The D & O Diary

A Fresh Look at a New Securities Lawsuit

Kevin LaCroix — Thu, 11 Mar 2010 04:50:35 -0500

For those of us who spend a lot of time looking at securities class action lawsuits, the cases often have a familiar pattern. Unfortunately, the familiarity may dull sensitivity to the allegations or even to the process itself. So it was interesting to read a layman’s reaction to a recently filed lawsuit, if for no other reason than it provided a look at the lawsuit and the process with a fresh set of eyes.

The lawsuit in question was filed in the Northern District of California on March 9, 2010 against Medivation and certain of its directors and offices. As is so often is the case in these kinds of lawsuits, Medivation is a life sciences company whose developmental stage product failed to meet certain clinical trial goals. Specifically, and as reflected in the plaintiffs’ lawyers March 9 press release (here), its product did not meet primary and secondary goals in a Phase 3 clinical trial for patients with mild to moderate Alzheimer’s disease. When the company announced this news, its stock price declined and the lawsuit followed. A copy of the complaint can be found here.

This lawsuit will work its way through the system. The lawyers involved, all of whom undoubtedly are (or when they are retained to defend will be) well versed in these things, and will raise familiar arguments that may or may not succeed. All very familiar to those of us who spend all of our time immersed in these kinds of things.

An interesting perspective about this lawsuit appeared on the Blogging Stocks site (here). The author, Gary E. Sattler, has a number of reactions to the plaintiffs’ complaint, summarizing his comments with the observation that "even when given my usually cynical nature, and my usual dislike for big pharmaceutical interests, I still take issue with this potential class action lawsuit."

After summarizing the plaintiffs’ allegations, the author notes that

The plaintiff class has to cross a significant threshold of proof in order to prevail in this case. Based on my reading of the original complaint, plaintiffs fail to establish intent, fail to reveal purposeful omission of fact, and fail to establish that the actions of the defendants were the true overt cause of any artificial inflation of Medivation's stock value. Furthermore, the plaintiff's complaint seems to disregard that Medivation has had broad yet cautious support from within the Alzheimer's treatment community. Was it all wishful thinking? Perhaps it was, but that support came from many well-educated minds experienced in the field.

Sattler goes on to note that "to me, this potential class action smacks of sour grapes." He then reiterates his support for the company and for the company’s Alzheimer’s product.

Sattler seems to be reasonably objective (he states that he has no investment interest in the company). Of course, his rough and ready assessments have no direct relationship to how the lawsuit and its allegations might fare in court. But I have often found that the court of public opinion is an accurate sounding board. True, it might be argued that because of Sattler’s preexisting interest in the company and in its product he might be biased in its favor. But just the same it is interesting to look at the allegations through his eyes and see his reaction to the allegations.

When the U.S. Supreme Court first issued its opinion in Tellabs, I thought it would make little fundamental difference, because I thought that in the end and regardless of the formal standard, courts would give the green light to cases that raised a stink and would cut short the rest. Regardless of whether I am right about the Tellabs standard, I think trial courts fundamentally assess cases on a smell test, which is basically what Sattler has done in his post, albeit without specific reference to legal standards. Viewed in that light, his rough and ready assessment is interesting. And perhaps significant, at least with respect to the case’s prospects.

More About the FCPA: Regular readers know that I have a certain fixation about the Foreign Corrupt Practices Act. (Indeed, one reader has gone so far as to accuse me of being "obsessive" about it.) I continue to believe that the FCPA will be an increasingly important corporate exposure in the years ahead, if for no other reason than the relentless globalization of commerce.

For those who remain skeptical on the topic, I suggest a quick review of the March 10, 2010 post by Bruce Carton on his Securities Docket blog (here). In his post, Carton painstakingly compiles all of the recent comments by regulators corroborating that the FCPA is a top priority. He also reviews the significance of the recent Africa Sting enforcement action, as well as the implications of the Bribery Bill which may soon become law in the U.K. As Bruce’s emphasizes, there are a number of very significant implications to the Bribery Bill.

As Carton puts it, top FCPA lawyers agree that the anti-bribery activity has reached "a fever pitch." Whether or not I am obsessive, it is indisputably clear that FCPA related enforcement activity will be a significant area of corporate exposure in the months and years ahead.

A Picture is Worth a Thousand Words: Want to know what the financial crisis is all about? Check out this graphic depicting the escalating mortgage default rate during the current crisis. No interpretation required. As for myself, I am considering investing in gold. And stocking my basement with water, canned goods, matches, stout rope and a knife. You never know.

This Too Shall Pass: You are probably familiar with the OK Go video performed on an array of treadmills. If not, you should get out more. I’ve seen it and I have serious social issues. (See prior item). However, and in any event, everyone should watch the new video from OK Go for its new song, "This Too Shall Pass." Rube Goldberg would be impressed. Smashing pianos, crashing trash cans, smashing TV sets (showing the treadmill video, no less), the whole enchilada.

Though I have embedded the Rube Goldberg version below, there is an alternative spoof marching band version here that is also funny in a completely different way. (Don’t you love the Internet?) Please also see the Author's Note below.

Authors’ Note: This blog post was written in its entirety on a laptop computer while the author was sitting in Cladgagh Irish Pub in Lyndhurst, Ohio and watching Real Madrid play Lyon in a UEFA Champions League game on the television. (In an excellent game, the teams played to a 1-1 tie.) I hope you enjoy reading this post as much as I enjoyed writing it. Gradus ad Parnassum.

A Status Update on the Subprime and Credit Crisis-Related Litigation Wave

Kevin LaCroix — Wed, 10 Mar 2010 05:13:10 -0500

It has now been over three years since the first subprime-related securities class action lawsuit was filed in February 2007, yet many of the cases filed in the ensuing litigation wave are still only in their earliest stages. While the vast majority of these cases are still unfolding, there have been some important recent developments, suggesting that the evolving litigation wave has passed some significant milestones. With that possibility in mind, it seems appropriate to check in for a status report on the subprime and credit crisis-related litigation wave.

In the latest issue of InSights (here), I take a look at the developments to date as the subprime and credit crisis-related cases have worked their way through the system, including trends in motion to dismiss rulings and settlements, as well as with respect to issues such as gatekeeper liability and defense expense costs.

Restatements Decline - Again

Kevin LaCroix — Wed, 10 Mar 2010 05:10:36 -0500

Both the number of restatements and the number of companies reporting restatements are declining according to a new study. The number of restatements has been declining for three years now, and the number has declined materially since the figures peaked in 2006, both because of better controls and changing standards.

The study, by Audit Analytics, is not yet available online, but it has been widely reviewed, including in a March 4, 2010 CFO.com article (here) and a March 1, 2010 article by Matt Kelly of Compliance Week (here).

As reflected in this article, the study shows that there were just 630 companies reporting 674 accounting restatements in 2009. There were 24% fewer restatements in 2009 compared to the prior year, when there were 923. The 2009 figures represent the lowest number of restatements since 2001 (when accounting scandals dominated the headlines).

The number of restatements has actually declined for three years in a row since they reached their peak in 2006, when 1,564 companies filed 1,796 restatements. In other works, the number of restatements in 2009 was 62 percent less than the number in 2006.

In addition to the declining number of restatements, accounting errors requiring a restatement are now being caught sooner. The average restatement in 2009 covers a period of 476 days, compared to 716 days in 2006.

Restatements also reduced earnings by smaller amounts. 2009 restatements on average reduced earnings by $4.6 million, compared to $7.2 million in 2008 and $23.5 million in 2006.

The CFO.com article reports that the study’s authors attribute the decline to two factors: improved internal controls as a result of Section 404 of the Sarbanes Oxley Act, and a 2008 recommendation by the SEC’s Advisory Committee on Improvements to Financial Reporting that the SEC “relax its requirements on what types of errors should trigger restatements.”

One circumstance supporting the suggestion that SOX may be contributing to the reduced number of restatements is the fact that the majority of U.S.-based companies issuing 2009 restatements (374 out of 522) were “nonaccelerated filers,” meaning that Section 404’s requirements do not yet apply to them. Of course, there are, in fact, more nonaccelerated filers than accelerated filers in the first place, so the raw numbers alone may not tell the whole story. In addition, the smaller nonaccelerated filers simply may be more likely to have problems due to their small staffs and fewer tools.

On his Compliance Week blog, Kelly points out that the number of restatements by accelerated filers grew between 2002 and 2005, the year they had to comply with Section 404, but they have declined since that time. Kelly concludes that, despite all of the criticism of the provision, Section 404 may be working.

To those who say we had a crisis in 2008 notwithstanding Section 404, Kelly points out that the most recent crisis “has largely been a crisis of flawed assumptions and reckless risk management coming home to roost – not accounting fraud.” Kelly concludes that whatever financial reform Congress might conjure up in response to the current crisis, it is not time to “start rewriting Sarbanes-Oxley wholesale,” as “the law is working just fine.”

The suggestion that the declining number of restatements is due to SOX reforms brings to mind the long-standing question whether the changes in the number of securities class action filings are also attributable to improved company behavior as a result of SOX.

However, though the number of restatements has declined steadily, the number of lawsuits has fluctuated from year to year. Indeed, the most recent year with the highest numbers of restatements, 2006, when there were almost three times as many restatements as in 2009, there were fewer class action lawsuit filings (116) than in any year since 1996, and certainly significantly fewer filings than in 2009, when there were (depending on whose count you are using) at least 178 filings.

So there may well be fewer restatements as a result of Sarbanes Oxley, but that alone does not explain what has been happening with fluctuating securities class action lawsuit filings. Changed corporate behavior as a result of Sarbanes Oxley, even if it has occurred, is not a sufficient explanation for lawsuit filing levels. There may simply be too many other areas of corporate activity, beyond those addressed in Sarbanes Oxley, that continue to attract the unwanted attention of the plaintiff’ class action securities lawsuits.

The bottom line seems to be that as good as the news is that the number of restatements is declining, that does not necessarily mean as a general matter that companies are necessarily less likely to be sued.

Madoff Feeder-Fund Survives Dismissal Motion

Kevin LaCroix — Tue, 09 Mar 2010 05:12:38 -0500

An astonishing amount of litigation followed in the wake of the Madoff scandal revelations, as I have detailed here. But thought the litigation filings have surged, the question remains whether the plaintiffs’ desperate attempts to recover their losses from third parties have any chance of success.

This question was underscored by the March 4, 2010 ruling by a Luxembourg court that individual investors who lost money in Madoff’s scheme lack standing to sue UBS AG and its auditor Ernst & Young for losses in the bank’s LuxAlpha funds. According to news reports, the court said that the investor plaintiffs had failed to show they had suffered individual damage separate and apart from the funds themselves. They also failed to show any individual damage suffered by the alleged behavior of UBS or Ernst & Young.

But though the Luxembourg dismissal received widespread coverage, there was a largely overlooked earlier Madoff-related case ruling out of Florida, in which the investor plaintiffs’ claims largely survived the defendants’ motions to dismiss. (The Florida case is mentioned in a March 5, 2010 Wall Street Journal article, here, which otherwise is devoted to the Luxembourg court ruling.)

The Florida case arose on May 7, 2009, when seventeen plaintiffs filed a 62-page complaint in Palm Beach County Circuit Court against Madoff feeder funds Tremont Group Holdings and Tremont Partners, as well as three associated Rye Select funds. The complaint also names KPMG, which had serves as the Rye funds’ auditor, as a defendant.

The plaintiffs’ complaint alleges that the Tremont and Rye Select Fund defendants failed to perform their professional duties, but rather simply turned invested funds over to Madoff. The plaintiffs allege that the defendants "did not analyze Madoff, investigate his companies, conduct significant due diligence, or ensure that there were rudimentary safeguards." The plaintiffs further allege that the defendants took tens of millions of dollars in management and other fees from the funds.

The complaint alleges that the defendants violated Florida securities laws, committed common law fraud, negligent misrepresentation, professional malpractice and negligence. The complaint also alleges that defendants breached their contractual and fiduciary duties. The defendants moved to dismiss.

In a February 5, 2010 order (here), Circuit Court Judge David E. French granted in part and denied in part the defendants’ motions to dismiss.

With respect to the Tremont and Rye funds defendants, Judge French granted the motions to dismiss, without prejudice, as to plaintiffs’ claims of breach of fiduciary duty (Count VI), breach of statutory fiduciary duty (Count VII), breach of contract (Count XI), and adding and abetting breach of fiduciary duty (Count XII), all essentially on the grounds that the plaintiffs had failed to allege individualized injury, apart from the injuries to the funds themselves.

However, Judge French denied the Tremont and Rye funds defendants’ dismissal motions as to plaintiffs’ claims for violation of state securities laws (Count I), Negligence Per Se (Count II), Fraud in the Inducement (Count III), Negligent Misrepresentation (Count IV), and Deceptive and Unfair Practices (Count VIII), as these are claims where the investor plaintiffs suffered their own individual injuries.

Judge French also granted without prejudice KPMG’s dismissal motions as to plaintiffs’ claims for Negligent Misrepresentation (Count V), Professional Malpractice (Count X) and Aiding and Abetting Breach of Fiduciary Duty (Count XIII), but denied KPMG’s dismissal motion as to plaintiffs’ allegations against KPMG for deceptive or unfair practices (Count IX).

While the defendants’ dismissal motions were granted in part, substantial portions of the plaintiffs’ complaint survived and the case will now go forward, showing that at least some Madoff victims may be able to allege claims sufficient to survive initial dismissal motions.

The February 5 ruling seems significant because as far as I am aware it represents the first instance in which a private plaintiff against a Madoff feeder fund has survived a motion to dismiss.

To be sure, on February 8, 2010, New York Supreme Court Judge Richard B. Lowe III did enter an order (here), denying the defendants’ motions to dismiss in the New York Attorney General’s civil fraud lawsuit pending against Ezra Merkin and his Madoff-related feeder funds. But the Florida ruling is the only ruling of which I am aware in which a private plaintiff lawsuit against a Madoff feeder fund has survived a dismissal motion and will be going forward.

Obviously, the massive amount of Madoff-related litigation will continue to grind through the courts for years to come. The Florida decision shows that plaintiffs may be able to survive dismissal motions in at least some of these cases. Of course, whether the plaintiffs will ever recover even a very small part of their losses remains to be seen.

Special thanks to a loyal reader for calling my attention to the Florida decision and providing me with a copy of the opinion.

Class Act on the Danube: Here at The D&O Diary, we scour the globe looking of interest for our readers. By way of example, we refer readers to the article that appeared in the March 8, 2010 issue of the Budapest Business Journal (here), in which it is reported that "a revision to the standing civil code will shortly introduce class action lawsuits to the Hungarian legal system and already has a number of nongovernmental interest groups revving up to start the proceedings."

The prospects for class litigation outside the U.S. apparently continue to spread. Everyone here will remain vigilant.

If You Are Even Thinking about Starting a Blog: As we have pointed out before, a blog is a harsh mistress, as we know all too well. However, there may be those at this very moment who may be thinking about starting a blog. For all the aspiring bloggers, we recommend an essay by Mark Herrmann (now an ex-blogger since relinquishing his role as co-author of the essential Drug and Device Law Blog) in the Winter 2010 issue of the ABA Section of Litigation Journal entitled "Memoirs of a Blogger" (here, hat tip to the WSJ.com Law Blog).

Although much of the article is focused on the question whether a law blog is a good idea for a big firm attorney, there are many more universal truths as well. Among other indispensible pointers with which we concur, Herrmann states: "If you’re thinking of launching a legal blog, have your eyes open. Once you launch a blog, you will face the relentless, mind-numbing, never-ending task of finding worthwhile material to publish. That burden begins on the day of your first post, and ends only the day you call it quits."

Amen, brother.

And along those lines, everyone here at The D&O Diary is always grateful when readers send along blog ideas and suggestions. We get our best material from readers, so please let us know if you see anything interesting out there.

Corporate Penalties and the SEC

Kevin LaCroix — Mon, 08 Mar 2010 04:32:31 -0500

The SEC first acquired the right to impose civil penalties against corporations in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. Since the Remedies Act was enacted, the SEC has struggled with the question of when it is appropriate to obtain money penalties from corporate issuers.

In January 2006, in order to put some clarity around the issue of corporate penalties, the SEC issued its Statement of the Securities and Exchange Commission Concerning Financial Penalties (here). More recently, the sharp questions of a prominent federal judge have put a harsh spotlight on the SEC’s practices regarding corporate money penalties. In light of these questions, it is hardly surprising that the SEC might feel compelled to reexamine its practices for the imposition of penalties on corporations.

In a recent speech, current SEC Commissioner Luis Aguilar has proposed revising the guidelines in order to put the "appropriate focus" on the issue of deterrence. However, for reasons discussed below, I question whether Commissioner Aguilar’s position is necessarily the best approach to accomplish the desired goals.

Background

In the 2006 Statement, and after reviewing the legislative history of the Remedies Act, the SEC articulated a standard whereby the question of the appropriateness of a corporate penalty turns on two considerations: "the presence or absence of a direct benefit to the corporation as a result of the violation," and "the degree to which the penalty will recompense or further harm the insured shareholders." The Commission also identified seven additional factors that are also "properly considered," including "the need to deter the particular type of offense."

In a February 6, 2010 speech (here), SEC Commission Luis Aguilar characterized the 2006 Statement as a "misguided approach." The "serious flaw" in the Statement’s approach, he said, is that "the conduct itself becomes of secondary importance." Aguilar contends that the Commission "fails to appropriately focus on deterrence." He called the Commission to promptly revisit the 2006 guidelines go that penalties are refocused on their "purpose," which is to "deter and punish misconduct."

A March 6, 2010 Wall Street Journal article further discussing Aguilar’s views can be found here.

Discussion

In the current environment, Aguilar’s desire to focus the Commission’s enforcement efforts on the deterrence of future misconduct is both appropriate and commendable. However, that does not necessarily mean that the imposition of penalties on corporations is the appropriate means to that goal or even that the 2006 Statement needs to be revisited.

First, upon review of the 2006 Statement, it is clear that in devising the current guidelines, the Commission took significant pains to consider and to try to implement the considerations expressed in the legislative history of the Remedies Act, particularly the relevant Committee Report. Whatever Aguilar’s views may be, the current guidelines track the sentiments expressed in the Committee Report.

The second problem with Aguilar’s view is that, at least as expressed in his recent speech, it appears that his proposed approach simply disregards the fundamental problem with corporate penalties, which is that in many instances the penalties inappropriately harm the company’s current shareholders.

In that respect, the timing of Aguilar’s speech advocating the use of corporate penalties for deterrence purposes is more than a little odd, coming as it does so closely on the heels of Southern District of New York Judge Jed Rakoff’s highly publicized questions of the proposed settlement of the SEC’s enforcement action against the Bank of America.

Readers will recall that in his blistering September 14, 2009 opinion (here), Judge Rakoff rejected the SEC’s proposed $33 million settlement, on among other grounds that the proposed settlement "does not comport with the most elementary notions of justice and morality" because it "proposes that shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for the misconduct."

In response to the SEC’s argument that the proposed settlement "sends a strong signal" and "allows shareholders to better assess the quality and performance of management," Judge Rakoff said that

the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion dollar purchase of a huge, nearly bankrupt company, need to lose another $33 million of their money in order to "better assess the quality and performance of management" is absurd.

Judge Rakoff did subsequently approve a $150 settlement of the SEC enforcement action, but essentially as an act of judicial restraint and only while the Court was "shaking its head." Rakoff called the settlement "half-baked justice at best."

Judge Rakoff’s strong words seemingly challenge the very idea of corporate penalties, both because of the burden they impose on corporate shareholders and because the disconnect between penalties and the possibility of deterrence. In the immediate aftermath of the questions surrounding the BofA settlement, Aguilar’s advocacy of corporate penalties as a way to achieve deterrence seems both off-key and tone deaf.

We can all agree, as Aguilar proposes, that misconduct should be punished and deterred. However, it does not follow that the imposition of corporate cash penalties is the best or even a potentially well-calibrated means to try to achieve those goals. Indeed, as Judge Rakoff’s comments suggest, the problem with corporate penalties is that both the punishment and the putative deterrence are misdirected. Indeed, the notion that penalties paid out of the assets of one corporation will deter future misconduct by another corporation seems both abstract and unpersuasive.

Viewed in this light, the principles articulated in the Committee Report accompanying the Remedies Act, as implemented in the 2006 Statement, arguably represent an appropriate balancing of the considerations that should be taken into account in connection with the imposition of corporate penalties – including in particular the question whether the proposed corporate penalty "will recompense or further harm the injured shareholders."

My further concern about Aguilar’s initiative to try to ramp up corporate penalties is that his proposal arises at a time when the SEC is desperate to reestablish its regulatory credentials. One danger is that in its eagerness to look tough that SEC might try to extract enormous penalties from corporate treasuries while accomplishing little except the addition of unnecessary and unwarranted costs on beleaguered companies and their long-suffering shareholders (which is in fact the very thing that troubled Judge Rakoff).

The bottom line for me is that in the wake of the pointed questions that Judge Rakoff raised in the BofA enforcement action, this is a very odd time for any SEC Commissioner to be advocating increased corporate penalties as a likely or even promising way for the SEC to best accomplish its goals.

Just Visiting this Planet: In her latest email epistle, our globetrotting eldest daughter, now working in Quito for a nonprofit organization, passed along the following observation about a recent therapy session for refugee women she attended:

I was oddly reminded of the time at the neighborhood barbeque in Hokkaido with the inebriated Japanese grandpas who wanted to sing Billy Joel. Totally unrelated to Spanish-speaking refugee women discussing how being a refugee increased their stress and messed up their female biorhythms. I think I drew the connection in my mind because of the "where on earth have I ended up" feeling I had both times.

More About the Responsible Corporate Officer Doctrine

Kevin LaCroix — Mon, 08 Mar 2010 04:24:38 -0500

Time-honored legal principles typically shield corporate officers and shareholders from direct personal liability for legal violations of the corporation itself, consistent with the notion that the corporation itself has a distinct and separate legal identity. However, as I noted in a prior post (here), courts have evolved a concept called "the responsible corporate officer doctrine," pursuant to which individuals can be held liable for corporate misconduct without involvement in or even awareness of the wrongdoing. Recent indications suggest that regulatory authorities may be planning a more aggressive use of this doctrine, a development that may have disturbing implications.

The responsible corporate officer doctrine was first articulated by the U.S. Supreme Court in the 1943 case of United States v. Dotterweich, in which corporate officers in positions of authority were held personally (and in that case, criminally liable) for violating strict liability statutes protecting the public welfare.

The Supreme Court approved the application of liability under the Food, Drug and Cosmetic Act (FDCA) in the 1975 case of United States v. Park holding that the FDCAs "requirements of foresight and vigilance" are "no more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and wellbeing of the public that supports them." The Supreme Court approved the imposition of liability in that case, though the defendant had no involvement in or personal knowledge of the violation.

The responsible corporate officer doctrine has been absorbed into environmental law as well, and, as discussed here, and has served as the basis of imposing liability in environmental enforcement actions.

According to a March 5, 2010 memo from the Skadden law firm entitled "FDA Announces New Push to Prosecute Corporate Officers and Executives for No-Intent Crimes" (here), the FDA, under fire for lack of active oversight of its office of criminal investigations, has advised Congress that it intends to "increase the appropriate use of misdemeanor prosecutions…to hold corporate officials accountable." The law firm memo suggests that this FDA statement to Congress is consistent with the "recent uptick" in prosecutions relying on the responsible corporate officer doctrine against pharmaceutical and medical device executives.

The responsible corporate doctrine unquestionably is a well-established tool for the imposition of liability on corporate officials in the context of public "health and wellbeing." But though well-recognized, it nevertheless has disturbing implications. The FDA’s apparent intention to use the responsible corporate officer doctrine more aggressively arguably is part of a larger and even more disturbing trend to try to hold corporate officers liable without regard to personal culpability.

First, the idea that liability can be imposed on an individual for corporate misconduct, in apparent disregard of the corporate form and without culpable involvement or even a requirement of a culpable state of mind, seems inconsistent with the most basic concepts surrounding the corporate form. The doctrine arguably imposes liability for nothing more than a person’s status. The word "responsible" in the doctrine’s name does not mean that the individual is responsible for the misconduct, but on that that the individual is responsible for the corporation.

Second, the application of the doctrine can have serious ramifications. The Skadden memo points out that in one recent FDCA prosecution, the individuals against whom liability was imposed on the basis of responsible corporate officer doctrine were required to pay criminal fines of $34.5 million (The imposition of liability is currently on appeal.) The imposition of criminal penalties of this extraordinary magnitude without any fault or even culpable state of mind seems fundamentally inconsistent with the fault-based framework of our criminal justice system.

But the most troubling thing about the responsible corporate office doctrine is that the apparently expanded willingness of regulators to use the doctrine to impose liability on corporate officials is entirely consistent with developments elsewhere that also suggest a willingness of government regulators to try to impose liability without regard to involvement of awareness of the alleged wrongdoing.

In that regard, there have been at least two instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged legal wrongdoing. Though these regulatory enforcement actions did not expressly rely on or even refer to the responsible corporate officer doctrine, the enforcement actions implicitly reflect a similar presumption, which is that in certain instances corporate officials can be held liable solely on the basis of their position without respect to the presence or absence of personal culpability.

First, as noted here, the SEC has initiated an enforcement action against the former CEO of CSK Auto, in which the SEC seeks to "clawback" compensation the CEO earned at a time with respect to which the company subsequently had to restate its financial statements. The SEC is pursuing this claim even though the former CEO is not only not charged with fraud, but is not even alleged to have had any involvement in or even awareness of the circumstances requiring the later restatement.

Similarly , the SEC more recently filed an enforcement action seeking impose control person liability on two officer of Nature’s Sunshine Products, in which the SEC sought to hold the individuals liable for the company’s Foreign Corrupt Practices Violation, though the individuals were not alleged to have had any involvement in or awareness of the wrongful conduct. The Nature’s Sunshine Products case is discussed here.

Though these recent SEC enforcement actions did not expressly rely on the responsible corporate officer doctrine, the SEC’s actions in these cases reflect a willingness – similar to that of the FDA and other regulatory authorities -- to impose liability on corporate officials without regard to fault or culpability. These regulatory actions raise a very disturbing specter of strict liability for executives.

Even if there are circumstances where, as the U.S. Supreme Court has long recognized, that public health and welfare may justify the imposition of liability without culpability under certain circumstance, the enormous burden this possibility would impose on the civil rights and liberties of the affected individuals would seem to argue that these principles be used to impose liability on individuals only in the rarest and most extreme purposes.

But rather than restrict its use of these principles out of an appropriate respect for basic notions of fairness and individual liberty, regulators are moving in the exact opposite direction and apparently seeking new opportunities to use these principles to expand their regulatory reach.

The regulators may well feel this approach may be justified in order to accomplish regulatory goals and ensure that somebody pays the price for wrongdoing. The problem is that scapegoating individuals for misconduct in which they were not involved and of which they were not even aware is fundamentally unfair. In my view, this approach is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

If there are circumstances where public health and welfare might sometimes require the imposition of responsibility on a strict liability basis, the use of those circumstances should be infrequent and unusual. Regulators should be looking for ways to avoid relying on these powers rather than looking to expand their use. The imposition of penalties without regard to fault or culpability is a fundamentally unfair practice that should be discouraged at every possible opportunity.

Book Review: "Circle of Greed" - The Rise and Fall of Bill Lerach

Kevin LaCroix — Tue, 02 Mar 2010 01:12:29 -0500

During his long and provocative legal career, former class action securities litigator and convicted felon Bill Lerach was a self-selected lightening rod for controversy. He taunted his foes, stalked his enemies, challenged convention, and in the process transformed himself into a larger than life figure.

And so when his legal career collapsed among revelations that he and his colleagues had paid improper kickbacks, the post-mortems almost inevitably reflected much of the same mythmaking hyperbole that Lerach himself generated. Lerach became a stock figure in a morality tale, in which the angry, defiant mortal is struck down for his pride.

The reality is that Lerach’s tale is so much more interesting that this stock narrative frame. And is certainly a tale worth telling, as demonstrated in the marvelous new book entitled "Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to Its Knees," written by two Pulitzer-prize winning journalists, Patrick Dillon and Carl Cannon. (Full disclosure: Carl is an old family friend, but I feel comfortable in saying I would have liked the book every bit as much if Carl and I had never met.)

The authors explain in their Prologue that initially, Dillon had intended to co-author a book with Lerach, but that project got waylaid when it became clear that Lerach’s legal difficulties were serious. Though the project moved into an unanticipated direction as a result of these events, Lerach continued to cooperate with the authors, right up to making himself available for interviews from prison.

The authors ask themselves why Lerach cooperated with them, and they confess they are not entirely sure. I was initially concerned the book might shade in Lerach’s favor or even fall into myth-making trap. Make no mistake, however, the authors fully and damningly document all of Lerach’s most outrageous flaws and faults.

The authors open their book at the point where Lerach’s many shortcomings have finally caught up to him, at the court hearing in October 2007 when Lerach pled guilty to one count of obstruction of justice. Then, to discern how the career of one of the most influential lawyers of our time could have come to this, the authors then trace his career from its very beginning, including his childhood in Pittsburgh and his early legal career with the Reed Smith firm. A case in which Lerach was involved for Mellon Bank took both took Lerach to San Diego and also introduced him to Mel Weiss, his law partner whose fame, fortune and fate would follow its own parallel trajectory.

Lerach’s skill and his excesses emerged in his first successful case in San Diego, in which he represented a group of retirees against the Methodist Church. Lerach’s legal performance was by all accounts brilliant, and produced a great result for his clients. But, the authors note, "along with the good came the other things: the hubris, the taunting, the acrimony with the opposing side, the hyperpartisanship borne of the Manichean world view."

Following after this victory, Lerach sooned carved out a career for himself as the high-profile scourge of Corporate America, and at the same time becoming the poster child for class action excesses. This list of companies Lerach ultimately sued reads like a membership list for the U.S. economy. Lerach became feared and reviled. And he also became enormously rich.

Despite (or perhaps because of) his enormous success, the weaknesses Lerach had shown in the Methodist Church case clearly could at times consume him. This is perhaps nowhere as evident as in his mad, ill-fated bid to avenge himself on Daniel Fischel, who had testified as a witness for the defense in the Nucor case. Lerach blamed Fischel for his stinging defeat in that case. When Lerach later filed a suit against Charles Keating in connection with the Lincoln Federal scandal, Lerach named Fischel and his firm as defendants. Though the claim was later compromised (in a "disposition," not a "settlement") Fischel never forgot the many outrageous things Lerach said along the way (many of which cannot be reproduced in this family-oriented blog).

In the end, Fischel was the one to get revenge. His subsequent slander suit against Lerach and his firm resulted in a $45 million verdict in his favor, and while the unresolved punitive damages phase was pending, the law firm agreed to pay $50 million to resolve the whole thing, agreeing even to have the settlement funded, in cash, that same day. There is something about this whole sequence of events that encapsulates so much about Lerach -- the excess, the outrageousness, and the way in which his own conduct caused him so much damage.

The book’s authors are not lawyers, but I think they deserve high marks for the way they deal with the legal topics. They also deserve credit for their appreciation of the atmosphere that Lerach’s excesses generated and how it influenced other participants in the process.

For example, the authors perceptively note that many of Lerach’s targets felt compelled to capitulate rather than confront a mad man – yet, the authors note, many of the companies who were unwilling to give in managed to walk away paying nothing. The lesson that the authors drew was that "if you really had done nothing wrong, it made sense to fight these class action securities cases in court. If more firms had done this successfully, there likely would have been fewer plaintiffs’ lawsuits."

The authors, unlike many other journalists that traverse this ground, also demonstrate an appreciation for the complex role that D&O insurance plays in the process, and indeed, that the actions and activities of class action attorneys have on the D&O insurance marketplace.

But what the authors do best, and what makes this book worth reading, is the way they weave the story of the criminal investigation through the massive corporate scandals, which were unfolding at the same time. The authors also methodically show how so much of Lerach’s crusading activities depending on his firm’s corrupt system for procuring plaintiffs on whose behalf to bring the suit, as well as on the testimony of a corrupt expert witness.

Many of the details of the criminal investigation may be familiar to many readers. The almost unbelievable way that a lover’s quarrel in Cleveland triggered a sequence of events that ultimate brought down Bill Lerach and Mel Weiss has been told elsewhere. The authors retell these tales particularly well. But what makes their version so compelling is the way the authors overlay events that were going on at the same time, particularly Lerach’s representation of the Enron litigants and his dispute with Weiss over the WorldCom case.

Frankly, Lerach’s contributions also help make the story compelling. His involvement provides a narrative tone and personal focus that bring the events to life. Lerach does not come off sympathetically, but he does come off as a real person – corrupt, deeply flawed, but real. As the authors say toward the end of their book, "Bill Lerach was no monster, but he had indeed gone after fraud by using fraud."

A Closer Look at Buffett's Letter to Berkshire Shareholders

Kevin LaCroix — Mon, 01 Mar 2010 04:22:46 -0500

The much-anticipated annual letter to Berkshire Hathaway shareholders of its Chairman Warren Buffett has long been valued for its business insights and occasionally humorous tone. The 2009 version, which was released on Saturday February 27, 2010, and which can be accessed here, is no exception, though the expanding size of Berkshire’s business portfolio has reduced Buffett’s discussion of many company operations to just a few sentences and left relatively little space for his usual commentary.

Buffett does manage to work in some choice observations about the responsibilities of financial institutions’ senior officials for their companies’ collapses, and also about boards’ responsibilities in the M&A context.

For many readers, the 2009 version may be noteworthy for the things it does not discuss. For example, the 79-year old Buffett has nothing to say about leadership succession planning at the company (although the February 27, 2010 Wall Street Journal does fill the gap somewhat with an interesting article, here, about possible Buffett successor David Sokol, the Chairman of MidAmerican Energy)

Buffett also has nothing to say about recent events of keen interest to Berkshire’s shareholders, including the company’s addition to the S&P 500 and its loss of its triple-A financial rating (owing to the company’s deployment of cash for its largest-ever acquisition of Burlington Northern Santa Fe).

But despite the omissions, there is still much of interest in this year’s letter. Full disclosure: I hold BRK.B shares, although not nearly as many as I wish I did. (Actually, I do own more shares than I used to, due to the January 2010 50-for-1 split of the B shares.)

Buffett on Boards of Directors

For readers of this blog, the most interesting comments in this year’s letter are Buffett’s remarks about senior management of the financial institutions at the center of the global financial crisis. Buffett prefaces his comments by stating that he would never "delegate risk control," going on to contend that "in my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control."

Buffett not only suggests that corporate leaders should have full responsibility, but that there should be liability consequences for failure. Buffett says that if the CEO "fails" at risk control, "with the government thereupon required to step in with funds or guarantees," the "financial consequences for him and his board should be severe." Buffett notes that it has "not been shareholders who have botched the operations of some of our country’s largest financial institutions," yet they have had to "bear the burden" caused by the management errors. Despite shareholder losses, "the CEOs and directors of the failed companies … have largely been unscathed."

Buffett proposes that "the behavior of the CEOs and the directors needs to be changed," and they way to do that he suggests is to ensure that if "institutions and the country are harmed by their recklessness," then "they should pay a heavy price – one not reimbursable by the companies they’ve damaged or by insurance." Senior managers have long enjoyed "oversized financial carrots," now their employment arrangements should now include "meaningful sticks."

Buffett’s grumpy ruminations about board behavior don’t stop there; later in his letter, he returns to the boardroom context to discuss board functioning in the M&A context. He notes, based on his "more than fifty years of board membership," that directors often are "instructed" by "high-priced investment bankers (are there any other kind?)" on the value of a proposed acquisition target. But "never" has he heard investment bankers "or management!" discuss the "true value of what is being given" for the acquisition when company stock is being used to finance the acquisition.

Buffett proposes, as the only way to get "a rational and balanced discussion," that directors hire a "second advisor to make the case against the proposed acquisition," with the advisor’s fee "contingent on the deal not going through." He concludes with an observation about the way deal advisors typically function by the aphorism "Don’t ask the barber whether you need a haircut."

Buffett on Berkshire’s Investments

Overall, Buffett’s letter is upbeat, as might be expected in a year in which his company’s net worth rose $21.8 billion and income rose 61 percent to $8.06 billion. (This after the company reported in 2008 its worst results ever, due to the effects of the global financial crisis.)

Buffett is particularly chipper in talking about the performance of the company’s investments. He notes that the company has "put a lot of money to work during the chaos of the last two years," adding that its been an ideal period for investors" because "a climate of fear is their best friend."

The tale of Berkshire’s recent cash deployment is truly remarkable. The company entered 2008 with $44.3 billion in cash and cash equivalents, and during 2008 and 2009 the company retained an additional $17 billion in earnings. Nevertheless, by the end of 2009, the company’s cash pile was "down" to $30.6 billion (with $8 billion of that earmarked for the Burlington Northern acquisition) – implying a net cash outflow of $47.6 billion, or as much as $55.6 billion if the Burlington Northern obligation is taken into account.

Where has the cash gone? Well, in addition to the massive Burlington Northern deal and other items, the company invested an absolutely astonishing $22.1 billion in non-traded securities of just five companies: Dow Chemical, General Electric, Goldman Sachs, Swiss Re and Wrigley. Under the heading "that’s why he’s Buffett and you're not," it should be noted that these investments (which cost $22.1 billion) have a carrying value of $26 billion and also deliver an aggregate $2.1 billion annually in dividends and interest (or roughly 10% of cost annually, meaning the investments will pay for themselves in about 7.2 years).

Moreover, these massive purchases are far from the only investment successes on Buffett’s scorecard. Berkshire’s $232 million investment in 2008 in Chinese battery maker BYD Company is now worth $1.9 billion. Buffett also accumulated corporate and municipal bonds in 2009, which he called "ridiculously cheap." But, he wrote "I should have done far more. Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble."

Not all of Buffett’s financial moves have been funded out of cash; the company also sold some investments, including in particular its holdings in Conoco Phillips, Proctor & Gamble and Moody’s. Each of these investment sales is interesting in its own way.

In his 2008 letter, Buffett cited his mid-2008 purchase of ConocoPhillips as one the "dumb things" he had done during the year, referring specifically to the purchase as a "major mistake of commission" because he bought the shares at their peak. Berkshire’s P&G holdings were the result of P&G’s acquisition of Gillette, which had been a major Berkshire holding for many years prior to that. Buffett seemingly was less interested in holding the shares of the more diversified company.

The sale of the Moody’s shares is perhaps the most interesting move, as the company’s Moody’s position had been a prominent part of its portfolio for many years. Moody’s share price has plunged during the last couple of years as a result of controversies surrounding the company’s ratings of subprime-related investments. Buffett has plenty to say in his 2008 letter about the excesses that cause the subprime meltdown, but even then he omitted any mention of Moody’s. Perhaps his sale of the company’s shares, even if accomplished without comment or observation, is the most eloquent statement he could make. (As an aside, in April 2009, Moody’s downgraded Berkshire from its highest investment rating.)

Buffett on Berkshire’s Balance Sheet

Though Buffett says nothing about the company’s loss of its triple-A financial rating, he has a great deal to say (perhaps defensively?) about the company’s financial strength. He emphasizes that "we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity."

He goes on to comment, somewhat triumphantly, that "when the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity to the system, not a supplicant." adding that "at the very peak of the crisis we poured $15.5 billion into a business world that could otherwise look only to the federal government for help."

Buffett on Berkshire Shareholders

As I have previously noted (here) about Buffett’s essays to Berkshire shareholders, one of the not so subtle goals of his missives is to try to ensure that the company has the right kind of shareholder – that is, investors willing to take a long-term view and patient enough to await long-term results. Due to the Burlington Northern acquisition (and the split of the company’s B shares), Berkshire now has many new shareholders, and in his 2009 letter, Buffett is trying to school these new owners on what he hopes for from them

Buffett is very explicit that he wants to "build a compatible shareholder population." On that topic, Buffett sounds some themes that will be familiar to regular readers of Buffett’s letters. He warns his new shareholders that "investors who buy and sell on media analyst commentary are not for us." Rather, Buffett wants "partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand."

Buffett on Berkshire’s Businesses

Much of the balance of Buffett’s letter is given over to a review of the operating companies’ performances. With a few exceptions (such as his lengthy exegesis of the systemic challenges facing mobile-home manufacturer Clayton Homes), most of his company-specific reviews are quite brief. Indeed, many Berkshire businesses are not even motioned in the letter. As Berkshire has enveloped more and more companies, the kind of meaningful review Buffett claims to want to provide investors has been increasingly more challenging.

Readers of this blog undoubtedly will be interested in Buffett’s review of Berkshire’s massive insurance businesses, which continue to perform magnificently, collectively producing over $1.5 billion in 2009 calendar year underwriting profit despite prevailing soft market pricing conditions. This continued underwriting profitability, even if not shared equally by all of Berkshire’s insurance competitors, virtually ensures that the soft market conditions will continue until either pricing collapses to the point where profit is simply no longer possible or some external event intervenes to overwhelm industry profitability.

Discussion

Some may find Buffett’s harsh words about CEOs and corporate boards alarming. His suggestion that company officials should be held liable for the harm they have caused, without benefit of indemnity or insurance, will strike fear into the hearts of company officials everywhere. It is particularly noteworthy that his prescription for individual liability is not limited just to CEOs but expressly extends also to members of the company boards.

However, a careful reading of suggests that these remarks may represent less of a threat to corporate officialdom that might appear at first blush. For example, it is clear that his remarks refer to officials at companies whose woes have required a government bailout. His suggestion of direct personal liability without benefit of indemnity or insurance is made with reference to misconduct that causes harm both to "institutions and the country." So, before anybody hits the panic button, Buffett is not necessarily suggesting that indemnification and insurance are never appropriate for corporate officials, but perhaps only when the officials’ misconduct has necessitated a government bailout.

But just the same, Buffett’s comments that corporate officials (including, apparently members of boards of directors) should not have recourse to insurance undoubtedly will make some board members uneasy – not to mention how uncomfortable it makes those of us who make our living in the D&O insurance industry.

Buffett’s plan for building a shareholder base built on owners who buy into Berkshire’s long term philosophy is commendable. However, as Berkshire has grown, this aspiration may be less realistic. Buffett may want partners invested "in a business they themselves understand" but the reality is that Berkshire may have grown beyond the point where the typical investor can fully appreciate and understand its business.

The fact is that much of this year’s letter seems a mile wide and an inch deep – indeed, at one point, he simply lists the names of companies, without any further gloss or detail.

Buffett’s description of the results of Berkshire’s insurance businesses is a good illustration of the challenge facing Berkshire’s new shareholders. Buffett is lavish in his praise of Ajit Jain and his thirty person operation. Indeed, Buffett adds the humorous aside that if he, Berkshire Vice Chair Charlie Munger and Ajit were in a sinking boat, "and you can save one of us, swim to Ajit."

But as for what Ajit’s 30 person team does to produce hundreds of millions of dollars of profit, shareholders are left with cryptic comments like this statement: "During 2009, he negotiated a life insurance contract that could produce $50 billion in premium for us over the next 50 or so years." Seems kind of important, but as for what kind of risks or uncertainties it involves, Buffett has little to say, because he has already moved on to the next topic.

The next topic, in fact, is another Berkshire insurance business, Gen Re, which prior to the Burlington Northern acquisition was Buffett’s largest ever acquisition and Berkshire’s largest operating division. Buffett spares only 125 words for Gen Re, 48 of which are actually about Gen Re’s European subsidiary Cologne Re.

Buffett also has relatively little to say about Berkshire’s derivatives exposures, other than to defend these complex transactions that cause Berkshire’s reported results to swing by billions from quarter to quarter. I hope that those of us who can recall that Buffett himself called derivative contracts "weapons of financial mass destruction" can be forgiven for feeling less than entirely comfortable with Buffett’s hasty sketch of Berkshire’s derivatives exposure.

Buffett says that "Charlie and I avoid businesses whose futures we can’t evaluate." Some of Buffett’s shareholders may wonder how in the world they are supposed to evaluate the future of a company that is entering massive, complex multi-decade financial commitments but whose leadership will be in place for only a few more years. Despite all of Buffett’s earnest attempts to educate Berkshire’s owners, current and prospective investors may simply have to take it on faith – which certainly does shine a harsh spotlight on that unanswered leadership succession issue.

But for all of that, the annual letter is not a disappointment. It continues to be worth waiting for. Buffett did manage to work in the zingers about corporate responsibility. And he even slipped in some of his signature humor. My personal favorite in this year’s letter is his remark, made as a demonstration of Prussian mathematician Jacobi’s inversion principles, that if you "sing a country song in reverse … you will quickly recover your car, house and wife." He ends his letter, with its extensive discussion of the Burlington Northern acquisition, with a postscript suggesting that visitors attending the May shareholders meeting should "come by rail."

Rating Agencies' Alleged Conflicts of Interest Held Immaterial

Kevin LaCroix — Mon, 01 Mar 2010 04:14:09 -0500

In a ruling that may have potential significance for the many claims that have been filed against the rating agencies in the subprime litigation wave, on February 17, 2010, Southern District of New York Judge Lewis Kaplan dismissed all but one of the claims that had been filed against the individual defendants in the Lehman Brothers Mortgage-Backed Securities Litigation. A copy of Judge Kaplan’s February 17 order can be found here.

Background

Plaintiffs had purchased the mortgage back securities that Lehman Brothers issued in August 2005 and August 2006. The plaintiffs allege that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the offering documents had failed to disclose that the rating agencies, which were paid for providing their ratings, had conflicts of interest and had been involved in helping to structure the securities. The plaintiffs also allege that the offering documents failed to disclose that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

The individual defendants in the case are the officers and directors of the Structured Asset Securities Corporation, which issued the registration statements and acted as depositor in the securitization process. The individual defendants moved to dismiss.

As noted in prior posts, Judge Kaplan has previously dismissed plaintiffs’ claims against the rating agencies themselves (refer here), rejecting plaintiffs’ arguments that the rating agencies were "underwriters" under the ’33 Act. Judge Kaplan also previously dismissed the separate ERISA class action claims (refer here, scroll down). In his February 17 decision, Judge Kaplan separately ruled on the individual defendants’ motion to dismiss.

The February 17 Decision

Judge Kaplan held that the plaintiffs’ allegations that the offering documents failed to disclose the rating agencies’ conflict of interest were insufficient to state a claim, for two reasons.

First, Judge Kaplan held that the Securities Act does not require disclosures of "that which is publicly known," and "the risk that the rating agencies operated under a conflict of interest because they were paid by the issuers had been known publicly for years."

Judge Kaplan then went on to hold that "the rating agencies’ role in structuring the certificates is not material as a matter of law." His conclusion is based on the following analysis:

If the fee arrangement undermined an investor’s confidence in the rating agencies’ independence, a disclosure that a rating agency was involved in structuring the Certificates prior to rating them would have added nothing important to the "total mix" of information. If, on the other hand, an investor trusted the ratings agencies to give an honest opinion notwithstanding the fact that they were paid by the issuer, the fact that they were involved in structuring the Certificates, assuming that they were, likewise would have been unimportant. In consequence, these claims are insufficient.

With respect to the plaintiffs’ allegations that the offering documents contained misrepresentations about the amount and form of credit enhancement, Judge Kaplan held that the statement about the credit enhancement was a "statement of opinion," which could be actionable only if the complaint alleged that the rating agencies did not actually hold that opinion.

Judge Kaplan found that "at best" the complaint’s allegations "support an inference that some employees believed the rating agencies could have used methods that better would have informed their opinions," which he held to be insufficient to state a claim.

But Judge Kaplan did hold that the complaint’s allegations that the loan originators "systematically failed to follow the underwriting guidelines" were "sufficient at this stage to support a reasonable inference that the offering documents’ description of the underwriting guidelines was materially misleading."

Accordingly, Judge Kaplan granted the individual defendants’ motion to dismiss all of the claims against them except plaintiffs’ Section 11 claims about the loan originators’ supposed departures from underwriting standards.

Discussion

Even though Judge Kaplan’s February 17 opinion was issued in connection with claims asserted against the individual defendants and not in connection with claims asserted against the rating agencies themselves, the opinion nevertheless potentially could be of great significance in other subprime mortgage-related cases in which claims have been raised against the rating agencies.

In particular, Judge Kaplan’s holding that the offering documents’ omissions about the rating agencies’ alleged conflicts of interest and role in structuring the securities were not legally actionable may be of particular significance.

In many of the other cases in which claims have been asserted against the rating agencies, the claimants have, like the plaintiffs in the Lehman case, alleged that the rating agencies had undisclosed conflicts of interest and were involved in structuring the investments at issue. The rating agencies will undoubtedly find Judge Kaplan’s holding that the alleged omission of this information is not legally actionable to be helpful.

Judge Kaplan did not reach the question whether or not the rating agencies’ ratings are protected by the First Amendment, which is another defense on which the rating agencies will attempt to rely. But if the alleged omissions about the rating agencies are not actionable in the first place, there may never be a need to reach the First Amendment issues.

Judge Kaplan conclusion that the disclosures concerning the securities’ credit enhancements represented opinion rather than statements of fact is also instructive, even without getting into the First Amendment issues. As his February 17 decision states, statements of opinion are actionable only if the allegations show that the opinions were not actually as disclosed. Again, Judge Kaplan’s rulings are instructive and potentially significant as they suggest ways in which the claims against the rating agencies may be considered without even getting into the First Amendment issues.

Finally, Judge Kaplan’s holding that the rating agencies’ alleged conflicts of interest and involvement in the securitization transaction are immaterial does raise interesting questions about claimants’ ability to overcome the rating agencies’ First Amendment defenses. The plaintiffs have argued that the rating agencies were not entitled to rely on the First Amendment defense in the context of these kinds of structured investments because of the conflicts of interest and involvement in the transaction. Perhaps Judge Kaplan’s rulings are unrelated to these issues, but it does seem incongruous that considerations that are immaterial would be sufficient to overcome a constitutional defense.

Of course, it is entirely possible that other courts may not be persuaded by Judge Kaplan’s analysis. It is not intuitively obvious that, because it was public knowledge that rating agencies had conflicts, the rating agencies’ involvement in the transactions is legally immaterial. Indeed, the jump between the public knowledge of the conflict of interest and the immateriality of the rating agencies’ involvement in the transactions is frankly unsatisfying. Other courts might well be unwilling to make that analytic jump.

I have in any event added Judge Kaplan’s February 17 opinion to my table of subprime-related lawsuit motion to dismiss rulings, which can be accessed here. Because a portion of the claims against the individual defendants survived the dismissal motion, I have listed the ruling in the table of dismissal motion denials.

Special thanks to a loyal reader for sending a copy of Judge Kaplan's February 17 opinion.

MoneyGram Settles Subprime-Related Securities Suit for $80 Million

Kevin LaCroix — Fri, 26 Feb 2010 04:58:34 -0500

In one of the largest subprime-related securities lawsuit settlements so far, Moneygram Corporation has agreed to settle its subprime-related securities class action and accompanying derivative suit for $80 million, according to the company’s February 25, 2010 press release (here).

Background

As reported here, the MoneyGram case represented the distinct group of subprime-related cases in which the allegation was not that the company was involved in originating or pooling subprime mortgages, but rather that the company had purchased the mortgage-backed securities as investments and misrepresented the value of these assets on its balance sheet.

MoneyGram’s global payment and money transfer business requires the company to hold, transfer or to guarantee payments of large amounts of cash. To secure these payments and guarantees, MoneyGram maintains an investment portfolio. At the beginning of the class period in January 2007, the majority of MoneyGram’s $5.85 billion portfolio was held in asset-backed securities, mortgage-backed securities and collateralized debt obligations, backed in part by residential mortgages.

By the end of the class period in January 2008, the value of the portfolio had significantly deteriorated. In order to be able to maintain adequate capital, the company entered a substantial financing transaction that forced the company to recognize over $1 billion in losses in its investment portfolio. The company’s share price declined nearly 50%, and securities litigation ensued.

The consolidated complaint alleges that during the class period, the defendants made a series of misleading statements regarding the composition, valuation and quality of the company’s investment portfolio, and about its investment valuation processes, standards and controls.

As discussed here, on May 20, 2009, District of Minnesota Judge David Doty had denied the defendants’ motion to dismiss, holding that "a reasonable person could find lead plaintiff’s fraud narrative to be cogent and at least as plausible as defendants’ opposing fraud narrative."

According to the company’s February 25 press release, the plaintiffs have agreed in principle to settle the claims for an $80 million cash payment, all but $20 million of which will be paid by the Company's insurance coverage. The settlement of the derivative claims provides for changes to MoneyGram's business, corporate governance and internal controls. The agreement in principle is subject both to final documentation and court approval.

Discussion

The MoneyGram settlement is only one of a handful of subprime-related securities cases that have reached the settlement stage (and surprisingly, the first settlement of these kinds of cases announced since September 2009). As reflected in my running tally of subprime lawsuit settlements, which can be accessed here, there have only been ten settlements out of the over 200 subprime-related securities class action lawsuits that have been settled.

The short list of subprime-related lawsuit settlements is dominated by the massive Merrill Lynch related settlements, in which Merrill settled the subprime-related securities lawsuit for $475 million (refer here), its related bond action for $150 million (here), and the subprime-related ERISA class action for $75 million (here). These massive settlements were all reached shortly after the BofA acquisition closed and are perhaps best understood in that context.

Outside of the massive Merrill Lynch settlements, the $80 million MoneyGram settlement is the largest subprime-related securities class action settlement so far. The next largest is the $37.25 million American Home settlement, which included contributions of $8.5 million from seven offering underwriter defendants and $4.75 million from the company’s auditor.

There undoubtedly will be many more settlements to come, particularly among cases like MoneyGram where the plaintiffs have managed to survive a motion to dismiss. But in thinking about these likely future settlements, it is worth noting here that the $80 million MoneyGram settlement included a $60 million contribution from the company’s D&O insurers, which is a reminder of how massive a hit these subprime-related cases are likely to be in the aggregate to the D&O insurers – keeping in mind, too, that the $60 million settlement contribution is on top of the likely substantial defense expenses that the insurers undoubtedly incurred.

Before all is said and done, the mountain of subprime-related litigation is likely to impose an enormous amount of loss costs on the D&O insurers. I would hesitate to guess how big the aggregate total will be, but I know for sure it will be a very large number.

So How Do Public Pension Funds and Plaintiffs’ Firms Get Hooked Up?: Those who may wonder how pension funds and plaintiff’ firms get matched up will want to take a look at the article (oddly, dated March 15, 2010) by Peter Beller in Forbes entitled "Paying Public Pensions to Sue."

The article describes how plaintiffs’ firms have "created a multibillion-dollar business lining up public funds as plaintiffs to sue publicly traded corporations whose stocks don’t do well." The article focuses in particular on various conferences the law firms sponsor, in which pension fund representatives are invited to places such as New York or San Diego and feted with Broadway shows, dinners and other entertainments. The article describes the ways in which the firms are caught up in an "arms race to line up suit-happy state local and union pension funds," which has led to "all manner of wining, dining and dishing out of cash."

The article concludes by noting that "a curious irony of all this flattery of pension officials is that the ostensible purpose of securities litigation is to keep corporate managers honest."

And Speaking of Plaintiffs’ Lawyers: The February 25, 2010 Financial Times has a review (here) of a new book by Patrick Dillon and Carl Cannon about Bill Lerach, once one of the leading plaintiffs’ class action attorneys and now a convicted felon. The book, which is entitled "Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to its Knees," apparently was written with Lerach’s cooperation, and the FT review is quite favorable, noting the value of having a couple of Pulitzer-Prize winning journalists involved as authors.

Everyone here at The D&O Diary is hoping for an early opportunity to read this book, which according to the publisher’s website will be available on March 2, 2010. We hope to publish our own review of the book shortly.

And Finally: "Ten Wall Street Blogs You Need to Bookmark Now" (according to the Wall Street Journal) – find the list here.

FDIC: Number of "Problem" Banks Continues to Grow

Kevin LaCroix — Wed, 24 Feb 2010 04:31:13 -0500

As of year-end 2009, the FDIC identified 702 banks as "problem institutions," representing about 9% of all institutions reporting to the FDIC and the highest number of problem banks since 1993, according to the FDIC’s latest banking report.

On February 23, 2010, the FDIC released its Quarterly Banking Profile for the fourth quarter 2009, which can be found here. The FDIC’s February 23, 2010 press release describing the report can be found here.

The FDIC defines "problem institutions" as those with "financial, operational or managerial weaknesses that threaten their continued financial viability." Problem institutions are ranked as either 4 or 5 on the FDIC’s 1 to 5 scale of "risk and supervisory concerns." The FDIC does not publicly identify the problem institutions by name.

The 702 problem institutions at year end (out of 8,012 reporting institutions) represent the largest number of problem institutions since 1993. The 702 institutions also represented combined assets of $402.8 billion. The year end number of problem institutions is 27 percent greater than the 552 problem institutions as of the end of 3Q09. The 2009 year end figures compare to the 252 problem institutions, representing $159 billion in assets as of the end of 2008.

Given that the "problem institution" category tracks banks with "financial viability" concerns, it is hardly surprising that the increase in the number of problem institutions has been accompanied by a growing number of failed financial institutions. There were 140 bank failures in 2009, and there have already been 20 bank failures already in just the first seven weeks of 2010. The number of bank failures so far this year suggests that we may have at least as many if not slightly more bank failures this year compared to last year.

The FDIC’s report comes on the heels of the recent report of the Congressional Oversight Panel (about which refer here), in which the watchdog committee warned that coming commercial mortgage woes could further damage many lending institutions.

But not all of the banking news is bad. FDIC Chairman Sheila Bair is quoted in the FDIC’s press release as saying that the FDIC sees "signs of improving performance in the industry, " although basically that means that the pace of deterioration has slowed, not necessarily that the negative trends have been reversed.

Whatever else that might be said, the continued increase in the number of problem institutions as 2009 progressed suggests that we can expect to continue to see growing numbers of failed financial institutions as 2010 unfolds.

A Business Week article about the FDIC’s report can be found here, and a New York Times report can be found here.

Ambac Financial Subprime Securities Suit Dismissal Motions Substantially Denied

Kevin LaCroix — Tue, 23 Feb 2010 04:34:13 -0500

In an interesting and potentially significant February 22, 2010 opinion (here), Southern District of New York Judge Naomi Reice Buchwald denied defendants’ motions to dismiss the plaintiffs’ ’34 Act claims in the Ambac Financial subprime-related securities suit. Judge Buchwald also denied the motion to dismiss the plaintiffs’ ’33 Act claims relating to the company’s February 2007 securities offering, but granted the defendants’ motion to dismiss the plaintiffs’ ’33 Act claims relating to the company’s March 2008 securities offering.

Judge Buchwald’s decision is particularly noteworthy for her rejection of defendants’ attempts to argue that the company’s woes were not the result of fraud but rather were the result of the global financial meltdown; among other things, she stated that "the conduct that plaintiffs’ allege, if true, would make Ambac an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim."

Background

Ambac Financial Group is a monoline insurer providing protection against credit risk. Traditionally the company insured municipal bonds, but in more recent years prior to the financial crisis, the company increasing provided default protection for structured financial products such as residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO).

In early January 2008, Ambac announced that it was taking a $5.4 mark-to-market loss on its CDO portfolio, that it was taking a $1.1 credit impairment charge, and that it expected a net loss for the quarter. The company also announced the resignation of the company’s CEO. The company’s share price declined, and two days later the company received the first of several rating downgrades from the rating agencies.

As noted here, the plaintiffs first filed their complaint in January 2008. In their ’34 Act claims, in which the defendants named are the company and certain of its directors and officers, the plaintiffs allege that the defendants mislead investors by continuing to portray Ambac’s underwriting procedures as cautious and conservative, while failing to disclose that the company had lowered its underwriting standards; by stating that Ambac was actively monitoring its RMBS and CDO portfolios and that the portfolios continued to outperform; and by failing to disclose in a timely manner any material impairment to the RMBS-related instruments that Ambac insured.

In their ’33 Act claims, which the plaintiffs asserted against the company and certain of its directors and officers, as well as against the offering underwriters and the company’s outside auditor (KPMG), the plaintiffs allege that the defendants made misleading statements in the offering documents about the company’s underwriting standards as well as regarding the company’s RMBS and CDO-related exposures.

The defendants moved to dismiss.

The February 22 Ruling

In rejecting the defendants’ motions to dismiss the ’34 Act claims, Judge Buchwald found that "the plaintiffs allegations of recklessness support a strong inference of scienter" for each of the ’34 Act claim defendants.

Judge Buchwald cited numerous allegations which she found sufficient to show that Ambac’s officers were aware that "Ambac lowered its underwriting standards in several ways." Among other things, she cited an internal October 2006 email to one of the defendants asking "Why are we willing to insure stuff in the secondary market [i.e., the CDO market] that we would not touch with a ten foot pole in the primary market [i.e., the RMBS market]?"

Judge Buchwald also found that the officers’ own public statements "detail the regular reports by which they would have learned of the allegedly drastic deterioration of their CDO portfolio." She went on to note that in various public statements the officers "themselves described in the means by which the raw material was collated and analyzed, as part of the surveillance process, and how this formed the basis for defendants’ statements."

In concluding that the plaintiffs had adequately pleaded recklessness, she rejected the alternative inference that the defendants urged her to draw from the allegations, namely that the officers could not have predicted the economic collapse and therefore the company’s modeling tools failed to identify the risk of loss in the CDO portfolio. In reaching this conclusion she noted:

Viewing the allegations collectively, there is a vast gap between the picture that Ambac presented to investors – of an insurance company that maintained its conservative approach over the years – and the alleged practices within the company, namely the undisclosed lowering of underwriting standards to drive short-term profits. Additionally, defendants’ arguments on this issue are premised on a convenient confusion of cause and effect. The conduct that plaintiffs’ allege, if true, would make Ambac an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim.

Judge Buchwald also found that the plaintiffs had adequately alleged misrepresentation and loss causation. Interestingly, in concluding that the plaintiffs had adequately alleged misrepresentation in connection with the CDO valuation issues, Judge Buchwald cited and apparently relied on the characterization of the company’s CDO portfolio in the plaintiff’s expert analysis, an interesting step at the motion to dismiss stage.

Finally Judge Buchwald held that the plaintiffs’ complaint adequately stated a ’33 Act claim with respect to the company’s February 2007 offering, but failed to state a claim with respect to the company’s March 2008 offering because the alleged misstatements in connection with that offering are not actionable under the "bespeaks caution" doctrine.

In allowing the claims relating to the February 2007 offering to go forward, she expressly rejected the defendants’ statute of limitations arguments, holding that the "storm warnings" on which the defendants sought to rely were not sufficient to put the plaintiffs on "inquiry notice," because Ambac’s officers had actively sought to reassure investors about those supposed storm warning.

Discussion

Judge Buchwald’s ruling in this case is interesting and perhaps significant in a number of respects.

First, reliable sources in the plaintiffs’ bar advise me that Judge Buchwald is viewed as a tough draw for plaintiffs. These same sources advise that the fact that she is the one that wrote the opinion makes it even more noteworthy.

Second, I think her language in rejecting the "hey, the whole economy tanked" argument is important. There are a number of companies about whom it might be alleged, as was alleged here of Ambac, that they were "an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim." In other words, the general collapse of the financial markets alone might not be enough to refute the potential existence of fraud, if the plaintiffs sufficiently allege that the defendant companies nevertheless contributed to their own collapse.

This is significant because many companies that have been sued in the wake of the credit crisis have tried to refute the inference of fraud by arguing that that no one could have foreseen what subsequently happened. However, as Judge Buchwald noted, the collapse was not the result of the operation of some inevitable physical force. While there were many factors that contributed to the collapse, one of the causes may well have been various companies’ actions and statements prior to the collapse.

The fact that the subsequent collapse was generalized is not necessarily inconsistent with the possibility that prior to the collapse that fraudulent misconduct may have taken place at any one specific company – or, as Judge Buchwald noted, that the misconduct may have helped bring the collapse about.

I also think Judge Buchwald’s rulings are interesting because of her willingness to rely on plaintiffs’ expert’s analysis in finding misrepresentations on the CDO valuation issue and also because of her rejection of the statute of limitations argument based on the contention that "storm warnings" put the plaintiffs on "inquiry notice."

But the final reason that Judge Buchwald’s ruling may be significant is that it is a very strong opinion ruling in the plaintiffs’ favor in a high profile subprime-related case in the Southern District of New York. So many of the subprime related cases are pending in the Southern District, so the plaintiffs lawyer will of course seek to rely on Judge Buchwald’s holdings in other cases pending in that District.

It of course remains to be seen to what extent plaintiffs will be able to get mileage out of Judge Buchwald’s holdings in other cases. But it does in any event represent a significant victory for the plaintiffs.

I have added the Ambac decision to my table of subprime and credit crisis-related securities class action lawsuit dismissal motion rulings, which can be accessed here. It certainly does seem that recently the dismissal motion rulings have been coming down fast and furious.

Special thanks to a loyal reader for providing me with a copy of the Ambac decision.

Climate Change and D&O Coverage: In a recent post (here), I noted the possibility that the requirements of the SEC’s new interpretive guidance about climate change disclosure could create a context within which climate change disclosure claims might arise. If these kinds of claims do materialize, they potentially could create important coverage issues under applicable D&O insurance policies.

A February 19, 2010 memo by Collin Hite and Sung Yhim of the McGuire Woods law firm entitled "Global Warming Litigation and D&O Insurance Coverage Issues" takes a look at the kinds of coverage issues that might be involved if climate change-related disclosure cases do arise. The memo can be found here.

Two More Subprime-Related Securities Suits Dismissed

Kevin LaCroix — Mon, 22 Feb 2010 04:49:09 -0500

Just when it seemed as if the dismissal motion rulings in the subprime-related securities suits might be breaking more favorably to the plaintiffs, two February 18, 2010 rulings granted the defendants’ motions to dismiss in two separate subprime cases. While only one of the two dismissals was with prejudice, both represent substantial defense victories. These latest rulings tend to support the view that, with some notable exceptions of course, the plaintiffs are as a general matter facing hurdles in many of the subprime cases.

Fortis: In a February 18, 2010 decision (here) that addressed recurring issues of the extraterritorial jurisdiction of U.S. courts under the U.S. securities laws, Southern District of New York Judge Denny Chin dismissed the subprime-related securities suit pending against Fortis and certain of its directors and officers, for lack of subject-matter jurisdiction.

As I detailed in a prior post about the Fortis lawsuit (here), Fortis is a Belgium-based financial company that in late 2008 received a massive bailout by the governments of Belgium, the Netherlands and Luxembourg. Fortis’ shares trade on several European exchanges and its ADRs trade over-the-counter in the U.S.

In their amended complaint, the plaintiffs allege that the defendants misrepresented the value of its collateralized debt obligations; the extent to which its assets were held as subprime-related mortgage backed securities; and the extent to which its ill-fated decision to acquire ABN-AMRO had compromised the company’s solvency.

In granting the motion to dismiss, Judge Chin found, applying the Second Circuit standard articulated in the National Australia Bank case, that the plaintiffs had not alleged either sufficient U.S.-based "conduct" or "effects" to support the court’s exercise of subject matter jurisdiction.

Specifically, the found that the company’s alleged New York-based data compilation was merely preparatory to the actual fraudulent misrepresentations, which were alleged to have been made by the company’s executives in Brussels. Judge Chin found that "the complaint describes the Brussels executives as the masterminds, and portrays the New York Office as uninvolved in decision-making regarding information to be communicated."

In finding that the complaint failed to satisfy the "effects" test, Judge Chin observed that the "lead plaintiffs do not explicitly allege what percentage of Fortis’s investors are U.S residents, nor the effect the fraud may have had in the United States."

Judge Chin noted that the complaint alleges that 17.2% of all institutional investors were located in North America, but "it does not break down what percentage of those were located in the U.S. – as opposed to Canada, Mexico or any of the approximately 38 countries on the continent."

In closing, Judge Chin denied plaintiffs leave to amend, noting that "plaintiffs have already had two bites of the apple, as they have already filed two complaints," adding that "it is difficult to imagine that plaintiffs did not allege all the facts they had a good faith basis for asserting," and a "third opportunity to plead would be futile."

Judge Chin’s refusal in the Fortis case to allow the plaintiffs’ to file an amended complaint stands in contrast to what happened in the Credit Suisse case, where, as I discussed here, Judge Victor Marrero at least allowed the plaintiffs to seek leave to file an amended complaint. Significantly, in the Credit Suisse case, the plaintiffs were able to present sufficient additional allegations to satisfy the "effects" test and to establish subject matter jurisdiction. Judge Chin’s refusal even to allow plaintiffs to seek leave to amend, and possibly to cure the pleading defect, stands in contrast to the Credit Suisse case.

MGIC: In a February 18, 2010 order (here), Eastern District of Washington Judge Lynn Adelman granted the defendants’ motion to dismiss in the subprime-related securities suit that had been filed against mortgage insurer MGIC Investment Corporation and certain of its directors and offices, as well as against certain officers of C-Bass, a subprime mortgage-securitizer in which MGIC was a joint venture partner with Radian Group.

In their complaint, the plaintiffs alleged that the MGIC defendants had misrepresented MGIC’s underwriting practices; that the MGIC defendants had misrepresented the performance of mortgages the company had insured in 2005 and 2006; and that the defendants had misled investors about the extent of C-Bass’s margin calls in July 2007.

Judge Adelman went through each of the allegedly misleading statements on which the plaintiffs sought to rely, and with respect to each, he found that the statements were either immaterial or not misleading, or even if misleading, that the plaintiffs had failed to establish that the statements had been made with scienter.

Judge Adelman granted the plaintiffs leave to amend, should they choose to do so. However, it will be very challenging for plaintiffs to overcome all of the concerns Judge Adelman noted. The very detailed, painstaking and comprehensive way that Judge Adelman considered each of the alleged misrepresentations may leave plaintiffs with very little room to try address his concerns.

In any event, the subprime-related securities suit filed against the other C-BASS joint venture partner, Radian Group, was previously dismissed, as discussed here.

Discussion

The plaintiffs’ difficulties trying to establish subject matter jurisdiction in the Fortis case are significant, because many of the other subprime-related cases also involve foreign-domiciled companies. Perhaps the pleading differences between the Credit Suisse case (where the plaintiffs had specifically identified the percentage of shares held by U.S. institutional investors) and the Fortis case provide plaintiffs in other cases enough of a road map, but the Fortis case still does suggest that plaintiffs may struggle to establish jurisdiction in many of these cases.

The difference in outcomes in the two cases may be a reflection of where each company’s ADRs traded. Credit Suisse’s ADRs traded on the NYSE, but Fortis’s ADRs traded only over the counter. As Ben Hallman noted in his February 19, 2010 Am Law Litigation Daily article (here) discussing the Fortis decision, over the counter purchases are "nearly impossible to track," and accordingly "the damage to U.S. investors impossible to quantify." The plaintiffs in subprime cases against other non-U.S. companies whose shares or ADRs do not trade on one of the formal U.S. exchanges may have similar difficulty quantifying the impact on U.S. investors.

One interesting related question is the extent to which the outcome of the National Australia Bank case, now pending before the U.S. Supreme Court, might affect these jurisdictional issues. Congress may also have its own say on these issues. The bottom line is that there are a lot of moving pieces that could affect consideration of these jurisdictional issues going forward.

In any event, these two dismissal motion rulings represent that much more evidence that overall plaintiffs do not seem to be faring particularly well in the subprime-related securities suits. As reflected on my running tally of the subprime and credit crisis-related dismissal motion ruling, which can be accessed here, the defendants have prevailed in far more motion rulings to date than have the plaintiffs.

Though plaintiffs have had some notable victories, and though plaintiffs have even managed to survive some renewed motions to dismiss after initial dismissal motions had been granted, in the majority of motion rulings, the defendants have prevailed. By contrast to historical patterns, where cases are dismissed somewhere between 33% and 40% of the time, in the subprime-related dismissal motion rulings, the defendants are prevailed about two-thirds of the time – at least so far. Many of the subprime and credit crisis cases have still not yet reached the dismissal motion stage.

So Many Updates, So Little Time: With all of the voices and sources, who is worth following? Bruce Carton, the author of the Securities Docket blog and a new media maven in the securities enforcement arena has put together an updated list of the 15 "must-follows" on Twitter. Special thanks to Bruce for including me on his list.

Some Winter Olympics Observations:

1. The key physical forces involved in the winter Olympics sports are the coefficients of friction and aerodynamic drag. (Contrary to what some might think, "aerodynamic drag" is not a description of Johnny Weir’s skating attire.)

2. Shaun White really did say, on camera, while describing his emotional state, "freaky deeky."

3. "Live curling." Discuss.

4. With reference to the commercial in which the female snowboarder leaves the earth’s atmosphere: (a) Does anybody have any idea what product or service is being advertised? (b) Where is she supposed to be snowboarding, the edge of some gigantic cosmic womb or something like that? (c) Am I the only one who is troubled that she never returns to earth, but instead drifts off further into the ether… it all seems so sad and weird.

5. In the summer Olympics, it was commercials with wind turbines. Now in the winter Olympics, it is commercials with girl ice hockey players.

6. Shen Xue and Zhao Hungbo not only came out of retirement to win gold in pairs figure skating, but they did something even more amazing – they managed to get us to root for a couple of Chinese athletes. (If you think that sounds xenophobic, just imagine how it is going to feel four years from now when Chinese snowboarders sweep the medals in the half pipe.)

7. In the entire history of the human race, from the dawn of man to the present moment, has there ever been anyone more unfortunately named than Dick Button?

Investors in Failed Georgia Bank File Suit

Kevin LaCroix — Mon, 22 Feb 2010 04:34:53 -0500

As the number of failed banks has surged over the past couple of years, one anticipated byproduct has been a corresponding wave of litigation against the failed institutions’ former directors and officers. The thing is, the anticipated wave really has not yet materialized. But nevertheless some suits are coming in, as demonstrated most recently in a new lawsuit filed this past week against certain former directors and officers of a failed Georgia bank.

On February 18, 2010, seventeen individual plaintiffs (including one trust) filed a Verified Complaint (here) in Cobb County (Ga.) Superior Court against three former directors of Alpha Bank and Trust, an Alpharetta, Ga. bank that failed on October 24, 2008. A February 18, 2010 Atlanta Journal-Constitution article about the filing can be found here.

The bank, according to press reports, was "one of the quickest bank failures in the nation in recent years, losing almost half of its assets after only 29 months in business."

The plaintiffs’ complaint seeks recovery for negligent misrepresentation and alleges that the three defendants had possession of material information about the bank that they failed to disclose to the plaintiffs, who owned shares in the bank.

There are a number of interesting things about this complaint. The first is that in paragraph 10, the complaint expressly purports to "exclude and disclaim any allegations whatsoever that could be construed as alleging or sounding in" the federal securities laws; common law fraud; intentional, knowing or reckless misconduct; breach of fiduciary duty, or mismanagement.

Clearly, the plaintiffs are not only aiming to avert procedural hurdles and potential defenses, but, as discussed below, they are also trying to circumvent the FDIC’s priority rights under FIRREA to claims the FDIC acquired as the bank’s receiver.

Second, the specific misrepresentations alleged – that the bank experienced undisclosed regulatory difficulties almost from its very beginning, that the bank submitted an undisclosed revised business plan to regulators, that the bank’s board dismissed the bank’s CEO for undisclosed reasons, among other things – all took place after the bank was launched and apparently after the plaintiffs’ acquired their shares.

As a result, plaintiffs’ claim is not that the they were misled into investing in the bank in the first place, but rather that as a result of a series of allegedly wrongful omissions, they "continued to hold their substantial respective investments," as the complaint puts it. A "continued to hold" assertion is a more challenging claim that an "induced to buy" argument.

Third, as suggested above, the plaintiffs clearly tried to shape their allegations in order to avert the FDIC’s rights as receiver to priority over all of the failed institution’s claims. (Refer here for my prior post discussing the FDIC’s right under FIRREA.) The plaintiffs have very carefully alleged that they seek to "recover individualized damages," as well as explicitly asserting that they are not alleging breach of fiduciary duty or mismanagement, which are claims to which the FDIC’s priorities would be clearest.

The FDIC may yet of course attempt to assert its right to priority over the claims the plaintiffs have asserted, and even assert its own claims, based on its status as the bank’s receiver. A recent memo from the Alston & Bird firm (here), citing the FDIC’s own statistics, reports that "of the financial institutions that failed in the period between 1985 and 1992, the FDIC initiated claims against the former directors and officers of 24 percent of those institutions."

There is absolutely no reason to expect that the FDIC will prove to be less litigious now than it was during the S&L crisis. So there would seem to be a considerable possibility the FDIC could yet assert its own claims, as receiver, against the former Alpha Bank officials.

Whether the existing investor claim or any future FDIC claim might succeed remains to be seen. However, were the FDIC to pursue a claim as receiver, and if it were unable to assert its priority under FIRREA over the investors’ claim, there could be a race to capture assets from which to recover – the most obvious asset being the D&O policy. A potential barrier under the D&O policy to any recovery by the FDIC would arise if the applicable policy has a regulatory exclusion.

Whether any successful claimant would be able to recover under the D&O policy will depend further on whether or not anything is remaining when the time arrives. If there were to be litigation free-for-all, defense costs alone could substantially erode the available insurance.

Finally, in terms of the anticiapted litigation wave, it is worth noting that approximately 16 months elapsed between the time Alpha Bank failed and the date the investors filed their suit against the former bank officials. Most of the closures of the most of the banks that have failed as part of the current banking crisis have failed more recently than Alpha Bank. The litigation may yet arrive, it may just follow more slowly than might have been anticiapted.

Special thanks to the several loyal readers who forwarded copies of the Alpha Bank complaint to me.

Belated Securities Suit Filings (Extreme Edition): In a number of recent posts (most recently here), I have noted the curious phenomenon of securities class action lawsuits that are filed well after the proposed class period cut off date. In some cases, the filing has come well over a year after the alleged stock price drop. However, a recent filing seems to set some kind of a belatedness record, as the complaint was filed nearly four and a half years after the proposed class period cutoff date.

In a complaint filed on February 18, 2010 against certain former directors and officers of the bankrupt Dana Corporation (here), the proposed class period runs from February 23, 2005 to October 7, 2005. The class period starting date is just short of five years, which is represents the period of the statute of repose for ’34 Act claims.

A great deal of context is necessary just to try to start to make sense of what might be going on here. First, there already is an existing securities class action lawsuit pending against other former directors and officers of Dana. The prior case, about which refer here, was first filed in the Northern District of Ohio in October 2005 and was dismissed with prejudice in August 2009 (here). The appeal of the dismissal is currently pending in the Sixth Circuit.

A knowledgeable observer suggested to me that the plaintiffs’ lawyers may think they have uncovered new facts implicating the four lower level defendants that are named in the new case. The speculation is that the plaintiffs’ lawyers filed the new case against the four new defendants to preserve the statute of limitations while the "main case" is on appeal. Because of the prior dismissal, the plaintiffs’ lawyers couldn’t just amend the previously existing complaint.

Where all of this might lead remains to be seen, but in the meantime the new complaint sets a new standard in superannuated securities lawsuit filings.

Special thanks to a loyal reader for sending along a copy of the new Dana complaint.

Congressional Panel Report: Commercial Real Estate Woes Mean More Bank Failures Ahead

Kevin LaCroix — Wed, 17 Feb 2010 04:38:59 -0500

After an initial flurry of bank failures in January, the pace of bank closures more recently has slowed. There has been only one failed bank so far in February, and there were none at all this past Friday night, the first failure-free Friday in several weeks. The apparent bank closure slowdown does not, however, mean that the worst is past; indeed, if a recent Congressional watchdog committee report is accurate, there may be many, many more bank failures ahead.

The Congressional Oversight Panel was created to oversee the expenditure of TARP funds and provide recommendations on regulatory reform. The Panel is chaired by Harvard Law Professor Elizabeth Warren.

On February 10, 2010, the Panel released its 190-page February Oversight Report, entitled "Commercial Real Estate Losses and the Risk to Financial Stability." The Report can be found here, and the Panel’s February 11, 2010 press release about the Report can be found here.

The Report paints a dire picture of the current and likely future performance of outstanding commercial real estate loans. The Report begins by observing that the Panel is "deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and that as damage spreads beyond smaller banks that it will contribute to prolonged weakness throughout the economy."

The fundamental problem is that between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are "underwater," meaning that the borrower owes more than the property is currently worth.

The commercial real estate borrowers’ problems are two-fold. The weakened economy means that the borrowers are having problems realizing sufficient cash from the properties to cover their principal and interest obligations (or, to give the problems its technical name, to maintain their "debt service coverage ratio"). The deeper problem is that when their debt obligation matures, they won’t be able to refinance the loan due to tougher bank underwriting standards or property value decreases.

Figure 31 on page 72 of the Report graphically illustrates the problem. The bar graph shows that commercial mortgage maturities will hit their highest levels between 2010 and 2014, with the peak coming during 2012 and 2013.

The timing of the debt maturities is all the more unfortunate, because they arise as signs point to continued (and perhaps progressively worse) deterioration of real estate market fundamentals. As the Report notes, "commercial real estate metrics tend to lag overall economic performance." For the last several quarters vacancy rates have risen and average rental prices have fallen for all major commercial property types.

Unless the nascent economic recovery picks up sufficient momentum to reverse these negative trends, the likelihood is that many of the maturing real estate loans will fail. Which means trouble for many smaller banks.

According to the Report, 2,988 of the roughly 8,100 U.S banks have a "CRE Concentration," meaning that such loans represent at least 300% of total capital or that construction and land loans exceed 100% of capital.

The danger is not just to the banks, according to the Report; rather, because of the downward spiral that defaults trigger, "a significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American."

The Report is neutral on the possibility whether an economic recovery could avert the worst of these concerns, saying only that "there is no way to predict with assurance whether an economic recovery of sufficient strength will occur to reduce these risks before the large-scale need for commercial mortgage refinancing is expected to begin in 2012-2013." The Report urges the Treasury and the banking regulators to "take coordinated action to address forthrightly and transparently the state of the commercial real estate markets."

Although the Report itself does not address this issue, an accompanying problem that is exacerbating these issues for many smaller banks is the banks’ past issuance of "trust preferred securities" to raise capital and fund loans. As I discussed at greater length here, these hybrid debt-equity instruments were a popular way in recent years for many banks to raise funds. Between 2000 and 2008, more than 1,500 small and regional banks issued about $50 billion in trust preferred securities, according to a February 12, 2010 Wall Street Journal article (here).

But as the current banking crisis has unfolded, certain features of these securities have operated to magnify many banks’ woes. The first is that the buyers of these instruments were in many cases other banks. As the issuing banks’ finances have deteriorated, the value of the instruments to the investor banks has also declined. Indeed, the deteriorating value has contributed to the demise of at least some of investor banks (about which refer here).

As the Journal article itself notes, these instruments give the buyers certain preferences. However, the existence of these preferences, which ensure that the holders of the instruments would be first in line to recover losses, means that other prospective investors now are wary of making any further investments, for fear that their investments would be subordinated to the trust preferred securities holders. These circumstances leave some banks unable to raise additional capital, "increasing the possibility that some of the weakest banks could fail."

Many banks are trying to repurchase their trust preferred securities at steep discounts, in a bid to circumvent these problems, but many of the holders (in many cases, other banks with their own problems) are reluctant to sell and be forced to recognize and absorb their losses. As the Journal article notes, "the standoff is particularly perilous for banks that are reeling from deteriorating real-estate portfolios."

The bottom line is that many banks will face daunting circumstance possibly for several years to come. These concerns in turn present a challenge for D&O insurance underwriters as they struggle to assess the risk exposures associated with these financial institutions. Whatever else might be said, it does seem likely that the current unsettled D&O insurance marketplace for lending institutions will continue.

As one time, and for many years, I was responsible for managing a team of D&O underwriters. If I were managing D&O underwriters today, particularly if our portfolio of risks included lending institutions, I would require all of my underwriters to read the Congressional Oversight Panel’s latest Report. It makes for some sobering reading.

Other Important Information: How to tell if your cat is plotting to kill you. Read it here.

Previously Dismissed Credit Suisse Subprime Securities Suit Allowed to Proceed

Kevin LaCroix — Tue, 16 Feb 2010 04:03:02 -0500

In an interesting February 11, 2010 decision (here), Southern District of New York Judge Victor Marrero allowed plaintiffs, whose subprime-related securities class action lawsuit Marrero had previously dismissed, leave to file a second amended complaint against Credit Suisse Global and certain of its directors and officers.

Judge Marrero also found the securities fraud allegations in the proposed amended complaint to be legally sufficient, meaning that the claims can now go forward, although he also ruled that the court lacked jurisdiction over the claims of plaintiffs that resided outside the U.S. and that had purchased their shares outside the U.S.

Background

Credit Suisse is domiciled in Switzerland. Its shares trade on several securities exchanges outside the U.S. and its ADRs trade on the NYSE. As reported in greater detail here, the plaintiffs filed their initial complaint in this action in April 2008. The plaintiffs alleged that the defendants had made material misrepresentations about the company’s asset valuation system, its internal controls (which allegedly allowed unauthorized placement of high risk mortgage-backed assets in client accounts), and its own exposure to losses related to subprime mortgages.

In an October 5, 2009 order (here), Judge Marrero had previously granted the defendants’ motion to dismiss, on the grounds that the court lacked subject matter jurisdiction over the claims of claimants who reside outside the U.S. and who had purchased their shares on foreign exchanges (so-called f-cubed claimants). The complaint had not identified the domicile of some other named plaintiffs, but Judge Marrero dismissed their claims as well.

In his prior ruling he required plaintiffs to seek leave to file an amended complaint, which the plaintiffs did. His February 11 opinion addressed the plaintiffs’ motion for leave to file an amended complaint.

The February 11 Opinion

In his February 11 decision, Judge Marrero granted the plaintiffs’ motion for leave to file their amended complaint, at least as to certain of the claimants.

Judge Marrero first found that the amended complaint failed to establish subject matter jurisdiction as to the foreign domiciled claimants that had purchased their shares on foreign exchanges. In reliance on the Second Circuit’s National Australia Bank standard (about which refer here), he found that because the alleged misrepresentations had originated in Switzerland, there was insufficient U.S.-based conduct to support the court’s exercise of subject matter jurisdiction over the claims of the non-U.S. claimants.

However, Judge Marrero found that the amended complaint contained sufficient allegations to permit the exercise of jurisdiction as to the claims of the U.S.-based claimants. The amended complaint alleged that more than 75 million Credit Suisse shares were held by institutional investors, representing over 11% of shares outstanding, and therefore there were sufficient "effect" alleged within the U.S. to support jurisdiction.

Judge Marrero then proceeded to determine that the plaintiffs’ securities fraud allegations were legally sufficient. Among other thing, he found that though the proposed amended complaint "contains much extraneous detail and irrelevant information," within the "remaining core of what is pertinent" the plaintiffs’ proposed complaint "sufficiently alleges scienter."

The proposed complaint relies heavily on confidential witness statements, from which Judge Marrero determined that the proposed complaint "alleges sufficient facts showing that the Defendants had direct knowledge of information contradicting their public statements or access to similar statements they should have monitored." Judge Marrero concluded that the proposed complaint properly pled scienter to support theories of fraud based on alleged schemes to "overvalue assets, underestimate risk, hide subprime exposure, ignored weaknesses of [the company’] risk management and internal controls, and violate GAAP."

Discussion

As a result of Judge Marrero’s February 11 ruling, the Credit Suisse Group subprime-related securities case, which had initially been dismissed, will now go forward. The Credit Suisse case is the latest in a series of subprime-related securities suits in which dismissal motions were initially granted, but in which the amended complaints later survived renewed dismissal motions. This list of cases in this series includes the PMI Group case (here), the Washington Mutual case (here), and the BankAtlantic Bancorp case (here).

The ability of the plaintiffs in these cases to cure initial pleading deficiencies and to overcome preliminary pleading hurdles is noteworthy. Among other things, it casts important light on the list of subprime-related securities cases in which motions to dismiss have been granted. Many of these dismissals are without prejudice, meaning that the plaintiffs in a number of these cases, like the plaintiffs in the Credit Suisse case, may yet find a way to survive renewed dismissal motions and live for another day.

The outcomes of many of the dismissal motion rulings (at least to this point) the subprime-related securities cases could possible be interpreted to suggest that the cases were not faring particularly well. As reflected in my table of subprime-related lawsuit dismissal motion rulings, which can be accessed here, of the 48 subprime-related securities lawsuits in which dismissal motion rulings had been entered, fully 31, or nearly 65%, had resulted in the dismissal motions being granted, a dismissal rate the far exceeds typical patterns.

However, in 16 of the 31 cases, the dismissals were without prejudice. Many of the cases in which dismissal motion motions have been granted may yet survive renewed dismissal motions.

In any event, there still have only been dismissal motion rulings in about 27% of the subprime and credit crisis-related securities suits. The dismissal motions have not yet heard in nearly three quarters of the subprime and credit crisis-related securities suits. Though the subprime litigation wave first started in February 2007 and is now entering its fourth year, it still has a very long way to run. And many cases yet to be heard and other cases surviving renewed motions to dismiss, it is far too early to try to say one way or the other that cases are or are not faring well.

The fact that the Credit Suisse claims involve a foreign-domiciled corporate defendant is also noteworthy. Many of the subprime-related securities cases involve non-U.S. companies. the Credit Suisse case show that in at least some of these cases against foreign companies, the plaintiffs will succeed in establishing jurisdiction, even if the allegedly misleading statements originated outside the U.S., although in those cases the claims of foreign domiciled investors who purchased their shares on foreign exchanges may or may be allowed to continue.

Many thanks to a loyal reader for sending me a copy of the Credit Suisse decision.

Speaking of Jurisdiction Over Foreign-Domiciled Companies: One of the ways in which companies domiciled outside the United States can, in at least some kinds of cases, seek to avoid the burden and risk of defending litigation in the United States is by asserting the principle of forum non conveniens. This judicial tenet allows a court to defer jurisdiction where principles of justice and convenience favor the action being brought in another forum.

A February 2010 memo by the Sherman & Sterling law firm (here) discusses this principle and analyzes its recent application in the Cadbury Shareholder Litigation, a purported derivative class action that had been filed in connection with Kraft Foods hostile takeover bid. The action was brought in New Jersey federal court though Cadbury is a U.K. company, U.K law governs the Board’s conduct, and none of the parties resided in New Jersey.

In the Cadbury case, the court granted the defendants’ motion to dismiss on forum non conveniens grounds, determining among other things that the U.K. was an adequate alternative forum and that the plaintiffs’ choice of forum was entitled to little deference. The court also found that the differences between U.K. and U.S. takeover law did not detract from the availability of an adequate alternative forum in the U.K.

The principles of forum non conveniens could provide a substantial defense in other derivative litigation involving foreign domiciled companies. It is less likely to be relevant in class action cases alleging violations of the U.S. securities laws, as the availability of an adequate alternative forum may be far less likely given the absence in many jurisdictions of adequate alternatives to the remedies available under the U.S. securities laws.

In any event, the recent decision in the Cadbury case represents yet another case in which U.S. courts have sought to determine the circumstances under which it is and is not appropriate for U.S. courts to exercise jurisdiction over foreign-domiciled companies.

Bankruptcy Court Did Not Abuse Discretion in Granted Relief From Automatic Stay Allowing D&O Insurer to Reimburse Individual’s Defense Expenses: In an opinion filed on January 29, 2010 (here), the Ninth Circuit Bankruptcy Appellate Panel held that the bankruptcy court did not abuse its discretion in granting relief from the automatic stay in bankruptcy to allow the company’s D&O insurer to advance an individual insured’s legal expenses.

Layne Sapp had been the sole director, chief executive officer and majority shareolder of MILA, Inc., a mortgage brokerage firm. The company had a $1 million D&O insurance policy. The company filed for bankruptcy and the trustee initiated an adversary proceeding against Sapp alleging a number of claims. Sapp incurred legal costs defending himself. The D&O carrier agreed to advance his defense expenses if Sapp obtained a comfort order stating that the Insurer was not violating the automatic stay by making the payments.

Sapp filed a request for relief from the automatic stay to allow the D&O insurer to pay his defense expense. The trustee opposed the motion on the ground arguing that the policy proceeds were estate property and that payment of Sapp’s defense expense would deplete the limits. (Oddly and unusually, MILA’s D&O policy did not have so-called entity coverage, so the Trustee’s assertions of the estate’s rights to the policy proceeds were limited to the company’s reimbursement coverage under Side B of the policy).

The bankruptcy court granted Sapp’s request and the Trustee appealed.

The appellate panel held that the bankruptcy court had not abused its discretion in granting relief from the stay. The appellate panel found that the bankruptcy court had appropriately weighed the parties’ respective harms and determined that Sapp had shown the requisite case for relief.

The debate about the right to D&O insurance policy proceeds in the bankruptcy context is a long-standing and sometimes vexatious issue. A good summary of the principles involved can be found in a 2006 memo by Wiley Rein’s Kim Melvin, here.

And Finally: A surprising number of people manage to figure this one out on their own without even requiring instruction -- "How to Suck at Facebook" (here).

Those Belated Securities Lawsuit Filing Blues, 2010 Edition

Kevin LaCroix — Tue, 09 Feb 2010 04:38:28 -0500

One of the most distinctive attributes of the 2009 securities class action lawsuit filings was the prevalence, particularly in the second half of the year, of new lawsuits in which the filing date came well after the date of the proposed class period cutoff. There has been much discussion over the cause of the belated filings. But whatever the reason may be for these filings, the phenomenon clearly has carried over into 2010, and at least so far seems to be a significant feature of the 2010 securities lawsuit filings.

The two new securities class action lawsuits filed on Friday, February 5, 2010 both represent this distinct class of cases.

First, as reflected in their press release (here), on February 5, plaintiffs’ lawyers filed a securities class action lawsuit in the Southern District of New York against Nokia and certain of its directors and officers, alleging that the defendants had misled the company’s ADR investors about delays and price competition the company was experiencing with respect to its communications handsets. Though the complaint (which can be found here) was not filed until February 5, 2010, the proposed class period cutoff date is September 5, 2008, well nearly a year and a half before the filing date.

Second, as reflected in their press release (here), on February 5, a different set of plaintiffs’ attorneys filed a securities class action lawsuit in the Southern District of New York against the Bermuda-based workers’ compensation insurer CRM Holdings, Ltd., and certain of its directors and officers, relating the company’s pricing and reserving practices. Though the complaint (which can be found here) was not filed until February 5, 2010, the proposed class period cutoff date is November 5, 2008, over a year before the filing date.

These latest lawsuit follow along behind two other seemingly belated lawsuits already filed this year. The proposed class period cutoff date in the securities class action lawsuit filed on January 15, 2010 against medical device company Stryker Corporation is November 13, 2008, over a year before the filing date.

The most extreme example among the belated 2010 filings is the securities class action lawsuit filed on January 21, 2010 against Motorola. The January 22, 2008 class period cutoff date is a full 1 year and 365 days before the filing date, bringing the new lawsuit just inside the two year statute of limitations for actions under the ’34 Act.

In addition to their apparent belatedness, these filings also have a number of other attributes. Most particularly, none of these cases seem related to the subprime meltdown and global credit crisis. Even though CRM holdings is in the financial services industry, the allegations in that case do not appear to related to the economic crisis.

To that extent at least, then, the belated securities lawsuit filings seem consistent with the theory, which some plaintiffs lawyers have advanced (as discussed here), that the reason for these lag filings is that throughout most of the last three years, the plaintiffs’ firms were preoccupied with filing subprime and credit crisis cases. Now that that filing wave has died down the plaintiffs firm, by their account, are turning back to cases that they backburnered.

The other theory about these belated cases, advanced most notably by Professor Joseph Grundfest (refer here), is that the plaintiffs’ lawyers are running out of meritorious cases so they are scraping the bottom of the barrel (my words, not his) to file cases that, based on his analysis of past lawsuit filings, are statistically more likely to be dismissed.

I don’t know for sure why these cases have been filed belatedly. All I can say is that it is a very distinct and observable pattern that clearly has carried over into the New Year. Among other things, these filing patterns create challenges for D&O underwriters, who will face a great deal of uncertainty about when a company that has experienced past issues may be "out of the woods." To borrow an auto racing analogy, it as if a yellow flag has been raised for all the cars on the track – proceed with caution.

One final note about these belated filings so far in 2010 is that at least the Nokia and the CRM holdings cases involve foreign domiciled companies – they are based in Finland and Bermuda respectively. The susceptibility of non-U.S. companies to securities litigation in U.S. courts is a hot topic right now, with the National Australia Bank pending before the U.S. Supreme Court and with the Vivendi jury verdict having just been returned. These latest lawsuits suggest that the incidence of U.S. securities lawsuits against non-U.S. companies will remain a hot button issue for the foreseeable future.

Fifth Circuit Stays Ruling that Stanford Group’s D&O Insurers Must Pay Defense Fees: As I noted in an earlier post (here), on January 26, 2010, Southern District of Texas David Hittner had ordered Stanford Financial Group’s D&O liability insurers to pay the defense expenses that former Stanford officers (including Allen Stanford) are incurring in connection with various legal matters arising out of the Stanford scandal.

However, according to a February 4, 2010 Houston Chronicle article (here), the Fifth Circuit Court of Appeals has entered a stay of Judge Hittner’s ruling. The article also reported that the Fifth Circuit has schedule oral argument on the legal issues in the case for February 25, 2010.

So the story goes on, with out any greater clarity on the question whether or not the individuals are entitled to have their defense fees paid by the company’s D&O insurance carriers. High-profile financial scandals make for some high stakes (and therefore fiercely litigated) coverage issues.

Hat tip to the Securities Docket (here) for the link to the Chronicle article

BofA: Securities Fraud Enforcement and Individual Liability

Kevin LaCroix — Mon, 08 Feb 2010 04:53:28 -0500

In a flurry of headline-grabbing events involving Bank of America last Thursday, the SEC announced the renewed settlement of its enforcement suit against the company, while at the same time New York Attorney General Andrew Cuomo announced his office’s initiation of a separate fraud action against the company and two former company officials. These high-profile developments pose a series of questions, not the least of which are the questions concerning the claims raised -- or not raised -- against the company officials, which in turn underscore some basic issues concerning the liability of individuals under the federal securities laws.

The first and most fundamental question is whether Southern District of New York Jed Rakoff will approve the current $150 million settlement, after previously rejecting the prior $33 million deal.

In his harshly worded September 14, 2009 opinion (here), Judge Rakoff rejected the prior settlement, finding that it was "neither fair, nor reasonable, nor adequate." He challenged the very premise of the deal, which he said "proposes that shareholders who were the victims of the Bank’s alleged misconduct must now pay the penalty for the misconduct."

Judge Rakoff further criticized the deal because the SEC did not explain why "it did not pursue charges against the Bank management or the lawyers who allegedly were responsible for the false and misleading proxy statements."

As Susan Beck of the AmLaw Litigation Daily points out in her February 4, 2010 article about the settlement (here, registration required), the renewed settlement seemingly does not address either of Judge Rakoff’s principal concerns. That is, the company is still proposing to settle the case at the expense of current shareholders. And the settlement does not address Rakoff’s earlier criticism of the SEC for failing to hold any individuals accountable.

Along the same lines, the WSJ.com Law Blog quotes (here) Duke Law Professor James Cox as saying "Either I’m hopelessly ignorant or this doesn’t address Rakoff’s concerns at all. Maybe they think Rakoff is getting senile in his old age. But I wouldn’t count on that."

The lack of SEC action against individual company officials is all the more evident because of the separate action the NYAG initiated virtually simultaneously with the SEC’s announcement of the renewed settlement. Cuomo’s lawsuit (here) not only names the company, but also names as defendants former BofA CEO Ken Lewis and former CFO Joseph Price. The New York action seemingly begs the question of why the SEC did not pursue claims against individuals, especially in light of Rakoff’s concerns.

There are some important considerations that need to be taken into account in contrasting the SEC’s and the NYAG’s respective actions. First of all, the SEC has said all along that the reason it did not pursue enforcement claims against individuals is because of concerns with its ability to satisfy scienter requirements. Indeed, in his September 14 opinion, Judge Rakoff expressly noted that the SEC had contended at that time that it had not pursued claims against individuals as "culpable intent was lacking because the lawyers made all the relevant decisions."

Thought the NYAG’s action asserts claims against two former executives, the legal basis of the claim is New York’s Martin Act. Unlike the liability provisions of the federal securities laws, the Martin Act does not require a finding that the individuals acted intentionally. The NYAG’s claims simply do not face the same pleading barriers as the SEC would if it were to pursue claims under the federal securities laws against company executives.

The challenge in substantiating claims under the federal securities laws against senior company officials even when their company was engaged in fraudulent misconduct was underscored in the recent Vivendi securities class action trial, where the jury found the company liable on all 57 counts, yet at the same time found the individual defendants not liable. In a post trial interview (here), the individual defendants’ trial counsel explained that this seemingly split verdict can be understood in part by the fact that the jury (defense counsel contend) was persuaded by the individuals’ testimony that they had not intended to mislead anyone.

The SEC’s reluctance to pursue the BofA executives and the odd split verdict in the Vivendi trial raise some interesting questions to ponder about the susceptibility of individuals to the imposition of liability under the federal securities law, although the lack of traction against the individual executives in those two cases may simply be a reflection of situation specific circumstances.

But in any event, the seeming contradiction between the SEC’s inaction against any individuals and the NYAG’s pursuit of the two executives may not be quite as first appears. Among other things, the SEC settlement and the NYAG’s lawsuit announcement were not in isolation from each other. To the contrary, Cuomo’s press release expressly references the SEC’s settlement and quotes him as saying that he support the SEC’s settlement.

The suggestion is that the two developments should not be viewed as in disjunction but rather as complementary. Perhaps the SEC will refer to the NYAG’s suit in response to Rakoff’s likely concerns with the settlement about the SEC’s inaction against individuals.

The most important differences between the SEC’s renewed settlement and the earlier version Rakoff rejected are that the latest deal represents significantly larger dollar amounts, and it also includes the company’s agreement to adopt certain corporate governance reforms.

The governance reforms arguably provide real value to the current shareholders. But even if the value to shareholders is substantial, the renewed deal still does not avoid Judge Rakoff’s earlier concerns that BofA’s shareholders are being forced to bear the cost for having been misled about the Merrill Lynch transaction. Indeed, the significantly larger dollar value of the renewed settlement seemingly exacerbates this very problem.

Given these concerns, it will be very interesting to see what Judge Rakoff does with the renewed settlement. It is very hard to read his September 14 opinion now and to think that this renewed settlement will fare any better than the prior version. It will be particularly interesting to see what Judge Rakoff’s response says about the fundamental notion of holding individuals accountable under the federal securities laws.

Broc Romanek’s post about the SEC’s renewed settlement on his CorporateCounsel.net blog (here) has some interesting observations about the role of corporate governance reforms within the resolution of SEC enforcement actions.

"Bump-Up" Claims Surge: Much ink has been spilled concerning the supposed decline in the number of securities class action lawsuit filings in 2009. But whether or not the class suits are in fact declining, another form of corporate litigation apparently is on the rise.

According to a February 4, 2010 Law.com article (here), there has been an "uptick in shareholder lawsuits over mergers and acquisitions." One source quoted in the article states that filings of those types of claims – referred to as "bump up" actions because they seek to increase the sale price – are up "at least 50 percent" over a few years ago.

The article also quotes Boris Feldman of the Wilson Sonsini law firm as saying that "plaintiffs lawyers are trying to replenish their inventory, because traditional securities suits have fallen." He goes on to say that "nature abhors a vacuum, so more and more plaintiff firms have been filing merger suits instead."

Many D&O insurance policies have express exclusions precluding coverage for the amount of any additional consideration paid to settle a bump up claim. Moreover, as I discussed at length in a prior post (here), some courts have held that there is no coverage for the additional consideration, even without respect to the exclusion. In many circumstances, however, defense costs at least may be covered.

Lehman Subprime-Related ERISA Suit Dismissed: In an earlier post (here), I noted that Judge Lewis Kaplan had dismissed liability claims filed against the rating agencies that had provided ratings opinions in connection certain Lehman Brothers securities offerings. In a separate opinion relating to the Lehman collapse, on February 2, 2010 Judge Lewis Kaplan also dismissed the subprime-related ERISA class action that beneficiaries had filed against former company officials. A copy of Judge Kaplan’s opinion can be found here.

In dismissing the case, Judge Kaplan held that the complaint failed to allege that the misconduct alleged against the eleven director defendants violated any fiduciary duties that the individuals had to plan beneficiaries. He further held that the complaint failed to allege that the sole remaining defendant (a member of the plan administrative committee) had any responsibility for or involvement with the company’s supposedly misleading disclosures, or any prior awareness of the company’s imminent collapse.

A February 3, 2010 AmLaw article discussing the opinion can be found here (registration required). I have in any event added the opinion to my list of subprime-related lawsuit dismissal motion rulings, which can be accessed here.

Lost Generation: If you have not yet seen it, you may want to take a couple of minutes to view the Lost Generation "mirror image" video. It is pretty bare bones, but is still makes an interesting statement. Hat tip to the CorporateCounsel.net blog for the link.

BAE Systems Settles Corruption Allegations:

Kevin LaCroix — Mon, 08 Feb 2010 04:34:29 -0500

On February 5, 2010, BAE Systems announced (here) that it has entered separate settlements with the U.S. Department of Justice and the U.S. Serious Frauds Office, pursuant to which the company will pay a total of nearly $450 million to settle long-standing investigations of improper payments.

Under the U.S. plea deal, the company will pay $400 million to settle one charge of conspiring to make false statements and under the U.K. deal the company will pay a penalty of £30 and plead guilty to one charge of breach of duty to keep accounting stemming from a payment to a former consultant in Tanzania. A February 6, 2010 Wall Street Journal article discussing BAE’s entry into these deals can be found here.

The investigations surrounding BAE’s improper payments have been both very high-profile and very controversial. As discussed at length in a prior post (here), the most sensational aspects of the investigation have involved allegations involving the Al-Yamamah Saudi Arms deal, which allegedly involved improper payments to Prince Bandar bin Sultan, a member of the Saudi royal family. The propriety of the Serious Fraud Office’s decision to terminate that aspect of the BAE investigation was particularly controversial and eventually made its way to the House of Lords, which, as noted here, concluded that the SFO had properly exercised its authority to terminate the investigation, after a lower court had previously ruled that the SFO must reconsider its decision to terminate the investigation. The DoJ continued its investigation of the controverisal arms deal, however.

Given the controversy surrounding the BAE investigation, it is hardly surprising that, notwithstanding the sheer size of BAE’s deals resolving the investigation, questions about the resolution of the investigation have arisen.

Among others concerns that have been noted, it is very difficult to discern from BAE’s press release and from the SFO’s release (which can be found here) which exactly the company is admitting to having done. Neither document contains words or phrases you might, under the circumstances, expect to see, including, for example, "bribery" "corruption" or even "improper payments" or "improper influence." As the FCPA Professor blog notes here, "can the enforcement agencies on both sides of the Atlantic say with a straight face that this case was merely about improper record keeping, making false statements to the government, and export licenses?"

The criminal information that the Department of Justice filed in the District Court for the District of Columbia is a little more specific, as it as least refers to improper payments that the company made in connection with military aircraft transactions involving the governments of the Czech Republic and Hungary. The criminal information also specifically references "undisclosed payments associate with the sale of Tornado Aircraft and other defense materials to the Kingdom of Saudi Arabia." The criminal information also specifically references "substantial benefits" provided to one unnamed Saudi official "who was in a position of influence" regarding the aircraft deals.

According to the FCPA Blog (here), the Al-Yamamah arms deal, about which the blog has additional information (including a link to video footage) is "at the heart" of the criminal information, though the details are slight.

The paucity of detail almost ensures that controversy will continue to surround the investigation. The tenor of the controversy is succinctly captured by the FCPA Professor blog’s comment in connection with the BAE deals that "transparency, corporate accountability, and indeed a criminal justice system all suffered setbacks today."

But though questions will continue to be raised, the sheer size of the payments BAE has agreed to make in order to resolve these investigations should not be overlooked. Along with the staggering amounts to which Siemens agreed to pay in connection with its own separate corrupt practices investigation, these payments demonstrate that corrupt practices investigations represent a very significant risk exposure. It should also not be overlooked that in the case of Siemens and BAE, as well as a number of other companies that U.S. authorities have targeted, these corrupt practices investigations often involved companies domiciled outside of the United States.

As I have previously noted (here), one parallel threat accompanying threat of regulatory investigations concerning corrupt payments is the possibility of follow-on civil litigation in U.S. courts. BAE systems was itself the target of a shareholders’ derivative suit regarding the corrupt payments investigation, although as noted here (scroll down after linking), the BAE Systems derivative suit was later dismissed due to the claimants lack of appropriate standing to bring the action.

Other foreign targets of FCPA investigations have also been subject to civil litigation in U.S. courts, as demonstrated by the recent securities lawsuit filed against Panalpina and certain of its directors and officers concerning its disclosures and accounting for certain alleged improper payments.

The point is that not only does the threat of an improper payments investigation represent a significant risk exposure for companies active in the global economy but that threat includes the risk of civil litigation in U.S. courts. This litigation threat all of these issues important considerations for purposes of D&O insurance, as I discussed in a prior post, here.

Will the SEC's New Interpretive Guidance Open the Door to Climate Change Disclosure Suits?

Kevin LaCroix — Mon, 08 Feb 2010 04:28:19 -0500

On February 2, 2009, the SEC published its interpretive release providing guidance to public companies on the SEC’s existing disclosure requirements as they apply to climate change. The release can be found here. A February 4, 2010 memo from the Gibson Dunn law firm analyzing the SEC’s release can be found here.

While the interpretive release take pains to emphasize that it only clarifies existing obligations, the release nevertheless represents the Commission’s clearest statement about expectations for public company’s climate change disclosures. The release’s specificity and its reliance on requirements that have themselves previously been cited in suits pertaining to more traditional environmental disclosures raise the question whether suits pertaining to climate change-related disclosure may be next.

The release cites several existing disclosure rules that it says required public companies to provide disclosures regarding climate change, including Items 101, 103 and 303 (among others) in Regulation S-K.

The release also identifies four topics that could require climate change-related disclosures, including: the impact of climate change legislation and regulation; the impact of international climate change accords; indirect consequences of climate change regulation or business trends; and the physical impacts of climate change.

Public companies will now have to accommodate their disclosure practices to the SEC’s guidance. While the SEC claimed only to be clarifying existing requirements, the practical reality is that many companies will now have to reconsider their disclosure process and practices, and, in many cases, alter the content of their disclosures.

With the SEC’s clarification of the disclosure requirements comes the opportunity for claimants or even for the SEC itself to later allege that a company’s climate change disclosures fell short of requirements. By way of illustration of how these claims might arise, it is worth considering that the very disclosure provisions with respect to which the SEC provided its climate change guidance have previously served as reference points in claims alleging misrepresentations or omissions of more traditional environmental liabilities and exposures.

For example, as I noted in a prior post (here), the SEC has in the recent past brought disclosure-related enforcement actions against reporting companies for alleged failures to observe existing environmental reporting requirements.

Nor are these types of claims limited solely to regulatory enforcement actions; investors have also brought damages actions relating to alleged misrepresentations or omissions regarding environmental issues. For example, as I noted in a recent post here, shareholders of Tronox Corporations recently filed a securities class action lawsuit against the company and certain of its directors and offices, as well as the company’s corporate predecessors in interest, based upon the company’s alleged failure to disclose the true nature of its environmental and tort liabilities.

There may be a temptation to view climate change related considerations as remote and distant future concerns, but as I noted in a recent post here, climate change related issues are already a practical component of current business conduct, for example, in the M&A context.

Just as disclosure obligations regarding traditional environmental concerns have given rise to disclosure-related enforcement actions and even shareholder litigation, the newly clarified expectations regarding climate change disclosures seem likely to create a context out of which similar actions may arise in the future.