D & O Underwriters Get Active in Underwriting Subprime Litigation Risk

In an earlier post (here), I commented on the D & O industry’s probable response the the litigation wave arising from the subprime lending mess, including the likelihood of increased underwriting around subprime exposures. The heightened scrutiny that I had surmised apparently is now a reality. An August 30, 2007 Bloomberg.com article reports (here) that a leading D & O insurer has created a "three-page questionnaire" to be used to determine whether applicants "make home loans to the riskiest borrowers or invest in sercurities backed by them." Other D & O insurers reporedly are inquiring about applicants' vulnerability to subprime exposure without requiring a questionnaire. (Full disclosure: I am quoted in the article).

According to the article, this effort"highlights insurers’ concerns that the rout in the subprime market could damage one of the most profitable lines of business." The article quotes an analyst from Sanford Bernstein as estimating that "subprime could add to D & O insurers’ claims by as much as $1.5 billion to $3.6 billion annually for three years" although also noting that that scenario is "extremely unlikely" and that actual losses will be 10 to 50 percent of those numbers.

The article also contains some sensible advice from my good friend Lauri Floresca, who suggests that clients should "avoid giving written answers [to any questionnaire] because they could later be used to deny coverage." (The insurer’s spokesperson is quoted in the article as saying that the written questionnaire is rarely mandatory.) Floresca also comments (as I noted in my prior post) that insurers "are really on high alert for anything that could be tangentially related to subprime."

The broad range of loss the analyst projected (that is, a three year total exposure ranging from $450 million to $10.8 billion) encompasses just about every possible outcome. Given how early we are on this story, any number that anyone would posit at this point could be nothing but pure conjecture, but I still wonder why the analyst even bothered to attempt a putative quantification of the exposure.

A final thought about the analyst's projection: If people really do get paid for coming up with that kind of, well, analysis, then there has to be some way that I can make money from this blog.

How Broadly Will the Subprime Wave Spread?: In earlier posts (most recently here), I commented that the greater risk from the subprime lending mess is that its effects could spread far beyond the subprime lending industry itself. An August 27, 2007 Financial Times article entitled "Internet Groups Brace for Subprime Fallout" (here) suggests just how broadly the subprime wave might spread. The article notes that "Internet companies are bracing for a possible fall-off in one of the biggest sources of advertising following the meltdown of the subprime mortgage market."

The article goes on to note that 16% of all online advertising comes from financial services companies, making it the second biggest source of income behind retail. Among the financial services companies advertising on the Internet, the biggest players include mortgage lenders such as Countrywide, Low Rate Source and Lending Tree.

The fact that the subprime mortgage mess could hurt the financial prospects of an industry seemingly as unrelated as the Internet suggests just how widespread and unpredictable the subprime mess potentially may be. The D& O underwriters mentioned above who are scrambling to develop underwriting tools to try to get ahead of the risk are understandably nervous, and in light of the stories about the subprime impact on Internet companies, may understandably extend their heightened underwriting well beyond the subprime lending industry itself.

Another Private Trading Platform: In earlier posts, I have taken a look at the new private trading platforms, such as the Goldman Sachs GSTrUE system (refer here) and the Nasdaq Portal (refer here), where accredited investors can trade Rule 144A shares. The attraction of these private exchanges is that they allow private companies to raise equity capital while providing investment liquidity but without assuming reporting company burdens and responsibilities. Recent news reports (here) that hedge fund giant Renaissance Technologies was considering selling an equity stake in a Rule 144A offering highlighted the fact that yet another private trading system has been launched.

According to the news reports, Renaissance is considering floating an offering on the new OPUS-5 system, announced this month by Morgan Stanley, Lehman Brothers, Citigrop, Merrill Lynch and the Bank of New York Mellon. According to the Bank of New York Mellon’s August 14, 2007 press release describing the system (here), its name is an acronym for "Open Platform for Unregistered Securities," and will "provide trade reservation, shareholder tracking and transfer management for privately offered equity securities transacted under Rule 144A." The press release goes on to state that :

OPUS-5 will support and enable an open platform with multiple market makers and is designed to provide broad liquidity to the U.S. private placement market and facilitate greater access to capital for issuers in the 144A equity market. The platform will also monitor the number of shareholders in these issuers. OPUS-5 is expected to launch in September 2007.

The reason that the platform’s managers will monitor the number of shareholder is that if the number of the issuer’s shareholders were to exceed 500, the issuer would trigger reporting company obligations.

The sudden efflorescence of these private trading platforms is clearly a part of the U.S. financial market’s response to the success of the London-based Alternative Investment Market (AIM). These platforms provide companies with ease of access to equity financing, addressing the need, noted in my prior post (here), that has driven AIM’s success. The active competition that has quickly arisen between the various private platforms will clearly be to the benefit of the issuer companies, as they will have the advantage of being able to choose on which platform they will have their Rule 144A shares traded. The more interesting question is whether these new private platforms will serve as a way station to an eventual public offering or whether they will serve as an alternative to going public. For a huge hedge fund like Renaissance, the OPUS-5 trading clearly is an alternative to going public.

In either case, as I noted in my prior post looking at the GSTrUE system, even though floatations on the private systems are less risky that an public offering, they are not risk free exercises. The D & O marketplace undoubtedly will innovate customized products to address the specific risks facing companies whose Rule 144A shares will be trading in these private systems.

Will His Retirement Attire Be Orange?: As has been well-documented in the press (refer here), Bill Lerach is resigning from his eponymous law firm, to be known after August 31 as Coughlin Stoia Rudman & Robbins. The most interesting media coverage of the resignation has been on the WSJ.com Law Blog, which not only reprinted the full text of Lerach’s resignation e-mail (here) but also posted (here) a fascinating comparison between the text of Lerach’s e-mail and Richard Nixon’s Resignation and Farewell speeches, and in addition (here) to the Godfather II movie.

But perhaps the most noteworthy aspect of the WSJ.com Law Blog’s coverage is the statement in its August 28 post (here) that Lerach "is in advanced talks with prosecutors on a plea deal that could be announced in September and involve serving time, according to two people familiar with the investigation (emphasis added)."

The law firm’s August 28, 2007 press release on Lerach’s resignation can be found here.

So Kids, That's Why You Should Do Your Math Homework: Renaissance Technologies, which has assets over $30 billion, was founded by mathematician James Harris Simons, and uses mathematically based trading strategies. Press reports commenting on the reasons why Renaissance might shun a public offering suggest that one reason was to avoid having to reveal more information about its trading strategies.

Another reason Renaissance might try to avoid a public offering is to avoid greater scrutiny of its executive compensation practices. According to Wikpedia, Simons earned an estimated $1.7 billion in 2006, after having made $1.5 billion in 2005 and $670 million in 2004. Forbes lists him (here) as the 64th richest person in America.

Speaker's Corner: I will be moderating the educational panel on "Current Issues in Directors' and Officers' Liability Insurance" at the Professional Liability Underwriting Society (PLUS) Midwest Chapter event in Cincinnati on September 12, 2007 (refer here for details). We have a distinguished panel including Dan Bailey from the Columbus law firm of Bailey & Cavalieri, Tom Reiter from K&L Gates in Pittsburgh, Jim Lash from the Hylant brokerage in Cinncinati, and Mark Lamendola from Travelers. This is going to be a great event, and I hope readers in the Ohio Valley and Great Lakes regions will try to attend.

Special Litigation Committee Terminates Options Backdating Derivative Action

On August 24, 2007, Rambus announced (here) that a Special Litigation Committee (SLC) of its board of directors had completed its review of “claims related to stock options practices that are asserted in derivative actions against a number of present and former directors and officers of the Company.”

Rambus had previously announced (here) on October 19, 2006 that its Audit Committee had completed an independent investigation into stock options grants and had “determined that a significant number of the stock option grants were not correctly dated or accounted for,” and that the company anticipated taking a $200 million charge. The Board also at that time formed the SLC to evaluate potential claims the company may have. The SLC consisted of two members of the company’s board, J. Thomas Bentley, a Managing Director of SVB Alliant (the recently closed investment banking arm of Silicon Valley Bank), and Abraham Sofaer, a former U.S. District Judge who is also a law professor at Stanford.

According to the company’s August 24 press release, the SLC determined, subject to the settlements described in the announcement, that “all claims should be terminated and dismissed against the named defendants in the derivative actions,” with the exception of claims against one individual who served as the Vice President of Human Resources between 1996 and 1999, and Senior Vice President of Administration from 1999 to 2004. The SLC determined that the claims against the individual should proceed and that the SLC itself will “assert control over the litigation.”

The announcement further disclosed that the SLC had “entered into settlement agreements with certain former officers of the Company.” The aggregate value of the settlements, which are “conditioned upon the dismissal of the claims asserted against them in the derivative actions,” exceeds $6.5 million in cash and cash equivalents “as well as additional value to the Company relating to the relinquishment of claims to over 2.7 million stock options." (The Company’s January 4, 2007 press release announcing the company’s former CEO’s relinquishment of the stock options can be found here.)

The company’s August 24 announcement is interesting by way of the contrast it provides to much of the litigation activity that has surrounded the options backdating scandal, where the battle lines typically have been drawn over the “demand futility” issue – that is, whether or not it would be futile to ask a company’s board to investigate and prosecute the alleged wrongdoing. The evidence of the Rambus SLC’s work presents an interesting counterpoint to the arguments that plaintiffs typically raise that it would be futile to demand that a board take responsibility for investigating alleged wrongdoing. There appears to have been nothing futile about the actions of Rambus’s board or its appointed committee.

I have no knowledge of the details of Rambus’s D&O coverage and I have no information beyond what appeared in the company’s news release, but based on the available information and assuming the provisions of the typical policy, the outcome of the SLC’s investigation could raise some potentially interesting coverage issues. To the extent that the amounts the individuals agreed to pay in settlement are in the nature of disgorgement or restitution, a D & O carrier would likely contend that it is not covered “loss.” (Of course, the individuals are likely to contend that the amounts are not restitutionary or otherwise do constitute covered loss.)

In addition, the company may well seek to recover its own investigative costs and costs incurred in connection with the SLC. Indeed, issues surrounding coverage for these kinds of costs have been a great source of tension between D & O carriers and policyholders in connection with the options backdating claims. Attorney and D & O commentator Dan Bailey has a good summary of the coverage issues associated with these kinds of costs in a recent article, here.

The continuing claims against the remaining individual defendant also presents an interesting issue; since the ongoing action would be direct rather than derivative, the carrier may contend that the claim would no longer appear to fall within the derivative claim exception to the insured versus insured exclusion. The availability of insurance (or absence thereof) could have a significant effect on the likely future direction of the claim against the remaining individual defendant.

Bad News and D & O Claims: In prior posts (most recently here), I have commented on the fact that sometimes it is the way a company deals with bad news, rather than the bad news itself, that determines whether or not the company will also have to deal with a securities class action lawsuit. The allegations in the purported securities class action lawsuit that the Lerach Coughlin firm filed on August 24, 2007 against Advanced Medical Optics and several of its directors and officers appears to provide another example of this phenomenon. The press release regarding the new lawsuit can be found here, and the complaint can be found here.

Let me just say at the outset that I have no knowledge of the facts and circumstances other than what is alleged in the complaint, and I do not mean to suggest that the circumstances are as the plaintiffs’ have alleged or that the claims are meritorious. For purposes of discussion, I have simply taken the plaintiffs' allegations as presented.

In the complaint, the plaintiffs allege that in November 2006, the Company announced a voluntary recall of CompleteMoisturePLUS (“Complete”), a bottled soft contact lens solution sold on a worldwide basis, because of bacterial contamination that compromised sterility. (The company’s press release regarding the November recall can be found here) The complaint further alleges that the defendants “moved to assure the market that the problem was isolated to Asia and that the prospects for the Complete product were favorable.”

The complaint cites a number of company statements that supposedly indicate that the Asian facilities had been sanitized, inspected and would be staged back into production, and that the company’s sales for the Complete product were or would be fully restored. The complaint alleges that in April the Company announced favorable results, including rising sales of Complete. The complaint alleges that the defendants made favorable disclosures about Complete though they knew that there were problems and that a recall was “not just a future possibility but a significant likelihood.” The complaint alleges that as a result of the company’s reassurances, the company’s stock performed well and the defendants were able to sell significant amounts of their personal holdings of the company’s stock at a profit.

The complaint goes on to allege that in a May 25, 2007 press release, the company announced that in response to “information received today from the Center for Disease Control regarding eye infections,” the company was immediately and voluntarily recalling its Complete contact lens solution. (A copy of the company's May 25 press release can be found here.) The complaint alleges that the company’s stock price declined 14% on this news.

There are several interesting things about this complaint. The first is that the initial bad news (the November 2006 product recall) is not the basis of the securities lawsuit; indeed, the class period does not even purport to begin until January 2007, well after the initial product recall. It is rather the supposedly reassuring statements that the company allegedly provided between November and May that are the basis of the complaint. The events alleged (again, without taking a position whether or not they are true or that plaintiff’s allegations correspond in any way to what actually happened) seem to illustrate the point, which I have previously observed here, that “partial, incomplete or overly optimistic disclosure can exacerbate damage from bad news disclosure and risk the creation of securities litigation exposure.” As the allegations seek to show, it may be that the “calming” statement itself may be alleged to be misleading – in other words the securities litigation exposure results from the “damage control,” not the underlying event.

The insider trading allegations also illustrate another important point for managing bad news disclosure (which point may or may not have been relevant to AMO's circumstances), which is that companies involved in bad news would be well advised to consider imposing a trading blackout until the problem is entirely contained. My prior essay presenting a more detailed program for managing bad news disclosure can be found here.

Another interesting thing about this lawsuit is the name of the company sued. Long ago, I noted the odd susceptibility to securities class action lawsuits of companies with the word “Advanced” as the first word in their name. The Stanford Law School Securities Class Action Clearinghouse index of securities lawsuits (here) identifies 12 different companies (including Advanced Medical Optics) that have been sued in class action lawsuits. I do not mean to engage in the much-derided confusion of correlation and causation, but I still do think that it is kind of weird that companies with the word “Advanced” in their name seem to get sued all the time.

AIM’s Success and U.S. Capital Market Competitiveness

As I have noted in prior posts (most recently here), the several blue-ribbon panels that have recently examined the competitiveness of the U.S. financial markets have been particularly concerned with the apparent loss of company listings to overseas exchanges, particularly the London Stock Exchange’s Alternative Investment Market (AIM). These would-be reformers have cited AIM’s success as evidence that the U.S. regulatory structures, and the Sarbanes Oxley Act in particular, are driving potential issuers to competitor financial markets. They have similarly contended that in order for U.S. financial markets to reclaim their competitive position, the U.S. regulatory structure (and SOX in particular) should be reformed.

Lacking from these studies has been a detailed analysis of the causes of AIM’s success, and the absence of this perspective arguably has led the would-be reformers to proscribe “solutions” that may not be best calculated to help U.S markets meet AIM's challenge. An August 2007 paper by Jose Miguel Mendoza of Javeriana University in Bogotá, Columbia, entitled “Securities Regulation in Low-Tier Listing Venues: The Rise of the Alternative Investment Market” (here), takes a closer look at the reasons for AIM’s success. His observations may suggest that an approach to regulatory reform that is more finely-tuned than that proposed by the reformers could be likelier to improve U.S markets’ competitive position while preserving its advantages.

Perhaps the most interesting aspect of Mendoza’s paper is his exploration of the historical reasons for AIM’s success. In his view, AIM’s success in recent years was in significant ways the result of historical circumstance. The failure of the other European New Markets (such as the Neuer Markt) left a relatively open field, at a time when the bursting of the Internet bubble in this country caused the senior U.S. exchanges to heighten listing requirements –especially with respect to minimum market capitalization requirements. These forces were exacerbated by the demutualization of the leading exchanges, and the exchanges’ conversion to listed, for-profit enterprises, which made smaller companies’ listings less attractive. As a result of these developments, a “public equity financing gap” developed for smaller enterprises, a need that the AIM was well-positioned to meet. As Mendoza puts it, the “main reason behind AIM’s growth lies with the fact that it supplies a scarce product to the marketplace: rapid and low-cost access to public equity for small firms with high growth potential.”

Mendoza also points out that AIM’s platform was successful because it was built in recognition that a “one-size fits all regulatory scheme” that works well for larger, better-capitalized companies may be poorly suited to the needs of smaller companies. AIM’s regulatory structure is “tailored to fit the needs of small firms with high-growth potential.” Mendoza characterizes this calibration of regulatory structure to company size and maturity as “the specialization of listing venues” and attributes AIM’s success to its specialization for smaller growth stage companies. As the same time, Medoza recognizes that more rigorous regulatory structures, which are better suited to larger, better-capitalized companies, can have benefits for those companies, such as lower costs of capital and higher valuations.

In my view, it is an appreciation for this aspect of AIM’s success formula that is missing from the would-be reformers' analysis; that is, the reformers overlook AIM’s particular value and attraction for smaller companies. The reformers’ proposed across-the-board reforms is a purported "one size fits all" solution to a problem that is due to a "one size fits all" regulatory system. But an across the board regulatory reform could eliminate the advantages of the U.S. markets for better-capitalized listing companies that benefit from lower costs of capital and higher valuations on U.S exchanges as a result of the U.S.’s highly regulated system. As alternative reform proposal that would be more likely to enable the U.S. financial markets to compete with AIM would be one that is not across the board, but rather one that is, to paraphrase Mendoza, tailored to meet the needs of the smaller, growth-stage companies that are attracted to AIM but that may be closed out now from the senior U.S. exchanges.

For that matter, it may be that the competitive dynamic of the global financial marketplace is already tending in this direction, without the need for governmental action. The recent launch of the OTCQX listing service (refer here) is a direct marketplace response to AIM’s success. Similarly, the recent debuts of the Nasdaq Portal (refer here) and the GSTrUE trading platform (refer here) – both of which are designed to permit institutional investors to trade ownership interests in companies that are not interested or not able to take on the reporting company burdens and responsibilities – are two additional ways that the marketplace is evolving to challenge AIM’s success and to provide smaller companies with access to equity capital.

The arrival of these trading innovations and the likelihood that further advances of this type will follow suggests the possibility that regulatory reform may not even be necessary for U.S. markets to be able to meet AIM’s challenge. Although Medoza’s paper does not expressly address this point, the logical extension of his analysis is that if there is to be any reform, it should be fine-tuned to meet the competitive challenge, and that an across the board one size fits all approach could weaken current competitive advantages the U.S markets offer companies that are able to meet the U.S.’s stricter regulatory regime.

If Mendoza’s paper has a weakness, it is its tendency to minimize the concerns that commentators have noted with respect to the AIM approach (about which refer here). Even while acknowledging that it “remains to be seen whether [AIM’s] particular system of self-regulation can take the strain of increased numbers of non-UK companies” and that the “venue’s performance could have been negatively affected by the poorer quality of companies coming into the market during 2006,” he nonetheless is an emphatic advocate for AIM’s self-regulatory approach, and particularly for the benefits of its Nominated Advisor (Nomad) gatekeeper system.

Prospective issuers are clearly well aware of the potential shortcomings of an AIM listing (as discussed here), and that awareness will clearly affect AIM’s competitive position going forward – indeed AIM’s growth has slowed in 2007, and AIM offerings during the first four months of 2007 were more than 50% below the number of offerings in the comparable period in 2006.

If the U.S. financial markets want to not only regain their competitive position but in fact achieve a competitive advantage, the best approach would be to encourage further marketplace innovation calculated to meet the needs of smaller, growth-oriented companies, while avoiding the concerns that AIM market participants have noted. By the same token, an across the board regulatory reform that is not fine-tuned to meet the needs of smaller companies could weaken the advantages of the senior U.S. exchanges and ultimately reduce the competitiveness of the U.S financial markets.

My prior post examining the question whether the proposed reforms would solve a problem or introduce a weakness can be found here.

Hat tip to the Ideoblog (here) for the link to Mendoza’s article.

Add One to the Subprime Lawsuit Tally: Regular readers know that I have been maintaining (here) a running tally of the subprime lending-related securities class action lawsuits. The filing this past week of a new securities class action case against Thornburg Mortgage (press release here), brings the number of subprime lending related securities class actions to 13.

More About Climate Change and D & O Risk: In earlier posts (here and here), I have examined the possible risk exposure of directors and officers arising from regulatory, legislative and judicial developments involving climate change. In the latest issue of InSights (here), I take a closer look at “Global Climate Change and D&O Insurance.”

Will the Subprime Meltdown Affect the D & O Marketplace?

As I have previously noted (most recently here), the subprime mortgage meltdown has produced a wave of lawsuits, including securities class action litigation (which I am tracking here). Even thought we are clearly only at the beginning of what will undoubtedly be a very long-developing story, the question is already being asked: what impact will the subprime mortgage mess have on the D & O insurance marketplace? For example, an August 22, 2007, Insurance Journal article entitled "The Blame Game and the Subprime Mortgage Meltdown"(here), among other things, examined the possible impact of the subprime mess on the D & O insurance marketplace. (Full disclosure: I was interviewed in connection with the article.)

In one sense, it may simply be too early to be asking these questions. As I noted in the Insurance Journal article, we are only at the very top of the first inning in what will probably be an extra-inning contest. This story has much further to run. But on the other hand, it may not be too early to begin to make some assessments of the seriousness of the situation.

And for my money, this is a very serious situation, indeed. It already may be potentially far more serious for the D & O industry than the options backdating scandal. The options backdating scandal involved chronologically remote events, arcane accounting principles, and, except in a few extreme cases, the claims were not accompanied by significant loss of market capitalization or other investor loss. (The exceptions to these generalizations are of course quite noteworthy, but from the perspective of the D & O industry, the backdating scandal taking collectively is simply not a market changing event.) By contrast, the subprime mess is immediate, involves immediately apparent and emotionally compelling issues, and has been accompanied by very substantial investor loss. Even though the backdating scandal involved many more lawsuits (so far, at least), the subprime mess already poses a potentially far more serious problem for the D & O industry, and the potential will only grow in the months ahead.

But what does all of that imply as a practical matter for the D & O marketplace? Because of the marketplace context within which the subprime mess is now unfolding, the subprime meltdown may or may not mean anything, at least in the short term, other than for companies directly involved in the subprime lending industry. The D & O marketplace has been in a declining pricing mode since late 2003, characterized by high levels of competition, with new entrants recently coming into the marketplace. These conditions are not going to change overnight, even given the potential seriousness of the developments resulting from the subprime mess. However, it is not too early to begin to ask whether or not the subprime mess might begin to have some effects, and to ask where all of this might eventually lead.

First of all, companies involved in the mortgage lending business are going to face a far different D & O insurance marketplace than even just 2 or 3 months ago. D & O underwriters are on high alert status for subprime lending risk. Companies with perceived subprime exposure will face, at an absolute minimum, heightened underwriting scrutiny, tightened terms and conditions, and increased pricing. It is fair to say that this sector will be in the "hard to place" category for the foreseeable future. Nor will these tightened circumstances be limited just to subprime lenders. Since problems have already begun to emerge with so-called Alt-A loans (for example, refer here), and even some other loan categories, the scrutiny will extend to all companies involved in the residential mortgage lending business.

Along those same lines, the exact location of the outer edge of the heightened scrutiny category will remain ill-defined for some time, and could potentially encompass a variety of other kinds of companies beyond those involved directly in residential mortgage lending. Certainly, home builders, real estate agents, residential REITs, and other businesses whose fortunes are tied directly to the residential real estate sector will also face a different D & O environment than even just a couple of months ago. The environment for commercial banks and other traditional lending institutions will also be affected, but the extent of the impact will vary, depending on the extent of each bank’s exposure to residential mortgage risk, particularly subprime mortgage risk. But even banks that no longer hold the mortgages could face stricter scrutiny to the extent the banks off-loaded the mortgages to outside investors.

In addition, all companies seeking D & O insurance will be facing the possibility of additional underwriting inquiry around the companies’ balance sheet exposure to mortgage investment risk. As I noted in my prior post (here), there is $1.08 trillion in subprime mortgage backed asset investment (meaured by cost, not necessarily current value) sitting on balance sheets somewhere out there. D & O underwriters will be trying to determine applicants’ balance sheet exposure to this mortgage investment risk. Obvious places to look for this risk include hedge funds and other alternative investment vehicles, mutual funds, investment banks, residential mortgage REITs, and insurance companies. But the inquiry will likely not be limited just to companies in these sectors; given the sheer magnitude of the mortgage-backed investment risk dispersed in the economy, the mortgage investment risk may have wound up in some unexpected places. In addition, underwriters’ questions will likely not be limited to whether the applicant directly holds investments in mortgage-backed assets, but will also inquire whether the applicant has investments in hedge funds or other investment vehicles with significant exposure to mortgage-backed investments.

Beyond these predictable underwriting effects, it is simply too early to tell what the overall impact will be on the D & O marketplace. The quick emergence of claims frequency around subprime mortgage issues and the uncertainty of the eventual extent of the problem has to be making the managers at the D & O insurers (and their reinsurers) more than just a little bit uncomfortable right now. But whether that uneasiness alone is enough to reverse the current downward pricing trend remains to be seen. My own expectation is that the effects on the D & O marketplace will be uneven, with some predictable sectors constricting but most others remaining competitive, at least in the short term. Whether the constrictive impact will become more generalized will depend on how large and how widespread the subprime litigation wave becomes. Stay tuned.

One Example Why I Think The Subprime Litigation Wave Will Grow: The potential for the subprime litigation wave to encompass an ever-wider variety of companies in an ever-broader variety of claims may be seen in the purported class action lawsuit previously filed in federal court in Florida against D’Alessandro & Woodyard, a Florida residential real estate broker; First Home Builders of Florida, a residential home builder specializing in the first-time home buyer segment; these two companies’ successors in interest; and certain principals of the real estate agency. The complaint may be found here.

The complaint alleges that the home builder would attract would-be home buyers to new home open houses. Would-be home buyers who could not qualify for home purchase financing were allegedly referred to the real estate broker, who helped the would-be buyers enter a lease-to-buy program, where the lease payments were intended to be used as documentation to help a later mortgage application to support the tenant’s ultimate purchase of the home. The homes to be leased purportedly were sold to investors, who would carry the home during the tenancy, and then after an interval would sell the homes to the tenants. The investors purportedly were promised "ready made" tenants, and a 14% return.

The plaintiffs allegedly purchased 3 lots on which 3 of these lease-to-own home would be built, borrowing $790,000 in construction financing from an alleged "hand picked" lender, despite having only $90,000 in gross annual income. The plaintiffs allege that no tenants have been procured for these houses, and that they now face foreclosure on the three properties. The plaintiffs allege on behalf of themselves and other similarly situated investors that the defendants breached Section 12 of the ’33 Act, Section 10 of the ’34 Act, breached their contract with the plaintiffs, and violated a variety of state trade practices acts.

There are several parts of these alleged factual circumstances that are interesting. The first is that the defendants include not only the home builder but also the real estate agents. As I have previously suggested (here), the wave of blame for the subprime mess will spread outward, and will involve an ever-broader variety of purported scapegoats, and an increasingly large number and variety of professionals. This gatekeeper blame is already being assigned to directors and officers, credit rating agencies, mortgage brokers and real estate appraisers. Before this situation is entirely played out, we undoubtedly will have blame cast upon auditors, attorneys, investment advisors, hedge fund and pension fund managers, and many others whom circumstances will show to have played some role.

The second is what this alleged investment opportunity required for its prospective success. Not only did it require the availability of tenants who could pay the rent under the lease to own program –even though they couldn’t afford a mortgage at the outset – but it also required a tenant who could later successfully acquire financing to buy out the investors. Allegedly, the Prospectus that was provided to potential investors explained that the "exit strategy" was possible due to the availability to the tenant-buyers of subprime financing. Among other things, the Prospectus allegedly stated that 14% gain would be paid to the investors

once the tenant refinances the home in their name buying the investor out of the deal. The refinance is possible because Sub-prime lenders will allow a refinance on a property with 12 cancelled monthly checks for a lease payment. Tenants are preliminarily screened for credit, income, and debt analysis. They are coached in the process of the refinance and how to qualify in the upcoming year.

In addition to the tenant, the investors too had to be able to secure financing. But the ultimate benefit to the tenants and investors depended upon their ability not only to qualify for but to repay the debt. Of course, in some circumstances (if not in these precise circumstances) the ability to repay may have been of less concern to some brokers or home builders, and for that matter, to some lenders, who counted on their ability to sell their loans to third party investors.

The allegations in the complaint are mere assertions, and I have no way of knowing whether or not they are true or false, nor do I know whether the plaintiffs’ claims are meritorious. However, the plaintiffs allegations suggest the true seduction that came with the availability of easy credit at a time of rising prices – everyone involved was going to make money, or at least prosper. The number of investors or eventual home-buyers who may have incurred debt beyond their means hoping to prosper or benefit in situations like this one, or in the untold number other variants that played out over the past few years, where marginal borrowers were "coached" into debt qualification but not on the challenge of debt repayment, create a multitude of individual situations where financial reversals will leave a plethora of aggrieved parties, whose grievance will, more likely than not, wind up in court. The assignment of blame will extend beyond individual cases to attempts to cast collective blame against the companies that facilitated and prospered from these arrangements, as well as the managers who ran the companies, the investment bankers who financed the lending and packaged the debt for resale, the investment managers who supported the system by buying the debt on behalf of their investment funds, and outward and onward. As this case shows, the blame shifting game will be actively supported by lawyers willing to pursue creative theories in support of their clients' interests.

As I have said, we are only in the top of the first inning. But the scoreboard already looks alarming, at least to me. Contrasting perspectives from responsible spokespersons are welcome.

Very special thanks to Timothy Raub at LexisNexis for calling my attention to this case, and to Adam Savett of the Securities Litigation Watch for providing a link to the complaint.

Speaking of the SLW, a hearty welcome back to Adam for his (alleged!) return (here) to the blogging circuit.

An Historical Sidenote: In his recent splendid biography (here) of Andrew Carnegie, historian David Nasaw describes the Panic of 1873, caused by the October 1873 failure of the Philadelphia finance firm of Jay Cooke & Co., which had overextended itself after getting caught up in the euphoria that accompanied the attempt to build the transcontinental railroad. Nasaw writes:

Like all financial panics, the signs had been there to see -- but no one bothered to look until it was too late. Businesses had been failing and banks hiking their interest rates since the spring. Jay Cooke, who had in 1869 been overtaken by the transcontinental madness, found it difficult, then impossible to borrow what he needed to complete construction of his Northern Pacific Railroad....He attempted to sell Northern Pacific bonds at a deep discount, but there were no takers....The failure of Jay Cooke & Co. set off a round robin of bank and business failures. Stocks tumbled, out-of-town banks took back the reserves they had parked in New York City, causing New York banks to call in their old loans and raise rates on new ones.... The railroads, which survived on credit, were instantly crippled. The effect on Pittsburgh's manufacturing firms, including Carnegie's, was immediate because the railroads with which they did so much business no longer had money to pay their bills. Banks were no use in the crisis. Those that remained open suspended payments....

The world is a different place than it was in 1873. The economy is stronger, more diverse, and is protected with more safeguards now, and there is no reason at this point to think the current conditions will lead to anything like what happened in 1873. But those prior circumstances have some oddly familiar echoes. One thing that has not changed is the fundamental dependence of the credit system on the ability of borrowers to repay their debt. When they cannot, then problems ensue, now as then, and the effects still reverberate across the entire economy.

Meanwhile, Back at the Ranch: The subprime mess may be the headline story, but that does not mean that the backdating scandal has gone away, and indeed, just this week a securities class action lawsuit was filed (press release here) against another company, in this case Semtech. (Semtech was already involved in an options backdating related shareholders derivative suit.) According to the running tally of options backdating related securities class action lawsuits that I am maintaining here, that brings the count of options backdating related class actions to 32. I also added two options backdating related shareholders derivative suits to the list as well (iBasis and Citrix), bringing the tally of options backdating related shareholders' derivative suits to 163. Thanks to Timothy Raub at LexisNexis for identifying the omissions.

Speaker’s Corner: The subprime mortgage litigation wave has captured the attention of quite a few observers, and it will undoubtedly lead to a number of legal issues as well as insurance coverage issues. On October 29-30, 2007 in Chicago, I will be co-Chairing, with Matt Jacobs of Jenner & Block, a Mealey’s conference entitled "Subprime Mortgage Litigation", the agenda for which may be found here. The conference will feature a number of recognized experts, both in the field of mortgage lending and in the field of insurance coverage issues. Because of the growing importance of these issues, this conference will surely attract a great deal of interest and attention.

Will the Subprime Meltdown Affect the D & O Marketplace?

As I have previously noted (most recently here), the subprime mortgage meltdown has produced a wave of lawsuits, including securities class action litigation (which I am tracking here). Even thought we are clearly only at the beginning of what will undoubtedly be a very long-developing story, the question is already being asked: what impact will the subprime mortgage mess have on the D & O insurance marketplace? For example, an August 22, 2007, Insurance Journal article entitled "The Blame Game and the Subprime Mortgage Meltdown"(here), among other things, examined the possible impact of the subprime mess on the D & O insurance marketplace. (Full disclosure: I was interviewed in connection with the article.)

In one sense, it may simply be too early to be asking these questions. As I noted in the Insurance Journal article, we are only at the very top of the first inning in what will probably be an extra-inning contest. This story has much further to run. But on the other hand, it may not be too early to begin to make some assessments of the seriousness of the situation.

And for my money, this is a very serious situation, indeed. It already may be potentially far more serious for the D & O industry than the options backdating scandal. The options backdating scandal involved chronologically remote events, arcane accounting principles, and, except in a few extreme cases, the claims were not accompanied by significant loss of market capitalization or other investor loss. (The exceptions to these generalizations are of course quite noteworthy, but from the perspective of the D & O industry, the backdating scandal taking collectively is simply not a market changing event.) By contrast, the subprime mess is immediate, involves immediately apparent and emotionally compelling issues, and has been accompanied by very substantial investor loss. Even though the backdating scandal involved many more lawsuits (so far, at least), the subprime mess already poses a potentially far more serious problem for the D & O industry, and the potential will only grow in the months ahead.

But what does all of that imply as a practical matter for the D & O marketplace? Because of the marketplace context within which the subprime mess is now unfolding, the subprime meltdown may or may not mean anything, at least in the short term, other than for companies directly involved in the subprime lending industry. The D & O marketplace has been in a declining pricing mode since late 2003, characterized by high levels of competition, with new entrants recently coming into the marketplace. These conditions are not going to change overnight, even given the potential seriousness of the developments resulting from the subprime mess. However, it is not too early to begin to ask whether or not the subprime mess might begin to have some effects, and to ask where all of this might eventually lead.

First of all, companies involved in the mortgage lending business are going to face a far different D & O insurance marketplace than even just 2 or 3 months ago. D & O underwriters are on high alert status for subprime lending risk. Companies with perceived subprime exposure will face, at an absolute minimum, heightened underwriting scrutiny, tightened terms and conditions, and increased pricing. It is fair to say that this sector will be in the "hard to place" category for the foreseeable future. Nor will these tightened circumstances be limited just to subprime lenders. Since problems have already begun to emerge with so-called Alt-A loans (for example, refer here), and even some other loan categories, the scrutiny will extend to all companies involved in the residential mortgage lending business.

Along those same lines, the exact location of the outer edge of the heightened scrutiny category will remain ill-defined for some time, and could potentially encompass a variety of other kinds of companies beyond those involved directly in residential mortgage lending. Certainly, home builders, real estate agents, residential REITs, and other businesses whose fortunes are tied directly to the residential real estate sector will also face a different D & O environment than even just a couple of months ago. The environment for commercial banks and other traditional lending institutions will also be affected, but the extent of the impact will vary, depending on the extent of each bank’s exposure to residential mortgage risk, particularly subprime mortgage risk. But even banks that no longer hold the mortgages could face stricter scrutiny to the extent the banks off-loaded the mortgages to outside investors.

In addition, all companies seeking D & O insurance will be facing the possibility of additional underwriting inquiry around the companies’ balance sheet exposure to mortgage investment risk. As I noted in my prior post (here), there is $1.08 trillion in subprime mortgage backed asset investment (meaured by cost, not necessarily current value) sitting on balance sheets somewhere out there. D & O underwriters will be trying to determine applicants’ balance sheet exposure to this mortgage investment risk. Obvious places to look for this risk include hedge funds and other alternative investment vehicles, mutual funds, investment banks, residential mortgage REITs, and insurance companies. But the inquiry will likely not be limited just to companies in these sectors; given the sheer magnitude of the mortgage-backed investment risk dispersed in the economy, the mortgage investment risk may have wound up in some unexpected places. In addition, underwriters’ questions will likely not be limited to whether the applicant directly holds investments in mortgage-backed assets, but will also inquire whether the applicant has investments in hedge funds or other investment vehicles with significant exposure to mortgage-backed investments.

Beyond these predictable underwriting effects, it is simply too early to tell what the overall impact will be on the D & O marketplace. The quick emergence of claims frequency around subprime mortgage issues and the uncertainty of the eventual extent of the problem has to be making the managers at the D & O insurers (and their reinsurers) more than just a little bit uncomfortable right now. But whether that uneasiness alone is enough to reverse the current downward pricing trend remains to be seen. My own expectation is that the effects on the D & O marketplace will be uneven, with some predictable sectors constricting but most others remaining competitive, at least in the short term. Whether the constrictive impact will become more generalized will depend on how large and how widespread the subprime litigation wave becomes. Stay tuned.

One Example Why I Think The Subprime Litigation Wave Will Grow: The potential for the subprime litigation wave to encompass an ever-wider variety of companies in an ever-broader variety of claims may be seen in the purported class action lawsuit previously filed in federal court in Florida against D’Alessandro & Woodyard, a Florida residential real estate broker; First Home Builders of Florida, a residential home builder specializing in the first-time home buyer segment; these two companies’ successors in interest; and certain principals of the real estate agency. The complaint may be found here.

The complaint alleges that the home builder would attract would-be home buyers to new home open houses. Would-be home buyers who could not qualify for home purchase financing were allegedly referred to the real estate broker, who helped the would-be buyers enter a lease-to-buy program, where the lease payments were intended to be used as documentation to help a later mortgage application to support the tenant’s ultimate purchase of the home. The homes to be leased purportedly were sold to investors, who would carry the home during the tenancy, and then after an interval would sell the homes to the tenants. The investors purportedly were promised "ready made" tenants, and a 14% return.

The plaintiffs allegedly purchased 3 lots on which 3 of these lease-to-own home would be built, borrowing $790,000 in construction financing from an alleged "hand picked" lender, despite having only $90,000 in gross annual income. The plaintiffs allege that no tenants have been procured for these houses, and that they now face foreclosure on the three properties. The plaintiffs allege on behalf of themselves and other similarly situated investors that the defendants breached Section 12 of the ’33 Act, Section 10 of the ’34 Act, breached their contract with the plaintiffs, and violated a variety of state trade practices acts.

There are several parts of these alleged factual circumstances that are interesting. The first is that the defendants include not only the home builder but also the real estate agents. As I have previously suggested (here), the wave of blame for the subprime mess will spread outward, and will involve an ever-broader variety of purported scapegoats, and an increasingly large number and variety of professionals. This gatekeeper blame is already being assigned to directors and officers, credit rating agencies, mortgage brokers and real estate appraisers. Before this situation is entirely played out, we undoubtedly will have blame cast upon auditors, attorneys, investment advisors, hedge fund and pension fund managers, and many others whom circumstances will show to have played some role.

The second is what this alleged investment opportunity required for its prospective success. Not only did it require the availability of tenants who could pay the rent under the lease to own program –even though they couldn’t afford a mortgage at the outset – but it also required a tenant who could later successfully acquire financing to buy out the investors. Allegedly, the Prospectus that was provided to potential investors explained that the "exit strategy" was possible due to the availability to the tenant-buyers of subprime financing. Among other things, the Prospectus allegedly stated that 14% gain would be paid to the investors

once the tenant refinances the home in their name buying the investor out of the deal. The refinance is possible because Sub-prime lenders will allow a refinance on a property with 12 cancelled monthly checks for a lease payment. Tenants are preliminarily screened for credit, income, and debt analysis. They are coached in the process of the refinance and how to qualify in the upcoming year.

In addition to the tenant, the investors too had to be able to secure financing. But the ultimate benefit to the tenants and investors depended upon their ability not only to qualify for but to repay the debt. Of course, in some circumstances (if not in these precise circumstances) the ability to repay may have been of less concern to some brokers or home builders, and for that matter, to some lenders, who counted on their ability to sell their loans to third party investors.

The allegations in the complaint are mere assertions, and I have no way of knowing whether or not they are true or false, nor do I know whether the plaintiffs’ claims are meritorious. However, the plaintiffs allegations suggest the true seduction that came with the availability of easy credit at a time of rising prices – everyone involved was going to make money, or at least prosper. The number of investors or eventual home-buyers who may have incurred debt beyond their means hoping to prosper or benefit in situations like this one, or in the untold number other variants that played out over the past few years, where marginal borrowers were "coached" into debt qualification but not on the challenge of debt repayment, create a multitude of individual situations where financial reversals will leave a plethora of aggrieved parties, whose grievance will, more likely than not, wind up in court. The assignment of blame will extend beyond individual cases to attempts to cast collective blame against the companies that facilitated and prospered from these arrangements, as well as the managers who ran the companies, the investment bankers who financed the lending and packaged the debt for resale, the investment managers who supported the system by buying the debt on behalf of their investment funds, and outward and onward. As this case shows, the blame shifting game will be actively supported by lawyers willing to pursue creative theories in support of their clients' interests.

As I have said, we are only in the top of the first inning. But the scoreboard already looks alarming, at least to me. Contrasting perspectives from responsible spokespersons are welcome.

Very special thanks to Timothy Raub at LexisNexis for calling my attention to this case, and to Adam Savett of the Securities Litigation Watch for providing a link to the complaint.

Speaking of the SLW, a hearty welcome back to Adam for his (alleged!) return (here) to the blogging circuit.

An Historical Sidenote: In his recent splendid biography (here) of Andrew Carnegie, historian David Nasaw describes the Panic of 1873, caused by the October 1873 failure of the Philadelphia finance firm of Jay Cooke & Co., which had overextended itself after getting caught up in the euphoria that accompanied the attempt to build the transcontinental railroad. Nasaw writes:

Like all financial panics, the signs had been there to see -- but no one bothered to look until it was too late. Businesses had been failing and banks hiking their interest rates since the spring. Jay Cooke, who had in 1869 been overtaken by the transcontinental madness, found it difficult, then impossible to borrow what he needed to complete construction of his Northern Pacific Railroad....He attempted to sell Northern Pacific bonds at a deep discount, but there were no takers....The failure of Jay Cooke & Co. set off a round robin of bank and business failures. Stocks tumbled, out-of-town banks took back the reserves they had parked in New York City, causing New York banks to call in their old loans and raise rates on new ones.... The railroads, which survived on credit, were instantly crippled. The effect on Pittsburgh's manufacturing firms, including Carnegie's, was immediate because the railroads with which they did so much business no longer had money to pay their bills. Banks were no use in the crisis. Those that remained open suspended payments....

The world is a different place than it was in 1873. The economy is stronger, more diverse, and is protected with more safeguards now, and there is no reason at this point to think the current conditions will lead to anything like what happened in 1873. But those prior circumstances have some oddly familiar echoes. One thing that has not changed is the fundamental dependence of the credit system on the ability of borrowers to repay their debt. When they cannot, then problems ensue, now as then, and the effects still reverberate across the entire economy.

Meanwhile, Back at the Ranch: The subprime mess may be the headline story, but that does not mean that the backdating scandal has gone away, and indeed, just this week a securities class action lawsuit was filed (press release here) against another company, in this case Semtech. (Semtech was already involved in an options backdating related shareholders derivative suit.) According to the running tally of options backdating related securities class action lawsuits that I am maintaining here, that brings the count of options backdating related class actions to 32. I also added two options backdating related shareholders derivative suits to the list as well (iBasis and Citrix), bringing the tally of options backdating related shareholders' derivative suits to 163. Thanks to Timothy Raub at LexisNexis for identifying the omissions.

Speaker’s Corner: The subprime mortgage litigation wave has captured the attention of quite a few observers, and it will undoubtedly lead to a number of legal issues as well as insurance coverage issues. On October 29-30, 2007 in Chicago, I will be co-Chairing, with Matt Jacobs of Jenner & Block, a Mealey’s conference entitled "Subprime Mortgage Litigation", the agenda for which may be found here. The conference will feature a number of recognized experts, both in the field of mortgage lending and in the field of insurance coverage issues. Because of the growing importance of these issues, this conference will surely attract a great deal of interest and attention.

The REALLY Troublesome Thing about the Subprime Mess

According to data form the Office of the Comptroller of the Currency (OCC), there was $10 trillion in outstanding mortgage debt at the end of 2006. Of this, subprime loans accounted for $1.4 trillion. Of that amount, about $1.08 trillion was packaged into securities that, according to the OCC, are not being held by banks, thrifts, credit unions or finance companies. Which means that $1.08 trillion in securitized subprime loan exposure is out there somewhere, on the balance sheets of hedge funds, mutual funds, insurance companies, investment banks, residential mortgage REITs, pension funds and God knows where else.

All of those mortgage-backed securities are being carried on their owners’ balance sheet at valuations based on some accounting convention. If current marketplace conditions persist, the relation between those balance sheet valuations and the actual realizable value of these assets could prove to be highly strained. For any company forced to sell those assets because of liquidity constraints (such as, for example, for a hedge fund or mutual fund, a heightened rate of redemptions), the amount realized could be far different than the current balance sheet valuation.

Even companies facing no immediate liquidation pressure face scrutiny, disclosure challenges, and potential turbulence in the financial marketplace. The sequence of events this past week involving Scottish Re Group illustrates just how volatile current circumstances are for any company holding material amounts of subprime mortgage-backed securities. In connection with its quarterly earnings release (here), Scottish Re provided information relating to its investment holdings in mortgage-backed securities. In supplemental disclosures (here) detailing its mortgage-backed securities investments, Scottish Re disclosed that within its $11 billion investment portfolio (amortized cost valuation), it holds subprime asset backed securities valued at $2.1 billion (about 19.1% of its investment assets) and another $1 billion (or 9.3% of investment assets) in Alt-A loans. (Alt-A loans are designed for borrowers with cleaner credit records, but with other issues that mean the borrowers provided fewer documents.)

In its quarterly earnings release, the company said that the market for these mortgage-backed securities has become “increasingly illiquid and unbalanced with an absence of buyers, causing prices to be well below what we and our third-party managers regard as their true fundamental value.” The financial market’s reaction to the disclosure of the company’s mortgage investment risk was sharp and harsh – the company’s share price dropped 28% in one day. (On Friday, the company's share price did recover 9.45%.)

So – if there are $1.08 trillion in mortgage backed securities out there, there are numerous other entities whose balance sheets, like that of Scottish Re, carry a substantial mortgage investment risk. A senior official at one of the federal regulatory agencies told me that the process of trying to figure out where that risk is like a “very complicated game of ‘Where’s Waldo?’.” There will be other companies making other disclosures like that of Scottish Re, but there will also be other companies who will quietly bump along, carrying the asset at the acquisition cost and counting on the marketplace for mortgage backed securities to reach some sort of equilibrium before the moment of truth. Either way, there is risk , but those companies that are not forthcoming or that soft-pedal the information face an unknown risk of greater hazards down the road.

These concerns are even more complex than may immediately meet the eye, as the balance sheet valuation issue is not limited to just asset-backed securities themselves. For example, insurance giant American International Group found itself providing extensive explanations (see the August 13. 2007 Wall Street Journal article here) of its exposure to certain kinds of insurance contracts called credit default swaps the company has issued to insure pools of collateralized debt obligations (CDOs) backed by mortgages. AIG apparently has written $465 billion in credit default swaps since 1998, about $64 billion of which is linked to multisector CDOs containing subprime debt. Accounting for these derivative instruments requires AIG to mark these instruments to market. The company says it has not changed the value of these instruments on their books since the first quarter of this year.

The problem for the holders of these securities and derivative investments is that in the final analysis the value of these instruments is linked to the performance of the underlying mortgages. Recent headlines have shown that default rates are rising, but the larger risk is that it will get worse. According to analysts at Bank of America Corp. (refer here), homeowners on about $515 billion in adjustable rate mortgages will pay more this year, and another $680 billion worth of mortgages will reset next year. More than 70 percent of the total was granted to subprime borrowers. As these mortgages reset, and some borrowers are unable to make the higher payments or refinance, the default rate will increase. The valuation of the instruments into which these mortgages are securitized will be affected accordingly.

The dilemma for any entity holding the subprime mortgage-backed or subprime mortgage-linked securities is not just that the current marketplace for these investments is illiquid and unbalanced; it is that the situation could well deteriorate further. This puts an enormous pressure on the balance sheets of any entity that has material exposure to these investments. It also creates an enormous disclosure dilemma -- how much should (or must) a company say about the value at which these assets are carried given the uncertainty in the financial marketplace?

For analysts, investors, D&O insurance underwriters, and anyone else who must assess companies’ accounting and financial risk, all of these concerns create a serious problem. It is relatively easy in this environment to understand that mortgage lenders themselves are facing significant challenges. But the question of which other companies are exposed to mortgage investment risk is far more difficult to discern. The $1.08 trillion in subprime mortgage backed securities is distributed on many other balance sheets. Exposures to derivative investments like AIG’s credit default swaps are also spread around the credit and financial marketplace. All of these financial and credit exposures represent significant imbedded risk. More companies will be making disclosures about their exposure to this risk. But the companies that are not disclosing, or that are soft-pedaling the disclosure, may represent the biggest problem.

That is why the SEC, according to the August 10, 2007 Wall Street Journal (here), is "checking the books at top Wall Street brokerage firms and banks to make sure they aren't hiding losses in the subprime-mortgage meltdown." According to the Journal article, the SEC is looking at "whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory, as well as assets held for customers such as hedge funds." While the large investment banks are definitely a good place to start, beyond the investment banks there is still a world of asset valuation risk that remains out there --unexamined, beyond scrutiny from outsiders, but fraught with malevolent potential.

And that is what is really troublesome about the subprime mortgage mess.

Because I hate to sound alarmist, and so as to close on a more reassuring note, I should add that on August 17, Fitch’s announced (here) that it had completed a review of the investment holdings of U.S. life insurers and concluded that the “direct exposure” to investments in mortgage backed securities is “relatively limited in the aggregate and largely concentrated in the high investment-grade securities with significant structural protection.” Of course, these securities are called “investment grade” based on the ratings they carry from the rating agencies….

UPDATE: In his August 20, 2007 column in Fortune magazine (here), Fortune columnist and PIMCO founder Bill Gross notes that "the bond and stock market problem is the same one puzzle player confront during a game of 'Where's Waldo' -- Waldo in this case being the bad loans and defaulting subprime paper of the U.S. mortgage market. While market analysts can estimate how many Waldos might actually show their faces over the next few years - $100 billion to $200 billion seems a reasonable estimate -- no one really knows where they are hidden....Many institutions, including pension funds and insurance companies, argue that accounting rules allow them to mark subprime derivatives at cost. Default exposure, therefore, can hibernate for many months before its true value is revealed to investors....Proper disclosure is, in effect, the key to the current crisis...."

This all has a familiar ring to me. Great minds with but a single thought. Apparently Waldo is on a lot of people's minds these days.

Another Subprime Related Securities Lawsuit: Shareholders have filed a purported securities class action lawsuit against IMPAC Mortgage Holdings and certain of its directors and officers (press release here). The complaint relates to "Impac's representations concerning its Alt-A loans are alleged to be patently untrue, with the Alt-A loans actually being sold to less creditworthy borrowers, so that the loan portfolio was experiencing the same risks and discounts in securitization as sub-prime mortgages. At the same time, Impac overstated its financial results by failing to write down the value of its loan portfolio, thus falsely inflating the prices investors paid for Impac securities."

With the addition of the IMPAC Mortgage lawsuit, the number of subprime mortgage-related securities class action lawsuits now stands at 11, according to the running tally of subprime related lawsuits I am maintaining here.

Delaware Chancery Court Reexamines, Allows Springloading Claim to Proceed

In an August 15, 2007 opinion (here), Delaware Chancery Court Chancellor William B. Chandler III reexamined his February 6, 2007 refusal to dismiss plaintiffs’ claim involving stock option springloading against directors and officers of Tyson Foods, Inc. In his earlier opinion (here), Chandler had held, in response to the defendants’ motion to dismiss, that the board’s authorization of springloaded options may, in certain circumstances, constitute a breach of a director’s fiduciary duties.

In his August 15 opinion, Chandler considered defendants’ motion for judgment on the pleadings, in which the defendants argued that the supposedly springloaded options were in fact authorized under the company’s shareholder approved stock option plan.

The defendants probably sensed that their motion’s prospects for success were dim when they read how Chandler characterized the circumstance that could be inferred from the consolidated complaint:

On three separate occasions between 2001 and 2003, defendants suspected that Tyson’s share price would climb once the market learned what the board already knew. Armed with this knowledge, members of the Compensation Committee granted non-qualified stock options to select Tyson employees, ensuring that these options would shortly be in the money. When the option grants were later revealed to shareholders, however, defendants did not straightforwardly describe such strike-price prestidigitation. Rather, they provided minimal assurances to investors that these options rested within the limits of the shareholder-approved plan. The crux of defendants’ argument is that a scheme that relies upon bare formalism concealed by a poverty of communication somehow sits within the scope of reasonable, good faith business judgment.

In analyzing the issues before him, Chandler first reviewed the legal standards governing directors’ conduct, which he summarized as follows:

Loyalty. Good faith. Independence. Candor. These are words pregnant with obligation. The Supreme Court did not adorn them with half-hearted adjectives. Directors should not take a seat at the board table prepared to offer only conditional loyalty, tolerable good faith, reasonable disinterest or formalistic candor. It is against these standards, and in this spirit, that the alleged actions of spring-loading or backdating should be judged.

The defendants argued that because the company’s Stock Incentive Plan allowed options to be granted at any price, the shareholders had authorized grants of the type at issue. The Company’s SEC disclosures revealed to investors only that the stated strike price on the options had to be the market price on the day of the grant. The SEC disclosures did not reveal the springloading, leading Chandler to observe that the disclosures “display an uncanny parsimony with the truth.” Chandler said that at the pleading stage, taking the inferences in the plaintiffs’ favor, the Court “may further infer that grants of spring-loaded stock 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.” Chandler added that “where I may reasonably infer that a board of directors later concealed the true nature of a grant of a stock options, I may further conclude that those options were not granted consistent with a fiduciary’s duty of utmost loyalty.”

In summarizing the reasons for his denial of the defendant’s motion, Chandler stated that:

What the defendants here fail to confront is that their disclosures regarding the options under attack do nothing to rebut the pleading stage inference that the defendants intended to conceal a pattern of unfairly stocking up insiders’ larders with option grants shortly before the announcement of events likely to increase the Company’s stock price. In fact, the magnitude and timing of the grants, when accompanied with no disclosure of the reasons motivating the grants, is suggestive, at the pleading stage, of a purposeful subterfuge. Put simply, the pleadings support an inference not only that the defendants engaged in self-dealing, but that they attempted to hide their conduct from the stockholders.

While a variety of courts have now weighed in on the backdating issue, the Delaware courts’ statements on these issues remain the most important, because of the prominence and influence of Delaware law and the Delaware courts themselves. Chandler’s views of backdating and springloading in the Tyson Foods case and Ryan v. Gifford (here), the Maxim Integrated Products case, have not prevented other courts from dismissing other cases, and in fact Chancery Court Vice Chancellor Leo Strine distinguished Chandler’s prior opinions in granted the dismissal motion in the Sycamore Networks case (here). But Chandler’s refusal to dismiss the springloading allegations in the Tyson Foods case -- essentially because the options related disclosures were inconsistent with the level of disclosures required by directors’ fiduciary duties -- could have an important impact, precisely because of its insistence that the directors' fiduciary duties require completely candid disclosures to shareholders about all the benefits from an options grant. Certainly his perception that the imbedded profit potential inherent within a springloaded option grant is a benefit of a kind that fiduciary duties require to be disclosed to shareholders will be an important point of view for future courts reviewing springloaded option grants.

The Delaware Corporate and Commercial Litigation Blog also has a post on Chandler's recent opinion in the Tyson Foods case (here). Very special thanks to Francis Pileggi, who maintains the DCCL blog, for providing a copy of the opinion.

"Seven Ways Counsel Can Help Clients With D & O Claims": In an August 16, 2007 post, here, I reviewed seven ways counsel can aid their clients in connection with D & O claims. Due to a snafu at my feed syndication service, no email went out to most of my subscribers about this post, so I just making sure that all readers are aware of the post.

Seven Ways Counsel Can Help Clients with D&O Claims

During a panel discussion on the topic of "Advising a Public Company in Crisis" at the ABA Annual Meeting earlier this week, unexpected time constraints forced me to dramatically abbreviate my planned remarks. On the fly, I fashioned what turned into a list of seven pointers for outside counsel who are assisting their clients in connection with the clients’ D&O claims. Perhaps proving once again that necessity is a mother, the points I conjured up on the spot actually withstand more leisurely scrutiny. Because I believe that these rules of thumb if followed could materially enhance most interactions with insurers on policyholders’ behalf, I reproduce the list of seven items here, with some additional commentary.

1. Keep the carrier informed: When a company is in crisis, communicating with the D & O carrier may seem low priority. But if the company has any expectation or hope of tapping into the D&O policy, there is a substantial detriment in treating the insurance as an afterthought. Complete and contemporaneous communications with the carrier is the single most important way to improve relations with the carrier, and will go a long way toward avoiding many of the problems that sometimes undermine efficient claims resolution.

2. Provide timely, detailed fee statements, separated by matter: Many of the messiest problems that arise in D & O claims involve defense fees, and far too many of these problems arise because billing statements are delayed, incomplete or unedited, or combine a host of legal matters all thrown together. Counsel should consider the legal bills as if they were collectively a brief presented to make the case for payment, and take the same care they would with any other brief. Moreover, counsel should anticipate that the carrier will read the bills very carefully, and in particular prepare and edit the bills with an eye toward the carrier’s likely response to the bills.

3. Threats don’t work: Experienced claims representatives have dealt with many lawyers, have had to face many disputes, have been called many names, have had their depositions taken, and have been accused of bad faith and worse. They have heard it all before, many times. They are inured to the threats, because they have to be to get their job done. But while they can disregard the threats because they must, they prefer to deal with people who have the self-confidence and professionalism to conduct business without resorting to threats. A professional tone is a much more effective approach that a warlike tirade. This of course does not mean backing down if the carrier takes an unreasonable position. The best response if that happens it not to make threats, but to provide reasons. Indeed, I believe it is possible to retain professionalism even if you have to sue the carrier. In the long haul, establishing a professional relationship with the carrier’s claim representative is far more likely to advance your client’s interests and will prove to be an asset if you must deal with the same representative again on a future claim.

4. If the carrier has questions, answer them: This point is really an extension of the prior point about maintaining professional relations. If the carrier feels it needs more information to process the claim, you are not advancing your client’s interests by treating the questions as an unthinkable impertinence. If for some reason it would be difficult or prohibitively expensive to answer the questions, pick up the telephone and try to find out what the carrier really needs and whether there might be a less burdensome or costly way to provide the information. Providing answers helps to remove barriers and expedite the process. Resisting questions and reviling the questioner can only cause problems.

5. Enlist the broker’s assistance: This one is particularly hard for some lawyers, as they presume that they bring everything to the table that is required to get claims resolved. The reality is that broker may have relationships that can help overcome barriers, and the broker may be able to play an important go-between role that can help smooth the path toward claims resolution. A skilled broker can help move the claims process toward the end game. It has been my privilege to be involved in the resolution of quite a number of D&O claims over the years. (As an aside, if your client’s broker is unable to play this role, there may be a serious issue with your client’s choice of broker.)

6. Help set expectations: As hard as it may be to accept, it is sometimes the case that there are defense fees or other costs that may not be covered under the policy. It is counterproductive to continue to agitate for the carrier to pay these items, and the more sharply the focus is kept on the items for which reimbursement appropriately is being sought, the more quickly the process can move toward the end game. Counsel can help here by helping to set the client’s expectations at a realistic level. False hope and unrealistic expectations only delay resolution and encourage unnecessary or even counterproductive disputes.

7. When difficulties emerge, try to resolve them in face-to-face meetings: Lawyers are excellent letter writers, but a letter-writing campaign has limited utility and is unlikely to get to the ultimate end game. In many instances, a face-to-face meeting for the purpose of trying to find a business resolution to disputed issues can get the claims process on a more productive track. Even a phone call is usually preferable to yet another letter.

Obviously, every circumstance is different, and there will be those situations to which these pointers are simply inapplicable. I have been involved in some unfortunate claims over the years where no amount of talking could eliminate the barriers to claims resolution. But in general, the pointers above if followed will in most circumstances substantially enhance the efficiency of the claims process and help avoid the kinds of problems that all too often undermine smooth claims resolution.

Hedge Fund Reassurance in an Uncertain Market: In an August 16 column on Bloomberg.com entitled "Hedge Fund Guy Atones for His Subprime Bond Sins" (here), Mark Gilbert takes a humorous look at what a current update from the fictitious hedge fund "Short-Term Capital Mismanagement LLP" might look like in light of the deterioration in the market for mortgage-backed securities. After reviewing the hedge fund's "proprietary investing tool" (sometimes called "a dartboard") and the "unique hexagonal cuboid models" used to select individual securities, the update reports that investment decisions of other funds using identical dice have resulted in "crowded trade."

After describing the efforts the fund has taken to verify the prices of the securities held in the fund, the update letter also reports:

We have, of course, been in touch with the rating companies to update our default-probability scenarios, particularly on the AAA rated investments we own. They recommended a forecasting method using stochastics to regress the drift-to-downgrade timescales for the past 100 years and throw them forward for the next five minutes. The technical term for this is ``induction,'' though those of you of a less quantitative bent may know it as ``guessing.''

We are pleased to report that, contrary to what current market prices might suggest, all of our top-rated securities remain absolutely AAA. Provided, that is, the future performance of the underlying collateral is identical to its history. Otherwise, the rating companies say our investments are likely to be reclassified as "toast.''

We have also been checking our back-up credit lines with our friends in the investment-banking world. As soon as they return our calls, we'll be able to update you on our emergency liquidity position. We are sure they are fine.

Some of you have written to us asking for your money back, citing clauses in the fund documentation called redemption rights....We have filed your letters in a special drawer in the filing cabinet marked "trash'' for now. Do you have any idea how much trouble you all would be in if we actually sold this stuff in the market today? At these crazy prices? Fuhgeddaboudit. You'll thank us later.

Special thanks to a loyal reader for the link to the Gilbert column.