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.”

The $277.5 million jury verdict in the Apollo Group securities lawsuit caused a great sensation at the time it was returned in January 2008 (as discussed here). The verdict heartened plaintiffs’ attorneys and it served as a counterweight to the defense verdict in the virtually contemporaneous JDSU Uniphase securities lawsuit trial (which is discussed here).

But on August 4, 2008, Judge James Teilborg of the United States District Court for the District of Arizona entered an order (here) granting the defendants’ motion for judgment as a matter of law, based on his finding that the trial testimony did not support the jury’s finding of loss causation. Judge Teilborg’s order vacated the judgment and entered judgment in defendants’ favor.

The Apollo Group securities lawsuit involved alleged misrepresentations and omissions relating to a February 6, 2004 “Program Review” in which a Department of Education representative discussed the company’ potential violation of DoE rules. News of the allegations in the Program Review first became public on September 14, 2004, but the company’s share price did not react. Apollo’s share price fell significantly on September 21, 2004, when a securities analyst issued a report (the “Flynn reports”) expressing concern about the company’s possible exposure to future regulatory issues.

Judge Teilborg had held in connection with the parties’ pre-trial cross-motions for summary judgment that the issue whether the Flynn reports constituted “corrective disclosure” sufficient to support a finding of loss causation was a question for the jury

In its post-trial motion, Apollo argued that the evidence at trial was insufficient to support a finding that the Flynn reports represented “corrective disclosure,” because they did not contain any new fraud-revealing information. Judge Teilborg found that “the evidence at trial undercut all bases on which [the plaintiff] claimed the Flynn reports were corrective.”

Accordingly, the court concluded that although the plaintiff “demonstrated that Apollo misled the markets in various ways concerning the DoE program review,” the plaintiff “failed to prove that Apollo’s actions caused investors to suffer harm.” The court therefore concluded that “Apollo is entitled to judgment as a matter of law.”

Judge Teilborg then went on to consider conditionally Apollo’s motion for a new trial, as a precaution against the possibility that the appellate court could reverse the grant of judgment as a matter of law. He found that “none of the reasons cited by Apollo warrant a new trial in the case” and so the court conditionally denied Apollo’s motion for a new trial.

The possibility of significant post-trial developments in the Apollo case is something I expressly suggested at the time of the jury verdict, and, indeed the case still has a great deal farther to run procedurally, with additional opportunities for even further developments in the case.

In the interim, the post-trial disposition in the Apollo Group case alters the mix of securities lawsuit trial outcomes. According to data from the Securities Litigation Watch (here), six post-PSLRA cases (including Apollo Group) have gone to verdict, with three of the verdicts in favor of the plaintiffs and three in favor of defendants, although on November 26, 2007, the Ninth Circuit reversed and remanded the defense verdicts in the Thane International case (about which refer here). With the vacatur of the plaintiff’s verdict in the Apollo Group case, the securities lawsuit jury verdict scoreboard now stands evenly distributed, three each for plaintiffs and defendants – subject to further procedural developments.

As for the significance of this development, it may be hard to say definitively until all proceedings are complete, but the verdict’s vacatur can’t be encouraging for plaintiffs’ lawyers. This development together with the defense verdict in the JDS Uniphase trial would seem to argue pretty compellingly in favor of avoiding jury trials and seeking pretrial resolution

One practical significance of the vacatur of the Apollo jury verdict is that it removes any suggestion that the jury’s verdict represents a finding of fraud sufficient to trigger the fraud exclusion in the company’s D&O insurance policy. This undoubtedly represents significant relief to the company and the other defendants, in addition to the sense of vindication the company likely feels following the court’s ruling.

The company’s August 5, 2008 press release about the Judge Teilborg’s ruling can be found here. A detailed summary of the Apollo Group securities case, including links to pleadings, can be found here.

Even though the current subprime litigation wave seemingly has swept the prior scandal into the past, lawsuits based on options backdating allegtions stubbornly continue to come in. Within recent days, plaintiffs’ lawyers have filed two new options backdating-related derivative lawsuits. The options backdating scandal may now be well over two years along, but it continues to generate new litigation activity and controversy.

 

First, as described in an August 1, 2008 article in the Seattle Intelligencer (here), on July 17, 2008, a shareholder filed a lawsuit in King County (Wash.) Superior Court on behalf of Costco Wholesale Corp. against 20 of its current and former directors and officers. According to the article, the suit seeks “unspecified financial damages and internal company reforms.” A copy of the complaint can be found here.

 

Second, as discussed in a July 30, 2008 Kansas City Star article (here), on July 29, 2008, a shareholder of Epiq Systems filed an options backdating-related shareholders derivative lawsuit on the company’s behalf against nine current and former directors and officers. A copy of the complaint can be found here.

 

The Epiq complaint alleges that the company “has secretly backdated millions of options to its top officers and directors for nearly a decade, reporting false financial statements and issuing false proxies to shareholders.”

 

With the addition of these two most recent lawsuits, my current tally of the total number of options backdating-related derivative lawsuits now stands at 168. The number of options backdating-related securities class action lawsuits stands at 39, including two new lawsuits filed in 2008. My updated list of the options backdating-related lawsuits can be found here.

 

Regular readers know that I have also been tracking options backdating-related case dispositions and settlements (here). Though the list of dispositions and settlements is now quite lengthy, the reality is that the vast majority of the options backdating cases are yet to be resolved. The fact that so many remain unresolved, together with the fact that new lawsuits continue to be filed, suggest that it will be quite some time before all of the options-backdating litigation is finally put to rest.

 

Special thanks to a loyal reader for the link to the Epiq article and for information about the Costco case.

 

Thoughts About Crisis Longevity: It is worth contemplating the likely long duration of the options backdating phenomenon in the context of the current subprime and credit crisis litigation wave. The subprime and credit crisis problems are so much more pervasive and so much more serious, and it likely that the related litigation will continue to emerge for months and perhaps years to come. It may be correspondingly even longer before the full dimensions of the subprime-related litigation wave can be fully assessed.

 

Indeed, in the Financial Times August 3, 2008 first anniversary retrospective of the subprime crisis (here), the paper specifially notes, "A year later, there is still no sign of an end to these problems. Instead, the sense of pressure on western banks has risen so high that by some measures this is now the worst financial crisis seen in the west for 70 years."

 

We may have options backdating litigation around for quite a while yet, but we will be living with the consequences of the subprime crisis for years to come.

 

Cross-Eyed Bear: When the history of the subprime crisis is finally written, the collapse of Bear Stearns will be a key part of the narrative. By the same token, the litigation involving Bear Stearns will also be a key part of the litigation history. The amount of litigation involving Bear Stearns is massive, but an August 4, 2008 Fortune article helpfully provides a comprehensive list and overview, here.

 

As the article correctly notes, "fortunately for former senior Bear executives like Jimmy Cayne, Alan Greenberg and Alan Schwartz, J.P. Morgan Chase agreed to indemnify Bear’s officers and directors for six years against these lawsuits."

 

Really Big Box Stores: I was surprised to learn, while writing this post, that Costco is as big of a company as it is. The companies’ current market capitalization is approximately $27 billion, with annual sales (2007) of $64 billion.

 

By most measures, those statistics would qualify Costco as a big company. But its competitor big box retailer Wal-Mart Stores manages to make Costco look modest by comparison. Wal-Mart’s current market cap is $230 billion and its 2007 sales were $378 billion.

 

If Wal-Mart were a country, and if its revenue were supposed to be equivalent to GDP, Wal-Mart would be the 25th largest economy in the world (according to the rankings of the International Monetary Fund, here) —  larger than Saudi Arabia, Austria or Greece. Or as big as Kuwait, New Zealand and Algeria combined. That’s big.

 

If you are still straining to comprehend how big Wal-Mart truly is, you may want to check out this amazing animation video (here) depicting the efflorescence of Wal-Mart stores across a map of the United States. Wal-Mart is amazing, this video simply makes that fact easier to grasp.  

 

A very special hat tip to Tom Kirkendall at the Houston’s Clear Thinkers blog (here) for the link to the cool Wal-Mart growth video. Kirkendall’s site also links to this very cool BBC video (here) tracking electronically the balletic conduct of commerce in the British Isles.

It remains to be seen whether the current economic turmoil will result in significant additional bank failures. But if history is any guide, to the extent that there are further bank failures, there likely will also be follow-on lawsuits in which the regulators pursue claims against the failed institutions’ former directors and officers. As these claims emerge, there may also be disputed issues regarding the applicability of the failed institutions’ D&O insurance policies.

 

As I noted in a recent post (here), among the issues that may arise is the applicability of the regulatory exclusion. In addition, another issue that may arise relates to the potential applicability of the so-called “insured v. insured” exclusion found in most D&O insurance policies.

 

The “insured v. insured” exclusion typically precludes coverage for claims by or on behalf of the insured corporation, its affiliates or directors and officers against other insured persons. Over the years, the standard exclusion has been modified to provide coverage carve-backs for certain types of claims for which coverage would otherwise be precluded, such as derivative claims and employment practices claims.

 

During the S&L crisis in the late 80s and early 90s, the federal banking regulators actively pursued claims against the failed institutions’ former officials. As described in a July 29, 2008 memorandum from the Latham & Watkins law firm entitled “The ‘Insured v. Insured’ Exclusion in D&O Policies” (here), many of these regulator claims implicated the insured v. insured exclusion.

 

As the law firm’s memorandum explains, in many instances the regulators were able to argue successfully that the exclusion should not apply to preclude coverage for their claims, because the lawsuits were not the “collusive” type disputes for which the exclusion historically was meant to preclude coverage. However, as the memorandum also notes, there were cases in which the exclusion was held to bar coverage for the regulators’ claims, on the grounds that the regulator was in effect “standing in the shoes” of the failed institution.

 

The memorandum correctly points out that the “insured v. insured” exclusion is “heavily litigated” and “continues to be at the heart of many coverage disputes.” There are a number of reasons why coverage disputes involving the exclusion are so frequent.

 

First, over the years, the scope of persons insured under the typical D&O policy has expanded – for example, to include “employees” within the definition of insured persons for purposes of securities claims. In addition, many companies for their own reasons have sought to schedule additional named insureds to the policy by endorsement. While these policy extensions may be desirable from the policyholder’s perspective, problems can arise later if the extensions are not also coordinated with the language and operation of the “insured v. insured” exclusion.

 

Second, companies may take on forms or structures that raise fundamental questions about who is an insured under the policy. For example, insolvent companies may continue in business as a debtor-in-possession or may have its activities taken over by a receiver. These and other situations have raised and continue to raise a myriad of contentious questions about the scope and applicability of the insured v. insured exclusion.

 

Third, in many lawsuits, the plaintiffs’ claims may be based on information or assistance provided by former company officials. The former officials’ involvement may run afoul of the wording in the typical insured v. insured exclusion, which specifies that for claims to be covered they must be “instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of” any insured person.

 

The question whether a former official’s litigation involvement falls within one of these precluded categories is a frequent source of contentious coverage disputes. (Refer here for discussion of a recent case involving these issues.) In order to try to reduce the opportunities for these types of disputes, many carriers will now agree upon request to add wording providing that the exclusion will not apply in the event of the involvement of former officials whose departure was more than a specified amount of time before (typically, four years).

 

As the Latham & Watkins memorandum discusses, one of the issues frequently disputed in these cases is whether the underlying claim must be “collusive” in order for the exclusion to be triggered. As the Latham & Watkins memo explains, the exclusion’s original intent was to bar coverage for collusive claims. However, not all courts have required collusion for the exclusion to be applied (refer, for example, here), although there are many jurisdictions in which collusion has been held to be required.

 

The importance of the “insured v. insured” exclusion and the opportunities to revise the standard wording to reduce the exclusion’s preclusive effect highlights the importance of addressing these basic wording issues at the time the policy is purchased. As the Latham & Watkins memorandum notes, each company “should seek the assistance of an insurance broker to attempt to limit the exclusion’s breadth.” The potential significance of these issues underscores the need for companies to enlist the assistance of an experienced and knowledgeable broker in their acquisition of D&O insurance.

 

Duties of Outside Directors Under Delaware Law: As noted by the ever-vigilant Francis Pileggi on his Delaware and Commercial Litigation Blog (here), on July 29, 2008, the Delaware Chancery Court issued an opinion in the Ryan v Lyondell Chemical Company case (opinion here) that has important implications for the duties and potential liabilities of outside directors in the merger and acquisition context.

 

The court held that the outside directors were not entitled to summary judgments and would have to stand trial for their role in the sale of the company, as Pileggi notes, “despite selling the company to the only known buyer for a substantial premium.”

 

As explained in the opinion, when the Lyondell board received the offer, it delegated much of the negotiations to the company’s Chairman and CEO; never conducted a “market check to determine whether a better price could be obtained; agreed to a deal that included protective rights, including a “no-shop provision.” Moreover, “the whole deal was considered, negotiated, and approved by the Board in less than seven days.”

 

The Chancery Court held that the Board could not invoke the exculpatory provisions under the company’s charter and the Delaware Code because “the Board’s apparent failure to make any effort to comply with the teachings of Revlon and its progeny implicates the directors’ good faith and, thus, their duty of loyalty, thereby, at least for the moment, depriving them of the benefit of the exculpatory charter provision.”

 

Pileggi’s post does an admirable job explaining the implications of the decision. Further valuable analysis of the decision can be found on the Legal Profession Blog (here).

 

Monster Settlement, Dude: As reflected in its July 31, 2008 press release (here), Monster Worldwide has reached a settlement in the options backdating related securities action lawsuit pending against the company and certain of its directors and officers. As reflected in the press release, the settlement consists of “a payment to the class by the defendants of $47.5 million in full settlement of the claims asserted in the securities class action. The Company’s cost is anticipated to be approximately $25 million (net of insurance and contribution from another defendant).”

 

The Monster settlement is only the latest of the options backdating related securities class action settlements. A full list of settlements and case dispositions in the options backdating related litigation can be accessed here.

 

A WSJ.com Law Blog post describing the Monster settlement (and containing a nice link to The D&O Diary) can be found here.

 

The Securities Litigation Watch blog as updated its detailed analysis of the options backdating securities class action lawsuits, which can be found here.

That sure didn’t take long.

 

GT Solar International completed its $500 million IPO on July 23, 2008. Then on August 1, 2008, a mere seven trading days later, the plaintiffs’ lawyers initiated a purported securities class action lawsuit in the United States District Court for the District of New Hampshire against the company and certain of its directors and officers, as well as the offering underwriters.

 

A copy of the plaintiffs’ lawyers August 1 press release can be found here. A copy of the complaint can be found here.

 

According to the press release, the proceeds of the IPO went to GT Solar Holdings, which in turn “intended to use the net proceeds … to make a distribution to its shareholders.” The press release also states that:

on July 25, 2008, before the market opened, LDK Solar Co., LTD (“LDK”), GT Solar’s largest customer, issued a press release announcing that it had signed a contract to purchase production equipment from one of GT Solar’s competitors. On this news, GT Solar’s stock price declined to as low as $9.30 per share before closing at $12.59 per share on July 25, 2008, losing 13% of its value in its second day of trading.

According to the complaint, the Registration Statement failed to disclose the true extent of the risks surrounding the Company’s relationship with LDK, including the fact that the Company was at imminent risk of losing out on a contract for future orders from LDK due to delays in shipping production equipment to LDK.

For whatever it may be worth, GT Solar’s amended filing on Form S-1 (here) did disclose the company’s dependence on a very few customers and consequent vulnerability (although there is no specific mention of any particular or imminent issues with LDK Solar); the risk factors in the company’s filing states:

We currently depend on a small number of customers in any given fiscal year for a substantial part of our sales and revenue.

In each fiscal year, we depend on a small number of customers for a substantial part of our sales and revenue. For example, in the fiscal year ended March 31, 2006 (on a combined basis), three customers accounted for 64% of our revenue; in the fiscal year ended March 31, 2007, three customers accounted for 70% of our revenue; and in the fiscal year ended March 31, 2008, one customer accounted for 62% of our revenue. In addition, as of March 31, 2008, we had a $1.3 billion order backlog, of which $769 million was attributable to three customers. As a result, the default in payment by any of our major customers, the loss of existing orders or lack of new orders in a specific financial period, or a change in the product acceptance schedule by such customers in a specific financial period, could significantly reduce our revenues and have a material adverse effect on our financial condition, results of operations, business and/or prospects. We anticipate that our dependence on a limited number of customers in any given fiscal year will continue for the foreseeable future. There is a risk that existing customers will elect not to do business with us in the future or will experience financial difficulties. Furthermore, many of our customers are at an early stage and many are dependent on the equity capital markets to finance their purchase of our products. As a result, these customers could experience financial difficulties and become unable to fulfill their contracts with us. There is also a risk that our customers will attempt to impose new or additional requirements on us that reduce the profitability of those customers for us. If we do not develop relationships with new customers, we may not be able to increase, or even maintain, our revenue, and our financial condition, results of operations, business and/or prospects may be materially adversely affected.

The lawsuit on the seventh trading day after GT Solar’s debut may represent some dubious kind of a record. Even Vonage Holding Company made it ten trading days before it was hit with a securities lawsuit (refer here for a more detailed discussion of the Vonage lawsuit). Indeed, Refco, which arguably represents the extreme example of an IPO flame out, was not hit with its first securities suit (about which refer here) until two full months after the company’s ill-fated IPO.

 

Historically, IPO companies have been more susceptible to securities lawsuits than the population of public companies as a whole. By my count, there have already been eleven securities lawsuits in 2008 alleging misrepresentations or omissions in connection with the defendant company’s IPO, even though 2008 has been an historically low year for IPO activity (although most of these eleven lawsuits relate to companies that completed their IPOs in 2007). Indeed, as I noted in my year-end analysis of the 2007 securities lawsuits (here), 29 of the 172 new securities lawsuits in 2007 were filed against IPO companies.

 

Because of IPO companies’ heightened susceptibility to securities lawsuits, a public company’s age (in terms of time since the company’s IPO) is one of the most important factors D&O underwriters consider in underwriting and pricing public company risks. The sudden turbulence GT Global has encountered certainly highlights the reason for that emphasis.

 

For a more detailed discussion of the considerations that D&O underwriters take into account in underwriting public company risk, refer here.

Two developments involving major European companies illustrate both the challenges and uncertain progress of global efforts to combat corruption.

 

First, on July 29, 2008, Siemens announced (here) that its Supervisory Board has resolved to claim damages from ten former members of the company’s Managing Board executive committee, including two former CEOs and a former CFO. The claims are “based on breaches of their organizational and supervisory duties in view of the accusations of illegal business practices and extensive bribery that occurred in the course of international business transactions and the resulting financial burdens to the company.”

 

The former executives will be “invited to respond to the claims before legal action is taken.” A July 30, 2008 Financial Times article describing the Siemens board action can be found here.

 

Second, in a July 30, 2008 opinion (here), the U.K. House of Lords overturned the April 10, 2008 ruling of the Queen’s Bench Divisional Court that the decision of the Serious Frauds Office Director to discontinue the investigation of possible corrupt activity involving BAE Systems was unlawful. (My prior post discussing the April 10 decision at length can be found here.)

 

The discontinued SFO investigation involved possible bribery in connection with the Al Yamamah arms contract between BAE Systems and the Saudi government. As detailed in the House of Lords opinion, the investigation proceeded despite Saudi resistance until investigators’ attempt to subpoena certain Saudi account information from Swiss banks led to direct threats that the Saudis would withhold cooperation with British antiterrorism efforts. Among other things, the threats included the explicit possibility that “British lives on British streets were at risk.”

 

In reaching its conclusion that the SFO director properly exercised his discretion to discontinue the investigation, the senior law lord, Lord Bingham of Cornhill, wrote:

The Director was confronted by an ugly and obviously unwelcome threat. He had to decide what, if anything, he should do….The issue in these proceedings is not whether the decision was right or wrong, nor whether the Divisional Court or the House agrees with it, but whether it was a decision which the Director was lawfully entitled to make….In the opinion of the House the Director’s decision was one he was lawfully entitled to make. It may be doubted whether a responsible decision-maker would, on the facts before the Director, have decided otherwise.

Baroness Hale of Richmond added in a concurring opinion that “it is extremely distasteful that an independent public official should feel himself obliged to give way to threats of any sort….Although I wish the world were a better place where honest and conscientious public servants were not put in impossible situations such as this, I agree that his decision was lawful.”

 

A July 30, 2008 article in The Guardian (here) describing the House of Lords opinion quotes counsel for the SFO as saying that “the SFO director was convinced that Saudi Arabia wasn’t bluffing.”

 

These significant developments have important implications both for companies and for continuing efforts to enforce anticorruption provisions.

 

First, the decision of the Siemens Supervisory board to pursue claims against the company’s former officials underscores the growing threat, which I have discussed at length in prior posts (most recently here), of follow-on civil litigation arising out of anticorruption enforcement activity. Although Siemens officials already are the target of a shareholders’ derivative lawsuit in the U.S., the Supervisory Board’s decision to take up claims against the former officials highlights the potential seriousness of the civil litigation threat.

 

The House of Lords decision also has great significance and represents an outcome that can only be regretted. To be sure, if it is assumed that the Saudi threats were serious (that is, if they were in fact not bluffing) then the threat to British lives justifies the decision to discontinue the investigation as well as the House of Lords opinion. Nevertheless, the capitulation to a threat of this kind represents a subordination of the rule of law to forces of a kind and character that should have no role in free societies.

 

The BAE Systems case clearly tested the limits of what any government might be willing to risk in resisting corruption. The implication of the decision to terminate the investigation is that if corrupt forces are sufficiently rich and powerful, they have nothing to fear from the force of law, and that anticorruption laws are enforceable only against those too weak or powerless to resist.

 

In its June 2008 Progress Report (which I discuss here), Transparency International noted that antibribery enforcement is “critical in draining the supply of bribe money that distorts public decision making in some of the world’s poorest states, with disastrous consequences for the decision making.” The outcome of the BAE Systems case suggests that it is not only in the world’s poorest countries that corrupt activity disrupts the processes of an ordered society.

 

The FCPA Blog has a post discussing the House of Lords opinion here. The FCPA Blog notes that the U.S authorities are continuing their investigation of the BAE Systems sales to Saudi Arabia.

 

Finally, and to bring this discussion full circle, the BAE Systems investigation is also the subject of follow on civil litigation, as discussed at greater length here.

Following close on the heels of the Cornerstone mid-year report released earlier in the day, on July 29, 2008, NERA Economic Consulting also released its mid-year 2008 securities class action report entitled “2008 Trends: Subprime and Auction Rate Cases Continue to Drive Filings, and Large Settlements Keep Averages High” (here). A copy of the July 29 press release describing the NERA Report can be found here.

 

The NERA Report differs in its numerical particulars from the Cornerstone Report, but the two reports are at least directionally consistent. The NERA Report is also directionally consistent with my own mid-year securities litigation study, which can be found here.

 

According to the NERA Report, there were 139 securities lawsuits filed in the first half of 2008 (by way of comparison, Cornerstone has the number at 110). Based on NERA’s analysis, the 2008 filings are on pace to reach almost 280 (compared to Cornerstone’s estimate of 220). The NERA Report, like prior mid-year reports concludes that the increased pace of filing activity is largely driven by the current subprime and credit crisis-related litigation.

 

The NERA Report also concludes that market volatility is positively correlated with the number of securities class action filings, and the “if market volatility is higher during a quarter, controlling for market returns, filings are likely to be higher in the same quarter.”

 

The NERA Report also notes that “the probability of a suit rises with the size of the price decline: whereas only 9% of drops of 20-30% are followed by a shareholder class action within three months, almost 31% of drops of 40% or more are followed by a filing within that time frame.”

 

Taking into account the settlements over $1 billion, the average settlement in the first half of the year remained around $30 million, but excluding the $1 billion settlements reduces the average first half settlement to around $10 million. The median settlement in the first half of 2008 was $6.2 million. Both the average and median are below similar figures for recent years.

 

However, the Report also notes that the investor losses associated with the recently filed lawsuits were substantially higher than the median for cases settled in the 2005-2007 time frame, suggesting that the 2008 cases (largely driven by the subprime-related cases) potentially could result in much larger settlements.

 

The Report also contains interesting and detailed information regarding the 21 cases that have gone to trial since the enactment of the PSLRA.

 

The NERA Report is quite detailed and very interesting, and contains numerous other useful observations beyond those summarized here.

 

The material divergence in lawsuit count between the NERA Report and the Cornerstone Report (and for that matter between the NERA Report and my own mid-year analysis) is a cause of concern for anyone interested in a precise understanding of the current lawsuit trends. In my own mid-year analysis of the 2008 securities lawsuit filings, I noted some of the reasons why “counting” lawsuits is particularly difficult in the current environment, and some of those factors undoubtedly are at work here.

 

But these foreseeable difficulties notwithstanding, the divergence in the numbers is disconcerting. Because so many observers depend on these respectable sources to understand securities litigation developments, it is troublesome when the sources disagree so widely. If these industry sources are unwilling to make their lawsuit lists publicly available, it would be helpful if these sources would at least identify their sorting criteria. I know from my own experience that there are a lot of decisions that must be made about which lawsuits should be included and which should be kept out. At least with the benefit of these sorting criteria, we could try to understand the differences.

 

In the past, it has always been sufficient for me to recognize the numerical differences between different reports while noting their directional consistency. But the difference in count between the two leading reports of 29 lawsuits is a material difference. The differences in their respective year-end projections are even more dramatic. Differences of this degree not only cause problems for industry participants and observers. Without suggesting one way or another where the issues may be, at some level, questions regarding consistency and even reliability start coming into the picture.

 

I welcome comments from responsible sources on the issues surrounding the diverging lawsuit counts. There could be significant value in a public discussion of these issues and I would be particulary interested in adding comments to this post from the respective research groups that track this information.

On July 29, 2008, Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse released their mid-year 2008 report on securities litigation, entitled “Securities Class Action Filings: 2008 Mid-Year Assessment” (here). A July 29, 2008 press release describing the Report can be found here.

 

Although the Cornerstone Report differs in some details, it is otherwise entirely consistent with my own mid-year 2008 securities lawsuit filing report (which can be found here). Consistent with the observatoins in my prior report, the Cornerstone Report observes that securities filings in the first half of 2008 “continued the rebound that started in the second half of 2007.”

 

The Cornerstone Report states that there were 110 securities class action filings in the first half of 2008, which projects to an annualized total of 220. A year end total of 220 lawsuits would represent a 27.2 percent increase over 2007 and a 14.6 percent increase over the annual average for the 11 years ending in 2007.

 

The Report also notes that over half of the 2008 first-half filings (58) were driven by subprime and credit crisis-related allegations. Of these, 17 were related to auction rate securities.

 

The Report also notes that “market capitalization losses for defendant firms associated with filings in the first half of 2008 were higher than the average semiannual loss in the eleven preceding years,” and rival “the historical highs seen in 2000-02.” These market capitalization losses may well drive the value of future settlements in these recently filed securities lawsuits.

 

The Report also contains analysis suggesting that the so-called filing lull that prevailed from mid-2005 to mid-2007 “was partly due to a strong stock market with low volatility,” and that the more recently increased filing level was associated with increased volatility.

 

While the Cornerstone Report reflects analysis regarding the apparent connection between stock market volatility and securities lawsuit filings, the most recent Report omits analysis that appeared in Cornerstone’s mid-year 2007 report suggesting that the reduced filings during the period mid-2005 to mid-2007 was due to a “permanent shift” to a lower securities class action lawsuit filing level. As I noted at the time (refer here), I regarded the low stock market volatility as a much likelier explanation than any permanent behavioral shift as an explanation for the reduced filing levels.  

 

The Ultimate Solution to Stock Trader Misconduct: According to a July 27, 2008 Reuters report (here) , “A Chinese court upheld the death sentence of a former securities trader charged with embezzling 97.56 million yuan ($14.31 million).”

 

Hat tip to Kelly Rehyer for the link to the Reuters report.