Subprime Litigation Risk: Outside the Financial Sector?

To view this page on The D & O Diary's new website, click here. To see the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Expanded Subprime Litigation Wave Hits Sallie Mae

To view this page on The D & O Diary's new website, click here. To see the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

Are FCPA Violations "The Next Corporate Scandal"?

To see this page on The D & O Diary's new website, click here. To go to home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

French Investors Hit Soc Gen with Subprime-Related Lawsuit

To see this page on The D & O Diary's new website, click here. To go to the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Subprime Tsunami Time

To see this page on The D & O Diary's new website, click here. To go to the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A New Options Backdating Securities Lawsuit?

To see this page on The D & O Diary's new website, click here. To go to the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Subprime Litigation Wave Hits National City Corporation

To see this page on The D & O Diary's new website, click here. To go to the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

Apollo Group Provides Jury Verdict "Clarification"

To see this page on The D & O Diary's new website, click here. To go to the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

$65 Million KLA-Tencor Options Backdating Class Action Settlement

To see this page on The D & O Diary's new website, click here. To go the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

To see this page on The D & O Diary's new website, click here. To go to The D & O Diary's new home page, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

Subprime Litigation and Politics: A Volatile Mix

To see this page on The D & O Diary's new website, click here. To go to the home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tyson Foods "Springloading" Derivative Lawsuit Settles

To see this page on The D & O Diary's new website, click here. To go to home page of The D & O Diary's new website, click here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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