Court Rejects D & O Insurer’s Attempted Policy Rescission

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

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

In seeking to rescind the policy, the carrier relied on statements made on the company’s behalf at a January 24, 2003 renewal meeting and in the company’s renewal application, which the company’s CEO signed and dated on February 20, 2003. The carrier bound the renewal coverage on February 28, 2003, and the renewal policy incepted on March 2, 2003, for a one-year policy term ending on March 2, 2004. The policy had a $10 million D & O limit, and a separate $10 million limit for offering underwriter coverage. The parties to the coverage case stipulated that by virtue of the dual limits, the policy provided a maximum of $20 million in aggregate limits (although, as noted below, an odd issue arose following trial on the question of the amount of limits available).

Essentially, the carrier took the position that the AFC knew but failed to disclose to the carrier at the January 24 renewal meeting and in the February 20 application that it would be restating its financials, and in any event that the company had a duty to update the application information when it became apparent to the company that it would be restating its financials.

The company’s auditor had been Arthur Anderson, but due to that firm’s legal woes following the Enron scandal, the company retained KPMG as its auditor in early 2002. The trial testimony showed that roughly at the same time as the underwriting process was unfolding, the company was going through its year-end audit for the first time with its new auditor. An issue arose during the audit regarding the method the company used to account for the impairment of long-lived assets. The company had previously used a "market-based" approach to evaluate its impairments; but in late 2001, the Financial Accounting Standards Board issued FAS 144, which KPMG contended required that long-lived assets be grouped together at an individual store level rather than on a market-wide basis. The company’s CFO and KPMG were in disagreement on this issue. The trial testimony showed that the FAS 144 question was an issue throughout the audit, but the court found that a decision had not been reached on the question until a series of meetings whose timing ultimately proved to be critical to the outcome of the rescission cases.

The minutes of the company’s audit committee’s February 28, 2003 meeting showed that the FAS 144 questions "were delaying completion of the audit" but that "no decision was reached on the resolution of those issues at the meeting." On March 1, 2003, a group of company officials met to discuss the status of the audit. The court found that at the meeting, company officials were "confused and frustrated" at KPMG’s position. In this March 1 meeting, the court found, "the subject of a possible restatement of AFC’s financial statements for 2001 and the first three quarters of 2002 was first discussed, because a restatement might be necessary to ensure a consistent presentation of earnings if a new methodology was adopted." The company’s President later that same day learned of the possible restatement "but no decision was made at that time."

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A September 27, 2007 Business Insurance article discussing the AFC Enterprises rescission case can be found here. A September 28, 2007 CFO.com article discussing the case can be found here.

Speaker's Corner: On October 10, 2007, I will be speaking at the C5 D & O Liability Insurance conference in Cologne, Germany on the topic "The Vulnerability of European Insurers and Reinsurers to U.S. Claims." The complete conference agenda can be found here.

Court Dismisses Options Backdating Securities Lawsuit

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

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

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

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

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

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

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

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

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

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

Will Subprime Gatekeeper Blame Reach Lawyers, Too?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Has the Two-Year Lull in Securities Lawsuit Filings Ended?

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

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

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

• Core Investment Trust;


• Net Bank;


• The Tube Media Corp.;


• LJ International Inc.


• Opteum;


• Orbcomm;


• W Holding;


• The Children's Place;

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

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

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

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

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

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

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

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

Where to Look for Subprime Risk: Everywhere?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Weiss Indictment and Schulman’s Plea Agreement

In what may be the beginning of the final act in the Milberg Weiss criminal investigation, on September 20, 2007, a federal grand jury indicted Mel Weiss of participating in a scheme that paid millions of dollars in kickbacks to paid plaintiffs in over 235 class action and shareholders derivative lawsuits. The payments, allegedly made over a 25-year period, garnered the Milberg Weiss firm over $250 million. The Second Superseding Indictment naming Weiss and adding additional allegations against the Milberg Weiss firm and against Seymour Lazar, one of the paid plaintiffs, can be found here. The U.S. Attorneys’ Office’s press release announcing the indictment can be found here.


In addition, on September 20, 2007, former Milberg Weiss partner Steven Schulman agreed to plead guilty to a federal racketeering charge and to acknowledge that he and others conspired to conceal the secret payments from courts and absent class members. Schulman’s plea agreement can be found here, and the U.S. Attorneys’ office’s September 20 press release announcing the plea agreement can be found here.



A September 21, 2007 Wall Street Journal article describing the new indictment and Schulman's guilty plea can be found here. A September 21, 2007 New York Times article can be found here.

The new indictment describes a scheme in which Weiss, Bill Lerach (refer here), David Bershad (refer here), Schulman, and unnamed Milberg Weiss partners E, F and G formed a conspiracy to provide individuals illegal kickbacks, and to cause the individuals to provide false and misleading statements in court documents and in depositions. The three named paid plaintiffs are alleged to have received at least $11.3 million in illegal payments, and others are alleged to have received hundreds of thousands of dollars in payments.

The new indictment alleges that in order to conceal the payments, some of the payments were made through intermediary law firms, and one of the criminal defendants named in the indictment is Paul Selzer, an attorney who is alleged to have received and transmitted the payments for Lazar.

Many of the allegations in the new indictment appeared in the indictments previously filed or were revealed at the time of Bershad’s plea agreement. The new indictment does add the allegation that the kickback payments were omitted from or mischaracterized within the Milberg Weiss law firm’s accounting books and records, and that as a result the law firm "provided false and misleading information to Milberg Weiss’s outside accountants and tax preparers concerning such payments." The indictment also alleges that the law firm prepared false tax documents to disguise the nature of the payments to the intermediary law firms. (There is certainly some significant irony in the fact that the law firm, which garnered hundreds of millions of dollars in fees by alleging that corporations misrepresented their financial condition, is itself alleged to have misrepresented itself financially and to have falsified its own books and records.)

The new indictment also contains some interesting new tidbits. For example, the indictment alleges that after Bershad warned Weiss that paying one of the named plaintiffs in Florida would violate Florida law, "Weiss and Partner F replied, among other things, that because they would be paying [the individual] in cash, there would be no paper trail and therefore there was little risk they would ever be caught." The indictment also alleges that in the mid-80s, Weiss carried thousands of dollars in cash to Florida to pay the Florida paid plaintiffs.

The new indictment also contains detailed allegations regarding the disposition of the Milberg Weiss firm’s $40 million fee from the Oxford Health case (about which refer here). Schulman’s plea agreement suggests where this information may have come from, and is described further below.

The Milberg Weiss firm and Weiss himself are also alleged to have obstructed justice by withholding and or misrepresenting the discovery of a 1990 fax from one of the paid plaintiffs (Stephen Cooperman, about whom refer here) to Bershad. The indictment alleges that the document was withheld from production called for by a Grand Jury subpoena, and that later Weiss made a false statement by stating that he had found the document in a safe in his office at the law firm and that he had forgotten about the document at the time of the document production. The new indictment alleges that Weiss "had not discovered the 11/15/1990 telefax in his safe, but instead had taken the document from David J. Bershad, who had found it in his desk drawer when searching for documents responsive to the Grand Jury Subpoena." (It appears that many of the details in the new indictment may have come from Bershad, who is cooperating with the government as part of his plea agreement.)


According to the U.S. Attorney’s Office press release, Weiss will appear in court on October 12, and will be arraigned on October 25. The press release also states that Weiss faces a maximum prison sentence of 40 years in federal prison. The indictment also seeks the Milberg Weiss firm’s forfeiture of the entire $251 million it is alleged to have made in the cases in which the paid plaintiffs allegedly participated.


Although somewhat overshadowed by the new indictment, Schulman’s plea agreement also has some interesting new information. As part of his agreement, Schulman agreed to pay a $250,000 fine and a criminal forfeiture of $1.85 million ($1 million within seven days of his guilty plea and $850,000 seven days before his sentencing). The plea agreement also contemplates a sentence of from 27 months to 32 months, but the sentencing calculation is not binding on the court. Schulman retains the right to appeal the amount of any forfeiture or fine and also the conditions of his supervised relese. Schulman has agreed to cooperate with the government.


Exhibit A to Schulman’s plea agreement reflects the factual allegations against him. The exhibit alleges that Schulman entered in to an agreement with Weiss, Bershad and unnamed Milberg Weiss partner E to make and conceal secret payments to Vogel. The specific allegations relate to payments made in connection with the settlement of the Oxford Health class action. Schulman and Vogel and alleged to have agreed that in light of the size of the Milberg Weiss law firm’s $40 million fee in the case, Vogel’s share should be reduced from his usual 12 percent.


Schulman allegedly told Weiss that Vogel was willing to accept a smaller percentage, but Weiss is alleged to have said that "in light of the pending criminal investigation" he did not want to negotiate over the telephone. Weiss allegedly instructed Schulman to set up a meeting, and Weiss later allegedly told Schulman that he had worked out an agreement. Schulman is alleged to have sent a Milberg Weiss law firm check to an intermediary attorney, in order to effect payment to Vogel, with a letter stating that the check was to the law firm in payment of services rendered in the Oxford Health case.


Schulman is also alleged to have made or to have caused to be made false and misleading statements in several cases, in which Vogel stated that he was not accepting payments for serving as a plaintiff.


According to the U.S. Attorney’s Office press release, Schulman is scheduled to appear in court on October 19 and is scheduled to be arraigned on October 22.


The prison term specified in Schulman’s plea agreement (27 to 32 months) seems to stand in odd contrast to the significantly shorter 12 to 24 months specified in Lerach’s plea agreement. (This may provide one more fact supporting the view, favored in certain quarters, that Lerach got off easy.) However, Schulman’s relatively greater recommended sentence may be due to the application of negative Sentencing Guideline factors specified in his plea agreement as "substantial interference with the administration of justice"; "obstruction extensive in scope"; and "abuse of a position of trust."


With all of the (currently) indicted Milberg partners having pled guilty, Weiss stands alone to face the allegations. The government’s case apparently will be aided by Bershad’s and Schulman’s cooperation. (Lerach did not agree to cooperate with the government in his plea agreement.) Meanwhile, the Milberg Weiss law firm also faces even more serious allegations than it did before. The firm released a statement today (here) that "we will continue to fight for our clients and class members and to achieve the record recoveries for which our firm has long been known." The statement adds that none of the firm’s active partners is alleged to have been involved in any wrongdoing." (Of course, the partners who are alleged to have committed wrongdoing on the firm’s behalf have all left the firm, and several of them have already pled guilty. But, hey, they aren't at the firm any more, are they?)

So cue the "Ride of the Valkyries" and raise the curtain for what may prove to be the final act, the one in which the fat lady could possibly sing.

Hat tip to the Legal Pad blog (here) for the links to the new indictment, press releases and Schulman plea agreement.

More Subprime Lawsuits: The D & O Diary is maintaining a running tally (here) of subprime-related securities class action lawsuits. Today, I added two new lawsuits to the list, a new lawsuit filed against NetBank (press release here) and a new lawsuit against Opteum (press release here). The addition of these two new lawsuits brings the total of subprime related lawsuits to 16, in addition to four subprime-related lawsuits that have been filed against construction companies.

Looking at Lerach's Agreement to Plead Guilty

According to news reports (here), on September 18, 2007, Bill Lerach has agreed to plead guilty to a federal conspiracy charge. The plea agreement can be found here, the criminal information can be found here, and the governement’s press release can be found here. Hat tip to the WSJ.com Law Blog (here) for the links to the plea documents.

The plea agreement has some interesting additional information. For example, the agreement states that Lerach is not required to cooperate with prosecutors, which probably comes as some relief to his former colleagues who are facing actual or potential criminal charges. In addition, by its entry into the agreement, the government has agreed that it will not prosecute Lerach in connection with a number of other matters, some of which are identified with a tantalizingly brief description. For example, the agreement states that the prosecutors will not continue to pursue criminal charges against Lerach in connection with "requests to courts for reimbursement of fees and costs of a damages expert witness," referred to in the plea agreement as the "Princeton Expert" – presumably John Torkelson, the plaintiffs’s style damages expert who has had legal troubles of his own (refer here).

The agreement also says that the prosecutors will not further pursue charges against Lerach in connection with "election, campaign, or other politicial contributions made using only funds generated by conduct described" in the plea agreement. The agreement also says that prosecutors will not pursue criminal charges concerning "defendant’s investment in, or relationship with, the Acorn Technology Fund." The agreement says just enough about these non-prosecution items to attract curiosity, but reveals little else about these items.

The plea agreement also contains the prosecutors agreement that they will not prosecute either "the Lerach firm" or current Lerach firm partners Patrick J. Coughlin or Keith F. Park for any of the conduct described in the agreement or in the list of non-prosecution items. (The inclusion of these particular provisions in the agreement make me wonder whether by his entry into this agreement, Lerach sought to protect his former firm and former law partners—and to wonder how big of a factor that was in his willingness to enter the agreement.) The agreement does not state what basis if any the prosecutors might have had to proceed against the former Lerach law firm or the two law firm partners.

For his part Lerach agrees to pay a fine of $250,000, to pay a forfeiture of $7,500,000 (in two installments), to appear at all required times, and so on. In addition, although the crime for which Lerach is pleading guilty is punishable by up to five years in prison, Lerach and the U.S. Attorney’s office agree that "an appropriate disposition of this case is…a sentence of imprisonment within the range of 12-24 months, with the court retaining discretion to substitute community confinement or home detention for no more than one-half of the term of imprisonment imposed," with the prison term to be followed by "a three-year period of supervised release." The defendant may withdraw from the agreement if the Court refuses to be bound by the agreement.

The factual basis for the plea agreement is set out in Exhibit A to the plea agreement. The exhibit states, among other things, that "certain senior Milberg Weiss partners agreed with various individuals that Milberg Weiss would secretly pay those individuals a portion of the attorneys’ fees that Milberg Weiss obtained in the Class Actions." The exhibit describes the partners who agreed to this arrangement as including Lerach, David Bershad (refer here), and others. The exhibit states that the paid plaintiffs were "promised that they would be paid approximately 10% of the net attorneys’ fees that Milberg Weiss obtained in their respective Class Actions." The exhibit states that by entering into these arrangments, the firm was able to secure a "reliable source of individuals who were ready, willing, and able to serve as named plaintiffs."

The exhibit states that Lerach and other conspiring partners and the paid plaintiffs understood that "to the extent necessary, they would make or cause to be make false or misleading statements in documents filed in federal Class Actions," including in documents under oath and in under oath testimony. The exhibit further states that Lerach believed that if these secret payment arrangements were discovered, the law firm and the named plaintiff would be disqualified from in the particular action as well as other actions. The exhibit also states that Lerach and other conspiring partners concealed the payments, though the use of intermediary law firms, with the understanding and intent that the funds would be distributed to the paid plaintiffs. The exhibit specifically details payments that were made to one of the named plaintiffs, Steven Cooperman (about whom, and about whose escapades with stolen paintings, refer here).

According to the government's press release, Lerach will appear for arraignment at a later date.

The most interesting question in the wake of Lerach’s guilty pleas is whether prosecutors will now attempt to proceed against Mel Weiss, who thus far has not been indicted. (A September 19, 2007 New York Times article commenting on the possible implications of the Lerach plea for Weiss can be found here.) In addition, it remains to be seen how the pending criminal charges against Steve Schulman, another former Milberg Weiss partner, will be resolved. Finally, the indictment also included the Milberg Weiss law firm itself. Theoretically, the criminal case, which would also include at least two of the paid plaintiffs, is scheduled to go to trial in January 2008.

I have previously commented extensively (for example here) about the possible impact that the Milberg Weiss firm's and the former Milberg partners' legal woes on the number of securities class action filings. It hardly seems a stretch to conclude that the involvement of the leading figures at the two industry leading law firms has has some impact on the filing of new lawsuits. More generally, it also seems like a stretch to suppose that these activities were limited exclusively to one law firm and took place no where else. The fact that the downturn in the number of lawsuit filings coincided with the first indictment handed up from the grand jury investigation these allegations does suggest some relation between these criminal prosecution and the number of lawsuit filings.

At this point, the more important question is what the impact will be going forward. There are certainly no shortage of other law firms willing to occupy the space previously occupied by the leading lawyers, and other firms have from outside the traditional plaintiff securities bar have been coming into the sector. But it remains to be seen whether any of these other firms have the carrying capacity of the former leaders, or whether they have the willingness or ability to finance the kind of massive litigation that the leading firms have been supporting in recent years.

A September 19, 2007 Wall Street Journal article regarding the plea agreement can be found here. The Point of Law blog has an interesting post here, with some pointed comments abou the plea deal (the post also has some links to some of the interesting literature from the Lerach-related archive). A September 19, 2007 Wall Street Journal editorial critical of the plea agreement can be found here.

Another Lawsuit Arising From the Disruption in the Credit Market?: Speaking of Lerach's former law firm, now known as Coughlin, Stoia, Geller, Rudman & Robbins, on September 18, 2007, the firm initiated a new lawsuit against Care Investment Trust and certain of its directors and officers, according to this press release, here. The complaint (which weishs in at a short nine pages and which may be found here) alleges that the company's June 22, 2007 prospectus failed to allege that certain of the assets in the company's portfolio of health-care related assets were materially impaired and therefore overvalued, and that the company was experiencing difficulty in securing warehouse financing lines.

Cases like this suggest that as the credit complications arising from the subprime lending mess spread outward, it is going to become increasinly maintaining definitional clarity over what is and what is not subprime lending related litgation. But as I have noted in numerous prior posts (most recently here) the litigation wave spreading outward from the subprime mess could encompass a broad variety of companies and cases, including companies and cases having nothing directly to do with subprime lending itself. But because this company's difficulties appear to derive from the complications in the credit market, I am aiding it to my list of subprime lending related lawsuits (here), on the theory that this company's woes derive from the follow on contagion effect of the subprime mess. Interested parties who disagree with this case's inclusion in the list should let me know.

Temperature Rises on Climate Change Disclosure Issues

In prior posts (refer here) and other publications (here), I have written about the growing potential exposure to directors and officers of publicly traded companies arising from global climate change concerns. My views have been met with some interest, but also with significant skepticism. But while there are admittedly as yet no D & O claims from climate change issues, several recent developments confirm my view that climate change-related issues represent a growing are of D & O exposure.

First, on September 14, 2007, New York Attorney General Andrew Cuomo subpoenaed five large energy companies demanding that they disclose the financial risks of their greenhouse gas emissions to shareholders. The letters Cuomo’s office sent to the energy companies accompanying the subpoenas can be found here. The five companies are AES Corporation, Dominion Resources, Xcel Energy, Dynegy, and Peabody Energy.

In the case of Dominion Resources, the letter (refer here) states that the purpose of the subpoena to Dominion is to obtain information "regarding Dominion’s analyses of its climate risks and its disclosure of such risks to investors." The letter refers to the company’s plans to build a new coal-fired electric generating facility, which, the letter stated, together with the company’s other carbon emissions generating activities will "subject Dominion to increased financial, regulatory, and litigation risks." The letter goes on to state that Dominion has "not adequately disclosed those risks to its shareholders, including the New York State Common Retirement Fund, which is a significant holder of Dominion stock." The letter adds that "we are concerned that Dominion has failed to disclose material information about the increased climate risks Dominion’s business faces."

The letter states further that:

In its 2006 Form 10-K, Dominion made no disclosure of projected CO2 emissions from the proposed plant or its current plants. Further, Dominion did not attempt to evaluate or quantify the possible effects of future greenhouse gas regulations, or discuss their impact on the company. Dominion also did not present any strategies to reduce CO2 emissions, as new regulations would likely require. These omissions make it difficult for investors to make informed decisions.

Under federal and state laws and regulations, Dominion’s disclosures to investors must be complete and not misleading. Selective disclosure of favorable information or omission of unfavorable information concerning climate change is misleading. Dominion cannot excuse its failure to provide disclosure and analysis by claiming there is insufficient information concerning known climate change trends and uncertainties. (Emphasis added.)

The letter carefully does not say that Dominion engaged in selective disclsoure, it merely states that selective disclosure is misleading. The letter and accompanying subpoena purport to require a response by October 9, 2007. The letters to the other four energy companies are all in a similar vein. Press coverage further detailing the New York Attorney General’s subpoenas can be found here.

In addition to Cuomo’s subpoenas, 22 petitioners, including two environmental groups (Ceres and Environmental Defense), the financial officers of ten states and New York City, and several institutional investors, including the massive California Public Employees' Retirement System (collectively representing over $1.5 trillion in assets), announced that they will petition the SEC to require companies to assess and fully disclose their financial risks from climate change. Ceres’s September 18, 2007 press release describing the petition can be found here, and the petition itself can be found here. The petition is quite lengthy but for those interested in the topic it provides a comprehensive overview. The essential thrust of the petition is that current reporting disclosure of global climate change risks is inadequate to afford investors to make informed decisions, and that clarifying guidance from the SEC is required for investors to be provided with complete information.

An excellent summary of the goals and legal status of the petition, as well as the state of climate change disclosure generally, can be found on the CorporateCounsel.net blog, here.

A September Journal 18, 2007 Wall Street Journal article about the petition (here) quotes Florida’s chief financial officer as saying that in supporting the petition the states’ representatives are "responding to the interest of the general public" in climate change issues and are seeking to "push the agenda forward" to change behavior. A representative from Environmental Defense stated that the petition is "part of a multi-pronged effort to compel the SEC and other federal agencies to take an active role in combating climate change." Ceres’s news release quotes its President as saying that "shareholders deserve to know if their portfolio companies are well positioned to manage climate risks or whether they face potential exposure."
A representative of Ceres, citing their group’s own January 2007 study that over half of the companies in the S & P 500 index do a "poor job disclosing their climate change risk," notes that more than half of these same 500 companies’ sales occur overseas, in nations that are parties to the Kyoto Protocol, yet their risk disclosures are nonetheless inadequate.

The petition notes that disclosures of climate change risk is important not only for companies (such as utilities or energy companies) whose emissions are deemed to be linked to rising atmospheric carbon levels, but also to banks, health-care companies, insurance companies, telecommunications companies and other firms who, the petition states, do not consider themselves as major emitters and so may be disregarding their exposures to climate change related risks.

These recent developments follow on the heels of last week’s decision (refer here) by a federal district judge that Vermont can limit greenhouse-gas emissions from cars and trucks, a ruling that potentially opens the door for wider action by states with respect to climate change issues. The decision also underscores the fact that climate change related regulation is approaching from many different directions, increasing the likelihood that these regulatory concerns will affect an increasingly larger number of publicly traded companies.

The most important aspect of the most recent events is their emphasis on the importance of corporate disclosure. The adequacy or inadequacy of corporate disclosure on climate change issues is clearly going to be a key battleground as part of activist "multi-pronged effort" to raise the profile of climate change issues. The involvement of key representatives of several states – whose responsibilities include oversight of massive public pension funds – undercuts any suggestion that this disclosure movement can be treated as a fringe issue. There may be some truth in the Florida representative’s suggestion that their actions are consistent with the interest of the general public, but because of the massive asset value for which these representatives are responsible, their actions in this area matter.

The danger for publicly traded companies comes not just from the agitation for greater disclosure; rather, the danger comes from the implications embodied in the New York’ Attorney General’s letters. That is, if companies are subject to greater disclosure obligations or expectations, they are also potentially subject to allegations of the same kind as suggested in the letters – that the targeted energy companies engaged in misleading "selective disclosure" or "omission" of unfavorable information. And while these allegations appear only in a letter, it may only be a matter of time before allegations of this type make their way into civil complaints.

Whether or not these kinds of allegations would be meritorious is of course a question that will have to await another day. On a positive note, a federal judge yesterday tossed (refer here) the global warming lawsuit that California had filed against six automakers. But while California’s nuisance theory in that case was unsuccessful, the outcome has little to say about what might follow from a lawsuit alleging misrepresentations or omissions regarding climate change issues. A lawsuit must, of course, allege more than purported misrepresentations or omissions; the lawsuit must also allege causally related damages, and in the absence of any significant shareholder losses supposedly related to climate change disclosures, there would be little incentive for plaintiffs’ lawyers to pursue a climate change disclosure lawsuit. But as significant shareholders of the type behind the SEC petition described above evince their issues, the possibility that a climate change related disclosure might affect a company’s stock price increases.

In any event, some D & O insurers are beginning to take these issues very seriously. A senior official at one of the leading D & O insurers told me recently that climate change issues have moved to the top of their list of longer range concerns. While some might regard this reaction as alarmist, it is not surprising. The recent events involving the petition to the SEC and the New York Attorney General’s subpoenas are unlikely to be isolated or concluding events; they will be followed by many other initiatives with a similar goal, and climate change disclosures will inevitably become an increasingly important governance issue. As its importance increases, so will the disclosure risk.

Another Home Construction Company Sued: Regular readers know that I have been tracking (here) subprime lending related securities class action lawsuits, including subprime related lawsuits against home construction companies. In that regard, a shareholder has filed a purported securities class action lawsuit (refer here) against the CFO of Hovnanian Enterprises, alleging that the CFO violated his fiduciary duties and also violated Section 10(b) of the Securities Act of 1934. The plaintiff purports to represent a class of Hovnanian shareholders who bought the company’s stock between December 8, 2005 and August 17, 2007. The complaint alleges that the CFO knew but filed to disclose that the company lacked requisite internal controls and misrepresented the company’s business and future prospects. The complaint also alleges that the company lacked a reasonable basis to make projections about the company’s financial results, and so the defendant’s statements about the company’s business and future prospects were misleading.

Welcome Back to WVZ: After a lengthy hiatus, the With Vigour and Zeal blog (here) is back online. We here at The D & O Diary are big fans of WVZ and so we are pleased to welcome back the WVZ blog and we look forward to seeing future WVZ posts.

NERA Releases Mid-Year 2007 Securities Class Action Study

In an earlier post (here), I noted Cornerstone Research’s release of its mid-year 2007 of securities class action lawsuits filings and settlements. On September 13, 2007, NERA Economic Consulting released its own mid-year 2007 study, entitled "Recent Trends in Shareholder Class Action Litigation: Filings Stay Low and Average Settlements Stay High – But Are These Trends Reversing?" (here). The NERA study differs in some of its numeric specifics from the Cornerstone study, but the two studies are directionally consistent. The NERA study also has some interesting additional observations, particularly with respect to possible future directions of current trends.

The NERA study, like the Cornerstone study, finds that the class action filing rates in the first half of 2007 were well below historical norms. The NERA study, extrapolating from first half filings, projects 153 full year 2007 filings, compared with a 1998 through 2005 annual average of 284. However, NERA also notes that the filings in the first half of 2007 increased 47% from the second half of 2006, "indicating that the trend in filings may be changing directions."

The NERA study also notes in particular that while there were only 28 new cases filed in the Ninth Circuit in 2006, there were already 20 new Ninth Circuit filings in the first half of 2007, suggesting that the "Ninth Circuit is on pace to return to 2005 levels." NERA also added that "to the extent this Circuits is ahead of the curve on filing trends, this may be a signal that other jurisdictions could also experience a rebound in filings in the months to come."

The NERA study also reviews the recent increases in the average securities class action settlement values, driven by the increase in the number of mega-settlements (over $100 million). NERA notes, the proliferation of mega-cases notwithstanding, that the majority of cases are still resolved for under $10 million, and during the 2005-2007 period "37% of the cases have resolved for less than $5 million, and 57% for less than $10 million." But the median settlement has risen along with the average. In the first half of 2007, the median settlement reached $9 million, compared to $7 million in 2006 and about $5 million in 2004.

The NERA study emphasizes, however, that these settlement value increases are largely being drive by the magnitude of investor losses; NERA notes that "we found no statistically significant change in settlement values since the passage of Sarbanes-Oxley once we control for other factors, including investor losses." The NERA study concludes that "higher investor losses for more recently resolved cases explain the rise in settlements." By the same token, the study also notes that because the cases filed in the first half of 2007 involve relatively lower median investor losses, future settlements may involve lower settlement values.

Other factors that the NERA study notes are correlated with settlement values include: the inclusion in the plaintiff class of the holders of additional classes of securities; the size of the defendant corporation’s market capitalization; the involvement of professional firms as co-defendants; the inclusion of allegations of accounting improprieties; the accompaniment of any kind of official investigation, consent decree or penalty; the service of an institutional investor as lead plaintiff; and the involvement of an IPO. In addition, a company's involvement in the health services sector also appears to positively correlate with settlement values.

When Cornerstone previously released its mid-year study, it created a stir by its inclusion of a statement by Stanford Law Professor Joseph Grundfest in which Grundfest speculated (refer here) that the lower levels of class action filings over the last two years may be the result of a "permanent shift" to reduced levels of class action filings. NERA’s contribution to this assessment of recent filing levels consists of its observation that filing levels in the first half of 2007 represented an uptick from the second half of 2006. In addition, the NERA study concludes with the observation that the stock market has performed well in recent years; the NERA study notes that "should the market have a substantial downturn, average investor losses are likely to increase and filing levels could begin to rise." The NERA study also notes that the subprime lending mess led to seven claims through mid-year 2007, and "may be the source of a significant number of filings in the near future."

In releasing its study several weeks after Cornerstone, NERA had the benefit of watching a couple of months of third quarter filing activities in making its observations. Ordinarily, a few weeks might not make that much of a difference, but so far in the second half of 2007, there has been an increased level of filing activity, including but not limited to a number of new subprime-related securities class action lawsuits (a running count of which can be found here). By my count, there have already been 36 companies sued for the first time during the third quarter of 2007, compared to the 66 filings that NERA counted for all of the first half of 2007. At least for the first weeks of the second-half of 2007, filing levels appear to have returned closer to historical norms. At this point, Professor Grundfest’s declaration that we have moved to a permanently lower level of class action activity appears to have been premature at best.

More Subprime Lawsuits

Regular readers know that I have been maintaining a list (here) of subprime lending-related securities class action lawsuits. A cluster of new subprime lending lawsuits arrived this week, and these new lawsuits suggest additional directions in which the suprime lending litigation wave may be heading.

First, a lawsuit filed in behalf of employees of Countrywide Financial Corporation alleges that actions by the company and its executives caused 401(k) plan participants to lose millions of dollars. News articles describing the Countrywide employees’ 401(k) plan lawsuit can be found here and here. Under the company match component of the plan, many employees received a 50 percent match of up to six percent of their plan contribution, which during 2005 and 2006 was paid in the form of company stock. The Complaint alleges that the defendants had a duty to warn employees’ of the company’s precarious financial condition and that the defendants intentionally concealed information from plan participants. (Many of the putative class members potentially are also part of the Company’s recently announced plan to eliminate 12,000 jobs.)

Second, the Coughlin, Stoia, Geller, Rudman & Robbins firm recently filed a securities class action lawsuit against Tarragon Corporation. Even though Tarragon is not itself a subprime lender (the company develops, renovates, and builds condominiums), the allegations in the complaint derive from the turbulence in the residential real estate sector and in the credit markets that has followed the subprime meltdown. A copy of the Complaint can be found here and the press release describing the complaint can be found here.

The Complaint alleges that Tarragon had failed to consolidate an unprofitable variable interest entity into its consolidated financial statements; had failed to take timely impairment charges and other write downs; and "due to a deterioration in the real estate credit markets … was experiencing liquidity issues due to its inability to obtain loan modifications and additional financing and there was serious doubt about Tarragon’s ability to continue as a going concern." The Complaint also alleges that "given the increased volatility in the homebuilding industry and the real estate credit markets, the Company had no reasonable basis to make projections about its 2007 results."

Third, on September 12, 2007, the Sheet Metal Workers’ National Pension Fund filed a shareholders’ derivative lawsuit against Beazer Homes as nominal defendant, and several of the company’s current and former directors and officers. (Refer here for a copy of the Complaint.) The Complaint alleges that the defendants breached their duties by failing to implement internal controls to prevent the operation of the company’s mortgage origination and brokerage subsidiary in an illegal manner; caused the company to issue false financial statements, and failed to prevent improper insider trading and the improper grant of bonuses to senior management.

None of these new lawsuits are straightforward securities class action lawsuits filed against subprime mortgage lenders of the kind that I have been tracking. But they are all consequentially related to the subprime mortgage mess. The Countryside 401(k) lawsuit is the most obvious example, since it involves a subprime lender, and the plaintiffs’ are merely pursuing alternative legal approaches after other plaintiffs’ lawyers have already occupied the securities class action space with relation to Countrywide. I have added the Countywide suit to my list of subprime lender 401(k) lawsuits, here.

The Beazer Homes derivative lawsuit is a related example. Beazer has also already been sued in a subprime lending-related securities class action lawsuit (refer here), but just as happened with the options backdating scandal, plaintiffs’ lawyers who are preempted from filing a securities lawsuit are suing the same companies under shareholders’ derivative theories. And as also happened in the options backdating cases, the derivative cases may be attracting attorneys from outside the traditional plaintiffs’ securities bar. The lead counsel in the Beazer Homes derivative case is the Motley Rice law firm, which is better known for its involvement in asbestos and tobacco litigation.

The Tarragon lawsuit is interesting because, while it is not directly related to subprime lending per se, it is directly related to the turbulence that has hit the larger residential real estate sector, and is largely due to more generalized disruptions in the credit marketplace. The worrisome implication is that the contagion effect of the subprime mess is not only having an adverse impact on larger segments of the economy, but those adverse effects could produce additional shareholder litigation outside the subprime arena itself. And on an even more general level, the heightened level of plaintiffs’ lawyer activity manifest in these three cases may perhaps bespeaks a broader litigation threat to a broader spectrum of companies.

More About Alternatives to Auditor Liability Caps: In a prior post (here), I reviewed a recent article in which Professor Lawrence Cunningham proposed a capital markets-based alternative to auditor liability caps. My post provoked a very detailed and thoughtful response from Professor Cunningham, which I have incorporated as an update in my prior post (please refer to the italicized text, here).

As an aside, this type of exchange of ideas is exactly what I had hoped would happen when I started this blog. Although idea exchanges have arisen from time to time, I wish it would happen even more frequently. And along those lines, I would like to emphasize that readers are cordially invited to post comments to any of my blog posts (using the "comment" link at the foot of the post). Readers who feel compelled to prepare a lengthier or more formal response to one of my post should just let me know, and it if makes sense, I will try to incorporate responsible commentary, just as I have incorporated Professor Cunningham’s response to my comments about his article.

Tarragon: Most readers likely will associate the name "Tarragon" with the familiar herb, sometimes known as "dragon’s wort." Perhaps I associate more freely than others, but to me the company’s name brings to mind Professor Hercules Tarragon (pictured to the left), one of the members of the ill-fated Sanders-Hardiman expedition in Hergè’s classic Tintin comic book, The Seven Crystal Balls. Professor Tarragon was one of several men who suffer the curse of Rascar Capac for transporting Capac’s mummified remains from Peru to Europe.

Another classic Tintin character is the garrulous and irrepressible insurance agent, Jolyon Wagg (pictured to the right), whose caricature of a backslapping, glad-handing insurance salesman is the humorous essence of the negative stereotype those of us in the insurance industry must live with on a daily basis.