support a separate U.S. proceeding against the company.

 

If the recent IMAX ruling stands, U.S. securities litigators might have to become a great deal more familiar with Ontario’s securities laws and procedures.

 

Special thanks to Mark Renzel for providing me a link to the Globe and Mail article.

 

More about the AIG Lawsuit: A couple of interesting items about the AIG lawsuit appeared after I wrote my recent post about the case.

 

First, in a Guest Column on the Securities Docket (here), Dimitri Lascaris of the Siskinds law firm provides interesting additional detail about the "substantive and procedural advantages" offered to aggrieved claimants under the Ontario Act, as well as the potential damages available. The Siskinds firm is lead counsel in the Ontario proceedings filed against both AIG and against IMAX.

 

Lascaris also wrote in his column that "for a long time, America has largely dictated the standards by which issuers are obliged to conduct themselves in a globalized capital market. Like much else that is coming to an end in today’s capital markets, that era may be over. "

 

Second, Law.com has a November 19, 2008 article (here) about the case against AIG filed in Ontario. Among other things the article quotes Lascaris as saying that the AIG action is the first use of the use of the liability provisions of the Ontario Securities Act against a non-Canadian company.

 

And Finally: I would like to thank all of the many Canadian readers who commented to me about the AIG case. Numerous readers provided me with helpful additional information about the Ontario Act and about securities litigation in Canada. In that respect, several readers added helpful and interesting comments to the blog post about the AIG case, and I commend those comments to everyone’s attention.

 

A November 13, 2008 Wall Street Journal article entitled "Inflated Credentials Surface in the Executive Suite" (here) reported on multiple instances where corporate officials lacked claimed academic or work credentials. The article is based on a survey conducted by Barry Minkow, a convicted felon who did jail time for his role in the ZZZZ Best stock scam, who now heads the Fraud Discovery Institute.

 

The article cites seven examples where corporate officials allegedly falsified credentials. The article notes that this "may be enough to raise investor concerns about executive credibility as well as company procedures for vetting by management and board members." The article also cites industry sources that as many as 20% of job seekers "are found to have inflated their education credentials."

 

The day after this article appeared, the Journal also reported (here) that J. Terrence Lanni, the departing Chairman and CEO of MGM Mirage, is now "in a dispute with his alma mater over his academic credentials." Contrary to the company’s published statements about Lanni’s education, USC business school has no record of Lanni having received an MBA there. The question about Lanni’s education only came to light after the Journal raised questions based on Minkow’s research.

 

The November 13 Journal article quotes a Wharton School business ethics professor as saying "I’m very concerned that if people believe you can lie and get away with it, then down the line people will start cheating on their expense report, they’ll start misrepresenting their billable hours, they’ll start misusing their corporate funds."

 

Credential Inflation and Securities Litigation: Given this sense that résumé falsification (or at least its toleration) could engender a culture of deception, it is hardly surprising that allegations of credential misrepresentation have from time to time made their way into securities class action lawsuits.

 

For example, in the October 2006 securities class action lawsuits filed against Xethanol and certain of its directors and officers (about which refer here), the plaintiffs allege that the company’s chairman and CEO had "fabricated his résumé" among other things, by allegedly falsely claiming to have worked at Unilever, Northrup Grumman, and Reed Elsevier.

 

Similarly, in the January 2003 case filed against MCG Capital (about which refer here), the plaintiffs alleged that the company’s November 2001 IPO offering documents misrepresented the "credentials, credibility and integrity" of the company’s Chairman and CEO. Specifically, the complaint alleged that the offering documents misrepresented that the individual had earned a B.A in Economics from Syracuse, when in fact he had not. (It should be noted that the case was later dismissed and the Fourth Circuit affirmed the dismissal.)

 

Securities lawsuits also frequently allege that companies have misled investors by failing to disclose key details of corporate officials’ backgrounds. For example, in the November 2006 lawsuit filed against Pegasus Wireless and certain of its directors and officers (about which refer here), the complaint alleges that the company’s failed to disclosure the CEO and President’s prior involvement with bankrupt companies, as well as with other companies whose histories the complaint suggests "suspected stock and market manipulation." The company’s CFO is also alleged to have a "history of involvement with failed and suspect ventures," as well as past ties to individuals with "felonious" records.

 

This last example arguably goes well beyond mere credential inflation, but it does underscore how integrally misrepresentations or omissions about key officials’ histories potentially can affect investor perceptions. That in part explains why disclosure of credential inflation or résumé falsification can produce a significant marketplace reaction. As Minkow is quoted as saying in the Journal article, "you have to ask yourself, as any good investigator would say, what else could there be?"

 

Identity Misrepresentation: A Short History: The problems of credential inflation and résumé falsification are not limited to the corporate world. There have been numerous recent examples in government, academia and elsewhere. Many readers will recall, among the more notable recent examples, the tale of George O’Leary, who was fired five days after being hired as Notre Dame’s football coach, after it was discovered that he had falsely claimed to have a master’s degree in education and to have played college football for three years. The Wall Street Journal has compiled an extensive list of other recent examples, here.

 

There is a temptation to classify these deceptive practices as just another byproduct of our iniquitous era of botox and breast implants, where packaging is valued above substance and identity represents not things as they are but as people can be made to believe them to be.

 

Identity misrepresentation is not, however, unique to our time. These kinds of impostures go back as far as biblical times, where, for example, Jacob’s mother disguised him as his twin brother Esau so that Jacob would received their father’s blessing, intended for Esau.

 

Similarly, history is full of royal pretenders and alleged monarchs. During the reign of England’s Henry VII, there were actually two pretenders. The first, Lambert Simnel, a commoner who was crowned by Yorkist supporters as the supposed "King Edward VI," and Perkin Warbeck, who pretended to the First Duke of York and the younger son of Edward IV. And of course, there was Anna Anderson, who was claimed to be the Grand Duchess Anastasia, youngest daughter of Tsar Nicholas II.

 

Literature is full of examples as well. These include the numerous instances of gender disguise in many of Shakespeare’s play, such occurs in Twelfth Night and As You Like It. More recent examples of gender disguise occur in Tootsie and Yentl.

 

One of the more entertaining examples of identity misrepresentation occurs in one of The D&O Diary’s favorite books, The Count of Monte Cristo, by Alexandre Dumas, in which Edmond Dantès dupes others into believing him to be a Count so that he can revenge himself on his enemies and tormentors.

 

Identity, Ambition and the Need for Affirmation: The most extensive literary examination of the interplay between the portrayal and the reality of identity may be F. Scott Fitzgerald’s The Great Gatsby. At one level, the book is about nothing more than Nick Carraway’s effort to understand who Gatsby really is.

 

The sycophants and partygoers that surround Gatsby at the book’s outset aren’t quite certain, but suspect that he may be a bootlegger and may even have killed a man. Gatsby tells Nick an elaborate tale of having been educated at Oxford and then having inherited the family fortune. But that Gatsby’s persona is a façade is so obvious that one of the uninvited partygoers at Gatsby’s house is astonished to learn that the volumes lining the shelves in Gatsby’s library are actually real books.

 

Gatsby’s self-portrayal is an elaborate invention, a manufactured identity that, as Nick puts it, sprang from Gatsby’s "Platonic conception of himself." Gatsby’s self-contrivance is all part of his involved effort to prove himself worthy of Daisy Buchanan. The origins of Gatsby’s obsession with Daisy are perhaps best understood in his explanation that Daisy’s voice is so fascinating because it is "full of money."

 

Driven by his obsession for Daisy, Gatsby (born James Gatz) attempts to recreate himself within an intricate structure of credential inflation. The Oxford education proves to have been only a five-month stint following the war. His wealth, supposedly inherited, was actually acquired by means that Gatsby himself is unwilling to discuss.

 

Gatsby’s determined striving helps explain the credential inflation to which contemporary corporate individuals seem particularly prey. Ambition and desire, combined with a desperate need for affirmation or acceptance, drives these individuals to represent themselves as improved versions of themselves, or perhaps even as somebody different altogether.

 

In any event, it is clear that when inflated credentials are involved, it may be indispensible to make certain that the books are real.

 

The Ultimate Inflated Credential: Divinity: Among the most outrageous identity misrepresentations in literature is that of Danny Dravot who, in Rudyard Kipling’s The Man Who Would Be King, is all too willing to be taken by the people of Kafiristan as a god, based on their delusion that he is the son of Alexander the Great. It all ends very badly for Danny and his sidekick, Peachey Carnahan, when the Kafiris discover that Danny is "Not god, not devil, but man!"

 

The story was made into a memorable 1975 movie (now somewhat disturbing for its colonialist presumptions) starring Michael Caine and Sean Connery. In this video excerpt, Danny and Peachy reckon the benefits of Danny being taken for a god, as well as the secrecy their deception requires:

 

 

https://youtube.com/watch?v=3dJf5rO0-BM%26hl%3Den%26fs%3D1