Investors undoubtedly were angry after Merrill Lynch announced on October 24, 2007 (here) that the company’s 3rd quarter results included “write-downs of $7.9 billion across CDOs and subprime mortgages, which are significantly greater than the incremental $4.5 billion write-down Merrill Lynch disclosed at the time of its earnings pre-release.” The $3.4 billion write-down increase less than three weeks after Merrill’s October 5, 2007 pre-release (here) perhaps made in inevitable that the lawsuits would fly, and so it comes as no surprise that on October 30, 2007, the Coughlin Stoia firm filed a complaint against Merrill Lynch and for of its directors and officers (including its now-former Chairman and CEO, Stanley O’Neill). The law firm’s October 30 press release about the case can be found here. The complaint can be found here.

The complaint is filed on behalf of shareholders who purchased Merrill Lynch stock between February 26, 2007 and October 23, 2007, and alleges that (as summarized in the press release):

during the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results. Merrill had gone heavily into Collateralized Debt Obligations (“CDOs”) which generated higher yields in the short term but which would be devastating to the Company as the real estate market continued to soften and the risky loans led to losses. According to the complaint, Defendants knew or recklessly disregarded that: (i) the Company was more exposed to CDOs containing subprime debt than it disclosed; and (ii) the Company’s Class Period statements were materially false due to their failure to inform the market of the ticking time bomb in the Company’s CDO portfolio due to the deteriorating subprime mortgage market, which caused Merrill’s portfolio to be impaired.

While at one level it is not surprising that Merrill Lynch has been targeted, there are reasons to wonder about the lawsuit filing. The most specific question relates to damages. Even though Merrill’s stock price dropped from 65.56 at a closing price of 63.22 on the day the larger than expected write down was announced, the stock closed today (October 30) at 65.56, just 2.34% less than the opening price on the day of the announcement. The plaintiffs apparently seek to augment these apparently shallow damages by stretching the purported class period back to February 2007, when Merrill’s stock was trading over 97. But the plaintiffs will have a difficult time establishing loss causation for the portion of the share price decline that preceded the October 24 announcement. The plaintiffs may try to claim that Merrill dribbled the corrective disclosure in two pieces, the pre-release and the actual release. Merrill’s share price opened at 76.67 the day of the pre-release, so plaintiff’s may try to rely on the decline from that point, but the emotional appeal of the case is the unexpected increase in the amount of the write-down, which of course came later and after the share price was already beaten down.

There is another sense in which the Merrill lawsuit is puzzling, at least from a detached point of view. It is arguable that all Merrill did was to try to get full disclosure of the deterioration in its subprime-backed assets out into the financial marketplace. As an October 30, 2007 Wall Street Journal editorial noted (here), while Merrill’s write-down was a “big surprise” suggesting that “oversight was late in coming,” the write-down “implies that Merrill did the right thing by taking a good hard look at its books before reporting its results,” while, the Journal notes, “some other banks haven’t been so candid.” The implication is that other investment banks have avoided the obloquy Merrill has faced simply by soft-pedaling their disclosure.

Whether or not Merrill was more forthcoming that its peers, it is clear that many more write-downs will be coming. For example, UBS, which pre-announced on October 1, 2007 (here) that it would be taking a $3 billion write down in mortgage related assets, announced on October 29, 2007 (here) that “further deterioration in the U.S housing and mortgage markets as well as rating downgrades for mortgage-related securities … could lead to further write-downs.” As the October 28, 2007 article on the online version of The Economist asked (here), “is Merrill the tip of the iceberg?” It seems probable, indeed inevitable, that there are further write-downs to come. More difficult to discern is who will be taking the write-downs and for how much (about which refer to my prior post, here).

In any event, I have added the new Merrill Lynch lawsuit to the running tally I am keeping of the subprime lending lawsuits (which can be found here). I fear there are many more cases to come.

Two Other New Real Estate-Related Lawsuits: Two other lawsuits filed this week, while not directly attributable to the subprime mortgage meltdown, definitely arise from previously frothy conditions in real estate lending, and reflect the current strained credit market conditions.

The first, filed on October 29, 2007, alleges, according to the plaintiffs’ lawyers press release (here), that BankAtlantic Bancorp and certain of its directors and officers “materially understated reserves for real estate loan losses on its financial statements.” The complaint also alleges that the bank gave a $27.8 million real estate loan to two borrowers without first getting an appraisal of the Florida property involved, which the borrowers were allegedly using as a part of a scheme to obtain real estate loans with inadequate collateral. The bank later had to increase its loan loss reserves as a result of problems with its Florida real estate portfolio.

The second, filed on October 30, 2007, alleges, according to the plaintiffs’ lawyers press release (here), that CBRE Realty Finance and certain of its directors and officers, in connection with the company’s September 2006 IPO, failed to disclose that “at the time of the IPO more than $20 million in loans on the company’s books were impaired and should have been written down but were not.” When the company announced in August 2007 that it was taking a $7.8 million impairment charge due to a foreclosed asset, the company’s share price declined.

Even though these two new lawsuits are not subprime-lending related, they show that deteriorating real estate market conditions and the turbulence in the credit sector are stressing many companies, not just those involved in subprime lending, and also generating additional lawsuits. There undoubtedly will be more to come.

Happy Birthday to the Drug and Device Law Blog: The Drug and Device Law blog has celebrated its first anniversary with an interesting note (here) reflecting on the burdens and rewards of the blogging life. Because the post captures so many of my own thoughts (particularly about how hard blogging is), I have linked to it here. And I would be remiss if I did not also wish happy birthday to an excellent blog.

As various options backdating lawsuit settlements and dismissals have accumulated in recent days, I have received a variety of inquiries from readers about comparisons with prior dispositions or about the outcomes of various other specific cases. The absence of a single, all-inclusive resource to address these questions led me to put together a compiled list of options backdating lawsuit settlements, dismissals and denials, which can be found here.

The options backdating lawsuits dispositions list linked-to above is arranged in a series of seven tables, which provide the following information: options backdating securities class action lawsuit settlements and dismissals, as well as dismissal motion denials; options backdating shareholders derivative lawsuit settlements, dismissals and dismissal denials; and options backdatings lawsuits that were voluntarily dismissed. With respect to each listed item, I have tried to provide a link to the relevant court order or other source material.

I created the list using information from a variety of sources. While I am reasonably confident that the information is accurate, the list may be incomplete. The list captures most of the options backdating case dispositions that have attracted publicity, but there undoubtedly are others that were not as highly publicized and about which I am unaware. Readers are encouraged to please let me know of any omissions from the list; links or citations for any needed additions would be greatly appreciated. I will do my best to keep the list updated with future dispositions as well as any supplemental information that readers provide.

In addition, a blank in the "links" column indicates that I have not been able to locate a link to the relevant source document. It would be great of readers can provide the missing source links so that the document is more complete.

Readers should note that I have written prior blog posts about many of these case dispositions. I did not attempt to incorporate into the options backdating disposition list any links back to my prior blog posts, but readers interested in any specific case disposition should just type the case name in the search box on the upper left hand corner of the blog home page to find my blog posts relevant to specific cases.

I welcome any comments readers may have about the attached list, particularly if readers have concerns about the accuracy or completeness of any entry.

 

For those keeping track, the options backdating-related securities class action lawsuit filed against Hansen Natural can be added to the list of options backdating-related securities class action dismissals. (Refer here regarding prior dismissals.) Hansen announced in its 8-K dated October 23, 3007 (here) that the court granted the defendants’ motion to dismiss the plaintiff’s complaint, without leave to amend.

In its October 16, 2007 opinion (here), the court granted the Hansen Natural defendants’ motion on several grounds. The court found that the complaint failed to allege fraud with particularity, and that the complaint failed to allege facts sufficient to give rise to a strong inference that the defendants acted with scienter. In particular, the court found that none of the plaintiff’s allegations of a backdating scheme, accounting fraud, lack of internal controls, corporate authority, or insider trading gave rise to a strong inference of scienter. The court also found that the plaintiff failed to sufficiently plead either materiality or loss causation.

The court clearly was not impressed with the plaintiff’s argument, based upon a comparison of the company’s stock price graph and the option grant dates, that the defendants “must have engaged in backdating.” The court declined to draw any inferences from the plaintiff’s analysis, which, as the court noted, “is no analysis at all, but simply a series of charts and graphs comparing Hansen’s stock price on the date of each of the stock option grants with the stock price on the tenth day after the stock option grant day.” The court noted that between 1997 and the end of 2005, Hansen’s stock price increased about 15,000 percent, so “it is not surprising that Hansen’s stock price would have risen following the twelve stock grants.”

As readers will recall, there was a stir (refer here) as the options backdating story unfolded last year about the fact that many companies apparently were late in filing their Form-4s (as was detailed in a well-publicized Glass Lewis report). The notion at the time was that perhaps the late Form-4 filing indicated (or at least facilitated) backdating. The Hansen Natural court specifically considered and rejected this argument, in part because the Form-4s by themselves showed nothing other than they were late, and in part because the company’s Special Committee had specifically found that the Form-4s did not support a finding of backdating.

The court’s perspective on the case was clearly influenced by external events surrounding the backdating allegations, particularly the Special Committee’s findings that there was no willful or intentional misconduct in connection with stock option grants; and that the company’s outside auditor’s conclusion that the needed options-related accounting adjustments were not material. The court took judicial notice of a wide variety of documents and materials outside the complaint. While the plaintiffs did not object to some of the items of which the court took judicial notice, the court’s ultimate conclusions do have an air of factual determination about them. The Tellabs decision’s requirement that courts weigh competing inferences puts them squarely in the business of making assessments. But reasonable minds might ask at what point the development and consideration of a voluminous record outside the complaint, supporting evaluations of factual allegations, is entirely consistent with the court’s limited role at the motion to dismiss stage.

Nevertheless, the Hansen Natural court’s categorical rejection of the plaintiff’s complaint may foreshadow developments in other pending backdating cases that depend upon the plaintiffs’ contention that there must have been backdating. For courts in the post-Tellabs business of weighing competing inferences, stock graphs overlain with option grant dates may simply not be enough to create a strong inference of scienter – as further corroborated below in the discussion of the Delta Petroleum options backdating-related shareholders’ derivative case.

Two More Backdating Derivative Lawsuit Dismissals: In separate decisions, two courts recently granted motions to dismiss in options backdating related derivative lawsuits. There are some features of these two dismissals that are particularly noteworthy.

The first dismissal involves the shareholders derivative lawsuit brought against Delta Petroleum, as nominal defendant, and several of its directors and officers. The court’s September 26, 2007 opinion dismissing the Delta Petroleum case can be found here. The second dismissal came in the derivative lawsuit filed against Glenayre Technologies, as nominal defendant, and several directors and officers. The court’s October 9, 2007 dismissal opinion can be found here.

The two cases raised both raised allegations (pled derivatively) under both the federal securities laws and under applicable state law. The Delta Petroleum court dismissed the federal securities law allegations on the grounds that the plaintiffs had not stated a claim, because they had not made sufficient allegations that the options were, in fact, backdated. The plaintiffs relied on the standard litany of sources: the March 2006 Wall Street Journal article, the May 2006 research of the Center for Financial Research and Analysis, and the supposed suspicious timing of the stock options grants. The court found these references “insufficiently specific,” noting that

The Plaintiffs have repeatedly alleged that the odds of there being so many option grants near the monthly low were “remote.” However, they allege no facts to support this conclusion, not do they explain why they believe this to be the case.

The court did allow the plaintiffs leave to attempt to replead; as of today, however, they have not yet filed an amended complaint.

The Glenayre Technologies court dismissed the federal securities laws allegations on the basis of the statute of limitations. The plaintiffs in the federal court case, faced with a competing state court case involving the same company and the same allegations, sought to secure their federal court case by alleging that the individual defendants violated the federal proxy solicitation statute and rules by filing false and misleading proxies. The court found that none of the proxy-related allegations were timely and dismissed the case on the basis of the statute of limitations applicable to claims alleging proxy solicitation violations.

Both the Delta Petroleum court and the Glenayre court, having dismissed the federal claims, declined to exercise jurisdiction over the remaining state law claims and dismissed those claims as well. In the Glenayre case, that is perhaps easier to understand, given the existence of the parallel state court action involving the same defendants and the same essential claims. But both courts had supplemental jurisdiction over the state law claims under 28 U.S.C. 1367, and while the statute says courts”may” dismiss supplemental jurisdiction claims when the original jurisdiction claims have been dismissed, the courts had discretion to retain the state law claims. (The existence of the parallel state court proceedings in the Glenayre case gets into complicated principles under the abstention doctrine and the application of the Colorado River abstention criteria, but the bottom line is that the federal courts both had the discretion to retain jurisdiction over the state law claims.) The alacrity with which the federal courts declined to retain supplemental jurisdiction over the state law claims suggest an earnest wish to banish to state court those annoying state corporate law issues.

While there have to date been some options backdating settlements, some quite substantial, and there have been some impressive decisions (particularly out of Delaware) denying motions to dismiss, there is an increasingly impressive list of options backdating cases where the motions to dismiss have been granted. For all of the options backdating sound and fury, in the end, the whole scandal may not signify all that much, even given the settlements so far, if most cases wind up getting dismissed. Certainly, the disdain of the courts cited above for the “must have been backdating” theory is a dark portent for the plaintiffs’ prospects in many of the pending backdating cases.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for copies of the Delta Petroleum and Glenayre opinions.

According to news reports (here , here and here), a jury trial in the securities class action lawsuit filed against JDS Uniphase commenced on Monday in federal court in Oakland. As documented in an October 2007 presentation from Risk Metrics Group (here), trials in securities cases are such a rarity that it is a historical record-keeping challenge to compile a list of the few securities cases that actually have been tried.

The lead plaintiff in the JDS Uniphase case is the Connecticut Retirement Plans and Trust Fund, and the defendants include the company itself and four of its former officers. The lawsuit relates back to the company’s astonishing $50.6 billion net loss the company report in fiscal 2001. The complaint alleges that the company knew that the boom was over and that the four individual defendants, also aware of that fact, sold more than $350 million in JDS Uniphase stock between July 31 and August 31, 2000, and that other insiders sold $503 million in stock.

The trial, which began on October 22, 2007, is scheduled to last 19 trial days, and the judge reportedly expects the jury to being deliberating before Thanksgiving.

As for why this case is going to trial, the AP news report quotes the Connecticut Treasurer’s general counsel as saying that the company “didn’t take the mandatory pretrial settlement talks seriously.”

I have always thought that if there more securities cases went to trial, fewer would get filed. Earlier in my career, I had the pleasure, while acting as an insurer’s claims attorney, of directing a securities case through a jury trial, and I suspect that until the moment the jury foreman read the defense verdict, the plaintiffs’ attorneys did not believe we actually wanted to take the case to verdict.

But as much pleasure as it gives me to recount that anecdote, there are some fairly practical reasons why so few of these cases go to trial. The first is that the theoretical damages are often potentially ruinous, exceeding not only the amount of available insurance but the ability of any defendant to pay. Indeed, this “magnitude of damages” consideration is one of the many intriguing things about why the JDS Uniphase case, of all cases, is actually going to trial – the potential damages in the case have to be astronomical. By contrast, in the trial in which I was involved, the maximum potential damages were manageable, a circumstance that will rarely be the case.

Another reason so few cases go to trial is the fraud exclusion in the typical D & O policy, which precludes coverage in the event of an “adjudication” of fraud. Defendants, aware of this provision, are unwilling to risk going to trial and having a jury finding wipe out their insurance. In the case in which I was involved, the insurer waived all potential coverage defenses (known and unknown), but perhaps few carriers would be willing to agree to that.

I have always thought that another important reason so few of these cases go to trial is that the plaintiffs’ lawyers really don’t want to try them. Much easier to make allegations and collect the fee award out of a settlement than to go through the hard work of making the allegations stand up in court. Indeed, given the enormous burden and expense required to try a securities case, it arguably makes no economic sense for a plaintiffs’ lawyer to take all of that on and to risk losing it all at trial. That is perhaps the most intriguing thing about the JDS Uniphase trial – the institutional investor lead plaintiff is clearly calling the shots, and is clearly willing to run the risk of a trial.

If the JDS Uniphase trial actually gets all the way to a verdict (at this point still an uncertain proposition), and if the defendants prevail, it may be a while before you see another plaintiff willing to push their case to a jury, even tough talking institutional investors who may have a political agenda. Indeed, a contrary dynamic could be established, with defendants threatening trial, as a way to try to leverage a better settlement.

On the other hand, if the JDS Uniphase plaintiff prevails and the jury awards substantial damages, an entirely new dynamic could be introduced into the securities litigation arena. We could see other institutional plaintiffs, emboldened by the JDS Uniphase plaintiff’s success, taking a more aggressive litigation approach and distaining settlement in favor of a jury trial – or making that threat to leverage settlement to their advantage.

All in all, this will be a very interesting case to watch. I wonder if Vegas has posted a line on the case.

Interesting blog posts about the case can be found on the WSJ.com Law Blog (here), the 10b-5 Daily (here) and the Securities Litigation Watch (here and here).

In a recent post (here), I wrote about the September 18, 2007 petition submitted to the SEC by several environmental groups, seeking to persuade the SEC to institute rules requiring companies to assess and fully disclose their financial risks from climate change. These groups clearly want to use the SEC’s disclosure requirements to pressure companies on climate change related issues. But while these groups want to increase companies’ disclosure, existing disclosure requirements already require companies to make environmental disclosures (refer here), and the SEC has recently shown an increased willingness to police environmental financial disclosures and to hold corporate officials responsible for disclosure violations.

In connection with the most recent environmental disclosure-related enforcement proceeding, the SEC announced on June 29, 2007 (here) its settlement with several former ConAgra Foods executives. The enforcement action pertained to a variety of different financial disclosures, but among other things the SEC specifically alleged that the former ConAgra officials “reversed $35 million in ConAgra’s excess legal and environmental reserves to income”; that ConAgra’s then-CFO should have know that the “accounting for $23.8 million of this reduction was not in accordance with GAAP”; and that the company’s 10-Q reflecting the reserve reduction “misleadingly failed to disclose that at least $23.8 million of these reserves were excess in prior periods.” These issues were among a variety of improper practices that the SEC alleged “resulted in ConAgra materially misstating its financial performance.” The former CFO agreed to pay a disgorgement of $425,531, as well as interest and other forfeitures and penalties.

The ConAgra settlement joins two other settlements that the SEC has entered in recent years involving environmental financial disclosures. Perhaps the most noteworthy of these prior actions is the accounting fraud proceeding the SEC brought against Safety-Kleen and several of its former top officials. As described in the SEC’s September 12, 2002 press release announcing the entry of judgment (here), the SEC alleged that the former officials engaged in a number of improper accounting adjustments to avoid an anticipated earnings shortfall.

As detailed in the SEC’s complaint (here), among the accounting improprieties alleged was the Safety-Kleen officials’ creation of “ficticious income” by “reducing several environmental reserve accounts.” The former CFO later pled guilty to criminal securities and bank fraud.

In another recent proceeding involving environmental financial disclosures, the SEC announced on November 29, 2006 (here) the institution and settlement of proceedings against Ashland, Inc. and its former Director of Environmental Remediation. The SEC found that the former official had improperly reduced Ashland’s estimates for environmental remediation at numerous chemical refinery sites. The reductions decreased Ashland’s total reserve estimates by approximately $160 million in both 1999 and 2000. The SEC found that there was no reasonable basis for the reduction, which had the effect of materially understating Ashland’s environmental remediation reserves and overstating net income. Ashland agreed to certain internal control changes and the former official was prohibited from further involvement in Ashland’s financial reporting. (I previously wrote about the Ashland case here because of the involvement in the case of a corporate whistleblower.)

As noted in a July 26, 2007 Jenner & Block memorandum entitled “Recent SEC Enforcement of Environmental Financial Disclosure” (here),

The SEC seems to have turned its attention on environmental financial disclosures and corporations and corporate executives should take special note of the heightened attention that the SEC is now giving to these disclosures. Although the SEC has not announced any new guidelines or initiatives, corporations and corporate executives should certainly be cognizant of the increased number of civil and criminal actions being brought by the SEC against corporations and officials who fail to observe existing environmental reporting requirements.

The SEC’s “heightened attention” to environmental disclosure issues preceded the recent petition in which the environmental groups seek increased climate change related disclosures. In other words, the SEC has already demonstrated its willingness to police existing environmental disclosure requirements. While the existing requirements do not explicitly address climate change issues or requirements, corporate officials should, as the Jenner memo put it, “certainly be cognizant” of the increased vigilance the SEC has shown on environmental disclosure issues, even in the absence of any new guidelines or initiatives. Even if, as seem likely, the SEC takes no action on the environmental groups’ climate change disclosure petition, reporting companies will still face potential scrutiny regarding their environmental disclosures relating to climate change issues.

On a related note, Hunton & Williams has published an October 2007 memorandum entitled “Climate Change Now on Court Dockets” (here) summarizing pending climate change-related litigation.

Under Section 104(b) of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) is required to inspect audit firms that regularly provide audit reports for fewer than 100 public companies “not less frequently than once every 3 years.” On October 22, 2007, the PCAOB released a Report regarding its inspections of these so-called “triennial firms” entitled “Report on the PCAOB’s 2004, 2005 and 2006 Inspections of Domestic Triennially Inspected Firms.” (here). The Report is significant because even though many of the 497 triennial firms inspected are small and may audit as few as a single public company, as a group the triennial firms “audit thousands of public companies.” Because the triennial firms audit so many public companies, the PCAOB’s Report detailing its concerns regarding the firms’ audits has significant implications for those who rely on those audits.

It is important to emphasize that the PCAOB’s concerns do not relate to all triennial firms or to all triennial firms’ audits. As many as 43% of the PCAOB’s 497 triennial firm inspections did not identify any audit performance deficiencies. And it is also important to note that the PCAOB’s inspections encompass only a fraction of the audits that the triennial firms have performed.
Nevertheless the PCAOB took the opportunity to identify the frequently recurring audit deficiencies, so that the triennial firms are fully aware of the areas where they can enhance the quality of their audits. The PCAOB Report identifies 11 areas where auditing or quality control deficiencies were noted. The 11 areas are summarized on the PCAOB’s October 22, 2007 news release (here), as well as in the October 22, 2007 CFO.com article entitled “PCAOB: The 11 Things Auditors Need to Fix”(here).
While the 11 items cover a lot of ground, several of the items appear to be quite important, particularly given that among the “thousands” of public companies that the triennial firms audit are likely to be smaller or less financially stable companies. Without reading too much into it, the Report does seem to suggest that in some instances the triennial firms’ audits may represent less of an assessment of the audited companies’ financial statements than those who rely on the audits might otherwise assume.
For example, the first concern noted in the Report has to do with the triennial firms’ failure to perform adequate procedures to test the validity and/or appropriate accounting of revenue. While revenue issues are of concern with regard to all companies, revenue issues may be of particular importance regarding smaller or developmental stage companies. For these kinds of companies, investors and others may put particular emphasis on revenue because often there are not profits and there is not lengthy operating history on which to assess the company.
Another troublesome issue relates to the PCAOB’s concern that some triennial firms were not performing sufficient procedures to determine whether or not an entity can continue as a going concern. Because an auditor’s “going concern” opinion would be critically important to investors, creditors and others who might rely on the audit opinion, some triennial firms’ failure to perform the required audit procedures is potentially very troublesome, particularly since among the companies that the triennial firms audit are likely to be smaller and less financially stable companies.
A more technical concern noted relates to the proper accounting for “reverse acquisitions,” where the auditor is required to determine the “accounting acquirer,” without regard to the legal form. Where, for example, an actively operating private company merges with a dormant shell, the private company is the accounting acquirer, rather than the shell. So, for example, accounting comparisons across reporting periods should relate back to the private company’s previous operations than to the public shell’s. The failure of some triennial firms to get this correct again raises serious concerns.
The PCAOB’s report identifies numerous other issues, some equally as if not more important than those noted above. However, it certainly should not be assumed that all problems are avoided with a Big Four auditor; indeed, the CFO.com article notes that “each of the Big Four inspection reports so far have listed at least seven audit deficiencies,” while 124 of the triennial firm inspections noted no deficiencies at all. Moreover, it would be a misinterpretation to take the PCAOB’s Report as a condemnation of triennial firms. To the contrary, the whole purpose of the Report is to help triennial firms to take steps to improve their audit quality, not to attack them.
Nevertheless, some of the issues discussed in the PCAOB’s Report are concerning. For investors, creditors, D & O underwriters and others who review and rely on public company audit reports, the PCAOB’s Report at least raises the question of the extent to which reliance on some audits could be misplaced. At a minimum, those reviewing public companies’ financial statements that have been audited by triennial firms may want to proceed cautiously and supplement their financial statement review with other inquiries.

As the subprime mortgage mess has unfolded, one of the contributing factors blamed for the meltdown has been the complicated investment instruments into which the subprime mortgage loans were packaged and then sold into the global financial marketplace. I have previously noted (most recently here) that the subprime mortgage meltdown has led to a growing wave of increasingly diverse litigation. A recent development as this wave has spread is the growth of complicated lawsuits arising from these complicated subprime mortgage-backed investments.

For example, as described in an October 19, 2007 Wall Street Journal article entitled “Metro PCS Sues Merrill Over Risky Investments” (here), Metro PCS Communications has sued Merrill Lynch in Dallas state court, alleging fraud, negligence and breach of fiduciary duty in connection with Merrill brokers’ investment of $133.9 million of Metro PCS’s cash in ten auction-rate securities, nine of which were collateralized debt obligations (CDO) that Merrill underwrote and that were backed by pools of mortgages and other assets. Metro PCS alleges that Merrill breached its duties in making the risky investments in violation of the company’s stated goal of holding only low-risk, highly liquid assets.
The Journal article notes that Merrill was the No.1 underwriter of CDOs since 2004, a ranking that depended on Merrill’s ability to sell CDOs to investors, such as Metro PCS. The Journal article notes that Metro PCS, which went public in April 2007, has seen its shares decline 48% since May. The Journal article also mentions MoneyGram International as another CDO investor that has sustained losses. On October 17, 2007, in connection with its third quarter earnings release Moneygram announced (here) that “net unrealized portfolio losses…increased by approximately $230 million as a result of illiquidity in the market for mortgage asset backed securities and CDOs” on a portfolio valued at $620 million as of June 30.
A separate October 19, 2007 Wall Street Journal article entitled “HSBC Is Sued Over Valuation of Fund’s Bonds” (here) describes a lawsuit that Luminent Mortgage Capital has filed against HSBC Holdings PLC. The lawsuit relates to so-called “repo” transactions that took place in late July and early August 2007, in which Luminent subsidiaries borrowed money from HSBC collateralized by securities that the subsidiaries issued to HSBC with the intent to repurchase at original cost plus interest. Luminent alleges that HSBC took advantage of turmoil in the mortgage securities marketplace to capture the nine mortgage-backed repo bonds from Luminent.
According to the Journal article, the Complaint alleges that when the market for mortgage securities “seized up” on August 6, 2007, repo deal lenders (such as HSBC) issued margin calls to make up for the falling bond values. Luminent claims that it stood ready to repurchase its subsidiaries bonds, but that it later learned that HSBC had auctioned the nine Luminent repo bonds and that “HSBC, conveniently, had submitted the highest bid for all of the bonds,” allowing HSBC to take ownership of the bonds for little more than half of the bonds’ value. Luminent contends that the bonds “have little chance of not paying 100% of principal and interested owed.”
A third Wall Street Journal article, an October 18, 2007 article entitled “State Street Is Sued Over Fund Losses” (here), describes an ERISA lawsuit that Unisystems filed in Manhattan federal court against State Street Corp., in which Unisystems alleged that State Street misrepresented its bond funds as conservatively managed even though the funds invested in “high-risk” investments and mortgage-backed securities. Unisystem alleges that 25 of its employees had $1.4 million in State Street’s Intermediate Bond Fund. (State Street was previously sued in a similar claim by Prudential Financial, about which refer here.)
The Unisystems complaint alleges that, contrary to the State Street fund’s representations, the State Street fund was highly leveraged and had 25% of its portfolio in asset-backed securities, and lost 25% of its value between July 1 and September 1, 2007, while its tracking index actually rose in value.
What these diverse lawsuits have in common is common thread of subprime mortgage investment instruments and the critical issue of asset valuation. As I have previously noted (refer here) one of the scariest things about the subprime mortgage meltdown is the dispersion of mortgage investment risk throughout the economy. These cases demonstrate not only that mortgage investment risk is broadly dispersed, but that the rapidly decline in mortgage-backed asset valuations is producing both losses and lawsuits.
Among the more important details of the cases described above are the balance sheet losses that Metro PCS and Moneygram International have sustained. These two examples underscore a point I have noted in a prior post (here) that mortgage investment risk potentially affects a broad variety of companies, including those outside the core financial services industry. The continuing lawsuit proliferation related to mortgage-backed asset valuation declines seems unlikely to omit lawsuits by public company shareholders alleging that companies did not adequately disclose balance sheet exposure to mortgage investment risk – particularly where (as in the examples above) declining mortgage investment valuations have contributed to declining share prices.

The audit industry’s collective commitment (refer here) to enforcing valuation integrity will undoubtedly produce further financial statement dislocations, leading, in turn, to an even wider array of complicated subprime-lending related lawsuits, potentially including shareholder lawsuits alleging insufficient disclosure of balance sheet exposure to mortgage investment risk.

In a prior post (here), I took a look at securities claims in U.S. courts by foreign litigants against foreign companies. An alert reader commenting on my prior post pointed out that a case currently before the Second Circuit squarely presents the fundamental jurisdictional questions involved in these cases.

The case, Morrison v. National Australia Bank, Ltd., began as a 2003 securities lawsuit (refer here) brought by four individual plaintiffs (three from Australia and one from the U.S.) against National Australia Bank, Ltd. (NAB), an Australian corporation and Australia’s laregest bank, whose shares trade on Australian securities exchanges and whose ADRs trade in the OTC markets in the U.S. The Complaint alleges fraud in connection with mortgage valuations at NAB’s Florida-based mortgage servicing subsidiary, which allegedly resulted in the overstatement of the parent’s financial statements. The plaintiffs’ claims allege violations of the U.S. securities laws.
In October 2006, the district court dismissed the Complaint, holding that the court lacked subject matter jurisdiction over the claims of the three foreign purchasers of NAB securities purchased on non-U.S. exchanges. The court also ruled that the U.S.-based plaintiff suffered no damages. The court gave leave to substitute another domestic plaintiff, but that claim was later voluntarily dismissed, and the court entered judgment as to the remaining plaintiffs, and the plaintiffs filed their appeal.
In their Second Circuit brief (here), the plaintiffs/appellants contend that the fraudulent activity, which they contend involved the Florida activities of NAB’s Florida-based subsidiary, all took place in the U.S. and therefore U.S. courts should exercise jurisdiction. The defendants/appellees in their brief (here) contend that U.S. courts, applying U.S. laws and U.S. class action procedures, should not exercise jurisdiction over a case involving the claims of Australian claimants against an Australian corporation, 99.97% of whose shares are held by persons outside the U.S.
Numerous parties have weighed in with amicus briefs. As described in their July 17, 2007 press release (here), the Washington Legal Foundation has filed an amicus brief (here) seeking affirmance and arguing that the allegedly fraudulent behavior of which the plaintiffs ultimately are complaining is the alleged misstatements of the parent corporation, which statements took place outside the U.S. As described in their July 11, 2007 press release (here), the Association of Corporate Counsel also filed an amicus brief (here) seeking affirmance, arguing that “the essence of the complained-about conduct occurred abroad and cannot be the basis for jurisdiction.”
In its July 12, 2007 press release (here), the U.S. Chamber of Commerce announced its amicus brief (here), in which the Chamber argued that “cross-border application of our securities laws would harm foreign direct investment in the U.S. and the competitiveness of our capital markets.”
The NAB case clearly will be a significant case on the question of the availability of U.S. courts in so-called “f-cubed” cases involving foreign claimants who wish to pursue claims, in the U.S. courts and under U.S. securities laws, against foreign companies in which they have invested outside of the U.S.
Special thanks to a loyal reader for providing the links to the Second Circuit briefs.

In a prior post (here), I noted that one of the scarier aspects of the subprime lending mess is the widespread dispersion of mortgage investment risk across the economy. While companies holding mortgage-backed assets might well want to avoid recognizing any diminution of these assets’ valuation, an audit industry group, the Center for Audit Quality, has made it clear that companies should recognize the asset valuation at current market prices, regardless of the depressed state of the market for those assets.

The Center for Audit Quality’s commentary is contained in three memoranda, which can be found here. Of particular interest is the October 3, 2007 paper entitled “Measurement of Fair Value in Illiquid (or Less Liquid) Markets” (here), which addressed the question of how to value mortage-backed assets in the current market environment. The paper expressly asks (and answers) the question whether the current market of mortgage-backed assets is functioning sufficiently to produce a market based-price for asset valuation purposes, or whether the current conditions are more indicative of distressed sale circumstances, in which case other specified valuation methods should be used.

Essentially, the paper states that if trading is taking place, even if at a much reduced level, the trading is sufficient to produce a market price appropriate for valuation purposes: “Notwithstanding current market conditions, there continues to be, for many mortgage-backed securities backed by subprime mortgage loans, quotable prices and observable transactions for identical assets, albeit at volumes far less than in the recent past.” These trades, the paper comments, provide the most reliable evidence of fair value.

As I have noted previously (refer here), mortgage investment risk is not limited just to financial services companies; a wide variety of other companies are carrying mortgage-backed investments on their balance sheets. The Center for Audit Quality’s valuation commentary makes it clear that these assets must be valued at market prices, at least where market prices exist, even if the prices are depressed. The application of these valuation principles to companies carrying mortgage-backed assets could require companies to recognize losses in the securities investments, which potentially could cause unrest if investors believe the risks have not previously been disclosed.

One particularly ominous aspect of the Center for Audit Quality’s report is its assessment of the likely longevity of the current liquidity crunch; the report notes that

It is not possible at this tie to predict how long investors will stay on the sidelines or which markets will be most affected, but it is not unreasonable to expect – especially for subprime mortgage-related assets – that current conditions could persist for an extended period of time until the uncertainty is reduced, that is, when it becomes clear that defaults have peaked and real estate prices have bottomed out.

In light of these comments about the likely duration of the current marketplace conditions for mortgage-backed assets, the justification for valuing these assets based on current market prices is all the more compelling. The more interesting question is the impact that these valuation considerations will have on the balance sheets of companies that carry substantial mortgage investment risk.

An October 17, 2007 Wall Street Journal article entitled “With New, United Voice, Auditors Stand Ground On How To Treat Crunch” discussing the Center for Audit Quality’s valuation statements can be found here. The article comments that auditors are being more disciplined in their approach than perhaps they were at the time of the corporate scandals earlier in this decade, or during the savings and loan crisis.

Subprime Mortgage Litigation: Regular readers know that I have been maintaining (here) a running tally of subprime mortgage-related litigation. The Stanford Law School Securities Class Action Clearinghouse has now added a separate web page (here) to its site, with its own running tally of the subprime lending related class action litigation. The Stanford website’s count of 18 lawsuits differs slightly from my tally of 17, but the difference is that the Stanford site included in its tally a lawsuit that has been filed against a home builder. I have been tracking the lawsuits that have been filed against the residential construction companies separately.
By my count there have been four lawsuits filed against residential construction companies, in addition to the 17 lawsuits in my general tally. In addition, there have also been two lawsuits that have been filed against the credit rating agencies based on subprime lending allegations.

The Stanford website not only identifies the lawsuits, but also helpfully identifies the court in which they are pending and identifies the date on which the case was first filed.

Speaker’s Corner: On October 29-30, 2007, I will be co-Chairing (with my good friend Matt Jacobs, from the Jenner & Block law firm) a Lexis/Nexis seminar entitled “Mealey’s Subprime Mortgage Litigation Conference,” to be held in Chicago. The program agenda can be found here.

As various blue-ribbon committees have struggled with the competitiveness of the U.S. securities exchanges in the global financial marketplace (about which refer here and here), one issue on which they have focused is the aversion overseas companies may have for the U.S. litigation system. But while overseas companies may seek to avoid U.S.-style litigation, overseas investors seem eager to join in the fray. The most recent example involved the securities class action lawsuit against U.K.-based GlaxoSmithKline, in which on October 5, 2007, the court appointed (here) a U.K. pension fund to act as lead plaintiff.

Avon Pension Fund, the institutional investor selected as lead plaintiff in that case, was only one of several European-based investors that petitioned to serve as lead plaintiff. A German pension fund in fact had the largest financial interest, but the court rejected the German fund’s petition because of uncertainty over whether German courts would enforce a U.S. class action judgment. The court also rejected the petition of another U.K.-based pension fund. Press coverage of the court’s lead plaintiff determination can be found here and here.
These overseas investors’ interest is serving as lead plaintiffs in a U.S. class action lawsuit represents merely the latest example of a phenomenon well-documented in a May 2007 study by Institutional Investor Services, which showed that at that time, on 182 occasions overseas institutional investors had sought to serve as lead plaintiffs in 98 different U.S securities class action cases.
The selection of a U.K. pension fund as lead plaintiff in a case against a U.K. based company does raise certain questions – such as, at what point does a case like this no longer belong in a U.S. court? The fact that GlaxoSmithKline’s American Depositary Receipts (ADR) trade on the New York Stock Exchange might provide some explanation for the presence of the case in the U.S., but that alone does not answer the question.
Indeed, in a September 26, 2007 decision involving Rhodia, S.A., a U.S. district court held (here) that it lacked subject matter jurisdiction in a securities lawsuit brought in U.S. court by two overseas investment funds against a foreign company whose shares trade on a foreign exchange but whose ADRs trade on the NYSE. As discussed at greater length in a October 8, 2007 Paul Weiss legal memorandum (here), courts are declining to exercise subject matter jurisdiction over claims brought by foreign investors against foreign companies, where the conduct at issue took place outside the United States. The mere fact that the company’s ADRs traded on the NYSE alone was not enough to provide jurisdiction.
These jurisdictional issues are perhaps most compelling in the so-called "f-cubed" cases, which involve foreign companies and foreign investors who acquired their shares on a foreign exchange. To the extent the alleged misconduct took place outside the U.S. the court may, like the Rhodia court, decline to exercise jurisdiction. A good overview of the jurisdictional issues, particularly of the questions involving the "f-cubed" cases, can be found in the June 14, 2007 Law.com article by Columbia Law Professor John Coffee entitled "Foreign Issuers Fear Global Class Actions" (here).
And even where the courts are exercising jurisdiction, they increasingly are willing to engineer the composition of the class to take account of disparate overseas components. For example, in certifying the class in the Vivendi securities litigation in March 2007, the court included within the class investors from France, the U.K, and Netherlands, but excluded from the class investors from Germany and Austria, on the theory that the courts in those countries may not recognize a U.S. class action judgment or settlement and the defendants could face duplicate litigation in those countries. (Refer here for a detailed discussion of the class certification decision in Vivendi.)
Clearly, overseas investors appear interested in pursuing redress in U.S. courts. Even if they face potential obstacles through jurisdictional challenges or class composition issues, these investors appear eager to pursue remedies under the U.S securities laws. Cynics might well assert that these investors are merely evincing the same jackpot justice mentality that has driven the U.S. litigation system for years. There may well be some truth to this view, as the massive settlements in the Royal Ahold and Nortel Networks cases undoubtedly provide a substantial incentive for foreign investors to consider the U.S. litigation alternatives. At the same time, it also appears to be the case that foreign investors are becoming more accustomed to the idea that aggrieved shareholders are entitled to hold company management accountable.
 
 
There may be no going back on this development, and indeed legislative changes in a variety of countries seem to represent a greater recognition of the rights of shareholders to pursue claims. No country has gone all the way to a U.S. style litigation system, and none seem likely to do so in the near future. But as overseas investors become comfortable with the U.S. system, they may become increasingly willing to use it and even to become reliant on it. (Indeed, the press coverage of the GlaxoSmithKline lead plaintiff selection suggests that the U.K. pension fund’s selection in that case may encourage other U.K. funds to become more involved in U.S. class litigation.)
 
 
 
As overseas investors’ become more comfortable with this type of litigation, they may become more likely to agitate for similar remedies in their own countries. In any event, one side effect from the increasing globalization of the financial marketplace is that overseas investors may become an increasingly important part of U.S class action litigation.
 
 
Special thanks to a loyal reader for the link to the news articles regarding the GlaxoSmithKline lead plaintiff selection.
 
 
UPDATE: As discussed in this subsequent post (here), a case pending in the Second Circuit involving the National Australia Bank squarely presents the jurisdictional issues involved in the "f-cubed" cases.
 
FURTHER UPDATE: The With Vigour and Zeal blog has some further additional insight (here)into the involvment of the U.K. institutional investor in the GSK action, as well as some interesting commentary on the perspective of the U.K. institutional investment community on U.S. style class action litigation.
Another Options Backdating Class Action Settlement: According to an October 15, 2007 press release from plaintiffs’ counsel (refer here), the Mercury Interactive options backdating securities class action lawsuit has settled for $117.5 million, which the law firm claims is "the largest in any stock options backdating case to date."
 
 
My own tracking of the options backdating class action settlements confirms the plaintiffs’ assertion, as the next largest options backdating related settlement of which I am aware is the Rambus case, which settled for $18 million (about which refer here). The only other options backdating class action settlements I have identified are: Newpark Resources, which settled for $9.5 million (about which refer here), and Vitesse Semiconductor, which settled for $10.2 million (about which refer here).
While the Mercury Interactive settlement amount is impressive, it is unlikely to serve as any kind of a guide for many other options backdating securities class action lawsuits. The Mercury Interactive case was relatively unusual in that its share price dropped significantly in reaction to the media reports about options backdating at the company. The share prices of most other companies with options backdating woes did not react significantly to the news. However, the Mercury Interactive settlement may be relevant to the handful of cases where there was a significant stock price drop, and there are other cases that are cast in a different light given the Mercury Interactive settlement.
I have been unable to find any disclosures revealing the contribution, if any, of D & O insurance to the Mercury Interactive settlement. Any readers who have information on this point and are willing to share are invited to let me know. Up to this point, most D & O carriers have taken the position that the options backdating cases will not be a significant collective event for the D & O industry. But if carriers are compelled to contribute to a group of settlements on the order of magnitude of the Mercury Interactive settlement, options backdating might turn out to have a significant impact on the D & O industry after all.