For those keen to cast blame for the subprime meltdown, the rating agencies have already emerged as a favored target. For example, when Citigroup recently announced (here) a significantly increased write-down of subprime mortgage assets, it attributed the action to recent rating agency asset downgrades.

The rating agencies’ own shareholders have already jumped on the blame game bandwagon, suing Moody’s (refer here and here) and S & P’s parent company, McGraw-Hill (refer here), alleging that the agencies assigned excessively high ratings to bonds backed by risky subprime mortgages – including bonds packaged as CDOs – causing investors to be misled as to the quality and riskiness of these investments. (My earlier post on the lawsuits against the rating agencies can be found here.)

Connecticut Attorney General Richard Blumenthal has even announced (here) that he has issued subpoenas to the three largest rating agencies as part of an antitrust investigation into the debt rating industry.

In addition, academics have, as discussed at greater length here, already questioned whether investors in mortgage-backed assets may try to target rating agencies, alleging that they (the investors) were misled into investing in assets on the mistaken belief that they were investing in investment-grade assets. Investors, the academics theorize, might allege that the rating agencies’ conflicts of interest and involvement in the deal process led to the agencies’ understatement of risk.

One possible constraint on claims of this sort may be that in the past when rating agencies have been sued (for example, in connection with the Orange County bond default), the agencies have successfully argued that their rating activities were protected by the First Amendment, as mere opinions of creditworthiness.

In a November 2007 paper entitled "Not ‘The World’s Shortest Editorial’: Why the First Amendment Does Not Shield the Rating Agencies From Liability for Over-Rating CDOs" (here), David Grais and Kostas Katsiris of the Grais & Ellsworth law firm take the position that "the First Amendment will not protect the rating agencies in the massive litigation likely to ensue from their role in the subprime debacle."

The authors concede that rating agencies are indeed entitled to First Amendment protection when they are "acting as a member of the press," as for example when they are publishing indicies, databases or periodicals. The authors contend that a different standard applies when the rating agencies are rating a security; in particular, they contend that the courts have found that rating agencies are not entitled to the First Amendment protection when three factors are present: when a rating agency "rates only those securities it is hired to rate"; when the rating agency "participated in structuring the security"; and if the security was "privately placed" rather than "offered to the public."

These factors, the authors argue, weigh against the rating agencies in connection with any attempts to rely on the First Amendment to protect their activities in rating CDOs. The authors contend:

 

In their traditional role of rating and writing for their subscribers about all debt securities offered and traded publicly, the rating agencies may well have acted as members of the press. But in rating structured securities like CDOs, which the agencies normally rate only for a fee, often participate in the structuring of, and which are usually sold and traded privately, the reverse is true: the rating agencies are not journalists gathering information and reporting to the public, but rather participants in the transactions that they rate.

The authors go on to argue that, even if the agencies activities are found to fall within the First Amendment’s protection, the protection afforded would not be sufficient to shield the agencies from liability, since the rating agencies would still have to show why they should be exempt from "laws of general application" (such as tort law provisions for negligence or fraud, for example). The authors argue that the rating agencies would not be able to rely on either of the usual bases on which such exemption is claimed. That is, the rating agencies will not, the authors contend, be able to rely on the usual defenses of the absence of "actual malice" or that their ratings were protected "opinion." Therefore, the authors contend, neither of these theories "will help the rating agencies in litigation for over-rating CDOs and similar securities."

The rating agencies are well aware that they face these kinds of criticisms and attacks and have already begun marshalling their defenses. For example, in an August 23, 2007 publication entitled "The Fundamentals of Structured Finance Ratings" (here), S & P set out to answer its critics and defend its structured finance practices. The publication defends the dialog that occurs during the process of rating structured finance products, such as CDOs, saying that it is no different than the routine discussions involved in non-structured finance-related issues, and an in any event does not amount to "advisory" work; the publication asserts that "we will never tell an arranger what it should or should not do."

And as for the fact that the rating agencies are paid by the issuers they rate, the S & P publication asserts that its ratings are "extremely transparent" because all ratings are published and all transactions are described in press and industry reports. "Any untoward behavior," the publication notes, "would attract instant attention and endanger both investor confidence in us and our entire franchise." The issuer-pay fee mechanism also allows S & P to publish ratings free to investors, promoting the "broad and free dissemination of important information to the marketplace quickly."

While the legal article’s authors recognized the S & P publication as "thoughtful," the legal article’s authors also contend that the S & P’s points "are unlikely to persuade the courts that S & P or its competitors act as members of the press when they rate CDOs." The role that the rating agencies play may not be an advisory one, but their participation in the structuring of the security by their commentary on the various iterations may be enough to establish a role that is incompatible with the invocation the full First Amendment protections.

Whether or not the legal article’s authors’ analysis ultimately proves correct, their theories are likely to receive an attentive hearing in certain quarters, and their views are likely to strengthen the already established tendency to assign blame to the rating agencies for the subprime meltdown. Given the authors’ analysis, it seems probable that the subprime litigation wave will include mortgage-backed asset investors blaming their losses on rating agencies for investments they contend were inappropriately rated as investment-grade.

Special thanks to Kostas Katsiris for providing a copy of and a link to the legal article.

$400 Billion in Subprime Losses?: Whatever incentives there are now for blame shifting against the rating agencies are only likely to increase in the coming months, as mortgage related investment losses grow. While estimates of the likely losses from the subprime meltdown are necessarily imprecise, some of the estimates are nonetheless impressive. For example, according to a November 12, 2007 Bloomberg.com article (here), a Deutsche Bank analyst has estimated that "losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide."

The Deutsche Bank analyst specifically projects that Wall Street banks and brokers ultimately may be forced to write down as much as $130 billion due to the decline in subprime debt, up to $60 or $70 billion of that this year. (Current write-downs total around $40 billion).

Losses anywhere near that order of magnitude will definitely provoke the investors and others to look for targets against whom to assign blame. I suspect strongly that before all is said and done, the First Amendment theories discussed above will be fully ventilated in the courts.

Rule 144A Markets Form Single Trading Platform: As I have previously noted, various parties have recently launched competing platforms for trading Rule 144A securities. For example, Goldman Sachs launched it s GSTrUE platform (as discussed here), several other investment banks had combined to form the OPUS 5 platform (refer here), and NASDAQ had lauched the Portal platform (refer here).

However, on November 12, 2007, Nasdaq announced (here) that the leading Wall Street firms had dropped their competing systems and agreed to cooperate on a single platform, the Nasdaq Portal system. The founding members include Bank of America, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley , Nasdaq, UBS and Wachovia Securities.

Nasdaq said about this intitiative that:

 

The PORTAL Alliance will work with third-party service providers to create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs").

The PORTAL Alliance participants will contribute the expertise gained in connection with the development of their existing 144A platforms to create an industry standard facility with a uniform set of procedures for issuers and QIBs to bring greater efficiency and transparency to the 144A equity marketplace.

A September 12, 2007 Wall Street Journal article discussing the formation of the single platform alliance can be found here.

 

In the days following Citigroup’s November 4, 2007 announcement (here) that it would be writing off an additional $8 to $11 billion due to declines in values of U.S. subprime related debt exposures, as well as its announcement (here) of the departure of its Chairman and CEO Charles O. Prince, the company has been hit with a heap of lawsuits, making it the latest company to be caught up in the subprime lending-related litigation wave.

The first lawsuit, initiated on November 6, 2007, was filed by a Citigroup employee on behalf of participants and beneficiaries of the Citigroup 401(k) plan and the Citibuilder 401(k) plan of Puerto Rico, for alleged violations of ERISA in connection with the loss of value in the Citigroup stock held in the plans. A copy of the plaintiff’s counsel’s press release can be found here, and the complaint can be found here. The complaint names as defendants the company, Prince, and the plans’ administrative and investment committees. According to the press release, the complaint alleges that

Citigroup and the various defendants breached their fiduciary duties owed to the Plans’ participants by: (1) failing to prudently and loyally manage the Plans’ assets; (2) failing to provide participants with complete, accurate and material information concerning Citigroup’s business and financial condition necessary for participants to make informed decisions concerning the prudence of directing the Plans to invest in Citigroup stock; and (3) failing to appoint and monitor the performance of the other fiduciaries. Citigroup’s exposure to the subprime market and its contingent liabilities with respect to various off-balance sheet transaction has led to the resignation of Citigroup’s CEO and caused the Plans to suffer well over $1 billion in market losses.

Next, on November 7, 2007, a Citigroup shareholder filed a shareholders’ derivative lawsuit (here), against the Company as nominal defendant, and numerous present and former directors and officers. The complaint alleges “breaches of fiduciary duties, waste of corporate assets, unjust enrichment, and violations of the Securities Exchange Act of 1934.” The complaint alleges that the violations took place between January 2007 and the present and caused substantial monetary loss to the largest U.S. bank and other damages such as to its reputation and goodwill. A November 7 Wall Street Journal article describing the derivative lawsuit can be found here.

Then on November 8, 2007, a Citigroup shareholder filed a purported securities class action lawsuit against Citigroup and several present and former directors and officers. A copy of the plaintiff’s counsel’s press release can be found here and a copy of the complaint can be found here. (There have been several additional substantially similar securities lawsuit complaints filed against the company.) According to the press release, the complaint alleges that between April 17, 2006 and November 2, 2007,

Defendants issued materially false and misleading statements regarding the company’s business and financial results. The complaint specifically alleges that: (i) Defendants’ portfolio of CDOs contained billions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (ii) Defendants failed to properly account for highly leveraged loans such as mortgage securities; and (iii) Defendants had failed to record impairment of debt securities which they knew or disregarded were impaired, causing the Company’s results to be false and misleading.

It is now common to refer to the period earlier this decade when Enron, WorldCom and other corporate meltdowns occurred as the era of the “big corporate scandals, ” usually with the unstated implication that this era is well in the past. But with the recent high profile turmoil involving such corporate titans as Citigroup, Merrill Lynch, Washington Mutual and Countrywide Financial, it seems appropriate to ask whether the unfolding subprime meltdown may have evolved into a new (or perhaps renewed) era of corporate scandals.

At a minimum, the subprime mess has generated an impressive amount of high-stakes litigation. As reflected in my running tally of subprime lending-related lawsuits (here), 20 companies have now been sued in subprime-related securities class action lawsuits, in addition to the four residential construction companies and two credit rating agencies that have been sued in securities lawsuits, as well the three lawsuits brought by employees against their employers under ERISA raising allegations pertaining to plan losses arising from the subprime meltdown. At this point, it seems highly likely that there is significant additional litigation yet to come. The subprime mess may not yet have created any massive corporate failures on the scale of the era of corporate scandals from earlier in this decade, but the mess clearly already represents its own distinct (and growing) category of corporate scandal and related litigation.
$3 Billion in Subprime Related D & O Losses?: A recent attempt to quantify the extent of D & O insurance industry exposure from subprime-related litigation appears in the November 2007 publication of Guy Carpenter entitled “Credit Market Aftershock Threatens Professional Liability Profits” (here). The report notes that while the estimates of losses to the D & O insurance industry have varied from $1 billion to $3 billion, “when the dust settles, total insured losses are likely to be at the top end of analyst estimates (i.e. $3 billion), because most reports have understated the D & O limits at risk and assume there will not be many claims beyond what has been filed already.”
The report notes further that “there was never any doubt that the subprime mortgage market collapse would have an insurance impact. The question was one of extent. While estimates vary from $1bn to $3bn, it looks like the reality may settle at the upper end of the scale. The final answer will not come until 2008 or maybe even 2009, but history, litigation tendencies and capital markets point toward the worst case scenario,” The report goes on to note that “insured losses could account for 30% to 35% of D & O industry premium.”
Notwithstanding the scale of the reports projected losses and the extended duration of the loss period, the report speculates that the losses losses are “unlikely to reduce available reinsurance capacity or substantially impair (re)insurers’ results of balance sheets.”
While I am inclined to agree that with the report’s conclusion that losses are likely to range beyond many of current estimates, I think it is simply too early to tell the overall impact on capacity or insurer financial stability. For example, the report’s analysis relates only to lawsuits filed only through the end of October, and so omits consideration of the lawsuits already filed in November, such as the new lawsuits against Merrill Lynch, Citigroup, and Washington Mutual. The filing of these lawsuits, and the suddenness of their emergence, does tend to underscore the likelihood that losses will range higher than previously assumed, but the unanticipated emergence of the lawsuits against these corporate giants also suggests that the subprime problem may be even bigger than Guy Carpenter assumed when drafting its report. So while I agree with the report that the subprime problem is shaping up to be bigger than previously assumed, it is simply too early to predict whether or not it will impact capacity or insurer financial strength. It is worth emphasizing that the situation is worse than Guy Carpenter assumed when they wrote their report.

Foreign Institutional Investors Opt-In to U.S. Securities Litigation: In an earlier post (here), I discussed the involvement of foreign institutional investors in U.S.-based securities class actions, and the fact that courts are certifying classes including foreign investors who bought shares overseas, at least foreign investors from countries whose courts it is believed would recognize the U.S. court’s judgment. This class definition necessarily precludes investors from other countries.

As Adam Savett notes on the Securities Litigation Watch blog (here), this process has the “altogether predictable consequence” of encouraging large institutional investors that are excluded from the class definition to file individual or group actions in the United States. In fact, that is exactly what has happened with respect to foreign institutional investors precluded from the class in the Vivendi securities class action. (A copy of the Vivendi class certification decision certifying a class to include only investors from the United States, France, England, and the Netherlands, can be found here.) There have now been over a dozen individual or group actions filed by international institutional investors after having been excluded from the Vivendi class. A copy of one of the group complaints can be found here.

Would-be reformers cite U.S.-style securities litigation as one of the factors undermining the competitiveness of U.S securities markets, on the theory that overseas companies shun the U.S. exchanges to avoid American litigiousness. However, it seems clear that overseas investors find U.S. style litigation attractive. It is not far-fetched to suppose that as overseas investors become habituated to these processes for holding company management accountable, they may come to expect or even demand procedural alternatives in the home countries to hold company management accountable.

The presence of these individual or group actions paralleling the ongoing class case represent but one set of factors testing the continuing utility of securities class action litigation. Another factor is the recently increased prevalence of class action settlement opt-outs (about which refer here). Both of these developments may illustrate growing limitations to class action procedures. While alleged class action abuse has long been a rallying cry for corporate reformers, class actions arguably may be far more preferable than the alternative of massive piecemeal litigation that multiplies litigation costs and complicates efforts toward efficient case resolution.

JDS Uniphase Trial Updates: In an earlier post (here), I noted the significance of the pending securities trial of involving JDS Uniphase and several of its directors and officers. It has proven difficult to follow the trial, but as Lyle Roberts points out on the 10b-5 Daily blog (here), the best way to monitor the trial is on Crash.net, a motorsports website that is following the trial because former JDS Uniphase CEO Kevin Kalkhoven, one of the trial defendants, is also one of the owners of the Champ Car World Series.

Unfortunatly, the Crash.net website is confusing and difficult to navigate. I found that the best way to find the reports of the JDS Uniphase trial is to enter a search on Kalkoven’s name in the search box on the left-hand column. The website reports that the parties expect to complete the submission of evidence by November 16, 2007, with argument, instructions and jury deliberations to begin after Thanksgiving.

Wecome Back, Nugget: We here at The D & O Diary were fans of the late, lamented PSLRA Nugget, a securities law blog that went dormant some time ago. Apparently the old blog has been reincarnated and will be reinvigorated as the Acquirelaw Nugget (here). The old Nugget was great, so we are looking forward to seeing regular posts again from the new Nugget.

Speaker’s Corner: On Thursday November 15, 2007, I will be speaking on a panel entitled “Exploring Director & Officer Liability” at the IQPC Securities Litigation Conference in New York. Further information about the conference can be found here.

On November 6, 2007, the court in the Brooks Automation options backdating-related securities class action lawsuit substantially denied the defendants’ motions to dismiss. A copy of the opinion of Judge Rya Zobel of the District Court of Massachusetts can be found here. The Brooks Automation decisions joins the recent Openwave Systems decision (refer here), as one of now several decisions in which motions to dismiss have been denied in options backdating-related securities class actions. A complete list of the dismissals, denials and settlements in options backdating lawsuits can be found here.

The defendants had moved to dismiss the plaintiff’s claims under Section 10 of the ’34 Act on the grounds of loss causation, scienter and the statute of limitations.

With respect to loss causation,

Defendants argue that Brooks has not adequately alleged loss causation because Brooks’ stock price rose after the March 18, 2006 Wall Street Journal article and again after the July 31, 2006 publication of the Restatement. However, plaintiffs have alleged particular details regarding the decline in Brooks’ stock price that occurred during the period from May 11, 2006, through May 22, 2006, when Brooks made several successive disclosures regarding investigations into its stock option practices.

The court said that “although the parties dispute the exact timing of some of the disclosures and the resultant effect they may have had on the stock price, the complaint’s allegations of loss causation are … sufficient at this stage.”

With respect to the issue of scienter, the court said that defendants’ argument that the challenged grants “were part of either legitimate, demonstrable patterns or predetermined dates is credible.” However, the court went on to note that “the data compiled by plaintiffs and the Wall Street Journal regarding stock price movements on grant dates, together with Brooks’ Restatement, in which it admitted that millions of options were accounted for on incorrect grant dates, creates a reasonable inference that intentional backdating may have occurred.” The court did go on to find that with respect to the individual who served as the company’s CFO from November 1998 through October 2002, and with respect to one individual who served on the Board’s audit and compensation committees, that the individual allegations did not adequately scienter (although the former CFO’s motion to dismiss was denied as to control person liability allegations.)

The court also found that a factual issue remained on the question as to when the plaintiffs had or could have sufficient information available to trigger the running of that statute of limitations. The court also found that the plaintiffs’ allegations under the ’33 Act were also sufficient to survive a motion to dismiss. Judge Zobel did grant the dismissal motion of PricewaterhouseCoopers.

In substantially denying the defendants’ motions to dismiss, Judge Zobel clearly seems to have been influenced by the fact that the company had been required to restate its prior financials and that the company’s special committee found that the company had not properly accounted for its options grants. Judge Zobel also refers throughout the opinion to the allegations in the civil complaint filed by the SEC against the company’s former CEO. The implicit admission that options were backdated, and the presence of a separate SEC action, contrast with the circumstances surrounding the backdating allegations against Amkor Technologies, whose motions to dismiss were recently granted (refer here). The differing circumstances may perhaps explain the different outcomes.

In any event, the Brooks Automation dismissal denial has been added to my running tally of options backdating lawsuit dismissals, denials and settlements, which can be accessed here.

If you are like me and you don’t feel fully briefed on Option-ARM mortgages, then you will want to read the September 2006 Business Week article entitled “Nightmare Mortgages” (here) describing the pitfalls of Option-ARM loans. Among other things, the article states: “The option adjustable rate mortgage (ARM) might be the riskiest and most complicated home loan product ever created.” The article also quotes one economist as saying that the option ARM is “like the neutron bomb–it’s going to kill all the people but leave the houses standing.” The article, written more than a year ago, reads like a prophecy of war foretold.

An Option-ARM (as explained here) is an adjustable rate mortgage on which the interest rate adjusts monthly and the payment adjusts annually, with borrowers offered options on how large a payment they will make. The options include interest-only, and a “minimum” payment that is usually less than the interest-only payment. The minimum payment option results in a growing loan balance, termed “negative amortization.” Negative amortization of course means that the principal amount increases, a truly revolting development under any circumstances, but a particularly pernicious development when housing prices are falling.

In an October 24, 2007 Wall Street Journal article entitled “Countrywide’s New Scare” (here) explains how the higher commissions, lower documentation requirements, and flexible payment options encouraged Countrywide Financial Corp.’s development of this product. Deterioration on these mortgages is further undermining the results of lenders already reeling from subprime problems. Among other things, the Journal article reports that in the period 2009-2011, monthly payments on $229 billion of option ARMs will readjust (so borrowers may have to pay more).

The problems with Option-ARMs have now claimed their first lawsuit victim: Washington Mutual, along with three of its directors and officers, has been sued in purported securities class action lawsuits federal court in Manhattan. A copy of the complaint can be found here.

According to the plaintiffs’ counsel’s November 5, 2007 press release (here), the complaint alleges that:

During the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results. WaMu’s loan portfolio contained more than $57 billion in adjustable-rate mortgages or Option-ARM loans. The complaint further alleges that the Company failed to disclose: (i) that it had far greater exposure to anticipated losses and defaults in its home loan portfolio, particularly with Option-ARMs, than it had previously disclosed; (ii) that defendants’ Class Period statements about the Company undertaking significant preparations and implementing defensive measures to weather the increasingly difficult credit and housing markets were patently false; (iii) that defendants had engaged in a conspiracy and scheme to inflate the appraisal value of homes with the intent to artificially increase the estimated loan-to-value ratio of its Option-ARM portfolio; and (iv) that due to the Company’s improper appraisal practices, the mortgages it had issued were much riskier than represented.

The class action lawsuit follows WaMu’s October 17, 2007 announcement (here) that it was setting aside an additional $1.3 billion in the fourth quarter to cover its loan losses (primarily as a result of problems with Option-ARMs), and the New York Attorney General’s November 1, 2007 announcement (here) of a lawsuit against FirstAmerican Corporation and ePraiseIT, alleging that they had conspired with WaMu to inflate residential real estate appraisals.

Even though the lawsuit does not specifically reference subprime loans, the connection to Option-ARMs (which often went to first time home-buyers, and one of the advantages of which was the low documentation requirements) persuades me to add it to my running tally of subprime-related securities lawsuits (here). With the addition of this case, the tally now stands at 19 lawsuits, not counting the four subprime-related lawsuits pending against home construction companies.

In prior posts, I have discussed how conflicts of interest in management-led buyouts can give rise to litigation (refer here), and I have examined the ways the recent credit market turmoil is not only undermining leveraged buyouts but also engendering lawsuits (refer here). I have also extensively reviewed options backdating litigation (most recently here). But I never expected to see all three of these woes afflict a single company at the same time, yet that is exactly what has happened to Affiliated Computer Services, which finds itself and several of its officers the target of an unusual lawsuit brought by give not-quite-former outside directors as part of a veritable conflagration of accusations between management, the company and its independent directors.

The starting point for this story is ACS’s larger-than-life founder and Chairman, Darwin Deason, a four-times married former Arkansas farm boy who reportedly drinks the heinous combination of Diet Coke and Kahlua to self-treat an acknowledged drinking problem and who either did or did not threaten to kill his personal chef on his yacht in September 2001. These colorful personal details, and many more, are described at much greater length in a June 2003 D Magazine article entitled “Lifestyles of the Rich and Shameless” (here), as is this particularly interesting note about an unsuccessful MBO bid that Deason led in 1988, in connection with MTech, a company Deason previously founded:

In 1988, with banks failing all over Texas, MTech’s majority owner MCorp…began to slide toward Chapter 11. Reading the tea leaves, Deason puts together a $360 million management buyout of his firm. As the last second, thought, Plano-based EDS raises its hand and shouts “Four hundred and sixty-five million!” MTech is sold to the highest bidder. Deason is furious. He resigns some 90 minutes into his employment with EDS, apparently walking out before anyone can get him to sign a noncompete agreement….Five months later, with 18 of his top 22 executives from MTech on board, he launches ACS.

Having formed ACS from the remnants of a failed MBO in which he was outbid by a competing bidder, it may well be supposed that Deason was determined not to permit himself to be similarly outbid in his attempted buyout of ACS itself.

In late 2006, options backdating allegations put Deason and ACS on the front page of the Wall Street Journal. In a December 30, 2006 article entitled “Living Large and Bouncing Back” (here), the Journal provided further interesting details about Deason’s background, noting, among other things, that “although Mr. Deason, who retired as CEO in 1999 and is still ACS’s Chairman, received two option grants on extremely favorable terms, two internal probes didn’t find evidence that Mr. Deason knew about or took part in any backdating.”

The Journal article details ACS’s internal backdating investigations, the second of which resulted in the November 2006 resignation of Deason’s successor as CEO, Mark King, as well as the company’s CFO (the company’s press release about which can be found here). The Company itself later announced in a January 5, 2007 filing on Form 8-K (here) that it was amending the exercise date of certain option grants, including one grant to Deason. The Company said it was taking the step to eliminate negative tax implications. According to the Journal, these option related issues created tensions between Deason and the independent directors that may have carried over to the circumstances surrounding the MBO.

An options backdating-related shareholders’ derivative lawsuit against the company as nominal defendant and against certain current and former directors and officers remains pending (refer here).

In March 2007, Cerberus Capital Management, in conjunction with Deason (who owns 42% of the ACS voting rights, but less than 10% of its ownership by valuation) made a buyout offer that as adjusted was worth $6.2 billion. Cerberus withdrew its offer on October 30, 2007 (refer here), explaining that the withdrawal was “due to the continuation of poor conditions in the debt markets.” But while debt market turmoil undoubtedly was the ultimate trigger of the demise, a full-throttle dispute between Deason and the independent Board committee set up to review the offer was a critical circumstance in which events unfolded, and which set the stage for the current public fracas between Deason and the directors.

The dispute between Deason and the Special Committee is dramatically revealed in a series of letters, all of which are now very publicly available. The first letter (here, Exhibit A), dated October 30, 2007, and written by the Kosowitz, Benson, Torres, & Freidman law firm on behalf of ACS’s current CEO, Lynn Blodgett, demands the “immediate resignation” of the five Special Committee members, alleging that they had “totally failed to discharge [their] responsibilities, accusing them of delays that “squandered an immensely valuable opportunity” and having failed to elicit any alternative bids.” The letter also accuses the directors of having disclosed “confidential trade secret information” to one of ACS’s direct competitors. The letter concludes by accusing the five individuals of “gross breaches of their fiduciary duties,” and states that the Special Committee must be terminated and they must each resign “forthwith.”

Deason sent his own letter to the five individuals dated November 1, 2007 (here) in which he said he “most respectfully asks that you resign today from the Board.” Deason’s letter also accuses the five of delaying consideration of the Cerberus bid while failing to produce another bidder, as a result of which the Board has “lost shareholder trust.” Deason asserts that “changing the membership of the Board is in the shareholders’ best interest.” The letter also proposes a slate of “replacement directors.” Deason states that “the management of the Company has indicated it may also take action, including potential litigation, in the interests of the shareholders of the Company.” Deason concludes by asking the individuals to make the “right choice” and “resign immediately.”

The five directors responded in two letters dated November 1, 2007. First, their counsel, Weil Gotshal & Manges, responded to the October 30 letter, in a letter (here, Exhibit B) noting that the October 30 letter is “premised on the remarkable principle that it is management rather than the Board of Directors that is ultimately responsible for the business and affairs of the Company.” The Weil Gotshal letter asserts that the delays in considering the Cerberus bid were due to the inclusion in the Cerberus deal of Deason’s agreement to work exclusively with Cerberus, which provision the letter asserts was “designed to and did in fact chill the interest of competing bidders,” a provision that Deason refused until June 10, 2007 to waive. The Weil.Gotshal letter asserts that the Special Committee process did in fact result in a higher bidder, but that “management and Mr. Deason worked hard to assure that no buyer would have a full and fair opportunity to obtain the information necessary to make a proposal.”

The five ACS directors also sent their own November 1 letter (here) in response to Deason’s letter, in which they assert that they have “acted appropriately and in a manner designed to safeguard the best interests of the company.” The directors’ letter recounts the delays occasioned by Deason’s exclusivity agreement, and asserts that “you [Deason] and your management team worked hard to make it difficult for any other buyer to have access.” Their letter states that “your interest only in a transaction in which you would participate on the buy side and management’s interest in retaining their jobs” delayed the process.

The directors’ letter goes on to state, with reference to the October 30 board meeting:

Your carefully choreographed power play Tuesday evening to coerce the independent directors of ACS into resiging on the spot is consistent with your continuing refusal to understand that the Board’s fiduciary duties are to all shareholders – not just you. Your ultimatum: resign in one hour or I will go to the press and smear your reputations – was a remarkable piece of bullying and thuggery, and it almost worked.

The directors’ remarkable letter goes to state that Deason’s interference with the Special Committee “made it impossible for us to continue to effectively serve as directors.” The letter notes Deason’s extraordinary authority in his employment agreement (which apparently gives him the ability to recommend the approval or removal of directors) as well as Deason’s conduct, rendered the individuals unable to “properly discharge” their fiduciary duties. The letter observes that “we could fire you and the entire management team, but that would not help our shareholders, customers or employees. Rather it would rip the Company apart and cause a lengthy fight and a period of uncertainty from which the Company would be unlikely to recover…we have decided …that the best way for us to discharge our fiduciary duties is to resign in favor of a new majority of independent directors.” The letter concludes by stating that upon completion of the process of vetting independent director candidates, the five would step down “with great relief.”

Having offered their prospective resignations, the five individuals took one further extraordinary step: they filed a declaratory judgment action (here) in Delaware Chancery Court against the company, Deason, Blodgett, and ACS’s current CFO. The not-yet-former directors’ lawsuit, clearly filed as a preemptive strike against anticipated actions by Deason or company management, briefly repeats the assertions from the directors’ November 1 letter, and asks the court to “declare that the Plaintiffs have not breached their fiduciary duties.”

There is always a potential for a conflict of interest in a management-led buyout, as I have previously noted (here). The November 2, 2007 New York Times article entitled “A Bitter Rift When the Boss is the Buyer” (here) said that “the [ACS] drama highlights the potential conflicts that can occur when a founder or chief executive leads a deal to acquire a company, something that has become common in the recent wave of leveraged buyouts.” One of the most challenging issues that can arise in an MBO is what the Wall Street Journal describes in its November 2, 2007 article “A Failed Deal at ACS Sets Off a Board Brawl” (here) as the “fraught dynamics created inside boardrooms when insiders try to take public companies under private ownership.”

But even within the fraught dynamics that characterize these kinds of deals, the ACS tussle is extraordinary. It is pretty clear that the fraught dynamics gave way to open warfare as the two sides sought to establish who was to blame for the deal’s failure. Clearly, Deason’s determination to avoid losing out to a higher bidder, as he lost his 1988 attempt to buy out MTech, seems to be a critical part of many of the events. The topsy-turvy ouster of the independent Board members by company management may perhaps be explained, if not entirely understood, by the extraordinary provision in Deason’s employment agreement that actually gives him the authority to recommend the approval or removal of directors.

The directors for their part were put in a position of struggling against the company’s forceful Chairman while trying to determine whether an alterative to Deason’s bid would be in the sharholders’ best interests. The directors efforts took place under circumstances where shareholders had already initiated litigation (refer here) alleging that management-led buyout provided shareholders with inadequate value and that Deason had misappropriated inside information to secure Cerberus’s participation in the transaction.

Ultimately, what doomed this deal was a perverse combination of timing and the changing marketplace conditions. Although Deason eventually waived the exclusivity agreement with Cerberus, that didn’t happen until June, and the waiver only extended for two months. By August, changed conditions in the credit marketplace had greatly complicated ACS’s effort to determine potential interest in alternative buyers, and the Board sought a further extension of Deason’s waiver (about which refer here). But by then, Cerberus itself was having trouble securing financing, and the deal failed. With no prospects left, the finger-pointing began.

The five directors’ declaratory judgment action, in which they sued the very company on whose Board they still serve (at least until their prospective resignations become effective), represents another extraordinary aspect of this unusual set of circumstances. Their attempt to defend themselves preemptively by initiating a declaratory judgment action effectively seeks to enlist the court on their side in their struggle to establish that they are not to blame for what happened.

While the intensity and the public nature of the ACS dispute may be unusual, there likely will be other similar recriminations as changed credit conditions cause other planned deals to fall apart. The “fraught dynamics” may give way to further lawsuits – yet another byproduct of the changed conditions in the credit marketplace. It is probably worth noting in that regard that every aspect of these circumstances — the backdating allegations, the management-led buyout offer, and the managment dispute with the board — led to litigation against directors and officers of the company. Just something that every board should keep in mind the next time the topic of D & O insurance comes up. When things go bad, a well-structured D & O program is absolutely indispensible.

The directors’ declaratory judgment action poses some interesting issues from a D & O insurance perspective. The typical D & O policy has a so-called Insured vs. Insured exclusion, sometimes referred to as an infighting provision. While this provision usually has a coverage carveback for shareholders derivative suits, the typical wording contains nothing that would help understand where this lawsuit might fit. It would be hard to characterize these circumstances as anything other than “infighting.”

Hat tip to the WSJ.com Law Blog (here) for the links to the letters and to the directors’ complaint.

UCLA Professor Stephen Bainbridge has detailed analysis of the ACS “soap opera” on his Business Associations blog (here), including a discussion of relevant Delaware case law.

Bonfire of the Historical References: There was a real temptation in writing this post to refer to the title of Tom Wolfe’s wickedly funny book, The Bonfire of the Vanities. Although Wolfe’s title seemed perfectly apt for his book and, by extension, to this post, the book title is in fact a misplaced historical reference. The phrase “Bonfire of the Vanities” does not refer to a titanic conflagration of egos, but instead refers “the burning of objects that are deemed the occasion of sin” (according to Wikipedia, here), the most famous of which was the February 1497 burning of luxury objects by supporters of Savonarola (pictured above) in Florence, Italy. The phrase was undeniably a great title for Wolfe’s book, but a perhaps overactive desire to avoid historical infidelity constrained me from using the phrase in this post, much as it seems to fit the circumstances at ACS.

With the recent dismissals of the options backdating securities class actions filed against Hansen Natural (refer here) and Amkor Technology (refer here), it was beginning to seem that momentum might be building against these suits. But in an October 31, 2007 opinion (here), the court denied in significant part the motion to dismiss the options backdating securities class action lawsuit pending against Openwave Systems and certain of its present and former directors and officers. The portion of the ruling of Judge Denise Cote of the federal court in Manhattan denying the dismissal motion may provide other plaintiffs some grounds to hope that their complaints may also survive motions to dismiss.

The amended complaint against Openwave contained allegations both under the Securities Act of 1933 and the Securites Exchange Act 0f 1934. The court granted the defendants’ motion to dismiss the ’33 Act claim, on the ground that claim, raising allegations related to Openwave’s 2005 secondary offering and only added to the lawsuit in the plaintiff’s amended complaint, was barred by the ’33 Act’s one-year statute of limitations. The dismissal included also the plaitniff’s ’33 Act claims against the company’s offering underwriters and the company ‘s auditors.
Judge Cote also granted certain individual defendants’ motions to dismiss the ’34 Act claims against them as well, on the grounds that the specific individuals had left the company before the beginning of the class period; did not arrive at the company until the alleged backdating took place; or were not alleged to have participated in the supposed misrepresentations.

Judge Cote denied the company’s and the remaining individual defendants’ motions to dismiss the ’34 Act claims. The defendants had moved to dismiss the allegations for failure to plead scienter and loss causation. In concluding that the plaintiffs had adequately pled scienter as to certain individual defendants, the court found that the individuals had “benefited in a concrete and personal way” by receiving backdated options from which they “garnered immediate returns,” which the court said were “immediate and risk free.” The court rejected as “irrelevant” defendants’ arguments that the options grant dates were nowhere near the monthly lows, noting that this “simply indicates that backdating did not achieve as much benefit to the grantee as it could have,” not that backdating did not occur.

The court also found, referring to plaintiff’s backdating allegations, that “such evidence” is “no less probative of scienter after the Supreme Court’s decision in Tellabs.” Judge Cote found that the defendants had “not pointed to any competing inferences” that “could explain their receipt of options bearing dates other than the ones on which they received them.” Judge Cote also rejected defendants’ arguments based on the fact that the defendants had received options prior to the class period, since the financials issued during the class period reflected faulty accounting based on the allegedly improper grants.

The court also specifically denied motions to dismiss as to the compensation committee member defendants, finding that their failure to monitor the exercise dates of the options grants “give rise to an inference of scienter.”

The court also found that plaintiff had adequately pleaded loss causation, rejecting defendants’ arguments that other causes explained the company’s stock price fluctuations, the factual determination of which the court found “is not an issue to be resolved on the basis of the pleadings alone,” but is rather “a matter for proof at trial.”

As shown on my running list of options backdating case dispositions (here), there has been at least one prior dismissal motion denial in an options backdating securities class action lawsuit (in the UnitedHealth Group class action case, refer here), but the Openwave Systems court’s denial, perhaps by contrast to the UnitedHealth opinion, is based on a detailed review of the allegations and applicable law. The Openwave dismissal denial also stands in contrast to the recent options backdating dismissal grants, such as in the recent Hansen Natural decision granting a motion to dismiss (refer here), where the court seemed very skeptical of plaintiffs’ allegations and very unwilling to find any support for the plaintiffs’ contention that the options had actually been backdated.

The short shrift given the defendants’ arguments represents a potentially significant development for plaintiffs in other options backdating securities cases. The quick work the court made of defendants’ arguments on scienter and loss causation could, if followed by other courts, have a significant impact on the ourcome of pending motions to dismiss.

The question is whether other courts will follow. Not all judges will be as willing as Judge Cote to conclude that the recipient of options “garnered returns” that were “immediate and risk free.” Other judges may focus on the fact there can be no gains on any options until they are exercised, and that until exercised, the share price can decline below the exercise price. Other judges might find the fact that the grants were not even at monthly lows to be inconsistent with the theory of fraud, just as when courts (and as did Judge Cote in another part of her opinion) will find an insider’s sale of a small portion of their share holdings to be inconsistent with the theory of fraud. Other courts might well conclude, in line with their duties under Tellabs, that options grants at other than the maximizing date to be similarly inconsistent with the theory of fraud, and sufficient to create a competing theory at least as compelling as theory that the defendants acted with the requisite intent.

In any event, I have added the Openwave Systems opinion to my running tally of options backdating lawsuit settlement, dismissals and denials, which can be found here. Press coverage discussing the October 31 opinion can be found here.

Openwave Systems (as nominal defendant) and certain of its current and former directors and officers were also the targets of options backdating-related shareholders’ derivative lawsuits. On May 17, 2007, the California federal court presiding over the consolidated shareholders’ derivative litigation granted (here) the defendants’ motion to dismiss with leave to amend. The plaintiffs filed an amended complaint June 29, 2007, and the defendants’ motion to dismiss the amended complaint remains pending.

In an earlier post (here), I questioned whether the two-year lull in securities class action filings had ended. I posed the question then because of the uptick in securities class action filings between August 1, 2007 and September 30, 2007. But with continued active filing levels during October 2007, the statement no longer has to put in the form of a question. It can be now be declared: the two-year lull is over.

According to my count, there were 24 new securities class action lawsuits filed in October 2007. That makes 61 companies sued for the first time between August 1, 2007 and October 31, 2007. If that three month filing rate were projected over a 12-month period, it would annualize to 244 filings (compared to the average of 202 annual filings during the period 1994 to 2004, according to Cornerstone Research). In other words, for the three solid months, the filings have been coming in at (or even arguably above) historical filing levels.

The final three days of October saw a particularly concentrated burst of new lawsuits, with eight companies sued for the first time in those three days alone:

Part of the increased activity is attributable to the subprime mortgage meltdown, but by no means all of it. For example, only two of the 24 October lawsuits (E*Trade and Merrill Lynch) clearly relate directly to the subprime mess. There are others that relate more generally to the strained real estate marketplace, but most of the October lawsuits have no apparent connection to subprime lending.

The 24 companies sued in October are in some ways a very diverse mix. Among the 24 companies, 21 different SIC Codes are represented. No SIC Code group had more than two companies represented. There are large companies (Merrill Lynch, Novartis) and small companies (Micrus Endovascular, Smart Online). It is interesting to note that five of the 24 companies are domiciled outside the United States, including three from China. Of the 19 remaining U.S. domiciled companies, four are based in Florida, four are based in California, two are from Connecticut and two are from New York.

Two of the three Chinese companies (LDK Solar and China Sunergy) are solar panel manufactures who launched their U.S IPOs to great fanfare earlier this year (about which refer here). Their fate (whether deserved or not) is not likely to help attract additional Chinese companies to offer their shares on U.S. exchanges. At least five of the new lawsuits (including the two against the Chinese solar panel manufacturers) contain allegations relating to the named companies’ recent IPOs.

While the view was expressed earlier this year (refer here), in light of the two-year stretch of reduced securities lawsuit filings, that perhaps there had been a “permanent shift” to a lower class action activity level, it now seems clear that there was nothing permanent about the lower filing levels that prevailed from mid-2005 to mid-2007. Recent turbulence in the financial markets, among other factors, clearly has led to renewed litigation activity at or even above historical levels. The likelihood of continued financial marketplace instability suggests that litigation levels may remain elevated for some time to come.

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.