In its January 24, 2008 quarterly earnings release (here), KLA-Tencor also announced that it had entered into an agreement to settle the options backdating-related securities class action lawsuit that had been pending against the company and certain of its directors and officers for $65 million.

KLA-Tencor was among the companies mentioned in a front-page May 22, 2006 Wall Street Journal article entitled "Five More Companies Show Questionable Options Pattern" (here). The article described how the company’s executives received stock option grants in 2001 on "unusually fortunate days." The article also said that the data the Journal reviewed suggested a "highly improbable pattern of option grants." The company’s shares dropped over ten percent on the news, representing a drop in market capitalization of $935 million.

On May 24, 2006, the company announced (here) that its Board of Directors had formed a special committee to investigate the company’s stock option practices between 1995 and 2001. On June 29, 2006, the company announced (here) that its Board "had reached a preliminary conclusion that the actual measurement dates for financial accounting purposes of certain stock option grants issued in prior years likely differ from the recorded grant dates of such awards."
On October 16, 2006, the company announced (here) that the special committee had completed its investigation, and that as a result of the committee’s conclusions "the company will restate its financial statements to correct the accounting for retroactively priced stock options." The company said that it anticipates that the "additional non-cash charges for stock based compensation expenses will not exceed $400 million." The company also announced that it had terminated "all aspects of its employment relationship" with Kenneth Schroeder, who had been President and COO from 1991 to 1999, and CEO and a director from 1999 to 2005.

On June 25, 2007, the SEC announced (here) that it had filed a civil complaint against the company and Schroeder. Among other things, the SEC charged that Schroeder "repeatedly engaged in backdating after becoming CEO in 1999," including "pricing large awards of options to himself" that "were never disclosed to KLA-Tencor’s shareholders." The SEC alleged that he even made one award in 2005, "after he received advice from company counsel that retroactively selecting grant dates without adequate disclosure was improper." KLA-Tencor agreed to the entry of a permanent injunction, without admitting liability.

The plaintiffs first filed a civil securities class action complaint against the company and certain of its officers and directors (including Schoeder) on June 29, 2006, in the United States District Court for the District of California (about which refer here). The company’s $65 million settlement, which secured the release of all defendants (including Schroeder), represents the second-largest options backdating-related securities class action settlement. The only larger settlement so far is the $117.5 million Mercury Interactive settlement, which perhaps may be explained as an effort by Mercury’s acquirer, HP, to put the case in the past.

The magnitude of the KLA-Tencor settlement may be a reflection of the prominence of the case (in light of the Journal article), the magnitude of the stock drop (many other options backdating cases do not involve a significant stock price drop), and the existence and apparent seriousness of the SEC complaint, as well as the company’s public admissions about the backdating and its termination of Schoeder and others. Significantly, perhaps, the KLA-Tencor announcement of the settlement says nothing about insurance.

In any event, I have added the KLA-Tencor settlement to my table of options backdating settlements, dismissals and denials, which may be accessed here.

In an earlier post (here), I discussed the March 14 , 2007 ruling (here) in the CNL Resorts case, in which the federal district court held that an issuing company’s settlement of a claim under Section 11 of the Securities Act of 1933 did not constitute covered "loss" under the company’s D & O liability insurance policy. In that prior case, the court did say that Section 11 settlements are not per se uninsurable, and noted that "in a Section 11 case, if an entity makes a payment that constitutes something other than disgorgement of its ill-gotten gains, it has suffered a loss."

An example of the kind of Section 11 settlement that would be insurable emerged in a December 19, 2007 decision in the Mecklenberg, N.C., Superior Court case captioned Bank of American Corporation v. SR International Business Insurance. A copy of the decision can be found here. The case involves an insurance coverage dispute between the Bank and one of the "follow form" excess insurers on its program of Professional Service liability insurance.

The Bank had been sued, along with other offering underwriters, in connection with its provision of underwriting services to WorldCom for two of WorldCom’s bond offerings. The underlying complaint alleged that the offering underwriters had violated Sections 11 and 12 of the ’33 Act for not making a reasonable investigation as to the validity of WorldCom’s registration statement and failing to include material facts. The Bank ultimately settled the claim in the WorldCom litigation for $460.5 million. The Bank sought to have the carriers in its program of Professional Service liability insurance pay or reimburse the settlement amount. According to the court, "the other carriers involved paid all or a substantial portion of the claims asserted by the Bank."

The "follow form" excess carrier in the North Carolina coverage case contested its obligation to fund the settlement under its policy on a number of grounds, including, in particular, on the grounds that the Bank’s settlement of its Section 11 liability did not constitute covered "loss" under the policy. (I do not discuss in this post the other grounds on which the excess carrier contested coverage.) The parties filed cross-motions for summary judgment, which included cross-motions on the question whether the Section 11 settlement was uninsurable as a matter of law.

The excess insurer first argued that "the public policy of North Carolina would not permit insurance coverage claims under Section 11 and Section 12," a position that the court found to be "without merit." After first pointing out that the insurer could cite "neither statutory authority nor judicial decision in North Carolina holding that claims under Section 11 are uninsurable," the court observed that "it is unlikely that the appellate courts would relieve an insurer of liability for claims arising out of coverage that the insurer actively sought to write based on an argument that it was bad public policy for the insurer to write that coverage." (With respect to the latter point, the court added a footnoted observation that the other carriers in the bank’s insurance program had paid the claims asserted by the Bank for Section 11 losses.)

The Court then went on to distinguish the cases on which the excess insurer sought to rely, the CNL Hotels & Resorts case and the prior Level 3 Communications case. In distinguishing these cases, the court noted that the insureds involved in those cases were issuers of securities that had been the recipient of money from the plaintiffs in the underlying action; that the courts in each of those cases had held that "loss" did not include restoration of ill-gotten gain; and that the plaintiffs in the underlying cases involving those insureds were trying to recover the money that the issuer/insured had received as a result of the misrepresentations.

The court said that, by contrast, in the underlying WorldCom litigation, there was "no claim that seeks restitutionary damages," but that rather the "damages sought were for losses resulting from negligent performance of the underwriters’ duties." Accordingly, the court held that, because the damages sought in the underlying case were for negligence rather than the return of ill-gotten gain, "the Bank is entitled as a matter of law to judgment that the amounts the Bank paid to settle the claim against it…are ‘losses’ as defined in its liability insurance policy."

The court’s holding provides some context for the CNL Hotels & Resorts court’s statement that not all Section 11 settlements are per se uninsurable, and it also supports the view that, whatever else may be said, there should be no prohibition for the insurance of Section 11 settlements for persons other than the issuer. The arguable prohibition against the insurance for the recovery of ill-gotten gains may extend to the issuer, but in any event does not apply to Section 11 settlements on behalf of offering underwriters.

The more interesting aspect of the court’s ruling is its observation about the North Carolina’s public policy as relates to Section 11 settlements, and in particular its statements about the unlikelihood that the State’s appellate courts "would relieve an insurer of the liability for claims arising out of coverage the insurer actively sought to write." The court’s analysis in this regard turns on its head the analysis that other courts have followed in examining the question; the other courts have focused on the unfairness of the insured recovering insurance to compensate for its return of ill-gotten gain. By contrast, the North Carolina court focused on the unfairness of relieving the insurer of its obligation to pay, particularly given that the insurer sought to write that class of business.

It is perhaps some indication of what the parties to liability insurance transactions actually expect (as opposed to the lawyers that represent them in subsequent claims) that, in the wake of the CNL Hotels & Resorts case, virtually every D & O insurance carrier has rushed to market with proposed policy language specifying that the carrier will not take the position that the insurance of Section 11 and Section 12 settlements, and even judgments, are against public policy or otherwise not covered under the policy. Everyone on the transaction side of the business, at least, recognizes that there would not be much utility to the insurance if it didn’t cover Section 11 settlements. But while the introduction of the customized Section 11 coverage language may eliminate these disputes going forward, there are still an untold number of claims out there that involve policies that lack the new language. Courts will continue to wrangle with these issues for some time to come.

In light of this possibility for further disputes on this issue, it is worth observing that once again in the Bank of America case we have a situation where a "follow form" excess insurer resisted coverage even though the underlying carriers paid. I do not mean to suggest that the excess carrier in the Bank of America case did anything improper; its lawyers were protecting its interests as they saw appropriate based on existing case law. But as I have previously noted (most recently here), disputes involving "follow form" excess carriers are becoming all too frequent and threaten to become a virtually standard part of the D & O claims process.. As a result of increasing average and median claims severity, excess insurance is becoming an increasingly important part of the D & O claims process, so these issues are likely to become increasingly more critical.

I note in closing that at the upcoming PLUS D & O Symposium (about which refer here), one of the panel topics will be "Excess D & O Insurance: What’s Up With That?" Perhaps this panel will be a start on the industry’s efforts to address the excess insurance issues.

Special thanks to Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm for providing me with a copy of the Bank of America opinon. I hasten to add that the view expressed in this post are exclusively my own, and having nothting to do with Joe.

In response to the developing credit crisis, politicians have proposed legislative fixes and, more recently, advocated the need for fiscal stimuli. Some politicians of a more aggressive cast have launched investigations (about which refer here). In this environment, it is hardly surprising that other politicians are also resorting to litigation – and not merely to recoup supposed subprime-related losses, but also to extract political gains from the current turmoil.

The most substantial examples of subprime-related litigation as political theater are from Ohio. Exhibit One is the case filed last week in the Northern District of Ohio (Youngstown Division) against the Federal Home Loan Mortgage Corporation (Freddie Mac) on behalf of the Ohio Public Employees Retirement System (OPERS). A copy of the complaint can be found here. . For its part, OPERS apparently believes that its losses from the fraud alleged in the complaint could be as much as $27.2 million.

It is the lawsuit’s context rather than its relative merits that concern me. The first of the troublesome contextual elements is the January 22, 2008 press release that Ohio Attorney General Marc Dann issued in connection with the lawsuit’s filing (here). The press release not only announces the lawsuit and describes its allegations, but also thanks OPERS "for supporting my effort to hold Freddie Mac accountable for the role the company and its top executives played in bilking investors and fueling the foreclosure crisis that is destroying neighborhoods across the state and the entire nation."

Dann goes on to say that "by authorizing me to bring the suit on their behalf," they are not only protecting pensioners’ and taxpayers’ interests but "sending a loud and clear message to Wall Street that this type of fraud and manipulation will not be tolerated by the people who live on Main Streets that are being devastated by what Freddie Mac has done." As may be seen from this January 23, 2008 Columbus Dispatch article (here), Dann’s epistle achieved the media attention his press release so obviously sought.

An additional contextual element of this lawsuit is the venue where it was filed. Dann did not file the suit in Virginia, where Freddie Mac has its headquarters, or in New York, where its shares trade and where a prior lawsuit against Freddie Mac on similar grounds is already pending, or even Columbus, where OPERS has its headquarters. Rather, Dann filed the lawsuit in Youngstown. The critical thing to know here is that Dann is from Youngstown, and that is where he has his political base.

Now, given the uncertainties of litigation, it is entirely possible that this case will wind up being litigated in Youngstown. And it is entirely possible that this lawsuit could ultimately even gain a substantial recovery on behalf of OPERS’ pensioners and other members of the purported class – indeed, OPERS already has an impressive track record against Freddie Mac, having recovered as lead plaintiff in a prior securities lawsuit against Freddie Mac a $410 million class settlement. And Dann did note in his press release that, in addition to the Youngstown lawsuit, he has also filed a lead plaintiff petition on behalf of OPERS in the previously pending New York securities lawsuit against Freddie Mac. But obviously, announcing a mere lead plaintiff petition wouldn’t make for much of a press release.

Nor is Dann the only Ohio politician using subprime-related litigation to portray themselves as the scourge of Wall Street and the champion of the oppressed masses. For example, in a January 11, 2008 press release (here), Cleveland Mayor Frank Jackson announced that the City of Cleveland was initiating a lawsuit against 21 investment banks and mortgage lenders who "financed and cultivated the subprime market." A copy of the complaint can be found here.

The Cleveland Plain Dealer reports (here) that the firms are accused of "creating a public nuisance by making mortgages available to people who had ‘no realistic means of keeping up their loan payments.’" The loans allegedly have resulted in thousands of foreclosures in Cuyahoga County. Jackson also told the newspaper that "to me this is no different than organized crime or drugs. It has the same effect as drug activity in neighborhoods."

The situation in Cleveland is dire, and the specter of thousands of empty, foreclosed houses haunts the city and silently testifies to its straitened condition. On that score, I am sympathetic to Jackson’s frustrated desire for retribution. But it is hard to know what to say about the lawsuit’s implicit suggestion that lenders should be liable for having had the audacity to lend money to the city’s residents. While subprime lending undoubtedly involved excesses, and even some unscrupulous practices, the city’s current desperate condition cannot possibly be improved without outside investment, and, yes, the availability of home financing, neither of which the Mayor’s lawsuit does anything to encourage.

Ohio has long-standing, complex economic problems. It saddens me that, rather than confront the real issues facing the state and its people, its political leaders would rather indulge in finger-pointing and scapegoating. Whatever the merits of these lawsuits, they will do little to solve or even relieve the deep economic problems that beset the state.

These lawsuits are troublesome not only because of the squandered political leadership they represent, they are also of concern because Ohio’s politicians clearly will not be the only ones tempted to seek political capital from subprime-related litigation. (Indeed, Baltimore’s leaders have also filed their own lawsuit against Wells Fargo, here, alleging reverse redlining) With so many forces already adding momentum to the growing subprime litigation wave, it is truly discouraging development that politicians feel compelled to exacerbate an already appalling situation. The problems from the subprime situation will only get worse if our political leaders are more interested in assigning blame than finding solutions.

Subprime and the Insurance Market: As the subprime meltdown has emerged, one of the recurring questions has been what impact it will have on the professional liability insurance industry. The latest attempt to answer this question appears in the January 2008 issue of Risk & Insurance, in an article entitled "Will the Liability Market Turn?" (here). (Full disclosure: I was interviewed in connection with the article.) Among other things, the article quotes "one estimate" as putting the "professional liability insurance losses connected with the subprime lending mess at $16 billion."

My own thoughts on the impact on the professional liability insurance industry are reflected in a December 17, 2007 interview published in full on the Risk & Insurance website and entitled "Coverage Expert on Subprime Pricing" (here).

A Closer Look at a Busted-Buyout: In prior posts (most recently here), I have examined the lawsuits that busted buyouts have spawned. Among other deals I have examined is KKR’s now canceled deal to acquire Harman International, which I discussed here. A January 23, 2008 Fortune article entitled "An Old Hand in a Strange New World" (here) takes a closer look at the failed deal, and examines the myriad of forces that led to its demise.

Of particular interest is the article’s discussion of the company’s increased capital spending while the deal was pending and that was the source of the "material adverse change" KKR attempted to invoke to try to scuttle the deal. Apparently, the company’s German division, anticipating KKR’s post-deal fiscal austerity, and exhibiting "exuberant behavior," overspent its capital budget by $25 million. The article, anticipating the presumed question, states, "no, there weren’t controls then in place to prevent this."

Though KKR and Harman have resolved their legal disputes, the separate lawsuit brought by Harman’s shareholders against Harman’s management remains pending. In that context, the article is particularly interesting.

Now This: The Professional Liability Underwriting Society has decided to join the blogosphere, with their new blog, The PLUS Blog (here). The site has just come out of beta testing and they are off to a great start. The blog, which will focus on breaking news and features affecting the professional liability insurance industry, should be worth watching.

A shareholders’ derivative lawsuit that generated the most prominent judicial pronouncements about options "springloading" has been settled. According to the company’s January 18, 2008 press release (here) and its filing on Form 8-K of the same date (here), the parties have settled the consolidated shareholders’ derivative lawsuit that has been been pending since 2005 against Tyson Foods, as nominal defendant, and certain present and former directors and officers of the company.

Under the terms of the settlement agreement (here), Don Tyson (the company’s former CEO) and the Tyson Limited Partnership, the Company’s largest shareholder are jointly and severally liable to pay the company $4.5 million. No other defendant will make any payments. The company also agreed to implement or continue certain governance measures, as detailed in the settlement agreement. The plaintiffs will be seeking a fee award of $3 million from the company, out of the $4.5 million to be paid under the settlement. The Company has said it will contest the fee award, but will not contest any award up to $1 million.

The derivative complaint contained a variety of allegations, only some of them relating to the timing of the company’s stock option grants. Other allegations related to certain consulting contracts, as well as to executive compensation and related-party transactions involving Tyson and his family. But what has drawn notoriety to the case are the complaint’s allegations concerning options "springloading" (that is, the award of options in anticipation of an event expected to trigger an increase in the company’s stock price). The opinions in the case regarding springloading are undoubtedly represent the leading judicial commentary on the practice.

In opinions dated February 6, 2007 (here), and August 15, 2007 (here), Chancellor William B. Chandler III used memorably scathing language in denying the defendants’ motions to dismiss the springloading allegations. Among other things, Chandler said that in the August 15 opinion that the company’s proxy disclosure describing the options grants displayed "an uncanny parsimony with the truth" that "raise an inference that the directors engaged in later dissembling to hide earlier subterfuge."

Chancellor Chandler added that he "may further infer that grants of springloaded options were both inherently unfair to shareholders" and that "the long-term nature of the deceit involved suggests a scheme inherently beyond the bounds of business judgment." He added that the Court "may reasonably infer that a board of directors later concealed the true nature of a stock option," from which it may further infer that the options "were not granted consistent with a fiduciary’s duty of utmost loyalty."

My prior more detailed discussion of Chandler’s August 15 opinion can be found here.

The settlement is of course still subject to court approval, a condition that may be a relevant consideration in this case, given the seeming disparity between the flights of the Court’s rhetoric and the scale of the settlement.

In any event, I have added the Tyson Foods settlement to my list of options backdating lawsuit settlements, dismissals and denials, which can be accessed here.

A January 21, 2008 CFO.com article further discussing the Tyson Foods settlement can be found here.

Supreme Court Rejects Enron Appeal: Less than a week after issuing the Stoneridge decision, the Supreme Court has denied (here) the petition for writ of certiorari in the case Enron investors had brought against a number of investment banks. News coverage of the denial can be found here and here.

As noted in the 10b-5 Daily blog (here), the Supreme Court also vacated and remanded to the Ninth Circuit the "scheme liability" case of Avis Budget Group v. California State Teachers Retirement, "for further consideration" in light of the Stoneridge decision.

While the Enron cert petition denial was probably inevitable after the Stoneridge decision, it is also dicey to read too much into the denial. For example, as the Conglomerate blog points out (here), the Enron case was in an odd procedural posture, having come up to the Supreme Court from the Fifth Circuit where it was on an interlocutory appeal after the denial of class certification. The Supreme Court does not have to explain itself when it declines to act. The lower courts will have to live with the Stoneridge decision and work out its meaning in the context of specific cases without further guidance from the Supreme Court, for now.

Professor Larry Ribstein has further thoughts about the meaning (and limitations on the meaning) of the Enron cert petition denial on his Ideoblog, here. The SEC Actions blog, here, finds greater significance to the Supreme Court’s actions in the wake of Stoneridge. The WSJ.com Law Blog has more "post-game" analysis on the Enron cert petition denial, here.

More About the Subprime Litigation Wave: Way back in July 2007, when I declared (here) that subprime litigation was "this year’s model" (that is, the hot litigation trend driving lawsuit activity), I noted that "subprime litigation is arising in an ever-increasing variety of additional forms" and that "as the concentric rings from asset valuation issues spread outward, an increasing array of companies will become engulfed in the litigation wave."

Sounding similar themes in a January 22, 2008 article entitled "If Everyone’s Finger-Pointing, Who’s To Blame?"(here), the New York Times observed that

a wave of lawsuits is beginning to wash over the troubled mortgage market and the rest of the financial world. Homeowners are suing mortgage lenders. Mortgage lenders are suing Wall Street banks. Wall Street banks are suing loan specialists And investors are suing everyone.

The article mentions a number of different cases, including in particular a case brought last week by the Maher family against Lehman Brothers Holdings. The lawsuit is described in greater detail in the a January 18, 2008 Bloomberg.com article entitled "Lehman Clients Demand $1.1 Billion on Auction Dispute" (here). The allegations have been brought by two brothers, Brian and Basil Mahan, in an arbitration complaint filed with the Financial Industry Regulatory Authority.

The complaint alleges that the brothers relied on Lehman to invest proceeds from the family’s sale of its ship container company, claiming that the family’s stated investment objectives were to preserve capital and provide liquidity. Lehman allegedly put the money in auction-rate securities, which lost value due to the turmoil in the credit markets. The brothers seek to require Lehman to buy the illiquid securities and pay treble damages of $857 million. The complaint accuses Lehman of negligence, deception, breach of contract, making unsuitable investments, and supervisory failures.

Thanks to the several readers who sent me copies of or links to the New York Times article.

Now This: The turbulence in the financial markets is scary enough in and of itself. Of perhaps even greater concern is what it may signify. George Soros, the Chairman of Soros Fund Management, suggests in a column in the January 23, 2007 Financial Times (here) that we now face "The Worst Market Crisis in 60 Years."

In a decision noteworthy both for the prominence of the case and for the implications of its analysis, the Seventh Circuit, hearing the Makor Issues & Rights Ltd. v. Tellabs Incorporated case on remand from the U.S. Supreme Court, has once again reversed the district court’s dismissal of the case.

The Supreme Court, in its June 21, 2007 opinion in the Tellabs case (about which refer here) had directed the Seventh Circuit to dismiss the complaint "unless a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."

In a January 17, 2008 opinion (here) written by Judge Richard Posner, the Seventh Circuit concluded that "the plaintiffs have succeeded…in pleading scienter" and therefore the court decided to "adhere to our decision to reverse the judgment of the district court in dismissing the suit."

In determining whether or not the plaintiffs’ allegations supported a "strong inference" that the defendants acted with scienter (as required in the heightened pleading requirements in the Private Securities Litigation Reform Act), the Seventh Circuit said that it was "exceedingly unlikely" that the alleged false statements "were the result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference to whether the statements were misleading."

In considering whether or not the plaintiffs’ allegations were sufficient to establish that the corporation itself acted with scienter, the court articulated a broad concept of "collective scienter"; the court said

it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud. Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false.

The court then turned to the question whether the plaintiffs had presented sufficient scienter allegations in connection with defendant Richard Notebaert, Tellabs’ former CEO, about whom the court noted that "almost all of the false statements that we have quoted emanated directly from him." The court asked

Is it conceivable that he was unaware of the problems of his company’s two major products and merely repeating lies fed to him by other executives of the company? It is conceivable, yes, but it is exceedingly unlikely.

Finally, the court noted that the complaint’s reliance on confidential sources "does not invalidate the drawing of a stong inference from the informants’ assertions." While acknowledging that there are circumstances when the accusations of anonymous informants would not be sufficient to meet the pleading requirements, the court distinguished the allegations in this complaint, observing that "the information that the confidential informants are reported to have obtained is set forth in convincing detail, with some of the information, moreover, corroborated by multiple sources."

The Seventh Circuit’s decision is not only a victory for the plaintiffs in that case, it is also a refutation of the position, advanced by some at the time, that the Supreme Court’s Tellabs decision represented a watershed victory for securities litigation defendants. As I wrote at the time about the Supreme Court’s Tellabs opinion (here) "neither side has been handed a strategically decisive weapon, and so the battle will rage on, in many ways as before."

The Seventh Circuit’s recent opinion also represents a victory for plaintiffs in two other important respects as well. First, it represents a strong affirmation that plaintiffs can, at least in certain circumstances and with sufficiently detailed support, fulfill the threshold pleading requirements in reliance on anonymous sources and informants.

Second, the Seventh Circuit’s opinion represents an important recognition of the ability of plaintiffs to fulfill the pleading requirements as to corporate defendants by relying on allegations of "corporate" or "collective scienter." (My observations here about the corporate scienter portion of the Seventh Circuit’s opinion draw on comments about the case by one of the leading members of the plaintiffs’ bar whom I am sure would prefer anonymity – I emphasize this point just to acknowledge my gratitude for and to disclaim the originality of these observations.)

The court’s holding that "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted or disseminated the fraud," is a vigorous endorsement of the "collective scienter" approach to pleading a corporation’s state of mind. The question of plaintiffs’ ability to satisfy the requirements for pleading scienter with allegations of collective or corporate scienter is precisely the issue that will be argued before the Second Circuit on January 30, 2008, in the Dynex Capital securities lawsuit.

In the district court proceedings in the Dynex Capital case, Judge Harold Baer, Jr. held in a February 10, 2006 opinion (here) that a plaintiff "may, and in this case has, alleged scienter on the part of the corporate defendant without pleading scienter against any particular employees of the corporation." In a June 2, 2006 ruling (here), Judge Baer denied the defendants’ motion for reconsideration but granted the defendant’s petition for leave to take an interlocutory appeal on the collective scienter issue. A wide variety of litigants and interested parties have filed amicus briefs in the case, the consideration of which will undoubtedly be influenced by the Seventh Circuit’s most recent decision in the Tellabs case.

The final note about the Seventh Circuit’s Tellabs decision has to be that while the plaintiffs have had some significant recent setbacks in the U.S. Supreme Court, they have not by any means been put out of businsess, and indeed, even the string of defense-oriented Supreme Court decisions clearly still allows plaintiffs room to maneuver.

After a week that included the Stoneridge decision, the jury verdict in the Apollo Group case and the Seventh Circuit’s opinion on remand in the Tellabs case, it has to be asked –has there ever been a week as eventful as this past week in the annals of securities litigation? It is getting difficult for even the most diligent blogger to keep up…

Rick Bortnick and Emilio Boehringer at the Cozen O’Conner firm has written a good summary of and commentary on the 7th Circuit’s opinion in the Tellabs case, here.

Tenth Circuit Says Further Details About Qwest Settlement Required: The appellate proceedings in another prominent case, the Qwest Communications securities lawsuit, were also in the news this past week (refer here and here). The case was before the Tenth Circuit on an appeal brought by Joseph Nacchio and Robert Woodruff, Qwest’s former CEO and CFO. Nacchio and Woodruff were not included on the $400 million class settlement, but they appealed from the district court’s rejection of their objections to the settlement.

Nacchio and Woodruff allegedly were informed that they would be included in the settlement only if they would pay personally into any settlement fund, which they refused to do, as a result of which they were excluded from the settlement. The settlement documents nevertheless contained a number of different features designed to preclude the two individuals’ assertion of any rights to indemnification or contribution. The two individuals objected to the settlement based on these features, but the district court overruled their objections, specifically holding that the settlement was "fair, reasonable and adequate" as to Nacchio and Woodruff.

In a January 16, 2008 opinion (here), the Tenth Circuit found that the two individuals had standing to challenge the settlement, holding that they had suffered "legal prejudice," because the provisions of the settlement agreement "essentially strip, and in any event, palpably interfere with Mr Nacchio and Mr. Woodruff’s preexisting rights and potential legal claims." The Tenth Circuit went on to hold that the district court’s explanation of its reasons for overruling the individual defendants’ objections were "insufficient." The Tenth Circuit said that "we are unwilling to guess at the path the district court followed in resolving serious legal issues….We need something to show how and on what basis the court analyzed Mr. Nacchio and Mr. Woodruff’s objections." The Tenth Circuit remanded the case for the district court to provide further analysis of the individuals’ objections to the settlement.

Even though the Tenth Circuit’s ruling is purely procedural, the tenor of its decision strongly suggests the court’s discomfort with the settlement agreement’s elimination of Nacchio’s and Woodruff’s indemnification and contribution rights. Of course, it remains to be seen whether the district court can present an explanation sufficient to pass muster in the Tenth Circuit. The Tenth Circuit’s opinion does underscore the complications that can arise when litigants attempt to compel individuals to contribute toward settlements without recourse to indemnification or insurance.

Securities Litigation Teleconference: On Friday January 25, 2008 at 11 a.m. I will be participating in a conference call sponsored by Risk Metrics entitled "Securities Litigation: What You Need to Know for 2008." The call will be moderated by Adam Savett, the author of the Securities LitigationWatch blog, and the panelists will also include Stuart Grant, Managing Partner of Grant & Eisenhofer, and Lyle Roberts, a partner at Dewey & LeBoeuf and author of The 10b-Daily blog. Registration for the conference call, which is free, can be accessed here.

Now This: We here at The D & O Diary have particular respect for Judge Posner, the author of the recent Tellabs opinion in the Seventh Circuit, not only because he is one of the most highly regarded jurists in the country, but also because he is a blogger. Posner writes widely read The Becker-Posner Blog (here), which he co-authors with Gary Becker, the Nobel prize-winning economist from the University of Chicago. Their presence raises the tone of the entire blogosphere. Judge Posner is also the only Circuit judge of whom I am aware who has a website containing a searchable database devoted exclusively to his opinions.

Judge Posner was also recently the subject of a profile on the WSJ.com Law Blog (here), which included this excerpt from another opinion Judge Posner wrote, containing good advice for all of us involved in any way with the insurance industry:

A note, finally, on advocacy in this court. The lawyers’ oral arguments were excellent. But their briefs, although well written and professionally competent, were difficult for us judges to understand because of the density of the reinsurance jargon in them. There is nothing wrong with a specialized vocabulary–for use by specialists. Federal district and circuit judges, however, with the partial exception of the judges of the court of appeals for the Federal Circuit (which is semi-specialized), are generalists. We hear very few cases involving reinsurance, and cannot possibly achieve expertise in reinsurance practices except by the happenstance of having practiced in that area before becoming a judge, as none of us has. Lawyers should understand the judges’ limited knowledge of specialized fields and choose their vocabulary accordingly. Every esoteric term used by the reinsurance industry has a counterpart in ordinary English, as we hope this opinion has demonstrated. The able lawyers who briefed and argued this case could have saved us some work and presented their positions more effectively had they done the translations from reinsurancese into everyday English themselves.

On January 16, 2008, plaintiffs’ lawyers filed a securities lawsuit in the Southern District of New York against Ambac Financial Group and certain of its directors and officers, raising allegations in connection with the company’s disclosures concerning its provision of insurance for collateralized debt obligations. A copy of the plaintiff’s counsel’s January 16 press release can be found here. A copy of the complaint can be found here.

According to the press release, the complaint alleges that

during the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results related to its insurance coverage on collateralized debt obligations (“CDO”) contracts. According to the complaint, the true facts, which were known by the defendants but concealed from the investing public during the Class Period, were as follows: (i) that the company lacked requisite internal controls to ensure that the Company’s underwriting standards and its internal rating system for its CDO contracts were adequate, and, as a result, the Company’s projections and reported results issued during the Class Period were based upon defective assumptions and/or manipulated facts; (ii) that the Company’s financial statements were materially misstated due to its failure to properly account for its mark-to-market losses; (iii) that, given the deterioration and the increased volatility in the mortgage market, the Company would be forced to tighten its underwriting standards related to its asset-backed securities, which would have a direct material negative impact on its premium production going forward; (iv) that the Company had far greater exposure to anticipated losses and defaults related to its CDO contracts containing subprime loans, including even highly rated CDOs, than it had previously disclosed; (v) that the Company had far greater exposure to a potential ratings downgrade from one of the credit ratings agencies than it had previously disclosed; and (vi) that defendants’ Class Period statements about the Company’s selective underwriting practices during the 2005 through 2007 timeframe related to its CDOs backed by subprime assets were patently false; as the Company’s underwriting standards were at best aggressive and at a minimum were completely inadequate. As the truth began to be disclosed, shares of Ambac common stock plummeted, causing substantial losses to investors.

Ambac now joins MBIA as a triple-A rated bond insurer whose disclosures in connection with its provision of insurance for mortgage-backed securities has resulted in a securities lawsuit. As discussed in my recent post (here) concerning the MBIA lawsuit, there have also been three other bond insurers sued in subprime-related securities lawsuits.

I have added the Ambac lawsuit to my running tally of subprime-related securities lawsuits, which can be found here. The addition of the Ambac lawsuit brings the total number of subprime-related securities lawsuits (including lawsuits against credit rating agencies and against residential construction companies) to 39. The Ambac lawsuit is the second subprime-related securities lawsuit filed in 2008.

On January 16, 2008, a civil jury in the Apollo Group securities lawsuit in the United States District Court for the District of Arizona entered a verdict in favor of the plaintiff class on all counts, awarding damages of $5.55 per share, an amount that according to Bloomberg (here) could reach as much as $277.5 million. The Bloomberg report also states that Apollo is responsible for 60 percent of the plaintiffs’ losses, former Apollo CEO Tony Nelson is responsible for 30 percent, and former CFO Kenda Gonzales is responsible for 10 percent. The company’s statement about the verdict can be found here. The plaintiff’s counsel’s statement about the verdict can be found here.

Background

Apollo Group is the parent of the University of Phoenix (UOP), the largest for-profit provider of higher education in the United States. According to the plaintiff’s amended complaint (here), in 2003, two former UOP employees filed a False Claims Act action against UOP alleging that UOP received U.S. Department of Education funding in violation of laws specifying the way company educational recruiters may be compensated. Background regarding the False Claims Act case can be found here.

The Department of Education initiated an investigation of the issues raised in the False Claims Act action, and on February 5, 2004, a Department of Education employee issued a "Program Review Report" that accused UOP of violating the Department of Education rules with respect to education employees’ compensation. The plaintiff in the securities case alleges that the violations in the report could have resulted in the limitation or termination of Department of Education funding to UOP.

On September 7, 2004, Apollo agreed to pay the Department of Education $9.8 million to settle the program review. The settlement agreement (a copy of which can be found here) specified that Apollo’s entry into the agreement did not constitute an admission of wrongdoing or liability. News of the allegations in the Department of Education report first became public on September 14, 2004. The price of Apollo’s stock fell significantly on September 21, 2004, when a securities analyst issued a report expressing concern about the company’s possible exposure to future regulatory issues.

The Lawsuit

The lead plaintiff in the case is the Policemen’s Annuity and Benefit Fund of Chicago, on behalf of a class of persons who purchased Apollo stock between February 27, 2004 and September 14, 2004. The case was pending before Judge James A. Teilborg.

In a September 11. 2007 order (here), Judge Teilborg denied the parties cross-motions for summary judgment. The defendants had sought summary judgment arguing that they had no duty to disclose an interim regulatory report (which they believed to be both unauthorized and false). The court found that while the defendants "may not have an affirmative duty to disclose the interim regulatory findings they do have ‘a duty to disclose material facts that are necessary to make disclosed statements…not misleading.’" Judge Teilborg found that there was a jury issue as to whether any of the defendants’ statements between the February delivery of the report and the September disclosure were misleading. Judge Teilborg also found that there were jury issues on the question whether the interim report was material and whether the defendants’ acted with scienter in withholding information about the report.

In a particularly interesting holding, Judge Teilborg also found that there was a jury issue on the question of loss causation. The defendants argued that that there was no jury issue because the company’s stock price did not react to the September 14 disclosure of the settlement. But the plaintiffs argued that the corrective disclosure was actually a cumulative process that included the analyst’s September 21 report. Judge Teilborg said he could not conclude as a matter of law that the analyst report was not part of the corrective disclosure. The judge said it was a jury question whether or not the corrective information was fully absorbed into the marketplace before the analyst’s report issued. (This mattered because there was no significant stock price drop until the report came out.)

Trial commenced on November 14, 2007. During the trial the plaintiff called both Nelson and Gonzalez to the stand to testify as hostile witnesses for the plaintiff. (Calling adverse parties as hostile witnesses is an unusual move, but it has the advantage of allowing the examining attorney to use leading questions and other techniques of cross-examination, which would otherwise not be allowed on direct examination.) According to news reports (here), Gonzalez testified that the company withheld the report from investors to avoid news coverage about the allegations. The news reports quote Gonzalez as having said that "when we received the program review report, we felt very strongly we did not want it basically tried in the press." The news reports also state that Nelson testified that the company’s lawyers advised the company against disclosing the report, and that he thought disclosing it would have caused the company’s stock price to drop.

The jury began deliberation on January 10, 2008 and returned a verdict on January 16. The jury found for the plaintiff on all counts. In its statement on the verdict (here), the company said that the case was premised on the company’s "supposed failure to disclose unsubstantiated allegations from a preliminary government report." The company’s counsel is quoted in the statement as saying that the "law does not require the disclosure of preliminary or unproven damages." The statement also says that "the ultimate disclosure of the report’s contents caused no statistically significant movement in Apollo’s stock price."

Discussion

According to the Securities Litigation Watch blog (here), 19 securities lawsuits have gone to trial since 1996. Of these, six cases (including the Apollo Group case) involving post-PSLRA conduct have reached a jury verdict, with three verdicts going in favor of the plaintiffs and three going in favor of the defendants. The Ninth Circuit recently reversed one of the three defense verdicts, as noted further below. Among the six verdicts is also the November 27, 2007 defense verdict in the JDS Uniphase trial (about which refer here).

It is important to keep in mind that this case is not over – indeed, it may have a long way yet to go. The defendants undoubtedly will pursue an appeal to the Ninth Circuit if their post-trial motions are unsuccessful. On appeal, both parties will look with interest (and in the defendants’ case, concern) on the Ninth Circuit’s November 26, 2007 opinion in the Thane International case (here), in which the Ninth Circuit reversed and remanded a trial verdict that had been entered on behalf of the defendants in that case. (Refer here for my prior discussion of the Thane International case). While the ultimate outcome of any appeal in the Apollo Group case remains to be seen, there may well be significant issues on appeal, particularly with respect to the defendants’ obligation to disclose the report; scienter; and loss causation. (Of course, the parties always have the opportunity of entering into a post-trial settlement, as well…)

It is worth asking why all of a sudden securities cases are going to trial. It is not clear why the Apollo Group case did not, like most of these cases, settle. The parties may simply have been unable to reach a mutually acceptable compromise. The Apollo Group case does seem like an odd case for the plaintiff to have pushed to trial since there were no insider trading allegations or other suggestions that the individual defendants personally benefited – although the jury verdict obviously validates the decision (to the extent there was an active decision) to try the case, and the absence of individual benefit clearly did not influence the ultimate outcome.

There is at least potentially an interesting insurance coverage question, which is whether the jury verdict represents an adjudication of fraud sufficient to trigger the fraud exclusion that typically is found in directors and officers liability insurance policies. I have not been able to obtain a copy of the questionnaire the jury used to see what specific factual findings the jury made, but to the extent the jury found knowing misrepresentations, the verdict could preclude coverage, although the possibility of an appeal could also affect this issue. (The possibility of a jury verdict triggering the fraud exclusion is one reason why so few securities cases go to trial.) It should also be noted that the amount of damages could exceed any amounts of insurance that are available. (I want to emphasize in making these insurance observations that I have no knowledge of any kind about the particulars of Apollo Group’s insurance, and so I am merely speculating not expressing any insurance opinions.)

With the Supreme Court decision in the Stoneridge case coming out yesterday and the verdict in the Apollo Group case today, this certainly has been an eventful couple of days in the world of securities litigation.
Special thanks to the several readers who sent me copies of news reports about the verdict.

On January 15, 2008, in a 5-3 majority opinion (here) written by Justice Kennedy (pictured to the left), the U.S. Supreme Court affirmed the Eighth Circuit in the Stonridge Investment Partners, LLC v Scientific Atlanta case. The Court concluded that the implied right of action under Section 10(b) did not reach the respondent companies’ conduct because the investor claimants did not rely on the alleged deceptive conduct. Justice Stevens, joined by Justices Souter and Ginsberg, dissented. Justice Breyer, as previously disclosed, did not take part in the case.

As discussed in a prior post (here), the investors claimed that Scientific Atlanta and Motorola had helped Charter Communications make its revenue targets through an arrangement whereby Charter overpaid its vendors for set-top cable boxes and the vendors agreed to return the overpayment by buying advertising from Charter. The vendors treated the two transactions as a wash sale, but Charter accounted for the transactions so that they favorably (and, the investors alleged, improperly) impacted its revenue and permitted the company to meet its revenue targets. Charter later restated is revenue to reclassify the revenue from the set-top deal.

Charter’s investors separately sued Charter and its accountant in a case that later settled, but the investors also sued the vendors, alleging that the vendors knowingly entered the transaction in order to permit Charter to achieve a desired accounting outcome. The investors alleged that the vendors falsified documents and backdated contracts to facilitate the outcome.

The district court granted the vendors’ motion to dismiss and the Eighth Circuit affirmed, holding that "any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission …is at most guilty of aiding and abetting and cannot be held liable under Section 10(b)."

The U.S. Supreme Court affirmed the Eighth Circuit, holding that the case against the vendors was properly dismissed. But the Supreme Court did not adopt the Eighth Circuit’s reasoning; rather, the Court says, with respect to the Eighth Circuit’s statement that Section 10(b) reaches only misstatements or omissions by one with a duty to disclose, that "if this conclusion were read to suggest that there must be a specific oral or written statement before there could be liability under Section 10(b) or Rule 10b-5, it would be erroneous." The Court would on to note explicitly that "conduct itself can be deceptive."

While the Supreme Court disclaimed the Eighth Circuit’s reasoning, it still affirmed the Eighth Circuit’s holding because the vendors’ "acts or statements were not relied upon by the investors and that as a result liability cannot be imputed."

Thus the Court’s decision turns on the absence of "reliance." The Court did note that there is a "rebuttable presumption of reliance" under two circumstances; first, if "there is a duty to disclose" and second, "under the fraud-on-the-market" doctrine, by which reliance is presumed when the statement at issue becomes public. The Court held with respect to these presumptions of reliance that

Neither presumption applies here. Respondents had no duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of respondents’ deceptive acts during the relevant time. Petitioner, as a result, cannot show reliance upon any of respondents’ actions except in an indirect chain that we find too remote for liability..

The investors sought to overcome these considerations by urging that that respondents engaged in a scheme, contending that the vendors had "engaged in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent" and that Charter’s release of false financial statements "was a natural and expected consequence of" the vendors’ deceptive acts.

The court rejected these "scheme liability" allegations, saying that the vendors’ "deceptive acts, which were not disclosed to the investing public, are too remote to satisfy the requirement of reliance. It was Charter, not respondents, that misled its auditor and filed fraudulent financial statements; nothing respondents did made it necessary or inevitable for Charter to record the transaction as it did."

The majority opinion noted a number of additional considerations that it found militated against the investors’ position; the Court found that:

1. Investors’ position seeks to apply Section 10(b) "beyond the securities markets–the realm of financing business – to purchase and supply contracts – the realm of ordinary business."

2. Recognizing the position urged by the investors "would revive in substance the implied cause of action against all aiders and abettors except those who committed no deceptive act in the process of facilitating the fraud."

3. In enacting the PSLRA, Congress recognized an SEC enforcement cause of action for aiding and abetting, but did not recognize a private right of action for aiding and abetting. The Court said "we give weight to Congress’ amendment to the Act restoring aiding and abetting liability in certain cases but not others."

4. Adopting the position urged by the investors "would expose a new class of defendants to these risks" who might "find it necessary to protect against these threats, raising the cost of doing business."

5. If the Court adopted investors’ position, "overseas firms" would be "deterred from doing business here," and could "raise the costs of being a publicly traded company under our law and shift securities offerings away from domestic capital markets."

6. The implied right of action under Section 10(b) "should not be further expanded beyond its present boundaries." The Court said that its holdings is "consistent with the narrow dimensions we must give to a right of action Congress did not authorize when it first enacted the statute and did not expand it when it revised the law."

7. The SEC’s enforcement power "is not toothless" and "both parties agree that criminal penalties are a strong deterrent." Moreover, there is an "express private right of action against accountants and underwriters under certain circumstances" and the "implied right of action in Section 10(b) continues to cover secondary actors who commit primary violations."

The dissent argues that the Court, having found that the Eighth Circuit’s reasoning was incorrect, should at a minimum have remanded the case for further proceedings on the reliance issue. The dissent also faults the majority’s "fraud on the market" analysis, saying that the doctrine does not require investors to be aware of the specific deceptive act to rely on the doctrine to establish reliance. Justice Stevens also argued that because the vendors’ actions were undertaken with the expectation that Charter would rely on them in making fraudulent statements, the causal connection between their allegedly improper action was sufficient to support a finding of reliance.
The dissent also rejects the majority’s finding regarding Congressional intent, arguing that Congress’ actions (or rather, inactions) cannot be read to bestow immunity on an undefined class of actors from liability under Section 10(b). Finally, the dissent conclude with a lengthy affirmation of the right of court’s to imply remedies, even in the absence of legislative action.

At its most basic level, the outcome of this case is unsurprising. The justices arrayed themselves just as I had speculated in my prior post. That is, the three justices still on the Court who were in the majority in Central Bank (Kennedy, Scalia and Thomas) were joined by the two recent appointees (Roberts and Alito), while the three justices who had been in the dissent in Central Bank (Stevens, Souter and Ginsberg) were also in the dissent on Stoneridge.

The majority’s opinion also, again perhaps unsurprisingly, essentially adopts the position advocated by the Solicitor General on behalf of the U.S. Department of Justice (in his amicus brief, here); that is, as I noted in my prior post, the Solicitor General urged that, while the Eighth Circuit concededly erred in concluding that conduct itself could not satisfy the statute’s deception requirement, the Supreme Court could nevertheless affirm the Eighth Circuit because the investors had not shown reliance – which was of course exactly what the majority held.

One aspect of the majority’s opinion that is striking is that the opinion does suggest an awareness of, and perhaps even the influence of, arguably extrajudicial considerations such as the potential impact the investors’ position might have had on the overall business environment or the relative competitiveness of U.S financial markets. These considerations, while undeniably important, arguably are irrelevant to whether or not these claimants have a remedy under the statute.

While the majority rejected the investors’ "scheme liability" theories, the Court did not hold that "secondary actors" can never be liable. To the contrary, and consistent with Central Bank, the Court held that any person who employs a manipulative device may held as a primary violator, assuming all the requirements of Section 10(b) are met. And in any event , the SEC still has statutory authority to pursue enforcement actions based on "aiding and abetting" allegations.

The Court is certainly correct when it says that were investors’ position recognized, then companies would seek to protect against the threats, which would raise the cost of doing business. Indeed, if companies had to procure insurance to protect against not only the securities liability arising from their own conduct but also with respect to every company with respect to whom they are a customer or vendor, the cost of liability insurance would have soared. (As an aside, the burden of trying to underwrite this exposure would have been enormous as well, not to mention extremely challenging.) These same points could also be made with respect to liability insurance for third-party professionals as well. The position that the investors urged, if successful, would have had a dramatic impact on the cost of liability insurance.
These practical considerations support the view that the Stoneridge case is a defense victory and represents a rejection of an expanded reading of Section 10(b). But the more expansive possibilities may never really have been in the cards, given the lineup of the court. Yes, the decision could have changed things, but in the end, it did not. In effect, Stoneridge represents a 5-3 vote for the status quo. So while a decision for the investors could have increased the cost of insurance, the actual outcome on behalf of the venors is unlikely to impact the cost of insurance.
News coverage of the decision can be found here and here. The Blog of the Legal Times reports a number of different reactions to the decision here.

On January 11, 2008, MBIA became the latest bond insurer to be named as a defendant in a subprime-related securities class action lawsuit. Bond insurers ACA Capital Holdings (about which refer here), Security Capital Assurance (refer here) and Radian Group (refer here) have previously been named in subprime-related securities lawsuits. MBIA is one of the leading triple-A rated bond insurers, and the company’s difficulties may represent among the more significant developments arising from the subprime meltdown. A copy of the plaintiffs’ lawyers January 11, 2008 press release regarding the MBIA securities lawsuit can be found here, and a copy of the securities lawsuit complaint, which also names MBIA’s CEO and CFO as defendants, can be found here.

In addition to the securities lawsuit, MBIA’s benefit plan fiduciaries were also hit with a lawsuit under ERISA, filed on behalf of MBIA employees in connection with company stock held in the employees’ 401(k) plan. The plaintiffs’ counsel’s January 11, 2008 press release about the ERISA lawsuit can be found here. The company also disclosed on January 8, 2008 (here) that the SEC and the New York Insurance Department have started informal inquiries into the company’s recent disclosures and a deal the company struck with Warburg Pincus.

The centerpiece of the securities lawsuit complaint is the company’s December 19, 2007 detailed accounting (here) of its exposures to collateralized debt obligations, a disclosure that contained information the complaint describes as a "bombshell." According to the complaint, in the December 19 release, the company "disclosed for the first time that it faced $8.1 billion of exposure from insuring some of the riskiest securities in the marketplace – collateralized debt obligations (CDOs) comprised of other CDOs (so-called "CDOs squared" securities) whose underlying collateral included residential mortgage backed securities (RMBS)." The complaint alleges that "with this disclosure, investors learned for the first time that Defendants had placed their triple-A rating in jeopardy."

The company’s December 20, 2007 press release (here) attempted to respond to the market criticism and reaction that followed the December 19 disclosure. Nevertheless, the company later came under further pressure when it announced on January 9, 2008 (here) that the company actually held $9 billion of the CDO squared securities, rather than the $8.1 disclosed just weeks before and that, according to the complaint, "nearly 60% of these securities were originated in 2006 or later (which was material because recent vintages are defaulting with greater consistency) and that the portfolio had already caused a $200 million impairment."

The MBIA securities lawsuit is the first subprime-related securities lawsuit of 2008. In light of the magnitude and recency of the events involved in the lawsuit, it seems likely that there will be further developments, both with respect to the company itself and in general. While it is obviously still quite early, the MBIA lawsuit does at least suggest that the 2007 subprime-related securities litigation wave was not, as some have suggested, a one-time event.

I have in any event added the MBIA lawsuit to my running tally of subprime-related securities lawsuits, which may be found here. With the addition of the MBIA lawsuit, the current tally (including subprime-related securities lawsuits pending against the credit rating agencies and against residential home construction companies) stands at 38. With the addition of the MBIA ERISA lawsuit, the number of subprime-related ERISA lawsuits stands at 9.

My prior discussion of bond insurers’ exposure to subprime risk, including a detailed discussion of the securities lawsuit that has been filed against ACA Capital Holding, can be found here.

CDOs Squared: I have previously noted (most recently here) that among the contributing factors to the subprime meltdown are the complicated investment instruments into which mortgage loans were repackaged and sold in the global financial marketplace. The MBIA complaint’s allegations about CDOs squared underscore this point rather impressively. MBIA (and other bond insurers) played a particularly critical role in the viability of these instruments, since MBIA’s willingness to provide insurance against the instruments’ default enabled the instruments to carry MBIA’s AAA rating making them acceptable even to conservative investors.

Readers who like me do not feely fully briefed on CDOs squared may want to review this 2005 Nomura Securities publication (here), which explains that a CDO squared security is a type of collateralized debt obligation where the underlying portfolio consists of other types of CDOs.

According to the article,

Synthetic CDOs-squared offer investors higher spreads than single-layer CDOs but also may present additional risks. These two-layer structures somewhat increase exposures to certain risks by creating performance "cliffs." That is, seemingly small changes in the performance of underlying reference credits can cause larger changes in the performance of a CDO-squared.

Of particular interest to bond insurers (and investors in a bond insurer that happens to insure CDOs squared) is that CDOs squared "display particular sensitivity" to "frequency of defaults." Based on a very detailed analysis, the Nomura article concludes that "higher default rates affect a CDO-squared tranche much more dramatically than the underlying CDO tranche." The report goes on to state, among other things that, that "for example, the probability of a [CDO squared] tranche wipeout goes from 0.6% to 41.2% as the [CDO tranche] default rate goes from 1.0% to 1.5%."

Snakes and Ladders: The Nomura article’s discussion of the risks involved with CDOs squared brings to mind Warren Buffett’s frequent diatribes against derivative securities. For example, in his letter to shareholders in the 2002 Berkshire Hathaway Annual Report (here), Buffett referred to derivatives as "time bombs" and as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." (Full disclosure: I own Class B Berkshire shares, although not nearly as many as I wish I did.)

I have struggled over the years to understand the vehemence of Buffett’s condemnation of derivatives, but I gained fresh insight recently when I read Roger Lowenstein’s excellent book When Genius Failed, which recounts the formation, growth and dramatic collapse of Long-Term Capital Management. The events described in the book took place a decade ago, but many of the same events, circumstances, complications, and even many of the same people, were involved then as are involved in the current subprime meltdown.

LTCM’s story is far more complicated than can easily be recounted here, but the most critical facts are that at the beginning of 1998, the firm had equity of $4.72 billion, but as a result of leverage, carried balance sheet assets of around $129 billion. Even more astonishing were the firm’s off-balance sheet derivative positions, which had a notional value of $1.25 trillion. Adverse global financial circumstances in August and September 1998 put LTCM on the wrong side of a huge number of arbitrage bets, and put the firm in a position where it had to liquidate positions, only to find that there were no willing buyers. Lack of liquidity and the firm’s highly leveraged position not only threatened the firm with failure, but, owing to LTCM’s massive indebtedness, threatened a constellation of financial institutions with enormous losses. The Federal Reserve became concerned that the ensuing fallout could cause panic and damage the financial markets.

The scramble to protect the financial markets from an LTCM meltdown involved a veritable who’s who of the financial world, including the redoubtable Mr. Buffett. Reading about Buffett’s role in the LTCM crisis gave me some insight into his loathing of derivative securities.

First, the book makes it clear that in connection with Berkshire’s then-pending acquisition of General Reinsurance Corporation (which ultimately closed in December 1998), Buffett was worried about Gen Re’s involvement in certain LTCM investments on which Gen Re had counterparty exposure or for which Gen Re had provided financing. (Full disclosure: At the time, I was an employee of a Gen Re operating subsidiary.)

In addition, Buffett was also deeply involved in a Goldman Sachs-led proposed buyout of LTCM, that would have given the acquirers control of LTCM’s assets for $250 million, a small fraction of the assets’ putative (and as events turned out, ultimate) value. The potential buyout did not come off, in part because of Buffett’s inaccessibility at critical moments while he was vacationing in the Pacific Northwest with Bill Gates.

As a result of these events, Buffett apparently had a window into LTCM’s portfolio and apparently came away with an unfavorable view of derivative securities. Indeed, Buffett specifically references LTCM’s near meltdown and disparages some of LTCM’s derivative investments ( particularly "total return swaps") in the 2002 Berkshire shareholders letter linked above.

As an aside, it is worth noting that Buffett is only one of a host of people now prominent in the subprime crisis who played one role or another in the LTCM bailout. For example, John Thain, recently given the assignment of turning around Merrill Lynch, was deeply involved in the LTCM bailout efforts as CFO of Goldman Sachs. Jon Corzine, now the democratic governor of New Jersey, was also involved in many of the discussions. James Cayne, who just this past week resigned as head of Bear Stearns as a result of that company’s subprime woes, played a significant although not particularly constructive role in the LTCM bailout as well.

Although Lowenstein’s book refers to events from ten years ago, it rewards reading now, because it shows how some of the same recurring behaviors drive occasional excesses and trigger periodic crises in the financial markets. Indeed, the recurrence of many of the same circumstances and names today gives the impression that the global financial marketplace represents nothing more than an elaborate game of Snakes and Ladders, where the same money, investments and people slide around in certain prescribed paths and wind up ahead or behind as the game unfolds.

There is also a certain symmetry between the events surrounding LTCM’s near-demise and the current subprime crisis; once again, for example, Buffett is cast in the role of potential rescuer, in particular now with respect to bond insurers (about which refer here). But the more important connection between the two sets of circumstances is the role of complicated derivative securities in contributing to the respective crises. Indeed, given the role that these immensely complicated derivative securities, such as CDOs squared , are playing in the current subprime crisis, Buffett’s comments in the 2002 shareholders letter about the dangers of derivative securities may be required reading for anyone who wants to understand what is going on today.

 

A Reflection on Winter in the Suburbs: Am I the only one who thinks the very idea of "decorative cabbages" is ridiculous?

More About Foreign Claimants, Foreign Companies: In earlier posts (here and here), I discussed issues arising as a result of foreign litigants suing foreign domiciled companies in securities class action lawsuits in U.S. courts. These issues were involved in a recent opinion in a case pending in the Southern District of New York. In a January 8, 2008 ruling (here), U.S. District Court Judge Denny Chin appointed Luxembourg-based investment company Axxion S.A. Luxembourg as lead plaintiff in the consolidated securities lawsuit pending against GPC Biotech AG, a biotechnology company based in Munich, Germany.

Three sets of plaintiffs had sought to serve as lead plaintiffs. Judge Chin selected Axxion, which through its Akrobat Fund-Value investment fund had spend $3.9 million purchasing 150,000 GPC Biotech shares and which claimed losses of $1.8 million, as having the “largest financial interest in the relief sought.” Judge Chin rejected the arguments of the other claimants, who had resisted Axxion’s petition on the grounds that its fund had purchased the shares on the German exchanges. (GPC Biotech’s shares trade both on the Nasdaq and on the Deutsche Bourse.)

In effect, the competing claimants argued that Axxiom’s petition should be rejected because Axxion is an “f-cubed claimant” (a foreign claimant suing a foreign company whose shares the claimant purchased on a foreign exchange.) Judge Chin found (citing the Nortel Networks case) that other courts in the District had previously selected foreign litigants as lead plaintiff to represent both foreign and U.S. investors. He also noted that while the defendants might raise a subject matter jurisdiction defense as to Axxiom, “such a defense would not appear ‘unique’ to Axxiom, as it would appear that many (if not most) of the class members would be foreign investors.”

Judge Chin further noted that there is no reason to doubt” the ability of Axxiom to respond to a motion to dismiss raising the subject matter jurisdiction defense. Judge Chin also commented “without prejudicing the issue” that “plaintiffs have alleged individual acts in the United States in furtherance of the alleged fraud.” As discussed at length in my prior post (here), the presence of substantial acts in the United States has been held by some other courts to be a sufficient basis to support the exercise of subject matter jurisdiction.

As I noted in my recent analysis of the 2007 securities lawsuits (here), there were 26 securities lawsuits filed in U.S. courts in 2007 against foreign domiciled companies, 21 of them in the Southern District of New York. As a result, the issues surrounding foreign litigants’ claims against foreign domiciled companies is likely to be the subject of a great deal of scrutiny and discussion in the months ahead, particularly in the Southern District. The subject matter jurisdiction issue will also receive a great deal of attention. As I noted in a prior post (here), the jurisdictional issue is also squarely raised in a case now pending before the Second Circuit.

Finally, although Judge Chin did not address the issue in his recent opinion, the presence of a significant number of foreign claimants who purchased their shares on foreign exchanges may raise significant class certification issues. In the Vivendi case (about which refer here), the court excluded certain foreign claimants from the class while including others, and, as discussed here, in the recent Royal Dutch Shell decision (refer here), the court (for reasons based on facts perhaps specific to that case) excluded non-U.S. purchasers from the class and dismissed their claims based on the lack of subject matter jurisdiction. These class certification issues will also be important in the new wave of securities claims filed against foreign domiciled companies.

In any event, it appears that even if foreign jurisdictions have not warmed to U.S. style class action litigation, foreign institutions increasingly are drawn to U.S. courts to attempt to recoup investment losses, even against foreign-domiciled companies. These institutions’ willingness to resort to U.S. courts and to rely about remedies available under U.S. law potentially could drive legal reforms in their own countries, as these foreign seek local alternatives to hold company management responsible. These overseas firms’ willingness to employ U.S. litigation suggests that the U.S. approach to litigation, usually portrayed as a disadvantage to the U.S. in the global financial market competition, may actually have a more complicated impact on U.S competitiveness than some would-be reformers assume.

One final observation about the GPC Biotech case is that it embodies a number of important 2007 litigation trends. First, as noted above, a significant factor in the 2007 uptick in securities lawsuit filings is the increased incidence of lawsuits in the Southern District of New York against foreign-domiciled companies, of which the GPC Biotech lawsuit is one example. Second, GPC Biotech is in the 2834 SIC Code (Pharmaceutical Preparations), which as I noted here was one of the SIC Code categories with the greatest number of 2007 filings.

In many ways, the GPC Biotech lawsuit is emblematic of a number of important trends that emerged in 2007, in particular because the case does not in any way relate to the subprime meltdown. As I have noted before, even though the subprime litigation wave was clearly an important 2007 development in connection with securities litigation, it was only one of several important factors at work during the year.

Tracking Subprime Lawsuits: In discussing (here) the 2007 year-end securities lawsuits analysis of NERA Economic Consulting, I noted that NERA’s count of 2007 subprime-related securities lawsuits filings and my own count (here) diverged. I have now had the opportunity to confer and compare notes with NERA, as a result of which I was able to identify the differences between our tallies. Based on these discussions, I have added three additional subprime-related securities class action lawsuits to my running tally: BankAtlantic Bancorp (here), First Home Builders of Florida (here), and Merrill Lynch/First Republic (here).

As a result of these additions, my current tally of subprime-related securities lawsuits (including lawsuits against the credit rating agencies and subprime-related lawsuits against residential construction companies) now stands at 37.

Very special thank to NERA, and especially to Svetlana Starykh, for the willingness to confer and to share information.

Accounting Discipline: According to a January 9, 2008 CFO.com article (here), the International Helsinki Federation of Human Rights must shut down as a result of its finance manager’s six-year embezzlement of $1.8 million. The finance manager apparently embezzled the funds to “support his mistress.”

The Federation’s mission had been “to protect and strengthen civil society groups that monitor and report on human rights issues from a non-partisan perspective.” Unfortunately, the Federation’s funds were put to some decidedly different uses. According to the news reports, “the mistress reportedly gambled away up to $7,000 a week at poker and told the finance executive she needed $44,000 to open a hair salon. She also spent some of the money for breast augmentation and a nose job.”

The finance manager told the court that he would not have agreed to finance the woman’s operations had he known about them ahead of time. (The news reports do not reveal what he thought about them afterwards, though.)

Apparently the finance manager regarded these transfers of cash as a loan transaction; he told the court that the woman had promised him she would pay him back from a large inheritance she expected.

The finance manager, age 43, has been sentenced to three years in jail; the woman, age 31, was sentenced to two years.

All of which is just a reminder of the importance of internal accounting controls for entitles of all sizes and types. It is perhaps an idle thought, but I do wonder how much financial fraud has its origins in some kind of marital infidelity or sexual indiscretion. Admittedly, it would be a difficult thing to try to underwrite…

What He Said: During the time that I have been blogging, I have felt within me an essay developing that would describe what it is like to blog and what the advantages and disadvantages are. My friend Mark Herrmann, who is one of the co-authors of the Drug and Device Law Blog (here), has gone ahead and delivered himself of the very essay I might have written, if I were as articulate as Mark. The essay, published in the National Law Journal, can be found here. He wrote it, now I don’t have to.
By the way, if you have any involvement with life sciences companies, the Drug and Device Law Blog is indispensible.
Hat tip to the Delaware Corporate and Commercial Litigation Blog (here) for the link to the NLJ article.

Last Chance: The early registration discount for the 2008 PLUS D & O Symposium expires January 11, 2008 at 5:00 p.m. CST. The registration materials and schedule can be found here. As I have previously noted, I will be co-chairing this year’s Symposium with Chris Duca from Navigators Pro. We are proud of the program we have put together. The speakers include former SEC Chairman William Donaldson, who will be the keynote speaker, and the panelists include, among many luminaries, SEC Enforcement Division Director Linda Chatman Thomsen.