In the latest in the series of significant opt-out settlements, two different state pension funds have announced settlements with Qwest in their separate securities actions against the company. In both instances, the funds announced that their separate settlements far exceeded the amounts that they would have recovered in Qwest’s $400 million class action settlement (refer here regarding the class action and its settlement) and it now appears that the aggregate amount Qwest has agreed to pay opt-out claimants exceeds the amount it agreed to pay the class.

In a November 21, 2007 press release (here), the Colorado Public Employees’ Retirement Association (PERA) announced a $15.5 million settlement of its separate action against Qwest. And in a November 21, 2007 announcement (here), the Alaska Permanent Fund Corporation (APFC) announced that the Alaska Department of Law had reached a $19 million settlement (net of fees and costs) on behalf of APFC, which will receive $13 million from the settlement, and on behalf of the Alaska State Department of Revenue and the Alaska Retirement Management Board, which together will split the remaining $6 million. Press article describing the Colorado settlement can be found here and regarding the Alaska settlement can be found here.

There are several significant features of these opt-out settlements. The first is what the settling funds themselves said about how they fared by proceeding separately rather than participating in the class settlement. Colorado PERA (which is Colorado’s largest pension fund and the 25th largest public pension fund in the country) said that its recovery in the class settlement would only have been $400,000, or less than one cent on the dollar of the fund’s investment losses, meaning the fund increased its recovery more than 38 times by pursuing a separate action.

The AFPC for its part said that the state’s combined recovery in the class settlement would only have been $422,000, on combined investment losses of approximately $89 million. While the state recovered only a quarter of its investment losses through its separate action, it recovered 45 times what it would have recovered in the class settlement. (The AFPC is the investment fund that receives and invests royalties from the Alaska pipeline. With over $38 billion in assets, the fund paid a fiscal 2007 dividend of $1,654 to each qualifying Alaskan state resident.)

The second significant thing about these opt-out settlements is what the funds said about their motivations in pursuing separate actions. Colorado PERA’s press release said that it “elected to forego the class recovery” because of its concerns about “excessive attorneys’ fees and an inadequate recovery” – it also reported that its counsel (the Entwistle & Cappucci firm) charged only a 5 percent fee, compared to the 15 percent fee awarded to class counsel. Although Alaska was less explicit in describing its motivations for opting out, the AFPC announcement does underscore the amount by which the state increased its recovery by opting out and also points out that the state has previously obtained opt-out settlement recoveries against WorldCom ($14 million) and AOL Time Warner ($45 million). Alaska’s opt out settlement with AOL Time Warner is discussed in a prior post here.

The third significant thing about the funds’ opt-out settlements is what their actions may say about their willingness to pursue their own actions in the future. Colorado State Treasurer Cary Kennedy (a PERA board member) said, referring to its opt-out settlement, that “Colorado’s public employees should take comfort in the fact that PERA continues to be vigilant in protecting their retirement.” PERA’s Board Chair added that “being involved in cases such as the separate proceeding against Qwest demonstrates our ongoing commitment to protecting the [members’] benefits.” (It should be noted that PERA has been active generally in securities litigation, having served, for example, as lead plaintiff in the Royal Ahold class action.) Similarly, an Alaskan state attorney is quoted in the news article as saying that “we have a system in place to monitor cases that get filed and then decide whether we should get actively involved.”

According to the Alaska press release, Entwistle & Capucci represented not only the Alaska and Colorado funds, but also the Florida State Board of Administration and the New York State Teachers’ Retirement System. These latter two funds do not appear to have made any recent announcements regarding their funds’ separate actions.

As discussed in an earlier post on The D & O Diary (here), there have been prior significant settlements involving Qwest class action opt outs. For example, the California State Teachers’ Retirement System previously entered a $46.5 million opt-out settlement that included a $1.5 million contribution on behalf of former Qwest CEO Joseph Nacchio. According to press reports (here), Qwest also reached separate settlements with the New York City Employees’ Retirement System and Stichting Pensioenfunds of Netherlands and the Teachers’ Retirement System of Louisiana. The amount of these other settlements has not been publicly disclosed.

In its October 30, 2007 filing on SEC Form 10-Q (here), Qwest disclosed that the aggregate amount claimed by various persons opting out from the class settlement is “in excess of $1.9 billion.” Qwest went on to state that “we have entered into settlement agreements with all of those persons.” Qwest added that in connection with those settlements, “we have agreed to pay up to an aggregate of approximately $411 million, including applicable interest, on or before June 30, 2008.” Although Qwest’s disclosure does not explicitly state that the $411 million amount includes the Colorado and Alaska settlements, the disclosure’s wording (“agreements with all of those persons”) suggests that the $411 million does include those two settlements.

It should be noted, with all due emphasis, that the $411 million in opt out settlements exceeds the $400 million that Qwest agreed to pay in the class settlement.

As I have noted at greater length here, the emergence of these opt-out settlements presents a host of potentially significant complicating problems for current and future securities class action litigants. The involvement of public pension funds with significant investment losses, who now have a track record of having substantially increased their recoveries by having proceeded separately, suggests that significant opt out actions could become a regular part of larger class action settlements. At a minimum, these developments may raise potentially serious concerns about the continuing utility of class actions, especially if the perception becomes more widespread that, as viewed by Colorado PERA, class actions entail higher fees and lower recoveries.

All of these concerns are exacerbated if public officials are convinced they can garner valuable publicity and advance their own political interests by pursuing separate actions on behalf of state funds. The fact that the aggregate amount of the Qwest opt out settlements apparently exceeds the amount of the class settlement puts the issue in even sharper focus; indeed, the fact that Alaska is now on its third significant opt-out settlement, and has procedures in place to govern its future opt out decisions, makes it even more emphatic that opting-out may now be more routine and could become standard practice for public pension funds.

The possibility of continuing significant opt-out litigation after class settlement has been achieved threatens to increase both litigation costs and settlement expense in civil securities litigation. At a minimum, class litigants, eager to try to deter opt-outs, will feel pressure to increase class settlement amounts, in an effort to try to reduce attrition from the class. And, at some point, opt-outs may trigger the standard “blow up” provisions in many class settlement provisions, by which the class settlement in set aside of a specified percentage of class members opt out.

From the beginning, one of the questions about these opt-out settlements has been whether they are merely an attribute of the massive corporate scandals from earlier in the decade. The thought was that perhaps as the corporate scandal cases work their way through the system, the opt-out phenomenon might die down. However, the massive cases now arriving in connection with the subprime lending meltdown may create their own dynamic. The scale of the investment losses in at least some of the subprime cases may create the same incentives to opt-out as existed in the cases arising from the corporate scandals.

Indeed, at a panel on which I participated at the recent PLUS International Conference, one of the leading plaintiffs’ attorneys, who was also on the panel, said that many institutional investors (particularly European investors) were not interested in pursuing class cases at all in connection with the subprime mess, but were solely interested in individual or group actions. And as Adam Savett has noted on his Securities Litigation Watch blog (here), narrow class certification rulings are forcing other institutional investors to initiate their own separate lawsuits. With these kinds of concerns looming, we may get to the place where class litigation, long reviled by would-be corporate reformers, starts to look pretty good compared to a piecemeal process with separate investors pursuing claims separately. But at a minimum, these events and trends raise troubling questions about the future of securities class action litigation.

In a couple of months, the various consulting groups will be issuing their annual reports discussing developments in securities class action settlements. But their standard analysis, focusing exclusively on class settlements, may no longer be a sufficient basis upon which to understand what is happening in terms of total securities lawsuit severity. We have indeed entered a brave new world.

Options Backdating Case Going Back, Back to California: In an April 11, 2007 opinion (here), the federal court in California dismissed the CNET options backdating derivative case with leave to amend, later specifically instructing the parties to cooperate to allow the plaintiffs to conduct a books and records inspection under applicable Delaware law before the plaintiff refilled an amended complaint.

The parties have been involved in extensive books and records proceedings is Delaware and in a November 21, 2007 opinion (here) in the Delaware Chancery Court, Chancellor William B Chandler III granted the plaintiff’s books and records request, providing lively commentary along the way. Among other things, the Chancellor said that “it is about time the defendant…provides the requested documents, ” — and, he added, quoting The Notorious B.I.G., it is time that the case gets “going, going/back back/to Cali Cali.”

The Delaware Corporate and Commercial Litigation Blog has a detailed and interesting discussion of the opinion here. Special thanks to blog author Francis Pileggi for forwarding a link to his post.

So What’s on Your iPod?: For those of you who may be wondering what Chancellor Chandler is listening to on his iPod, the song he quotes in the opinion, “Going Back to Cali,” is from the Notorious B.I.G.’s posthumous double-album entitled “Life After Death,” which Rolling Stone listed as #483 on its list of the greatest 500 albums of all time. According to Wikipedia, the song “Going Back to Cali,” reflects the East Coast/West Coast feud that may have led to Mr. B.I.G’s as-yet-unsolved March 1997 murder.

The “Cali” in the song apparently is a shorthand reference to “California,” which would explain, sort of, the Chancellor’s reference to the song in his opinion, as that is the state to which the CNET case will now be returning. Many of the song’s lyrics are unsuitable for this family-oriented blog. Suffice it to say that Mr. B.I.G apparently believed that West Coast females possess certain physical characteristics that he regarded positively. He also apparently believed that the West Coast offered attractive leisure time alternatives. However, he also felt antagonism (apparently reciprocated) against certain West Coast rivals, and this rivalry included mutual threats of physical violence.

It must be said that Chancellor Chandler’s musical allusion reflects a remarkably ecumenical taste in music. Not to mention a phenomenally broad diversity of resources on which to draw for guidance in his judicial decision-making.

And Finally: The D & O Diary’s stock of literary allusions is considerably narrower than Chancellor Chandler’s. The “brave new world” referenced in this post’s title is an allusion to the line from the Shakespeare’s The Tempest, in which Miranda exclaims “What brave new world/That has such people in it!” (To which Prospero replies ” ‘Tis new to you.”)

There is a sense in which this reference is particularly apt; the island on which Miranda and her father have been exiled is traditionally thought to be Bermuda, which is also where many of the financial consequences from heightened securities lawsuit severity could be felt.

On November 21, 2007, plaintiffs’ lawyers initiated separate securities class action lawsuits against the Federal Home Loan Mortgage Corporation (better known as Freddie Mac) and against bond insurer ACA Capital Holding. Both of these lawsuits reflect the deepening seriousness of the credit problems arising from the subprime lending meltdown, and the problems besetting these companies suggest even larger problems ahead.

Freddie Mac is the better known of the two companies, and the November 20, 2007 announcement (here) of a larger-than-expected third quarter loss of $2.03 billion due to its deteriorating home mortgage loan portfolio caused its share price to drop by 29%. Perhaps not unexpectedly, plaintiffs’ lawyers have seized on these developments and launched a lawsuit against Freddie Mac and certain of its directors and officers. A copy of the plaintiffs’ lawyers November 21, 2007 press release can be found here and a copy of the complaint can be found here. According to the press release, the complaint alleges that

defendants concealed the following information, which caused their statements to be materially false and misleading: (a) defendants were not implementing sufficient risk management controls to protect the Company from acquiring billions of dollars worth of mortgages with poor underwriting standards, causing the Company to have an untenable amount of risky loans; (b) defendants were not implementing controls to ensure that appraisals were done appropriately and to prevent collusion between lenders and appraisers, increasing the risk of defaults; (c) the Company was not adequately reserving for uncollectible loans, causing its financial results to be misleading; and (d) the Company had billions of dollars of bad loans which it would eventually have to write off, causing losses and capital deficiencies.

The problems at the heart of this lawsuit bespeak the fundamental problems afflicting the U.S. residential real estate market. Just since the end of October, problems stemming from these issues have led to lawsuits against some the country’s largest financial institutions, including Citigroup, Merrill Lynch, Washington Mutual – and now Freddie Mac. But the problems leading up to the lawsuit against relatively small ACA Capital hint at even more complicated problems that may yet arise, and may lead to even larger problems outside the residential real estate sector.

ACA Capital is a bond insurer that conducted its initial public offering barely a year ago, on November 10, 2006. Like other bond insurers, ACA Capital provides bond issuers credit enhancement and protection by agreeing to cover interest and principal payments in the event of credit default. Like other bond insurers, ACA Capital’s main traditional business is insuring municipal bonds. But again, like many other bond insurers, ACA Capital has in recent years become increasingly involved in insuring structured financial products, including collaterlized debt obligations backed by residential mortgages. Because of rating agency downgrades of many CDOs over the course of recent months, ACA Capital’s stock price has plunged precipitously, down by over 90% this year.

As a result of these developments, on November 21, 2007, plaintiffs’ counsel initiated a securities class action lawsuit against ACA Capital. A copy of the plaintiffs’ counsel’s November 21 press release can be found here, and a copy of the complaint can be found here. According to the press release, the complaint alleges that the company’s Registration Statement (prepared in connection with the company’s November 2006 IPO) “failed to disclose that the Company’s CDO assets were materially impaired and overvalued.”

While ACA Capital clearly already had lots of problems and the lawsuit merely adds to its woes, an even greater potential concern looms ahead. According to a November 21, 2007 Bloomberg.com article (here), ACA Capital’s credit ratings are under review for possible downgrade. Indeed, according to a November 8, 2007 Wall Street Journal article entitled “Bond Insurers Shaky As Credit Climate Worsens” (here), the same combination of circumstances plaguing ACA Capital afflicts a number of other bond insurers, and a number of the bond insurers may be in line for a rating downgrade. Nor is this problem limited to U.S bond insurers; the Financial Times reports in a November 22, 2007 article (here) that French bond insurer CIFG has received a $1.5 billion transfusion from two French mutual banks in order for the insurer to maintain its triple-A rating.

If a bond insurer were to be downgraded, there would be immediate repercussions, none of them pleasant. The most immediate concern if a bond insurer were downgraded is that “it could,” according to the Journal article, “trigger a domino effect of bond-rating downgrades.” Looming in the background is the possibility that a bond insurer, like ACA Capital, defaults. If a bond insurer were to default, banks would be, according to Bloomberg, forced to “take on $60 billion of collateralized debt obligation.” Merrill Lynch alone may need to write down $3 billion of CDOs if ACA defaults on its obligations. A November 22,2007 Financial Times article entitled “CDOs and Insurers” (here) discusses in greater detail the consequences that would follow if ACA were to be downgraded.
UPDATE: Events move faster than even the most diligent blogger can keep up with; it appears that on November 21, 2007, S & P in fact already downgraded bond insurer MGIC, and is reviewing three other bond insurers for possible downgrade, as reported here. Obviously the MGIC downgrade puts the other comments in this blog post in even sharper relief.

The contagion effects from the bond insurers’ weakness is already roiling the municipal bond market, according to a November 16, 2007 Wall Street Journal article entitled “Credit Pressure Filters Down to Muni Market” (here). According to the Journal, the bond insurers’ troubles are “affecting the market for new municipal debt” because “buyers are backing away, in part because of concerns about the financial guarantors.” The Journal reports that if the bond insurers were to be downgraded, it would “have a direct negative impact on the muni debt they insure, potentially even triggering forced selling by some investors.”

All of these fears are fed by concerns that the bond insurers may not have come clean about their exposures. These concerns were underscored on November 19, 2007, when giant reinsurer Swiss Re announced (here) that it had accrued $876.4 million in after-tax losses on credit default swaps. The credit default swaps on which Swiss Re took the losses present one form of the kind of financial guarantee that bond insurers provide. Swiss Re’s reduction of the value of these instruments to zero certainly raises concerns about valuations that the bond insurers themselves may be retaining for similar transactions. Swiss Re’s write down raises concerns about the possibility of even greater turbulence ahead for the bond insurers, and perhaps for other reinsurers and insurers, that, like Swiss Re, had diversified into nontraditional products like credit default swaps.

All of which suggests that ACA Capital may not be the last bond insurer to face a shareholder claim. But of even greater concern is the possibility that ACA or another bond insurer will be downgraded, or worse, default, which would lead to a cascade of adverse consequences for bond issuers and bond investors alike. Moreover, Swiss Re’s announcement underscores that these concerns are not limited just to bond insurers. Indeed, the November 20, 2007 Wall Street Journal article discussing the Swiss re write-down (here) specifically emphasized that Swiss Re is only one of many traditional reinsurers and other insurers that expanded into nontraditional products such as credit default swaps in recent years.

So it appears that the subprime litigation wave will continue to spread outward, encompassing an ever broader diversity of companies. Indeed, in a November 21, 2007 article (here), the Wall Street Journal took a close look at the subprime credit problems distressing General Motors, as a result of deteriorating mortgage assets held by its finance unit, GMAC. The dispersion of the subprime credit problems throughout the economy suggests that the negative effects, and the ensuing litigation, will impact a widening array of companies.

I have added the Freddie Mac and ACA Capital lawsuits to the list of subprime-lending related securities class action lawsuits that I am maintaining here. With the addition of these two most recent lawsuits, the tally of subprime lending related lawsuits now stands at 22, not counting the two securities lawsuits that have been initiated against the credit rating agencies and the four subprime lending related securities class action lawsuits that have been filed against residential construction companies. (That makes 28 total.)

It is probably worth noting that the lawsuit against ACA Capital is not the first subprime lending related securities lawsuit against a bond insurer. That distinction belongs to the securities lawsuit (refer here) filed against bond insurer Radian Group earlier this year after its planned merger with rival MGIC fell through.
Yes, But Who Insures the Insurer?: Adding to the drama of the Swiss Re downgrade is the fact that it came just two weeks after the company announced its third quarter results. Floyd Norris, the New York Times financial reporter, commenting on the Swiss Re writedown in his blog (here), noted that

Analysts are feeling abused and embarassed. One muttered that such losses evidently were not unforseeable to the people who bought the insurance. Another suggested that perhaps this would become an issue for whatever company provides directors and officers insurance for the people who run Swiss Re, and asked what company had taken on that risk.

Swiss Re would not answer that question.

Special thanks to alert reader Matt Rossman at Citigroup for links to the Swiss re articles and the Floyd Norris blog post.

Thanksgiving is nigh, but big things are still happening. The Apple options backdating derivative complaint has been dismissed, AIG has been sued in a subprime-related derivative lawsuit, the Non-U.S. claimants were excluded from the Royal Dutch Shell Class, a leading plaintiff’s lawyer had some interesting things to say about subprime lawsuits, and a disappointed busted buyout target company has been sued by its own shareholders, of all things. Interested? Read on.

Apple Backdating Derivative Lawsuit Dismissed: In a recent post (here), I noted that U. S. District Judge Judge Jeremy Fogel dismissed the Apple backdating securities lawsuit, with leave for the plaintiff to refile the complaint as a derivative lawsuit. However, before that plaintiff refiles, its lawyers will want to read Judge Fogel’s November 19, 2007 opinion (here) in the previously pending derivative lawsuit against Apple (as nominal defendant) and several of its directors and officers. Judge Fogel has granted the defendants’ motion to dismiss. While the dismissal was with leave to amend, it was hardly on terms that would cheer the plaintiffs’ hearts.

Judge Fogel first considered the plaintiffs’ federal law claims, on the theory that the court’s jurisdiction depends on the existence of a viable federal claim. Judge Fogel found that the plaintiffs’ Section 14(a) claims were barred by the applicable three year statute of limitation. He did allow the plaintiffs leave to amend the Section 14(a) claims, but admonished them that they should not amend the claims unless the wrongful acts alleged took place after July 30, 2003, and he further noted that “greater specificity would likely strengthen the claim considerably.”

Judge Fogel next held that the five-year statute of limitations was applicable to the plaintiffs’ Section 10(b) claims, but he also found that the plaintiffs had tried to bootstrap earlier option grants by alleging that the financial misstatements caused by earlier grants were perpetuated in later financial statements. He found that this “combination” was insufficient, and that because the Section 10(b) claims depend on “such a combination, it will be dismissed.” He allowed plaintiffs leave to replead the Section 10(b) claims but only as to wrongful acts that occurred on or after June 30, 2001.

The judge then went on to consider whether the plaintiffs had adequately alleged scienter. He found that the complaint is “characterized by conclusory, general and non-individualized assertions as to all Defendants.” He found that plaintiffs “must provide more detailed allegations giving rise to a stronger inference of scienter on the part of each defendant.” He then went on and noted that the plaintiff’s “scheme liability” allegations are subject to the pending Stoneridge case (about which refer here) and in any event were dismissed because they reflected “insufficient allegations that the various defendants’ contributions to the overall scheme had a deceptive purpose and effect.”

Because the plaintiffs had not yet established a valid federal claim and therefore established federal jurisdiction, Judge Fogel did not reach the plaintiffs’ state law claims. He did, however, note that the defendants “appear to raise a number of valid arguments with respect to these claims, and plaintiffs may wish to amend the claims accordingly.”

Judge Fogel’s rulings, particularly those regarding the statute of limitations issues, might well be instructive to other courts and other litigants involved in other options backdating cases. However, Judge Fogel has once again indulged in his infuriating practice of issuing his opinions “not for citation.” As I previously noted here, this regrettable practice does a disservice to all litigants and every other court.
One other backdating note is that on November 19, 2007, U.S. District Judge Joel Pisano dismissed (here) the options backdating derivtive lawsuit pending against Bed Bath & Beyond (as nominal defendant) and several of its directors and officers on the grounds of the New York state court’s prior dismissal (refer here) of the same claims. More about Judge Pisano below…
The Apple and Bed, Bath & Beyond dismissals have been added to the running tally of options backdating dismissals, denials and settlements that I am maintaining and that can be accessed here.
Special thanks to Robert Benjamin of the Kaufman, Borgeest & Ryan firm for the link the Apple derivative opinion.

Subprime Litigation Wave Hits AIG: The outward-expanding wave of subprime-related litigation has now hit the insurance industry. According to news reports (here and here), on November 20, 2007, a shareholder filed a derivative lawsuit against AIG (as nominal defendant)and several of its directors and officers. The complaint apparently alleges that AIG improperly concealed the extent of its exposure to subprime mortgage crisis, and contains claims for breaches of fiduciary duties, unjust enrichment, and other charges.

The news articles report that the complaint alleges that the defendants had “claimed that AIG’s portfolio was so sufficiently diversified that the mortgage market would have to reach ‘Depression proportions’ before negatively impacting the company. AIG was not as invulnerable as defendant claimed, however.” The complaint reportedly goes on to allege that “while defendants were directing AIG to issue improper statements concerning its exposure to the subprime mortgage crisis, they were also directing AIG to repurchase over $3.7 billion of its own shares at artificially inflated prices. Even worse, certain defendants sold their personally held shares while in possession of material nonpublic information for over $6 million in proceeds.”

The complaint alleges that AIG’s results were hurt by $1.4 billion in losses in AIG’s investment portfolios and mortgage insurance business.

The new lawsuit is significant because it represents the first subprime-related D & O claim in the broader insurance industry. Given the recent news from other companies in the insurance sector (as, for example, with Swiss Re, refer here) there may well be more claims to come in the insurance sector. But even more importantly, it seems increasingly likely that the subprime wave will continue to expand, even beyond insurance and the financial services industry generally, to encompass an even broader range of companies. An example of this risk outside the financial services sector may be seen in the recent problems reports at General Motors (about which refer here). Given the remarks of the leading plaintiffs’ lawyer reported below, this possibility appears to loom even larger.

“F-Cubed” Claimants Out of Royal Dutch Shell Securities Case: As I noted in an earlier post (here), a critical question arising with increasing frequency is the jurisdiction of U.S courts for foreign litigants’ securities claims against foreign companies. This question is presented in its starkest form with the so called “F-Cubed” claimants (foreign domiciled claimants who bought their shares of a foreign company on a foreign exchange, for further discussion of which refer here). In the context of a U.S. class action, the question is whether or not these claimants should or should not be included within the plaintiff class.

In a November 13, 2007 decision (here), Judge Joel Pisano of the federal court in New Jersey held that “Non-U.S. Purchasers” should not be included in the class for the Royal Dutch Shell securities class action lawsuit, and dismissed their claims on the ground of lack of subject matter jurisdiction. It should be noted for purposes of this discussion that Royal Dutch Shell is a Dutch corporation with headquarters in the Netherlands, and co-defendant Shell Transport and Trading Company is a U.K. corporation with headquarters in the U.K.

The “Non-U.S. Purchasers” consisted of “persons or entities who purchased their shares on exchanges outside of the United States and at the time of such purchase were residents or citizens of, or were created in or under the laws of any jurisdiction other than the United States.” The question whether or not these person should be included in the class was particularly important in the Royal Dutch Shell case because “a great majority of the securities traded during the Class Period were traded on foreign exchanges and by the Non-U.S. Purchasers.” In order to address the question, Judge Pisano appointed a Special Master, whose findings he adopted in his November 13 opinion.

In adopting the Special Master’s findings, Judge Pisano clearly was influenced by the $352.6 settlement that Shell had entered in the Amsterdam Court of Appeals in the Netherlands, with a Dutch foundation specifically formed to represent the non-U.S. purchasers’ interests. (Refer here for background regarding the Dutch settlement.) Judge Pisano specifically noted that the Dutch settlement agreement is conditioned on whether the U.S. court exercised subject matter jurisdiction over the non-U.S. purchasers.

The parties had agreed that the U.S. court’s jurisdiction over the non-U.S. purchasers depended on whether the defendants’ conduct occurred with the U.S. Essentially (I am simplifying here) because the court (adopting the Special Master’s findings) found that “the genesis of all of the original disclosures relevant to the investing public was in Europe,” and the court concluded there was insufficient conduct in the U.S. to support the exercise of extraterritorial jurisdiction.

The Royal Dutch Shell opinion stands in arguable contrast to the recent Vivendi class certifications decision in which some (but not all) of the non-U.S. Vivendi purchasers were included within the class (about which refer here).
The importance of the Dutch settlement’s existence to the outcome in the Royal Dutch Shell case also presents an interesting question – would the outcome have been the same if there were no existing alternative vehicle for relief of the Non-U.S. purchasers?

In any event, while the Royal Dutch Shell class decision represents an important development in the evolving issue of U.S. court’s jurisdiction over foreign shareholders’ claims against foreign companies, it is important to note that the decision was very fact specific. Because of the decision’s fact dependency, it is unlikely to control other courts, although it does represent a procedural model and a compelling summary of the relevant legal considerations.
Finally, it should be noted that Judge Pisano later affirmed that his November 13 opinion represents a final judgment, and it is therefore appealable to the Third Circuit. So there may yet be more to be heard on this issue in this case.

Subprime: What’s Happening Now: As noted above, the subprime wave is already expanding outward, but the plaintiffs’ lawyers may just be getting started. According to recent news reports (here), Patrick Coughlin of the Coughlin, Stoia, Geller, Rudman & Robbins firm, has declared subprime the “top priority.” The article quotes Coughlin as saying that subprime is “really everything and the only thing now.” The news article reports that the firm had “already filed 25 mortgage-related complaints against investment banks, mortgage lenders, and others, and it expects to bring about 15 more cases.” The firm is considering bringing on more lawyers.

And speaking of the Coughlin Stoia firm, I recently noted (here) that the increased securities litigation activity in the second half of 2007 is due in large part to the sudden increased activity of the firm, a fact that is corroborated in the recent news reports. The article quotes Coughlin as saying “we have filed more cases in the last three or four months than we filed in the previous year.”

So much for the supposed “permanent shift” to a lower level of securities lawsuit filings.

Adding Injury to Insult: In an earlier post (here), I commented on United Rental’s litigation efforts and threats to try to compel Cerberus Capital Management to honor its agreement to acquire United Rentals. It now appears in addition to United Rental’s lawsuit against Cerberus, on November 20, 2007, certain United Rentals shareholders initiated a purported securities class action lawsuit. According to the plaintiffs’ attorneys’ press release (here), the plaintiffs allege that the company and its directors and officers violated the federal securities laws by “failing to disclose that, several weeks after the Merger Agreement was signed, Cerberus contacted [United Rentals] and expressed concern about its ability to proceed with the merger given the changes in the credit and financial markets.” The plaintiffs allege that the failure to disclose these facts misled investors and caused United Rental’s shares to trade at artificially inflated prices.

While I have previously speculated that the buy-out bubble bust would provoke litigation, I confess I never anticipated the possibility of securities lawsuits by the shareholders of the disappointed target company. But there certainly are no shortage of these kinds of situations around these days, and hyperactive plaintiffs’ lawyers could well create an entire category of lawsuits like this one.

The purport of the allegations suggests a keen dilemma for company managers who are trying to hold a floundering merger together; the plaintiffs’ allegations suggest that at the very time that managers are engaged in fraught negotiations to salvage the deal, they should be publicly disclosing the challenges confronting the merger’s completion.

The problem here is that the deal fell apart, which event management was trying to prevent – there would have been no injury if the deal went through, and whatever chance there was to salvage the deal would not have been advanced if management had been issuing press releases every day about the ebb and flow of the discussions.

I feel like throwing a flag on this lawsuit. Unsportsmanlike conduct, unnecessary roughness, piling on. But that doesn’t mean there won’t be more cases like this one, I suppose.
UPDATE: Adam Savett of the Securities Litigation Watch blog points out that a buyout bust up previously resulted in a securities class action lawsuit in connection with the failed Harman Interational buyout. I actually discussed the Harman lawsuit in an earlier post, here. So, does two lawsuits constitute a trend?

As a result of the Sarbanes-Oxley Act and other reforms, a variety of structures and procedures were put into place to try to prevent or detect fraud. A number of these reforms involve auditors and the audit profession, in the implicit assumption that auditors have an important role to play in preventing and detecting corporate fraud. But a recent Grant Thornton survey (here) shows that many CFOs still do not feel constrained by their auditors’ oversight, notwithstanding the reform measures.

According to the survey, 62% of the 221 CFOs surveyed believe it would be possible to intentionally misstate their financial statements to their auditors. As one commentator in the November 15, 2007 CFO.com article (here) commenting on the survey put it, these numbers are “alarming,” given that “CFOs – if they’ve a mind to -are in a unique position, having the necessary information, intelligence and access to trick auditors in ways that are hard to decipher.”

Indeed, it is disconcerting that nearly two-thirds of CFOs feel they could fool their auditors on intentionally falsified financial statements. Clearly, if such a large percentage of CFOs feel they could, some of them might, and a few of them will. This intimation of the possibility of undetected fraud should be disconcerting to investors, analysts, and others (including D & O underwriters) who rely on auditors’ assurance that the financial statements are free from “material misstatement.”

The disappointment and even anger that investors and others feel when they find they have been misled by falsified financial statements often encompasses a sense of frustration that the auditors failed to detect the fraud. Accordingly, auditors are often named as co-defendants in securities fraud lawsuits, based on a failure to detect the fraud and the auditors’ statements that there are no material misstatements in the financial statements.

But a further Grant Thornton survey finding underscores the theoretical limitations of audit fraud detection. 83 percent of the surveyed CFOs said they did not feel that it was even possible for auditors to detect corporate fraud in all cases. This survey finding embodies the same sentiment expressed in the November 2006 statement of the heads of the six leading accounting firms entitled “Global Capital Markets and the Global Economy: A Vision From the CEOs of the International Audit Networks” (here). The accounting industry leaders noted that “there are limits to what auditors can reasonably uncover, given the limits inherent in today’s audits.” They go on to note that while there are audit techniques whose principal goals are to “ascertain whether fraud has occurred,” these techniques are “not foolproof, nor can they be expected to be.”

The problem for everyone, both auditors and those who rely in their audits, is that there is, in the words of the industry leaders’ statement, an “expectations gap.” According to the accounting leaders, the gap arises because “many investors, policy makers, and the media believe that the auditor’s main function is to detect all fraud, and thus, where it materializes and auditors have failed to find it, the auditors are presumed to be at fault.” The accounting leaders go on to assert that:

Given the inherent limitations of any outside party to discover the presence of fraud, the restrictions governing the methods auditors are allowed to use, and the cost constraints of the audit itself, this presumption is not aligned with the current auditing standards.

The accounting leaders’ frustration is palpable; they apparently recognize, as do the CFOs that responded to the Grant Thornton survey, that management bent on misrepresenting their company’s financial condition can conceal the misrepresentations from the auditors. But the reason there is nonetheless an expectations gap is that investors and others do rely, as they must, on company’s audited financial statements. Merely naming the problem as an expectations gap, or citing the limitations of current auditing standards, does not address the problem, which is that investors and others rely on the audited financial statements in ways the auditors apparently wish they wouldn’t or believe they shouldn’t. It almost seems as if the auditors’ message to those who would rely on financial statements is – don’t (or, at least, not so much).

Given the CFOs’ and the accounting leaders’ recognition of the limitations of audit fraud detection, it may be well argued that audited financial statements in fact should not be relied upon. But what alternative do investors have? The investors necessarily place some value on the fact that professionals independent of management have examined the financial statements.
It is nevertheless a significant concern that nearly two-thirds of CFOs believe they can fool their auditors. And apparently the auditors agree with the general proposition as well. This ought to make anyone who needs must rely on audited financial statements very uneasy.

Special thanks to John Condon at Audit Integrity for the link to the survey results and the CFO.com article.

A Service Error Apology: I am sorry that early in the evening on November 19, 2007, my syndication service spontaneously generated an erroneous email with the cryptic message “Forbidden 403.” (For those, like me, who have to know, Error 403 messages are explained –sort of — here.) I do not know why this error message was sent. I apologize to all of my readers for the unsolicited distribution email. I am attempting to ensure that this error will not recur.

A November 18, 2007 New York Times article entitled "If Buyout Firms Are So Smart, Why Are They So Wrong?" (here) takes a critical look at many buyout firms’ sudden haste to walk away from deals that were much ballyhooed only a short time ago. Clearly the bloom has gone off the buyout vine. As I discussed in an earlier post (here), litigation is an inevitable byproduct of the bursting of the buyout bubble. The battle lines in many of these lawsuits will the "material adverse effects" provision in the various buy-out agreements, which permit termination of the transaction where the target company’s business conditions have deteriorated.

The right of a would-be buyer to invoke this provision is getting a close examination in the lawsuits arising our of the failed J.C. Flowers takeover of Sallie Mae. As discussed in a November 14, 2007 Law.com article entitled "Sallie Mae Litigation Raises Issue of Deal ‘Adverse Effect’" (here), J.C. Flowers is arguing that the collapse of the securitization market and the disruption of asset-backed commercial paper have disproportionately affected Sallie Mae, and therefore have had a materially adverse effect on the company. Sallie Mae for its part contends that the credit crunch was excluded from the adverse effect clause. The court has set a July trial for the dispute.

The invocation of the materially adverse effect clause is one way for a would-be buyer to attempt to bail from a pending acquisition that no longer looks as attractive. An alternative approach, albeit one rarely followed, may be seen in the action of Cerberus Capital Management, which on November 14, 2007 advised United Rentals that it was not prepared to complete its planned acquisition of the company. (Refer here for the company’s announcement.) Rather than arguing that there has been a materially adverse development, Cerberus has simply terminated the contract and tendered the specified termination fee of $100 million. As United Rentals put it,

Cerberus has specifically confirmed that there has not been a material adverse change at United Rentals. United Rentals views this repudiation by Cerberus as unwarranted and incompatible with the covenants of the merger agreement. Having fulfilled all the closing conditions under the merger agreement, United Rentals is prepared to complete the transaction promptly. The Company also pointed out that Cerberus has received binding commitment letters from its banks to provide financing for the transaction through required bridge facilities. The Company currently believes that Cerberus’ banks stand ready to fulfill their contractual obligations.

The Company’s November 14, 2007 filing on Form 8-K (here) attaches all of the critical correspondence between Cerberus and United Rentals pertaining to the deal termination. It makes for rather interesting reading.

As discussed in an excellent post on the M & A Law Prof Blog (here), buyout firms in the past would have avoided terminating a deal and triggering payment of the reverse termination fee, both because of the cost involved and because reputational harm involved in walking away from a deal. The blog post puts it, "Cerberus has decided that the reputational impact of their actions is overcome in this instance by the economics." The New York Times article cited above states that "Cerberus just proved itself to be the ultimate, flighty, hot-tempered partner."

In its November 14 press release, United Rentals also announced that it had retained counsel to represent it in potential litigation. As discussed in the M & A Law Prof Blog post, it seems likely there will be litigation, possibly involving the investment banks as well. The blog post has a detailed analysis of the relative merits of the parties’ positions as well as the likely practical implications. UPDATE: The Wall Street Journal online reported on November 19, 2007 (here) that United Rentals has initiated an action against Cerberus in Delaware Chancery Court.

In short, the prospects are that the bust of the leveraged buy-out boom will entail a wave of follow-on litigation. But it should be noted that in many instances, litigation may prove to have merely been negotiation by other means. As the Times notes,

private equity firms seem to believe that they have plenty of wiggle room. In many of the recently broken deals, they appear to have relied on litigation threats rather than contractual language when telling sellers they plan to back out. As the law firm Weil, Gotshal & Manges recently noted in a briefing to its clients, "even a weak, but plausible" argument that a material financial change has occurred may "provide a buyer with a significant leverage in negotiating a deal."

On the other hand, it is worth noting that the most celebrated case in which a buyer sought to invoke the materially adverse change clause in order to cancel a deal, Tyson Foods attempt to cancel its acquisition of IBP, was unsuccessful — the Delaware Chancery Court granted IBP’s request that the court specificially enforce the acquisition agreement (about which refer here). A good overview of the issues surrounding the "materially adverse change" clause can be found here.

More About the End of the Securities Litigation Lull: As recently noted on the 10b-5 Daily blog (here), respected experts who really should know better are continuing to repeat the now-dated view that securities lawsuits are in a downturn with "no real upturn… in sight." Regular readers of this blog know that in recent posts (here and here), I have shown that while securities filings may have been down between mid-2005 and mid-2007, since July 1, 2007, securities filings have returned to historical levels.

In a recent post on the Securities Litigation Watch blog (here), Adam Savett not only corroborated my earlier conclusion about securities lawsuit filing levels, but (armed with superior information), also further concluded that filings during the second-half of 2007 in fact are above historical levels. He specifically notes that the filing rates during the period August 1, 2007 through October 31, 2007 translate to an annualized filing rate of as many as 272 filings, which could represent as much as a 41% increase over historical filing averages (depending on whose average you use by way of comparison).

This recent increased filing trend has continued so far in November, as well. By my count, as of November 16, there had already been 13 new securities class action lawsuits in November 2007. The 10b-5 Daily notes that much of this activity is being driven by the sudden hyperactivity of the Coughlin Stoia law firm, which has been the first to file many of the newest lawsuits – which, it might be added, involved in many instances foreign domiciled defendant companies. While a full statistical analysis of the 2007 filings must await a later date, it is clear that we are long past the point where responsible persons can continue to repeat that we are in a filings lull. The lull is over, having ended months ago in the wake of subprime meltdown and the disruption in the credit market.

A particularly good discussion of the reasons for the lull and the reasons why its eventual end was inevitable may be found here, in a column written by my good friend Randy Hein of Chubb and appearing in the December 2007 issue of Directors & Boards.

Dodgy Debts, Yes, But Very Good Names: As the subprime meltdown has unfolded, many of us have struggled to understand what happened and what the effects may be. A good example of a recent attempt to explain the possible consequences may be found in the November 13, 2007 Vinson & Elkins memorandum entitled "Subprime Fallout: A Ripple Effect?"(here).

 
A more entertaining attempt to explain the subprime meltdown and its effects may be found on this YouTube video (special thanks to Faten Sabry at NERA Economic Consulting for the link), here:

https://youtube.com/watch?v=SJ_qK4g6ntM%26rel%3D1

 

As the options backdating cases flooded in a year ago, the standard explanation of the plaintiffs’ lawyers preference for shareholders derivative lawsuits over securities class action lawsuits was that stock price declines rarely accompanied companies’ options backdating disclosures. (A list showing the predominance of derivative lawsuits among options backdating cases can be found here.) Any doubts about the challenge that the absence of a stock price drop poses for erstwhile options backdating securities class action litigants should be put to rest by the November 14, 2007 opinion (here) dismissing the options backdating-related securities class action lawsuit pending against Apple and 14 of its current and former directors and officers. Background on the lawsuit can be found here.

Judge Jeremy Fogel first addressed the defendants’ contention that the plaintiff’s claim for “corporate overpayment” properly represented a derivative rather than a direct claim. Judge Fogel noted that

The thrust of the allegation is that the recipients of the backdated options were overpaid, in violation of Apple’s stock option plans. Such allegations necessarily involve an injury to the corporation in that overpayment entails a reduction in corporate assets…. Lead Plaintiff has not identified a unique injury independent of any harm done to the corporation….Were Plaintiff to file an amended complaint, their claims would be stated as derivative claims on behalf of Apple. However, any derivative claims on behalf of Apple arising from the facts alleged in the Complaint likely would be subject to consolidation with the pending derivative action.

Judge Fogel then went on to analyze the plaintiff’s purported claim for fraudulent proxy solicitation under Section 14(a). Judge Fogel noted that in order to establish this claim the plaintiff must plead “both economic loss and loss causation.” Because Apple’s stock price did not decline on the news of options backdating, the plaintiff bases its economic harm argument on the purported dilution to the shareholders’ interests from the issuance of backdated options. Judge Fogel noted that dilution is not necessarily accompanied by economic loss, because share prices might rise on the news of retention of a key executive upon issuance of options. Judge Fogel stated that “without a discernable drop in the stock price there is no basis upon which to establish an injury to shareholders. Dura bars any suit brought solely on the basis that a misrepresentation caused an inflated share price, and Lead Plaintiff alleges no more harm.”

Judge Fogel dismissed the case with leave to amend, but also with the further admonition that any amended pleading should be filed as a derivative rather than as a direct complaint.

An earlier post discussing the New York City Employees’ Retirement System as the lead plaintiff in the Apple options backdating securities lawsuit can be found here.

Special thanks to a loyal reader for forwarding a link to the Apple opinion.
UPDATE: The November 19, 2007 Wall Street Journal has an article entitled “Firms Settle Backdating Suits” (here) discussing options backdating lawsuit dispositions. Full disclosure: I am quoted in the article.

A Comment on Judge Fogel’s Opinion: Judge Fogel’s opinion is seemingly important, particularly his comments with respect to loss causation, given that many of the options backdating cases have been filed in his judicial district – and indeed many backdating cases are pending before Judge Fogel himself. However, in issuing his opinion, Judge Fogel has repeated his unfortunate practice of issuing his opinions as “Not for Citation.”

As I discussed at greater length here with respect to Judge Fogel’s prior effort to bar citation of one of his earlier options backdating opinions, the attempt to delimit the precedential authority of a judicial decision is a truly regretable practice. It is as if he is attempting to say that the court’s business is strictly a private affair of no concern to anyone except the immediate parties. The sheer number of options backdating cases in Judge Fogel’s courthouse belies this notion. Clearly, his conclusions about loss causation are of potentially great significance for other cases and litigants. It is absurd to suppose that litigants with cases presenting loss causation issues of the kind raised in the Apple case cannot refer to the Judge’s own determinations on the issue but must reargue them all over again, but that is what his citation bar suggests.
It is as if he is saying, here’s my decision, but don’t quote me on it. Seriously, what is that all about?
The inferential suggestion that Judge Fogel is deciding cases on other than universally applicable principles ought to be a concern both to the immediate litigants and to litigants everywhere. The practice of issuing opinions, particularly on matters of great interest and obvious significance for similar pending matters, as “not for citation” is inconsistent with our common law traditions and notions of public justice and rightly deserves the strongest disapprobation.

Two Other Options Backdating Cases: There were two other options backdating case developments in the past week. First, according to the company’s November 13, 2007 8-K (here), the federal court in Oregon has dismissed four consolidated options backdating cases pending against Flir Systems as nominal defendant due to lack of standing. Reportedly, however, a separate options backdating derivative suit remains pending.

In addition, on November 14, 2007, the federal court in Manhattan denied the motion of Monster Worldwide founder Andrew J. McKelvey to dismiss the options backdating-related securities class action lawsuit pending against him. (The decision apparently relates only to McKelvey and not to other defendants in the case, which include the company itself.) According to news reports (here), the court’s opinion explaining the denial. will be forthcoming shortly.

In any event, I have added the Apple, Flir Systems and Monster dispositions to my list of options backdating-related lawsuit dismissals, denials and settlements, which can be accessed here.
Thanks to a loyal reader for links regarding the Monster decision.

SEC Drops Backdating Enforcement Actions: The above litigation developments occurring in the same week in which it was revealed that the SEC will not be pursing options backdating related enforcement actions against a host of companies it had been investigating. According to a November 13, 2007 Law.com article (here), Electronic Arts, Linear Technology, Nvidia, PMC-Sierra, and Zoran have each recently announced that the SEC has advised them that it had closed its backdating investigations. In addition, Verisign (refer here) and TriQuint Semiconductor (refer here) also made recent similar announcements.

It always seemed probable that the SEC would not ultimately pursue all of the companies it was investigating for options backdating. But the collective termination of this group of investigative actions, as well as other recent judicial developments, does reinforce the impression that the options backdating scandal may have been more than a little bit overblown. However, as the White Collar Crime Prof blog notes (here), the SEC may be “clearing out its investigative docket, likely clearing out weaker cases while it prepares stronger ones for some type of enforcement action.”

SEC Options Backdating Enforcement Actions: The List: We here at The D & O Diary set a lot of store by lists, having gotten such great mileage out of our lists of options backdating lawsuits (here), options backdating lawsuit dispositions (here), and subprime lending lawsuits (here). So we here were very pleased recently to discover the SEC’s own list of its options backdating-related enforcement actions (here).
The SEC site not only lists the SEC’s options backdating-related enforcement actions in reverse chronological order, but includes links to complaints and press releases for each action. The site also indexes SEC statements and speeches on backdating, as well as links to options backdating press releases from the Department of Justice and various U.S. Attorneys’ offices. For those tracking backdating generally, this site is a great resource.

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

Nasdaq said about this intitiative that:

 

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

With respect to loss causation,

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

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

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

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

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

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