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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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


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

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

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

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

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

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


I was only away one week, but even in that short time there were many interesting developments in stories I have been following on this blog. Here is a news round-up, in no particular order:

NASDAQ’s Private Portal Approved: In an earlier post (here), I discussed the arrival of private securities markets, where accredited investors can exchange Rule 144A shares without the issuing companies becoming subject to reporting company burdens and responsibilities. On August 1, 2007, Nasdaq announced (here) that the SEC had approved its Portal system for centralized trading of Rule 144A securities. The new Portal system, which will be available to qualified users on August 15, is “intended to improve the efficiency and transparency of the private placement market – thereby encouraging capital formation.”

Interestingly, in its press release, one of the advantages Nasdaq cited for the market is not (as I had supposed) that it provides an alternative means to raise capital without the burdens and delay of an IPO; rather the press release suggests that the existence of an efficient trading market for private placements will smooth the companies’ path to going public by providing, among other things, more accurate pricing. The Nasdaq press release does say (as I would have expected) that as a result of the Portal market’s availability, “companies considering a traditional IPO should have an attractive new option to gain faster, simpler, less expensive access to the capital they require.”

The press release also explains that, to aid companies avoid the 500 shareholder threshold that would trigger reporting responsibilities, NASDAQ will collaborate with third-party providers to incorporate industry-wide shareholder tracking.

Because the Nasdaq Portal system will not be limited to customers of any one investment firm, it will be interesting to see what effect its availability will have on the proprietary trading markets, such as the Goldman Sachs GSTrUE system (about which see my prior post, here).

Tellabs in the Courts (Already!): So soon after the recent Tellabs decision in the Supreme Court (about which refer here), we are already getting some feedback about how the lower courts will apply the decision. In a July 27, 2007 opinion, the Seventh Circuit held in the Baxter International case (here) that a securities class action plaintiff’s allegations attributed to confidential witnesses must be “discounted” because it cannot be weighed in competing inferences, and thus are not sufficiently “compelling” to support a “strong inference” of scienter. The Seventh Circuit affirmed the lower court’s dismissal of the case. Hat tip to the 10b5-Daily (here) for the link to the Seventh Circuit decision.

The Seventh Circuit is of course the circuit whose ruling was reversed in the Tellabs case, and so it might have been predicted that the court might be likelier to dismiss a case (or affirm a dismissal) after Tellabs. (In fact, I predicted that very thing, here.) The decision may nevertheless have a larger significance, in that many securities class action plaintiffs rely on allegations based on information from confidential witnesses. If confidential information generally is held to be insufficiently compelling to support a strong inference of scienter, the Baxter International holding could have a significant impact.


More Milberg Woes: Regular readers know that I have been following (most recently here) the developments surrounding the criminal indictment of the Milberg Weiss firm and two of its former partners (refer here for the indictment). In what can only be called “turnabout,” the Milberg firm, three of its present or former partners, and the Lerach Coughlin firm have been sued in Manhattan federal court. The Complaint can be found here, and news coverage discussing the Complaint can be found here. Hat tip to the WSJ.com Law Blog (here) for the link to the Complaint.

The six individual plaintiffs previously were class members in two securities class action lawsuits (the Safeskin and the Schein Pharmaceuticals cases). They purport to represent a class of “all persons or entities who were members of the certified plaintiffs classes in the lawsuits in which Defendants and/or [the Milberg firm] made illegal payments to their clients to appear as plaintiffs, Lead Plaintiffs, and Class Representatives.”

The plaintiffs allege that the defendants breached their fiduciary duties to members of the various classes; engaged in a pattern of “racketeering activities,” including “commercial bribery”, in violation of RICO; and violated the statutes governing selection of lead counsel. The plaintiffs seek compensatory damages as well as treble damages under RICO.

The Complaint does not explain or even really suggest why the Lerach Coughlin firm was named as a defendant. The Lerach Coughlin firm’s inclusion is odd, since at this point neither the firm nor any of its attorneys has been indicted. The civil complaint is replete with references to actions by or on behalf of the Milberg firm, but contains no allegations specifically addressed to the Lerach Coughlin firm. Indeed, the complaint does not mention the Lerach Coughlin firm by name after the firm’s identification as a defendant.

It seems probable that the plaintiffs will face challenges trying to establish sufficient commonality to support the certification of a class, but even if a class is established, the plaintiffs will face a monumental challenge in attempting to identify all of the members of the purported class.

But even as the proceedings continue in the criminal case and as the lawyers gear up to do battle in the civil case, a parallel discussion is emerging over whether the Milberg firm’s alleged misconduct, even if it took place, is legally objectionable. The Wall Street Journal ran a column on August 4, 2007 (here, subscription required) referring to an unpublished article (here) by Ideoblog author Larry Ribstein and Bruce Kobyashi. In the article, the two academics argue that fee sharing (“kickbacks,” in the pejorative terms used in the indictment) provides an incentive for a plaintiff to file a case and to take the role of lead plaintiff. They further argue that no one is harmed, since the persons sharing in the fee are motivated to maximize the class recovery to improve the returns on the fee sharing agreement.

This argument is interesting, but whatever its theoretical merits, I don’t think it helps the Milberg defendants defend themselves against allegations that they supported, encouraged or suborned false swearing, misrepresented fees and arrangements to courts and to class members, and so on. In other words, the theory may or may not be debatable, but the actual practices at issue may be less arguably blameless. According to August 7 news reports (here), the court presiding over the criminal case rejected the remaining Milberg defendants’ motion to dismiss built around similar arguments as those raised in the academics article.

The Legal Pad blog has an interesting post on the civil RICO suit, here.


This Year’s Pink: Jolly Roger?: In an earlier post (here), I noted the new OTCQX system that Pink Sheets LLC has adopted in order that qualifying companies trading on the Pink Sheets would be able to (positively) distinguish themselves from other, less savory companies trading on the system. (A list of the 15 companies that have qualified for the OTCQX system can be found here.)

A July 28, 2007 Washington Post article entitled “Watch Out for the Skull and Crossbones” (here) discusses some additional markers that Pink Sheets has adopted to help investors assess companies that trade on the system. For example, a black skull and crossbones icon will identify securities promoted by “spam” or “other questionable action.” A pink check mark will indicate a company “whose issuers currently and fully disclose their financial results.” A triangular “yield” sign will indicate issuers that have disclosed limited financial information, and a stop sign will mean the issuer has provided no information for six months.

According to the Post article, these new labels are part of the efforts of the current owners of Pink Sheets to clean up the joint. But there is no reason why this rating system (or something similar) should not be adopted by the various exchanges. Certainly, all retail investors would benefit from a system that separates companies by quality. For that matter, D & O underwriters could use some objective guidance too; for example, it certainly would be useful for underwriters to know which publicly traded companies are going to be sued in securities class action lawsuits in the next, say, twelve months. Perhaps a skunk icon next to the ticker symbol, or maybe a ticking time bomb…


Sun Times Media Group Settles: In a recent post (here), I discussed coverage litigation that had arisen between the Sun Times Media Group (formerly known, and referred to here, as Hollinger International) and several of its former officers and directors, on the one hand, and the company’s excess D & O carriers on the other hand. In a July 31, 2007 press release (here), the company announced that it had settled the underlying securities lawsuits, and that it had also “reached an agreement to settle litigation over its directors and officers insurance coverage.”

The securities class action settlement will resolve the consolidated U.S securities litigation, as well as related Canadian litigation. The Company’s settlement of the lawsuits “will be funded entirely by $30 million in proceeds from the Company’s insurance policies.”

The press release further states that the insurers will deposit $24.5 million in escrow to fund payment of defense fees, with the allocation of the escrow funds to be judicially determined. Upon the funding of the escrow and the settlement, the D & O carriers “will be released from any other claims for the July 1, 2002 to July 1, 2003 policy period.”

The defense fee arrangement appears to resolve the coverage litigation that was the subject of my earlier post. It is unclear whether the insurance settlement described in the press release entirely resolves all related insurance issues. For example, the reference in the press release to a specific policy period certainly suggest the possibility that issues relating to policies applicable to other periods may be unresolved. There may also be issues remaining with the respect to the former Hollinger officers and directors who have pled guilty to or been found guilty of criminal misconduct. But even taking the statement about the resolution of insurance claims on its face, I still am curious about where these arrangements leave the various D & O carriers that were in the Hollinger insurance program.

As discussed in my prior post (here), Hollinger carried $130 million in limits arranged in four basic layers. The first two layers, totaling $50 million, were apparently exhausted in a shareholders’ derivative settlement (refer here). The third layer consisted of $40 million excess of the $50 million, and the fourth layer consisted of $40 million excess of $90 million. The recent class action settlement and related defense fee escrow fund together will require a total of $54.5 million, which would appear to exhaust the third layer as well as a portion of the fourth layer, all other things being equal.

A lifetime of D & O claims involvement makes me curious about exactly how the class action settlement and escrow obligations are to be allocated amongst the third and fourth layer excess insurers. It seems unlikely to me (although it is of course possible) that only the fourth layer insurers would benefit; without any direct knowledge of what the actual arrangements were (and feeling unrestrained from speculating), I suspect that the “savings” were distributed in some fashion among all of the excess carriers in the third and fourth layers – although I obviously could be completely mistaken in that speculation, too. Any readers who care to disabuse me of my illusions are encouraged to let me know what the actual circumstances may be.


Options Backdating Litigation: With all of the current focus on the growing wave of subprime mortgage lending lawsuits (refer here), it is very hard not to treat the options backdating mess as old news. But the shareholders’ derivative suit filed against past and current officers and directors of Eclipsys shows that while this story may well be aging, it still has legs. (An August 1, 2007 Law.com article describing the Eclipsys lawsuit can be found here.) With the filing of the Eclipsys lawsuit, the number of options backdating-related derivative lawsuits now stands at 161, according to the running tally that I have been maintaining here.

And in an interesting development in one of the longer-standing options backdating related securities class action lawsuits, on July 30 , 2007, Judge Jeremy Fogel, in the Mercury Interactive securities class action lawsuit, granted the defendants’ motion to dismiss, with leave to amend. (A copy of the opinion can be found here.) The judge found that the plaintiffs had inadequately argued that the plaintiffs had defendants had acted (as required under the Ninth Circuits’ idiosyncratic definition of scienter) with “deliberate recklessness.” Judge Fogel also found that the plaintiffs did not state a specific enough amount of loss that shareholders supposedly had suffered as a result of share-price drop. Judge Fogel also found that the Complaint should have omitted shareholders who held Mercury Interactive stock before September 2001, because the statute of limitations for those allegations had passed.

Even though Judge Fogel allowed the plaintiffs 30 days to amend their complaint, the ruling is potentially significant, particularly with respect to the statute of limitations issues. Many of the pending options backdating related securities lawsuits reach far back in time. Were other courts similarly to refuse to allow allegations to relate back to earlier periods, the scope of potential damages in these cases could be significantly reduced, since many of the options backdating securities cases involve technology companies whose shares were flying high in the late 90s. However, it should be noted that Judge Fogel’s opinion is designated as “not for citation.” Judge Fogel is a great judge and a fine American, but designating an opinion as “not for citation” runs counter to the system of precedent embodied in Anglo American jurisprudence. Previously decided cases should inform and help decide future cases, not merely resolve the immediate dispute before the court. If cases cannot be treated as providing precedential authority, judges are reduced to little more than referees, deciding whether the runner is safe or out. If I were king of the world, judges would never be allowed to publish a decision “not for citation.”

An August 2, 2007 Law.com article further describing the Mercury Interactive decision can be found here.

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As Walter Cronkite would say, that’s the way it is — even after a week away. This news round up proves that we here at The D & O Diary are deeply committed to upholding the principles embodied in our motto: all the news we are interested in, we print.


In a July 25, 2007 opinion (here), the Tenth Circuit examined whether misrepresentations in financial statements incorporated by reference in a D & O policy application could serve as a basis for policy rescission under Utah law.

The case involved a D & O policy issued to ClearOne Communications in 2002. In early 2003, ClearOne issued a press release stating that its financial statements from the preceding two years should not be relied upon, in part because the company had discovered that the company had entered distributor agreements that had the effect of accelerating revenue recognition. This disclosure triggered shareholder lawsuits (refer here), for which the company sought coverage under the D & O policy. The D & O carrier sought to rescind the 2002 policy based on the financial misstatements, which the carrier contended had been incorporated by reference in the policy application. ClearOne and one of its directors sued the carrier, seeking to enforce their rights under the D & O policy. The District Court held that the carrier had properly rescinded the policy.

On appeal, the Tenth Circuit made a number of findings. The Tenth Circuit found first that Utah law did not prohibit incorporating the financial statements into the application by reference; second, that the District Court did not err in finding that there was a sufficient misstatement to establish rescission, if the other elements were met; third, under Utah law, a misrepresentation occurs if the applicant knows or should have known about a misstatement in the application and still presents it to the insurer; and fourth, that the record was unclear whether the official that completed the application “should have known” about the financial misstatements, and so the Tenth Circuit remanded the case back to the District Court on this question.

The Court went on to construe the “severability” clause in the policy, which limits the imputation to other insureds of knowledge of misstatements, and so potentially preserves coverage for insureds who were unaware of the misstatements. The severability language in the ClearOne policy was limited by the language in the relevant section’s preamble that restricted nonimputation to the “questions 8, 9 and 10” in the application. Since the insurer’s rescission claim was based on answers and information provided in response to question 14, rather than on questions 8,9 or 10, “the severability clause does not cover ClearOne’s misstatement and it would be ineffective against [the carrier’s] rescission of the insurance policy in its entirety should the financials be deemed to be a non-innocent misrepresentation.”

This Tenth Circuit’s discussion of the severability issue is an important reminder of the potential significance of seemingly subtle differences in policy language. If the ClearOne severability language had been broader and not restricted to the specific application questions, then there would be a possibility that coverage might be preserved for innocent insureds even if the carrier were otherwise able to establish grounds for rescission. The marketplace has evolved significantly since the ClearOne policy was placed in 2002, so it is hardly fair to judge the language in that policy by today’s standards. But there is no doubt that in the current marketplace it is possible to obtain severability language that provides more comprehensive and less restricted nonimputation protection for innocent insureds. In addition, a complete management liability insurance program today would also include a Side A/DIC policy intended to protect the directors and officers in the event that the traditional D & O policy were to be rescinded. These considerations collectively represent another example of the importance of involving knowledgeable insurance professionals in the D & O insurance acquisition process.

For a good summary of the issues surrounding the severability clause in D & O policies, refer to this article (here) by noted D & O commentator Dan Bailey.

Special thanks to Dan Standish of the Wiley Rein law firm for forwarding a link to the 10th Circuit opinion in the ClearOne case.

Climate Change and Board Duties: In earlier posts (most recently here), I have examined the increasing D & O risk arising from global climate change liability exposures. A July 24, 2006 Law.com article entitled “Boardroom Climate Change” (here) written by Jeffrey Smith and Matthew Morreale of the Cravath law firm takes a closer look at board room risks arising from global climate change and examines the ways in which climate change decision-making will “test the limits and scope of fiduciary duties of officers and directors as their responses to matters relating to climate change are questioned by stakeholders.”

The authors identify “five new phenomena” that “pose new challenges for directors overseeing climate change decision-making”: 1) uncertain and fragmented environmental legislation and regulation; 2) the reactions of capital and insurance markets to emerging climate change business opportunities; 3) increasing stakeholder activism; 4) pending litigation; and 5) the rapidly evolving scientific debate.

The authors contend that these factors have “added a new dimension to management’s obligation to monitor corporate performance and make informed decisions in light of all reasonably available material information.” The article concludes by noting that:

To the extent that a company’s response to climate change becomes a proxy for both smart management and corporate stewardship, directors have an incentive to be increasingly vigilant in assuring that management has maximized economic opportunity, reduced economic risk and preserved corporate reputation.

As I have previously noted, these changing circumstances not only provide opportunities for “smart management and corporate stewardship”; they also provide a context within which it is prudent to assume that claims will arise, alleging that boards failed to exhibit appropriate management and stewardship. For that reason, boards must anticipate that “stakeholders” increasingly will demand action and information surrounding climate change issues. Companies should also anticipate that D & O underwriters increasingly will inspect companies’ climate change related disclosures and actions. By the same token, D & O insurance policy wordings, particularly the pollution and the bodily injury/property damage exclusions, and program structure, including the incorporation of appropriate Side A/DIC protection, will be increasingly important parts of corporate risk management, in light of increasing potential exposures arising from global climate change.

A good summary of the climate change-related D & O policy wording issues can be found in this recent article (here) by my good friend Joe Monteleone. Joe and I will be among the panelists speaking in a Mealey’s teleconference on D & O Litigation Topics on August 15, 2007 (refer here), including, among other things, issues pertaining to global climate change.

Hat tip to the SOX First blog (here) for the link to the Law.com article.

“Exploding” FCPA Enforcement Activity: In earlier posts (most recently here), I have addressed the growing corporate exposure arising from antibribery enforcement. The significance of these issues was underscored in a July 25, 2007 memorandum from the Gibson, Dunn & Crutcher law firm entitled “The FCPA Enforcement Explosion Continues” (here).
According to the memorandum, the law firm has identified “approximately 100 companies” that currently have open Foreign Corrupt Practices Act (FCPA) investigations. The memorandum’s authors also state that they “expect U.S. authorities to initiate an increasing number of enforcement actions in the next few years and to seek more severe penalties for FCPA violators.”

This growing FCPA enforcement threat was demonstrated just this week, with the news, according to the July 25, 2007 Wall Street Journal (here), that the Department of Justice is conducting a criminal investigation involving nearly a dozen oil and oil services companies focusing on illegal payments to customs agents in Nigeria, Kazakhstan, and Saudi Arabia.

In earlier posts (refer here), I have noted that the D & O risk associated with FCPA enforcement actions arises not so much from the FCPA enforcement action itself, but from the threat of follow-on civil claims brought by shareholders and based on the improper activity or associated disclosures. The Gibson Dunn memorandum, referring to the same cases I have previously cited, expressly notes the growing threat of FCPA-related follow-on civil litigation and states that “in the current environment of heightened scrutiny” these kinds of claims “may start to gain traction.’ The memorandum further emphasizes that “one thing is clear: the legal road towards resolving an FCPA violation in the U.S. now stretches far beyond achieving peace with the DOJ and the SEC.”

Away Message: The D & O Diary’s publication schedule will slow down for the next few days. I will resume my “normal” schedule after August 6.


In a recent post (here), I discussed the recent work of two blue-ribbon groups focused on eliminating “short-termism” and recommending, among other things, the elimination of quarterly earnings guidance. The results of the National Investor Relations Institute’s 2007 Earnings Guidance Practices Survey (press release here, survey results here) suggest that more companies are shifting away from quarterly earnings per share guidance. The survey results also appear to refute the suggestion that companies that eliminate guidance suffer adverse effects, as discussed further below.

The NIRI survey’s results appear somewhat contrary to some recent academic research on related topics. An April 2007 paper by Joel Houston and Jenny Tucker of the University of Florida and Baruch Lev of New York University entitled “To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance” (here) takes a look at a sample of 222 companies that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005. The authors found that the “stoppers” ceased guidance for a variety of reasons, all suggesting operating weakness or other concerns, such as poor earning performance, poor record beating estimates, change in management, or difficulty in predicting earnings. The authors also found that “stoppers” experienced a relative decrease in analyst coverage and a relative increase in analyst forecast dispersion.

In summarizing their findings, the authors state:

In a nutshell, guidance cessation follows a poor operating performance and causes a deterioration in the information environment about the company. The major benefits claimed from stopping quarterly guidance – enhanced investment in the long-term and increased strategic disclosures – do not appear to materialize. Moreover, 31% of the stoppers in our sample subsequently resumed quarterly guidance, suggesting that it is rather difficult for firms to buck the trend and abstain from quarterly earnings guidance. Thus, we conclude that, consistent with economic theory, decreasing disclosure – stopping guidance in our case -does not seem to benefit investors or firms.

The 2007 NIRI survey report paints a different picture, perhaps because its survey reflects a later time period than the period the academics studied. The NIRI survey group also includes companies that never provided earnings guidance, as well as “stoppers,” which may account for some of the differences in findings.

The NIRI survey found that only 51% of 2007 survey respondents provide earnings guidance of some kind, compared to 60% of 2006 survey respondents, and that only 47% of 2007 survey respondents provide revenue guidance, compared to 56% of 2006 survey respondents. Of the survey respondents that provide guidance of some kind, only 27% provide quarterly guidance. The 133 responding companies that provide quarterly guidance represents only 17.68% of the 752 survey respondents.

The NIRI survey’s findings about the impact on “stoppers” who ceased providing earnings guidance in the last 24 months contrasts significantly from the findings in the academics’ research. The NIRI survey results reflect an indifferent reaction from both the buy-side and the sell-side to the elimination of quarterly earnings guidance. The NIRI survey respondents reported that discontinued guidance had a neutral effect on their company’s stock’s valuation and volatility, and that their companies had not experienced unusual shareholder turnover. Moreover, only 11% of the companies that do not provide guidance were even considering providing guidance in the future.

Perhaps the later time period reflected in the NIRI survey compared to the time period reflected in the academics’ research explains some of the differences between the two reports. A more cynical view might be that the NIRI study is a survey that depends on respondents’ views, whereas the academics’ analysis was based on the companies’ actual performance.

In any event, the presence or absence of guidance may make less of a difference for companies’ goals than is generally assumed. A July 23, 2007 Wall Street Journal article entitled “Numbers Game: Why ‘Guidance’ May Not Matter” (here, subscription required) reported on a recent study by Thomson Financial that took a look at company performance relative to guidance. Conventional wisdom holds that company executives use guidance to “manage expectations” by keeping analysts’ estimates low ahead of earnings announcements, so that the reported numbers look better. But the Thomson Financial study found that between 2001 and 2006, the S & P 500 companies that issued guidance beat analysts’ estimates 65% of the time, while companies that didn’t issue guidance beat analysts’ estimates 63% of the time.

But whatever companies’ motivations may be for providing guidance, the NIRI survey suggests that fewer and fewer companies are doing it. I don’t think the academics’ research can be disregarded, but I think it may need to be updated. For example, if the class of “stoppers” were brought up to date and the early part of the academics’ data set eliminated (say, data from years 2002 and 2003), the academics’ research might well more closely resemble the NIRI survey’s results.

In any event, the academics’ analysis also represents a particular point of view. The academics expressly advocate the view that it is better if companies provide guidance, on their generalized economic theory that more information is better for the marketplace. But whatever the merits of this analysis in its own context, it is divorced from the practical effect that a public earnings prediction has on the behavior of company officials. Specifically, companies that have established a target will strain to meet it. As I have previously noted (most recently here), a short term orientation driven by earning estimates is frequently at the heart of problems that lead to shareholder claims. I am all in favor of complete disclosure about past performance. But whatever the arguable economic benefits from trying to make public predictions about the future, from a risk standpoint, companies will always be better off keeping their projections to themselves, particularly on quarterly projections.

A July 24, 2007 CFO.com article discussing the NIRI survey results and the academics’ reserach can be found here.

Deeper Dive: In an earlier post (here), I took a look at the 2007 year-to-date securities lawsuits, and I also took a look (here) at the question whether the downturn in securities lawsuits may be temporary or is permanent. In the latest issue of InSights (here), I take a deeper look at both of these topics.

D & O Litigation Update Teleconference: On August 15, 2007, from 2:00 pm to 3:45 pm Eastern, I will be participating in a Mealey’s sponsored D & O Litigation Update teleconference (here). My co-panelists are Marialuisa Gallozzi of the Covington & Burling law firm and Joe Monteleone of the Tressler, Soderstrom law firm. Topics to be discussed include the impact of global warming legal and regulatory issues on the board room and on D & O exposure; the impact of recent Supreme Court decisions, including Tellabs; D & O coverage issues arising from the subprime lending lawsuits; and problems with insurability of Section 11 settlements.


In an earlier post (here), I examined recent academic research questioning whether the rating agencies have played a blameworthy role in the subprime lending industry, and speculating on the rating agencies’ possible litigation exposure. On July 19, 2007, the rating agencies potential litigation risk moved from supposition to reality when a shareholder of Moody’s filed a purported class action lawsuit (here) alleging that Moody’s failed to disclose that it “assigned excessively high ratings to bonds backed by risky subprime mortgages,” and that Moody’s maintained the ratings “even as the downturn in the housing market caused rising delinquencies of the subprime mortgages.”

The Complaint also alleges that on July 11, 2007,

Moody’s shocked investors when it announced that the Company was downgrading 399 mortgage-backed securities issued in 2006 and reviewing an additional thirty-two for downgrade, affecting approximately $5.2 million of bonds. The Company also disclosed that it had downgraded 52 bonds issued in 2005.

A July 11, 2007 Wall Street Journal article discussing Moody’s downgrade of the mortgage-backed securities can be found here.

There are a number of odd things about this Complaint. First, there is the fact that it is Moody’s shareholders who are bringing the lawsuit, not, as you might suppose, investors who purchased the mortgage-backed securities that supposedly were assigned excessively high ratings. The lawsuit is brought on behalf of “all purchasers of the common stock of Moody’s between October 25, 2006 and July 10, 2007. ” I guess the wrongdoing Moody’s is alleged to have committed affected a wide variety of arguably aggrieved persons, even including Moody’s shareholders. As I noted in my recent post (here), subprime lending related litigation is arising in an ever-increasing variety of forms. It’s just that the investors whose investments supposedly were misleadingly rated would seem to be the ones more likely to assert a grievance about supposedly excessive ratings Moody’s allegedly assigned.

The second odd thing about the Complaint is that the lawsuit names as the sole defendant Linda Huber, Moody’s CFO. The Complaint does not name Moody’s itself or any of its other officers or directors as defendants. The Complaint alleges that Huber was in possession of “adverse undisclosed information about the company’s business.” There is of course no requirement that any plaintiff name any particular defendant in a lawsuit, but there is something, well, unusual about just naming the CFO and no one else. (UPDATE: Alert reader Avi Wagner of the Stoock $ Stroock & Lavan law firm suggests that the explanation for the complaint only naming the CFO might be that the attorney hopes to bury the notice; by not naming a corporate defendant, a notice might catch fewer eyes and might not be registered with people searching courthouse news or other litigation filing reports.)

Another odd thing about the Complaint is that it involves Moody’s, rather than another of the rating agencies. Of course, that is who Moody’s shareholders would sue, if in their status as Moody’s shareholders they would sue anybody. But the Complaint was filed just a day after Moody’s own rather public whinge that, as the Wall Street Journal put it in its July 18, 2007 article “Moody’s Says It is Taking a Hit” (here, subscription required), it is “paying a high price for its tough stance on lax lending standards for commercial mortgage backed securities.” According to the Journal article, Moody’s claims that it was “passed over and not hired to 75% of the commercial mortage-backed securities rating assignments” because the securities issuers “were hiring competitors that would hand out higher ratings on securities.” In other words, by Moody’s account, if there were excessively high ratings for mortgage-backed securities, it wasn’t Moody’s doing, thank you very much.

To be sure, even by Moody’s own account, it was not until this past April 10 that it announced that it was (according to the Journal) “raising subordination levels of commercial mortgage-backed securities in an effort to enhance credit quality and further reduce the possibility of widespread defaults.” The negative inference is that prior to April 10, Moody’s did not have these heightened requirements.

Whatever the merits and ultimate fate of this recently filed lawsuit, the purported class of Moody’s shareholders who acquired their stock between October 2006 and July 2007 would not include Moody’s most prominent shareholder, Warren Buffett. According to Berkshire Hathaway’s 2006 Annual Report (here), Berkshire owned 48 million Moody’s shares – or 17.2% of the company – as of December 31, 2006. These shares have been reported in every Berkshire annual report since 2001, suggesting that Berkshire acquired the shares some time during 2001 — in any event, well before the beginning of the class period.

It is probable in any event that Buffett has much more positive feelings about Moody’s than does the plaintiff who initiated the lawsuit. According to Berkshire’s 2006 Report, its Moody’s shareholdings cost only $499 million, but as of December 31, 2006, were worth $3.315 billion. (Assuming Berkshire still holds the same number of Moody’s shares, the stock would be worth about $2.832 billion today.) As I have noted more than once in this blog, you do have to admire Buffett’s touch.

Hat tip to the WSJ.com Law Blog (here) for the link to the Moody’s Complaint.

UPDATE: On August 29, 2007, shareholders of McGraw-Hill filed a lawsuit (refer here) alleging that the company failed to disclose that its Standard & Poor’s subsidary “assigned excessively high ratings to bonds backed by risky subprime mortgages — including bonds packaged as collateralized debt obligations — which was materially misleading to investors concerning the quality and relative risk of these investments.”


In keeping with the Harry Potter theme of my prior post, it may be worth noting here that one of the ill-fated Defense Against Dark Arts teachers at Hogwarts was none other than Alastor “Mad Eye” Moody. “Mad Eye” Moody has no known relationship with the rating agency, however. Nor as far as I know did he have any role in the subprime lending mess.


In a July 18, 2007 publication entiled "IPO Executive Insights 2007" (here) the Nixon Peabody law firm published the results of its survey of 100 chief executive officers and chief financial officers whose companies conducted initial public offerings in the past three years. The report contains a number of interesting observations, but perhaps the most remarkable are in the summary of advice the executives have for companies now considering going public. For example, one survey respondent cautioned:

Going public is like standing in front of the X-Ray machine for every. Once one goes public one cannot go back. In other words, you are completely exposed; everything about the business is in the public domain and is in front of the competition. It is a very different environment than being a private company….Living under regulations like Sarbanes-Oxley can be crushing to a company that is not prepared to understand and manage such regulations.

A July 23, 2007 Wall Street Journal article further summarizing the survey results can be found here (subscription required).

The noted regulatory constraints might be a reason that some companies might consider listing their shares on the London Stock Exchange’s Alternative Investment Market (AIM) (here). Perhaps the most valuable part of the survey report is its brief discussion of the advantages and disadvantages for a U.S.-based company in listing shares on the AIM.

The report notes that "utilizing AIM does provide a company certain advantages due to its flexible regulatory approach, lower costs and streamlined admissions process." However, the report also points out a number of risks for U.S.-based companies considering an AIM offering." The risks include:

Number of Shareholders May Trigger Reporting Obligations: Once shares are issued, "a company may have difficulty controlling the number of shareholders of record who eventually own its stock." The problem is that U.S. companies that have more than $10 million in assets "will become subject to the provisions of the Exchange Act" (including its periodic reporting requirements) if they have 500 or more shareholders of record.

Time Requirements: A company selling its shares on AIM must develop a relationship with institutions selling the company’s shares. Because of travel requirements and time zone differences, these requirements can be substantial.

Reduced Liquidity: AIM has a reputation for being illiquid, and as a result investors may have difficulty disposing of their shares.

Poor Post-IPO Performance: "Post-IPO Performance for AIM shares compare unfavorabley with companies listed on NASDAQ."

AIM’s Limited Diversity: Mining and energy companies account for close to half of AIM’s total market value. A company that is not in one of these industries "may not garner the interest of institutional investors who buy AIM stock or the attention the company would otherwise get in another marketplace."

In light of these limitations, it is hardly surprising that, as the report notes, "AIM’s growth has slowed in 2007." According to the report, the number of AIM offerings during the first four months of 2007 was more than 50% below the number of offerings during the comparable period in 2006.


Book Note: We here at The D & O Diary are impatiently waiting for our household resident teenagers to hurry up and finish reading the recently released Harry Potter book so that we can get a crack at it. While waiting our turn, we have been fortunate to have found a terrific book that we are happy to recommend to our readers.

Some readers will be sure to recall the rich combination of modern physics, philosophy and drama in Michael Frayn’s Tony award-winning play "Copenhagen." (Others may recall Frayn’s superbly funny farce, Noises Off.) In his 2006 book The Human Touch: Our Part in the Creation of the Universe (here) Frayn returns to the overlapping area between theoretical physics and philosophy to examine, in brilliant and entertaining fashion, questions about the universe and man’s role in it. This book is as rich and rewarding as it is well-written. It would be difficult to capture the depth and breadth of this book in a single snippet, but I offer the following brief excerpt of an example of the book’s reach and elegance:

Our own particular speck of the universe, the planet we live on, is as irregular as everything else. A sphere, which seems a neat enough idea – but a sphere that isn’t exactly spherical, wobbling a little on its axis and spinning not quite regularly. With a surface as rumpled as an unmade bed, splashed with seas and lakes as haphazard as the spills on a bar, under a shifting blanket of air and water vapour as confused as a drawerful of tangled string.

The oddest feature of this wobbly spheroid, though, is one particular class of things scattered about amidst the rest: a range of entirely anomalous objects that construct themselves out of the material around them, and then replicate themselves – perhaps the only objects of this sort in the entire universe. Among these weird anomalies is a sub-group with a few thousand million members that are even odder, because they also have some inkling of just how odd they are.

Perhaps not everyone will find this kind of thing an adequate substitute for the urgent strivings of the adolescent wizards at Hogwarts, but I find it sufficient (at least for now).

 
One of the increasingly critical features of the current D & O claims environment is the growing likelihood of disputes arising over defense fees. A June 20, 2007 decision in Delaware Superior Court for New Castle County in connection with coverage litigation arising out of the Hollinger International claims reflects many of the recurring aspects of these disputes and underscores the growing significance of issues surrounding defense fees.

The insurance coverage case in Delaware was brought by Sun-Times Media Group, the successor in interest to Hollinger International (hereafter, referred to herein as Hollinger), and by nine former outside directors of Hollinger. During the relevant period, Hollinger had purchased a total of $130 million in D & O insurance. The $130 million was arranged in four basic layers. The first two layers totaled $50 million. The third layer consisted of $40 million excess of $50 million, and the fourth layer consisted of $40 million excess of $90 million.

As a result of the now infamous corporate scandal involving Lord Conrad Black and several other Hollinger insiders (including David Radler, Hollinger’s former President, Chief Operating Officer and director, who ultimately pled guilty to participating in a scheme to defraud Hollinger’s shareholders), Hollinger shareholders filed a number of lawsuits against Hollinger, its corporate parents, the insiders, and the outside directors, Among the lawsuits was a shareholder derivative suit filed on Hollinger’s behalf in the Delaware Court of Chancery by Cardinal Value Equity Partners. Shareholders also filed several securities class action lawsuits, later consolidated, in Illinois (about which refer here).

The Cardinal derivative lawsuit settled in May 2005 (refer here). As part of the settlement, the carriers in the first two layers of the Hollinger D & O insurance program agreed to pay a total of $50 million, exhausting all of the insurance below the third layer in the Hollinger D & O insurance program.

In November 2006, Hollinger and the nine outside directors initiated a declaratory judgment action in Delaware Superior Court against the third layer insurers, who had denied coverage for the Illinois Class Action. Hollinger has been funding the outside directors ongoing litigation costs in the Illinois Class Action. In the coverage action, Hollinger and the outside directors, who are the plaintiffs in the coverage action, claim to have “incurred over $20 million (and expect to incur over $40 million) in defense costs” in defending the various shareholder lawsuits. The plaintiffs in the coverage action filed a motion for partial summary judgment seeking an order declaring that the third layer insurers have a duty to pay the coverage action plaintiffs’ past and future defense costs in the Illinois Class Action.

Although the defendant insurers opposed the motion on a number of grounds, the most substantial ground was based on the conduct exclusions in the operative policy language. The carriers argued that because Hollinger is advancing the outside directors’ fees, only Hollinger has a “ripe claim” for reimbursement of defense costs. The carriers further argued that Hollinger was not entitled to recover amounts it had incurred in defense of itself and others, because of Radler’s guilty plea. The defendants argued that the operative policy language imputed Radler’s conduct to Hollinger and triggered the conduct exclusions.

Specifically, the carriers argued that Hollinger was not entitled to defense cost coverage because coverage is precluded under the personal profit exclusion and the fraud/dishonesty exclusion. They argued that Radler’s fraudulent and dishonest acts are imputed to Hollinger under the operative policy language, relieving the carriers from their duty to advance defense fees. The carriers further argued that because Hollinger is paying their fees, the outside directors have no present claim to recover their fees from the defendants.

In its June 20, 2007 opinion (here), the Court quickly moved past preliminary issues to find that the defendants were obligated to advance both Hollinger’s and the outside directors’ defense costs. The Court ruled that because the Illinois Class Action is within the D & O policies’ coverage and “potentially could result in indemnity, the duty to advance is triggered.” With respect to the outside directors, the Court reasoned that “the fact that [Hollinger] has paid some or all of the costs does not relieve the Third Layer Insurers from their duty under the policy to address defense costs.” The Court held that the fraud implicit in Radler’s guilty plea could not be imputed to the outside directors under the policy’s imputation language.

The Court further held that the conduct exclusions did not preclude advancement of defense fees for Hollinger, notwithstanding the possible imputation to Hollinger of Radler’s misconduct. The Court found that the Policy “contains an unequivocal duty to advance defense costs prior to the final disposition of a claim.” The Court ruled that

the personal exclusions do not override a present contractual duty to advance defense costs unless the Defendants can unequivocally now show that all of the allegations in the Illinois Class Action complaint fall within the personal conduct exclusions. Defendants have failed to show at this juncture that any of the exclusions are definitely imputed to [Hollinger] Even though the Defendants argue that Radler’s guilty plea imputes the transactions to [Hollinger], the Illinois Class Action includes transactions that were not part of Radler’s guilty plea….Because the Defendants have failed to show at this time the applicability of the exclusions to [Hollinger], the Court need not decide the potential applicability of the exclusions at this time.

Finally, the Court noted that the Policy “provides that the Insured must pay back amounts they received but were not entitled to.” The Court reasoned that because of this repayment provision, “the plain language of the policy guaranteeing an advancement of defense costs is not precluded by any implication of exclusions” to Hollinger. The Court quickly disposed of the carriers’ other coverage objections, and granted the coverage plaintiffs’ partial motion for summary judgment on the duty to pay defense costs.

This ruling is clearly just the first of several rounds. Among other things, the July 13, 2007 convictions of Conrad Black and the other insider defendants (refer here) adds relevant facts and underscores the need for the court to address the potential imputation to Hollinger of the criminal misconduct and the consequences for the ultimate coverage determination. There will eventually have to be a day when the convictions and the guilty plea will have to be compared and contrasted with the allegations in the Illinois Class Action to determine what is covered and excluded, and it is entirely possible that some portion (if not all) of the defense fees the court ordered to be advanced in the June 20 opinion will have to reimbursed to the carriers.

The Court’s relative ease in reaching its conclusions was, it must be noted, substantially enhanced by the Court’s willingness to overlook certain considerations raised by the policy’s other terms and conditions. The Court clearly was not concerned to differentiate whether Hollinger sought reimbursement under Side B of the policy for amounts for which it had indemnified the directors and officers, or under Side C for amounts the company had incurred directly in its own defense. The Court’s analysis of the carriers’ obligation to advance the outside directors’ defense fees was unaffected by any analysis whether the outside directors’ direct coverage under Side A of the policy had even been triggered, given that the outside directors are being fully indemnified by Hollinger. The Court was unconcerned by the possibility that even if Radler’s guilty plea, as imputed to the Company, did not preclude coverage for all of the claims in the Illinois Coverage Action, it might preclude coverage for some of the claims- the fact that amounts paid that were not owed must be repaid apparently was sufficient for the Court.

In effect, the Court held that the policy does not require an allocation between covered and uncovered claims until it is possible to make the final and ultimate allocation determination, and in the interim the policyholder (rather than the carriers) gets to hold the stakes. There is a rough sort of justice to this outcome, without regard to what the Court did or did not have to say about the policy’s other requirements and provisions.

Even if the Court’s disinterest in certain features of the policy may make the opinion less instructive, the case itself nevertheless is important in larger respects, for what the underlying dispute signifies about important issues in the D & O claims context.

The first of these larger aspects is that the present dispute arises between the insureds and the excess carriers, after the underlying carriers apparently have already acknowledged and provided coverage. The existence of active coverage disputes with excess carriers after the underlying carriers have acknowledged coverage is becoming unfortunately more common. Just to mention a couple of examples, the CNL Resorts case (here) and the Conseco case (mentioned in the CNL Resorts post) both involved disputes between insureds and excess insurers after the underlying carriers had already recognized coverage. The increasing willingness of excess carriers to assert or stand upon coverage defenses that underlying carriers had not maintained is a potentially troublesome development.

To be sure, the excess carriers’ position in the Hollinger dispute may ultimately prove to be valid and I do not mean to suggest that there is anything questionable about their positions in that case. Given the significant level of criminal misconduct involved, the excess carriers’ position is certainly understandable. But in general, the phenomenon of excess carriers disputing coverage when underlying carriers do not could disrupt to efficient claims resolution. At a minimum, claims resolution becomes substantially more contentious and litigious, in a way that is contrary to the reasonable commercial expectations of insurance buyers at the time they enter into the insurance contract. Insurance buyers who purchase a multilevel program of insurance certainly do not expect to have to fight their way through each successive layer.

Another larger concern is the sheer magnitude of attorneys’ fees that increasingly are required to defend D & O claims. Without a doubt, the Hollinger claim is unusually complex, and given the criminal misconduct involved, unusually serious. The accumulation of as much as $40 million in attorneys’ fees is nevertheless arresting. Moreover, there are all too many other cases these days that do not involve near the complexity or seriousness of the Hollinger claims in which defense counsel are earnestly working to achieve the same level of defense expenditure, or as close to it as they can get. The astonishing acceleration of defense expense is one of those facts that everyone recognizes but that no one is willing to say or do anything about. The astronomical level of defense fees represents a serious problem for every participant in the claims process (except perhaps the defense attorneys themselves). The reality is that the rapid escalation of defense fees all too often may threaten to leave policyholders uninsured or underinsured for the costs ultimately required to resolve claims.

I would argue that the most significant challenge for the D & O industry right now is the dramatic increase in defense fees. (An earlier post on this same topic can be found here.) The increasing level of defense fees creates difficulties at every stage of the insurance transaction, from contract formation, when the specter of escalating fees makes limits selection increasingly challenging, to the claims process, when escalating fees complicate efficient claims resolution (and perhaps may be the real reason behind the increase in disputes with excess carriers). Moreover, the accumulated cost of escalating defense expense is undoubtedly a significant factor working against further reductions in the levels of D & O premiums.

As is well explained in a recent article (here) by noted D & O commentator Dan Bailey, controlling defense expense is in everyone’s interests, in order to maximize the protection available under the D & O insurance program. To be sure, that does not imply that carriers are justified in resisting payment for reasonable and necessary expenses that policyholders rightfully expect carriers to pay. But everyone in the industry has an interest in the development of mechanisms and controls to ensure that claims defense goes forward in the most efficient and cost effective way. Defense expenditures that exhaust or substantially deplete the available insurance are a problem for all concerned.

Very special thanks to Francis Pileggi of the Delaware Corporate and Commercial Litigation blog (here) for providing a copy of the June 20 opinion.


SOX Anniversary: The approaching fifth birthday of the Sarbanex-Oxley Act has already been the subject of extensive commentary; for example, it is the cover story of the July 2007 issue of CFO Magazine (here). The Audit Trail blog (here) wants to celebrate as well as observe the anniversary. Its site not only displays a running SOX birthday countdown clock, but also features a SOX birthday music video. The site even allows you to send a SOX anniversary eCard (here) to that special someone in your life. The next thing you know, there will be SOX anniversary decorations for sale at Wal-Mart.

In prior posts (most recently here), I have noted the threat of Foreign Corrupt Practices Act (FCPA) investigations as a growing area of corporate risk. Several recent reports substantiate this concern and help explain why this area of risk continues to grow, and also highlight some of the barriers to antibribery enforcement.

A June 26, 2007 memorandum prepared by the Shearman & Sterling law firm entitled “Recent Trends and Patterns in FCPA Enforcement”(here) reports that “there has been a dramatic increase in new investigations” and that “both the DOJ and the SEC have become increasingly aggressive.” According to the memorandum, there are now 55 open FCPA investigations (at least that have been publicly reported by the companies under investigation).

Part of the reason for the increased investigative activity is the increase in governmental resources devoted to foreign bribery investigations. According to a July 16, 2007 Law.com article entitled “Why Are More Companies Self-Reporting Overseas Bribes?” (here), the SEC has “added about 700 staffers to help enforce all compliance laws,” and the DOJ and the FBI have both added substantial staff focused exclusively on FCPA investigations.

The more important factor for the growth of FCPA cases may potential corporate defendants desire for leniency under federal sentencing guidelines. A corporation’s cooperation can produce substantial benefits; the Law.com article linked above describes in detail the substantial efforts to cooperate that Baker Hughes recently undertook in connection with its ongoing FCPA investigation (about which see my prior post, here), as a result of which Baker Hughes apparently avoided paying “an additional $27 million in fines.”

These kinds of incentives have motivated companies to come forward and self-report (as I have previously noted, here). According to the Shearman & Sterling memo, during the period 2005 to 2007, some 23 of 26 new FCPA cases were self-reported. The memo notes that these numbers “underscore the trend toward companies taking on the onus of reporting or accountability and may indicate that companies now perceive the act of self-reporting to be favorable to the ultimate outcome of the investigation.” An interesting additional statistic the memo notes is that many of the voluntary disclosures came after violations were unearthed in the due diligence process for a merger or acquisition. (The memo cites the recent ABB, InVision and Titan Corporation investigations as examples.) As the M & A pace continues, there may be more of these M & A related self-disclosures.

The international scope of the crackdown on corrupt practices is documented on the 2007 Progress Report (here) of Transparency International (here) on enforcement of the Convention on Combating Bribery of Foreign Public Officials (here) of the Organization for Economic Co-Operation and Development (OECD) (here). The OECD Convention, first established in 1997, is a compact of now 37 countries (including the United States) to adopt and enforce antibribery laws. The Report shows that while there has been some progress in the battle against bribery and corruption, “there has been little or no enforcement in twenty countries, demonstrating significant lack of political commitment by over half the signatories.”

The Report specifically cites the UK’s termination of its investigation of bribery allegations against BAE Systems on the Al Yamamah arms project in Saudi Arabia (see my prior post here) as a “serious threat to the convention,” and states that the UK’s “national security concern” explanation for terminating the investigation “opens a dangerous loophole that other parties could assert when investigations may offend powerful officials in important countries.” Because of these concerns, the Report notes that the Convention may be “at a crossroads.”

Despite these concerns, the Report does also note that during the prior year foreign bribery investigations were brought in twenty countries out of then thirty-four active signatory countries, as opposed to only seventeen out of thirty-one countries the preceding year. In addition, during the prior year there were bribery prosecutions bourght in sixteen of the thirty-four then-active signatories.

These numbers, as well as the growing number of Convention signatories, suggest that notwithstanding troublesome setbacks and lapses in political will, enforcement of antibribery laws remains an important factor in the global business marketplace. As I have noted previously (here), this exposure represents a substantial area of D & O risk, particularly with respect to the threat of follow on civil litigation based on antibribery investigations. These recent reports suggest that this could become even more significant in the months ahead.

Special thanks to a loyal reader for the link the Law.com article. Hat tip to the SOX First blog (here) for the link to the Transparency International report.

A Backdating Case Dismissal: In an order dated July 16, 2007 (here), in the consolidated options backdating related Ditech Networks derivative litigation, Judge Jeremy Fogel of the Northern District of California granted (with leave to amend) the individual defendants’ motion to dismiss based on the insufficiency of the plaintiffs’ pleading. The Opinion states:

As currently pled, the Complaint alleges fraudulent conduct by labeling various grants as backdated and describing them as having been made at low points within certain defined periods….While counsel for Plaintiffs represented at oral argument that the statistical likelihood of the options having been granted properly is very low, that theory is not alleged in the Complaint or in a document that the Court may consider on this motion. Even assuming that the factual allegations of the Complaint are true, many explanations other than options backdating exist for the coincidence of the grants and a low share price. The following factual detail likely would strengthen the Complaint: the degree to which the options were granted at the discretion of the compensation committee or the board, versus at fixed, preestablished times; the actual grant dates of the options and the appropriate price of the options; the date that the options were exercised; whether required performance goals were met before the options were granted; the presence or absence of other major corporate events, such as an acquisition, at the time of the grants; and the results of any request by Plaintiff for information.

Because of the inadequacy of the plaintiff’s allegations, Judge Fogel noted that it would be “premature” to address federal statute of limitations and Delaware state law demand futility issues. (It should be noted that the Ditech opinion is designated as “not for publication” and “may not be cited.”)

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for the link to the Ditech Networks opinion.

Photo Sharing and Video Hosting at Photobucket The July 17, 2007 Wall Street Journal reports (here, subscription required) that private equity firm Apollo Management L.P. will (after selling a portion of the firm to the Abu Dhabi Investment Authority) be listing its shares on the new Goldman Sachs private securities exchange. The Apollo listing follows a couple of months after Oaktree Capital Management listed on the Goldman Sachs exchange.

The new Goldman Sachs exchange is one of several new private (or lightly regulated public) exchanges that have emerged in recent months. These developments raise some interesting (and potentially urgent) questions, such as: What are these new exchanges? Why are issuers and investors drawn to them? What are the implications for existing traditional markets? And what are the risks and exposures for the listing companies that access these markets?

What Are The New Exchanges?: The full name of the new Goldman Sachs exchange is the “GS Tradable Unregistered Equity OTC Market,” or GSTrUE for short. A good introduction to the GSTrUE can be found here. The idea behind the market is to allow private firms to raise money and create a way for their executives to cash out, without the burden, expense, delay – or scrutiny — of registering shares or taking on reporting responsibilities. The Goldman Sachs exchange is private and unavailable to individual investors. The exchange is available only to institutional and other sophisticated investors.

According to news report (here), NASDAQ is preparing to introduce a new electronic platform called “The Portal,” to allow buying and selling of Rule 144A shares. The purpose of the exchange is to allow institutional buyers of the securities to have a market within which to later trade the shares, in the hope that the availability of a trading platform will improve investment liquidity and support improved valuations. The Portal is slated to launch in August (refer here). NASDAQ touts the Portal’s advantage over the GSTrUE exchanges as a neutral platform that is not restricted to customers of a single bank. NASDAQ’s application for SEC approval for the trading platform can be found here.

In addition to these private exchanges, the London Stock Exchange announced on July 12, 2007 (here) that it will launch a dedicated market for issuers of specialized funds (the “Specialized Fund Market”) to create a separate market for alternative assets such as hedge funds and private equity vehicles. The market is designed to provide a trading platform and investment liquidity, in a structure restricted to trading professionals. The market is for issuers that wish to target institutional investors, such as single strategy funds, feeder funds, specialized sector funds, and specialized geographical funds. Commentators suggest (here) that the new LSE market , which unlike the GSTrUE and the Portal will at least be “lighly regulated,” is designed to compete with Euronext Amsterdam for listing alternative funds.

Each of these initiatives is different and each of them is designed to achieve different goals. What they have in common is that they each provide a way for issuer companies and funds to reach institutional investors through a trading platform on which their shares can trade without the need for full registration or the adoption of full reporting status.

What Does the Record So Far Suggest?: Prior to Apollo’s announcement, the only prior issuer to list on the GSTrUE was Oaktree. According to news reports (here), in May 2007, Oaktree raised $800 million by selling about 14% of the firm to 50 investors. According to today’s Journal article, “Oaktree listed at only a slight discount to the valuation it could have received on the public markets.”

At least based on Oaktree’s experience, the GSTrUE exchange (and potentially, The Portal) offer plausible alternative ways for firms to issue tradable shares without undertaking an IPO in the public securities markets. Specifically, the Oaktree and Apollo transactions seem to represent an alternative to the public offerings that Blackstone Group and Fortress Investment Group recently completed, with the advantage that Oaktree and Apollo could complete their offerings without the burdens and scrutiny of a public offering. The Portal provides a way for private companies to offer their qualifying investors a public market and enhanced liquidity for the private company investment.

While these private markets may offer issuers an alternative to the public markets, to the public markets these innovations represent yet another threat. As I have previously noted (most recently here) several blue ribbon panels have recently been concerned with the competitiveness of the U.S. securities exchanges. But the new markets represent an innovation that addresses needs that may not be possible to meet in the public markets. Like the forces of globalization that are encouraging new markets that compete with the U.S. based public securities markets, the need for innovation is yet another force stronger than the gravitational pull of the public securities markets themselves.

What is the Regulatory Context?: For the private exchanges to avoid SEC regulation, investors will have to be limited those with over $100 million in investable assets, and in order to avoid triggering reporting requirements, any listed U.S. entity will have to make sure it does not exceed more than 500 shareholders. These restrictions obviously put certain limitations on liquidity (as, it should be noted, does the likely absence of analyst coverage).

The absence of regulatory scrutiny and reporting requirements may act as a deterrent to some investors. The potential lack of transparency may even violate the investment policies of certain public funds or other fiduciary entities. In addition, the continued ability of these markets to attract investors will largely depend on the markets perceived trustworthiness. A scandal or report of a deceptive practice by one or more issuers trading on these private exchanges could undermine market trustworthiness and potentially the confidence of the investors. The incentives of the exchanges to maintain their integrity could potentially conflict with the issuers’ interests, or at least the interests of those issuers whose primary attraction to the exchange is a desire to avoid transparency and scrutiny.

What is the Risk Environment?: While the listing companies, if compliant with the requirements, will remain outside the reporting system, they will not be trading in a parallel universe to which the laws do not apply. Aggrieved or disappointed investors who believe they have been misled or deceived will identify any number of legal theories they might use to pursue legal claims against the private exchange listed firms, including, for example, common law fraud and misrepresentation theories. Of course, the institutional investors who are able to invest on these private exchanges would perhaps be less likely than retail investors to initiate litigation. But as, for example, institutional hedge fund investors have recently shown (here), given sufficient provocation, institutional investors are very willing to use litigation to redress concerns.

Issuer companies of the caliber of Oaktree and Apollo would enhance any market. But a market whose main attraction is lack of scrutiny and of reporting obligations could potentially attract participants whose presence may ultimately have a different effect on the market than enhancement. If that should happen, and unanticipated losses emerge, the lawsuit genie inevitably will escape from the bottle.

The point is that the issuers trading on these new private exchanges will not exist in a risk free environment. The perception of risk for hedge funds, private equity funds and venture capital funds has evolved in recent years; so too will the risk perception for issuer companies whose shares trade only on these private exchanges. The trading nonpublic company will represent a new category of risk. The arrival of private securities markets and of the companies whose shares trade only on their exchanges will require adaptation. To the extent the demand emerges, the insurance industry will likely need to develop new products designed to address the special needs and evolving risks of these companies.

But make no mistake, the continuing development of GSTrUE market and the anticipated arrival of the NASDAQ Portal, as well as the continued innovation in the public markets such as the LSE, represent categorically new developments that will require innovation and adaptation, particularly if their impact on the public markets is anything more than marginal.

Government Cash, Global Markets: The Abu Dhabi Investment Authority (here), with estimated assets of over $600 billion, receives the governemental revenue of Abu Dhabi’s oil industries. ADIA is the largest of the new breed of governmental investment authority that is playing an increasingly large role on the global financial scene. In a prior post (here), I discussed the Norwegian Government Pension Fund (here), which at nearly $300 billion in assets is not only large, but is also playing an increasingly activist role in governance matters. Other significant governmental investment authorities include the Government of Singapore Investment Corporation (here). The very size of these entities make them important players in the financial markets. Their influence will only continue to grow as commodities scarcities dictate global cash flows. The unavoidable importance of these institutions is a looming omnipresence, that for good or ill will increasingly affect international investments in the years ahead. The political risk behind all this is a large and scary topic, but one that at least for now can be left for another day.

Location, Location, Location: Abu Dhabi, the largest of the seven emirates of the United Arab Emirates, and also UAE’s capital, has a population of about 1.8 million people, about the same size as metropolitan Cleveland. But it doesn’t have Lake Erie. Sure, sure, Abu Dhabi has lots of oil. But think about it. In the 21st century, fresh water could prove to be a lot more imporant than oil. I wonder if the ADIA will amasss enough wealth to be able to buy Lake Erie?