As I have noted in prior posts (most recently here), the several blue-ribbon panels that have recently examined the competitiveness of the U.S. financial markets have been particularly concerned with the apparent loss of company listings to overseas exchanges, particularly the London Stock Exchange’s Alternative Investment Market (AIM). These would-be reformers have cited AIM’s success as evidence that the U.S. regulatory structures, and the Sarbanes Oxley Act in particular, are driving potential issuers to competitor financial markets. They have similarly contended that in order for U.S. financial markets to reclaim their competitive position, the U.S. regulatory structure (and SOX in particular) should be reformed.

Lacking from these studies has been a detailed analysis of the causes of AIM’s success, and the absence of this perspective arguably has led the would-be reformers to proscribe “solutions” that may not be best calculated to help U.S markets meet AIM’s challenge. An August 2007 paper by Jose Miguel Mendoza of Javeriana University in Bogot�, Columbia, entitled “Securities Regulation in Low-Tier Listing Venues: The Rise of the Alternative Investment Market” (here), takes a closer look at the reasons for AIM’s success. His observations may suggest that an approach to regulatory reform that is more finely-tuned than that proposed by the reformers could be likelier to improve U.S markets’ competitive position while preserving its advantages.

Perhaps the most interesting aspect of Mendoza’s paper is his exploration of the historical reasons for AIM’s success. In his view, AIM’s success in recent years was in significant ways the result of historical circumstance. The failure of the other European New Markets (such as the Neuer Markt) left a relatively open field, at a time when the bursting of the Internet bubble in this country caused the senior U.S. exchanges to heighten listing requirements -especially with respect to minimum market capitalization requirements. These forces were exacerbated by the demutualization of the leading exchanges, and the exchanges’ conversion to listed, for-profit enterprises, which made smaller companies’ listings less attractive. As a result of these developments, a “public equity financing gap” developed for smaller enterprises, a need that the AIM was well-positioned to meet. As Mendoza puts it, the “main reason behind AIM’s growth lies with the fact that it supplies a scarce product to the marketplace: rapid and low-cost access to public equity for small firms with high growth potential.”

Mendoza also points out that AIM’s platform was successful because it was built in recognition that a “one-size fits all regulatory scheme” that works well for larger, better-capitalized companies may be poorly suited to the needs of smaller companies. AIM’s regulatory structure is “tailored to fit the needs of small firms with high-growth potential.” Mendoza characterizes this calibration of regulatory structure to company size and maturity as “the specialization of listing venues” and attributes AIM’s success to its specialization for smaller growth stage companies. As the same time, Medoza recognizes that more rigorous regulatory structures, which are better suited to larger, better-capitalized companies, can have benefits for those companies, such as lower costs of capital and higher valuations.

In my view, it is an appreciation for this aspect of AIM’s success formula that is missing from the would-be reformers’ analysis; that is, the reformers overlook AIM’s particular value and attraction for smaller companies. The reformers’ proposed across-the-board reforms is a purported “one size fits all” solution to a problem that is due to a “one size fits all” regulatory system. But an across the board regulatory reform could eliminate the advantages of the U.S. markets for better-capitalized listing companies that benefit from lower costs of capital and higher valuations on U.S exchanges as a result of the U.S.’s highly regulated system. As alternative reform proposal that would be more likely to enable the U.S. financial markets to compete with AIM would be one that is not across the board, but rather one that is, to paraphrase Mendoza, tailored to meet the needs of the smaller, growth-stage companies that are attracted to AIM but that may be closed out now from the senior U.S. exchanges.

For that matter, it may be that the competitive dynamic of the global financial marketplace is already tending in this direction, without the need for governmental action. The recent launch of the OTCQX listing service (refer here) is a direct marketplace response to AIM’s success. Similarly, the recent debuts of the Nasdaq Portal (refer here) and the GSTrUE trading platform (refer here) – both of which are designed to permit institutional investors to trade ownership interests in companies that are not interested or not able to take on the reporting company burdens and responsibilities – are two additional ways that the marketplace is evolving to challenge AIM’s success and to provide smaller companies with access to equity capital.

The arrival of these trading innovations and the likelihood that further advances of this type will follow suggests the possibility that regulatory reform may not even be necessary for U.S. markets to be able to meet AIM’s challenge. Although Medoza’s paper does not expressly address this point, the logical extension of his analysis is that if there is to be any reform, it should be fine-tuned to meet the competitive challenge, and that an across the board one size fits all approach could weaken current competitive advantages the U.S markets offer companies that are able to meet the U.S.’s stricter regulatory regime.

If Mendoza’s paper has a weakness, it is its tendency to minimize the concerns that commentators have noted with respect to the AIM approach (about which refer here). Even while acknowledging that it “remains to be seen whether [AIM’s] particular system of self-regulation can take the strain of increased numbers of non-UK companies” and that the “venue’s performance could have been negatively affected by the poorer quality of companies coming into the market during 2006,” he nonetheless is an emphatic advocate for AIM’s self-regulatory approach, and particularly for the benefits of its Nominated Advisor (Nomad) gatekeeper system.

Prospective issuers are clearly well aware of the potential shortcomings of an AIM listing (as discussed here), and that awareness will clearly affect AIM’s competitive position going forward – indeed AIM’s growth has slowed in 2007, and AIM offerings during the first four months of 2007 were more than 50% below the number of offerings in the comparable period in 2006.

If the U.S. financial markets want to not only regain their competitive position but in fact achieve a competitive advantage, the best approach would be to encourage further marketplace innovation calculated to meet the needs of smaller, growth-oriented companies, while avoiding the concerns that AIM market participants have noted. By the same token, an across the board regulatory reform that is not fine-tuned to meet the needs of smaller companies could weaken the advantages of the senior U.S. exchanges and ultimately reduce the competitiveness of the U.S financial markets.

My prior post examining the question whether the proposed reforms would solve a problem or introduce a weakness can be found here.

Hat tip to the Ideoblog (here) for the link to Mendoza’s article.

Add One to the Subprime Lawsuit Tally: Regular readers know that I have been maintaining (here) a running tally of the subprime lending-related securities class action lawsuits. The filing this past week of a new securities class action case against Thornburg Mortgage (press release here), brings the number of subprime lending related securities class actions to 13.

More About Climate Change and D & O Risk: In earlier posts (here and here), I have examined the possible risk exposure of directors and officers arising from regulatory, legislative and judicial developments involving climate change. In the latest issue of InSights (here), I take a closer look at “Global Climate Change and D&O Insurance.”

As I have previously noted (most recently here), the subprime mortgage meltdown has produced a wave of lawsuits, including securities class action litigation (which I am tracking here). Even thought we are clearly only at the beginning of what will undoubtedly be a very long-developing story, the question is already being asked: what impact will the subprime mortgage mess have on the D & O insurance marketplace? For example, an August 22, 2007, Insurance Journal article entitled “The Blame Game and the Subprime Mortgage Meltdown”(here), among other things, examined the possible impact of the subprime mess on the D & O insurance marketplace. (Full disclosure: I was interviewed in connection with the article.)

In one sense, it may simply be too early to be asking these questions. As I noted in the Insurance Journal article, we are only at the very top of the first inning in what will probably be an extra-inning contest. This story has much further to run. But on the other hand, it may not be too early to begin to make some assessments of the seriousness of the situation.

And for my money, this is a very serious situation, indeed. It already may be potentially far more serious for the D & O industry than the options backdating scandal. The options backdating scandal involved chronologically remote events, arcane accounting principles, and, except in a few extreme cases, the claims were not accompanied by significant loss of market capitalization or other investor loss. (The exceptions to these generalizations are of course quite noteworthy, but from the perspective of the D & O industry, the backdating scandal taking collectively is simply not a market changing event.) By contrast, the subprime mess is immediate, involves immediately apparent and emotionally compelling issues, and has been accompanied by very substantial investor loss. Even though the backdating scandal involved many more lawsuits (so far, at least), the subprime mess already poses a potentially far more serious problem for the D & O industry, and the potential will only grow in the months ahead.

But what does all of that imply as a practical matter for the D & O marketplace? Because of the marketplace context within which the subprime mess is now unfolding, the subprime meltdown may or may not mean anything, at least in the short term, other than for companies directly involved in the subprime lending industry. The D & O marketplace has been in a declining pricing mode since late 2003, characterized by high levels of competition, with new entrants recently coming into the marketplace. These conditions are not going to change overnight, even given the potential seriousness of the developments resulting from the subprime mess. However, it is not too early to begin to ask whether or not the subprime mess might begin to have some effects, and to ask where all of this might eventually lead.

First of all, companies involved in the mortgage lending business are going to face a far different D & O insurance marketplace than even just 2 or 3 months ago. D & O underwriters are on high alert status for subprime lending risk. Companies with perceived subprime exposure will face, at an absolute minimum, heightened underwriting scrutiny, tightened terms and conditions, and increased pricing. It is fair to say that this sector will be in the “hard to place” category for the foreseeable future. Nor will these tightened circumstances be limited just to subprime lenders. Since problems have already begun to emerge with so-called Alt-A loans (for example, refer here), and even some other loan categories, the scrutiny will extend to all companies involved in the residential mortgage lending business.

Along those same lines, the exact location of the outer edge of the heightened scrutiny category will remain ill-defined for some time, and could potentially encompass a variety of other kinds of companies beyond those involved directly in residential mortgage lending. Certainly, home builders, real estate agents, residential REITs, and other businesses whose fortunes are tied directly to the residential real estate sector will also face a different D & O environment than even just a couple of months ago. The environment for commercial banks and other traditional lending institutions will also be affected, but the extent of the impact will vary, depending on the extent of each bank’s exposure to residential mortgage risk, particularly subprime mortgage risk. But even banks that no longer hold the mortgages could face stricter scrutiny to the extent the banks off-loaded the mortgages to outside investors.

In addition, all companies seeking D & O insurance will be facing the possibility of additional underwriting inquiry around the companies’ balance sheet exposure to mortgage investment risk. As I noted in my prior post (here), there is $1.08 trillion in subprime mortgage backed asset investment (meaured by cost, not necessarily current value) sitting on balance sheets somewhere out there. D & O underwriters will be trying to determine applicants’ balance sheet exposure to this mortgage investment risk. Obvious places to look for this risk include hedge funds and other alternative investment vehicles, mutual funds, investment banks, residential mortgage REITs, and insurance companies. But the inquiry will likely not be limited just to companies in these sectors; given the sheer magnitude of the mortgage-backed investment risk dispersed in the economy, the mortgage investment risk may have wound up in some unexpected places. In addition, underwriters’ questions will likely not be limited to whether the applicant directly holds investments in mortgage-backed assets, but will also inquire whether the applicant has investments in hedge funds or other investment vehicles with significant exposure to mortgage-backed investments.

Beyond these predictable underwriting effects, it is simply too early to tell what the overall impact will be on the D & O marketplace. The quick emergence of claims frequency around subprime mortgage issues and the uncertainty of the eventual extent of the problem has to be making the managers at the D & O insurers (and their reinsurers) more than just a little bit uncomfortable right now. But whether that uneasiness alone is enough to reverse the current downward pricing trend remains to be seen. My own expectation is that the effects on the D & O marketplace will be uneven, with some predictable sectors constricting but most others remaining competitive, at least in the short term. Whether the constrictive impact will become more generalized will depend on how large and how widespread the subprime litigation wave becomes. Stay tuned.

One Example Why I Think The Subprime Litigation Wave Will Grow: The potential for the subprime litigation wave to encompass an ever-wider variety of companies in an ever-broader variety of claims may be seen in the purported class action lawsuit previously filed in federal court in Florida against D’Alessandro & Woodyard, a Florida residential real estate broker; First Home Builders of Florida, a residential home builder specializing in the first-time home buyer segment; these two companies’ successors in interest; and certain principals of the real estate agency. The complaint may be found here.

The complaint alleges that the home builder would attract would-be home buyers to new home open houses. Would-be home buyers who could not qualify for home purchase financing were allegedly referred to the real estate broker, who helped the would-be buyers enter a lease-to-buy program, where the lease payments were intended to be used as documentation to help a later mortgage application to support the tenant’s ultimate purchase of the home. The homes to be leased purportedly were sold to investors, who would carry the home during the tenancy, and then after an interval would sell the homes to the tenants. The investors purportedly were promised “ready made” tenants, and a 14% return.

The plaintiffs allegedly purchased 3 lots on which 3 of these lease-to-own home would be built, borrowing $790,000 in construction financing from an alleged “hand picked” lender, despite having only $90,000 in gross annual income. The plaintiffs allege that no tenants have been procured for these houses, and that they now face foreclosure on the three properties. The plaintiffs allege on behalf of themselves and other similarly situated investors that the defendants breached Section 12 of the ’33 Act, Section 10 of the ’34 Act, breached their contract with the plaintiffs, and violated a variety of state trade practices acts.

There are several parts of these alleged factual circumstances that are interesting. The first is that the defendants include not only the home builder but also the real estate agents. As I have previously suggested (here), the wave of blame for the subprime mess will spread outward, and will involve an ever-broader variety of purported scapegoats, and an increasingly large number and variety of professionals. This gatekeeper blame is already being assigned to directors and officers, credit rating agencies, mortgage brokers and real estate appraisers. Before this situation is entirely played out, we undoubtedly will have blame cast upon auditors, attorneys, investment advisors, hedge fund and pension fund managers, and many others whom circumstances will show to have played some role.

The second is what this alleged investment opportunity required for its prospective success. Not only did it require the availability of tenants who could pay the rent under the lease to own program -even though they couldn’t afford a mortgage at the outset – but it also required a tenant who could later successfully acquire financing to buy out the investors. Allegedly, the Prospectus that was provided to potential investors explained that the “exit strategy” was possible due to the availability to the tenant-buyers of subprime financing. Among other things, the Prospectus allegedly stated that 14% gain would be paid to the investors

once the tenant refinances the home in their name buying the investor out of the deal. The refinance is possible because Sub-prime lenders will allow a refinance on a property with 12 cancelled monthly checks for a lease payment. Tenants are preliminarily screened for credit, income, and debt analysis. They are coached in the process of the refinance and how to qualify in the upcoming year.

In addition to the tenant, the investors too had to be able to secure financing. But the ultimate benefit to the tenants and investors depended upon their ability not only to qualify for but to repay the debt. Of course, in some circumstances (if not in these precise circumstances) the ability to repay may have been of less concern to some brokers or home builders, and for that matter, to some lenders, who counted on their ability to sell their loans to third party investors.

The allegations in the complaint are mere assertions, and I have no way of knowing whether or not they are true or false, nor do I know whether the plaintiffs’ claims are meritorious. However, the plaintiffs allegations suggest the true seduction that came with the availability of easy credit at a time of rising prices – everyone involved was going to make money, or at least prosper. The number of investors or eventual home-buyers who may have incurred debt beyond their means hoping to prosper or benefit in situations like this one, or in the untold number other variants that played out over the past few years, where marginal borrowers were “coached” into debt qualification but not on the challenge of debt repayment, create a multitude of individual situations where financial reversals will leave a plethora of aggrieved parties, whose grievance will, more likely than not, wind up in court. The assignment of blame will extend beyond individual cases to attempts to cast collective blame against the companies that facilitated and prospered from these arrangements, as well as the managers who ran the companies, the investment bankers who financed the lending and packaged the debt for resale, the investment managers who supported the system by buying the debt on behalf of their investment funds, and outward and onward. As this case shows, the blame shifting game will be actively supported by lawyers willing to pursue creative theories in support of their clients’ interests.

As I have said, we are only in the top of the first inning. But the scoreboard already looks alarming, at least to me. Contrasting perspectives from responsible spokespersons are welcome.

Very special thanks to Timothy Raub at LexisNexis for calling my attention to this case, and to Adam Savett of the Securities Litigation Watch for providing a link to the complaint.
Speaking of the SLW, a hearty welcome back to Adam for his (alleged!) return (here) to the blogging circuit.

An Historical Sidenote: In his recent splendid biography (here) of Andrew Carnegie, historian David Nasaw describes the Panic of 1873, caused by the October 1873 failure of the Philadelphia finance firm of Jay Cooke & Co., which had overextended itself after getting caught up in the euphoria that accompanied the attempt to build the transcontinental railroad. Nasaw writes:

Like all financial panics, the signs had been there to see — but no one bothered to look until it was too late. Businesses had been failing and banks hiking their interest rates since the spring. Jay Cooke, who had in 1869 been overtaken by the transcontinental madness, found it difficult, then impossible to borrow what he needed to complete construction of his Northern Pacific Railroad….He attempted to sell Northern Pacific bonds at a deep discount, but there were no takers….The failure of Jay Cooke & Co. set off a round robin of bank and business failures. Stocks tumbled, out-of-town banks took back the reserves they had parked in New York City, causing New York banks to call in their old loans and raise rates on new ones…. The railroads, which survived on credit, were instantly crippled. The effect on Pittsburgh’s manufacturing firms, including Carnegie’s, was immediate because the railroads with which they did so much business no longer had money to pay their bills. Banks were no use in the crisis. Those that remained open suspended payments….

The world is a different place than it was in 1873. The economy is stronger, more diverse, and is protected with more safeguards now, and there is no reason at this point to think the current conditions will lead to anything like what happened in 1873. But those prior circumstances have some oddly familiar echoes. One thing that has not changed is the fundamental dependence of the credit system on the ability of borrowers to repay their debt. When they cannot, then problems ensue, now as then, and the effects still reverberate across the entire economy.
Meanwhile, Back at the Ranch: The subprime mess may be the headline story, but that does not mean that the backdating scandal has gone away, and indeed, just this week a securities class action lawsuit was filed (press release here) against another company, in this case Semtech. (Semtech was already involved in an options backdating related shareholders derivative suit.) According to the running tally of options backdating related securities class action lawsuits that I am maintaining here, that brings the count of options backdating related class actions to 32. I also added two options backdating related shareholders derivative suits to the list as well (iBasis and Citrix), bringing the tally of options backdating related shareholders’ derivative suits to 163. Thanks to Timothy Raub at LexisNexis for identifying the omissions.

Speaker’s Corner: The subprime mortgage litigation wave has captured the attention of quite a few observers, and it will undoubtedly lead to a number of legal issues as well as insurance coverage issues. On October 29-30, 2007 in Chicago, I will be co-Chairing, with Matt Jacobs of Jenner & Block, a Mealey’s conference entitled “Subprime Mortgage Litigation”, the agenda for which may be found here. The conference will feature a number of recognized experts, both in the field of mortgage lending and in the field of insurance coverage issues. Because of the growing importance of these issues, this conference will surely attract a great deal of interest and attention.

As I have previously noted (most recently here), the subprime mortgage meltdown has produced a wave of lawsuits, including securities class action litigation (which I am tracking here). Even thought we are clearly only at the beginning of what will undoubtedly be a very long-developing story, the question is already being asked: what impact will the subprime mortgage mess have on the D & O insurance marketplace? For example, an August 22, 2007, Insurance Journal article entitled “The Blame Game and the Subprime Mortgage Meltdown”(here), among other things, examined the possible impact of the subprime mess on the D & O insurance marketplace. (Full disclosure: I was interviewed in connection with the article.)

In one sense, it may simply be too early to be asking these questions. As I noted in the Insurance Journal article, we are only at the very top of the first inning in what will probably be an extra-inning contest. This story has much further to run. But on the other hand, it may not be too early to begin to make some assessments of the seriousness of the situation.

And for my money, this is a very serious situation, indeed. It already may be potentially far more serious for the D & O industry than the options backdating scandal. The options backdating scandal involved chronologically remote events, arcane accounting principles, and, except in a few extreme cases, the claims were not accompanied by significant loss of market capitalization or other investor loss. (The exceptions to these generalizations are of course quite noteworthy, but from the perspective of the D & O industry, the backdating scandal taking collectively is simply not a market changing event.) By contrast, the subprime mess is immediate, involves immediately apparent and emotionally compelling issues, and has been accompanied by very substantial investor loss. Even though the backdating scandal involved many more lawsuits (so far, at least), the subprime mess already poses a potentially far more serious problem for the D & O industry, and the potential will only grow in the months ahead.

But what does all of that imply as a practical matter for the D & O marketplace? Because of the marketplace context within which the subprime mess is now unfolding, the subprime meltdown may or may not mean anything, at least in the short term, other than for companies directly involved in the subprime lending industry. The D & O marketplace has been in a declining pricing mode since late 2003, characterized by high levels of competition, with new entrants recently coming into the marketplace. These conditions are not going to change overnight, even given the potential seriousness of the developments resulting from the subprime mess. However, it is not too early to begin to ask whether or not the subprime mess might begin to have some effects, and to ask where all of this might eventually lead.

First of all, companies involved in the mortgage lending business are going to face a far different D & O insurance marketplace than even just 2 or 3 months ago. D & O underwriters are on high alert status for subprime lending risk. Companies with perceived subprime exposure will face, at an absolute minimum, heightened underwriting scrutiny, tightened terms and conditions, and increased pricing. It is fair to say that this sector will be in the “hard to place” category for the foreseeable future. Nor will these tightened circumstances be limited just to subprime lenders. Since problems have already begun to emerge with so-called Alt-A loans (for example, refer here), and even some other loan categories, the scrutiny will extend to all companies involved in the residential mortgage lending business.

Along those same lines, the exact location of the outer edge of the heightened scrutiny category will remain ill-defined for some time, and could potentially encompass a variety of other kinds of companies beyond those involved directly in residential mortgage lending. Certainly, home builders, real estate agents, residential REITs, and other businesses whose fortunes are tied directly to the residential real estate sector will also face a different D & O environment than even just a couple of months ago. The environment for commercial banks and other traditional lending institutions will also be affected, but the extent of the impact will vary, depending on the extent of each bank’s exposure to residential mortgage risk, particularly subprime mortgage risk. But even banks that no longer hold the mortgages could face stricter scrutiny to the extent the banks off-loaded the mortgages to outside investors.

In addition, all companies seeking D & O insurance will be facing the possibility of additional underwriting inquiry around the companies’ balance sheet exposure to mortgage investment risk. As I noted in my prior post (here), there is $1.08 trillion in subprime mortgage backed asset investment (meaured by cost, not necessarily current value) sitting on balance sheets somewhere out there. D & O underwriters will be trying to determine applicants’ balance sheet exposure to this mortgage investment risk. Obvious places to look for this risk include hedge funds and other alternative investment vehicles, mutual funds, investment banks, residential mortgage REITs, and insurance companies. But the inquiry will likely not be limited just to companies in these sectors; given the sheer magnitude of the mortgage-backed investment risk dispersed in the economy, the mortgage investment risk may have wound up in some unexpected places. In addition, underwriters’ questions will likely not be limited to whether the applicant directly holds investments in mortgage-backed assets, but will also inquire whether the applicant has investments in hedge funds or other investment vehicles with significant exposure to mortgage-backed investments.

Beyond these predictable underwriting effects, it is simply too early to tell what the overall impact will be on the D & O marketplace. The quick emergence of claims frequency around subprime mortgage issues and the uncertainty of the eventual extent of the problem has to be making the managers at the D & O insurers (and their reinsurers) more than just a little bit uncomfortable right now. But whether that uneasiness alone is enough to reverse the current downward pricing trend remains to be seen. My own expectation is that the effects on the D & O marketplace will be uneven, with some predictable sectors constricting but most others remaining competitive, at least in the short term. Whether the constrictive impact will become more generalized will depend on how large and how widespread the subprime litigation wave becomes. Stay tuned.

One Example Why I Think The Subprime Litigation Wave Will Grow: The potential for the subprime litigation wave to encompass an ever-wider variety of companies in an ever-broader variety of claims may be seen in the purported class action lawsuit previously filed in federal court in Florida against D’Alessandro & Woodyard, a Florida residential real estate broker; First Home Builders of Florida, a residential home builder specializing in the first-time home buyer segment; these two companies’ successors in interest; and certain principals of the real estate agency. The complaint may be found here.

The complaint alleges that the home builder would attract would-be home buyers to new home open houses. Would-be home buyers who could not qualify for home purchase financing were allegedly referred to the real estate broker, who helped the would-be buyers enter a lease-to-buy program, where the lease payments were intended to be used as documentation to help a later mortgage application to support the tenant’s ultimate purchase of the home. The homes to be leased purportedly were sold to investors, who would carry the home during the tenancy, and then after an interval would sell the homes to the tenants. The investors purportedly were promised “ready made” tenants, and a 14% return.

The plaintiffs allegedly purchased 3 lots on which 3 of these lease-to-own home would be built, borrowing $790,000 in construction financing from an alleged “hand picked” lender, despite having only $90,000 in gross annual income. The plaintiffs allege that no tenants have been procured for these houses, and that they now face foreclosure on the three properties. The plaintiffs allege on behalf of themselves and other similarly situated investors that the defendants breached Section 12 of the ’33 Act, Section 10 of the ’34 Act, breached their contract with the plaintiffs, and violated a variety of state trade practices acts.

There are several parts of these alleged factual circumstances that are interesting. The first is that the defendants include not only the home builder but also the real estate agents. As I have previously suggested (here), the wave of blame for the subprime mess will spread outward, and will involve an ever-broader variety of purported scapegoats, and an increasingly large number and variety of professionals. This gatekeeper blame is already being assigned to directors and officers, credit rating agencies, mortgage brokers and real estate appraisers. Before this situation is entirely played out, we undoubtedly will have blame cast upon auditors, attorneys, investment advisors, hedge fund and pension fund managers, and many others whom circumstances will show to have played some role.

The second is what this alleged investment opportunity required for its prospective success. Not only did it require the availability of tenants who could pay the rent under the lease to own program -even though they couldn’t afford a mortgage at the outset – but it also required a tenant who could later successfully acquire financing to buy out the investors. Allegedly, the Prospectus that was provided to potential investors explained that the “exit strategy” was possible due to the availability to the tenant-buyers of subprime financing. Among other things, the Prospectus allegedly stated that 14% gain would be paid to the investors

once the tenant refinances the home in their name buying the investor out of the deal. The refinance is possible because Sub-prime lenders will allow a refinance on a property with 12 cancelled monthly checks for a lease payment. Tenants are preliminarily screened for credit, income, and debt analysis. They are coached in the process of the refinance and how to qualify in the upcoming year.

In addition to the tenant, the investors too had to be able to secure financing. But the ultimate benefit to the tenants and investors depended upon their ability not only to qualify for but to repay the debt. Of course, in some circumstances (if not in these precise circumstances) the ability to repay may have been of less concern to some brokers or home builders, and for that matter, to some lenders, who counted on their ability to sell their loans to third party investors.

The allegations in the complaint are mere assertions, and I have no way of knowing whether or not they are true or false, nor do I know whether the plaintiffs’ claims are meritorious. However, the plaintiffs allegations suggest the true seduction that came with the availability of easy credit at a time of rising prices – everyone involved was going to make money, or at least prosper. The number of investors or eventual home-buyers who may have incurred debt beyond their means hoping to prosper or benefit in situations like this one, or in the untold number other variants that played out over the past few years, where marginal borrowers were “coached” into debt qualification but not on the challenge of debt repayment, create a multitude of individual situations where financial reversals will leave a plethora of aggrieved parties, whose grievance will, more likely than not, wind up in court. The assignment of blame will extend beyond individual cases to attempts to cast collective blame against the companies that facilitated and prospered from these arrangements, as well as the managers who ran the companies, the investment bankers who financed the lending and packaged the debt for resale, the investment managers who supported the system by buying the debt on behalf of their investment funds, and outward and onward. As this case shows, the blame shifting game will be actively supported by lawyers willing to pursue creative theories in support of their clients’ interests.

As I have said, we are only in the top of the first inning. But the scoreboard already looks alarming, at least to me. Contrasting perspectives from responsible spokespersons are welcome.

Very special thanks to Timothy Raub at LexisNexis for calling my attention to this case, and to Adam Savett of the Securities Litigation Watch for providing a link to the complaint.
Speaking of the SLW, a hearty welcome back to Adam for his (alleged!) return (here) to the blogging circuit.

An Historical Sidenote: In his recent splendid biography (here) of Andrew Carnegie, historian David Nasaw describes the Panic of 1873, caused by the October 1873 failure of the Philadelphia finance firm of Jay Cooke & Co., which had overextended itself after getting caught up in the euphoria that accompanied the attempt to build the transcontinental railroad. Nasaw writes:

Like all financial panics, the signs had been there to see — but no one bothered to look until it was too late. Businesses had been failing and banks hiking their interest rates since the spring. Jay Cooke, who had in 1869 been overtaken by the transcontinental madness, found it difficult, then impossible to borrow what he needed to complete construction of his Northern Pacific Railroad….He attempted to sell Northern Pacific bonds at a deep discount, but there were no takers….The failure of Jay Cooke & Co. set off a round robin of bank and business failures. Stocks tumbled, out-of-town banks took back the reserves they had parked in New York City, causing New York banks to call in their old loans and raise rates on new ones…. The railroads, which survived on credit, were instantly crippled. The effect on Pittsburgh’s manufacturing firms, including Carnegie’s, was immediate because the railroads with which they did so much business no longer had money to pay their bills. Banks were no use in the crisis. Those that remained open suspended payments….

The world is a different place than it was in 1873. The economy is stronger, more diverse, and is protected with more safeguards now, and there is no reason at this point to think the current conditions will lead to anything like what happened in 1873. But those prior circumstances have some oddly familiar echoes. One thing that has not changed is the fundamental dependence of the credit system on the ability of borrowers to repay their debt. When they cannot, then problems ensue, now as then, and the effects still reverberate across the entire economy.
Meanwhile, Back at the Ranch: The subprime mess may be the headline story, but that does not mean that the backdating scandal has gone away, and indeed, just this week a securities class action lawsuit was filed (press release here) against another company, in this case Semtech. (Semtech was already involved in an options backdating related shareholders derivative suit.) According to the running tally of options backdating related securities class action lawsuits that I am maintaining here, that brings the count of options backdating related class actions to 32. I also added two options backdating related shareholders derivative suits to the list as well (iBasis and Citrix), bringing the tally of options backdating related shareholders’ derivative suits to 163. Thanks to Timothy Raub at LexisNexis for identifying the omissions.

Speaker’s Corner: The subprime mortgage litigation wave has captured the attention of quite a few observers, and it will undoubtedly lead to a number of legal issues as well as insurance coverage issues. On October 29-30, 2007 in Chicago, I will be co-Chairing, with Matt Jacobs of Jenner & Block, a Mealey’s conference entitled “Subprime Mortgage Litigation”, the agenda for which may be found here. The conference will feature a number of recognized experts, both in the field of mortgage lending and in the field of insurance coverage issues. Because of the growing importance of these issues, this conference will surely attract a great deal of interest and attention.

According to data form the Office of the Comptroller of the Currency (OCC), there was $10 trillion in outstanding mortgage debt at the end of 2006. Of this, subprime loans accounted for $1.4 trillion. Of that amount, about $1.08 trillion was packaged into securities that, according to the OCC, are not being held by banks, thrifts, credit unions or finance companies. Which means that $1.08 trillion in securitized subprime loan exposure is out there somewhere, on the balance sheets of hedge funds, mutual funds, insurance companies, investment banks, residential mortgage REITs, pension funds and God knows where else.

All of those mortgage-backed securities are being carried on their owners’ balance sheet at valuations based on some accounting convention. If current marketplace conditions persist, the relation between those balance sheet valuations and the actual realizable value of these assets could prove to be highly strained. For any company forced to sell those assets because of liquidity constraints (such as, for example, for a hedge fund or mutual fund, a heightened rate of redemptions), the amount realized could be far different than the current balance sheet valuation.

Even companies facing no immediate liquidation pressure face scrutiny, disclosure challenges, and potential turbulence in the financial marketplace. The sequence of events this past week involving Scottish Re Group illustrates just how volatile current circumstances are for any company holding material amounts of subprime mortgage-backed securities. In connection with its quarterly earnings release (here), Scottish Re provided information relating to its investment holdings in mortgage-backed securities. In supplemental disclosures (here) detailing its mortgage-backed securities investments, Scottish Re disclosed that within its $11 billion investment portfolio (amortized cost valuation), it holds subprime asset backed securities valued at $2.1 billion (about 19.1% of its investment assets) and another $1 billion (or 9.3% of investment assets) in Alt-A loans. (Alt-A loans are designed for borrowers with cleaner credit records, but with other issues that mean the borrowers provided fewer documents.)

In its quarterly earnings release, the company said that the market for these mortgage-backed securities has become “increasingly illiquid and unbalanced with an absence of buyers, causing prices to be well below what we and our third-party managers regard as their true fundamental value.” The financial market’s reaction to the disclosure of the company’s mortgage investment risk was sharp and harsh – the company’s share price dropped 28% in one day. (On Friday, the company’s share price did recover 9.45%.)

So – if there are $1.08 trillion in mortgage backed securities out there, there are numerous other entities whose balance sheets, like that of Scottish Re, carry a substantial mortgage investment risk. A senior official at one of the federal regulatory agencies told me that the process of trying to figure out where that risk is like a “very complicated game of ‘Where’s Waldo?‘.” There will be other companies making other disclosures like that of Scottish Re, but there will also be other companies who will quietly bump along, carrying the asset at the acquisition cost and counting on the marketplace for mortgage backed securities to reach some sort of equilibrium before the moment of truth. Either way, there is risk , but those companies that are not forthcoming or that soft-pedal the information face an unknown risk of greater hazards down the road.

These concerns are even more complex than may immediately meet the eye, as the balance sheet valuation issue is not limited to just asset-backed securities themselves. For example, insurance giant American International Group found itself providing extensive explanations (see the August 13. 2007 Wall Street Journal article here) of its exposure to certain kinds of insurance contracts called credit default swaps the company has issued to insure pools of collateralized debt obligations (CDOs) backed by mortgages. AIG apparently has written $465 billion in credit default swaps since 1998, about $64 billion of which is linked to multisector CDOs containing subprime debt. Accounting for these derivative instruments requires AIG to mark these instruments to market. The company says it has not changed the value of these instruments on their books since the first quarter of this year.

The problem for the holders of these securities and derivative investments is that in the final analysis the value of these instruments is linked to the performance of the underlying mortgages. Recent headlines have shown that default rates are rising, but the larger risk is that it will get worse. According to analysts at Bank of America Corp. (refer here), homeowners on about $515 billion in adjustable rate mortgages will pay more this year, and another $680 billion worth of mortgages will reset next year. More than 70 percent of the total was granted to subprime borrowers. As these mortgages reset, and some borrowers are unable to make the higher payments or refinance, the default rate will increase. The valuation of the instruments into which these mortgages are securitized will be affected accordingly.

The dilemma for any entity holding the subprime mortgage-backed or subprime mortgage-linked securities is not just that the current marketplace for these investments is illiquid and unbalanced; it is that the situation could well deteriorate further. This puts an enormous pressure on the balance sheets of any entity that has material exposure to these investments. It also creates an enormous disclosure dilemma — how much should (or must) a company say about the value at which these assets are carried given the uncertainty in the financial marketplace?

For analysts, investors, D&O insurance underwriters, and anyone else who must assess companies’ accounting and financial risk, all of these concerns create a serious problem. It is relatively easy in this environment to understand that mortgage lenders themselves are facing significant challenges. But the question of which other companies are exposed to mortgage investment risk is far more difficult to discern. The $1.08 trillion in subprime mortgage backed securities is distributed on many other balance sheets. Exposures to derivative investments like AIG’s credit default swaps are also spread around the credit and financial marketplace. All of these financial and credit exposures represent significant imbedded risk. More companies will be making disclosures about their exposure to this risk. But the companies that are not disclosing, or that are soft-pedaling the disclosure, may represent the biggest problem.

That is why the SEC, according to the August 10, 2007 Wall Street Journal (here), is “checking the books at top Wall Street brokerage firms and banks to make sure they aren’t hiding losses in the subprime-mortgage meltdown.” According to the Journal article, the SEC is looking at “whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory, as well as assets held for customers such as hedge funds.” While the large investment banks are definitely a good place to start, beyond the investment banks there is still a world of asset valuation risk that remains out there —unexamined, beyond scrutiny from outsiders, but fraught with malevolent potential.

And that is what is really troublesome about the subprime mortgage mess.

Because I hate to sound alarmist, and so as to close on a more reassuring note, I should add that on August 17, Fitch’s announced (here) that it had completed a review of the investment holdings of U.S. life insurers and concluded that the “direct exposure” to investments in mortgage backed securities is “relatively limited in the aggregate and largely concentrated in the high investment-grade securities with significant structural protection.” Of course, these securities are called “investment grade” based on the ratings they carry from the rating agencies….
UPDATE: In his August 20, 2007 column in Fortune magazine (here), Fortune columnist and PIMCO founder Bill Gross notes that “the bond and stock market problem is the same one puzzle player confront during a game of ‘Where’s Waldo’ — Waldo in this case being the bad loans and defaulting subprime paper of the U.S. mortgage market. While market analysts can estimate how many Waldos might actually show their faces over the next few years – $100 billion to $200 billion seems a reasonable estimate — no one really knows where they are hidden….Many institutions, including pension funds and insurance companies, argue that accounting rules allow them to mark subprime derivatives at cost. Default exposure, therefore, can hibernate for many months before its true value is revealed to investors….Proper disclosure is, in effect, the key to the current crisis….”
This all has a familiar ring to me. Great minds with but a single thought. Apparently Waldo is on a lot of people’s minds these days.
Another Subprime Related Securities Lawsuit: Shareholders have filed a purported securities class action lawsuit against IMPAC Mortgage Holdings and certain of its directors and officers (press release here). The complaint relates to “Impac’s representations concerning its Alt-A loans are alleged to be patently untrue, with the Alt-A loans actually being sold to less creditworthy borrowers, so that the loan portfolio was experiencing the same risks and discounts in securitization as sub-prime mortgages. At the same time, Impac overstated its financial results by failing to write down the value of its loan portfolio, thus falsely inflating the prices investors paid for Impac securities.”
With the addition of the IMPAC Mortgage lawsuit, the number of subprime mortgage-related securities class action lawsuits now stands at 11, according to the running tally of subprime related lawsuits I am maintaining here.

In an August 15, 2007 opinion (here), Delaware Chancery Court Chancellor William B. Chandler III reexamined his February 6, 2007 refusal to dismiss plaintiffs’ claim involving stock option springloading against directors and officers of Tyson Foods, Inc. In his earlier opinion (here), Chandler had held, in response to the defendants’ motion to dismiss, that the board’s authorization of springloaded options may, in certain circumstances, constitute a breach of a director’s fiduciary duties.

In his August 15 opinion, Chandler considered defendants’ motion for judgment on the pleadings, in which the defendants argued that the supposedly springloaded options were in fact authorized under the company’s shareholder approved stock option plan.

The defendants probably sensed that their motion’s prospects for success were dim when they read how Chandler characterized the circumstance that could be inferred from the consolidated complaint:

On three separate occasions between 2001 and 2003, defendants suspected that Tyson’s share price would climb once the market learned what the board already knew. Armed with this knowledge, members of the Compensation Committee granted non-qualified stock options to select Tyson employees, ensuring that these options would shortly be in the money. When the option grants were later revealed to shareholders, however, defendants did not straightforwardly describe such strike-price prestidigitation. Rather, they provided minimal assurances to investors that these options rested within the limits of the shareholder-approved plan. The crux of defendants’ argument is that a scheme that relies upon bare formalism concealed by a poverty of communication somehow sits within the scope of reasonable, good faith business judgment.

In analyzing the issues before him, Chandler first reviewed the legal standards governing directors’ conduct, which he summarized as follows:

Loyalty. Good faith. Independence. Candor. These are words pregnant with obligation. The Supreme Court did not adorn them with half-hearted adjectives. Directors should not take a seat at the board table prepared to offer only conditional loyalty, tolerable good faith, reasonable disinterest or formalistic candor. It is against these standards, and in this spirit, that the alleged actions of spring-loading or backdating should be judged.

The defendants argued that because the company’s Stock Incentive Plan allowed options to be granted at any price, the shareholders had authorized grants of the type at issue. The Company’s SEC disclosures revealed to investors only that the stated strike price on the options had to be the market price on the day of the grant. The SEC disclosures did not reveal the springloading, leading Chandler to observe that the disclosures “display an uncanny parsimony with the truth.” Chandler said that at the pleading stage, taking the inferences in the plaintiffs’ favor, the Court “may further infer that grants of spring-loaded stock options were both inherently unfair to shareholders and that the long-term nature of the deceit involved suggests a scheme inherently beyond the bounds of business judgment.” Chandler added that “where I may reasonably infer that a board of directors later concealed the true nature of a grant of a stock options, I may further conclude that those options were not granted consistent with a fiduciary’s duty of utmost loyalty.”

In summarizing the reasons for his denial of the defendant’s motion, Chandler stated that:

What the defendants here fail to confront is that their disclosures regarding the options under attack do nothing to rebut the pleading stage inference that the defendants intended to conceal a pattern of unfairly stocking up insiders’ larders with option grants shortly before the announcement of events likely to increase the Company’s stock price. In fact, the magnitude and timing of the grants, when accompanied with no disclosure of the reasons motivating the grants, is suggestive, at the pleading stage, of a purposeful subterfuge. Put simply, the pleadings support an inference not only that the defendants engaged in self-dealing, but that they attempted to hide their conduct from the stockholders.

While a variety of courts have now weighed in on the backdating issue, the Delaware courts’ statements on these issues remain the most important, because of the prominence and influence of Delaware law and the Delaware courts themselves. Chandler’s views of backdating and springloading in the Tyson Foods case and Ryan v. Gifford (here), the Maxim Integrated Products case, have not prevented other courts from dismissing other cases, and in fact Chancery Court Vice Chancellor Leo Strine distinguished Chandler’s prior opinions in granted the dismissal motion in the Sycamore Networks case (here). But Chandler’s refusal to dismiss the springloading allegations in the Tyson Foods case — essentially because the options related disclosures were inconsistent with the level of disclosures required by directors’ fiduciary duties — could have an important impact, precisely because of its insistence that the directors’ fiduciary duties require completely candid disclosures to shareholders about all the benefits from an options grant. Certainly his perception that the imbedded profit potential inherent within a springloaded option grant is a benefit of a kind that fiduciary duties require to be disclosed to shareholders will be an important point of view for future courts reviewing springloaded option grants.

The Delaware Corporate and Commercial Litigation Blog also has a post on Chandler’s recent opinion in the Tyson Foods case (here). Very special thanks to Francis Pileggi, who maintains the DCCL blog, for providing a copy of the opinion.

“Seven Ways Counsel Can Help Clients With D & O Claims”: In an August 16, 2007 post, here, I reviewed seven ways counsel can aid their clients in connection with D & O claims. Due to a snafu at my feed syndication service, no email went out to most of my subscribers about this post, so I just making sure that all readers are aware of the post.

During a panel discussion on the topic of “Advising a Public Company in Crisis” at the ABA Annual Meeting earlier this week, unexpected time constraints forced me to dramatically abbreviate my planned remarks. On the fly, I fashioned what turned into a list of seven pointers for outside counsel who are assisting their clients in connection with the clients’ D&O claims. Perhaps proving once again that necessity is a mother, the points I conjured up on the spot actually withstand more leisurely scrutiny. Because I believe that these rules of thumb if followed could materially enhance most interactions with insurers on policyholders’ behalf, I reproduce the list of seven items here, with some additional commentary.

1. Keep the carrier informed: When a company is in crisis, communicating with the D & O carrier may seem low priority. But if the company has any expectation or hope of tapping into the D&O policy, there is a substantial detriment in treating the insurance as an afterthought. Complete and contemporaneous communications with the carrier is the single most important way to improve relations with the carrier, and will go a long way toward avoiding many of the problems that sometimes undermine efficient claims resolution.

2. Provide timely, detailed fee statements, separated by matter: Many of the messiest problems that arise in D & O claims involve defense fees, and far too many of these problems arise because billing statements are delayed, incomplete or unedited, or combine a host of legal matters all thrown together. Counsel should consider the legal bills as if they were collectively a brief presented to make the case for payment, and take the same care they would with any other brief. Moreover, counsel should anticipate that the carrier will read the bills very carefully, and in particular prepare and edit the bills with an eye toward the carrier’s likely response to the bills.

3. Threats don’t work: Experienced claims representatives have dealt with many lawyers, have had to face many disputes, have been called many names, have had their depositions taken, and have been accused of bad faith and worse. They have heard it all before, many times. They are inured to the threats, because they have to be to get their job done. But while they can disregard the threats because they must, they prefer to deal with people who have the self-confidence and professionalism to conduct business without resorting to threats. A professional tone is a much more effective approach that a warlike tirade. This of course does not mean backing down if the carrier takes an unreasonable position. The best response if that happens it not to make threats, but to provide reasons. Indeed, I believe it is possible to retain professionalism even if you have to sue the carrier. In the long haul, establishing a professional relationship with the carrier’s claim representative is far more likely to advance your client’s interests and will prove to be an asset if you must deal with the same representative again on a future claim.

4. If the carrier has questions, answer them: This point is really an extension of the prior point about maintaining professional relations. If the carrier feels it needs more information to process the claim, you are not advancing your client’s interests by treating the questions as an unthinkable impertinence. If for some reason it would be difficult or prohibitively expensive to answer the questions, pick up the telephone and try to find out what the carrier really needs and whether there might be a less burdensome or costly way to provide the information. Providing answers helps to remove barriers and expedite the process. Resisting questions and reviling the questioner can only cause problems.

5. Enlist the broker’s assistance: This one is particularly hard for some lawyers, as they presume that they bring everything to the table that is required to get claims resolved. The reality is that broker may have relationships that can help overcome barriers, and the broker may be able to play an important go-between role that can help smooth the path toward claims resolution. A skilled broker can help move the claims process toward the end game. It has been my privilege to be involved in the resolution of quite a number of D&O claims over the years. (As an aside, if your client’s broker is unable to play this role, there may be a serious issue with your client’s choice of broker.)

6. Help set expectations: As hard as it may be to accept, it is sometimes the case that there are defense fees or other costs that may not be covered under the policy. It is counterproductive to continue to agitate for the carrier to pay these items, and the more sharply the focus is kept on the items for which reimbursement appropriately is being sought, the more quickly the process can move toward the end game. Counsel can help here by helping to set the client’s expectations at a realistic level. False hope and unrealistic expectations only delay resolution and encourage unnecessary or even counterproductive disputes.

7. When difficulties emerge, try to resolve them in face-to-face meetings: Lawyers are excellent letter writers, but a letter-writing campaign has limited utility and is unlikely to get to the ultimate end game. In many instances, a face-to-face meeting for the purpose of trying to find a business resolution to disputed issues can get the claims process on a more productive track. Even a phone call is usually preferable to yet another letter.

Obviously, every circumstance is different, and there will be those situations to which these pointers are simply inapplicable. I have been involved in some unfortunate claims over the years where no amount of talking could eliminate the barriers to claims resolution. But in general, the pointers above if followed will in most circumstances substantially enhance the efficiency of the claims process and help avoid the kinds of problems that all too often undermine smooth claims resolution.

Hedge Fund Reassurance in an Uncertain Market: In an August 16 column on Bloomberg.com entitled “Hedge Fund Guy Atones for His Subprime Bond Sins” (here), Mark Gilbert takes a humorous look at what a current update from the fictitious hedge fund “Short-Term Capital Mismanagement LLP” might look like in light of the deterioration in the market for mortgage-backed securities. After reviewing the hedge fund’s “proprietary investing tool” (sometimes called “a dartboard”) and the “unique hexagonal cuboid models” used to select individual securities, the update reports that investment decisions of other funds using identical dice have resulted in “crowded trade.”

After describing the efforts the fund has taken to verify the prices of the securities held in the fund, the update letter also reports:

We have, of course, been in touch with the rating companies to update our default-probability scenarios, particularly on the AAA rated investments we own. They recommended a forecasting method using stochastics to regress the drift-to-downgrade timescales for the past 100 years and throw them forward for the next five minutes. The technical term for this is “induction,” though those of you of a less quantitative bent may know it as “guessing.”

We are pleased to report that, contrary to what current market prices might suggest, all of our top-rated securities remain absolutely AAA. Provided, that is, the future performance of the underlying collateral is identical to its history. Otherwise, the rating companies say our investments are likely to be reclassified as “toast.”

We have also been checking our back-up credit lines with our friends in the investment-banking world. As soon as they return our calls, we’ll be able to update you on our emergency liquidity position. We are sure they are fine.

Some of you have written to us asking for your money back, citing clauses in the fund documentation called redemption rights….We have filed your letters in a special drawer in the filing cabinet marked “trash” for now. Do you have any idea how much trouble you all would be in if we actually sold this stuff in the market today? At these crazy prices? Fuhgeddaboudit. You’ll thank us later.

Special thanks to a loyal reader for the link to the Gilbert column.

At about this time last year, it sometimes seemed to me as if all I was writing about on this blog was the options backdating scandal, but that was because there were backdating-related issues emerging on virtually a daily basis. Now it is beginning to feel as if all I am writing about is the subprime lending mess, but if that is so it is because it is an issue that is dominating the headlines, the financial markets, the credit markets, and, predictably, the litigation docket.

Of perhaps greatest interest to readers of this blog, the wave of litigation growing out of the subprime lending related mess continues to grow. Yesterday, plaintiffs’ lawyers initiated a purported securities class action lawsuit (press release here) against Countrywide Financial Corp., the number one mortgage originator in the country. This lawsuit preceded by one day the drubbing that Countrywide’s stock took today, when a Merrill Lynch analyst’s downgrade (and speculation that Countrywide could face bankruptcy risk as liquidity worsens) triggered a 13% decline in the Countrywide’s share price.

Then today, the Lerach Coughlin firm filed a securities class action lawsuit (press release here) against Radian Group, a credit enhancement company that provides credit protection products (such as mortgage guaranty insurance) and financial services to mortgage lenders and other financial institutions. The lawsuit relates to circumstances arising from Radian’s affiliate, Credit Based Servicing & Asset Securitization (C-Bass), an investor in the credit risk of subprime residential mortgages. Radian, which is a joint venturer in the affiliate with MGIC, recently announced that the value of its investment in C-Bass is “materially impaired.” According to the Wall Street Journal (here) “disruptions in the market for risky mortgages might wipe out the value of C-Bass, which was valued at more than $1 billion just five weeks ago.” The turbulence surrounding the C-Bass affiliate may also have undermined a pending merger beteween Radian and MGIC (refer here).

In addition to the Countrywide and Radian lawsuits, plaintiffs’ lawyers also filed a purported class action lawsuit (here) against IndyMac Bancorp. Special thanks to a loyal reader who prefers anonymity for drawing my attention to the IndyMac case, and to Adam Savett of the Securities Litigation Watch blog (here) for providing a link to the IndyMac complaint.

The addition of these three lawsuits brings the total number of subprime lending-related securities class action lawsuits to 10, according to the running tally of subprime lending-related lawsuits I am maintaining here. In an earlier post (here), I described the flood of new subprime lending related lawsuits as a “wave” which I also said is growing. The influx of new lawsuits certainly reinforces the view that we face a growing wave of subprime related lawsuits.

Will the Gatekeepers Get Blamed?: One of the things that happened after the options backdating scandal first emerged is that momentum quickly developed to try to hold the corporate gatekeepers responsible for permitting the backdating to happen (for example, see my prior posts on this topic, here and here). It remains to be seen whether or not this same dynamic will emerge in connection with the subprime lending mess, but the questions are clearly already being asked.

For example, an interesting August 15, 2007 column by Jonathan Weil on Bloomberg.com (here) examines questions surrounding the possible responsibility of subprime lenders’ auditors. Weil points out that a number of the auditors quite recently gave some of the now-failed subprime lenders clean audit-opinion letters. He cites the example of American Home Mortgage Corporation, whose auditors (Deloitte & Touche) gave the company a clean opinion in March, five months before the company’s August 6 bankruptcy filing. He notes the auditors’ dilemma, which is that a going concern letter would have represented a default to the company’s own lenders, and so the issuance of a going concern audit letter would almost certainly represent a self-fulfilling prophecy. On the other hand, a going concern letter “would have spared investors from the company’s April 30 public offering of 4 million shares at $23.75 each, the prospectus for which incorporated Deloitte’s audit opinion.”

Weil also cites as an example of this same issue HomeBanc Corp., which filed an August 9 bankruptcy petition “still sporting a clean opinion from Ernst & Young.” (By contrast, Weil notes, KPMG issued a going-concern letter on New Century Financial Corp. a month before the company’s Chapter 11 filing.)

It may not yet be blame the gatekeeper time, but I think it is probable that we will get there sooner or later — most likely sooner rather than later.

Lax Underwriting or Fraud?: One recurrent theme surrounding the subprime lending mess is wheter the lenders lax underwriting standards are to blame for the whole situation. But an article in the August 20 issue of Business Week entitled “Did Big Lenders Cross the Line?” (here) asks the question whether at least some of the lending went beyond lax underwriting all the way to fraud.

The article cites several recent lawsuits in which borrowers have sued lending institutions alleging that the lenders, eager to “keep up loan volume and generate sales,” falsified documents by beefing up the borrower’s income and “lowballing” the borrower’s outstanding debt. In another instance cited in the article, a lender is alleged to have “created false tax returns, employment records and a 401(k) to make it appear that the loan was affordable.” The article also states that in “some cases lender fraud appears to have involved forged signatures and other deceptive practices.”

As in-force adjustable rate mortgages reset at higher interest rates, borrowers face increasing pressure to escape the financial consequences. It is hardly surprising that borrowers are alleging entrapment or worse to try to evade the loan’s requirements. A cynic might well ask exactly where the fraud might be found to lie on some of the loan transactions. That said, the recent allegations do raise serious concerns about certain practices that may have developed as the residential real estate frenzy built. The one thing that is for certain is that all of these concerns are further grist for the subprime lending related litigation wave.

“And the Jaguar is Black, Dammit! Can’t You Bastards Get Anything Right?”: Some readers may recall that Jonathan Weil (author of the Bloomberg piece cited above), a former Wall Street Journal reporter widely credited with breaking the Enron story while at the Journal, earlier this year rather publicly resigned from his position as research director of Glass Lewis proxy advisory firm (refer to news coverage of his resignation here). His widely quoted letter of resignation said, among other things, “I am uncomfortable with and deeply disturbed by the conduct, background and activities of Glass Lewis’s new parent, Xinhua Finance Ltd., its senior management, and its directors.” Apparently after his resignation, Weil landed at Bloomberg.

The Journal recently ran a fascinating biographical study (here) of Xinhua’s Chief Executive Officer, Loretta “Fredy” Bush. The Journal subsequently ran what is my all-time favorite “correction” item, about the Fredy Bush article: “American businesswoman Loretta Fredy Bush’s ranch property in Hawaii totals 1,172 acres, and she is chauffeured around Shanghai in a black Jaguar. The article incorrectly said that the ranch is 230 acres and that her Jaguar is blue.”

The Kobi Watch: The recent news of the options backdating-related criminal conviction of Gregory Reyes, the former CEO of Brocade Communications, made me wonder what was happening with another former CEO caught up in the backdating brouhaha. When we last checked in on Kobi Alexander (prior post here) the fugitive former head of Comverse Technology had sucessfully postponed the hearing on his possible extradition from Namibia to the U.S., where he would have to face backdating related criminal charges (about which refer here). According to the August 7, 2007 issue of The Namibian (here), Alexander was in front of the Namibian High Court in Windhoek on August 6, successfully arguing to lift travel restrictions imposed as part of his bail conditions.

The hearing, at which Alexander was represented by two attorneys at least one of who was from Cape Town, reportedly lasted an entire day. Alexander informed the court that he was investing millions of Namibian dollars (one Namibian dollar = .14 U.S. dollar, refer here) in housing development projects in Walvis Bay (pictured above), and he needed to travel to the project for site inspections. The prosecutorial authorities opposed the application for fear that the risk of Alexander absconding would be increased were he to travel to the seacoast. The obvious response is – where else would he go? He would almost certainly find himself in a place where the U.S. would stand a better chance of extraditing him. In any event, the Court granted his request to alter the travel restrictions in his bond conditions, allowing him to travel from Windhoek within Namibia as long as he gave authorities 24 hours notice.

I expect by now Alexander is well informed about the Reyes conviction. I am also guessing he is not leaving Namibia except under extreme duress. I mean, what could be bad about a place where a bail condition alteration hearing can consume an entire day?

Hat tip to the White Collar Crime Prof blog (here) for the link to The Namibian. (I confess that I do not read that particular newspaper on a regular basis myself.)

The Real Spamalot: In March 2007, the SEC suspended trading in 35 companies that have been the subject of repeated spam email campaigns, as part of an SEC effort dubbed “Operation Spamalot.” In announcing the suspension (here), the SEC noted that up to 100 million stock pumping spam email messages were sent each week. But all of that is nothing compared to the spam onslaught described in an August 8, 2007 article in the Toronto Globe and Mail entitled “Inbox Hell: Half-a-Billion Stock Spam E-Mails”(here). According to the article “obscure little”Prime Time Group, Inc., a convenience store company based in Branson, Missouri that trades on the Pink Sheets, was the subject of what one expert cited in the article described as “the most widespread Internet email stock pumping scam in history.”

According to the article, during the preceding two days, more than a half a billion emails were sent touting the company’s stock. According to the same expert, the spam message “created a 30 percent surge in global traffic over a 24-hour period.” The scheme seems to be having its intended effect. The company’s share price, which was as low as five cents as recently as last Friday, closed at 10 cents today. Not many stocks double in four trading days.

Of course, there is no apparent reason to suspect that anyone at the company had anything to do with the email scam. But how would you feel about writing their D & O?

Outside Directors Outside the Target Area?: On July 17, 2007, the Department of Justice Corporate Fraud Task Force issued a press release (here) reporting on the various convictions the Task Force has recorded during its five-year existence. Lisa Fairfax, a professor at Maryland Law School, has an interesting observation on the Conglomerate blog (here) about the Task Force’s conviction statistics. She notes that while the Task Force has obtained numerous convictions of CEOs, CFOs, and other corporate officials, “the one group of actors who did not appear on the list was outside directors.” She notes that

while there appear to have been plenty of inside directors, including board chairs, who have been convicted of various white collar offenses within the last five years, there do not appear to be many, if any, instances in which directors who were not employed by a corporation were convicted of corporate fraud

She does comment that at one level “the exclusion of outside directors makes sense” because “it seems unlikely that outside directors, who have more of an oversight role in the corporation, would have the kind of knowledge or intent necessary to be subjected to criminal liability.”

Professor Fairfax did observe in a later post (here) that while outside directors seem to have escaped criminal prosecution, outside directors of companies that are sued do appear to experience “reputational damage” and are invited to serve on fewer boards, according to research she cites.

The professor’s observations about the apparent unlikelihood of outside directors facing criminal prosecution is, as she noted in her initial post, consistent with the research of Stanford Law Professor Michael Klausner and others (here) documenting the relative unlikelihood of outside directors facing direct personal civil liability. Of course, there is the recent example of the Just for Feet outside directors (discussed in a prior post here), who entered into a $41.5 million civil settlement in response to a bankruptcy trustee’s breach of fiduciary duty claims. Call the Just for Feet settlement a Black Swan if you like, but for my money, if a company wants me as an outside director, the company better have D&O insurance. Come to think of it, make mine a double, thank you very much.

Another Subprime Lending Lawsuit: With the addition of the securities class action lawsuit recently filed against Luminent Mortgage Capital (press release here), the current tally of subprime mortgage related securities lawsuits now stands at seven (in addition to the two home construction companies that have also been sued), as detailed on the counting webpage I am maintaining here.

Luminent was only one of several residential mortgage REITs mentioned in the Wall Street Journal’s August 8, 2007 article entitled “Mortagage REITs Feel Squeeze” (here).

As average D&O claims severity has increased and accompanying defense expense has escalated in recent years (about which refer here), excess D&O insurance has become an increasingly critical part of D&O claims resolution. Perhaps because of the increasing claims involvement of excess D&O insurance, it seems as if the number of D&O coverage disputes involving excess insurers is growing. Two recent court decisions – one in Michigan federal court involving Comerica Incorporated and one in the Supreme Judicial Court of Massachusetts involving Allmerica Financial Corporation – illustrate the kinds of excess insurance coverage disputes that are arising, and also underscore the problems these disputes create.

Allmerica: In an August 6, 2007 opinion (here) written by Justice Robert Cordy, the Massachusetts Supreme Judicial Court addressed an "issue of first impression in Massachusetts," the question "whether a ‘follow form’ insurer is bound by the decision of a primary insurer to settle a claim." The coverage dispute arose out of an underlying class action lawsuit alleging improper practices in the sale of life insurance. The underlying case ultimately settled. The total value of the underlying settlement plus litigation expense was $39.4 million.

Allmerica’s primary liability insurance policy’s limit of liability was $20 million, over a $2.5 million self-insured retention. Allmerica’s liability insurance program also included an additional $10 million layer of "follow form" excess insurance over the primary policy. The excess policy’s follow form language provided that "this Policy is subject to the same conditions, limitations and other terms…as are contained in or may be added to the Polic(ies) of the Primary Insurer(s)."

Following the class action settlement, Allmerica and its primary insurer reached an agreement in which the primary insurer agreed to pay its full $20 million policy limits. However, Allmerica’s excess liability insurer "generally disclaimed coverage for any loss encompassed by the settlement," in reliance upon certain policy exclusions. Allmerica filed a declaratory judgment action against the excess insurer in Massachusetts state court.

On consideration of cross-motions for summary judgment, the trial court ruled that the excess carrier was not bound by the primary carrier’s actual or implied coverage determination, and also ruled that certain exclusions and coverage defenses precluded coverage under the excess policy. The trial court judge granted summary judgment in favor of the excess insurer, and Allmerica appealed. (For procedural reasons not entirely clear from the opinion, Allmerica’s appeal wound up before the Supreme Judicial Court rather than the intermediate appellate court).

The appeals court agreed with the trial court’s ruling that the "follow form" excess insurer was not bound by the primary carrier’s decision to provide coverage, but the appeals court also found that disputed issues of material fact remained with respect to the excess insurer’s coverage defenses, and so remanded the case back to the trial court for further proceedings.

In ruling that the excess carrier was not bound by the primary carrier’s coverage determination, notwithstanding the excess policy’s "follow form" language, the appeals court emphasized that the two policies are "separate and distinct contracts," in which each insurer had agreed "individually to cover a particular portion of risk." The follow form language "allows an insured to have coverage for the same set of potential losses" but the follow form language "does not…bind the various insurers to a form of joint liability." The "layer of risk" each insurer covers is "defined and distinct." The appeals court specifically noted that "primary and excess insurers act independently of each other with respect to decisions about their policies including coverage determinations and settlements."

With respect to the excess carrier’s "follow form" language, the appeals court also said:

An excess carrier’s intent to incorporate the same words used in a separate agreement between the primary insurer and the insured does not imply an intent by the excess carrier to accept decisions made by the primary carrier about the extent of obligations under its own agreement. By adopting the form of words used by [the primary carrier], [the excess carrier] did not also cede to it the right to make decisions about the [excess carrier’s] obligation to perform in certain circumstances. To conclude otherwise would undermine the distinct and separate nature of each insurer’s contract with Allmerica.

Comerica: The July 27, 2007 opinion (here) by Eastern District of Michigan Judge David Lawson in the coverage dispute between Comerica and its excess D&O insurer addresses the issue of the enforceability of an excess insurance policy when a compromise between the policyholder and the primary insurer creates a "coverage gap" that is funded by the policyholder.

The dispute arose out of securities class action lawsuits (about which refer here and here) that were filed against Comerica and certain of its directors and officers. The class actions ultimately settled following mediation for $21 million.

Comerica’s primary D&O insurance policy had a $20 million limit of liability, and Comerica also had an additional "follow form" $10 million policy excess of the primary coverage. (Comerica had additional excess coverage beyond that, but the additional coverage is nor relevant here.) By its terms, the excess policy recognized "depletion" or "exhaustion" of the underlying policy "solely as a result of payment" under the underlying policy. The excess policy also specifically noted that it did not provide coverage for any loss that is covered under the underlying policy but that is not paid by the underlying insurance.

Both before and after the underlying settlement, the primary carrier disputed coverage. The primary insurer contended that Comerica had violated the policy’s cooperation and consent requirements. The primary insurer also contended that $6 million of the settlement had been paid in resolution of claims under Section 11 and Section 12 of the ’33 Act and was restitutionary in nature and therefore not covered under the primary policy. The primary insurer also contended that Comerica had made misrepresentations in the application process. Comerica and the primary insurer ultimately resolved their coverage dispute, with the primary insurer agreeing to pay $14 million toward the $21 million underlying settlement.

Comerica then demanded that the excess insurer pay $1 million toward the underlying settlement plus $2.1 million in defense costs. The excess carrier refused to pay on the grounds that the primary policy had not been exhausted and that Section 11 damages are not covered. Comerica filed a declaratory judgment action against the excess carrier.

In his July 27 opinion addressing the declaratory judgment action parties’ cross-motions for summary judgment, Judge Lawson, applying Michigan law, ruled in favor of the excess insurer and granted the excess carrier’s summary judgment motion.

Comerica had made three arguments: first, that the excess carrier had repudiated its policy by its coverage position; second, that allowing the excess insurer to disclaim coverage would violate public policy, and third, that the excess carrier’s policy was ambiguous. Judge Lawson rejected all three of these arguments.

Comerica’s repudiation argument was based on the excess carrier’s contention that Section 11 damages are not covered. Essentially, Comerica contended that this coverage position represented an "anticipatory repudiation" by the excess carrier of its intent to perform under its insurance contract, giving Comerica the right to sue for breach. Judge Lawson found however that the excess carrier’s position was not an unequivocal declaration of intent not to perform, but was merely a statement that "Comerica had not yet fulfilled the condition precedent on the excess policy" – that is, exhaustion of the underlying policy. Judge Lawson concluded that Comerica had not shown that the excess carrier had repudiated the policy.

Comerica’s public policy argument was based on the contention that Comerica’s own payment of the $6 million "gap" between the $14 million compromise with the primary carrier and the $20 million excee policy attachment point was the "functional equivalent of exhausting the primary policy." Comerica argued that to require exhaustion of the underlying policy, triggering payment obligations under the excess policy, would violate public policy by causing delay, promoting litigation, and preventing dispute adjustment. Judge Lawson found that the cases on which Comerica relied generally involved only excess policies with ambiguous definitions of "exhaustion." Judge Lawson found that Comerica’s excess policy unambiguously "requires that the primary insurance be exhausted or depleted by the actual payment of losses by the underlying insurer. Payments by the insured to fill the gap …are not the same as actual payment."

Judge Lawson added that Comerica could have sued the primary carrier and tried to establish that the primary carrier was obligated to pay its entire $20 million limit, but instead Comerica compromised for a $14 million payment, about which Judge Lawson noted:

Comerica seeks the certainty that its settlement [with the primary insurer] brought and the benefit of coverage from its excess carrier as if it had won its dispute with the primary insurer, despite language in the excess policy to the contrary. No public policy argument says that Comerica may have its cake and eat it too.

Comerica’s argument that the excess policy’s exhaustion language is ambiguous was based on the contention that other policy provisions allow the insured to fund gaps with its own payment (for example, if the underlying policy lapses). Judge Lawson found that the fact that the policy provided elsewhere for policyholder gap funding but that the exhaustion provision did not suggests that the omission of policyholder gap funding in the exhaustion provision was deliberate. Judge Lawson said that to find the excess policy to be ambiguous "would require a holding that parties simply cannot contract for an excess policy to be triggered only upon full, actual payment by the underlying insurer." He noted that Comerica could have, but did not, bargain for an excess policy that would pay for any liabilities over $20 million, even if the underlying insurer did not pay the entire $20 million – "the present agreement does not say that, and it cannot be rewritten now."

The most prominent parallel between these two cases (other than the odd similarity of the two companies’ rather awkward names) is that in both cases the excess carriers substantially prevailed and the companies’ arguments were largely rejected. An apologist for the carriers would contend that the carriers prevailed because their positions were meritorious, and there undoubtedly is some truth to that. My concern is that these two insurer-friendly decisions could embolden other excess carriers to resist coverage in other cases, even where their positions are not as meritorious.

It is of course true, as the Massachusetts court noted, that the primary policy and the excess policy are separate contracts of insurance and each carrier has the right to make its own separate coverage determination. The problem I see is that disputes with excess carriers are becoming all too frequent and are threatening to become a virtually standard part of the D&O claims process.

The reason an insurance buyer acquires "follow form" excess insurance is, as the Massachusetts court noted, because it wants "to have coverage for the same set of potential losses." If the different carriers in an insurance program with "follow form" excess coverage are effectively not going to cover the same losses in the same way, the intent of the insurance acquisition process is frustrated. The insurance buyer certainly does not expect to have to fight its way through each successive layer in the program. The prospect of compulsory separate fights with separate carriers not only threatens undesirable burden and vexation for the policyholder, it hazards the deeper threat that one of the disputes with one of the carriers will result a coverage "gap" of the kind that defeated Comerica’s excess coverage.

Clearly these kinds of concerns need to inform the D&O insurance acquisition process. Both the Allmerica and the Comerica courts expressly noted that they reached their decisions in reliance upon policy language and absent other language to the contrary – the inference is that different excess policy language could have produced a different result. One particularly important area of concern, as demonstrated in the Comerica case, is the excess policy’s exhaustion language. There clearly is a need for more flexible language, to reduce restrictions surrounding the kinds of payments of loss that could trigger the excess carrier’s payment obligation. The need for these issues to be addressed in the insurance acquisition process is yet another reminder of the need for the involvement of skilled insurance professionals in the acquisition process.

The possibility of addressing, in the language of the excess policy, the problem that Allmerica faced with its excess carrier is more problematic, because few excess carriers likely would be willing to cede to another carrier their right or ability to make their own separate coverage determination. But the recent ramp up in coverage disputes in which excess carriers are taking coverage positions not asserted by the primary carrier is a problem for policyholders and for the D&O industry as a whole. I do not mean to suggest in any way that the excess carriers in the Allmerica or Comerica cases did anything improper. There are, however, serial coverage deniers out there; as an industry we ought to do a better job keeping score. When it threatens to become routine for excess carriers to take positions that primary carriers do not, the industry has a problem it needs to address, whether through modification of the policy language or through the development of serial denier league tables. Given the increasing importance of excess insurance in D&O claims resolution noted above, these issues are likelier to become increasingly more critical.

I suspect that my friends in the D&O underwriting community might have a lot to say about my observations here — I can almost hear the sputtering and indignation while I type this. I hope that any underwriters out there who are particularly exercised by my remarks will take the time to post a comment. I am very interested in hearing others’ thoughts on this topic.

The Comerica court did not reach the merits of the issue of the insurability of the settlement of Section 11 liability. This issue was however addressed in the recent CNL Hotels case, about which I previously wrote here. As I noted in my prior post, the need for D&O policies to expressly address the question of Section 11 settlements is another issue with which the industry needs to grapple.

An August 7, 2007 Business Insurance article discussing the Allmerica decision can be found here. An August 7, 2007 Insurance Journal article can be found here.

Thanks to a loyal reader who prefers anonymity for alerting me to the Allmerica opinion. Thanks to Dan Standish of the Wiley Rein law firm for alerting me to the Comerica decision, and to Adam Savett of the Securities Litigation Watch blog for providing a link to the Comerica decision. I should probably emphasize that while these fine gentlemen provided me with copies of the cases, the views about the cases in this post are solely my own. I suspect that one or more of these guys would want to distance themselves from my analysis, big time. Don’t blame them, OK?


The wave of subprime lending related lawsuits (which I am tracking here) continues to grow. On July 31, 2007, the Lerach Coughlin law firm sued beleaguered home lender American Home Mortgage Investment Corp. (press release here) in a securities class action lawsuit. The suit alleges that American Home is a REIT that engages in investment and origination of residential mortgage loans. The company (prior to its bankruptcy filing, about which refer here), originated residential home mortgages and sold mortgage loans to institutional investors. The complaint alleges that the Company failed to disclose increasing delinquency levels and difficulties in selling loans it originated, and overstated its financial results, in part by failing to write down the value of the troubled loans.

The prospective amplitude of the subprime lending litigation wave really lies in the potential for follow-on litigation, as the consequences from the subprime lending mess spread beyond mortgage lenders to other companies that did business with them. An example of the possibilities of this kind of litigation may be seen from the securities lawsuit filed on August 1, 2007 (refer here) against RAIT Financial Trust. RAIT is also a REIT that, among other things, provided debt financing options to the real estate industry. According to the plaintiffs’ lawyers’ press release, the complaint alleges that RAIT failed to disclose its “financial relationship” to American Home, a relationship that allegedly could involve a net exposure for RAIT of $95 million, an exposure for which RAIT allegedly failed to establish appropriate reserves. Upon RAIT’s July 31 announcement (here) that it did not receive its July 31 scheduled preferred securities payment from American Home, RAIT’s share price allegedly declined from approximately $16/share to approximately $10/share.

According to the running tally that I have been maintaining (here), the addition of these two new lawsuits brings the number of securities class action lawsuits against subprime lenders and related companies to six, in addition to the two securities class action lawsuits that have been brought against home builders. Although I have not been tracking the cases, there have also been a number of subprime lending related shareholder derivative lawsuits, in addition to the securities class action lawsuits; for example, on August 3, 2007, officers and directors of Countrywide Financial Corp. were sued in California state court (no link available) on grounds that the defendants breached their fiduciary duties by misleading investors about the company’s loan delinquency rate and preparedness for a downturn, while selling their personal holdings in company stock.

The suddenness of the spread of American Home’s misfortune, and the speed with which litigation followed not just against American Home itself but also against a company with which it had an investment relationship, shows the contagion potential of the subprime lending mess. Even though some savants have been proclaiming a permanent reduction in the level of securities class action lawsuits (refer here), it is the potential for exactly this kind of contagion dynamic that has led me to be skeptical that recent low securities litigation levels will prove to be permanent. I have long believed that the lower levels of securities class action activity were due in part to relatively benign economic and market conditions. Conditions have, however, changed. The strong possibility that other companies (not just subprime lenders) will suffer ill effects from the subprime mess and from restricted credit availability generally suggests that the contagion will continue spread, and as it does, other companies will find themselves the target of an increasingly broad wave of litigation activity. (An earlier post discussing the potential of the subprime lending litigation wave may be found here.)

Bull (Litigation) Market for Bear (Stearns): The potential reach of the subprime litigation wave may also be seen in the claim an individual investor filed last week against Bear Stearns Cos. and Bear Stearns Asset Management, alleging that the firms were misleading investors about their exposure to subprime mortgages. (A Washington Post article describing the claim can be found here.) The claim, which was filed with NASD (which is now part of FINRA), follows the collapse of two Bear Stearns hedge funds that invested in subprime mortgages and related instruments. The plaintiffs’ lawyer who filed the claim, Jacob Zamansky of Zamansky & Associates, is quoted as saying that he has been contacted by numerous investors and that “we expect to file claims in excess of $100 million in losses.”

According to the Courthouse News Service (here), Bear Stearns and several of its directors and officers have also been sued in a shareholders derivative suit in New York state court (link unavailable) on similar grounds.


Self-Reporting: I’m Chiquita Banana and I’ve Come to Say, One of Our Subsidiaries (Allegedly) Has Been Paying Off Terrorists in a Certain Way: In earlier posts (most recently here), I have discussed the increasing pressure on publicly traded companies to self-report regulatory violations, particularly violations involving improper foreign payments. An August 2, 2007 Wall Street Journal article (here) discusses circumstances involving Chiquita Brands International and the company’s problems following its self-reporting of payments that one of its subsidiaries allegedly made to a Columbian terrorist group.

According to the Journal, the current investigation “illustrates the recent posture taken by the U.S. authorities to prosecute aggressively even when companies turn themselves in for breaking the law.” The government’s aggressive posture may cause some companies, according to the Journal article, to think twice about self-reporting.

A very interesting commentary on the Chiquita Brands story appears on the Race to the Bottom blog (here). According to the blog’s August 6, 2007 post, Chiquita’s case is not “the usual case of a company discovering improper behavior, putting a stop to it, and self-reporting to the government.” Rather, the blog asserts, “this is a case that involves a fundamental breakdown in the system of corporate governance.” In particular, the blog notes (and details) that the existence of the payments “was apparently widely known among top management and allowed to continue.”

I should add that the Race to the Bottom blog, which is a joint effort of students and two professors from the University of Denver Law School, is an interesting and often provocative resource on corporate governance issues. I read it regularly and commend it to the attention of readers of The D & O Diary.

Speaker’s Corner: On August 13, 2007, I will be speaking at the 2007 American Bar Association Annual Meeting in San Francisco (about which refer here), at the ABA Section of Business Law session entitled “Representing the Public Company in Crisis: Current Developments in Securities Litigation and Government Investigations.” The session, which will be moderated by my friend Bill Baker of the Latham & Watkins law firm, and which will include Marc Fagel, who runs the enforcement program in the SEC’s San Francisco Office, and Barry Sabin, the Deputy Assistant Attorney General for the Criminal Division, will be held in the Fairmount Hotel Grand Ballroom from 10:30 am to 12: 30 pm. If you are planning on attending the ABA Annual Meeting, I hope you will attend our session and if you do I hope you will greet me and introduce yourself.

Bananas Have to Ripen in a Certain Way: For those readers too young to recall the iconic Chiquita Banana commercial alluded to above, here it is, for nostalgia’s (if not for art’s) sake. The commercial certainly has lots of useful banana-related advice, but it does neglect to mention the utility of avoiding making protection payments to terrorist organizations.