Earlier this week when I posted my list of subprime lawsuits dismissal motion grants and denials (here), I was hoping the publication would encourage readers to let me know about case dispositions of which I was previously unaware. My strategy worked, because a loyal reader who prefers anonymity responded to my post by alerting me to the May 19, 2008 opinion (here) in the subprime-related securities class action lawsuit involving Standard Pacific. Because the court’s opinion is particularly thorough, it merits a detailed review.

 

Standard Pacific is a California-based residential construction company that concentrated in recent years on the formerly go-go growth areas of California, Florida, Texas and Nevada. As s result of the residential real estate slump, the company’s sales activity declined in 2006 and 2007. Plaintiff shareholders initiated a securities class action lawsuit against two Standard Pacific executives in August 2007.

 

The plaintiffs alleged that the defendants misrepresented Standard Pacific’s ability to open new, successful communities; misled the public about the demand for Standard Pacific homes; and lied about the company’s ability to continue its historically strong earning growth. Further background regarding the lawsuit can be found here.

 

In a May 19, 2008 opinion, Judge Margaret M. Morrow of the United States District Court for the Central District of California granted the defendants’ motion to dismiss, but allowed the plaintiffs’ 45 days’ leave to amend.

 

The defendants first argued that the plaintiffs’ complaint failed to satisfy the PSLRA’s pleading requirements because it is a “classic example of prohibited puzzle-pleading,” in that it contains extensive block quotations from the company’s class period statements “without specifying the particular statements that are false and misleading.”

 

The plaintiffs sought to address this issue in their reply papers, but the court found that “the organization the plaintiffs offer in their opposition brief does not cure the deficiencies in the complaint. To the contrary, it highlights plaintiffs’ failures to plead defendants’ purportedly false and misleading statements with specificity as required by the PSLRA,” and accordingly the court granted the motion to dismiss, with leave to amend.

 

The defendants also moved to dismiss on the grounds that the plaintiffs had not adequately pled scienter. The plaintiffs alleged, based on the confidential witness information, that defendants misled investors because they continued to cite sales information in reliance on internal reports they supposedly knew to be inaccurate. Defendants contended that, to the contrary, they informed investors that the company was experiencing sales declines, and that “the crux of plaintiffs’ fraud claim is not that the defendants flatly misrepresented the company’s performance but that they were deliberately reckless because the failed to lower their projections enough.”

 

The court found that

the fact that defendants reduced earnings and home delivery guidance cuts against plaintiffs’ claim that defendants acted with fraudulent intent. As no facts are pled supporting an inference that defendants selected the level of reductions they announced fraudulently or with deliberate recklessness, the complaint suggests a plausible nonculpable explanation for defendants’ conduct…. Taken as a whole…plaintiffs’ allegations do not give rise to a “strong inference” that at the time they made the statements, defendants knew or should have known that the state of affairs was much worse than they had acknowledged publicly….In effect, by arguing that defendants’ predictions and forecasts were not low enough, plaintiffs improperly attempt to allege “fraud by hindsight.”

The court similarly rejected the plaintiffs’ attempt to rely on the defendants’ certifications of the company’s SEC filings.

 

The dismissal, even though it is without prejudice, is still significant. First, the opinion is very detailed and thorough, which could carry some weight in other subprime securities cases, particularly the numerous other cases pending in the Central District of California.

 

Second, many of the other subprime complaints arguable share the “puzzle pleading” defect of the complaint in this case – all too often, the complaints in these subprime cases consist of block quotations from the defendants company’s disclosure documents, without direct connections specifying what about the disclosure the plaintiffs allege is false and misleading, and in what way the statements are false and misleading.

 

Third, many of the companies named in subprime securities lawsuits, like Standard Pacific, are accused not of failing to acknowledge problems but of failing to recognize the problems enough. To the extent other courts view these pleadings with the same level of skepticism as Judge Morrow, the complaints could face some formidable challenges at the motion to dismiss stage.

 

In any event, I have added the Standard Pacific opinion to the list of subprime lawsuit dismissal motion grants and denials. I hope other readers will let me know of any other subprime lawsuit dismissal motion rulings of which they are aware, so that the list can be as complete as possible.

 

Special thanks to the anonymous loyal reader for alerting me to the Standard Pacific opinion.

 

Another Option ARM Lawsuit: In a different post earlier this week (here), I noted the lawsuits that had been filed up to that point relating to Option ARM mortgages, and I suggested the likelihood that there would be further lawsuits relating to Option ARMs. In a quick confirmation of my prediction, on June 11, 2008, plaintiffs’ counsel initiated a securities class action lawsuit in the Central District of California against IndyMac Bancorp and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ June 11 press release can be found here. A copy of the complaint can be found here.

 

According to the press release, the complaint alleges that

defendants issued materially false and misleading statements regarding the Company’s business and financial results. Specifically, defendants downplayed and concealed IndyMac’s growing exposure to non-performing assets, particularly loans in its pay-option adjustable-rate mortgage (“Option ARM”) and homebuilder construction portfolios, and made numerous positive representations regarding the Company’s capital position to alleviate investors’ fears concerning the Company’s capital erosion. As a result of defendants’ false statements, IndyMac stock traded at artificially inflated prices during the Class Period.

It is important to note that IndyMac had previously been sued in a subprime-related securities class action lawsuit, the background regarding which can be found here. In concluding that this latest lawsuit is sufficiently distinct from this prior lawsuit to represent a new lawsuit, I note the following: first, the class period of the prior lawsuit was May 4, 2006 to March 1, 2007, whereas the purported class period for the new lawsuit is from August 16, 2007 to May 12, 2008. In addition, the substantive allegations in the two lawsuits relate to different alleged misrepresentations. In particular, the prior lawsuit does not appear to relate to the companies representations regarding Options ARM mortgages or the company’s capital position.

 

Accordingly, I am recognizing this latest complaint as a new and separate filing. However, I encourage readers who may disagree to let me know of any circumstances that might militate in favor of a different conclusion.

 

I have added the new IndyMac lawsuit to my running tally of subprime and credit-crisis related securities lawsuits, which can be found here. With the addition of the new IndyMac lawsuit, the tally of subprime and credit crisis-related lawsuits now stands at 90, of which 50 have been filed in 2008.

 

Finally, it is worth noting that, as reflected in my list of subprime dismissal motions grants and denials referenced above that motion to dismiss have twice been granted with leave to amend in the prior IndyMac lawsuit.

 

More Subprime ERISA Lawsuits:  I have also added two subprime-related ERISA lawsuits to my running tally of subprime-related lawsuits.

 

First, in a June 11, 2008 press release (here), plaintiffs’ lawyers announced that they had initiated a lawsuit in the Southern District of New York under ERISA against Wachovia Corporation and various of its officers and administrators. According to the press release, the defendants allegedly violated their duties to participants in the Wachovia Savings Plan by “continuing to invest in and hold Wachovia stock despite the fact that they knew or should have known that Wachovia was not properly reporting its financial condition and was not disclosing significant problems which had the effect of inflating the value of Company stock.”

 

Second, on May 9. 2008, plaintiffs’’ counsel initiated a lawsuit in the Western District of Tennessee on behalf of past and present employees of First Horizon National Corporation who participated in the First Horizon Savings Plan. A copy of the complaint can be found here. The complaint alleges that the defendants breached their fiduciary duty by requiring plan participants to invest in First Horizon shares, which the plaintiffs contend was “imprudent… because First Horizon was not fairly and accurately disclosing the risks and likely consequences of a number of its banking practices such that the Plan was purchasing shares of First Horizon Stock at an inflated price.” Among the undisclosed risks alleged is the company’s exposure to subprime and Alt-A mortgages.

 

I have added the Wachovia and First Horizon ERISA lawsuits to my running tally of subprime-related ERISA lawsuits, which can be found here. With the addition of the new ERISA lawsuit, the tally of subprime-related ERISA lawsuits now stands at 17

 

Special thanks to a loyal reader for identifying the new ERISA lawsuits.

In prior posts (most recently here), I have discussed the fact that life sciences companies remain a favored target of the plaintiffs’ securities bar. A June 2008 memorandum by Michael Kichline and David Kotler of the Dechert law firm entitled “Dechert Survey of Securities Fraud Class Actions Brought Against Life Sciences Companies”  (here) takes a closer look at the 2007 life sciences securities lawsuits and concludes that “life sciences companies remain firmly in the crosshairs of the plaintiffs’ securities bar.”

 

The authors note that the 25 securities class action lawsuits filed in 2007 against life sciences companies represents a 64% increase over the 16 filed the preceding year, and also represents 14% of the 175 total securities lawsuits filed in 2007. (My own numerical analysis of the 2007 life sciences lawsuits, which can be found here, differs slightly, but only in the details, not the direction, and the difference undoubtedly is due to the narrow definition of “life sciences” I used in my analysis.)

 

The authors also have a number of interesting observations about the 2007 life sciences lawsuits, including the fact that “life sciences companies with the greatest market capital — more than $10 billion – were sued at the same rate as companies with less than $250 million.”

 

The authors also note that the securities lawsuit allegations against life sciences companies “continue to span the product life cycle” and that many of the companies sued 2007 were sued “based on information they communicated, or failed to communicate, to the public about a drug’s efficacy, safety, and/or the results of the FDA approval process.”

 

One particularly interesting observation in the study is that “research personnel were frequently named as defendants,” and specifically that in five cases, the plaintiffs alleged that because “key research personnel had a high level position with the company and access to internal information, they both knew and failed to disclose the alleged adverse non-public information.”

 

The authors predict that life sciences companies will continue to be the targets of securities fraud lawsuits, noting that “the structural factors that lead plaintiffs’ lawyers to target life sciences companies – volatile stock prices and a drug or device product life cycle fraught with potential for adverse and unpredictable events, such as a negative clinical trial result of FDA decisions – remain challenging, especially in the current stock market and regulatory environment.” The authors predict that plaintiffs’ counsel will continue to strive to find new theories. The authors cite as an example the likelihood that “more securities lawsuits will be premised on off-label communication or sales.”

 

The survey, which concludes with practical risk minimization suggestions, is quite good and merits reading at length and in full.

 

While I concur in all of the authors’ views, I think that in order to fully appreciate life sciences companies’ securities litigation exposure, it is important to consider not only the lawsuit filings, but also the case dispositions. Life sciences companies may be frequent lawsuit targets, but that does not mean that all or even most of the lawsuits are meritorious.

 

As I have noted in prior posts (most recently here), many of the securities lawsuits filed against life sciences companies are dismissed. Indeed, many of the large life sciences companies that have been targeted in securities suits in recent months – including, for example, Guidant, Pfizer and Astra Zeneca – have successfully managed to get the cases dismissed. And it is not just the larger companies that have prevailed; smaller companies, such as, for example, Micrus Endovascular (which recently prevailed on its motion to dismiss, about which refer here), have also prevailed on their dismissal motions.

 

To be sure, there have also been many settlements of life sciences securities lawsuits, some of which have been quite significant. But overall life sciences securities lawsuits have not always been as productive for the plaintiffs’ lawyers as might be suggested by the sheer numbers of filings.

 

I do agree that the volatility of life sciences companies’ share price and the companies’ susceptibility to product-driven dislocations will continue to attract the unwanted attention of the plaintiffs’ lawyers. The good news for these companies is that they have potentially effective defenses available and they may be able to use these defenses to stave off the litigation assault. The risk protection steps suggested in the authors’ memorandum are particularly good starting points for preparing these defenses.

 

Special thanks to David Kotler of the Dechert firm for providing me with a copy of the life sciences securities litigation survey.

The subprime and credit crisis-related litigation wave has come a long way since the first of the subprime lawsuits was filed in February 2007. Now that the litigation phenomenon is now nearly a year and a half old, the rulings on the motions to dismiss are finally starting to accumulate. It appears to be time for The D&O Diary to initiate the latest in its ongoing and ever-popular series of lists, this most recently created one to track the accumulated subprime and credit-crisis related lawsuit dismissals and dismissal motion denials.

The D&O Diary’s newly created list of subprime and credit crisis-related dismissals and motion denials can be found here. PLEASE NOTE that this document also lists all settlements of subprime and credit crisis related lawsuits as well

As befits the relatively early stages of most of this litigation, the list of case dispositions is, as of the time of the list’s initial creation, pretty sparse. I will endeavor to update the list as new dismissal motion rulings emerge, and wherever possible I will provide a link to the actual ruling. As I update the list, I will indicate at the top of the list the date of the list’s most recent revision.

The more complete the list is, the more useful it will be for everyone, so all readers are strongly invited and encouraged to let me know about any subprime and credit crisis related lawsuit dismissal motion rulings that are not already on the list.

As of the date of the creation of this post, I am not aware of any subprime or credit-crisis related lawsuit settlements. The settlements will emerge sooner or later, and when the do, I will created a supplemental document tracking the settlements.

Readers who may be unaware of the other lists that I am maintaining may be interested to know about the following lists:

  1. The List of Subprime and Credit Crisis-Related Securities Class Action Lawsuit Filings (which may be accessed here).
  2. The List of Subprime and Credit Crisis-Related Derivative Lawsuits (here).
  3. The List of Options Backdating-Related Lawsuit Filings (here)
  4. The List of Options Backdating-Related Dismissals, Denials and Settlements (here).
  5. The List of Securities Class Action Opt-Out Settlements (here).

I am always interested in any additional information or correcting information that is required to make these lists more accurate or complete. I am also always interested in readers’ thoughts and comments, about these lists or anything else.

Welcome Back: Serial blogger Bruce Carton is back at it again, with his new blog, Unusual Activity, which can be found here. The blog describes itself as "The Securities Litigation and Enforcement Reporter."  Many readers will recall that Bruce is the founder and long-time author of the Securities Litigation Watch blog. Bruce more recently wrote the Best in Class blog. Everyone here welcomes Bruce back to the blogging circuit, and we look forward to reading his new blog.

Speakers’s Corner: On June 19 and 20, 2008, I will be co-Chairing the Mealey’s Subprime Mortgage & Insurance Coverage Litigation Conference at the Ritz-Carlton in Pentagon CIty, Virginia, with my good friend, Matt Jacobs, of Jenner & Block.

The agenda (which can be found here), includes many distinguished speakers and panelists, such as Andrew Carron of NERA Economic Consulting, Adel Turki of Cornerstone Research, Robert Rothman of the Lerach Coughlin firm, Dan Bailey of Bailey & Cavalieri, John McCarrick of Edwards Angell Palmer & Dodge, David Hensler of Hogan & Hartson, and Mitchell Dolin of Covington & Burling.

Registration instructions and other intormation about the conference can be found here.

And Finally: If you have never heard of the Social Science Research Network (SSRN), then you will want to review the article yesterday’s New York TImes (here) discussing the latest in academic anxieties. It used to be all publish or perish, but it is now all about the downloads and links. And you thought your job was competitive.

 As I have previously observed, the current credit crisis is about more than subprime loans. Among the other kinds of credit are so-called Option ARMs, which frequently involve prime borrowers. These loans are adjustable rate mortgages where the borrower has the option of paying less than the full amount of interest due, with the unpaid balance added to the principle (that is, the loan can negatively amortize). My prior post describing and discussing the nature of Option ARM loans can be found here.

 

This negative amortization payment feature of Option ARMs only makes sense (if at all) at a time of rising home prices. At a time of declining home values, it can quickly put the borrower in a position where they owe more than the value of their home. As unattractive as this position is, it can get worse when the interest rate adjusts upwards, leaving the borrower in a position of paying even more to stay in a home that is worth less than the mortgage debt.

 

Unsurprisingly, borrowers are having difficulties with Option ARM loans, which in turn is leading to problems for lenders with Option ARM portfolios. These problems in turn are leading to litigation.

 

The latest company to be sued in a securities class action lawsuit arising out of problems with Option ARM loans is Wachovia Corporation, which was sued, together with certain of its directors and officers, on June 6, 2008 in the United States District Court for the Central District of California. The plaintiffs’ lawyers’ June 9, 2008 press release about the lawsuit can be found here. The complaint can be found here. UPDATE: As correctly noted in the reader comment, this case is actually pending in the Northern District of California, rather than the Central District as original text incorrectly stated.

 

According to the press release, the complaint alleges that:

Defendants misled investors by falsely representing that Wachovia had strict and selective underwriting and loan origination practices and a conservative lending approach that set it apart from other lenders. Such reassurances were repeated by defendants throughout the Class Period in order to artificially support Wachovia’s stock price in the midst of a weakening mortgage market. In response to increased market concern with the mortgage lending industry, and Wachovia’s option ARMs in particular, Wachovia falsely represented that its loan underwriting practices were much better than at other banks and that this would allow it to prosper while lenders with less exacting standards and procedures would fare much worse. In reality, Wachovia’s actual lending practices differed materially from the description of those practices in statements made to investors. The Company’s ability to weather the deterioration in the real estate and credit markets was grossly exaggerated by Defendants, at precisely the worst time, when analysts began to ask tough questions. The Company, moreover, had inadequate loan loss reserves and falsely represented that its capital position was sufficient to fund its dividend.

Shortly after last assuring the market of its liquidity, the strength of its underwriting practices, and the adequacy of its reserves, Wachovia reported a surprise quarterly loss, undertook emergency measures to increase capital, and cut its dividend. On April 14, 2008, before the open of ordinary trading, Wachovia reported a loss of $350 million, or $0.20 per share, for the first quarter of 2008. The Company attributed the results to: (1) a $2.8 billion increase credit loss reserves, including $1.1 billion specifically for “Pick-A-Pay” reserve build, the lending program highly touted by the Company during the Class Period. The need to increase Pick-A-Pay reserves was attributed to Wachovia’s adoption of a “refined reserve modeling” that resulted in “higher than expected loss factors on Pick-a-Pay”; and (2) $2 billion in mark-to-market losses for mortgage backed securities, including a “$729 million loss on unfunded leveraged finance commitments.” In order to shore-up its capital, Wachovia announced the following steps: (1) reduce the dividend 41% to $0.375; and (2) plan to raise capital by $7-8 billion through public offerings.

Wachovia is only the latest company to become embroiled in securities litigation arising out of Option ARM problems. Companies previously sued in securities lawsuits involving Option ARM allegations include Washington Mutual (about which refer here) and Downey Financial (refer here). It seems highly unlikely that these companies will be the only ones to become involved in lawsuits involving these concerns.

 

Indeed, as bad as the situation involving Options ARMs may now appear, circumstances are likely to deteriorate in the months ahead. As discussed in the June 5, 2008 Business Week article entitled “The Next Real Estate Crisis” (here), foreclosures on Options ARMs have already tripled in the last year, but could further hasten as “monthly options recasts are expected to accelerate starting in April 2009, from $5 billion to a peak of about $10 billion in January 2010.” The Option ARM loan defaults “could accelerate next year even if subprime defaults subside.”

 

The possibility of further Option ARM related securities litigation seems likely.

 

In any event, I have added the new Wachovia case to my running tally of subprime and credit-crisis related securities class action lawsuits, which can be accessed here. The current tally now stands at 89, of which 49 have been filed in 2008.

 

It is probably worth noting that this new case is the third in which Wachovia has become involved as part of the current credit-crisis related litigation wave. In addition to the new lawsuit, Wachovia was previously sued in an auction rate securities lawsuit (refer here), and in a Prospectus Liability case arising out of the company’s offering of certain Trust Preferred Securities (about which refer here).

In prior posts (refer here), I have discussed the increasing reluctance of U.S. courts to exercise subject matter jurisdiction over securities claims against foreign-domiciled companies brought by foreign claimants who bought their shares on foreign exchanges (so-called “f-cubed” claimants).

 

In the most recent example of this, Judge Thomas Griesa of the United States District Court for the Southern District of New York, in a June 3, 2008 opinion (here), granted the defendants’ motion to dismiss the claims of “f-cubed” claimants against AstraZeneca and certain of its directors and offices.

 

The complaint essentially alleges that Exanta, a pharmaceutical being develop by the AstraZeneca (a U.K.-based company) “was not as safe or effective as defendants’ public statements made it out to be.” The plaintiffs’ claimed that these statements inflated the company’s share price. Refer here for background regarding the lawsuit.

 

The outcome of the subject matter jurisdiction question was probably tipped in the court’s opening observation that “over 90% of the members of the putative class are foreigners who purchased their shares on foreign exchanges.”

 

The court reviewed the propriety of its exercise of jurisdiction over claims brought on behalf of these foreign shareholders, by considering whether or not there were sufficient allegations of U.S.-based conduct causing sufficient U.S.-based effects. The court found that while there were sufficient allegations of U.S.-based conduct, plaintiffs “do not allege facts in support of the second prong of the test – that the United States conduct ‘directly caused’ plaintiffs’ losses.”

 

The court said that in order to establish this requisite causal link, the plaintiffs must have “sufficiently alleged that the foreign purchasers relied on United States based conduct when deciding to acquire the stock”. In order to establish this kind of reliance, the plaintiffs urged the court in effect to adopt a global “fraud-on-the-market” theory, arguing that “it is illogical to suggest that the fraud-on-the-market theory applies within the United States but not outside of it.”

 

The court noted that other courts had rejected the global fraud-on-the-market theory, out of concerns that it would “extend the jurisdictional reach of the United States securities laws too far.” The court further noted that the Second Circuit had not yet provided guidance on whether the fraud-on-the-market theory should apply to foreign countries, and “in the absence of clear authority in favor of a global fraud-on-the-market theory, the court declines to adopt such a theory.” The court dismissed the claims of the foreign claimants based on lack of subject matter jurisdiction.

 

The court further concluded that the plaintiffs had not sufficiently alleged that two foreign-domiciled individual defendants had the requisite “minimum contacts” with the U.S. for the court to exercise personal jurisdiction over them.

 

Finally, the court concluded that the plaintiffs had not sufficiently pled scienter, and dismissed the remaining claims on that basis. The court held that neither the allegations of insider trading nor the allegations relating to a secondary offering were sufficient to establish scienter.

 

The court further rejected the plaintiffs allegations that the defendants had consciously disregarded the truth, based on the court’s own review of the various disclosure documents on which the plaintiffs sought to rely. The court concluded that the plaintiffs “have not alleged anything to negate the idea that that defendants were attempting to develop a drug they thought beneficial and were do describing it to the public.” The court found that the plaintiffs had “not alleged an inference of scienter as compelling as the opposing inference.”

 

The fact that the case will not be going forward even as to the domestic shareholders reduces the impact of the court’s ruling to exclude the f-cubed claimants from the class. The dispersion of the class, with such an overwhelming percentage of f-cubed claimants in the purported class members may well have inclined the outcome on the jurisdictional issue in any event.

 

Plaintiffs’ attorneys in the most recently filed cases seem to be anticipating that courts are inclined to exclude these claimants from the putative class and increasingly are taking that into account in their initial pleadings. For example, as discussed here, when plaintiffs’ lawyers recently launched a U.S. securities lawsuit against Société Générale, they included in the purported class only U.S residents and investors who bought ADRs on U.S. exchanges. Their purported class by its own construction excludes foreign residents who bought shares on foreign exchanges.

 

The increasing exclusion of f-cubed litigants from U.S. securities class actions (whether voluntary or as a result of court action) is one of the reasons that interest in U.S.-style securities relief is increasing in other countries, as I discussed in a recent post (here).

 

In any event, the court’s dismissal of the AstraZeneca case also continues another trend, which is that while life sciences companies are frequently sued (compared to companies in most other categories), the cases filed against them are often dismissed, as I also discussed in a prior post (here)

As the subprime crisis has unfolded, one of the recurring themes has been the conflicted role of the rating agencies. Last week’s announcement (here) of a negotiated resolution of the New York State regulatory investigation of the rating agencies reflects one aspect of the recurring questions surrounding the rating agencies’ role in the current crisis. These questions are likely to persist in light of the recent revelation (here) that Moody’s continued to assign mortgage-backed securities investment grade ratings despite a whistleblower’s alarm about potential problems with the ratings.

But while the questions about the rating agencies’ role have persisted, and while the agencies own shareholders have sued the rating agencies over the agencies’ own disclosures (about which refer here and here), to date subprime investors have not targeted the rating agencies for their rating activities, to the best of my knowledge.

As discussed in a prior post (here), case law suggests that the rating agencies enjoy First Amendment protection for their rating opinions and activities. And, as also discussed in my prior post, while thoughtful commentators have suggested bases on which these defenses might be overcome with respect to the rating agencies subprime-related investment rating activity, subprime investors have not targeted the rating agencies. Until now.

In a lawsuit filed on May 15, 2008 in New York Supreme Court (New York County), the New Jersey Carpenters’ Vacation Fund has filed a securities class action lawsuit under the ’33 Act on behalf of investors in the three HarborView Mortgage Loan Trusts. In a petition dated June 3, 2008, the defendants removed the case to the United States District Court for the Southern District of New York. A copy of the notice of removal, to which the original complaint is attached, can be found here.

The defendants in the lawsuit include the three HarborView mortgage pass-through certificate trusts; the Royal Bank of Scotland Group (“RBS Group”) and its subsidiary, Greenwich Capital Holdings and related entities, including Greenwich Capital Acceptance (“GCA”) and five individual directors of GCA; and the three rating agencies, Fitch’s Ratings, Moody’s Investor Services, and McGraw Hill, as corporate parent for Standard & Poor’s Rating Services.

The three trusts were issuers of bonds (the mortgage pass-through certificates) created by RBS Greenwich Capital. The offerings were collateralized with loans originated and underwritten by Countrywide Home Loans. The complain alleges that the Registration Statement issued in connection with the offerings failed to disclose “the true impaired and defective quality of the loans collateralizing the Bonds” and that the “loans were not originated pursuant to the underwriting guidelines stated in the Registration Statement.”

The complaint alleges that the rating agency defendants “failed to conduct due diligence and willingly assigned the highest ratings to such impaired instruments since they received substantial fees from the issuer.” The complaint alleges further that the rating agencies “issued the ratings based on an outdated methodology designed in about 2002.” The ratings were alleged to be misleading because the rating agencies “presumed that the loans were of high credit quality issues in compliance with the stated underwriting guidelines, when, in fact, Countrywide had systematically disregarded its stated Underwriting Guidelines.”

The rating agencies later downgraded the mortgage-backed securities. The complaint alleges that the rating agencies “admission that they had not used an appropriate rating methodology …resulted in a substantial decline in the value of the Bonds.” The plaintiff itself claims that its investment in the instruments has declined by 55 percent.

All of the claims asserted in the Complaint are based on the ’33 Act. In Count I of the Complaint, the plaintiff specifically alleges (in paragraph 98) that the rating agencies “served as appraisers” as defined in Section 11(a)(4) of the ’33 Act. The paragraph further alleges that the rating agencies “purportedly reviewed and analyzed each offering and provided the credit rating for each tranche of the HarborView Bonds.” The paragraph further alleges that the service of providing the ratings “was essential to pricing and marketing the Bonds,” and that the ratings were contained in the Prospectus.

As far as I am aware, the plaintiffs’ complaint in the HarborView Mortgage Loan Trust lawsuit represents the first occasion as part of the current subprime litigation wave where subprime investors have sought to hold the rating agencies liable for their ratings. The plaintiff’s allegations will face a number of hurdles, including the jurisdictional issue discussed below.

In addition, the rating agencies will undoubtedly assert a number of substantive defenses, including the First Amendment defense discussed in my prior blog post (here), as well as whether the rating agencies even owed the plaintiff any duties. The rating agencies will particularly dispute the plaintiffs’ attempt to rely on Section 11(a)(4) of the ’33 Act as a basis for the rating agencies’ liability.

The jurisdictional issue pertains to the plaintiff’s initiation of the lawsuit in state court pursuant to the concurrent state court jurisdiction in Section 22 of the ’33 Act. The HarborView case is just the latest of the state court ’33 Act lawsuits arising as part of the current subprime-related litigation wave, as discussed in my prior post (here). In each case, the defendants have sought to remove these cases to federal court, notwithstanding the express prohibition in Section 22 of removal of state court cases to federal court. In at least one of the prior cases, the federal court has remanded the case back to state court in reliance on Section 22’s express removal prohibition (refer here for a discussion of the prior remand case).

It remains to be seen whether or not these cases will go forward in state or federal court. Although it is not altogether clear why the plaintiffs have sought to pursue these cases in state court, the plaintiffs clearly perceive some advantage in doing so. In any event, the success of the plaintiffs’ attempts to hold the rating agencies liable for their investment in subprime-related securities will be interesting to watch. It will also be interesting to see if other investor plaintiffs similarly seek to hold the credit rating agencies liable.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the HarborView removal petition.

Run the Numbers: I have added the HarborView case to my running tally of subprime-related securities class action lawsuits. (My tally can be accessed here). According to my count, the addition of this case, as well as the case filed late last week against Franklin Bank Corp. (about which refer here), the current tally of subprime and credit crisis-related securities class action lawsuits now stands at 88, of which 48 have been filed in 2008.

Speakers’ Corner: On June 19 and 20, 2008, I will be co-Chairing the Mealey’s Subprime Mortgage & Insurance Coverage Litigation Conference at the Ritz-Carlton in Pentagon City, Virginia, with my good friend Matt Jacobs of the Jenner & Block law firm.

The agenda (which can be found here), includes many distinguished speakers and panelists, such as Andrew Carron of NERA Economic Consulting, Adel Turki of Cornerstone Research, Samuel Rudman of the Lerach Coughlin firm, Dan Bailey of Bailey & Cavalieri, John McCarrick of Edwards Angell Palmer & Dodge, David Hensler of Hogan & Hartson, and Mitchell Dolin of Covington & Burling.

Cablevision: On June 4, 2008, Cablevision Systems announced (here) that it had entered a stipulation to settle the options-backdating litigation pending against the company, as nominal defendant, certain of its directors and officers, and other defendants. Although the Cablevision settlement is only the latest in a growing list of options backdating-related lawsuit resolutions (as is detailed on my running tally, which can be accessed here), the settlement is noteworthy both regarding the nature of the allegations involved and regarding certain aspects of the settlement, particularly as pertains to the individuals’ contributions to the settlement.  

The options backdating problems at Cablevision drew a great deal of attention when first disclosed. The company revealed that it had awarded options to a Vice Chairman after his 1999 death, but backdated the options to make it appear that the grant was awarded when he was still alive. A front page September 22, 2006 Wall Street Journal article entitled “Cablevisions Gave Backdated Grant to Dead Official” (here) quoted Columbia Law Professor John Coffee as saying that “trying to incentivize a corpse suggests they were not complying with the spirit of the shareholder-approved stock-option plan.” The ISS Corporate Governance Blog referred (here)  to the awards as “Sixth Sense” options (“I pay dead people.”)

As if that were not enough, the company also disclosed that it had also awarded options to its outside compensation consultant, Lyons Benenson & Co., but the grant had been accounted for as if the consultant (Harvey Benenson) were an employee. As I noted in a blog post at the time (here), the derivative lawsuit allegations were amended to include allegations against the compensation consultant.

According to the Stipulation of Settlement (here), the Cablevision derivative lawsuit was settled for cash payments and other consideration that the parties have represented to the court has an aggregate value of $34.4 million. Specifically, the parties agreed that Cablevision will received a cash payment of $10 million from its D&O insurer, and “cash payments from and/or relinquishment of value and/or the waiver of specific claims by certain individuals” totaling $24.4 in valued. The plaintiffs’ counsel will seek payment of fees and expenses of no more that $7.116 from the settlement fund.

The description of the components of the individuals’ $24.4 million contribution makes for some interesting reading. First, the compensation consultant, Harvey Benenson, and/or his firm, Lyons Benenson, agreed to pay $2 million over three years, at 6 percent interest, secured by his Connecticut home. He will also forfeit $1.5 million severance he claimed.

The estate of former Vice Chairman Marc Lustgarten (the recipient of the Sixth Sense option grant) relinquished all claims to $4.9 million in stock options and restricted shares, including those granted improperly after his death.

A number of other individuals agreed to return specified amounts in connection with prior option grant exercises and to relinquish other unexercised options or waive other stock or share rights.

In addition to these individual contributions, and in what is to me the most interesting part of this settlement, Cablevision Chairman Charles Dolan agreed to make a $1 million cash payment to Cablevision, “to facilitate the resolution of the case.” His son, Chief Executive James Dolan, will also make a $1 million contribution, in addition to returning $366,250 for previously exercised options.

What makes this agreement of the two Dolans to pay $1 million each interesting is Section 3.4 of the Stipulation of Settlement, which provides that the Settling Defendants “will not seek insurance coverage, reimbursement, contribution or indemnification for any of the consideration they provide …from any source, including but not limited to Cablevision, other Settling Defendants, any of the Insurers, or any other Related Person.”

The various individual defendants’ returned options exercise proceeds or waived benefits arguably would not have been covered under the typical D&O policy in any event, as it appears to represent the return of compensation to which they were not entitled (coverage for which arguably would be excluded under most policies). However, there might well have been at least a colorable basis on which the Dolans might have been able to argue that their million dollar payments would be covered, assuming the typical D&O policy and assuming other potential policy provision did not otherwise preclude coverage. The language of Section 3.4 appears to represent a deliberate effort to ensure that the Dolans and the other defendants directly bore the cost of their settlement contributions.

There was a time following the Enron and World Com settlements when there was a concern that indemnity and insurance bar provisions might become a regular feature of the settlement of claims against corporate officials. These fears were largely unrealized, and the presence of an indemnity and insurance bar remains an unusual settlement feature. Nevertheless, the possibility that these provisions might become more commonplace is a concern for corporate officials and their advisors.

It remains to be seen whether these types of provisions will be a part of other options backdating settlements, but in light of recent judicial concerns about possible collusive options backdating settlements (refer here), litigants may feel some pressure to show that the settlement was both arms’-length and represents real value. To that extent at least, there could be some pressure for other options backdating litigants to consider incorporating settlement provisions like an indemnity and insurance bar.

A June 6, 2008 Newsday article describing the Cablevision settlement can be found here. A copy of the June 7, 2008 Wall Street Journal article about the settlement can be found here.

Marvell Technology: It its June 6, 2008 filing on Form 10-Q (here), Marvell Technology disclosed that on March 5, 2008, the company had entered a stipulation of settlement regarding the consolidated options backdating-related shareholders’ derivative lawsuit that had been filed against the company, as nominal defendant, and certain of its directors and officers. According to the 10-Q, the settlement includes “certain corporate governance enhancements and an agreement by us to pay up to $16 million in plaintiffs’ attorneys’ fees, an amount less than the $24.5 million that we received from a recent settlement with our directors’ and officers’ liability insurers.”

There are a number of interesting things about this settlement, particularly concerning the $16 million plaintiffs’ attorneys’ fee. At least in the absence of any other details about the settlement in any of the company’s disclosure document or even in the court filings to date, the amount of the plaintiffs’ attorneys’ fee seems, well, high. For example, compare the $16 million fee in the Marvell Technology settlement to the $7.116 million fee amount agreed to in the Cablevision case. The Cablevision case involved some fairly noteworthy complications, and the settlement of the Cablevision case resulted in the payment of significant amounts back to the corporation. By contrast, at least as far as can be discerned from the company’s recent 10-Q, the Marvell Technology settlement involved no cash payment to the company.

The $8.5 million increment of the insurance settlement in excess of the $16 million plaintiffs’ counsel’s fee is not explained in the 10-Q. It could be supposed that that $8.5 million represents a benefit to the corporation (although it could just as easily represent a reimbursement to the company for its own fees incurred in defense of the lawsuit). Even if the $8.5 million represents some benefit that accrued to the company as a result of the derivative lawsuit, the expenditure of $16 million in fees to recover $8.5 million seems like a poor exchange.

The question of what the company got out of the lawsuit is relevant and likely to be asked in light of the concerns that Judge Alsop raised in connection with the recent Zoran options backdating-related derivative lawsuit settlement (about which refer here). The Marvell Technology settlement could be argued to have the same issues as the Zoran settlement, in which, as Judge Alsop stated, “the corporation would receive no cash, all the cash is going to the counsel.” Of course, the $8.5 million insurance settlement increment could be argued to represent some cash to the company, but the ratio of the benefit to the corporation versus the benefit to plaintiffs’ counsel does not favor the settlement.

According to Marvell’s 10-Q, the settlement still requires court approval. Perhaps with the benefit of a full explanation of the settlement, the merits of the settlement might be more apparent. However, the description of the settlement in the 10-Q does at least suggest some serious questions.

A June 9, 2008 Law.com article discussing the Marvell Technology settlement can be found here. Special thanks to Zusha Elinson of The Recorder for providing a link to the 10-Q.

In arguably the most substantive ruling yet in a subprime-related securities class action lawsuit, Judge Ortrie Smith of the United States District Court for the Western District of Missouri, in a June 4 opinion (here) in the NovaStar Financial subprime-related securities class action lawsuit, granted the defendants’ motion to dismiss with prejudice.

The NovaStar lawsuit, which was first filed on February 23, 2007, was one of the first subprime-related securities class action lawsuits to be filed. Background regarding the lawsuit can be found here. The lawsuit alleges that NovaStar, a real estate investment trust, lacked adequate internal controls, as a result of which the company materially misstated its financial results and condition. The lawsuit followed the company’s February 20, 2007 announcement of disappointing results and deteriorating marketplace conditions.

Judge Smith granted the motion to dismiss on the grounds that the complaint does not adequately plead falsity and does not adequately plead scienter.

In addressing the falsity requirements, Judge Smith noted the PSLRA’s specificity requirements, and observed that the complaint, despite its over 100 pages and over 200 paragraphs “presents a very broad picture, and Plaintiff discusses his claims in generalities – precisely what the PSLRA counsels against.” This, Judge Smith said, allowed the Complaint to “create the illusion of detail and insinuate the existence of fraud, which in turn has made it exceedingly difficult for the Court to conduct the analysis required by law.”

After reviewing the complaint’s specific allegations of falsity and finding them each in turn to be inadequate, Judge Smith concluded that “ultimately, Plaintiff fails to identify a single false entry in the Company’s financial statements, nor does he identify the ‘truth’ that should have been disclosed.” Judge Smith goes on to add that the Complaint “reads more like a cautionary tale from a treatise on business management than a charge of knowing misstatements and concealments.” Companies, the court said, “are not expected to be clairvoyant and bad decisions do not constitute fraud.”

With respect to plaintiff’s scienter allegations, the court concludes that the plaintiff “had not presented facts creating an inference of scienter that is at least as strong as an inference that Defendants lacked fraudulent intent.” The court noted that the allegations are “more consistent with a company and executives confronting a deterioration in the business and finding itself unable to prevent it than they are with a company and executives recklessly deceiving the investing community.”

Judge Smith declined to allow the plaintiffs leave to replead, concluding it “would be futile,” since there is “no suggestion that any material was concealed or that any Defendant acted with fraudulent intent, and there is no reason to think further or different pleading will created the necessary inferences.”

The Court’s opinion is pretty much a clean sweep for the defendants, but it is hard to know what the larger significance of the opinion might be. There are few other subprime cases pending in the Western District of Missouri (for which the plaintiffs’ bar is undoubtedly grateful, given the outcome in the NovaStar case), and courts in other jurisdictions may or may attach weight to Judge Smith’s ruling.

One aspect of the opinion that could be significant if it represents the perspective with which other courts will view these cases, and that is the extent to which Judge Smith viewed this case through the screen of the generally deteriorating financial markets and business conditions. Other judges, like Judge Smith, may be similarly disinclined to find anything nefarious in a company’s failure to anticipate declining business conditions – at least in the absence of insider trading or other more compelling factors.

While there may be cases such as the Countrywide derivative lawsuit which courts may be predisposed to allow (about which refer here), there may be others, like the NovaStar case, where courts prove unwilling to infer wrongdoing from business reverses. At a minimum, the NovaStar opinion is a reminder that merely because a company’s fortunes have declined and the plaintiffs have filed a lawsuit does not necessarily mean that the plaintiffs will prevail or make any recovery. There may be more than a few of the cases filed as part of the subprime litigation wave that also fail to survive the initial pleading hurdles.

In a prior post (here), I described the growing litigation risk arising out of credit default swap (CDS) transactions. In their recent overview of subprime-related litigation entitled “The Pebble and the Pool: The (Global) Expansion of Subprime Litigation” (here), John Doherty and Richard Hans of the Thacher Proffitt and Wood law firm note that “more lawsuits involving credit default swaps are likely to be initiated in the near future, as the current trend has the potential for huge losses resulting from the defaults on ‘high-yield’ or ‘junk” bonds in connection with the general market failure.”

In a June 1, 2008 article entitled “First Came the Swap. Then It’s the Knives” (here), New York Times columnist Gretchen Morgenson takes a close look at one failed CDS transaction and the litigation that has followed, about which she quotes “experts” as saying that the case is “the first of what will likely be a flood of disputes between big banks and hedge funds that typically strike swap deals.”

The swap involved was issued by a Paramax Capital hedge fund in early 2007 to insure $1.31 bilion of AAA-rated super senior notes that “reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS.” The Paramax fund, which itself had just $200 million in capital, organized a special purpose entity capitalized with just $4.6 million, to conduct the swap. Paramax was to receive an annual fee of 0.155 percent of the notes’ $1.31 billion value (or slightly more than $2 million), and would be subject to additional collateral requirements if the notes’ value declined.

Over the course of 2007, UBS presented escalating requirements that Paramax post a total of $33 million in additional collateral. When Paramax refused, UBS sued. According to the Times article, Paramax now contends that a UBS managing director (no longer with the company) induced Paramax to enter the transaction, and to address Paramax’s concern that it might be called upon to post additional collateral, reassured Paramax that the mark-to-market risk on the underlying securities was low because UBS used “subjective valuations” designed to reduce the impact of market fluctuations.

As detailed further in the Times article, there are a number of interesting things about this transaction. From my perspective, the most noteworthy aspect is that UBS considered a special purpose entity with only $4.6 million in capital to be an appropriate source of default insurance for instruments with a face value of $1.31 billion. UBS’s contractual right to demand additional collateral from the hedge fund, which itself had capital of only $200 million (which presumably was deployed in other ways and accordingly unavailable in its entirety as additional collateral), seems a woefully inadequate explanation for this transaction.

The Naked Capitalism blog (here) notes that “UBS was clearly well aware of Paramax’s limits, so the next question is: was UBS solely responsible for pulling a fast one on the CDO buyers or is Paramax a co-conspirator?”

This litigation between UBS and Paramax resembles the CDO Plus litigation I discussed in my prior post (here) about swaps. In those cases as well, a thinly capitalized hedge fund was unable to meet demands for additional collateral and wound up in litigation with the large commercial banks that had purchased CDS protection from the fund. As consequences from the credit crisis continue to roll through the financial marketplace, CDS counterparties are likely to face further collateral demands, which can only fuel further litigation.

But the counterparties themselves are not the only potential litigants. Behind the CDS purchaser are the investors who made investments in the belief that the investment interests were “insured” against default. As it emerges that this insurance depended upon facially inadequate counterparties, investors may join the fray. As the Naked Capitalism blog post linked above notes, “since over 30% of the credit default swaps were written by hedge funds, many of whom were probably as incapable as Paramax of performing in the event of default, it’s not unreasonable to assume that some of these CDS lawsuits will lay the groundwork for investor litigation.”

Another aspect of the role of CDS in the financial marketplace is leading to yet another variety of CDS-related litigation. That is, because there is no requirement that a CDS buyer hold the underlying instruments, swaps are often used as a means to speculate on interest spreads. That means that these instruments can serve an investment purpose separate apart from their insurance purpose.

The problem for companies that have used swaps for investment purposes is that as a result of the credit turmoil, the market for these instruments in an uproar, and the instruments’ valuation has become uncertain. Indeed, as recent circumstances have shown, these valuation issues are present whether a company holds the swap as an investor or as an insurer. Several of the most significant recent financial institution asset write-downs have involved these CDS valuation uncertainties; for example, a substantial part of the recent write-downs of Swiss Re and of American International Group related to CDS valuation issues. Significantly, in both instances, shareholders litigation ensued following the write-downs. (Refer here regarding the Swiss Re litigation and refer here regarding the AIG litigation). It seems highly improbable that there will not be further shareholder litigation over these CDS valuation issues.

As reflected in the June 6, 2008 Wall Street Journal (here), the recent signs are that the turmoil in the financial marketplace is far from over , as a result of which the pressure on CDS will remain, and there likely will be further litigation. Even if only a tiny percentage of CDS transactions beget litigation, the problem could be huge. According to the International Swaps and Derivatives Association (here), the aggregate notional value of credit defaults swaps outstanding at the end of 2007 was $62 trillion, an amount which arguably exceeds the value of bank deposits worldwide. It is nearly three times the value of the U.S. stock markets.

With numbers that astronomical, even a small sliver represents a mammoth problem. With nominal values of $62 trillion, issues concerning valuation present a potentially frightening prospect for companies, their investors, and their insurers. As Time Magazine said in its recent article entitled “Credit Default Swaps: The Next Crisis?” (here), “a meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis.”

Susan Mangiero has an interesting post (here) on her Pension Risk Matters blog about these issues.

The “Pebble in the Pool” article I linked to above presents a very good overview of the subprime-related litigation generally and is worth reviewing on its own for those purposes.

Another Subprime-Related Lawsuit Against Mutual Fund: On June 5, 2008, plaintiffs’ attorneys initiated a securities class action lawsuit in the United States District Court for the District of Massachusetts under the Securities Act of 1933 on behalf of purchasers of the Fidelity Ultra-Short Bond Fund who purchased their fund shares within three years of the lawsuit’s filing.

According to the complaint (which can be found here), the defendants in the lawsuit include Fidelity Management & Research Company, which is the investment advisor to the Fidelity mutual funds, and related entities, and also include the 21 individual trustees of the Ultra-Short Bond Fund.

According to the plaintiffs’ lawyers’ June 5, 2008 press release describing the complaint (which can be found here), the plaintiffs allege that the defendants solicited investors to purchase fund shares by making statements that described the fund as a fund that “(i) “Seeks a high level of current income consistent with the preservation of capital”; (ii) “allocates its assets across different market sectors and maturities”; (iii) has a “similar overall interest rate risk to the Lehman Brothers® 6 Month Swap Index”; and (iv) is geared toward the “preservation of capital.”  

The complaint alleges that these statements were false because “defendants did not adequately disclose the risks associated with investing in the Fund, including, for example, that the Fund was: (i) failing to compete with the Lehman Brothers® 6 Month Swap Index; and (ii) so heavily invested in high-risk mortgage-backed securities.”

I have added this case to my running tally of subprime-related litigation, which can be found here. With the addition of this lawsuit, the tally now stands at 86 subprime-related securities class action lawsuits, of which 46 have been filed in 2008.

I note that by my count, this new lawsuit represents the fourth subprime-related lawsuit against a mutual fund or mutual fund family. The other include Calamos Global Dynamic Income Fund (about which refer here), Regions Morgan Keegan Funds (refer here), and the Schwab Yield Plus Fund (refer here).

For many companies, one of the hardest parts of the D&O insurance transaction is determining how much insurance to buy. Against a backdrop of basic affordability, the company must consider complex issues of limits adequacy – that is, how much insurance is “enough”? These issues are even more fraught in a time of generally rising claims severity (about which, refer here).

 

As discussed below, recent developments in one current claim underscore the fact that in addition to rising settlement levels, escalating defense expense is an increasingly important part of the limits adequacy equation. In addition, these recent developments also demonstrate that many related issues should also weigh into the limits adequacy analysis, and these same issues also have important implications for the structure of the insurance program, as well.

 

University of Denver Law Professor J. Robert Brown, Jr. has a post today (here) on his indispensable blog, The Race to the Bottom, discussing developments involving Paul Barnaba, a former employee of bankrupt auto parts supplier Collins & Aikman. Barnaba is caught up in the criminal case involving David Stockman, the former head of the OMB under Ronald Reagan, who was C&A’s CEO from 2001, when Stockman’s private equity fund took control of C&A, until shortly before the company’s 2005 bankruptcy. Barnaba is described in the indictment as “employed by the purchasing department” and identified as Director of Financial Analysis and eventually Director and Vice President of Purchasing for the Plastics Division. Background regarding the criminal prosecution can be found here.

 

As Professor Brown explained in an earlier post (here), Barnaba has moved to sever his criminal case from the other criminal defendants and to set the case for an early trial date. Barnaba asserts that, due to his indictment, he faces overwhelming personal and professional difficulties. He also argues that the protracted criminal proceedings threaten him with financial ruin, and he contends further that the proceeds of the applicable D&O policy “are quickly dwindling.”

 

The government opposed Barnaba’s motion, arguing among other things that Barnaba’s concerns about the dwindling D&O insurance are “wholly speculative and unsubstantiated.”

 

In his Reply to the government’s opposition, Barnaba vigorously disagrees with the government’s attempt to belittle his concerns about the dwindling D&O policy. His Reply explains that Collins & Aikman has a $50 million insurance program arranged in four layers. This insurance “provides coverage to a wide variety of former Collins & Aikman executives and employees,” including not only the criminal defendants, but also “those who have been sued or subpoenaed in the civil SEC matter, and those who have been sued or subpoenaed in various class actions and other civil suits.”

 

Barnaba explains in his Reply that the first $15 million layer of coverage was exhausted on or about June 15, 2007, and the second $15 million layer was exhausted on or about March 31, 2008 (for defense work completed through February 2008). As Barnaba notes, “the second $15 million layer of coverage was exhausted in nine months at a rate of approximately $1.67 million per month” and he adds that the “monthly rate was higher at the end of than at the beginning of this nine-month period.”

 

In any event, for the defense work completed in March 2008 and later, only $20 million of coverage remains. Barnaba argues that “[a]ssuming a monthly burn rate of $2 million to $3 million, which is realistic and likely conservative, all policy proceeds will be exhausted sometime between mid-September 2008 and December 31, 2008. This is not speculative.”

 

It is hard not to sympathize with Barnaba’s plight, regardless of the merits of the criminal matter. He has been caught in the maelstrom. The outcome of his motion to sever and to set a trial date remains to be seen, but it is hard to imagine a court agreeing to allow a high-profile criminal case like this one to be tried piecemeal. The D&O insurance could well be gone long before the case finally goes to trial.

 

Separate and apart from the actual merits of Barnaba’s motion are the implications of his plight for the issue of D&O insurance limits adequacy.

 

The first and most basic point is the importance of defense expense in the limits adequacy analysis. The potential for defense expense to exhaust or substantially deplete the available limits is most obvious in a catastrophic claim like the one involving Collins & Aikman, but even in less catastrophic circumstances, accumulating defense expense can substantially reduce the indemnity protection available even in a large insurance program. And the insurance is supposed to able to respond adequately in all circumstances, even the unlikely event of a catastrophic claim. In considering the requirements that a catastrophic claim can present, it is important to note that the aggregate defense expense related to the Collins & Aikman claim consumed $15 million in just nine months.

 

The second point is that one of the problems in the Collins & Aikman claim is that so many different people are accessing the policy, for a wide variety of different matters. The potential for the policy limits to drain away through so many different access points is perhaps inherent in the current standard D&O policy structure, in which so many different people are included as “insured persons” and so many different kinds of matters fall within the definition of a covered “claim.”

 

While this breadth of coverage is generally viewed as a positive thing from the policyholder’s perspective, it has the inherent potential (a potential that is being dramatically realized in the Collins & Aikman claim) for accelerated policy erosion and even depletion. The erosion potential inherent in the breadth of available policy coverage is a consideration that is too infrequently considered in connection with the question of limits adequacy.

 

Third, the problem Barnaba faces is not just his alone – all of the other “insured persons” are also facing imminent insurance program depletion. Once the available insurance is used up, these individuals will face continued complex litigation without further insurance available to defend or indemnify themselves. Among other things, it could prove difficult and painful for the defendants in the civil lawsuits to extricate themselves without insurance available.

 

All of that said, the solutions to these problems are not easy. With the benefit of hindsight, it is tempting to argue that the company should have carried higher limits. The fact is that many companies of Collins & Aikman’s pre-catastrophe size (the company had a market capitalization of approximately $500 million a year before it went bankrupt) choose to carry D&O limits lower than the $50 million that Collins & Aikman carried. Many companies are unwilling or unable to buy greater limits.

 

In the end the analysis comes down to the perennial question of limits adequacy – that is, how much insurance is enough?

 

In light of the escalating average claims severity, and of the numerous implications from Barnaba’s plight (including the catastrophic potential for defense expense to deplete policy limits), it may be time to rethink commonplace concepts of limits adequacy, because past notions may no longer be sufficient. Average claims severity is increasing. Defense expense does have the catastrophic potential to exhaust policy limits. In addition, new developments, such as the growing opt-out phenomenon (discussed most recently here), pose additional challenges to the traditional limits adequacy analysis.

 

Increased program limits alone, however, may not solve all of the problems. Indeed, it could be argued that even were higher limits available, they might not adequately protect Barnaba and the other Collins & Aikman defendants. Given the astonishing potential for defense expense to consume available insurance (I mean, $15 million in nine months, for crying out loud), even a substantially larger insurance program than the one Collins & Aikman maintained might prove to be insufficient.

 

Part of the solution has to be program structure. Clearly, a key reason that the Collins & Aikman program is melting away is that so many different people are accessing it. One way that well-advised corporate officials can ensure they are not left without insurance to protect them as individuals is through supplemental D&O insurance structures dedicated solely to their own protection. These supplemental structures might take any one of a number of different forms, including for example, excess Side A coverage for a specified group of individuals, or even through an individual D&O insurance policy (so-called IDL coverage). While there are a variety of ways this supplemental insurance might be structured, the crisis Barnaba faces underscores the importance of addressing these issues as part of the insurance acquisition process.

 

One final thought about Barnaba. That is, the typical insurance acquisition process conversation is usually limited to considerations involving the exposures of the most senior corporate officials. The possible exposures of “supporting cast” employees such as Barnaba are usually not a central part of the dialog. For that reason, it is relatively unlikely that the deployment of supplement insurance structures, as important as they are, would do much for someone like Barnaba.

 

In the end, someone at Barnaba’s level is, in all likelihood, going to be (as in the case of Barnaba himself) dependent on the continued availability of insurance proceeds under the traditional D&O insurance policy. This final point underscores the importance of a thorough review of all considerations involved in the issue of limits adequacy, including in particular the number of persons potentially dependent on the policy for protection. As I noted, it may be time to reconsider traditional notions of limits adequacy, in light of all of these considerations.

 

Very special thanks to Professor Brown for providing a heads up about his post.

 

Brocade Settles Options Timing-Related Securities Class Action Lawsuit: According to the company’s June 2, 2008 press release (here), Brocade Communications has reached an agreement to settle the options-backdating related securities class action lawsuit pending against the company and certain of its directors and officers, in exchange for an agreement to pay $160 million. Background regarding the litigation can be found here.

 

I have added the Brocade settlement to my table of options backdating-related settlements and dismissals, which can be accessed here.

 

A WSJ.com Law Blog post about the settlement can be found here.