The current securities litigation wave first arose out of the collapse of the residential real estate subprime mortgage market. As I have previously noted (here), the wave long ago ceased to be just about subprime mortgages, as the litigation as expanded to encompass the fallout from a more general credit crisis. As demonstrated in a recent lawsuit, the wave now includes litigation arising from disruptions in major development construction project financing.

 

According to their August 20, 2008 press release (here), plaintiffs’ counsel have initiated a purported securities class action in the United States District Court for the District of Massachusetts against Perini 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 Perini, a company that offers general contracting, construction management and design-build services to private clients and public agencies worldwide, failed to disclose:

(a) that the developer of Perini’s Las Vegas, Nevada projects, including the CityCenter Project, was experiencing financial problems because it failed to secure financing for the entire project and was dependent upon raising the remainder of the financing from the expected sale of residential units. However, the proceeds from the residential unit sales were based on unrealistic and aggressive prices at a time when the condo market in Las Vegas, Nevada was extremely weak; (b) that the Company’s Las Vegas projects were being delayed, and could possibly be halted; (c) that the developer was in risk of defaulting on its construction loan; (d) that the Company’s future revenue and profit was dependent upon the Las Vegas projects since the projects consisted of approximately 20% of its backlog; and (e) as a result of the foregoing, the Company’s ability to maintain its profit margins was in serious doubt.

Then, on January 17, 2008, the Company issued a press release announcing that Deutsche Bank "delivered a notice of loan default to the developer of the Cosmopolitan Resort and Casino project under construction in Las Vegas, Nevada." In response to this announcement, shares of the Company’s common stock fell $10.05 per share, or 27%, to close at $27.65 per share, on heavy trading volume.

The general economic downturn is now affecting a broad variety of companies in diverse industries. As I have previously noted (most recently here), in all likelihood, in the weeks and months ahead, other companies will be finding that transactions entered in more clement circumstances now appear troubled. As more companies stumble on these troubled transactions, further lawsuits undoubtedly will emerge. And as is the case with the Perini lawsuit, most of these lawsuits will have little to do with subprime mortgages directly.

 

In any event, I have added the Perini lawsuit to my list of subprime and credit crisis-related securities class action lawsuits, which can be accessed here. With the addition of the Perini lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands at 108, of which 68 have been filed in 2008.

 

For those who are curious, information about the CityCenter Las Vegas project can be found here. Background about the Cosmopolitan Resort and Casino can be found here.

 

As a result of recent academic research (refer here and here) and other recent developments, Rule 10b5-1 trading plans have attracted critical attention, including SEC scrutiny (refer here). Allegations of alleged misuse of Rule 10b5-1 trading plans have even made their way into shareholder litigation. For example, allegations of Andrew Mozillo’s alleged misuse of his Rule 10b5-1 plans are a central part of the Countrywide shareholders’ derivative complaint (refer here).

 

An August 18, 2008 Latham & Watkins memorandum entitled "Rule 10b5-1 Plans: Recommended Guidelines for Managing Risks in the Current Environment" (here) takes a look at the heightened scrutiny currently surrounding Rule 10b-1 trading plans and presents a set of "better practices to consider" in developing and deploying the plans.

 

Among other things, the authors examine the Rule’s various requirements, and in particular the Rule’s provision specifying that an individual may "in good faith" modify a prior plan, so long as he or she is not aware of material nonpublic information at the time of the modification. The authors correctly note that "the good faith requirement is an important constraining, and problematic, factor because it is inherently subjective. Modifications that do not have a good faith justification will lose the benefit of the affirmative defense. Frequent modifications may be especially hard to justify."

 

The authors review other questions that have been raised in connection with Rule 10b5-1 plan structure and implementation. They suggest that to avoid these kinds of problems or questions companies can adopt certain guidelines to "limit opportunities for their insiders to engage in abusive practices, and more importantly, to avoid the appearance of practices that might be viewed as abusive based on later developments."

 

The authors make a number of good, practical suggestions that should go a long way toward avoiding some of the issues that have raised questions in connection with Rule 10b5-1 plans. The suggestions that appear particularly important in light of recent questions is the authors’ suggestions that "companies should prohibit insiders from entering multiple overlapping 10b5-1 plans," and that companies should promptly disclose insiders’ adoption of Rule 10b5-1 plans through a press release or 8-K filing. The authors also suggest tight restrictions on plan modifications and terminations, as well as on "fast sales," suggesting instead a requirement for a cooling off period.

 

The recent questions surrounding alleged Rule 10b5-1 plan misuse haveraised concerns about the protective value these plans may offer. But as the authors make clear, properly structured plans may continue to provide valuable protection. It is true that insiders who are starting or stopping plans, or running multiple plans, may find themselves unable to rely on the Rule’s safe harbor. But trading plans structured and implemented according to the original intent of the Rule should still afford the protection for which the Rule was designed.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing me with a copy of the Latham & Watkins memorandum.

 

Rating Agencies and Subprime Litigation: As I noted in a prior post (here), the SEC recently released a report critical of rating agencies’ "shortcomings" in connection with their provision of ratings on mortgage-backed securities and other instruments now at the cent of the subprime meltdown. As also discussed in a separate prior post (here), claimants in a recent securities lawsuit have also raised allegations against the rating agencies, alleging conflicts of interest and other alleged misconduct.

 

According to an August 12, 2008 article entitled "Rating Agencies: A New Front in Subprime Litigation" (here), by Larry Ellsworth and Ishan Bhabha of Jenner & Block, the recently filed lawsuit naming rating agency defendants "may just be the tip of the iceberg." The authors suggest that regulatory investigations and other developments may portend further claims against the rating agencies.

 

However, the authors also note that the "agencies are not without defenses." In particular the rating agencies may be able to rely on case authority developed in connection with the Orange County and Enron cases that their rating activities are protected by the First Amendment.

 

The authors question whether the rating agencies will actually be able to rely on these defenses in the circumstances surrounding their rating of the subprime mortgage-backed assets and other related instruments. The authors note that "the agencies only rated those securities for which they were paid, and furthermore had substantial and ongoing involvement with the banks in order to structure the offerings." (For further discussion of the availability of the rating agencies’ potential defenses, refer here.)

 

In addition, the authors also note that "to the extent the rating agencies were actively working with issuers to help them package products in order to get a higher rating the agencies may be especially vulnerable to charges of self-dealing and conflicts of interest, and, if the agencies did not reveal these relationships, these actions might be investigated as material omissions."

 

The authors conclude by noting that these issues are "sure to generate contentious and interesting litigation for years to come."

One of the legacies of the era of corporate scandals earlier in this decade is a heightened awareness of corporate governance issues. This development is most obvious for publicly traded companies in the United States, with the governance requirements embodied in the form of the Sarbanes-Oxley Act. The heightened governance awareness has also had spill-over effects for private companies (refer here) and even non-profit entities (refer here).

 

But there are many other types of non-listed firms, beyond just private companies and non-profit enterprises – including joint ventures and family-owned firms, as well as venture funds, private equity firms and hedge funds. The heightened governance awareness has also affected these other kinds of non-listed firms. But many of the principles and practices developed for publicly traded companies may be ill-suited to these other kinds of non-listed firms.

 

 

In a comprehensive book entitled “Corporate Governance of Non-Listed Companies” (here), Professors Joseph McCahery of the University of Amsterdam and Erik P.M. Vermuelen of Tilberg University take a look at corporate governance principles and practices for these other kinds of non-listed firms.

 

 

The professors begin with observations about current attitudes toward governance, particularly those evolved from the context of publicly traded companies. They note that “it could very well be argued that non-listed companies do not always benefit from the spill-over effect of the application of disproportionate governance rules” and that a “corporate governance framework that is not consistent with the social and economic requirement of non-listed companies will yield imperfections over time.”

 

 

In their book, the authors propose a corporate governance framework for non-listed firms that will “foster strong decision-making, accountability, transparency and ultimately firm performance.”

The authors organize their corporate governance analysis around “three pillars.” The “core pillar” represents “company law, which provides rules and standards for registration and formation, organization and operation.” The second pillar consists of “contractual mechanisms, such as joint venture agreements and shareholder limitations.” The third pillar consists of the non-listed firms “embrace of the corporate governance rules and principles that are tailored to the organization of their publicly held counterparts.”

 

 

The authors’ exhaustive overview of the transjurisdictional development of “company law” demonstrates how various legal norms have evolved in many jurisdictions to address concerns arising from the need to protect investors and creditors from “managerial opportunism.” But these paramount principles of governance for publicly traded firms, whose ownership is widely dispersed and at an informational disadvantage to management, may not be as relevant within the ownership structures of non-listed firms.

 

 

Because of the differing needs and structures of non-listed firms, many of their governance requirements and expectations are highly contractual in nature, and tend to be more focused on protecting one set of owners and shareholders from another set of owners or shareholders. These contractual arrangements tend to address “four fundamental elements – risk of losses, return, control and duration.”

 

 

From the authors’ perspective, the value and importance of these contractual arrangements underscores the limitations of a “one-size-fits-all” approach to corporate governance and also militates against the regulatory imposition of rigid governance mandates on non-listed companies. The authors particularly address these concerns in depth in the context of private equity firms and hedge funds.

 

The third pillar of the authors’ governance framework pertains to non-listed firms’ voluntary adoption of governance measures to improve transparency and accountability. The authors suggest that companies have “strong incentives to adopt or disregard governance recommendations based on a cost-benefit assessment.” Non-listed firms have a “high-powered incentive to comply with corporate governance provisions.” The implementation of appropriate internal control measures, for example can “(1) reduce financial/reporting errors; (2) help firms follow their business practices and performance; (3) assist in tracking inventory; and (4) signal potential weaknesses within the firm.”

 

 

The authors argue for the adoption of an “optimal set of recommendations” that not only would “create a dynamic and sustainable network of business practices and advice tailored to the needs of non-listed companies” but would also “head off legislative pressures.” The “steady and healthy growth” of these kinds of firms, which are so critical to overall economic growth and development, would be advanced by their implementation of mechanisms ensuring that

 

(a) financial statements fairly present the performance of the business; (b) independent and knowledgeable directors and/or supervisors are appointed; (c) audit committees are established; and (d) strong internal control systems and processes reduce business risks and lower costs.

 

The authors’ ultimate point is that “the ‘one-size-fits-all’ and regulatory mentality arguably led to some undesirable spill-over effects to non-listed companies.” They advocate “the introduction of a separate approach” based on the development of guidelines for non-listed firms that are “sufficiently attractive and coherent from a cost-benefit perspective to persuade non-listed companies to opt into a well-tailored framework of legal mechanisms and norms.” The authors conclude that non-listed companies that operate under “well-designed and effective governance structures are likely to perform better and consequently will be more attractive to external investors.”

 

 

The authors’ analysis of the limitations of a one-size-fits-all approach to corporate governance is well-founded, and indeed these concerns may be valid even among listed companies as well as between listed companies and their non-listed counterparts. The authors’ analysis of the possibilities for and limitations of contractual mechanisms for non-listed companies is perceptive, particularly with regard to private equity firms and hedge funds.

 

 

In the end, the implementation of effective governance mechanisms and controls is critical for all firms, regardless of the particular form within which any specific firm operates. The most critical point is that mechanisms adopted must be suited to the form in which any particular firm does business. Mandatory regulatory requirements may not be sufficiently sensitive to the differing needs of different kinds of firms.

 

 

Very special thanks to Professor McCahery for providing me with a copy of this excellent book.

 

 

Olympic Questions:

 

1. Am I the only one that found the opening ceremonies scary?

 

2. Who decided beach volleyball is such a big deal?

 

3. Why does Bob Costas think Cris Collinsworth is so damned funny?

 

4. How did Mark Spitz win seven gold medals without a swim cap or goggles?

 

5. Bela Karolyi. Discuss.  

 

6. Why do so many commercials (including political ads for both Presidential candidates) have images of wind turbines?

 

7. With a 32-year old winning two swimming relay gold medals, a 38-year old winning the women’s marathon, a 33-year old female gymnast winning silver in the vault competition,  and a 41-year old winning two swimming silver medals, is it possible the Chinese are on the wrong track with their prepubescent “women’s” gymnastics team? 

As the subprime litigation wave has churned on, many of the more recently filed lawsuits have been similar to previously filed suits. But amidst the repetition, there has also been some innovation, or at least variation, as a result of which the subprime litigation wave has continued to evolve. Two recently filed subprime and credit crisis- related lawsuits demonstrate both of these elements.

 

Fannie Mae Secondary Offering Litigation: First, on August 7, 2008, plaintiffs filed a purported securities class action under Section 12(a)(2) of the ’33 Act, in the New York (New York County) Supreme Court, in connection with the May 9, 2008 secondary offering of Federal National Mortgage Association (Fannie Mae) A copy of the complaint can be found here.

 

The complaint purports to be filed on behalf of all purchasers who bought Fannie Mae shares in the May 9 offering, in which the company sold approximately 94 million shares at $27.50 a share. (The shares closed today at $7.69.) Interestingly, Fannie Mae itself is not named as a defendant. The plaintiffs have named defendants only the offering underwriters, Lehman Brothers, J.P. Morgan and Citigroup.

 

The complaint alleges that the offering documents failed to disclose a pending change to FAS 140, which change if adopted, the complaint alleges, "could require the Company to raise as much as $46 billion of capital in order to remain in compliance" with its regulatory capital requirements. The complaint alleges that FAS 140 had previously allowed Fannie Mae to account for its liabilities for mortgage-backed securities issued by the company as if the company had sold the securities, even though the company was still obligated to guarantee the securities against defaults in the underlying assets. The supposed pending changes would require Fannie Mae to account on its balance sheet for these now off-balance sheet liabilities.

 

The complaint alleges that the offering documents had stated that upon the successful completion of the offering, the company’s capital requirements would be reduced. The complaint alleges that in July 2008, well after the offering’s completion, an analyst for Lehman Brothers (which was also one of the offering underwriters) issued a report disclosing the pending changes and the supposed impact on the company’s need for as much as $46 billion additional capital. The complaint alleges that in the week following the report, Fannie Mae’s share price dropped from $18.76 per share to $7.07 a share.

 

There are a number of curious things about this complaint. The first is that the complaint names only the offering underwriters as defendants; it does not name Fannie Mae itself. I expect this is because in connection with this firm commitment offering, the offering underwriters were the actual "sellers." (The complaint alleges that the underwriters, who directly bought the shares from the company, were "directly responsible for the offering and sale" of the shares to the market.) This would perhaps explain why the plaintiffs sought to pursue their Section 12 claim only against the underwriters, but it does not clarify why the plaintiffs did not also include in their complaint a Section 11 claim against Fannie Mae or other defendants.

 

UPDATE: Please note the reader comment below explaining that the May offering was an unregistered equity offering, and as such there was no registration statement — hence no Section 11 claim. As an aside, I note that I am always grateful when a reader provides this kind of clarifying information. I hope that all readers will lelt me know when statements on this blog are in need of clarification or correction.  

The other interesting thing is that plaintiffs have chosen to proceed in state court rather than federal court. I have previously noted (here) the apparent interest of some plaintiffs’ lawyers as part of the current litigation wave to pursue ’33 Act claims in state court, and I have also noted that plaintiffs have had some success in having these cases remanded back to state court in opposition to defendants’ efforts to remove them to federal court. Even though this most recent lawsuit asserts claims only under Section 12, it apparently continues the developing trend of plaintiffs pursuing ’33 Act actions (primarily Section 11 actions) in state court.

 

Jurisdiction for ’33 Act actions is concurrent, meaning that plaintiffs have a choice and they are consciously choosing to proceed in state court. I have previously speculated (here) that the decision to proceed in state court represents some form of forum shopping, or perhaps a bid to avoid the requirements of the PSLRA. Whatever the reason, the court selection appears calculated and tactical, much like the decision in this case to assert claims only against the offering underwriters and only under Section 12.

 

Special thanks to Adam Savett of the Securities Litigation Watch for the complaint in this Fannie Mae Secondary Offering lawsuit.

 

Stifel Financial Auction Rate Securities Litigation: The second of these two recent lawsuits is a purported securities class action lawsuit filed in the Eastern District of Missouri on behalf of all persons who purchased auction rate securities from Stifel Financial (or its affiliate, Stifel Nicolaus & Company) between June 11, 2003 and February 13, 2008. A copy of the complaint can be found here.

 

As I have noted (here), there have been many of these auction rate securities class action lawsuits filed. By my count, about which refer below, Stifel and its affiliate are the eighteenth different set of defendants to be separately named in an auction rate securities class action lawsuits.

 

What makes this complaint noteworthy is not its allegations, which are virtually identical to those raised in the earlier auction rate securities lawsuits. Rather, what makes this complaint noteworthy is its timing. There were a flood of these auction rate securities lawsuits filed in March and April 2008, but the filings tapered off after that. The most recent of these auction rate securities class action lawsuits, as near as I can determine, was filed in May 2008.

 

The other interesting element of the lawsuit’s timing is that it comes now, shortly after the largest financial institutions have entered settlements in which the big banks have agreed to massive buy backs of these securities from retail investors (refer here). As I noted in a recent post (here), even though these settlements might have seemed to suggest that the auction rate securities mess was winding wrapping up, the lawsuits relating to the securities continue to accumulate. Notwithstanding the settlements involving the largest banks, problems with these securities continue, and the related lawsuits continue to be filed.

 

A copy of an August 13, 2008 St. Louis Business Journal article relating to the new Stifel Financial lawsuit can be found here.

 

 Run the Numbers: In any event, I have added these two new lawsuits to my running tally of the subprime and credit crisis-related securities lawsuits, which can be accessed here.

 

With the addition of these two new lawsuits, the current tally of the subprime and credit crisis-related securities lawsuits now stands at 105, of which 65 were filed in 2008. As noted above, there have been 18 separate sets of defendants sued in auction rate securities class action lawsuits.

 

Subprime Coverage: Accompanying this litigation wave is the related question of insurance coverage for these lawsuits. Matthew Jacobs, Lorelie Masters and David Weiner of Jenner & Block have written an article in the July/August 2008 issue of Coverage entitled "Insurance Coverage and the Subprime Crisis: A Broad Overview" (here), which provides a comprehensive overview of the subprime litigation and the related insurance issues, from a policyholder perspective. The article is comprehensive and well-written, and raises a number of useful and interesting observations about the subprime-related coverage issues.

 

The heightened susceptibility of life sciences companies to securities class action lawsuits is a phenomenon that I and others have previously noted (refer here). But while life sciences companies may experience greater securities class action claim frequency, many of these lawsuits against life sciences companies are dismissed (as discussed here).

In a case the First Circuit itself called “paradigmatic” of securities cases involving life sciences companies, the appeals court recently affirmed the lower court’s dismissal of the securities lawsuit pending against Biogen Idec and certain of its directors and officers. The court’s analysis is noteworthy because of its emphasis of the issues that contribute to the vulnerability of these kinds of companies to securities lawsuits. But by way of contrast I also discuss below a recent Ninth Circuit opinion reversing the district court’s dismissal of a securities lawsuit involving Gilead Sciences.

 

The First Circuit’s Opinion in the Biogen Idec Case: On August 7, 2008, in an opinion written by Chief Judge Sandra L. Lynch, the First Circuit issued its opinion in New Jersey Carpenters Pension & Annuity Fund v. Biogen Idec (here). The case involves Biogen’s alleged misrepresentations and omissions pertaining to Tysabri, a new drug for multiple sclerosis and other autoimmune disorders.

 

In November 2004, the FDA granted accelerated approval of Tysabri. Less than three months later, on February 18, 2005, continuing clinical trials “revealed that two patients had contracted a type of infection perhaps associated with the drug.” One of the two patients died. On February 25, 2005, the company voluntarily withdrew the drug from the market. Its stock price dropped and several lawsuits were filed.

 

In their amended complaint, the plaintiffs alleged that, in order to facilitate their sale of shares of company stock at inflated prices, the defendants misrepresented the safety and efficacy of the drug. As the First Circuit summarized the case, the “key theme” of the lawsuit is that the defendants were “aware or at least recklessly unaware of greater safety risks with TYSABRI for opportunistic infections, particularly in combination with other MS therapies, than had been announced to the public,” and that defendants “intentionally failed to disclose this information in order to keep the share price high.”

 

The district court dismissed the complaint, finding that while the plaintiffs had alleged material misrepresentations and omissions with appropriate specificity, they had not alleged scienter with appropriate specificity. The plaintiffs appealed.

 

In evaluating the plaintiffs’ allegations, the allegations relating to the timing of defendants’ receipt of information were critical, because, as the First Circuit noted, “defendants cannot have committed fraud if they did not know at the time that the failure to provide additional information was misleading.” In that regard, the First Circuit found that “plaintiffs’ amended complaint fails to allege facts both (1) as to when defendant had information about non-PML opportunistic infection and (2) that the information available sufficiently suggested a causal connection between TYSABRI and non-PML opportunistic infections.”

 

The First Circuit expressed its willingness to consider factual allegations supported only by confidential sources, but the confidential sources’ allegations did not create a strong inference of scienter, because the allegations do not indicate when during the clinical trials information about infections became known.

 

The court also found plaintiffs’ allegations that defendants had fraudulently failed to disclose dangers of use of Tysabri in combination with other drug therapies were insufficient. Plaintiffs’ allegations that defendants had no reasonable basis to say that Tysabri was safe in combination with other drug therapies, the First Circuit found, were “not nearly so compelling as opposing inferences from the undisputed facts in the record.”

 

Because the First Circuit concluded that the plaintiffs had not “sufficiently alleged … that defendants had any reason to know their statements were misleading before February 18, 2005,” the Court disregarded all insider trading prior to that date. Only one insider sale was alleged on or after that date, a February 18 sale by the company’s General Counsel. But the General Counsel was not a defendant to the Section 10(b) claim, and the First Circuit held that based solely on the General Counsel’s trading “a strong inference of scienter on the part of Biogen and other individual defendants cannot be drawn.”

 

The First Circuit found that the plaintiffs’ allegations of scienter were not sufficient to support an alleged violation of Section 10(b), and affirmed the district court.

 

The court’s opinion was informed by its observations of the peculiar characteristics of securities lawsuits filed against companies involved in the drug and device development business:

 

The situation here is paradigmatic of securities fraud cases against drug companies where a promising drug or medical device is approved by the FDA and then later proves to have health risks which affect the market for the drug.

 

The court also noted that disclosures about regulatory developments provide an important context within which sudden stock price changes can occur:

 

The investing public is well aware drug trials are exactly that: trials to determine the safety and efficacy of experimental drugs. And so trading in the shares of companies whose financial fortunes may turn on the outcome of such experimental drug trials inherently carry more risk than some other investments.

 

With these comments, the First Circuit recognized the circumstances that make life sciences companies susceptible to securities lawsuits. These companies have volatile share prices that are vulnerable to sudden shocks due to the uncertainty of the regulatory process or to unexpected safety concerns. All too often these reverses result in securities lawsuits, supported only by allegations that the reverses occurred and therefore company management must have known about the problems from which the reverses arose.

 

The First Circuit’s opinion also evinced an appreciation of the fact that merely because a company has encountered these types of setbacks does not mean that the company has committed securities fraud. The First Circuit’s analysis helps explain why both life sciences may find themselves accused of securities fraud more frequently than other kinds of companies, and also why these cases are frequently dismissed.

 

Ninth Circuit Reverses Dismissal of Gilead Science Case: But while a number of the securities lawsuits filed against life sciences companies may be dismissed, that certainly does not mean that life sciences companies inevitably prevail. Indeed, there have been a number of significant settlements in securities cases involving life sciences companies (particularly large pharmaceutical companies).

 

Life sciences companies also face the same challenges involved in securities claims against any corporate defendant, including the possibility that a victory at the trial court level can be reversed at the appellate level. That is exactly what happened in the securities litigation involved Gilead Sciences. In an opinion dated August 11, 2008 (here), the Ninth Circuit reversed the lower court’s ruling dismissing the case for failure to adequately plead loss causation.

 

Gilead’s flagship produce, Viread, is an agent used with other drugs to treat HIV. The complaint alleges that the company actively marketed the drug for off-label uses, in violation of FDA rules. The company received a Warning Letter from the FDA on this topic, which the company disclosed on August 8, 2003. The company’s share price did not decline in response to this news; in fact, the share price was higher on the following trading days.

 

In order to address the absence of any share price decline, the plaintiffs alleged that it was not until October 28, 2003 that the public “finally realized the impact of the off-label marketing and the Warning Letter.” After market close that day, the company disclosed that Viread sales had fallen below expectations due to wholesaler overstocking during the quarter. Market analysts attributed the sales decline to “lower end-user demand.” The plaintiffs alleged that the reduced demand was “a direct result” of the Warning Letter, which exposed Gilead’s off-label marketing.

 

The district court found that the complaint failed to “connect the chain of events” between the failure to disclose the off-label marketing; that the decline in demand for Viread was due to the Warning Letter; and that the reduced sales caused a decrease in Gilead’s share price. The district court said there were “too many logical and factual gaps.” The district court said it could not make “the unreasonable inference that a public revelation caused a price drop three months later.” The district court dismissed the complaint for failure to adequately plead loss causation.

 

The Ninth Circuit, by contrast, found “the complaint sufficiently alleges a causal relationship between (1) the increase in sales resulting from the off-label marketing, (2) the Warning Letter’s effects on Viread orders, and (3) the Warning Letter’s effect on Gilead’s share price.”

 

The Ninth Circuit went on to observe that “perhaps what truly motivated the dismissal was the district court’s incredulity.” The Ninth Circuit said that a district court ruling on a motion to dismiss “is not sitting as a trier of fact,” and as long as plaintiffs allege a theory that “is not facially implausible, the court’s skepticism is best reserved for later stages … when the plaintiffs’ case can be rejected on evidentiary grounds.” The Ninth Circuit concluded that “a limited temporal gap between the time of the misrepresentation is publicly revealed and the subsequent decline…does not render a plaintiffs’ theory of loss causation per se implausible.”

 

The Ninth Circuit said the market “did react immediately to the corrective disclosure” which the plaintiffs claims to be the October 28 press release, the date on which it is alleged the market had complete information to process the revelations about off-label marketing.

 

It is hardly my place to comment on the merits of a judicial opinion. Suffice it to say that reasonable minds may differ whether the district court was guilty of “incredulity” or the Ninth Circuit of “credulity.” Reasonable minds may also differ whether the three months’ lapse between the disclosure of the Warning Letter and the stock price drop is a “limited temporal gap.” Reasonable minds may also differ whether plaintiffs’ Rube Goldberg explanation for the delayed market reaction “is not facially implausible.”

 

On the other hand, it seems apparent that the allegation of off-label marketing troubled the Ninth Circuit and it is certainly true that a company whose alleged reverses are not due to unexpected regulatory developments or unanticipated clinical outcomes but rather to marketing activities is in a less sympathetic postion. That is obviously why the plaintiffs strained so hard to try to make the stock price drop relate back to the off-label marketing Warning Letter, because that supposed connection put the defendants in a less favorable light. Regardless, I suppose, of whether or not the stock price drop was due to the wholesaler overstocking.

 

The one thing that is clear is that all litigants are susceptible to the vicissitudes of the litigation process, life sciences companies as well as any other kind of company. The plaintiffs in Gilead certainly established the value of continuing to fight, as you never know when an initially disfavored hand might still be just enough to take a trick. Of course, the plaintiffs must now go back to the district court and face a court whose skepticism even the Ninth Circuit acknowledged could justify rejecting plaintiffs’ case later.

 

The SEC Actions Blog has an excellent lawyerly analysis critical of the Ninth Circuit’s opinion in Gilead, here.

 

More Drug News: Biogen Idec’s drug, Tysabri, which the FDA permitted the company to reintroduce to the market in July 2006, was back in the news recently. According to an August 1, 2008 Wall Street Journal article (here), two MS patients treated with the drug have recently contracted a potentially deadly brain infection. The article stated that the company “had no plans to recall the drug or restrict its use.”

 

The WSJ.com Health Blog also has a post (here) discussing this development. The comments following the post make for interesting reading. It is all too easy to consider these legal issues in a vacuum, but there are real patients whose only hope is the use of these kinds of drug therapies. The eloquent pleas of these patients for the drugs to remain available are moving and impressive.

 

But the adverse developments cannot be minimized, and in that regard it should also be noted that Biogen Idec also faces a lawsuit from the estate of one of the deceased patients. Recent procedural developments in the case were also discussed recently on the WSJ.com Health Blog (here).

 

All of that said,  this about business too, and it may come as no surprise that Carl Ichan viewed the stock price drop following Biogen’s recent advserse news as an opportunity to increase his holdings in the company’s shares, perhaps to advance his agenda of getting the company to sell itself, as discussed here.

 

There is a Balm in Gilead: Perhaps I am presuming too much, but for me the name Gilead Sciences evokes Jeremiah, Chapter 8, Verse 22: “Is there no balm in Gilead? Is there no physician there? Why then has the health of my poor people not been restored?” (New Revised Standard Version).

 

This line is memorably recalled in the African-American spiritual, There is a Balm in Gilead, whose refrain captures the soothing power of the song:

There is a balm in Gilead

To make the wounded whole;

There is a balm in Gilead

To heal the sin-sick soul.

The headlines on the business pages have been dominated in recent days by the news of the blockbuster Citigroup and UBS auction rate securities settlements (about which refer here). But as noted in an August 8, 2008 CFO.com article (here), at the same time, a number of other leading banks have been hit with regulatory subpoenas as problems surrounding auction rate securities become “the crisis of the day for the large global financial services companies.”

 

In addition, investor litigation against the banks related to auction rate securities continues to accumulate. For example, on August 6, 2008, STMicroelectronics sued Credit Suisse Group in the Eastern District of New York, alleging that Credit Suisse placed $450 million of the chipmaker’s securities in unauthorized auction rate securities. A copy of the complaint can be found here. An August 7, 2008 Bloomberg article describing the lawsuit can be found here.

 

The complaint’s tone is blistering. The complaint alleges that in August 2007, when the company sought to liquidate what it thought was a portfolio of “liquid, safe and authorized student loan securities,” it discovered that Credit Suisse had actually invested in “illiquid, risky and unsustainable auction rate securities consisting of collateralized debt obligations and credit linked notes, some of which are backed by subprime real estate loans.”

 

Not stopping there, the complaint further alleges that “at least a dozen other multinational corporations are victims of the same scheme,” allegedly carried out by the same Credit Suisse brokers. The complaint alleges that this supposed scheme “involves more than $2 billion of these clients’ money.” The complaint further alleges that Credit Suisse “furthered the fraud by keeping it hidden from victims, governmental authorities and the investing public” and by “refusing to follow instructions to liquidate the assets.”

 

The complaint also alleges that Credit Suisse had an “intentional strategy” reducing its own exposure to auction rate securities and that it accomplished that goal by “dumping into the accounts of unsuspecting clients some of the worst ARS on the market.”

 

According to the complaint, ST has separately filed a FINRA arbitration against Credit Suisse Securities (USA), but because Credit Suisse Group itself is not a member of FINRA, it is not subject to its arbitration requirements, and therefore is not a party to the FINRA action, which remains pending. As a result, the newly filed civil lawsuit presents the spectacle of one Swiss domiciled company suing another Swiss domiciled company in U.S. federal court.

 

With relation to the matters alleged in the ST complaint, it is interesting to note that on July 9, 2008, the Wall Street Journal reported (here) that federal prosecutors in the Eastern District of New York are “investigating whether two former Credit Suisse Group brokers lied to investors about how they placed their money into short-term securities.” Prosecutors are investigating whether investors were “misled about the nature of the auction rate securities they bought.”

 

The July 9 article quotes a statement from Credit Suisse as saying that the two employees, who resigned in September 2007, had “violated their obligations to Credit Suisse and to our clients.” The Credit Suisse statement added that “we promptly notified regulators when this matter arose last year and we have continued to work closely with them”

 

In addition, the Wall Street Journal reported in a front page article on July 31, 2008 (here) that one of the two brokers under investigation, a 35-year old broker named Julian Tzolov, “has left the U.S. and could have fled to his native Bulgaria.” The July 31 article also lists ten overseas companies (including ST Microelectronics) that have initiated arbitration proceedings against Credit Suisse affiliate companies based on auction rate securities companies.

 

On U.S. Market Competitiveness: Consider Departing Foreign Companies: Would-be reformers cite concerns that U.S financial markets are losing out to other countries’ markets due to concerns about U.S regulatory burdens and litigiousness (about which refer here). But if these concerns were as significant as the reformers suggest, you would expect that foreign companies cross-listed on U.S. exchanges would see a positive boost in their share price when they eliminate their U.S. listing. Recent academic suggest the opposite may be true.

 

In an August 2008 paper entitled “Why do Foreign Firms Leave U.S. Equity Markets”  (here), Andrew Korolyi and Rene Stulz of Ohio State and Craig Doidge of the University of Toronto took at look at the 59 foreign companies that chose to deregister their U.S. listings after the SEC enacted Rule 12h-6 in March 2007, making it easier for such companies to do so.

 

Their study produced two essential findings. First, they found that the 59 companies as a group “experienced significantly lower growth and lower stock returns than other U.S-exchange listed foreign firms in the years preceding the decision.” Second, they found that there is only “weak evidence that firms experience negative stock returns when they announce deregistration and stronger evidence that the stock price return is worse for firms with higher growth.”

 

The authors said their finding “support the hypothesis that foreign firms list shares at the lowest cost to finance growth opportunities and that, when those opportunities disappear, a listing become less valuable to corporate insiders so that firms are more likely to deregister and go home.”

 

As discussed here, the authors’ prior research substantiates that overseas firms benefit, through lower cost of capital, when they choose to list their shares on U.S. exchanges, and their shares trade for higher prices than do those of similar companies that do not choose to list here. One theory for this “listing premium” is the “bonding hypothesis,” which speculates that investors put more confidence in companies complying with American disclosure requirements and accounting standards. The authors’ more recent research suggest that the only companies punished for delisting from the U.S. exchanges are those that continued to have growth opportunities and a need to attract American capital. Other companies, who lack those opportunities, delist with impunity.

 

Perhaps ironically, current efforts to make the U.S. markets more competitive arguably may be undercutting the “listing premium,” which might be the U.S. markets’ greatest competitive advantage. As discussed in Floyd Norris’s August 8, 2008 New York Times article entitled “Reasons Some Firms Left the U.S.” (here):

By letting companies walk away easily, the advantage of an American registration is reduced, Mr. Stulz has argued. The S.E.C. is moving to allow foreign companies to use international accounting rules, so any advantage from confidence in U.S. accounting rules will vanish. And the commission is making it much easier for brokers to sell unregistered foreign shares to Americans.

“I think there is a grave risk that the advantage may be lost because of the continued chipping away at the rock,” Mr. Karolyi said. “It just doesn’t seem like the right time or the right place to be engaged in a serious deregulation of financial markets.”

In recent days, settlements relating to two high-profile securities class action lawsuits were announced. Because there are some interest things about these two settlements, I take a closer look at each of them below.

 

Is the Qwest Securites Class Action Lawsuit Finally Settled?  In Qwest Communications  August 6, 2008 filing on Form 10-Q (here), the company announced that it would pay an additional $40 million, and that its former CEO, Joseph Nacchio, and its former CFO, Robert Woodruff, would “contribute a total of $5 million insurance proceeds,” to try to settle the long-standing consolidated Qwest securities litigation. These payments, together with amounts to which Qwest previously agreed, bring the total value of the class settlement to $445 million.

 

The court had previously approved the $400 million settlement, to which Nacchio and Woodruff were not parties, over Nacchio and Woodruff’s objections. Among other things, the two individuals contended that the prior settlement was structured to strip them of their indemnification rights. As I discussed here, on a January 16, 2008 opinion, the Tenth Circuit held that the two individuals had standing to challenge the settlement because provisions interfered with the two individuals’ potential rights and existing legal claims for indemnification. The Tenth Circuit remanded the case for the district court to provide further analysis of the individuals’ settlement objections.

 

According to the company’s 10-Q, the revised settlement resolves the class claims against the two individuals (in addition to all other defendants, the claims against who were resolved in the initial settlement), in exchange for which the two individuals withdrew their objections to the settlement and resolved their indemnification dispute with the company.

 

In a statement that is noteworthy in the larger context, the 10-Q reports that the company has “the right to terminate the settlement if class members representing more than a specified amount of alleged securities losses elect to opt-out.” The 10-Q provides no information as to what might constitute the “specified amount.”

 

This “blow up” provision, by which the deal is off if a specified percentage opts out, is not atypical, but it is interesting in the context of the Qwest settlement. As I noted in a prior post (here), the now superseded Qwest settlement had the distinction of being the first settlement (of which I am aware) in which the value of the individual opt-out settlements exceeded the value of the class settlement. (At that time, the aggregate value of the opt-out settlements totaled $411 million, compared to the $400 million class settlement).

The revised Qwest settlement value exceeds the aggregate value of the prior publicly disclosed value of the opt-out settlements. But given the magnitude of the prior opt-outs, there certainly is an interesting question of what greater quantity of opt-outs might be required to blow up the revised settlement? And are the prior opt-outs included in that equation? Along those lines, it should also be noted that in its October 30, 2007 filing on Form 10-Q (here), the company announced that the aggregate amount claimed by various persons then opting out from the class settlement is "in excess of $1.9 billion" (which presumably included the $411 million in opt out settlements entered to that point). And if that amount of opting out is not enough to blow up the settlement, then just how much is?

 

Whether or not this settlement finally resolves this class action, the entire sequence of events may be significant in another respect as well. The events have the potential at least to mark the end of an approach to securities class action case resolution that became fashionable during the era of corporate scandals – that is, to try to ensure that as part of the case settlement that the certain individual defendants were forced to pay out of their own assets to resolve claims asserted against them. The extreme cases reflecting this approach were Enron and WorldCom, where individuals were made to pay settlement amounts without recourse to insurance or indemnity.

 

The Qwest securities class action, and in particular the difficulties that the company encountered in trying to settle the case without resolving claims against Nacchio and Woodruff, could constrain future attempts to implement this approach. Of course, it may also be argued that the Tenth Circuit did not specifically disallow the prior settled that excluded the two individuals; it merely required the district court to provide further explanation of why it approved the settlement that arguably deprived the individuals of their indemnification rights.

 

One puzzling note about the amended settlement is the statement in the company’s 10-Q’s that Nacchio and Woodruff were contributing $5 million “insurance proceeds.” The document does not specify the source of the insurance, nor how there could be further insurance available after prior settlements, defense expense and other litigation expense.

 

Another odd note about this insurance component of the settlement is the suggestion that the two individuals were "contributing" the insurance funds, as if the $5 million was drawn from funds that these two individuals alone controlled, or at least that they were in a position to direct. Given that this case first arose way back in 2001, it is relatively unlikely (albeit not impossible) that these individuals carried individual director liabiltiy (IDL) insurance or that the company carried separate Side A insurance (although if the company did carry separate Side A coverage, the company’s refusal to indemnify would trigger the protection). The other possibiltiy is that earlier on the parties and the company’s insurers reached some accomodation that dedicated certain insurance funds solely for these two individuals, an arrangement that would be unusual particulary in the context of a claim that would seem likely to exhaust all available insurance.

 

In any event, in the end, despite all the efforts to the contrary, the claims against Naccho and Woodruff were settled without these two individuals having to make a contribution out of their own assets. The Qwest securities class action, and in particular the difficulties that the company encountered in trying to settle the case without including the claims against Nacchio and Woodruff, could constrain future attempts to implement this approach. (Of course, it may also be argued that the Tenth Circuit did not specifically disallow the prior settled that excluded the two individuals; it merely required the district court to provide further explanation of why it approved the settlement that arguably deprived the individuals of their indemnification rights.)

 

An August 7, 2008 Rocky Mountain News article describing the revised settlement can be found here.

 

About the GM Securities Litigation Settlement: As noted on the 10b5-Daily blog (here), in the company’s August 7, 2008 filing on Form 10-Q (here), General Motors announced that on July 21, 2008, it had settled the securities class action lawsuit pending against the company and certain of its directors and officers. For background regarding the lawsuit, refer here. The company agreed to pay $277 million and its auditor, Deloitte & Touche, agreed to pay $26 million, bringing the total value of the settlement to $303 million.

 

The 10-Q also announced that on August 6, 2008, the parties had also reached an agreement to settle the related shareholders’ derivative lawsuit. The settlement agreement “requires our management to recommend to the Board of Directors and its committees that we implement and maintain certain corporate governance changes for four years.” The company also agreed not to oppose the derivative plaintiffs’ petition for attorneys’ fees and costs “not to exceed $7.465 million.”

 

The 10-Q states further that the company believes “that a portion of our settlement costs are covered by insurance.” The document states that the company anticipates “recording income of approximately $200 million in the third quarter with insurance-related indemnification proceeds for previously recorded indemnification costs” including “the cost incurred to settle the General Motors Securities Litigation suit.”

 

An August 8, 2008 Business Insurance article (here) reports that a GM spokeswoman clarified that only $100 million of the $200 million of insurance relates to the securities lawsuit settlement; “half” of the $200 million, the article reports that the spokeswoman said, “is for settlements of litigation the company is not disclosing.”

 

Notwithstanding the odd note about $100 million of insurance for the settlement of undisclosed litigation, the overall suggestion is that $177 million of GM’s contribution to the securities lawsuit settlement is uninsured – or perhaps $7.645 million more than that if the attorneys’ fees in the derivative lawsuit are to be paid by insurance.

 

An interesting aspect of this case is the identity of the lead plaintiffs. Despite the defendant company’s iconic status as an American company, the lead plaintiffs were two overseas institutional investors, Deka Investment GmbH, an investment fund manager based in Germany, and Luxembourg-based fund manager Deka International S.A, both affiliates of DekaBank. The presence of foreign plaintiffs in U.S. class actions has become increasingly common, a trend that is likely to continue as U.S.-based plaintiffs firms expand their presence overseas. The Securities Litigation Watch has frequently discussed this trend, as noted here.

 

One additional interesting aspect of this settlement is that it the parties were able to resolve the case at such an early stage. According to an August 11, 2008 article on Law.com (here), the federal judge to whom the case was assigned sent the case to mediation while the defendants’ motions to dismiss were still pending.

 

According to RiskMetrics data quoted in the Business Insurance article, the GM settlement ranks as the twenty-fifth largest securities fraud settlement ever. And again, citing RiskMetrics data, the August 9, 2008 Wall Street Journal reported (here) that the GM settlement is the third largest securities lawsuit settlement of 2008, after the $895 million UnitedHealth Group settlement and the $750 Xerox settlement.

 

Special thanks to a loyal reader for the link to the Business Insurance article.

 

D&O Funds Gone, Case Grinds On: In a prior post (here), I noted that in the criminal case arising out of the collapse of Collins & Aikman, one of the defendants had sought an early  trial date because of the approaching depletion of the D&O insurance policy limits, potentially leaving him without resources to fund his defense.

 

In an August 8, 2008 post on his Race to the Bottom blog (here), Professor Jay Brown reports that even though no date has yet been set for the criminal trial in the case, the D&O insurance policy limits are now entirely exhausted. Counsel for one of the defendants reportedly stated at a July 24, 2008 status conference in the case that “the fourth and final layer carrier has informed us that – basically not to assume that there’s going to be any money after invoices submitted on July 31st.”

 

The possibility that $50 million in insurance limits might be exhausted before a trial date is even set is a nightmare scenario for any director or officer.

 

As I noted in my prior post, escalating defense expense is an increasingly important consideration in the D&O limits selection equation. The potential for defense expense alone to deplete all available insurance in a catastrophic claim like the one involving Collins & Aikman may seem like an extreme case, but D&O insurance ought to be able to respond and provide protection even in a catastrophic claim. However, increased limits along may not be the answer; rather, insurance structures, designed to ensure dedicated protection to specified individuals, may be the most important protection against the devastating potential of catastrophic D&O claims.

After New York Attorney General Andrew Cuomo announced (here) earlier today that Citigroup had agreed to a blockbuster settlement regarding auction rate securities, it certainly seemed like the deal would put pressure on other investment banks to adopt similar measures. So perhaps it was not unexpected later in the day that Merrill Lynch announced (here) that it too would "buy back at par auction rate securities sold by it to its retail clients."

 

If Merrill Lynch’s response is any indication, other banks and broker-dealers may also now find themselves pressured to buy back auction rate securities from their retail clients at par. UPDATE: It appears that UBS got the memo, too; the August 8, 2008 headlines include reports that UBS will be entering its own deal today with state and federal regulators (refer here). There were quite a number of other features to Citigroup’s settlement beyond the retail investor buy back. In addition, Citigroup not only settled with the NY AG, but also preliminarily settled with the SEC as well, as discussed in the SEC’s August 7, 2008 press release (here).

 

 

Other companies that want the same degree of resolution as Citigroup may have to swallow many if not all of the terms to which Citigroup agreed, so the entire package is worth a closer look.

 

Without access to all of the settlement documents, it is not possible to obtain a complete understand of everything to which Citigroup agreed. But there is a great deal of information in NYAG’s and SEC press releases linked above, as well as Citigroup’s own press release about the settlement (here).

 

The major components of the deal are that Citigroup will buy back at par $7.5 billion in auction rate securities that it sold to individual investors, small business and charities. In addition, Citigroup agreed to use its "best efforts" to liquidate another $12 billion in auction rate securities sold to retirement plans and institutional investors by the end of 2009.

 

Citigroup also agreed to pay the state of New York a civil penalty of $50 million, and to pay a separate civil penalty of $50 million to the North American Securities Administrators, which, according to the NYAG’s press release, has had a task force conducting investigations into the marketing and sale of auction rate securities.

 

Beyond these basic outlines, there are a number of other terms designed to make investors whole.

 

First, Citigroup will, according to the NYAG, "fully reimburse all retail investors who sold their auction rate securities at a discount after the market failed."

 

Second, as described in the SEC press release, "until Citi actually provides for the liquidation of the securities…Citi will provide no-cost loans to customers that will remain outstanding until all the ARS are repurchased, and will reimburse customers for any interest costs incurred under any prior loan program."

 

Third, according to the SEC, "Citi will not liquidate its own inventory of a particular ARS before it liquidates its own customers’ holding in that security."

 

Fourth, in one of the deal’s more interesting components, Citigroup agreed that (according to the SEC press release, which has the best description of this component) with respect to any customer who contends that he or she has "incurred consequential damages beyond the loss of liquidity," that it will participate in a "special arbitration process that the customer may elect and that will be overseen by FINRA." In these proceedings, Citigroup "will not contest liability for its misrepresentations and omissions…but may challenge the existence or amount of any consequential damages." Customers who elect not to participate in these special procedures "may pursue all other arbitration or legal of equitable remedies available through any other administrative or judicial process."

 

Fifth, with respect to its investment bank clients, according to Citigroup’s press release, "Citi will refund refinancing fees to municipal ARS issuers that issued ARS in the primary market between August 1, 2007 and February 11, 2008, and refinanced those securities after February 11, 2008."

 

The SEC’s press release emphasizes that Citigroup’s settlement with the SEC is "preliminary" and that the company "faces the prospect of a financial penalty to the SEC after it has completed its obligations under the settlement agreement." The amount of the penalty if any will be based on an assessment "whether Citi has satisfactorily completed its obligations under the settlement," as well as the costs Citi incurred in meeting those obligations.

 

With respect to the issue of costs to Citigroup, the company itself noted that the financial impact it would sustain as a result of acquiring the $7.3 billion of its retail investors’ auction rate securities "is expected to be de minimus." The company estimates that the difference between the purchase price and the market price is ‘in the range of $500 million on a pretax basis," although the actual pre-tax loss will depend on market values at the time of purchase.

 

Citigroup did not attempt to estimate the costs to the company of its commitment to use its "best efforts" to liquidate its institutional investors $12 billion in auction rate securities. Nor does its press release reflect an estimate of the costs to the company of the various provisions designed to make its retail and investment bank customers whole. The "consequential damages" arbitrations could be particularly interesting in the respect, and I am guessing these proceedings will also involve some pretty elaborate allegations. Given the marketplace’s reaction to the settlement announcement — Citigroup’s stock closed down 6.24% today — the perception seems to be that the overall costs will something more than "de minimum."

 

It is worth noting that the $12 billion retail investor buy back that Merrill Lynch announced today, while clearly designed to try to ingratiate the company to regulators and to try to buy the company some room to maneuver, acknowledged only one part of the Citigroup’s multi-component settlement. Merrill’s initiative lacked any provision for liquidation of institutional investors’ holdings, and it similarly lacked any of the "make whole" components of the Citigroup settlement. Regulators will undoubtedly press Merrill for similar concessions.

 

Whatever the aggregate costs to Citigroup of the settlement announced today will ultimately be depends to an enormous extent on whether this settlement, and the others that undoubtedly will be reached in the coming days and weeks, are collectively enough to melt the frozen auction rate securities market. At this point, nobody is buying the securities because they don’t want to get stuck with an asset they can’t turn around and sell if they have to. But if confidence does return, the banks and other companies will be able either to hold these newly acquired assets on their balance sheets at par, rather than at a discount, or to sell the assets in an orderly marketplace at reasonable marketplace prices.

 

On the other hand, it is possible that all that is happening is that the problems are being shifted around. The banks will have to be taking on to their balance sheets a huge quantity of illiquid assets at a time when their balance sheets are already under pressure. All of them will face the same desire, and perhaps need, to sell these assets, at the same time that they will also be under pressure to use their "best efforts" to help their institutional investor clients unload their holdings. These arrangements address the retail investors problems (which is fair, appropriate and necessary, from both a practical and prudential standpoint), but the other problems are not yet solved, and they will not be finally solved until there are as many interested buyers as they are eager would-be sellers. And these arrangements certainly bake in a host of holders who will want to be sellers.

 

The key component of the settlement may be the "best efforts" provision pertaining to institutional investors, which Citigroup described in its press release as follows:

Citi will work with issuers and other interested parties to provide liquidity solutions for Citi institutional investor clients. In doing so, Citi will use its best efforts to facilitate issuer redemptions and/or to resolve its institutional investor clients’ liquidity concerns through resecuritizations and other means. The New York Attorney General will monitor Citi’s progress and, beginning on November 4, 2008, retains the right to take legal action against Citi with respect to its institutional investor clients. The other regulators have entered into a similar arrangement but with a December 31, 2009 date.

If these efforts prosper, they may go a long way toward restoring an efficient marketplace for these securities. The problem is that, without a funtioning marketplace, it is not immediately apparent (at least from this brief description), how institutional investors’ "liquidity concerns" will be resolved, short of Citigroup itself buying out the institutional investors too –although to my eyes at least this "best efforts" stops short of a firm buyout commitment.

 

It may be that a Citigroup buyout of institutional investors is implied in this "best efforts" provision, especially given the looming threat of further state regulatory action, amoint to an implicit buyout commitment. To the extent other banks provide similar commitments, it might well be enough to unfreeze the marketplace for these securities. Which unquestionably would be a good thing for all concerned. The risk of course is that the banks could wind up holding a pile of assets nobody else wants.

 

There are many unanswered questions. One of the more practical questions is what the Citigroup settlement announced today will do for the private auction rate securities litigation pending against the company (about which refer here). The settlement clearly seems calculated to try to make at least the retail investors whole, and at least for those retail investors who are comfortable with the special "consequential damages" procedure, there would seem to be no point for continuing the class action (although I would be interested to know if readers have a different perspective). Institutional investors may well have another view, particularly until it is known whether Citigroup’s "best efforts" to liquidate the investors’ auction rate securities holding are successful.

 

The Citigroup settlement was discussed in a number of news articles today, including articles appearing on CFO.com (here) and Bloomberg (here).

 

Or is the Worst Yet to Come?: Coincidentally, my friends Kimberly Melvin and Cara Tseng Duffield of the Wiley Rein law firm published a memorandum today whose title seems even more provocative in light of today’s development. Their memo, entitled "Auction Rate Securities: Is the Worst Yet to Come?" (here), has a detailed overview of the outstanding claims involving auction rate securities that is informative and useful.

 

The memo was written prior to and therefore without awareness of the Citigroup settlement, The memo still makes for interesting reading. Among other things, the memo contains a number of interesting observations concerning the insurance implications of the ARS claims. The authors note that because many of the ARS claims arise out of the defendant companies’ investment sales activities, the claims likely do not represent D&O insurance losses; rather the claims "appear to represent primarily E&O exposures."

 

Finally, and pertinent to the Citigroup settlement, the authors note that "to the extent that the investment banks buy back or rescind their customers’ ARS, thereby receiving the securities in return for par value, issues exist regarding whether the banks have suffered a covered loss."

 

I Never Really Wanted to Sell CDOs, I Wanted to be a Lumberjack: And now, for something completely different, I recommend Mark Gilbert’s August 7, 2008 Bloomberg column entitled "CDO Market is Dead, Not Just Pining for Fjords" (here).

Just when you thought it was safe to go outside again, the subprime litigation wave has struck once more. On August 7, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the Southern District of New York against KKR Financial Holdings LLC and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ August 7 press release can be found here, and the complaint can be found here.

 

According to the complaint, KKR Financial Holdings LLC (KFN) is an affiliate of the private equity firm Kohlberg, Kravis, Roberts & Co. KFN is a specialty finance company that invests in multiple asset classes. The complaint relates to representations allegedly made in connection with May 4, 2007 merger and share issuance transaction associated with the affiliate’s conversion from a REIT to a limited liability company. In this transaction, investors holding shares in the predecessor company received an equal number of shares in the successor company.

 

The complaint asserts claims based on the Securities Act of 1933. According to the press release,

the Registration Statement was false and misleading in that it misrepresented and/or omitted material facts, including: (a) the problematic real-estate-related assets held by the Company were a much bigger risk to the Company than the Registration Statement had represented; (b) the Company’s capital would be insufficient given the deterioration in its portfolio which would necessitate capital preservation and the need to raise capital to the detriment of common stockholders; and (c) the Company was failing to adequately record loss reserves for its mortgage-related exposure, causing its balance sheet and financial results to be artificially inflated.

During May, June and most of July 2007, KFN’s stock traded above $25 per share. In late July, many mortgage-related companies’ stock prices declined, including KFN’s. Nevertheless, KFN’s stock closed at $18.02 per share on August 13, 2007. Then, on August 15, 2007, KFN issued a release which revealed that KFN would be selling $5.1 billion in mortgage backed securities at a loss. When this news was revealed, KFN’s stock price collapsed to as low as $9.39 per share, eventually closing at $10.52 per share, a decline from the prior day of 31%. KFN shares currently trade for approximately $10 per share, a 63% decline from the $26.90 per share at which they were sold to plaintiff and the Class.

After the last year and a half, when there has been a flood of new subprime-related lawsuits, there is perhaps nothing too surprising about the kinds of allegations in the KFN complaint. What may be a little bit surprising is that the disclosures on which the complaint is based, and the ensuing stock price drop, took place nearly a year ago.

 

While the subprime litigation wave has been unfolding, there have been occasional periods where it has seemed as if the plaintiffs’ lawyers are engaging in a little backing and filling, as if catching up with unfinished business that went unattended due to occasional logjams. Given the magnitude of the stock price drop associated with the disclosure (more than $1 billion), as well as the prominence of the company’s affiliated relations, this case seems like it might not have been overlooked.

 

But in any event, I have added this case to my running tally of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of the KFN lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands as 103, of which 63 were filed in 2008.

Over the past two days, plaintiffs’ attorneys have launched a couple of new securities lawsuits. Nothing particularly noteworthy about that, in and of itself. But upon closer review, there are some rather interesting things about these new lawsuits. I note my observations below after briefly describing each of the two new lawsuits.

 

The first of these lawsuits was filed on August 5, 2008 in the Southern District of Indiana against medical device manufacturer Zimmer Holdings, its CEO, and its CFO. A copy of the plaintiffs’ August 5 press release can be found here, and the complaint can be found here.

 

According to the press release, the Zimmer complaint alleges that:

defendants failed to disclose material flaws in the quality systems at Zimmer’s Dover, Ohio facility, which manufactured Zimmer Orthopedic Surgical Products. In addition, defendants failed to disclose that patients receiving the Company’s Durom Acetabular Component, used in total hip replacement procedures, disproportionately experienced cup loosening requiring additional corrective surgery after implantation. As a result of defendants’ materially false and misleading statements, Zimmer’s common stock traded at artificially inflated prices during the Class Period. When the true condition of the Company, its facilities, and its products began to come to light, the price of Zimmer stock declined, falling from $70.88 to $66.01 per share in one day.

The second of the two lawsuits was filed on August 6, 2008 in the Eastern District of Virginia against automobile retailer CarMax and certain of its directors and officers. A copy of the plaintiffs’ August 6 press release can be found here and the complaint can be found here.

 

According to the press release, the CarMax complaint alleges that:

during the Class Period, CarMax was not meeting internal sales targets and was facing a 55% shortfall in its net income for first quarter of fiscal year 2009, later prompting the Company to suspend its financial guidance for the rest of fiscal 2009. According to the complaint, CarMax publicly issued materially false and misleading statements and failed to disclose: (i) that CarMax was not positioned to meet its sales targets or earnings objectives for fiscal 2009; (ii) that the Company had completed a refinancing of its warehouse facility which had materially increased the Company’s funding costs; and (iii) as a result of the foregoing, defendants had no reasonable basis for their revenues and earnings guidance for fiscal 2009.

On June 18, 2008, the Company issued a press release announcing its financial results for the first quarter of fiscal 2009, the period ended May 31, 2008. The Company also announced that it was suspending its financial guidance for the rest of fiscal 2009. Upon this news, shares of the Company’s stock fell $2 per share, or approximately 11%, to close at $16.34 per share, on heavy trading volume.

The first noteworthy thing about these two lawsuits is the relative modesty of the stock price drops they allege. In general, plaintiffs’ lawyers’ try to rely on allegations of dramatic stock price drops to try to show that the marketplace was shocked by the unexpected revelation of previously withheld information. Stock price drops of 11% in CarMax’s case, and less than 7% in the case of Zimmer, are not really the type of dramatic share price declines that you might expect to attract plaintiffs’ lawyers’ attention.

 

In CarMax’s case, it clearly was not just the stock price decline that caught the plaintiffs’ attorneys’ eyes. CarMax was also the subject of a June 25, 2008 Wall Street Journal article entitled “CarMax Executives Sold Before Shortfall” (here), noting that CarMax insiders had sold $4.3 million in company stock in April and May 2008, ahead of the company’s June announcement of disappointing revenue.

 

The Journal article stated that the “had the insiders waited and conducted their transactions after the earnings report, their proceeds would have been just $2.7 million, a drop of nearly 40%.” As might be expected, the CarMax complaint quotes the Journal article extensively.

 

The Zimmer lawsuit is little harder to fathom. Not only does the complaint allege only a 7% stock price drop, but unlike the CarMax complaint, it contains no insider trading allegations. Perhaps even more significantly, not only was Zimmer’s stock price drop modest, but it has been completely erased in the eleven trading days following the company’s July 22, 2008 second quarter earnings release. Indeed, Zimmer’s stock closed today at 70.89, which is basically unchanged from the company’s share price of 70.88 preceding the stock drop.

 

To be sure, these are both large companies and even modest share price declines represent significant amounts in dollar terms. The two dollar share price drop alleged in the CarMax complaint represents a market capitalization loss of roughly $440 million. The $4.87 share price drop alleged in the Zimmer complaint represents a slightly more than $1 billion drop in Zimmer’s market cap – although all of that has been recovered in the eleven trading days since the decline. While these dollar figures represent undeniably impressive sums, as a percentage matter they make less of an impression.

 

The other interesting thing about these two lawsuits is what they do not involve. That is, they do not involve subprime or credit crisis-related allegations. As I discussed in recent posts (here and here), two recent studies confirmed that securities activity in the first half of 2008 was largely driven by subprime and credit crisis-related litigation. These two new lawsuits suggest that plaintiffs’ lawyers still have time to indulge in other pursuits.

 

But while these cases do not involve subprime or credit crisis-related allegations (at least not directly), the CarMax case does suggest that the more general economic decline is starting to burden companies and, in CarMax’s case at least, attract the unwanted attention of plaintiffs’ lawyers.

 

CarMax’s June 18, 2008 press release (here) that triggered its stock price drop quotes its CEO as saying that “the slowdown in the economy, the dramatic rise in gasoline and food costs and the related impact on consumer spending adversely affected our first quarter performance.” The release also states that “for the first time in more than two years, we experienced a modest decline in customer traffic in our stores. Additionally, credit availability from our third-party nonprime lenders declined slightly in the quarter.”

 

CarMax is far from the only company that in the weeks and months ahead will be reporting disappointing earnings as a result of the slowdown in the economy and declining consumer spending. Not all of the companies that report disappointing earnings will get sued. But if a stock price drop of 11%, or even just 7%, is enough to attract a lawsuit, there could be a period of heightened litigation activity ahead. Based on these two lawsuits, the plaintiffs’ securities bar seems primed for action – regardless of whether or not subprime or credit crisis-related issues are involved.

 

Politics on a New Plane?: A July 31, 2008 article in The Economist (here) reports the following about recent political events in India:

India’s coalition government went to outlandish lengths to win a vote of confidence in Parliament on July 22nd, a victory it hopes will prolong its life until early next year. To appease one politician, it even renamed the airport in Lucknow, a state capital, after his father. (The ingrate still voted the other way.) Asked to justify this ploy, India’s finance minister dryly remarked, “It will facilitate better take-offs and landings.”