As I have previously observed (most recently here), life sciences companies remain favored targets of the plaintiffs’ class action securities bar. Even during the two-year securities lawsuit filing lull between mid-2005 and mid-2007, lawsuit filings against life sciences companies continued more or less unabated. Indeed, as I noted here, during 2007, a year in which subprime-related securities lawsuits predominated, pharmaceutical companies were nevertheless among the most frequent sued. 

But while life sciences companies may be frequent securities lawsuit targets, that does not mean that all or even most of those lawsuits are meritorious. The recent dismissals of two securities lawsuits pending against two high-profile life sciences companies underscores the hurdles these lawsuits face.

Guidant: In an Order dated February 27, 2008 (here), Judge Sarah Evans Barker of the United States District Court for the Southern District of Indiana granted defendants’ motion to dismiss the securities class action lawsuit filed against Guidant Corporation and certain of its former directors and officers. Background on the consolidated Guidant securities lawsuit can be found here.

In their consolidated complaint (here), the plaintiffs allege that the defendants knew and intentionally concealed material information including the fact that there were defects in certain Guidant implantable defibrillators and pacemaker devices; that some patients were experiencing serious health issues (and in one instance, death) resulting from those defects; and that disclosure of those defects would have negatively affected both revenue and the company’s then-pending merger with Johnson & Johnson. (The company ultimately merged not with J & J, but with Boston Scientific.) The plaintiffs allege that defendants made false and misleading public statements about the defective devices and the planned J & J merger to keep Guidant’s stock at artificially inflated levels, in violation of Section 10(b) of the ’34 Act and Rule 10b-5 thereunder.

The defendants sought to have the complaint dismissed first on the ground that the complaint failed to satisfy the PSLRA’s heightened pleading requirements for alleging misleading statements, and second, on the grounds that the plaintiffs had not pled particularized facts giving rise to a strong inference of scienter.

The plaintiffs urged that the defendants’ statements were misleading because they “failed to disclose material information about known product defects (and in some cases, because the statements were intended to enhance then-pending merger negotiations with J & J, which would have been jeopardized had Defendants disclosed the defects).” In rejecting this argument, Judge Barker said “there is no affirmative independent duty for a company to disclose all information that could potentially affect its stock price, unless such silence renders an affirmative statement misleading.” She observed that the plaintiffs “have not demonstrated with the requisite particularity how omission of product defect information rendered any affirmative statements misleading.” Judge Barker then went on to note that several of the statements on which the plaintiffs attempt to rely “can be understood as immaterial, non-actionable corporate puffery.”

The plaintiffs also sought to rely on the Guidant’s ultimate product defect disclosures, arguing that the disclosures were partial and contained “half-truths” intended to minimize the impact. Judge Barker found, however, that “it is unclear precisely what facts were omitted from these disclosures that – in Plaintiffs’ opinion – would have more fully and truthfully informed the investing public about Guidant product defects.” Judge Barker went on to note that the plaintiffs “appear to argue” that the company was required “to ‘ring an alarm bell’ of sorts,” but, Judge Barker said, the relevant law “does not require a company to make such a statement – nor does omission of such a statement constitute fraud.”

Judge Barker also found that the plaintiffs had failed to allege sufficient facts to support a strong inference of scienter. The plaintiffs largely relied on the defendants’ stock sales, but Judge Barker found that the plaintiffs “have not demonstrated – as they are required to do – that such sales were dramatically out of line with prior trading practices at times calculated to maximize the personal benefit from undisclosed inside information.” 

Judge Barker further rejected plaintiffs’ arguments that defendants, as a result of their positions within the company, had knowledge of falsity of the company’s statements. Judge Barker found that plaintiffs’ arguments “are entirely conclusory and do not demonstrate with any particularity that any Individual Defendant had knowledge of product defects.” She concluded by noting that “attribution of scienter to Defendants, without particularized allegations indicating how or when Defendants came to possess information about product defaults, constitutes impermissible pleading of ‘fraud by hindsight’.”

Special thanks to a loyal reader for a copy of the Guidant opinion.

Pfizer: In an order dated February 28. 2008 (here), Judge Lewis Kaplan granted the defendants’ motion to dismiss the plaintiffs’ complaint in the consolidated securities class action lawsuit pending against Pfizer and certain of its current and former directors and officers. The complaint alleges that prior to the company’s December 2, 2006 announcement (here) that it was terminating its Phase III trials on torcetrapib, a developmental drug intended to reduce heart disease by raising “good” cholesterol, the company failed to disclose facts that lessened the likelihood that torcetrapib ultimately would prove safe and effective.

The plaintiffs allege that the misleading statements were designed to avoid Pfizer’s erosion of market share due to its impending loss of patent protection by principal Pfizer drugs, and in order to maximize the severance package for Henry McKinnell, the company’s then-Chairman and CEO. Further background regarding the case can be found here. A copy of the consolidated amended complaint can be found here.

In support of their allegations that the defendants’ statements about torcetrapib’s efficacy were misleading, the plaintiffs relied on a variety of sources (including as noted further below, an anonymous blog post). Judge Kaplan found that at most these statements support only an inference that the evidence available during the class period concerning torcetrapib’s efficacy was inconclusive – which the court found would not support an inference that the defendants’ statements were materially misleading. Judge Kaplan found that defendants were “entitled to take an optimistic view” and “need not present an overly gloomy or cautious picture” as long as the public statements “are consistent with reasonably available data.” Judge Kaplan further found that in any event “the conflicting evidence of torcetrapib’s efficacy were part of the total mix of information available to the marketplace.”

In attempting to establish that the defendants’ statements about torcetrapib were misleading, the plaintiffs also cited concerns about the blood pressure side-effects. Judge Kaplan found that the plaintiffs had failed to plead facts supporting the view that the defendants did not believe these side effects were manageable. Judge Kaplan said that “torcetrapib’s ultimate failure is not evidence that the side effects were thought to be unmanageable at the time the alleged miststaments were made. Fraud by hindsight is not sufficient to establish liability under Rule 10b-5.”

Judge Kaplan also found that plaintiffs had failed to establish scienter. The plaintiffs had argued that the defendants had a motive to mislead because Pfizer had a “desperate need to assure the financial community of the existence of a new blockbuster drug.” Judge Kaplan observed that “this is not a unique motive” and “it is a way of saying, in a manner tailored to a pharmaceutical company, something that is true for all profit enterprises – each has an incentive to portray the likelihood that it will continue to prosper.”

Judge Kaplan further noted that with respect to the alleged motive to maximize McKinnell’s severance package that “if scienter could be pleaded on that basis alone, virtually every company in the United States that experiences a downturn in stock prices could be forced to defend securities fraud actions.”

Judge Kaplan granted the motion to dismiss and denied the plaintiffs’ motion for leave to amend, but without prejudice to a renewed motion for leave to amend supported by a proposed amended complaint.

Hat tip to the Courthouse News Service (here) for a copy of the Pfizer decision.

Analysis: On the one hand, it is hard to generalize based only on two case dispositions. But on the other hand, these two high-profile cases in many ways embody the kinds of securities lawsuit allegations that life sciences companies all too frequently are required to confront. The fact is that publicly traded life sciences companies often face significant and unanticipated challenges, of both a regulatory and clinical nature, in the drug development process. And even drugs or devices that have been introduced into commercial distribution can experience unexpected adverse developments. Either kind of setbacks can trigger significant stock price declines.

Even though these kinds of obstacles are fundamental and arguably unavoidable parts of the business and regulatory environment for life sciences companies, all too often these reverses result in securities lawsuits, supported only by allegations that the reverses occurred and therefore company management must have known about the problems from which the reverses arose.

Each of the district court judges in these two cases implicitly recognized these considerations in their rejection of the “fraud by hindsight” allegations. In each case, the courts effectively said that it is not enough to state a claim under the federal securities laws to allege that problems arose and that the defendants must have known about the problems. The courts’ unwillingness to accept fraud by hindsight allegations is significant, as without this recognition, life sciences companies could face significant liability exposures based on the uncertainties and unpredictabilties inherent in their business.

However, because of the stock price volatility that inevitably follows these kinds of adverse developments, life sciences companies likely will continue to attract the unwanted attention of plaintiffs’ securities’ attorneys. The more interesting question is whether these kinds of lawsuits will succeed. The district courts’ recent decisions in the Guidant and Pfizer cases suggest that these kinds of cases may face substantial hurdles in order to survive a motion to dismiss.

A Blog Too Far: One of the interesting twists in the Pfizer lawsuit is the plaintiffs’ unsuccessful attempt to rely on the scribblings of an anonymous blogger to establish the alleged falsity of the defendants’ statements. Judge Kaplan found that “there is no reason to believe that the author of this blog, identified only as RADmanZulu, is likely to have known the relevant facts.” The plaintiffs contended that RADmanZulu was a former Pfizer vice president, but Judge Kaplan said that “the blog post, plaintiffs’ purported source, does not contain any information about RADmanZulu’s identity, and plaintiffs do not articulate any other basis for their belief.” (Some of RADmanZulu’s postings appear in the comments on this blog post, here.)

Moreover, with respect to the specific factual allegations drawn from the blog post, Judge Kaplan noted that “RADmanZulu’s allegation does not claim to be based on personal knowledge and lacks detail that might suggest personal knowledge.” Ultimately, in reaching his conclusion that the plaintiffs had “not pleaded with particular facts sufficient to support their allegation that defendants’ statements were materially misleading,” Judge Kaplan found that the plaintiffs’ factual allegations “are not based on an adequate source or are unsupported by the purported source.”

We here at The D & O Diary choose to believe that Judge Kaplan was not saying that RADmanZulu’s statements were inadequate merely because they appeared on a blog. Rather, it appears that Judge Kaplan found RADmanZulu’s factual allegations inadequate because they were anonymous and unsupported. That is why everyone here at The D & O Diary eschews anonymity and wherever possible tries to provide factual support for our statements.

Bloggers everywhere have a mutual interest in maintaining the credibility of the blogging medium, and while some bloggers will choose anonymity for their own purposes, overall blogging credibility depends on a fundamental sense of personal responsibility with which anonymity may be inconsistent. (We should also add that maintaining anonymity on the Internet is a lot less feasible than some Internet users may casually assume.)

Warren Buffett’s annual letter to Berkshire Hathaway shareholders has become a capitalist cult classic, eagerly awaited each year not only by Berkshire shareholders but also by a broader audience of readers keen to read Buffett’s observations about both his company and the larger business and economic environment. This year’s letter (here), issued after market close on February 29, 2008, does not disappoint, as it brims with commentary on a variety of matters, as well as about the performance of Berkshire itself. But to an unusual extent, this year’s letter may be as noteworthy for what it omits as for what it includes, as I discuss further below. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

Buffett’s letter is of course a part of the Berkshire 2007 annual report, and the letter does contain quite a few interesting nuggets about Berkshire. Even though Buffett seemingly goes out of his way to detail his past investing errors (particularly emphasizing his failed Dexter Shoes investment as well as his failure to buy a Dallas TV station), the overall effect is to reinforce Buffett’s astonishing investing success. For example, after documenting his lapses at length, he almost parenthetically mentions the company’s 2007 sale of its 1.3% interest in PetroChina, acquired during 2002 and 2003 for $488 million, for which Berkshire received $4 billion – a staggering 820% gain in approximately five years.

On the other hand, Buffett’s letter also emphasizes that although Berkshire’s insurance businesses had another “excellent year” in 2007 (producing underwriting profit of $3.37 billion, on top of $3.8 billion in 2006), it is “a certainty that insurance industry profit margins, including ours, will fall significantly in 2008.” Buffett’s bases for this conclusion are that “prices are down and exposures inexorably rise.” If natural catastrophes occur, “results could be far worse.” Buffett warns Berkshire’s shareholders “to be prepared for lower insurance earnings during the next few years.”

Buffett also provides a detailed explanation of Berkshire’s growing derivatives exposure. The existence of these contracts in Berkshire’s portfolio may strike some as contradictory, as Buffett has for years railed against derivatives as, among other things, “financial weapons of mass destruction” (as he called them in his 2002 shareholders’ letter). He has bemoaned for years the losses Berkshire sustained in winding down Gen Re Securities derivatives operation (on which Buffett reported in his 2006 letter that Berkshire had sustained a cumulative pre-tax loss of $409 million).

Buffett nevertheless reports in this year’s letter that Berkshire had entered a total of 94 derivative contracts (up from 62 in 2006), apparently in the form of credit default swaps and futures put options on four stock indices. (The stock indices put represents a bet that these indices will close at far-forward dates at levels above where they stood when Berkshire entered the contracts.) While Buffett’s willingness to enter these contracts seems surprising given his long-standing and often-expressed hostility to derivatives generally, he emphasizes that with respect to each of the contracts, Berkshire is holding the cash – which means not only that Berkshire has no counterparty risk, but also that Berkshire has the opportunity to earn investment income in the interim. It is also important to contrast Berkshire’s current portfolio of 94 derivative contracts with the 23,318 contracts that were formerly held by Gen Re Securities. 

Buffett does warn that the mark-to-market accounting required on the derivative contracts “will sometimes cause large swings in reported earnings.” Buffett compares this exposure to Berkshire’s catastrophe insurance exposure and Berkshire’s long-standing willingness to “trade volatility in reported earnings in the short run for greater gains in net worth in the long run.” I have more to say below about Buffett’s comparison between the derivatives portfolio and Berkshire’s catastrophe reinsurance business.

Buffett’s commentaries about Berkshire’s performance are interesting, but Buffett’s letters are valued for far more than their observations on Berkshire’s own performance. Most readers scour Buffett’s letters for his discourse on larger topics, and his most recent letter has much to offer in that regard. In this year’s letter, Buffett returns to some of his familiar themes and also launches into some new topics.

The first familiar theme Buffett sounds relates to problems in the residential mortgage sector. Buffett commented on this topic in last year’s letter, where he decried “weakened lending practices” and mortgage loan structures that subjected borrowers to potentially escalating repayment obligations. In this year’s letter, Buffett has a “told-you-so” tone when he references the “staggering problems” that “major financial institutions” have recently experienced. He comments that “our country is experiencing widespread pain” because of the “erroneous belief” that “house price appreciation” would “cure all problems.” Buffett notes that

As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide does out – and what we are witnessing at some of our largest financial institutions is an ugly sight.

Another recurring theme Buffett revisits in this year’s letter is the U.S. trade deficit and its impact on the dollar’s valuation. In last year’s letter, while reporting on Berkshire’s direct foreign exchange gains, he bemoaned the U.S.’s transformation into a net debtor country as a result of which the country is now shipping “tribute” overseas in the form of an interest income burden that finances what he called U.S. “over-consumption.” Buffett returns to this topic in this year’s letter, specifically commenting on how these circumstances have led to the emergence of sovereign wealth funds:

There has been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot of foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here.  Why should we complain when they choose stocks over bonds?

In last year’s letter, Buffett did note that Berkshire had “come close to eliminating our direct foreign exchange position,” on which Berkshire had earned roughly $2.2 billion between 2002 and 2006 in investments in 14 different currencies. In this year’s letter, Buffett notes that in 2007 Berkshire had only one direct currency position, in the Brazilian real. Buffett also noted that Berkshire had invested in bonds denominated in currencies other than dollars, citing as a specific example euro-denominated Amazon.com bonds Berkshire purchased in 2002 for $162 million, that were redeemed in 2007 for $253 million (having paid 6 7/8 % interest in the interim).

Yet, Buffett emphasizes, Berkshire’s assets “will always be concentrated in the U.S.,” citing as justification “America’s rule of law, market-responsive economic system, and belief in meritocracy,” which Buffett contends, “are almost certain to produce ever-growing prosperity for its citizens.”

One standard feature of Buffett’s annual letter is a penultimate portion in which he skewers some particular foible of the financial scene. Last year, Buffett targeted the “2-and-20 crowd” of hedge fund “helpers” whose fees enrich themselves at their clients’ expense. This year, in a section of the letter captioned “Fanciful Figures – How Public Companies Juice Earning,” Buffett targets “the investment return assumption a company uses in calculating pension expense.”

Buffett notes that the 2006 average assumed pension return among the 363 S & P companies that have pensions is 8%. Buffett compares this assumed 8% return to the 5.3% average annual increase in the Dow Jones average during the 20th century. In order for the Dow Jones average to continue to grow at just a continued 5.3% annual rate in the 21st century, the Dow Jones average would have to close at 2,000,000 on December 31, 2099. And the companies that are projecting a 10% return “are implicitly forecasting a level of about 24,000,000 on the Dow by 2100.” Buffett characterizes the “helpers” who make these kinds of assumptions as “direct descendants of the Queen in Alice in Wonderland” who has “believed as many as six impossible things before breakfast.”

The reason for these high investment return assumptions, Buffett notes, “is no puzzle,” as they allow CEOS to “report higher earnings,” securing the knowledge that “the chickens won’t come home to roost until long after they retire.”

Having disparaged corporate pension fund accounting, Buffett then moves on to “public pension promises” for which “funding is woefully inadequate.” The “fuse on this time bomb is long,” but the promises that politicians find so easy to make “will be anything but easy to keep.”

Buffett’s annual letter is always entertaining and informative, and this year’s letter is no exception. But it strikes me that there are omissions from this year’s letter, some of which seem to me to be particularly conspicuous.

First, Buffett’s letter makes absolutely no reference to the recent “finite reinsurance” criminal trial that resulted in guilty verdicts against four former Gen Re officials (as well as one former AIG officer). Buffett’s silence on this matter is at one level understandable, as his name did arise in trial testimony, and as news reports suggest (here) that the criminal investigation is continuing. But given the fact that the former CEO and former CFO of Berkshire’s largest subsidiary were found guilty of criminal wrongdoing, Buffett’s lack of any reference to the verdicts (even to say that he could not comment) seems like a significant omission.

Buffett did implicitly draw a seeming contrast between prior Gen Re management (the ones on trial) and current Gen Re management; Buffett said that current management is doing “first-class business in a first-class way” despite “costly and time consuming legacy problems.” Buffett also commented that he learned to his regret that when he acquired Gen Re in 1998, it was no longer the “Tiffany of reinsurers” as it had been previously. Buffett made similar comments in the 2001 and 2002 Berkshire annual reports. (Full disclosure: I was for ten years an employee of a Gen Re operating subsidiary, and for that reason I feel obliged to forebear from any further commentary on these circumstances.)

Second, other than commenting on the mortgage lending industry’s lamentable shortcomings, Buffett provides no further commentary on the subprime crisis. Other insurers reporting their earnings in recent weeks have felt compelled to address both their potential insurance loss exposure to subprime-related liabilities and their companies’ investment portfolio vulnerability to subprime investment losses. On the one hand, Buffett’s credibility is such that if Berkshire had significant exposure in these areas, we would all expect him to have said something about it. On the other hand, given the prominence of these issues, it does not seem too much to have expected him to address these issues, and, again, his failure to comment on these topics seems like an omission.

Third, and related to the topic of subprime, Buffett’s letter makes no reference to Berkshire’s recent high profile entry into the municipal bond insurance business, in the wake of turmoil involving the traditional monoline insurers. While we may perhaps look forward to reading about this development in next year’s letter, this initiative did unfold in late 2007, and I would have expected some commentary about it in this year’s letter, especially given the high profile nature of the move.

But while Buffett did not mention Berkshire’s move into municipal bond insurance, his commentary on the problems public pension funds may face does put Berkshire’s move into providing municipalities with default guarantee protection in an interesting perspective. As Floyd Norris of the New York Times observes on his blog, Notions on High and Low Finance (here), “Why, you might wonder, would Mr. Buffett want to put Berkshire Hathaway into the business of insuring municipal bonds issued by such governments?”

One final apparent omission from Buffett’s letter is that he does not mention Berkshire’s recent acquisition of 3% interest in Swiss Re, or Berkshire’s agreement to assume 20% of Swiss Re’s property and casualty reinsurance business for the next five years. (Refer here for background on these transactions.) On the one hand, the Swiss Re transactions represent 2008 business, and so I suppose we should just be patient and wait until next year’s letter to see what Buffett says about the transactions. But the particular reason that Buffett arguably ought to have discussed the Swiss Re transactions, and in particular the timing of the Swiss Re transactions, is his commentary in this year’s letter about the likely future prospects of the insurance industry. I agree with Buffett that we should all “be prepared for lower insurance earnings over the next few years.” Given these prospects, the timing of the Swiss Re transactions cries out for further explanation.

A Final Observation: Perhaps others might be unwilling to find any relation between the two companies’ respective positions, but I find Berkshire’s increased derivatives exposure somewhat disconcerting in light of AIG’s recent $11.2 billion mark-to-market derivatives portfolio write-down. It may also fairly be argued that Berkshire’s volatility exposure is much smaller than is AIG’s. But after years of Buffett’s lectures about the evils of derivatives, Berkshire’s growing derivatives exposure seem incongruous.

Questions may also be raised about the appropriateness of the analogy Buffett draws between Berkshire’s volatility exposure as a catastrophe reinsurer and the potential volatility from Berkshire’s growing derivatives portfolio. The Wall Street Journal’s March 1, 2008 Breaking Views column (here) put its finger precisely on the problem in its commentary on AIG’s write-down, by pointing out that logical shortcoming of insurers’ putative qualifications to assess and accept risk from these financial instruments:

Insurers say they are experts at managing just this sort of high-severity, low-probability risk. They argue that insuring against floods, hurricanes, and earthquakes has given them peerless expertise in managing it.

But since there’s no market in acts of nature, insuring against them can’t lead to massive mark-to-market write-downs, as financial exposures can. And there’s a big difference between acts of nature, which can be modeled statistically, and the behavior of complex structured-finance instruments packed with assets that have little historical performance data, which frequently confounds statisticians.

The Journal column ends with the observation that “AIG isn’t alone in falling for this false analogy.” 

To be sure, Buffett did not claim that Berkshire’s expertise in underwriting catastrophe reinsurance qualified the company to underwrite derivatives, only that Berkshire’s willingness to accept the volatile results of catastrophe reinsurance was comparable to its willingness to accept volatile impacts from its derivatives portfolio, in exchange for the long run net worth benefits.

In prior posts (most recently here), I have commented on the growing threat of follow-on shareholder litigation ensuing in the wake of Foreign Corrupt Practices Act (FCPA) enforcement actions. A lawsuit recently filed in the United States District Court for the Western District of Pennsylvania represents an entirely different kind of threat arising from allegations of foreign corrupt activities, in the form of a civil action brought directly against the alleged wrongdoer(s) by the alleged victims of the corrupt activity, without any preceding FCPA enforcement action.

On February 27, 2008, Aluminum Bahrain B.S.C. ("Alba") filed a lawsuit against Alcoa, an Alcoa affiliate, and two individuals, one of whom was an officer of an Alcoa affiliate. Alba (owned by an entity in which the Bahrain government has a 70% ownership interest), alleges that the defendants engaged in a 15-year conspiracy involving overcharging, fraud, and bribery of Bahraini officials. A copy of the complaint can be found here. Alba is in the aluminum smelting business, and it has depended since 1990 on Alcoa affiliates for its supply of alumina, a key ingredient in the production of aluminum.

The complaint alleges that beginning in 1993, over $2 billion in payments were funneled through companies (located in Singapore, Guernsey, Switzerland and elsewhere) owned or controlled by a Canadian businessman of Jordanian descent named Victor Dahdaleh, who is named as a defendant in the complaint. A portion of these payments were secretly directed to one or more (unnamed) Bahraini government officials as part of an alleged conspiracy to cause Alba to cede a substantial portion of its equity to Alcoa, to pay inflated prices for alumina, and to corrupt the integrity of senior Bahraini government officials.

A front-page February 28, 2008 Wall Street Journal article describing the complaint (here) states that the lawsuit emerged from Bahrain’s own effort "to root out misbehavior." The Journal also reports that last year Bahrain retained Kroll Associates, which "had uncovered cases of corruption in its state-owned enterprises, and numerous individuals had been arrested."

The FCPA prohibits corrupt payments to foreign officials, but, as pointed out in a post on The FCPA Blog (here) commenting on the Alba case, "there is no private right of action under the FCPA." So enforcement of the FCPA is exclusively the province of the Department of Justice and the SEC. But as the Department of Justice notes in its Lay Person’s Guide to the FCPA, "conduct that violates the antibribery provisions of the FCPA may also give rise to a private cause of action for treble damages under the Racketeer Influenced and Corrupt Organizations Act (RICO) or to actions under other federal or state laws." Alba’s complaint, in fact, seeks to recover damages from the defendants based on their alleged violations of RICO, conspiracy to violate RICO, and for fraud.

The Alba complaint underscores the civil liability exposure that may potentially arise from foreign corrupt practices. While I have previously emphasized the potential threat of lawsuit filed by shareholders against company management as a follow-on to government FCPA enforcement actions, the Alba lawsuit illustrates the threat of direct civil litigation based on foreign corrupt activity without any prior enforcement activity.

This kind of litigation may represent a significant corporate threat for companies engaged in business in countries whose cultures encourage or even seemingly compel this type of corrupt activity. This threat may also extend beyond the corporation and its corporate affiliates to individuals, as well. Only one of the individual defendants named in the Alba lawsuit appears to be an officer of an Alcoa affiliate, but the complaint does also specifically allege that Alcoa’s Chairman and CEO traveled to Bahrain in connection with Alcoa’s efforts to obtain an equity ownership position in Alba. The complaint alleges that this effort was corrupted by the bribery-induced intervention of a Bahraini government official.

Individual directors and offices who find themselves the target of corruption-based civil litigation may face challenges in securing insurance protection in connection with these allegations. Certainly, a determination of liability for the kinds of corrupt conduct alleged in the Alba complaint could run afoul of the typical D & O liability policy’s conduct exclusions. In addition, some D & O policies still retain a commissions and payments exclusions specifically calculated to preclude liability for improper payments. However, individual director or officer defendants could have a strong basis on which to argue that their defense expenses incurred in connection with this kind of litigation should be covered. They could even have a basis on which to try to argue that settlement amounts, in the absence of an actual finding of liability, ought to be covered.

With respect to the corporate entity defendants in these kinds of lawsuits, the picture is slightly different. The typical public company D & O policy provides entity coverage only for claims based on alleged violations of the securities laws. None of the allegations in the Alba complaint arise under the securities laws, so there would not appear to be coverage under the typical public company D & O policy, even for defense expense. Even were entity coverage to extend beyond securities claims (as is the case for many private company D & O policies), the conduct exclusions and any applicable commissions and payments exclusion would preclude coverage for damages imposed on the basis of an adjudication of liability

But in any event, given the increasing globalization of trade and the increasing significance being given to anticorruption efforts in many jurisdictions, the possibility exists for further civil litigation based on alleged corrupt activity, even in the absence of prior enforcement actions. This litigation threat represents another way in which corrupt activity exposure may possibly represent, as I recently wrote, the "next corporate scandal."

Now This:

According to Wikipedia (here), Bahrain is "slightly larger than the Isle of Man, though it is smaller than … King Fahd International Airport" in Saudi Arabia.

New York Subprime Lawsuit Between Two Foreign Banks: As I noted in prior posts (most recently here), mortgage-backed securities investors have already initiated several lawsuits against the investment banks and others that created the securities, some lawsuits filed as individual actions and some as class actions. A mortgage-backed securities investor’s individual lawsuit initiated this week in New York Supreme Court (Manhattan) presents some new twists on this evolving litigation category.

According to the company’s press release (here), on February 25, 2008, German state-owned bank HSH Nordbank AG sued UBS and UBS Securities LLC. The lawsuit relates to one of HSH’s constituent bank’s $500 million investment in 2002 in collateralized debt obligation (CDO) securities known as North Street 2002-4 that were created and managed by the Swiss bank. In its complaint, HSH described itself as a “regional German bank with little familiarity with international structured finance.” As described in a February 25, 2008 Wall Street Journal article (here), the HSH relation with UBS was “more complicated” because in addition to its investment in the CDO, HSH also provided UBS with insurance protection in the form of credit default swaps.  

As reflected in news coverage describing the complaint (here and here), HSH claims that UBS’s now-shuttered internal hedge fund division, Dillon Read Capital Management, selected inferior collateral and used the CDO as a dumping ground for troubled mortgage-backed securities as a way to profit from the credit default swap.

The complaint alleges that during 2007 Dillon Read made substitutions to the “reference pool” of securities linked to the CDO, bringing in securities lined to the ABX index of subprime mortgage instruments, thereby allegedly increasing the CDOs exposure to subprime mortgages “at a time when the outlook on subprime mortgages was already negative.”

HSHS claims that the structure, and in particular its position on the credit default swap, allowed UBS to realize profits of up to $275 million at HSH’s expense. As also reflected in the bank’s February 24 press release (here), HSH alleged that “UBS exploited the structure for its own ends, at HSH’s expense,” and that “UBS evidently regarded North Street 4 not as an investment platform but as an opportunity to defraud HSH.”

HSH alleges that UBS “knowingly and deliberately created a compromised structure.” HSH accuses UBS of breach of contract, fraud, negligent misrepresentation, and breach of fiduciary duty.” HSH is demanding at least $275 million in restitution plus punitive damages.

There are several interesting things about this new lawsuit. The first is that it involved a New York state court lawsuit between two foreign-domiciled companies. This may be due in part to the role played by the now defunct UBS affiliate Dillon Read. But an even likelier explanation is the prospect of the remedies available under U.S. laws, which undoubtedly influenced HSH to pursue its claims in what would otherwise seem to be an inconvenient forum. It is, in any event, singular to find two foreign companies squaring off in a U.S courthouse.

The availability of alternative dispute resolution forums in which the case might also have gone forward may be seen from the fact that UBS itself has already filed a counterclaim against HSH, but (as reflected here), in London rather than in New York. According to news reports, the counterclaim itself has not been made available publicly.

Perhaps the most interesting thing about the HSH lawsuit is the core allegation. The prior lawsuits against the securitizers have essentially been disclosure-based lawsuits, in effect that the securitizers did not provide full or accurate information about the securities they initiated or about the assets underlying the securities. HSH’s complaint also contains these kinds of allegations, but the core of its complaint is not mere misrepresentation, but rather that UBS fraudulently manipulated the transaction structure to its own profit and to the investors’ detriment. These kinds of allegations clearly raise the stakes, and make this case most interesting to watch.

Finally, this is the first subprime-related case of which I am aware between counterparties on credit default swaps. Given the massive volume of credit default swap activity, there is an enormous potential for credit default swap counterparty litigation.

More Auction Rate Securities Write-Downs: In a prior post (here), I discussed the $275 million write-down that Bristol-Myers Squibb took related to its investment in auction rate securities. At the time, I wondered whether other companies would face similar write-downs, with particular interest in the possible impact on companies outside the financial sector.

At least two other nonfinancial companies have now taken their own subprime-backed asset write-downs, in examples that underscore that impact that the breakdown of the auction rate securities market is having on the value of those securities. These write-downs also highlight the fact that the impact of the subprime meltdown extends far beyond the financial sector.

On February 27, 2008, MetroPCS announced (here) in connection with its fourth quarter earnings release that it had recorded a fourth quarter charge of $83 million in unrealized loss on its $134 investment in auction rate securities. Including the company’s $15 million third-quarter write-down, the year-end value of its $134 investment was at $36 million. As I discussed in a prior post (here), MetroPCS has filed a lawsuit against Merrill Lynch in connection with the company’s investment in the auction rate securities. A copy of the complaint can be found here. It is worth noting that company’s reported fourth quarter loss of $47 million included the $83 million impairment charge.

And on February 21, 2008, SBA Communications reported (here) an impairment charge of $15.6 million on three auction rate securities the company held as short term investments. The company’s net loss for the quarter was $24.2 million including the asset impairment charge.

A February 27, 2007 CFO.com article discussing the MetroPCS write-down can be found here. A February 22, 2008 CFO.com article discussing the SBA Communications write-down can be found here.

Got Those Valuation Blues Again, Mama: A February 24, 2008 post on the Re:Balance blog (here) takes a look at the accounting and valuation issues arising out of the subprime crisis, and suggests that the mortgage asset-backed securities valuation problems that are currently emerging are not merely an attribute of the current disrupted market conditions but were inherent in the terms of the instruments at the time they were created.

Jim Peterson, the blog’s author, writes “the more candor and rigor are brought into this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality.” Peterson, who is the accounting columnist for the International Herald Tribune, adds that “the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable as a mirror held up to commercial society.”

On February 27, 2007, plaintiffs’ lawyers’ initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Swiss Reinsurance Company, the world’s largest reinsurance company, and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

The lawsuit relates to the company’s November 19, 2007 announcement (here) of a 1.2 billion Swiss Franc mark-to-market loss on the two related credit default swaps the company had issued to provide loss protection against certain asset backed securities.

According to the plaintiffs’ attorneys’ press release,

The complaint alleges that during the Class Period, defendants made false and misleading statements about the Company’s financial condition. Specifically, defendants failed to disclose that Swiss Re’s Credit Solutions unit had written two credit default swaps that exposed the Company to great financial risk. In a credit default swap, one party guarantees that a third party borrower will not default on a debt. In this case, Swiss Re guaranteed certain mortgage-backed securities which included some subprime and collateralized debt obligations. When the existence and nature of the credit default swaps was disclosed, Swiss Re’s stock price dropped from CHF97.55 to CHF87.55 (Swiss Francs) the next day.

The complaint particularly emphasizes that the November 19 announcement came just days after the company’s November 6, 2007 third quarter earnings release (here), which did not mention the credit default swap write-off but contained certain representations about the company’s exposure to subprime issues.

There are several interesting things about this lawsuit. While this is not the first lawsuit filed against companies that provided default guarantee protection to subprime securities, the prior companies to be sued in this regard have been the bond insurers whose primary business is providing default protection. As far as I know, the Swiss Re lawsuit is the first lawsuit against a company specifically linked to the issuance of credit default swaps guaranteeing against the default of subprime-related securities. There have been other companies that have announced accounting write-downs in connection with credit default swaps (see, for example, AIG’s recent announcement here), and there undoubtedly will be others – just as there undoubtedly will be other lawsuits in relating to credit default swaps issued on mortgage-backed assets.

The second interesting thing about this suit is who the plaintiff is – the plaintiff is the Plumbers’ Union Local No. 12 Pension Fund, on whose behalf the same law firm (Coughlin Stoia) previously filed a securities class action lawsuit against Nomura Asset Acceptance Corporation and related entities, as discussed in my recent post here. This union fund certainly does seem to have had some remarkably bad luck with its investments as a result of the subprime meltdown. It also seems to have a durable client-attorney relationship with the Coughlin Stoia firm.

The third interesting thing about this lawsuit is that it comes more than three months after Swiss Re’s November 19 announcement. Up to this point, the subprime related lawsuits have followed pretty closely in the wake of disclosure of subprime related accounting adjustments. The delay in filing this lawsuit suggests that the "moping up" exercise may have begun – that is, the process of going back and combing over the prospective claims that might have been missed the first time through. There certainly have been a host of companies who have made fairly significant announcements over the last few months who have not yet been sued. Their date may yet be coming.

It is interesting in another respect that this lawsuit has arisen now. The company got a boost even after write down when on January 23, 2008 it announced (here) that Berkshire Hathaway had taken a 3% interest in the company and would be taking 20% of the company’s property and casualty reinsurance business over the next five years. This seeming validation from the sage of Omaha may not have been enough to mollify at least some investors, apparently.

I have in any event added the Swiss Re case to my running tally of the subprime-related securities lawsuits, which can be found here. The addition of the Swiss Re case brings the total count of subprime securities lawsuits to 47, eight of which have been filed in 2008. As I noted above, the Swiss Re case is to the best of my knowledge the first subprime related lawsuit based on the loss in value of credit default swaps; it seems prudent to assume at this point that there will be more to come.

Everyone Remain Calm: The subprime crisis not only threatens financial losses, it apparently could also hazard a massive loss of life. According to a February 26, 2008 Financial Times article entitled "Banking Crises Shown to Trigger Heart Attack Deaths" (here), between 1,300 and 5,100 people could die if "a significant proportion of banks suffered crises similar to that at North Rock.

Cambridge University researchers studied 40 years of data from the World Bank and the World Health Organizations, and concluded that "system-wide" crises increase average deaths from heart disease an average of 6.4 percent in wealthy countries – and more in developing countries. Researchers warn that a global banking crisis "would kill tens of thousands of people by heart attacks brought on by stress and anxiety." One of the researchers noted that "containing hysteria and preventing widespread panic is important not only to stop these incidents leading to a systemic banking crisis but also to prevent thousands of heart disease deaths."

More About Subprime: Just a reminder that Mealey’s is sponsoring a Subprime-Backed Securities Litigation Conference on March 6, 2008 at the Harvard Club in New York City. The conference is to be chaired by David Grais of the Grais & Ellsworth firm. I will be speaking on the topic of "CDOs, Asset Valuation and the Subprime Litigation So Far." A copy of the conference brochure can be found here.

On February 20, 2008, the United States Supreme Court issued a unanimous holding (here) in LaRue v. DeWolff, Boberg & Associates that ERISA authorizes individual defined contribution plan participants to sue for fiduciary breaches that impair the value of plan assets in the individual’s plan account. This holding could have important implications for future ERISA litigation activity, and the individuals’ claims potentially could present significant insurance coverage issues.

James LaRue is a former employee of DeWolff, Boberg & Associates. He participated in DeWolff’s 401(k) plan. He claims that in 2001 and 2002 he directed DeWolff to “make certain changes to the investments in his individual account” but that DeWolff never made the changes and that this omission “depleted” his interest in the plan by $150,000.

LaRue sued the DeWolff firm and the DeWolff 401(k) plan seeking “make whole” or other equitable relief under Section 502(a)(3) of ERISA, codified as 29 U.S.C. Section 1132(a)(3). (Section 502, which is referred to throughout this post, can be accessed here.)

The district court dismissed LaRue’s complaint on the grounds that LaRue sought money damages, which are not permitted under Section 502(a)(3).

LaRue appealed to the Fourth Circuit, in reliance on both Section 502(a)(2) and 502(a)(3). The Fourth Circuit affirmed the Section 502(a)(3) dismissal on the same grounds as the district court. The Fourth Circuit rejected LaRue’s Section 502(a)(2) claim on the ground that the Supreme Court’s 1985 opinion in Massachusetts Life Ins.Co. v. Russell permitted Section 502(a)(2) claims only on behalf of the entire plan rather than on behalf of any one participant’s individual interest. LaRue sought and obtained a writ of certiorari to the United States Supreme Court.

Associate Justice John Paul Stevens wrote the majority opinion for the court. (There were two concurring opinions, one by Chief Justice Roberts, in which Justice Kennedy joined, and one by Justice Thomas, in which Justice Scalia joined). The majority opinion held that an individual plan participant does have the right to pursue an individual action, notwithstanding the court’s prior holding the Russell case (the majority opinion for which Justice Stevens also wrote). The majority opinion’s analysis turns on the view that, by contrast to the era when ERISA was first enacted and defined benefit plans predominated, “defined contribution plans dominate the retirement scene today.”

The circumstances for an individual participant in a defined benefit plan, Justice Stevens wrote, are quite different than under a defined contribution plan because misconduct relating to a defined benefit plan would not affect any one individual’s plan interest unless the misconduct caused a default of the defined benefit plan itself. Justice Stevens wrote that:

For defined contribution plans, however, fiduciary misconduct need not threaten the solvency of the entire plan to reduce benefits below the amount that participants would otherwise receive. Whether a fiduciary breach diminishes plan assets payable to all participants and beneficiaries, or only to persons tied to particular individual accounts, it creates the kind of harms that concerned the draftsmen of [ERISA’s liability provisions]. Consequently, our references to the “entire plan” in Russell…are beside the point in the defined contribution context.

Accordingly, the court held that Section 502(a)(2) “does authorize recovery for fiduciary breaches that impair the value of plan assets in a participant’s individual account.” The court vacated the Fourth Circuit’s judgment and remanded the case for further proceedings.

Press coverage of the LaRue case has suggested ( for example, here) that the decision may trigger “a raft of lawsuits by employees, particularly as stock market volatility once again is causing havoc with investment accounts.” It may well be that the LaRue decision will lead to a wave of new employee driven litigation. However, employees considering a lawsuit like LaRue’s should consider several things about the Supreme Court’s opinion.

The first is that the only thing LaRue has won is the right to continue his fight. He must now go back to the trial court to substantiate his claim. Justice Stevens specifically noted that “we do not decide whether petitioner made the alleged declarations in accordance with the requirements specified in the plan.”

An additional consideration is that LaRue will still have to overcome potentially significant defenses. For example, Justice Stevens also noted that the court did not decide whether LaRue is “required to exhaust remedies set forth in the Plan before seeking relief in federal court pursuant to Section 502(a)(2).” (Justice Roberts’ concurring opinion has extensive, technical discussion of the “exhaustion of administrative remedies” issue; suffice it to say here that the applicability of the exhaustion requirement is at best unresolved.)

Justice Stevens also said that the court did not resolve the question whether LaRue “asserted his rights in a timely fashion.”

In other words, even though LaRue’s has survived to fight another day, on remand he will face both potentially formidable defenses and daunting evidentiary challenges. Just because an individual may now have the right to pursue an individual claim for 401(k) losses does not mean that the individual has a great claim. Portfolio.com has a more detailed discussion of these issues here, stating among other things that “a ruling that should have been a comfort for the workingman is now a cause of concern.”

But assuming for the sake of argument that the LaRue decision will indeed result in a flood of litigation, these potential claims present a daunting prospect for company 401(k) plan sponsors. The possibility of many small, potentially vexatious individual claims arising out of the company’s defined contribution plan is an unwelcome development.

The prospect of a flood of claims also immediately presents questions about the availability of insurance protection for the claims. I have already had discussions with persons in the insurance industry about how the typical fiduciary liability policy might respond to this type of claim. These discussions have been preliminary only, but one question that has arisen is whether these individual 401(k) claims would trigger the “benefits due” exclusion found in the typical fiduciary liability policy.

While the various carriers’ policies vary, a fairly typical “benefits due” exclusion provides that the carrier “shall not be liable for that part of Loss, other than Defense Costs” that

constitutes benefits due or to become due under the terms of a Benefit Program unless, and to the extent that, (i) the Insured is a natural person and the benefits are payable by such Insured  as a personal obligation, and (ii) recovery of the benefits is based on a covered Wrongful Act.

There are several important considerations presented in this language, but a preliminary (and perhaps preclusive) consideration is whether the “benefits due” exclusion would even apply to the kind of claim LaRue asserted. This preliminary consideration turns on a critical distinction about LaRue’s claim. That is, his claims for breach of fiduciary duty were based on Section 502(a)(2), and he did not assert claims for “benefits due” under Section 502(a)(1)(B). Indeed, in his concurring opinion, Chief Justice Roberts made much of this distinction, and in fact argues that LaRue should have filed his claim as a benefits due claim under 502(a)(1)(B) – which would more clearly have required exhaustion of administrative remedies – rather than as a claim for breach of fiduciary duty under 502(a)(2). A subtle statutory distinction perhaps, but it strongly suggests that the “benefits due” exclusion is irrelevant to an individual’s breach of fiduciary duty claim under Section 502(a)(2).

(For regular practitioners in this area, the foregoing distinction may be obvious, but as I am only an occasional  visitor to this area of the law, the establishment of these critical distinctions requires conscious effort on my part)

Even assuming that the exclusion would be triggered, there are also several additional considerations that would determine how the exclusion would be applied. The first is that the exclusion does not in any event apply to defense expenses. This defense cost carve out from the exclusion could be very significant for companies confronted with a wave of individual employee 401(k) lawsuits. A host of small cases could become very expensive to defend.

The second point about the exclusion is that the exclusion’s coverage carve back at least preserves coverage for natural person insureds with a “personal obligation” to pay benefits due. (ERISA Section 409(a), the statute’s liability provision, specifies that plan fiduciaries are “personally liable”). Natural person fiduciaries are sometimes named as defendants in ERISA lawsuits, but it is noteworthy that LaRue at least named no natural person defendants in his lawsuit. If there were both natural person and entity defendants, and if this exclusion is otherwise triggered, there could potentially be difficult allocation issues for indemnity amounts.

One final note about the insurance issues is that most 401(k) plans are administered by third-party service providers. Plan fiduciaries of course retain their fiduciary responsibilities even if the plan retains a third party administrator, but to the extent insurers foot a loss, they might well seek to subrogate against the third party administrators.

The LaRue decision is still very fresh and reactions are still emerging. One issue that will be particularly interesting to watch, if the predicted flood of individual claims does indeed arise, is whether insurers will respond either through altered terms and conditions (such as requiring increased per claim self-insured retentions as a barrier to low level defense expense) or through changed pricing structures. Dramatic changes seem unlikely in the current environment, but if there really is a flood of claim, insurers may well react.

A particularly good, albeit technical, analysis of the LaRue decision can be found on the Workplace Prof Blog (here). An interesting analysis of the differences between and among the majority and the two concurring opinions can be found on the Boston ERISA & Insurance Litigation Blog (here).

In prior posts (here and here), I noted two subprime securities lawsuit rulings in which defendants’ motions to dismiss were granted with leave to amend. But in a January 4, 2008 order (here) in the Accredited Home subprime-related securities lawsuit pending in the United States District Court for the Central District of California, the defendants’ motions to dismiss were largely denied, except with respect to certain of the outside director defendants’ dismissal motions.

The lead plaintiff in the case is the Arkansas Teacher Retirement System. The corrected consolidated class action complaint can be found here. Background regarding the case can be found here. The complaint names as defendants the company, a subprime-mortgage lender; its mortgage REIT subsidiary; five individuals who served as executives at the company or the REIT; and five individuals who had served as outside directors on the company’s board.

The complaint contains three basic sets of alleged misrepresentations: first, that the company maintained certain loan underwriting standards, when, it is alleged, the standards were in fact lax and were even undermined by the individual defendants; second, that the company maintained adequate reserves and allowances, when, it is alleged, that its reserves in fact did not adequately take into account the deterioration of the company’s mortgage loan portfolio and were even reduced as the portfolio deteriorated, resulting in an overstatement of the company’s earnings; and three, that the company misleadingly accounted for goodwill in connection with its May 2006 acquisition of Ames Investment Corp.

The plaintiffs asserted claims under Section 10 of the ’34 Act (and Rule 10b-5 thereunder); Section 14 of the ’34 Act (and Rule 14a-9 thereunder); and Sections 11, 12 and 15 of the ’33 Act.

In ruling on the motions to dismiss, Judge Marilyn Huff separately assessed the allegations against the various defendants. Judge Huff found that the complaint’s allegations as to the company and the five officer defendants adequately pled that the alleged misrepresentations were false and misleading. In making this finding, the court relied on the “group pleading doctrine,” which the court found properly applied to the officers since the individuals had “direct involvement with the company’s day-to-day affairs and financial statements.”

But Judge Huff declined to extend this finding to the outside directors or to the REIT. Judge Huff said that the complaint “fails to establish any basis for attributing statements” to these defendants. Accordingly, Judge Huff granted the motion to dismiss the Section 10 claims against the outside directors and the REIT.

Judge Huff also found that the complaint adequately pled scienter as to the five officer defendants and the company. She cited the complaint’s allegations that these individuals had “access to periodic reports that included detailed information regarding widespread deviations from company policy” and the allegations from several confidential witnesses that the defendants “actually directed these deviations.” Judge Huff also cited the allegations that the defendants “caused or permitted large decreases in several significant reserve accounts” in violation of GAAP while at the same time aware of the mortgage portfolio’s deterioration.

Judge Huff also found that the plaintiffs had adequately pled materiality, reliance and loss causation. Judge Huff denied the motions to dismiss the Section 14 claim, largely on the same grounds as with respect to the Section 10 claim, although once again she separated out the outside director defendants and granted their Section 14 dismissal motions. She denied the motion to dismiss the ’33 Act claims as well, although she again separated out the outside directors and granted their motion to dismiss the section 12 claims against them .

Special thanks to an alert reader, who felt that if I were going to write about the dismissals granted, I also had to write about the Accredited Home dismissal denial, to which he referred me.

Motion to Dismiss Denied in Comverse Options Backdating Securities Lawsuit: On February 19, 2008, Judge Nicholas Garaufis entered an order (here) denying the defendants’ motions to dismiss the Consolidated Amended Complaint (here) in the Comverse Technology options backdating securities lawsuit. Refer here for background regarding the case.

The motions actually came in the form of an appeal from the prior report and recommendation of Magistrate Judge Ramon Reyes, to whom the court had referred the case.

Significantly, Judge Garaufis reversed the Magistrate Judge’s recommendations in one significant respect. The Magistrate Judge had recommended dismissal of the Section 10(b) claims against the three outside director defendants who had served on the board’s audit and compensation committees. The court found that the three individuals’ “knowledge and experience” coupled with “red flags” evident in the board consent forms, made it “at least as plausible” that the three “were aware of, but ignored a strong likelihood of wrongdoing when the signed the unanimous consent forms.”

The court affirmed the Magistrate Judge’s recommendations in all other material respects.

The plaintiffs’ lawyers’ press release describing the dismissal order can be found here.

I have added the Comverse Technology order to my list of options backdating lawsuit dismissals, denials and settlements, which can be accessed here.

Doomsday estimates of subprime related write-downs of as much as $400 billion, at a time when current Wall Street losses are “only” around $120 billion, beg the question of where the rest of these losses are. Undoubtedly, some part of these as yet unannounced losses will be revealed in many financial institutions’ upcoming earnings releases, as discussed in the February 19, 2008 New York Times article entitled “Wall St. Banks Confront a String of Write-Downs” (here).

But Wall Street woes alone do not encompass the universe of potential losses. As discussed in the February 11, 2008 Financial Times article entitled “The $280bn Question: Where are the Rest of the Subprime Bodies?,” (here), the question that “everyone is trying to work out is where the rest of the bodies are.” The Financial Times article notes that:

Outside Wall Street, suspicions are rife that other institutions are still concealing losses…In particular, there is now rising concern about so-called “buyside” institutions, or entities that have been purchasing mortgage-linked securities in recent years, rather than selling them on. “The problems are moving from the sellside to the buyside – that is where the losses are still to be recognized,” one structured finance expert told a conference in London last week.

There have been some buyside disclosures, the most prominent of which at this point is Bristol-Myers Squibb’s recent $275 write-down of auction rate securities (about which I previously commented here). Whether and to what extent these kinds of write-downs will spread to other nonfinancial companies remains to be seen.

The observers monitoring these developments apparently include plaintiffs’ securities attorneys. A February 19, 2008 Reuters article entitled “Subprime Lawsuits Seen Hitting More Industries” (here) reports that plaintiffs’ attorneys expect that investors lawsuits “likely will spread beyond the financial and housing sectors, as more companies reveal write-downs linked to bad mortgage investments.” The article quotes Salvatore Graziano of the Bernstein Litowitz law firm as saying that “we expect non-real estate companies to start being impacted by this.” He added that his firm has “already gotten a number of inquiries from clients” who are suffering losses from investments they thought were very safe.”

Graziano specifically mentioned the Bristol Myers write-down, commenting that shareholders could potentially bring legal claims against companies that take these kinds of write-downs if the assets were not previously properly valued. He added that “what Bristol-Myers did puts a lot of pressure on the auditors for other companies. That’s why I expect a lot more in coming quarters.”

Graziano also mentions AIG’s recent announcement of potential losses of up to $5 billion in its derivatives portfolio. “I think AIG, without reaching an ultimate conclusion, is a case we’re interested in looking at further.”

More About Auction Rate Securities: In a recent post (here), I discussed the possibility of claims arising from problems connected with auction rate securities. A separate February 19, 2008 Reuters article entitled “Marketing of Auction Rate Securities May Bring Lawsuits” (here) notes that “banks and brokers could face a wave of lawsuits from clients who claim they were not properly told about risks in the now nearly frozen auction rate securities market.” The article quotes Graziano as saying that he has heard “concerns from institutional investors that funds invested in auction rate securities carried an inappropriate level of risk for the kinds of investments they authorized brokers to make.”

Along those same lines, on February 15, 2008, the Miami law firm of Diamond, Kaplan & Rothstein announced (here) that it is “investigating claims involving investment losses in auction rate securities.” The press release specifically mentions broker-dealers that sold auction rate securities, including Lehman Brothers, Goldman Sachs, Merrill Lynch, Citigroup and UBS.

And Then There are the Rating Agencies: One of the recurring themes arising in discussions about subprime issues is the question of the potential liability of the rating agencies (which I discussed most recently here). Jim Peterson at the Re:Balance blog has an interesting discussion (here) of the issues surrounding the rating agencies involvement in the subprime meltdown. Peterson takes the position that the credit rating agencies may not be able to “dodge the bullet” this time. (Peterson is a financial and accounting columnist for the International Herald Tribune.)

Speaker’s Corner: Readers interested in subprime related issues will want to know about two upcoming conferences on the subject. First, IQPC is holding a conference entitled “Subprime and the Credit Crisis” on February 26-27, 2008, in New York City. (agenda here). I will be moderating a panel entitled “Exploring Potential D & O Insurers’ Liability.”

And on March 6, 2008, Mealey’s is sponsoring an event in New York entitled “Subprime-Backed Securities Litigation Conference,” the agenda for which can be found here. I will be speaking on the topic of “CDOs, Asset Valuation and Subprime Litigation So Far.”

The subprime meltdown has already provoked a wave of shareholder lawsuits (as detailed here), in which public company shareholders have alleged subprime-related misrepresentations or omissions that shareholders contend inflated the companies’ share price. But the plaintiffs in an unusual class action securities lawsuit recently filed in Massachusetts state court are not public company shareholders but rather mortgage-backed securities investors who have sued the securitizers who created, issued and underwrote the securities.

In a complaint filed on January 31, 2008 in Suffolk County Mass. Superior Court (here), the Plumbers’ Union Local No. 12 Pension Fund has brought a lawsuit under Section 11, Section 12 and Section 15 of the Securities Act of 1933. The Fund has brought the lawsuit on behalf of itself and the class of investors who purchased mortgage-pass through certificates in connection with Nomura Asset Acceptance Corporation’s July 29, 2005 and April 24, 2006 issuance of hundreds of millions of dollars of the certificates. The defendants in the lawsuit include Nomura Asset and certain of its directors and officers; the eight Delaware trusts in which the underlying mortgage assets were held; and the six investment banks that underwrite the offerings, including Nomura Securities, Goldman Sachs, Merrill Lynch and Citigroup.

The plaintiff alleges that the Registration Statements and Prospectuses issued in connection with the offerings contain false and misleading statements concerning the underwriting standards that would apply to the mortgages to be included; the borrower qualifications to be applied; and the collateral requirements and appraisal standards. The complaint alleges that the actual lending and other practices fell far below the standards described in the Registration Statement, and as a result the assets in the pool “had a much greater risk profile than represented in the Registration Statement.”

The complaint alleges that beginning in the summer of 2007, “the truth about the performance of the mortgage loans that secured the certificates began to be revealed.” The delinquency rates of the underlying mortgages “have skyrocketed.” Several classes of the certificates were downgraded in July 2007 and again in December 2007. The complaint alleges that as a result of the underlying assets’ deteriorating performance, the certificate investors “should receive less absolute cash flow in the future and will not receive it on a timely basis.” In addition, the complaint alleges that the certificates “are no longer marketable at prices anywhere near the price paid” and the investors are “exposed to much more risk with respect to both the timing and absolute cash flow to be received than the Registration Statement …represented.”

There have been prior subprime-related cases brought by mortgage-backed securities investors against the financial institutions that packaged and sold the mortgage instruments. Probably the most prominent example is the case of Bankers Life Insurance Company v. Credit Suisse First Boston, et al., pending in the United States District Court for the Middle District of Florida (amended complaint here). In that case, Bankers Life also alleges misrepresentations in connection with the issuance of certain mortgage-backed pass through certificates. But the Bankers Life case is an individual action, not a class action. In addition, the Bankers Life case does not allege violations of the federal securities laws. Bankers Life alleges negligent misrepresentation, common law fraud, breach of contract, and breach of fiduciary duty, among other things.

UPDATE: An alert reader who prefers anonymity points out another action by a mortgage-backed asset investor against securitizers is the Luminent Mortgage Capital v. Merrll Lynch case pending in the Eastern District of Pennsylvania (complaint here). Luminent alleges that the defendants misled investors concerning certain mortgage loan asset-backed certificates they offered and sold to Luminent. Luminent asserts claims under Section 10(b) of the ’34 Act, Section 12 of the ’33 Act and state law claims of fraud, misrepresentation, negligence, breach of contract and rescission.

So far as I know, the Nomura Asset case is the first class action and the first federal securities case in connection with the current subprime meltdown where mortgage-backed asset investors have sued the mortgage securitizers. (There may well be other federal securities class actions, about which readers are encouraged to let me know .)

UPDATE: Obviously, the Luminent case refered to in the update above asserts claims under the federal securities laws. In addition, an alert reader has brought to my attention another federal securities law class action, captioned as Luther v. Countrywide Home Loans Servicing, originally filed in Los Angeles Ca. County Superior Court, later removed to federal court. The federal court case is now pending in the Central District of California under Civil No. 07-8165. The removal issues are discussed further below. In the Luther case, as in the Nomura Assets case, the plaintiff asserts claims that the defendants omitted material information about the mortgage pass through certificates they sold. The plaintiffs assert claims on behalf of themselves and the class of other certificate purchasers under Sections 11, 12 and 15 of the ’33 Act. Because of the similarities between the Luther case and the Nomura case, the issues surrounding the Luther case are highly relevant to the issues discussed below regarding the Nomura caqse.

The lawsuit is unusual in another respect, which is that it is a federal securities class action lawsuit brought in state court.

The filing of the federal class action lawsuit in state court cannot be written off as the misguided action of some backwater law firm. The plaintiffs’ firms on the complaint include the Coughlin Stoia firm and the Shapiro Haber & Umry firm. I think the only fair assumption is that these lawyers made a deliberate and informed decision to file this case in state court. Which of course begs the question: why?

It is late here at blog central, and there aren’t many people around at this hour with whom I can discuss this question. So I am left to my own meager speculation, which I have set out below. My speculation probably reveals little except my own ignorance of the securities laws. But these are the only reasons I can come up with to explain why this case was filed in state court.

Presumably, the plaintiff intends to rely on the concurrent state court jurisdiction provision in Section 22(a) of the ’33 Act. Whether or not this case is removable to federal court under the Securities Litigation Uniform Standards Act (SLUSA) also seems to be addressed in Section 22(a), which provides that other than with respect to “covered class action” under SLUSA, “no case arising under this title brought in any state court of competent jurisdiction shall be removed to any court of the United States.”

The jurisdictional argument thus turns on whether this is a “covered class action” under SLUSA. The language of SLUSA, codified in Section 16(b) of the ’33 Act, defines a “covered class action” as one “based upon the statutory or common law of any State or subdivision thereof” containing specified allegations in connection with the purchase or sale of a security. The plaintiff will undoubtedly argue that the claims in this case are brought only under federal law, not under the “statutory or common law of any State” and therefore SLUSA does not apply, and the case can therefore remain in state court under the ’33 Act’s concurrent state court jurisdiction.

But even if I am right about this jurisdictional argument (and I will be the first to concede that my jurisdictional analysis could be 100% wrong), that still does not answer the question why the plaintiffs would choose to avail themselves of the state court jurisdiction in the first place, even if it is an available jurisdiction. The best guess I have is that the plaintiffs may intend to argue, under the provisions of the Private Securities Litigation Reform Act (PSLRA) codified into Section 27(a)(1) of the ’33 Act, that the PSLRA applies only to private actions “brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure.” The plaintiff’s argument may be that because the case was not brought pursuant to the Federal Rules of Civil Procedure, the various provisions of the PSLRA do not apply – for example, the discovery stay or the lead plaintiff provisions. In other words, the plaintiff is proceeding in state court to try to circumvent the hurdles and obstacles of the PSLRA.

An alternative theory is that the plaintiff filed the action in state court to try to circumvent the Supreme Court’s recent holding in the Stoneridge case (about which refer here). But the plaintiff’s claims against the offering underwriters are not based on scheme liability or aiding and abetting theories. The plaintiff is asserting that the various defendants each violated their respective primary duties under the ’33 Act. So it does not appear that the state court filing is an attempt to get around Stoneridge.  

My speculative analysis might be completely wrong. But there has to be some reason why these experienced plaintiffs’ attorneys filed this suit in state court. I have tried to come up with the most plausible theory I could thing of. I welcome readers’ thoughts and commentary, particularly any alternative theories as to why this lawsuit was brought in state court.

UPDATE: As mentioned above, the Luther v. Countrywide Homes case is also a federal securities law action that was filed in state court. Defendants removed the case to federal court and the plaintiffs have moved to remand the case back to state court. The memorandum in support of the plaintiffs’ remand motion can be found here. The plaintiffs argue that the sole basis on which defendants sought to remove the case is the Class Action Fairness Act of 2005, not SLUSA as I had speculated. The plaintiffs argue that Section 22(a) affirnatively forbids the removal of state court ’33 Act cases to federal court and that CAFA did not change that and does not apply to ’33 Act cases. The remand petition will be argued on February 25, 2008.

In any event, it has seemed likely it was only a matter of time before mortgage-backed securities investors pursued federal securities class action lawsuits against the financial institutions that were involved in packaging the subprime mortgages into investment securities. The Nomura Asset case, even though brought in state court, may well portend a whole new category of subprime-related securities litigation. UPDATE: With the added reference to the Luther case, the conclusion that there may be a whole new category of securities cases seems even stronger.

This case poses one other problem for me, which is whether or not to include it in my running tally of subprime related securities lawsuits (which can be found here). While I have faced other definitional issues in maintaining the tally, the one issue that all of the cases have in common is that they were all brought against public companies by the public companies’ shareholders. This case obviously represents something different. Nevertheless, because it is a subprime-related securities lawsuit, I have decided to include in the running tally. Even if I did not forsee all of the kinds of securities litigation that would arise in connection with the subprime meltdown, I did undertake to capture all of the subprime-related securities litigation. So I have added it to the list, even though reasonable minds could disagree over whether it belongs there. UPDATE: I have also added the Luther case to the list as well.

The addition of the Nomura lawsuit to the list brings the total of subprime-related securities lawsuits to 45, including eight so far in 2008. To the extent future developments warrant, I may separately tally the subprime-backed securities investor lawsuits from the shareholder lawsuits. UPDATE: The addition of the Luther case brings the total to 46

As courts have wrestled with the issue whether certain foreign shareholders can act as lead plaintiffs, or indeed can even be included in the plaintiff shareholder class, they have faced an ever-broader array of questions and challenges. The kinds of issues that foreign shareholder litigants present are illustrated in the February 13, 2008 lead plaintiff selection order (here) of Judge Saundra Brown Armstrong of the United States District Court for the Northern District of California in the BigBand Networks securities class action lawsuit. Refer here for background regarding the case.

BigBand, which is based on California, went public on March 14, 2007 (refer here). Its shares trade on Nasdaq. On September 27, 2007, the company announced (here) a revised revenue estimate for the third quarter of 2007. The company’s share price declined and several shareholders filed securities class action lawsuits against the company and certain of its officers and directors as well as the IPO offering underwriters and others.

The two leading contenders for the lead plaintiff role were Gwyn Jones, “a British citizen who resides in the Republic of Cyprus,” and Sphera Fund, an Israeli-based institutional hedge fund investor. The two would-be lead plaintiffs agreed that Jones has the largest financial interest in the case, having sustained losses of $438,617, whereas Sphera sustained losses of $374,889. Sphera nevertheless asserted three grounds on upon which it sought to rebut the presumption that Jones, with the largest financial interest in the  case, was the most adequate plaintiff.

Sphera first argued that in enacting the Private Securities Litigation Reform Act, Congress sought to encourage institutional investors to serve as the lead plaintiff in securities class action lawsuits. Judge Armstrong found however that “a plaintiff’s mere status as an institutional investor does not provide any presumption that the institutional plaintiff is a more adequate plaintiff than an individual investor with a larger financial interest.” Judge Armstrong went on to note that Congress could have created a per se presumption in favor of institutional plaintiffs but did not do so.

Sphera next sought to overcome the presumption that Jones was the most adequate plaintiff by arguing that Jones was subject to a “unique defense.” Sphera argued that the judgment of the U.S. court in a class action securities lawsuit might not be given preclusive effect in Cyprus and that fact was sufficient to overcome the presumption. In making this argument, Sphera drew upon prior holdings in the Vivendi and GlaxoSmithKline cases that the most adequate plaintiff presumption can be rebutted where the presumptive lead plaintiff’s country may not give res judicata effect to a U.S. court’s class action judgment. (Refer here for my prior discussion of the GlaxoSmithKline case, in which the court rejected the lead plaintiff petition of a German investor with the most significant financial interest out of concern that a German court might not enforce the U.S. court’s judgment in the case.)

Sphera’s attempt to challenge Jones broke down on its attempt to substantiate its characterizations of Cypriot law. Judge Armstrong held that “the arguments and evidence presented …are a totally inadequate basis for this Court to form any opinion as to whether Cypriot courts would give binding effects to this Court’s judgments.” Judge Armstrong observed regarding Sphera’s attempt to establish the relevant Cypriot law that

Sphera Fund does not even so much as provide an authenticated version of the Cypriot Civil Procedure Rules, but instead provides only a link to a webpage that is primarily in Greek and appears to contain translations of various Cypriot laws….Moreover, the versions of the rules on this website appear to use idiomatic phraseology that is literally Greek to this Court….The Court therefore has no basis on which to render an informed opinion on this question.

Judge Armstrong went on to note that “on the evidence before this Court,” Sphera’s concern about the enforceability of the U.S. court’s judgment in Cypriot courts “applies equally to Sphera Fund, an Israeli entity as to Jones.” Sphera “provided no specific argument that an Israeli court would give preclusive effect to a securities class action judgment such as may be rendered in this case.” Although relegated to a footnote, a further observation of the court seems particularly relevant to the entire analysis; that is, the court notes that the country of Jones’ citizenship (U.K.) rather than the country of his residence (Cyprus) may be the more relevant consideration, and prior courts have found that U.S. judgments may be preclusive in U.K. courts.

Finally, Sphera’s third argument against the presumption that Jones is the most adequate plaintiff is that Jones is in any event unqualified to serve as lead plaintiff. Sphera’s arguments in this regard are, the court notes, “simply ad hominem attacks on Jones,” which the court dismisses as “sophomoric.”

While there is something more than slightly comical about Sphera’s attempt to present arguments based on Cypriot law in reliance on a partially translated webpage, the spectacle of a court making significant procedural determinations that potentially could affect the interests of absent class members based this kind of process is disheartening. Sphera’s attempt to introduce Cypriot law may have been particularly clumsy, but this kind of spectacle is the almost inevitable absurd extreme to which the courts have been led based on the process of U.S. courts making assessments of foreign laws and of the likelihood that foreign courts would honor U.S. courts’ judgments in class action lawsuits.

Even with respect to jurisdictions such as the U.K. where the law is relatively accessible, the U.S. courts are nevertheless making assumptions that may or may not be valid about what a court in another jurisdiction might do in applying its own laws. And for countries where English translations of relevant legal provisions are unavailable, the entire exercise can simply break down. The inevitably scattershot results are underscored in the BigBand case when the court emphasized that it could not determine one way or another whether the judgment would be enforced in Cyprus or Israel but it was nevertheless proceeding ahead. It is hardly reassuring that the Court more or less acknowledged that it was making its decision in express recognition that it did not know what the relevant law is.

Moreover, with the increasing globalization of investor activity, the prospects for more instances of this kind of exercise, both at the lead plaintiff and at the class certification stage, seems likely. U.S. courts will be increasingly plagued by requirements to discern and make assessments upon the laws of a bewildering array of countries, and make decisions about the substantive rights of aggrieved absent potential class members based on assessments about what a foreign court might do under its law.  

Nor is the inaccessibility of some jurisdictions’ laws the only practical issue involved. For example, in the class certification context, and as Adam Savett pointed out on his Securities Litigation Watch blog, the practical alternative for foreign investors precluded from the shareholder class is for those precluded investors to file individual actions, which is precisely what foreign investors precluded from the Vivendi class have done, as Savett documents here.

The complications arising from foreign shareholder litigants’ involvement in U.S. securities actions defy easy solutions, but it seems increasingly apparent that these issues will continue to arise as foreign investors demonstrate their interest in accessing U.S. courts to seek available remedies under U.S. securities laws. While there are no easy solutions, the current ad hoc case by case method, informed only by U.S. courts’ rough and ready assessments of what the laws of other jurisdictions provide and how those jurisdictions’ courts might apply those laws to a U.S. class action judgment, seems poorly calculated to serve the best interests of absent, aggrieved class members.  

Speakers’ Corner: On March 6, 2008, I will be speaking at the Mealey’s Subprime-Backed Securities Litigation Conference in New York. I am honored to be included with a very illustrious group of speakers, who will be addressing the critical issues in a very comprehensive way. The program is being chaired by David Grais of Grais & Ellsworth. The entire program agenda and other conference information can be found here.