On February 7, 2007, New Century Financial Corp. became the first company to be named in subprime-related securities lawsuit. On January 31, 2008, just short of one year later, Judge Dean Pregerson of the United States District Court for the Central District of California, granted the defendants’ motions to dismiss, but without prejudice and with leave to amend. For background on the lawsuit, refer here. For a copy of the January 31 opinion, refer here.

The plaintiff shareholders had initiated the complaint following the company’s February 7, 2007 announcement (here) that it would be restating its financial statements for the quarters ended March 31, June 30 and September 30, 2006, because of the company’s need to readjust the company’s allowance for “the potential repurchase of loans resulting from early-payment defaults by the underlying borrowers.” The company said that the reserve did not allow for the discounted price the company sustained upon its disposition of repurchased loans. The company’s press release also said that

the company’s methodology for estimating the volume of repurchase claims to be included in the repurchase reserve calculations did not properly consider, in each of the three quarters of 2006, the growing volume of repurchase claims outstanding.

On April 2, 2007, the company announced (here) that it had filed for relief under Chapter 11 of the U.S Bankruptcy Code. The company’s shares ultimately declined more than 97% percent.

On September 14, 2007, the lead plaintiff in the subprime-related securities lawsuit pending against New Century, the New York State Teachers’ Retirement System, filed a consolidated class action complaint. The consolidated complaint names as defendants the company and certain of its directors and officers; the company’s auditor, KPMG, and investment banks that underwrote the company’s June 2005 and August 2006 preferred stock offerings. The consolidated complaint raises allegations against all defendants under Section 11 of the ’33 Act, and against the company and its directors and officers under Section 10 of the ’34 Act.

In assessing the plaintiffs’ allegations, Judge Pregerson said that the complaint “lacks clarity in articulating the grounds for its claims.” The complaint “does not clearly identify the allegedly false statements or which of the factual allegations support and inference that particular statements are false or misleading.” The court attributed these shortcomings to the “lack of organization and somewhat unclear presentation of the allegations.” As a result, Judge Pregerson said, he “has difficulty determining whether plaintiffs have stated a claim.”

Judge Pregerson granted the motions to dismiss but allowed the plaintiffs leave to amend their complaint, by which the plaintiffs may attempt to “resolve deficiencies in the complaint by simple reorganization, revision and clarification of the currently long and at times meandering set of allegations.” The court instructed the plaintiffs that for each of the supposedly false or misleading statements, “the Complaint should identify some facts suggesting that the statement is false or misleading.” The court also directed the plaintiffs to attach to their amended complaint a chart specifying each allegedly false or misleading statement, the supporting factual allegations and the plaintiffs’ conclusion.

Like the prior dismissal of the subprime-related securities lawsuits involving IndyMac (about which refer here), the dismissal in the New Century case is without prejudice. Judge Pregerson’s opinion in the New Century case does not reach the merits, but nevertheless shows great impatience with the plaintiffs’ scattershot pleading approach. (“The Court,” Judge Pregerson observed in a footnote, “should not have to comb through the complaint to identify reasonable inferences from factual allegations to the legal conclusions.”) The plaintiffs have until February 25, 2008 to file an amended complaint. The court has scheduled argument on the updated motions to dismiss on April 21, 2008.

And so the motion to dismiss on the first-filed subprime securities lawsuit might be ready to be decided some 15 months (or more) after the complaint was initially filed. Obviously, at this rate it will take many years before the many subprime related cases have finally ground their way through the system, and before the full impact of the still evolving subprime crisis can be fully assessed.

But it is interesting to reflect, upon review of the events leading up to the New Century lawsuit, and as the subprime meltdown continues to unfold, that as early as the first quarter of 2006, New Century was already experiencing unanticipated loan repurchase requirements resulting from early-payment defaults on subprime loans. The subprime meltdown may seem like a sudden crisis, but has actually already been years in the making and will be even longer in the unfolding. Clearly, the wheels of finance, like the wheels of the law, grind exceeding slow but exceeding fine.

Hat tip to the Class Action Defense Blog (here) for the link to the January 31, 2008 opinion in the New Century case.

Loaded for Bear: The February 15, 2008 Wall Street Journal had an interesting article entitled “Bear Probe May Center on Investor Call” (here) discussing how federal prosecutors’ investigating the collapse of two Bear Stearns hedge funds managed by Ralph Cioffi are examining Cioffi’s statements in an April 25, 2007 conference call with hedge fund investors. Readers interested in this investigation will want to refer back to the December 17, 2007 Business Week article entitled “The Bear Flu: How it Spread” (here) for further background on the circumstances under investigation.

According to the Business Week article, in the April 25 call, Cioffi made statements about a Bear Stearns branded CDO mechanism that Cioffi also managed called “Klio funding.” This mechanism sold commercial paper and other short term debt to money market funds to allow the CDO to buy other higher yielding, longer-term securities. The money market funds were willing to invest because Citigroup agreed to refund their initial stake plays interest (in a so-called “liquidity put”). Citigroup, in turn, drew fees and also was able to sell the Klios mortgage-backed securities of its own.

According to Business Week, the Klio structure spread rapidly as other hedge funds, CDO managers and bankers “followed Cioffi’s lead.” Between 2004 and 2007, Wall Street raised $100 billion through these types of CDOs, “essentially creating a whole new way for industry to finance risky subprime loans.” The article goes on to detail how the Klios offered the Bear Stearns hedge funds a “ready, in-house trading partner,” and that in many months “the Cioffi-managed Klios traded only with the Cioffi-managed Bear funds.” The daisy chain ended in disaster when the subprime loans underlying these investments began to deteriorate. Much of the subprime-related writedowns amongst the investment banks are related to the liquidity puts they provided.

The Journal article reports that in the April 25 call, one participant wondered whether the packaged mortgage securities in the Bear hedge funds were tied to subprime assets. Cioffi reportedly responded that he didn’t have time to teach “CDO 101” or answer basic questions about the securities. It is probably worth observing that the April 25 call came several weeks after New Century had (as noted above) filed for bankruptcy as a result of deteriorating subprime mortgages that were already a problem more than a year before that. The questioner’s inquiry in the April 25 call about subprime was not, as Cioffi’s belittling response suggests, the result of naïveté, but rather well-grounded concern.

Cioffi’s response, although lacking the vulgarity, calls to mind Jeffrey Skilling’s now infamous conference call statement in the fateful final months of Enron. In response to an analyst’s comment that Enron was the only company that releases its earnings statement without a balance sheet, Skilling said “Well, thank you very much, we appreciate that … asshole.” (Refer here for the details about Skilling and the infamous call.)

The comparison may or may not be fair. But every scandal needs a villain, and fair or not, it appears at least based on the news coverage concerning the collapse of the two Bear Stearns hedge funds, that the casting is now complete. It appears that during the current Act of the subprime drama that the role of villain is to be played by Ralph Cioffi, and as with those called to play the villains in prior dramas, his arrogance will be one of the things held against him.

The Backdating Disposition List, Updated: Regular readers know that I have been maintaining a list (accessed here) reflecting all backdating lawsuit dismissals, denials and settlements. I have recently updated the list to add three additional dismissals in options backdating-related derivative lawsuits, two of which are late additions of dismissals I missed last fall. The three dismissals are as follows:

Openwave: On February 12, 2008, the United States District Court for the Northern District of California granted (here) the defendants’ motion to dismiss the plaintiffs’ options backdating related derivative suit, with leave to amend. The court had previously dismissed the plaintiffs’ initial complaint, with leave to amend.The February 12 decision related to the plaintiffs’ amended complaint. The court will allow the plaintiffs another opportunity to amend.

Westwood One: According to the company’s November 1, 2007 filing in Form 10-Q (here), on August 3, 2007, the N.Y. Supreme Court granted the defendants’ motion to dismiss the plaintiffs’ options backdating-related shareholders’ derivative suit. On September 20, 2007, the plaintiffs’ appealed the court’s dismissal and moved for “renewal” under relevant statutes. The appeal remains pending.

Clorox: According to the company’s November 1, 2007 filing on Form 10-Q (here), on October 27, 2007, the plaintiffs voluntarily dismissed their options backdating-related derivative lawsuit in response to the recommendation of the company’s Board’s Audit Committee’s recommendation to the Board that the Board reject the plaintiffs’ suit demand, on the grounds that the suit was not in the best interests of the company.

Special thanks to Adam Savett of the Securities Litigation Watch blog for the information regarding the Westwood One and Clorox dismissals.

Headline of the Week: Still unexplained: why would anyone want TWO dead dogs?: From the February 16, 2007 Financial Times: “Ground-Dog Day as Woman Pays $50,000 to Clone Dead Pitbull” (here).

On February 12, 2008, a plaintiff initiated a securities class action lawsuit in the United States District Court for the Central District of California relating to Morgan Stanley’s subprime-related woes. The complaint (here) purports to be filed on behalf of a class of persons who purchased Morgan Stanley’s shares between July 10, 2007 and November 7, 2007. The gist of the complaint is that Morgan Stanley "failed to disclose its significant exposure to losses related to the declining value of the subprime-related derivatives that the Company traded for its own proprietary account."

The purported class period ends on November 7, 2007, when Morgan Stanley announced (here) that as a result of the decline in "fair value" of "subprime related balance sheet exposures," the company’s revenues for the two months ended October 31, 2007 "were reduced by $3.7 billion." The complaint contends that "analysts and the market" had been "led to believe that Morgan Stanley’s smaller presence in the underwriting of CDOs would not lead to a major write-down."

While the complaint aspires to assert a  number of very serious allegations, the complaint also has a number of features suggesting something other than a highly engineered litigation assault.

First, the complaint does not name the company, its most senior managers, or its directors as defendants. Instead, the sole defendant named in the complaint is one individual, Gary Lynch, identified in the complaint as the company’s Executive Vice President and Chief Legal Officer. (The complaint also alleges that the company’s Internal Audit Department reports to Lynch, but the complaint does not explain the significance of that fact with relation to the complaint’s allegations.)

The complaint refers to no statements that Lynch himself allegedly made, but instead refers only to statements of Morgan Stanley itself. The allegations against Lynch are based solely on his position and responsibilities within the company. However, the complaint does not explain why Lynch should be held liable while none of the other senior company officials, who also obviously held positions of responsibility, are even named as defendants. There are no allegations that Lynch sold his shares of company stock. The scienter allegations are based solely on allegations of Lynch’s supposed actual knowledge of falsity, but there are no specific allegations of which facts he supposedly knew to be false or the basis of plaintiff’s allegations of Lynch’s knowledge. It is not particularly clear why Lynch has been named. Actually, it is not clear at all.

Concerning the company’s own statements, the complaint refers only to the company’s July 10, 2007 and October 10, 2007 filings on Form 10-Q, with respect to each of which the complaint says only that "nowhere within the filing did the company adequately disclose its exposure to losses incurred from trading in its subprime mortgage-backed derivatives, CDOs or the subprime-backed security organizations for which it was responsible."

Second, although the purported class representative’s certification establishes that the plaintiff did indeed pay $17,211 for 340 Morgan Stanley shares, the plaintiff bought his shares on March 14, 2006, well over a year before the commencement of the purported class period. In other words, the purported representative of the class of persons who purchased shares between July 10, 2007 and November 7, 2007 himself bought no shares during that period. The plaintiff will obviously face certain obstacles satisfying the "commonality" requirement, as he is not even a member of the class he purports to represent.

Third, the complaint was filed in the Central District of California. Morgan Stanley’s world famous headquarters are of course located on Broadway, in the heart of New York City. The only apparent connection to California is the plaintiff’s counsel’s office, which is on South Figueroa Avenue in Los Angeles. (According to a search on Google Maps , the distance from the plaintiff’s lawyer’s office to Morgan Stanley’s headquarters is 2,782 miles, a distance that seems metaphorically apt given the attributes of the plaintiff’s complaint.)

But whatever its merits, the complaint does in fact purport to represent a subprime-related class action lawsuit. Accordingly, I have added the case to my running tally of subprime-related lawsuits, which can be found here. As reflected in my tally, the addition of the Morgan Stanley complaint brings the number of subprime-related securities class action lawsuits to 44, and also brings the total number of 2008 subprime-related securities lawsuits to seven. 

It remains to be seen whether another plaintiffs’ firm will follow up on the Los Angles attorney’s salvo and file a more, well, calibrated securities lawsuit, or if this complaint will be the only attempt. It should be noted that Morgan Stanley has already been named in a subprime-related action purportedly brought on behalf of company employees’ under ERISA in connection with their company shares in their defined contribution plans, as described in the plaintiffs’ counsel’s December 18, 2007 press release (here). As noted in my running tally, the Morgan Stanley ERISA suit is one of nine subprime-related ERISA actions.

Subprime: BIgger Than the S & L Crisis?: On February 14, 2008, Navigant Consulting released a report on the 2007 subprime-related litigation (executive summary here). Among other things, the report notes that (including all categories of lawsuits, including borrower suits, bankruptcy actions, employment claims, as well as securities cases) there were 278 subprime-related lawsuits filed in 2007.

Navigant also issued a February 14, 2008 press release (reported here) stating that, by way of  comparison of the subprime litigation wave to the litgation filed in connection with the S & L Crisis, that the 278 subprime lawsuits, all filed in a single calendar year, "already equal one-half of the total 559 actions handled by the RTC over a multiple-year period." The report’s author said that “The S&L crisis has been a high water mark in terms of the litigation fallout of a major financial crisis. The subprime-related cases appear on their way to eclipsing that benchmark.”

The report also notes that, in addition to mortgage bankers and loan correspondents, subprime litigation defendants include "mortgage brokers, appraisers, title companies, homebuilders, mortgage servicers, issuers, underwriting firms, securitization trustees, bond insurers, rating agencies, money managers, public accounting firms and company directors and officers."

The report also notes that "Fortune 100 companies were named in 56 percent of cases" and around "half of all cases were filed in California and New York." Litigation, the report concludes, "is only likely to increase in 2008."

Hat tip to the WSJ.com law blog (here) for the link to the Navigant report.

Subprime Primer: One of the more daunting aspects of the subprime crisis has been the veritable outburst of obscure and confusing terminology. In a recent post, The Sox First blog published a very helpful "Crunch Time Glossary" (here) explaining a long list of the subprime-related terms. My favorite is the Ninja Loan, defined as "a loan given to a person with No Income, No Job, and No Assets." (100% of Ninja loans are now less euphemistically and less colorfully known as "nonperforming.")

A developing breakdown in an obscure corner of the credit-market involving debt instruments called “auction rate securities” could represent the latest threat to emerge from the credit crisis. According to news reports (here and here), the absence of buyers for these securities has caused several recent auctions to fail, forced isuers to abandon their offerings or pay exorbitant rates, and stuck many holders with instruments they did not intend to keep. The declining values for these securities confronts many holders with the prospect of significant balance sheet write-offs, and presents another source of possible litigation arising from the evolving crisis. These circumstances also present more evidence to support my view (expressed most recently here) that the fallout from the credit crisis will ultimately extend far beyond just the financial sector.

 

Auction rate securities are long-term bonds or preferred stock on which the interest rates are reset periodically, usually every seven, 28 or 35 days. The interest rate resets make the instruments more like short-term securities. Holders can also sell the instruments on the reset dates – assuming there are enough buyers.

 

According to a February 13, 2008 article in the Wall Street Journal entitled “Credit Woes Hit Funding for Loans to Students” (here) the market for these securities has “gone into the deep freeze.” Roughly half of the $20 billion in these securities put up for auction on February 12 “failed to generate enough demand to sell.” Problems have been mounting for weeks. According to one commentator in a February 13, 2008 Bloomberg article entitled “Auction-Bond Failures Roil Munis, Pushing Rates Up” (here), “it’s the beginning of the end of the auction rate market.” UPDATE: The lead article on the front page of the February 14, 2008 Wall Street Journal (here) says that this "once-obscure type of bond is now sending shock waves through a broad swatch of the U.S. economy. The February 14 Wall Street Journal also has a separate article entitled "Train Pulls Out of New Corner of Debt Market" (here)

 

According to the Bloomberg article, “investor demand for the securities has declined on waning confidence in the credit insurers backing the debt.”  Whereas in the past, the broker-dealers selling the securities might have intervened to support the market, these dealers are now wrestling with balance sheet issues of their own and can’t take the risk of getting stuck with the securities. These conditions are hitting issuers, such as student lenders, who depend on these instruments to raise funds to loan to students, and municipalities, who are finding the lending costs skyrocketing. The conditions are also hitting investors that purchased the securities in the past and now fund themselves unable to sell, or with interest rate reset mechanisms that are malfunctioning.

 

The February 13 Journal article reports that the size of the auction rate securities market is “$325 billion to $360 billion,” and the Bloomberg article reports that about a third of the 449 companies responding to a May 2007 survey reported that their companies permitted investment in auction rate securities.

 

The turmoil in the market for auction rate securities is already taking a toll on some companies. As I previously noted (here), Bristol-Myers Squibb recently took an impairment charge of $275 million in connection with its investment in auction rate securities. Lawson Software also recently took a charge to adjust for the fair market value on auction rate securities. The February 14 Journal reports that 3M and US Air have also made auction rate securities related accounting adjustments. 

 

As I noted in my prior post discussing the Bristol-Myers write-down, these balance sheet issues potentially affect companies in many different sectors. As I have long said (refer here), before all is said and done, the subprime meltdown is going to be about a lot more than just the financial sector.

 

Indeed, according to a February 6, 2008 CFO.com article entitled “Subprime Woes Just Beginning” (here) Samuel DiPizza, the CEO of PricewaterhouseCoopers, says that the next wave from the subprime mortgage crisis “will flow past lenders and homebuilders and strike nonfinancial U.S. companies with forced writedowns.” DiPiazza specifically referenced the fact that “these securities sit in cash equivalent accounts of industrials; they sit in investment portfolios of pensions. We are having to deal with thousands of companies, not just a handful of big banks.” In a Reuters account of his comments (here), DiPiazza added that a "first wave" of write-downs was likely in the current audit cycle this quarter.

 

Nor does the disruption of the auction rate securities market raise only accounting and valuation issues. There have already been at least two lawsuits brought by auction rate securities investors against investment managers based on soured auction rate securities investments.

 

The first, as reported in the Wall Street Journal (here), was the Texas state court lawsuit (complaint here) brought by Metro PCS against Merrill Lynch. The lawsuit alleges that Merrill invested $133.9 million of the company’s cash in 10 auction-rate securities without appropriate authorization or disclosure and that Merrill later misrepresented the riskiness of the assets and their suitability under the company’s investment guidelines. I previously discussed the Metro PCS lawsuit here.

 

The second lawsuit, first reported Bloomberg (here), involves a FINRA arbitration complaint brought against Lehman Brothers Holdings by Brian and Basil Maher, who claim that Lehman’s investment of $286 million of the brothers’ funds in auction rate securities was inconsistent with the brothers’ stated investment objectives. UPDATE: The February 14, 2008 Wall Street Journal has a front-page article entitled "Debt Crisis Hits a Dynasty" (here) that details how the Mahers earned their fortune and  what happened after they invested a portion with Lehman. The article also describes the Mahers’ arbitration complaint in greater detail.

 

Both of these lawsuits relate to an earlier freeze-up in the market for auction rate securities, in August and September 2007. The more recent market seizure is much more widespread, affects many different levels of securities, and many more investors, including corporate investors. As the PricewaterhouseCoopers CEO’s remarks underscore, many of the companies and investment funds holding these investments face complicated evaluation and accounting issues. Many companies may find themselves compelled (perhaps at their auditor’s insistence) to take asset write-downs or impairment charges. Shareholders and fund investors who may feel they were not fully informed about the balance sheet assets and valuation risks may, like the plaintiffs in the lawsuits cited above, seek legal redress.

 

But in any event, as I have long said, before all is said and done, the subprime litigation wave is going to have spread far beyond just the financial sector.

 

An excellent  February 13, 2008 CFO.com article entitled "Is Your ‘Cash" in Danger" (here) discusses the current state of the auction rate securities market in greater detail (the market is "coming to a screeching halt") and discusses the valuation and accounting implications for companies that hold these securities on the balance sheets. My prior post regarding asset valuation issues in the context of the current credit crisis can be found here.

 

Opt-Out Lookout: As I have tracked the rising significance of securities class action opt-out settlements (most recently here), I have tried to discern whether or not the rash of recent opt-out cases was a temporary phenomenon or more enduring. And while it does not definitively answer the question, the recent analysis on the Securities Litigation Watch blog (here) regarding the opt-outs from the Tyco class action settlement provides some very interesting additional data.

 

According to the SLW, 288 class members excluded themselves from the class settlement (which was finally approved on December 19, 2007). While not all the opt-outs have filed individual actions (yet), so far 88 institutional investors and high net worth individuals have joined in a total of five separate opt-out complaints. The opt-outs include several high profile mutual fund families and investment fund groups, as the SLW details at length.

 

The presence of such a significant number of opt-outs certainly suggests that opting out may prove to be a more enduring phenomenon. On the other hand, the fact that the specific class settlement involved is the Tyco securities case means that we will have to await another day to assess whether the opt-out phenomenon is merely an attribute of the corporate scandals or will become a standard fixture of all securities class action settlements.

 

A Rare Spectacle — Securities Litigation Trials: Another interesting recent phenomenon was the surprising recent coincidence of two securities class action trials, in the JDS Uniphase case and the Apollo Group case. In the latest issue of InSights (here), I take a more detailed look at these two trials and analyze their possible significance.  

 

After nearly two years publishing at its original site on Blogger, The D & O Diary is proud to move into its new home on LexBlog. I hope that all of my readers will welcome and enjoy the new site’s features. The new site should be easier to navigate, and has some added functionality, such as the ability to print individual posts in a printer friendly format (use the little printer icon at the bottom of the post), and the ease of locating popular posts in the (soon to be populated) "Posts of interest" function in the right hand column.

Email and RSS Feed subscribers who had subscribed to the old site should continue to receive emails or feeds when new posts are added to this site. However, anyone who has any problems should let me know right away and I will try to remedy the situation. Just click on the blue “Contact” link in the right hand column below my picture to send me a message.

Those of you who had Bookmarks or Favorites links to the old site will need to change the link to this site. The address for this site is https://www.dandodiary.com . All of my prior posts will remain available on my old site, but I have also ported all of my prior posts over to this site as well. I will not be adding any new posts to this site.

I look forward to continuing to provide posts of interest on this new site. Please let me know if you have any questions, comments or concerns. Welcome to The New D & O Diary.

Cheers.

Over the past several weeks, several industry observers and analysts have tried to put a number on the insurance industry’s aggregate subprime-related loss exposure. At one end, Bear Stearns on January 24, 2008 estimated the industry’s exposure at $8-9 billion (refer here). By contrast, on February 8, 2008, Lehman Brothers estimated (here) that the insurance industry’s losses might range up to $3 billion, and on February 6, 2008, Advisen announced (here) that it will be releasing a report estimating that the industry’s ultimate losses at $3.6 billion.

I don’t envy these experts whose job it is to try to quantify something as big, amorphous and evolving as the subprime-related litigation wave. Nor do I profess to have any particular insight into whose estimate is more accurate or what the ultimate number will be. I do have some observations about some considerations that are or should be being taken into account in making these kinds of estimates, in light of the circumstances surrounding the evolving subprime meltdown. (I should add that in making these observations, I have not had the benefit of reading the entire Advisen report, which as of this writing is not yet available; I have only had an opportunity to review the press release summary.)

In general, I think the various estimates have correctly noted that a potentially large portion of the amounts to be paid in settlements or judgments in the subprime litigation may not represent insured loss. In particular, the observers have correctly noted that many of the largest commercial and investment banks that are involved in the subprime-related litigation carry very large self-insured retentions and also often carry only Side A insurance programs (covering only nonindemnifiable loss, unlikely to occur here for these entities) or in some cases no insurance at all for certain exposures. These various observers have made a number of other valid observations concerning other factors that could restrict the impact of subprime losses for D & O insurers.

But at the same time, it seems to me that there are a number of other considerations that these observers have undervalued or even overlooked in assessing the possible impact of the subprime meltdown on insurers.

First and foremost, I think it is important to stress that we are only at the very earliest stages of the emergence of the subprime-related litigation. To be sure, there are (as documented here) already 43 subprime-related class action lawsuits, as well as nine subprime-related ERISA lawsuits, but before all is said and done, there are going to be many, many more of these and other kinds of lawsuits. We have not even completed the first round of subprime loss truth-telling (refer here), and it is probable that there will be even further deterioration in the mortgages underlying the subprime-backed assets as homeowners find it easier to walk away that to continue to pay down debt on a house that is declining in value (about which refer here).

As Couglin Stoia attorney Sam Rudman observed at last week’s PLUS D & O Symposium, there are likely to be more securities class action lawsuits in 2008 than any year since the passage of the PSLRA (Rudman is himself already involved as plaintiffs’ counsel on many of the subprime-related lawsuits).The subprime-related litigation wave is likely to continue to emerge well into 2009 and possibly beyond (just as the options backdating litigation wave continues to emerge). The possible extent of this future litigation threat may be discerned from the recent litigation commenced against the Cadawalader firm (about which refer here), in which the allegations relate to commercial mortgage securitization documents the firm prepared in 1997. In other words, any dollar estimate of the possible subprime-related insurance losses should be accompanied by a healthy appreciation of how little of the ultimate amount of subprime-related litigation we can currently even see. Since we still don’t know how big of an event this ultimately will be, and because it is likely to be years before we have clear idea, any attempt at quantification should carry some very substantial caveats.

Second, many of these estimates seem to presume that the insurance industry’s subprime-related losses will be limited to the financial institutions sector. I do not think this is a conservative assumption. To the contrary, I think it should be assumed that the subprime-related litigation wave will both spread beyond subprime and beyond the financial sector (as I discuss at greater length here). The recent securities class action lawsuits against student loan company SLM Corporation (about which refer here) and Levitt Homes (about which refer here) underscore that the claims have already spread. Bristol Myers Squibb’s recent $275 million write-down for subprime-related investment losses (refer here) further highlights that the credit crisis is no longer just about the financial sector. The possibility of further credit-related losses in many sectors outside the financial sector, and for ensuing claims, at this point seems likely — or at least that would appear to be the conservative assumption.

Third, much of the analysis of the insurance industry’s exposure has been concentrated largely (although, it must be recognized, not exclusively) on potential losses for D & O insurers. To be sure, the growing number of subprime-related securities class action lawsuits represents a very substantial threat to the D & O insurance industry. But the potential for insured losses in coverage lines outside of D & O could also be very substantial. By way of illustration, State Street’s recent $618 million charge for anticipated subprime-related litigation expenses was in connection with lawsuits that do not (as discussed in my recent post, here) appear to implicate D & O coverage, but that could present significant fiduciary liability or even investment management E & O losses.

By the same token, the recently revised complaint in the subprime-related securities litigation involving Countrywide (about which refer here) added accountant liability claims, as well as claims against Countrywide’s offering underwriters. Other professionals undoubtedly will find themselves caught up in subprime related litigation, including, for example, lawyers; hedge fund and pension fund managers; mortgage brokers; appraisers and surveyors; real estate brokers; and insurance agents, among many others. The cumulative losses from claims against other professionals could be very substantial, and at this early stage particularly difficult to prognosticate.

Even with respect to the analysts’ breakdown of the likely D & O losses, the breadth of the current and likely future claims may or may not be being fully taken into account. That is, while it is true that some of the lawsuits against the largest financial institutions may not, because of the way that these entities structure their insurance, involve the prospect for insured losses, most of the current and likely future subprime litigation defendants do not have these types of insurance arrangements. As the claims spread to secondary players and targets in the hinterlands (about which refer here), the claims are hitting defendants that have more traditional insurance structures. Those (far more numerous) claims may involved a greater percentage of insured losses than (the relatively few claims, as a percentage matter) against the largest banks and financial institutions.

Fourth, I am well aware that one of the issues with which these analysts have had to grapple is the need to try and put the subprime meltdown into context. The challenge is not just to say how it compares, for example, to the S & L crisis or the bursting of the dotcom bubble, but also to come up with a figure for those prior events in order to compare the current subprime crisis. I don’t have data for those prior events, but I do know that the still unfolding options backdating scandal may present a useful comparison. As I have detailed in another post today, the options backdating losses, on the few cases that have been resolved so far, already represent in aggregate some very impressive numbers. There are many more options backdating cases yet to be resolved. The total options backdating related losses are likely to by very substantial. Given that just about everyone assumes that the subprime related crisis represents an even greater threat to insurers than the options backdating scandal, the implication is that the subprime related losses could be very significant indeed.

Fifth, whatever else might be said, nothing meaningful about the extent of the subprime threat can be derived from the D & O insurers’ current marketplace behavior. My comment here relates specifically to the comment in the Lehman Brothers report linked above that "if insurers were concerned about suffering multi-billion dollar subprime D & O losses that could spread outside financial institutions sector, the market would tighten significantly." If the D & O industry had a long track record of skillfully adjusting its prices to changing exposures, this remark might have greater validity. Unfortunately, the industry’s consistent history suggests that the industry is only capable of disciplining itself when losses become so painful that it is forced to change its ways. The current D & O pricing environment is a reflection only of the amount of available capacity, not of any calibration to emerging exposures. The marketplace will remain competitive until cumulating losses force the changes of necessity, and then any changes would be abrupt and disruptive — as they have always been in the past.

Sixth, as most of the analysts have noted, the defense expense associated with the subprime cases in and of itself could be staggering. As an example of how expensive these cases can be, Apollo Group recently reported (here) that it had spent $25 million dollars taking the securities lawsuit pending against the company through trial. Because of the legal and factual complexity surrounding the subprime cases, they could be extremely costly to defend. Much of the associated defense expense, other than for the large investment bank defendants, is likely to be covered loss. For each of the securities cases, the defense expenses are likely to be many millions of dollars, and, for the cases in the aggregate (including those already filed and those yet to be filed), to be many hundreds (and possibly thousands) of millions of dollars. To these costs must be added the costs of defending the claims raised against other professionals.

Finally, it would be unfortunate if the subprime hype were to obscure the fact that the subprime-related litigation is only one of several very important current developments affecting D & O insurers’ exposure. As I have noted elsewhere (refer here) securities litigation levels would be elevated compared to the prior two years’ activity levels even without the subprime-related litigation. The Securities Litigation Watch blog recently noted (here) that January 2008 securities activity remained at elevated levels, only in part because of the subprime related litigation. None of this could be discerned from D & O insurers’ current conduct. It has been ever thus.

Blog Warning: This week I hope to be making some long needed adjustments to The D & O Diary. While these changes are taking place, I will not be adding any new blog posts (although the current posts will remain available). These adjustments should result in several improvments to The D & O Diary. I will report further on the adjustments once they have been completed.

Amidst all the subprime hoopla, it would be easy to forget that only a year ago, options backdating was the hot topic. Options backdating might now seem passé, but several considerations suggest that options backdating remains important and that we still have a long way to go before we can be sure we have seen all of the options backdating scandal fallout.

Accumulating Lawsuits: The first important consideration about options backdating in early 2008 is that the options backdating related lawsuits are still coming in. As I previously noted (here), last month shareholders filed an options-backdating related securities class action lawsuit against Teletech Holdings.

In addition, on February 6, 2008, plaintiffs’ lawyers announced (here) that they had initiated a securities class action lawsuit in the United States District Court for the Northern District of California against Maxim Integrated Products and certain of its directors and officers. The lawsuit relates to Maxim’s January 17, 2008 announcement (here) that, as a result of its Board’s special committee’s investigation of the company’s stock option practices, the company would be restating its financial statements to record non-cash, pre-tax charges of between $550 and $650 million for additional stock-based compensation expense. The company also announced that investors should not rely on the company’s financial statements for the fiscal years 1997 through 2005 and corresponding interim reporting periods through March 25, 2006.

The timing of Maxim’s recent announcement is relevant here. The company had first announced its anticipated restatement nearly a year prior, in January 2007 (here), and the company’s January 2008 announcement indicated that the company’s review was not only not yet complete, but would have to be expanded backwards to include its 1995 and 1996 fiscal years. Maxim is surely not the only company that continues to struggle with the accounting clean-up from options backdating-related issues. There may well be additional options backdating related lawsuits filed in the months ahead.

But in any event, with the addition of the Maxim Integrated Products lawsuit to my running tally of options backdating related lawsuits (which can be found here), the current total number of options backdating related class action lawsuits now stands at 36. These 36 class action lawsuits are in addition to the 166 options backdating related derivative lawsuits that have also been filed.

Accumulating Settlements: The second important consideration about options backdating in early 2008 is that the settlements of the options backdating related cases are accumulating in a material way. Indeed, on February 8, 2008, HCC Insurance Holdings announced (here) that it had settled the options backdating-related securities class action lawsuit that had been filed against the company and certain of its directors and officers, for a payment of $10 million dollars (to be funded entirely by insurance). The company had previously announced on January 9, 2008 (here) that it had settled the options backdating related derivative lawsuit in which the company was involved, in exchange for an agreement to adopt certain governance reforms and the payment of $3 million of the plaintiffs’ attorneys’ fees.

As reflected in my table of options backdating-related lawsuits dismissals, denials and settlements (which can be accessed here), the HCC settlement represents the seventh of the options backdating-related securities class action lawsuits to settle. The aggregate amount of these seven settlements is $244.55 million. Three other options backdating-related securities class action lawsuits have also been dismissed, meaning that at this point, ten of the 36 options backdating related securities lawsuits have either settled or dismissed, with another 26 yet to be resolved.

As also reflected on my list of options backdating related case dispositions, there have also been a number of options backdating related derivative settlements. The value of some of these settlements has not publicly disclosed, but the value of the disclosed settlements – not counting the $900 million UnitedHealth Group derivative settlement – is over $61 million.
The sum of the value of these two categories of options backdating-related lawsuit settlements is over $300 million – and if the UnitedHealth Group settlement is included, the total value so far is over $1.3 billion. (It should be kept in mind that these figures do not reflect the derivative settlements that were not publicly disclosed). Of course, these figures do not include the costs the companies incurred to defend these cases, as well as to defend themselves and their senior officials against SEC investigations and other regulatory and criminal matters. And, perhaps most significantly here, there are many more of these cases yet to be resolved than have so far been settled or dismissed.

The Securities Litigation Watch blog has a more detailed analysis of the options backdating securities class action settlements here.

I have gone through this exercise to point out that when all is said and done, the options backdating scandal is going to have proven to have had a very significant event. While not all of the settlement and amounts and defense expenses represent covered loss (for example, the UnitedHealth Group would appear to be excluded from coverage under the typical D & O insurance policy), much of these amounts will be paid by D & O insurers.

As is clear from the fact that options backdating related lawsuits continue to emerge, and the fact that the vast majority of the options backdating-related cases are yet to be resolved, D & O insurers are going to continue to incur these losses for some time to come. And while it can certainly be hoped that the insurers’ reserving practices fully anticipate future developments in these cases (and the cases yet to emerge), the possibility that options backdating might be a bigger deal than everyone has been assuming right now cannot be overlooked.

This analysis of the options backdating-related cases provides some significant context for the current rapidly unfolding subprime-related litigation wave. By any measure, the subprime wave represents a bigger threat than the options backdating related cases. There are going to be many more subprime-related securities class action lawsuits (right now, there are 43 subprime-related securities lawsuits vs. the 36 options backdating related securities lawsuits, and the subprime related lawsuits are going to be rolling in for the rest of this year and probably into the next); the subprime cases involve much more significant shareholder losses; the subprime cases will be very expensive to defend; and, due to their complexity, the subprime cases will take a long time to resolve.

Bottom line: the options backdating scandal and the subprime meltdown together represent adverse circumstances for D & O insurers – something you would never be able to discern from the current marketplace conditions.

Special thanks to Adam Savett of the Securities Litigation Watch for the link to the HCC settlement and for suggesting to me the aggregation of the options backdating related class action settlements.

As I have previously noted (here), securities backed by subprime and other residential mortgages are not just held by financial companies. A wide variety of companies invested in these securities in order to try to improve their return on cash and short-term investments. As the credit markets have deteriorated, many of these investments have declined in value, and the companies holding these investments have been forced to take write-downs or charges. The most dramatic write-downs have come from companies in the financial sector. But now companies outside the financial sector are announcing downward accounting adjustments, and some of these accounting adjustments are occurring in some unexpected places.

The most significant of these downward accounting adjustments outside the financial sector so far was announced in connection with the January 31, 2007 fourth quarter and year end earnings release (here) of Bristol-Myers Squibb. The company reported an overall net fourth quarter loss of $89 million. The loss included "an impairment charge of $275 million on the company’s investments in auction rate securities." The company reported that it has a total of $811 million invested in auction rate securities (ARS), the underlying collateral for some of which "consists of sub-prime mortgages."
The company reported that as a result of "multiple failed auctions" and downgrades, the year-end estimated market value of the ARS investments was $419 million. Although the ARS continue to pay interest, as a result of valuation models and "an analysis of other-than-temporary impairment charges," the company recorded an impairment charge of $275 million, and an unrealized pre-tax loss of $142 million. The company noted that if the credit market deteriorates further, "the company may incur additional impairments."
Bristol-Myers Squibb is not the only company outside of the financial sector to report a write-down or to take a charge based on deterioration of mortgage-backed assets. In its December 13, 2007 fiscal fourth quarter earnings release (here), Ciena reported a $13 million loss related to commercial paper issued by two structured investment vehicles (SIV) "that entered receivership and failed to make payment at maturity." And in its January 7, 2008 fiscal second quarter earnings release (here), Lawson Software reported that its revenue gains were offset by a non-operating permanent impairment charge of $4.2 million…to reduce the fair value of the auction-rate securities held by the company.
While these downward accounting adjustments are noteworthy, they do have to be put in perspective. Bristol-Myers Squibb’s $275 impairment charge should be looked at in conjunction with the company’s $2.2 billion in cash, cash equivalents and short-term securities, that it carries on its balance sheet in addition to the principal the company invested in ABS. Ciena’s $13 million loss needs to be put in the context of the company’s $1.7 billion total cash position. These companies’ adverse financial developments, while negative, certainly do not threaten these companies’ financial health.
The significance of these financial adjustments is that they happened at all; their occurrence strongly suggests that other companies outside the financial sector may also find themselves taking charges or write-downs. Some of these accounting adjustments may not be as relatively insignificant as they were for the companies mentioned above, and it is possible that some of the downward adjustments could involve a more significant impact on these other companies.

Along those lines, the Tech Trader Daily blog had an interesting recent post entitled "Tech More Exposed to Debt Troubles Than You Think" (here), in which it reported on a Merrill Lynch analysis of 190 technology companies. The analysis sought to determine which of these companies had invested their cash in "mortgage-backed securities, asset-backed securities, auction rate issues and paper issued by government-sponsored enterprises like Fannie Mae." The study found that 22 of the companies studied had "25% or more of their cash in these potentially risky categories."

Among companies specifically mentioned were Foundry Networks (with 68.3% of its $946 million cash "at risk"); Texas Instruments (66.2% of its $3.9 billion cash); Entergis (62.4% of its $126 million cash); Photon Dynamics (53.9% of its $90 million cash); Novellus (52.5% of its $1 billion cash) and Intersil (47.1% of its $578 million).

Whether these or other companies will be making downward accounting adjustments as a result of their holdings in these "risky categories" of investment remains to be seen. But the list clearly suggests at least the possibility that one or more companies could wind up taking charges or write-downs that would have a greater impact than those of Bristol-Myers Squibb or Ciena.
These kinetic possibilities pose an enormous risk for investors and for D & O underwriters. The uncertainty around where these "risky categories" of assets may reside and about whether or not these assets create balance sheet or income statement vulnerabilities makes investment and underwriting assessments enormously complicated. Indeed, the very lack of transparency around these issues could itself become an issue, because it raises the potential for later accusations that aggrieved parties were misled about a company’s true financial condition.

To be sure, there have as yet been no shareholder claims against companies outside the financial (and residential home construction) industries on these types of issues as part of the current subprime litigation wave. But as I demonstrated in my year-end analysis of the 2007 subprime-related securities lawsuits (here), the subprime wave has already expanded to encompass a broad variety of different kinds of defendant companies. At this point, the prudent assumption is that lawsuits arising out of nonfinancial companies’ exposure to mortgage-related investment risk will arise. This potential creates a very significant challenge for D & O underwriters as they attempt to underwrite, segment, and price the subprime risk, which is now clearly not limited just to the financial sector.
UPDATE: The February 1, 2008 Financial Times has an editorial entitled "Writedown Infection Spreads" (here) which is very much in the same vein as this blog post, and specifically discusses the Bristol Myers’ subprime related accounting action.
Special thanks to Thomas Smith for alerting me to the Bristol-Myers impairment charge and to a loyal reader who also flagged the Brisol-Myers action and sent along the Tech Trader Daily blog link.

One More Thing to Worry About: Credit Default Swaps: As the recent turbulence involving the bond insurers has demonstrated, another type of complex instrument with which we are all going to have to get familiar is the credit default swap. According to the Seeking Alpha blog (here), the notional value of the CDS market is in excess of $45 trillion, of which the major financial institutions hold about 40% — the implication being that the other 60% is held by somebody other than the major financial institutions.

The kind of threat this might represent is demonstrated in the January 2007 Second Circuit decision in the Aon Financial Products v. Société Générale case (here). To simplify, AON had provided a credit default swap to another party, and to protect itself, in turn bought a credit default swap from SG. The ultimate debtor defaulted, AON paid its guarantee, but SG refused. The Second Circuit held, in effect, that because of the differences in the way different guarantees were worded, SG did not have to pay even though AON did, so AON lost $10 million rather than making $100,000.

The Seeking Alpha blog post linked above has a very good short summary of the case. The blog post notes that the case provides "a fascinating insight into the risks posed by credit default swaps and demonstrates how even financial institutions and hedge funds that have used such instruments prudently may find themselves facing unexpected damages in the coming months as default rates begin their inexorable upward climb."
Special thanks to a loyal reader for the link to the Seeking Alpha post.

In a prior post (here), I noted that the subprime meltdown story is no longer just about subprime, and that the crisis spreading to other types of credit could stretch the subprime litigation wave to areas outside of subprime. The lawsuit filed today against SLM Corporation (better known as "Sallie Mae") officially brought the subprime litigation wave to the student lending arena.

According to their January 31, 2008 press release (here) the plaintiffs’ lawyers have filed a securities class action lawsuit in the United States District Court for the Southern District of New York against Sallie Mae and certain of its directors and officers. Even though Sallie Mae is in the student lending business, the complaint (here) refers to "subprime" loans, although in this case the reference is to loans made to students at so-called "non-traditional schools."

According to the press release, the complaint alleges that the defendants concealed from the investing public that:

(a) the Company failed to engage in proper due diligence in originating student loans to subprime borrowers, particularly those attending nontraditional institutions; (b)the Company was not adequately reserving for uncollectible loans in its non-traditional portfolio in violation of generally accepted accounting principles, causing its financial results to be materially misstated; (c) the Company had far greater exposure to anticipated losses and defaults related to its non-traditional loan portfolio than it had previously disclosed; and (d) given the deterioration and the increased volatility in the subprime market and reductions in federal subsidies, the Company would be forced to tighten its lending standards on both its federal loans and private education loans which would have a direct material negative impact on its loan originations going forward.

As I have noted in connection with the running tally I have been maintaining (here) of the subprime lawsuits, as the subprime litigation wave has evolved, it has gotten increasingly more difficult to maintain absolute definitional specificity about what constitutes a subprime lawsuit. The fact that this case uses the word "subprime" is clearly not alone sufficient to answer the question whether or not the case belongs on my tally. I have decided that it does belong on the tally, though, because for some time the evolving subprime litigation wave has really been more about the fallout from the larger credit crisis rather than just about subprime lending in and of itself.
So the addition of the Sallie Mae lawsuit brings the current tally of subprime related securities lawsuits (including lawsuits against the credit rating agencies and against residential construction companies) to 42. The Sallie Mae lawsuit is also the fifth subprime related lawsuit filed so far in 2008.
The Sallie Mae lawsuit also represents another important trend that is driving securities litigation, that is, it is also a lawsuit arising out of a failed merger. I noted recently that the new lawsuit against Levitt Corp. fell into this same category of lawsuits the involve both subprime allegations and allegations relating to a failed attempted merger. The earlier lawsuit against Radian Group also falls into this category. My prior discussion of the failed merger securities litigation trend can be found here. My prior discussion of the attempted Sallie Mae merger deal can be found here.
Another State Street Lawsuit: In an earlier post (here), in which I discussed the $618 million reserve for litigation expenses that State Street posted, I detailed and analyzed five lawsuits that had been filed in connection with investments two of its funds had made in subprime related assets. On January 30, 2007, the Houston Police Officers’ Pension Fund filed yet another lawsuit against State Street (here), this one in the United States District Court for the Southern District of Texas. The lawsuit alleges breach of fiduciary duty, breach of contract, fraud, negligent misrepresentation, and violation of the Texas state securities laws.

This lawsuit is the first of the State Street lawsuits to raise a claim for breach of the securities laws. In my prior post, I noted that, among other things, because the other lawsuits named no individual defendants and raised no securities laws violations (the allegation of a securities law violation being a prerequisite to trigger so-called "entity"coverage), the lawsuits would not seem to implicate the typical D & O policy. But the inclusion of the securities claim in the latest lawsuit raises the possibility that the new lawsuit at least implicates the D & O policy. However, the absence of individual defendants and the involvement of a host of claims that typically would not be covered under a D & O policy could set up a potentially complicated allocation problem. (I reiterate that I have no direct knowledge of State Street’s insurance program, and I am expressing no definitive coverage opinions, I am merely making observations based on the publicly available information. The actual circumstances may be quite different than I have assumed).

The Subprime ERISA Lawsuits: In my running tally of the subprime lawsuits (which, again, is here) I have been tracking, in addition to the subprime-related securities class action lawsuits, subprime-related lawsuits raised under ERISA, typically brought on behalf of employees in connection with the company stock held in their defined contribution plan accounts. A January 2008 memorandum by the Greenberg Traurig firm entitled "Suprime Mortgage Crisis Impacts ERISA Plan Investment in Employer Stock" (here) provides an overview of the subprime-related ERISA lawsuits, including the legal issues that are likely to be involved.

In prior posts (most recently here), I have discussed the growing threat that Foreign Corrupt Practices Act (FCPA) enforcement may present for companies doing business overseas. This trend became even more pronounced in 2007, and at least one legal commentator has suggested (here) that the increasing FCPA enforcement trends raise the possibility that FCPA violations "may be this year’s corporate crime of the century."

The one thing that is clear is that FCPA enforcement activity is escalating. As discussed in the January 28, 2008 Fenwick & West memorandum entitled "The Foreign Corrupt Practices Act: The Next Corporate Scandal?" (here), 2007 was "a watershed year for FCPA enforcement." Among other things, the memo notes that that "the number of enforcement actions brought by the DoJ and the SEC doubled compared with the number brought in 2006."

The memo also notes that "public companies disclosed over 50 pending government investigations." In addition, the DoJ and the SEC imposed the largest combined civil and criminal fines in history in 2007, the total fines of $44 million imposed against Baker Hughes and its subsidiaries (as discussed in my prior post, here).

There are a number of important trends driving this increased FCPA enforcement. Obviously the globalization of business activity provides an important context, but globalization alone does not explain the increased enforcement. The enforcement activity is being driven by a number of trends and patterns.

First, the DoJ and the SEC have developed a practice of targeting specific industries, through an industry-wide investigation. For example, a January 25, 2008 Sidley Austin memo entitled "FCPA Enforcement Trends During 2007" (here) notes that the authorities have targeted "sales and marketing practices of companies in the medical device industry in Europe." A January 24, 2008 Jenner & Block memorandum entitled "Recent Enforcement Activity Under the Foreign Corrupt Practices Act" (here) also cites the recent enforcement actions involving the "companies participating in the U.N. Iraq Oil for Food program." The Fenwick & West memo cited above also notes that the FCPA is now "being actively enforced against technology companies."

Second, the authorities have targeted companies doing business in countries where bribery is part of the local business culture. The Jenner & Block memo notes that the authorities have "continued to press enforcement as to companies doing business in Nigeria." Business activities in China have also drawn scrutiny, which is certainly a challenge given that many companies are finding it indispensible to have a China strategy.

Third, the U.S. authorities have shown an increased willingness to cooperate with foreign governments in joint investigations, even, the Jenner & Block memo notes, where the target companies "are already the subject of law enforcement investigation or sanction in their home country." The most prominent example of this latter phenomenon is the current investigation involving Siemens (which I discussed in prior posts, here and here). Another example is the investigation of BAE Systems (which has been surrounded by some significant controversy, as discussed here).

Fourth, increased M & A activity has led to the discovery and disclosure to the authorities of a number of FCPA violations. The Sidley & Austin memo referenced above cites the entry of Delta & Pine into a $300,000 FCPA settlement following its merger with Monsanto (refer here) and York International’s FCPA settlement following its merger with Johnson Controls, whereby York agreed (here) to a $10 million criminal penalty, a $2 million civil penalty, and the disgorgement of $10 million profit.

The Sidley & Austin memo notes that "acquisition due diligence is an essential program, and the failure to adequately assess potential liabilities can result in serious consequences." The Fenwick & West memo notes that "FCPA issues can be a major sticking point in negotiations with the acquiring party, often causing delay of the deal or a change in the price terms."

Fifth, as a result of changing priorities and increased resources, the authorities are no longer dependant on self-reporting alone as the means by which FCPA violations are identified. In recent year, the combination of the increased self-scrutiny SOX requires and corporations’ desire to obtain cooperation credits have led companies to self-report, providing the authorities with the bases for many of the FCPA enforcement investigations. But, as the Jenner & Block memo notes, "the Government is increasingly interested in developing cases affirmatively, without relying on disclosures." Both the DoJ and the SEC have increased their staffing in this area, and the agencies have said repeatedly said publicly that they will be more "proactive."

As I have previously noted, companies’ exposures in this area represent an increasing source of corporate risk. In addition, all three law firm memos cited above also note that the threat of enforcement activity is a growing threat for individuals as well as companies. As described above, these enforcement activities can result in very substantial fines and penalties. But as I have also observed in prior posts (most recently here), these investigations can also trigger follow-on civil lawsuits. Indeed, many of the most prominent recent FCPA investigations, including Siemans, Baker Hughes, and BEA Systems, have all also involved follow-on shareholders’ derivative lawsuits.

While the FCPA’s fines and penalties would not be covered under the typical D & O policy, the defense costs and indemnity amounts incurred in connection with the follow-on civil litigation would trigger coverage under the typical D & O policy. Given the increased enforcement activity and the authorities’ heightened priority in this area, the exposure arising from the threat of civil litigation following-on from FCPA enforcement activity could represent an increasingly important D & O risk.

More About 2007 Securities Lawsuits, Trends: Adding to the prior 2007 year-end securities litigation reports issued by NERA Economic Consulting (here) and Cornerstone Research (here), The Corporate Library has released its own year-end report entitled "Predicting Securities Litigation." The report is proprietary (refer here), but there is a good short summary of the report’s details in this January 28, 2008 Business Insurance article (here).

The Corporate Library’s report is directionally consistent with the two prior reports. It does, however, add a number of interesting additional observations. For example, the report notes that the increased securities litigation activity in the second-half of 2007 suggests "a rising tide of activity that may not crest until well into the coming year [i.e., 2008] – if then." The report also notes that if the heightened activity continues into 2008, "this rise in frequency alone could render today’s low D & O rates unsustainable, perhaps even resulting in [securities class action] filings against the insurers themselves."

The report also has an interesting observation with respect to the comment (refer here) that the increased litigation activity in 2007 may have been a "one-time event" driven by the nonrecurring phenomenon of the subprime litigation wave. The Corporate Library, by contrast, "believes that the lull in new [securities class actions] that occurred in 2006 was the anomaly," not the increase filing rate in 2007. The report also speculates that "new [securities class actions] filed in 2008 will in fact more likely exceed those filed in 2007, perhaps even reaching the historical mean of 192 cases per year cited by Cornerstone Research."

The Corporate Library report concludes with an analysis of the criteria it believes can be used to predict securities litigation. Among other things, the report notes that "CEO compensation practices that are poorly aligned with shareholder interests remain a powerful indicator of potential securities fraud." The report notes that "good corporate governance and effective boards have never been more important or a better indicator of potential liability."

Many thanks to Ric Marshall at the Corporate Library for sharing a copy of the report with me.

Bear Stearns Conference Call Summary: On January 28, 2008, I participated in a telephone conference call hosted by Bear Stearns entitled "D & O Losses from the Credit Crunch," in which I discussed emerging trends from the subprime litigation wave and the implications for the D & O insurance industry. The MAPO Online blog (here) has a good short sketch of my comments on the call. Special thanks to Mason Power for posting his notes of the call online.

Take Five, Jérôme (Days Off, Not Billions Away): Many interesting details have emerged from the Société Générale rogue trading incident, but I think my favorite item is the speculation that one of the ways Jérôme Kerviel may have evaded detection is by avoiding taking any time off. As discussed in the January 29, 2008 Wall Street Journal article entitled "Too Many Days on the Job" (here), Kerviel’s bosses "ultimately went along with his excuses for staying at work." The article observes that "if he had gone, his frauds probably would have been spotted." The implication? "Obligatory time off" is a "best practice."

We may yet celebrate Monsieur Kerviel if a new workplace ethic emerges in which corporate management is suspicious of workaholism and considers it part of its job to ensure that all employees take extended vacations. The Journal article cites a vacation "rule of thumb" of "at least five workdays in a row, and often 10."

If stamping out rogue trading requires that we all take off at least ten days in a row – for the good of the company, mind you – then who are we to stand in the way? Those workaholics now -possible rogue traders? Who knows…?

As further details have emerged, Soci�t� G�n�rale’s account of how J�r�me Kerviel triggered billions of dollars in losses has come under scrutiny, as reported on the January 29, 2009 Wall Street Journal (here). But questions are also being raised about trades in SG shares by SG director Robert Day and foundations he controls in the days prior to SG’s recent disclosures, as reported here, and those questions have now apparently taken the form of a lawsuit.

Given the nature of SG’s recent disclosures, it is hardly surprising that investors might file a legal action seeking management accountability. But the first lawsuit filed appears to relate not to the bank’s January 24, 2008 disclosures about Kurviel’s unauthorized trading, but instead to the bank’s announcement the same day of a 2.08 billion euros write-down for losses related to subprime lending in the United States. As the Wall Street Journal stated on January 25, 2008 (here) when reporting on the bank’s announcements of the prior day, “the disclosure of allegedly fraudulent trading overshadowed fourth-quarter write-downs by Soci�t� G�n�rale totaling 2.05 billion euros to cover its mortgage exposure.”

According to news reports (here and here) French lawyer Frederik-Karel Canoy has filed an insider trading lawsuit on behalf of 130 individual investors and “four to five” companies with stakes in the bank. Frustratingly, the news reports do not specify where the lawsuit has been filed, what the specific basis for the lawsuit is, or who the defendants are.

The news reports are clear that the lawsuit relates to the timing of Robert Day’s January 2008 trades in SG shares. Day is an American billionaire financier (here), who founded the Trust Company of the West, which was sold to SG in 2001. Day is currently Chairman of The TCW Group. According to forms filed on the website of the Autoriti� des March�s Financiers (AMF), the French market regulator, Day or foundations he controls made five sales between January 9 and January 18, 2008.

The first sale (documented here), in Day’s own name, took place on January 9, 2008 at a price of 95.27 euros a share and resulted in proceeds of 85.7 million euros.

The second sale (documented here), on behalf of the Robert Day Foundation, took place on January 10, 2008, as a price of 95.9 euros a share and resulted on proceeds of 8.6 million euros a share.

The third sale (documented here), on behalf of the Kelly Day Foundation, also took place on January 10, 2008, at a price of 95.9 euros a share, and resulted in proceeds of about 959,000 euros.

The fourth trade (documented here), on behalf of Day, took place on January 18, 2008, at a price of 90 euros a share and resulted in proceeds of 40.5 million euros.

The fifth trade (documented here), on behalf of the Robert Day Foundation, took place at a price of 90 euros a share, and resulted in proceeds of 4.5 million euros.

The total proceeds from all of the sales total about 140 million euros, or about $208 million. All of the trades took place at prices of between 90 and 95 euros. The bank’s shares closed at 75.81 euros on January 24, the day of the bank’s announcements. Day still holds about 1.8 million SG shares, worth about 148.2 million euros ($220 million) at today’s closing price.

Of Day’s total trades, 45 million euros ($67 million) took place on January 18, the date that bank management says that it discovered the unauthorized trading. January 18 is also the Friday immediately proceeding the Monday, January 21, on which the bank had originally scheduled to disclose its subprime mortgage write-down, but that announcement apparently was postponed to January 24 after the discovery of the unauthorized trades.

Canoy, the lawyer who filed the lawsuit, reportedly said that he questions the “precision and sincerity” of the bank’s disclosures about its subprime exposures. A January 29, 2008 Bloomberg.com article (here) quotes a spokesperson for ADAM, a French shareholder activist association, as citing a November 2007 letter to investors from SG’s CFO Chief estimating the bank’s subprime loss at 230 million euros. The spokesperson is quoted as saying that “shareholders who put their trust in these reassuring statements were clearly led astray.”

The shareholders association apparently has also asked that the AMF to launch an investigation into SG for insider trading, failure to disclose the extent of its subprime losses, and how it accounted for the losses attributed to resolving Kerviel’s positions. The AMF confirmed (refer here) that it has opened an investigation.

Finally, Canoy is also quoted as saying that he has filed a separate lawsuit related to Kurviel’s alleged fraud. According to press reports (here), Canoy sued the bank over the way the bank unwound the unauthorized positions and sold securities into the marketplace. Unfortunately, there is even less information in the news reports about this second lawsuit.

The bank for its part denies that the trades were improper. The bank claims (refer here) that Day sold the shares during a limited window when board members are authorized to sell stock. The bank spokesperson says that “no inside information was used in any way.” The spokesperson denied that Day was advised of Kurviel’s trading losses and said that Board members were not told of the subprime write-down until January 20th. According to the Financial Times (here), the bank also says that the January 20th meeting was set on January 18, but that the “meeting was called in the evening of January 18, after Mr Day had executed his share sales and ‘without any indication on the agenda’. “

None of the press coverage explains why the bank would have a trading window that would remain open on the Friday immediately preceding the Monday on which the company planned to make its year-end earnings release. Obviously, the danger with allowing trading that close to an earnings release is the possibility that it might create the appearance that the insider traded with knowledge of undisclosed information in the earnings release or perhaps even because of information in the earnings release.

Call it a hunch, but there just might be some additional future litigation involving one or more aspects of these various circumstances.