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

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

In an earlier post (here), I took a look at recent research questioning whether corporate officials may be abusing the Rule 10b5-1 share trading safe harbor. SEC Enforcement Director Linda Thomsen said at the time that the SEC is looking hard at the issue. But months have now passed without further SEC action and questions have begun to arise whether the any SEC actions will be forthcoming.

However, in an October 10, 2007 speech (reported here), Thomsen reported that the SEC is continuing to examine whether 10b5-1 plans are being used to shield insider trading abuse. Thomasen reportedly said (refer here), that the SEC is “making sure that a rule designed to help executives with a legitimate purpose is not being used for illegitimate purposes.” Thomsen said that regulators are examining a range of issues relating to insider trading plans, including improper disclosure, the appearance of favorable dates when plans were begun or halted, and the use of excessive selling discretion.

The SEC has been asked to take a look in particular at the trading practices and trading plan of Countrywide Financial CEO Angelo R. Mozilo. According to an October 11, 2007 New York Times article entitled “Stock Sales By Chief of Lender Questioned” (here), North Carolina Treasurer Richard Moore sent SEC Chairman Christopher Cox an October 8, 2007 letter asking the Commission to examine Mozilo’s stock trading program. (A copy of Moore’s letter can be found here.) According to data first supplied by the Los Angeles Times (here), Mozilo started a trading plan in October 2006, but then twice raised the number of shares that could be sold under the plan – once in December 2006, when Countrywide stock was at $40.50 a share, and again in February 2007, when Countrywide sock hit an all-time high of $43.05 – all before the stock plunged this summer toward its current level of approximately $19 per share.

According to the Times, Mozilo has had gains of $132 million since starting the October 2006 plan, and that Mozilo expects to sell his remaining shares at the end of this week, “a move that will generate millions more.” The North Carolina Treasurer said:

As an investor and a Countrywide shareholder, I was shocked to learn that C.E.O. Angelo Mozilo apparently manipulated his trading plans to cash in, just as the subprime crisis was heating up and Countrywide’s fortunes were cooling off. The timing of these sales and the changes to the trading plans raise serious questions whether this is a mere coincidence.

The SEC apparently has declined to say whether it will examine Mozilo’s trades. Whether or not any further action follows Mozillo’s plans, the questions and Thomsen’s statements underscore the emerging risk involving 10b5-1 plans. The greater risks will involve plans that started, stopped or were altered at suspicious times, or where multiple plans were in place. In any event, it is clear that practices involving these plans will remain under scrutiny.

The Costs of Defending Backdating: According to Brocade Communications’ most recent Form 10-Q (here), Brocade’s quarterly legal expenses, including apparently the costs of defending its former CEO Gregory Reyes, were $18 million, in a quarter in which its net income was only $10.7 million. So far this fiscal year, Brocade has spent $38.4 million in legal fees, an amount that is unlikely to include the costs of Reyes’s criminal trial, which ended on August 7, 2007 with Reyes’s conviction.

According to an October 10, 2007 Bloomberg. com article entitled “Brocade Legal Bills Outpace Profits in Options Cases” (here), the company has broad indemnification plans covering its directors and officers. The article also quotes a Brocade spokesperson as saying that “we are continuing to work with our D & O insurance providers to recoup applicable costs.”

While Brocade’s directors and officers may well enjoy broad indemnification rights as well as the protection of liability insurance, Reyes’s criminal conviction would clearly affect the availability of both indemnity and insurance in connection with his legal fees. Indeed the Bloomberg article specifically acknowledges rights that typically are available to companies to recoup attorney’s fees from officials convicted of criminal misconduct.

Brocade may or may not seek to enforce any rights of recoupment it may have, but the magnitude of its legal expenses reveal the enormous costs backdating proceedings are imposing on many companies. An October 12, 2007 American Lawyer article entitled “Companies With Backdating Troubles Are Paying Astronomical Legal Fees” (here) shows that Brocade is only one of several companies that have sustained stratospheric fees in defending against backdating allegations. The American Lawyer article specifically notes that many companies are facing resistance from their D & O carriers over payment of these attorney’s fees; the carriers reportedly are withholding payment on the grounds of the personal profit exclusion and other policy provisions.

While there are cases, such as that involving Brocade’s Reyes, where there have been affirmative findings of wrongdoing, in many more cases, there have only been allegations, and the cases are settled before there on any determinations regarding the allegations. Without conclusive legal determinations, companies should be obtaining reimbursement from their D & O carriers for defense costs incurred on behalf of directors and officers. In my experience, the disputes more often arise with respect to related expense (such as the cost of internal investigations or special litigation committees, or of informal SEC investigations), or when each corporate official wants their own lawyer, and the cumulative expenses deplete the available policy limits.

Special thanks to a loyal reader for sending along the Brocade article.

Another Options Backdating Class Action Settlement: On October 11, 2007, Vitesse Semiconductor announced (here) the settlement of all of the securities class action and shareholders’ derivative litigation that had been filed against the company in connection with stock options backdating allegations. (Refer here for further particulars regarding the lawsuits.) Vitesse agreed to make a cash payment of $10.2 million, $8.75 million of which is to be paid by the company’s D & O insurers. Vitesse will also contribute 2.65 million shares of stock to the class fund and will contribute an additional 4.9 million shares to cover the derivative plaintiffs’ counsel’s attorney’s fees. (The company’s stock is currently trading at about $1.00 per share.) The company has also agreed to adopt corporate governance measures.

In addition to the company’s settlement undertakings, two Vitesse executives agreed to contribute $1.45 million and all of their over 1.2 million Vitesse shares toward the settlement. The two individuals and one more former official also agreed to release the company from indemnification of all future defense costs.

The Vitesse settlement joins the prior options backdating class action settlements previously announced involving Newpark Resources (refer here) and Rambus (refer here). The Vitesse settlement appears distinct, at least among the prior class action settlements, in the individuals’ cash contribution, which, reading between the lines, appears as if it was not intended to be reimbursed by insurance.

Vitesse may have resolved the options backdating related litigation. But the same day as it announced the backdating settlement, news of an additional lawsuit arose. In an October 11, 2007 press release, Nu Horizons Electronics announced (here) that Nu Horizons and its wholly-owned subsidiary Titan Supply Chain Services had been named as co-defendants with Vitesse in a purported securities class action lawsuit that has been filed by Vitesse shareholders. According to the press release, the lawsuit alleges that Nu Horizon and Titan “participated in a scheme to inflate Vitesse’s sales from January 2003 to April 2006.”

The new lawsuit appears to concern allegations of a type that will be directly affected by the outcome of the Stoneridge case now pending before the U.S. Supreme Court (refer here); Stoneridge will clearly determine whether or not a scheme liability case like this will be permitted to go forward.

Pundits struggling to portray the significance of the Stoneridge v. Scientific Atlantic case, to be argued before the U.S. Supreme Court on Tuesday October 9, have asserted that it may be the most important business case of the generation. I am more comfortable with the more restrained assessment of the October 6, 2007 Wall Street Journal editorial (here) that it is “the business case of the year.” But even if it is not a potentially epoch defining case, it is still nonetheless important, and it could, regardless of outcome, have ramifications for the potential liability exposures of prospective securities lawsuit defendants, including accountants, lawyers, investment banks, and arguably any publicly traded company.

The case arises out of events that took place in 2000. Apparently fearing a revenue shortfall and missing analyst estimates, Charter Communications reached an agreement with two vendors, Scientific Atlanta and Motorola, to sell the vendors cable set-top boxes at a premium price. The premium was returned to Charter as a “marketing expense.” Charter immediately booked the return funds as revenue. On April 1, 2003, Charter announced (here) that it was restating its financial statements for a variety of reasons, including the reclassification of the revenue from the set-top deal with the vendors.

Investors quickly filed securities class action lawsuits against Charter, its directors and officers, its former auditor (Arthur Anderson) and the vendors. According the petitioners? opening brief (here) the claims against all the defendants other than the vendors ultimately settled for $146.5 million. The claims against the vendors included allegations that the set-top deal had no business purpose and was intended solely to create a desired accounting outcome. The investors further alleged that the vendors were aware of the desired outcome, and not only helped structure the deal to accomplish the outcome, but affirmatively helped facilitate the outcome, among other things, allegedly backdating documents and issuing other false documents. (The Race to the Bottom blog has a detailed summary of the active misconduct alleged against the vendors, here.)

The district court granted the vendors’ motion to dismiss the Charter shareholders’ claims, and the Eighth Circuit affirmed (here). In ruling in the vendors’ favour, the Eighth Circuit relied on the Supreme Court?s decision in the Central Bank of Denver case (here). Central Bank held that there is no private cause of action for aiding and abetting under Section 10(b). The Eighth Circuit stated that

any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Section 10(b).

The investor plaintiffs (who are the petitioners before the Supreme Court) argue that the Eighth Circuit erred in holding that because the vendors themselves did not make any misstatements or omissions, they cannot be held liable under Section10(b). The petitioners argue that because the vendors engaged in deceptive conduct as part of a scheme to defraud, they can be subject to Section 10(b) liability. The respondents also argue that this case is different from Central Bank, because here the defendants are alleged to have actively engaged in the fraud.

The respondents and the various parties that have filed amicus briefs urging affirmance of the Eighth Circuit argue that petitioners are trying to overthrow Central Bank, and that if the Eighth Circuit’s decision is overturned, the litigation floodgates will be opened, which it is urged will further erode the competitiveness of U.S. financial markets.

Looking at the composition of the current court would as an initial matter suggest that the petitioners prospects appear difficult. Of the current justices who will be hearing the case (Justice Breyer having recused himself) that were on the court at the time of Central Bank, three were part of the Central Bank majority (Scalia, Thomas and Kennedy) and three were in dissent (Ginsberg, Souter and Stevens). The two newest Justices (Roberts and Alito) would seem more likely to vote with the conservative group, seemingly providing the respondents? with a strong prospective 5-3 majority.

But there is a lot more to prognosticating this case than just dividing the justices into seemingly congenial groups. In fact, there may be reasons to suppose that even this Supreme Court might reverse the Eighth Circuit. As the Solicitor General noted in the amicus brief he filed on behalf of the Department of Justice (here) , the Eighth Circuit concededly erred in concluding that the petitioners had failed to satisfy the deception requirement, and indeed conduct other than making statements or omissions can be deceptive within the meaning of Section 10(b). A group of justices looking for a narrow ground on which to reverse might be able to build a majority around this issue.

There are also narrow grounds on which the Supreme Court might affirm as well, without foreclosing the possibility that there might be other “scheme liability” cases that might satisfy Section 10(b)’s requirements. For example, the Central Bank case did not hold that that secondary actors were immune from liability under the securities laws. Central Bank in fact held that any person who employs a manipulative device “may be held liable as a primary violator” assuming all the requirements of Section 10 are met. So in order for the vendors here to be held liable, all of the Section 10 requirements would need to be established.

The court could affirm the Eighth Circuit on the grounds that the claims against the vendors do not satisfy all of the Section 10(b) requirements, and in particular cannot satisfy either the reliance requirements or the that the deceptive acts were made in connection with the purchase or sale of a security. Indeed, the ground on which the Solicitor General urges affirmance of the Eighth Circuit is that the petitioners had not show that the Charter investors detrimentally relied on the vendors’ alleged deceptive acts, and in fact were completely unaware of the conduct constituting the alleged deception. By the same token, the respondents argue that even if the alleged conduct were fraudulent, it did not involve nor was it involved in the purchase or sale of a security.

While the Court might well affirm this case on one or more of these narrow grounds, the kinetic potential of the case is the possibility that the court takes the occasion of having the Stoneridge case before it to further define the possibility of a scheme liability case under Section 10. We can never be too sure of what the court might do. The Court’s relative restraint in the recent Tellabs case (refer here) leads me to believe that the Court may not reach beyond a narrow ground here, particularly since it apparently does not need to do so to resolve the case. But if the Court does go further and seeks to provide further definition to a theory of scheme liability under the securities laws, it seems to me that given the composition of the current Court, it is unlikely to come up with an expansive definition for scheme liability.

Nevertheless, there is the perhaps incalculable possibility that the Court might well be affected by the alleged fraudulent conduct in which the vendors are alleged to have engaged , and it is possible that the Court could conclude that the securities laws were intended to reach the kind of conduct of which the vendors stand accused, in which case there could be a decision that provides an expansive allowance for scheme liability claims. Were the Court to do so, the potential liability of many third parties could be expanded enormously, with significant ramifications for accountants, lawyers, investment bankers and basically any firm that does business with a reporting company.

In the event that the Supreme Court were to rule for the petitioners and reverse the Eighth Circuit, the outcome could have immediate practical consequences for those of us in the D & O industry, particularly if the outcome of the case is an expansive recognition of the viability of the kinds of claims raised against the vendors here. If vendors, professionals or investment banks can be held liable under the securities laws for the statements of others, the challenge of underwriting potential securities risk escalates enormously. Professional liability underwriters are long accustomed to underwriting their applicants’ prospective legal exposures by reviewing the applicants conduct; in the case of prospective public company accounts, underwriters are accustomed to reviewing the company’s own public statements. But if a company potentially can be held liable based on the alleged statements of others with whom the company does business, the universe of potential sources of exposure multiplies exponentially, as does the job of underwriting the risk.

And by the same token, policy wordings may have to be adjusted as well. For example, it may no longer be sufficient for policy definitions to target claims by a company’s own securities holders, as the claim could come from another company’s securities holders. The definitions must be adjusted to reflect the possibility of any claim under the securities laws, rather than just a securities claim by a company’s own investors.

An expansive recognition of scheme liability also could have a potentially significant impact on claim frequency, and by extension, upon pricing. But at this point the extent of these potential effects is uncertain and it would be speculation to try to provide any estimation of the effects, until the outcome of the case is better known.

If, as seems like the likelier outcome, the Supreme Court sides with the respondents and affirms the Eighth Circuit, the case could also have some very significant effects. If Supreme Court seizes on the occasion of this case to rule out any type of secondary liability, the case would significantly reduce the liability exposure of third party professionals. But this possibility is unlikely. Even if the Court simply reaffirms the Central Bank of Denver case and holds that the petitioners have not met the requirements for primary liability, the impact could be more nuanced. The specific contours will define the practical effects. If the Court decides the case based on narrow grounds of the type supposed above, the may well be little categorical impact on the potential liability exposure.

What makes this case interesting is the potential that arises any time the Supreme Court accepts jurisdiction of a securities case. The possibility that the Court will use the occasion to rewrite some well established part of securities liability exposure creates a dramatic tension that makes this case worth watching closely –whether or not it is the most important case of the generation.

In September 2006, I wrote about the “Four Things to Watch in the World of D & O” (here). As I noted then, the world of directors’ and officers’ liability was (and remains today) characterized by constant change. With the passage of a year’s time, it seems appropriate to check in and survey the important current trends in the world of D & O. Though many of the issues are the same, or at least similar, the circumstances and the context have evolved. In connection with a presentation I will be giving at the C5 Conference entitled “D & O Liability Insurance” in Cologne, Germany on October 10, 2007 (refer to program information, here), I have put together this list of issues worth watching now in the world of D & O.

Will Securities Class Action Filings Return to Historical Levels?: As has been noted in several recent statistical studies (for example, refer here), the level of securities class action lawsuit filings has been well below historical averages since mid-2005. This phenomenon has begun to seem so well-established that Stanford Law Professor Joseph Grundfest speculated (here) in July that that there may have been a “permanent shift” to a lower level of class action filings.

But in its recently released study of class action lawsuit filings through the first half of 2007, NERA Economic Consultants noted that while class action filings in the first of 2007 were well below historical norms, the level of filings in the first half of the year was well above the filing level in the second half of 2006. Moreover, the NERA study looked only at filings through June 30, 2007. If anything, the filing trend since that time has accelerated, and (as noted here) the number of securities lawsuit filings during August and September 2007, when extrapolated to an annualized filing rate, was well above historical averages.

By my count, during the two-month period between August 1 and September 30, 2007, 37 publicly traded companies were sued for the first time in securities class action lawsuits. If this filing rate were extrapolated over a 12-month period, the resulting annualized filing rate would be 222 lawsuits. By way of comparison, according to Cornerstone, the average number of securities class action filings during the nine-year period between 1996 and 2004 was 202, compared with 116 filings for the full year 2006.

The accelerated securities class action lawsuit filing level so far in the second half of 2007 is being driven in part by the wave of lawsuits growing out of the subprime lending mess (about which, see more below). But the subprime lending-related litigation wave, while substantial, is only a part of the story. The lawsuits filed so far in the second half of 2007 have swept across many industries and arisen from a variety of circumstances. While a couple of months may be too short of a period from which to generalize, it is certainly true that it has been several years since the securities lawsuit filing level has been as high as it has been so far in the second half of 2007. It may be too early to call the change, but it certainly appears possible that filing levels may be reverting back to historical levels.

How Big Will the Subprime Lending-Related Litigation Wave Become?: The subprime lending meltdown has dominated the headlines, riled the credit marketplace, and disrupted the financial markets. It has also generated a wave of litigation, much of it directed against directors and officers of publicly traded companies. As of October 4, 2007, according to the running tally of subprime lending-related lawsuits I am maintaining here, there have been 17 companies sued in subprime lending-related securities class action lawsuits, in addition to four home construction companies that have been sued in securities lawsuits arising from subprime related issues. There have also been two shareholder lawsuits filed alleging that credit rating agencies failed to disclose that they were providing inflated ratings to subprime mortgage-backed securities (about which refer here), and two lawsuits filed on behalf of employees against their subprime-related employers alleging violations of ERISA in connection with the companies’ 401(k) plans.

The subprime lending-related litigation filed so far already represents a substantial development for D & O insurers. The larger concern for insurers at this point is how much worse the problem will become. As I have noted previously (most recently here), D & O insurers have stepped up their underwriting related to subprime issues, not only to identify companies that were directly involved in subprime lending but also to identify companies that may be carrying troubled mortgage-backed securities on their balance sheets. These assets are only as valuable as the performance of the underlying mortgages. Because so many mortgages are adjustable rate mortgages that will reset to higher interest rates in the months ahead, there would appear to be reason to concerned about the possibility of further deterioration in the value of subprime mortgage-backed assets. (For a more detailed discussion of this later point, refer here.)

Unfortunately, under there circumstances, it appears likely that the subprime mortgage-related litigation wave will continue to grow, at least in the near term. My detailed overview of “The Subprime Lending Mess and the D & O Marketplace” can be found here.

How Will the Securities Plaintiffs’ Bar Respond to Changes at the Industry-Leading Firms?: Bill Lerach has agreed to plead guilty to a criminal charge (about which refer here), and Mel Weiss has taken a leave from his firm to contest the criminal indictment that has been returned against him (about which refer here). These two lawyers unquestionably were the most prominent figures in the plaintiffs’ securities class action bar, and their respective law firms unquestionably were the most active plaintiffs’ securities class action firms. The firms already have shown the effects of their leaders’ legal woes; the Milberg Weiss firm essentially has filed no new lawsuits since mid-2005 (not coincidentally, the same time period during which there had been a general lull in class action filings, as noted above) and the former Lerach Coughlin firm was recently reconstituted as Coughlin Stoia Geller Rudman and Robbins.

There certainly is no shortage of firms already jockeying to position themselves to take advantage of the changes at the industry leading firms. For that matter, a number of plaintiffs’ firms more commonly associated with asbestos and tobacco litigation, such as the Motley Rice firm and the Kahn Gauthier Swick firm, have recently entered the securities class action space, and new plaintiffs firms, such as Saxena White, have formed from former Milberg Weiss partners.

But while there are many opportunistic plaintiffs’ lawyers hoping to capitalize on the misfortune of the industry leaders, it is not yet clear whether any of these players can play the role that Lerach and Weiss previously played. As the September 21, 2007 Wall Street Journal noted in reporting (here) on Weiss’s indictment, the Milberg Weiss firm was willing to make big investments to support cases and “fronted costs that could be recouped only if it achieved a result that forced opponents to pay damages.” It remains to be seen whether the would-be successors to Weiss and Lerach will be willing to make this kind of investment or otherwise play the role they played in the past.

Will Securities Class Action Settlement Opt-Outs Be a Significant Part of Future Claims Resolution?: There have always been class action settlement opt-outs – that is, shareholders who chose not to participate in the settlement of a securities class action lawsuit. What has changed is that more investors, representing significant investment interests, are concluding that it is in their financial interest to opt-out. As noted in greater detail here, over the last several months, public pension funds have announced their settlement of individual opt-out claims, often claiming that their opt-out recoveries exceeded what they would have recovered in the class settlement.

The sheer scale of these opt-out settlements is enormous. In the Time Warner securities lawsuit alone, the aggregate $795 million that the nine publicly announced opt-out claimants have garnered represents a significant portion of the $2.65 million class settlement. And there are many more opt-out claims in that case yet to be resolved.

If investors believe they can substantially improve their recoveries by proceeding individually rather than as part of a class, the utility of class action lawsuits will be undermined. At some point, if enough investors opt out, the defendants may invoke the “blow” provisions to have the class settlement set aside. A more universal trend toward opting out as a routine part of the class action settlement process could also increase the total litigation cost. If a defendant must defend itself against both a class action settlement and multiple opt-out lawsuits, the costs of defense and of ultimate claims resolution could escalate enormously.

These developments could pose a significant problem for D & O insurers and policyholders. Insurers base their pricing and claims reserves on data derived from past settlements. But with the emergence of significant opt out claims, past claims data may not longer be indicative of future claims severity. And for policyholders, the emergence of opt out claims significantly complicates the question of limits adequacy.

It is unclear whether the recent wave of opt-outs will become a permanent part of the class action settlement process. All of the recent opt-outs have come in “mega-cases” associated with the corporate scandals from earlier in the decade. But while it remains to be seen whether opt out settlements will or will not be a significant part of class action settlements going forward, it is hard to disagree with Columbia Law School’s John Coffee, who called the emergence of class action opt-outs “possibly the most significant new trend in class action litigation.”

My prior detailed analysis of the opt out issue can be found here.

Will Claims Disputes With Excess Carriers Become a Standard Part of the D & O Claims Process?: Many of the same studies noted above detailing the recent reduction in securities class action filings have also noted a rise in both the average and median securities class action settlements (refer, for example, here). As settlement amounts have escalated, and as defense expense also has continued to increase, excess D & O carriers, and in particular, upper level excess D & O carriers, have become an increasingly important part of D & O claims resolution.

Perhaps because of their increasing involvement in D & O claims, excess carriers also have been increasingly involved in disputed D & O claims and claims litigation. Indeed, a very significant number of the recent significant D & O claims litigation developments have involved litigated claims disputes between policyholders and their excess D & O carriers. (For example, the recent high-profile CNL Resorts case, refer here, involved coverage litigation with two excess insurers.) Strikingly, many of the disputes with excess carriers have arisen after the primary carrier and even the lower level excess carriers have paid all or substantially all of their policy limits.

As discussed at length in a prior post (here), some of these disputes involved follow form excess insurers who take the position that they are not bound by the primary carrier’s actual or implied coverage decisions. Other disputes with excess D & O carriers have arisen when the excess carrier has taken the position that an underlying carrier’s payment of less than its full policy limit relieves the excess carrier of its payment obligation, even if the policyholder funds the “gap” resulting from the underlying carrier’s partial payment.

One particularly important area of concern is the excess policy’s exhaustion language. Policyholders’ interests are best served by flexible language that reduces restrictions around the kinds of payments of loss that could trigger the excess carrier’s payment obligations. And as for the problem of follow form excess carriers that take different coverage positions than the underlying carriers, the industry ought to be doing a better job keeping track. When it threatens to become routine for follow form excess D & O carriers to take positions that the underlying carriers are not, the industry has a problem that 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, these issues will remain critical in the months ahead.

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The issues cited above are all likely to develop and evolve. So many dynamics affect directors and officers liability exposure, but it is that very dynamic that makes the world of D & O so interesting.

One Final Note: Last year’s big story arguably was the whole option backdating scandal, and while the options backdating cases will be working their way through the system for quite a while, the story does seem like old news. Yet, the options backdating cases are still coming in. Just today, the Coughlin Stoia Geller Rudman Robbins firm filed a new options backdating related securities class action lawsuit against Sonic Solutions. The firm’s October 4 press release can be found here, and the complaint can be found here. (An options backdating related shareholders derivative complaint had previously been filed against the company.)

With the filing of the lawsuit against Sonic Solutions, the total number of options backdating related securities class action lawsuits now stands at 34, according to the running tally I have been maintaining here.

As credit market disruption has reached the leveraged buyout world, a number of deals announced earlier this year to great fanfare have been unceremoniously snuffed, while others are on life support. Not too surprisingly, one direct result from this deal derailment has been a spate of lawsuits, as jilted partners and disappointed investors cast blame and seek to recoup their lost expectancy.

 

The most interesting of these litigation developments is the securities class action lawsuit that a Harman International Industries shareholder filed on October 1, 2007 against the company and three of its officers and directors. (A copy of the complaint can be found here and a copy of the plaintiffs’ lawyers’ press release can be found here.) The Harman International lawsuit filing follows hard on the heels of the company’s September 21, 2007 announcement (here) that its erstwhile acquirers, Kohlberg Kravis Roberts and a Goldman Sachs investment fund, had informed the company that they "no longer intend to complete the previously announced acquisition" of the company, and that they "believe a material adverse change in Harman’s business has occurred." The Wall Street Journal’s September 22, 2007 article discussing the cancellation of the $8 billion deal can be found here.

 

The lawsuit, filed on behalf of shareholders who bought the company’s stock between the time of the company’s April 26, 2007 merger announcement (here) and the September 24 cancellation announcement, alleges among other things that the company failed to disclose that it had breached the merger agreement; that it had R & D and other capital expenses, as well as inventory levels, above disclosed amounts; and that its relationship with a key customer had deteriorated. The complaint further alleges that Harman’s Chairman and controlling shareholder "had a strong personal motive" for the completion of the merger, from which he would received proceeds of $420 million. The implication is that the company withheld the true information to ensure that the merger would be completed, and that the merger fell apart only when the misrepresentations came to light.

 

 
In addition to the possibility of shareholder lawsuits, it may also be anticipated that other disappointed targets will sue their former suitors for breach of contract. The current dustup between Genesco and Finish Line provides an example of what this kind of dispute looks like. On June 18, 2007, Finish Line announced (here) that it would be acquiring Genesco in a transaction valued at approximately $1.5 billion. But something happened on the way to the altar; on September 21, 2007, Genesco sued Finish Line in Tennessee state court seeking an order requiring Finish Line to complete the merger and forcing UBS to fulfill its agreement to finance the deal. A September 25, 2007 CFO.com article describing the parties’ dispute and the Genesco lawsuit can be found here.

 

Finish Line, in turn, has filed a counterclaim asking the court, according to news reports (here), to compel Genesco to "provide information related to their proposed merger or else rule that a materially adverse event has occurred."

 

 
To my knowledge, no lawsuit has yet arisen in connection with the other very prominent deal in which the would-be acquirer invoked the "material adverse change" clause to cancel a deal – that would be the $25 billion deal to take over SLM Corp. (better known as Sallie Mae) that J.C. Flowers cancelled last week. A September 27, 2007 Wall Street Journal article discussing the kibosh put on the Sallie Mae deal can be found here. But while there is no lawsuit yet, Sallie Mae did issue a September 26, 2007 press release (here) saying that "the buyer group has no contractual basis to repudiate its obligations under the merger agreement and intends to pursue all remedies available to the fullest extent of the law." While there apparently remains some hope that the Sallie Mae deal might be salvaged, Sallie Mae today rejected the would-be buyers latest reduced offer. If the deal dies altogether, keep an eye out for a lawsuit — by somebody against somebody else.

 

 
It seems like only yesterday that the business pages were full of stories about increasing numbers of ever-larger buyout bids. Now the papers are covering the same deals as they fall apart. As the Journal noted, the termination of the Harman deal "represents a severe setback for the overall deal market as it tries to close upward of $350 billion of leveraged buyouts amid tightening credit conditions." If buyers’ remorse or tight credit undermines more deals, the disappointed targets can be expected to launch lawyers. Chances are that the lawsuits will live on long after the buyout bubble has become a distant memory.

 

New Subprime Lawsuit: As regular readers are aware, I have been tracking subprime related securities class action lawsuits here. I have updated the list to add the new lawsuit that was filed on October 2, 2007 against E*Trade Financial Corp. The plaintiffs’ lawyers press release can be found here, and the complaint can be found here. With the addition of the E*Trade lawsuit, the current tally of subprime related class action lawsuits now stands at 17, in addition to the four securities class action lawsuits filed against construction companies based on subprime-related allegations, and the two class action lawsuits against credit rating agencies.
 
I mentioned E*Trade in a recent post (here), in which I discussed the dispersion of the subprime mortgage risk into the larger economy and the problems that posed for analysts, investors, D & O underwriters and others who must try to locate and isolate subprime risk. As I commented in the earlier post, the risk is dispersed widely and resides in some perhaps unexpected places. Who would have supposed that E*Trade, for example, was not only exposed to subprime risk but would face a securities lawsuit as a result?
 
Another Subprime Lawsuit Variation: In prior posts (most recently here), I have noted that the subprime lending mess lawsuit wave has involved a variety of claimants seeking redress from a host of different kinds of defendants. A recent lawsuit represents another variation on this theme.

 

In an October 1, 2007 filing on Form 8-K (here), Prudential Financial announced that one of its subsidiaries, "in its fiduciary capacity and on behalf of certain defined benefit and defined contribution plan clients," had initiated a lawsuit against two State Street Corp. affiliated entities. The lawsuit seeks to recover approximately $80 million in losses allegedly suffered by 28,000 individuals in 165 retirement plans that the Prudential unit markets. Prudential ascribed the losses to the State Street affiliates’ "undisclosed, highly leveraged" investments that included subprime mortgages. Prudential said that its subsidiary would cover the losses, and that it seeks to recoup the loss from the State Street defendants, on the theory that the defendants "failed to exercise the standard of care of a prudent investment managers."

 

An October 2, 2007 Wall Street Journal article discussing the Prudential lawsuit can be found here. Special thanks to the several alert readers who send me copies of news stories relating to the Prudential lawsuit.
 
The Subprime Mess is a Royal Pain: In her monthly survey of subprime dislosures (here), Footnoted.org author Michelle Leder reproduced the following interesting observation from the Appendix to the Kingdom of Sweden’s SEC September 28, 2007 filing on Form 18-K (here):

Recent, widely discussed problems in the sub-prime mortgage market have led to greater uncertainty about the magnitude of the U.S. economic slowdown in 2007. Because more and more people with subprime mortgages are having trouble making payments, many lenders have declared bankruptcy. Falling house prices and rising mortgage rates have probably caused these problems. It is not inconceivable that the impact on house prices will thereby increase and detrimentally affect household consumption even more than anticipated by the base scenario of this forecast.

There are two things interesting about this item. The first is that even the Kingdom of Sweden is worried about fallout from the subprime meltdown. The second is that the Kingdom of Sweden has SEC reporting obligations; as Michelle noted, "who knew"? (Apparently, the country must report to the SEC owing to certain bonds it issued that are traded in the U.S.)

 

The Subprime Mess and the D & O Marketplace: In the latest issue of InSights (here), I discuss "The Subprime Lending Mess and the D & O Marketplace."

 

 
In addition, I remind readers interested in subprime-related issues that I will be co-Chairing a Mealey’s conference on Subprime Lending Litigation, to be held on October 29 and 30, 2007, in Chicago. Complete conference information can be found here.
 

In a September 21, 2007 opinion (here), issued following an earlier bench trial, United States District Judge Charles A. Pannell, applying Georgia law, rejected AFC Enterprises’ D & O carrier’s attempt to rescind AFC’s D & O policy and ordered the carrier to pay over $24 million in compensatory damages and prejudgment interest. AFC’s September 26, 2007 news release announcing the decision can be found here.

Judge Pannell essentially held that the carrier was obligated to pay its full $20 million policy limits (plus interest) to cover amounts AFC incurred in defense and settlement of the consolidated shareholder litigation that followed the company’s March 24, 2003 announcement that it would be restating its financial statements for 2001 and the first three quarters of 2002. The March 24 announcement came just three weeks after the inception date of the company’s renewal D & O policy.

In seeking to rescind the policy, the carrier relied on statements made on the company’s behalf at a January 24, 2003 renewal meeting and in the company’s renewal application, which the company’s CEO signed and dated on February 20, 2003. The carrier bound the renewal coverage on February 28, 2003, and the renewal policy incepted on March 2, 2003, for a one-year policy term ending on March 2, 2004. The policy had a $10 million D & O limit, and a separate $10 million limit for offering underwriter coverage. The parties to the coverage case stipulated that by virtue of the dual limits, the policy provided a maximum of $20 million in aggregate limits (although, as noted below, an odd issue arose following trial on the question of the amount of limits available).
Essentially, the carrier took the position that the AFC knew but failed to disclose to the carrier at the January 24 renewal meeting and in the February 20 application that it would be restating its financials, and in any event that the company had a duty to update the application information when it became apparent to the company that it would be restating its financials.
The company’s auditor had been Arthur Anderson, but due to that firm’s legal woes following the Enron scandal, the company retained KPMG as its auditor in early 2002. The trial testimony showed that roughly at the same time as the underwriting process was unfolding, the company was going through its year-end audit for the first time with its new auditor. An issue arose during the audit regarding the method the company used to account for the impairment of long-lived assets. The company had previously used a “market-based” approach to evaluate its impairments; but in late 2001, the Financial Accounting Standards Board issued FAS 144, which KPMG contended required that long-lived assets be grouped together at an individual store level rather than on a market-wide basis. The company’s CFO and KPMG were in disagreement on this issue. The trial testimony showed that the FAS 144 question was an issue throughout the audit, but the court found that a decision had not been reached on the question until a series of meetings whose timing ultimately proved to be critical to the outcome of the rescission cases.
The minutes of the company’s audit committee’s February 28, 2003 meeting showed that the FAS 144 questions “were delaying completion of the audit” but that “no decision was reached on the resolution of those issues at the meeting.” On March 1, 2003, a group of company officials met to discuss the status of the audit. The court found that at the meeting, company officials were “confused and frustrated” at KPMG’s position. In this March 1 meeting, the court found, “the subject of a possible restatement of AFC’s financial statements for 2001 and the first three quarters of 2002 was first discussed, because a restatement might be necessary to ensure a consistent presentation of earnings if a new methodology was adopted.” The company’s President later that same day learned of the possible restatement “but no decision was made at that time.”

On March 3, 2003, the company’s CFO recommended to the audit committee that the company re-audit and restate the prior financial statements, which recommendation the audit committee approved on March 10, 2003. On March 24, 2003, the company announced that it would be restating the prior financial statements. Almost immediately, a number of securities class action lawsuits and shareholders’ derivative lawsuits were filed. (A description of the shareholder class action lawsuit can be found here. The Third Amended Class Action Complaint can be found here.) The named defendants in the shareholder suits included both the company and its directors and officers as well as the company’s offering underwriters. On August 24, 2004, the company announced that it had rescinded the policy.

The company ultimately settled the consolidated shareholder lawsuits and derivative lawsuits for a total of $16.7 million, with an added agreement to pay 60% of any amount recovered against AFC’s insurers, up to a maximum of $6 million. The company also spent a total of $8.7 million defending the cases.

The carrier filed a declaratory judgment action against the company and its directors and officers, and the company counterclaimed for breach of contract and bad faith.

In the coverage case, Judge Pannell found that the carrier did not carry its burden of showing a misrepresentation in the February 20, 2003 application. The court found that the company’s CEO “had very little knowledge about the technical audit issues” until he was told about the possibility of a restatement at the March 1, 2003 meeting. Indeed, the court found that “there was no evidence presented at trial that anyone at AFC ever considered a restatement of AFC’s earnings prior to the March 1, 2003 meeting,” and in any event no decision to restate was made until the March 10, 2003 audit committee meeting.

The court also found that the carrier had not carried its burden of showing that there had been misrepresentations at the January 24, 2003 underwriting meeting.

In addition, the court found that the company did not violate its duty to update the application material, holding first that there was no information that needed to be updated, and that even assuming for the sake of argument that a decision to restate financial would have required an update, the actual decision to restate did not take place until March 10, 2003, after the policy had incepted. (The court also specifically found elsewhere that timing of the company’s actions had nothing to do with the dates of the D & O renewal process.)

The court held that the company was entitled to recover the full $20 million policy limit plus prejudgment interest of over $4 million. However, the court rejected the company’s bid for statutory bad faith damages of $10 million, holding that even though the carrier’s attempt to rescind the policy had failed, the carrier had “reasonable and probable cause for its coverage decision.”

In finding the carrier’s position to have been reasonable even if ultimately unsuccessful, Judge Pannell noted that “the timing of the restatement announcement suggested that AFC might have known more about a possible restatement than it disclosed” to the carrier before the policy incepted, and after the restatement announcement, the carrier “promptly initiated and conducted an investigation.” The court further noted that the company’s “lack of cooperation in that investigation reasonable added to [the carrier’s] belief that AFC had been less than forthcoming in the negotiations for the policy.”

One very odd aspect of the case relates to the correct amount of the policy limits at issue. You wouldn’t think there would be much question around an issue like that, and indeed the parties stipulated in pretrial filings that the aggregate limit of $20 million under the dual coverages was at issue. However, the carrier later sought to amend its pleadings to allege that only the $10 million D & O limit was available. There was in fact trial testimony that the company had only paid for the $10 million D & O limit and that the issuance of the policy with the dual limits had been due to a computer error.

Judge Parnell clearly was not happy with the post-trial motion in light of the pretrial stipulation that the full $20 million was at issue. Judge Parnell’s opinion reviews testimony showing that the carrier’s underwriters and claims attorneys were previously aware that the policy had been incorrectly issued, but that the carrier “had made a conscious decision” not to raise the issue in the pleadings, in order to be able to argue that the company had “increased its limits.” (I am extrapolating here, but I guess the argument was something like this: the company knew the restatement was coming so it withheld the information about the restatement to be able to increase its limits, so that more insurance was available for the ensuing claim.) This testimony and the tactical maneuvering, as well as other aspects of the underwriters’ testimony, clearly left a negative impression on Judge Parnell. In any event, he rejected the carrier’s attempt to argue that only $10 million was at issue.

The carrier undoubtedly feels ill-used by the court’s opinion and is considering its appeal options. The reality is that until the court superimposed a layer of precision on the record through its factual findings, the record was murkier than might be supposed from the court’s opinion alone. Indeed, the court itself noted that the FAS 144 issue had arisen as a serious question before the March 1 date when the court said the issue of a possible restatement first arose. And as the court itself noted, the temporal proximity of the renewal date and the restatement not unreasonably raised questions about the company’s renewal disclosures. The carrier may also have had to make decisions about whether or not to rescind without the benefit of complete information, owing to the company’s refusal to provide information. For these reasons, it would be unfair to second-guess the carrier’s position based upon the ultimate outcome.

A Few Final Thoughts about D & O Policy Rescission: While I would not presume to second-guess the carrier’s position here, I do think it is fair to note that the D & O industry as a whole remains deeply conflicted about rescission. (I should emphasize that none of the following remarks are intended to reflect in any way upon the actions of the carrier in the AFC Enterprises case; these remarks related to rescission as a general issue, not to the any particular case.) For the insurance professionals involved on the transaction side of the business, rescission is a potent but theoretical concern that can somehow be fixed with policy language tinkering, while for claims professionals, rescission (or at least its threat) is just a tactical weapon, merely another tool in the toolkit to be used in claims resolution. The disconnect between the assumptions on the transaction side and the practical reality on the claims resolution side remains a problem for everyone in the D & O industry, and particularly for D & O insurance policyholders.

Short of making all policies nonrescindable under any circumstance (not likely to happen), rescission will remain a troublesome issue for the D & O industry. Both policyholders and carriers would be better off it were more widely recognized that policy rescission wreaks havoc on all concerned. There is not only the litigation expense, but there is also the reputation risk involved for the carrier – I guarantee you that, in light of Judge Pannell’s pointed remarks in his opinion, the carrier representatives who were involved in the AFC renewal and rescission now have a deeper appreciation for the reputational risk involved when a carrier attempts to rescind a policy. Indeed, my own experience has taught me the hard way that even when a carrier prevails in a rescission case, the carrier’s reputational damage may outweigh the benefit of the successful policy rescission. Rescinding a policy is like setting of an unusually powerful bomb – even if using the bomb seems necessary and appropriate, you can’t always predict the extent of the collateral damage.

My proposal to address the rescission issue is to suggest that the decision whether or not to rescind a policy should rest exclusively with the business unit head, rather that with a claims manager. The business unit head would be much more likely to consider the business context of the rescission decision. I would never argue that carriers must perform even if a policy has been procured through active fraud. However, I think the industry would be much better off if the rescission standard were raised sufficiently high that only active fraud would trigger a rescission and that in all gcases, consideration of business reputation would act as a check against exercising the rescission trigger. The superimposition of these kinds of controls might help eliminate the disconnect between the transaction and the claims sides of the business when it comes to the issue of rescission.

A September 27, 2007 Business Insurance article discussing the AFC Enterprises rescission case can be found here. A September 28, 2007 CFO.com article discussing the case can be found here.
Speaker’s Corner: On October 10, 2007, I will be speaking at the C5 D & O Liability Insurance conference in Cologne, Germany on the topic “The Vulnerability of European Insurers and Reinsurers to U.S. Claims.” The complete conference agenda can be found here.

On September 27, 2007, Amkor Technology announced (here) that the United States District Court for the District of Arizona had granted the defendants’ motion to dismiss the securities class action lawsuit pending against the company and several of its directors and officers. As noted in a prior post (here), the initial complaint that the plaintiffs had filed in January 2005 did not contain options backdating allegations. After the company’s revelation during 2006 of options backdating concerns, the plaintiffs amended their complaint to add the backdating allegations. The plaintiffs’ second amended complaint can be found here.

In a September 25, 2007, U.S. District Judge Paul Rosenblatt granted the defendants’ motion to dismiss the second amended complaint. A copy of the September 25 dismissal ruling can be found here. Judge Rosenblatt granted the motion with respect to the options backdating allegations on two grounds: first, that the plaintiffs had failed to adequately plead loss causation as required under the Dura Pharmaceuticals case; and second, that the plaintiffs had failed to adequately plead scienter.

In attempting to establish loss causation, the plaintiffs attempted to rely on the stock price drop following the Company’s July 26, 2006 press release (here) in which the company both announced its second quarter 2006 operating results and also announced that it had voluntarily formed a Special Committee to examine options practices. Judge Rosenblatt, reviewing all of the allegations, considered that the price drop following the July 26 announcement was due to the company’s second quarter results and weak third quarter forecast, rather than to the two sentence announcement of the Special Committee. In reaching this decision, Judge Rosenblatt considered the fact that at the time of the company’s August 16, 2006 announcement (here) that it would be restating its prior financials and its October 6, 2006 announcement (here) of the Special Committee’s findings, the company’s stock price went up. Judge Rosenblatt said “the Plaintiffs have failed to link their losses to the alleged misrepresentations by showing the Amkor price dropped upon revelation of the true state of the facts. As noted by the Defendants, once a corrective disclosure was issued the stock price actually increased.”

Judge Rosenblatt’s finding that the plaintiffs had failed to adequately plead scienter is based on his conclusion that “other than general assertions about the Individual Defendants’ roles and responsibilities and motivations, the Plaintiffs do not plead specific facts to support their allegations of scienter.” Although Judge Rosenblatt mentions the Supreme Court’s recent Tellabs opinion (about which refer here), the Tellabs decision is basically irrelevant to the scienter ruling.

The Amkor dismissal is interesting in and of itself , as the first dismissal of an options backdating related securities class action lawsuit of which I am aware. (Readers are encouraged to correct me on this point if I missed a prior options backdating securities lawsuit dismissal.)

UPDATE: Alert reader Avi Wagner points out that on July 30, 2007, Judge Fogel dismissed the Mercury Interactive options backdating securities lawsuit without prejudice. Judge Fogel’s order may be found here. (I am embarrassed to admit that I actually had an item about this dismissal in an earlier post, here — I should learn to rely on the blog rather than trusting my memory.)

In addition, alert reader John Orr points out that on September 14, 2007, the Court granted the defendants’ motion to dismiss in the Verisign options backdating lawsuit, a case that combined both 10b-5 and derivative allegations. The Verisign dismissal order can be found here. The court granted the motion to dismiss the Section 10b-5 action based on the Tellabs case and the failure to allege sufficient facts to support a scienter finding and also failure to plead sufficient facts to establish loss causation. Similarly to the Amkor derivative case (as discussed below), the court granted to motion to dismiss the derivative allegations based on the platiniffs’ failure to allege sufficient facts to establish demand futility and to establish that the plaintiffs had standing.

Another aspect of the dismissal is that it corroborates a view that was widely held at the time the options backdating scandal was unfolding a year ago as an explanation why there were relatively few options backdating securities lawsuits but a relatively large number of shareholder derivative lawsuits – that is, the view at the time is that the backdating revelations were not accompanied by stock price declines of the type necessary to support a securities claim. The plaintiffs in the Amkor lawsuit may have been unable to resist the temptation to try to upgrade their existing securities lawsuit by adding allegations relating to options backdating. But the absence of the ability to show causally related damages ultimately doomed their options backdating allegations. (It should also be noted that Judge Rosenblatt also dismissed the plaintiffs original unrelated allegations as well.)

None of this is to say that the plaintiffs’ counsel who elected to file derivative lawsuits necessarily can be expected to fare better. Indeed, on August 28, 2007, Judge Rosenblatt also dismissed the separate options backdating related derivative complaint that had been filed against Amkor as nominal defendant as well as against several of its directors and officers. (Refer here for a copy of Judge Rosenblatt’s dismissal opinion in the Amkor derivative lawsuit.) Judge Rosenblatt granted the dismissal motion on the ground that the plaintiff had failed to plead facts sufficient to establish demand futility. He also found that the plaintiff had failed to plead facts sufficient to show that he had the requisite share ownership for the requisite time period necessary to establish that he had standing to bring the claim.

The timing of the Amkor dismissal is interesting because is follows so closely after the recently announced $16 millions settlement in the Rambus options backdating securities lawsuit (about which refer here). While the Rambus settlement might have been (and may still prove to be) a precursor to further settlements, the Amkor dismissal may embolden some options backdating securities lawsuit defendants to continue to resist in the hopes of securing a dismissal, rather than attempting to reach an early compromise.

In an earlier post (here), I discussed a recent case in which investors sued a subprime mortgage lender’s auditor, as one example of the ways in which aggreived parties may seek to impose gatekeeper blame on professionals for the subprime lending mess. A recent lawsuit filed against the prominent New York law firm of Cadwalader, Wickersham & Taft, though it arises in the context of commercial mortgages, may suggest a way that law firms may also get drawn into litigation arising from the subprime lending mess.

According to a September 26, 2007 Law.com article entitled “$70 Million Suit Against Cadwalader Reflects Risks of Practice in Mortgage-Backed Securities” (here), in October 2006, Nomura Asset Capital Corp. filed a state court lawsuit in Manhattan “over documents the law firm drafted for a 1997 securitization transaction in which Nomura pooled 156 commercial mortgages worth around $1.8 billion.”

The securitization documents warranted that the pool “qualified” for special tax treatment, and also warranted that that this qualification meant that the mortgages were backed by properties worth at least 80% of the mortgage amounts. After some of the mortgages in the pool defaulted, LaSalle Bank, which held the pool in trust, sued Nomura, alleging that the mortgage loans were not “qualified” because one large property in the pool was worth substantially less than 80% of the loan value.

Ultimately, the Second Circuit held (here) that the inclusion of the 80% warranty, in addition to the warranty that the pool was “qualified,” imposed additional duties on Nomura. Nomura later settled with LaSalle for $67.5 million, and subsequently filed the legal malpractice action against Cadwalader for the inclusion of the 80% warranty in the securitization documents. According to the Law.com article, Cadwalader’s motion to dismiss remains pending.

Though Nomura’s lawsuit against Cadwalader grows out of the commercial mortgage context and relates to transactions from ten years ago, it is, as the article states, “unfolding against a backdrop of a credit crisis centering on such securities and the default of mortgages behind them.” The article notes that “the situation is worrisome to those law firms that have large securitization practices.”

As losses on subprime mortgage-backed securities mount, aggrieved parties will cast about for deep pockets to target, and if the Nomura case is any indication, aggrieved parties may well attempt to seize on purported defects in the securitization documents to attempt to target the law firms that drafted the documents. To the extent law firms’ clients and former clients are compelled to pay investor losses on securities they sold to investors, the clients and former clients may attempt to shift those losses to the lawyers that drafted the securitization documents.

To be sure, the Nomura case against Cadwalader involves the unusual circumstance that the presence of a single phrase in the documentation is allegedly linked to Nomura’s obligation to have to pay the prior settlement to LaSalle. Other potential litigants will face greater difficulties showing how the the lawyer’s conduct supposedly caused their losses. But clearly the gatekeepers on whom aggrieved parties will attempt to pin the blame for subprime-lending losses will include lawyers, as well as other professionals.

Hat tip to alert reader Kelly Reyher for the link to the Law.com article.

SEC to Convene Securities Lawsuit Roundtable: According to a September 24, 2007 Wall Street Journal article entitled “SEC to Study Revamp to Shareholder Suits” (here), the SEC will be convening a roundtable in the first quarter of 2008 to explore possible revisions to the U.S. system of private securities litigation.

The SEC’s decision to convene the roundtable is in response to an August 2, 2007 letter to the SEC from six prominent law professors, who suggested that the SEC “take a leadership role in studying [private securities litigation] and making or recommending policy changes if and where appropriate.”

The professors initiative, and the SEC decision to convene a roundtable, follows the suggestions of the Paulson Committee (refer here) and the Bloomberg/Schumer report (refer here) that the litigiousness in the U.S. is harming the competitiveness of U.S. capital markets.

In addition to their letter, the professors also provided a list of fifteen suggested discussion topics (here). Readers of this blog will be interested to note that among the topics that the professors suggested to be discussed is the following:

What is the role of insurance in [private securities class action] settlements? What portion of the settlements (and the costs associated with the litigation) is funded by insurance carriers? What is the impact on investors of the insurers’ role, including the impact of any insurance rate increases?

The list of questions also includes an extended bibliography of academic papers on related topics, which may also be of interest to readers of this blog.

The D & O Diary sincerely hopes that if the SEC is going to examine this question about the role of insurance that the SEC will consult persons who are actually involved in the D & O insurance industry. All too often, commentators prefer to theorize based on economic models (or even worse, nothing more than their own assumptions) about how D & O insurance functions, without actually talking to anybody who is directly involved with the operation of D & O insurance within the U.S. litigation system. I know a few people in the D & O industry who would have quite a lot to say about the professors’ proposed D & O insurance question.

Hat tip to the 10b5-Daily (here) for the links to the professors’ letter and list of questions.

Did the Expert Say Why the Airport Police Don’t Plan on Doing Things Correctly?: The front page of the September 26, 2007 Cleveland Plain Dealer carried the following headline: “Airport Police Plan a Mistake, Expert Says.”

One of the most oft-noted observations (refer, for example, here) concerning directors’ and officers’ liability exposure is that since mid-2005 the number of securities class action filings has fallen well-below historical averages. When NERA Economic Consulting recently released its 2007 mid-year report on securities class actions (refer here for my prior post about the NERA report), the report noted that while lower class action filing levels persist, the filing rate during the first-half of 2007 did represent an increase over immediately prior six-month period. The NERA study was focused on filing during the period ending on June 30, 2007, but it is clear the filing levels since June 30 have continued the upward trend that NERA noted, particularly since August 1, 2007.

By my count, during the eight weeks between August 1 and September 21, 2007, 37 companies were sued for the first time in securities class action lawsuits. If this filing rate is extrapolated over a 52-week period, the resulting annualized rate would be 296 lawsuits, well above historical norms.

Perhaps the most active week during the recent 8-week period was the immediate past week of September 17 through September 21, when eight companies were sued for the first time in securities class action lawsuits:

Part of what is driving this litigation is the growing wave of subprime lending-related litigation, which I have more specifically identified in my running tally of subprime lawsuits, here. The lawsuits filed last week include as many as three subprime-related cases, depending on how broadly you define the category: Care Investment, NetBank, and Opteum. But it is significant that the subprime litigation wave is not all or even most of the story here; the lawsuits are arising in a diversity of sectors and involve a variety of allegations, most of them having nothing to do with subprime lending.

Clearly part of what is going on here is that volatility has returned to the financial marketplace. As I have argued elsewhere (refer here), the 2-year lull in securities lawsuit filings arguably was simply a side-effect of an unusually stable financial marketplace. But a disrupted credit arena and a more volatile securities environment has stressed a number of companies. And so, far from having arrived at a “permanent shift” in the level of securities filings, as Stanford Law Professor Joseph Grundfest suggested just a couple of months ago (here), we were rather simply enjoying a period of unusual calm, which now appears will be followed by more normal conditions, if they do not in fact turn out to be worse than that. To be sure, eight weeks may prove to have been far too short of a period from which to generalize. But at least based on the last eight weeks, it appears that we may be headed back to historical filing levels.

One very important observation about the heightened filing levels during the last eight weeks is what an important part of this activity has been played by former Lerach Coughlin law firm, known since Bill Lerach’s August 31 departure as Coughlin Stoia Geller Rudman & Robbins. Amidst the generally elevated filing levels, the Coughlin Stoia firm has been the first to file against quite a number of the companies sued during the last eight weeks, including most recently Jones Soda, Terragon, Care Investment, The Children’s Place, and W Holding. Given everything that has been going on at the firm during this same eight week time period, its activity levels are truly remarkable. Either they are not distracted or they are very committed to showing that they are not distracted. They also appear to be trying to communicate that Lerach’s departure is not going to slow them down. Or I suppose they could be just trying to make a buck the best way they know how.

CFO.com has an interesting September 21, 2007 article entitled “Signs of Life: Securities Suits Rise” (here) commenting on the recent NERA report and its conclusions about filing rates during the first half of 2007. The SOX First blog has a September 22, 2007 post on the same topic here.

Corporate Corruption and Follow-on Shareholder Litigation: Regular readers know that I have commented frequently (most recently here) on the risk of shareholder litigation following Foreign Corrupt Practices Act investigations. I also recently wrote (here) about the corrupt practices investigation at BAE Systems. In that connection, it is interesting to note that among the lawsuits that the Coughlin Stoia firm has recently filed is a shareholder derivative suits against the BAE board of directors and several of its present and former officers “seeking to recover losses BAE suffered in connection with the more that $2 billion in alleged bribes paid to Prince Bandar Bin Sultan and others.” The law firm’s September 19, 2007 press release describing the lawsuit can be found here, and the complaint can be found here.

The defendants are accused of intentional, reckless and negligent breaches of their duties of care, control, compliance and candor. The defendants, which include Prince Bandar bin Sultan, three former officers of Riggs Bank, and PNC Financial Services (successor in interest to Riggs), are alleged to have engaged in illegal, improper and ultra vires conduct, including causing BAE to violate the laws of the United States and international business codes and conventions relating to corrupt business practices.

I have long identified the risk of follow-on shareholder litigation following FCPA investigations as a growing area of D & O risk. The involvement of a prominent plaintiffs’ firm like the Coughlin Stoia firm underscores the growing significance of this risk.

The new BAE lawsuit could well run afoul of the Internal Affairs Doctrine, about which I previously commented here. This doctrine holds generally that only one state should have the authority to regulate a corporation’s internal affairs, and many courts will refuse to allow actions to proceed against corporations from other jurisdictions if the shareholders have sufficient avenues to address management malfeasance under the laws of the corporation’s domicile. BAE will undoubtedly contend that shareholders have avenues available, particularly under the new U.K. Companies Bill (about which refer here).

As the subprime lending mess has unfolded, one of the more interesting challenges has been trying to figure out where the subprime risk is. This query is not simply a matter of figuring out which financial institutions engaged in subprime lending (although this surely is part of the equation). The more complicated part of the inquiry is figuring out where all that subprime debt wound up, either as mortgages or after being sliced, diced, and repackaged into mortgage-backed financial instruments sold to investors.

This question is no small inquiry. As noted in a prior post (here), according to the Office of the Comptroller of the Currency, there is over $1.08 trillion in subprime mortgage debt being held outside the lending industry. What that much debt dispersed into the economy, it seems probably that the debt instruments have wound up in some pretty unexpected places. As Gretchen Morgenstern notes in her September 23, 2007 New York Times column entitled “Guess Who’s Feeling the Mortgage Pain” (here), “nine months after the meltdown in the home loan market, investors are still waiting for banks, brokerage firms and other companies to come clean on losses incurred” on mortgage-backed securities.

One obvious place to look for this debt is at other financial institutions, as shown, for example, in the case of Scottish Re Group, whose recent disclosure (here) of its exposure to mortgage investment risk rocked its stock price. Morgenstern’s September 23rd Times column also discusses potential issues at E*Trade Financial Corporation and the valuation of mortgage-backed assets on its balance sheet. But financial institutions are not the only companies carrying mortgage backed securities on their balance sheets. Nonfinancial companies apparently are also carrying a significant amount of these investments, too.

A September 19, 2007 Wall Street Journal article entitled “Why Firms Like Smucker May Feel Pinch of Debt Crunch” (here) took a look at several nonfincial companies that are carrying mortgage-backed securities on their balance sheets. The companies mentioned in the article include J.M. Smucker (the jelly maker), Garmin (the navigation device manufacturer), Microsoft, Netflix, and Sun Microsystems. These companies invested in the mortgage-backed instruments because they “had been viewed as relatively safe investments that produced slightly better returns than cash and governmental bonds – and could be sold quickly if needed.”

The problem for these companies in the current financial environment is how these assets should be carried on their balance sheets, and specifically whether, in light of the complicated valuation questions surrounding these assets, “the cash stated on the balance sheet is a true representation of the cash available to the company.” The Journal article states:

The issue for investors is how these companies determine the “fair” value of their mortgage-backed securities in the current environment, and whether they are telling the whole story about how easily these assets can be liquidated — and for how much.

In light of the current marketplace conditions, “a company’s portfolio of securities might not be fairly valued, and the cash it could raise in a sale could be less than reported.”

To be sure, the companies discussed in the Journal article may not face any immediate concerns, because by and large they are cash-rich and face no immediate pressure to sell. In addition, for most of these companies, the mortgage backed assets represent only a small part of their securities holdings. For example, mortgage-backed debt represents just 1.2% of Smucker’s assets (although it does represent 22% of the company’s total marketable securities and 100% of its noncurrent marketable assets.)

But the the list of companies in the Journal article clearly does not encompass the entire universe of nonfinancial companies that hold mortgage-backed assets on their balance sheets. And as the Scottish Re and E*Trade examples cited above shows, for some companies these investments potentially could represent a more significant percentage of assets, and raise much more serious questions regarding balance sheet valuations.

For analysts, investors, D & O underwriters, and others who want to try to understand the extent and location of mortgage investment risk, the dispersion of mortgage-backed securities on balance sheets across the economy poses a double challenge. The first challenge is that the balance sheets of the companies holding these assets may not accurately represent the true value of those companies. The companies could be vulnerable to asset value write-downs or to cash shortfall if forced to liquidate these assets, particularly if forced to accept distressed prices. The other challenge is that the very lack of transparency around asset valuations may itself be an issue, because it raises the potential for later accusations that aggrieved parties were misled about a company’s true financial condition.

The possibilities that these types of exposures could lead to shareholder claims and other disputes may not be purely theoretical. As I have noted in my running tally of subprime lending-related securities class action lawsuits (here), the subprime litigation wave is encompassing an ever-wider variety of companies and involving an increasingly diverse assortment of claims, based on a growing number of kinds of financial problems attributable to the contagion effect of the subprime lending mess. The possibility of a shareholder lawsuit arising out of a company’s exposure to mortgage investment risk may be very real.

As noted in a prior post (here), D & O underwriters have already begin inquiring about companies’ balance sheet exposure to mortgage investment risk. While at least one leading D & O insurer reportedly has sought to introduce a written questionnaire, other carriers for now have been satisfied with obtaining information more informally. It is important for applicants called upon to give supplemental information in meetings or in conference calls to keep in mind that if they make oral representations, the carrier will later look carefully at its ability to deny coverage or even to rescind the policy based on those representations. Well-advised applicants will take the same degree of care in providing answers in a meeting or in a call that they would in providing written answers in a questionnaire.

Special thanks to Dave Hensler for providing me with a copy of the Journal article.

Readers may be interested to know that Dave is one of the numerous prominent experts scheduled to speak at the Mealey’s conference on “Subprime Mortgage Litigation,” which I will be co-Chairing and which will take place on October 29 and 30, 2007 in Chicago. The agenda and complete list of speakers can be found here.

Jabil Circuit Settles Option Backdating Case: On September 20, 2007, Jabil Circuit announced (here) that it had settled the shareholders’ derivative lawsuits that had been filed against the company as nominal defendant and several of its directors and officers based on options backdating allegations. A Special Review Committee of the company’s Board had been appointed to review the allegations; as the company previously announced (here), the Committee concluded “that there was no merit to the allegations that the Company’s officers or anyone else issued themselves backdated stock options or attempted to cause others to issue them.”

Under the settlement, which is subject to court approval, the company agreed to adopt “several new policies and procedures to improve the process through which equity awards are determined, approved and accounted for.” The company also agreed that it would not object to an award to plaintiffs’ counsel of $800,000, $600,000 of which will be borne by the company’s D & O insurers.

Climate Change Disclosure: In a recent post (here), I noted the efforts of several environmental groups, state officials, and public pension funds to petition the SEC to try to require publicly traded companies to provide greater disclosure regarding their climate change exposures. In a column in the September 22, 2007 New York Times (here), Joe Nocera gave this initiative “no chance” of being adopted. He went on to describe these efforts as “feats primarily of environmental grandstanding” and noted further that:

The real problem is that these measures, appealing thought they may seem at first glance, are misleading and disingenuous. To put it more bluntly, they are an attempt to use regulation and litigation to force companies to toe the environmentist party line on global warming, and to change corporate business models in ways that are more pleasing to the environmental community. It’s environmental tyranny disguised as public policy.

Nocera concludes his column by noting that “if you want to attack global warming, then for goodness sake, attack global warming. But trying to force change through the bogus mechanism of ‘investor disclosure’? It would be funny if it weren’t so sad.”

Nocera is a skilled writer who has written a compelling column. Reasonable minds may differ on his views, and whether or not the reformers’ present efforts immediately succeed, I think their larger goals of compelling publicly traded companies to provide greater disclosure of climate change related issues will, directly or indirectly, succeed over time. I think Nocera is absolutely correct that there is a political agenda at work here, but where I disagree with him is his view that the agenda has “no chance.” It may be a question of when, but I think the agenda will succeed sooner or later, and I happen to think it will be sooner rather than later. That is not a statement of my political views, it is simply an observation of the current political and cultural dynamic.