According to news reports (here), on September 18, 2007, Bill Lerach has agreed to plead guilty to a federal conspiracy charge. The plea agreement can be found here, the criminal information can be found here, and the governement’s press release can be found here. Hat tip to the WSJ.com Law Blog (here) for the links to the plea documents.

The plea agreement has some interesting additional information. For example, the agreement states that Lerach is not required to cooperate with prosecutors, which probably comes as some relief to his former colleagues who are facing actual or potential criminal charges. In addition, by its entry into the agreement, the government has agreed that it will not prosecute Lerach in connection with a number of other matters, some of which are identified with a tantalizingly brief description. For example, the agreement states that the prosecutors will not continue to pursue criminal charges against Lerach in connection with “requests to courts for reimbursement of fees and costs of a damages expert witness,” referred to in the plea agreement as the “Princeton Expert” – presumably John Torkelson, the plaintiffs’s style damages expert who has had legal troubles of his own (refer here).

The agreement also says that the prosecutors will not further pursue charges against Lerach in connection with “election, campaign, or other politicial contributions made using only funds generated by conduct described” in the plea agreement. The agreement also says that prosecutors will not pursue criminal charges concerning “defendant’s investment in, or relationship with, the Acorn Technology Fund.” The agreement says just enough about these non-prosecution items to attract curiosity, but reveals little else about these items.

The plea agreement also contains the prosecutors agreement that they will not prosecute either “the Lerach firm” or current Lerach firm partners Patrick J. Coughlin or Keith F. Park for any of the conduct described in the agreement or in the list of non-prosecution items. (The inclusion of these particular provisions in the agreement make me wonder whether by his entry into this agreement, Lerach sought to protect his former firm and former law partners–and to wonder how big of a factor that was in his willingness to enter the agreement.) The agreement does not state what basis if any the prosecutors might have had to proceed against the former Lerach law firm or the two law firm partners.

For his part Lerach agrees to pay a fine of $250,000, to pay a forfeiture of $7,500,000 (in two installments), to appear at all required times, and so on. In addition, although the crime for which Lerach is pleading guilty is punishable by up to five years in prison, Lerach and the U.S. Attorney’s office agree that “an appropriate disposition of this case is…a sentence of imprisonment within the range of 12-24 months, with the court retaining discretion to substitute community confinement or home detention for no more than one-half of the term of imprisonment imposed,” with the prison term to be followed by “a three-year period of supervised release.” The defendant may withdraw from the agreement if the Court refuses to be bound by the agreement.

The factual basis for the plea agreement is set out in Exhibit A to the plea agreement. The exhibit states, among other things, that “certain senior Milberg Weiss partners agreed with various individuals that Milberg Weiss would secretly pay those individuals a portion of the attorneys’ fees that Milberg Weiss obtained in the Class Actions.” The exhibit describes the partners who agreed to this arrangement as including Lerach, David Bershad (refer here), and others. The exhibit states that the paid plaintiffs were “promised that they would be paid approximately 10% of the net attorneys’ fees that Milberg Weiss obtained in their respective Class Actions.” The exhibit states that by entering into these arrangments, the firm was able to secure a “reliable source of individuals who were ready, willing, and able to serve as named plaintiffs.”

The exhibit states that Lerach and other conspiring partners and the paid plaintiffs understood that “to the extent necessary, they would make or cause to be make false or misleading statements in documents filed in federal Class Actions,” including in documents under oath and in under oath testimony. The exhibit further states that Lerach believed that if these secret payment arrangements were discovered, the law firm and the named plaintiff would be disqualified from in the particular action as well as other actions. The exhibit also states that Lerach and other conspiring partners concealed the payments, though the use of intermediary law firms, with the understanding and intent that the funds would be distributed to the paid plaintiffs. The exhibit specifically details payments that were made to one of the named plaintiffs, Steven Cooperman (about whom, and about whose escapades with stolen paintings, refer here).

According to the government’s press release, Lerach will appear for arraignment at a later date.

The most interesting question in the wake of Lerach’s guilty pleas is whether prosecutors will now attempt to proceed against Mel Weiss, who thus far has not been indicted. (A September 19, 2007 New York Times article commenting on the possible implications of the Lerach plea for Weiss can be found here.) In addition, it remains to be seen how the pending criminal charges against Steve Schulman, another former Milberg Weiss partner, will be resolved. Finally, the indictment also included the Milberg Weiss law firm itself. Theoretically, the criminal case, which would also include at least two of the paid plaintiffs, is scheduled to go to trial in January 2008.
I have previously commented extensively (for example here) about the possible impact that the Milberg Weiss firm’s and the former Milberg partners’ legal woes on the number of securities class action filings. It hardly seems a stretch to conclude that the involvement of the leading figures at the two industry leading law firms has has some impact on the filing of new lawsuits. More generally, it also seems like a stretch to suppose that these activities were limited exclusively to one law firm and took place no where else. The fact that the downturn in the number of lawsuit filings coincided with the first indictment handed up from the grand jury investigation these allegations does suggest some relation between these criminal prosecution and the number of lawsuit filings.
At this point, the more important question is what the impact will be going forward. There are certainly no shortage of other law firms willing to occupy the space previously occupied by the leading lawyers, and other firms have from outside the traditional plaintiff securities bar have been coming into the sector. But it remains to be seen whether any of these other firms have the carrying capacity of the former leaders, or whether they have the willingness or ability to finance the kind of massive litigation that the leading firms have been supporting in recent years.
A September 19, 2007 Wall Street Journal article regarding the plea agreement can be found here. The Point of Law blog has an interesting post here, with some pointed comments abou the plea deal (the post also has some links to some of the interesting literature from the Lerach-related archive). A September 19, 2007 Wall Street Journal editorial critical of the plea agreement can be found here.
Another Lawsuit Arising From the Disruption in the Credit Market?: Speaking of Lerach’s former law firm, now known as Coughlin, Stoia, Geller, Rudman & Robbins, on September 18, 2007, the firm initiated a new lawsuit against Care Investment Trust and certain of its directors and officers, according to this press release, here. The complaint (which weishs in at a short nine pages and which may be found here) alleges that the company’s June 22, 2007 prospectus failed to allege that certain of the assets in the company’s portfolio of health-care related assets were materially impaired and therefore overvalued, and that the company was experiencing difficulty in securing warehouse financing lines.
Cases like this suggest that as the credit complications arising from the subprime lending mess spread outward, it is going to become increasinly maintaining definitional clarity over what is and what is not subprime lending related litgation. But as I have noted in numerous prior posts (most recently here) the litigation wave spreading outward from the subprime mess could encompass a broad variety of companies and cases, including companies and cases having nothing directly to do with subprime lending itself. But because this company’s difficulties appear to derive from the complications in the credit market, I am aiding it to my list of subprime lending related lawsuits (here), on the theory that this company’s woes derive from the follow on contagion effect of the subprime mess. Interested parties who disagree with this case’s inclusion in the list should let me know.

In prior posts (refer here) and other publications (here), I have written about the growing potential exposure to directors and officers of publicly traded companies arising from global climate change concerns. My views have been met with some interest, but also with significant skepticism. But while there are admittedly as yet no D & O claims from climate change issues, several recent developments confirm my view that climate change-related issues represent a growing are of D & O exposure.

First, on September 14, 2007, New York Attorney General Andrew Cuomo subpoenaed five large energy companies demanding that they disclose the financial risks of their greenhouse gas emissions to shareholders. The letters Cuomo’s office sent to the energy companies accompanying the subpoenas can be found here. The five companies are AES Corporation, Dominion Resources, Xcel Energy, Dynegy, and Peabody Energy.

In the case of Dominion Resources, the letter (refer here) states that the purpose of the subpoena to Dominion is to obtain information “regarding Dominion’s analyses of its climate risks and its disclosure of such risks to investors.” The letter refers to the company’s plans to build a new coal-fired electric generating facility, which, the letter stated, together with the company’s other carbon emissions generating activities will “subject Dominion to increased financial, regulatory, and litigation risks.” The letter goes on to state that Dominion has “not adequately disclosed those risks to its shareholders, including the New York State Common Retirement Fund, which is a significant holder of Dominion stock.” The letter adds that “we are concerned that Dominion has failed to disclose material information about the increased climate risks Dominion’s business faces.”

The letter states further that:

In its 2006 Form 10-K, Dominion made no disclosure of projected CO2 emissions from the proposed plant or its current plants. Further, Dominion did not attempt to evaluate or quantify the possible effects of future greenhouse gas regulations, or discuss their impact on the company. Dominion also did not present any strategies to reduce CO2 emissions, as new regulations would likely require. These omissions make it difficult for investors to make informed decisions.

Under federal and state laws and regulations, Dominion’s disclosures to investors must be complete and not misleading. Selective disclosure of favorable information or omission of unfavorable information concerning climate change is misleading. Dominion cannot excuse its failure to provide disclosure and analysis by claiming there is insufficient information concerning known climate change trends and uncertainties. (Emphasis added.)

The letter carefully does not say that Dominion engaged in selective disclsoure, it merely states that selective disclosure is misleading. The letter and accompanying subpoena purport to require a response by October 9, 2007. The letters to the other four energy companies are all in a similar vein. Press coverage further detailing the New York Attorney General’s subpoenas can be found here.

In addition to Cuomo’s subpoenas, 22 petitioners, including two environmental groups (Ceres and Environmental Defense), the financial officers of ten states and New York City, and several institutional investors, including the massive California Public Employees’ Retirement System (collectively representing over $1.5 trillion in assets), announced that they will petition the SEC to require companies to assess and fully disclose their financial risks from climate change. Ceres’s September 18, 2007 press release describing the petition can be found here, and the petition itself can be found here. The petition is quite lengthy but for those interested in the topic it provides a comprehensive overview. The essential thrust of the petition is that current reporting disclosure of global climate change risks is inadequate to afford investors to make informed decisions, and that clarifying guidance from the SEC is required for investors to be provided with complete information.
An excellent summary of the goals and legal status of the petition, as well as the state of climate change disclosure generally, can be found on the CorporateCounsel.net blog, here.

A September Journal 18, 2007 Wall Street Journal article about the petition (here) quotes Florida’s chief financial officer as saying that in supporting the petition the states’ representatives are “responding to the interest of the general public” in climate change issues and are seeking to “push the agenda forward” to change behavior. A representative from Environmental Defense stated that the petition is “part of a multi-pronged effort to compel the SEC and other federal agencies to take an active role in combating climate change.” Ceres’s news release quotes its President as saying that “shareholders deserve to know if their portfolio companies are well positioned to manage climate risks or whether they face potential exposure.”
A representative of Ceres, citing their group’s own January 2007 study that over half of the companies in the S & P 500 index do a “poor job disclosing their climate change risk,” notes that more than half of these same 500 companies’ sales occur overseas, in nations that are parties to the Kyoto Protocol, yet their risk disclosures are nonetheless inadequate.

The petition notes that disclosures of climate change risk is important not only for companies (such as utilities or energy companies) whose emissions are deemed to be linked to rising atmospheric carbon levels, but also to banks, health-care companies, insurance companies, telecommunications companies and other firms who, the petition states, do not consider themselves as major emitters and so may be disregarding their exposures to climate change related risks.

These recent developments follow on the heels of last week’s decision (refer here) by a federal district judge that Vermont can limit greenhouse-gas emissions from cars and trucks, a ruling that potentially opens the door for wider action by states with respect to climate change issues. The decision also underscores the fact that climate change related regulation is approaching from many different directions, increasing the likelihood that these regulatory concerns will affect an increasingly larger number of publicly traded companies.

The most important aspect of the most recent events is their emphasis on the importance of corporate disclosure. The adequacy or inadequacy of corporate disclosure on climate change issues is clearly going to be a key battleground as part of activist “multi-pronged effort” to raise the profile of climate change issues. The involvement of key representatives of several states – whose responsibilities include oversight of massive public pension funds – undercuts any suggestion that this disclosure movement can be treated as a fringe issue. There may be some truth in the Florida representative’s suggestion that their actions are consistent with the interest of the general public, but because of the massive asset value for which these representatives are responsible, their actions in this area matter.

The danger for publicly traded companies comes not just from the agitation for greater disclosure; rather, the danger comes from the implications embodied in the New York’ Attorney General’s letters. That is, if companies are subject to greater disclosure obligations or expectations, they are also potentially subject to allegations of the same kind as suggested in the letters – that the targeted energy companies engaged in misleading “selective disclosure” or “omission” of unfavorable information. And while these allegations appear only in a letter, it may only be a matter of time before allegations of this type make their way into civil complaints.

Whether or not these kinds of allegations would be meritorious is of course a question that will have to await another day. On a positive note, a federal judge yesterday tossed (refer here) the global warming lawsuit that California had filed against six automakers. But while California’s nuisance theory in that case was unsuccessful, the outcome has little to say about what might follow from a lawsuit alleging misrepresentations or omissions regarding climate change issues. A lawsuit must, of course, allege more than purported misrepresentations or omissions; the lawsuit must also allege causally related damages, and in the absence of any significant shareholder losses supposedly related to climate change disclosures, there would be little incentive for plaintiffs’ lawyers to pursue a climate change disclosure lawsuit. But as significant shareholders of the type behind the SEC petition described above evince their issues, the possibility that a climate change related disclosure might affect a company’s stock price increases.

In any event, some D & O insurers are beginning to take these issues very seriously. A senior official at one of the leading D & O insurers told me recently that climate change issues have moved to the top of their list of longer range concerns. While some might regard this reaction as alarmist, it is not surprising. The recent events involving the petition to the SEC and the New York Attorney General’s subpoenas are unlikely to be isolated or concluding events; they will be followed by many other initiatives with a similar goal, and climate change disclosures will inevitably become an increasingly important governance issue. As its importance increases, so will the disclosure risk.

Another Home Construction Company Sued: Regular readers know that I have been tracking (here) subprime lending related securities class action lawsuits, including subprime related lawsuits against home construction companies. In that regard, a shareholder has filed a purported securities class action lawsuit (refer here) against the CFO of Hovnanian Enterprises, alleging that the CFO violated his fiduciary duties and also violated Section 10(b) of the Securities Act of 1934. The plaintiff purports to represent a class of Hovnanian shareholders who bought the company’s stock between December 8, 2005 and August 17, 2007. The complaint alleges that the CFO knew but filed to disclose that the company lacked requisite internal controls and misrepresented the company’s business and future prospects. The complaint also alleges that the company lacked a reasonable basis to make projections about the company’s financial results, and so the defendant’s statements about the company’s business and future prospects were misleading.

Welcome Back to WVZ: After a lengthy hiatus, the With Vigour and Zeal blog (here) is back online. We here at The D & O Diary are big fans of WVZ and so we are pleased to welcome back the WVZ blog and we look forward to seeing future WVZ posts.

In an earlier post (here), I noted Cornerstone Research’s release of its mid-year 2007 of securities class action lawsuits filings and settlements. On September 13, 2007, NERA Economic Consulting released its own mid-year 2007 study, entitled “Recent Trends in Shareholder Class Action Litigation: Filings Stay Low and Average Settlements Stay High – But Are These Trends Reversing?” (here). The NERA study differs in some of its numeric specifics from the Cornerstone study, but the two studies are directionally consistent. The NERA study also has some interesting additional observations, particularly with respect to possible future directions of current trends.

The NERA study, like the Cornerstone study, finds that the class action filing rates in the first half of 2007 were well below historical norms. The NERA study, extrapolating from first half filings, projects 153 full year 2007 filings, compared with a 1998 through 2005 annual average of 284. However, NERA also notes that the filings in the first half of 2007 increased 47% from the second half of 2006, “indicating that the trend in filings may be changing directions.”
The NERA study also notes in particular that while there were only 28 new cases filed in the Ninth Circuit in 2006, there were already 20 new Ninth Circuit filings in the first half of 2007, suggesting that the “Ninth Circuit is on pace to return to 2005 levels.” NERA also added that “to the extent this Circuits is ahead of the curve on filing trends, this may be a signal that other jurisdictions could also experience a rebound in filings in the months to come.”

The NERA study also reviews the recent increases in the average securities class action settlement values, driven by the increase in the number of mega-settlements (over $100 million). NERA notes, the proliferation of mega-cases notwithstanding, that the majority of cases are still resolved for under $10 million, and during the 2005-2007 period “37% of the cases have resolved for less than $5 million, and 57% for less than $10 million.” But the median settlement has risen along with the average. In the first half of 2007, the median settlement reached $9 million, compared to $7 million in 2006 and about $5 million in 2004.

The NERA study emphasizes, however, that these settlement value increases are largely being drive by the magnitude of investor losses; NERA notes that “we found no statistically significant change in settlement values since the passage of Sarbanes-Oxley once we control for other factors, including investor losses.” The NERA study concludes that “higher investor losses for more recently resolved cases explain the rise in settlements.” By the same token, the study also notes that because the cases filed in the first half of 2007 involve relatively lower median investor losses, future settlements may involve lower settlement values.

Other factors that the NERA study notes are correlated with settlement values include: the inclusion in the plaintiff class of the holders of additional classes of securities; the size of the defendant corporation’s market capitalization; the involvement of professional firms as co-defendants; the inclusion of allegations of accounting improprieties; the accompaniment of any kind of official investigation, consent decree or penalty; the service of an institutional investor as lead plaintiff; and the involvement of an IPO. In addition, a company’s involvement in the health services sector also appears to positively correlate with settlement values.

When Cornerstone previously released its mid-year study, it created a stir by its inclusion of a statement by Stanford Law Professor Joseph Grundfest in which Grundfest speculated (refer here) that the lower levels of class action filings over the last two years may be the result of a “permanent shift” to reduced levels of class action filings. NERA’s contribution to this assessment of recent filing levels consists of its observation that filing levels in the first half of 2007 represented an uptick from the second half of 2006. In addition, the NERA study concludes with the observation that the stock market has performed well in recent years; the NERA study notes that “should the market have a substantial downturn, average investor losses are likely to increase and filing levels could begin to rise.” The NERA study also notes that the subprime lending mess led to seven claims through mid-year 2007, and “may be the source of a significant number of filings in the near future.”

In releasing its study several weeks after Cornerstone, NERA had the benefit of watching a couple of months of third quarter filing activities in making its observations. Ordinarily, a few weeks might not make that much of a difference, but so far in the second half of 2007, there has been an increased level of filing activity, including but not limited to a number of new subprime-related securities class action lawsuits (a running count of which can be found here). By my count, there have already been 36 companies sued for the first time during the third quarter of 2007, compared to the 66 filings that NERA counted for all of the first half of 2007. At least for the first weeks of the second-half of 2007, filing levels appear to have returned closer to historical norms. At this point, Professor Grundfest’s declaration that we have moved to a permanently lower level of class action activity appears to have been premature at best.

Regular readers know that I have been maintaining a list (here) of subprime lending-related securities class action lawsuits. A cluster of new subprime lending lawsuits arrived this week, and these new lawsuits suggest additional directions in which the suprime lending litigation wave may be heading.

First, a lawsuit filed in behalf of employees of Countrywide Financial Corporation alleges that actions by the company and its executives caused 401(k) plan participants to lose millions of dollars. News articles describing the Countrywide employees’ 401(k) plan lawsuit can be found here and here. Under the company match component of the plan, many employees received a 50 percent match of up to six percent of their plan contribution, which during 2005 and 2006 was paid in the form of company stock. The Complaint alleges that the defendants had a duty to warn employees’ of the company’s precarious financial condition and that the defendants intentionally concealed information from plan participants. (Many of the putative class members potentially are also part of the Company’s recently announced plan to eliminate 12,000 jobs.)

Second, the Coughlin, Stoia, Geller, Rudman & Robbins firm recently filed a securities class action lawsuit against Tarragon Corporation. Even though Tarragon is not itself a subprime lender (the company develops, renovates, and builds condominiums), the allegations in the complaint derive from the turbulence in the residential real estate sector and in the credit markets that has followed the subprime meltdown. A copy of the Complaint can be found here and the press release describing the complaint can be found here.

The Complaint alleges that Tarragon had failed to consolidate an unprofitable variable interest entity into its consolidated financial statements; had failed to take timely impairment charges and other write downs; and “due to a deterioration in the real estate credit markets … was experiencing liquidity issues due to its inability to obtain loan modifications and additional financing and there was serious doubt about Tarragon’s ability to continue as a going concern.” The Complaint also alleges that “given the increased volatility in the homebuilding industry and the real estate credit markets, the Company had no reasonable basis to make projections about its 2007 results.”

Third, on September 12, 2007, the Sheet Metal Workers’ National Pension Fund filed a shareholders’ derivative lawsuit against Beazer Homes as nominal defendant, and several of the company’s current and former directors and officers. (Refer here for a copy of the Complaint.) The Complaint alleges that the defendants breached their duties by failing to implement internal controls to prevent the operation of the company’s mortgage origination and brokerage subsidiary in an illegal manner; caused the company to issue false financial statements, and failed to prevent improper insider trading and the improper grant of bonuses to senior management.

None of these new lawsuits are straightforward securities class action lawsuits filed against subprime mortgage lenders of the kind that I have been tracking. But they are all consequentially related to the subprime mortgage mess. The Countryside 401(k) lawsuit is the most obvious example, since it involves a subprime lender, and the plaintiffs’ are merely pursuing alternative legal approaches after other plaintiffs’ lawyers have already occupied the securities class action space with relation to Countrywide. I have added the Countywide suit to my list of subprime lender 401(k) lawsuits, here.

The Beazer Homes derivative lawsuit is a related example. Beazer has also already been sued in a subprime lending-related securities class action lawsuit (refer here), but just as happened with the options backdating scandal, plaintiffs’ lawyers who are preempted from filing a securities lawsuit are suing the same companies under shareholders’ derivative theories. And as also happened in the options backdating cases, the derivative cases may be attracting attorneys from outside the traditional plaintiffs’ securities bar. The lead counsel in the Beazer Homes derivative case is the Motley Rice law firm, which is better known for its involvement in asbestos and tobacco litigation.

The Tarragon lawsuit is interesting because, while it is not directly related to subprime lending per se, it is directly related to the turbulence that has hit the larger residential real estate sector, and is largely due to more generalized disruptions in the credit marketplace. The worrisome implication is that the contagion effect of the subprime mess is not only having an adverse impact on larger segments of the economy, but those adverse effects could produce additional shareholder litigation outside the subprime arena itself. And on an even more general level, the heightened level of plaintiffs’ lawyer activity manifest in these three cases may perhaps bespeaks a broader litigation threat to a broader spectrum of companies.

More About Alternatives to Auditor Liability Caps: In a prior post (here), I reviewed a recent article in which Professor Lawrence Cunningham proposed a capital markets-based alternative to auditor liability caps. My post provoked a very detailed and thoughtful response from Professor Cunningham, which I have incorporated as an update in my prior post (please refer to the italicized text, here).

As an aside, this type of exchange of ideas is exactly what I had hoped would happen when I started this blog. Although idea exchanges have arisen from time to time, I wish it would happen even more frequently. And along those lines, I would like to emphasize that readers are cordially invited to post comments to any of my blog posts (using the “comment” link at the foot of the post). Readers who feel compelled to prepare a lengthier or more formal response to one of my post should just let me know, and it if makes sense, I will try to incorporate responsible commentary, just as I have incorporated Professor Cunningham’s response to my comments about his article.

Tarragon: Most readers likely will associate the name “Tarragon” with the familiar herb, sometimes known as “dragon’s wort.” Perhaps I associate more freely than others, but to me the company’s name brings to mind Professor Hercules Tarragon (pictured to the left), one of the members of the ill-fated Sanders-Hardiman expedition in Herg�’s classic Tintin comic book, The Seven Crystal Balls. Professor Tarragon was one of several men who suffer the curse of Rascar Capac for transporting Capac’s mummified remains from Peru to Europe.

Another classic Tintin character is the garrulous and irrepressible insurance agent, Jolyon Wagg (pictured to the right), whose caricature of a backslapping, glad-handing insurance salesman is the humorous essence of the negative stereotype those of us in the insurance industry must live with on a daily basis.

As the various blue-ribbon panels studying the competitiveness of the U.S. financial markets have proposed various regulatory reforms, one recurring theme has been the proposal for auditor liability caps (refer here), a topic that is also under study by the European Commission (refer here). A 2007 paper by Professor Lawrence Cunningham of the George Washington University Law School entitled “Securitizing Audit Failure Risk: An Alternative to Caps on Damages” (here) proposes an alternative to auditor liability caps for the risk of catastrophic audit failure, by having the audit firms issue bonds to the capital markets to provide coverage for the risks.

Cunningham notes that at the center of the arguments in support of auditor liability caps are concerns about the limited availability of insurance for auditors; while these arguments are most persuasive during hard insurance markets when insurance is relatively unavailable, the arguments may be less persuasive during soft insurance markets when insurance is relatively more available. Cunningham notes that “proposals to cap liability that are supported by arguments about lack of insurance may be unable to respond to the dynamics of these markets.” The likelihood of a legislative liability cap solution that is appropriately sensitive to these changing insurance marketplace dynamics is unlikely.

But in any event, the periodic fluctuations of the insurance market clearly present limitations on the value of insurance-based risk transfer mechanism; Cunningham’s article reviews those limitations at length. As an alternative to the insurance-based model, Cunningham proposes “insurance-based securitization” that would “distribute risk of audit failure through the capital markets.” Cunningham’s proposal is modeled in the existing use of catastrophe bonds (or cat bonds as they are more commonly known) to transfer risk for extreme property loss or damage events. These bonds pool investor funds, which are invested in low-risk investment vehicles and pay out interest income, with the principal available to pay loss in the event of the occurrence of certain defined events. Cunningham proposes that just as these bonds are available to protect against the risk of natural events such as earthquakes and hurricanes, similar types of bonds could also be used to protect against the risk of catastrophic audit failure.

Cunningham advances a number of arguments in support of his proposal. Among other things, he argues that managing these risks through the capital markets “should reduce the volatility that auditors have faced for decades and that is an important basis for the insurance based arguments in favor of establishing ex ante damage caps on auditor liability for auditor failures.” Cunningham also argues that, through risk-sensitive interest rate requirements, capital markets will introduce “capital market monitoring of auditing firm performance.” Finally, Cunningham notes that a private bond offering “is relatively simple for auditing firms to complete compared to the political challenge necessary…to establish caps on damages.”

Cunningham’s innovative proposal is both novel and interesting. The general success of the existing cat bond market does suggest the innovative potential of this proposal. I do have several concerns about the proposal though, which are as follows.

In general, the cat bond market has extended only to first-party property damage risk, not to third-party liability risk. I am guessing there are several reasons for this. The first is that the triggering event for a property cat bond is easily identifiable, and the losses are short-tail – that is, the event occurs and the losses are ascertained within a relatively short time thereafter. In contrast, a third-party liability claim can have a very protracted life with an uncertain outcome. The extent and duration of this uncertainty may be ill-suited to the requirements of the capital markets and of investors; the claims uncertainty could undermine reliable bond valuations during the long duration of the claim.

In addition, the losses that trigger cat bond payments are beyond anyone’s control; the mere existence of the bonds do not and cannot attract claims. By contrast, the actions of third parties can cause events that would trigger liability bond losses, and indeed the very existence of the bonds arguably could attract claims (consistent with the old insurance adage that limits attract losses).

Along the same lines, the existing cat bond market is supported by a very sophisticated cat modeling industry that produces robust, scientific frequency predictions concerning the likelihood of one of the triggering natural events. As someone who as spent a lifetime pondering liability claim frequency and severity, I know that projecting either liability frequency or severity are very difficult and uncertain enterprises. It would be a very difficult task indeed to compose the kind of disclosure that would be required to provide investors with the kind of projections these bonds would require in order to support a robust marketplace. This difficulty could require interest rate payments on the bonds that could make the bonds uneconomical for the marketplace. (This same principle is at work in insurance pricing, where the loss ratio insurers use as a pricing input is usually more demanding than for property lines, leading to higher pricing requirments to account for the uncertainty.)

In addition, the big four accounting firms operate as private entities. Their history and their clients’ expectations could both militate against their voluntarily undertaking the kind of disclosure investors would require. Investors clearly would expect detailed information about the distribution of the firms’ clientele, and logically could expect disclosures about firm representation of certain specific companies. The level of disclosure the accounting firms would be required to provide investors, even if limited to the context of a private offering and to select investors, could prove to be a difficult if not insurmountable barrier for the accounting firms themselves.

Finally, the whole value of a capital market based solution is to avoid the cyclicality and volatility of the insurance marketplace, but the capital markets for these kinds of bonds could be subject to the own cyclicality. Indeed, during a time of significant losses, there may be little or no market interest in bonds of this kind, just as when insurer losses mount insurance can be scarce or unavailable. For that reason, I am uncertain whether the availability of this type of capital market alternative, even if the other barriers could overcome, would in the end remedy the concerns for which an alternative to the traditional insurance marketplace was sought.

These concerns notwithstanding, Professor Cunningham’s paper is interesting and makes a valuable contribution to the dialog surrounding proposed auditor liability caps. Special thanks to Professor Cunningham for providing me with a link to his article.

UPDATE: Professor Cunningham Reponds: Here are Professor’s Cunningham’s responses to my comments about his article:

Thanks, Kevin, for your thoughtful comments on my paper exploring adapting cat bonds to auditor liability.

Some more background on my motivations before addressing your concerns:

1. Statistical research (here and here) suggests a non-trivial medium-term risk that large liability cases could destroy one of the remaining four big auditing firms and thus threaten our system of private auditing of public enterprises.

2. Reducing this risk by putting legal caps on auditor damages is a hard political sell–Members of Congress find it difficult explaining to American investors why these firms should enjoy such a privilege and any choice of cap levels could seem arbitrary.

3. Proponents of caps currently have incentives, when in doubt, to interpret information in ways that overstate the stakes (as when asserting that the prevalence of self-insurance is due to unavailability of external insurance, a claim I evaluate in the paper).

4. Elsewhere, I endorse Josh Ronen’s novel idea of financial statement insurance to address some such problems, but recognize that it is also a hard political sell absent a crisis rationalizing the radical change it entails.

5. Here, I consider cat bonds because they: (a) could add resources to meet claims that threaten to destroy audit firms or the industry; (b) avoid political obstacles facing both caps and financial statement insurance; and (c) highlight informational problems in the policy debate on caps.

On the substance of your excellent points about cat bonds, particularly how they are used in first-party property damage contexts but not yet for third-party liability contexts:

1. True, property cat bonds address shorter tail losses than third-party claims usually do, raising concerns addressed by contract and pricing. Cat bonds have a set contractual maturity, such as one year or two, and state contractual triggering events that determine whether principal is repaid or lost at maturity (such as judgments or settlements exceeding stated catastrophic amounts during the bond term). So bondholders don’t wait until claims are resolved before the payout determination is made. True, a bond’s maturity date influences strategic decisions in pending litigation (whether to settle or not and for how much). Contract terms limit this capacity (through tailored rules governing litigation management and general principles like good faith). These contractual features are priced into the bond.

2. Also true, property cat bonds address risks that are purely fortuitous while auditors have some control over exposure, creating the serious problem of moral hazard. But moral hazard exists under existing external insurance and even self-insurance to an extent. Worse, the fact that only four large firms exist can create moral hazard if partners and employees act as if their firms are too big to fail (about which refer to my prior paper, here). So reducing moral hazard seems vital. Financial statement insurance may be better than cat bonds for that purpose but cat bonds contribute bondholders offering market monitoring to diminish the problem not exacerbate it. Also, cat bonds do not attract suits against auditors because they fund only catastrophic loss layers, with negotiated triggers set at upwards of $500 million.

3. True, again, cat bonds for natural disasters are supported by scientific risk modeling tools enabling valid predictions that may not be adaptable to auditing risks. Lacking requisite information could dissuade investors from buying bonds, at least at interest rates less than costs of auditor self-insurance or external insurance. But (a) the statistical research referred to earlier provides a foundation for such exercises and (b) at least some reasonably reliable facsimile of such models seems necessary to justify political decisions to establish caps on auditor liability by legal fiat.

4. Your fourth point seems the most compelling explanation for why auditors have not issued cat bonds and presents the most significant impediment: for understandable reasons, firms don’t want to disclose information that investors would require about their client base, financial resources or claims history. Again, however, similar data should be required to justify a political decision to cap liability or set optimal cap levels.

On this and the preceding point, it is possible to see informational problems as a sort of market failure supporting regulatory intervention. Yet the information is within firms’ control and they can decide whether to use it in the political arena, in markets, or not at all. Notably, using this data in the political arena to support caps creates incentives to overstate risk whereas using it in the marketplace to sell cat bonds creates incentives to understate risk.

Admittedly, cat bonds may or may not work for auditing. But if they work or might work, this may weaken arguments for caps (and could add protection against audit industry destruction); if they are shown to be unworkable, this may strengthen the case for caps. So either way, I appreciate your giving the idea a public forum for debate (and for your comments that will improve my paper). It would be wonderful if risk modeling firms and investment banks would consider the idea, perhaps even pitch it to auditing firms, for a non-academic test.

More About the AIM Challenge: Behind the reform proposals of the blue-ribbon panels mentioned above are concerns about U.S. financial market’s loss of IPO market share to overseas’ securities markets, particularly London’s Alternative Investment Market (AIM) (about which I most recently commented here). But changing marketplace conditions have put the AIM in an altogether different light, as illustrated in the September 10, 2007 Bloomberg.com article entitled “London’s AIM Exchange Loses Members on Costs as Nasdaq Prospers” (here).

According to the article, companies that have listed on AIM are starting to grow disenchanted. 116 companies exited AIM in the first half of 2007, 35 more than a year earlier, and delisting more than doubled to 40 during the same period, compared to 15 last year. (Delistings on Nasdaq meanwhile fell from 41 to 30.) Among other reasons for these departures are high costs and a perceived lack of issuer company benefit – the AIM market is “showing signs of saturation.”

As one commentator cited in the article noted, while “there’s a good market for small caps,” the supply of investment has not been able to keep up with the supply of equity. Another commentator cited in the article notes that the increase in companies leaving AIM “is probably a reflection of the market having attracted too many poor quality businesses,” as there has been a “deluge of companies that should never have been brought to market.”

As I have noted before (refer here), the would-be reformers case for regulatory reform has always seemed to be “weak,” but as the global marketplace evolves there appear to be increasing reasons to question whether the premise on which the reformers’ proposals are based even exist. (For further commentary on this same topic, refer here)

Subprime Litigation Wave: The D & O Diary has commented frequently (most recently here) on the wave of litigation growing out of the subprime lending mess. The Washington Post has a September 11, 2007 article entitled “Mortgage Mess Unleashes Chain of Lawsuits” (here) which sounds many of the same themes.

Among other tidbits in the article is the comment that the SEC has formed a working group to examine “accounting and disclosure issues, as well as stock sales earlier this year by executives at companies that have since been ensnared by the subprime mess.” An official at the SEC enforcement division is quoted as saying “we will look at those responsible for any potential fraud, by company management, auditors, lawyers, credit-rating agencies or others.”

You Can’t Make This Stuff Up – But Plaintiffs’ Lawyers Can!: This article appeared in Crain’s Chicago Business on September 10, 2007 (here) — please note that in referring to this article I mean no disrespect to Mrs. Akkad, and I do not in any way mean to make light of her terrible loss. Mrs. Akkad has our deepest sympathies. My inclusion of this article relates particularly to her lawyer’s comments in the final two paragraphs about her case:

The widow of a Hollywood producer who died in a Jordan terrorist bombing is suing hotel chain Global Hyatt Corp.

A guest at the Hyatt in Amman, Jordan, Moustapha Akkad was killed Nov. 9, 2005, in an attack by a suicide bomber, according to a statement from law firms representing his widow, Sooha Akkad.

The complaint alleges that Chicago-based Hyatt was negligent in failing to responsibly protect its registered guests from foreseeable criminal attacks,
failing to provide metal detectors, and failing to keep unauthorized individuals from accessing the inside of the hotel, according to the statement.

A spokeswoman for Hyatt declined to comment.

Hyatt should’ve had heightened security on the date Mr. Akkad was killed in part due to the date itself, according to the statement. In the Middle East and in many countries, date precedes month when writing out full dates, according to the statement.

“Thus, November 9 becomes 9/11,” said Thomas Demetrio, a lawyer with Chicago-based law firm Corboy & Demetrio.

Special thanks to a loyal reader for proving a link to this article.

Rambus Settles Securities Lawsuit: In a September 7, 2007 press release (here), Rambus announced that it had settled the July 2006 options backdating-related securities class action lawsuit that had been filed against the company and certain of its directors and officers. Rambus has agreed to pay $18 million in exchange for a dismissal with prejudice of all claims against all defendants. The press release also stated that the settlement is subject to court approval and that the company “has been and will continue to be in discussions with its insurers concerning their contribution of a portion of the settlement amount.”

A September 7, 2007 San Jose Mercury News blog article entitled “Here’s $18 Million, Now Go Away” (here) provides further background regarding Rambus’s options backdating woes and related litigation.

The Rambus settlement represents the second options-backdating related securities class action settlement of which I am aware. But, as discussed here, the first settlement, related to Newpark Resources, involved a securities lawsuit that pertained only peripherally to options backdating. The Rambus securities class action settlement appears to represent the first settlement that involve a case related solely to options backdating-related allegations.

As discussed here, Rambus previously announced that its special litigation committee had reached a settlement of the options backdating-related shareholders’ derivative lawsuit that had been filed against the company as nominal defendant as well as against certain of its past and current officers and directors.

Barnes & Noble Settles Derivative Suit: On September 6, 2007, Barnes & Noble announced (here) that it had “agreed to settle all pending shareholder derivative actions filed in state and federal court alleging that certain stock option grants had been improperly dated.” As part of the settlement, the company agreed to adopt certain (unspecified) corporate governance and internal control measures, and agreed to pay plaintiff’s counsel’s fees and expenses of $2.75 million. The company’s press release is silent regarding the availability of insurance to cover the settlement payment.

The Barnes & Noble derivative settlement is, based on my experience, fairly typical of the way many of the options backdating derivative lawsuits are being resolved. That is, for the cases that are settling, companies are agreeing to adopt some mild corporate therapeutics, and paying some negotiated amount supposedly corresponding to the amount of the plaintiffs’ attorneys’ fees. The sole benefit to the shareholders on whose behalf the plaintiffs’ ostensibly proceeded is the ostensible benefit of the corporate therapeutics. I am sure there are skilled advocates who have persuaded themselves, at least, that this process represents something more than a highly stylized form of larceny.

Though the Barnes & Noble press release is silent about insurance issues, I know from my own experience with the backdating claims that the insurance issues surrounding similar options backdating related derivative settlements are gradually being worked out on a case by case basis. There are usually several interrelated questions at the point of settlement: Will the carrier consent to the settlement? Will the carrier fund the settlement? Will the carrier dispute coverage (usually either on the ground that the settlement amount is not covered “loss” or that one or more of the policy’s conduct exclusions applies) for any portion of the settlement? And how will the question of the carrier’s ultimate responsibility be resolved?

Responsible carriers are consenting to and funding the settlements, and agreeing to an alternative dispute resolution mechanism to quickly resolve remaining coverage questions and determine the carrier’s ultimate responsibility. Given the number of the options cases that remain pending, it would be in everyone’s interests if the carriers were to actively facilitate the expeditious resolution of these claims.

A Final Options Backdating Note: At least one commentator has observed that the options backdating civil cases are in many instances proving challenging for the plaintiffs to pursue successfully. In a September 3, 2007 article in BNA Securities Regulation & Law Report entitled “Private Civil Litigation: The Other Side of Stock Option Backdating,” (here), Lee Dunst of the Gibson, Dunn & Crutcher law firm notes that as the civil options backdating cases “have made their way through motion practice, many of them have been unable to survive dismissal due to many of the defects spotted at the outset, as well as due to some unforeseen obstacles, which have made these cases difficult for the private bar to successfully prosecute.”

Dunst notes in particular the challenges that securities lawsuit plaintiffs have had established scienter, and the barriers the plaintiffs have faced due to statute of limitations constraints. Dunst does note that there have been some successes, “many of the private class actions involving allegations of improper stock option backdating have been dismissed or failed to gain much traction in the courts.”

Special thanks to Lee Dunst for providing a copy of the article.
Refco Bankruptcy and Excess Policy Coverage for Defense Fees: In earlier posts (most recently here), I have raised the concern that follow-form excess carriers are taking coverage positions that had not been asserted by the primary carriers. Recent developments in connection with the Refco bankruptcy proceeding appear to present another instance of this phenomenon.

According to September 5, 2007 news reports (here), three former Refco executives are fighting to compel one of Refco’s excess D & O carriers to pay their legal fees. The press reports state that Refco’s D & O insurance program was structured with a $10 million primary layer and five excess layers on top of the primary. The primary layer was exhausted after the primary carrier paid its limit after receiving bankruptcy court approval. The first excess layer carrier also paid out its $7.5 million limit after receiving bankruptcy court approval.

However, the carrier that issued the next excess layer in the program reportedly has taken the position that it has no obligation to advance the three executives’ defense fees. According to news reports (here), on August 30 the bankruptcy judge rejected the carrier’s argument, but the excess carrier reportedly is contending that the bankruptcy court’s ruling did not specifically name the carrier, and that the three executives would have to file a separate motion, and than in any event the carrier would appeal the bankruptcy court’s ruling. The three executives for their part contend that the excess carrier’s position is “straining” their ability to defend themselves and that they “face an imminent risk of irreparable harm, including but not limited to the risk of an adverse outcome in the criminal action or the civil actions caused by their inability to mount an adequate defense.”

I do not know the basis on which the excess carrier is resisting its obligation to advance the executives’ defense expense, and I am therefore in no position to judge its position. I have no grounds to question whether the excess carrier’s position is legitimate. But I do note that once again we appear to have a case where the primary carrier and the first level excess carrier have paid their limits yet a coverage dispute has arisen involving an upper level excess carrier. As I have argued before (here), I think the industry has a growing problem when it starts to become routine for excess carriers to contest coverage on grounds not raised by the primary carriers. If different carriers in a “follow form” insurance program are not going to respond to claims in the same way, the intent of the insurance acquisition process is frustrated. Policyholders do not put together a follow form program with the expectation that they are going to have to fight their way through each successive layer of insurance.

Again, I am not questioning the excess carrier’s position in the Refco bankruptcy, because I don’t know the basis for the position, which for all I know is entirely legitimate. But in general, there is a growing problem in the way that excess D & O insurance is responding to claims, and that is an issue the industry needs to address.

Special thanks to alert reader Kelly Reyher for providing a link to the Refco news article.

How Big is the Subprime Lending Mess?: As the subprime mess has unfolded, many commentators, including yours truly, have struggled to assess just how big the subprime mess will be. While only time will tell, it is interesting to note that former SEC Chairman Arthur Levitt, Jr., in a September 7, 2007 Wall Street Journal op-ed column (here), stated:

In terms of market meltdowns and the degree of pain inflicted on the financial system, the subprime mortgage crisis has the potential to rival just about anything in recent financial history from the savings-and-loan crisis of the late 1980s to the post-Enron turndown at the beginning of this decade.

How Often Do You Suppose Something Like This Has Happened in the Current White House?: In her recent fine book entitled Team of Rivals: The Political Genius of Abraham Lincoln, which examined the significant collaboration of Abraham Lincoln and his Presidential cabinet, author Doris Kearns Goodwin recounts the following incident:

Congressman William D. Kelley of Pennsylvania recalled bringing the actor John McDonough to the While House on a stormy night. Lincoln had relished McDonough’s performance as Edgar in King Lear and was delighted to meet him. For his part, McDonough was “an intensely partisan Democrat, and had accepted the theory that Mr. Lincoln was a mere buffoon.” His attitude changed after spending four hours discussing Shakespeare with the president. Lincoln was eager to know why certain scenes were left out of productions. He was fascinated by the different ways that classic lines could be delivered. He lifted his “well-thumbed volume” of Shakespeare from the shelf, reading aloud some passages, repeating others from memory. When the clock approached midnight, Kelley stood up to go, chagrined to have kept the president so long. Lincoln swiftly assured his guests that he had “not enjoyed such a season of literary recreation” in many months. The evening had provided an immensely “pleasant interval” from his work.

Lincoln, of course, had little formal education. No Yale Skull and Bones. No graduate degree from Harvard.

There is an understandable tendency to focus on emerging risks and latest trends, because new issues often are the most interesting and because no one wants to get blindsided by something coming over the horizon. But sometimes the old standard issues are the most important ones. Amidst all the hubbub about subprime lending, options backdating, and other headline-grabbing stories, an old fashioned problem like insider trading still remains vitally important.

As detailed in an August 28, 2007 Reuters article (here), the SEC has brought 35 insider trading cases this fiscal year, which began in October 2006. And Christopher Steskal of the Fenwick & West firm in his September 4, 2007 article entitled “Insider Trading is Back” (here), notes that during the first half of 2007, the SEC has sued over 20 professionals for insider trading.

Tom Gorman at the SEC Actions blog has put together a good summary (here) of the various kinds of insider trading enforcement actions that the SEC has brought this year. Gorman notes (in support of which he provides supporting citations) that the SEC has gone after major Wall Street players, and has targeted their use of “big boy letters” (about which refer here); that the SEC has gone after trading in advance of takeover or earnings announcements; and the SEC has also cracked down on spousal trading and “pillow talk” cases, as well as cases involving trading by family and friends. Gorman notes that these actions are “examples of the increasing number of cases being brought,” and also “clearly demonstrate the increasing focus of the SEC and the DOJ on insider trading.”

Steskal, the Fenwick & West attorney cited above, also notes along the same lines that “most of the SEC enforcement actions this year” against Wall Street professionals and corporate executives “involve insider trading in advance of mergers and acquisitions,” adding that the recent level of M&A activity “has provided fertile ground for SEC enforcement actions.” Steskal also notes that the SEC has identified Rule 10b5-1 trading plans as an are for special scrutiny, a topic I discussed in an earlier post (here).

But the dangers involved with insider trading are not limited just to the risk of an SEC enforcement action. As has long been the case, trading by insiders in their personal shares of company stock at sensitive times and in sensitive amounts magnifies the litigation and liability exposures for companies and their directors and officers. The simple fact is that trading by insiders, even if innocent, colors the facts and invites heightened judicial scrutiny. For all the recent judicial and media attention (refer here) given to the heightened pleading standard under the PSLRA, the fact is that a case with insider trades that the plaintiffs are able to portray as suspicious is likely to survive a motion to dismiss.

I have long advocated (refer here) companies’ adoption of a written insider trading policy as a way to try to control the risks that potentially can arise from trading by insiders. The minimum components for an effective insider trading policy include: trading windows and blackouts; appointment of a compliance officer, who has responsibility for preclearance of trades; and the adoption of a prohibition against specified types of trading by insiders, with stiff sanctions to be applied in the event of violations. Finally, the development of well-designed Rule 10b5-1 trading plans can be a powerful tool to reduce securities litigation exposure.

Steskal’s memo, linked above, has a good bullet point summary of the basic requirements for an effective insider trading policy. My own dated but still surprisingly relevant discussion of the issues surrounding a written insider trading policy can be found here.

Insider trading is an old, perhaps even time-worn topic, but once again it appears to be the case that classics never go out of fashion. Those of us in the D & O insurance business can become so focused on insurance-based risk mitigation solutions, but the reality is that, above and beyond risk-shifting strategies like insurance, there are perhaps even more important practical steps that companies can take to manage their securities litigation risk. And those of us who have been around awhile remember that there was a time and a place when securities litigation loss prevention was an important part of the dialog in the D & O marketplace. Perhaps it is time for a revival, sort of like classic rock for D & O wallahs.

My earlier, somewhat more pessimistic post on the possibilties for D & O insurers to play a role as a corporate governance monitor may be found here.

Options Backdating Update: Regular readers know that I have been maintaining (here) a running tally of the options backdating lawsuits. For several months now, the pace of adding new cases to the list has slowed, but today I added two new lawsuits to the lists.

First, as a result of yesterday’s news (here) that Pediatrix has been named as a nominal defendants in a shareholders’ derivative suit, I have added the company to the list, bringing the total of options backdating related derivative lawsuits to 164.

Second, plaintiffs’ lawyers have filed a purported securities class action lawsuits against UTStarcom (a shareholders derivative lawsuit was previously pending against the company), according to their September 5, 2007 press release (here). The addition of the UTStarcom lawsuit brings the total number of options backdating related securities class action lawsuits to 33.

As I noted in prior posts (most recently here), the long-running options backdating blame game eventually morphed into an exercise that included suing the gatekeepers. Even though the subprime mortgage lending litigation machine has only recently gotten cranked up, it has already turned into yet another round of gatekeeper scapegoating. According to a September 3, 2007 International Herald Tribune article entitled “Citigroup Unit and Deloitte are Sued over Subprime Lender’s Share Issue” (here), a lawsuit filed on August 27, 2007 relating to American Home Mortgage’s April 2007 secondary offering (about which refer here) seeks to extend the blame to the company’s auditors and offering underwriters. A copy of the complaint can be found here. (Hat tip to Adam Savett at the Securities Litigation Watch for the link to the complaint.)

The lawsuit is brought on behalf of shareholders who purchased shares in American Home’s secondary offering of 4 million shares, which was completed on April 30, 2007, less than four months before American Home’s August 6, 2007 bankruptcy filing. The shares sold in the offering at $23.75/share. American Home’s shares closed today at 27 cents a share. The defendants include ten present or former directors and officers of American Home, as well as Deloitte & Touche, which allegedly prepared and certified certain reports and statements used in the offering materials, and Citigroup Global Markets, which allegedly was the sole underwriter for the offering.

According to an August 31, 2007 press release describing the lawsuit (here), the complaint alleges that the offering materials failed to disclose that at the time of the offering, American Home was experiencing an increasing number of loan delinquencies, and that it had failed to establish adequate reserves against future loan losses and failed to write down the value of delinquent loans. The complaint also alleges that at the time of the offering American Home was increasingly unable to sell its loans, even at sharp discounts, increasing its mortgage lending related exposure. The complaint alleges that the defendants withheld this information from the investing public and that as a result the defendants violated Sections 11, 12 and 15 of the Securities Act of 1933.

As I previously noted (here), Jonathan Weil at Bloomberg.com wrote on August 15, 2007 (here) about what he called the “poor schlimazels at Deloitte & Touche LLP who blessed the books at American Home…mere months before it went belly up.” Weil noted the unenviable position that the auditors were in, given that a “going concern” audit opinion would have represented a default under American Home’s credit facility. A going concern opinion would almost certainly have been a self-fulfilling prophecy, but as Weil noted, “a self-fulfilling prophecy would have spared investors from the Company’s April 30 offering of 4 million shares.” Weil’s article also cites other instances where auditors issued clean opinions shortly before a subprime lender’s failure.

While there is no apparent reason to think its actions are in any way related to these prior events involving American Home Mortgage, Deloitte appears to have taken a different approach in connection with NovaStar Financial’s more recent financing attempts. A September 4, 2007 CFO.com article entitled “Deloitte Forecloses on NovaStar Stock Offerings” (here) states that Deloitte “torpedoed” NovaStar’s efforts to sell $150 million in preferred stock. According to NovaStar’s own September 4 news release (here), the company was unable to meet the offering requirements of filing a registration statement by August 30, essentially because. as the press release states,

Deloitte & Touche LLP, NovaStar’s independent auditors (“Deloitte”), advised NovaStar in the last week of August 2007 that it was not willing to issue a consent or otherwise be associated with the rights offering unless the Company reissued its 2006 financial statements to include footnote disclosures regarding these matters. In addition, Deloitte further advised NovaStar that its reissued report on such financial statements would include an explanatory paragraph about the uncertainty of NovaStar’s ability to continue as a “going concern”. NovaStar determined that work necessary for the reissuance of its 2006 financial statements and the reissuance of
Deloitte’s audit report would not be completed by August 30, 2007, and [the offering managers] indicated that they were not willing to waive or extend this requirement.

As I have noted before (refer here), the subprime lending litigation wave is likely to sweep in a broad variety of defendants, as would-be plaintiffs seek an ever-broader variety of defendants to try and stick with plaintiffs’ losses. The circle of blame has already encompassed not only the subprime lenders and their directors and officers (here), but also credit rating agencies (here), real estate brokers and home builders (here), mortgage brokers and real estate appraisers (here), as well as auditors and offering underwriters, as noted above. The wave is likely to continue to spread outward.

One final note: according to news reports (here) the U.S. Trustee in Wilmington, Delaware reportedly has moved to preclude the law firm of Cadwalader, Wickersham & Taft from acting as American Home’s special counsel in connection with the company’s bankruptcy because the firm acted as the company’s counsel in connection with the April 2007 stock offering.

It’s Official: For those of you who were unsure whether the news of Bill Lerach’s retirement would prove to have been greatly exaggerated, you may want to check out the revamped website (here) of the newly renamed law firm of Coughlin Stoia Geller Rudman and Robbins LLP. Lerach’s name has been removed from the roster of attorneys at the firm. The firm with the new name is apparently eager to prove it will move just as quickly as it did under its old guise; the firm announced today (here) that it had launched a securities class action against Jones Soda Company and several of its directors and officers.

And for those of you interesting in such things (there must be some of you out there), the Houston Chronicle has an article (here) that praises Lerach’s work on behalf of Enron’s shareholder, and honors his “unblemished” legacy. That’s what the article says.

Predicting the First Climate Change-Related Securities Lawsuit?: In earlier posts (refer here), as well as separate publications (here), I have written about the possibility of D & O claims arising out of climate change issues, particularly climate change related disclosures. Admittedly, the discussion of these issues has been somewhat abstract, as there have yet been no D & O claims related to climate change issues. I still believe that it is prudent to consider these exposures, because I believe it is only a matter of time before these claims begin to emerge.

Of course, the mere assertion that it is only a matter of time begs the question – when will these claims emerge? While I would hesitate to make any specific prediction myself, Adam Savett at the Securities Litigation Watch (here) has, in light of the “proliferation of corporate sustainability reports,” boldly put the over/under at “June 30, 2008 for the first securities class action lawsuit to include allegations from a corporate sustainability report.” We won’t have long to wait to see whether Adam is correct, as his target date is only ten months away. We’ll be watching closely…

Blogger Move: We here at The D & O Diary are big fans of the Drug and Device Law Blog (here), and so we noted with interest that Mark Herrmann, one of the blog’s co-authors (the other author is Jim Beck), has relocated (refer here) from Cleveland to Chicago. Mark not only was at Michigan Law School with me, but he was – prior to his move – part of the well-known blogging elite here in Cleveland. While the shores of Lake Erie will miss Mark (and his wife Brenda, who happened to be my dentist), we wish him every success on the shores of Lake Michigan. All I can say is – Mark, how could you leave in a year when it looks like the Indians might finally make the playoffs?

Speakers’ Corner: On September 12, 2007, I will be moderating a panel at a Professional Liability Underwriting Society (PLUS) Midwest Chapter Event, to be held at the Cincinnati Hyatt at 3 pm. The panel, entitled “Current Issues in Directors and Officers Liability Insurance” includes noted D & O commentator Dan Bailey, policyholder attorney Tom Reiter, leading broker Jim Lash, and Mark Lamendola of Travelers. Details about the event can be found here. The panel will be followed by at cocktail reception at 5 pm. I hope readers in the Great Lakes and Ohio Valley regions will plan to attend.

In an earlier post (here), I commented on the D & O industry’s probable response the the litigation wave arising from the subprime lending mess, including the likelihood of increased underwriting around subprime exposures. The heightened scrutiny that I had surmised apparently is now a reality. An August 30, 2007 Bloomberg.com article reports (here) that a leading D & O insurer has created a “three-page questionnaire” to be used to determine whether applicants “make home loans to the riskiest borrowers or invest in sercurities backed by them.” Other D & O insurers reporedly are inquiring about applicants’ vulnerability to subprime exposure without requiring a questionnaire. (Full disclosure: I am quoted in the article).

According to the article, this effort”highlights insurers’ concerns that the rout in the subprime market could damage one of the most profitable lines of business.” The article quotes an analyst from Sanford Bernstein as estimating that “subprime could add to D & O insurers’ claims by as much as $1.5 billion to $3.6 billion annually for three years” although also noting that that scenario is “extremely unlikely” and that actual losses will be 10 to 50 percent of those numbers.

The article also contains some sensible advice from my good friend Lauri Floresca, who suggests that clients should “avoid giving written answers [to any questionnaire] because they could later be used to deny coverage.” (The insurer’s spokesperson is quoted in the article as saying that the written questionnaire is rarely mandatory.) Floresca also comments (as I noted in my prior post) that insurers “are really on high alert for anything that could be tangentially related to subprime.”

The broad range of loss the analyst projected (that is, a three year total exposure ranging from $450 million to $10.8 billion) encompasses just about every possible outcome. Given how early we are on this story, any number that anyone would posit at this point could be nothing but pure conjecture, but I still wonder why the analyst even bothered to attempt a putative quantification of the exposure.

A final thought about the analyst’s projection: If people really do get paid for coming up with that kind of, well, analysis, then there has to be some way that I can make money from this blog.

How Broadly Will the Subprime Wave Spread?: In earlier posts (most recently here), I commented that the greater risk from the subprime lending mess is that its effects could spread far beyond the subprime lending industry itself. An August 27, 2007 Financial Times article entitled “Internet Groups Brace for Subprime Fallout” (here) suggests just how broadly the subprime wave might spread. The article notes that “Internet companies are bracing for a possible fall-off in one of the biggest sources of advertising following the meltdown of the subprime mortgage market.”

The article goes on to note that 16% of all online advertising comes from financial services companies, making it the second biggest source of income behind retail. Among the financial services companies advertising on the Internet, the biggest players include mortgage lenders such as Countrywide, Low Rate Source and Lending Tree.

The fact that the subprime mortgage mess could hurt the financial prospects of an industry seemingly as unrelated as the Internet suggests just how widespread and unpredictable the subprime mess potentially may be. The D& O underwriters mentioned above who are scrambling to develop underwriting tools to try to get ahead of the risk are understandably nervous, and in light of the stories about the subprime impact on Internet companies, may understandably extend their heightened underwriting well beyond the subprime lending industry itself.

Another Private Trading Platform: In earlier posts, I have taken a look at the new private trading platforms, such as the Goldman Sachs GSTrUE system (refer here) and the Nasdaq Portal (refer here), where accredited investors can trade Rule 144A shares. The attraction of these private exchanges is that they allow private companies to raise equity capital while providing investment liquidity but without assuming reporting company burdens and responsibilities. Recent news reports (here) that hedge fund giant Renaissance Technologies was considering selling an equity stake in a Rule 144A offering highlighted the fact that yet another private trading system has been launched.

According to the news reports, Renaissance is considering floating an offering on the new OPUS-5 system, announced this month by Morgan Stanley, Lehman Brothers, Citigrop, Merrill Lynch and the Bank of New York Mellon. According to the Bank of New York Mellon’s August 14, 2007 press release describing the system (here), its name is an acronym for “Open Platform for Unregistered Securities,” and will “provide trade reservation, shareholder tracking and transfer management for privately offered equity securities transacted under Rule 144A.” The press release goes on to state that :

OPUS-5 will support and enable an open platform with multiple market makers and is designed to provide broad liquidity to the U.S. private placement market and facilitate greater access to capital for issuers in the 144A equity market. The platform will also monitor the number of shareholders in these issuers. OPUS-5 is expected to launch in September 2007.

The reason that the platform’s managers will monitor the number of shareholder is that if the number of the issuer’s shareholders were to exceed 500, the issuer would trigger reporting company obligations.

The sudden efflorescence of these private trading platforms is clearly a part of the U.S. financial market’s response to the success of the London-based Alternative Investment Market (AIM). These platforms provide companies with ease of access to equity financing, addressing the need, noted in my prior post (here), that has driven AIM’s success. The active competition that has quickly arisen between the various private platforms will clearly be to the benefit of the issuer companies, as they will have the advantage of being able to choose on which platform they will have their Rule 144A shares traded. The more interesting question is whether these new private platforms will serve as a way station to an eventual public offering or whether they will serve as an alternative to going public. For a huge hedge fund like Renaissance, the OPUS-5 trading clearly is an alternative to going public.

In either case, as I noted in my prior post looking at the GSTrUE system, even though floatations on the private systems are less risky that an public offering, they are not risk free exercises. The D & O marketplace undoubtedly will innovate customized products to address the specific risks facing companies whose Rule 144A shares will be trading in these private systems.

Will His Retirement Attire Be Orange?: As has been well-documented in the press (refer here), Bill Lerach is resigning from his eponymous law firm, to be known after August 31 as Coughlin Stoia Rudman & Robbins. The most interesting media coverage of the resignation has been on the WSJ.com Law Blog, which not only reprinted the full text of Lerach’s resignation e-mail (here) but also posted (here) a fascinating comparison between the text of Lerach’s e-mail and Richard Nixon’s Resignation and Farewell speeches, and in addition (here) to the Godfather II movie.

But perhaps the most noteworthy aspect of the WSJ.com Law Blog’s coverage is the statement in its August 28 post (here) that Lerach “is in advanced talks with prosecutors on a plea deal that could be announced in September and involve serving time, according to two people familiar with the investigation (emphasis added).”

The law firm’s August 28, 2007 press release on Lerach’s resignation can be found here.

So Kids, That’s Why You Should Do Your Math Homework: Renaissance Technologies, which has assets over $30 billion, was founded by mathematician James Harris Simons, and uses mathematically based trading strategies. Press reports commenting on the reasons why Renaissance might shun a public offering suggest that one reason was to avoid having to reveal more information about its trading strategies.

Another reason Renaissance might try to avoid a public offering is to avoid greater scrutiny of its executive compensation practices. According to Wikpedia, Simons earned an estimated $1.7 billion in 2006, after having made $1.5 billion in 2005 and $670 million in 2004. Forbes lists him (here) as the 64th richest person in America.

Speaker’s Corner: I will be moderating the educational panel on “Current Issues in Directors’ and Officers’ Liability Insurance” at the Professional Liability Underwriting Society (PLUS) Midwest Chapter event in Cincinnati on September 12, 2007 (refer here for details). We have a distinguished panel including Dan Bailey from the Columbus law firm of Bailey & Cavalieri, Tom Reiter from K&L Gates in Pittsburgh, Jim Lash from the Hylant brokerage in Cinncinati, and Mark Lamendola from Travelers. This is going to be a great event, and I hope readers in the Ohio Valley and Great Lakes regions will try to attend.

On August 24, 2007, Rambus announced (here) that a Special Litigation Committee (SLC) of its board of directors had completed its review of “claims related to stock options practices that are asserted in derivative actions against a number of present and former directors and officers of the Company.”

Rambus had previously announced (here) on October 19, 2006 that its Audit Committee had completed an independent investigation into stock options grants and had “determined that a significant number of the stock option grants were not correctly dated or accounted for,” and that the company anticipated taking a $200 million charge. The Board also at that time formed the SLC to evaluate potential claims the company may have. The SLC consisted of two members of the company’s board, J. Thomas Bentley, a Managing Director of SVB Alliant (the recently closed investment banking arm of Silicon Valley Bank), and Abraham Sofaer, a former U.S. District Judge who is also a law professor at Stanford.

According to the company’s August 24 press release, the SLC determined, subject to the settlements described in the announcement, that “all claims should be terminated and dismissed against the named defendants in the derivative actions,” with the exception of claims against one individual who served as the Vice President of Human Resources between 1996 and 1999, and Senior Vice President of Administration from 1999 to 2004. The SLC determined that the claims against the individual should proceed and that the SLC itself will “assert control over the litigation.”

The announcement further disclosed that the SLC had “entered into settlement agreements with certain former officers of the Company.” The aggregate value of the settlements, which are “conditioned upon the dismissal of the claims asserted against them in the derivative actions,” exceeds $6.5 million in cash and cash equivalents “as well as additional value to the Company relating to the relinquishment of claims to over 2.7 million stock options.” (The Company’s January 4, 2007 press release announcing the company’s former CEO’s relinquishment of the stock options can be found here.)

The company’s August 24 announcement is interesting by way of the contrast it provides to much of the litigation activity that has surrounded the options backdating scandal, where the battle lines typically have been drawn over the “demand futility” issue – that is, whether or not it would be futile to ask a company’s board to investigate and prosecute the alleged wrongdoing. The evidence of the Rambus SLC’s work presents an interesting counterpoint to the arguments that plaintiffs typically raise that it would be futile to demand that a board take responsibility for investigating alleged wrongdoing. There appears to have been nothing futile about the actions of Rambus’s board or its appointed committee.

I have no knowledge of the details of Rambus’s D&O coverage and I have no information beyond what appeared in the company’s news release, but based on the available information and assuming the provisions of the typical policy, the outcome of the SLC’s investigation could raise some potentially interesting coverage issues. To the extent that the amounts the individuals agreed to pay in settlement are in the nature of disgorgement or restitution, a D & O carrier would likely contend that it is not covered “loss.” (Of course, the individuals are likely to contend that the amounts are not restitutionary or otherwise do constitute covered loss.)

In addition, the company may well seek to recover its own investigative costs and costs incurred in connection with the SLC. Indeed, issues surrounding coverage for these kinds of costs have been a great source of tension between D & O carriers and policyholders in connection with the options backdating claims. Attorney and D & O commentator Dan Bailey has a good summary of the coverage issues associated with these kinds of costs in a recent article, here.

The continuing claims against the remaining individual defendant also presents an interesting issue; since the ongoing action would be direct rather than derivative, the carrier may contend that the claim would no longer appear to fall within the derivative claim exception to the insured versus insured exclusion. The availability of insurance (or absence thereof) could have a significant effect on the likely future direction of the claim against the remaining individual defendant.

Bad News and D & O Claims: In prior posts (most recently here), I have commented on the fact that sometimes it is the way a company deals with bad news, rather than the bad news itself, that determines whether or not the company will also have to deal with a securities class action lawsuit. The allegations in the purported securities class action lawsuit that the Lerach Coughlin firm filed on August 24, 2007 against Advanced Medical Optics and several of its directors and officers appears to provide another example of this phenomenon. The press release regarding the new lawsuit can be found here, and the complaint can be found here.

Let me just say at the outset that I have no knowledge of the facts and circumstances other than what is alleged in the complaint, and I do not mean to suggest that the circumstances are as the plaintiffs’ have alleged or that the claims are meritorious. For purposes of discussion, I have simply taken the plaintiffs’ allegations as presented.

In the complaint, the plaintiffs allege that in November 2006, the Company announced a voluntary recall of CompleteMoisturePLUS (“Complete”), a bottled soft contact lens solution sold on a worldwide basis, because of bacterial contamination that compromised sterility. (The company’s press release regarding the November recall can be found here) The complaint further alleges that the defendants “moved to assure the market that the problem was isolated to Asia and that the prospects for the Complete product were favorable.”

The complaint cites a number of company statements that supposedly indicate that the Asian facilities had been sanitized, inspected and would be staged back into production, and that the company’s sales for the Complete product were or would be fully restored. The complaint alleges that in April the Company announced favorable results, including rising sales of Complete. The complaint alleges that the defendants made favorable disclosures about Complete though they knew that there were problems and that a recall was “not just a future possibility but a significant likelihood.” The complaint alleges that as a result of the company’s reassurances, the company’s stock performed well and the defendants were able to sell significant amounts of their personal holdings of the company’s stock at a profit.

The complaint goes on to allege that in a May 25, 2007 press release, the company announced that in response to “information received today from the Center for Disease Control regarding eye infections,” the company was immediately and voluntarily recalling its Complete contact lens solution. (A copy of the company’s May 25 press release can be found here.) The complaint alleges that the company’s stock price declined 14% on this news.

There are several interesting things about this complaint. The first is that the initial bad news (the November 2006 product recall) is not the basis of the securities lawsuit; indeed, the class period does not even purport to begin until January 2007, well after the initial product recall. It is rather the supposedly reassuring statements that the company allegedly provided between November and May that are the basis of the complaint. The events alleged (again, without taking a position whether or not they are true or that plaintiff’s allegations correspond in any way to what actually happened) seem to illustrate the point, which I have previously observed here, that “partial, incomplete or overly optimistic disclosure can exacerbate damage from bad news disclosure and risk the creation of securities litigation exposure.” As the allegations seek to show, it may be that the “calming” statement itself may be alleged to be misleading – in other words the securities litigation exposure results from the “damage control,” not the underlying event.

The insider trading allegations also illustrate another important point for managing bad news disclosure (which point may or may not have been relevant to AMO’s circumstances), which is that companies involved in bad news would be well advised to consider imposing a trading blackout until the problem is entirely contained. My prior essay presenting a more detailed program for managing bad news disclosure can be found here.

Another interesting thing about this lawsuit is the name of the company sued. Long ago, I noted the odd susceptibility to securities class action lawsuits of companies with the word “Advanced” as the first word in their name. The Stanford Law School Securities Class Action Clearinghouse index of securities lawsuits (here) identifies 12 different companies (including Advanced Medical Optics) that have been sued in class action lawsuits. I do not mean to engage in the much-derided confusion of correlation and causation, but I still do think that it is kind of weird that companies with the word “Advanced” in their name seem to get sued all the time.