For many companies, one of the most challenging parts of the Directors and Officers (D&O) insurance procurement process is determining how much insurance to purchase. Against a backdrop of basic affordability, the company must consider complex issues such as limits adequacy – that is, how much insurance is enough?

 

Determining limits adequacy is even more challenging in light of today’s escalating claims severity. Recent developments underscore the fact that in addition to rising settlement levels, growing defense expense is an increasingly important part of the limits adequacy analysis.

 

 

In the September 2008 issue of InSights (here), I review recent D&O claims defense expense developments and consider their ramifications for purposes of both limits selection and insurance program structure. The article concludes with a brief review of claims management implications arising from these defense expense issues.

From the earliest days of the options backdating scandal, one of the recurring questions has been the potential extent of outside director liability exposure (refer, for example, here). On September 17, 2008, In a development that may also have significant implications for more recent events, the SEC filed settled options backdating-related charges against three former outside directors of Mercury Interactive.

 

A copy of the SEC’s September 17 press release regarding the settled charges can be found here. A copy of the Complaint can be found here.

 

 

The SEC’s complaint alleges that the three outside directors “recklessly approved backdated stock option grants, and reviewed and signed public filings that contained materially false and misleading disclosures about the company’s stock option grants and company expenses.”

The complaint alleges that the three individuals approved 21 backdated stock option grants between 1997 and April 2002. The complaint alleges that the three were aware that options with an exercise price lower than the date on which the options were actually approved created a compensation expense. Nevertheless, the complaint alleges, they repeatedly executed stock option documents while “failing to observe, among other things, that the exercise price of stock options they were approving was less than the market price of the company’s stock at the time of approval.”

 

 

The three individuals are alleged to have routinely signed unanimous consents “despite being presented with numerous facts and circumstances indicating that management was backdating option grants.” In addition to signing options grants made with earlier “as of” dates, on a few occasions the three “signed multiple written consents presented to them by management for the same grant with different grant dates that had more favorable prices.”

 

 

Without admitting or denying the allegations, the three agreed to permanent injunctions and each will pay a $100,000 financial penalty to settle the charges.

 

 

In light of the current circumstances, in which scapegoat hunting is in high gear, the SEC enforcement division’s statements about outside director liability may be instructive. SEC enforcement division director Linda Thomsen is quoted as saying, among other things, that “today’s action serves as further notice that misconduct by outside directors, as well as company management, will not be tolerated.”

 

 

Another enforcement division official is quoted as saying that, even though they understood how options expensing worked, “time and again, directors approved in-the-money option grants that had been backdated” and that the directors “recklessly approved option grants despite numerous facts and circumstances indicating to them that the grant dates they were approving were improperly backdated.”

 

 

While options backdating enforcement actions may seem like yesterday’s news (or even the day before yesterday’s news), these developments have significance today. If nothing else, they demonstrate the SEC’s willingness to pursue enforcement actions against outside directors, at least in certain circumstances, particularly if apparently knowing and active violations are involved.

These developments also underscore the continuing liability exposures to which outside directors potentially may be subject, and the need to address these exposures as part of any well-designed directors’ and officers’ liability insurance program. The SEC’s willingness to pursue outside directors for options backdating-related violations also suggests that today’s even more dramatic circumstances potentially could involve significant outside director liability exposure. The SEC’s interest in the possibility must be presumed.

 

 

Some readers may want to know what happened to the Mercury Interactive managers that proposed the backdating options for the directors’ approval. The SEC previously filed civil fraud charges against the company and four former officers (refer here). The company agreed to pay a $28 million penalty. The case against the former officers remains pending. A securities class action lawsuit arising from the Mercury Interactive options backdating allegations settled for $117.5 million (about which refer here).

 

UPDATE: The Race to the Bottom blog has an interesting post (here) discussing the SEC enforcement proceeding against Mercury Interactive’s outside directors. Professor Brown suggests that this case represents another instance where federal regulatory authorities may be creating federal standards of director conduct, in a gradual preemption of state law.

 

 

Despite Settlements, Auction Rate Lawsuit Proceeds: Following the recent high-profile auction rate securities settlements, one of the unanswered questions was what impact the settlements would have on the previously pending auction rate securities lawsuits. There are still no definitive answers. But, notwithstanding the settlements, at least one auction rate securities lawsuit is going forward.

 

 

As reported in the September 17, 2008 Wall Street Journal (here), Judge Gary Sharpe of the Northern District of New York has ruled that they auction rate securities lawsuits that Plug Power filed against UBS can go forward notwithstanding UBS’s recent $19 billion action rate securities buy-back settlement. A copy of the transcript of the September 17 hearing in the case can be found here. (Hat tip to the Wall Street Journal Law Blog, here, for the transcript link.)

 

 

According to Plug Power’s Amended Complaint (here), the company had alleged that, based on supposed assurances that the auction rate securities investments were safe and liquid, the company had bought $62.9 million in auction-rate securities backed by student loans. After the market for the securities seized up in February 2008, the company was (and remains) unable to liquidate its investments. The securities make up nearly half of the company’s investment portfolio.

Under the UBS auction rate settlements, institutional investors’ securities are expected to be bought back in 2010. The Journal quotes Plug Power’s attorney as saying that “we need the funds before 2010 and they’re not providing us a guarantee that they will be able to pay out.”

 

 

The disfavored position of institutional investors is one of the features of the auction rate securities settlements I noted at the time (refer here). Other institutional investors may be motivated similarly to Plug Power to proceed with litigation notwithstanding the buy back settlements. And the September 17 ruling in the Plug Power case suggests that at least some of the cases may go forward notwithstanding the settlements.

 

 

As noted in a September 18, 2008 post on the Securities Docket (here), plaintiffs’ attorney Daniel Girard of the Girard Gibbs law firm argues that private litigation still has a role to play in the auction rate securities debacle. He points out that many billions worth of these investments are not yet part of any settlement and that even with regard to the securities covered by the settlements, it will be a considerable time before the buybacks kick in (this in connection with investments that supposedly were liquid and just like cash.).

 

 

BAE Systems Lawsuit Dismissed: In prior posts discussing civil litigation arising out of corrupt practices investigations (for example, here) one of the cases to which I have frequently referred is the derivative lawsuit filed in the District of Columbia by shareholders of BAE Systems. (For background regarding the BAE Systems case, refer here and here).

 

 

In a September 11, 2008 opinion (here), Judge Rosemary Collyer dismissed the BAE Systems derivative lawsuit on the grounds that the plaintiff lacked standing to bring the lawsuit.

The court’s ruling, while narrow, is interesting. The court held that as a result of the “internal affairs doctrine,” the law of the United Kingdom (the country in which BAE Systems is incorporated) governs the case. Under U.K. law, beneficial owners of a company’s securities lack standing to sue derivatively.

 

 

The plaintiff in the derivative suit did not directly own BAE systems shares but rather owned American Depositary Receipts (ADRs) as a result of which its ownership is merely beneficial under U.K. law. Accordingly, the plaintiff lacks standing to sue derivatively under U.K. law, and the court granted the defendants’ motion to dismiss.

 

 

Even though the court’s holding is narrow, it is significant in at least one respect. That is, it underscores the numerous potential obstacles that any plaintiff will face in attempting to use U.S. courts to assert civil liability in connection wtih a foreign domiciled company’s allegedly corrupt activities. Notwithstanding these obstacles, however, I continue to believe that the threat of civil litigation arising from corrupt practices investigations remains significant.

 

 

As the Wall Street Journal noted in its September 12, 2008 article entitled “U.S., Other Nations Step Up Bribery Battle” (here), anticorruption enforcement activity is an increasingly important prosecutorial priority worldwide, in which cross-jurisdiction cooperation is an increasingly important factor. As prosecutorial activity affects an increasing number of companies, investor interest n recovering civil damages for alleged harm to companies from the allegedly corrupt practices will continue to grow.

 

 

Special thanks to a loyal reader for the link to the BAE Systems decision.

 

One of the most closely followed recent case developments in the D&O insurance arena is the ruling in the CNL Hotels & Resorts case that a Section 11 settlement did not represent covered loss under a D&O insurance policy. As I noted in a recent post (here), on August 18, 2008, the CNL Hotels & Resorts holding was affirmed by the Eleventh Circuit. These developments have occasioned a great deal of discussion and commentary in the D&O insurance community.

 

Among the more noteworthy commentary on this topic is the analysis of the well-known and widely respected D&O insurance coverage attorney, Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm. Joe’s commentary appeared in his firm’s August 2008 Specialty Lines Advisory (here, at page 2). As always, I found Joe’s analysis interesting, but I also found that I disagreed with him on a portion of his analysis.

 

Because I thought an exchange of views on these topics would be useful and perhaps even entertaining, I approached Joe to determine his willingness to engage in a colloquy on this topic to be reproduced on this site. Joe agreed, and our exchange follows below. First, I have quoted a portion of Joe’s article, which is followed by my comments on his article. Joe’s rebuttal appears after my comments.

 

Joe’s Article (Extract):

In his commentary, Joe wrote the following with respect to the CNL Hotels & Resorts case (and cases with similar holdings): 

 

When you cover the entity for its Section 11 loss, you are in effect saying that your IPO was overpriced by perhaps tens of millions of dollars. While not saying that it is OK, what you are saying is we will let the insurer step in and pay that loss and the corporation can keep its ill-gotten gain. How is that any different than a company simply refusing to pay for goods it has ordered and then letting its insurer pay when it is sued for a breach of its contract to pay? Insurance may cover negligent and even reckless misconduct, but it should not cover crooked behavior.

  Kevin’s Comments:

 

In his article, Joe makes a number of valid and interesting points, particularly with respect to the history of these issues. However, underlying Joe’s legal analysis is a series of value judgments. It seems to me that these value judgments misapprehend several critical considerations. I have set out these critical considerations below. In doing so, I also recognize that courts may have disfavored several of my arguments; readers will judge for themselves whether it is legitimate for me to reference these judicially disfavored points here

 

The first important consideration is that while companies that are the target of Section 11 claims may be alleged to have made all sorts of misrepresentations or omissions, these allegations are virtually never put to the test of proof. The mere fact that plaintiffs allege that offering documents contained supposed misrepresentations does not mean that the offering proceeds were in fact "ill-gotten." These kinds of claims, like all claims, are compromised because of the burdens and expense of litigation and because few are willing to accept the risk of an adverse verdict.

 

Nor does the fact that substantial sums are paid to compromise these claims, in and of itself, mean that the defendants company’s IPO was overpriced, much less that the company engaged in "crooked behavior." These settlements take place after the company has experienced a significant stock price drop. Compromising claims in the context of significant market capitalization losses can prove costly, but entry into even a costly settlement is far different than a determination of culpability or wrongdoing.

 

But I have even deeper concerns beyond just the fact that a settlement does not in and of itself betoken that a company’s IPO was "overpriced" or that the company is improperly keeping "ill-gotten gains." The fact is that the use of heavily freighted words such as "ill-gotten" and "crooked" are fundamentally misplaced in connection with alleged corporate liability in a Section 11 claim.

 

Under well-established legal principles, corporations are said to be "strictly liable" under Section 11 for material misrepresentations and omissions in offering documents. There is no element of fraud or scienter required in a Section 11 claim, and indeed plaintiffs pleading claims under Section 11 now routinely state (as a means of averting onerous pleading requirements) that they are not alleging or averring fraud in relation to these claims. The point is that in general not even the plaintiffs asserting the claims against these companies allege that the companies engaged in "crooked behavior."

 

In his article, Joe concedes that insurance properly can be paid for behavior that is merely negligent or even for behavior that is reckless. How then is it appropriate to withhold insurance benefits from companies who can be found liable without any fault at all?
 

 

I know that the district court in the CNL Hotels & Resorts case said that the absence of fraud allegations in Section 11 claims represents "distinction without a difference." But the absence of allegations of knowing or reckless misconduct does matter, deeply. The use of acutely pejorative words – that are completely unwarranted given the strict liability standard for corporate liability under Section 11 — has the effect of demonizing the company and putting it the position of moral error. The danger is that it is easier to withhold insurance benefits from a "bad" company. The use of these morally freighted words not only inappropriately shapes the tone of the dialog but potentially enables an unjustified result.

 

Moreover, even if a Section 11 claimant should allege fraud or dishonesty, the typical D&O policy’s fraud exclusion ensures that insurers do not have to pay benefits for "crooked behavior." But here’s the thing about the fraud exclusion – at least as worded in most current policies, it is only triggered after an adjudication of fraud. The fraud exclusion is no barrier to the payment of insurance benefits to fund settlements of claims alleging fraud.

 

Indeed, insurance companies regularly fund Section 10(b) claim settlements, notwithstanding allegations of fraudulent misconduct. Surely Joe is not suggesting that insurers cannot properly fund Section 10(b) settlements? And if Section 10(b) settlements properly can be funded because there has been no adjudication of fraud, why can insurers withhold payment of insurance benefits from Section 11 benefits in the absence of an adjudication of fraud, merely because of unproven allegations of "ill-gotten gains" or even "crooked behavior"?

 

An August 25, 2008 New York Law Journal article by Joshua Sohn of the DLA Piper law firm entitled "Liable Until Proven Innocent" (here) decries the leniency of Section 11 and Section 12(a)(2) pleading requirements. Among other things, Sohn quotes the Supreme Court’s recent Twombley opinion to assert that lenient Section 11 and 12(a)(2) pleading standards will continue to "push cost-conscious defendants to settle even anemic cases."

 

The lenient pleading standards make IPO companies that experience sharp stock price drops likely targets for Section 11 claims. The leniency of the Section 11 liability standards also means that the lawsuits are likely to survive preliminary motions, leaving defendant companies few options other than settling. Because of this heightened susceptibility to dangerous litigation, companies about to conduct an IPO are particularly sensitive to the need for D&O insurance.

 

An IPO company is generally regarded as an attractive insurance prospect, and many insurers compete actively to write the insurance for IPO companies. The confounding thing is that insurers that actively competed for the business and voluntarily undertook to insure an IPO company would later contend that the most likely and most dangerous claim the company would face is uninsurable. Whether or not this coverage position makes the insurance agreement illusory, it certainly raises serious concerns about the utility of the insurance agreement.

 

It will be argued that public policy prohibits insurance for corporate Section 11 liability because the relief sought is restitutionary in nature. As a general matter, the determination of private contractual matters based on public policy grounds raises certain fundamental question about the sources and uses of law. One particular concern is that the supposed requirements of public policy lack a definite point of reference and could become simply a matter of perspective. The notion than insurance for Section 11 claims is against public policy is neither inherent nor absolute, and indeed is an issue on which pertinent parties take a point of view different than followed in recent case law.

 

The SEC’s perspective is particularly relevant to this public policy question. On the one hand, the SEC takes the position (here) that corporate indemnification for ’33 Act liabilities is "against public policy" and unenforceable. On the other hand, the SEC emphatically does not specify that insurance for ’33 Act liabilities is against public policy. To the contrary, the SEC expressly designates (here) as among the expenses that properly may be charged to the costs of a securities offering the premium charged for insurance "which insures or indemnifies directors or officers against any liability they may incur in connection with the registration, offering or sale of such securities."

 

The SEC’s public policy analysis distinguishes between the indemnification of Section 11 liability and the provision of insurance for Section 11 liabilities. The SEC’s statements suggest that in its view public policy does not prohibit the enforcement of policies insuring against Section 11 liability, by contrast to its indemnification.

 

If nothing else, the SEC’s views ought to suggest that what public policy dictates as far the insurability of Section 11 claims is neither self-evident nor universally held. All of which should raise serious concerns about using judicially declared principles of supposed public policy to determine private contractual rights.

 

It was a nearly universal reaction among both D&O underwriters and brokers that this line of case law produced a result that, while perhaps perfectly logical to an insurance lawyer, ran absolutely contrary to marketplace understanding and commercial expectations. It is worth considering that both underwriters (the ones who sell insurance) and brokers (the ones who procure insurance on behalf of insurance buyers) universally agree that D&O policies should cover these kinds of settlements.

 

In response to these concerns, the entire D&O insurance industry has taken steps, as quickly and as vigorously as any insurance-related industry has ever done anything, to try to insert policy language calculated to prevent lawyers from making arguments that while perhaps logical to the lawyers defy the expectations and understandings of the commercial marketplace. The marketplace understands that the compromise of disputed Section 11 claims in no way means that a company has engaged in "crooked behavior" and in fact represents the very contingency for which policyholders buy insurance.

 

Joe’s Counterpoints:

Kevin’s repeated admonishments for my use of the term "crooked behavior" call to mind Judge Posner’s words in the Level 3 decision, a case that perhaps more than any other establishes the public policy rationale relied upon by the CNL Resorts courts.

   

 

An insured incurs no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than ‘stolen’ is used to characterize the claim for the property’s return.

 

 

 

Taking a cue from Judge Posner, I should have refrained from use of the pejorative term "crooked", and I regret any possible inadvertently implied mischaracterization of the motive of the corporate issuer in CNL Resorts or other cases.

 

Nonetheless, I will now "politely" set forth a number of rebuttal points.

 

First, I believe the fact that the underlying CNL Resorts litigation, like many other similar litigations, concluded with a settlement and, hence, no evidentiary proof of ill-gotten gain, misses the point of these insurance coverage cases. Regardless of the culpability of the conduct, there could be no liability of the issuer unless the offering was in fact overpriced. To have an insurer pay the amount of the overpricing, rather than have the issuer disgorge it uninsured, results in an unentitled windfall to the issuer.

 

That being said, I share Kevin’s observation of the irony that in these cases of what is in essence strict liability there can be no insurance recovery, but yet insurers routinely pay to cover liabilities resulting from reckless conduct in other securities cases. Ironic, yes, but it is supportive of the point that culpability of conduct is not the issue.

 

Also, I would agree that in most of these cases that are disposed via settlement, the insurer cannot apply one or both of its "conduct exclusions", which with increasing frequency in today’s insurance market are written with requirements of a final adjudication in the underlying proceeding. That may hold true for both the dishonesty exclusion and that for personal profit. The latter would arguably apply to preclude coverage for these settlements, but for an adjudication requirement, and in addition to the uninsurability reasoning of the courts in applying the law and public policy.

 

By no means do these decisions render the insurance agreement illusory, because none of them have applied the uninsurability argument to the individual directors and officers defendants. Thus, in most cases, an allocation should result, but certainly not a complete absence of coverage for all defendants. Although the court in the SR International decision enunciated a public policy argument of having the insurers stand behind the way they market their policies, that was in the context of a dispute over coverage for an underwriter defendant. There is little argument that an underwriter does not receive the proceeds of the offering, and thus its settlement payment cannot be fairly characterized as a disgorgement of ill-gotten gain. Nevertheless, the public policy arguments in that decision give a degree of validity and support to those D&O insurers who have voluntarily attempted to underwrite around the issue by endorsement, notwithstanding what may be the law now in some jurisdictions.

 

I do not want to belabor the seeming contrast between the SEC’s views on indemnification vs. insurance, but I believe the SEC may well not be inclined to enforce an indemnification prohibition in a settlement context where arguably no Section 11 "liability" has been established.

 

Finally, I must raise a bit of skepticism at Kevin’s conclusion that insurance underwriters and brokers are in universal accord as to providing "full" coverage for a Section 11 settlement, and that the debate remains only an arcane one among the wonks in the insurance coverage bar. I cannot speak for any particular insurer on this, but it appears at least some were vigorously contesting this issue before the Eleventh Circuit until its decision last month in CNL Resorts. Yes, the endorsements and new policy language purporting to clarify and grant the coverage are frequently seen in today’s market (and, in full disclosure, I have even crafted some of the endorsements and policy language at the request of clients), but I remain reluctant to concede the approach is universal.

 

Afterword: Consistent with the rules of engagement that I established for this colloquy, Joe gets the last word, so I will offer no surrebuttal. I would like to thank Joe for his willingness to engage on this topic and to offer his views. I would also like to invite readers to chime in on the debate using the blog’s comment feature. (Please note that you can add a comment without providing identifying information, so it possible to add comments anonymously.)

 

In a statement issued on Tuesday evening (here), the Federal Reserve announced that it had authorized a loan of up to $85 billion to American International Group. This move is described in detail in a September 17, 2008 Wall Street Journal article entitled "U.S. to Take Over AIG in a $85 Billion Bailout" (here). Bloomberg’s article describing the development can be found here.

 

The Outlines of the Loan Facility

The loan facility, which the statement says has been extended pursuant to Section 13(3) of the Federal Reserve Act, has been "designed to protect the interests of the U.S. government and taxpayers." According to the Real Time Economics blog (here), the only other time this specific Fed power has been exercised since the Depression era was in connection with the Bear Stearns bailout.

 

The Fed statement says that it exercised its authority because of adverse economic effects that would follow from a "disorderly failure" of AIG. The loan facility is designed to permit AIG to "meet obligations" in order to "facilitate a process under which AIG will sell certain of its businesses in an orderly manner."

 

The facility has a 24-month term. The interest rate is set at three month LIBOR plus 850 basis points. Three month LIBOR is a variable rate that resets weekly. The current weekly rate (here) is 2.81%, so the current interest rate on this loan facility is 11.31% — pretty hefty. Just keep in mind that annual (simple) interest of 11.31% on $1 billion is $113.1 million. On $10 billion it is $1.131 billion. And on $85 billion it is $9.61 billion.

 

The loan is collateralized by all of the assets of AIG and of its non-regulated subsidiaries. (The good news here is that the assets of the regulated subsidiaries – the insurance companies – are off limits.) The loan is to be repaid from asset sale proceeds.

 

According to the Fed statement, the government "will receive a 79.9% equity interest" in AIG, with the right to veto dividends to common and preferred shareholders.

 

The size of the facility presumably was set to accommodate all likely requirements, so AIG may or may not draw down all of it. But AIG will most likely draw down a very large part of it. AIG will have to repay its borrowings (plus interest). In referring to the means of repayment, the press release refers to the orderly sale of "businesses," so one can assume that the non-core subsidiaries are on the blocks for an "orderly" sale.

 

Questions about the Loan Facility

The problem for AIG is that sale of its non-core subsidiaries alone may not be sufficient to pay back even half of $85 billion. The Deal Journal blog estimates (here) that sales of AIG’s non-core subsidiaries and minority interests might raise "as much as $42 billion" – and that, I might add, is before taxes. (I think Uncle Sam will insist on the payment of all applicable taxes.) Which raises the question whether the sale of "businesses" specifically contemplates the sale of some or all of AIG’s core insurance operations?

 

Left unanswered in the Fed press release is the question of what this development means for AIG’s continuing business operations. The primary goal of the Fed facility is the orderly sale (as opposed to the "disorderly failure," as the Fed statement put it) of AIG’s businesses. What does this imply about the future of AIG’s operating companies? And what will be left of AIG after the "orderly sale"?

 

Presumably, the answers to many of these questions will become apparent in the days ahead. In the meantime, there are some things that everyone will want to know. I have posed some of these questions below. Please note that many of these questions may simply be a reflection of the limited amount of information currently available. Many of these questions may appear simple-minded once the information is known. But based on what we know so far, here are the other things we still need to know:

 

1. Who will run the company? Is current senior management to remain in place, or will AIG get its third CEO this year? (For the record, the government did embed new management at Fannie Mae and Freddie Mac as part of the recent takeover.). How about the Board of Directors, will they also be replaced?

 

UPDATE: The New York Times reports (here) that AIG CEO Robert Willumstad will be replaced by Edward M. Liddy, the former chairman of Allstate Corporation.

 

2. What exactly does government ownership of 79.9% of the company equity mean? Is this just a shorthand way of saying that the government is entitled roughly 80% of any later liquidation? Or is there more to it than that?

 

For example, does the government want the value of its ownership interest to grow? What will the government ultimately do with its ownership interest? Will the government sell its interest, and if so, when, to whom, for what price, and under what circumstance? Why is the government now the majority owner of a major insurance company? Does the government want its insurance company to compete and succeed in a competitive marketplace against investor owned insurance companies?

 

3. The government wants to get repaid, so it wants the "orderly sale" of the businesses to produce sales values sufficient to effect repayment. That implies that the operating companies should continue operating. But among the insurance companies, for example, there are many practical questions that only active and engaged management can decide – risk appetite, level of pricing aggressiveness, extent of reinsurance, limit exposures, prohibited classes, and so on. All of these decisions must now take place under potentially unusual conditions, in effect under the supervision of a government appointed caretaker/liquidator?

 

4. What impact will these developments have on credit ratings, both at the parent company level and at the insurance subsidiary level? The fact the company’s primary mission now seems to be a slow-motion liquidation is clearly a relevant factor, as are the unusual operating conditions. In addition, I would expect that all of AIG’s other debt is subordinate to the Fed loan, which also seems relevant to financial strength ratings.

 

5. What happens if $85 billion is not enough? This is not as absurd of a question as it might seem at first glance. Keep in mind that AIG just raised $20 billion in the second quarter and that clearly was not enough. What does the current lending facility imply about the future – for AIG, for taxpayers, for the economy?

 

6. What about the credit rating for the U.S. government? How far can this go? The U.S. government just assumed responsibility for $5 trillion in Fannie Mae and Freddie Mac debt. When do we start to get concerned about the government’s balance sheet? When do we start to get concerned about the ability of the U.S. to meet of all of its obligations?

 

Policyholders’ Interests

Finally, I must address the interests of policyholders. On Tuesday, AIG released a statement (here) that its insurance subsidiaries "remain adequately capitalized and fully capable of meeting their obligations to policyholders." Along those lines, it is important to keep in mind that AIG’s current predicament is not the result of insurance losses, so the separately capitalized insurance companies’ ability to meet its obligations essentially remains unchanged.

 

Moreover, the collateral securing the Fed’s lending facility does not include the insurance companies’ assets, so even if the parent company heads south in a big way despite the $85 billion loan, the insurance companies’ existing surplus should remain to address policyholder claims, subject of course to the effects of claims payment.

 

In the days ahead it will be very important to understand how the current operating circumstances will affect the insurance companies and their operations, and in particular whether there are any other implications for policyholder surplus and the insurance companies’ claims paying ability.

 

Since the earliest days of the subprime litigation wave, one of the recurring questions has been whether the wave would spread beyond the financial sector. The question remains, but allegations in a new securities lawsuit suggest that circumstances arising from the subprime crisis are affecting a diverse variety of companies, and by extension the claims asserted against them.

 

According to their press release (here), on September 16, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the United States District Court for the Southern District of California against NextWave Wireless and certain of its directors and officers. NextWave is a mobile broadband and multimedia technology company that develops, produces and markets mobile multimedia and wireless broadband products. A copy of the complaint can be found here.

 

According to the press release, the complaint alleges that:

 

Defendants issued materially false and misleading statements regarding the Company’s business and financial results. As a result of defendants’ false statements, NextWave stock traded at artificially inflated prices during the Class Period, reaching as high as $10.10 per share in June 2007.

 

On August 7, 2008, after the market closed, Nextwave issued its second quarter 2008 financial results, announcing it only had $71.1 million in cash and similar instruments available as of June 30, 2008 and, unless it raised money, its cash would run out at the beginning of October 2008. As a result, the Company was seeking financing that would give the Company enough money to operate through June 2009. On this news, NextWave’s stock fell $1.90 per share to close at $0.95 per share, a one-day decline of 67%.

 

According to the complaint, the true facts, which were known by the defendants but concealed from the investing public during the Class Period, were as follows: (a) NextWave did not have adequate sources of liquidity to continue operations as it executed its growth strategy and continued making aggressive worldwide acquisitions; (b) defendants had no reasonable basis to make favorable statements that the Company’s WiMAX semiconductor products would be available for commercial sale in the first half of 2008; (c) NextWave’s growth and acquisition strategy was not financially successful and did not provide the basis for continued growth or financial success because it was straining NextWave’s fragile liquidity position and NextWave did not have the financial resources to continue to operate its world-wide operations through the end of 2008; (d) NextWave failed to timely disclose that it had invested all of its marketable securities in extremely high-risk and illiquid auction rate securities; and (e) NextWave’s ability to continue as a going concern was seriously in question by reason of the facts alleged in subparagraphs (a)-(d) above.

 

The most interesting part about these allegations to me is the reference to the company’s investment in auction rate securities. The complaint itself further alleges with respect to these "extremely high-risk and illiquid auction rate securities" that NextWave "had misrepresented these investments as marketable securities on its balance sheet included in its financial statements disseminated in its Form 10-K and 10-Q and press release."

 

There have of course been many prior lawsuits against investment banks and broker-dealers in which it is alleged that the financial institutions misrepresented the risks of auction rate securities. But this new lawsuit against NextWave represents the first instance of which I am aware in which an auction rate investor has been sued for failing to disclose its exposure to auction rate securities investments. Obviously, there are a lot of other allegations in the lawsuit, but the auction rate investments allegations are an important part of the complaint and, if nothing else, are noteworthy.

 

The allegations about the company’s alleged balance sheet misclassification of its auction rate investments is of particular concern. Many companies (and other entities) hold auction rate securities investments, and all of these entities have been struggling both with valuation issues and with balance sheet classification issues. These classification and disclosure issues affect not just auction rate related investments but subprime and other mortgage-backed investments as well. At least theoretically, plaintiffs’ lawyers could allege similar investment disclosure and asset classification issues in connection with these companies.

 

Perhaps I am getting ahead of myself, but I also wonder whether similar "failure to disclose investment exposure" allegations might be alleged against companies that will be reporting significant write-downs in their holdings of securities of, for example, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG. Admittedly, this may be a far-fetched possibility at this point. But some companies’ write-downs of their investments in those assets could be material, which in turn could affect the reporting companies’ own stock market valuations. If the impact is significant, angry investors might consider their litigation alternatives.

 

Another Credit Crisis Lawsuit: There was also a more conventional credit crisis lawsuit filed today. According to the plaintiffs’ counsel’s September 16, 2008 press release (here), plaintiffs have filed a securities class action lawsuit against BankUnited Financial Corp. and certain of its directors and officers. A copy of the complaint can be found here.

 

According to the press release, the complaint alleges that

 

Defendants made false and misleading statements about BankUnited. Specifically, defendants misrepresented: (a) the losses the Company was likely to suffer due to BankUnited’s poor underwriting standards, which losses would occur once interest rates reset on the billions of dollars of pay-option arms (adjustable rate mortgages where borrowers had the ability to choose their payment amount during the initial period of the loan); (b) BankUnited’s sketchy appraisal process, which permitted borrowers to obtain mortgages in excess of their ability to pay and in excess of the value of the underlying property; and (c) BankUnited’s policies with regard to "piggy-back" loans, which are essentially second mortgages made at the time a home is purchased to fund a down payment.

 

The BankUnited lawsuit is the latest to raise allegations involving Option ARM mortgages, which I have discussed in prior posts, most recently here.

 

Run the Numbers: Many readers know that I have been tracking subprime and credit crisis-related securities lawsuits. My running tally can be accessed here. As time has gone by, definitional issues have become increasingly challenging. The NextWave lawsuit may present the most significant definitional challenge to date, because the auction rate investment allegations arguably are a peripheral part of the complaint.

 

I could go either way on this one, but after some thought, I have decided to include the NextWave lawsuit in my count, simply due to the fact that the company’s financial problems apparently were due in part to its investments in auction rate securities. Reasonable minds could differ on whether or not to include the lawsuit.

 

But with the addition of the NextWave and BankUnited lawsuits, the current tally of subprime and credit crisis-related lawsuits now stands at 114, of which 74 have been filed in 2008.

 

Dear Bob, you might not remember me, but I used to work at AIG: If you have not yet seen it, you must read the September 16, 2008 letter (here) that Maurice "Hank" Greenberg, AIG’s former Chairman and CEO and current Chairman and CEO of C.V. Starr, to now-former AIG Chairman and CEO Robert Willumstad.

 

I can’t imagine why Greenberg thinks Willumstad might have been concerned that Greenberg would "overshadow" him. Willumstad undoubtedly was reassured that, although Greenberg did feel compelled to note "you and the Board have presided over the virtual destruction of shareholder value built up over 35 years," it was not Greenberg’s "intention to point fingers or be critical."

 

Hat tip to the Wall Street Journal for the link.

 

Because of trees felled last night as Ike’s remnants swept through Ohio, I was unable to make it to the office today. I spent more or less the entire day on the telephone talking about AIG, looking out at my yard strewn with fallen tree limbs, branches, twigs and leaves – a visually suitable tableau give the winds that ripped through Wall Street over the last 48 hours.

 

With respect to AIG, can I just say that today’s mainstream media coverage regarding AIG was absolutely terrible? For most of the day, various news reports seemed to suggest that New York insurance regulators had authorized AIG’s insurance subsidiaries to loan the parent company $20 billion. However, when the transcript of New York Governor David Paterson’s Monday afternoon press conference (here) was later made available on the Governor’s website, it became clear that what the regulators had authorized was quite a bit different than depicted in the media.

 

As the transcript explains (if you read the whole thing), the regulators have authorized an "asset swap." The idea is that the insurance subsidiaries are swapping the more liquid assets they hold for less liquid assets of equal or greater value held by the parent company, so that the parent company can post the liquid assets as collateral. The transaction is further explained in a CFO.com article here.

 

The governor himself noted that this swap transaction alone is not sufficient to see AIG through this current crisis, as the working number for AIG’s current requirements is $40 billion. Much about the asset swap transaction "depends" – that is, it depends on the company’s ability to raise the additional funds it requires, it depends on the actual assets that are transferred, it depends on what further capital requirements AIG may have in this rapidly changing environment.

 

The critical question of the sufficiency of policyholder protection in light of the asset swap will depend on the quality of the assets exchanged. One can hope that given what is at stake that there is a great deal of transparency concerning the assets the insurance subsidiaries receive. Given the regulators’ involvement, one can also hope that policyholders’ interests will not be subordinated to the interests of AIG’s shareholders or bondholders.

 

In the final analysis, AIG’s ultimate circumstances may finally depend on what the credit rating agencies do. CNN is reporting tonight (here) that Fitch’s has already downgraded AIG’s financial ratings, which potentially could trigger significant additional collateral requirements on the AIG’s credit default swap contracts, perhaps as much as $13.3 billion. The specifics regarding the Fitch downgrades can be found here. Following suit, S&P has also downgraded AIG’s counterparty and financial strength ratings (refer here), with the lowered ratings remaining on credit watch "with negative implications." Apparently the downgrades fully considered the potential benefits to AIG as a result of the asset swap transaction.

 

Perhaps of equally significant (if not greater) concern to readers of this blog is the action this evening by A.M. Best’s to downgrade AIG’s property/casualty insurance financial strength rating to A (Excellent) from A+ (Superior), about which refer here.

 

UPDATE: A September 16, 2008 Financial Times article entitled "Downgrades Deepen AIG Woes" can be found here. Moody’s has apparently downgraded AIG as well (refer here).

 

There will be further material developments ahead. The ultimate outcome remains to be seen. The company itself did not publicly comment as these events unfolded today, but some reports suggest that there will be a company statement prior to the opening of the markets tomorrow.

 

About Lehman: At the same time as AIG’s struggles, the details of Lehman’s demise have started to emerge, starting with the company’s Monday morning bankruptcy petition, which can be found here. The Dealbreaker blog has distilled some of the more interesting tidbits from the petition, here.

 

A more scholarly look at the Lehman petition can be found on the Bankruptcy Litigation Blog (here), which notes that the petition bears the indicia of having been prepared in haste. The blog also notes that as a result of recent bankruptcy law revisions, Lehman’s petition may face some rather complicated challenges. (Hat tip to Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog, here, for the link to the Bankruptcy Litigation Blog.)

 

Roger Parloff also discusses on the Legal Pad blog (here) the challenges that Lehman’s petition presents. As statements Parloff quotes on his blog make clear, Lehman may not be able to enjoy one of the primary benefits usually available to company’s filing a bankruptcy petition, the automatic stay. Bankruptcy laws relating exclusively to investment banks provide that Lehman’s transaction counterparties can now, even after the petition filing, seek to terminate their contracts with Lehman, which could further exacerbate the current distress.

 

And on another note, CFO.com has an interesting article (here) asking the question whether Lehman’s creditors can try to recoup the $5.7 billion in bonuses that Lehman paid its employees in December 2007.

 

The damage from Lehman’s collapse will be widespread, as investors holding its shares and even its debt securities will likely see little or nothing on their investment. This asset wipeout comes on the heels of the Fannie Mae and Freddie Mac takeout, and at the same time as the precipitous decline in AIG’s shares. All of this means that in a few short days a significant chunk of asset valuation has disappeared (and that is not even counting the overall decline in market values today). These investment losses are going to hit a lot of other companies, not to mention pensions, mutual funds, hedge funds, other insurance companies, endowment funds and so on. These losses will have to be reckoned in the weeks and months to come.

 

The extent of the consequences from these events may be difficult to foresee even now,  though the events have been widely reported. Who could have foreseen that when Ike came roaring ashore early Saturday morning in Galveston that on Monday morning trees would be down all over Northeast Ohio?

 

For Those Who Can’t Wait: If you are (like me) one of those people who need to know what it all means, you will want to refer to Professor Davidoff’s overview on the Dealbook blog (here). An analysis that takes a darker, more cynical view of these events can be found on The Big Picture blog (here).

 

According to various news sources (here), Kansas Bankers Surety (KBS, about which refer here), a unit of Berkshire Hathaway, is exiting the business of privately insuring bank deposits beyond the $100,000 limit of the Federal Deposit Insurance Corporation. The September 10, 2008 Wall Street Journal reported (here) that the company is notifying about 1,500 banks in more than 30 states that it will no longer offer bank deposit guaranty bonds.

 

The part of this story that interests me (and, I am guessing, most other people, too) is the Journal’s statement that, according to sources, the order to stop insuring bank deposits came directly from Warren Buffett himself, although a spokesman for the company declined to comment on the report.

 

The Journal article also shed a little bit of light on what might have precipitated the decision. The article reports that KBS insured some deposits of Columbian Bank & Trust Company of Topeka, Kansas which failed on August 19, 2008 (about which refer here), which at the time of its failure had 610 accounts representing approximately $46 million potentially exceeding government insurance limits.

 

It is unclear from news reports what KBS’s exposure is in connection with the Columbian Bank failure. However, Columbian Bank is one of eleven banks to have failed already this year, and concerns about further failures loom. As the Journal article stated, the decision for KBS to withdraw from bank deposit guaranty bonds is "an indicator of how many in the industry are worried about future bank failures."

 

The prospect of future losses could have been a precipitating factor in KBS’s pullback. But I am guessing that Buffett himself needed little persuading to exit this business. He has a long-standing and very public antipathy for the banking business. As he wrote in one of his annual letters to Berkshire’s shareholders (here):

 

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

 

Some readers may wonder about these comments in light of Berkshire’s substantial investment in Wells Fargo. Specifically, as of December 31, 2007, Berkshire owned 303,407,068 Wells Fargo shares, representing 9.2% of the shares outstanding, at today’s price worth more than $10 billion. Buffett commented on his willingness to invest in Wells Fargo at the time he made his first significant investment in the company, notwithstanding his general antipathy for banks, citing the quality of Wells Fargo’s management and its culture.

 

However, at the same time Buffett lauded Wells Fargo’s virtues, he also acknowledged its vulnerabilities:

 

Of course, ownership of a bank – or about any other business – is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic – the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market’s major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

 

Readers may be interested to know when Buffett wrote these statements. Both Buffett’s remarks about the lemming-like qualities of banking managers and the potential problems of systemic risk and overbuilding on the West Coast appeared in Buffett’s 1990 letter to Berkshire shareholders. Reading his 1990 remarks some eighteen years later does suggest that history seems destined to repeat, at least when it comes to banking. From the 1990 shareholders’ letter is also clear that part of the reason Buffett was willing to invest in Wells Fargo then was that, due to terrible banking results at the time, bank stocks were beaten down and Wells Fargo was a relative bargain.

 

There have been numerous reports that we are now facting the worst set of conditions for the banking industry since that prior period. Although Buffett was then able to make a favorable investment in Wells Fargo, he undoubtedly recalls what happened to others in the banking industry in the late 80’s and early 90’s. The current conditions are similar to those from which Buffett profited in the past. He undoubtedly has aspirations of repeating that performance this time around, but at the same time he has no interest in footing the bill for depositors’ losses in excess of FDIC insurance.

 

If Buffett thinks this movie looks like a remake of old familiar classic, his actions suggest that he is pretty sure he know what is going to happen in the next scene.

 

From the Archives: Buffett is not the only one who memory runs back to the earlier era of failed banks. Many of us oldsters in the D&O business earned our spurs during the S&L crisis and era of failed banks in the early 80s and 90s. If we are indeed headed into another period of significant bank failures, many of the themes from that earlier time may again be relevant, including some venerable D&O insurance coverage issues, as I noted on a recent post, here.

 

Back to the Future: Comparisons back to the earlier era of failed banks seems to be the order of the day. According to a September 11, 2008 press release (here) from Navigant Consulting, the subprime-related litigation filed in federal court in the last 18 months already exceeds the amount of litigation filed in the S&L crisis.

 

The press release states "the number of subprime-related cases filed in federal courts through the second quarter of 2008 has topped the 559 savings-and-loan (S&L) lawsuits of the early 1990s, until now viewed by many as the high-water mark in terms of litigation fallout from a major financial crisis."

 

The release specifically cites the "rising tide of bank failures" as one potential source from which future litigation could emerge.

 

The Navigant data is interesting, but it would be even more helpful if the company had specified how it collected its data and what it was "counting" as subprime litigation. I know from my own efforts to track the subprime securities litigation that deciding what to count and what to exclude is an extremely challenging task. It would enhance the Navigant reports if the company were to provide a little more specificity about exactly what the company’s "count" actually represents.

 

Special thanks to the several readers who sent me links about the Navigant report.

 

The Hits Just Keep on Coming: In my prior post (here) commenting on the government takeover of and litigation involving Fannie Mae, I noted that the company’s huge loss of market capitalization would translate to significant losses throughout the marketplace and that in the weeks and months ahead we would find out where those losses landed. Along those lines, Progressive Corp. today announced (here) a monthly loss for August 2008 of over $135 million, based on large part on the write-down of the company’s holdings in Fannie Mae and Freddie Mac securities.

 

The company reported that during August, its holdings of Fannie and Freddie preferred stock declined $271.4 million and its holdings of the two companies’ common stock declined $6.8 million. The company also reported that following the government’s recent takeover, its holdings in Fannie and Freddie preferred stock declined an additional $171.3 million, which loss will be reported in the company’s September monthly results.

 

For those keeping score at home, that means that the value of Progressive’s holdings in Fannie and Freddie’s preferred securities declined a total $442.7 million in August and September. Even for a company the size of Progressive (the company had YE 2007 assets of nearly $19 billion), that is significant.

 

Progressive is far from the only company that will be reporting these kinds of results in the weeks and months ahead. Indeed, and to bring this blog post full circle, I note in that regard that a September 11, 2008 CFO.com article entitled "Fannie-Freddie Bailout  Losses Hit Banks" (here)  reports that a number of banks have issued warnings about the hits they must take to their balance sheet because of Fannie and Freddie’s collapse.

 

In what is, according to news reports (here), the largest settlement to date in a shareholders’ derivative lawsuit in Delaware Chancery Court, four former AIG executives and former AIG managing general agent C.V. Starr today reached a $115 million settlement in the 2002 AIG derivative lawsuit.

 

The lawsuit was filed by the Teachers’ Retirement System of Louisiana in 2002 against AIG, as nominal defendant; certain former AIG directors and officers (many of whom were later dropped from the case); and Starr.

 

According to news reports (here), the plaintiff alleged that half of the $2 billion AIG paid C.V. Starr between 2000 and 2005 "represented sham commissions for work that, in some cases, was done by AIG employees." The lawsuit also questioned "why some executives were allowed to serve simultaneously as officers of C.V. Starr, a closely held insurance agency, while profiting from business between the two companies." The complaint also alleged that Starr gave the individual defendants bonuses on fees from AIG. In effect the complaint alleged that the commissions were a mechanism for the defendants to "line their pockets."

 

The case was scheduled to go to trial on September 15, 2008. The four settling individual defendants include former AIG Chairman and CEO Maurice Greenberg; former AIG CFO Howard Smith; former Vice Chairman of Investments Edward Matthews; and former director and Vice Chairman of Insurance Thomas Tizzio.

 

The vast bulk of the settlement — $85.5 million – is to be paid by AIG’s D&O insurance carriers. A list of the carriers on AIG’s D&O program can be found here.

 

The more interesting question is where the remaining $29.5 million will come from. Some of the news reports give the impression that the individuals are funding the settlement. However, it appears that the individuals themselves are funding only a small portion of the remaining $29.5 million.

 

Greenberg’s counsel’s statements to the press (for example, here) are quite emphatic that Greenberg himself will not be contributing anything the settlement. One news report (here) does suggest that Tizzio "is expected to pay between $1 million and $5 million," Smith and Matthews "would pay very small amounts, if anything."

 

It appears that the bulk of the $29.5 million will be paid by C.V. Starr. According to Greenberg’s counsel, Starr "expects to contribute between $20 million and $30 million."

 

The details about who will be paying what seem surprisingly imprecise. In particular, the wide potential variance in Tizzio’s contributions seem odd to me, as even a wealthy individual generally would require a more precise determination of how many millions of his dollars are going to be required. Which makes me wonder whether perhaps Tizzio has an individual source of insurance that may be contributing on his behalf.

 

There are a variety of other odd features to this settlement, at least as it is described in the news reports, the most striking of which is that Tizzio apparently will be making a material settlement contribution but apparently Greenberg will not. To be sure, C.V. Starr, of which Greenberg is still Chairman and CEO, will be making a more than $20 million contribution, raising the question whether the amount of Starr’s contribution and the fact that Greenberg himself is not contributing to the settlement are linked.

 

And even with respect to C.V. Starr’s contribution, certain questions arise. For example, given the fact that some or all of the individual defendants apparently were also officers of C.V. Starr, is Starr’s D&O carrier funding some or all of Starr’s contribution to the settlement?

 

It should also be noted with respect to Starr’s payment to AIG that Starr is in fact AIG’s largest shareholder. As of July 15, 2008, Starr owned 10.5% of AIG’s outstanding shares, which represents Starr’s largest asset. Maybe that is just context, but it is an interesting context nonetheless.

 

I also have questions concerning the $85.5 million contribution from AIG’s D&O carriers. Beyond sheer curiosity about how much of AIG’s D&O insurance tower was depleted by defense expense, I also wonder whether the insurer’s settlement contribution to this derivative settlement drew upon the insurance program’s Side A coverage, which provides protection for nonindemnifiable loss. You would not expect the $85.5 million payment to AIG to be indemnifiable in the absence of insurance, so all else equal the amount would seem to represent a Side A loss. The same would also seem to be true with respect to the individuals’ own separate contribution to the settlement.

 

My question about which D&O policy coverage funded the settlement may require some context. Given the size of this derivative settlement, as well as other recent large derivative settlements (including, for example, the $50 million Hollinger derivative settlement), there seems to be a growing threat of very large derivative settlements, which is a relatively new development.

 

Many companies, particularly large financial services companies, often have D&O insurance programs built exclusively or predominantly of Side A-only protection. These kinds of programs have become increasingly common in recent years, but in general losses have really not yet caught up to this coverage to a significant degree.

 

The options backdating derivative cases presented the possibility of significant potential losses for these types of coverages, but it is my understanding that the Side A-only losses from these cases really have not yet significantly materialized. There has been speculation that the subprime litigation wave might also produce significant Side A losses, but those cases are only in their earliest stages yet, so the losses have yet to fully develop.

 

The possibility of derivative settlements of the magnitude of the recent AIG settlement may represent the most significant threat to these Side A programs and coverages, at least outside of the bankruptcy context. Which is why I am curious to know which policy coverage funded the AIG D&O insurers’ portion of the AIG settlement.

 

Finally, I am curious about how likely coverage issues were dealt with in connection with this settlement. I expect that the insurers would have raised the personal profit exclusion typically found in most D&O policies as at least a potential defense to coverage. I am guessing that the existence of this issue complicated the settlement process (or at least the insurers’ contribution to the settlement). The absence of a judicial determination that the individuals had improperly profited undoubtedly ameliorated this potential impediment. The individuals’ desire to avoid any determination that might preclude coverage may have helped precipitate settlement on the eve of trial.

 

As always, I am interested if any readers can shed any light on the details. I am particularly interested details involved with the individuals’ contributions; around the extent of insurance funding for C.V. Starr’s contribution; and concerning AIG’s insurers’ contributions. Anonymity will be scrupulously protected.

 

According to news reports (here), on September 8, 2008, Judge Jeremy Fogel of the Northern District of California preliminarily approved the settlement of the Apple options backdating derivative litigation.

 

As reflected in the parties’ Stipulation of Agreement of Settlement (here), the plaintiffs in the consolidated Apple derivative action agreed to dismiss the action subject to the defendants agreement to pay $14 million to the company; the defendants’ agreement to pay the plaintiffs’ counsel’s various attorneys’ fees and costs totaling $8.85 million; and the company’s agreement to adopt certain corporate governance reforms. According to the Stipulation, the various derivative lawsuits "were a material factor in obtaining the $14 million payment from Apple’s liability insurers." The total cash value of the various payments is $22.85 million.

 

UPDATE: An alert reader has raised an important question about my statement that the total cash value of this settlement is $22.85 million. The reader said the following in an e-mail to me: "You describe the settlement as involving a cash payment of $22.85 million based on the $14 million D&O settlement paid to Apple and the $8.85 million fee award expense payment made by Apple to the plaintiffs. However, as a practical matter aren’t you ‘double counting’ since, presumably, the plaintiff fee awared was paid by Apple from the D&O proceedsit received from its carriers?"

 

Assuming this reader’s analysis is correct, this is a very important distinction. The Stipulation of settlement is consistent with the reader’s hypothesis, but not definitive. The Stipulation is clear that the $14 million payment is coming from Apple’s D&O carriers. It also says that the $8.85 million is to be paid by Apple. It is not clear whether or not the D&O insurers will be reimbursing Apple for the $8.85 million or if the $14 million is the only payment that the D&O insurers will be making in connection with the settlement. It would be helpful if any reader with more specific knowledge of the insurance arrangements pertaining to this settlement would let me know.

This reader’s question also suggests another component that is relevant to these insurance issues but that is not addressed in the Stipulation, and that is the question of defense expense. In a case like this where there are regulatory proceedings and special litigation committee activities as well as civil litigation, there frequently are disputes about which defense fees are covered and which are not. In a case like this one, the aggregate amount of all fees could well exceed $10 million. To the extent the insurer’s $14 mllion payment is the total amount of insurance remitted to Apple, leaving the company to absorb both the $8.85 million of plaintiffs’ attorneys’ fees and expenses as well as all of the related defense expense, the $14 million payment could even be less than the amounts for which the company itself is reponsible.

 

The settling defendants include the Company; its Chairman, Steven Jobs; and certain other present and former directors and officers of the company. Judge Fogel set a final settlement hearing for October 31, 2008.

 

I have already received inquiries from persons questioning the size of the Apple options backdating derivative lawsuit settlement. The questioners are concerned that the settlement amount is seemingly small, especially in light of who the company is and the nature of the allegations.

 

There is no doubt that the Apple options backdating allegations have been very high profile. In addition, parallel SEC enforcement proceedings did result in the payment of some significant fines. On August 14, 2008 former Apple general counsel Nancy Heinen agreed to pay $2.2 million to settle options backdating charges (about which refer here), and last year former Apple CFO Fred D. Anderson agreed to pay $3.5 million to settle SEC claims against him (about which refer here).

 

The consolidated amended complaint also contains some apparently serious allegations. As discussed here, the amended complaint raised certain options springloading allegations, including the allegation that three Apple executives received a windfall when they were granted options to buy over 2 million shares the day before the announcement of a significant technology investment and other developments sent Apple’s shares up 48 percent. The amended complaint also alleges that Jobs himself received backdated options that were later cancelled in exchange for restricted stock.

 

Despite these allegations and notwithstanding the SEC settlements, the plaintiffs’ case faced certain potentially significant challenges. First, in a December 19, 2007 opinion (here), Judge Fogel had dismissed the plaintiffs’ initial pleadings, with leave to amend. In issuing this ruling, Judge Fogel did not even reach the demand futility issue, deferring that to a later date.

 

The plaintiffs filed their consolidated amended complaint on December 18, 2006 (refer here), seeking to overcome the deficiencies in the original pleadings. However, just days later, on December 29, 2006, Apple announced the completion of the special investigative committee’s investigation of the company’s stock option practices.

 

A joint statement by the committee’s co-chairs, former Vice President Al Gore and audit committee chair Jerome York, stated that Apple’s board "has complete confidence in the senior management team." The company’s 10-Q issued the same day (here) stated that the committee "found no misconduct by current management." (The 10-Q did go on to say that the investigation had "raised serious concerns about the actions of two former officials"—presumably Heinen and Anderson).

 

It is no surprise to me that faced with an apparently skeptical court and an unhelpful (if also somewhat controversial at the time) investigative committee report, the plaintiffs’ found it expedient to settle. The questions I have received have not reflected concerns about the fact that the plaintiffs settled; the concerns have had more to do with the amount of the settlement.

 

If you disregard for a moment that a high-profile company like Apple is involved, there is nothing particularly unusual about the size of this options backdating derivative settlement, at least in the context of other options backdating derivative settlements. Setting to one side the UnitedHealth Group derivative settlement (about which refer here), the options backdating derivative lawsuit settlements to date have been relatively modest, and the total value of the Apple derivative settlement is well within range of the other settlements.

 

As reflected in my running table of the options backdating lawsuit case resolutions (which can be accessed here), the total value of very few of the options backdating derivative settlements has exceeded seven figures. Indeed, the Apple settlement is actually one of the larger options backdating derivative settlements. The total cash value of only three derivative settlements exceeds the Apple settlement: UnitedHealth Group; Cablevision ($34.4 million, about which refer here); and Electronics for Imaging ($24 million, refer here).

 

By and large the options backdating derivative settlements (in the cases that have not been dismissed outright) have been relatively modest, consisting in many cases only of a payment of plaintiffs’ attorneys’ fees and the agreement to adopt certain governance reforms. Although there were a truly impressive number of options backdating derivative lawsuits filed (168 by my count, as reflected here), very few of them seem to be resulting in significant payouts.

 

As the options backdating scandal recedes in the rear view mirror, it definitely has started to seem like less and less of a big deal, particularly in the context of the current daily diet of government bailouts, floundering investment banks, and multibillion dollar securities buybacks – with one big exception, as noted below.

 

And Speaking of UnitedHealth: The UnitedHealth Group cases have definitely been the most notable big-dollar exception in the options backdating scandal. The company was back in the news again today with the announcement (here) from the options backdating securities lawsuit lead plaintiff, Calpers, that the company’s former CEO William McGuire had agreed to pay $30 million and its former general counsel David Lubben had agreed to pay an additional $500,000 in settlement of the options backdating securities claims pending against them. McGuire’s own press release about the settlement can be found here.

 

Taken together with the $895 million previously announced settlement (refer here) in the UnitedHealth Group options backdating securities lawsuit, the aggregate value of the options backdating securities settlements in the case now totals $925.5 million, certainly a large number by any measure. This settlement total is also in addition to the UnitedHealth options backdating derivative settlement, which had a total value of over $600 million.

 

Although the various press releases are not specific in this respect, the implication is that McGuire’s $30 million settlement payment will come out of his own personal assets, rather than insurance or corporate indemnity. If that is the case, this settlement would represent one of the larger individual payments of its kind.

 

Fifth Circuit Affirms Options Backdating Securities Lawsuit Dismissal: In a September 8, 2008 per curiam opinion (here), the Fifth Circuit affirmed the dismissal of an options backdating related securities lawsuits. (The district court’s October 4, 2007 dismissal can be found here. Background regarding the case can be found here.)

 

The Fifth Circuit affirmed the district court’s dismissal on loss causation grounds. The holding is interesting because the company’s stock actually did drop on the date of the alleged corrective disclosure.

 

The Fifth Circuit held that the press release in question was not sufficient to satisfy the requirements to establish loss causation because "although the stock price dropped dramatically on the day of the 1 August 2006 press release, no new facts concerning Cyberonics’ stock-option accounting were disclosed in that release which demonstrated that the ‘truth became known’ about Cyberonics’ challenged financial statements." Therefore the Fifth Circuit concluded, "a causal connection between the material misrepresentations and the loss was not adequately pled."

 

Special thanks to Neil McCarthy of Lawyer Links for alerting me to the Fifth Circuit’s opinion.

Each fall for the last two years, I have taken a look at the current trends and hot topics in the world of D&O. There are of course certain perennial topics that are always critical, but this overview is intended  to focus on the issues the most significant current interest for D&O insurance professionals and their clients. Here is my list of the current issues to watch:

 

1. Limits Adequacy: The question of limits adequacy has long been one of the more challenging parts of the D&O acquisition process. Against a backdrop of basic affordability, the company must try to determine how much insurance is "enough"?

 

Several recent developments have surrounded these issues with even greater urgency. The most dramatic of these developments arises from the claims surrounding the collapse of auto parts supplier Collins & Aikman. The company carried $50 million D&O insurance limits, but the cumulative expense of the various civil, regulatory and criminal proceedings arising from the company’s demise have entirely exhausted the $50 million insurance program, leaving individual defendants to face ongoing criminal prosecutions and civil litigation without insurance available to fund their defense. (Refer here and here for further discussion of the Collins & Aikman case.)

 

There have been several other recent examples where astronomical defense expense has exhausted or substantially depleted entire D&O insurance programs.

 

The escalating cost of defense is only one of several factors raising limits adequacy concerns. The steady rise in average and median claims severity, as well as the growing threat of separate opt-out litigation following the settlement of class litigation (about which refer here), also underscore the growing complexity of limits adequacy issues.

 

In light of these developments, particularly the catastrophic potential for defense expense to deplete policy limits, it may be time to rethink traditional notions of limits adequacy, because past assumptions may no longer be sufficient.

 

2. Insurance Structure: For several years now, conversations in connection with the D&O insurance transaction have included the discussion of additional Side A insurance to provide additional protection for individuals’ liability and defense expense that is not indemnifiable due to insolvency or legal prohibition. In recent months, interest in Side A protection and other auxiliary D&O insurance structures has recently taken on increased urgency, as a result of two developments.

 

The first derives from the preceding topic; that is, concerns about limits adequacy inevitably lead to questions about structure, because even substantially increased limits may not be sufficient to address all concerns, given the potential for defense expense to consume available limits.

 

One way for corporate officials to ensure they are not left without insurance to protect them is through the creation of an auxiliary insurance structure dedicated solely to their protection. There are a number of different auxiliary D&O insurance products available to address these concerns. Most of these structures have been available in various forms for some time now. What has changed is the level of interest in these insurance structures.

 

A separate legal development is also driving interest in auxiliary insurance structures. In March 2008, a Delaware Chancery Court opinion in the Schoon v. Troy Corporation case held that a Delaware corporation may retroactively eliminate former directors’ advancement rights. (Refer here for my prior discussion of the case). The possibility that former directors could lose their rights to indemnification or advancement after the end of their board service may come as unwelcome news to many directors.

 

The typical D&O insurance policy provides coverage for former directors and officers. Under most circumstances, a former director from whom corporate advancement and insurance has been withheld would still be able to seek defense expense protection and indemnification under the company’s D&O insurance policy.

 

Directors who are concerned that events following their departure from the board could conspire to leave them unprotected (for example, if limits were exhausted or substantially depleted , as discussed above), yet another auxiliary insurance product is now available. A retired director insurance policy is dedicated solely to the protection of the named individual and cannot be terminated or discontinued by the action of others.

 

The point is that directors and officers rightly are more concerned about the availability of insurance protection when they need it most. As a result, interest in the wider variety of auxiliary insurance structures has increased.

 

3. Excess Insurance: For reasons that should be clear from the first point above, excess D&O insurance is an increasingly important part of the D&O claims resolution process. Perhaps because of excess D&O insurance’s increasing involvement, there have been a series of D&O insurance coverage disputes involving excess D&O insurance. These disputes have highlighted the importance of two particularly important issues concerning excess D&O insurance.

 

The first of these issues involves the excess policy’s language describing the circumstances under which the excess policy’s payment obligations are triggered. This language can become critically important if the policyholder reaches a compromise with an underlying insurer as a result of which the underlying insurer pays less than its full policy limits, leaving an insurance "gap" to be funded by the policyholder.

 

In two recent decisions, one involving Comerica (refer here) and one involving Qualcomm (refer here), courts interpreting policy language providing that the excess insurer’s obligations are triggered only if the underlying insurance is exhausted by the underlying insurer’s payment of loss held that the excess insurer’s obligations were not triggered even if the policyholder funded an insurance "gap."

 

These case developments have increased the awareness of the importance of excess insurance exhaustion language and coverage triggers. Alternatives now available in the marketplace allow payments by policyholders funding "gaps" as sufficient to trigger excess insurance payment obligations.

 

The second of the excess insurance issues involves coverage issues that so-called "follow form" excess insurers. The particularly troublesome issues arise when excess insurers raise policy defenses that the underlying insurers did not assert. Each policy of course represents a separate contract, but policyholders obviously expect each layer of a single insurance program to respond similarly to the same set of claims circumstances.

 

These issues have drawn even greater scrutiny in recent cases in which "follow form" excess insurers contend that their policy contains exclusions not found in the underlying policies, or that the excess insurer has policy application defenses different from the underlying insurers.

 

Although excess insurance frequently is described as "follow form," the increasing frequency of coverage defenses raised only by excess insurance suggest that, regardless of how the policy is characterized, the operation of excess insurance can be something substantially different than "follow form." The factors described above regarding escalating defense expense and increasing average and median claims severity ensure that these excess insurance issues are likely to be increasingly important.

 

4. Subprime Claims and The Cost of D&O Insurance: Largely as a result of the litigation activity surrounding the subprime meltdown, D&O claims activity has in recent months returned to historical levels after a period of reduced activity. Because much of the subprime litigation has been high profile, there is a frequent assumption that the cost of D&O insurance must be increasing.

 

As I noted in a recent post (here), so far, except with respect to certain marketplace segments such as the financial sector, D&O insurers generally have not restricted capacity, reduced coverage or raised prices. These buyer-friendly conditions are largely the result of the relatively positive results insurers have enjoyed in recent years. The insurance marketplace remains competitive.

 

The subprime litigation wave is continuing to spread. The risk for insurers is that in a competitive environment, pricing can fall below risk-related requirements, leading to an eventual correction. To the extent the current litigation wave produces significant insurance payouts, the current competitive conditions could change quickly, particularly if the litigation wave spreads beyond the financial sector. However, at this point, these possibilities continue to appear remote and the marketplace remains competitive.

 

Afterword: There are other developments that I think are important and worth watching, such as the growing potential for possible climate change disclosure issues (about which refer here) and the emergence of civil litigation arising from corrupt practices enforcement proceedings (about which refer here). These and other developing concerns still fall more in the category of emerging issues rather than current trends. The one thing that is clear is that the world of D&O continues to be characterized by constant change.

 

I have set out above what I consider to be the critical current issues but I am certain that others may have a different view of what the hot topics are in the current environment. I would like to encourage readers to use the comment function to add their own views about the current hot D&O insurance topics. Please note that comments can be added anonymously.