The D & O Diary Has Moved!

I am proud to announce that as of today, February 13, 2008, The D & O Diary has relocated to a new and improved website, here. The new site not only has an upgraded look and feel, it also has a number of improved features, such as the ability to print individual posts in a printer-friendly format

All e-mail and RSS Feed subscribers should automatically have their subscriptions transferred over. You should continue to receive emails or feeds when I add a new post at the new site. Unfortunately, those of you who have linked to this site on your Favorites or Bookmarks page will need to change the links to the new site, which can be found at this address: http://www.dandodiary.com/.

Any reader having access or subscription issues as result of The D & O Diary’s relocation to the new site should please let me know right away at dandodiary@gmail.com and I will try to fix the problem.

Anyone who would like to receive email notifications of new posts on the new site should use the "Subscribe" dialog box in the right-hand column on the new site’s home page. Just enter your email address in the dialog box, hit enter, and follow the instructions. You must click on the link in the confirmatory email to activate your email subscription.

All of my prior posts will remain available on this site, but I have also ported over all of the prior content from this site to the new site. I will not be adding any new posts to this site. I will have a "Posts of Interest" function in the right hand column of the new site, which will link to popular posts in the their new location on the new site (such as my list of subprime-related lawsuits or my lists of options backdating related lawsuits and case resolutions).

I hope everyone will come and visit The D & O Diary on its new site, here. I welcome your comments and reactions. Thanks to everyone who visited The D & O Diary here at its original home. Hope to see you all on the other site.

Cheers.

About Those Subprime D & O Loss Estimates

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Over the past several weeks, several industry observers and analysts have tried to put a number on the insurance industry’s aggregate subprime-related loss exposure. At one end, Bear Stearns on January 24, 2008 estimated the industry’s exposure at $8-9 billion (refer here). By contrast, on February 8, 2008, Lehman Brothers estimated (here) that the insurance industry’s losses might range up to $3 billion, and on February 6, 2008, Advisen announced (here) that it will be releasing a report estimating that the industry’s ultimate losses at $3.6 billion.

I don’t envy these experts whose job it is to try to quantify something as big, amorphous and evolving as the subprime-related litigation wave. Nor do I profess to have any particular insight into whose estimate is more accurate or what the ultimate number will be. I do have some observations about some considerations that are or should be being taken into account in making these kinds of estimates, in light of the circumstances surrounding the evolving subprime meltdown. (I should add that in making these observations, I have not had the benefit of reading the entire Advisen report, which as of this writing is not yet available; I have only had an opportunity to review the press release summary.)

In general, I think the various estimates have correctly noted that a potentially large portion of the amounts to be paid in settlements or judgments in the subprime litigation may not represent insured loss. In particular, the observers have correctly noted that many of the largest commercial and investment banks that are involved in the subprime-related litigation carry very large self-insured retentions and also often carry only Side A insurance programs (covering only nonindemnifiable loss, unlikely to occur here for these entities) or in some cases no insurance at all for certain exposures. These various observers have made a number of other valid observations concerning other factors that could restrict the impact of subprime losses for D & O insurers.

But at the same time, it seems to me that there are a number of other considerations that these observers have undervalued or even overlooked in assessing the possible impact of the subprime meltdown on insurers.

First and foremost, I think it is important to stress that we are only at the very earliest stages of the emergence of the subprime-related litigation. To be sure, there are (as documented here) already 43 subprime-related class action lawsuits, as well as nine subprime-related ERISA lawsuits, but before all is said and done, there are going to be many, many more of these and other kinds of lawsuits. We have not even completed the first round of subprime loss truth-telling (refer here), and it is probable that there will be even further deterioration in the mortgages underlying the subprime-backed assets as homeowners find it easier to walk away that to continue to pay down debt on a house that is declining in value (about which refer here).

As Couglin Stoia attorney Sam Rudman observed at last week’s PLUS D & O Symposium, there are likely to be more securities class action lawsuits in 2008 than any year since the passage of the PSLRA (Rudman is himself already involved as plaintiffs’ counsel on many of the subprime-related lawsuits).The subprime-related litigation wave is likely to continue to emerge well into 2009 and possibly beyond (just as the options backdating litigation wave continues to emerge). The possible extent of this future litigation threat may be discerned from the recent litigation commenced against the Cadawalader firm (about which refer here), in which the allegations relate to commercial mortgage securitization documents the firm prepared in 1997. In other words, any dollar estimate of the possible subprime-related insurance losses should be accompanied by a healthy appreciation of how little of the ultimate amount of subprime-related litigation we can currently even see. Since we still don't know how big of an event this ultimately will be, and because it is likely to be years before we have clear idea, any attempt at quantification should carry some very substantial caveats.

Second, many of these estimates seem to presume that the insurance industry’s subprime-related losses will be limited to the financial institutions sector. I do not think this is a conservative assumption. To the contrary, I think it should be assumed that the subprime-related litigation wave will both spread beyond subprime and beyond the financial sector (as I discuss at greater length here). The recent securities class action lawsuits against student loan company SLM Corporation (about which refer here) and Levitt Homes (about which refer here) underscore that the claims have already spread. Bristol Myers Squibb’s recent $275 million write-down for subprime-related investment losses (refer here) further highlights that the credit crisis is no longer just about the financial sector. The possibility of further credit-related losses in many sectors outside the financial sector, and for ensuing claims, at this point seems likely -- or at least that would appear to be the conservative assumption.

Third, much of the analysis of the insurance industry’s exposure has been concentrated largely (although, it must be recognized, not exclusively) on potential losses for D & O insurers. To be sure, the growing number of subprime-related securities class action lawsuits represents a very substantial threat to the D & O insurance industry. But the potential for insured losses in coverage lines outside of D & O could also be very substantial. By way of illustration, State Street’s recent $618 million charge for anticipated subprime-related litigation expenses was in connection with lawsuits that do not (as discussed in my recent post, here) appear to implicate D & O coverage, but that could present significant fiduciary liability or even investment management E & O losses.

By the same token, the recently revised complaint in the subprime-related securities litigation involving Countrywide (about which refer here) added accountant liability claims, as well as claims against Countrywide’s offering underwriters. Other professionals undoubtedly will find themselves caught up in subprime related litigation, including, for example, lawyers; hedge fund and pension fund managers; mortgage brokers; appraisers and surveyors; real estate brokers; and insurance agents, among many others. The cumulative losses from claims against other professionals could be very substantial, and at this early stage particularly difficult to prognosticate.

Even with respect to the analysts’ breakdown of the likely D & O losses, the breadth of the current and likely future claims may or may not be being fully taken into account. That is, while it is true that some of the lawsuits against the largest financial institutions may not, because of the way that these entities structure their insurance, involve the prospect for insured losses, most of the current and likely future subprime litigation defendants do not have these types of insurance arrangements. As the claims spread to secondary players and targets in the hinterlands (about which refer here), the claims are hitting defendants that have more traditional insurance structures. Those (far more numerous) claims may involved a greater percentage of insured losses than (the relatively few claims, as a percentage matter) against the largest banks and financial institutions.

Fourth, I am well aware that one of the issues with which these analysts have had to grapple is the need to try and put the subprime meltdown into context. The challenge is not just to say how it compares, for example, to the S & L crisis or the bursting of the dotcom bubble, but also to come up with a figure for those prior events in order to compare the current subprime crisis. I don’t have data for those prior events, but I do know that the still unfolding options backdating scandal may present a useful comparison. As I have detailed in another post today, the options backdating losses, on the few cases that have been resolved so far, already represent in aggregate some very impressive numbers. There are many more options backdating cases yet to be resolved. The total options backdating related losses are likely to by very substantial. Given that just about everyone assumes that the subprime related crisis represents an even greater threat to insurers than the options backdating scandal, the implication is that the subprime related losses could be very significant indeed.

Fifth, whatever else might be said, nothing meaningful about the extent of the subprime threat can be derived from the D & O insurers’ current marketplace behavior. My comment here relates specifically to the comment in the Lehman Brothers report linked above that "if insurers were concerned about suffering multi-billion dollar subprime D & O losses that could spread outside financial institutions sector, the market would tighten significantly." If the D & O industry had a long track record of skillfully adjusting its prices to changing exposures, this remark might have greater validity. Unfortunately, the industry’s consistent history suggests that the industry is only capable of disciplining itself when losses become so painful that it is forced to change its ways. The current D & O pricing environment is a reflection only of the amount of available capacity, not of any calibration to emerging exposures. The marketplace will remain competitive until cumulating losses force the changes of necessity, and then any changes would be abrupt and disruptive -- as they have always been in the past.

Sixth, as most of the analysts have noted, the defense expense associated with the subprime cases in and of itself could be staggering. As an example of how expensive these cases can be, Apollo Group recently reported (here) that it had spent $25 million dollars taking the securities lawsuit pending against the company through trial. Because of the legal and factual complexity surrounding the subprime cases, they could be extremely costly to defend. Much of the associated defense expense, other than for the large investment bank defendants, is likely to be covered loss. For each of the securities cases, the defense expenses are likely to be many millions of dollars, and, for the cases in the aggregate (including those already filed and those yet to be filed), to be many hundreds (and possibly thousands) of millions of dollars. To these costs must be added the costs of defending the claims raised against other professionals.

Finally, it would be unfortunate if the subprime hype were to obscure the fact that the subprime-related litigation is only one of several very important current developments affecting D & O insurers’ exposure. As I have noted elsewhere (refer here) securities litigation levels would be elevated compared to the prior two years’ activity levels even without the subprime-related litigation. The Securities Litigation Watch blog recently noted (here) that January 2008 securities activity remained at elevated levels, only in part because of the subprime related litigation. None of this could be discerned from D & O insurers’ current conduct. It has been ever thus.

Blog Warning: This week I hope to be making some long needed adjustments to The D & O Diary. While these changes are taking place, I will not be adding any new blog posts (although the current posts will remain available). These adjustments should result in several improvments to The D & O Diary. I will report further on the adjustments once they have been completed.

Don’t Forget About Options Backdating

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Amidst all the subprime hoopla, it would be easy to forget that only a year ago, options backdating was the hot topic. Options backdating might now seem passé, but several considerations suggest that options backdating remains important and that we still have a long way to go before we can be sure we have seen all of the options backdating scandal fallout.

Accumulating Lawsuits: The first important consideration about options backdating in early 2008 is that the options backdating related lawsuits are still coming in. As I previously noted (here), last month shareholders filed an options-backdating related securities class action lawsuit against Teletech Holdings.

In addition, on February 6, 2008, plaintiffs’ lawyers announced (here) that they had initiated a securities class action lawsuit in the United States District Court for the Northern District of California against Maxim Integrated Products and certain of its directors and officers. The lawsuit relates to Maxim’s January 17, 2008 announcement (here) that, as a result of its Board’s special committee’s investigation of the company’s stock option practices, the company would be restating its financial statements to record non-cash, pre-tax charges of between $550 and $650 million for additional stock-based compensation expense. The company also announced that investors should not rely on the company’s financial statements for the fiscal years 1997 through 2005 and corresponding interim reporting periods through March 25, 2006.

The timing of Maxim’s recent announcement is relevant here. The company had first announced its anticipated restatement nearly a year prior, in January 2007 (here), and the company’s January 2008 announcement indicated that the company’s review was not only not yet complete, but would have to be expanded backwards to include its 1995 and 1996 fiscal years. Maxim is surely not the only company that continues to struggle with the accounting clean-up from options backdating-related issues. There may well be additional options backdating related lawsuits filed in the months ahead.

But in any event, with the addition of the Maxim Integrated Products lawsuit to my running tally of options backdating related lawsuits (which can be found here), the current total number of options backdating related class action lawsuits now stands at 36. These 36 class action lawsuits are in addition to the 166 options backdating related derivative lawsuits that have also been filed.

Accumulating Settlements: The second important consideration about options backdating in early 2008 is that the settlements of the options backdating related cases are accumulating in a material way. Indeed, on February 8, 2008, HCC Insurance Holdings announced (here) that it had settled the options backdating-related securities class action lawsuit that had been filed against the company and certain of its directors and officers, for a payment of $10 million dollars (to be funded entirely by insurance). The company had previously announced on January 9, 2008 (here) that it had settled the options backdating related derivative lawsuit in which the company was involved, in exchange for an agreement to adopt certain governance reforms and the payment of $3 million of the plaintiffs’ attorneys’ fees.

As reflected in my table of options backdating-related lawsuits dismissals, denials and settlements (which can be accessed here), the HCC settlement represents the seventh of the options backdating-related securities class action lawsuits to settle. The aggregate amount of these seven settlements is $244.55 million. Three other options backdating-related securities class action lawsuits have also been dismissed, meaning that at this point, ten of the 36 options backdating related securities lawsuits have either settled or dismissed, with another 26 yet to be resolved.

As also reflected on my list of options backdating related case dispositions, there have also been a number of options backdating related derivative settlements. The value of some of these settlements has not publicly disclosed, but the value of the disclosed settlements – not counting the $900 million UnitedHealth Group derivative settlement – is over $61 million.
The sum of the value of these two categories of options backdating-related lawsuit settlements is over $300 million – and if the UnitedHealth Group settlement is included, the total value so far is over $1.3 billion. (It should be kept in mind that these figures do not reflect the derivative settlements that were not publicly disclosed). Of course, these figures do not include the costs the companies incurred to defend these cases, as well as to defend themselves and their senior officials against SEC investigations and other regulatory and criminal matters. And, perhaps most significantly here, there are many more of these cases yet to be resolved than have so far been settled or dismissed.

The Securities Litigation Watch blog has a more detailed analysis of the options backdating securities class action settlements here.

I have gone through this exercise to point out that when all is said and done, the options backdating scandal is going to have proven to have had a very significant event. While not all of the settlement and amounts and defense expenses represent covered loss (for example, the UnitedHealth Group would appear to be excluded from coverage under the typical D & O insurance policy), much of these amounts will be paid by D & O insurers.

As is clear from the fact that options backdating related lawsuits continue to emerge, and the fact that the vast majority of the options backdating-related cases are yet to be resolved, D & O insurers are going to continue to incur these losses for some time to come. And while it can certainly be hoped that the insurers’ reserving practices fully anticipate future developments in these cases (and the cases yet to emerge), the possibility that options backdating might be a bigger deal than everyone has been assuming right now cannot be overlooked.

This analysis of the options backdating-related cases provides some significant context for the current rapidly unfolding subprime-related litigation wave. By any measure, the subprime wave represents a bigger threat than the options backdating related cases. There are going to be many more subprime-related securities class action lawsuits (right now, there are 43 subprime-related securities lawsuits vs. the 36 options backdating related securities lawsuits, and the subprime related lawsuits are going to be rolling in for the rest of this year and probably into the next); the subprime cases involve much more significant shareholder losses; the subprime cases will be very expensive to defend; and, due to their complexity, the subprime cases will take a long time to resolve.

Bottom line: the options backdating scandal and the subprime meltdown together represent adverse circumstances for D & O insurers – something you would never be able to discern from the current marketplace conditions.

Special thanks to Adam Savett of the Securities Litigation Watch for the link to the HCC settlement and for suggesting to me the aggregation of the options backdating related class action settlements.

Subprime Litigation Risk: Outside the Financial Sector?

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As I have previously noted (here), securities backed by subprime and other residential mortgages are not just held by financial companies. A wide variety of companies invested in these securities in order to try to improve their return on cash and short-term investments. As the credit markets have deteriorated, many of these investments have declined in value, and the companies holding these investments have been forced to take write-downs or charges. The most dramatic write-downs have come from companies in the financial sector. But now companies outside the financial sector are announcing downward accounting adjustments, and some of these accounting adjustments are occurring in some unexpected places.

The most significant of these downward accounting adjustments outside the financial sector so far was announced in connection with the January 31, 2007 fourth quarter and year end earnings release (here) of Bristol-Myers Squibb. The company reported an overall net fourth quarter loss of $89 million. The loss included "an impairment charge of $275 million on the company’s investments in auction rate securities." The company reported that it has a total of $811 million invested in auction rate securities (ARS), the underlying collateral for some of which "consists of sub-prime mortgages."

The company reported that as a result of "multiple failed auctions" and downgrades, the year-end estimated market value of the ARS investments was $419 million. Although the ARS continue to pay interest, as a result of valuation models and "an analysis of other-than-temporary impairment charges," the company recorded an impairment charge of $275 million, and an unrealized pre-tax loss of $142 million. The company noted that if the credit market deteriorates further, "the company may incur additional impairments."

Bristol-Myers Squibb is not the only company outside of the financial sector to report a write-down or to take a charge based on deterioration of mortgage-backed assets. In its December 13, 2007 fiscal fourth quarter earnings release (here), Ciena reported a $13 million loss related to commercial paper issued by two structured investment vehicles (SIV) "that entered receivership and failed to make payment at maturity." And in its January 7, 2008 fiscal second quarter earnings release (here), Lawson Software reported that its revenue gains were offset by a non-operating permanent impairment charge of $4.2 million…to reduce the fair value of the auction-rate securities held by the company.

While these downward accounting adjustments are noteworthy, they do have to be put in perspective. Bristol-Myers Squibb’s $275 impairment charge should be looked at in conjunction with the company’s $2.2 billion in cash, cash equivalents and short-term securities, that it carries on its balance sheet in addition to the principal the company invested in ABS. Ciena’s $13 million loss needs to be put in the context of the company’s $1.7 billion total cash position. These companies’ adverse financial developments, while negative, certainly do not threaten these companies’ financial health.

The significance of these financial adjustments is that they happened at all; their occurrence strongly suggests that other companies outside the financial sector may also find themselves taking charges or write-downs. Some of these accounting adjustments may not be as relatively insignificant as they were for the companies mentioned above, and it is possible that some of the downward adjustments could involve a more significant impact on these other companies.

Along those lines, the Tech Trader Daily blog had an interesting recent post entitled "Tech More Exposed to Debt Troubles Than You Think" (here), in which it reported on a Merrill Lynch analysis of 190 technology companies. The analysis sought to determine which of these companies had invested their cash in "mortgage-backed securities, asset-backed securities, auction rate issues and paper issued by government-sponsored enterprises like Fannie Mae." The study found that 22 of the companies studied had "25% or more of their cash in these potentially risky categories."

Among companies specifically mentioned were Foundry Networks (with 68.3% of its $946 million cash "at risk"); Texas Instruments (66.2% of its $3.9 billion cash); Entergis (62.4% of its $126 million cash); Photon Dynamics (53.9% of its $90 million cash); Novellus (52.5% of its $1 billion cash) and Intersil (47.1% of its $578 million).

Whether these or other companies will be making downward accounting adjustments as a result of their holdings in these "risky categories" of investment remains to be seen. But the list clearly suggests at least the possibility that one or more companies could wind up taking charges or write-downs that would have a greater impact than those of Bristol-Myers Squibb or Ciena.

These kinetic possibilities pose an enormous risk for investors and for D & O underwriters. The uncertainty around where these "risky categories" of assets may reside and about whether or not these assets create balance sheet or income statement vulnerabilities makes investment and underwriting assessments enormously complicated. Indeed, the very lack of transparency around these issues could itself become an issue, because it raises the potential for later accusations that aggrieved parties were misled about a company’s true financial condition.

To be sure, there have as yet been no shareholder claims against companies outside the financial (and residential home construction) industries on these types of issues as part of the current subprime litigation wave. But as I demonstrated in my year-end analysis of the 2007 subprime-related securities lawsuits (here), the subprime wave has already expanded to encompass a broad variety of different kinds of defendant companies. At this point, the prudent assumption is that lawsuits arising out of nonfinancial companies’ exposure to mortgage-related investment risk will arise. This potential creates a very significant challenge for D & O underwriters as they attempt to underwrite, segment, and price the subprime risk, which is now clearly not limited just to the financial sector.

UPDATE: The February 1, 2008 Financial Times has an editorial entitled "Writedown Infection Spreads" (here) which is very much in the same vein as this blog post, and specifically discusses the Bristol Myers' subprime related accounting action.

Special thanks to Thomas Smith for alerting me to the Bristol-Myers impairment charge and to a loyal reader who also flagged the Brisol-Myers action and sent along the Tech Trader Daily blog link.

One More Thing to Worry About: Credit Default Swaps: As the recent turbulence involving the bond insurers has demonstrated, another type of complex instrument with which we are all going to have to get familiar is the credit default swap. According to the Seeking Alpha blog (here), the notional value of the CDS market is in excess of $45 trillion, of which the major financial institutions hold about 40% -- the implication being that the other 60% is held by somebody other than the major financial institutions.

The kind of threat this might represent is demonstrated in the January 2007 Second Circuit decision in the Aon Financial Products v. Société Générale case (here). To simplify, AON had provided a credit default swap to another party, and to protect itself, in turn bought a credit default swap from SG. The ultimate debtor defaulted, AON paid its guarantee, but SG refused. The Second Circuit held, in effect, that because of the differences in the way different guarantees were worded, SG did not have to pay even though AON did, so AON lost $10 million rather than making $100,000.

The Seeking Alpha blog post linked above has a very good short summary of the case. The blog post notes that the case provides "a fascinating insight into the risks posed by credit default swaps and demonstrates how even financial institutions and hedge funds that have used such instruments prudently may find themselves facing unexpected damages in the coming months as default rates begin their inexorable upward climb."

Special thanks to a loyal reader for the link to the Seeking Alpha post.

Expanded Subprime Litigation Wave Hits Sallie Mae

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In a prior post (here), I noted that the subprime meltdown story is no longer just about subprime, and that the crisis spreading to other types of credit could stretch the subprime litigation wave to areas outside of subprime. The lawsuit filed today against SLM Corporation (better known as "Sallie Mae") officially brought the subprime litigation wave to the student lending arena.

According to their January 31, 2008 press release (here) the plaintiffs’ lawyers have filed a securities class action lawsuit in the United States District Court for the Southern District of New York against Sallie Mae and certain of its directors and officers. Even though Sallie Mae is in the student lending business, the complaint (here) refers to "subprime" loans, although in this case the reference is to loans made to students at so-called "non-traditional schools."

According to the press release, the complaint alleges that the defendants concealed from the investing public that:

(a) the Company failed to engage in proper due diligence in originating student loans to subprime borrowers, particularly those attending nontraditional institutions; (b)the Company was not adequately reserving for uncollectible loans in its non-traditional portfolio in violation of generally accepted accounting principles, causing its financial results to be materially misstated; (c) the Company had far greater exposure to anticipated losses and defaults related to its non-traditional loan portfolio than it had previously disclosed; and (d) given the deterioration and the increased volatility in the subprime market and reductions in federal subsidies, the Company would be forced to tighten its lending standards on both its federal loans and private education loans which would have a direct material negative impact on its loan originations going forward.

As I have noted in connection with the running tally I have been maintaining (here) of the subprime lawsuits, as the subprime litigation wave has evolved, it has gotten increasingly more difficult to maintain absolute definitional specificity about what constitutes a subprime lawsuit. The fact that this case uses the word "subprime" is clearly not alone sufficient to answer the question whether or not the case belongs on my tally. I have decided that it does belong on the tally, though, because for some time the evolving subprime litigation wave has really been more about the fallout from the larger credit crisis rather than just about subprime lending in and of itself.

So the addition of the Sallie Mae lawsuit brings the current tally of subprime related securities lawsuits (including lawsuits against the credit rating agencies and against residential construction companies) to 42. The Sallie Mae lawsuit is also the fifth subprime related lawsuit filed so far in 2008.

The Sallie Mae lawsuit also represents another important trend that is driving securities litigation, that is, it is also a lawsuit arising out of a failed merger. I noted recently that the new lawsuit against Levitt Corp. fell into this same category of lawsuits the involve both subprime allegations and allegations relating to a failed attempted merger. The earlier lawsuit against Radian Group also falls into this category. My prior discussion of the failed merger securities litigation trend can be found here. My prior discussion of the attempted Sallie Mae merger deal can be found here.

Another State Street Lawsuit: In an earlier post (here), in which I discussed the $618 million reserve for litigation expenses that State Street posted, I detailed and analyzed five lawsuits that had been filed in connection with investments two of its funds had made in subprime related assets. On January 30, 2007, the Houston Police Officers’ Pension Fund filed yet another lawsuit against State Street (here), this one in the United States District Court for the Southern District of Texas. The lawsuit alleges breach of fiduciary duty, breach of contract, fraud, negligent misrepresentation, and violation of the Texas state securities laws.

This lawsuit is the first of the State Street lawsuits to raise a claim for breach of the securities laws. In my prior post, I noted that, among other things, because the other lawsuits named no individual defendants and raised no securities laws violations (the allegation of a securities law violation being a prerequisite to trigger so-called "entity"coverage), the lawsuits would not seem to implicate the typical D & O policy. But the inclusion of the securities claim in the latest lawsuit raises the possibility that the new lawsuit at least implicates the D & O policy. However, the absence of individual defendants and the involvement of a host of claims that typically would not be covered under a D & O policy could set up a potentially complicated allocation problem. (I reiterate that I have no direct knowledge of State Street's insurance program, and I am expressing no definitive coverage opinions, I am merely making observations based on the publicly available information. The actual circumstances may be quite different than I have assumed).

The Subprime ERISA Lawsuits: In my running tally of the subprime lawsuits (which, again, is here) I have been tracking, in addition to the subprime-related securities class action lawsuits, subprime-related lawsuits raised under ERISA, typically brought on behalf of employees in connection with the company stock held in their defined contribution plan accounts. A January 2008 memorandum by the Greenberg Traurig firm entitled "Suprime Mortgage Crisis Impacts ERISA Plan Investment in Employer Stock" (here) provides an overview of the subprime-related ERISA lawsuits, including the legal issues that are likely to be involved.

Are FCPA Violations "The Next Corporate Scandal"?

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In prior posts (most recently here), I have discussed the growing threat that Foreign Corrupt Practices Act (FCPA) enforcement may present for companies doing business overseas. This trend became even more pronounced in 2007, and at least one legal commentator has suggested (here) that the increasing FCPA enforcement trends raise the possibility that FCPA violations "may be this year’s corporate crime of the century."

The one thing that is clear is that FCPA enforcement activity is escalating. As discussed in the January 28, 2008 Fenwick & West memorandum entitled "The Foreign Corrupt Practices Act: The Next Corporate Scandal?" (here), 2007 was "a watershed year for FCPA enforcement." Among other things, the memo notes that that "the number of enforcement actions brought by the DoJ and the SEC doubled compared with the number brought in 2006."

The memo also notes that "public companies disclosed over 50 pending government investigations." In addition, the DoJ and the SEC imposed the largest combined civil and criminal fines in history in 2007, the total fines of $44 million imposed against Baker Hughes and its subsidiaries (as discussed in my prior post, here).

There are a number of important trends driving this increased FCPA enforcement. Obviously the globalization of business activity provides an important context, but globalization alone does not explain the increased enforcement. The enforcement activity is being driven by a number of trends and patterns.

First, the DoJ and the SEC have developed a practice of targeting specific industries, through an industry-wide investigation. For example, a January 25, 2008 Sidley Austin memo entitled "FCPA Enforcement Trends During 2007" (here) notes that the authorities have targeted "sales and marketing practices of companies in the medical device industry in Europe." A January 24, 2008 Jenner & Block memorandum entitled "Recent Enforcement Activity Under the Foreign Corrupt Practices Act" (here) also cites the recent enforcement actions involving the "companies participating in the U.N. Iraq Oil for Food program." The Fenwick & West memo cited above also notes that the FCPA is now "being actively enforced against technology companies."

Second, the authorities have targeted companies doing business in countries where bribery is part of the local business culture. The Jenner & Block memo notes that the authorities have "continued to press enforcement as to companies doing business in Nigeria." Business activities in China have also drawn scrutiny, which is certainly a challenge given that many companies are finding it indispensible to have a China strategy.

Third, the U.S. authorities have shown an increased willingness to cooperate with foreign governments in joint investigations, even, the Jenner & Block memo notes, where the target companies "are already the subject of law enforcement investigation or sanction in their home country." The most prominent example of this latter phenomenon is the current investigation involving Siemens (which I discussed in prior posts, here and here). Another example is the investigation of BAE Systems (which has been surrounded by some significant controversy, as discussed here).

Fourth, increased M & A activity has led to the discovery and disclosure to the authorities of a number of FCPA violations. The Sidley & Austin memo referenced above cites the entry of Delta & Pine into a $300,000 FCPA settlement following its merger with Monsanto (refer here) and York International’s FCPA settlement following its merger with Johnson Controls, whereby York agreed (here) to a $10 million criminal penalty, a $2 million civil penalty, and the disgorgement of $10 million profit.

The Sidley & Austin memo notes that "acquisition due diligence is an essential program, and the failure to adequately assess potential liabilities can result in serious consequences." The Fenwick & West memo notes that "FCPA issues can be a major sticking point in negotiations with the acquiring party, often causing delay of the deal or a change in the price terms."

Fifth, as a result of changing priorities and increased resources, the authorities are no longer dependant on self-reporting alone as the means by which FCPA violations are identified. In recent year, the combination of the increased self-scrutiny SOX requires and corporations’ desire to obtain cooperation credits have led companies to self-report, providing the authorities with the bases for many of the FCPA enforcement investigations. But, as the Jenner & Block memo notes, "the Government is increasingly interested in developing cases affirmatively, without relying on disclosures." Both the DoJ and the SEC have increased their staffing in this area, and the agencies have said repeatedly said publicly that they will be more "proactive."

As I have previously noted, companies’ exposures in this area represent an increasing source of corporate risk. In addition, all three law firm memos cited above also note that the threat of enforcement activity is a growing threat for individuals as well as companies. As described above, these enforcement activities can result in very substantial fines and penalties. But as I have also observed in prior posts (most recently here), these investigations can also trigger follow-on civil lawsuits. Indeed, many of the most prominent recent FCPA investigations, including Siemans, Baker Hughes, and BEA Systems, have all also involved follow-on shareholders’ derivative lawsuits.

While the FCPA’s fines and penalties would not be covered under the typical D & O policy, the defense costs and indemnity amounts incurred in connection with the follow-on civil litigation would trigger coverage under the typical D & O policy. Given the increased enforcement activity and the authorities’ heightened priority in this area, the exposure arising from the threat of civil litigation following-on from FCPA enforcement activity could represent an increasingly important D & O risk.

More About 2007 Securities Lawsuits, Trends: Adding to the prior 2007 year-end securities litigation reports issued by NERA Economic Consulting (here) and Cornerstone Research (here), The Corporate Library has released its own year-end report entitled "Predicting Securities Litigation." The report is proprietary (refer here), but there is a good short summary of the report’s details in this January 28, 2008 Business Insurance article (here).

The Corporate Library’s report is directionally consistent with the two prior reports. It does, however, add a number of interesting additional observations. For example, the report notes that the increased securities litigation activity in the second-half of 2007 suggests "a rising tide of activity that may not crest until well into the coming year [i.e., 2008] – if then." The report also notes that if the heightened activity continues into 2008, "this rise in frequency alone could render today’s low D & O rates unsustainable, perhaps even resulting in [securities class action] filings against the insurers themselves."

The report also has an interesting observation with respect to the comment (refer here) that the increased litigation activity in 2007 may have been a "one-time event" driven by the nonrecurring phenomenon of the subprime litigation wave. The Corporate Library, by contrast, "believes that the lull in new [securities class actions] that occurred in 2006 was the anomaly," not the increase filing rate in 2007. The report also speculates that "new [securities class actions] filed in 2008 will in fact more likely exceed those filed in 2007, perhaps even reaching the historical mean of 192 cases per year cited by Cornerstone Research."

The Corporate Library report concludes with an analysis of the criteria it believes can be used to predict securities litigation. Among other things, the report notes that "CEO compensation practices that are poorly aligned with shareholder interests remain a powerful indicator of potential securities fraud." The report notes that "good corporate governance and effective boards have never been more important or a better indicator of potential liability."

Many thanks to Ric Marshall at the Corporate Library for sharing a copy of the report with me.

Bear Stearns Conference Call Summary: On January 28, 2008, I participated in a telephone conference call hosted by Bear Stearns entitled "D & O Losses from the Credit Crunch," in which I discussed emerging trends from the subprime litigation wave and the implications for the D & O insurance industry. The MAPO Online blog (here) has a good short sketch of my comments on the call. Special thanks to Mason Power for posting his notes of the call online.

Take Five, Jérôme (Days Off, Not Billions Away): Many interesting details have emerged from the Société Générale rogue trading incident, but I think my favorite item is the speculation that one of the ways Jérôme Kerviel may have evaded detection is by avoiding taking any time off. As discussed in the January 29, 2008 Wall Street Journal article entitled "Too Many Days on the Job" (here), Kerviel’s bosses "ultimately went along with his excuses for staying at work." The article observes that "if he had gone, his frauds probably would have been spotted." The implication? "Obligatory time off" is a "best practice."

We may yet celebrate Monsieur Kerviel if a new workplace ethic emerges in which corporate management is suspicious of workaholism and considers it part of its job to ensure that all employees take extended vacations. The Journal article cites a vacation "rule of thumb" of "at least five workdays in a row, and often 10."

If stamping out rogue trading requires that we all take off at least ten days in a row – for the good of the company, mind you – then who are we to stand in the way? Those workaholics now –possible rogue traders? Who knows…?

French Investors Hit Soc Gen with Subprime-Related Lawsuit

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As further details have emerged, Société Générale’s account of how Jérôme Kerviel triggered billions of dollars in losses has come under scrutiny, as reported on the January 29, 2009 Wall Street Journal (here). But questions are also being raised about trades in SG shares by SG director Robert Day and foundations he controls in the days prior to SG’s recent disclosures, as reported here, and those questions have now apparently taken the form of a lawsuit.

Given the nature of SG’s recent disclosures, it is hardly surprising that investors might file a legal action seeking management accountability. But the first lawsuit filed appears to relate not to the bank’s January 24, 2008 disclosures about Kurviel’s unauthorized trading, but instead to the bank’s announcement the same day of a 2.08 billion euros write-down for losses related to subprime lending in the United States. As the Wall Street Journal stated on January 25, 2008 (here) when reporting on the bank’s announcements of the prior day, "the disclosure of allegedly fraudulent trading overshadowed fourth-quarter write-downs by Société Générale totaling 2.05 billion euros to cover its mortgage exposure."

According to news reports (here and here) French lawyer Frederik-Karel Canoy has filed an insider trading lawsuit on behalf of 130 individual investors and "four to five" companies with stakes in the bank. Frustratingly, the news reports do not specify where the lawsuit has been filed, what the specific basis for the lawsuit is, or who the defendants are.

The news reports are clear that the lawsuit relates to the timing of Robert Day’s January 2008 trades in SG shares. Day is an American billionaire financier (here), who founded the Trust Company of the West, which was sold to SG in 2001. Day is currently Chairman of The TCW Group. According to forms filed on the website of the Autoritié des Marchés Financiers (AMF), the French market regulator, Day or foundations he controls made five sales between January 9 and January 18, 2008.

The first sale (documented here), in Day’s own name, took place on January 9, 2008 at a price of 95.27 euros a share and resulted in proceeds of 85.7 million euros.

The second sale (documented here), on behalf of the Robert Day Foundation, took place on January 10, 2008, as a price of 95.9 euros a share and resulted on proceeds of 8.6 million euros a share.

The third sale (documented here), on behalf of the Kelly Day Foundation, also took place on January 10, 2008, at a price of 95.9 euros a share, and resulted in proceeds of about 959,000 euros.

The fourth trade (documented here), on behalf of Day, took place on January 18, 2008, at a price of 90 euros a share and resulted in proceeds of 40.5 million euros.

The fifth trade (documented here), on behalf of the Robert Day Foundation, took place at a price of 90 euros a share, and resulted in proceeds of 4.5 million euros.

The total proceeds from all of the sales total about 140 million euros, or about $208 million. All of the trades took place at prices of between 90 and 95 euros. The bank’s shares closed at 75.81 euros on January 24, the day of the bank’s announcements. Day still holds about 1.8 million SG shares, worth about 148.2 million euros ($220 million) at today’s closing price.

Of Day’s total trades, 45 million euros ($67 million) took place on January 18, the date that bank management says that it discovered the unauthorized trading. January 18 is also the Friday immediately proceeding the Monday, January 21, on which the bank had originally scheduled to disclose its subprime mortgage write-down, but that announcement apparently was postponed to January 24 after the discovery of the unauthorized trades.

Canoy, the lawyer who filed the lawsuit, reportedly said that he questions the "precision and sincerity" of the bank’s disclosures about its subprime exposures. A January 29, 2008 Bloomberg.com article (here) quotes a spokesperson for ADAM, a French shareholder activist association, as citing a November 2007 letter to investors from SG’s CFO Chief estimating the bank's subprime loss at 230 million euros. The spokesperson is quoted as saying that "shareholders who put their trust in these reassuring statements were clearly led astray.''

The shareholders association apparently has also asked that the AMF to launch an investigation into SG for insider trading, failure to disclose the extent of its subprime losses, and how it accounted for the losses attributed to resolving Kerviel's positions. The AMF confirmed (refer here) that it has opened an investigation.

Finally, Canoy is also quoted as saying that he has filed a separate lawsuit related to Kurviel’s alleged fraud. According to press reports (here), Canoy sued the bank over the way the bank unwound the unauthorized positions and sold securities into the marketplace. Unfortunately, there is even less information in the news reports about this second lawsuit.

The bank for its part denies that the trades were improper. The bank claims (refer here) that Day sold the shares during a limited window when board members are authorized to sell stock. The bank spokesperson says that "no inside information was used in any way." The spokesperson denied that Day was advised of Kurviel’s trading losses and said that Board members were not told of the subprime write-down until January 20th. According to the Financial Times (here), the bank also says that the January 20th meeting was set on January 18, but that the "meeting was called in the evening of January 18, after Mr Day had executed his share sales and 'without any indication on the agenda'. "

None of the press coverage explains why the bank would have a trading window that would remain open on the Friday immediately preceding the Monday on which the company planned to make its year-end earnings release. Obviously, the danger with allowing trading that close to an earnings release is the possibility that it might create the appearance that the insider traded with knowledge of undisclosed information in the earnings release or perhaps even because of information in the earnings release.

Call it a hunch, but there just might be some additional future litigation involving one or more aspects of these various circumstances.

Subprime Tsunami Time

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Since I first began chronicling the subprime litigation wave in April 2007 (here), the wave has gained amplitude and speed. But a spate of recent subprime-related litigation developments, seemingly unrelated, suggest that the litigation wave's magnitude has crossed a significant threshold. Things seemingly have changed, decidedly for the worse.

The first development that makes me think things have worsened is the lawsuit that has been filed against Levitt Corp., which is described in the plaintiffs’ counsel’s January 25, 2008 press release (here). Although there are several noteworthy things about this lawsuit (as discussed further below), the significance to me of this lawsuit for the larger issue of the subprime litigation generally is the lawsuit’s purported class period, which extends from January 31, 2007 to August 14, 2007. That is, the allegations in the complaint related to events that took place several months ago.

Most of the prior subprime-related lawsuits up until now have been filed in the immediate flash of dramatic subprime-related disclosures, on some occasions even on the same day. The arrival of a lawsuit based on more remote events suggests that plaintiffs’ lawyers have now begun a grim process of backing and filling, completing a more comprehensive sweep of the subprime landscape.

The impression that we have entered a backing and filling phase that will entail an expansion in the scope of subprime litigation is reinforced by recent developments in the subprime-related securities lawsuit pending against Countrywide Financial Corporation. According to a January 25, 2008 press release (here), issued by New York Comptroller Thomas DiNapoli, who is one of the co-lead plaintiffs in the Countrywide securities lawsuit, the plaintiffs in that case have filed an amended complaint that, among other things, adds as defendants "26 different financial services companies that underwrote Countrywide stock and bond offerings, [and] two global accounting firms."

The 26 financial services companies are listed in the press release. The two accounting firms named are Grant Thornton LLP and KPMG LLP. According to the press release, by expanding the suit, the plaintiffs "seek to ensure that the underwriters and accounting firms who participated in the marketing of Countrywide securities to the public are held accountable for their actions." A copy of the Countrwide complaint can be found here. Special thanks to Adam Savett of the Securities Litigation Watch blog for supplying a copy of the complaint.

A third development suggesting that the stretch and sweep of the subprime litigation wave has amplified is the subprime-related securities lawsuit I previously noted (here) and that was filed last week against National City Corporation, a regional bank holding company based in Cleveland. Unlike many other subprime-related lawsuits, which have largely (although not, of course, exclusively) involved financial firms in New York, Florida and California that have experienced gargantuan writedowns or losses, the National City lawsuit involves a company in the hinterlands that experienced substantial but not nearly as massive writedowns and losses.

These disparate events are at one level unrelated. But the pattern I detect is the suggestion that plaintiffs are expanding the field of the companies and defendants they are targeting. Companies like Levitt, that seemingly were bypassed in the earliest stages. Defendants like the financial services companies and accountants in the Countrywide case, whom the plaintiffs’ lawyers just didn’t get to in the initial pleadings. And secondary targets like National City.

All of this suggests to me that the subprime litigation wave has entered a more encompassing and potentially more devastating phase. Up until now, plaintiffs have concentrated on what one plaintiffs’ attorney recently called the "low hanging fruit." But these most recent lawsuits suggest that the threat now extends more broadly. The impression is that the subprime wave will hit not just the biggest obstacles but could inundate a much broader area of the landscape. The destructive force of the wave could prove to be even more catastrophic than seemed likely, even a short time ago.

One final observation about the changing menace of the subprime wave actually relates to a consequence from subprime litigation. That is, this past week saw the first subprime-related downgrade of a mainstream property and casualty insurer (about which refer here), in part because of the carrier’s exposure to mortgage default risk though a former bond insurer affiliate, and in part because, as one rating agency noted, of the insurer’s "subprime exposure through its D&O and E&O liability portfolio on both a primary and reinsurance basis."

The rating agency went on to note that this D & O and E & O exposure "gives rise to concerns that there may be a potential resurgence in claims for these lines as they relate to subprime issues in the future." More ominously, the rating agency noted that "adverse developments" in these insurance lines beyond the rating agency’s expectations "will result in further rating actions." Clearly I am not the only one concerned that things have gotten bad, and could get worse.

As I noted above, there are other interesting things about the Levitt Corp. lawsuit. The first is that the lawsuit combines not just one, but two of the recent securities litigation trends. That is, it is not only a subprime-related securities lawsuit, but it is also a securities lawsuit arising out of a failed merger. I have previously noted, most recently here, there has been a recent surge of lawsuits arising from failed deals.

According to the plaintiffs’ lawyers’ press release (here), the Levitt Corp. lawsuit relates to the failed 2007 merger of the company with BFC Financial Corp. Levitt had announced the planned merger to great fanfare on January 31, 2007 (here), but on August 15, 2007, the company announced (here) that the merger agreement had been terminated (according to the plaintiff’s lawyers’ lawsuit press release, "without giving any explanation.").

The plaintiff’s lawyers’ press release goes on to state that the complaint alleges that

during the Class Period, defendants issued materially false and misleading statements and failed to disclose: (i) that the Company’s Levitt and Sons subsidiary was in much worse financial condition than publicly represented. Levitt and Sons was saddled with excessive amounts of unneeded and overpriced land which would not be feasible to develop for some time. Furthermore, Levitt and Sons was struggling to complete projects it had already begun and in many instances was failing to complete construction of homes that it had already sold as it lacked the financial resources to follow through on its contracts; (ii) that as a result of the foregoing, the Company was materially overstating its financial results because it was failing to timely record an impairment in the value of its homebuilding inventory at Levitt and Sons. Although Defendants acknowledged the difficult housing market, their public statements failed to advise investors of the true financial condition of the Company; (iii) that the company’s loans and advances to Levitt and Sons would not be recovered as the subsidiary lacked the financial resources to pay now and in the foreseeable future; and (iv) that Levitt and Sons was insolvent.

A copy of the Levitt lawsuit complaint can be found here.

The joinder of the additional defendants in the Countrywide securities lawsuit illustrates one of the reasons why commentators have struggled to quantify what the subprime litigation wave ultimately will mean for liability insurers. That is, the subprime litigation wave represents a significant threat to both D & O and E & O insurers, sometimes (as illustrated in the amended Countrywide complaint) in the same case. The subprime litigation exposure encompasses a wide variety of professionals and entities, not just issuing companies and their directors and officers. For that reason, many of the estimates of the insurers’ exposure have blended together the D & O and E & O exposures. But the sheer spread of the potential exposure underscores how difficult it is now to try to estimate the insurers’ ultimate aggregate exposure (or even one insurer’s exposure) – the scope of the exposure (which seemingly is expanding exponentially) makes estimation particularly difficult, which would explain the dramatic variance in the various estimates.

The Countrywide plaintiffs’ attempt to join the third party defendants looks interesting in light of the Supreme Court’s recent decision in the Stoneridge case. The Countrywide plaintiffs apparently will be arguing that their claims against the third parties, unlike the investors’ claims in Stoneridge, are not based on a theory of secondary liability , but rather are based on alleged primary violations of the Securities laws, under the ’33 Act.

In any event, the addition of the Levitt Corp. case brings the total number of subprime-related securities lawsuits to 41, as reflected in my running tally of subprime-related securities lawsuits, which can be found here. The Levitt Corp. lawsuit also brings the number of subprime-related securities lawsuits against residential home building and development companies to six. The lawsuit also brings the number of subprime related securities lawsuits so far in 2008 to four.

And In This Week’s Headlines: At a minimum, a headline should identify an article’s basic subject. A good headline will encourage the reader to actually read the article. A great headline does both of these things and is at the same time clever, funny or interesting. By these standards, the January 25, 2008 issue of the Wall Street Journal scored two great headlines.

The first headline, "The Hoarse Race" (here) led an article about the presidential candidates' campaign-trail struggles with voice fatigue. The second headline, "The Wait of the World’s on Dan Brown" (here), describes the beleaguered publishing industry’s impatient anticipation of DaVinci Code author Dan Brown’s next book.

All I can say is: "Journal’s Headline Designs Not Just Fine, But Divine." Or something even cleverer than that, if only I had the crackerjack cunning of the Journal’s editors.

Now This: Am I the only one who thinks the whole Davos "World Economic Forum" is a colossal bore?

A New Options Backdating Securities Lawsuit?

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It has been such a while since a new options backdating securities lawsuit has appeared that it was with some surprise I noted the new case that has been filed against Teletech Holdings and certain of its directors and officers. According to the plaintiffs’ counsel’s January 25, 2008 press release (here), the lawsuit, filed in the Southern District of New York, relates to the company’s November 8, 2007 press release (here), in which the company announced a "self-initiated review of accounting for equity-based compensation practices and likely restatement of prior period financial statements."

According to the company’s filing on Form 8-K (here), also dated November 8, the company delayed the filing of its quarterly report for the quarter ending September 30, 2007, due to the company’s Audit Committee’s review of the company’s "historical stock option and other equity-based compensation grant practices." The filing also states that based on the review completed to date, "management presently believes that it will be required to incur additional non-cash compensation charges for prior periods and that restatement of interim and annual financial statements for the periods 1999 through 2007 is likely." The filing also states that the company’s interim and annual financial statements for the period 1999 through the second quarter of 2007 "should not be relied upon."

In light of the TeleTech lawsuit’s allegations, I have, somewhat unexpectedly as this late date, amended my tally of options backdating-related lawsuits. The tally can be found here. With the addition of the TeleTech lawsuit, my count of options backdating-related securities lawsuits stands at 35.

Finding Orwell: I read with interest in the January 23, 2008 Wall Street Journal profile (here) of newly-appointed U.S. Attorney General Michael Mukasey that when he was a federal judge, Mukasey would require his new law clerks to read George Orwell’s essay, "Politics and the English Language." Orwell’s essay, which can be found here, is a declamation against the "vagueness and sheer incompetence" that Orwell believed to characterize contemporary prose, particularly political writing.

Orwell wrote that "the great enemy of clear language is insincerity. When there is a gap between one’s real and one’s declared aims, one turns to long words and exhausted idioms, like a cuttlefish spurting ink."

After providing many examples of bad writing, Orwell reduced his principles for clear writing to six rules, which undoubtedly are the reason Mukasey required his law clerks to read the essay. The six rules are:

1. Never use a metaphor, simile, or other figure of speech you are used to seeing in print.

2. Never use a long word where a short one will do.

3. If it is possible to cut a word out, always cut it out.

4. Never use the passive where you can use the active.

5. Never use a foreign phrase, a scientific word, or a jargon word if you can think of an everyday English equivalent.

6. Break any of these rules sooner than say anything barbaric.

Readers whose acquaintance with Orwell is limited to a barely remembered high school encounter with Animal Farm or 1984 and who may question Orwell’s continuing relevance today will want to explore Emma Larkin’s inestimable book Finding George Orwell in Burma (here).

Orwell (then known by his given name, Eric Arthur Blair) as a young man served for several years in the Burma in the Imperial Police Force, from which he resigned to commence his writing career. Not only was much of his inspiration drawn from his Burmese experiences, but, it turns out, his books anticipated the country’s current political condition. As Larkin notes, "Orwell’s description of a horrifying and soulless dystopia paints a chillingly accurate picture of Burma today, a country ruled by one of the world’s most brutal and tenacious dictatorships."

Larkin’s book about Burma and what Orwell experienced there is more than just a travelogue of an oppressed country. It is also a chronicle of the author’s own search for meaning in a lost place. The writing is compelling, occasionally brilliant. For example, she writes of a house she visited:

The interior was dark and cool. The front room was crammed with wooden furniture. An empty teacup sat on the arm of an old planter’s chair and the glass-fronted book cabinets were filled with old newspapers, their corners orange and crackling with age. Two grandfather clocks stood in opposite corners, each telling a different time.

In a few, spare stokes, Larkin not only vividly describes a specific place, she also manages to evoke an entire country where time is out of place and that is haunted by fading memories. It is the kind of writing Mukasey had in mind when he required his clerks to read Orwell’s essay.

Subprime Litigation Wave Hits National City Corporation

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On January 22, 2008, National City Corporation, a Cleveland-based bank holding company, announced (here) a fourth quarter loss of $333 million, including a write-down of $181 million on its mortgage business and a $691 million provision for credit losses. On January 24, 2008, the company was hit with a securities class action lawsuit.

According to their January 24 press release (here), the plaintiffs’ counsel filed a complaint (here) against the company and certain of its directors and officers in the United States District Court for the Northern District of Ohio.

According to the plaintiffs’ counsel’s press release, the complaint alleges that:

In October 2007, National City announced a big decline in earnings due to losses related to its mortgage business but assured the market about the dividend. Then, on January 2, 2008, the Company announced a 49% reduction in its quarterly dividend to $0.21 per share from $0.41 per share. On this news, National City’s stock dropped from $16.46 per share to as low as $15.45 per share, closing at $15.59 per share on January 2, 2008 on volume of over 12.7 million shares.

The true facts, which were known by defendants but concealed from the investing public during the Class Period, were as follows: (a) the subprime mortgages on the Company’s books were a much bigger risk to the Company’s financial position than represented; (b) the Company was failing to adequately reserve for mortgage-related exposure, causing its balance sheet and financial results to be artificially inflated; and (c) defendants had no reasonable basis to make favorable predictions
about the Company’s future dividend payments and future financial performance given the problems in the business.

I have added the National City lawsuit to my running tally of subprime-related securities lawsuits, which can be found here. The addition of the National City lawsuit brings the total number of subprime-related securities lawsuits to 40. It is also the third subprime-related securities lawsuit to have been filed already in 2008 – further proof that the subprime lawsuits in 2007 were something more than a ‘one time event."

Apollo Group Provides Jury Verdict "Clarification"

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As reported in a prior post (here), on January 16, 2008, a civil jury returned a verdict in favor of the plaintiffs in the securities class action lawsuit pending against Apollo Group and its former CEO and CFO. In a January 24, 2008 statement (here), the company provided "clarification of certain matters in regard to the verdict."

1. Damages: "The actual amount of damages payable cannot be determined until notices are published and shareholders present valid claims….Based on the plaintiffs’ estimate, the damages could range between $166.5 million and $277.5 million. The Company…intends to record its best estimate of the potential loss, including future legal and other costs, in the second quarter of fiscal 2008."

2. Liability: "Liability in the case is joint and several, which means that each defendant, including the Company, is liable for the entire amount of the judgment." Apollo Group will be responsible for posting the appeal bond.

3. Insurance: "The Company does not expect to receive material amounts of insurance proceeds from its insurers to satisfy any amounts ultimately payable to the plaintiff class."

4. Defense Costs: Defense costs including legal fees total approximately $25 million. Although the company expects the insurers to make payments for defense costs, "the insurers have not waived their rights to object to coverage."

5. Company Credit: "If the judgment is not stayed or discharged within 60 days, it will constitute an event of default under the credit facility." The company "expects to cause the judgment to be stayed by filing any necessary bond in a timely manner."

While the company obviously intended this statement for other purposes, the statement is also a very powerful testament to why so few securities lawsuits go to trial. There is not just the trial risk of a significant adverse judgment (although this is obviously compelling in an of itself, particularly in light of the magnitude of the Apollo verdict.) There are other considerations, too: an adverse trial outcome creates accounting, reporting and disclosure issues; it potentially undermines the availability of insurance, perhaps even for defense expense; and it creates complications with creditors. All of these reasons are, of course, on top of the burden, distraction and expense a trial entails.

There may be other securities lawsuits that go to trial in the future, but I doubt that many defendants would voluntarily go to trial after reading considering the jury verdict in the Apollo Group case and reading the company’s January 24 "clarification."

$65 Million KLA-Tencor Options Backdating Class Action Settlement

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In its January 24, 2008 quarterly earnings release (here), KLA-Tencor also announced that it had entered into an agreement to settle the options backdating-related securities class action lawsuit that had been pending against the company and certain of its directors and officers for $65 million.

KLA-Tencor was among the companies mentioned in a front-page May 22, 2006 Wall Street Journal article entitled "Five More Companies Show Questionable Options Pattern" (here). The article described how the company’s executives received stock option grants in 2001 on "unusually fortunate days." The article also said that the data the Journal reviewed suggested a "highly improbable pattern of option grants." The company’s shares dropped over ten percent on the news, representing a drop in market capitalization of $935 million.

On May 24, 2006, the company announced (here) that its Board of Directors had formed a special committee to investigate the company’s stock option practices between 1995 and 2001. On June 29, 2006, the company announced (here) that its Board "had reached a preliminary conclusion that the actual measurement dates for financial accounting purposes of certain stock option grants issued in prior years likely differ from the recorded grant dates of such awards."

On October 16, 2006, the company announced (here) that the special committee had completed its investigation, and that as a result of the committee’s conclusions "the company will restate its financial statements to correct the accounting for retroactively priced stock options." The company said that it anticipates that the "additional non-cash charges for stock based compensation expenses will not exceed $400 million." The company also announced that it had terminated "all aspects of its employment relationship" with Kenneth Schroeder, who had been President and COO from 1991 to 1999, and CEO and a director from 1999 to 2005.

On June 25, 2007, the SEC announced (here) that it had filed a civil complaint against the company and Schroeder. Among other things, the SEC charged that Schroeder "repeatedly engaged in backdating after becoming CEO in 1999," including "pricing large awards of options to himself" that "were never disclosed to KLA-Tencor’s shareholders." The SEC alleged that he even made one award in 2005, "after he received advice from company counsel that retroactively selecting grant dates without adequate disclosure was improper." KLA-Tencor agreed to the entry of a permanent injunction, without admitting liability.

The plaintiffs first filed a civil securities class action complaint against the company and certain of its officers and directors (including Schoeder) on June 29, 2006, in the United States District Court for the District of California (about which refer here). The company’s $65 million settlement, which secured the release of all defendants (including Schroeder), represents the second-largest options backdating-related securities class action settlement. The only larger settlement so far is the $117.5 million Mercury Interactive settlement, which perhaps may be explained as an effort by Mercury’s acquirer, HP, to put the case in the past.

The magnitude of the KLA-Tencor settlement may be a reflection of the prominence of the case (in light of the Journal article), the magnitude of the stock drop (many other options backdating cases do not involve a significant stock price drop), and the existence and apparent seriousness of the SEC complaint, as well as the company’s public admissions about the backdating and its termination of Schoeder and others. Significantly, perhaps, the KLA-Tencor announcement of the settlement says nothing about insurance.

In any event, I have added the KLA-Tencor settlement to my table of options backdating settlements, dismissals and denials, which may be accessed here.

Offering Underwriter’s Section 11 Settlement Held Covered "Loss"

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In an earlier post (here), I discussed the March 14 , 2007 ruling (here) in the CNL Resorts case, in which the federal district court held that an issuing company’s settlement of a claim under Section 11 of the Securities Act of 1933 did not constitute covered "loss" under the company’s D & O liability insurance policy. In that prior case, the court did say that Section 11 settlements are not per se uninsurable, and noted that "in a Section 11 case, if an entity makes a payment that constitutes something other than disgorgement of its ill-gotten gains, it has suffered a loss."

An example of the kind of Section 11 settlement that would be insurable emerged in a December 19, 2007 decision in the Mecklenberg, N.C., Superior Court case captioned Bank of American Corporation v. SR International Business Insurance. A copy of the decision can be found here. The case involves an insurance coverage dispute between the Bank and one of the "follow form" excess insurers on its program of Professional Service liability insurance.

The Bank had been sued, along with other offering underwriters, in connection with its provision of underwriting services to WorldCom for two of WorldCom’s bond offerings. The underlying complaint alleged that the offering underwriters had violated Sections 11 and 12 of the ’33 Act for not making a reasonable investigation as to the validity of WorldCom’s registration statement and failing to include material facts. The Bank ultimately settled the claim in the WorldCom litigation for $460.5 million. The Bank sought to have the carriers in its program of Professional Service liability insurance pay or reimburse the settlement amount. According to the court, "the other carriers involved paid all or a substantial portion of the claims asserted by the Bank."

The "follow form" excess carrier in the North Carolina coverage case contested its obligation to fund the settlement under its policy on a number of grounds, including, in particular, on the grounds that the Bank’s settlement of its Section 11 liability did not constitute covered "loss" under the policy. (I do not discuss in this post the other grounds on which the excess carrier contested coverage.) The parties filed cross-motions for summary judgment, which included cross-motions on the question whether the Section 11 settlement was uninsurable as a matter of law.

The excess insurer first argued that "the public policy of North Carolina would not permit insurance coverage claims under Section 11 and Section 12," a position that the court found to be "without merit." After first pointing out that the insurer could cite "neither statutory authority nor judicial decision in North Carolina holding that claims under Section 11 are uninsurable," the court observed that "it is unlikely that the appellate courts would relieve an insurer of liability for claims arising out of coverage that the insurer actively sought to write based on an argument that it was bad public policy for the insurer to write that coverage." (With respect to the latter point, the court added a footnoted observation that the other carriers in the bank’s insurance program had paid the claims asserted by the Bank for Section 11 losses.)

The Court then went on to distinguish the cases on which the excess insurer sought to rely, the CNL Hotels & Resorts case and the prior Level 3 Communications case. In distinguishing these cases, the court noted that the insureds involved in those cases were issuers of securities that had been the recipient of money from the plaintiffs in the underlying action; that the courts in each of those cases had held that "loss" did not include restoration of ill-gotten gain; and that the plaintiffs in the underlying cases involving those insureds were trying to recover the money that the issuer/insured had received as a result of the misrepresentations.

The court said that, by contrast, in the underlying WorldCom litigation, there was "no claim that seeks restitutionary damages," but that rather the "damages sought were for losses resulting from negligent performance of the underwriters’ duties." Accordingly, the court held that, because the damages sought in the underlying case were for negligence rather than the return of ill-gotten gain, "the Bank is entitled as a matter of law to judgment that the amounts the Bank paid to settle the claim against it…are ‘losses’ as defined in its liability insurance policy."

The court’s holding provides some context for the CNL Hotels & Resorts court’s statement that not all Section 11 settlements are per se uninsurable, and it also supports the view that, whatever else may be said, there should be no prohibition for the insurance of Section 11 settlements for persons other than the issuer. The arguable prohibition against the insurance for the recovery of ill-gotten gains may extend to the issuer, but in any event does not apply to Section 11 settlements on behalf of offering underwriters.

The more interesting aspect of the court’s ruling is its observation about the North Carolina’s public policy as relates to Section 11 settlements, and in particular its statements about the unlikelihood that the State’s appellate courts "would relieve an insurer of the liability for claims arising out of coverage the insurer actively sought to write." The court’s analysis in this regard turns on its head the analysis that other courts have followed in examining the question; the other courts have focused on the unfairness of the insured recovering insurance to compensate for its return of ill-gotten gain. By contrast, the North Carolina court focused on the unfairness of relieving the insurer of its obligation to pay, particularly given that the insurer sought to write that class of business.

It is perhaps some indication of what the parties to liability insurance transactions actually expect (as opposed to the lawyers that represent them in subsequent claims) that, in the wake of the CNL Hotels & Resorts case, virtually every D & O insurance carrier has rushed to market with proposed policy language specifying that the carrier will not take the position that the insurance of Section 11 and Section 12 settlements, and even judgments, are against public policy or otherwise not covered under the policy. Everyone on the transaction side of the business, at least, recognizes that there would not be much utility to the insurance if it didn’t cover Section 11 settlements. But while the introduction of the customized Section 11 coverage language may eliminate these disputes going forward, there are still an untold number of claims out there that involve policies that lack the new language. Courts will continue to wrangle with these issues for some time to come.

In light of this possibility for further disputes on this issue, it is worth observing that once again in the Bank of America case we have a situation where a "follow form" excess insurer resisted coverage even though the underlying carriers paid. I do not mean to suggest that the excess carrier in the Bank of America case did anything improper; its lawyers were protecting its interests as they saw appropriate based on existing case law. But as I have previously noted (most recently here), disputes involving "follow form" excess carriers are becoming all too frequent and threaten to become a virtually standard part of the D & O claims process.. As a result of increasing average and median claims severity, excess insurance is becoming an increasingly important part of the D & O claims process, so these issues are likely to become increasingly more critical.

I note in closing that at the upcoming PLUS D & O Symposium (about which refer here), one of the panel topics will be "Excess D & O Insurance: What’s Up With That?" Perhaps this panel will be a start on the industry’s efforts to address the excess insurance issues.

Special thanks to Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm for providing me with a copy of the Bank of America opinon. I hasten to add that the view expressed in this post are exclusively my own, and having nothting to do with Joe.

Subprime Litigation and Politics: A Volatile Mix

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In response to the developing credit crisis, politicians have proposed legislative fixes and, more recently, advocated the need for fiscal stimuli. Some politicians of a more aggressive cast have launched investigations (about which refer here). In this environment, it is hardly surprising that other politicians are also resorting to litigation – and not merely to recoup supposed subprime-related losses, but also to extract political gains from the current turmoil.

The most substantial examples of subprime-related litigation as political theater are from Ohio. Exhibit One is the case filed last week in the Northern District of Ohio (Youngstown Division) against the Federal Home Loan Mortgage Corporation (Freddie Mac) on behalf of the Ohio Public Employees Retirement System (OPERS). A copy of the complaint can be found here. . For its part, OPERS apparently believes that its losses from the fraud alleged in the complaint could be as much as $27.2 million.

It is the lawsuit’s context rather than its relative merits that concern me. The first of the troublesome contextual elements is the January 22, 2008 press release that Ohio Attorney General Marc Dann issued in connection with the lawsuit’s filing (here). The press release not only announces the lawsuit and describes its allegations, but also thanks OPERS "for supporting my effort to hold Freddie Mac accountable for the role the company and its top executives played in bilking investors and fueling the foreclosure crisis that is destroying neighborhoods across the state and the entire nation."

Dann goes on to say that "by authorizing me to bring the suit on their behalf," they are not only protecting pensioners’ and taxpayers’ interests but "sending a loud and clear message to Wall Street that this type of fraud and manipulation will not be tolerated by the people who live on Main Streets that are being devastated by what Freddie Mac has done." As may be seen from this January 23, 2008 Columbus Dispatch article (here), Dann’s epistle achieved the media attention his press release so obviously sought.

An additional contextual element of this lawsuit is the venue where it was filed. Dann did not file the suit in Virginia, where Freddie Mac has its headquarters, or in New York, where its shares trade and where a prior lawsuit against Freddie Mac on similar grounds is already pending, or even Columbus, where OPERS has its headquarters. Rather, Dann filed the lawsuit in Youngstown. The critical thing to know here is that Dann is from Youngstown, and that is where he has his political base.

Now, given the uncertainties of litigation, it is entirely possible that this case will wind up being litigated in Youngstown. And it is entirely possible that this lawsuit could ultimately even gain a substantial recovery on behalf of OPERS’ pensioners and other members of the purported class – indeed, OPERS already has an impressive track record against Freddie Mac, having recovered as lead plaintiff in a prior securities lawsuit against Freddie Mac a $410 million class settlement. And Dann did note in his press release that, in addition to the Youngstown lawsuit, he has also filed a lead plaintiff petition on behalf of OPERS in the previously pending New York securities lawsuit against Freddie Mac. But obviously, announcing a mere lead plaintiff petition wouldn’t make for much of a press release.

Nor is Dann the only Ohio politician using subprime-related litigation to portray themselves as the scourge of Wall Street and the champion of the oppressed masses. For example, in a January 11, 2008 press release (here), Cleveland Mayor Frank Jackson announced that the City of Cleveland was initiating a lawsuit against 21 investment banks and mortgage lenders who "financed and cultivated the subprime market." A copy of the complaint can be found here.

The Cleveland Plain Dealer reports (here) that the firms are accused of "creating a public nuisance by making mortgages available to people who had ‘no realistic means of keeping up their loan payments.’" The loans allegedly have resulted in thousands of foreclosures in Cuyahoga County. Jackson also told the newspaper that "to me this is no different than organized crime or drugs. It has the same effect as drug activity in neighborhoods."

The situation in Cleveland is dire, and the specter of thousands of empty, foreclosed houses haunts the city and silently testifies to its straitened condition. On that score, I am sympathetic to Jackson’s frustrated desire for retribution. But it is hard to know what to say about the lawsuit’s implicit suggestion that lenders should be liable for having had the audacity to lend money to the city’s residents. While subprime lending undoubtedly involved excesses, and even some unscrupulous practices, the city’s current desperate condition cannot possibly be improved without outside investment, and, yes, the availability of home financing, neither of which the Mayor’s lawsuit does anything to encourage.

Ohio has long-standing, complex economic problems. It saddens me that, rather than confront the real issues facing the state and its people, its political leaders would rather indulge in finger-pointing and scapegoating. Whatever the merits of these lawsuits, they will do little to solve or even relieve the deep economic problems that beset the state.

These lawsuits are troublesome not only because of the squandered political leadership they represent, they are also of concern because Ohio’s politicians clearly will not be the only ones tempted to seek political capital from subprime-related litigation. (Indeed, Baltimore’s leaders have also filed their own lawsuit against Wells Fargo, here, alleging reverse redlining) With so many forces already adding momentum to the growing subprime litigation wave, it is truly discouraging development that politicians feel compelled to exacerbate an already appalling situation. The problems from the subprime situation will only get worse if our political leaders are more interested in assigning blame than finding solutions.

Subprime and the Insurance Market: As the subprime meltdown has emerged, one of the recurring questions has been what impact it will have on the professional liability insurance industry. The latest attempt to answer this question appears in the January 2008 issue of Risk & Insurance, in an article entitled "Will the Liability Market Turn?" (here). (Full disclosure: I was interviewed in connection with the article.) Among other things, the article quotes "one estimate" as putting the "professional liability insurance losses connected with the subprime lending mess at $16 billion."

My own thoughts on the impact on the professional liability insurance industry are reflected in a December 17, 2007 interview published in full on the Risk & Insurance website and entitled "Coverage Expert on Subprime Pricing" (here).

A Closer Look at a Busted-Buyout: In prior posts (most recently here), I have examined the lawsuits that busted buyouts have spawned. Among other deals I have examined is KKR’s now canceled deal to acquire Harman International, which I discussed here. A January 23, 2008 Fortune article entitled "An Old Hand in a Strange New World" (here) takes a closer look at the failed deal, and examines the myriad of forces that led to its demise.

Of particular interest is the article’s discussion of the company’s increased capital spending while the deal was pending and that was the source of the "material adverse change" KKR attempted to invoke to try to scuttle the deal. Apparently, the company’s German division, anticipating KKR’s post-deal fiscal austerity, and exhibiting "exuberant behavior," overspent its capital budget by $25 million. The article, anticipating the presumed question, states, "no, there weren’t controls then in place to prevent this."

Though KKR and Harman have resolved their legal disputes, the separate lawsuit brought by Harman’s shareholders against Harman’s management remains pending. In that context, the article is particularly interesting.

Now This: The Professional Liability Underwriting Society has decided to join the blogosphere, with their new blog, The PLUS Blog (here). The site has just come out of beta testing and they are off to a great start. The blog, which will focus on breaking news and features affecting the professional liability insurance industry, should be worth watching.

Tyson Foods "Springloading" Derivative Lawsuit Settles

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A shareholders’ derivative lawsuit that generated the most prominent judicial pronouncements about options "springloading" has been settled. According to the company’s January 18, 2008 press release (here) and its filing on Form 8-K of the same date (here), the parties have settled the consolidated shareholders’ derivative lawsuit that has been been pending since 2005 against Tyson Foods, as nominal defendant, and certain present and former directors and officers of the company.

Under the terms of the settlement agreement (here), Don Tyson (the company’s former CEO) and the Tyson Limited Partnership, the Company’s largest shareholder are jointly and severally liable to pay the company $4.5 million. No other defendant will make any payments. The company also agreed to implement or continue certain governance measures, as detailed in the settlement agreement. The plaintiffs will be seeking a fee award of $3 million from the company, out of the $4.5 million to be paid under the settlement. The Company has said it will contest the fee award, but will not contest any award up to $1 million.

The derivative complaint contained a variety of allegations, only some of them relating to the timing of the company’s stock option grants. Other allegations related to certain consulting contracts, as well as to executive compensation and related-party transactions involving Tyson and his family. But what has drawn notoriety to the case are the complaint’s allegations concerning options "springloading" (that is, the award of options in anticipation of an event expected to trigger an increase in the company’s stock price). The opinions in the case regarding springloading are undoubtedly represent the leading judicial commentary on the practice.

In opinions dated February 6, 2007 (here), and August 15, 2007 (here), Chancellor William B. Chandler III used memorably scathing language in denying the defendants’ motions to dismiss the springloading allegations. Among other things, Chandler said that in the August 15 opinion that the company’s proxy disclosure describing the options grants displayed "an uncanny parsimony with the truth" that "raise an inference that the directors engaged in later dissembling to hide earlier subterfuge."

Chancellor Chandler added that he "may further infer that grants of springloaded options were both inherently unfair to shareholders" and that "the long-term nature of the deceit involved suggests a scheme inherently beyond the bounds of business judgment." He added that the Court "may reasonably infer that a board of directors later concealed the true nature of a stock option," from which it may further infer that the options "were not granted consistent with a fiduciary’s duty of utmost loyalty."

My prior more detailed discussion of Chandler's August 15 opinion can be found here.

The settlement is of course still subject to court approval, a condition that may be a relevant consideration in this case, given the seeming disparity between the flights of the Court’s rhetoric and the scale of the settlement.

In any event, I have added the Tyson Foods settlement to my list of options backdating lawsuit settlements, dismissals and denials, which can be accessed here.

A January 21, 2008 CFO.com article further discussing the Tyson Foods settlement can be found here.

Supreme Court Rejects Enron Appeal: Less than a week after issuing the Stoneridge decision, the Supreme Court has denied (here) the petition for writ of certiorari in the case Enron investors had brought against a number of investment banks. News coverage of the denial can be found here and here.

As noted in the 10b-5 Daily blog (here), the Supreme Court also vacated and remanded to the Ninth Circuit the "scheme liability" case of Avis Budget Group v. California State Teachers Retirement, "for further consideration" in light of the Stoneridge decision.

While the Enron cert petition denial was probably inevitable after the Stoneridge decision, it is also dicey to read too much into the denial. For example, as the Conglomerate blog points out (here), the Enron case was in an odd procedural posture, having come up to the Supreme Court from the Fifth Circuit where it was on an interlocutory appeal after the denial of class certification. The Supreme Court does not have to explain itself when it declines to act. The lower courts will have to live with the Stoneridge decision and work out its meaning in the context of specific cases without further guidance from the Supreme Court, for now.

Professor Larry Ribstein has further thoughts about the meaning (and limitations on the meaning) of the Enron cert petition denial on his Ideoblog, here. The SEC Actions blog, here, finds greater significance to the Supreme Court's actions in the wake of Stoneridge. The WSJ.com Law Blog has more "post-game" analysis on the Enron cert petition denial, here.

More About the Subprime Litigation Wave: Way back in July 2007, when I declared (here) that subprime litigation was "this year’s model" (that is, the hot litigation trend driving lawsuit activity), I noted that "subprime litigation is arising in an ever-increasing variety of additional forms" and that "as the concentric rings from asset valuation issues spread outward, an increasing array of companies will become engulfed in the litigation wave."

Sounding similar themes in a January 22, 2008 article entitled "If Everyone’s Finger-Pointing, Who’s To Blame?"(here), the New York Times observed that

a wave of lawsuits is beginning to wash over the troubled mortgage market and the rest of the financial world. Homeowners are suing mortgage lenders. Mortgage lenders are suing Wall Street banks. Wall Street banks are suing loan specialists And investors are suing everyone.

The article mentions a number of different cases, including in particular a case brought last week by the Maher family against Lehman Brothers Holdings. The lawsuit is described in greater detail in the a January 18, 2008 Bloomberg.com article entitled "Lehman Clients Demand $1.1 Billion on Auction Dispute" (here). The allegations have been brought by two brothers, Brian and Basil Mahan, in an arbitration complaint filed with the Financial Industry Regulatory Authority.

The complaint alleges that the brothers relied on Lehman to invest proceeds from the family’s sale of its ship container company, claiming that the family’s stated investment objectives were to preserve capital and provide liquidity. Lehman allegedly put the money in auction-rate securities, which lost value due to the turmoil in the credit markets. The brothers seek to require Lehman to buy the illiquid securities and pay treble damages of $857 million. The complaint accuses Lehman of negligence, deception, breach of contract, making unsuitable investments, and supervisory failures.

Thanks to the several readers who sent me copies of or links to the New York Times article.

Now This: The turbulence in the financial markets is scary enough in and of itself. Of perhaps even greater concern is what it may signify. George Soros, the Chairman of Soros Fund Management, suggests in a column in the January 23, 2007 Financial Times (here) that we now face "The Worst Market Crisis in 60 Years."

Tellabs 7th Circuit Redux: Why it Matters

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In a decision noteworthy both for the prominence of the case and for the implications of its analysis, the Seventh Circuit, hearing the Makor Issues & Rights Ltd. v. Tellabs Incorporated case on remand from the U.S. Supreme Court, has once again reversed the district court’s dismissal of the case.

The Supreme Court, in its June 21, 2007 opinion in the Tellabs case (about which refer here) had directed the Seventh Circuit to dismiss the complaint "unless a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."

In a January 17, 2008 opinion (here) written by Judge Richard Posner, the Seventh Circuit concluded that "the plaintiffs have succeeded…in pleading scienter" and therefore the court decided to "adhere to our decision to reverse the judgment of the district court in dismissing the suit."

In determining whether or not the plaintiffs’ allegations supported a "strong inference" that the defendants acted with scienter (as required in the heightened pleading requirements in the Private Securities Litigation Reform Act), the Seventh Circuit said that it was "exceedingly unlikely" that the alleged false statements "were the result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference to whether the statements were misleading."

In considering whether or not the plaintiffs’ allegations were sufficient to establish that the corporation itself acted with scienter, the court articulated a broad concept of "collective scienter"; the court said

it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud. Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false.

The court then turned to the question whether the plaintiffs had presented sufficient scienter allegations in connection with defendant Richard Notebaert, Tellabs’ former CEO, about whom the court noted that "almost all of the false statements that we have quoted emanated directly from him." The court asked

Is it conceivable that he was unaware of the problems of his company’s two major products and merely repeating lies fed to him by other executives of the company? It is conceivable, yes, but it is exceedingly unlikely.

Finally, the court noted that the complaint’s reliance on confidential sources "does not invalidate the drawing of a stong inference from the informants’ assertions." While acknowledging that there are circumstances when the accusations of anonymous informants would not be sufficient to meet the pleading requirements, the court distinguished the allegations in this complaint, observing that "the information that the confidential informants are reported to have obtained is set forth in convincing detail, with some of the information, moreover, corroborated by multiple sources."

The Seventh Circuit’s decision is not only a victory for the plaintiffs in that case, it is also a refutation of the position, advanced by some at the time, that the Supreme Court’s Tellabs decision represented a watershed victory for securities litigation defendants. As I wrote at the time about the Supreme Court's Tellabs opinion (here) "neither side has been handed a strategically decisive weapon, and so the battle will rage on, in many ways as before."

The Seventh Circuit’s recent opinion also represents a victory for plaintiffs in two other important respects as well. First, it represents a strong affirmation that plaintiffs can, at least in certain circumstances and with sufficiently detailed support, fulfill the threshold pleading requirements in reliance on anonymous sources and informants.

Second, the Seventh Circuit’s opinion represents an important recognition of the ability of plaintiffs to fulfill the pleading requirements as to corporate defendants by relying on allegations of "corporate" or "collective scienter." (My observations here about the corporate scienter portion of the Seventh Circuit’s opinion draw on comments about the case by one of the leading members of the plaintiffs' bar whom I am sure would prefer anonymity – I emphasize this point just to acknowledge my gratitude for and to disclaim the originality of these observations.)

The court’s holding that "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted or disseminated the fraud," is a vigorous endorsement of the "collective scienter" approach to pleading a corporation’s state of mind. The question of plaintiffs’ ability to satisfy the requirements for pleading scienter with allegations of collective or corporate scienter is precisely the issue that will be argued before the Second Circuit on January 30, 2008, in the Dynex Capital securities lawsuit.

In the district court proceedings in the Dynex Capital case, Judge Harold Baer, Jr. held in a February 10, 2006 opinion (here) that a plaintiff "may, and in this case has, alleged scienter on the part of the corporate defendant without pleading scienter against any particular employees of the corporation." In a June 2, 2006 ruling (here), Judge Baer denied the defendants’ motion for reconsideration but granted the defendant’s petition for leave to take an interlocutory appeal on the collective scienter issue. A wide variety of litigants and interested parties have filed amicus briefs in the case, the consideration of which will undoubtedly be influenced by the Seventh Circuit’s most recent decision in the Tellabs case.

The final note about the Seventh Circuit’s Tellabs decision has to be that while the plaintiffs have had some significant recent setbacks in the U.S. Supreme Court, they have not by any means been put out of businsess, and indeed, even the string of defense-oriented Supreme Court decisions clearly still allows plaintiffs room to maneuver.

After a week that included the Stoneridge decision, the jury verdict in the Apollo Group case and the Seventh Circuit’s opinion on remand in the Tellabs case, it has to be asked --has there ever been a week as eventful as this past week in the annals of securities litigation? It is getting difficult for even the most diligent blogger to keep up…

Rick Bortnick and Emilio Boehringer at the Cozen O'Conner firm has written a good summary of and commentary on the 7th Circuit's opinion in the Tellabs case, here.

Tenth Circuit Says Further Details About Qwest Settlement Required: The appellate proceedings in another prominent case, the Qwest Communications securities lawsuit, were also in the news this past week (refer here and here). The case was before the Tenth Circuit on an appeal brought by Joseph Nacchio and Robert Woodruff, Qwest’s former CEO and CFO. Nacchio and Woodruff were not included on the $400 million class settlement, but they appealed from the district court’s rejection of their objections to the settlement.

Nacchio and Woodruff allegedly were informed that they would be included in the settlement only if they would pay personally into any settlement fund, which they refused to do, as a result of which they were excluded from the settlement. The settlement documents nevertheless contained a number of different features designed to preclude the two individuals’ assertion of any rights to indemnification or contribution. The two individuals objected to the settlement based on these features, but the district court overruled their objections, specifically holding that the settlement was "fair, reasonable and adequate" as to Nacchio and Woodruff.

In a January 16, 2008 opinion (here), the Tenth Circuit found that the two individuals had standing to challenge the settlement, holding that they had suffered "legal prejudice," because the provisions of the settlement agreement "essentially strip, and in any event, palpably interfere with Mr Nacchio and Mr. Woodruff’s preexisting rights and potential legal claims." The Tenth Circuit went on to hold that the district court’s explanation of its reasons for overruling the individual defendants’ objections were "insufficient." The Tenth Circuit said that "we are unwilling to guess at the path the district court followed in resolving serious legal issues….We need something to show how and on what basis the court analyzed Mr. Nacchio and Mr. Woodruff’s objections." The Tenth Circuit remanded the case for the district court to provide further analysis of the individuals' objections to the settlement.

Even though the Tenth Circuit’s ruling is purely procedural, the tenor of its decision strongly suggests the court’s discomfort with the settlement agreement’s elimination of Nacchio’s and Woodruff’s indemnification and contribution rights. Of course, it remains to be seen whether the district court can present an explanation sufficient to pass muster in the Tenth Circuit. The Tenth Circuit’s opinion does underscore the complications that can arise when litigants attempt to compel individuals to contribute toward settlements without recourse to indemnification or insurance.

Securities Litigation Teleconference: On Friday January 25, 2008 at 11 a.m. I will be participating in a conference call sponsored by Risk Metrics entitled "Securities Litigation: What You Need to Know for 2008." The call will be moderated by Adam Savett, the author of the Securities LitigationWatch blog, and the panelists will also include Stuart Grant, Managing Partner of Grant & Eisenhofer, and Lyle Roberts, a partner at Dewey & LeBoeuf and author of The 10b-Daily blog. Registration for the conference call, which is free, can be accessed here.

Now This: We here at The D & O Diary have particular respect for Judge Posner, the author of the recent Tellabs opinion in the Seventh Circuit, not only because he is one of the most highly regarded jurists in the country, but also because he is a blogger. Posner writes widely read The Becker-Posner Blog (here), which he co-authors with Gary Becker, the Nobel prize-winning economist from the University of Chicago. Their presence raises the tone of the entire blogosphere. Judge Posner is also the only Circuit judge of whom I am aware who has a website containing a searchable database devoted exclusively to his opinions.

Judge Posner was also recently the subject of a profile on the WSJ.com Law Blog (here), which included this excerpt from another opinion Judge Posner wrote, containing good advice for all of us involved in any way with the insurance industry:

A note, finally, on advocacy in this court. The lawyers’ oral arguments were excellent. But their briefs, although well written and professionally competent, were difficult for us judges to understand because of the density of the reinsurance jargon in them. There is nothing wrong with a specialized vocabulary—for use by specialists. Federal district and circuit judges, however, with the partial exception of the judges of the court of appeals for the Federal Circuit (which is semi-specialized), are generalists. We hear very few cases involving reinsurance, and cannot possibly achieve expertise in reinsurance practices except by the happenstance of having practiced in that area before becoming a judge, as none of us has. Lawyers should understand the judges’ limited knowledge of specialized fields and choose their vocabulary accordingly. Every esoteric term used by the reinsurance industry has a counterpart in ordinary English, as we hope this opinion has demonstrated. The able lawyers who briefed and argued this case could have saved us some work and presented their positions more effectively had they done the translations from reinsurancese into everyday English themselves.

Subprime Litigation Wave Hits Ambac Financial Group

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On January 16, 2008, plaintiffs’ lawyers filed a securities lawsuit in the Southern District of New York against Ambac Financial Group and certain of its directors and officers, raising allegations in connection with the company’s disclosures concerning its provision of insurance for collateralized debt obligations. A copy of the plaintiff’s counsel’s January 16 press release can be found here. A copy of the complaint can be found here.

According to the press release, the complaint alleges that

during the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results related to its insurance coverage on collateralized debt obligations ("CDO") contracts. According to the complaint, the true facts, which were known by the defendants but concealed from the investing public during the Class Period, were as follows: (i) that the company lacked requisite internal controls to ensure that the Company’s underwriting standards and its internal rating system for its CDO contracts were adequate, and, as a result, the Company’s projections and reported results issued during the Class Period were based upon defective assumptions and/or manipulated facts; (ii) that the Company’s financial statements were materially misstated due to its failure to properly account for its mark-to-market losses; (iii) that, given the deterioration and the increased volatility in the mortgage market, the Company would be forced to tighten its underwriting standards related to its asset-backed securities, which would have a direct material negative impact on its premium production going forward; (iv) that the Company had far greater exposure to anticipated losses and defaults related to its CDO contracts containing subprime loans, including even highly rated CDOs, than it had previously disclosed; (v) that the Company had far greater exposure to a potential ratings downgrade from one of the credit ratings agencies than it had previously disclosed; and (vi) that defendants’ Class Period statements about the Company’s selective underwriting practices during the 2005 through 2007 timeframe related to its CDOs backed by subprime assets were patently false; as the Company’s underwriting standards were at best aggressive and at a minimum were completely inadequate. As the truth began to be disclosed, shares of Ambac common stock plummeted, causing substantial losses to investors.

Ambac now joins MBIA as a triple-A rated bond insurer whose disclosures in connection with its provision of insurance for mortgage-backed securities has resulted in a securities lawsuit. As discussed in my recent post (here) concerning the MBIA lawsuit, there have also been three other bond insurers sued in subprime-related securities lawsuits.

I have added the Ambac lawsuit to my running tally of subprime-related securities lawsuits, which can be found here. The addition of the Ambac lawsuit brings the total number of subprime-related securities lawsuits (including lawsuits against credit rating agencies and against residential construction companies) to 39. The Ambac lawsuit is the second subprime-related securities lawsuit filed in 2008.

Jury Awards Plaintiff $277.5 Million in Apollo Group Securities Trial

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On January 16, 2008, a civil jury in the Apollo Group securities lawsuit in the United States District Court for the District of Arizona entered a verdict in favor of the plaintiff class on all counts, awarding damages of $5.55 per share, an amount that according to Bloomberg (here) could reach as much as $277.5 million. The Bloomberg report also states that Apollo is responsible for 60 percent of the plaintiffs’ losses, former Apollo CEO Tony Nelson is responsible for 30 percent, and former CFO Kenda Gonzales is responsible for 10 percent. The company’s statement about the verdict can be found here. The plaintiff’s counsel’s statement about the verdict can be found here.

Background

Apollo Group is the parent of the University of Phoenix (UOP), the largest for-profit provider of higher education in the United States. According to the plaintiff’s amended complaint (here), in 2003, two former UOP employees filed a False Claims Act action against UOP alleging that UOP received U.S. Department of Education funding in violation of laws specifying the way company educational recruiters may be compensated. Background regarding the False Claims Act case can be found here.

The Department of Education initiated an investigation of the issues raised in the False Claims Act action, and on February 5, 2004, a Department of Education employee issued a “Program Review Report” that accused UOP of violating the Department of Education rules with respect to education employees’ compensation. The plaintiff in the securities case alleges that the violations in the report could have resulted in the limitation or termination of Department of Education funding to UOP.

On September 7, 2004, Apollo agreed to pay the Department of Education $9.8 million to settle the program review. The settlement agreement (a copy of which can be found here) specified that Apollo’s entry into the agreement did not constitute an admission of wrongdoing or liability. News of the allegations in the Department of Education report first became public on September 14, 2004. The price of Apollo’s stock fell significantly on September 21, 2004, when a securities analyst issued a report expressing concern about the company’s possible exposure to future regulatory issues.

The Lawsuit

The lead plaintiff in the case is the Policemen’s Annuity and Benefit Fund of Chicago, on behalf of a class of persons who purchased Apollo stock between February 27, 2004 and September 14, 2004. The case was pending before Judge James A. Teilborg.

In a September 11. 2007 order (here), Judge Teilborg denied the parties cross-motions for summary judgment. The defendants had sought summary judgment arguing that they had no duty to disclose an interim regulatory report (which they believed to be both unauthorized and false). The court found that while the defendants “may not have an affirmative duty to disclose the interim regulatory findings they do have ‘a duty to disclose material facts that are necessary to make disclosed statements…not misleading.’” Judge Teilborg found that there was a jury issue as to whether any of the defendants’ statements between the February delivery of the report and the September disclosure were misleading. Judge Teilborg also found that there were jury issues on the question whether the interim report was material and whether the defendants’ acted with scienter in withholding information about the report.

In a particularly interesting holding, Judge Teilborg also found that there was a jury issue on the question of loss causation. The defendants argued that that there was no jury issue because the company’s stock price did not react to the September 14 disclosure of the settlement. But the plaintiffs argued that the corrective disclosure was actually a cumulative process that included the analyst’s September 21 report. Judge Teilborg said he could not conclude as a matter of law that the analyst report was not part of the corrective disclosure. The judge said it was a jury question whether or not the corrective information was fully absorbed into the marketplace before the analyst’s report issued. (This mattered because there was no significant stock price drop until the report came out.)

Trial commenced on November 14, 2007. During the trial the plaintiff called both Nelson and Gonzalez to the stand to testify as hostile witnesses for the plaintiff. (Calling adverse parties as hostile witnesses is an unusual move, but it has the advantage of allowing the examining attorney to use leading questions and other techniques of cross-examination, which would otherwise not be allowed on direct examination.) According to news reports (here), Gonzalez testified that the company withheld the report from investors to avoid news coverage about the allegations. The news reports quote Gonzalez as having said that “when we received the program review report, we felt very strongly we did not want it basically tried in the press.” The news reports also state that Nelson testified that the company’s lawyers advised the company against disclosing the report, and that he thought disclosing it would have caused the company’s stock price to drop.

The jury began deliberation on January 10, 2008 and returned a verdict on January 16. The jury found for the plaintiff on all counts. In its statement on the verdict (here), the company said that the case was premised on the company’s “supposed failure to disclose unsubstantiated allegations from a preliminary government report.” The company’s counsel is quoted in the statement as saying that the “law does not require the disclosure of preliminary or unproven damages.” The statement also says that “the ultimate disclosure of the report’s contents caused no statistically significant movement in Apollo’s stock price.”

Discussion

According to the Securities Litigation Watch blog (here), 19 securities lawsuits have gone to trial since 1996. Of these, six cases (including the Apollo Group case) involving post-PSLRA conduct have reached a jury verdict, with three verdicts going in favor of the plaintiffs and three going in favor of the defendants. The Ninth Circuit recently reversed one of the three defense verdicts, as noted further below. Among the six verdicts is also the November 27, 2007 defense verdict in the JDS Uniphase trial (about which refer here).

It is important to keep in mind that this case is not over – indeed, it may have a long way yet to go. The defendants undoubtedly will pursue an appeal to the Ninth Circuit if their post-trial motions are unsuccessful. On appeal, both parties will look with interest (and in the defendants’ case, concern) on the Ninth Circuit’s November 26, 2007 opinion in the Thane International case (here), in which the Ninth Circuit reversed and remanded a trial verdict that had been entered on behalf of the defendants in that case. (Refer here for my prior discussion of the Thane International case). While the ultimate outcome of any appeal in the Apollo Group case remains to be seen, there may well be significant issues on appeal, particularly with respect to the defendants’ obligation to disclose the report; scienter; and loss causation. (Of course, the parties always have the opportunity of entering into a post-trial settlement, as well…)

It is worth asking why all of a sudden securities cases are going to trial. It is not clear why the Apollo Group case did not, like most of these cases, settle. The parties may simply have been unable to reach a mutually acceptable compromise. The Apollo Group case does seem like an odd case for the plaintiff to have pushed to trial since there were no insider trading allegations or other suggestions that the individual defendants personally benefited – although the jury verdict obviously validates the decision (to the extent there was an active decision) to try the case, and the absence of individual benefit clearly did not influence the ultimate outcome.

There is at least potentially an interesting insurance coverage question, which is whether the jury verdict represents an adjudication of fraud sufficient to trigger the fraud exclusion that typically is found in directors and officers liability insurance policies. I have not been able to obtain a copy of the questionnaire the jury used to see what specific factual findings the jury made, but to the extent the jury found knowing misrepresentations, the verdict could preclude coverage, although the possibility of an appeal could also affect this issue. (The possibility of a jury verdict triggering the fraud exclusion is one reason why so few securities cases go to trial.) It should also be noted that the amount of damages could exceed any amounts of insurance that are available. (I want to emphasize in making these insurance observations that I have no knowledge of any kind about the particulars of Apollo Group’s insurance, and so I am merely speculating not expressing any insurance opinions.)

With the Supreme Court decision in the Stoneridge case coming out yesterday and the verdict in the Apollo Group case today, this certainly has been an eventful couple of days in the world of securities litigation.

Special thanks to the several readers who sent me copies of news reports about the verdict.

Supreme Court Rules in Stoneridge Defendants’ Favor

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On January 15, 2008, in a 5-3 majority opinion (here) written by Justice Kennedy (pictured to the left), the U.S. Supreme Court affirmed the Eighth Circuit in the Stonridge Investment Partners, LLC v Scientific Atlanta case. The Court concluded that the implied right of action under Section 10(b) did not reach the respondent companies’ conduct because the investor claimants did not rely on the alleged deceptive conduct. Justice Stevens, joined by Justices Souter and Ginsberg, dissented. Justice Breyer, as previously disclosed, did not take part in the case.

As discussed in a prior post (here), the investors claimed that Scientific Atlanta and Motorola had helped Charter Communications make its revenue targets through an arrangement whereby Charter overpaid its vendors for set-top cable boxes and the vendors agreed to return the overpayment by buying advertising from Charter. The vendors treated the two transactions as a wash sale, but Charter accounted for the transactions so that they favorably (and, the investors alleged, improperly) impacted its revenue and permitted the company to meet its revenue targets. Charter later restated is revenue to reclassify the revenue from the set-top deal.

Charter’s investors separately sued Charter and its accountant in a case that later settled, but the investors also sued the vendors, alleging that the vendors knowingly entered the transaction in order to permit Charter to achieve a desired accounting outcome. The investors alleged that the vendors falsified documents and backdated contracts to facilitate the outcome.

The district court granted the vendors’ motion to dismiss and the Eighth Circuit affirmed, holding that "any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission …is at most guilty of aiding and abetting and cannot be held liable under Section 10(b)."

The U.S. Supreme Court affirmed the Eighth Circuit, holding that the case against the vendors was properly dismissed. But the Supreme Court did not adopt the Eighth Circuit’s reasoning; rather, the Court says, with respect to the Eighth Circuit’s statement that Section 10(b) reaches only misstatements or omissions by one with a duty to disclose, that "if this conclusion were read to suggest that there must be a specific oral or written statement before there could be liability under Section 10(b) or Rule 10b-5, it would be erroneous." The Court would on to note explicitly that "conduct itself can be deceptive."

While the Supreme Court disclaimed the Eighth Circuit’s reasoning, it still affirmed the Eighth Circuit’s holding because the vendors’ "acts or statements were not relied upon by the investors and that as a result liability cannot be imputed."

Thus the Court’s decision turns on the absence of "reliance." The Court did note that there is a "rebuttable presumption of reliance" under two circumstances; first, if "there is a duty to disclose" and second, "under the fraud-on-the-market" doctrine, by which reliance is presumed when the statement at issue becomes public. The Court held with respect to these presumptions of reliance that

Neither presumption applies here. Respondents had no duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of respondents’ deceptive acts during the relevant time. Petitioner, as a result, cannot show reliance upon any of respondents’ actions except in an indirect chain that we find too remote for liability..

The investors sought to overcome these considerations by urging that that respondents engaged in a scheme, contending that the vendors had "engaged in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent" and that Charter’s release of false financial statements "was a natural and expected consequence of" the vendors’ deceptive acts.

The court rejected these "scheme liability" allegations, saying that the vendors’ "deceptive acts, which were not disclosed to the investing public, are too remote to satisfy the requirement of reliance. It was Charter, not respondents, that misled its auditor and filed fraudulent financial statements; nothing respondents did made it necessary or inevitable for Charter to record the transaction as it did."

The majority opinion noted a number of additional considerations that it found militated against the investors’ position; the Court found that:

1. Investors’ position seeks to apply Section 10(b) "beyond the securities markets—the realm of financing business – to purchase and supply contracts – the realm of ordinary business."

2. Recognizing the position urged by the investors "would revive in substance the implied cause of action against all aiders and abettors except those who committed no deceptive act in the process of facilitating the fraud."

3. In enacting the PSLRA, Congress recognized an SEC enforcement cause of action for aiding and abetting, but did not recognize a private right of action for aiding and abetting. The Court said "we give weight to Congress’ amendment to the Act restoring aiding and abetting liability in certain cases but not others."

4. Adopting the position urged by the investors "would expose a new class of defendants to these risks" who might "find it necessary to protect against these threats, raising the cost of doing business."

5. If the Court adopted investors’ position, "overseas firms" would be "deterred from doing business here," and could "raise the costs of being a publicly traded company under our law and shift securities offerings away from domestic capital markets."

6. The implied right of action under Section 10(b) "should not be further expanded beyond its present boundaries." The Court said that its holdings is "consistent with the narrow dimensions we must give to a right of action Congress did not authorize when it first enacted the statute and did not expand it when it revised the law."

7. The SEC’s enforcement power "is not toothless" and "both parties agree that criminal penalties are a strong deterrent." Moreover, there is an "express private right of action against accountants and underwriters under certain circumstances" and the "implied right of action in Section 10(b) continues to cover secondary actors who commit primary violations."

The dissent argues that the Court, having found that the Eighth Circuit’s reasoning was incorrect, should at a minimum have remanded the case for further proceedings on the reliance issue. The dissent also faults the majority’s "fraud on the market" analysis, saying that the doctrine does not require investors to be aware of the specific deceptive act to rely on the doctrine to establish reliance. Justice Stevens also argued that because the vendors’ actions were undertaken with the expectation that Charter would rely on them in making fraudulent statements, the causal connection between their allegedly improper action was sufficient to support a finding of reliance.

The dissent also rejects the majority’s finding regarding Congressional intent, arguing that Congress’ actions (or rather, inactions) cannot be read to bestow immunity on an undefined class of actors from liability under Section 10(b). Finally, the dissent conclude with a lengthy affirmation of the right of court’s to imply remedies, even in the absence of legislative action.

At its most basic level, the outcome of this case is unsurprising. The justices arrayed themselves just as I had speculated in my prior post. That is, the three justices still on the Court who were in the majority in Central Bank (Kennedy, Scalia and Thomas) were joined by the two recent appointees (Roberts and Alito), while the three justices who had been in the dissent in Central Bank (Stevens, Souter and Ginsberg) were also in the dissent on Stoneridge.

The majority’s opinion also, again perhaps unsurprisingly, essentially adopts the position advocated by the Solicitor General on behalf of the U.S. Department of Justice (in his amicus brief, here); that is, as I noted in my prior post, the Solicitor General urged that, while the Eighth Circuit concededly erred in concluding that conduct itself could not satisfy the statute’s deception requirement, the Supreme Court could nevertheless affirm the Eighth Circuit because the investors had not shown reliance – which was of course exactly what the majority held.

One aspect of the majority’s opinion that is striking is that the opinion does suggest an awareness of, and perhaps even the influence of, arguably extrajudicial considerations such as the potential impact the investors’ position might have had on the overall business environment or the relative competitiveness of U.S financial markets. These considerations, while undeniably important, arguably are irrelevant to whether or not these claimants have a remedy under the statute.

While the majority rejected the investors’ "scheme liability" theories, the Court did not hold that "secondary actors" can never be liable. To the contrary, and consistent with Central Bank, the Court held that any person who employs a manipulative device may held as a primary violator, assuming all the requirements of Section 10(b) are met. And in any event , the SEC still has statutory authority to pursue enforcement actions based on "aiding and abetting" allegations.

The Court is certainly correct when it says that were investors’ position recognized, then companies would seek to protect against the threats, which would raise the cost of doing business. Indeed, if companies had to procure insurance to protect against not only the securities liability arising from their own conduct but also with respect to every company with respect to whom they are a customer or vendor, the cost of liability insurance would have soared. (As an aside, the burden of trying to underwrite this exposure would have been enormous as well, not to mention extremely challenging.) These same points could also be made with respect to liability insurance for third-party professionals as well. The position that the investors urged, if successful, would have had a dramatic impact on the cost of liability insurance.

These practical considerations support the view that the Stoneridge case is a defense victory and represents a rejection of an expanded reading of Section 10(b). But the more expansive possibilities may never really have been in the cards, given the lineup of the court. Yes, the decision could have changed things, but in the end, it did not. In effect, Stoneridge represents a 5-3 vote for the status quo. So while a decision for the investors could have increased the cost of insurance, the actual outcome on behalf of the venors is unlikely to impact the cost of insurance.

News coverage of the decision can be found here and here. The Blog of the Legal Times reports a number of different reactions to the decision here.

"CDO Squared" Securities Lawsuit Hits MBIA

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On January 11, 2008, MBIA became the latest bond insurer to be named as a defendant in a subprime-related securities class action lawsuit. Bond insurers ACA Capital Holdings (about which refer here), Security Capital Assurance (refer here) and Radian Group (refer here) have previously been named in subprime-related securities lawsuits. MBIA is one of the leading triple-A rated bond insurers, and the company's difficulties may represent among the more significant developments arising from the subprime meltdown. A copy of the plaintiffs’ lawyers January 11, 2008 press release regarding the MBIA securities lawsuit can be found here, and a copy of the securities lawsuit complaint, which also names MBIA's CEO and CFO as defendants, can be found here.

In addition to the securities lawsuit, MBIA’s benefit plan fiduciaries were also hit with a lawsuit under ERISA, filed on behalf of MBIA employees in connection with company stock held in the employees’ 401(k) plan. The plaintiffs’ counsel’s January 11, 2008 press release about the ERISA lawsuit can be found here. The company also disclosed on January 8, 2008 (here) that the SEC and the New York Insurance Department have started informal inquiries into the company’s recent disclosures and a deal the company struck with Warburg Pincus.

The centerpiece of the securities lawsuit complaint is the company’s December 19, 2007 detailed accounting (here) of its exposures to collateralized debt obligations, a disclosure that contained information the complaint describes as a "bombshell." According to the complaint, in the December 19 release, the company "disclosed for the first time that it faced $8.1 billion of exposure from insuring some of the riskiest securities in the marketplace – collateralized debt obligations (CDOs) comprised of other CDOs (so-called "CDOs squared" securities) whose underlying collateral included residential mortgage backed securities (RMBS)." The complaint alleges that "with this disclosure, investors learned for the first time that Defendants had placed their triple-A rating in jeopardy."

The company’s December 20, 2007 press release (here) attempted to respond to the market criticism and reaction that followed the December 19 disclosure. Nevertheless, the company later came under further pressure when it announced on January 9, 2008 (here) that the company actually held $9 billion of the CDO squared securities, rather than the $8.1 disclosed just weeks before and that, according to the complaint, "nearly 60% of these securities were originated in 2006 or later (which was material because recent vintages are defaulting with greater consistency) and that the portfolio had already caused a $200 million impairment."

The MBIA securities lawsuit is the first subprime-related securities lawsuit of 2008. In light of the magnitude and recency of the events involved in the lawsuit, it seems likely that there will be further developments, both with respect to the company itself and in general. While it is obviously still quite early, the MBIA lawsuit does at least suggest that the 2007 subprime-related securities litigation wave was not, as some have suggested, a one-time event.

I have in any event added the MBIA lawsuit to my running tally of subprime-related securities lawsuits, which may be found here. With the addition of the MBIA lawsuit, the current tally (including subprime-related securities lawsuits pending against the credit rating agencies and against residential home construction companies) stands at 38. With the addition of the MBIA ERISA lawsuit, the number of subprime-related ERISA lawsuits stands at 9.

My prior discussion of bond insurers' exposure to subprime risk, including a detailed discussion of the securities lawsuit that has been filed against ACA Capital Holding, can be found here.

CDOs Squared: I have previously noted (most recently here) that among the contributing factors to the subprime meltdown are the complicated investment instruments into which mortgage loans were repackaged and sold in the global financial marketplace. The MBIA complaint’s allegations about CDOs squared underscore this point rather impressively. MBIA (and other bond insurers) played a particularly critical role in the viability of these instruments, since MBIA's willingness to provide insurance against the instruments' default enabled the instruments to carry MBIA's AAA rating making them acceptable even to conservative investors.

Readers who like me do not feely fully briefed on CDOs squared may want to review this 2005 Nomura Securities publication (here), which explains that a CDO squared security is a type of collateralized debt obligation where the underlying portfolio consists of other types of CDOs.

According to the article,

Synthetic CDOs-squared offer investors higher spreads than single-layer CDOs but also may present additional risks. These two-layer structures somewhat increase exposures to certain risks by creating performance "cliffs." That is, seemingly small changes in the performance of underlying reference credits can cause larger changes in the performance of a CDO-squared.

Of particular interest to bond insurers (and investors in a bond insurer that happens to insure CDOs squared) is that CDOs squared "display particular sensitivity" to "frequency of defaults." Based on a very detailed analysis, the Nomura article concludes that "higher default rates affect a CDO-squared tranche much more dramatically than the underlying CDO tranche." The report goes on to state, among other things that, that "for example, the probability of a [CDO squared] tranche wipeout goes from 0.6% to 41.2% as the [CDO tranche] default rate goes from 1.0% to 1.5%."

Snakes and Ladders: The Nomura article’s discussion of the risks involved with CDOs squared brings to mind Warren Buffett’s frequent diatribes against derivative securities. For example, in his letter to shareholders in the 2002 Berkshire Hathaway Annual Report (here), Buffett referred to derivatives as "time bombs" and as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." (Full disclosure: I own Class B Berkshire shares, although not nearly as many as I wish I did.)

I have struggled over the years to understand the vehemence of Buffett’s condemnation of derivatives, but I gained fresh insight recently when I read Roger Lowenstein’s excellent book When Genius Failed, which recounts the formation, growth and dramatic collapse of Long-Term Capital Management. The events described in the book took place a decade ago, but many of the same events, circumstances, complications, and even many of the same people, were involved then as are involved in the current subprime meltdown.

LTCM’s story is far more complicated than can easily be recounted here, but the most critical facts are that at the beginning of 1998, the firm had equity of $4.72 billion, but as a result of leverage, carried balance sheet assets of around $129 billion. Even more astonishing were the firm’s off-balance sheet derivative positions, which had a notional value of $1.25 trillion. Adverse global financial circumstances in August and September 1998 put LTCM on the wrong side of a huge number of arbitrage bets, and put the firm in a position where it had to liquidate positions, only to find that there were no willing buyers. Lack of liquidity and the firm’s highly leveraged position not only threatened the firm with failure, but, owing to LTCM’s massive indebtedness, threatened a constellation of financial institutions with enormous losses. The Federal Reserve became concerned that the ensuing fallout could cause panic and damage the financial markets.

The scramble to protect the financial markets from an LTCM meltdown involved a veritable who’s who of the financial world, including the redoubtable Mr. Buffett. Reading about Buffett’s role in the LTCM crisis gave me some insight into his loathing of derivative securities.

First, the book makes it clear that in connection with Berkshire’s then-pending acquisition of General Reinsurance Corporation (which ultimately closed in December 1998), Buffett was worried about Gen Re’s involvement in certain LTCM investments on which Gen Re had counterparty exposure or for which Gen Re had provided financing. (Full disclosure: At the time, I was an employee of a Gen Re operating subsidiary.)

In addition, Buffett was also deeply involved in a Goldman Sachs-led proposed buyout of LTCM, that would have given the acquirers control of LTCM’s assets for $250 million, a small fraction of the assets' putative (and as events turned out, ultimate) value. The potential buyout did not come off, in part because of Buffett’s inaccessibility at critical moments while he was vacationing in the Pacific Northwest with Bill Gates.

As a result of these events, Buffett apparently had a window into LTCM’s portfolio and apparently came away with an unfavorable view of derivative securities. Indeed, Buffett specifically references LTCM's near meltdown and disparages some of LTCM’s derivative investments ( particularly "total return swaps") in the 2002 Berkshire shareholders letter linked above.

As an aside, it is worth noting that Buffett is only one of a host of people now prominent in the subprime crisis who played one role or another in the LTCM bailout. For example, John Thain, recently given the assignment of turning around Merrill Lynch, was deeply involved in the LTCM bailout efforts as CFO of Goldman Sachs. Jon Corzine, now the democratic governor of New Jersey, was also involved in many of the discussions. James Cayne, who just this past week resigned as head of Bear Stearns as a result of that company’s subprime woes, played a significant although not particularly constructive role in the LTCM bailout as well.

Although Lowenstein’s book refers to events from ten years ago, it rewards reading now, because it shows how some of the same recurring behaviors drive occasional excesses and trigger periodic crises in the financial markets. Indeed, the recurrence of many of the same circumstances and names today gives the impression that the global financial marketplace represents nothing more than an elaborate game of Snakes and Ladders, where the same money, investments and people slide around in certain prescribed paths and wind up ahead or behind as the game unfolds.

There is also a certain symmetry between the events surrounding LTCM’s near-demise and the current subprime crisis; once again, for example, Buffett is cast in the role of potential rescuer, in particular now with respect to bond insurers (about which refer here). But the more important connection between the two sets of circumstances is the role of complicated derivative securities in contributing to the respective crises. Indeed, given the role that these immensely complicated derivative securities, such as CDOs squared , are playing in the current subprime crisis, Buffett’s comments in the 2002 shareholders letter about the dangers of derivative securities may be required reading for anyone who wants to understand what is going on today.

A Reflection on Winter in the Suburbs: Am I the only one who thinks the very idea of "decorative cabbages" is ridiculous?

Updates and Notes

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More About Foreign Claimants, Foreign Companies: In earlier posts (here and here), I discussed issues arising as a result of foreign litigants suing foreign domiciled companies in securities class action lawsuits in U.S. courts. These issues were involved in a recent opinion in a case pending in the Southern District of New York. In a January 8, 2008 ruling (here), U.S. District Court Judge Denny Chin appointed Luxembourg-based investment company Axxion S.A. Luxembourg as lead plaintiff in the consolidated securities lawsuit pending against GPC Biotech AG, a biotechnology company based in Munich, Germany.

Three sets of plaintiffs had sought to serve as lead plaintiffs. Judge Chin selected Axxion, which through its Akrobat Fund-Value investment fund had spend $3.9 million purchasing 150,000 GPC Biotech shares and which claimed losses of $1.8 million, as having the "largest financial interest in the relief sought." Judge Chin rejected the arguments of the other claimants, who had resisted Axxion’s petition on the grounds that its fund had purchased the shares on the German exchanges. (GPC Biotech’s shares trade both on the Nasdaq and on the Deutsche Bourse.)

In effect, the competing claimants argued that Axxiom’s petition should be rejected because Axxion is an "f-cubed claimant" (a foreign claimant suing a foreign company whose shares the claimant purchased on a foreign exchange.) Judge Chin found (citing the Nortel Networks case) that other courts in the District had previously selected foreign litigants as lead plaintiff to represent both foreign and U.S. investors. He also noted that while the defendants might raise a subject matter jurisdiction defense as to Axxiom, "such a defense would not appear ‘unique’ to Axxiom, as it would appear that many (if not most) of the class members would be foreign investors."

Judge Chin further noted that there is no reason to doubt" the ability of Axxiom to respond to a motion to dismiss raising the subject matter jurisdiction defense. Judge Chin also commented "without prejudicing the issue" that "plaintiffs have alleged individual acts in the United States in furtherance of the alleged fraud." As discussed at length in my prior post (here), the presence of substantial acts in the United States has been held by some other courts to be a sufficient basis to support the exercise of subject matter jurisdiction.

As I noted in my recent analysis of the 2007 securities lawsuits (here), there were 26 securities lawsuits filed in U.S. courts in 2007 against foreign domiciled companies, 21 of them in the Southern District of New York. As a result, the issues surrounding foreign litigants’ claims against foreign domiciled companies is likely to be the subject of a great deal of scrutiny and discussion in the months ahead, particularly in the Southern District. The subject matter jurisdiction issue will also receive a great deal of attention. As I noted in a prior post (here), the jurisdictional issue is also squarely raised in a case now pending before the Second Circuit.

Finally, although Judge Chin did not address the issue in his recent opinion, the presence of a significant number of foreign claimants who purchased their shares on foreign exchanges may raise significant class certification issues. In the Vivendi case (about which refer here), the court excluded certain foreign claimants from the class while including others, and, as discussed here, in the recent Royal Dutch Shell decision (refer here), the court (for reasons based on facts perhaps specific to that case) excluded non-U.S. purchasers from the class and dismissed their claims based on the lack of subject matter jurisdiction. These class certification issues will also be important in the new wave of securities claims filed against foreign domiciled companies.

In any event, it appears that even if foreign jurisdictions have not warmed to U.S. style class action litigation, foreign institutions increasingly are drawn to U.S. courts to attempt to recoup investment losses, even against foreign-domiciled companies. These institutions’ willingness to resort to U.S. courts and to rely about remedies available under U.S. law potentially could drive legal reforms in their own countries, as these foreign seek local alternatives to hold company management responsible. These overseas firms’ willingness to employ U.S. litigation suggests that the U.S. approach to litigation, usually portrayed as a disadvantage to the U.S. in the global financial market competition, may actually have a more complicated impact on U.S competitiveness than some would-be reformers assume.

One final observation about the GPC Biotech case is that it embodies a number of important 2007 litigation trends. First, as noted above, a significant factor in the 2007 uptick in securities lawsuit filings is the increased incidence of lawsuits in the Southern District of New York against foreign-domiciled companies, of which the GPC Biotech lawsuit is one example. Second, GPC Biotech is in the 2834 SIC Code (Pharmaceutical Preparations), which as I noted here was one of the SIC Code categories with the greatest number of 2007 filings.

In many ways, the GPC Biotech lawsuit is emblematic of a number of important trends that emerged in 2007, in particular because the case does not in any way relate to the subprime meltdown. As I have noted before, even though the subprime litigation wave was clearly an important 2007 development in connection with securities litigation, it was only one of several important factors at work during the year.

Tracking Subprime Lawsuits: In discussing (here) the 2007 year-end securities lawsuits analysis of NERA Economic Consulting, I noted that NERA’s count of 2007 subprime-related securities lawsuits filings and my own count (here) diverged. I have now had the opportunity to confer and compare notes with NERA, as a result of which I was able to identify the differences between our tallies. Based on these discussions, I have added three additional subprime-related securities class action lawsuits to my running tally: BankAtlantic Bancorp (here), First Home Builders of Florida (here), and Merrill Lynch/First Republic (here).

As a result of these additions, my current tally of subprime-related securities lawsuits (including lawsuits against the credit rating agencies and subprime-related lawsuits against residential construction companies) now stands at 37.

Very special thank to NERA, and especially to Svetlana Starykh, for the willingness to confer and to share information.

Accounting Discipline: According to a January 9, 2008 CFO.com article (here), the International Helsinki Federation of Human Rights must shut down as a result of its finance manager’s six-year embezzlement of $1.8 million. The finance manager apparently embezzled the funds to "support his mistress."

The Federation’s mission had been "to protect and strengthen civil society groups that monitor and report on human rights issues from a non-partisan perspective." Unfortunately, the Federation’s funds were put to some decidedly different uses. According to the news reports, "the mistress reportedly gambled away up to $7,000 a week at poker and told the finance executive she needed $44,000 to open a hair salon. She also spent some of the money for breast augmentation and a nose job."

The finance manager told the court that he would not have agreed to finance the woman's operations had he known about them ahead of time. (The news reports do not reveal what he thought about them afterwards, though.)

Apparently the finance manager regarded these transfers of cash as a loan transaction; he told the court that the woman had promised him she would pay him back from a large inheritance she expected.

The finance manager, age 43, has been sentenced to three years in jail; the woman, age 31, was sentenced to two years.

All of which is just a reminder of the importance of internal accounting controls for entitles of all sizes and types. It is perhaps an idle thought, but I do wonder how much financial fraud has its origins in some kind of marital infidelity or sexual indiscretion. Admittedly, it would be a difficult thing to try to underwrite...

What He Said: During the time that I have been blogging, I have felt within me an essay developing that would describe what it is like to blog and what the advantages and disadvantages are. My friend Mark Herrmann, who is one of the co-authors of the Drug and Device Law Blog (here), has gone ahead and delivered himself of the very essay I might have written, if I were as articulate as Mark. The essay, published in the National Law Journal, can be found here. He wrote it, now I don’t have to.

By the way, if you have any involvement with life sciences companies, the Drug and Device Law Blog is indispensible.

Hat tip to the Delaware Corporate and Commercial Litigation Blog (here) for the link to the NLJ article.

Last Chance: The early registration discount for the 2008 PLUS D & O Symposium expires January 11, 2008 at 5:00 p.m. CST. The registration materials and schedule can be found here. As I have previously noted, I will be co-chairing this year’s Symposium with Chris Duca from Navigators Pro. We are proud of the program we have put together. The speakers include former SEC Chairman William Donaldson, who will be the keynote speaker, and the panelists include, among many luminaries, SEC Enforcement Division Director Linda Chatman Thomsen.

Tracking the Opt-Out Settlements

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In prior posts (most recently here), I have written about the increasing importance of opt-out settlements in the context of securities class action litigation. Along the way, numerous readers have inquired whether I am aware of a publicly available resource that is tracking the securities lawsuit opt-out settlements. I am not aware of any public resource, but because there clearly is an interest in having this information available, I have gone ahead and compiled all of the opt-out settlement information of which I am aware. My list of the opt-out settlements can be found here.

Readers should understand that the opt-out information I have compiled is necessarily limited to the settlements of which I am aware and is limited to publicly available information. The information is also limited to recent prominent securities lawsuit opt out settlements; there may well be earlier or other cases that had opt out settlements of which I am simply unaware. As a result, the information on the linked document is undoubtedly incomplete. I welcome any additional information that any readers would be willing to provide, and I will endeavor to keep the data updated as new or additional information becomes available.

My most recent comprehensive overview of the opt-out settlements generally can be found here. My recent post detailing the Qwest opt-out settlements can be found here. Readers should be further aware that virtually all of the opt-out settlements identified in the linked document have been described or at least mentioned in prior posts on this blog, and these prior discussions can be retrieved by using the search box in the upper left hand corner of the blog home page.

Options Backdating Settlement: On January 4, 2008, Nabors Industries announced (here) that it had entered a settlement agreement in connection with the consolidated options backdating-related shareholders derivative lawsuit that had been filed against the company and certain of its directors and officers in the Southern District of Texas. In connection with the settlement, Nabors Industries agreed to "certain corporate governance reforms, a new equity award policy, and a modified Compensation Committee Charter." The company and its insurer also agree to pay up to $2.85 million to plaintiffs’ counsel for the plaintiffs' attorneys' fees and expenses.

I have added the Nabors Industries settlement to my list of options backdating lawsuit dismissals, denials and settlements, which can be accessed here.

International Corporate Governance: Over at the Race to the Bottom blog, an excellent blog that I follow regularly, University of Denver Professor J. Robert Brown is running a series of blog posts (beginning here) taking a look at corporate goverance standards and issues in countries other than the United States, drawing on student research. So far, the blog series has featured posts on Norway and Board Diversity (here), and the first part of a two-part post on Corporate Governance and the United Kingdom (here). This series promises to be very informative and we look forward to following its progress.

A Closer Look at the 2007 Life Sciences Securities Lawsuits

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In prior posts (most recently here), I noted that even during the two-year lull in securities lawsuits filings that prevailed between mid-2005 and mid-2007, filings against life sciences companies – and pharmaceutical companies in particular – continued more or less unabated. More recently I noted (here) that pharmaceutical companies in the Standard Industrial Classification Code category 2834 represented one of the two most frequently sued categories of companies among the 2007 securities lawsuits. Because of this heightened lawsuit frequency involving life sciences companies, it seems worthwhile to take a closer look at the 2007 life sciences securities lawsuits.

First a word about categorization. For purposes of this post, I am including under the heading "life sciences" any company in either SIC Code series 283 (Drugs) or SIC Code series 384 (Surgical, Medical and Dental Instruments and Supplies). Reasonable minds might differ about whether additional categories should be included, but I decided to go for simplicity here.

Companies within the SIC Code series 283 were particularly hard hit in 2007, especially companies in the 2834 SIC Code (Pharmaceutical Preparations), within which 14 companies were sued in 2007. In addition, two companies in SIC Code 2836 (Biological Products) and one company in SIC Code 2833 (Medicinal Chemical and Botanical Products) were also sued, bringing the total number of companies sued in 2007 from SIC Code Series 283 to 17. These 17 lawsuits compare to eight lawsuits in the SIC Code Series 283 among the 2006 securities lawsuits.

There were four companies sued in SIC Code series 384, including two within SIC Code 3841 (Surgical and Medical Instruments) and two within SIC Code 3845 (Electromedical and Electrotherapeutic Apparatus).

The 21 total lawsuits against companies in these two SIC Code series categories means that lawsuits against life sciences companies represent roughly 12% of the 172 securities lawsuits filed in 2007. (Refer to my prior post here for a description of the data I am using in my analysis). This compares to 34, or slightly less than 20%, of the 2007 securities lawsuits related to the subprime meltdown. As I have said before, the subprime lawsuits were an important factor but by no means the only important factor in the increase of securities lawsuit filings in 2007.

The 2007 securities lawsuits against life sciences companies involved a wide variety of allegations. By far the most common contention is the allegation of unexpected or undisclosed set-backs in the regulatory or clinical trial process, which was raised against nine of the 21 life sciences companies sued. The next most prevalent type of allegation was related to disclosures surrounding product safety (five companies).

Other allegations included slowing sales or missed projections (two companies), misrepresentations regarding product efficacy (one company), disclosure of a criminal investigation (one company), failure to disclose merger-related information (one company), misrepresentations or omissions regarding sales practices (one company), and misrepresentations regarding the status of regulatory approvals (one company).

Of the 21 life sciences companies sued in securities lawsuits in 2007, five are foreign-domiciled, including two from France, and one each from Germany, Switzerland and the U.K.

As I noted in my prior posts regarding pharmaceutical company lawsuits (here), while life sciences companies have proved to be popular targets for plaintiffs’ lawyers, they have not always proved to be easy targets. Many of the past securities lawsuits against pharmaceutical companies have been dismissed. The dismissal levels may have something to do with the prevalence of allegations regarding regulatory or clinical trial setbacks. While these setbacks may indeed rock the companies’ stock prices, these kinds of setbacks are an almost inevitable attribute of the regulatory and scientific environment in which these companies operate. These risks are often comprehensively disclosed, creating a particular challenge for plaintiffs’ attorneys.

While it is far too early to tell how the 2007 securities lawsuits against life sciences companies will fare, it will be interesting to monitor these cases to see how many go forward beyond the motion to dismiss stage.

The Return of the "Club Deal" Antitrust Case: According to news reports (here), plaintiffs’ lawyers have filed an antitrust lawsuits against the leading private equity firms and investment banks, alleging that the 13 defendants conspired to fix prices in connection with seven specific private equity "club deals" between 2004 and 2007. In fall 2006, a different set of plaintiffs lawyers had originally filed a complaint in the Southern District of New York raising substantially similar allegations, but they withdrew their complaint after the U.S. Supreme Court handed down its May 2007 opinion, specifying a heightened pleading standard for antitrust cases, in Bell Atlantic v. Twombley. The new plaintiffs' counsel apparently feels they can meet the Twombley standard.

The new complaint, which can be found here, was filed in the District of Massachusetts, and alleges that the large buyout firms conspired to keep acquisition prices low by "clubbing together" rather than competing on large buyout deals. The private equity firm defendants include, for example, Bain Capital, Blackstone Group, KKR, and Thomas H. Lee Partners. The seven specific deals referenced in the complaint include Kinder Morgan, HCA and Freescale Semiconductor. The lawsuit also targets investment banks for the conflicted role they allegedly sometimes play as both advisers to the target companies and as lenders (or even co-investors) to or with the acquirers.

Special thanks to Ned Kirk of the Sedgwick Detert firm for a link to the news reports and for a copy of the Complaint.

Need for Speed: If you not yet seen it, you have to read the Wired Magazine article entitled "The Pedal-to-the-Metal, Totally Illegal, Cross-Country Spring for Glory" (here), which tells the tale of Alex Roy, who is consumed by a passion to recreate Cannonball Run and set the speed record for driving between Manhattan and Santa Monica (a feat Roy accomplished in an astonishing 31 hours and 4 minutes). You have to read it to believe it.

Special thanks to new reader Michael Barker the link to the article.

Subprime Litigation Wave Hits State Street

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On January 3, 2008, State Street Corporation announced (here) that for the fourth quarter of 2007, it will be establishing a reserve of $618 million, on a pre-tax basis, "to address legal exposure and other costs associated with the underperformance of … fixed-income strategies managed by… the company’s investment management arm." The net charge to the company, "after taking into account the tax effect of the reserve and associated lower incentive compensation cost" will be $279 million.

In its January 3 press release, the company did not identify the specific litigation to which the reserve will relate; rather, the company referenced only "customer concerns as to whether the execution of [the fixed-income strategies] was consistent with the customers’ investment intent." The press release goes on to state that the strategies "were adversely impacted by exposure to, and the lack of liquidity in, subprime mortgage markets."

A January 4, 2007 New York Times article entitled "State Street Corp. Is Sued Over Pension Losses" (here) states that State Street decided to create the reserve "after five clients sued it, claiming they had lost tens of millions of dollars in State Street funds they were told would be invested in risk-free debt like Treasuries." The Times article briefly identifies four of the claimants, but adds that "it was unclear who brought the fifth suit."

Because of the possibility that, as stated in the Times article, that State Street’s litigation and related reserve "highlight the legal challenges that lie ahead for financial firms," it would appear to be worthwhile to review here the five State Street lawsuits. The value of this exercise is underscored by the perception (which I share) voiced by one commentator quoted in the Times article that "there could be many, many more" lawsuits like those against State Street.

The first of the five lawsuits was brought on October 1, 2007 by Prudential Retirement Insurance and Annuity Company. (I previously posted about the Prudential lawsuit here.) A copy of the Prudential complaint can be found here. According to Prudential Financial’s October 1, 2007 filing on Form 8-K (here), the action "seeks, among other relief, restitution of certain losses attributable to certain investment funds" sold by State Street’s investment management arm, and alleges that State Street "failed to exercise prudent investment management." The specific legal basis of Prudential’s claim is that State Street and its investment arm violated the Employee Retirement Income Security Act of 1974 (ERISA).

The complaint alleges that the defendants "radically altered" the investment strategies of two bond funds, the Intermediate Bond Fund and the Government Credit Bond Fund. The complaint alleges that the funds "took undisclosed, highly leveraged positions in mortgage-related financial derivatives" and thereby "exposed" the funds to "an inappropriate level of risk" that during the summer of 2007 "produced catastrophic results." The complaint further alleges that as these events unfolded the defendants provided "untimely, incomplete and misleading information."

The Prudential complaint alleges that the defendants caused losses of "roughly $80 million" to assets held by about 165 retirement plans for which Prudential is responsible, affecting approximately 28,000 plan participants. The complaint seeks restitution and compensation for the investor losses (which Prudential has, according to an October 2, 2007 Wall Street Journal article, here, already reimbursed). The complaint also seeks recovery of fees and other amounts the defendants’ received, as well as recovery of the plaintiff’s attorneys’ fees.

Of the five lawsuits against State Street in connection with which the company established its litigation reserve, three others (in addition to the Prudential lawsuit) allege violations of ERISA. The first of these three other ERISA lawsuits was brought on October 17, 2007 by Unisystems and the trustee of the Unisystems Employees’ Profit Sharing Plan. A copy of the Unisystems amended complaint can be found here. (My prior post about the Unisystems complaint can be found here.)

The second of the three other ERISA lawsuits was brought on October 24, 2007 by the Composite Pension Trust of Nashua Corporation. A copy of the Nashua complaint can be found here.

The third of the three other ERISA lawsuits (and the fourth of the five total lawsuits brought against State Street) was brought on October 31, 2007 by the plan administrator and the trustee of the Employees’ Savings and Profit Sharing Plan of the Andover Companies. A copy of the amended Andover Complaint can be found here.

The fifth of the five lawsuits against State Street (which is also the lawsuit which the Times was unable to identify) was brought on November 5, 2007 in Harris County, Texas, District Court by Memorial Hermann Healthcare System. On December 3, 2007, the defendants removed the Memorial Hermann complaint to the Southern District of Texas. A copy of the removal petition, to which the initial state court complaint is attached, can be found here. Unlike the four other State Street lawsuits, the Memorial Hermann complaint does not allege a violation of ERISA. Instead, the complaint asserts against the State Street defendants a variety of state law claims, including breach of contract, fraud and negligent misrepresentation.

The Memorial Hermann complaint essentially alleges that the State Street defendants breached an "Agreement of Trust" to serve as trustee of nearly $91 million in the plaintiff’s assets. The assets allegedly were invested in the State Street Limited Duration Bond Fund, which the complaint alleges lost 37 percent of its value during three weeks in August 2007, and 42 percent of its value for the 2007 year. The losses allegedly were the result of "unjustified investments in mortgage securities without diversification and using derivatives, all contrary to the stated Investment Objectives and representations."

UPDATE: In a later post, I discuss (here) a sixth lawsuit that has been filed against State Street.

The State Street lawsuits are significant in and of themselves, but also for what they might foreshadow. As I noted above, these lawsuits may well represent the kinds of legal problems that other financial services companies may face, particularly as the mortgages backing many of these investment funds and investment securities continue to detiorate.

There are a number of other important implications from the State Street lawsuits. The first relates to the identity of the claimants – these are very large institutions suing other very large institutions. These lawsuits are not the kind of lawyer-driven stock drop lawsuits that have drawn so much ire from would be reformers. These are conservative business litigants using plaintiffs’ tools seeking to recoup significant losses. These sophisticated litigants may be unlikely to accept quick compromises, and, mindful of their own fiduciary obligations, may well be unwilling to accept any compromise that does not represent a very significant percentage of the losses.

The second important implication of the State Street lawsuits is the sheer magnitude of the dollars involved, as demonstrated by State Street’s pre-tax set aside of $618 million for cases that are only in their earliest stages. The State Street litigation reserve underscores the staggering exposures that these cases and others like it represent. The stakes in these cases are enormous.

The third implication derives directly from the enormity of the financial exposures involved; that is, these cases clearly have very serious repercussions for liability insurers, a consideration discussed in a January 4, 2008 Dow Jones newswire article entitled "Subprime Litigation May Dent D & O Insurers Like Chubb, AIG" (here). The article’s overall conclusion – that the subprime litigation wave may represent a significant concern for D & O insurers – is a valid point that I have in fact previously considered in a prior post (here). However, while I generally agree with the Dow Jones article’s overall thrust, I do disagree with some the article’s premises.

The most egregious of the article’s faulty premises is that the State Street lawsuits represent a D & O insurance exposure. The article disregards the fact that four of the five State Street lawsuits are brought under ERISA. The typical D & O policy contains an ERISA exclusion, primarily because exposures under ERISA are covered under a separate fiduciary liability policy, not a D & O policy.

In addition, none of the five complaints name as a defendant any individuals; there are no director or officer defendants in any of these complaints (although there are John Doe defendants named without further identification in several of the complaints). The entity coverage under the typical D & O policy provide coverage only for securities claims against insured entities, and none of the five complaints raise securities law allegations.

So, contrary to the Dow Jones article’s presumption, the State Street complaints do not themselves appear to embody any particular D & O insurance threat, as in their current forms at least, they would not appear implicate the typical D & O insurance policy. To be sure, the complaints may represent serious threats to fiduciary liability insurers and perhaps even to investment management errors and omissions (E & O) insurers, and to that extent the implication would seem to be that the subprime litigation wave represents a much more extensive threat to the insurance industry beyond just D & O. All of which does indeed suggest that the subprime litigation wave is a potentially complex and serious threat to insurers generally. To that extent, at least, the Dow Jones article is correct when it states that State Street’s reserve "has increased concern that insurers offering policies covering such exposures could be hit with big claims from the credit crisis."

In any event, I do agree that the subprime litigation wave represents a threat to the D & O insurers, even if the State Street lawsuits themselves may not. My prior blog posts on the potential impact on D & O insurers from the subprime meltdown can be found here and here; even though I wrote these posts months age, the analysis still appears more or less valid.

It should also be noted that there have been a number of other subprime related lawsuits brought under ERISA, primarily by employees raising allegations relating to company stock held in the 401(k) plans. A list of these employee ERISA lawsuits may be found in my running tally of subprime-related litigation, here.




The January 6, 2007 New York Times has an article entitled "Testing Investors' Faith in State Street" (here) that examines the market's curious reaction to State Street's announcement concerning its litigation reserve -- its stock price went up, hitting a 52-week high, a response that Times columnist Gretchen Morgenson is at a loss to explain.



Now This: The American Dialect Society has chosen (here) "subprime" as the 2007 Word of the Year. Pondering this development, I was moved to reflect that the subprime meltdown has moved beyond a mere financial event; it has become a cultural, social, and even political phenomenon.


Like all important phenomena, the subprime meltdown has deep roots, which arguably go back to the early 80s when the market for mortgage securities was more or less invented at Salomon Brothers, as entertainingly retold in Michael Lewis’s classic, Liar’s Poker. Though the events described in Lewis’s book took place over twenty years ago, they resonate now with irony and sometimes even ominous portent, although much of the current resonance was perhaps unintended when the words were originally written.


The most portentous segments detail the creation in the mid-80s of the recently eventful mortgage security, the collateralized mortgage obligation (CMO), about which Lewis notes, in words that contemporary investors in Norway, Japan, Australia and the U.K might now rue, that "CMOs opened the ways for international investors who thought American homeowners were a good bet." Lewis also notes, in an observation that seems particularly ironic today, that that as a result of the innovation of CMOs, "investors now had a new, firm idea of what the price of a mortgage bond should be." Lewis goes on to describe how the Wall Street Bankers "found a seemingly limitless number of ways to slice and dice home mortgages."


Space constraints prevent doing full justice to Lewis’s account, so fraught with significance in light of today’s circumstances. Suffice it to say that given recent events, Liar’s Poker merits and rewards a re-reading. It is as entertaining as it ever was, but the description of the invention of the market for mortgage bonds seems to matter in ways that it did not previously.


Special thanks to loyal reader Matt Rossman, who pointed out Liar’s Poker’s newly relevant historical value some time ago – I only recently got around to following up on Matt’s suggestion to re-read the book.

Web Notes and Updates

Chinese Checkered: In an earlier post (here), I reviewed the recent checkered track record of Chinese companies listed on the U.S. securities exchanges, including in particular Chinese IPOs. A December 2007 Dewey & LeBoeuf article entitled "China’s Top Ten at the Corporate Governance Bottom" (here) sounds many of the same themes as my prior post.

The article notes that "the ten largest Chinese companies trading in the U.S. rate poorly when it comes to corporate governance." The article cites research showing that the ten companies have "an average rating of 0.5 stars for corporate governance, with five being the highest rating and three being average." Five of the companies received "0" ratings for corporate governance.

Among the reasons for the low ratings is a NYSE guideline allowing "foreign private issuers" to follow their home country governance rules. Because China does not require that a majority of directors to be independent, "Chinese companies listed on the NYSE are allowed to stack the board with inside directors."

In addition, that article notes, "lack of strong outside oversight" can lead to problems "when it comes to transfer pricing, related-party transactions, intergroup guarantees, tax rates, and the valuation of contingent liabilties." The control role of the Chinese government in these companies’ ownership and operation can "lead to considerable pressure," because "these large companies are instruments of state policy."

There may be a view that the exchanges’ allowances for Chinese companies are indispensable if the U.S. financial markets are to attract these and other overseas listings. And it may well be argued that the governance concerns, which reflect the biases of U.S. expectations, are merely components of the market information that should be taken in to account in the companies’ valuations.

At a minimum, these considerations certainly do argue in favor of a more cautious approach to Chinese companies, both for investors and D & O underwriters alike. As I noted in my prior post, a disproportionate number of Chinese companies have become involved in securities litigation in the U.S.. a fact that may not be unrelated to the governance concerns.

Changing Environment for Climate Change Disclosure: In prior posts (here and here), I have reviewed the changing circumstances surrounding environmental disclosures, particularly as relates to global climate change. A January 2008 McKenna, Long & Aldridge article entitled "The SEC is Getting Hot and Bothered Over Climate Change" (here) takes a detailed look at the current and proposed requirements that potentially could affect public companies’ disclosure obligations relating to global climate change.

The article’s conclusions are that "publicly traded companies can expect scrutiny of their SEC filings to increase" and that "companies that have yet to squarely confront the question should consider taking a closer look at future filings."

Apollo Group Securities Lawsuit Trial Wrapping Up: In recent posts (most recently here), I discussed the JDS Uniphase securities lawsuit trial, which, on November 27, 2007, resulted in a jury verdict in the defendants’ favor. The JDSU trial was noteworthy because trials in securities cases are so rare. But as I also noted that there was, coincidentally, another securities trial, involving Apollo Group, going on at the same time.

Adam Savett reports on his Securities Litigation Watch blog (here) that the plaintiffs in the Apollo Group trial rested their case on December 12, 2007, and the court subsequently denied the defendants’ motion for directed verdict. Closing arguments in the case apparently are scheduled to take place on January 9, 2008. Savett predicts a jury verdict on January 10.

In any event, we won’t have long to wait to find out the outcome of yet another civil securities lawsuit trial. It is probably a worthy topic for another day to consider why this flurry of trial activity is taking place now and what it may mean. Certainly, if the Apollo Group trial results in another defense verdict, it would further discourage other plaintiffs from hazarding a jury, and perhaps further encourage settlement.

Readers my be interested to note that the Securities Litigation Watch blog is also maintaining (here) a list of all post-PSLRA securities class action lawsuits that have gone to trial.

Finally, readers interested in details of the trial may want to read this December 7, 2007 Arizona Republic article (here) describing the trial testimony of Apollo Group's former CFO.

Busted Buyout Lawsuit Reaches the Finish Line: In an earlier post (here) I discussed the litigation arising out of Finish Line’s bid to walk away from its planned $1.5 billion acquisition of Genesco. In case you missed the news over the holidays, on December 27, 2007, the Tennessee court (here) rejected Finish Line’s contention that there had been a "materially adverse effect" sufficient to permit Finish Line to invoke the termination procedures in the agreement. The court ordered Finish Line to complete the transaction.

However, as noted in the December 28, 2007 CFO.com article (here) discussing the ruling, there is still a second action pending in New York, that could affect whether or not the transaction ultimately is completed. UBS, which had committed to finance the transaction, contends that the merger will result in an insolvent entity. The Tennessee court has said that if that is the case, the court would "halt the agreement."

Finally, the WSJ.com Law Blog notes (here) that though the court has issued its ruling in the Genesco case, there are still plenty of other busted deals to fuel additional litigation for the foreseeable future in the New Year.

PLUS D & O Symposium: The 2008 Professional Liability Underwriting Society (PLUS) D & O Symposium will take place on February 6 and 7, 2008 in New York. I will be co-chairing the Symposium again this year, with my good friend Chris Duca of Navigators Pro. We are very proud of this year’s agenda, which includes former SEC Chairman William Donaldson as the keynote speaker and features a stellar lineup of panelists, including SEC Enforcement Division Director Linda Chatman Thomsen. The entire schedule is available at the PLUS website, here.

Readers will be interested to know that the early registration discount is available only until January 11, 2008, so you will want to be sure to register before the end of this week.

Cornerstone Releases Year-End 2007 Securities Litigation Report

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As the latest of the year-end 2007 securities lawsuit reports (including my own, here), Cornerstone Research has released (here) its 2007 report on securities class action filings. Cornerstone’s January 3, 2008 press release describing the report can be found here. The numbers in the Cornerstone report differ from those in the previously released year-end report of NERA Economic Consulting (here), but the numbers are directionally consistent. The Cornerstone report does make some additional observations about the 2007 securities lawsuit filings, and also adds some interesting analysis.

The Cornerstone report notes the following findings:

1. Cornerstone reports that there were 166 securities class action lawsuit filings in 2007, which represents a 43% increase over the 116 filings in 2006. The 2007 yearly total is, however, 14 percent below the average for the ten-year period ending in December 2006.
2. Stock market volatility is important in explaining the number of filings. The increase in filings in the second half of 2007 coincided with an increase in volatility in the U.S. stock market from the historically low levels that prevailed in 2006 and the first half of 2007.
3. Securities lawsuit filings as a percentage of the total number of publicly traded companies increased in 2007. 2.19% of publicly traded companies were sued in securities lawsuits in 207, compared to only 1.57% in 2006, and by contrast to the 2.27% ten-year average from 1997-2006.
4. For cases filed in 2007, the drop in market capitalization both from the beginning to the end of the class period and from the class period high to the end of the class period increased, largely driven by several large case filings in the fourth quarter of 2007.
5. Of the 2,646 cases in Cornerstone’s database, 81 percent have been resolved. Of the resolved cases, 41 percent were dismissed and 59 percent settled. For the cases filed from 1996 to 2001, almost all of which have been resolved, the median time to resolution is 33 months. The median time to dismissal is 25 months, and the median time to settlement is 36 months. Cases with larger shareholder losses are likely to take longer to resolve.
6. The Finance sector had the largest amount of litigation activity, with 47 Finance cases in 2007, driven by the subprime crisis.
7. The top three Circuits in terms of the number of 2007 filings were the Second Circuit, with 58 filings; the Ninth Circuit, with 39 filings; and the Eleventh Circuit, with 18 filings.
8. Cornerstone counted 32 cases attributable to the subprime crisis (by contrast to my own count of 34 cases, here). The report notes that the subprime filings reflect a shift in emphasis from allegations related to traditional income statement line items to allegations related to balance sheet components.

In attempting to discern the significance of the 2007 filing levels, the Cornerstone report revisits the analytic framework Cornerstone first postulated in its mid-year 2007 report (here). The mid-year report raised two alternative theories for the lull in litigation activity from mid-2005 to mid-2007, the "less fraud" hypothesis and the "lower volatility" hypothesis. The "less fraud" theory, associated with Stanford Law Professor Joseph Grundfest, involved the theory that as a result of corporate reforms, there is less fraud and hence less litigation. (Professor Grundfest went further and speculated that perhaps, as a result of the reforms, there had been a "permanent shift" to a lower litigation level.) The "lower volatility" theory noted that the period of lower litigation activity coincided with historically low stock market volatility, and speculated that litigation activity might return to historical norms if volatility returned.

The year-end Cornerstone report expressly attributes the increased litigation activity in the second-half of 2007 to the heightened level of stock market volatility during that period. Nevertheless, the report also states that "the ‘less fraud’ theory suggests a significant and permanent shift in the class action landscape" that is "not inconsistent with the recent increase in filing." The report finds this possibility because of the significant amount of 2007 litigation activity that was directly associated with the subprime crisis, which the Cornerstone report describes as "a likely ‘one time’ event," that "may not be indicative of future filing activity."

To support this analysis, the report suggests that there is an identifiable "core litigation rate," which is a statistical construct based on historical filings from which "one time events" like "backdating, subprime cases [and] IPO Allocation filings are excluded." Using this construct, the report finds that "litigation activity remains well below historical norms." Professor Grundfest describes this "core litigation rate" as "the litigation rate observed net of one-time systemic shocks."

I cannot disagree with the report’s overall conclusion that more data is needed before the "less fraud" hypothesis can be conclusively rejected. Indeed, only time will tell. But for a number of reasons, I disagree with the Cornerstone Report’s analysis of the 2007 filings, and in particular with the report’s conclusions about the significance of the 2007 filing activity.

First, the Cornerstone report treats the 2007 subprime litigation activity as if it consists of a single, uniform phenomenon, limited in scope and duration. But my own view is that even though the subprime meltdown is still relatively recent, the litigation activity has already evolved into a highly diverse set of circumstances, lawsuits and litigants. As I detail at greater length here, the subprime litigation wave already involves a wide variety of kinds of companies and allegations. Moreover, it is likely to continue to evolve in the months ahead. To isolate the subprime cases as if they represent a narrow or contained phenomenon minimizes the potential of the ongoing subprime litigation wave to drive litigation activity for months and perhaps years to come, and disregards the very real possibility that the wave will expand to encompass a far wider variety of litigants and allegations.

Second, even if the subprime litigation wave can fairly be characterized as a "one-time" event, that is hardly sufficient to marginalize its continuing significance. The fact is the world of D & O liability has experienced a steady progression of "one time events" in recent years -- the bursting of the Internet bubble, the telecom crash, the IPO Allocation cases, the corporate scandals, the options backdating cases, and now the subprime crisis. Indeed, the joke among D & O insurance industry professionals at the recent PLUS International Conference was that subprime is "just a one time event" – the joke being that in the D & O industry, there is a one time event every year, and that results are driven by the constant recurrence of supposed "one time events." When one time events become the norm, they are not extraneous, they are the very essence of the risk exposure.

The reality is that the claims experience in the D & O arena is characterized by a succession of one time events. Indeed, no D & O insurance manager who wished to retain his credibility with senior insurance company management would attempt to try to marginalize the subprime litigation wave by describing it as a one time event, simply because there have been too many supposed one time events in recent years for the phrase to retain any meaning. D & O claims are and for years have been driven by these kinds of events. There perhaps may be a statistical construct by which to postulate a "core litigation rate," but the construct would be disregarded by insurance professionals as lacking credibility and unlikely to provide adequate predictive power to describe likely future events. The practical reality is that it must be assumed that there will always be one time events – not as unusual occurrences, but in the ordinary course.

Finally, as I have documented elsewhere (here and here), subprime litigation is only one of a number of important factors driving the recently increased litigation activity. Even without the subprime cases, the uptick in litigation activity is significant.

To be sure, only time will tell whether the increased litigation activity in the second-half of 2007 is indicative of future activity levels. But as I previously stated (here), I think there is already a sufficient basis upon which to declare that the two-year lull in securities lawsuit filings is over, and to state that there does not appear to have been a "permanent shift" to lower securities lawsuit filing levels.

A Closer Look at the 2007 Securities Lawsuits

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The first of the 2007 year-end securities class action reports has already appeared (refer here), with others soon to follow. As I have noted elsewhere (most recently here), the most important securities trend during 2007 was the return of lawsuit filing activity to historical levels, after a two-year lull. But there were numerous other important securities lawsuit trends in 2007, as discussed below.

First, a word about data. My observations about the 2007 securities lawsuits are based on my own tally of the 172 securities lawsuits, which I derived from publicly available data plus information from readers. My tally differs from the numbers that appeared in NERA Economic Consulting’s 2007 year-end report (here). NERA counted 198 securities lawsuits through mid-December, and projected 207 lawsuits by year-end. The projected number was not borne out, but NERA’s actual year-end number around 200 is materially higher than my own count of 172. NERA undoubtedly has superior data; readers should be aware that I have used my own data for purposes of this post.

The year-end tally of 172 new securities class action lawsuits includes 103 new securities lawsuits that were first filed in the second-half of 2007. This half-year total is virtually identical to the six-month average of 101 that Cornerstone Research noted in its mid-year 2007 securities litigation report (here) for the period from the second half of 1996 through the first half of 2005. In addition, the year-end total of 172 lawsuits represents an increase of 56 cases over the 2006 year-end total of 116, an increase of 48 per cent.

The companies named in securities lawsuits in 2007 represent 80 different Standard Industrial Classification (SIC) Code categories. In a year in which subprime lawsuits were such a significant factor (refer here for my analysis of the 2007 subprime lawsuits), it is hardly surprising that one of the SIC Code categories with the highest number of new lawsuits is SIC Code 6798 (Real Estate Investment Trusts), which had 14 new lawsuits. But SIC Code 2834 (Pharmaceutical Preparations) also had 14 new lawsuits, which is entirely consistent with my frequent observation that while subprime lawsuits are an important part of the 2007 securities lawsuit trends, the subprime lawsuits represent only one of several important trends.

Other SIC Code categories that had significant activity unrelated to the subprime mess include SIC Code category 3674 (Semiconductors), which had seven lawsuits; SIC Code category 3663 (Radio and Telephone Equipment), which had six lawsuits; SIC Code category 7372 (Prepackaged Software), which had five lawsuits; and SIC Code category 4899 (Communications Services) which also had five lawsuits.

26 of the 172 securities lawsuits that were filed in 2007 involved companies domiciled outside the United States. These 26 companies are based in 12 different countries, including China (seven companies); Switzerland (three companies); Bermuda, Canada, France, Hong Kong, Israel and the U.K (each of which had two companies each); and Germany, South Korea, Sweden and Taiwan (each of which had one company each). My detailed analsysis of the securities lawsuits involving Chinese companies can be found here.

Many of the 2007 securities lawsuits involved allegations of misrepresentations in connection with the defendant company’s IPO within twelve months of the lawsuit. 29 of the 172 new lawsuits involved IPO allegations. Interestingly, 20 of the 29 lawsuits against IPO companies were filed in the second-half of 2007, which suggests that an increase in the number of cases involving IPO companies was an important part of the increased level of securities litigation activity in the second-half of 2007. In addition, nine of the 29 IPO company lawsuits involved foreign-domiciled companies, so the level of IPO-related activity and the level of foreign-domiciled company activity appears to be correlated to a certain extent.

The 2007 securities lawsuits were filed in 52 different federal district courts. By far the largest numbers of lawsuits were filed in the Southern District of New York, where a whopping 52 of the 172 lawsuits (or about 30%) were filed. The court with the next highest total, the Central District of California, had only 18. Indeed, if the lawsuits filed in the Central, Southern and Northern Districts of California are combined, the total of 32 cases is still far short of the S.D.N.Y. total.

The high number of filings in the S.D.N.Y. is in part attributable to the number of financial services companies that have been sued in Manhattan as a result of the subprime mess. But another important factor in the number of S.D.N.Y. lawsuits is the significant number of lawsuits against foreign domiciled companies. 21 of the 26 foreign-domiciled companies sued in securities lawsuits in 2007 were sued in the S.D.N.Y.

Other courts that had a significant number of securities lawsuits in 2007 include the Southern District of Florida (10); Eastern District of Pennsylvania (6); Northern District of Texas (5); and the Western District of Washington (5).

I have noted elsewhere (here) the significance of the number of 2007 securities lawsuits. Another important attribute of the 2007 securities lawsuits is their diversity. More specifically, the increase in 2007 securities litigation activity clearly was driven by a number of factors, not just the litigation activity surrounding the subprime meltdown. Indeed, even if the 34 subprime-related lawsuits (listed here) were withdrawn from the 2007 total, the resulting 138 lawsuits would still represent a material increase over the 116 lawsuits that were filed in 2006. The fact that there were significant numbers of cases aggregated in categories completely isolated from subprime-related issues demonstrates that the story of the renewed securities litigation activity involves far more than just the subprime meltdown.

Finally, one of the other many factors contributing to the renewed level of securities lawsuit activity in 2007 is the outbreak of lawsuits arising from busted buyouts, which I discuss at greater lenghth here.

A Closer Look at the 2007 Subprime-Related Securities Lawsuits

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In its 2007 year-end study of securities class action trends (here), NERA Economic Consulting noted that the "sharp increase" in 2007 securities lawsuit filings was "driven in part by litigation related to subprime lending," an observation I have also noted elsewhere. Given the importance of the subprime lawsuit filings to the overall 2007 securities lawsuit picture, it is worth taking a closer look at the 2007 subprime-related securities lawsuits.

As a preliminary matter, it should be noted that I have counted 34 subprime-related securities lawsuits during 2007 (as detailed here), whereas in its year-end report NERA stated that there were 38 subprime-related lawsuits. The difference may be merely definitional, as it became harder to classify cases as the year progressed. NERA may also have superior information, a not unlikely possibility given that my data are derived solely from publicly available sources. In any event, readers should be aware that the analysis in this post is limited to the 34 lawsuits in my tally.

The 34 companies sued in the subprime-related lawsuits represent 15 different Standard Industrial Classification (SIC) Codes. The largest concentration of cases is in the 6798 SEC Code (Real Estate Investment Trusts), which accounted for 11 of the34 cases. Fully 30 of the 34 companies sued fall within the 6000 SIC Code Series (Finance, Insurance and Real Estate).

Another way to look at the companies is by industry, rather than by SIC Code. As might be expected, there are more companies is in the banking/mortgage lending business than any other industry; this group accounted for 12 of the companies sued. Other industry groups with multiple companies represented included residential home builders (5), REITs (5), Bond Insurers (3) and Credit Rating Agencies (2). Other industries represented with one company each include mortgage investment companies, mutual funds, and savings and loans. (The list of companies also includes Freddie Mac, which as a government sponsored entity is hard to classify.)

The subprime-related lawsuits were filed in 15 different federal district courts, with the largest number filed in the Southern District of New York (11). Other courts with multiple filings include the Central District of California (6), Eastern District of Pennsylvania (3) and the Northern District of California (2).

The list of companies sued includes two that are domiciled overseas: UBS (Switzerland) and Security Capital Assurance (Bermuda). One of the subprime-cases – the one involving Security Capital Assurance – involves IPO-related allegations.

The 34 subprime-related lawsuits were filed between February and December 2007, with at least one lawsuit filed in each month during that period. There were two in February, four in March, two in July, eight in August, four in September, two in October, five in November, and four in December.

In other words, the subprime-related lawsuits, while concentrated in the Finance, Insurance and Real Estate SIC Codes, represent a number of different industries. The lawsuits have been filed in a number of different courts, but with a concentration in New York and Los Angeles. The lawsuit filings were spread (albeit somewhat unevenly) throughout the year. These observations seem relevant to any analysis of what the cases might represent within the larger context of securities filing trends.

Mortgage Investigations Face Challenges: A December 27, 2007 Washington Post article entitled "Mortgage Probes Face Big Hurdles" (here) notes that as problems have emerged following the subprime mortgage meltdown, "government subpoenas are flying, investor lawsuits are mounting, and in the nastiest cases, businesses are pointing the finger of blame at one another. "

But despite the almost irrepressible urge to find scapegoats, investigators could face significant hurdles due to the "tangled system" of regulatory authority and oversight. In addition, another consideration that could stymie investigators, and that could be a factor in the many investor lawsuits, is that "many of the assets that tumbled were explicitly marketed as involving borrowers with trouble credit histories, alerting investors that they were high-risk bets."

White Collar Fraud is Not Just Wrong, It’s Insane!: Regular readers may recall my prior post (here) about former Crazy Eddie CFO (and convicted felon) Sam E. Antar, who is now making a name for himself warning others about how to spot fraud. A lengthy December 25, 2007 Fortune Magazine article entitled "Takes One to Know One" (here) takes a closer look at Antar. and his current campaign to combat fraud.

The detailed article reviews the Crazy Eddie fraud in depth and explains how Antar has become a roving lecturer on accounting fraud. The article summarizes Antar’s strategy for finding fraud as "sustained and disciplined paranoia." He also says that the only safeguards against accounting fraud that work are "stringent disclosure rules for companies and better fraud training for auditors."

Interested readers may want to check out Antar’s blog, White Collar Fraud (here), for further commentary from Antar, who signs his blog posts as follows: "Respectfully, Sam E. Antar (former Crazy Eddie CFO and convicted felon)."

Top Ten D & O Stories of 2007

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With the year-end fast approaching, it is time to take a look back and review the top D & O stories of 2007. It was an eventful year, with some important developments that will have implications for the year ahead, and perhaps for years to come. Here are the top stories, with the year’s most important story leading the way.

1. Subprime Meltdown Launches Litigation Wave: When I first started tracking subprime-related litigation in April (here), I already knew that the subprime meltdown was going to be an important story. By July (here), I knew that the subprime story was "this year’s model"—that is, the hot litigation trend being driven by the business scandal most prominent at the time. By August, I wrote (here) that the developing story had become "All Subprime, All the Time." But even at that point, I don’t think I really appreciated what the subprime story would become. I certainly didn’t envision that it would lead to a surge of lawsuits against some of the giants of the financial services world, such as Merrill Lynch (refer here), Citigroup (refer here), Washington Mutual (refer here), and UBS (refer here).

As of year end, my current tally (refer here) of subprime-related lawsuits stands 34; the recently released NERA year-end securities litigation survey (here) put the number at 38. The litigation includes lawsuits against accountants (here), real estate brokers (here), and many others. The securities lawsuits have come not just against the lenders and the investment banks, but home builders, bond insurers, credit rating agencies, mutual funds, and a host of others. Even more ominously, there is an unmistakable sense of foreboding that the worst may lie ahead (refer here). But whatever may actually lie ahead, there is no doubt that the litigation resulting from the subprime meltdown is the 2007 D & O story of the year.

2. Two-Year Lull in Securities Filings Comes to an End: In mid-year 2007 studies, NERA (here) and Cornerstone (here) both observed that securities filings had been well below historical averages since mid-2005. Stanford Law Professor Joseph Grundfest questioned (here) whether or not there might have been a "permanent shift" to a lower level of securities lawsuit filings.

But as I detailed more thoroughly here, and as further documented in NERA’s recent 2007 year end survey (here), the two-year lull came to an end in the second half of 2007. Indeed, the 81 securities lawsuits filed during the period between August 1, 2007 and November 30, 2007 represents the highest level of lawsuit filings in a four-month period since June-October 2004, and the 25 new securities lawsuits filed in November 2005 represents the highest monthly total since January 2005.

Perhaps even more noteworthy is the fact that the new lawsuit activity is not being driven exclusively by the subprime litigation wave; while the subprime lawsuits collectively represent one important factor, the lawsuits are actually hitting a wide variety of companies for a wide variety of reasons, many having nothing to do with the subprime meltdown. The likelihood of continued financial marketplace volatility suggest that litigation levels may remain elevated for some time to come.

3. Supreme Court Issues Tellabs Decision: The Supreme Court does not take many securities cases; for that reason, and because the Tellabs case had the potential to significantly affect the threshold resolution of many securities cases, the Supreme Court’s opinion in the Tellabs case was much anticipated. When the Tellabs opinion finally came out in June 2007, it was a victory for defendants, although perhaps not as extensive a defense victory as it could have been, as detailed further here and here.

The Tellabs opinion reversed the Seventh Circuit’s ruling and held, interpreting the securities lawsuit pleading standards described in the Private Securities Litigation Reform Act, that for an inference that a defendant acted with scienter to be "strong," the inference "must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." The majority opinion expressly rejected the position urged by concurring Justices Scalia and Alito that "the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence."

While the Tellabs court’s more balanced approach seemed less likely to have a dramatic impact on dismissal motions as would the position urged by the concurring justices, the early returns suggest that the Tellabs case has made it more difficult for securities cases to survive a motion to dismiss (as discussed on this post on the 10b5-Daily blog, here). The Tellabs case has, in fact, proven to be an important factor in many of the motions to dismiss in the options backdating cases (about which refer here). The Tellabs decision and the Supreme Court’s 2005 opinion in the Dura Pharmaceuticals case are now important tools for defendants to try to use at the motion to dismiss stage in securities class action litigation.

4. Top Plaintiffs’ Lawyers Face Criminal Woes: Even a short time ago, who would have thought that the two leading securities plaintiffs’ attorneys would face criminal prosecution? Yet on October 29, 2007, Bill Lerach entered a guilty plea (refer here), and on September 20, 2007, Mel Weiss was indicted on criminal charges (here). (For more about Lerach’s criminal charges, refer here; for Weiss’s, refer here).

The impact of the criminal issues involving the two leading securities plaintiffs’ lawyers is perhaps incalculable, but it does not seem a mere coincidence that shortly after Lerach left his former law firm (now reconstituted as Coughlin, Stoia,Geller, Rudman & Robbins) the firm seemingly went into high gear, filing numerous new securities class action lawsuits. The Milberg Weiss firm, meanwhile, which also faces its own criminal charges, has essentially filed no new lawsuits since 2005.

While there are many opportunistic lawyers hoping to capitalize on the changes at the leading plaintiffs’ firms, it remains to be seen whether any of these firms can duplicate the role that the erstwhile leading firms have played in the past.

5. Largest Derivative Settlement Ever in UnitedHealth Option Backdating Case: The 2006 D & O story of the year undoubtedly was the options backdating scandal. The story has faded from the headlines in 2007 as the subprime scandal has emerged, but the numerous backdating lawsuits (refer here for a complete tally) are now working their way through the system. Although many of the options backdating lawsuits have been dismissed or have settled for relatively nominal amounts (refer here for a complete list of options backdating case dispositions), there have been some exceptions. The most exceptional outcome is the record settlement in the UnitedHealth Group options backdating derivative lawsuit, which apparently represents the largest derivative settlement ever.

As detailed here, in the settlement, former UnitedHealth CEO William McGuire and several other former UnitedHealth directors and officers agreed to a combination of surrender or relinquishment of stock others and other interests; repayment of certain compensation; and the repricing of other stock option awards, all of which collectively represents a value to the company in excess of $900 million. The value of McGuire’s contribution alone reportedly was valued at more that $600 million.

The sheer magnitude of these values makes this settlement noteworthy. The more interesting question is the extent to which this settlement will affect the resolution of the options backdating cases that remain pending, as well as future shareholders’ derivative lawsuit resolutions.

6. Stoneridge Case Argued: The Tellabs decision was not the only important D & O story out of the Supreme Court this year. On October 9, 2007, the Supreme Court head argument in the Stoneridge v. Scientific Atlanta case. At the time, the case was described as the "business case of the year." How important it will ultimately be remains to be seen, but it could have a very significant impact, as detailed at greater length here.

The case will determine the extent to which a third-party that did not actually make a misrepresentation or misleading statement can be held liable under for securities fraud under Section 10 of the ’34 Act and Rule 10b-5 thereunder. The seemingly likeliest outcome is a narrow holding that does not expand the scope of Section 10(b) liability. The Court’s opinion will be released some time before the end of the current Supreme Court term in June 2008. Until the outcome is known, the possibility (however remote) that the Court might overturn the Eighth Circuit and find an expansive basis for "scheme liability" makes this an important case to watch.

7. Global Warming Disclosure Issues Heat Up: Because global warming is one of the predominant social, political and economic issues of our age, it is almost inevitable that it would be come an important D & O issue as well. As I discuss at length here, the Supreme Court’s April 2007 decision in the Massachusetts v. EPA case provided a new context within which global warming has emerged as a concern for corporate officials. Existing disclosure requirements and activists’ proxy ballot initiatives ensure that this issue will remain as a significant corporate challenge.

Several developments that emerged as the year progressed underscore that global climate change is likely to remain a hot button issue for the foreseeable future, as detailed further here. The first occurred on September 14, 2007, when the New York Attorney General subpoened (refer here) five energy companies demanding that they disclose the financial risks of their greenhouse gas emissions to shareholders. The second is the petition submitted to the SEC by 22 different groups seeking to have the SEC require companies to assess and fully disclose their financial risks from greenhouse gas emissions and global climate change.

The activists’ focus on disclosure issues has serious implications because issues surrounding are at the heart of most D & O claims. Because this issue is likely to grow in importance in coming years, companies may face even greater disclosure pressures and a corresponding increase in liability exposures.

8. Busted Buyouts Beget Litigation: The bursting of the private equity buyout bubble has not only left a raft of busted buyouts in its wake, but has also led to a host of new securities lawsuits. Disappointed target companies that have not become the target of securities class action lawsuits included Radian (about which refer here), Harman Industries (refer here), United Rentals (refer here), and Genesco (refer here). Disappointed target companies that have also lawsuits against their erstwhile acquirers include United Rental’s unsuccessful lawsuits against Cerberus Management Company (refer here) and Genesco’s lawsuit against Finish Line (refer here).

There are a host of other deals that are dead or on life support, as detailed on the M & A Law Prof blog (here). There may be one or more of the companies on this list that may yet find themselves with a securities lawsuit to complement their woes. In any event, the busted deal securities lawsuits collectively represent just one more factor driving the increase in securities lawsuits in 2007.

9. Qwest Opt-Out Settlements Exceed Amount of Class Action Settlement: There have always been opt-outs from securities class action settlements, but during 2007, a number of separate and very substantial opt-out settlements raised potentially important implications for future class action settlements, as well as for D & O insurers’ severity assumptions and policyholders’ views of limits adequacy.

The case with the highest dollar value of publicly reported opt-out settlements is the AOL Time Warner securities litigation, where the nine publicly disclosed opt-out settlements total $795 million, as detailed here. But perhaps even more significant is the Qwest securities litigation, where the $411 million aggregate value of the collective opt-out settlements exceeded the $400 million class action settlements, as further detailed here. When the value of the opt outs settlements tops the value of the class settlement, you know you've got a problem.

The emergence of the opt-out settlements presents a host of potentially complicating problems for current and future securities class action litigants, particularly if significant opt-out settlements become a regular part of securities litigation. These developments could increase litigation expense and aggregate settlement expense in civil securities litigation, and even further complicate efforts to resolve class action lawsuits.

10. Section 11 Settlement Held Not Covered "Loss": Although there had been a prior case holding that a Section 11 settlement is not a covered "loss" under a D & O policy, the prior decision was an intermediate state appellate court decision from Indiana, and was viewed as an anomaly in some quarters. So there was quite a reaction when, on March 14, 2007, Judge Gregory Presnell of the United Stated District Court for the Central District of Florida held (refer here) that the $35 million settlement to which CNL Hotels & Resorts agreed to resolve Section 11 claims does not constitute covered "loss" under a D & O policy and was not insurable as a matter of law.

While at one level, Judge Presnell’s decision was merely an extension of existing case law, it did pose a challenge for the D & O insurance industry to address Section 11 settlement issues in the policy itself. Judge Presnell did specifically note that Section 11 settlements are not "per se" uninsurable. Since the CNL Hotels & Resorts opinion came down, the industry has been scrambling to come up with a policy-based solution, to address policyholder expectations of coverage for Section 11 settlements. The industry is still struggling toward equilibrium on this issue, which remains potentially very important for insured companies and their directors and officers.

Top Top Ten Lists: What could top a top ten list but a list of top top ten lists-- Time Magazine has compled fifty top ten lists for 2007 here.

Updates and Notes

Options Backdating Developments: On December 21, 2007, McAfee announced (here) that it had reached a tentative settlement in the pending federal and state derivative lawsuits related to its options practices. The company said that it "has accrued $13.8 million" that amounts "related to expected payments pursuant to the tentative settlement." The company's press release does not specify to what specific costs this accrual would be applied.

In a separate development, on December 5, 2007, the United States District Court for the Western District of Washington, applying Delaware law, denied the defendants’ motion to dismiss the plaintiffs’ complaint in the derivative lawsuit shareholders have filed against the Getty Images, as nominal defendant, and certain of its directors and officers. A copy of the court’s opinion can be found here. The court found that the plaintiffs’ allegations were sufficient, at least at the pleading stage, to excuse the demand requirement. The Race to the Bottom blog has a detailed discussion of the decision, here.

I have added these case developments in the McAfee and Getty Images cases to my table of options backdating settlements, dismissals and denials. The table can be accessed here.

Cerberus Wins Right to Walk Out on United Rentals: In an earlier post (here) in which I surveyed litigation arising from busted buyouts, I discussed the lawsuit that United Rentals had filed against Cerberus Capital Management, in which United Rentals sought to compel Cerberus to complete the acquisition of United Rentals, from which Cerberus was trying to walk away. The busted United Rentals transaction was somewhat different than other failed deals, in that Cerberus was not claiming that changed circumstances allowed it to renege on the deal; rather Cerberus claimed that the deal documents themselves allowed Cerberus to terminate the contract upon tender of a $100 million termination fee.

In a December 21, 2007 ruling (here), Delaware Chancellor William B. Chandler III, after a two-day trial, issued a 68-page ruling in favor of Cerberus, ruling that Cerberus could abandon the purchase by paying the $100 million breakup fee.

The outcome of the United Rentals lawsuit, while noteworthy, may have only slight influence on the other lawsuits arising from busted deals, because, unlike the erstwhile suitors in those other cases, Cerberus was not relying on the supposed occurrence of "material adverse effect" from a changed circumstance. Rather, the outcome turned on a specific provision of the United Rental agreement that Chancellor Chandler held to reflect an understanding that Cerberus could call of the deal simply by paying the fee.

The M & A Law Prof Blog has a short, interesting post on the decision here. Professor Larry Ribstein also has an interesting discussion of the decision on his Ideoblog, here. The WSJ.com Law Blog comments here on Chancellor Chandler’s language of and use of classical allusions in the decision.

More About Option ARMs: On November 5, 2007, I wrote here about Option ARM mortgages and asked the question whether they represent the next litigation front in the subprime meltdown, referring specifically to the securities lawsuit shareholders had filed against Washington Mutual. The Wall Street Journal asked many of the same questions in a December 22, 2007 article entitled "Option ARM: Next Weakling" (here), noting that Options ARMs "could be the next wave of trouble for the mortgage industry." The article cires a Merrill Lynch report stating that Option ARMs are "ticking time bombs" that will start "ticking louder next year."

Option ARMs give borrowers a choice about how much to pay each month. If borrowers choose to pay only the minimum, the principal amount of their loans can rise – a result known as "negative amortization." Negative amortization would be an unwelcome development at any time, but it is a particular problem when home prices are falling, as they are now. Many option ARMs carried initial teaser rates that are scheduled to reset in the months ahead. According to sources cited in the Journal article, nearly $156 billion in Options ARMs are scheduled to reset between 2008 and the first quarter of 2012. Perhaps worst of all, most Option ARMs carry stiff prepayment penalties, making the loans into a financing form of an existentialist play.
According to the Journal article, both the Colorado and the Illinois attorneys general have subpoenaed mortgage companies as part of larger investigations into Option ARM sales practices.

The option ARMs are not subprime loans; many of the borrowers on these had good credit. But the prospect of potentially significant interest rate increases could raise, perhaps significantly, the level of the payments required to avoid negative amortization. The prospects for further defaults and foreclosures seems high. Merrill Lynch estimates that losses on Option ARMs could top $100 billion. Those losses would be on top of the estimated losses from subprime mortgages of as much as $400 billion.

NERA Releases 2007 Year-End Securities Lawsuit Report

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On December 21, 2007, NERA Economic Consulting released (here) its 2007 Year-End Update analyzing recent trends in shareholder class actions. The NERA reports notes, as I have discussed in prior reports (most recently here), that securities lawsuit filing activity levels returned to historical levels in the second half of 2007. In addition, the NERA report also notes that in 2007 both average and median class action settlements were at all-time highs.

The NERA report’s key findings are as follows:

1. "Despite some well-publicized speculation that filings had moved to a permanently lower level," securities lawsuit filings "increased in 2007 after a marked decline that began in the second half of 205 and continued through 2006."


2. The report states that there were 198 securities lawsuits filed through December 15, 2007, and extrapolates a total of 207 lawsuits through year end, which the report notes would be slightly above the 2005 level but still below the 1998-2004 average annual filing level of 234.


3. The growth in filings was "driven at least in part by litigation related to subprime lending." The NERA report states that there were 38 subprime related securities filings during 2007.


4. The average settlement in 207 was $33.2 million, a jump from $22.7 million in 2006, and well above the 2002-2007 average of $24.4 million. (The averages do not include the nine settlements over $1 billion).


5. In 2007, the annual median settlement also reached an all-time high of $9.6 million, up from $7 million in 2006 and well above the 2002-2007 median of $6.8 million.


6. The most important factor affecting settlements amount is "investor losses"; the median investor loss for cases settled in 2007 was $310 million. The median investor loss in cases filed in 2007 is $355 million, which the Report states is "a signal that the settlements associated with these new filings might remain high."

The NERA report’s conclusions about filing levels are directionally consistent with my prior observations on this blog. I do think it is important to note, as I have detailed elsewhere, that while the subprime-related lawsuits are collectively a significant factor in the increase of filings in the second half of 2007, they are only one among many important factors. More to the point, securities filing activity in the second half of 2007 would still be up significantly over the preceding two years even if there were no subprime cases.

In addition, the NERA report’s lawsuit count is quite a bit higher than my own. My count, which consists of data taken from publicly available sources supplemented by tips I get from readers, show only 171 securities class action lawsuits through December 20, 2007. NERA counts 198 through December 15, 2007 and extrapolates 207 through year-end. I doubt that after today we are going to see too many new lawsuits by year end, so the extrapolated number might be high. It is hard to assess NERA’s count of 198 lawsuits though mid-December, without knowing what cases account for the difference between their tally and mine. I am willing to assume that they just have better data than I do, but I sure would be interesting in knowing what cases I supposedly missed.

Finally, I note that NERA’s count of 38 subprime-related class actions differs from my own count of 34 (refer here for my tally). Part of this difference might be definitional, as it is has become more difficult to sharply describe what is and is not subprime-related. If generalized credit issues cause a company’s problems, is the ensuing lawsuit subprime-related or not? I will say this, I have openly listed the lawsuits I have included on my count here. If NERA or anybody else wants to tell me which cases I have omitted, I will add them to my list with alacrity.

In any event, the NERA report closes with a couple of important points with which I completely agree. First, the report notes that "as the crisis in the credit markets continues to deepen and the market for subprime mortgages continues to suffer accordingly, more litigation is likely to follow." The second is that given the investor losses on the 2007 lawsuits, "the settlements associated with these new filings might remain high."

So here's what the weather gauge says: clouds gathering, storms ahead.

CFO.com has a December 21, 2007 article on the NERA report, here. (Full disclosure, I was intereviewed in connection with the CFO.com article.)

Subprime: The Truth-Telling (and the Lawsuits) Yet to Come

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The various central banks' efforts to improve short-term liquidity in the global financial system have dominated the headlines the business pages in recent days, most recently with respect to the news that the European Central Bank has injected an astonishing $501.7 billion of lending capacity into the banking system, an amount that the Wall Street Journal called "the largest sum the central bank has ever lent in a single shot."

These measures reportedly are calculated to overcome banks’ reluctance to provide each other with short-term loans. What has received less attention is why the banks are reluctant to lend to each other. Closer scrutiny suggests that the banks are wary because they know that many other banks have not yet come clean about the existence of undisclosed losses relating to subprime mortgage problems in the U.S. As one commentator stated in a December 19, 2007 Wall Street Journal article (here),

"Given the degree of uncertainty [and] continuing concerns about where the next losses are and what the next shoe to drop will be, that certainly drives the cautious behavior….It’s a question of grater clarity." That might not come until next spring, when auditors comb through banks’ financial statements in advance of their annual reports. That process "could prove better disclosure and greater clarity to the market. But it might not."

The view that the root cause of the banks’ unwillingness to provide each other short-term credit is based on a perception of undisclosed losses was echoed by the Bank of England governor Mervyn King. In a December 19, 2007 Wall Street Journal article entitled "Bank Losses Still Unclear" (here), King is quoted as saying "We need patience now to get through the period where banks have to disclose the losses they’ve made."

There are several thoughts implicit in these comments. The first is that the banks do in fact have extensive as-yet undisclosed losses. (The banks’ refusal to lend to each other eloquently testifies to the existence of this generalized perception within the banking industry.) The second is that there are banks that will not be disclosing these losses until the banks are compelled to do so by a combination of their reporting obligations and their auditors’ insistence. The overall implication is that these companies have a appointment with truth-telling, scheduled according to their next reporting obligation, presumably to take place sometime in early 2008.

All of this suggests that we should expect a series of bank announcements of losses or significant asset write-downs during the first weeks, perhaps months, of 2008. But the mortgage-backed assets at the center of these losses and write-downs are not held only at banking institutions. Hedge funds, pension funds, insurance companies, mutual funds, REITs and other companies carry these assets as well, and as I have pointed out before (most recently here), this exposure is not limited solely to companies in the financial services sector. There may be a wide variety of companies that have an appointment with truth-telling early in 2008.

Reporting obligations may compel eventual disclosure, but the longer the day of reckoning is delayed, the greater may be the ire of disappointed investors. As I have detailed in my running tally of the subprime-related lawsuits (here), many of the subprime related securities lawsuits have followed dramatic announcements of losses or asset-write downs. With more announcements ahead, further lawsuits seem probable. My depressing assessment is that the worst is yet to come, a conclusion reinforced by the analysis in the following section, below.

Along those lines, it is worth noting that, in connection with the latest big bank write-down announcement – Morgan Stanley’s $9.4 million fourth quarter write-down – that Morgan Stanley employees have already filed a purported class action lawsuit (refer here) on behalf of Morgan Stanley employees in connection with their holdings of company stock in their 401(k) plans.

Why The Losses Will Take Time to Tally: While it is easy to bemoan the truth-telling delay, the reality is that it is going to take time for many of the losses to work their way through the system. These problems are fully illustrated in the December 17, 2007 Wall Street Journal article entitled "CDO Battles: Royal Pain Over Who Gets What" (here), which details the dispute that has arisen as a result of an "event of default" on a single $985 million collateralized debt obligation (CDO) called Sagittarius CDO I Ltd.

Deutsche Bank, the Sagittarius CDO trustee, has filed an interpleader action (view complaint here) to determine whether the CDO’s investors (led in this case by UBS) or the CDO’s credit insurer (a unit of MBIA that entered into a credit default swap) have the right to the remaining payments under the CDO. As the interpleader complaint states, "different Defendants now claim different rights in how the limited fund of Interest Proceeds and Principal Proceeds should be applied." The interpleader complaint names as defendants "Does 1 though 100, the owners of the beneficial interests" – that is the investors who bought the interests in the CDOs. The MBIA unit claims it has senior rights as a result of provisions in the credit default swap agreement, a position that unnamed investors have, according to the complaint, characterized as "neither reasonable nor correct." The interpleader action seeks to sort out the competing interests.

There are several interesting things about this dispute. The first is that it shows that as the mortgage-backed investments deteriorate, there are going to be disputes over who gets stuck with the losses or at least who gets which proportion of the losses. The second is that the Sagittarius "event of default" is not an isolated occurrence; according to the Journal article, "about 40 consumer-debt backed CDOs have declared an event of default; their face value is near $45 billion – about 7% of the $640 billion in the CDOs outstanding rated by Moody’s." Indeed, three CDOs have started liquidation, and JP Morgan projects that by the second quarter, "$40 billion to $50 billion in subprime-mortgage bonds could be sold by distressed CDOs that decide to liquidate."

The final thing to note about this dispute is who is identified as facing the losses. According to the Journal article, the UBS investors in the Sagittarius CDO are two UBS mutual funds – the UBS Absolute Return Bond Fund and the UBS Global Bond Fund – which bought $1.2 million of the CDO this year. As I noted above, the deteriorating market for asset-backed securities could impact a wide variety of investors, funds and companies. It may take a while for the losses to sort themselves out, but eventually the losses will hit home.

The investors who get hit with these losses are unlikely to take these losses quietly. In addition, many CDO investors (such as hedge funds, pension funds, and mutual funds) in turn have investors of their own that will upset about the fund losses. I have previously noted (here) that there has already been one securities class action lawsuit brought involving subprime-related losses in a mutual bond fund.

The lawsuits against these investment funds may well come from a variety of directions, as illustrated by the action that Barclays filed on December 19, 2007 against the Bear Stearns companies in connection with the subprime-related collapse of two Bear Stearns hedge funds. Barclays was not an investor in the collapsed funds, at least not in the conventional sense; it was rather in the position of lender, supplying borrowed capital, Barclays claims, based on misrepresentation, as part of a complex hedged counterparty relationship. The complaint alleges that Bear Stearns misled Barclays about the nature of the funds' investments as well as about the condition of the funds as they deteriorated. A December 19, 2007 Wall Street Journal article describing the Barclays suit can be found here. A copy of the Barclays complaint can be found here.

Lawsuits are also likely to follow against the entities that sold the CDO investments in the first place. For example, the Financial Times reports in a December 17, 2007 article entitled "Lehman Faces Australian Lawsuit Threat Over High-Risk Debt Deals" (here), Lehman Brothers faces the threat of legal action by three Australian municipal councils over the sale of CDOs by Lehman’s local subsidiary. The CDOs in which the municipal councils invested are in some cases now marked down to as low as 16 cents on the dollar.

All of which, I think, underscores the point that the losses and lawsuits yet to come will be widespread. The title of this December 19, 2007 Financial Week article (here) says it all: "Lawsuits Linked to Subprime Damage Expected Next Year." As the article notes, "the other litigation shoe to drop in the CDO implosion will involve legal claims against banks and hedge funds by institutional investors, including other hedge funds and pension funds."

Hat tip to the WSJ.com Law Blog (here) for the link to the Deutsche Bank interpleader complaint.

Subprime Litigation Wave Hits Huntington Bancshares: According to a December 19, 2007 press release (here), shareholders have initiated a subprime-related securities class action lawsuit against Huntington Bancshares Incorporated in the United States District Court for the Southern District of Ohio. A copy of the complaint can be found here.

According to the press release, the complaint alleges that

Huntington had acquired more than $1.5 billion in exposure to subprime mortgages with its July 2007 acquisition of Sky Financial Group, Inc. ("Sky Financial"). As the real estate and credit markets continued to soften, defendants repeatedly assured Huntington investors that the Company had undertaken significant preparations and implemented defensive measures to weather the deteriorating real estate and credit markets. By the time Huntington closed the merger with Sky Financial, the housing and credit crisis had deepened, yet defendants continued to conceal Huntington’s growing exposure to these problems so as to not acknowledge the acquisition was a debacle so soon after it closed. As a result of defendants’ false statements, Huntington stock traded at an artificially inflated price of approximately $18 per share during much of the Class Period.

Then, on November 16, 2007, Huntington announced its fourth quarter 2007 financial results, stating that as a result of the recently announced actions of Franklin Credit Management Corporation, which had a commercial lending relationship with Sky Financial, and related deterioration in Franklin’s mortgage portfolios, 2007 fourth quarter results for Huntington were expected to include an after-tax charge of up to $300 million, or $0.81 per common share. As a result of this charge, Huntington would report a 2007 fourth quarter net loss.

On this news, Huntington’s stock dropped from $16.08 per share to as low as $14.38 per share, closing at $14.75 per share on November 16, 2007 on volume of over 10 million shares.

I have added the Huntington Bancshares lawsuit to my running tally of subprime-related securities lawsuits, which can be found here. The addition of the Huntington case brings the number of subprime-related lawsuits to 27, not counting the five subprime related securities lawsuits that have been brought against home builders, and the two that have been brought against the credit rating agencies. Adding these categories together brings the total number of subprime-related securities lawsuits to 34. The addition of the list of Morgan Stanley 401(k) lawsuit cited above brings the total number of subprime-related ERISA/401(k) lawsuits to 6.

Another Securities Class Settlement Complication: Government Intervention

In recent posts (most recently here), I have discussed the potential difficulties that opt-out actions may present for securities class settlements. As if that were not complication enough, now the government wants to get into the act. As discussed below, the Department of Justice has appeared to object to the pending settlement of the consolidated class action securities lawsuit and derivative litigation involving DHB Industries (known since October 2. 2007 as Point Blank Solutions). The government’s appearance in the case raise some interesting questions.

The securities lawsuit and the shareholder derivative litigation first arose in September 2005, when shareholders sued the company and certain of its directors and officers. Refer here for background regarding the litigation. The shareholders’ amended complaint alleged that the individual defendants inflated the company’s share value then sold substantially all their shares, shortly prior to the company’s announcement of law enforcement officials’ concerns regarding the protective value of the company’s bullet proof vests and of certain issues regarding the company’s financials. The company ultimately withdrew reliance on its financial statements for 2003, 2004 and the first nine months of 2005.

On July 13, 2006, the company announced (here) a joint settlement of the securities lawsuit and the derivative litigation. According to the company’s announcement, the settlement consisted of the company’s agreement to pay $34.9 million in cash, plus 3,184,713 shares of company stock. The derivative case was settled in consideration of the company’s agreement to adopt corporate governance reforms and pay $300,000 of the derivative plaintiffs’ counsel’s fees. $12.9 million of the cash payment is to be paid by the company’s insurers. In addition, the company’s founder, Chairman and CEO, David Brooks, agreed to resign from all positions he held.

The company itself lacked cash to fund the portion of the cash settlement in excess of the insurance. To fund the settlement, the company entered into a transaction with Brooks whereby he would received nonregistered company shares in exchange for cash the company could use to fund the settlement. In return for his agreement to provide financing sufficient to fund the settlement, Brooks required that the company release him from any claims the company might have arising from his conduct as an officer of the company.

The court has held a series of hearings to consider final approval of the settlement, but the settlement has not yet been finally approved.

In a separate but related development, on October 25, 2007, the U.S. Attorney’s Office for the Eastern District of New York filed a superseding criminal indictment (here) charging Brooks and the company’s former Chief Operating Officer with insider trading, fraud, obstruction of justice, and tax evasion. As described here, the indictment alleges that the two officials inflated the company’s stock price by manipulating its financial records to increase earnings, including fraudulent accounts of armor inventory. The two were also charged with cutting themselves company checks for personal gain. Among the personal expenses Brooks is alleged to have charged to the company are $16,000 for a photographer for his son’s Bar Mitzvah and $101,190 for a "belt buckle studded with diamonds, rubies and sapphires." A scathing commentary on the indictment and the company’s allegedly unsatisfactory role in the provision of body armor to U.S. troops in Iraq can be found here. His daughter's Bat Mizvah, which allegedly cost $10 million, has also drawn, well, interesting commentary on the Internet.

At the same time as prosecutors commenced the criminal action, the SEC also initiated a civil enforcement action against Brooks (refer here). Among other things, the SEC complaint alleges that Brooks sold $186 million of his personal holdings of DHB stock while in the possession of material nonpublic information. Among other things, the SEC complaint seeks reimbursement by Brooks to DHB of bonuses and profits from stock sales pursuant to Section 304 (the so-called "clawback" provision) of the Sarbanes-Oxley Act.

These developments in the criminal proceeding and the SEC enforcement action became relevant to the securities lawsuit and the derivative lawsuit on November 19, 2007, when the Department of Justice filed its objections to the pending shareholder litigation settlement (here).
The government’s objections to the pending settlement are two-fold: first that the criminal defendants might try to use their release in the proposed settlement "to avoid their obligation, if convicted, to make full restitution." Second, the government also objects on the ground that the proposed settlement release document purports to release the defendants from Section 304 liability, and to indemnify them for any third party Section 304 claim or settlement.

With respect to the release potentially absolving the defendants of their potential restitution obligation, the government asks for the "addition of a specific provision to the proposed settlement agreement providing that ‘nothing contained in this settlement is intended to limit the United States’ ability to pursue forfeiture, restitution or fines in any criminal, civil or administrative proceeding.’"

With respect to the government’s objections relating to Section 304, the government notes that to allow the defendants to be released and indemnified by the company "would undermine the very purpose behind Congress’ enactment of section 304." The government "asks the Court not to approve the settlement unless this provision is removed."

But the government did not stop there. Having had its say about the parts of the settlement that affect the interests of the United States, the government then went on to express its views about other aspects the settlement. As the government put it, "there are several other aspects of the proposed settlement that may warrant specific attention." In explaining its provision of these additional comments, the government added that it "takes no position" on "whether these aspects of the proposed settlement should preclude a finding that the proposed settlement is fair, adequate and reasonable."

The government’s extra two cents worth consists of the observation first that "the majority of the Defendants in these actions are [sic] not paying any consideration towards the settlement, but are nonetheless receiving broad releases." The second is that, because the company’s share price has risen since the settlement was first proposed, the value of the shares Brooks purchased to fund the settlement have appreciated, as a result of which Brooks could "earn a profit of approximately $10 million on those shares, thus reducing his out-of-pocket contribution to the settlement." Accordingly, the government notes "the Court may therefore want to assess whether Brooks’ contribution to the settlement is appropriate."

The government is of course not a party to the private securities lawsuit. The bases on which the government made its appearance are under the Class Action Fairness Act of 2005 (pursuant to which the Attorney General must be given notice of class settlement) and 28 U.S.C. Section 517 (which gives the Attorney General the right to send an officer "to attend to the interests of the United States in a suit pending in a court of the United States.")

While the U.S. government uses its Section 517 authority to appear in a wide variety of cases (refer, for example, here and here), I am not familiar with the government using this authority to intervene in a private securities class action to object to its settlement --I welcome others' comments if this is more common than I am aware. In any event, it may be that the government resorted to this approach due to the fact that the case settlement preceded the indictment, as a result of which the government was unable to arrange the kind of collaborative settlement, for example, recently announced in connection with the UnitedHealth Group options backdating derivative settlement and SEC settlement.

But the troublesome thing about the government’s objection in the DHB Industries case is that having made its appearance, the government took the liberty of providing its own commentary on the merits of other aspects of the settlement. Section 517 may give the government authority to "attend to the interests of the United States" in pending lawsuits, but even under Section 517, the government's role is limited to "attending" to the interests of the United States.

Whatever else anybody might want to say about these circumstances, the parties to the lawsuit have the right to negotiate their interests, without concerns of the government providing potentially obtrusive supervision. The class members are fully and appropriately represented under class action procedures, subject to the court's review. Individual class members retain all of their rights to object to the proposed settlement and in fact some members of the class in fact have done so. What right does the government have to criticize elements of the settlement beyond the government’s interests?

The government’s actions undoubtedly are a reflection of the unique circumstances surrounding the case. But the prospect of the government acting as a kibitzer on class settlements is a concern. The terrain surrounding private securities class action litigation is already challenging enough without the government getting into the act.

Special thanks to Bill Baker of Latham & Watkins for sending along a copy of the government’s objections.

Securities Litigation Filing Trends: In recent posts (most recently here), I have noted that during the second-half of 2007, securities lawsuit filing levels have returned to historical norms after a tw0-year lull. In the most recent issue of InSights, entitled "The Two-Year Lull is Over: Securities Lawsuit Filings Rise" (here), I detail the recent increase in securities lawsuits filing activity and comment on the potential significance of these changes for the D&O insurance marketplace.

Blog Watch: The D & O Diary has recently been reading with interest the postings on the new blog PomTalk (here), a blog on corporate and securities law issues of interest to institutional investors produced by the Pomerantz Haudek Block Grossman & Gross law firm. The blog looks like a worthy addition to the blogosphere, and we look forward to reading future PomTalk posts.
Oil in Hell: Those struggling to understand how so many of the big investment banks have gotten burned so badly on their own holdings in subprime mortgage-backed securities may gain some insight from this excerpt, taken from the Chairman's Letter in the 1985 Berkshire-Hathaway Annual Report:

You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not .... Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence," said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

Subprime Litigation Wave Hits UBS – and Other Web Notes

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In a prior post (here), I compared the similarity of the piecemeal way that UBS, Merrill Lynch and Citibank have disclosed their subprime-related asset valuation write-downs. Now UBS has one more thing in common with the other two banks – it has been named as a defendant in a securities class action lawsuit.

According to the plaintiff’s counsel’s December 13, 2007 press release (here), the plaintiffs initiated a securities lawsuits in the Southern District of New York against UBS AG and certain of its directors and officers. A copy of the complaint can be found here. According to the press release, the complaint alleges that

On October 30, 2007, UBS issued a press release announcing its financial results for the third quarter of 2007. In the days following this announcement, the price of UBS stock declined to as low as $49.27 per share. Then, on December 10, 2007, UBS announced writedowns of around $10 billion as a result of its subprime mortgage related positions. Following this announcement, the price of UBS stock declined to $48.78 per share, a 26% decline from the Class Period high. The action purports to be brought on behalf of all shareholders who purchased UBS stock between March 13, 2007 and December 11, 2007.

The complaint quotes at length from an October 12, 2007 Wall Street Journal article entitled "U.S. Investors Face An Age of Murky Pricing" (here) which discusses at length how in March 2007, a hedge-fund unit of UBS (Dillon Read) was slashing its valuations on subprime-related assets at a time when UBS was carrying similar assets at much higher valuations. The article describes tense communications between UBS bankers and the Dillon Read trader, in which they questioned where he was coming up with his valuations, and he questioned the bankers’ valuations at higher levels that he felt were unavailable in the marketplace. UBS closed the hedge fund this summer, but it also did later write down its assets to lower valuations, and more recently to much lower valuations. (I commend this article if you have not yet read it; I re-read it for purposes of writing this blog post and even though it is only two months old it already provides some interesting and useful perspective.)

In addition to the securities class action, according to a separate December 13, 2007 press release (here), separate plaintiffs’ counsel have filed a separate lawsuit in the Southern District of New York, raising similar allegations, on behalf of UBS employees who suffered losses as purchasers of their employers stock in their 401(k) plans.

As I discussed at greater length in my prior post (here), the pattern of piecemeal disclosure of subprime-related losses is one factor contributing to the subprime litigation wave. Unfortunately, the difficulties that many companies are having in valuing assets in a deteriorating environment contributes to this disclosure pattern, and potentially to further subprime-related litigation.

I have added the new UBS lawsuits to my running tally of subprime related litigation (here). With the addition of the UBS action, the current tally of subprime related securities class action lawsuits now stands at 26, not counting the four subprime-related securities lawsuits that have been filed against residential home construction companies and the two subprime-related securities lawsuits that have been filed against the rating agencies. These categories taken together add up to 32 subprime-related securities lawsuits. In addition, the UBS 401(k) lawsuit brings the total of subprime-related ERISA/401(k) lawsuits to five.

Options Backdating-Related Securities Settlement: On December 13, 2007, American Tower announced (here) that it has reached a settlement in principle of the consolidated options backdating-related securities class action lawsuits that had been filed against the company and certain of its directors and officers. Refer here for background regarding the lawsuit. In connection with the settlement, the company will make a $14 million cash payment. The company stated that "it has been and will continue to be in discussions with its insurers concerning the amount of their contribution to the settlement."

I have added the American Tower settlement to my cumulative table of options backdating-related lawsuit settlements, dismissals, and denials. The table can be accessed here.

Another Target for Subprime Ire: The list of purported scapegoats for the subprime crisis is already lengthy, but a December 13, 2007 Washington Post article entitled "Analysts Late to the Alarm" (here) adds yet another new category of targets to blame. The article notes that securities analysts "did not sound the alarm on the subprime mess," but asks whether "analysis [should] have seen the meltdown coming?"

The article observes that while there have been much "finger-pointing" at the analysts, there has as yet been "no conclusion." Among other things, the complexity of the financial instruments involved and the multifaceted nature of the credit issues eluded all but a few analysts. Other contributing factors for the analysis included "the pressure to always be right, the difficulty of going against the tide, and the need to hang onto clients." The article also examines, without expressing views, whether conflicts of interests could have played a role.

Why the JDS Uniphase Securities Suit Went to Trial: Law.com has a December 13, 2007 article entitled "In-House Lawyers Go for All or Nothing in Securities Case" (here), which gives an inside look at why the JDS Uniphase case went to trial (for background about the trial refer here). The article examines the process that led up to the decision to take the case to trial and the barriers that prevented settlement. The article also gives a look at the pressure the company’s in-house counsel faced as a result of the decision to take the case to trial.

The lawyers involved in this case clearly deserve credit for courage and perseverance. But after reading the account of what they went through, it is hard to imagine may others being willing to make the same decision and to face that kind of pressure. The JDS Uniphase verdict theoretically might embolden others to push a case to trial, but the reality is that very few would be willing to undertake the risk and the pressure.

Subprime Disclosures and Accounting

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Among the more disconcerting aspects of the unfolding subprime crisis has been the unseemly spectacle of major financial institutions taking dramatically increased asset value write-downs shortly after having disclosed smaller write-downs on the same assets. UBS became the latest company to follow this pattern earlier this week when it announced (refer here) an increased $10 billion asset write-down, only three weeks after taking a $4.4 billion write-down in connection with the same assets. UBS’s increased write down following the more or less same sequence of events as were involved with write-down disclosures at Merrill Lynch (about which refer here) and Citigroup (about which refer here).

In its December 10, 2007 press release explaining its most recent write-downs (here), UBS said it was making its move “in response to continued deterioration in the U.S. subprime securities market,” as a result of which, the company “revised assumptions and inputs used to value U.S. subprime mortgage related positions.”

Perhaps due to the deterioration in the market for U.S. mortgage-backed securities, but also likely in response to the undesirability of the pattern of piecemeal asset valuation disclosures, SEC Chairman Christopher Cox reportedly said on December 10, 2007 (refer here) that the SEC will be sending letters to approximately two dozen financial service firms, including banks and insurance firms, urging them to disclose “more information about their exposure to potentially problematic loans in light of the massive number of gargantuan write-offs caused by the subprime lending crisis.”

Underlying these developments is the fundamental difficulty companies are facing in valuing many of these mortgage-backed assets. The asset valuation difficulty is apparently of particular concern to the Public Company Accounting Oversight Board (PCAOB), which on December 10, 2007 released an Audit Practice Alert entitled “Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists” (here). The Alert is written in light of the circumstances that may “make it difficult to obtain relevant market information to estimate the fair value of many mortgage-backed securities,” which is likely to “increase audit risk.”

The Alert’s purpose is to draw auditors’ attention to certain areas of the new fair value accounting standards under SFAS No. 157, which is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. In other words, these new standards are about to start applying to many companies for the first time in the reporting period that is currently underway. The PCAOB is clearly worried that there may be problems as the new fair value standards are applied to many mortgage-backed securities.

According to a December 11, 2007 CFO.com article (here), the PCAOB issued the Alert “over concerns that the subprime mortgage crisis will increase the volume of fair value recalculations companies will be forced to make after accounting for losses from the subprime collapse.” At the heart of the Alert is a discussion of the hierarchy of inputs to be used in determining whether a company’s financial statement disclosures are complete, accurate and in compliance with GAAP.
Under SFAS No. 157, as the reliability of the inputs decreases, the company’s disclosure obligations increase. (UBS’s recent increased write-down is in effect a practical example of these principles in action, as the company said that its increased write-down was the result of the results derived from changing the inputs used in its asset valuation.) The Alert observes that this hierarchy creates some obvious, potentially unhealthy incentives: “Because there are different consequences associated with each of the three levels of hierarchy, the auditor should be alert for circumstances in which the company may have an incentive to inappropriately classify fair value measurements within the hierarchy.”

The PCAOB’s encouragement for auditor attentiveness to these issues clearly reflects a concern that in order to avoid certain adverse disclosures, some companies may not come clean. The PCAOB’s alert is obviously intended to ensure that auditors are fully engaged in their critical audit function in assessing the valuations companies assign to mortgage-backed assets. While time will tell how these changing standards and audit processes will play out, the Alert implicitly assumes that auditors may be forced to challenge their clients’ valuation assumptions, which in turn could lead to additional financial statement disclosures (and, potentially, asset valuation write-downs).

These accounting issues not only directly affect financial statement disclosure issues, but they may also be at the heart of future subprime related litigation. Many of the subprime-related lawsuits that have already arisen are built around accounting-related allegations, including, for example, the adequacy of loan loss reserves; the failure to properly account for the allowance for loan repurchase losses; and the failure to properly account for the residual interests in securitizations. But more to the point for purposes of this blog post, many of the subprime-related lawsuits have contained allegations related to the failure to timely write down impaired assets. An excellent, detailed discussion of the accounting issues that have arisen in subprime-related litigation can be found in NERA Economic Consulting’s December 6, 2007 publication “The Subprime Meltdown: Understanding Accounting-Related Allegations” (here).

The piecemeal process by which many companies have disclosed their valuation write-downs on mortgage-backed assets has already engendered litigation. The PCAOB’s alert suggests that it is concerned that in connection with their implementation of SFAS No. 157, auditors may also be called upon to reassess asset valuations, a process that could lead to further disclosure and even write-offs. These circumstances certainly present the possibility for even further subprime-related litigation following adjusted asset valuation disclosures.

One final note is probably worth emphasizing. As I have previously discussed at greater length (here), these asset valuation problems are not restricted to the financial sector. The mortgage-backed assets at the center of these valuations are broadly dispersed in the economy and can found on the balance sheets of a wide variety of entities. The potential exists for the asset valuation issues discussed above to affect some unexpected companies, which, in turn, could further spread the growing subprime litigation wave.

The December 12, 2007 Wall Street Journal has an article entitled "A Subprime Gauge, in Many Ways?" (here), discussing problems that many companies (including, for example, UBS) are having with one of the inputs that might be used in subprime-mortgage backed asset valuations, the ABX index, which tracks the value of securities backed by subprime home loans. The article underscores the difficulties that companies are having in determining the approriate asset valuation inputs.

Mortgage Professionals’ Litigation Exposure: As this blog has noted before (most recently here), the subprime-related litigation wave is likely to hit a wide variety of professionals. Among the professionals that have already become involved in subprime-related litigation have been those in the real estate industry (as discussed here). According to a December 2007 report (here) prepared by reinsurance broker Guy Carpenter, real estate professionals’ susceptibility to litigation may vary by state, depending on a set of possible variables.

According to the report, real estate professionals “may have more cause to worry depending on the states in which they practice,” according to the “convergence of a variety of legal and business conditions” that “create an overall climate of risk.” The report ranks the various states based on an index of factors (such as the percentage of mortgages in foreclosure, the number of litigation attorneys, and the frequency of Truth in Lending lawsuits). States ranked as having a high risk of mortgage professional litigation according to this index includes Alabama, Connecticut, Georgia, and Illinois. The lowest ranking states include Wyoming, Vermont, South Dakota and Oregon.

Chinese IPOs: Discuss

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Chinese companies’ listing debuts are a vital force in the current global IPO marketplace. According to a December 8, 2007 Wall Street Journal chart (here), 195 Chinese companies listed their shares through November, raising $87.3 billion – representing a 26.7% share of the 2007 global IPO volume. By contrast, the IPOs of 174 U.S. domiciled companies raised $38.5 billion, which represents an 11.8% share. In addition, according to a December 3, 2007 Wall Street Journal article entitled "Chinese Firms Will Test Market Appetite for IPOs" (here), "December could see the launch of three issues that, in total, might eventually raise more than $12 billion." By years’ end, the amount raised in 2007 by Chinese company IPOs could well exceed $100 billion.

Stock exchanges around the world are jockeying for a piece of this action. A December 3, 2007 Financial Times article entitled "Markets Jostle to be China’s IPO Buddy" (here) notes that "Singapore and Hong Kong are falling all over themselves to be the destination of choice for capital hungry mainland companies, while smaller Chinese companies are still attracted to the perceived lighter-touch regulation of London’s Alternative Investment Market." By the same token, the three anticipated December offerings mentioned above are all scheduled to take place in Hong Kong or Shanghai – not in New York.

In order to try to increase its share of this business, on December 3, Nasdaq opened a Beijing office. The Financial Times article, commenting on the office opening, snipes that the U.S. exchanges "face steep challenges, including the time zone and worries about the country’s litigious environment." (More about what the litigious environment has meant for Chinese companies below.) But the biggest challenge for the U.S. exchanges is that "Asia is so awash with liquidity that issuers rarely need to look beyond Hong Kong."

For all that, in 2007, Nasdaq still managed to increase the number of its Chinese listings. According to a December 3, 2007 Wall Street Journal article about the Nasdaq Beijing office opening (here), as of the end of November Nasdaq had 52 listed mainland Chinese companies, with a combined market capitalization of $57 billion, up from 33 Chinese firms with a total capitalization of $25 billion at the end of 2006. The 19 listings by Chinese companies this year are "more than double last year’s total of nine."

Give the ample liquidity available in Asian financial markets, it is worth asking why Chinese companies would nevertheless be willing to confront U.S regulatory requirements, litigiousness, and time zone differences to list their shares in New York. According to a May 10, 2007 Financial Times article entitled "New York Proves an Attractive Destination" (here), the large privatized Chinese enterprises are attracted to Hong Kong, but maturing small venture-capital backed companies are attracted to New York because "they can still get better valuations and wider analyst coverage in [the high tech and life sciences] sectors than in the resurgent Chinese domestic markets or in the other parts of the world.’ One source is quoted in the article as saying that a New York listing helps the companies to establish their brand internationally, for which "nothing matches a U.S. listing."

But before we break out the champagne to celebrate Nasdaq’s success in attracting more Chinese companies’ offerings in 2007, it is worth taking a look at what the increased number of Chinese listings has actually wrought. Even a quick look suggests that just because a Chinese company is eager to list its shares does not necessarily mean that the company is ready for the scrutiny that comes with a U.S. listing. Indeed, a more detailed analysis confirms that some of the Chinese companies that have listed their shares on U.S. exchanges may not have been ready for the burdens and responsibilities, to their investors’ disappointment.

The most telling fact is that of the roughly 165 companies that have been sued in securities class action lawsuits in 2007, seven are Chinese companies. Even more significantly, of those seven companies, five completed their IPOs less than 12 months prior to the initial lawsuit filing – including one, Giant Interactive, that debuted on November 1, 2007 and was first sued on November 26. A sixth company, Focus Media Holdings, which was first sued on November 27, 2007, had just completed a secondary offering on November 7, 2007.

A review of the allegations of the lawsuits against the seven companies reinforces the view that at least some of these Chinese companies that the U.S exchanges succeeded in attracting to New York may not have been ready for prime time.

Here is a brief summary of the allegations against the seven companies:

Xinhua Finance Media (first sued on May 22, 2007, refer here): The plaintiffs allege that the Prospectus issued in connection with the company’s March 8, 2007 IPO failed to disclose that the company’s CFO at the time of the offering was simultaneously an investment banker in charge of a securities firm that is the subject of an SEC investigation, and that he was also an investor in two companies that had been sued by the SEC for fraud.

Qiao Xing Universal Telephone (first sued on August 9, 2007, refer here): The lawsuit arises out of the company’s restatement of its financials for the years 2003, 2004 and 2005. The company stated at the time that misstatements resulted from deficiencies in the company’s internal controls over financial reporting.

China Sunergy Company Limited (first sued on September 10, 2007, refer here): The lawsuit alleges that the company’s Prospectus in connection with its May 17, 2007 IPO failed to disclose that the company was having difficulty obtaining a sufficient supply of polysilicon, which forseeably would have a near-term impact on earnings.

LDK Solar Company (first sued on October 9, 2007, refer here): The company was sued after the company’s financial controller resigned, reporting to the SEC and the company’s external auditor that the company lacked internal controls and that the company’s reported polysilicon inventory was 25% overstated.

Fuwei Film (Holdings) Company (first sued on November 19, 2007, refer here): The lawsuit alleges that the Prospectus in connection with the company’s December 19, 2006 offering failed to disclose that the company’s main operating assets were obtained through transactions that may not have been valid under Chinese law. On October 15, 2007, three of the company’s major shareholders, including one director, were arrested on suspicion of legal violations.

Giant Interactive Group (first sued on November 26, 2007, refer here): The lawsuit alleges that the Prospectus released in connection with the company’s November 1, 2007 IPO failed to disclose that the company had experienced a third-quarter 2007 decline in users (i.e., prior to the offering), which it disclosed for the first time on November 19 (less than 3 weeks after the offering).

Focus Media Holding (first sued on November 27, 2007, refer here): The lawsuit alleges that the company’s Prospectus in connection with its November 7, 2007 secondary offering failed to disclose that acquisitions in its Internet advertising division were depressing the division’s gross margins. In the company’s November 19 earning release, it disclosed that its gross margins had declined due to several recent acquisitions.

To be sure, there is nothing uniquely Chinese about these kinds of allegations (except perhaps with respect to the Fuwei Film allegations). But it is the frequency of these allegations relative to the number of listings that is disturbing. Five of these seven companies are listed on Nasdaq (LDK Solar and Giant Interactive are NYSE listed), meaning that these five represent roughly ten percent of the 52 Nasdaq listed Chinese companies. Moreover, four of the seven are among the 19 Chinese companies that debuted on Nasdaq in 2007 – representing roughly 21% of all Chinese companies that listed on Nasdaq this year.

If the U.S. exchanges' "success" means only that they have attracted companies that stumble out of the blocks, investors may soon lose their sinophilia. This process may already be taking place. A December 7, 2007 Wall Street Journal article entitled "China IPOs Lose Some Allure" (here) noted that two Chinese companies, WSP Holding and VisionChina Media, had to cut their prices to sell shares in their December 6 offerings.

All of this could be interpreted to suggest that in the U.S exchanges’ haste to woo Chinese listings, they may be attracting companies that are not prepared for everything that goes with a U.S. listing. U.S toy retailers learned the hard way that consumers expect to be protected from toys with lead-based paint. The U.S exchanges shouldn’t have to learn this same lesson all over again in the financial marketplace. The measure of the U.S exchanges’ "success" in the global IPO marketplace should not be based on quantity, but on quality, in order for the U.S markets to maintain their reputation for transparency and integrity and to continue to offer superior valuations for companies that can, in fact, withstand the scrutiny. For the sake of the competitiveness of the U.S financial markets, the U.S exchanges themselves must take steps to ensure that foreign issuers continue to perceive that "nothing matches a U.S. listing."

Subprime Litigation Wave Hits Another Financial Guarantor

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In an earlier post (here), I noted how the subprime related securities litigation wave has reached the bond insurance sector. The forces creating turmoil for the bond insurers have now reached another company in the credit enhancement business, leading to a further subprime-related litigation.

According to its December 7, 2007 press release (here), the Coughlin Stoia firm filed a securities lawsuit against Security Capital Assurance, a Bermuda-based provider of financial guaranty insurance, reinsurance and other credit enhancement products. A copy of the complaint can be found here. According to the press release, the complaint alleges that in connection with the company’s June 6, 2007 secondary offering, the company’s Prospectus failed to disclose that:

(i) the Company was materially exposed to extremely risky structured financial credit derivatives; and (ii) the Company was materially exposed to residential
mortgage-backed securities relating to sub-prime real estate mortgages.

The lawsuit follows the company’s October 16,2007 announcement (here) that its third-quarter results would be affected by an unrealized mark-to-market loss of $145 million with respect to its credit derivatives portfolio. The lawsuit also follows Fitch’s November 13, 2007 downgrade (here) of two transactions insured by the company and representing $792 million in net par insured. On the date the complaint was filed, the company’s share price was 80% lower than the share price in the secondary offering.

With the addition of the Security Capital Assurance lawsuit, the tally of the subprime-related lawsuits that I am maintaining here now stands at 24, not counting the four residential home construction companies that have been sued in subprime-related lawsuits and the two rating agencies that have been sued in subprime lawsuits. These three categories together represent a total of 30 subprime-related securities lawsuits.

The Thought Bubble Over Gregory Reyes’s Head Says "Whatever Happened to ‘No Harm, No Foul’?": On August 7, 2007, Gregory Reyes, Brocade Communications' former CEO was convicted of ten felonies in connection with the company’s stock options practices. The court is now faced with determining Reyes’s sentencing under the federal Sentencing Guidelines. Under the Guidelines, the most significant factor in determining the sentence for the crimes of which Reyes is convicted is the extent of the pecuniary loss attributed to his conduct.

In a November 27, 2007 order (here), Judge Charles Breyer found that the government had failed to "quantify any amount of loss that can be attributed to Reyes’ conduct." As a result, Judge Breyer calculated Reyes’s recommended sentence to be in the range of 15-21 months, far below the government’s recommended range of 292-365 months.

As discussed at greater length in the Legal Pad blog (here), the court rejected the government’s arguments that the loss could be calculated based on a single-day drop in the company’s market capitalization; based on the amount of the fines and penalties the company paid; based on the shareholders’ "rescissory loss" (because the fluctuating share price was affected by so many factors); or based on Reyes’s own personal gains – because, Judge Breyer concluded, there weren’t any gains that could be proven with clear and convincing evidence.

The date of Reyes’s sentencing is not yet scheduled.

More About the UnitedHealth Derivative Settlement: The record-setting settlement in the UnitedHealth options backdating derivative lawsuit (about which refer here) has continued to provoke commentary.

The Lex column in the December 8, 2007 Financial Times (here), commenting on the fact that William McGuire’s settlement contribution represented the first exercise of the statutory clawback provisions under the Sarbanes Oxley Act, observed that:

By in effect activating Sarbox’s clawback provision, the settlements may spur other shareholder committees to extend their talons in search of reimbursement for backdated options. Companies have long whinged about the onerous requirements imposed on them after the Enron and WorldCom accounting scandals. But here, at least, is an instance where Sarbox seems to have done exactly what it is meant to in protecting shareholders. For once, executives will find it tough to complain and expect any sympathy.

Gretchen Morgenson, writing in the December 9, 2007 New York Times (here), commented that the UnitedHealth settlement demonstrates the importance of special litigation committees. But, she commented, "that the outcome of the UnitedHealth case is so remarkable is a distressing indication of how far shareholders still have to go to hold executives and directors accountable."

Busted Buyout Lawsuits: A 2007 Trend?

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When the dust finally settles and the reports on 2007 class action filings are being written, one development that should be noted as a contributing factor to the increased filings in the second half of 2007 is the emergence of class action lawsuits based on busted buyouts. Disappointed target companies that have become the target of securities lawsuits following busted buyouts include Radian (about which refer to my prior post here), Harman Industries (prior post here) and United Rentals (prior post here).Now plaintiffs’ lawyers have launched a securities lawsuit against Genesco, as a fallout from the busted merger between Genesco and The Finish Line.

Genesco and The Finish Line had announced on June 18, 2007 (here) that The Finish Line would acquire all of Genesco’s stock for $1.5 billion. Problems ensued, and on September 14, 2007, The Finish Line issued a press release (here) announcing that it had received letters from the UBS entities providing the deal financing to the effect that the entities were "extremely concerned about the deteriorating financial position" of Genesco. The UBS entities also noted that they were "not yet satisfied that Genesco has not experienced a Material Adverse Effect." (A Material Adverse Effect would relieve the acquirer from its obligations under the merger agreement.) The UBS entitles had also asked The Finish Line to "cause Genesco" to provide all financial information required for the entities to "conclude whether a Material Adverse Effect had occurred."

Thereafter, on September 21, 2007, Genesco announced (here) that it had filed a lawsuit in Tennessee Chancery Court "seeking an order requiring The Finish Line, Inc. to consummate its merger with Genesco and to enforce The Finish Line’s rights against UBS under the Commitment Letter for financing the transaction."

On September 28, 2007, The Finish Line announced (here) that it had filed an answer, counterclaim and third-party claim for declaratory judgment in the Tennessee action. Among other things, in its September 28 press release, The Finish Line stated that "it has asked Genesco for certain financial and other information as well as access to Genesco’s Chief Financial Offier and financial staff. However, to date Genesco has not responded and refused to comply with these requests." The announcement also stated that The Finish Line was seeking a declaratory judgment that a Material Adverse Effect had occurred.

In its own response to the lawsuit, UBS not only answered but filed a counterclaim against Genesco for fraud. UBS has also sued both Genesco and The Finish Line in federal court in Manhattan seeking to void its financing commitment letter.

The Tennessee case is scheduled to go to trial on December 10, 2007. A copy of the court’s order identifying the issues for trial can be found here. An exhaustive and interesting analysis of the legal issues in the Tennessee case can be found on the M & A Law Prof blog, here.

Just to provide a cold steel edge to these circumstances, the U.S. attorneys’ office in Manhattan served a subpoena on Genesco. According to Genesco’s November 26, 2007 press release (here), the subpoena "states that the documents are sought in connection with alleged violations of federal fraud statutes." The press release quotes the company’s Chairman and CEO has saying that the subpoena "come on the heels of the baseless fraud allegations made by UBS ten days ago."

Circumstances like these were bound to excite the plaintiffs’ lawyers’ interest, and so it comes as no surprise that on December 5, 2007, the Coughlin Stoia firm announced (here) that it had filed a securities lawsuit in federal court in Tennessee against Genesco and certain of its directors and officers. A copy of the complaint can be found here.

According to the press release, the complaint alleges that:

During the Class Period, defendants made false and misleading statements oncerning Genesco’s business and prospects. As a result of their representations, Genesco was seen as an attractive acquisition target for Foot Locker, Inc. Foot Locker ultimately made an offer and The Finish Line, Inc. and Headwind, Inc., a wholly owned subsidiary of Finish Line, subsequently made an increased offer, based on Genesco’s purported success. When the truth about Genesco’s results began to be revealed, however, Finish Line indicated it would no longer pursue the acquisition. Then, on November 26, 2007, Genesco received a subpoena from the Office of the U.S. Attorney for the Southern District of New York seeking documents related to its merger agreement and in connection with alleged violations of federal fraud statutes. On this news, Genesco’s stock plunged to $25.44 per share on November 27, 2007, almost a 16% drop from the closing price of $30.17 on November 26, 2007, on volume of 2.4 million shares.

According to the complaint, during the Class Period defendants concealed the following information, which caused their statements to be materially false and misleading: (a) the Company’s stores were not performing well and would not produce the financial results being forecast for the Company; (b) the Journeys stores were performing poorly relative to plan with big same store sales declines; and (c) these poor results would be considered adverse events to potential acquirors, leading to significant share price declines at Genesco.

The Genesco saga clearly has further to run, particularly in light of the Tennessee state court trial that will begin on Monday. But Genesco’s busted deal with The Finish Line is only one of a host of transactions previously announced with great fanfare that are now dead or on life support. The M & A Law Prof blog (which is, by the way, a truly excellent blog) has a comprehensive overview of the status of these busted deals (here), subdivided between the "dead", the "walking wounded" and the "troubled." There may be one or more disappointed target companies on this list (or soon to be added to the list) that may find themselves getting a securities lawsuit as a complement to their woes.

As I noted at the outset, these busted deal securities lawsuits are just one more factor driving the increase in securities lawsuits in the second half of 2007. For more about the second-half 2007 securities lawsuit filing increase, refer here.

Another Qwest Opt-Out Settlement: In a recent post (here), I detailed two significant opt-out settlement in connection with the Qwest Communications securities litigation. In the latest of the Qwest opt-out settlements, on December 5, 2007, the Teacher Retirement System of Texas (TRS) announced (here) that it had entered a $61.6 million settlement with Qwest.

In its press release, TRS said that had it remained in the class its recovery would only have been $1.4 million, implying that it had increased its recovery 44 times by opting out. In explaining the reason it opted out, TRS’s executive director said that "we considered the high attorneys’ fees and the insufficient recovery anticipated from the class action lawsuit and decided to seek damages from Qwest on our own."

A December 6, 2007 Wall Street Journal article entitled "First the Losses, Now Bond-Fund Lawsuits" discussing other lawsuits (other than securities class action lawsuits) can be found here.

As I discussed in my prior post about the Qwest opt-out settlements, Qwest had disclosed in its most recent filing on Form 10-Q that the company had agreed to pay the class action opt-outs a total of $411 million. According to a December 6, 2007 report in the Austin American-Statesman (here), the $411 million amount includes the amount paid in settlement with the Texas fund. As I also noted in my prior post, the $411 million total opt out settlements exceeds the $400 million that Qwest agreed to pay the class.

Subprime Litigation Wave Hits Mutual Fund Family: Add mutual funds to the list of list of kinds of companies that have been hit with the subprime securities litigation wave. According to its December 6, 2007 press release (here), the Lockridge Grindal Nauen law firm has filed a securities class action lawsuit against Morgan Asset Management, Inc., Morgan Keegan & Company, Inc., MK Holding, Inc., Regions Financial Corporation (NYSE:RF), PricewaterhouseCoopers LLP, and certain individuals, officers and directors associated with these entities in the United States District Court for the Western District of Tennessee, on behalf of investors who purchased shares of the Regions Morgan Keegan Select Intermediate Bond Fund ("MKIBX") and Regions Morgan Keegan Select High Income Fund ("RHIIX").

The bond funds referenced has been in the news for its losses as a result of some subprime related investments. According to a December 6, 2007 article (here) on the Morningstar website, the Morgan Keegan Select Intermediate Bond Fund has lost 55% of its value this year, which the Morningstar site comments is "a staggering loss for a bond fund." The site goes on to comment that "The fund lost a bundle on subprime mortgages and then redemptions forced it to sell other holdings under duress, and the net is a horrific loss. It shows that sometimes you really are better off panicking and yanking your money from a troubled fund, because redemptions can make a bad situation even worse."

I have added the Morgan Keegan/Regions Financial lawsuit to my running tally of subprime-related securities lawsuits, which can be found here. With the addition of this new lawsuit, the tally of subprime securities lawsuits now stands at 23, not counting the four subprime related securities lawsuits that have been filed against home construction companies, and the two rating agencies that have also been sued in subprime related securities lawsuits.

Added together, these various categories total 29 subprime-related securities class action lawsuits, all of which have been filed in 2007.

UnitedHealth Derivative Settlement “Largest Ever”

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On December 6, 2007, UnitedHealth Group announced (here) that its Special Litigation Committee had concluded its review of claims relating to the company’s option backdating practices that had been brought against certain of the company’s directors and officers.

The company also announced that its former CEO William McGuire had agreed surrender certain rights and interests which, together with previous repricing of all stock options awarded to McGuire, have a value in excess of $600 million.

Certain other current and former officers also agreed to relinquish certain rights and repay other amounts, which in combination with the repricing of certain stock option, have a value of approximately $300 million.

According to the company’s statement:

The SLC has valued the total amounts to be relinquished pursuant to these settlement agreements, together with the value previously and voluntarily relinquished by current and former executives, through the surrender and repricing of options, to be approximately $900 million.

A December 6, 2007 Bloomberg.com article (here) states that “if approved by a court, the settlement …would be the largest ever in a ‘derivative’ suit…according to data compiled by Bloomberg.”

Separately, the SEC announced on December 6, 2007 (here) that it had reached a $468 million enforcement action settlement with McGuire, which, the SEC said, includes the “largest penalty assessed against an individual in an options backdating case.” The $468 million SEC settlement consists of “a $7 milllion civil penalty and reimbursement to the Minneapolis-based health care company for all incentive- and equity-based compensation he received from 2003 through 2006.”

The SEC’s press release also stated that the McGuire settlement “is the first with an individual under the ‘clawback’ provision (Section 304) of the Sarbanes-Oxley Act to deprive corporate executives of their stock sale profits and bonuses earned while their companies were misleading investors.”

According to UnitedHealth’s press release, McGuire’s settlement consists of the following elements:

• Surrender to UnitedHealth Group certain stock options to acquire 9,223,360 shares of Company stock, which the SLC has valued at approximately $320 million;


• Surrender his interest in the Company’s Supplemental Executive Retirement Plan, valued at approximately $91 million;


• Surrender to the Company approximately $8 million in his Executive Savings Plan Account; and


• Relinquish claims to other post-employment benefits under his Employment Agreement.

According to the company. these amounts, combined with a previous repricing of all stock options awarded to Dr. McGuire from 1994 to 2002, result in a total value to be relinquished by McGuire in excess of $600 million.

A copy of McGuire’s settlement agreement with the company and the derivative plaintiffs can be found here.

The UnitedHealth press release described the settlement with the company’s former General Counsel, David Lubben, as consisting of the surrender to UnitedHealth Group of his stock options to acquire 273,000 shares of Company stock, which the SLC valued in excess of $3 million; and the repayment to the Company $20.55 million of the compensation realized by him as a result of his March 2007 exercise of stock options.

According to the company, these amounts, combined with a previous repricing of stock options awarded to Lubben, result in a total value relinquished by Lubben of approximately $30 million.

A copy of the settlement agreement between Lubben and the company and the derivative plaintiffs’ counsel can be found here.

The UnitedHealth press release also stated that under the settlement agreement that the company reached with its former director William Spears, “the fair settlement value of the Company’s claims … will be determined by binding arbitration.”

According to the Bloomberg article, current United Health CEO Stephen J. Helmsley had agreed to repay $240 million, although the company apparently says he voluntarily did so months ago.

A copy of the UnitedHealth special litigation committee’s December 6, 2007 report can be found here.

The Wall Street Journal's December 7, 2007 article discussing the settlement can be found here.

Special thanks to alert reader Kelly Reyher for sending alerting me to this story and sending along the Bloomberg link.

The magnitude of these settlements is obviously arresting. The scale of the settlements is proportionate to the scale of the backdating problems at UnitedHealth, which had forced the company to restate $1.13 billion in earnings over a 12-year period. The scale of these settlements could have a significant impact on at least some of the other pending options backdating derivative cases, particularly where the company has been forced to restate and where top company officials have personally benefited from the backdating.

Readers should note that the table I am maintaining of all options backdating related settlements, dismissals and denials can be accessed here.

From a D & O insurance perspective, it is noteworthy that all or virtually all of the amounts to be paid to the company or to the SEC may be characterized as disgorgement, return of ill-gotten gains, return of compensation to which the individual was not legally entitled, or fines and penalties. Assuming that these are in fact accurate characterizations of the settlement payments, these amounts would not constitute covered loss under the typical D & O insurance policy.

Dismissal Granted in Subprime-Related Securities Lawsuit

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As I have previously detailed (refer here), the subprime meltdown has led to a flood of new securities lawsuits. The extent to which many of these subprime-related lawsuits will withstand judicial scrutiny still remains to be seen. A recent opinion from the Central District of California -- which is as far as I know the first decision on a dismissal motion in a subprime-related securities lawsuit -- may provide some indication of the challenges many of these new lawsuits may face as they proceed.

In a November 29, 2007 order (here)in the Indymac Bancorp securities lawsuit , Judge George Wu of the federal court in Los Angeles granted the defendants’ motion to dismiss the securities class action lawsuit that had been filed against Indymac and three individual defendants. The dismissal is without prejudice, and the plaintiffs have until January 18, 2008 to file an amended complaint. Although the dismissal is without prejudice, the court’s analysis may be indicative of the obstacles that may confront many of the subprime-related lawsuits.

The plaintiffs’ allegations, as summarized by the court, are that "despite the downturn in the national housing and mortgage markets, Defendants maintained that they were well-positioned, contrary to the other players in the markets." Plaintiffs contend that the defendants’ statements about the company’s position were misleading, because Indymac had "inappropriately loosened its underwriting guidelines such that it had extended far riskier loans that were going into default at an increasing rate"; had "inadequately hedged against its risks"; and had "inadequate internal controls."

The defendants moved to dismiss the complaint in reliance on the U.S. Supreme Court’s recent Tellabs opinion (about which refer here). The defendants argued that the plaintiffs "failed to allege sufficient facts giving rise to a ‘strong inference’ of scienter."

In response, the plaintiffs had "cited the beliefs and opinions of certain confidential witnesses with respect to the allegedly problematic areas." But the court noted that the plaintiffs "failed to allege that the individual Defendants share these beliefs" or even "that they were aware of them."

The plaintiffs also cited press statements where the defendants admitted certain mistakes, and also cited subsequent actions where the company increased loan loss reserves and took certain charge-offs. The court, weighing competing inferences as required under Tellabs, found that these allegations, rather than supporting an inference of scienter, supported "an even stronger inference…that Defendants were simply unable to shield themselves as effectively as they anticipated from the drastic changes in the housing and mortgage markets, and once that inability became evident, Indymac’s financials were changed accordingly."

The Court went on to note that the plaintiffs might have been able to satisfy the scienter requirements with insider trading allegations or allegations of GAAP violations. But because two of the individual defendants sold no shares and the third individual’s sales were "relatively small given his overall holdings and less than half what he sold in the preceding year," the insider trading allegations did not give rise to a strong inference of scienter. The Court also found that the plaintiff had "failed to plead facts regarding GAAP accounting which would strongly support" a finding of scienter.

The court did not reach the defendants’ further contention that their cautionary statements brought their alleged misrepresentations within the safe-harbor for forward looking statements. The court said it would address these arguments once the plaintiffs had filed their amended pleading. The court sounded its own precautionary note when it observed that "Plaintiffs would appear to have a hard time convincing the Court that the safe harbor warnings employed here…were ‘blanket’ or ‘boilerplate.’"

Even though the IndyMac dismissal is without prejudice, it is a good reminder that even though the plaintiffs’ lawyers are piling on the lawsuits in response to the subprime mess, many of these lawsuits face some formidable obstacles. At lease in cases that, like the Indymac case, lack significant insider sales during the class period, the plaintiffs may face hurdles in satisfying the Tellabs scienter requirements. In addition, the precautionary disclosures for many of the financial services companies that are the targets of the subprime lawsuits are also as profuse as Indymac’s appear to be. The statutory safe harbor protection or the "bespeaks caution" doctrine may afford these defendants a substantial defense.

Finally, and even though it was not a factor in the Indymac order, plaintiffs in many of these cases may have a difficult time satisfying the loss causation pleading requirements. Given the general decline in financial services companies’ stock prices as a result of macroeconomic circumstances behind the subprime meltdown, it may be difficult in many cases for the plaintiffs to pinpoint a specific price decline that resulted for the alleged corrective disclosure. The challenges that plaintiffs in these cases may face in this regard is clearly suggested by Judge Wu's reference to the "defendants' inability to shield themselves" from the "drastic changes in the housing and mortgage markets."

There are of course some cases where plaintiffs will have little difficulty in overcoming these obstacles. And of course the Indymac plaintiffs might well succeed in filing an amended complaint that can withstand a motion to dismiss. But the recent decision in the Indymac case is a reminder that the mere fact that a lawsuit has been filed does not necessarily mean that plaintiffs will achieve a substantial recovery or that the company or its D & O insurer will sustain a substantial loss. This could be an important consideration to keep in mind when assessing various estimates of the likely exposure of the D & O insurance industry to litigation arising from the subprime meltdown.

Special thanks to Tom Geyer of the Bailey Cavalieri firm for providing a copy of the Indymac order.

Securities Regulation a Little Lax, Eh?: Would-be corporate reformers cite the burdensome U.S. securities regulation as one factor affecting U.S competitiveness in the global financial marketplace. But at least the U.S securities regulator is an effective regulator. It would be far worse for the U.S. to have an expensive, ineffective regulator, as is amply demonstrated in the December 1, 2007 Toronto Star article about the Ontario Securities Commission (OSC), entitled "Why the OSC Rarely Gets Its Man" (here).

According to the article, because of the OSC’s ineffectiveness, "many high-profile cases of stock market manipulation or corporate fraud in recent years have left investors fuming that authorities have either failed to hold people accountable or taken way too long to apply justice."

The article quotes an Indiana University finance professor who completed a comparative study of the OSC and the SEC and who said that "we found that enforcement in Ontario was pathetic. Canada is a first-world country with second-world capital markets and third-world enforcement." As if that is not enough, the article also quotes the former CEO of the Toronto Stock Exchange as saying that Canada’s securities enforcement is an "international embarrassment."

Ouch.

The problem does not seem to be funding. According to a Harvard law professor the article cites, "Canadian budgets and staffing may actually be somewhat more intensive than those in the United States." Yet, despite this expenditure, as one commentator noted, "if you did a cost-benefit economic model, Canada would be the place to go for white-collar crime. Your chance of detection is small and the consequences of getting caught are not high."

It should probably be noted that the apparently lax Canadian enforcement is simply the result of ineffectiveness; it is not the intended result of a conscious effort to make Canadian financial markets more competitive. But on the whole, the article indirectly makes a pretty strong case that the best way to maintain market integrity and an international reputation is to maintain effective regulation.

Special thanks to alert reader Shelley Lloyd for providing a link to the Toronto Star article.