In flush times, the balm from the boom economy covers a multitude of sins. But when the economy sours, even transactions that once appeared favorable can turn bad. When they do, lawsuits can, and usually do, arise. Two recently filed securities class action lawsuits illustrate this point and also suggest that adverse economic circumstances may fuel even further litigation.

 

The first of these two recent lawsuits involves FCStone Group. FCStone is “an integrated commodity risk management company providing risk management consulting and transaction execution services to commercial commodity intermediaries, end users and producers.” Basically, it helps those involved in commodities business to manage their exposure to commodities price fluctuations.

 

Plaintiffs filed a purported securities class action lawsuit against FC Stone and certain of its directors and offices in the Western District of Missouri on July 15, 2008. The plaintiffs’ counsel’s July 16, 2008 press release describing the lawsuit can be found here and the complaint can be found here.

 

According to the complaint, the lawsuit relates to “a misdescription of an important hedge instrument purchased by the Company.” According to the complaint, the hedge transaction provided net income to the company for the first two fiscal quarters of 2008, ending on February 29, 2008. The press release describing the lawsuit states:

In an conference call on April 10, 2008, the Company concealed the true nature of the Hedge, by failing to reveal that should there develop a significant spread between the U.S. based Fed Funds interest rate (the “Feds Funds Rate”) and the London Inter-Bank Rate (“LIBOR”), the Hedge would decline in notional value. Based on what the market was told, the investing public viewed the hedge as simply one to protect the Company from falling interest rates, and not one which was crucially dependent upon the spread between the Fed Funds Rate and LIBOR not widening.

The complaint alleges that in the company’s 2008 third fiscal quarter, a spread arose between the Fed Funds Rate and LIBOR and the company’s gains for the first two fiscal quarters were eliminated. The press release describing the lawsuit states:

On July 10, 2008, FCStone shocked the market by announcing third quarter earnings per share of 28 cents versus the expected 47 cents. Much of the deviation was due to the decline and sale of the Hedge. In addition, the Company announced previously unmentioned and significant bad debt expenses due to volatility in the cotton markets which had occurred in March. Nothing was said about this volatility and its adverse effects on the April 10, 2008 conference call. Upon revelation of this adverse news FCStone shares dropped over 41% wiping out over $300 million in shareholder value.

The second of the two lawsuits was filed in the Southern District of New York on July 17, 2008 based on the failure of Hexion Specialty Chemicals to follow through on its planned acquisition of Huntsman Corporation.

 

The Huntsman lawsuit arises out of the agreement announced on July 12, 2007 (here), that Hexion would acquire the company in a transaction valued at $10.6 billion. According to the original press release, Hexion is a portfolio company of Apollo Management. . The sale was approved by Huntsman’s shareholders on October 16, 2007 (here). On January 26, 2008, Hexion exercised its rights to extend the termination date of the merger agreement (here), to obtain regulatory approvals, and further extended the date in April 2008 (here). In its May 14, 2008 earnings release (here), Hexion provided a “transaction update” in which it noted that the parties had agreed, pursuant to the Merger Agreement, to allow additional time in order to obtain necessary regulatory approvals.

 

However, on June 18, 2008, Hexion issued a press release stating that the “transaction is no longer viable” and announcing that it had initiated a lawsuit in Delaware Chancery Court to declare its rights under the merger agreement. Huntsman later announced that it had counterclaimed to enforce the merger agreement in the Delaware lawsuit (here) and separately announced (here) that it had filed its own lawsuit against Apollo and two of its partners for fraud in inducing Huntsman to terminate its prior merger agreement with a separate merger partner, by presenting the Hexion merger proposal.  

 

On July 17, 2008, plaintiffs’ lawyers, purporting to represent a class of Huntsman shareholders, filed a lawsuit in the United States District Court for the Southern District of New York against Hexion, its CEO and one of its directors. A copy of the plaintiff’s counsel’s July 17, 2008 press release announcing the filing can be found here and a copy of the complaint can be found here.

 

According to the press release,

On May 14, 2008, Hexion disclosed that it agreed to allow additional time to obtain the regulatory approvals. Unbeknownst to the public, defendants had determined to abort the merger and took steps to abrogate the Merger Agreement. Defendants retained the services of Duff & Phelps to render an opinion that the combined entity lacked financial viability. On June 18, 2008, Duff sent a letter to the Board of Directors of Hexion opining that the combined company’s assets would not exceed its liabilities, that it would not have the ability to pay its total debts and liabilities as they become due and that it would have an unreasonably small amount of capital. On that same date, defendants filed a complaint in the Delaware Court of Chancery, seeking abrogation of the Merger Agreement. The reaction in the marketplace was devastating to the price of Huntsman’s common stock. On June 19, 2008, the first day of trading after the June 18, 2008 actions by Hexion, the market price of Huntsman common stock fell approximately $8, or 40%, from $20.86 to close at $12.84, on enormous volume of approximately 43 million shares.

The complaint purports to be filed on behalf of the class of persons who purchased Huntsman shares between May 14 and June 18, 2008.

 

According to the complaint, Hexion started to try to back away from the agreement because the defendants “were disturbed by Huntsman’s financial results for the three quarters after the signing of the Merger Agreement as well as the state of the economic market and the global credit crunch.”

 

Interestingly, though the plaintiffs’ class consists of Huntsman shareholders, their lawsuit is filed against Hexion and two of its senior officials. The complaint does not allege secondary liability, but rather it alleges that the defendants violated their primary obligations under Section 10(b). Specifically, the plaintiffs allege that

Defendants failed to disclose the material facts that they had decided to abort the merger if possible and had taken affirmative steps to determine whether they could abort the merger and abrogate the Merger Agreement and retained the services of Duff to render an opinion that the combined entity lacked financial viability and Wachtell to draft and filed a complaint. These material misstatements and omissions had the cause and effect of creating in the market an unrealistically positive assessment that the merger would close by July 4, 2008 … causing the Huntsman’s common stock to be overvalued and artificially inflated during the Class Period.

The attempt by Huntsman shareholders to hold Hexion and its officials liable under the federal securities laws raises some unusual issues and will be interesting to watch. The unusual occurrence of a securities lawsuit brought by another company’s shareholders also potentially raises an interesting theoretical issue depending on the definition of “Securities Claim” in Hexion’s D&O insurance policy. There are two usual variants of this definition, one of which defines the term by reference to the kind of claims (that is, claims under specifies securities law), and one that defines the term by reference to the kind of claimant (that is, by reference to claims by holders of securities of the company).

 

I have no direct knowledge of Hexion’s insurance program, but because so-called entity coverage under D&O policies is typically limited to “Securities Claims,” the definition of that term in the Hexion policy could determine whether or not the company itself has coverage for the claims brought against them by the Huntsman shareholders. The availability of coverage for the claims against the entity could well depend on which variant of the definition of the term “Securities Claim” appears in the Hexion policy. To the extent the term is restrict to claims brought by holders of Hexion’s own securities, coverage potentially might not be available for the company itself for the Huntsman shareholders’ lawsuit.

 

Perhaps the circumstances involved in these two cases might have arisen even in more stable economic times, but the troubled transactions underlying the lawsuits seem symptomatic of the currently turbulent economy. Indeed, the Huntsman shareholders lawsuit specifically alleges that among the reasons why Hexion sought to back away from the merger were “the state of the economic market and the global credit crunch.”  In both of these instances, transactions that initially appeared favorable appeared unfavorable as circumstances changed.

 

The challenging circumstances that undermined these transactions are hardly unique to these two companies.  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.

 

One final note. These is nothing about these lawsuits that make them subprime related, and it is only in the broadest sense that they lawsuits might be categorized as credit crisis related. If nothing else, these lawsuits at the outer edge of the current litigation wave demonstrate the complicated definitional problems involved with trying to track subprime and credit crisis related lawsuits. In the end, I have decided not to “count” these lawsuits in my running tally of subprime and credit crisis related litigation (which can be accessed here), because they seem to relate to much larger economic issues (such as interest rates and the adverse business climate). Reasonable minds may differ on this categorization.

 

Tellabs Not a Filing “Deterrent”: When the U.S. Supreme Court issued its June 2007 opinion in the Tellabs case, it was widely hailed as a significant defense victory. My own view at the time (refer here) is that the outcome was at most a draw, and in the end is unlikely to have a significant impact.

 

A July 2008 memorandum from the Jones Day law firm entitled “Tellabs Proves to Be No Deterrent to Securities Class Action Filings” (here) suggests that commentators predicting that Tellabs would have “little impact on future securities class action filings” were “the better prognosticators.”

 

The memorandum notes that in federal circuits (such as the First, Fourth, Sixth and Ninth) that actually had more demanding pleading standards than the one articulated by the Supreme Court in Tellabs, “cases are actually more likely to survive a motion to dismiss after Tellabs than before.” The memorandum goes on to note that “even in formerly less demanding circuits, Tellabs did not set the pleading bar at a level that deters filings.”

 

The memorandum concludes by stating that “Tellabs plainly has not operated to deter securities class action filings. To the contrary, the data confirms [sic] that filing opportunities remain wide open for plaintiffs.”

 

Special thanks to a loyal reader for supplying a copy of the Jones Day memorandum.

Over the last several years, Congress has made several different efforts to concentrate class action litigation in federal court.

 

For example, in the Securities Litigation Uniform Standards Act of 1998 (SLUSA), Congress amended portions of the Securities Act of 1933 and the Securities Exchange Act of 1934 to preempt class actions alleging fraud under state law in connection with the purchase or sale of securities. The Act specifically made state law securities class action lawsuits removable to federal court.

 

In addition, in the Class Action Fairness Act of 2005 (CAFA), Congress expanded federal court jurisdiction over class actions and mass actions. CAFA gives federal courts jurisdiction over certain class actions in which the amount in controversy exceeds $5 million and in which any of the class members is a citizen of a state different from any defendant.

 

But while Congress enacted these various legislative changes designed to concentrate class action litigation in federal court, Section 22(a) of the ’33 Act preserved state court jurisdiction by specifying that federal courts’ jurisdiction for ’33 Act lawsuits is “concurrent with State and Territorial courts.” Moreover, Section 22(a) specifically provides that no case “brought in any state court of competent jurisdiction shall be removed to any court of the United States.”

 

These jurisdictional provisions have been a part of the federal securities laws since the basic statutes’ enactment. But the legislative developments in the interim raise the question whether the subsequent enactments override the concurrent state court jurisdictional provisions in Section 22(a).

 

As I have previously noted (here), plaintiffs’ lawyers have chosen to file a number of subprime-related securities class action lawsuits alleging ’33 Act violations in state court. In particular, plaintiffs’ lawyers have elected to file in state court several class action lawsuits alleging misrepresentations in connection with the creation and issuance of subprime mortgage-backed securities. These lawsuits, of which by my count there have been at least four, exclusively allege violations of the ’33 Act.

 

One of the first of these lawsuits to be filed is the case styled as Luther v. Countrywide, the background regarding which can be found here. The plaintiffs originally filed their complaint in California Superior Court for Los Angeles County. The Luther complaint names as defendants several Countrywide subsidiaries and affiliated individuals, multiple loan trusts, and Countrywide’s offering underwriters.

 

The claims in the Luther lawsuit are brought on behalf of purchasers of billions of dollars of mortgage pass-through certificates issued between June 2005 and June 2007. The complaint alleges that the defendants violated Sections 11, 12 and 15 of the ’33 Act, essentially on the grounds that the risk of investing in the mortgage pass-through certificates was much greater than represented by the registration and prospectus supplements, which allegedly omitted and misstated the creditworthiness of the underlying borrowers.

 

The defendants, in reliance on CAFA, removed the Luther case to federal court. The plaintiffs filed a motion to remand the case to state court.

 

As discussed here, on February 28, 2008, Judge Mariana R. Pfaelzer granted the plaintiffs’ motion to remand the case to state court, holding that Section 22(a)’s removal bar trumps CAFA’s general grant of diversity and removal jurisdiction. The defendants appealed.

 

In an opinion filed on July 16, 2008 (here), the Ninth Circuit affirmed the district court, specifically holding that CAFA, “which permits in general the removal to federal court of high-dollar class actions involving diverse parties, does not supersede Section 22(a)’s specific bar against removal of cases arising under the ’33 Act.”

 

The defendants had argued that CAFA superseded Section 22(a)’s removal bar. But the Ninth Circuit, applying principles of statutory construction, held that while CAFA applies to a “generalized spectrum” of class actions, the ’33 Act is “the more specific statute” and that the removal bar “more precisely applies only to claims” under the ’33 Act. The Ninth Circuit concluded that the plaintiff’s initial state court class action “was not removable” and that “the motion to remand was properly granted.”

 

In other words, the Luther lawsuit will now go forward in state court. In light of the Ninth Circuit’s opinion, it seems likely that the various other subprime-related class action lawsuits filed against the mortgage securitizers will also eventually proceed in state court as well.

 

The “where” question has been resolved, but the “why” question still remains – that is, why do plaintiffs’ counsel want to proceed in state court rather than federal court?

 

One possibility is that plaintiffs’ counsel believes that state courts will be more sympathetic to the interests of local claimants, especially in connection with their claims against out-of-state moneyed interests. The search for a more favorable court has always driven forum shopping, and there may be some of that here. But I do wonder why plaintiffs’ securities attorneys, whose practices historically (especially in recent years) have concentrated in federal court, want to litigate in a state court with which they may be less familiar, and that will be unfamiliar with federal securities laws and securities litigation generally.

 

Another possible reason plaintiffs lawyers want to proceed in state court is that they want to try to circumvent the procedural requirements of the PSLRA. I have speculated elsewhere (most recently here) that plaintiffs’ counsel may try to argue that the PSLRA’s procedural requirements do not apply to a ’33 Act case in state court. The plaintiffs’ argument would be that the PSLRA, codified in Section 27(a) of the ’33 Act, provides that the PSLRA applies only to private actions “brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure.” The plaintiffs’ counsel may argue that because their suit was not brought pursuant to the Federal Rules of Civil Procedure, the PSLRA’s procedural requirements (such as the notice provisions, the discovery stay, and the lead plaintiff provision) do not apply. There could be a great deal of litigation turbulence if plaintiffs’ lawyers pursue these arguments (which seems likely).

 

Plaintiffs’ counsel apparently have the right to pursue ’33 Act claims in state court, which for whatever reason they seem inclined to do. There were of course a few securities lawsuits filed in state court after the enactment of the PSLRA, but my recollection is that that experiment did not go particularly well. Due to the state courts’ crowded dockets and unfamiliarity with federal securities laws, the cases bogged down. The enactment of SLUSA seemingly ended this prior flawed experiment.

 

Nevertheless, plaintiffs’ securities attorneys, for reasons they deem good and sufficient, are back again in state court, a place where they now seem eager to be. Some recalibration may be required to accommodate the prospect of further state court securities litigation. The plaintiffs’ lawyers’ interest in pursuing state court ’33 Act class action litigation is an unexpected development with uncertain implications. The road could be rough for all concerned.

On June 26, 2008, Judge Gerard Lynch of the Southern District of New York issued another opinion (here) in the D&O insurance coverage litigation arising out of the Refco debacle (My recent post discussing Judge Lynch’s prior opinion in the case discussing insurance application issues can be found here.)

 

In yet another judicial decision that resonates with significance for excess D&O insurance issues, Judge Lynch, hearing an appeal from a bankruptcy court ruling, addressed the question whether an excess insurer may withhold advancement of defense costs based on its determination that an exclusion in its policy precluded coverage. Judge Lynch held that even if the excess policy has the distinct exclusions, the policy’s terms do not  affect the operation of the applicable defense cost advancement provisions, and the advancement provisions should be enforced according to their terms.

 

The background of the case can be found in my prior post. Of significance here, the primary insurer’s $10 million limit and the first level excess insurer’s $7.5 million were exhausted in payment of defense expense. As also discussed in the prior post, the second level excess insurer disputes coverage on a number of grounds. The second level excess insurer also disputes that it has any obligation to advance defense costs pending a determination of coverage.

 

The parties agree that the advancement provisions in the primary policy control the advancement issue; they dispute how the provisions apply in the context of the second level excess carrier’s policy.

 

The primary policy specifies that:

The Insurer will pay covered Defense Costs on an as-incurred basis. If it is finally determined that any Defense Costs paid by the Insurer are not covered under this Policy, the Insureds agree to repay such non-covered Defense Costs to the Insurer.

The second level excess insurer [hereafter in this post, simply “the insurer”] contended that notwithstanding this language, it has no obligation to advance defense costs. In making this argument, the insurer relied on the word “covered” in the first sentence of the advancement provision, qualifying the type of defense costs that the provision requires to be paid on an as-incurred basis.

 

The insurer’s argument is based on its contention that its policy’s conduct exclusions, unlike the primary and first level excess policies’ exclusions, do not have an adjudication requirement. The insurer argued, according to the court, that because the conduct exclusions in its policy have no adjudication requirement, “prior to a court determination, [the insurer] has the unilateral right to determine whether defense costs are ‘covered,’” and that it has made a “good faith determination” that the insureds’ claims are precluded under its policy.

 

As the court paraphrased the insurer’s position, the insurer contended that the terms of its contract “authorize it to apply its exclusions to deny coverage unilaterally – and thus to refuse to advance defense costs – unless and until a court determines that the costs are ‘covered’” under its policy.

 

The insureds contend in their counterclaim in the coverage litigation that the exclusions on which the insurer relies to deny coverage “are not, in fact, part of the policy.” With respect to the advancement issue, the insureds argued that the advancement provisions require the insurer to advance defense expense, contending that as long as the claim “falls within the policy’s insuring agreement, it is covered unless and until there is a final determination that an exclusion applies.”

 

The insureds also argued that nowhere in the insurer’s policy does it state that the insurer can unilaterally withhold defense expense absent a court determination, and nothing in the insurer’s policy states that its exclusions are not subject to the “final determination” language in the second sentence of the advancement provisions.

 

In his June 26 opinion, Judge Lynch observed that “in essence, the central dispute among the parties centers on who bears the burden regarding whether defense costs are ultimately covered.” Judge Lynch, while noting that the insurer’s position regarding advancement “is not unreasonable on its face,” also noted that the insurer’s interpretation “places enormous emphasis on the word ‘covered.’” Judge Lynch said that the word’s inclusion in the advancement provisions “can hardly be said to make an unambiguous change in the provision’s literal meaning,” and “seems, at best, an unusual way to effectuate a fundamental change in the parties’ expectations.”

 

Because the court found the wordings to be ambiguous, it interpreted the provision in favor of the insureds – a result that the court noted “makes eminent sense, as adopting [the insurer’s] interpretation … would effectively render the advancement obligation worthless.” Judge Lynch concluded by saying that if the insurer “wants the unilateral right to refuse a payment called for in the policy, the policy should clearly state that right.” (citations omitted)

 

Whatever else might be said about the court’s opinion, it is certainly a sharp reminder of the importance of inclusion of adjudication requirements in the D&O policy’s conduct exclusions. If, in the absence of an adjudication requirement, the insurer may contend (as did the insurer in the Refco coverage litigation) that it has the unilateral right to determine coverage and withhold policy benefits, then the omission of adjudication requirements is perilous indeed for insureds.

 

But the crux of the dispute is whether the second level excess insurer’s policy contains exclusions not found in the primary or first level excess policies. The insureds apparently dispute that the exclusions are part of the second level excess policy (although the precise nature of that dispute is not clear from the face of the opinion). Assuming that the distinct exclusions are in fact part of the second level excess insurer’s policy, it does suggest that the insurance program is something less than pure “follow form” insurance. Indeed, many insurance programs that are characterized as “follow form” in fact have characteristics that may make them something less than follow form, a consideration that may sometimes be overlooked in the insurance transaction process.

 

It is of course true that each policy in a tower of insurance represents a separate contract. Excess insurers have every right to insist on terms differing from the underlying layers. The Refco coverage dispute highlights the pitfalls that can arise when (or perhaps if) an excess policy has terms that differ from the underlying policies. Indeed, the arguments raised by the second level excess insurer in the Refco coverage litigation show that differences in wording between the layers potentially can cause the different layers to operate quite differently, potentially in ways that may not necessarily be apparent or anticipated.

 

One final note has to do with the parties’ apparent dispute whether the exclusions are in fact part of the second level excess policy. It is hard to tell from the face of the opinion, but this dispute may be due to the process issues discussed briefly in my prior post. At least until the merits are sorted out, it may be premature to try to draw any conclusions. But as I noted in my prior post, and to the extent the dispute is due to process issues, this case may be a reminder of the opportunities for and the dangers of ambiguities in insurance placement process communications. From the perspective of every process participant, after a serious claim has arisen is a very difficult time to have to try to sort out, for example, whether or not exclusions are part of a policy.

 

Special thanks to Kelly Reyher for providing me with a copy of Judge Lynch’s June 26 opinion.

 

And Finally: For those of us laboring in the salt mines of the blogosphere, it is always exciting when a fellow blogger steps out in some dramatic way. And so I was delighted to see in the July 16, 2008 Wall Street Journal that Mark Herrmann of the Drug and Device Law Blog published a book review critically analyzing the recent book "Side Effects" by Alison Bass. Kudos to Mark for his excellent and well written review.

May all new media practitioners continue to prosper and succeed. Gradus ad Parnassus.

In a June 25, 2008 decision (here), the Delaware Superior Court (New Castle County) refused to apply a D&O policy adjudicated fraud exclusion to preclude coverage for the settlement, defense fees and costs incurred in connection with an underlying securities lawsuit.

 

The coverage action arose out of the AT&T Corporation Securities Litigation, the background regarding which can be found here. The case ultimately settled for $100 million. Prior to the settlement, the trial court granted the defendants’ motion for partial summary judgment, narrowing the case. The case went to trial on the remaining issues, but the parties reached a settlement before the jury reached a verdict. The court in the subsequent coverage litigation specifically noted that “there is no dispute that no court has held, and no jury has every found, that AT&T or any of the defendants in the Common Stock Litigation engaged in any deliberate, dishonest, fraudulent, or criminal act or omission.”

 

The primary policy in the applicable D&O insurance program provided in its base form that the insurer “shall not be liable to make any payment in connection with any Claim: brought about or contributed to in fact by any dishonest, fraudulent or criminal act or omission.” However, by Endorsement, this exclusion was deleted and replaced by language providing that he insurer is not obligated to pay any claim:

brought about or contributed to in fact by any deliberate dishonest, fraudulent or criminal act or omission, or any personal profit or advantage gained by any of the Directors and Officers to which they were not legally entitled and providing any such finding is material to the cause of action so adjudicated.

The primary carrier’s $20 million limit had been exhausted through payment of defense fees and costs. The first level excess carrier provided $25 million in “follow form” excess coverage. The excess carrier refused to pay either defense fees or contribute toward the settlement, claiming that the fraud exclusion bars coverage.

 

The Delaware court first turned to the question of what law to apply. The court ultimately determined that New York law governed. Interestingly, the basis of the court’s decision was language in the fourth level excess carrier’s policy. Because the court assumed that the parties’ intended that only one jurisdiction’s law would govern the entire program, the court found that the fourth level excess carrier’s language controlled even though the fourth level excess policy sits above the first level excess carrier’s policy.

 

The court then turned to the merits of the insurance coverage issue. The court paraphrased the exclusion as precluding coverage “for deliberate, dishonest, fraudulent, or criminal acts or omissions upon ‘such finding is material to the cause of action so adjudicated.’”

 

The court said that “no fact finder considered all the evidence and rendered a ‘finding” or verdict.” The court also observed that neither the summary judgment ruling nor the settlement adjudicated anything.

 

The court also specifically ruled that “the ‘adjudication’ contemplated in the policy does not, as [the excess insurer] asserts, mean an adjudication within the coverage dispute. It means an adjudication in the underlying action.” The court specifically noted that the excess insurer “cannot argue its way around” the change that the Endorsement introduced in the dishonesty exclusion wording. The court said the position argued by the excess carrier is “belied by the plain language of the policy.” The court added that “it is not a close question.” The court also observed that “to hold the fraud exclusion applicable” to a securities claim in the absence of an adjudication “would effectively eviscerate the purpose of the policy.”

 

The precise wording at issue in the AT&T coverage case is not typically used today. But the court’s analysis is nevertheless important as it pertains to the adjudication requirements for the typical adjudicated fraud exclusion that is found in many policies today. The court’s refusal to read into the clause a right by the insurer to adjudicate the issue of fraud in a separate coverage case amounts to a ruling that an adjudication fraud exclusion does not permit the fraud issue to be separately litigated, at least absent language to the contrary.

 

This is an important holding because while most contemporary D&O policies have an “adjudicated” fraud exclusion, there are also still some other policies that allow the insurer to litigate the fraud exclusion in a separate proceeding. The court’s holding in the AT&T case underscores the point that, without the separate proceeding language, the “”adjudication” referenced in the fraud exclusion pertains to the underlying proceeding, and the fraud exclusion therefore is inapplicable if there has been no fraud determination in the underlying proceeding.

 

The excess carrier’s inability to further litigate the fraud issue in the ATT&T coverage case also demonstrates the value to the policyholder of fraud exclusion language that does not permit separate adjudication. The presence of separate adjudication language potentially could have permitted the AT&T coverage litigation to go forward and potentially could have led to a finding that could have barred coverage. For that reason, a fraud exclusion that permits separate adjudication is undesirable from the policyholder’s standpoint. In the current insurance environment, most policyholders should be able to obtain adjudicated fraud exclusion language without any provision allowing separate adjudication.

 

A couple of final points about the decision. The first is that yet again a coverage dispute has arisen in which the excess carrier contested coverage after the primary carrier’s limits were exhausted. As I have frequently noted (most recently here), the D&O insurance industry continues to be challenged with issues arising as losses escalate through the insurance tower. The problem of excess insurer coverage disputes is an increasingly important issue that the industry must address.

 

Second, the court’s resolution of the question of the law to be applied to the first level excess carrier’s policy based on language in the fourth level excess carrier’s policy is interesting but at the same time potentially troublesome. The court’s reasoning seems practical and informed by a desire to reach a common sense solution; it is logical that only one jurisdiction’s law   should apply to the entire tower.

The troublesome part is the court’s reference to upper layer policy provisions to resolve lower layer issues. The lower layer insurers often are unaware of provisions in the upper layer policies, and problems could emerge if the view were to develop that the meaning of lower layer policies can be discerned from language in upper layer policies. Maybe this concern reads too much into the court’s opinion, but the mere suggestion is troubling.

 

Very special thanks to Francis Pileggi at the Delaware Corporate and Commercial Litigation Blog (here) for alerting me to the AT&T coverage decision and providing me a copy.

 

Nearer to the Heart’s Desire: A July 12, 2008 Cleveland Plain Dealer article (here) reports that 34 Ohio charitable organizations will share a $14 million pool of uncollected money from a class action lawsuit. The settlement arose out of a class action lawsuit based on an auto insurer’s alleged overcharges for uninsured motorist coverage. The case settled for $51 million, but when some of the funds went unclaimed, the plaintiff class’s attorney succeeded in having the doctrine of “cy pres” applied to the unclaimed funds so that, rather than going back to the defendant insurer, the funds would go the charitable organization.

 

The term "cy pres" is law French, derived from the phrase  cy pres comme possible  — meaning as near as possible or as close as possible to the original intent. The phrase is sometimes relevant in the trust and estates context when the trustor’s or the testator’s original intentions can no longer be fulfilled due to changed circumstances.

 

The concept of a cy pres settlement is actually not new, although it apparently has gained popularity recently among certain plaintiffs’ attorneys. Ted Frank wrote an interesting article earlier this year entitled “Cy Pres Settlements” (here) in which he discusses other recent cy pres settlements and some of the problems they present.

 

The phrase has a certain poetic quality, and not merely because of its gallic residue. The very concept is almost literary, as it requires an exercise of the imagination to implement. I have always felt this attribute of the doctrine is nicely summarized in the lines from The Rubaiyat of Omar Khayyam: “Ah Love! could you and I conspire/To grasp this sorry scheme of things entire/Would not we shatter it to bits—and then/Remold it nearer to the heart’s desire!”

 

And Finally: In a recent post (here), I discussed an academic paper in which three Stanford professors analyzed four corporate governance companies’ governance ratings. In the post, I expressly invited the governance rating companies, if they so desired, to provide a response to my discussion of the academic paper.

 

In reply to my invitation, Ric Marshall, the Chief Analyst of The Corporate Library, and Kimberly Gladman, the Director of Research and Ratings at The Corporate Library, sent me a response, which I have added to the end of my original post.

 

Because Ric and Kimberly make a number of interesting points, I urge all readers to refer back to the now updated post (here) to see their comments.

While I have been keeping track of the subprime and credit crisis-related litigation as it has accumulated (refer here), it has been some time since I have undertaken a detailed litigation overview. Fortunately, NERA Economic Consulting, in a July 3, 2008 report entitled “Subprime Securities Litigation: Key Players, Rising Stakes and Emerging Trends” (here), has taken care of it, with an excellent analysis of the subprime litigation to date.

 

The NERA Report, written by my friend Dr. Faten Sabry and her colleagues Anmol Sinha and Sungi Lee, observes that the growing wave of subprime lawsuits has swept up an increasingly diverse array of plaintiffs and defendants. With respect the defendants, the Report notes that:

Almost every market participant in the securitization process—which transforms illiquid assets such as mortgages, auto loans, and student loans into tradable securities—has been named as a defendant. The list of defendants includes lenders, issuers, underwriters, rating agencies, accounting firms, bond insurers, hedge funds, CDOs, and many more.

The Report also describes the way that the litigation has evolved, noting that:

The majority of the early lawsuits have been against mortgage lenders. As various other market participants reveal the extent of their losses and exposure, they too are being dragged into litigation. The plaintiffs include shareholders, investors, issuers and underwriters of securities, plan participants, and others.

The NERA Report specifically discusses the subprime-related lawsuits that have been filed against lenders, issuers, rating agencies, bond insurers and asset management companies. The Report also observes (as has been noted on this blog, here) that as the litigation has accumulated, it has spread far beyond just subprime-related issues, and has encompassed parties and circumstances “in the context of the trouble in the broader markets.”

 

The Report notes that as the subprime litigation has evolved, the broader “credit crunch” litigation has encompassed a wider variety of lawsuits and litigants, including lawsuits involving asset-backed commercial paper, lawsuits related to failed deals, lawsuits related to corporate debt losses, and lawsuit related to asset-backed securities.

 

The NERA Report was clearly intended to be descriptive and not exhaustive, so it is no criticism of the report  for me to add some additional observations. There are, in fact, a few notes I would add to the report’s overview.

 

In addition to the categories of litigants the NERA Report discusses, there are some additional categories I think merit attention. The first relates to hedge funds. While the NERA Report does reference hedge funds, I think the involvement of hedge funds is worth of separate comment. Hedge funds have become involved both as plaintiffs (refer here) and as defendants (refer here and here). The likelihood of additional litigation involving hedge funds seems strong.

 

One group not specifically mentioned in the NERA report is the mutual fund industry. By my count, there have been at least five subprime securities lawsuits against mutual funds and mutual fund families. (Refer for example here and here.) These lawsuits are brought by investors claiming that the mutual funds misrepresented the relative stability of their investment strategy and assets.

 

The NERA report does specifically discuss the litigation against the credit rating agencies. The only thing I would add is that the credit rating agency litigation falls into two categories. The first involves lawsuits brought by the credit rating agencies’ own shareholders, for allegedly inadequate disclosures (refer, for example, here). The second involves investor lawsuits brought against the rating agencies for the rating company’s actual rating activities (about which refer here).

 

Yet another industry group that has been hit with subprime lawsuits is the mortgage insurance industry, in which all of the leading participants – including MGIC (refer here), The PMI Group (refer here), and Radian (refer here) – have all been hit with securities lawsuits. Indeed, the Blackstone Group was also hit with a securities lawsuit (refer here) for alleged disclosure issues relating to its investment in mortgage insurer FGIC. As discussed in a July 11, 2008 Wall Street Journal article (here), the mortgage insurers’ woes are one of the litany of problems besetting Fannie Mae and Freddie Mac. Freddie Mac has also itself been the target of a subprime-related securities class action, as noted here.

 

The NERA Report specifically acknowledges the fact that the litigation wave has long since moved past subprime lending alone. For example, the NERA report specifically mentions lawsuits involving corporate debt (as I also noted, here). An important corollary of this observation is that even with respect to residential real estate lending, the litigation wave has swept far beyond subprime lending alone; for example, it has also encompassed Option ARM loans, as I discussed here. IndyMac, the lending institution whose dramatic collapse over the weekend may potentially signal a dark new inflection point in the evolving credit crisis, was focused on so-called Alt-A loans.

 

In addition, other kinds of debt have also been the source of credit crunch litigation. For example, in addition to corporate debt, problems arising from student loans have also been the source of litigation, as discussed here and here.

 

Finally, I do think it is noteworthy that at least one credit crisis lawsuit, involving MoneyGram International (refer here), relates to the company’s disclosures about its investments in subprime-related assets. Many companies, including many companies outside the financial sector, have balance sheet exposure to subprime assets, and therefore there is the potential at least for this kind of litigation to spread far beyond the financial sector. I have discussed this issue at length in prior posts (most recently here), but I recognize at this point that it remains to be seen whether or not there will be substantial credit crisis-related litigation outside the financial sector. As I recently noted in my mid-year review of securities litigation (refer here), the vast bulk of credit crisis-related litigation has been in the financial sector.

 

The NERA report concludes with the observation that “most of the lawsuits are still in their initial stages and it is too early to predict the outcomes,” but that “given the continuing turmoil in the financial markets, the mounting losses, and the growing list of lawsuits, this story is far from over.” I couldn’t agree more, and as the story continues to evolve, I will continue to track the lawsuits – the securities and ERISA lawsuits here, and the derivative lawsuits here. I will also continue to track subprime and credit crisis-related lawsuit case dispositions, here.

 

Rubble Without a "Cause"?: I was struck by the reports in the press coverage surrounding the regulatory seizure of IndyMac Bank, for example in the July 12, 2008 Wall Street Journal (here), that Office of Thrift Supervision director John Reich blamed the bank’s failure on “comments made in late June by Senator Charles Schumer, who sent a letter to the regulator raising concerns about the bank’s solvency.” Spooked depositors reportedly withdrew $1.3 billion in 11 days. The Journal reports that “Mr. Reich said Sen. Schumer gave the bank a ‘heart attack.’”  A July 14, 2008 Wall Street Journal article (here) also quotes Reich as saying that "Schumer sparked a deposit run that ‘pushed IndyMac over the edge.’ "

 

Schumer is reported to have responded that if the regulator had done its job and prevented the bank’s “poor and loose lending practices,” we “wouldn’t be where we are today.”  (This is of course the same Senator Schumer who barely a year ago urged that regulatory standards should be loosened in order for America’s financial markets to be more competitive globally.)

 

The sharp exchange between Reich and Schumer dramatically highlights the fundamental question of causation that surrounds so many problems arising from the entire subprime meltdown. While Senator Schumer’s letter may well have undermined IndyMac depositor confidence, it was also merely one link in a chain of events leading up to the bank’s failure. The bank’s very business model, built around so-called Alt-A loans, in which borrowers are not required to fully document income or assets, arguably could be a more fundamental cause. Or if plaintiffs’ allegations are to be believed, the bank’s failure to follow its own underwriting standards also could have led to the bank’s failure.

 

Indeed, it is arguably possible to take the causal chain even further back. Here, I have in mind several driving trips I made during 2005 and 2006 on the I-10 corridor between LA and Palm Springs. It seemed as if on each trip, yet another roadside hilltop even further east than the last had been scraped bare and festooned with hundreds of cookie-cutter monstrosities “attractively priced in the low 500,000s."

 

The continuing emergence of these self-described “lifestyle” communities depended in the end on ever-rising house prices, record low interest rates, and two dollar a gallon gas. When all of these circumstances changed, the construct collapsed. (A more technical summary of this analysis can be found in a July 14, 2008 Wall Street Journal article, here, entitled "Continuing Vicious Cycle of Pain in Housing and Finance Ensnares Market.")

 

The ensuing defaults may or may not have been inevitable but they surely were a latent possibility built into lending arrangements borrowers had to stretch to afford. Every participant in the process contributed and accepted some part of this risk. In other words. it could plausibly be argued that the ultimate cause of the subprime meltdown (even if not the collapse of IndyMac) was cultural, or perhaps social. Call it cultural complicity.

 

Theorists would contend that the cultural context was merely a causally relevant condition but not the proximate cause either of the subprime meltdown or of IndyMac’s collapse, and perhaps they would be correct. Indeed, in a society that insists on assigning legal blame, proximate causation may be the only relevant inquiry.

 

But on that score, it may be worth noting that Reich, the OTS official, is reported to have asked rhetorically, “Would the institution have failed without the deposit run? We’ll never know the answer to that question”

 

Reich’s rhetorical inquiry, technically a “counterfactual,” poses a causal inquiry based on possible consequences from alternative facts. An interesting recent discussion of counterfactuals in the securities litigation context appears in yet another recent NERA Economic Consulting paper, entitled “Shareholder Class Actions and the Counterfactual” (here). This interesting June 24. 2008 paper poses questions that may prove particularly provocative in the context of the subprime meltdown.

 

The courts will eventually assign blame for IndyMac’s collapse. (Somehow, I doubt the blame will ultimately be placed on Senator Schumer.) But, the legal inquiry aside, it is possible that the final answer to the question of ultimate causation may be found only at the bottom of a bottomless well.

Subprime-related litigation may be all the rage, but the latest securities class action lawsuit harkens back to the era of the prior scandal-driven event. On July 8, 2008, plaintiffs’ attorneys filed an options backdating-related securities class action lawsuit against MRV Communications and certain of its directors and officers.

 

A copy of the plaintiffs’ attorneys’ July 8 press release can be found here, and a copy of the complaint can be found here.

 

The lawsuit follows the company’s June 5, 2008 announcement (here) that it has "established a committee of independent directors to review the company’s historical stock option practices." During late 2006 and early 2007, the company had previously conducted "an informal and voluntary review" of its share practices and found no problems. However, in the course of reviewing transactions involving two European subsidiaries, the company identified information suggesting that "the conclusions reached in the earlier review were incorrect," and the company is now undertaking a comprehensive review, not just limited solely to the European subsidiaries.

 

The company also indicated that financial reports issued during the period 2002 to 2008 may be affected and "the company expects to restate its financial statements for the impacted period." The company indicated that investors should not rely on the company’s financial statements issued during those periods. The company’s share price dropped 24% on the news.

 

According to the plaintiffs’ counsel’s press release,

during the Class Period, defendants made false and misleading statements concerning the Company’s employee stock option grant practices and financial results. Defendants allegedly caused or allowed MRV to issue statements that failed to disclose or misstated the following: (i) that the Company had problems with its internal controls that prevented it from issuing accurate financial reports and projections; (ii) that because of improperly recorded stock-based compensation expenses the Company’s financial results violated GAAP; and (iii) that the Company’s public disclosures covering a seven-year period presented an inflated view of MRV’s earnings and earnings per share, which would later have to be restated.

Even though the options backdating scandal may now seem like ancient history, new options backdating lawsuits have continued to filter in during 2008. Indeed, the MRV Communications lawsuit is the third new options backdating related securities class action lawsuit to be filed during 2008. (The prior two involved TeleTech Holdings, about which refer here, and Maxim Integrated Products, refer here.)

 

The one thing that is clear is that we still have a very long way to go before we have seen the end of the options backdating scandal. This may be an important thing to keep in mind when assessing the current subprime and credit crisis mess, which is in my view an infinitely bigger deal than the options backdating scandal. It undoubtedly will be many, many years before we reach the end of the subprime mess.

 

In any event, I have added the MRV Communications lawsuit to my running tally of options backdating-related securities class action lawsuits, which can be found here. With the addition of the MRV Communications lawsuit, the current tally of options backdating related securities class action lawsuits now stands at 39.

 

Finally, I have substantial grounds on which to suspect that MRV Communications was also named as nominal defendant in a shareholders’ derivative lawsuit filed in the Los Angeles County Superior Court. I have not yet been able to verify this filing, so I have not yet added MRV Communications to my list of options backdating related derivative lawsuits. I would be grateful if any reader out there who can verify the filing of the MRV Communications options backdating-related derivative complaint would please let me know.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for the link to the MRV Communications complaint.

 

Updated Options Backdating Settlement Analysis:  And speaking of the Securities Litigation Watch, Savett has posted on the blog (here) an updated version of his analysis of the value and timing of the options backdating-related class action settlements. The updated analysis accounts for the recent UnitedHealth option backdating class action settlement.

 

And Finally: Readers interested in the blogosphere’s internal dynamics of will be interested to follow the sequence events that ensued after I added The D&O Diary’s post last night about mid-year FCPA enforcement and litigation activity.

 

The post was quickly picked up by Dick Cassin’s excellent FCPA Blog (here). The FCPA Blog clearly (and deservedly) enjoys a strong and influential readership, which apparently includes, among others, Dan Slater at the WSJ.com Law Blog, who added his own post (here) referencing back to my item. The Law Blog’s inclusion of a picture of The D&O Diary’s author made this sequence perfect and complete.

This blogging stuff never ceases to amaze me.

Those eager to try to hold the credit rating agencies responsible for supposedly enabling the subprime mess will undoubtedly be encouraged by a July 8, 2008 SEC Report identifying rating agency “shortcomings.”

 

The Report, entitled “Summary Report of Issues Identifies in the Commission Staff’s Examinations of Selected Credit Rating Agencies” (here) reflects the SEC’s efforts to “evaluate whether the three leading rating agencies “adhered to their published methodologies for determining ratings and managing conflict of interest.” According to the Commission’s July 8 press release (here), the SEC was “particularly interested in the rating agencies’ policies and practices in rating mortgage-backed securities and the impartiality of their ratings.”

 

According to a July 8, 2008 CFO.com article about the Report (here), about 50 Commission staffers reviewed more than 100,000 pages of internal records and more than two million E-mail messages, mostly concerning rating activities related to Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs) during the period 2002 through 2006. The SEC’s massive review of electronic communications unearthed exchanges that, while not necessarily incriminating, do not reflect well on the overall integrity of the rating process, to say the least.

 

The SEC’s Report, which does not cite any particular rating agency by name, concludes that the rating agencies “struggled significantly with the increase in the number and complexity of these securities.”

 

As evidence that the rating agencies struggled with the transaction volume, the Report cites a number of e-mail communications, including one stating that “our staffing issues, of course, make it difficult to justify our fees.”

 

As evidence that the rating agencies struggled to keep up with the deal complexity, the Report cites another e-mail communication in which an analyst expressed concern that her firm’s model did not capture “half” of the deal’s risk, but that “it could be structured by cows and we would rate it.”

 

The Report also examines the “issuer pays” conflicts at length. Under this payment approach, the entity that issues the security pays the rating agency for the rating. The Report found that while each of the rating agencies had policies that prohibited rating analysts from discussing fees with the issuers, “these procedures still allowed key participants in the rating process to participate in the fee discussion process.” The Report also found that the rating agencies “do not appear to have taken steps to prevent considerations of market share and other business interests” that “could influence ratings or ratings criteria.”

 

Along those lines, the SEC found evidence to suggest that analysts were concerned that specific rating actions might affect business or cost market share. The Report quotes one analyst’s email message as stating “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision and if so how much.”

 

The Report also found that there are particular aspects of the RMBS and CDO rating process that may exacerbate some of these “issuer pays” conflicts. For example, the Report noted that the deal “arranger” is “often the primary designer of the deal and as such has more flexibility to adjust the deal structure to obtain the desired credit rating as opposed to managers of non-structured asset classes.”

 

The high concentration of this business among a very small number of “arrangers,” together with the high profit margins associated with the business, potentially could allow or encourage influence on the use, application and revision of credit rating processes.

 

The SEC said that it found no evidence that these kinds of considerations affected “rating methodology or models.” However, the Report quoted emails inferentially suggesting that analysts at least turned a blind eye to concerns. One email referring to CDOs as a “monster” and went on to observes that “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

 

The Report noted a number of other deficiencies, including the lack of disclosure about rating processes; insufficient documentation of process and of deviations from models to adjust ratings; and lagging surveillance in updating previously issued ratings.

 

As a result of September 2007 congressional action, the rating agencies must now register with the SEC as “nationally recognized statistical rating organizations” (NRSRO). In addition, in June 2008, the SEC issued a set of proposed rules that are designed to address many of the kinds of issues identified in the Report, particularly regarding conflicts of interest, documentation and report transparency. Because the SEC has only been regulating the rating agencies since 2007, it is unclear whether or not the SEC has the authority to file enforcement proceedings against the rating agencies in connection with the conduct described in the report, even if the SEC were otherwise so inclined.

 

Regulatory processes may well be underway to prevent the recurrence of the kinds of “shortcomings” identified in the Report. The Report also notes a variety of other remedial efforts already underway at the rating agencies themselves. But the Report also catalogs a litany of past practices that clearly may have played a role in the events that led up to the collapse of the subprime mortgage market. The ratings shortcomings apparently accompanied (and, it may be argued, enabled) the flood of mortgage securitizations that contributed to the subprime meltdown.

 

I recently noted (here) that investors and their counsel are starting to try to hold the rating agencies responsible for their investment losses. These claims may well face formidable obstacles (refer here). But, even though the report does not attribute statements or actions to specific rating agencies or to particular transactions, the tenor and content of the SEC’s Report undoubtedly will encourage those who want to try to hold the rating agencies responsible.

 

Of course, the SEC was able to muster formidable resources and undertake a massive review of electronic communications while passing the cost along to U.S. taxpayers. Those eager to exploit the same communications in separate civil litigation against the rating agencies may be forced to undertake a massive expense just to try to establish whether or not these or similar communications related to the agency or transaction they have targeted.

 

A July 9, 2008 Wall Street Journal article discussing the Report can be found here. Bloomberg’s July 8, 2008 article about the Report can be found here.

 

Auditor Liability Cap Alternative: George Washington Law School Professor Larry Cunningham has an interesting post on the Concurring Opinions blog (here) in which he reiterates his proposal for a market-based solution to manage the potentially ruinous liability exposures of auditors. In the post, Professor Cunningham reviews his suggestion that the audit firms “issue bonds in debt markets to provide a backstop against the big judgment,” paying interest commensurate with the risk. I have previously commented on Professor Cunningham’s proposal here.

 

In his most recent blog post, Professor Cunningham argues persuasively that the auditor liability cat bonds are “a practical, cost-effective solution to the risk that another large auditing firm could disappear.” He also argues that making auditor liability cat bonds a serious point of public debate would reveal the “true stakes” involved in the auditor liability debate.

 

Special thanks to Professor Cunningham for the link to the blog post.

The latest issue of InSights, entitled “The Foreign Corrupt Practices Act: A 70’s Revival?” (here), presents an overview of a frequent topic on this blog – the growing significance of FPCA enforcement activity. Not only is the heightened activity a regulatory and operational concern for all companies with overseas operations, but it also presents a growing source of potential liability in the form of follow-on civil litigation.

 

Many of the themes discussed in the InSights article are underscored in a July 7, 2008 Gibson, Dunn & Crutcher memorandum entitled “2008 Mid-Year FCPA Update” (here). The memo reports that the “frenetic pace” of FCPA enforcement activity “has carried through the first half of 2008.” Year to date prosecutions are up “substantially” from “last year’s record-setting totals.” Indeed, the memo notes that in the first half of 2008, there were more FCPA prosecutions than in any prior full year except 2007.

 

Among the many topics addressed in the Gibson Dunn memo is a theme I have frequently sounded on this blog and that I reviewed at length in the InSights article, which is the threat of civil litigation following along in the wake of an FCPA enforcement action. The Gibson Dunn memo characterizes the level of this litigation activity as an “outburst,” adding that “our recurring advice to clients and friends has been to expect and prepare for ‘tag along’ civil litigation when a new governmental FCPA investigation becomes public.”

 

In addition to the specific FCPA-related securities class action lawsuits I note in the InSights article, the Gibson Dunn memo also cites the recent settlement in the FARO Technologies securities litigation. According to the company’s press release (here), the company’s D&O insurers paid $6.875 million to settle securities law claims alleging, among other things, that the company or its representatives had made payments in connection with the company’s Asian sales in possible violation of the FCPA. The company apparently was also named as nominal defendant in a related shareholders’ derivative lawsuit.

 

As an aside, and in addition to the FCPA-related litigation described in the Gibson Dunn memorandum, a loyal reader advised me of yet another FCPA securities class action lawsuit settlement of which I was previously unaware, involving Titan Corporation. (Background regarding the lawsuit can be found here.) The plaintiffs in that case alleged that Titan Corporation, in order for its planned merger to go forward, had failed to disclose that foreign consultants had made improper payments to foreign officials in violation of the FCPA, and that the company had improperly accounted for funds used in those payments. The case settled in 2005 for $61.5 million.

 

In addition to the FCPA-related shareholder lawsuits, the Gibson Dunn memo also notes a “new diversity of FCPA-inspired civil litigation theories.” The memo specifically notes the arrival of civil litigation brought by foreign governments alleging that U.S. companies had corrupted the government’s own officials. The memo specifically references the Alcoa action, which I discussed in a prior post, here.

 

The memo also refer to an action brought in June 2008 by the Republic of Iraq against Chevron and ninety other companies, alleging that the defendants conspired with Saddam Hussein’s regime to corrupt the Oil-for-Food program by diverting as much as $10 billion to Hussein’s government. Iraq claims that the defendants violated RICO, as well as other fraud and money laundering statutes.

 

These FCPA-related cases and others are proceeding even though there is no private right of action under the FCPA itself. However, the Gibson Dunn memo notes that on June 4, 2008, Rep. Ed. Perlmutter (D. Colo.) introduced the “Foreign Business Bribery Prohibition Act of 2008” (H.R. 6188), which would provide for a limited private right of action under the FCPA. However, potential litigation targets are limited to “foreign concerns,” so the class of potential defendants is restricted to foreign persons unaffiliated with U.S. stock exchanges. While the Bill itself is still before the relevant Congressional committees, it represents yet another part of the increasing focus on corrupt activity as well as the increasing risk of civil litigation arising out of  that process.

 

The Gibson Dunn memo concludes that the trend of “continually increasing enforcement is here to stay for the near future.” As the FCPA enforcement activity continues to grow, an increasing number of companies will find themselves involved in FCPA-related civil litigation. Even though the FCPA enforcement fines and penalties generally would not be covered under the D&O policy, the policy could be called upon to respond to the costs of defending against an FCPA enforcement action. In any event, any follow-on civil litigation would also trigger the company’s D&O coverage, subject to all of the policy’s terms and conditions.

 

The growing importance of this litigation activity makes this an increasingly important issue to be considered in connection with the policy placement process. The specific issues involved are discussed at greater length in the InSights article.

One of the received truths from the era of corporate scandals earlier this decade is that corporate governance matters. As a result, a high-profile part of the current assessment of any company is whether or not the company practices “good” governance. Even though the evaluation of any particular company’s governance has an eye-of-the-beholder aspect, several different commercial enterprises have emerged in recent years, each offering to provide their subscribers with objective governance ratings.

 

In the space of just a few short years, these governance ratings have become ubiquitous. They are now a critical part of company evaluations for investors, regulators, the financial press, and even D&O insurance underwriters. The quick acceptance of these ratings suggests that they meet a widely perceived need. However, their wide acceptance notwithstanding, it is still worth asking what exactly these ratings actually tell us about the companies and future company performance.

 

In a June 26, 2008 paper entitled “Rating the Ratings: How Good Are Commercial Governance Ratings?” (here), Stanford Law Professors Robert Daines and Ian Gow, and Stanford Business School Professor David Larcher examine four leading ratings firms’ ratings and analyze “the association between these ratings and future firm performance and undesirable outcomes such as accounting restatements and shareholder litigation.”

 

The authors reach a number of provocative conclusions, including in particular their finding that “the level of predictive validity for these ratings is well below the threshold necessary to support the bold claims made for them” by the commercial ratings firms.

 

The authors examined the corporate governance ratings produced by Audit Integrity, RiskMetrics (previously Institutional Shareholder Services), Governance Metrics International, and The Corporate Library. The authors compiled ratings for U.S. firms for each of the four ratings services, cover the period from late 2005 to early 2007. The analysis was primarily focused on ratings available as of December 31, 2005, as that was the earliest date at which the authors established “a sizeable cross-section of ratings across the four ratings firms.”

 

The authors first looked at whether the various ratings were at least consistent with each other. The authors noted that “if, as seems to be often posited, there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it, then we would expect these measure to be highly correlated.”

 

However, the authors found that there is “surprisingly little cross-sectional correlation among the ratings.” Indeed, the ratings are “close to being uncorrelated.”

 

In particular, the authors found that in certain instances, the various ratings rated specific companies dramatically differently. The authors concluded that “either the ratings are measuring very different corporate governance constructs and/or there is a high degree of measurement error (i.e., scores that are not reliable) in the rating process across the firms.”

 

With respect to future outcomes, the authors found that three of the ratings have “a very modest ability to predict accounting restatements” and two of the ratings have “a very modest ability to predict class action lawsuits.” The authors further concluded that at least one rating firm’s ratings exhibited “virtually no predictive validity.” Overall, the authors concluded that “the level of predictive validity even for the best ratings is well below the threshold necessary to support the bold claims by the corporate rating firms.”

 

The authors’ observation about the lack of agreement between the four ratings is, to me at least, unsurprising, as they various ratings clearly aim to measure different things, based on different visions of “good governance.” Even though “good governance” is a widely used term, there is no consensus definition. As the authors themselves note, “defining good governance and distinguishing good governance from bad governance has proved…elusive.”

 

The authors’ conclusions about the ratings’ relative lack of predictive power undoubtedly will be disputed by the ratings firms themselves. From my perspective, the authors’ overall conclusion about the ratings’ overall lack of strong predictive power is unsurprising, particularly as it relates to predicting securities class action litigation.

 

In my prior life running a D&O underwriting facility, my colleagues and I spent a great deal of time and effort attempting to determine what factors might predict securities litigation. We had conjectured early on that corporate governance might afford a useful tool in segmenting litigation risk. Over many years’ time,  we concluded that corporate governance alone was not sufficiently predictive of securities litigation risk, and that certain other criteria (including company size, industry, and age) were much more highly correlated with securities litigation risk.

 

Because of this experience, my colleagues and I were always somewhat skeptical of commercial governance-based securities litigation prediction tools. In my own experience, these tools are at their best when used negatively, that is, when identifying companies to avoid, but they were less helpful when used to determine which risks to accept, which is of course how D&O underwriters earn their keep.

 

The authors’ conclusions are more or less consistent with my own experience on these points. However, the real value of the authors’ thorough examination of these issues is that it will likely start a dialogue on these issues. It may well be that a different analysis or a different approach might support a different conclusion about the predictive power of the ratings.

 

Indeed, the authors themselves expressly acknowledge that they might not have used the “right model” to measure the ratings, and that “given the right model specification,” the ratings “might well prove to be significant and informative.” The authors state that, to the degree this is true, then the ratings firms should “disclose the ‘right’ model” and disclose “how well their ratings predict future performance using the ‘right’ model.” This disclosure “would enable investors to evaluate the net benefits produced by their purchase of the ratings.”

 

The authors’ interesting analysis and discussion undoubtedly will provoke debate, particularly in the corporate governance community itself. I would welcome responsible comments from the representatives of the ratings firms who might wish to respond on this blog to the authors’ conclusions about the ratings’ predictive power. (PLEASE see below for responses.)

 

 A June 30, 2008 Stanford Law School press release describing the article can be found here. A June 26, 2008 Fortune report discussing the article can be found here.

 

Very special thank to the authors for their permission to quote their article on this blog.

UPDATE: In response to my invitation to the governance rating firms to respond to the authors’s study, Ric Marshall, the Chief Analyst at The Corporate Library, and Kimberly Gladman, the Director of Research and Ratings at The Corporate Library, submitted this repsonse:

Thank you for your invitation to respond to the recent Stanford study regarding the predictive value of governance ratings, including those of The Corporate Library (TCL).
 
The study found that TCL’s ratings have a statistically significant ability to predict accounting restatements and future operating performance. In addition, at the extremes (very poor or very good ratings), the study found that our ratings correlated with future alpha.  The authors state that these relationships are modest, and suggest that they may be inadequate to make our ratings useful. Our clients, however, who come from a wide range of industries, do find value in our ratings. For example, a portfolio manager who has used our ratings over the past four years in stock selection has told us that doing so has contributed substantially to his returns; our insurance clients regularly and successfully employ our ratings to identify companies that warrant greater due diligence and may present higher risk.
 
We understand that, as you point out in your recent posting about the study, it is not always effective to use governance indicators alone as a guide to financial or litigation risk.  Indeed, most of our clients combine our ratings with a number of other tools, and our own Securities Litigation Risk Analyst Ratings (which were not examined in the Stanford study) combine governance data with a number of financial and industry-related variables. We also agree with your assessment that governance indicators are often most useful in identifying areas of concern, rather than strengths; this is the essence of our approach. Client feedback has shown that taking governance ratings into account, especially in cases where doing so helps chiefly to avoid problems, brings substantial benefits to their businesses.  The Stanford study suggests that corporations themselves tend to agree: according to interviews the authors conducted with boards of directors, they often use low governance ratings as a red flag indicating that they should step up monitoring.
 
The authors’ surprise at how “little cross-sectional correlation” they found among these ratings reveals the study’s chief flaw, which is the assumption that, “there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it.” This is not the case at all, as each of the four rating services reviewed have a different focus, and are employed in different ways by a wide range of commercial clients. While Riskmetrics and GMI do both measure ‘good governance’ against specific standards, our own focus is on identifying governance weaknesses and thereby companies for clients to avoid. We have always taken issue with the notion that any one governance model can be the most effective for every company.

Special thanks to Ric and Beverly for taking the time to provide a detailed written response.

FURTHER UPDATE: Jack Zwingli, the CEO of Audit Integrity, has also provided a detailed response to the academic study. Jack’s response can be found here.
 

About the UnitedHealth Group Class Action Settlement: UnitedHealth Group announced on July 2, 2008 (here) that it reached an agreement to settle its high profile options backdating-related securities class action lawsuit for $895 million. A July 3, 2008 Law.com article discussing the settlement can be found here.

 

Not only is this settlement the largest options backdating related securities lawsuit settlement to date, it is one of the largest securities settlements ever. The settlement does at least provide some counterweight to the view that some have expressed (refer here) that the options backdating related lawsuits may be settling low compared to historical standards.

 

This settlement, together with the $750 million Xerox settlement announced in March 2008 (including $80 million from the company’s auditor) and the flood of high profile, high stakes subprime-related litigation, may also undercut the view that has been expressed that overall settlements may begin to decline as the cases from the era of corporate scandals cycle out of the system.

 

It is probably worth noting that, as reported in the July 3, 2008 Wall Street Journal (here), the UnitedHealth settlement has not yet been completely resolved, as the settlement does not include United ealth’s former CEO William McGuire, nor does it include its former General Counsel, David Lubben.

 

Although it has not received nearly as much attention, it is also noteworthy that in its July 2 press release UnitedHealth also announced that it had also settled for $17 million the options backdating related ERISA lawsuit pending against the company and certain of its officials. As far as I am aware, this is the roughly half dozen options backdating related ERISA lawsuit to have settled. (To see a complete list of options backdating related ERISA lawsuits, refer here.)

 

Derivative litigation related to the options backdating woes at UnitedHealth previously resulted in the largest reported derivative settlement, as I discussed in a prior post, here.

 

I have added the UnitedHealth options backdating securities class action lawsuit settlement and ERISA lawsuit settlement to my table of the options backdating related settlements and dismissals, which can be accessed here.

 

Credit Rating Lawsuits: As I discussed in a recent post (here), even though the credit rating agencies’ conflicted role has been a central topic in the discussions surrounding the subprime meltdown, the plaintiffs’ lawyers have largely avoided drawing the credit rating agencies into the subprime litigation. However, lawsuits filed just in the past several days suggest that this may be changing, in addition to the lawsuit discussed in my prior post.

 

Though the plaintiffs’ lawyers had not generally been targeting the credit rating agencies for their rating activities, they have previously filed lawsuits on behalf of the shareholders of Moody’s (refer here) and  of The McGraw Hill Company, parent of Standard & Poor’s (refer here), alleging misrepresentation in their financial disclosures.

 

As described in a July 1, 2008 press release (here), plaintiffs’ lawyers have now initiated a shareholder securities class action lawsuit against Fimalac, S.A., the corporate parent of Fitch’s rating agency. According to the press release, the complaint (which can be found here) alleges that the defendants failed to disclose with respect to Fitch’s ratings of Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDO) that:

(i) the information upon which Fitch based its ratings of RMBS and CDOs was misleading and in many cases fraudulent; (ii) to continue to collect fees for its ratings, Fitch was applying lax standards or no standards at all when issuing its RMBS and CDO ratings; and (iii) Fitch was failing to monitor the credit quality of RMBS and CDOs after issuing its initial ratings, as Fitch was obligated to do, and many of these securities had deteriorated badly after Fitch had issued its ratings. Fitch is now under investigation by the New York Attorney General, the Connecticut Attorney General, the Ohio Attorney General and the SEC as a result of its practices of rating billions of dollars of securities without a reasonable basis for doing so and Fimalac’s stock is trading at approximately 50% of its Class Period high.

But the new Fimilac shareholder lawsuit is directed against Fimilac as a reporting company, not directly against the company for Fitch’s rating agency activities. As I noted in my prior post, plaintiffs’ lawyers have largely avoided allegations against rating agencies for their rating activities. However, in a lawsuit initiated in New York state court on June 3 , 2008 and removed to federal court on June 23, 2008, plaintiffs have alleged that entities affiliated with Credit Suisse, and the Moody’s, S&P  and the Dominion Bond Rating Service (DRBS) rating agencies misrepresented the values of Mortgage Pass-Through Certificates issued by the Home Equity Mortgage Trusts. (Refer here for background regarding the lawsuit.)

 

The basis of the claims of liability against the rating agencies in the Home Equity Mortgage Trust lawsuit, as alleged in paragraph 87 of the complaint (here), is that  the rating agencies  “prepared valuations, i.e., assigned ratings to the Certificates, in connection with the Offering, as defined in Section 11 (a)(4) of the Securities Act.” These allegations are similar to the allegations against the credit rating agencies in the HarborView case discussed in my prior post.

 

Whether or not these cases against the credit rating agencies for their rating activities ultimately go forward remains to be seen. As I have previously discussed (here), the credit rating agencies will contend that their rating activities are protected by the First Amendment.

 

In addition, it remains to be seen whether the Home Equity Mortgage Trust case will go forward in state or federal court. As discussed at length in my prior post (here), the ’33 Act expressly provides for concurrent state court jurisdiction and also expressly proscribes removal of state court ’33 Act actions to federal court. As discussed here, in at least one case, a federal court has concluded that a ’33 Act claim that has been initiated in state court and removed to federal court must be remanded back to state court.

 

One More Note About the Fimalac Lawsuit:  Fimilac is a foreign-domiciled company whose shares do not trade on U.S. exchanges. Many of its shareholders obviously are domiciled outside the United States. If these non-U.S. shareholders were to be included in the class, the new class action complaint against Fimilac might present the complicated f-cubed litigant problem (which I discussed most recently here). However, the plaintiffs’ counsel in the Fimilac case purport to represent a class composed solely of U.S. residents, apparently as a way of avoiding the f-cubed litigant problem.

 

As I discussed in my recent post relating to the new securities class action filed against EADS (refer here), these attempts to plead around the issues involving foreign-domiciled  plaintiffs still test the outer limits of the jurisdictional reach of U.S. securities laws against foreign-domiciled companies whose shares do not trade on U.S. exchanges. The case against Fimilac will be interesting to watch for reasons other than the involvement of a credit rating agency.

 

And Finally: The news about the dismissal of the lawsuit against Richard Grasso has gained a great deal of press attention. Indeed, the Wall Street Journal, in a July 3, 2008 editorial (here), congratulates Grasso and fellow defendant Kenneth Langone for their success in fighting the lawsuit, which the Journal viewed as an example of the overreaching of former New York AG Eliot Spitzer.  

 

The Journal’s editorial is perhaps closest to the mark in its observation that “Mr. Grasso is fortunate he had the resources to fight back.” Had Grasso not had the wherewithal to resist, he might never have tasted vindication. Readers of this blog will be particularly interested to know that it was insurance funds – a very large amount of insurance funds – that ultimately allowed Grasso to succeed.

 

According to Langone, and as reported on Bloomberg (here), in defending themselves against the lawsuit, Grasso, Langone and the NYSE directors “spent more than $70 million fighting the case, all covered by insurance.”

 

So Grasso is indeed fortunate that he had the resources to fight back, but perhaps contrary to the Journal’s suggestion, and even Grasso’s own prior comments (refer here) it was not his own treasure that financed the fight.

 

The expenditure of the mind-boggling sum of $70 million in litigating this case is yet another reminder of the extraordinary costs associated with the kind of high stakes litigation in which directors and officers can become involved. As I recently noted (here), the escalating expense associated with this kind of litigation has important implications for limits adequacy assumptions.

 

While it may be that only extraordinary cases consume these astonishing quantities of money, a company’s D&O program is expected to be able to respond even to catastrophic claims. As seems to be increasingly apparent, the costs associated with just defending a catastrophic claim could exhaust many insurance programs. All of this may suggest the need to reexamine conventional assumptions about limits adequacy.