The D & O Diary

Class Certification Denied in Securities Suit Against U.S.-Listed Chinese Company

Kevin LaCroix — Thu, 24 May 2012 03:40:25 -0500

During 2010 and 2011, a number of securities class action lawsuits were filed against U.S.-listed Chinese companies. Plaintiffs’ lawyers seemed eager to pursue these cases despite likely procedural and practical challenges such as likely difficulties in obtaining discovery, as well as language and cultural barriers. And if a recent decision in one of these cases is any indication, you can add to the list of potential difficulties the risk that it may not be possible to obtain class certification, at least where the plaintiffs are unable to establish that the defendant company’s shares trade on an efficient market.

China Agritech, a Delaware holding company with its principal place of business in Beijing, China, obtained its U.S. listing through a reverse merger. In February 2011, online analyst reports raised allegations that the company’s factories were either not in operation or were producing far less than reported. In addition, the online reports claimed that the company’s SEC filings reported far higher levels of net revenue than the company reported to the Chinese State Administration for Industry and Commerce. The company’s share price fell on these reports and, as discussed at greater length here, litigation ensured. The plaintiffs moved to have a class of aggrieved investors certified as a plaintiff class.

In May 3, 2012 order (here), Central District of California Judge R. Gary Klausner denied the plaintiffs’ motion for class certification. The court found that the plaintiffs’ allegations satisfied the class certification requirements of numerosity, commonality, typicality, and adequacy. However, the court found that the plaintiffs’ allegations did not satisfy the requirement that the questions of law or fact common to the class members predominate over questions affecting individual members.

The court’s particular concern had to do with the reliance element of the plaintiffs’ securities class action claims. In most contexts, reliance is an individual issue. However, in a securities class action lawsuit, courts will use the fraud-on-the-market presumption to presume reliance if the defendant company’s shares trade in an efficient market.

In order to determine whether or not China Agritech’s shares trade in an efficient market, the Court consider five factors: (1) the average weekly trading volume of the company’s securities; (2) the number of securities analysts following the company; (3) the extent to which market makers trade in the security; (4) the company’s eligibility to file an SEC Form S-3 (the short form registration statement for the sale of new shares); and (5 )the existence of a cause-effect relationship between unexpected corporate news and a change in the price. As Judge Klausner noted, “several courts have recognized that the fifth factor is the most important.”

Judge Klausner found that the plaintiffs had satisfied a number of these factors. However, the plaintiffs were unable to establish the cause and effect relationship between company disclosures and resulting movements in stock price. He concluded that the plaintiffs “are unable to establish that Agritech stock was traded on an efficient market,” as a result of which “they are unable to rely on the fraud-on-the-market presumption of reliance.” Without the presumption, the plaintiffs “are unable to establish that questions of law or fact common to class members predominate over any questions affecting only individual members.” Accordingly, Judge Klausner denied the plaintiffs’ motions for class certification.

As discussed in a May 22, 2012 memorandum from the Debevoise & Plimption law firm about Judge Klausner’s decision (here), the class certification denial in the China Agritech case “appears to be the first China-focused case to reach the procedural stage at which the court had to consider whether the plaintiffs could satisfy the efficient market test and the other requirements of class certification.” The law firm memo notes that the China Agritech plaintiffs’ failure to satisfy the test “may have a significant impact on other China-focused securities cases if the defendants can show that their securities were as thinly traded as China Agritech’s,” adding that “if a company’s securities are thinly traded and the company is not the subject of press coverage, investors may have different levels of knowledge about the company and their reliance on particular statements cannot be presumed.”

The plaintiffs who brought the case “still can pursue claims on their own behalf,” but their inability to proceed with the proposed class action “significantly limits the potential damages that can be awarded in the case.”

Many of the U.S.-listed Chinese companies that have been the subject of securities class action litigation may be able to raise similar questions of whether or not their shares trade or traded in an efficient market. To the extent the companies can show that their shares did not trade in an efficient market, they may be able to overcome the fraud-on-the-market presumption of reliance, and the value of the claims against them may be substantially diminished. And as I noted at the outset, there are a host of other potential difficulties that may also impede the plaintiffs’ efforts to pursue these claims. Many of these cases were filed, but not all of them will prove to be valuable for the plaintiffs and their counsel.

Kudos: Everyone here at The D&O Diary congratulates Dan Bailey and his colleagues at the Bailey & Cavalieri firm for their selection as the recipients of one of the 2012 Burton Awards for Legal Achievement. The Burton Awards are a series of prestigious national awards for outstanding achievement in legal writing. As reflected I n the firm’s May 22, 2012 press release (here), the firm is the winner of this year’s competition in the category of Best Law Firm Encyclopedic Handbook, for authoring the book entitled Liability of Corporate Directors and Officers.

Dan as the book's co-author, will accept the awardin a June 12, 2012 ceremony at the Library of Congress. The awards ceremony will feature Retired Supreme Court Justice John Paul Stevens, who will be introduced by Supreme Court Justice Sonia Sotomayor. Our congratulations to Dan and to his colleagues for this recognition for their excellent book.

A complete list of the 2012 Burton Award winnerc can be found here.

Facebook IPO Fizzle Draws Securities Suits

Kevin LaCroix — Wed, 23 May 2012 10:29:25 -0500

Facebook’s disappointing public company debut has drawn a great deal of media scrutiny and criticism. But the finger pointing has not been contained just to the front pages of the newspapers. Disappointed investors have also now resorted to the courts, and further lawsuits seem likely to follow.

First, on May 22, 2012, an investor who claims to have purchased shares in the Facebook IPO filed a purported securities class action lawsuit in California (San Mateo County) Superior Court against Facebook, CEO Mark Zuckerberg, CFO David Ebersman, seven outside directors, and 32 offering underwriters.

The complaint (which can be found here) alleges that the offering documents “failed to disclose during the IPO roadshow” that “the lead underwriters, including Defendants Morgan Stanley, J.P. Morgan, and Goldman Sachs, all cut their earnings forecasts and that news of the estimate cut was passed on only to a handful of large institutional clients, not to the public.” The complaint further alleges that the company’s registration statement “was negligently prepared, and as a result, contained untrue statements of material facts or omitted to state other facts necessary to make the statements not misleading.”

In support of these allegations, the complaint cites only two articles by analyst Henry Blodgett. Specifically, the complaint cites (and quotes at length from) Blodgett’s May 19, 2012 article entitled “If This Really Happened During the Facebook IPO, Buyers Should be Mad as Hell” (here), and Blodgett’s May 22, 2012 article entitled “BOMBSHELL: Facebook Bankers Secretly Cut Facebook’s Revenue Estimates in Middle of IPO Roadshow” (here).

The state court securities class action complaint asserts substantive claims under Sections 11 and 15 of the Securities Act of 1933. The complaint is filed in state court in reliance on the “concurrent jurisdiction” provisions of Section 22 of the ’33 Act.

Second, in their May 23, 2012 press release, separate plaintiffs’ counsel announced (here) that they had filed a securities class action lawsuit in the Southern District of New York in connection with the Facebook offering. The complaint (which can be found here) names as defendants the company; its CEO and CFO; seven outside directors: and six offering underwriters, asserts claims under Sections 11, 12 and 15, on behalf investors who purchased shares in the Facebook offering.

According to the press release, this federal court lawsuit alleges that the defendants “failed to disclose that because Facebook was experiencing a pronounced reduction in revenue growth due to an increase of users of its Facebook app or website through mobile devices rather than traditional PCs, at the time of the IPO the Company had told the lead underwriters to reduce their 2012 performance estimates for Facebook.” The press release reports that the complaint further alleges that these revised performance estimates were “not shared with all investors, but rather, was selectively disclosed by defendants to certain preferred investors and omitted from the Registration Statement and/or Prospectus.”

In support of these allegations, the federal court complaint cites a May 19, 2012 Reuters article entitled "Morgan Stanley Was a Control Freak on the Facebook IPO -- And It May Have Royally Screwed Itself" (here) and a May 22, 2012 Reuters article entitled "INSIGHT: Morgan Stanley Cut Facebook Estimates Just Before Facebook IPO" (here).

Third, on May 22, 2012, an investor who alleges that NASDAQ “failed to promptly and accurately execute” his order for Facebook shares has filed a purported class action lawsuit in the Southern District of New York against NASDAQ OMX Group and the NASDAQ Stock Market LLC, on behalf of all individuals and entities whose purchase and cancellation orders during the Facebook IPO were delayed or otherwise improperly processed.

The complaint against NASDAQ, which can be found here and which asserts claims for Negligence, alleges that “the IPO was badly mishandled” and that because the attempted Facebook trades were not processed “promptly and efficiently,” the parties attempting to purchase Facebook shares “were unable to determine if they had properly done so.” As a result of the misprocessing of both buy and sell orders, the class members “did not know whether they owned Facebook shares, or at what price, and were accordingly unable to timely sell those shares, suffering losses.”

In support of its allegations, the complaint cites the named plaintiff’s own experiences in his attempt to buy Facebook IPO shares. He alleges that when his purchase orders “failed to execute,” he “sought to cancel” the order. However, rather than cancelling the trades, his account listed the cancellations as “pending.” Despite the cancellation, the purchase order was finally executed more than three hours after it was placed and after the cancellation order. He alleges that as a result of this sequence, he was “unable to determine what shares, if any, of Facebook he held” and that he was “unable to trade in accordance with a rational trading strategy.” The complaint also cites public reports of similar experiences by other investors, as well as public acknowledgement from NASDAQ CEO Robert Greifeld of a malfunction in the trading system’s order processing system.

The question of the existence of concurrent state court jurisdiction under the Securities Act of 1933 as been well ventilated in a variety of cases filed in connection with the subprime meltdown and the credit crisis. As discussed at length here, both the Ninth Circuit and the California state courts upheld the finding of continuing state court jurisdiction for ’33 Act claims in connection with the Luther v. Countrywide case. At least based on the developments in that prior litigation, there would appear to be substantial grounds on which the plaintiffs in the recently filed action against Facebook might proceed in California state court. (Outside the Ninth Circuit, there would likely be less support for concurrent state court jurisdiction.)

In light of the high profile nature of the Facebook IPO and surrounding events, it is hardly surprising that the missteps surrounding the offering have attracted litigation. It does seem as if there is a definite trend in which the securities class action litigation has become a sort of headline hit parade. For example, when Wal-Mart announced the existence of FCPA allegations in connection with its Mexican operations, it got hit with a securities lawsuit. And shortly after JP Morgan Chase announced significant trading losses on a failed hedging strategy, lawsuits followed shortly thereafter. Given that the Facebook IPO is now the story dominating the business headlines, it was perhaps inevitable that securities litigation has now appeared. Indeed, it seems likely that further litigation will follow, as well.

Cornerstone Research Releases Study of Accounting Class Action Securities Cases

Kevin LaCroix — Wed, 23 May 2012 03:29:55 -0500

On the eve of the tenth anniversary of the enactment of The Sarbanes Oxley Act, Cornerstone Research has released a study of the filing trends and settlements of securities class action lawsuits involving accounting allegations. The May 2012 report entitled “Accounting Class Action Filings and Settlements: 2011 Review and Analysis” can be found here. A summary of the report’s findings can be found here.

According to the report, the share of securities class action lawsuit filings involving accounting allegations increased in 2011, compared to the prior year. In 2011, the number of accounting cases increased in both number and as a proportion of all securities lawsuit filings, compared with 2010. The number of accounting cases increased to 70 in 2011, compared to only 46 in 2010, and the proportion of total case filings represented by accounting cases increased from 26 to 37 percent.

This increase in the number of accounting cases in 2011 was largely driven by the increase in Chinese reverse merger cases during 2011. The Chinese reverse merger cases “are significantly more likely to involve restatements of financial restatements, and as a result, plaintiffs are more likely to allege violation of generally accepted accounting principals” in those cases compared to other securities class actions.

For similar reasons, the number of accounting case filings involving financial restatements increased in 2011 compared to 2010, reversing a four-year trend of declines. For the second consecutive year, more than 60 percent of accounting case filings included allegations of internal control weaknesses. However, in 2011, only 17 percent of the internal control deficiency claims were accompanied by company announcement of internal control weaknesses, which suggests that “plaintiffs may believe that including these claims will bolster their position in litigation, regardless of whether material internal control weaknesses were actually present.”

Cases with accounting allegations are less likely to be dismissed than non-accounting cases. For example, of cases filed in 2006, only 38 percent of accounting cases were dismissed by the end of 2011, compared to 46 percent of non-accounting cases. Accounting cases are also more likely to settle than non-accounting cases. 56 percent of accounting cases filed in 2006 had settled by the end of 2011 compared with only 50 percent of the non-accounting cases. These same patterns on dismissal and settlements held with respect to the 2007 and 2008 filings as well.

During 2011, there was a sharp decline in the number of securities class action settlements (measured with reference to the date on which the settlement was approved), compared to prior years. There was also a drop in the percentage of settlements in 2011 involving accounting cases. In the five years preceding 2011, more than 60 percent of all settlements involved accounting cases, but in 2011, less than half of the settlements involved accounting cases. Nevertheless, even though the accounting cases represented less than half of the total number of settlements, these cases represented more than 70 percent of the total 2011 settlement value. The report notes that accounting cases typically involved substantially higher settlement amounts compared to non-accounting cases.

For cases settled during 2006 to 2011, median settlements were higher both in dollar amounts and as a percentage of “estimated damages for cases involving internal control weaknesses with accompanying company announcements. However, when internal control weakness allegations are made without any corresponding company announcement, settlements are not higher either in dollar value or as a percentage of estimated damages, compared with cases with no internal control allegations.

Cases involving asset valuation write-downs settle for higher dollar values than cases not involving write-downs (even when compared to cases involving financial restatements). Cases involving financial restatements “settle for a significantly higher percentage of ‘estimated damages’ compared with cases involving write-downs,” which suggests that the higher settlement dollar values for cases involving write-downs are “due in part to the higher investor losses involved with those cases.”

From 2006 to 2011, about 34 percent of all accounting cases involved accompanying SEC actions, compared to only about 10 percent for non-accounting cases.

SOX Party: And speaking of the tenth anniversary of SOX, Broc Romanek has an interesting post on his CorporateCounsel.net blog (here), recognizing the anniversary of the legislation, His post contains a number of links to interesting articles about the tenth anniversary of SOX.

Emerging Growth Companies: You Have Been Warned

Kevin LaCroix — Mon, 21 May 2012 02:52:01 -0500

In order to try to boost the number of companies going public, the recently enacted JOBS act provides for certain procedural and reporting advantages for “Emerging Growth Companies,” which are defined in the Act as companies within five years of their IPO and with revenues less than $1 billion. A number of companies planning IPOs are already taking advantage of the new provisions. But at the same time, those same companies are warning investors that their status as Emerging Growth Companies may itself be a risk of which investors should be aware.

As discussed at greater length here, the JOBS Act contains a number of IPO “on ramp” procedures designed to ease the process and burdens of the “going public process” for Emerging Growth Companies (EGCs). The “on ramp” advantages are intended to ease the going public process. For example, EGCs can elect to submit their IPO registration statement for SEC review on a confidential, nonpublic basis, although the registration statement must be publicly filed at least 21 days before the IPO roadshow.

The Act also provides for reduced disclosure and reporting burdens for EGCs for as long as five years after an IPO - as long as the company continues to meet the definitional requirements. For example, an EGC will not be subject to Section 404(b) of the Sarbanes Oxley Act requiring an outside auditor’s attestation report on the company’s internal controls. Similarly, an EGC would be exempt from the requirements under the Dodd-Frank Act to hold shareholder advisory votes on executive compensation and on golden parachutes.

Since the enactment of these provisions, a number of commentators have noted that while these JOBS Act provisions may serve the laudable goal of easing the IPO process, these provision also introduce risks for investors. Nor are these remarks just coming from sideline commentators. Indeed many of the most specific warnings are coming from the companies themselves.

In her May 15, 2012 CFO.com article entitled “A New Risk Factor: The JOBS Act” (here), Sarah Johnson reports that for many of the companies taking advantage of the JOBS Act IPO on-ramp provisions, the fact that the companies are relying in the JOBS Act “is itself a risk factor.” Her article notes that in recent days, at least 13 companies “have warned investors in their prospectuses filed with the Securities and Exchange Commission that the JOBS Act’s breaks on SEC rules could actually be a turnoff.” By way of example, she quotes Cimarron Software’s recently filed S-1, in which the company states that “we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.”

In a May 14, 2012 post on his CorporateCounsel.net blog entitled “JOBS Act: EGC Status as a Risk Factor” (here), Broc Romanek takes a detailed look at one of the recent IPO filings, the S-1 that LegalZoom filed in connection with its proposed initial public offering. He notes that right on the cover page of the filing, the company warns that “we are an ‘emerging growth company’ under the federal securities laws, and will be subject to reduced public company reporting requirements.” Among other things, the company notes in its filing that it will be taking advantage of the JOBS Act reporting exemptions as long as the company qualifies to do so, adding that “we cannot predict if investors will find our common stock less attractive because we rely on these exemptions.” The company further notes that “if some investors find our common stock less attractive as a result, there may be less active trading for our common stock and our stock price may be more volatile.”

These disclosures not only have the virtue of warning investors that the companies’ status as emerging growth companies may make their stock less attractive. The warnings may, according to one commentator quoted in the CFO.com article, provide "cheap insurance” that could help the company if it later runs into trouble. As the commentator noted, if the emerging growth company is later sued, the company can say “We warned you that there weren’t auditors looking independently at this.”

These emerging growth companies advisory statements may indeed represent good precautionary disclosure. But it is fair to ask whether the cautionary statements go quite far enough. It is one thing to say that the company’s reduced reporting requirements may make the company’s stock less attractive. What the companies don’t seem to be saying, at least not directly, is that the reduced reporting requirements could make their reported financial results less reliable. As a plaintiff’s lawyer quoted in the CFO.com article notes, the emerging growth companies’ precautionary disclosure may forewarn that their stock may not trade as high or as frequently as it might otherwise, but they are not saying that as a result of the reduced reporting requirements you “may get a nasty surprise” when the company no longer qualifies for the exemptions.

All of which says that while companies are now just trying to adjust to the newly enacted IPO process and reporting provisions, we will have to wait to see how all of this plays out in the securities litigation arena. For now, the companies taking advantage of the new rules do seem to be recognizing that while the new processes do present certain advantages, they do involve possibly increased risks as well.

The one thing that is certain is that because of the JOBS Act’s broad definition of “emerging growth companies,” a very larger percentage of companies going public will be eligible to take advantage of the new rules. Indeed, according to one report, of the 113 companies that went public in 2011, only 15 (or 13%) would not have qualified for the JOBS Act’s IPO on-ramp procedures.

In other words, the disclosure issues discussed above, and the related liability concerns, could be an issue for a significant number of companies. Indeed, if the JOBS Act achieves its fundamental goals, these considerations could be a concern for an increasingly larger number of companies.

Delaware Seminar on Corporate and LLC Law: On Tuesday May 22, 2012, I will be participating in a panel the Delaware State Bar Association Corporate Law Section’s annual “Recent Developments in Delaware Corporate and Alternative Entity Law” seminar. The seminar will be co-chaired by Francis Pileggi of the Eckert Seamans firm and also the author of the Delaware Corporate and Commercial Litigation Blog, and his law partner Kevin F. Brady and R. Montgomery Donaldson of the Montgomery McCracken Walker & Rhoads firm. Pileggi’s recent post on his blog about the event can be found here.

The panel I will be participating in is entitled “Corporate Law Updates Via Blogs,” and my fellow panelists will include Doug Batey of the Stoel Rives law firm and the author of theLLC Law Monitor blog; University of Illinois Law Professor Christine Hurt, of The Conglomerate blog; and Boston College Law Professor Brian Quinn, of The M&A Law Prof blog. Batey’s recent blog post about our upcoming panel can be found here.

Our panel should afford the panelists an opportunity to reflect and comment upon the blogging process and experience. Along those lines, in an interesting May 18, 2012 post entitled “What Then is Blogging” (here), Dick Cassin of the indispensable The FCPA Blog sets out some of his views and thoughts about blogs and blogging. (Thanks to Cassin for quoting one of my prior blog posts).

Looking for Life in All the Wrong Places?: A May 18, 2012 Wall Street Journal article entitled “Searching a Billion Planets for Life” (here) describes scientists’ efforts to write a recipe for “perfect planet”—that is, a place that is “not too cold, not too hot, not too toxic and chemically suitable for life as we know it” as a way to aid in the search for “potentially habitable alien worlds.”

The challenge for the scientists is that the process of trying to come up with the recipe leaves them “grappling with the nature of life itself.” Perhaps the most fundamental problem is that the analysis depends on presumptions “based on life as we know it” – that is, life on Earth.

The potential limitations of this Earth-biased analysis are revealed most dramatically just by looking at what has happened in recent years to our knowledge about life on Earth. Through a series of interesting discoveries, our awareness of the range of conditions in which life on Earth can thrive has expanded far beyond what was previously thought possible.

An interesting article in the May/June 2012 issue of The Economist’s Intelligent Life magazine entitled “Some Like it Very Hot” (here) takes a look at the scientific advances that have revealed the teeming existence of “hyper-resilient microbes,” organisms that can survive “levels of heat, cold, pressure, radiation and salt or acid concentrations that previously would have been thought fatal to all living things.” These previously unknown organisms, now known as extremophiles, have been found deep beneath the sea floor; in the depths of Mexican caverns; in the core of nuclear reactors; in hydrothermal vents on the sea bed; and are constantly being discovered in ever more unlikely and seemingly inhospitable environments.

Among many other things, these discoveries show that “life can sustain itself in many more environments than was previously thought possible.” This realization not only has enormous implications for the study of life on Earth; it has also given new life to the “idea that life is dispersed throughout the universe and is disseminated on meteorites or asteroids.” Or to put it another way, “the bandwidth of survivable environments – and therefore, forms of life, has broadened enormously.”

The implication for scientists hoping to increase their chances of finding life beyond Earth by narrowing their search only to the “perfect planets,” may be that by narrowing their search, they may actually diminish their chances of finding outside our planet. But on the positive side, the likelihood that life outside of earth might exist and someday might actually be discovered both seem to have increased significantly.

Personally, I find all of this quite fascinating and even exciting. The possibility that life in the universe is not rare but could actually be quite common and even widely dispersed represents an entirely new way of looking at things. Instead of the Earth as a lone life-bearing vessel whirling through an empty, heartless void, it could instead be one of countless places where life is thriving. Of course, the possibility that life elsewhere might be merely microbial might not satisfy the most febrile science fiction fantasies. It would of course be much more exciting if there seemed to be a greater likelihood of discovery of intelligent life beyond earth. But it may be too much to hope for, to expect to find intelligent life beyond earth. After all, think of how hard it is to find intelligent life on our own planet.

In Case You Missed It: For the second weekend in a row, a major European soccer title has been determined in a last-minute come from behind victory. Last Sunday, it was Manchester City scoring two goals in stoppage time in their final game of the season to capture the English Premier League crown. This Saturday, Chelsea, playing against Bayern Munich on the German team’s home field, won the UEFA Champions League club team title in almost equally dramatic fashion, winning in a penalty kick shootout.

Bayern Munich had many chances to put the game away, and seemingly had the game won when they finally scored on a Thomas Müeller header in the 82^nd minute. But then with just two minutes left in regulation, on Chelsea’s first corner kick of the game, Didier Drogba scored on a header to tie the game. As regulation time expired the game went into extra time (a thirty minute overtime period).

Drogba’s fine goal to tie the game looked like it might have been naught when early in extra time he committed a foul by tripping Franck Ribèry in the penalty area. It seemed like another golden opportunity for Bayern Munich to put the game away, but Chelsea’s goalie, Petr Čech Arjen Robben’s penalty kick. The 30-minute period ended with the teams still tied, setting up a penalty kick shootout. , stopped

Bayern Munich once again appeared to have the advantage as its goalie, Manuel Neuer, stopped the first Chelsea penalty kick from Juan Mata. After each team had attempted three penalty kicks, Bayern had made all three of its attempts, while Chelsea had only made two. Bayern substitute, Ivica Olic then missed his team’s fourth shot while Ashley Cole made the next shot for Chelsea, bringing the two teams even. On Bayern Munich’s fifth and final shot, Bastian Schweinsteiger , who looked as if taking the penalty kick was about the last thing in the world he wanted to do, hit the post. Drogba, looking calm and confident, smashed his kick into the corner of the net, securing Chelsea’s improbable victory. The game-winner might be the 34-yearold Drogba’s last act for Chelsea, as his contract with the team expires this summer.

It was a great game, although the Bayern Munich fans are not the only ones unhappy about the outcome. Tottenham Hotspurs, who finished fourth in the English Premier League and therefore otherwise qualified for the UEFA Champtions League competition, were dispossessed of the spot by Chelsea’s win. Chelsea, which didn’t otherwise qualify for the Champions league (since they finished sixth in the Premier League), secured an automatic spot in next year’s Champions League competition with their win on Saturday. Since only four teams from each participating country can compete, that meant that Chelsea’s win forced Tottenham out of its spot.

With all of this great end of season soccer just completed, it is even more exciting to look forward to the Euro 2012 national team championship competition, which kicks off on June 8, 2012 in Poland and Ukraine.

Securities Suit Filed Against JP Morgan Chase Over Massive Trading Losses

Kevin LaCroix — Wed, 16 May 2012 03:35:45 -0500

In the wake of JP Morgan Chase’s startling news last week of its $2 billion trading loss, and of the equaling startling statements of Jamie DImon, the bank’s CEO, that the losing trades were, among other things, “flawed, complex, poorly reviewed, poorly executed, and poorly monitored,” there has been speculation whether these disclosures would lead to litigation. In particular, commentators have asked whether Dimon’s candid statements would hurt the company in any litigation that might arise.

Well, it looks like we will be finding out. On May 14, 2012, plaintiffs filed a securities class action in the Southern District of New York, against the bank; Dimon; Ina Drew, the bank’s former Chief Investment Officer: and Douglas Bronstein, the bank’s chief financial officer. A copy of the complaint can be found here.

According to the plaintiffs’’ lawyers’ May 14, 2012 press release (here), the complaint alleges that during the class period of April 13, 2012 through May 11, 2012, the defendants issued “materially false and misleading statements regarding certain securities trading by the Company’s Chief Investment Office (“CIO”). Specifically, Defendants misrepresented and/or failed to disclose that the CIO had engaged in extremely risky and speculative trades that exposed JPMorgan to significant losses.” The complaint specifically references the defendants’ reassuring statements made between the time the rumors about the trading activity first surfaced in April and the time of the disclosures of the trading losses, and blockbuster admissions about the trades.

The initial complaint is just 18 pages. Although the complaint quotes extensively from Dimon’s statements in a May 10, 2012 conference call, it does not refer to many other highly publicized features involved with the trading losses, including for example, the April rumors of trading activities by a JP Morgan trader labeled the “London whale,” whose trades had roiled the derivatives market (the complaint refers to the trades, just not to the “whale,” at least not by that name) nor Dimon’s statements to Meet the Press aired on Sunday May 13, 2012, that the bank had been “sloppy” and “stupid” and that he had been “dead wrong” when he characterized questions about the derivatives trades as a “tempest in a teapot.”

The complaint’s scienter allegations do not allege any motivations for alleged misrepresentations made during the relatively short class period. There are no allegations that any of the defendants’ traded on basis of allegations or that the defendants otherwise personally benefitted from the misrepresentations. The complaint does allege that the defendants did not believe their earlier statements about the bank’s derivatives trading activities at the time the statements were made.

To be sure, it is not uncommon for an initial securities class action complaint to be skeletal, with more detailed allegations added in subsequent amended pleadings after lead counsel has been selected and the cases consolidated. Along those lines, there may well be other complaints filed on behalf of other prospective class representatives that may contain different or additional allegations. Subsequent complaints or amended complaints may well be more detailed. These complaints may also draw on subsequent news reports that JPMorgan’s senior management allegedly had disregarded “red flags” regarding the bank’s trading activities.

Even if they are able to add additional details, however, plaintiffs seeking to plead this case will be faced with the challenge of attempting to present scienter allegations sufficient to overcome the initial pleading hurdles. The defendants will argue that it is not enough for plaintiffs to rely on the magnitude of the losses or even on the fact that the losses resulted from a trading strategy that Dimon has now publicly acknowledges was flawed. In attempting to show that the early reassurances are not merely misleading but are actionable, the plaintiffs may find that they must allege more than the subsequent admissions about the trading activities.

How the securities class action plaintiffs will proceed and how they will fare remains to be seen. But in the meantime, there are now press reports circulating that the Department of Justice has “opened an inquiry” regarding the bank’s trading losses. The news of the DoJ inquiry follows prior reports that the SEC had opened a review of the developments. President Obama, among many others, has seized upon the bank’s trading losses as evidence of the need for greater bank regulation, including in particular the so-called “Volker Rule.” Questions are also being raised whether the bank will or should seek to “claw back” compensation from the three trades who were released following the disclosure of the losses.

The fallout from the trading losses will continue to roil the markets and the media for some time to come, and could hound both Dimon and J.P. Morgan for some time as well. In the meantime, the private securities class action lawsuit will unfold, as these cases do, in the fullness of time. I will say that as interesting as it is that a securities class action complaint has been filed, it will be more interesting to see the plaintiffs’ allegations as they appear in the consolidated, amended complaint that ultimately will be filed.

D&O Insurance: Officer Not Acting in Insured Capacity When Guaranteeing Company Debt

Kevin LaCroix — Wed, 16 May 2012 03:28:24 -0500

A company’s D&O insurance policy provides liability protection for the company’s individual directors and officers, but only for their actions undertaken in their capacities as directors and officers. It does not protect them when they are acting in a personal capacity. So, when a company’s CEO signs a loan guaranty for the company, is he acting in an official or personal capacity, and will the D&O insurance policy provide protection for liability under the guaranty? Those were the questions addressed in a May 14, 2012 decision of a three-judge panel of the Court of Appeals of the State of Washington. A copy of the opinion can be found here.

Background

In March 2008, S-J Management LLC (SJM) obtained a $3.5 million line of credit from Commerce Bank. Michael Sauter, SJM’s CEO and manager, signed the loan agreement and promissory note in his official capacity on behalf of SJM. In addition Sauter provided Commerce Bank a guaranty, which he signed as “Michael J. Sauter” and which was secured by seven deeds of trust on real property owned by Sauter and his wife.

In May 2009, SJM’s line of credit matured and SJM failed to pay its indebtedness. Commerce Bank demanded that Sauter pay in full under his “personal guaranty of indebtedness” SJM’s $2.8 million obligation. Sauter in turn demanded that SJM indemnify him for the amount he was obligated to pay, to which SJM’s members (of which Sauter was one) agreed. However, SJM was financially unable to indemnify Sauter. After Commerce Bank threatened that Sauter’s failure to cure the default could result in the sale of the six real properties securing the guaranty, SJM’s counsel tendered the bank’s demand to SJM’s D&O insurer.

SJM’s insurer denied coverage with respect to Sauter’s obligation, and Sauter filed an action against the insurer seeking damages and a judicial declaration of coverage. The parties filed cross motions for summary judgment. The trial court denied Sauter’s motion but granted the insurer’s motion, holding that there was no coverage because no act by Sauter constituted a “Wrongful Act” under the policy and Sauter suffered no “Loss” as defined by the Policy. Sauter appealed.

The Appellate Court’s May 14, 2012 Opinion

In an opinion written for the three-judge panel by Judge Stephen J. Dwyer and applying Washington law, the intermediate appellate court affirmed the trial court’s ruling. The court noted that the policy provides that an act by an “Insured Person” constitutes a “Wrongful Act” only when that person commits the act “while acting in [his or her] capacity as…such on behalf of the Insured Organization.” An “Insured Person” acts “in his capacity as ...such on behalf of the Insured Organization” when that person commits the act in his or her official capacity as a “director, officer, general partner, manager or equivalent executive” of the insured company.

In recognition of this language, the court said that because the policy “explicitly provides coverage for the personal liability of the corporate officer incurred for acts performed in his or her capacity as such,” the policy “does not insure against losses incurred where the officer acts in his or her personal capacity.”

The court said that “the fact that Sauter is an officer of SJM is not dispositive of the question presented,” which is -- in what capacity did Sauter sign the guaranty, his capacity as an officer or his personal capacity? The Court noted that “a guaranty executed by a corporate officer that secures the indebtedness of the corporation is not executed in the officers’ official capacity.” Indeed, the execution of the guaranty in an official capacity “would result in the corporation itself guaranteeing its own indebtedness, thus negating the very purpose of the guaranty.”

Because Sauter was acting in his personal capacity when he signed the guaranty, Sauter committed no “Wrongful Act” as defined in SJM’s D&O insurance policy, and thus the court concluded that the policy does not provide coverage for Sauter’s financial obligation to Commerce Bank.

The Court went on to note in addition that any purported “Loss” suffered by Sauter did not result from a “Claim” made against Sauter for a “Wrongful Act.” Rather, the court noted, “Sauter incurred the obligation to pay SJM’s indebtedness by executing the guaranty – not by failing to satisfy his obligation pursuant thereto.” In other words, the court said, “his obligation to Commerce Bank was not the result of Commerce Bank’s demand on the guaranty; instead his obligation was the result of the guaranty itself.” Accordingly, because his obligation to pay was the result of his voluntary undertaking, “it is not a ‘Loss resulting from any Claim … for a Wrongful Act.”

Discussion

D&O insurance policies protect individual directors and officers. But that protection does not extend to everything those individuals might do. Rather, the protection only extends to their actions undertaken in their capacities as directors and officers, not to actions undertaking in the personal capacities.

There principles are easy to state, but the lines of demarcation between actions undertaken in an official capacity and actions undertaken in a personal capacity may not always be clear. This case illustrates how the lines can sometimes be difficult to discern. Here, it was SJM that wanted to borrow the money, and Sauter was clearly motivated by a desire to facilitate SJM’s borrowing. What matters though is not his motivations but his actions. When he signed the loan agreement and the promissory note, he was clearly acting in his official capacity. But he separately signed a guaranty. Sauter’s guaranty was designed to obligate Sauter not the corporation, and his undertaking was clearly a separate, personal undertaken, as evidence by the fact that the guaranty was secured by deeds of trust on property owned by Sauter and his wife.

There is a further reason why Sauter’s guaranty should not be the responsibility of the insurance company. One cannot undertake an obligation to pay, default on that obligation, and send the bill to the insurance company. For that reason, many courts have held that as a matter of public policy repayment of a contractual obligation does not represent a Loss under a D&O insurance policy. As discussed here, many D&O policies incorporate express contractual liability exclusions.

Coverage disputes arising from the questions of whether or not an individual was or was not actin g in an insured capacity are occur frequently, particularly in connection with smaller or closely held corporations, when an individual’s roles may overlap or run together. It may sometimes be very difficult, for instance, in the context of a closely held company to distinguish when an individual is acting as an investor or shareholder and when the individual is acting as a director or officer.

Indeed, in many instances, individuals may have been acting in dual capacities or multiple capacities, which can make questions concerning coverage for related claims particularly challenging. One critical coverage issue that is sometimes overlooked in the dual capacity context is that to trigger coverage under most policies, an individual need only have been acting in an insured capacity – most policies do not require that the individual have been acting “solely” in an insured capacity. The problem then of course, if the individual is insured only to the extent he or she was acting in an insured capacity, is figuring out the extent of coverage. The fact that these kinds of disputes tend to be very fact-specific does not make them any easier to resolve.

Similar questions can also arise when a director or officer is also acting a director or officer of more than one entity or organization -- for example, where an individual is serving at the request of a private equity or venture capital firm on the board of a portfolio company. These concerns are among the many issues that may arise as a result of the interplay between the investment firm’s insurance and the portfolio company’s insurance, as discussed here.

Many thanks to Aidan McCormick of DLA Piper for sending me a copy of the decision. DLA Piper represented the D&O insurer in this case.

Crowdfunding: Who Will (and Who Won't) Be Doing It

Kevin LaCroix — Sun, 13 May 2012 12:46:22 -0500

Among the features of the recently enacted JOBS Act that has attracted the most attention are the legislation’s provisions for “crowdfunding.” Under these provisions, a company is permitted to raise up to $1 million during any 12-month period through an SEC-registered crowdfunding portal. While these provisions have attracted a great deal of discussion and even controversy, a more basic question is – who will actually be taking advantage of this new fundraising procedure?

A common assumption about the new crowdfunding procedure is that it will be most beneficial to start-up companies. But at least according to a May 9, 2012 CFO.com article (here), due to the procedural burdens and costs associated with the JOBS Act’s crowdfunding provisions, crowdfunding is unlikely to be an attractive alternative for start-up companies.

According to the article, the crowdfunding provisions in the JOBS Act may be “too complex and onerous” and “not very cost-effective“ for an early-stage company. Among other things, entrepreneurs launching a new venture “may lack the financial acumen and robust business plans they’ll need to comply with the JOBS Act” and they also “may not have the cash to hire the accountants and lawyers they will need to navigate the law.”

Instead, the companies likeliest to be using crowdfunding will be “more mature firms” that “have the experience of searching for sources of capital” and that are “able to show, based on financial information, performance metrics and forecasts, that they are heading in the right direction.” Among other things, the crowdfunding process will require a certain amount of rigor, if for no other reason than the company using the process will have to provide financial statements.

The financial statement requirements will impose a cost-benefit analysis on companies considering a crowdfunding financing, due to the Act’s sliding scale requirements. Companies raising up to $100,000 need provide only a financial statement signed by the company’s directors. But companies raising between $100,000 and $500,000 must provide financials reviewed by a CPA. And for companies raising between $500,000 and $1 million, audited financials must be provided. Companies will have to decide whether their financing requirements justify the expense of having their financials reviewed or audited. In addition, the Internet platforms through the crowdfunding offerings will be conducted will also be charging fees, which will add to the cost.

As I have previously noted (refer here), the JOBS Act’s crowdfunding features also expressly include liability provisions. The potential liability exposures mean that issuers trying to raise money through a crowdfunding offering “will probably need to get a lawyer involved,” which, as a commentator quote in the article notes, is “not ever cheap.”

There is also the possibility that the SEC will add even greater burdens and expense when it releases its crowdfunding rules in January 2013. Among other things, the SEC could add additional burdens in the way that it regulates the funding portals. The SEC has also no secret of its concerns about the possibility of scam artists using crowdfunding to try to con investors, as a result of which, as a commentator quote in the article notes, the SEC might “layer on more regulation.” For example, the SEC might require disclosure after the crowdfunding offering, which “could make crowdfunding potentially cost prohibitive.”

The Venue That Suits You Best: Where is the best place in the world to file a lawsuit? Well that depends on the kind of lawsuit you want to file. Want to sue for libel? Then you want to file in the U.K. Thinking of suing for patent infringement? Then you should file in Germany. All of this is according to the “best and worst places to sue” atlas published on May 10, 2012 in BusinessWeek, and which can be found here.

More Thoughts on Asia: As I discussed in a blog post summing up my observations of my recent Asia trip, there is an incredible amount going on now in Asia. The present and future business opportunities in Asia are enormous – so much so that I really regretted during my trip that my children were not there to see what I was seeing.

It is in this context that I note an article that appeared on May 11, 2012 Wall Street Journal. The article, entitled “P&G Unit Bids Goodbye to Cincinnati, Hello to Asia” (here), describes how Proctor & Gamble is moving its cosmetics and personal-care unit from Cincinnati to Singapore. The company is making the move based on its “decision to base the business in the fast-growing Asia beauty market,” as part of a larger plan to move employees and manufacturing facilities closer to its key customer bases. The article goes on to note that the Asia-Pacific region already accounts for half of the world’s market for skin care, and is also by far the fastest growing region.

The article includes a sidebar identifying a number of similar moves developed-world companies have made recently. For example, GE has moved its X-ray unit from Wisconsin to Beijing; Halliburton has set up a separate headquarters in Dubai; DSM Engineering Plastics has moved its headquarters from the Netherlands to Singapore: and Rolls-Royce has moved its global marine headquarters to Singapore from London. (As I understand it, AON’s recent decision to move its headquarters from Chicago to London is in part explainable as part of this same phenomenon, because so much of its business and growth is outside the U.S.)

Maybe I am giving too much significance to these developments I am overly focused on Asia so soon after my return home from Asia. Even allowing for that possibility, these companies’ moves still seem significant. These companies are re-orienting themselves because the world is re-orienting. It seems pretty clear to me that the path to future business success is going to run through Asia. Those of us doing business in the U.S. and in Europe now need to prepare for the fact that our clients, or at least those who are likeliest to succeed, are going to be positioning themselves to participate in Asian opportunities. Provides of services will need to be prepared to adjust as the companies reposition.

China in Ten Words: Another observation from my Asia trip is how vast, complex and enigmatic China is. Since returning home, I have read several books about China and its history, trying to get a better sense of the country and the changes it has been through in recent years. The country is so large and the changes it has been through have been so momentous that it seems nearly impossible to briefly summarize it all. For that reason, the slim, readable book China in Ten Words by Yu Hua, a Chinese author who lives in Beijing, is so interesting and impressive.

Yu’s book is divided into ten short chapters, each of which has a single word as a theme. The ten chapters are: people; leaders; reading; writing; Lu Xun (a pre-revolutionary Chinese author); revolution; disparity; grassroots; copycat; and bamboozle. Yu took this thematic approach because, as he says, if he tried to capture everything about China, the result would be a book so long that no one could ever read it. By limiting himself to just ten words, he gives us “ten pairs of eyes” to scan the contemporary Chinese scene.

Yu’s method has a very specific purpose, which he explains in his introduction:

“The arrow hits the target, leaving the string,” Dante wrote, and by inverting cause and effect he impresses on us how quickly change can happen. In China’s breathtaking changes during the past thirty years we likewise find a pattern of development where the relationship between cause and effect is turned in its head. Practically every day we find ourselves surrounded by consequences, but seldom do we trace those outcomes back to their roots. The result is that conflicts and problems –which have sprouted everywhere like weeds during these past decades – are concealed amid the complacency generated by our rapid economic advances. My task here is to reverse normal procedure; to start from the effects that seem so glorious and search for their causes, whatever discomfort that may entail.

In tracing the current outcomes back to their roots, Yu tells the story of contemporary China from the perspective of his own personal experiences. What quickly becomes apparent is not only how much Yu has seen and experienced in his life, but how much everyone in China older than, say, forty or so, has seen and experienced. The dramatic and appalling details of the scenes he witnessed during the Great Leap Forward and the Cultural Revolution, which took place during his childhood and adolescence, provide an almost incredible backdrop to China’s current prosperity and economic growth. As Yu says, “in this quest to follow things back to their source, we cannot help but stumble on one misfortune after another.”

The unexpected and interesting message that emerges from Yu’s account is the directness of the connection between the events during the Great Leap Forward and the Cultural Revolution and contemporary circumstances. Yu finds parallels between the excesses of those earlier eras and many of the excesses of modern China. In his chapter titled “Revolution,” he shows how the propaganda deceptions of the Great Leap Forward era and the revolutionary violence of the Cultural Revolution era continue to shape behavior and events.

The consequences for China emerge Yu’s book progresses; his final four chapters – disparity, grassroots, copycat and bamboozle – portray a country beset with “moral bankruptcy and confusion of right and wrong.” For example, in discussing the “copycat” phenomenon – whereby, as a result of an engrained revolutionary era ethos, counterfeiting and infringement are accepted as part of the “anarchist spirit” – Yu characterizes the trend as “a sign of something awry in China’s social tissue.”

In the same vein, in the book’s final chapter, Yu explains how the word “bamboozle” has come to gain such broad acceptance in modern China, as its particular usage “throws a cloak of respectability over deception and manufactured rumor.” Yu describes a society where the people routinely bamboozle the government and the government routinely bamboozles the people Yu recounts several different tales illustrating this process in action, and then comments that “there is really no end to these stories of fraud and chicanery, for ‘bamboozle’ has already insinuated itself into every aspect of our lives.”

Yu concludes that “the rapid rise in popularity of the word ‘bamboozle,’ like that of ‘copycat,’ demonstrates to me a breakdown of social morality and a confusion in the value system in China today,” which he says is “an aftereffect of our uneven development these past thirty years.” Yu ends his book with a personal anecdote showing how the attempt to bamboozle can backfire. (Yu recounts how as a child he faked a stomachache to get out of doing chores and wound up getting his appendix removed.) Yu doesn’t expressly connect the link between his personal experiences and China, but the implicit message seems to be that China could wind up as the victim of its own bamboozlement.

Yu writes simply and clearly, and his many anecdotes humorously illustrate his themes. Using ten words, Yu manages to provide an interesting and though-provoking picture of contemporary China. In the portrait he paints, China is a troubled giant still struggling to recover from the painful events of the country’s early history.

D&O Insurance: Layers and Tiers and Problems

Kevin LaCroix — Thu, 10 May 2012 03:05:00 -0500

One of the critical issues in putting together a D&O insurance program is the question of how to structure the insurance. Among the more complex issues is how to divide the program between “traditional” D&O insurance coverage and Excess Side A DIC insurance (which in effect provides catastrophic protection for individual directors and officers in certain defined circumstances). A more basic issue is the question of how to “layer” the program between primary and excess insurers, and how large each of these layers should be in the overall program.

The question of how to layer a D&O insurance program is certainly not new, but it remains a vital question and even a source of continuing scrutiny and debate. The latest example of how topical these issues are appeared in a May 8, 2012 post in Alison Frankel’s On the Case blog (here). Within the context of a post in which Frankel discusses the overall importance of D&O insurance in securities suit settlements, Frankel quotes Steve Toll of the Cohen, Milstein, Sellers & Toll law firm. Toll has some harsh words to say for the way in which companies structure their D&O insurance.

Among other things, Toll objects to the fact that over the last decade insurers have splintered their D&O insurance into multiple layers, which in the event of a claim means that plaintiffs ‘ lawyers are often negotiating multiple insurance company representatives. In Toll’s eyes, the problem with this arrangement is that “at every step, every carrier puts up a roadblock,” which he says “dramatically affects the resolution of these cases. In almost every one, it’s the same fight.”

Toll is one of the country’s leading plaintiff’s securities attorneys. I understand that his comments are based on extensive experience and that his frustration about the settlements is real. However, with all due respect for Toll, I think it is fair to note that it is hardly a concern to the parties to the insurance contract(s) that the plaintiffs or the plaintiff’s attorneys don’t like the way the insurance is structured. D&O insurance is not there to make claimants or their attorneys happy nor is it intended to be a reserve pool on which claimants or their attorneys’ get to draw; it is there to protect the company’s directors and officers.

It could be argued that it is to the long term benefit of both companies and their insurers that there is a certain amount of friction for plaintiffs and their attorneys to be able to get at the insurance. It ensures that loss costs are contained, which in turn should help to keep insurance costs down.

Indeed, at least one leading defense attorney has recommended that D&O insurance should be arranged in tiers, for that very reason. In his venerable article entitled “The Veil of Tiers: Shareholder Lawsuits and Strategic Insurance Layers” (here), first published way back in 1997, Boris Feldman of the Wilson Sonsini law firm argued that “the ‘strategic tiering’ of directors’ and officers’ (D&O) insurance is a useful consideration in designing an effective risk management program.” Feldman argued in favor of arranging D&O insurance program in multiple layers, asserting that “Each separate layer of insurance constitutes a firebreak. It is extremely difficult, in ordinary cases, for plaintiffs to jump from layer to layer in funding a settlement – especially early in the litigation.” That is, what the plaintiffs’ lawyer is complaining about is the very thing that the defense attorney is recommending.

Alas, there is a lot more to the question of how to structure D&O insurance that just splitting the program up in to a bunch of layers to the everlasting frustration of plaintiffs’ lawyers. Even Feldman acknowledges in his article that “there is no magic formula as to the right amount or structure of a D&O portfolio.” He also says that if there are too many layers “you may expend substantial energy trying to keep your insurance house in order during a lawsuit” and “should you find yourself in a situation where you really need all of that insurance to settle a troublesome claim, it will be harder to get carriers to participate as you go higher up the chain.” In other words, the issue of too many insurers and too many insurers’ representatives in the settlement room can be a problem for policyholders and for defense counsel as well as for plaintiffs’ lawyers.

More recently, an entirely different perspective on the layering of D&O insurance has emerged. In his April 2012 paper “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits” (which can be found here, and which I previously reviewed here – and the author’s comments on my review can be found here), Fordham Law School Professor Richard Squire raises an entirely different set of objections to the layering of D&O Insurance.

Professor Squire contends that insurers in the primary layers and lower level excess layers are often compelled to contribute toward settlement when the settlement demand (or more accurately, the settlement opportunity) exceeds their layer. This compulsion, Squire notes, is often effectively given legal force through a rarely identified but nonetheless very real “duty to contribute.” The compulsion results in a “cramdown” effect, where the upper layer excess insurers and the policyholder pressure the primary insurer and lower level excess insurers to settle. These forces lead to a number of ills, including “plaintiff overcompensation at insurer expense”; overpriced liability insurance; and lawsuits of doubtful merit.

That is, Squire contends that as a result of the pressures that the insurance layering brings about, plaintiffs (and, presumably their lawyers) are “overcompensated.” I suspect that somehow Steve Toll might dissent from this perspective, or from any contention that his clients or he are overcompensated. Toll’s comments certainly don’t evince any awareness of a cramdown effect.

In my view, there is no single perspective that explains the way that the layering of D&O insurance will affect the settlement dynamic in every case. In cases involving particularly egregious facts, the layering is going to be irrelevant. (For example, the entire Lehman Brothers D&O insurance tower was always going to be toast, regardless of how it was layered). And in weaker cases, layering could have the firewall effect that Feldman described in his article, which given the weakness of the case involved is a good thing. In most other cases, the impact will be complicated and will vary according to the circumstances, including in particular how quickly defense expenses are accumulating and how likely it is that future defense expenses will burn through several of the lower layers.

What is important to understand is why D&O insurance is layered in the first place. The reason that D&O insurance programs are layered is that no D&O insurer could sustain the concentration of risk that would be involved with exposing outsized amounts of capital to any single large corporate exposure. As a result, the insurance needs of most buyers of D&O insurance (particularly among public companies) exceed the insuring capacity of any one carrier – and usually, the insurance capacity of several carriers is required in order to put together a program large enough to meet the insurance needs of most buyers.

In general, most buyers would probably prefer fewer, larger layers in the program. However, it is not always feasible to obtain larger layers, and as a result in most cases the participation of multiple carriers will be required in order to complete most buyers programs.

There might be ways to avoid the layered insurance structure. One possibility would be to arrange the D&O insurance in a quota share program. In a quota share program, the various carrier participants’ interests are arranged vertically, rather than horizontally. Under this arrangement, each carrier would share ratably in each dollar of loss costs, so the carriers’ interests in trying to save loss costs would be aligned in a way that would eliminate many of the conflicts the various commentators have noted.

The shortcoming of the quota share approach is that it would be very difficult for all of the participating insurers to cede control to a single decision maker. In the absence of a single point of control, the claims process could be reduced to chaos. The other thing about quota share D&O insurance is that people have been talking about it for years, yet it has never gone anywhere. As a practical matter, at least as things currently stand, quota share insurance is not an available alternative to the current customary layering of D&O insurance.

If D&O insurance layering is an inevitable aspect of most D&O Insurance programs, at least as things currently stand, the question then is how can the problems the various commentators have identified be reduced? I have no comprehensive solutions, but I do have a few suggestions of ways some of the problems might be reduced:

1. Keep the Excess Carriers in the Loop: Problems often arise when the excess carriers are advised only at the eleventh hour that there is a settlement demand that pierces their layer or that the defense expenses are about to exhaust the underlying layers. If the excess carriers are provided complete information as the claims develop, they are less likely to resist requests for quick action based on lack of information.

2. Keep Track of Difficult Players: I have long felt that as an industry we don’t do nearly enough to hold carriers accountable over time for recalcitrant behavior. I think that over the long haul, everyone would benefit if there were more of a league table of claims responsiveness. If carriers knew that their claims reputations truly depended on their responsiveness, there would be greater disincentives against foot-dragging and other undesirable behavior.

3. Horses for Courses: This point is really a corollary of the prior point. That is, when the D&O insurance program is being structured at the outset, a great deal of care should be taken to give precedence to the carriers that have consistently demonstrated themselves to be responsive players.

4. The Broker Has a Role to Play: One way to try to keep the claims process on track and settlement efforts moving forward is to enlist the assistance of the broker that place the coverage, at least to the extent that the broker has claims resources sufficiently knowledgeable and experienced to be able to participate meaningfully in the claims process and to be able to act as a claims advocate for the policyholder. The broker can also serve as a reminder to the various carriers involved of points 2 and 3 above.

There are probably a lot more points that might be made here, and I strongly urge readers who have thoughts along those lines to weigh in here by adding their thoughts using the comment feature on this blog.

The final point I want to make is that all of this underscores the fact that the process of putting together an appropriate D&O insurance program is an art not a science, and it requires not only a great deal of technical knowledge, but it also requires a broad perspective on the claims process and on the various carriers’ track records in that process. All of which is another way of saying that perhaps the most important step in putting together an appropriate D&O insurance program is making sure that a knowledgeable and experienced broker has been enlisted to guide the process.

This Could Get Interesting: Readers of this blog are well aware of the rash of securities litigation involving U.S.-listed Chinese companies that arose in the last couple of years. Securities regulators have also gotten interested in some of the revelations involving Chinese companies. A significant challenge that faces both private litigants and the U.S. regulators is the difficulty of investigating and conducting discovery involving companies that have their principal places of operation in China.

Along those lines, the SEC has now taken an aggressive move in its efforts to try to investigate alleged accounting issues involving Longtop Financial. The SEC had attempted to subpoena Longtop’s auditor, Shanghai-based Deloitte Touche Tomahtsu, in an attempt to obtain the audit firm’ audit work papers in connection with the firm’s audit of Longtop. The audit firm has resisted producing the work papers, asserting that production of the work papers would violate Chinese law.

On May 9, 2012, the SEC instituted an administrative proceeding against the audit firm. A copy of the SEC’s order instituting the administrative proceedings can be found here. The SEC’s May 9, 2012 press release about the action can be found here. The firm is charged with violating the Sarbanes-Oxley Act, which requires foreign public accounting firms to provide audit work papers concerning U.S. issuers to the SEC upon request. This is the first time the SEC has brought an enforcement action against a foreign audit firm for failing to comply with a request. The administrative proceeding will be assigned to an Administrative Law Judge at the agency. The judge would determine the appropriate remedial sanctions if the judge finds in favor of the SEC staff.

As reflected in Ross Todd’s May 9, 2012 Am Law Litigation Daily article about the SEC’s action (here), the SEC's latest action follows extensive procedural efforts by the agency to try to obtain the work papers. Todd also reports that efforts between regulators in the U.S. and China may have resulted in the development of some type of compromise that may break the impasse.

Whether or not these issues can be worked out remains to be seen. But in the meantime, the SEC’s so far unproductive efforts serves to underscore the difficulties involved with trying to pursue actions involving companies with their principal places of business in China.

Rating Agencies Must Defend Negligent Misrepresentation Claims for Toxic SIV Ratings

Kevin LaCroix — Tue, 08 May 2012 03:07:07 -0500

The rating agencies must defend against claims for negligent misrepresentation in connection with the ratings the firms assigned to a pair of structured investments vehicles, Southern District of New York Judge Shira Scheindlin has ruled in a pair of May 4, 2012 decisions. Judge Scheindlin did grant the defendants’ motions to dismiss claims for negligence, breach of fiduciary duty and aiding and abetting, which substantially narrowed the plaintiffs’ claims. But she denied the rating agencies’ motions to dismiss with respect to the negligent misrepresentation claims, finding that, based on the plaintiffs’ allegations, the ratings qualified as actionable misstatements under New York law.

Judge Scheindlin issued the opinions in two cases involving structured investment vehicles, one called Rhinebridge and one called Cheyne Financial. Judge Scheindlin’s opinion in the Rhinebridge case can be found here and the opinion in the Cheyne Financial case can be found here.

The background on the Cheyne financial case can be found here. The Rhinebridge case arose out of the Rhinebridge structured investment vehicle’s (SIV) June 27, 2007 offering of certain investment securities to certain Qualified Institutional Buyer and Qualified Purchasers. In connection with the offering, the rating agencies gave the Rhinebridge securities the highest ratings. The plaintiffs also allege that the rating agencies helped structure the investment vehicle. The offering proceeds were invested in a variety of residential mortgage related investments. The SIV was forced into receivership on October 22, 2007, becoming, the plaintiffs alleged, “perhaps the shortest-lived ‘Triple A’ investment fund in the history of corporate finance.” In addition to the rating agencies, the plaintiff investors had also sued IKB Deutsche Industriebank AG , the bank that sponsored the SIV, and Morgan Stanley, which had acted as offering underwriter.

Judge Scheindlin had originally dismissed the plaintiffs’ common law claims, holding under New York law that the common law claims were preempted by the Martin Act. However, in December 2011, as discussed here, the New York Court of Appeals rejected Martin Act preemption for common law claims, and Judge Scheindlin allowed the plaintiffs leave to amend their pleadings to assert common law claims. After the plaintiffs amended their pleadings the defendants renewed their motions to dismiss.

In her May 4 ruling in the Rhinebridge case, Judge Scheindlin granted the defendants’ motions to dismiss the plaintiffs’ claims for negligence, breach of fiduciary duty and aiding and abetting. However, she denied the motion to dismiss the plaintiffs’ claims against the rating agencies for negligent misrepresentation.

In denying the motions to dismiss the negligent misrepresentation claims, Judge Scheindlin said that:

the Rating Agencies (1 intended that their ratings would be used to evaluate the SIV; (2) intended that the plaintiffs –members of a select group of qualified investors – would rely in the ratings to evaluate the SIV; and (3) prepared their ratings with the end and aim of inducing investors such as the plaintiffs to invest in the SIV.

Judge Scheindlin’s ruling was specifically dependent on her determination, based on the plaintiff’s allegations, that “there was a privity-like ‘special relationship’ between the plaintiffs and the Rating Agencies.” Judge Scheindlin also allowed the negligent misrepresentation claims to go forward as to IKB Deutsche Industriebank and Morgan Stanley.

Judge Scheindlin’s ruling in the Cheyne Financial case paralleled her rulings in the Rhinebridge case, and her order in the Cheyne Financial case expressly referenced her rulings in the Rhinebridge case.

Discussion

Among the causes many cite for the subprime meltdown is the willingness of the rating agencies to assign investment grade rating to securities backed by subprime mortgages. For that reason, in many of the lawsuits filed as part of the subprime litigation wave, plaintiffs have named rating agencies as defendants, seeking to hold them responsible for their investment losses. However, as discussed here, whether the rating agencies could actually be held liable is unclear, because in the past courts have found the rating agencies’ rating opinions to be protected by the First Amendment. The rating agencies have also raised a number of other defenses regarding their rating opinions.

A series of rulings in several cases have questioned the rating agencies’ defenses. As discussed here, in a September 2009 ruling in the Cheyne Financial case, Judge Scheindlin held that, at least where the rating agencies’ ratings were released only to a select group of investors, the rating agencies could not rely on their First Amendment defense. In May 2010, a California state court judge followed Judge Scheindlin in rejecting the rating agencies first amendment defense, as discussed here. In November 2011, in a case involving Thornburgh Mortgage mortgage pass through certificates, District of New Mexico Judge James Browning also rejected the rating agencies first amendment defenses, also relying on Judge Scheindlin’s opinion in the Cheyne Financial case, as discussed here.

Judge Scheindlin’s May 4 rulings arguably represent the latest decisions holding that the rating agencies could at least potentially be held liable for their ratings opinions. However, Judge Scheindlin’s latest rulings, like the prior rulings holding that the rating agencies could not rely on First Amendment defenses, were largely reliant on the fact at that the securities in question had only been distributed to a select group of investors. Indeed, in the Rhinebridge case, Judge Scheindlin found that the plaintiffs had adequately alleged that there was a privity-like relationship between the plaintiff investors and the rating agencies.

The various rulings In these cases, including also Judge Scheindlin’s most recent rulings in the Rhinebridge and Cheyne Financial cases, represent significant developments in connection with investors’ efforts to try to hold the rating agencies liable. However because these rulings are all dependent on the fact that the securities at issue were distributed only to a select group of investors, these rulings may not be helpful in cases involving securities that were more broadly distributed. But though these rulings have limitations, they also represent a growing body of case law on which investors can try to rely in asserting their claims against the rating agencies.

David Bario’s May 7, 2012 Am Law Litigation Daily article discussing Judge Scheindlin’s rulings can be found here. Special thanks to Dan Newman of SCN Strategies for sending along copies of the opinions.

FCPA-Related Securities Class Action Suit Filed Against Wal-Mart: In yesterday’s post, I noted that CalSTRS had filed a shareholder derivative action against Wal-Mart, as nominal defendant, and certain of its directors and officers, in connection with the revelations concerning the company’s Mexican bribery allegations. Now, in addition to the shareholder derivative lawsuits, investors have also launched a securities class action lawsuit in connection with the bribery allegations.

According to their May 7, 2012 press release (here), the plaintiffs’ lawyers have filed a securities class action lawsuit against the company and certain of its directors and officers in the Middle District of Tennessee. The complaint, which can be found here, features a quote from and even a picture of company founder Sam Walton (allegedly taken from the company’s annual report). According to the press release, the complaint alleges that the defendants “ concealed from the investing public during the Class Period” that “the Company had violated the Foreign Corrupt Practices Act in connection with the bribery payments” and that "Walmart management did not address ethical concerns in a ‘timely and effective manner’ as represented by defendants.”

As I said previously about the CalSTRS derivative suit, these lawsuit filings reinforce the view that follow-on civil litigation is an almost invariable accompaniment of FCPA-related investigations, and show that FCPA-related exposures are a matter of serious shareholder concern. Taken collectively, the risk of an FCPA investigation as well of the related follow-on civil litigation risk are increasingly important liability exposures for companies and their directors and officers.

The FDIC's Failed Bank Litigation, So Far

Kevin LaCroix — Mon, 07 May 2012 03:58:33 -0500

The number of bank failures has been winding down for a while now, but at same time the FDIC’s failed bank litigation has been ramping up. Through April 20, 2012, the FDIC has filed a total of 29 lawsuits against former directors and officers of failed banks, involving 28 different institutions. In a May 4, 2012 BankDirector.com post (here), Cornerstone Research takes a detailed look at the failed bank litigation so far. Cornerstone Research’s related May 2012 paper entitled “Characteristics of FDIC Lawsuits Against Directors and Officers of Failed Financial Institutions” can be found here.

According to the paper, during 2012 the FDIC has been “intensifying its litigation activity associated with failed financial institutions.” So far, the FDIC has filed 11 lawsuits in 2012, compared with 16 during all of 2011. The 2012 filing activity is on pace for a total of 35 lawsuits this year.

Currently, about 6 percent of financial institutions that have failed since 2007 have been the subject of FDIC lawsuits. (That compares to about 24 percent of all institutions that failed during the S&L crisis.). According to the Cornerstone Research paper, the lawsuits filed during the current bank failure wave have targeted the larger institutions and those with a higher estimated cost of failure.

The median size of the 28 institutions targeted so far was approximately four times as large as the median size of all failed institutions and six times as large as the median size of currently active institutions. The 28 targeted institutions had median total assets of $973 million, compared with median total assets of approximately $241 for all failed institutions. The 28 institutions had a median estimated cost to the FDIC of $222 million at the time of seizure, compared to the median cost of failure of $59 million for all failed financial institutions. The median cost of failure for financial institutions that have been targeted in 2012 lawsuits was $355 million, compared with $158 million for institutions sued from 2007 through 2011.

The states with the largest numbers of bank failures during the period 2007 through April 2012 were Georgia, Florida, Illinois and California. With the exception of Florida, the percentage of FDIC lawsuits targeting failed institutions is slightly higher than the percentage of failed institutions in those states. Despite the large number of failed institutions in the state, there has only been one failed bank lawsuit filed in Florida so far.

The 29 lawsuits filed so far have targeted a total of 239 former directors and officers. Outside directors were named as defendants in 20 of the 29 lawsuits. The remaining lawsuits targeted only inside directors and officers. Three cases have also included insurance companies as named defendants, and one case included a law firm defendant. Three cases have included directors or officers’ spouses as named defendants.

Losses on Commercial Real Estate and Acquisitions, Development and Construction loans were the most common bases for alleged damages. 17 of the complaints identified CRE loans as the basis for claimed damages and 15 of the complaints identified ADC loans.

The most recent lawsuits have been filed just prior to the expiration of the three-year statutes of limitations. During 2012, the median time between an institution’s failure and the filing of an FDIC lawsuit was 2.97 years, compared with 2.26 years for the lawsuits filed during the period 2007 through 2011. Among the 11 lawsuits filed so far in 2012, five involved lawsuits that failed in 2010, five involve lawsuits that failed in 2008, and one involved a bank that failed in 2008.

The FDIC has indicated on its website that through April 25, 2012, the agency has authorized lawsuits involving 493 individuals at 58 institutions. As these figures are inclusive of the lawsuits already filed, the authorization figures imply a pipeline of as many as 30 additional lawsuits -- which were they to be filed would represent another 7 percent of all failed banks. That is, the filed and authorized lawsuits together could involve as much as 13 percent of all failed institutions. These figures of course represent only the lawsuits authorized to date; the FDIC has been increasing the number of authorizations monthly over the course of the past several months.

The FDIC’s latest authorization figures on its website did not specify an aggregate damages figure that the authorized lawsuits represent, but the figure the agency used (for a lesser number of lawsuits) in January 2012 was $7.7 billion, which compares to the aggregate damages claimed so far of $2.4 billion – which suggests that the authorized lawsuits may include some very significant additional claimed damages.

The Cornerstone Research report notes that a number of the large and costly bank failures during 2008 (and 2009) have not yet been the subject of an FDIC lawsuit. The report notes that the directors and officers of these institutions may be involved in negotiations with the FDIC. Whether these additional large bank failures will become the subject of future FDIC lawsuits “will depend on the outcome of such negotiations, statute of limitations restrictions, and tolling agreements that may be agreed upon during such negotiations.”

Only three of the FDIC’s failed bank lawsuits have settled so far, as discussed on page 13 of the Cornerstone Research report. These settlements include the WaMu settlement (about which refer here) and the First National Bank of Nevada settlement (about which refer here).

On a final note, the Cornerstone Research report projects that given the current pace of bank failures this year, we are on track for about 69 bank failures in 2012, compared to 92 in 2011 and 157 in 2010. With the addition of another failed bank this past Friday evening, there have been a total of 23 bank failures so far this year.

CalSTRS Takes on Wal-Mart Over FCPA Issues: As I have previously noted on this blog, a frequent accompaniment of an investigation of a Foreign Corrupt Practices Act investigation is a follow-on civil lawsuit, in which investors alleged either that the company’s management failed to properly supervise the company’s operations or that the company issued misleading statements about its internal controls or financial condition.

Given the relative frequency of this type of litigation, it was hardly surprising that Wal-Mart’s recent announcements of FCPA-related concerns involving its Mexican operations attracted litigation. Just the same, as Alison Frankel points out in a May 4, 2012 article on her On the Case blog (here), the filing of a lawsuit against Wal-Mart, as nominal defendant, and 27 of its current and former directors and officers, by the California State Teachers Retirement System (CalSTRS) represents a significant and noteworthy development.

In its May 3, 2012 complaint, which can be found here, CalSTRS alleges, among other things, that “prolonged failure to address detailed and credible allegations of criminal activity undertaken with the tacit or express consent of current and former senior corporate officials, and the complicity of the Company’s highest level executives in shutting down any investigation into those allegations, is causing and will continue to cause the Company substantial harm.”

As Frankel comments, when an “800-pound gorilla” like CalSTRS gets involved in this type of follow-on civil litigation, things have definitely become “serious.” The CalSTRS lawsuit will also set up a potential conflict between the actions previously filed in Arkansas in connection the Wal-Mart’s FCPA revelations and the CalSTRS action, which was filed in Delaware.

From my perspective, the CalSTRS lawsuit not only reinforces the view that follow-on civil litigation is an almost invariable accompaniment of FCPA-related investigations, but the involvement of CalSTRS itself highlights that FCPA-related exposures are a matter of serious shareholder concern. Taken collectively, the risk of an FCPA investigation as well of the related follow-on civil litigation are increasingly important liability exposures for companies and their directors and officers.

Judge Wants to Know About Lehman Executives Wealth Before Approving D&O Settlement: Last August when it was first announced that the parties to the shareholder suit arising out of the collapse of Lehman Brothers had agreed to settle the case for $90 million – the amount of the remaining limits of the company’s D&O insurance program – I knew there could be trouble, especially since the settlement did not contemplate any contribution from the individual defendants themselves.

I was not the only one that anticipated possible problems. The plaintiffs lawyers themselves foresaw there could be trouble, as well. Aware of a possible “hue and cry” about the Lehman executives “getting off the hook without paying any money,” the plaintiffs tried to head off controversy by hiring John S. Martin, Jr., a retired federal judge, in order to determine whether the executives had a combined net worth of $100 million. Judge Martin prepared a report in which he concluded that “I am satisfied that the Liquid Worth of the Officer Defendants taken together, is substantially less than $100 million.”

The parties submitted their proposed settlement – including Judge Martin’s report -- to Southern District of New York Judge Lewis Kaplan. In a May 3, 2012 opinion that opens with a quotation from noted legal scholar Kenny Rogers, Judge Kaplan concluded that the information in Martin’s report was not sufficient to permit him to determine whether or not he should approve the settlement. Judge Kaplan’s opinion evinces full awareness of the fact that if the parties had failed to reach their agreement to settle the case for the remaining D&O insurance program limits, the amount of insurance remaining would rapidly have diminished, leaving the shareholders with perhaps an even smaller recovery.

Judge Kaplan’s concern has to do with the nature of the inquiry Judge Martin was asked to address. Specifically, Judge Kaplan was concerned with the fact that Judge Martin looked only at whether or not the defendants’ liquid net worth is less than $100 million. Judge Martin’s answer, Judge Kaplan said, “is not informative as is necessary and appropriate for this Court to consider” all of the requisite factors for class action settlement approval. In the end, Judge Kaplan called for the in camera production of all the information that had been submitted to Judge Martin, so that Judge Kaplan could consider all information (presumably including information about assets the defendants may have held that is not “liquid”) in order to determine how the settlement compared to possible available alternatives by assessing the extent to which the defendants could withstand a judgment in excess of the remaining amount of insurance.

Everything about this situation is highly unusual, starting with the fact that the case involved is perhaps the highest profile civil lawsuit arising out of the financial crisis and that the collapse of Lehman Brothers may have been the most critical development during the crisis. The fact that the case settled as it did may not have been all that unusual, as parties often reach compromises based on dwindling amounts of insurance. However, the plaintiffs, anticipating trouble, took extraordinary steps to try to substantiate the settlement, by hiring Judge Martin to assess the individual defendants’ net worth. By the same token, Judge Kaplan’s further consideration of the individual defendants’ collective net worth arguably is even more unprecedented.

The defendants have until May 10, 2012 to submit the information they had provided to Judge Martin to Judge Kaplan for in camera review.

Susan Beck’s May 4, 2012 Am Law Litigation Daily article about Judge Kaplan’s decision can be found here.

The Impact of the JOBS Act on D&O Liability and Insurance

Kevin LaCroix — Mon, 07 May 2012 02:07:55 -0500

On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (commonly referred to as the JOBS Act). This legislation, which enjoyed strong bipartisan support in Congress, is intended to ease the IPO process for emerging growth companies and to facilitate capital-raising by reducing regulatory burdens and disclosure obligations. Among other things, the Act also introduces changes that could impact the potential liability exposures of directors and officers of both public and private companies. These changes could have important D&O insurance implications.

In the latest issue of InSights, I take a detailed look at the provisions of the JOBS Act and consider the Act’s possible impact on D&O liability and insurance. The InSights article can be found here.

Ontario Court: Company with Shares Trading Only on Foreign Exchange Subject to Canadian Securities Suit

Kevin LaCroix — Fri, 04 May 2012 03:32:56 -0500

On March 30, 2012, in a decision that may highlight the extent to which Canadian courts are increasingly willing to enforce securities laws in ways that may have extraterritorial effects, the Ontario Court of Appeals held that the liability regime under the Ontario Securities Act applies to Canadian Solar, a company whose shares trade only on NASDAQ and that do not trade on any Canadian exchange, and that has its principal place of business in China. A copy of the Court of Appeal decision can be found here.

Background

An Ontario resident initiated a putative class action lawsuit against Canadian Solar under the Ontario Securities laws, alleging that the company overstated its financial results. Section 138.3 of the Ontario Securities Act creates a cause of action in the event of a misrepresentation by a “responsible issuer.” The statute defines “responsible issuer” as a reporting issuer or “any issuer with a real and substantial connection to Ontario, any securities of which are publicly traded.”

Canadian Solar is not a “reporting issuer.” Its shares are listed only on NASDAQ. Its shares do not trade on any Canadian exchange. Canadian Solar’s principal place of business is in China. However, it is registered as a Canadian federal corporation with its registered office and executive offices in Ontario.

A motions judge held that Canadian Solar is “responsible issuer” within the meaning of the statute. Among other things, the motions judge held that Canadian Solar’s shares did not have to be publicly traded in Canada for it to come within the definition of “responsible issuer.” Canadian Solar appealed this aspect of the motions judge’s ruling, arguing that only a company whose shares were publicly traded in Canada came within the definition of a “responsible issuer.”

The Ruling of the Court of Appeals

In a March 30, 2012 opinion, written by Justice Alexandra Hoy for a three-judge panel, the Ontario Court of Appeal s held that “the general principles with respect to extraterritorial regulation do not require that the definition of ‘responsible issuer’ be interpreted as confined to issuers any of whose securities are publicly traded in Canada.” Justice Hoy added that “there is a sufficient connection between Ontario and Canadian Solar to support the application of Ontario’s regulatory regime to Canadian Solar.”

Among other things, in connection with the sufficiency of the connection to Ontario, the court also noted that the plaintiff , “an Ontario resident who placed his order in Ontario for shares of a corporation based in Ontario, would reasonably expect that his claim for misrepresentations in documents released or presented in Ontario would be determined by an Ontario court.”

Discussion

The Ontario Court of Appeals decision in the Canadian Solar case is interesting and potentially significant because of its holding that the secondary market misrepresentation damages class action under the Ontario securities laws could be asserted against a company even though the company’s securities were not publicly traded in Canada. Because all of the Canadian provinces have enacted legislation simalar to Ontario's (similar at least in this respect), the decision could have implications across all of the Canadian provinces. There obviously are factors that made this situation somewhat distinct, if not perhaps unique; Canadian Solar is a Canadian registered corporation with both its registered office and its executive offices in Ontario. In addition, the plaintiff, an Ontario resident, purchased his Canadian Solar shares in Ontario.

Nevertheless, as noted in an April 4, 2012 memo from the Osler, Hoskin & Harcourt law firm (here), the Court’s decision “makes it clear that non-reporting issuers whose shares do not trade anywhere in Canada may nevertheless find themselves subject to Ontario’s liability regime for misrepresentations made in the secondary market, provided however that the issuer has a ‘real and substantial connection’ to Ontario.”

At a minimum, as discussed in a May 2012 memo from the Blake, Cassels & Graydon law firm (here), the Canadian Solar opinion provides “possible guidance that may be instructive to determining when a real and substantial connection exists for purposes of the statute.” In particular, the memo also notes, it appears that “there is no one factor that will insulate companies from Canadian securities law.”

The Blake law firm’s memo goes on to suggest that “it is feasible that the current state of the law may result in Ontario and other Canadian jurisdictions becoming the forum of choice for shareholders attempting to seek remedies even where the connection to Canada is tenuous.” What remain to be determined in future cases, as the Osler, Hoskin law firm’s memo notes, “is the extent of the connections that other foreign issuers will be required to have with the province before they will be considered ‘responsible issuers’ for purposes of” the statute.

In the wake of the U.S. Supreme Court’s decision in Morrison v. National Australia Bank, one of the questions that has been asked is whether another jurisdiction will emerge as an alternative forum in which aggrieved investors precluded from U.S courts can pursue their remedies. The Canadian Solar case provides an interesting point of view on the consideration of these issues, given that because the company’s shares trade on NASDAQ, an action against the company and its directors and officers under the U.S. securities laws is not precluded under Morrison. (Indeed, a separate action against the company has been filed in the United States, about which refer here.)

Nevertheless, the case does provide interesting additional insight into the possible availability of Canada as an alternative forum. This possibility was already the subject of a great deal of focus since Canadian courts have certified a global plaintiff class in the Imax case (about which refer here), and in the Arctic Glacier case (about which refer here).

The possibility that the Canadian courts might emerge as an alternative forum of choice seems to be advanced by the Court’s holding that it is not preclusive of an action under the relevant laws that the defendant company’s share were not traded on a Canadian exchange. Of course there were many other factors involved in this case that supported the application of the Ontario laws here that are not going to be present in many other cases. Nevertheless, the case does reflect a willingness by Canadian courts to apply its laws to cases with significant foreign aspects as well.

The Other Kind of Merger-Related Litigation

Kevin LaCroix — Thu, 03 May 2012 03:41:13 -0500

Much has been written recently (including on this blog) about the growing prevalence of M&A related litigation. These lawsuits, typically launched by the target company shareholders, are filed shortly after a merger announcement and usually object to some aspect of the proposed merger or of the merger-related disclosure. But the merger objection lawsuit is not the only kind of lawsuit that mergers can produce – there is also the kind of lawsuit that can arise post-merger when, it is alleged, the merger was not successful.

In a recent example of this second kind of merger lawsuit, on May 2, 2012, plaintiffs filed a shareholder class action lawsuit in the Northern District of Illinois against Allscripts Healthcare Solutions and two of its officers. Allscripts is, according to the complaint, the “corporate result” of the merger of Allscripts-Misys Healthcare Solutions and Eclipsys Corporation, which was announced on June 9, 2010.

The complaint references the company’s April 26, 2012 filing on Form 8-K (here), in which the company “shocked the market” by reporting earnings sharply lower than guidance, as well as the termination of the Chairman of the company’s board of directors; the resignations of three other directors; and the resignation of the company’s CFO. According to the 8-K, the termination and resignations followed board discussions regarding the leadership of the company. The complaint alleges that in reaction to the news the company’s share price dropped sharply.

According to plaintiff’s counsel’s May 2, 2012 press release (here), the complaint alleges that during the class period:

Allscripts concealed that: (a) the process of developing a unified product offering after the Merger had suffered debilitating setbacks, including major undisclosed schisms among the most senior levels of the Company, which ultimately resulted in the loss of key personnel and harmful upheaval in Company leadership; (b) a material portion of Allscripts' revenue and net income was predicated on the successful integration of these systems, and substantial business relationships had been destroyed by the Company's inability to make material progress in this area; and (c) as a result of the foregoing, Allscripts lacked a reasonable basis for its claims of progress in post-Merger integration, sound operations, profitable results, and continued growth.

This latest lawsuit exemplifies the second type of merger-related lawsuit, typically filed post-merger and typically alleging that the merger did not live up to expectations. Perhaps the highest profile example of this type of lawsuit is the litigation filed in July 2002 in the wake of the failed AOL Time Warner merger. That litigation ultimately resulted in a settlement of $2.5 billion (not to mention extensive additional opt-out settlements), which is the seventh largest securities class action lawsuit settlement of all time.

Another high-profile case of this same type is the lawsuit that was filed in 2000 following the December 1998 merger transaction that led to the formation of Daimler Chrysler. That case ultimately settled for $300 million.

Nor are high-profile mergers the only types of transactions that can produce this type of merger-related litigation. For example, in September 2011, shareholders filed a securities class action in the Northern District of California against Equinix and certain of its directors and officers, in which the plaintiffs disclosed that the company was having difficult with the integration of Switch & Data Facilities Company, which Equinix had acquired in April 2010. (To be sure, in March 2012, the court granted the defendants’ motion to dismiss, albeit with leave to amend.)

My point here is that the merger objection cases are not the only type of litigation that mergers and acquisitions activity can generate. As these examples show, there is also the possibility that to the extent the merger does not live up to expectations (or rather – allegedly does not live up to expectations) there could be post-merger litigation as well. These post-merger suits may either allege (as was the case in the Daimler Chrysler litigation) that the merger related documents contained misrepresentations, or that the company made misrepresentations regarding its post-merger operations or merger-related integration (as was the case in the Equinix case and in the recently filed Allscropts case). At some level it is hardly surprising that litigation might arise post-merger from time to time, given that – depending on who you ask – “mergers have a failure rate of anywhere between 50 and 85 percent.”

Indeed the possibility of a lawsuit alleging that the merger did not live up to expectations is itself not the only type of post-merger litigation that can arise. Another variant that can sometimes arise is the post-merger lawsuit alleging that the surviving company failed to properly account for the transaction or to properly present the financials of the combined companies. An example of this latter type is the July 2011 lawsuit filed against JBI, Inc. and certain of its directors and officers, in which the plaintiff alleged that the company did not properly account for certain media credits it had acquired in connection with an acquisition transaction.

All of which serves to underscore a point which has long been known to D&O underwriters – that is, the mergers and acquisitions transactions provide context out of which litigation sometimes (perhaps frequently) arises. The recent rise in merger objection litigation has certainly amplified this point. But as the examples in this blog post demonstrate, there are other types of lawsuits beyond the merger objection cases that can arise in connection with or following a merger transaction.

Are We There Yet?: One of the huge by-products of the July 2010 enactment of The Dodd-Frank Act is the huge rulemaking burden that the Act imposed on a variety of federal agencies. As I have noted in a prior post (here), the agencies have been laboring under the rulemaking burdens, and in many cases have fallen far beyond their rulemaking deadlines the Act required.

Although there obviously is no joy in the exercise, the Davis Polk law firm has been diligently tracking the agencies’ rulemaking progress. In its May 2012 Dodd-Frank Progress Report (here) the law firm details the current status of the agencies’ rulemaking efforts.

Among other things, the study shows that as of May 1, 2012, a total of 221 Dodd-Frank rulemaking requirement deadlines have passed. Of those 221, 148 (67%) have been missed and 73 (33%) have been met with finalized rules. Regulators have not yet released proposals for 21 of the 148 missed deadlines.

Of the total of 398 rulemakings that Dodd-Frank required, 108 (27.1%) have been met with finalized rules and 146 rules have been proposed that would meet the requirement (36.7% more). Rules have not been proposed to meet 144 (36.2%) rulemaking requirements.

The Dodd-Frank Act’s rulemaking juggernaut grinds onward. Your government at work. At the direction of Congress.

Predicting Securities Suit Case Outcomes

Kevin LaCroix — Wed, 02 May 2012 03:27:16 -0500

A great deal of the analysis of securities class action lawsuit settlements revolves around measures of aggregate, average and median settlement amounts. These data, while useful, are relatively unhelpful in trying to anticipate the outcome of any particular case, particularly at the outset. To try to develop a way to predict likely case outcome at the outset of a securities class action lawsuit, four academics conducted a detailed statistical analysis of securities class action settlements in order to identify factors that affect outcomes.

In their April 30, 2012 paper entitled “Predicting Securities Fraud Settlements and Amounts: A Hierarchical Bayesian Model of Federal Securities Class Action Lawsuits” (here), Northwestern University Business Professor Blakeley McShane, Juridigm Principal and Vice President Oliver Watson, U. Penn Law Professor Tom Baker and Fordham University Law Professor Sean Griffith set out to create a “predictive model to forecast case outcomes based exclusively on information available at the time the lawsuit is filed.”

Their model, described in their paper, “estimates (i) the probability of the settlement versus dismissal of a securities class action lawsuit and (ii) the amount for which the class action will settle conditional on the settlement.”

A great deal of the authors’ paper is devoted to a description of the methodology used to derive the data on which their analysis is based. Another significant part of the paper is devoted to a description of their analytic methodology, which, as their title suggests, employs high level statistical approaches and techniques. A detailed description of the authors’ data derivation and statistical methodologies is beyond the scope of this blog (which is another way of saying that I know my limits).

For purposes of understanding the authors’ conclusions, it is useful to note that the authors derived a data set of nearly 1200 securities class action lawsuits and associated case resolutions. Among other critical steps taken to derive their data set, the authors focused exclusively on cases filed post-PSLRA that were filed five years or more before the starting date of their analysis. (The five year cut-off was used to ensure the likelihood that the cases in the data set had been finally resolved). Essentially, the authors looked at cases filed between 1996 and 2005 that otherwise survived the authors’ filters and sorting criteria.

The authors also derived several of their own measures using variety of data sources. For example, in order to determine the “notoriety” or “newsworthiness” of a particular company or case, the authors considered the number of Google News Archive hits associated with the company in the year prior to the lawsuit filing.

Using these and other data points and applying selected statistical methods to develop their model, the authors identified a number of variables predictive of whether a case is settled or dismissed, and variables predictive of the settlement amount if a case is settled.

The variables the authors identified that indicate that a case will most likely settle include “a number of classes or types of securities associated with the case, a higher return on the S&P 500 during the class period, whether or not GAAP violations were alleged and having an individual plaintiff listed.” Factors that indicate that a case is less likely to settle (that is, more likely to be dismissed) include “longer filing times, higher market capitalization, a higher company return during the class period, having an institutional plaintiff listed, and greater public notoriety (as measured by the number of Google hits in the year prior to filing).”

The variables the authors found that positively impact the settlement amount include “the total number of securities, the length of the class period, market capitalization, the company return during the class period, whether or not earnings were restated, whether or not the case was a Securities Act Section 11 case, whether or not insider trading was alleged, the existence of an institutional plaintiff, and the number of Google hits.” Factors associated with lower settlement amounts include “longer filing times and not having an institutional investor listed (i.e., having only an individual plaintiff listed or having no plaintiff listed).”

The authors also found that though GAAP cases are more likely to settle, the GAAP cases that do settle do not have higher settlement amounts. The authors speculate that this is likely due to the fact that an allegation of a GAAP violation significantly bolsters the merits of the case, which increases the chances the case will survive a dismissal motion. The authors suggest that this makes it more appealing for plaintiffs to take on a GAAP violation case even if the potential damage award is relatively low.

At the same time, Rule 10b-5 cases are less likely to settle (that is, more likely to be dismissed) but those that do settle have higher settlement amounts. The authors attribute this to the greater damages available to Rule 10b-5 plaintiffs. The authors suggest that plaintiffs rationally might be willing to pursue cases with a lower survivability probability when the cases are likelier to have larger settlements, assuming the cases survive dismissal. Cases without institutional plaintiffs are more likely to survive motions to dismiss, which the authors interpret to suggest both that institutional investors select the high potential value cases and that plaintiffs’ lawyers exercise more care regarding the merits of cases with only an individual plaintiff.

The authors also noted a number of differences among the various circuits and industries. For example, the authors note that the eleventh circuit appears to have modestly lower settlement amounts whereas the ninth and tenth circuits have modestly higher settlement amounts. Similarly, utilities have somewhat higher settlement amounts.

Discussion

I have necessarily summarized here the authors’ much more detailed analysis. The only way to fully understand and appreciate the authors’ predictive analysis, as well as the ways in which the authors’ conclude that the various factors are predictive, is to read their paper in full, which I recommend.

I do note that the ability to predict case outcomes at the outset is important for a number of process participants, including in particular the affected D&O insurers. Among other things, D&O insurers must have reliable means to assess and predict case outcomes at the outset in order to try and set case reserves appropriately. In addition, D&O insurers whose coverage attaches only in the excess layers will want to be able to assess cases at the outset in order to try to determine the likelihood that losses associated with any particular claim will penetrate their attachment point. For the involved D&O insurers, the authors’ predictive model could provide a useful tool.

The authors’ model could prove a useful tool for the defendant companies themselves as well as for their defense counsel. It is critically important for companies and their counsel in setting their litigation strategy to have an accurate understanding of the seriousness of the claim. The authors’ model may provide a useful way for companies and their counsel to make a realistic assessment of the seriousness of the case in order to try to set defense strategy appropriately.

If I were to make one suggestion to the authors in order to make their analysis more accessible, it would be to expand their summary description of the relevant factors so that the factors are not only identified but also so that the nature of their relevance is more apparent. For example, it is of course important for the authors to state in the summary of their conclusions that, for example, “the length of the class period” is a relevant factor positively impacting settlement. It would be even more helpful for the non-mathematician reader for the authors to explain in the conclusion section how the variation of the length of the class period affects the settlement (that is, is it a shorter or a longer class period that positively affects the settlement?). A more detailed explanation in the paper’s discussion section of the authors’ specific conclusions with respect to each of the identified factors would make the authors’ otherwise somewhat intimidating paper more approachable to a wider variety of readers and would make the authors’ conclusions both clearer and more useful for those trying to understand the implications of the authors’ analysis.

I would like to thank Professor Tom Baker for providing me with a copy of this interesting paper.

UPDATE: Following my publication of this post, and in particular in response to my comments about the paper, one of the paper's authors, Blakeley McShane, contacted me with a supplement to the article, to provide further explanation of the paper and its conclusions. Because I think the supplement significantly aids an understanding of the paper, I have reproduced the supplement in full below. My thanks to McShane for taking the time to prepare a detailed supplement and for his willingness to allow me to publish it here. Here is the supplement:

Thank you for your interest in our paper “Predicting Securities Fraud Settlements and Amounts: A Hierarchical Bayesian Model of Federal Securities Class Action Lawsuits” which is forthcoming in the Journal of Empirical Legal Studies. We really enjoyed reading your write-up of our results and wanted to follow up on your last paragraph where you requested a more friendly description of the effect of each variable. We will attempt to be as clear as possible and focus on our “best guess” of the effect of each variable (i.e., the dots in Figures 8a and 9a respectively). Of course our estimates are subject to uncertainty (indicated by the thick and thin lines of Figures 8a and 9a) but we will ignore that for the purpose of this discussion.

First, let’s begin by discussing the data. Our principal data source comes from the Riskmetrics Group’s Securities Class Action Services Division which tracks securities fraud class action lawsuits on a commercial basis. Nonetheless, as you mentioned, a substantial amount of processing as well as augmentation with data from other sources was required. This is detailed in Section II of our paper so we will just give a brief description of each of the variables that are “statistically significant” in either of the two stages of our model (i.e., the settlement versus dismissal stage and settlement amount conditional on settlement stage).

• Total Securities: The number of different securities (e.g. stocks, bonds, etc.) associated with the case.
• Filing Time: The length of time from the end of the class period until the filing date.
• Class Length: The length of the class period.
• Market Capitalization: The market capitalization of the plaintiff firm.
• Company Return: Roughly speaking, the percentage return on the plaintiff firm’s stock during the class period (see Section II.C for full details on how we constructed this variable).
• S&P 500 Return: The percentage return on the S&P 500 during the class period.
• GAAP: Whether or not GAAP violations were alleged in the case.
• Restated: Whether or not the allegation mentions that the company’s financial statements were restated.
• 10b5: Whether or not the case was a Rule 10b-5 case.
• Section 11: Whether or not the case was a Securities Act Section 11 case.
• Plaintiff: The plaintiff variable has three values. If one or more institutions are listed as the plaintiff, we set out Plaintiff variable equal to “Institutional”. If no institutions are listed but one or more individuals are, we set it equal to “Individual”. Finally, if nothing is listed in the database, we set it equal to “Unknown”. Of course, this does not mean there is no plaintiff in the case; rather, it means Riskmetrics has not obtained the information for this variable. This is potentially informative for whether or not a case settles and for how much it settles for if it does settle, but probably says more about Riskmetrics’ priorities in gathering data than anything else. In particular, given the nature of Riskmetrics’ business, they are most highly incented to collect complete data for cases which settle and especially those which settle for large amounts. Consequently, we would, for example, a priori expect Empty plaintiff cases (i) to be less likely to settle and (ii) to settle for less when they do settle.
• Insider Trading: Whether or not insider trading was alleged in the case.
• Google Hits: A measure of the newsworthiness or notoriety of the case. In particular, the number of Google News Archive associated with the company name in the year prior to the filing date (see Section II.E for full details on how we constructed this variable).

With the variables defined, let’s begin with the factors that predict settlement amount conditional on a case settling. We identified eleven “statistically significant” predictors of the settlement amount:
• Total Securities: A 1% increase in total securities is associated with a 0.25% increase in the settlement amount.
• Filing Time: A 1% increase in the filing time is associated with a 0.1% decrease in the settlement amount.
• Class Length: A 1% increase in the length of the class period is associated with a 0.1% increase in the settlement amount.
• Market Capitalization: A 1% increase in market capitalization of the plaintiff firm is associated with a 0.4% increase in the settlement amount.
• Company Return: A 1% increase in plaintiff firm’s return over the class period is associated with a 0.2% increase in the settlement amount.
• Restated: Restated financial statements are associated with a 20% increase in the settlement amount.
• Section 11: Securities Act Section 11 cases are associated with a 45% increase in the settlement amount.
• Individual Plaintiff: Individual plaintiff cases are associated with a 35% decrease in the settlement amount relative to cases with an institutional plaintiff.
• Unknown Plaintiff: Unknown plaintiff cases are associated with a 40% decrease in the settlement amount relative to cases with an institutional plaintiff.
• Insider Trading: Insider trading cases are associated with a 30% increase in the settlement amount.
• Google Hits: A 1% increase in the number of Google News hits is associated with a 0.05% increase in the settlement amount.

Many of these variables make intuitive sense. For instance, the total number of securities, market capitalization, and number of Google hits are associated with the size of the firm and hence how much damage can be done and how large a settlement can be extracted. Similarly, the longer the class length, the greater the number of securities traded during the period and, hence, the larger the damages. The higher damages for Section 11 cases (all other things being equal) may reflect the fact that plaintiffs do not need to prove scienter to succeed. The filing time result has a plausible basis as there is often a rush to file the “best” cases. Interestingly, some “merits” variables such as Restated and Insider Trading, which in theory should only affect whether or not a case settles or is dismissed, also impact the settlement amounts thus suggesting that decisions over whether or not there were damages versus how great those damages were may not be entirely independent. The Company Return finding is somewhat surprising, since a lower return during the class return would indicate larger damages from the alleged fraud. Our hypothesis is that that this finding is picking up on the capacity of the defendant to pay. Other things being equal, a company that recently made money is going to be better able to pay a settlement. Finally, the result for the identity of plaintiff is consistent with Riskmetrics’ business model as outlined above.

The interpretation of the significant coefficients for the model which predicts whether a case settles or is dismissed is somewhat more complicated than that for the settlement amount model. This is because each case is associated with a “latent score” giving the probability of dismissal: cases with high scores are very likely to settle and cases with low scores are very likely to be dismissed. The tricky part is that the relationship between the latent score and the probability is non-linear. Instead, it follows an S-shaped curve called a logistic curve:

With a logistic curve, the increase in the probability of settlement associated with a small change in the latent score depends on the original latent score: at the extremes, the change in probability is quite small whereas in the middle it is quite large. For example, an increase of 0.1 from -4.0 to -3.9 hardly changes the probability as can be seen in the above figure (the probability only goes from 1.8% to 1.9%). Similarly, an increase of 0.1 from 4.0 to 4.1 hardly changes the probability as can be seen in the above figure (the probability only goes from 98.2% to 98.4%). On the other hand, in the middle of the curve, small changes can have a substantial impact. For example, an increase of 0.1 from 0.0 to 0.1 changes the probability substantially from 50% to 52.5%. In the descriptions which follow, the increase in probability will be for the middle of the curve where the “action” is.

We identified ten “statistically significant” predictors of the probability of settlement:
• Total Securities: A 1% increase in total securities is associated with a 0.4% increase in the probability of settlement.
• Filing Time: A 1% increase in the filing time is associated with a 0.02% decrease in the probability of settlement.
• Market Capitalization: A 1% increase in market capitalization of the plaintiff firm is associated with a 0.02% decrease in the probability of settlement.
• Company Return: A 1% increase in plaintiff firm’s return over the class period is associated with a 0.15% decrease in the probability of settlement.
• S&P 500 Return: A 1% increase in plaintiff firm’s return over the class period is associated with a 0.3% increase in the probability of settlement.
• GAAP: Allegations of GAAP violations are associated with a 13% increase in the probability of settlement.
• 10b5: Rule 10b-5 cases are associated with a 25% decrease in the probability of settlement.
• Individual Plaintiff: Individual plaintiff cases are associated with an 8% increase in the probability of settlement relative to cases with an institutional plaintiff.
• Unknown Plaintiff: Unknown plaintiff cases are associated with a 60% decrease in the probability of settlement relative to cases with an institutional plaintiff.
• Google Hits: A 1% increase in the number of Google News hits is associated with a 0.02% decrease in the probability of settlement.

Again, many of these results have an intuitive basis. The result for filing has the same intuition as for settlement amounts: many of the “best” cases are filed early. While we had no a priori expectation for the market capitalization result, perhaps bigger firms are better able to defend themselves; regardless, the effect is weak. Nonetheless, this as well as the result for Google Hits may be a result of the “plaintiff selection effect” whereby plaintiffs select cases which are more likely to be dismissed but will settle for a large amount conditional on surviving the motion to dismiss. This is consistent with the results presented above. Not surprisingly, as the company’s return during the class period goes down (potential evidence of fraud), the likelihood of settlement goes up; this is exacerbated when the market as a whole (as measured by the S&P 500) goes up during the same period. GAAP violations are a classic merits variable and therefore associated with increased likelihood of settlement. A combination of Riskmetrics’ incentive in gathering data as well as the plaintiff selection effect are likely at play in explaining the plaintiff results (i.e., Riskmetrics’ is more likely to gather plaintiff information for cases which settle and, further, institutional plaintiffs are more likely to become involved in cases with larger damages potential). Riskmetrics’ incentives are also likely to explain the number of securities result, as Riskmetrics will be more likely to gather all of the securities information for cases that actually do settle. Finally, the lower probability of settlement of 10b5 cases likely reflects the greater difficulty of proving the knowledge required (scienter) as compared to, for example, Section11 cases.

We hope this is more interpretable and clarifies matters some. Thank you again for your interest in and coverage of our work

Cornerstone Research Releases Updated Study of M&A Litigation

Kevin LaCroix — Tue, 01 May 2012 03:02:10 -0500

On April 25, 2012, Cornerstone Research released a report written by Stanford Business School Professor Robert Daines and Cornerstone Research Principal Olga Koumrian entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions – March 2012 Update” (here). This memorandum is the latest in a series of recent papers documenting the growth in merger related litigation in the United States. The research described in this paper is consistent with the prior reports but it also contains some new additional insights.

The report opens with a number of observations about the incidence of litigation in connection with mergers valued at $500 or greater during the period 2007 to 2001. The report shows that while in 2007 only about 53% of such deals attracted litigation, by 2011 almost all deals (96%) of those deals attracted litigation.

In addition, with respect to the deals of that size that attracted litigation during that period, the number of lawsuit per deal also increased between 2007 and 2011. Thus, while in 2007, the average number of lawsuits per litigated deal was 2.8, in 2011, the average number of lawsuits per litigated deal was 6.2 million. The report also shows that these trends were not limited just to the largest deals; during 2010 and 2011, for deals valued between $100 million and $500 million, 85% of the deals attracted litigation, and the average number of lawsuits per litigated deal was 4.1.

The absolute count of lawsuits involving deals with values of $500 million or greater also nearly doubled during that period, with 289 lawsuits filed in 2007 and 502 lawsuits filed in 2011.

The authors also note that as of March 2012, 67 lawsuits have already been reported for thirteen out of seventeen deals announced during January and February 2012.

Certain deals attracted far more than the average number of lawsuits. A table in the report shows that fifteen deals with a valuation of $100 million or greater during the period 2007-2011 attracted fifteen or more lawsuits. Interestingly, of these fifteen, twelve of these deals were announced in 2010 or 2012. The report notes that size alone does not explain which deals attracted these large numbers of suits, and that in fact several relatively small acquisitions attracted fifteen or more lawsuits.

The report also shows that deals in certain industries seem to attract the most numbers of lawsuits. Thus, deals in the energy industry attracted an average of 8.6 lawsuits per deal, and deals in the consumer goods industries attracted an average of 6.0 lawsuits per deal.

There is a common perception that there is a “race to file” these lawsuits after deals are announced. However, the report shows that while filings arrive quickly after deal announcements, the time to filing has not accelerated in any material way since 2007. Indeed, the proportion of lawsuits filed in the first week after the deal announcement declined from 55 percent in 2007 to 39 percent in 2011. In all years studied, “a significant percentage of lawsuits were filed more than four weeks after a deal’s announcement.”

One phenomenon that has been the subject of discussion with respect to this type of litigation is whether or not there has been a “flight from Delaware” as claimants seek to pursue claims in the courts of other states. This study shows that with respect to merger litigation involving Delaware corporations, the share of M&A lawsuits filed in Delaware was higher in 2011 (45%) than in 2007 (34%) and that the percentage has increased steadily since 2008. However, according to the report, the “most striking trend in venue choice” is that challenges to the same deal in both Delaware and some other venue (as opposed to just Delaware alone or to some other venue alone) are now more common than in 2007. Most lawsuits brought in non-Delaware courts were filed in California, Texas and New York, “likely reflecting where many deal targets are headquartered.”

The report shows that M&A shareholder lawsuits “typically settle and often settle quickly.” Of the 2010 and 2011 lawsuits where the authors were able to track the resolution, 28 percent were voluntarily dismissed, four percent were dismissed by the court, and 67 percent settled. This represents a “significant change in outcomes observed a decade ago.” A prior study cited in the report shows that in 1999 and 200, 59 percent of cases were dismissed and only 28 percent settled. Of the 202 unique settlements involving 2010 and 2011 deals, 194 were reached before the merger closed. The median time between lawsuit filing and settlement was forty-four days.

Settlement terms have also changed over time. Whereas during 1999 and 2000, the majority of settlements (52%) involved cash awards and only 10% involved additional disclosures only, only 5% of 2010 and 2011 lawsuits related to M&A deals involved cash payments, and a large majority (83%) involved additional disclosure only settlements.

The average fee awards in connection with the M&A suits in 2010 and 2011 in connection with deals valued at $500 million or greater was $1.2 million. However, this average was pulled upward by some larger awards. Only 23% of plaintiff fee awards were $1 million or higher, while 44 percent were at or under $500,000 or under. Of the largest plaintiffs few awards, several were associated with settlements that did not involve any payment to shareholders. Average fees per deal fluctuated between 2007 and 2011, and while the average fees as a percentage of deal value in 2010 and 2011 remained higher that in 2007, the average fees as a percentage of deal value declined in 2010 and 2011 compared to 2009.

Discussion

The analysis in the Cornerstone Research report corroborates many of the observations noted in prior analyses of these same topics. That is, M&A related litigation is becoming increasingly more prevalent, and each deal is attracting an increasing number of lawsuits. At a minimum, the Cornerstone Report helps explain why M&A related litigation has become increasingly more expensive to defend. The impact of M&A litigation settlements and of plaintiffs’ fee awards on the cost of this litigation is less clear, but overall the implication is that the growing frequency of this type of litigation remains a very significant corporate and securities litigation trend, with important implications for D&O insurers.

One very important consideration to be kept in mind when comparing the various reports regarding M&A litigation is that each of the reports has used its own deal size definition to define the merger transactions that are the basis of each report’s analysis. The definitions used in the various reports are not necessarily consistent. At a minimum, the differences in the definitions used can make comparisons between the reports challenging. In any event, it is important in considering the analysis in any one of the reports to keep clearly in mind what definitions the report has used in determining what merger transactions to include the study.

The FDIC’s Latest Failed Bank Lawsuit: On April 20, 2012, the FDIC filed its latest failed bank lawsuits against ten former directors and officers of the failed First Bank of Beverly Hills. In its complaint (here), which the FDIC filed in its capacity as receiver for the failed bank, the FDIC seeks to recover losses of at least $100.6 million the bank allegedly suffered on nine poorly underwritten acquisition, development and construction loans and commercial real estate loans from March 2006 through July 2007.

The bank failed on April 24, 2009, or just short of three years prior to the date the FDIC filed its lawsuit. The complaint asserts claims against the ten defendants for negligence, gross negligence and breach of fiduciary duties. The complaint alleges that the defendants approved or allowed the loans in question in willful disregard of the bank’s own loan policies and with “willful blindness” to the risks and imprudence of the loan decisions. The complaint alleges that at the same time the defendants were approving these risky strategies, they were “weakening the Bank’s capital position by approving large quarterly dividend payments to the Bank’s parent company,” of which several defendants were shareholders. The complaint alleges that the individual defendants “lined their own pockets” with these dividends.

The FDIC’s lawsuit against the former directors and officers of the First Bank of Beverly Hills is the 29^th the FDIC has filed as part of the current wave of failed bank litigation, and the fifth so far involving a failed California bank. In its latest website update, the FDIC announced that as of April 25, 2012, the agency has authorized lawsuits in connection with 58 failed institutions against 493 individuals for D&O liability, inclusive of the 29 filed D&O lawsuits naming 239 former directors and officers. Given the large number of failed banks like the First Bank of Beverly Hills approaching the third anniversary of their closure, it seems likely that we will be seeing a flurry of new FDIC failed bank lawsuits in the months ahead.

In the meanwhile, the FDIC continues to take control of additional failed banks. This past Friday evening, the FDIC closed five additional banks, the most the FDIC has closed in a single day this year. These additional closures bring the 2012 year to date number of bank closures to 22. This flurry of bank closures is a little bit surprising as up to this point, the pace of closures had begun to suggest that the FDIC was winding down its new bank closures. The five closures on Friday night suggest that there may still be a number of bank failures yet to come.

For Almost As Long As Our Country Has Existed, Man Has Dreamed of Traveling to Cleveland: NASA announces its plan to put a man on a bus to Cleveland. Get the details here.

The Travel Issue: Singapore Edition - And What I Learned in Asia

Kevin LaCroix — Mon, 30 Apr 2012 03:27:08 -0500

The final stop on The D&O Diary’s Asian Tour was the island city-state of Singapore. Located only about 60 miles north of the equator, Singapore is a sun-drenched commercial center that has managed despite its slight size to become one of the world’s wealthiest countries.

Prior to boarding my flight to Singapore, I purchased a bottle of water, drank about half of it, and stuck the unfinished bottle in a side pocket of my backpack. As I boarded the flight, I stuck the backpack in the overhead compartment. I guess the lid popped off of the water bottle, and all of the remaining water spilled out. Now, if you are about to spend four hours sitting next to a total stranger, it is a very poor idea to start things off by dumping about eight ounces of cold water on them. I was vigorously cursed out in a language I was unable to identify, and all of my apologies were disdained -- even though during the course of the flight it became apparent that my damp seat mate spoke English fluently. Fortunately, no permanent harm was done, and this episode, though embarrassing, did not otherwise affect my Singapore visit.

The whole country of Singapore covers an area only slightly larger than Chicago, but with double the population. It is also one of the world’s wealthiest countries, with the highest percentage of U.S. dollar millionaires of any country in the world (15.5% of all households). It is a global trade, financial and manufacturing center. As a result, and despite its equatorial location, it has a tidy, orderly, prosperous feel.If you were suddenly dropped there, and if it were not for the cars driving on the right-hand side, you would probably guess you were in a particularly well-off suburb of Miami. I suspect that most Americans would find Singapore a particularly comfortable place to visit.

As far as I can tell, the basic institutional unit in Singapore is the shopping mall. There not only seems to be an endless supply of upscale malls, but they all seem to be busy as well. Singapore’s two casinos have only been open for less than four years, but, flush with Chinese gamblers, Singapore is already a larger gambling market than Las Vegas. The Marina Sands Singapore Casino, which sort of like a massive, three-hulled cruise ship tipped on its end, with a gigantic skateboard stretching across the towers, dominates the downtown Marina district.

My stay in Singapore was relatively brief, much shorter than my visits to my other Asian destinations, but I was there long enough to get a strong sense of the essential commercial energy of the place. Location is one of the country’s natural advantages; its proximity to India and China and to the emerging economies of South East Asia makes it the natural hub for regional commerce. As a result, the city is extraordinarily cosmopolitan. At the PLUS event that was the reason for my visit, there were attendees not only from Singapore itself, but a wide variety of other countries, including India, Malaysia, Thailand, Mauritius, and United Arab Emirates, among many others.

One of the literal high points on my brief visit was a ride on the Singapore Flyer, which, depending on who you ask, may be the highest ferris wheel in the world. It does in any event provide some astonishings views of the city, of the Singapore harbor, and of Indonesia to the South and Malaysia to the North.

In addition to the climate, economy and atmosphere, another reason to visit Singapore is its food. I can’t recall the last time I enjoyed so many interesting meals in such a short amount of time. Among many other local specialties I enjoyed is rendang, a spicy meat dish with a lot of kick, mee siam, a spicy seafood noodle dish, and tandoori murgh (yogurt marinated chicken). A particular high point for me was the opportunity to sample a rich diversity of local dishes while sitting on the verandah of the Singapore Cricket Club, a local landmark, as the guest of my good friend, Aruno Rajaratnam, whose hospitality helped make my Singapore visit so enjoyable.

One particularly interesting area to explore and to eat is Holland Village, a small enclave of shops, restaurants and bars in the western end of the urban center. There is a lively, street-café feel to the area, but the main attraction is the several indoor food courts where you can quickly sample a wide-variety of regional foods. On a warm, sunny afternoon, it was a very pleasant to sit in a shady café drinking Tiger Beer and watching the incredibly diverse local populace stroll by.

The PLUS event in Singapore was extraordinarily successful. The event was held at The American Club and it drew a standing-room only crowd. As I noted above, many of the attendees had traveled a long way just to attend. It is clear that there is a great deal of interest among the insurance professionals in South East Asia in the networking and educational opportunities that PLUS affords. It was a privilege for me to be able to address and to meet so many Asian insurance industry professionals. I congratulate the PLUS leadership for taking the initiative in launching the Asian events, and I congratulate the local committee that organized the events, particularly Aruno Rajaratnam and Shasi Gangadharan. I can only hope that the two events this past week in Hong Kong and Singapore are just the first of many PLUS Events in Asia. I also hope that PLUS will continue to offer our Asian industry colleagues the opportunity to become a part of our professional community. On a personal note, it was personally gratifying to learn how many of my industry colleagues in South East Asia are loyal readers of The D&O Diary.

What I Learned in Asia: The world is incredibly large, rich and diverse. But as large as the world is, it is still possible for me to start the day in Singapore and have dinner at my home in Ohio. Modern technology and transport have shrunk the world. Nor is this merely a geographic phenomenon. I found in my business meetings during my travels that my Asian counterparts are dealing with many of the same challenges and issues as I am every day.

However, one important difference is the pace of economic activity in Asia, which is far beyond anything I have ever experienced. In many ways, business growth in the developed economies all too often is about taking existing business away from competitors. In Asia, there is true, organic economic growth. The future opportunities in the growing economies of South East Asia and in the newly developing countries, like, for example, Cambodia and even Myanmar, are enormous.

One particular regret I have about my Asian trip is that I was not able to take any of my kids with me to see what I saw. I think it is going to be incredibly important for our future work force to understand what is happening in Asia and in the larger global economy. Today and increasingly in the future, our young people will be competing not only with their counterparts down the street but also with their counterparts on the opposite side of the world. We all need to recognize that the global counterparts are extraordinarily motivated and are also positioning themselves to compete in an economy that they fully understand is global.

Our Asian counterparts are training their work force to be adaptable and to be able to function in a variety of languages and cultures. To be sure, one advantage we have in the United States is that the rest of the world is racing to learn our language. But at the same time, I fear that we have been too slow to recognize that is not going to be enough simply to expect the rest of the world to speak English. Our future work force will have to be culturally adaptable. Our chronic cultural parochialism could put our work force at a substantial disadvantage in the global economic competition.

However, if the increasingly global economy presents a challenge, it also represents an opportunity. That is, there may be an opportunity to participate in the developing economies’ growth – which could be a positive spin on the possibility that future growth and many of the future jobs will in Asia, rather than at home. It will under any circumstances be critically important for our future work force here to be able to function globally.

An additional note is that Asia is far from a block or economic unit. To the contrary, cultural differences, natural geographic and resource advantages, as well as differences in political and legal systems, will have an enormous impact on how different Asian countries will fare going forward. To cite but one example of this, it will be critically important to see which countries strike the appropriate balance between the ability of economic participants to extract profits and the ability of those participants to shift “external” costs onto their society. For example, in China, the willingness to allow businesses to prosper while society chokes on the fumes ultimately could undercut the country’s long run success.

One of the side effects of the wealth creation that has followed economic development in Asia is the emergence of a rising middle class. With the growth of the middle class has come a convergence around a common set of life styles, living patterns and even values. At its most superficial, this convergence includes the emergence of global brands with nearly universal appeal. But it also includes rising expectations about housing, education, and health care, as well as about the free flow of information and ideas.

As a result of this convergence, it is not just technology and transport that have shrunk the world. Rather, it is an increasingly shared set of experiences, expectations and aspirations that characterize ever greater parts of the world. The growing global economy may include both challenges and opportunities; but at its most basic level, it may mean that we live in a more integrated world. Although a global economy seems to mean global competition, there will also be possibilities for global collaboration within a more integrated world.

I find the possibilities for global collaboration the most interesting of all. Indeed, if there is a common thread through all of the business meetings on my trip, it is the common assumption that collaboration presents the greatest promise, both in and with Asia. Throughout my Asian travels, I was struck with how enthusiastic everyone I met was about finding ways to collaborate. I left Asia with three hopes; one, that I might return again soon;two, that the apparently extensive prospects for collaboration in Asia might quickly bear fruit; and three, that I am able to stay in close touch with my many new Asian friends.

More Singapore Pictures:

The Marina Sands Casino, Singapore:

Looking out to the Singapore Strait (from the Singapore Flyer):

A Country of Shopping Malls:

The Travel Issue: Hong Kong Edition

Kevin LaCroix — Thu, 26 Apr 2012 18:43:12 -0500

The D&O Diary’s Asian mission continued this week, with Hong Kong the next stop on the itinerary following Beijing. If Beijing is a Chinese city wearing a new Western-style business suit, then Hong Kong is a Western city with a Chinese heart.

Hong Kong is topographically complicated; it is divided by bays, harbors and waterways; and it includes islands, peninsulas and even a bit of the mainland. All in, it is physically smaller than Los Angeles, though its population of 7 million is nearly double that of L.A. On Hong Kong Island, the city spreads along the slopes of rugged mountains covered with lush vegetation. Packed into every bit of buildable ground, Hong Kong is a densely populated urban area with crowded streets jammed with traffic.

Despite the density and slope, however, Hong Kong is still a surprisingly walkable city. At the second story level, a network of walkways connects much of the central city, by-passing the busy city streets. In addition, a clever center city escalator system connects the lower business district along the waterfront with the residential area in the “Mid-Levels.”

One basic thing you need to know about Hong Kong (that I did not) is that it has a humid, subtropical climate. Its latitude and climate are both about the same as Honolulu. I definitely did not pack the right clothes at all. Hong Kong is also yet another island locale with right hand drive vehicles, along with Great Britain, Japan, Ireland, Australia, Bermuda, New Zealand and Singapore. The currency is the Hong Kong dollar, which currently is valued at about 7.7 HK$ to the US$. Invoices and bar bills are simply presented in dollars, which can induce heart attacks late at night when you get a bar bill for $250 for a couple of rounds of drinks.

Upon arrival on a steamy Saturday, we set out for an afternoon walk, starting amongst the thick foliage of the Hong Kong Park and of the Zoological and Biological Gardens. Our roving stroll quickly revealed the incredible diversity of Hong Kong’s sights and sounds. First, in one of those chance events that makes travel so interesting and rewarding, we happened upon a musical rehearsal at St. John’s Cathedral , which is close by the parks. The church’s cool interior was a welcome relief against the humid afternoon heat, and we were treated to a rehearsal of the musical ensemble Die Konzertisten . The ensemble was rehearsing Leonard Bernstein’s Chichester Psalms, which the choir and orchestra were going to be performing in concert that evening.

We then strolled into an area of narrow pedestrian lanes and alleyways lined with shops and vendors selling clothes, toys, leather goods and shoes, and vegetables and fruit. Butchers carved meat right out along the street and fish vendors displayed tanks full of lobsters, crabs and assorted other kinds of sea life. You can buy fried or dried octopus, fermented bean curd, curry fish balls , put chai ko (a sweet pudding cake), and chee cheong fun (rice noodle roll stuffed with meat). Or maybe you might just want to walk past and content yourself with wondering what, say, snake meat might taste like.

After wandering through this colorful street market scene, the thought did occur to us that it would be awfully nice to find a place to sit down and have something cool to drink. Almost simultaneously with the thought, we found ourselves in the Soho neighborhood, full of restaurants and bars. We went into the Globe Pub on Graham Street, which turned out to be every bit as British as if it were in Notting Hill. We sat at the bar and drank draft Old Speckled Hen ale. Though it was evening in Hong Kong, back in merry England it was still early afternoon, so we were able to watch an English Premier League game live. The bar was full of vocal Arsenal fans, who were disappointed that the Gunners played to a nil-nil draw against London rivals Chelsea. After the game, we returned to our hotel quite persuaded that Hong Kong is a fabulous town.

The next morning dawned clear and bright, so we took the Peak Tram to the top of Victoria Peak. At about 1,800 feet, the Peak (as it is known locally) is the highest mountain on Hong Kong Island. Oddly and incongruously, the tram terminates near the top at a modern shopping mall. Outside the mall, a paved pathway winds around the Peak through parklands and near some very high end residential real estate. The path affords glorious panoramic views of the harbor and the Kowloon Peninsula to the North and of the South China Sea to the South.

After we descended, we went to the waterfront and took the famous Star Ferry across Victoria Harbor to Kowloon. With a bit of wandering, we found our way to Kowloon Park, a cool, shady oasis on a muggy afternoon. We didn’t know that we had wandered into the Sunday afternoon singles’ scene for young South East Asians. The park was full of young men and women in their late teens and early 20s – Malays, Thais, Vietnamese, Cambodians, and a host of other ethnic groups and nationalities that I could only guess at. Many of the women were wearing head scarves and others were wrapped in colorful silks fabrics. Some groups sat on fabric ground covers and chatted. Others were playing music and dancing. One group of gently swaying and elaborately dressed women played drums, tambourines and bells. I felt as I were from another planet.

As the afternoon light faded, we took the ferry back to across to Hong Kong Island, and hopped into a cab to go back to Soho for dinner. Seconds after we jumped out, I realized I had left my backpack in the cab. Shock and surprise gave way to distress as it sunk in that in a city as massive as Hong Kong where there are literally thousands of essentially identical taxi cabs, there was no chance I would ever see my backpack again.

We went to get some (excellent) Thai food but not even a couple of Singha beers could raise my spirits. As I picked at my Pad Thai, I slowly remembered all of the things I had been carrying in my bag – my camera (with all of the pictures from my trip); guide books (borrowed from the Shaker Heights Public Library); a CD play with a Berlitz Mandarin language CD in it (also borrowed from the library); a memory stick with my presentation; important traveling accessories, like a corkscrew and a bottle of aspirin and several packages of gum. And then – I remembered the envelope. The envelope with the cash. Over 400 U.S. dollars, plus US$300 worth of Singapore dollars. My spirits, already low, plunged to new depths. (I know you are thinking -- what kind of idiot carries around that much cash in a backpack? Well, apparently the same kind of idiot that would leave a backpack in a taxi cab. That is to say, a complete and total idiot.)

Back at the hotel, I told the concierge what had happened. He was friendly and polite and he dutifully took down all of the information. He said that he would call the taxi commission and that he would let me know if he learned anything useful. However, the look on his face pretty much told me that I was never going to see my backpack again.

When I went up to my room, I picked up my iPad for a quick email check. To my astonishment, in my inbox was an email with the following Re line: “Your Missing Bag in a Hong Kong Taxi.” The email, from a woman whose email domain was “christiandior.fr,” said

My husband and I just got in a taxi in Hong Kong where we found your missing bag. We got your name card from your bag and tried to call you without success. Now we left the bag with the taxi driver Mr. [name] (you could find attached his Driver ID card picture), his phone no is : [phone number]. Please contact him asap. Good luck!

Attached to the mail was a photo of the driver’s taxi license, with his name, the name of his taxi company, his taxi ID number, and the driver’s picture.

I ran back downstairs to the concierge. He called the driver’s cell phone number and got him on the phone. They quickly figured out that the cab was not far from my hotel. Within minutes, I was reunited with my bag. The driver went home with a tip so big that he couldn’t stop thanking me. After the driver left, the concierge said, “I have been working at this hotel for a long time. Guests are always leaving things in taxicabs. Of course we always try to do whatever we can, but this is the very first time that anyone actually got their stuff back.”

The whole sequence reaffirms my faith in humanity. The lengths to which the lovely French woman went to try to find me fills me with a sense of gratitude and indebtedness. And then there’s the driver. He not only returned my bag, but he returned all of its contents – including every last one of the US and Singapore dollars. All I can say that as unlucky as I was to leave my bag in the cab, it was incredibly good fortune that these two were there to protect me from my stupidity. By the way, the pictures accompanying this post were nearly lost forever.

My Hong Kong sojourn also included the highly successful inaugural meeting of the Professional Liability Underwriting Society in Asia. It was a standing-room only event at the Royal Hong Kong Yacht Club. I thoroughly enjoyed the chance to meet and to address so many industry colleagues from Hong Kong and from all across Asia. I was also delighted to learn that so many of them are loyal readers of The D&O Diary. (The Internet is such an amazing thing).

I came away from Hong Kong with very warm feelings for the place. It is a dynamic city of incredible charm as well as a seemingly endless supply of diverse sights and sounds. Put Hong Kong down as a new entry on the list of favorite travel destinations. The next time I visit, though, I will remember to put my valuables in the hotel room safe. And friends, if on some future occasion you should find yourself riding with me in a cab, before we exit the vehicle, please ask me to make sure that I remembered to take all of my belongings.

More Hong Kong Scenes:

Guest Post: Professor Squire Responds Concerning "Collective Settlements" of Securities Suits

Kevin LaCroix — Mon, 23 Apr 2012 20:39:14 -0500

In a prior post, I discussed Fordham Law Professor Richard Squire's April 2012 article entitled “How Collective Settlements Camouflage the Costs of Shareholder Litigation” (here). After my post appeared, Professor Squire communicated to me his concerns about my comments regarding his paper. Because his comments and concerns about my post were quite substantial, it seemed that the best approach would be simply for Professor Squire to publish his response in full in a separate blog post. I have set out Professor Squire’s response below. I am very grateful to Professor Squire for taking the time to present his views in full here. I encourage readers to review Professor Squire’s paper as well. As Professor Squire indicates at the conclusion of his guest post, he and I will be participating in a session at Fordham Law School on May 8, 2012 to discuss his paper. Information about the session can be found here . Here is Professor Squire’s response:

I am most grateful to Kevin both for devoting a full blog entry to pay my current article on D&O insurance, titled “How Collective Settlements Camouflage the Costs of Shareholder Litigation,” and for giving me here the chance as a guest blogger to respond to his comments. This has been a valuable opportunity for me to learn more about the D&O field from Kevin, a recognized expert whose knowledge of the market for D&O insurance greatly exceeds my own.

In his generously extensive comments about my article, Kevin identifies several places in which he thinks I describe the dynamics of D&O insurance settlements accurately. At the same time, however, he expresses numerous concerns with my proposed method for reforming such settlements. In this blog entry, I wish to focus on his concerns, and in particular to say why I think several of them are not warranted or are addressed by other aspects of my article that Kevin’s comments do not mention.

To provide context, it will be useful to begin with a summary of my article, which has five interrelated points as follows:

1. In a shareholder lawsuit against a defendant with one or more D&O insurance policies, the current practice is to require any settlement of the suit to be a single, collective resolution that binds all defense-side parties, meaning the defendant and each of its insurers.

2. The current system of collectivized settlements encourages strategic liability-shifting among defense-side parties. This strategic behavior imposes a variety of costs on shareholders, only some of which have been previously recognized by judges and academic commentators.

3. The collective action problem we see in shareholder lawsuit settlements is not inevitable. Rather, it is “contrived” in the sense that it is a byproduct of how D&O insurance contracts are written and enforced.

4. At least in theory, settlements could be de-collectivized in a manner that greatly reduced or eliminated the costs to shareholders from strategic liability-shifting. My article describes such an approach, which I calls “segmented” settlements.

5. Even if de-collectivizing the settlement process would benefit shareholders, corporate managers would oppose it because the change would reduce the managers’ ability to use D&O insurance to shift settlement liability to insurers and thus to insulate corporate earnings reports from the impact of the managers’ conduct that gives rise to shareholder litigation.

Kevin’s comments suggest that he agrees with me on points 1, 2 and 5. Most of his criticisms of my paper are aimed at points 3 and 4—my arguments that settlements could in theory be de-collectivized and that such a change would benefit shareholders. His comments also stress how “policyholders” would resist my proposal, though in so doing he does not acknowledge the degree to which he and I are in agreement on this point as long as by “policyholders” we mean the corporate managers who actually make the decisions to buy D&O insurance on behalf of themselves and their corporations.

Since most of Kevin’s concerns are focused on the desirability of my alternative system of segmented settlements, I will illustrate my proposal here with a very simple example. Imagine a corporate manager who is covered by a single D&O policy with a limit of $1 million. This means that if the manager is sued in a shareholder lawsuit, the insurer is responsible for the first $1 million in liability, and the manager is responsible for the excess, if any. Under the current system of collective settlements, the insurer could not settle with the plaintiff unless the plaintiff also agreed to waive his rights to collect from the manager, including his right to collect damages in excess of the $1 million policy limit. Conversely, the manager and plaintiff could enter into a settlement for, say, $1.2 million, and then use the “duty to contribute” (a duty not previously identified in the academic literature, but whose existence and importance Kevin confirms) to force the insurer to “tender” (pay) its $1 million policy amount in support of the settlement. In this way, any settlement must be “collective”—i..e, jointly binding on both the insured (the manager) and the insurer.

One of the main problems with this system of collective settlements is that it can lead to plaintiff overcompensation. Since the manager and plaintiff can enter into a settlement whose costs are borne mostly by a third party—i.e., the insurer—they can jointly gain at the insurer’s expense by entering into a settlement that exceeds the expected damages at trial. In my article I call this the “cramdown” dynamic. The manager’s incentive to engage in this settlement is that it avoids the risk of a trial at which the total damages in case of a verdict for the plaintiff may exceed the $1M policy limit by a large amount, leaving the manager with greater personal liability than she incurs by settling.

Under a system of “segmented” settlements, by contrast, the manager and insurer could settle separately out of the case, and by so doing could neither shift liability onto the other nor bind the other in a settlement without the other’s consent. So, for example, the insurer could settle separately with the plaintiff, in which case the insurer would pay the plaintiff a settlement amount and the plaintiff in exchange would waive his right to collect the first $1 million in damages awarded at trial (if any). If the manager did not also settle, then a trial would occur, but only damages awarded in excess of $1 million would be collectible. Conversely, the manager could settle separately from the insurer, whereby the plaintiff would waive his right to collect any damages awarded that exceed $1 million. Under this system, “cramdown” settlements could not occur, and collective-action costs would be reduced for the reason that defense-side parties would no be able to shift liability onto each other.

Many corporate defendants have not just one D&O policy, but rather a primary policy plus one or more excess policies, forming an insurance “tower.” Adding these additional insurance layers increases the opportunity for strategic conduct but does not otherwise alter the basic conflict of interests created by a collectivized settlement approach nor the benefits of the alternative approach I describe.

With that overview for context, I’ll now turn to Kevin’s specific concerns and criticisms.

Holdouts: Kevin argues that strategic holding out by insurers would still occur under if settlements were de-collectivized. To illustrate, he gives an example of a case in which all defense-side parties have settled except for one mid-level insurer. I actually anticipate something close to this hypothetical on pages 29 and 30 of my article. Contrary to Kevin’s argument, under the system I describe a mid-level insurer in that position would not have an incentive to hold out, as by doing so the insurer could not externalize liability onto the policyholder or other insurers.

To make the example concrete, let's assume a policyholder with a tower of five D&O policies worth $1M each. We’ll assume further that all defense-side parties, including the policyholder, have settled with the plaintiff except for the excess insurer occupying the $2M to $3M slice of the tower. This means that if a trial occurs, the plaintiff could collect only those awarded damages (if any) that fall between $2M and $3M, and these would be collectible solely from the holdout insurer. Thus, regardless of whether the holdout insurer ultimately settles or goes to trial, no damages liability can be shifted to the policyholder.

Kevin expresses in connection with this example a concern that defense costs (i.e., attorneys’ fees and similar expenses) might reduce this "sole remaining layer" of coverage, leaving the policyholder exposed (though, to be sure, only to defense costs plus damages in the $2M to $3M range—i.e., the unsettled remaining slice). I anticipate this concern on pages 29-30, but I offer a simple solution: "We can predict that [if settlements were de-collectivized] liability policies would be written so that the non-settling insurers in such cases [in which the policyholder had separately settled] bore the defense-side trial expenses without regard to policy limits, as otherwise those insurers could externalize onto other defense-side parties some of the costs of their refusal to settle."

Kevin earlier in his post had expressed “trepidation” about the “world of academic analysis,” which seems to him “unbound by constraints that operate in the world to which I am accustomed.” But there is nothing otherworldly about my simple solution to the holdout problem with respect to defense costs. Under most other types of liability insurance (such as auto and homeowners insurance), defense costs do not count toward the policy limit. It is D&O insurance that is unusual in its use of "burning candle" policies. Thus, by suggesting that defense costs would no longer count toward policy limits in situations in which the policyholder has settled out of the case, I am incorporating a solution to the cost-shifting hazard that will already be familiar to people with real-world knowledge of liability insurance.

After presenting his holdout hypothetical, Kevin goes on to write that my proposal would "substitute a different cramdown dynamic for the existing one" and would "put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their insured." It seems to me that his concerns here stem from this same misunderstanding about how holdouts would be handled under my proposal. For this reason, I don't think these concerns are warranted. Under my proposed system, defense-side parties would have significantly less ability to engage in strategic cost-shifting than they do now.

Distributional Impact: Kevin observes that the distributional impact of separate settlements would be to reduce liability for primary insurers and increase it for excess insurers. This observation is accurate, as my article acknowledges at several points. But it is not grounds for concern, as the excess insurers would adjust by charging higher premiums ex ante, and so they would not on net be worse off. However, because the current system’s cramdown dynamic would be eliminated, overall settlements would be lower, as there would be a reduction in plaintiff overcompensation (a phenomenon which Kevin acknowledges occurs under the current system). So overall insurance costs will be lower, a benefit to policyholders.

Expected Trial Liability: Kevin devotes several paragraphs to criticizing my reliance on the concept of "expected trial liability" (meaning expected damages if the case goes to trial). In particular, he criticizes my article for arguing that this figure is "objective" rather than "subjective" and can be reduced to a "single knowable measure." Here I think Kevin is attacking a straw man. Nowhere does my article claim that expected trial damages are knowable with certainty ex ante or that parties will form identical estimates of them. To the contrary, I acknowledge that estimates will differ, and on pages 35 and 36 I model what settlement negotiations look like when they do.

Similarly, Kevin criticizes me for not taking into account "myriad factors" that affect negotiations, including "whether some insurers believe they have unique coverage defenses." But on pages 37-40 I do model the impact of coverage exclusions on settlement negotiations.

To be sure, I don't model the impact of another factor Kevin identities—namely, the pendency of related lawsuits. But the fact that a model does not include every conceivably relevant factor does not mean that we can derive no insight from its results. Indeed, the article’s models are what revealed to me how the cramdown effect under the current system can lead to plaintiff overcompensation, a result whose accuracy Kevin confirms. More generally, while Kevin calls into question the usefulness of abstract models in the study of complex insurance negotiations, he does not identify any specific results produced by the article’s models that he thinks are inaccurate or unrealistic.

Delay: Kevin worries that separate settlements would introduce delay. But delay results from holdout problems, and de-collectivizing the settlement process would greatly reduce the advantages to holding out. Indeed, under my system, as each defense-side party settles out of the case, the incentive both for the plaintiff and for the remaining defense-side parties to settles increases. This is because each settlement reduces the plaintiff's potential recovery at trial but not the trial expenses that both sides would have to incur if trial occurred. Returning to the example above involving the mid-level insurer holdout, that insurer's incentives to settle are maximized when it is the only defense-side party left in the case, since at that point it will bear all of the defense-side trial costs. And the plaintiff's incentive to settle is maximized as well since the damages recoverable at trial have been pared down to a thin slice, but winning that slice would still require the plaintiff to incur the full costs of putting on his case. Since there is no advantage to anyone under my proposed system of delaying resolution of a lawsuit, we can expect less rather than more delay than we see now.

Achievability: Kevin criticizes me for writing that "segmented settlements could easily be achieved contractually," a statement he says "lacks a connection to the insurance marketplace" because insurance buyers would resist such a change. But all I meant was that nothing prevents segmented settlements as a matter of contract law. I acknowledge full well that D&O insurance buyers—i.e., corporate managers—benefit from the current system of collectivized settlements. See, for example, my abstract: "Yet corporate managers probably prefer the status quo." That's why on pages 42 and 43 I argue that, if reform were to occur, it probably would have to be initiated by courts.

Reinsurance: In my article I make the uncontroversial observation that excess insurance and reinsurance are substitutes: both help insurers diversify their risk exposure. A simple example will illustrate. Imagine that Company A buys a $10 million primary policy and a $10M excess policy. Meanwhile, Company B buys a $20M liability policy, and its insurer then purchases coverage for the top half of this policy from a reinsurer. In both cases we have a division of risk between two insurers.

I think it interesting that in the D&O market we see Company As rather than Company Bs—that is, we see towers rather than reinsurance. I raised the question in my article whether this might reflect a preference among insurance buyers for a system that encourages covered settlements through the cramdown dynamic. Kevin criticizes me on this point, arguing that there are "a finite number of reinsurers and they require a spread of risk every bit as much as the insurers do." But the fact that currently there is a relatively small number of reinsurers is not a criticism of my hypothesis; rather, it is a restatement of the question my hypothesis seeks to answer—i.e., the question why this particular insurance market has developed to rely on towers rather than reinsurance. And his claim that reinsurers also "require a risk spread" is misleading since reinsurance is, by definition, risk-spreading, as my example of Companies A and B illustrate.

Finally, Kevin claims that the presence of towers is explained solely by the preferences of insurers, but this claim is in tension with his earlier claim that D&O insurance is a buyers' market, and it fails to explain why the carriers should prefer the tower model over the reinsurance model.

***

As I said at the beginning of my comments, I am most grateful to Kevin for not only highlighting my article on his blog but also giving me the chance to respond as a guest as I’ve done here. As Kevin mentioned, he and I will be co-panelists at a conference at Fordham Law School (where I’m privileged to teach) next month, where I’ll have the opportunity to be able to discuss these matters with him further. I hope Kevin’s readers have found my exchange with him interesting. If any reader has any comments or questions on the subject matter discussed here, I’d welcome hearing from you at rsquire@law.fordham.edu.

The Travel Issue: Beijing Edition

Kevin LaCroix — Sun, 22 Apr 2012 23:07:30 -0500

The D&O Diary is on assignment in Asia this week, with a first stop in Beijing and with other Far Eastern stops scheduled after that. Even traveling “over the top,” Asia is very far away. When the flight progress monitor shows your plane traveling over Irkutsk and Ulan Bator, you know you are far from home.

Beijing is a vast, sprawling, teeming city. At first blush, it is a thoroughly modern city, its wide boulevards lined with ranks of modern steel and glass office towers. Yet inside the Forbidden City or the Temple of Heaven (both of which, like the city itself, are huge), Beijing reveals itself as an ancient city with a long and fascinating history. And yet again, in the warren-like hutong neighborhoods (at least the ones that remain), with their narrow alleys and winding passageways, Beijing can feel daunting, mysterious and even a little dangerous.

With the city's ubiquitous modern buildings and traffic congestion, it is something of a shock to suddenly find yourself standing in Tiananmen Square, facing the entrance to the Forbidden City, the enormous portrait of Chairman Mao hanging over the entry gate (pictured above). It is hard to believe that barely forty years ago, more than a million people gathered in the Square waving Little Red Books, and that only 23 years ago a single soul faced down a Red Army tank. The street where the lone protestor stood is now clogged with tour buses, Porsche SUVs and Mercedes sedans. The Square itself is full of tour groups and vendors hawking Mao hats and “genuine” Rolex watches.

The Forbidden City is an enormous complex of buildings, courtyards and temples that defies easy description. Its grounds are larger than those of the Palace at Versailles. I visited it twice on this trip and still feel as if I only saw a very small part. Many of the buildings were dazzlingly restored for the 2008 Beijing Olympics, and during my visit the courtyards were full of blooming fruit trees and blossoming flowers.

Over the centuries, twenty-four Ming and Qing emperors lived in the Forbidden City, but the tour guides seem to concentrate on the last Ming emperor, Chongzhen, who slew his own family and then hanged himself in 1644 to avoid capture by rebel armies and the oncoming Manchu invaders, and Puyi, “the Last Emperor,” who abdicated in 1912 and who fled the Forbidden City in 1924.

Emerging at the Northern gate of the Forbidden City, you suddenly leave behind the venerable vestiges of the country’s imperial past and plunge into the tumult of the city’s jarring present. Vendors, beggars with shocking wounds and deformities, school kids, and tourists jostle and push along a walkway not nearly large enough for the crowds. Beijing can be simply overwhelming at times.

Perhaps detecting my sensory overload, my tour guide suggested that we retreat to a tea house. We had to take a city bus (fare = 1 yuan, about 16 cents) to where he had parked his car in a hutong. We then drove through back streets to a quiet tea house, where a chatty young woman performed a simple tea ceremony. We sampled seven different varieties of tea – this one for longevity, that one for your complexion, this one for serenity. Perhaps it was the soothing effect of the warm drink, but I wound up buying an enormous quantity of tea and even a couple of tea cups and saucers. After the tea, the guide (happy to increase his tea-sotted client’s fee) took me on a tour of the Yonghe Temple, a Qing-dynasty Buddhist monetary that still houses chanting and incense-burning monks.

The tea-induced serenity proved short-lived. With 19.6 million people, Beijing is well more than twice as large as New York City. It is almost incomprehensible that it is only the third largest city in China. With 23 million people, Shanghai is the second largest, and with nearly 29 million, Chongqing is the largest. The sheer scale is beyond anything I have ever experienced.

Beijing is also a city of five million vehicles, and at any moment it is easy to believe that all five million are out on the roads at the same time – but that is a mistaken impression. Each weekday, traffic regulations bar one-fifth of the cars from the inner city based on vehicle registration number, and trucks are banned altogether during the daytime. But even with these restrictions, the roads are jammed at all hours. Picture the worst traffic you have ever seen in, say, L.A., multiply times ten, and then allow for the fact that rules of the road are viewed as purely advisory. A red left-turn arrow does not mean no left turn; it means jockey for position until you see an opening and then go for it (and for Beijing drivers, an “opening” means only ten or fewer pedestrians directly ahead).

Contemporary Beijing has many other attributes of any modern city. I was surprised and disappointed to find that the Westin hotel in which I was staying felt like a Westin hotel anywhere, and the Financial District in which it was located had the exact feel of say, Tyson’s Corner, Virginia or Stamford, Connecticut, except with even less charm. On the cross street adjacent to the hotel were a Starbuck’s, a KFC, a Pizza Hut and a TGI Friday’s. I felt as if I were in a containment zone for Americans hoping to have as little contact with China as possible.

Fortunately, the area near my hotel is not representative. There are several areas full of restaurants and street life. One afternoon, we had lunch in a lakeside restaurant in the Back Lakes area (pictured left), where we were served plate after plate of spicy, delicious food – chicken with walnuts; mushrooms in a spicy sauce; saffron rice dusted with crushed, fragrant flowers, thick noodles flecked with bits of pork; a gigantic fish with its head and fins still intact; and plates of sweet and savory dumplings. And what would a visit to Beijing be without a meal of Peking Duck? We enjoyed a very special meal at the famous Da Dong Roast Duck restaurant, a multicourse (and breathtakingly expensive) extravaganza that culminated in the table-side carving of the wood-roasted duck. I saw just enough of the city on these outings to know that there is an incredible diversity of things to see and do, but I just did not have the chance to explore these areas the way I would have liked. Stuck in the American containment zone, I was simply (and disappointingly) out of position to fully explore the parts of the city with a pulse.

My Beijing sojourn did include the obligatory excursion to the Great Wall. Sixty miles north of Beijing, past the sixth and last of the city’s ring roads, the flat plain gives way to jagged mountains shrouded in mists. A Ming dynasty section of the Wall bristles along a rugged ridge-top. Today, a chair lift sweeps visitors up to the top, but to see the guard towers at the highest elevations, you still must scramble up a long, steep incline of uneven steps. When you finally reach the top, panting and sweating, you are greeted by a wise-cracking vendor in a Mao hat:”Where you from? Ohio? Cool! You need cold beer, Ohio, only eight yuan [about $1.30], very cold.”

The Mutianyu section of the Wall that we visited was built in very rugged terrain, and is surrounded by thick forest. On the day of our visit, the woods were full of flowering trees and I can only imagine how beautiful the view is on a clear day. As it was though, a thick mist obscured the view. The clouds closed in and a fine rain began to fall shortly after we returned to the bottom.

To descend to the bottom, we did not take the chair lift back but instead we rode a toboggan that traveled along a curved metal track. The slope is steep, and as I careened along at breakneck speeds, I thought to myself that the momentum could easily carry me off the track and into the woods. I suppose life-threatening pleasures are just part of the checklist when on travel to distant lands. Fortunately, no one was killed, in our group at least, and after several in our group had filled their backpacks with souvenir tee shirts, chopsticks, and straw hats, we gathered for lunch in a restored old schoolhouse. Along the serving table were heaping plates of duck, pork, and noodles, toether with enormous bottles of beer.

Somehow the metal toboggan run seems to me like a metaphor for Beijing itself. The city’s incredible pace and dazzling prosperity are very impressive, but there is a dark edge to the city’s vitality. In ways that are readily apparent, the city is literally choking on its prosperity. All the Gucci and Cartier stores and speeding Audi A6s with tinted windows cannot hide – and indeed may even underscore – the fact that all is not well.

One cultural difference many Americans visitors to Beijing often note is that it is quite common for people on the street to hawk loudly and spit onto the pavement. Some Americans may find this unpleasant or even rude but after just a few days in the city, I began to better understand the behavior. After only one day, my throat was scratchy. By the second day my throat was sore. After that, I found that I had to keep popping throat lozenges just to get by. I am sure that before too long I would be hawking and spitting just like a native.

I had arrived during a particularly clear interlude (as shows in many of my pictures). But the thicker air soon settled back in. Nearby buildings nearly disappeared in the haze. The sun faded into a diffuse, low wattage glimmer behind a blanket of smog.

Nor is the foul air the only sign that all is not well. At first it seemed trivial to me, but the fact that the government has blocked Facebook, Twitter and Google, along with many other parts of the Internet, really does show that for all of its apparent prosperity and dynamism, China remains a closed and controlled society. In several different conversations, I heard complaints about difficulties getting housing, health care and educational services. Inflation is becoming an increasing concern as well. When the yuan was eight to the dollar, Beijing may have been a bargain, but at 6.3 yuan to the dollar, it is no longer cheap. Several different business people shared with me their concerns about rising prices and shrinking or disappearing margins, as well as the scarcity of credit. After years of growth at a breakneck pace, there are increasing concerns that the economy could be headed off the tracks.

In the end, Beijing remains for me an immense puzzle of conflicting impressions. Because it is so vast and multi-faceted, even after a week there, I felt that I had barely scratched the surface. One very special experience while I was there illustrates the challenge of trying to get to the heart of the place.

Early one morning, I took a cab to the Temple of Heaven, now a huge park with walkways, pavilions and gardens, as well as the actual temple buildings where Ming and Qing emperors fasted and prayed annually for a bountiful harvest. The temple buildings, though 19^th century restorations, are beautiful, but the grounds and gardens are the main attraction. Wandering amongst the blossoming trees and surrounded by families and school children, it was easy to feel as if I were indeed in a blessed place.

Near one of the ornate pavilions (pictured to the left), a group of traditional musicians attracted my attention. I sat and listened to them for a long time. Their music sounded strange to my ears; there seemed to be no rhythm or melody, at least that I could discern. The singing sounded, to me, tuneless and off-key. I found the music strange and absolutely fascinating. I would have liked to have spoken to the musicians, to know more about their music and their instruments. But as it was, I hesitated even to take their pictures for fear of being intrusive or causing offense.

Like the music, I found Beijing itself interesting and enigmatic, a complex puzzle with many surfaces and hidden meanings. The only thing I know for sure is that I must go back, to try to get closer to the heart of a fascinating city.

A containment zone for Americans :

Tianamen Square, genuine Rolex watches, you buy, how much?

The Hall of Prayer for Good Harvests at the Temple of Heaven:

Flames Must be Fully Clothed at All Times:

And if your relics have a persistent problem, we can get them extra strength anti-itching powder:

We Make Our Dumpling By the Book:

At those other tourist sites, you have to put up with a lot of uncivilized sightseeing:

Can Separate Settlements Improve the Securities Suit Settlement Process?

Kevin LaCroix — Mon, 16 Apr 2012 02:48:03 -0500

The negotiated resolution of securities class action lawsuits – and absent dismissal, there is rarely any other types of securities suit resolution – is always complicated and occasionally messy, and often involves inefficiencies and sometimes produces distortions and even excesses. Anyone who has ever been through a securities suit settlement negotiation likely will have had the thought that there has to be a better way for resolving the cases.

In an April 12, 2012 paper entitled “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits” (here), Fordham Law School Professor Richard Squire catalogues the many shortcomings in the current securities class action settlement process and sets out his proposal to improve the process and to eliminate process inefficiencies and excesses. UPDATE: Please note that Professor Squire also completed a separate response to this blog post in a seprate guest post of his own. His guest post can be found here.

According to Squire, securities class action settlements suffer from a “collective action problem,” owing to the fact that current practices and law require a single case resolution that collectively binds the defendant and all of its D&O insurers – even though the D&O insurance itself is “segmented” in a tower of insurance with the insurers in the different layers having different settlement positions and differing perspectives and interests regarding the settlement.

Among other things, Squire notes that insurers in the primary layers and lower level excess layers are often compelled to contribute toward settlement when the settlement demand (or more accurately, the settlement opportunity) exceeds their layer. This compulsion, Squire notes, is often effectively given legal force through a rarely identified but nonetheless very real “duty to contribute.” These forces lead to a number of ills, including “plaintiff overcompensation at insurer expense”; overpriced liability insurance; and lawsuits of doubtful merit.

Identifying the requirement for collective settlements as the source of the problem, Squire proposes allowing “segmented settlements” – that is, allowing each defense-side party (and in particular each of the carriers in the D&O insurance tower) to “settle with the plaintiffs separately for its respective slice of the damages ranges.” Under this approach, trial would occur unless all slices settled and the plaintiff would collect at trial only those awarded damages (if any) that fell within the unsettled slice.

Squire postulates that this approach would eliminate the conflict of interest between the defense-side parties, “removing the cramdown dynamic that can lead to plaintiff overcompensation.” The elimination of this dynamic will, Squire contends, ultimately lead to more shareholder lawsuit settlements being paid by corporations rather than by insurers, an outcome Squire that further contends would “benefit shareholders, as it would improve the accuracy of a firm’s reported earnings as a measure of the contribution of that firm’s managers to overall shareholder wealth.”

I have set out below my thoughts about Squire’s proposal. I note at the outset that I approach commenting on academic papers with trepidation. Even though D&O insurance and D&O claims resolution are areas to which I have devoted my entire professional life, the world of academic analysis, even with respect to a topic within my area of expertise, seems unbound by constraints that operate in the world to which I am accustomed. My usual trepidation is even greater where, as here, I am already committed to commenting in person on the academic analysis in a public forum. Specifically, on May 8, 2012, I will be attending a conference at Fordham Law School at which I will be participating in panel in with my friends Tom Baker of U.Penn. Law School and Sean Fitzpatrick of Endurance Risk Solutions. The purpose of the panel is to discuss Professor Squire’s paper.

As a threshold matter, I will say that an important aspect of Squire’s analysis for which I give him high marks is his understanding of the central importance of D&O insurance in the securities class action settlement process. All too often, commentators under-appreciate the significance of the role that D&O insurance plays in the process. A particularly important insight Squire has with respect to the role of D&O insurance is that the different D&O insurers’ interests and positions in the settlement process differ based on where they are in the insurance tower.

Squire’s understanding of the role of D&O insurance is particularly accurate when he describes the “cramdown” effect – that is, the pressure that the insured company and the upper level excess carriers can bring to bear on the primary and lower level excess insurers to force the lower level insurers to throw in their limits. Squire perceptively describes what is too often unconsidered, which is the presumed “duty to contribute” that compels lower level insurers to tender their limits where there is pressure to settle a case at a number beyond their limit of liability.

Squire is also on target with his identification of the undesirable consequences this dynamic can produce. It can, as he notes, produce plaintiff overcompensation (which he also correctly notes, inures disproportionately to the benefit of the plaintiffs’ lawyers) and it can result in higher priced liability insurance. And the opportunity for further occasions of overcompensation undoubtedly attracts additional lawsuits.

Having identified these problems with the current system, the question is whether Squire’s proposed solution would in fact solve the problems in an appropriate and acceptable way, a question to which I turn below. However, having noted above the respects in which I agree with Squire’s understanding of the process and the dynamic, I must also as a preliminary matter identify the respects in which my understanding differs from Squire’s. These considerations may or may not alter the ultimate merits or demerits of Squire’s proposed solution to securities suit settlement; but to the extent these considerations might (and they well might, given that much of Squire’s analysis depends on these understandings and assumptions), it is worth my setting out here my differing understandings.

First and foremost, D&O insurance provides a contractual way for companies to manage their indemnification obligations, and to ensure that these indemnification obligations can be honored even if the company itself is unable to do so when the need arises. Because D&O insurance derives from the indemnification obligation, and because the company’s indemnification obligation includes both the obligation to provide for defense expense and for indemnity amounts, the D&O insurance policy has always provided coverage for both defense expense and for settlements and judgments.

Second, companies buy D&O insurance in a marketplace that has been “soft” for almost all of the last 25 years. During that time, dozens of new insurers have entered the marketplace, while at the same time there are many fewer public companies than there were even a short time ago. With an abundance of insurance capacity chasing a dwindling number of insurance buyers, the marketplace is heavily tilted in the favor of the buyers. Buyers expect and get very broad coverage for prices that remain advantageous for the buyer. Owing to the constraints of competition, insurers have a limited ability to impose defensive measures or to constrain coverage. The insurers’ options are two-fold: either to play ball or to sit out the game. Most decide to continue to play.

Third, as a result of the number of persons insured under D&O policies and the number of insurers that are involved in the typical D&O insurance tower, there are in connection with any securities class action settlement many participants, each with their own counsel. Often there are other parties (auditors, underwriters) who are named as defendants but who are strangers to the D&O policy. Not only are the insurers’ interests not aligned but often the insured persons’ interests are not aligned, and the insured persons’ interests often differ from the other named defendants. The carriers’ interests differ not only according to their attachment point in the insurance tower, but also based on situation specific factors such as how much defense expense has been expended and what the anticipated defense expense burn rate will be. The various carriers’ approach to settlement may also depend upon whether they believe they may have coverage defenses that potentially affect their payment obligations.

Not only are there a host of negotiating parties, there often are a host of proceedings involved, other than just the securities class action lawsuit. If a securities suit is serious enough to implicate the excess insurance, there will almost always be multiple other actions ongoing at the same time – usually a parallel derivative suit, often a pending SEC investigation or enforcement action, sometimes even a DoJ investigation or prosecution. The existence of these other proceedings can complicate the settlement dynamic in myriad ways. Serious securities class action settlement negotiations usually do not take place in a vacuum.

A final point about securities suits that should be emphasized is that securities class action lawsuits go to trial so rarely that the possibility of trial can safely be disregarded for most practical purposes. Everyone involved in the case knows it will never go to trial. There are very good reasons that these cases very rarely go to trial. The most important is that the theoretical damages almost always exceed the available insurance and in many cases outstrip the defendant company’s financial resources as well. A less dramatic constraint is that trials are costly, burdensome, and unpredictable and would constitute a huge distraction on senior company management. By the same token, the company could ill-afford a judicial determination that conduct that would preclude coverage has taken place. The plaintiffs have their own concerns; the expense of a complex jury trial could be enormous yet at the same time involves the risk of a defense verdict.

Together with these preliminary observations about D&O insurance and about the settlement process, I should also add the following observations on Professor Squire’s understandings and assumptions about D&O insurance.

First, Professor Squire assumes that corporate buyers consciously and deliberately structure their D&O insurance in multi-layered tiers because that creates “conflicts of interest among insurers that serve the interests of corporate managers,” as, he postulates, the conflicts “actually make insurance-covered settlements more likely.” There may be some buyers out there who are so canny that they manage their insurance buying decisions with these calculations in mind.

My own experience is that most insurance buyers would prefer to buy fewer, larger layers of insurance, because that would afford claims administrative simplicity, eliminate the headaches that always arise in the claims context when the insured company has to fight its way through multiple layers, and would simplify the insurance acquisition process.

The reason that D&O insurance programs are layered is because of the carriers’ preferences, not the buyers’ preferences. No D&O insurer could sustain the concentration of risk that would be involved with exposing outsized amounts of capital to any single large corporate exposure. Professor Squire assumes away this concern by saying that insurers could issue a single policy and simply “protect themselves from this risk through reinsurance.” However, there are a finite number reinsurers and they require a spread of risk every bit as much as the insurers do. The layering of D&O insurance is an inevitable by-product of an insurance marketplace where any given company’s insurance needs exceed the ability of any one insurer (or even one insurer and its reinsurers) to absorb all of the concentrated exposure associated with one risk.

Professor Squire also sees something amiss with the fact that D&O insurance policies cover both defense expenses and indemnity amounts. From my perspective, this arrangement is a natural reflection of the outgrowth of D&O insurance as a way for companies to contractually manage their indemnification obligations. In any event, the typical insurance buyer would consider it a strange notion indeed that their D&O liability insurance would not provide defense expense protection or at least that they would have to buy a defense cost policy separate from their liability policy.

With respect to Professor Squire’s analyses of the settlement dynamic, I note that in all of Professor Squires hypothetical settlement examples (and all of his examples are in fact hypothetical), he refers to the “expected trial liability” or “the actuarially fair settlement amount.” These are abstractions. There is no such thing in the securities context as “expected trial liability,” simply because there is effectively no data to describe such a thing. (For the same reason, talk of a party’s “bias to toward trial” or “aversion to trial” is equally inapposite.) By the same token, the idea that there is an objectively knowable amount equivalent to an “actuarially fair settlement amount’ is equally unwarranted.

What we actually have is a much rougher, much more approximate concept that usually is described as “what cases like this settle for.” Basically every single person in the settlement room will have their own version of this number, as well as their own concept of what features of the case make the comparables relevant. These points of reference are subjective, not objective; rarely the subject of agreement between the parties, at least at the outset; dependent on a host of assumptions; and allow for a range of possible outcomes that might constitute reasonable case resolutions depending on the myriad of factors.

In addition, the procedural posture of the case matters; the existence of related pending actions matter; the level of defense expenditure and the anticipated defense expense burn rate matters; the extent to which the defendants’ interests are aligned matters; whether some insurers believe they have unique coverage defenses matters; these and many other features matter and will influence the settlement dynamic and possibly affect the outcome of negotiations.

My point is that the settlement dynamic is complex and multifaceted. The very idea that settlement negotiations can be reduced to a mathematical formula with a few variables that explain outcomes in all cases – or even one case – is an interesting theory, as is the idea that settlement outcomes might be measured against a single, knowable measure that represents the “fair” outcome. The idea that settlement of the class action could be taken in isolation from the myriad other factors – for example, the existence of other related pending proceedings – is an interesting hypothesis.

Turning to the specifics of Professor Squire’s proposal that settlements should be segmented rather than collective, I have the following observations. It is possible that the alternative settlement arrangement Professor Squire has proposed could work to produce settlements that are fairer to all participants and that could eliminate the many ills that Professor Squire has identified. I suspect his proposal would be particularly attractive to the carriers that are most routinely in the primary and first level excess layers. It would less attractive to the insurers that are most often in the upper excess layers. And it would be extremely unattractive to policyholders.

First, with respect to the upper level excess participants, if all defense side participants have to negotiate their own settlements, there could be an unfortunate dynamic that forces the excess to the settlement table and forces them to pony up money that they otherwise shouldn’t have to pay and wouldn’t pay now. This effect, the direct result of reducing the protection to the excess carrier from the underlying layers, would increase the loss costs of the excess insurers. This would likely make excess insurance more expensive and partially or entirely offset any savings that might be available if primary and lower level excess carrier loss costs were reduced. In other words, to eliminate the cramdown effect, the segmented settlement process would substitute a “cram-around” effect, or maybe a “cram-up” effect.

Second, the possibility of a settlement holdout will not be eliminated. But the process when there is a holdout will change. Let’s consider the possibilities. Assume that all of the other participants have settled except one middle layer insurer. Sure, there would be a lot of pressure on the holdout. But there would be enormous pressure on the policyholder, too. Every additional dollar of defense expense incurred will reduce the sole remaining layer, forcing the policyholder toward a possible trial with ever-dwindling amounts of defense costs protection and little or no insurance remaining for any judgments that might result. For all the reasons outlined above, the policyholder could never run this trial risk, and so could be forced to contribute to settlement to avoid the range of unpalatable outcomes. Indeed, crafty insurance players aware of this possible dynamic might become strategic obstructionists, in order to compel the policyholder to absorb settlement costs and possibly allow the obstructing insurer to negotiate a discount settlement deal.

My concern is that one almost inevitable outcome of the segmented settlement process that Professor Squire has proposed is that policyholders would be compelled to contribute more frequently and in much greater quantities toward settlement. To the extent I read Professor Squire’s proposal correctly, he fully anticipates this process effect. For example, he says “If the settlements were segmented, more of them would be paid for by corporations rather than by their insurers.” Indeed, as I understand his analysis, he reckons this as one of the positive factors supporting his proposal, because it would force more companies to recognize in their securities litigation loss costs in their financial statements.

However, if I am right about the way that this settlement dynamic would work out, the introduction of a segmented settlement process would simply substitute a different cramdown dynamic for the existing one. The new dynamic would be particularly pernicious as it would threaten to put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their own insured. I am at a loss to see how this could ever be viewed as an appropriate or desirable arrangement of affairs between an insurer and a policyholder. No insurer interested in maintaining its reputation as a good corporate citizen would ever propose such a thing. No well-informed policyholder would ever propose such a thing, either.

Another practical concern is that requiring segmented settlements would prolong cases. Process participants jockeying for position would have every incentive to try to game the system, hoping that the eroding limits and the ongoing litigation burden will compel other participants, particularly the policyholder, to pony up to get rid of the case. Company management would be burdened and distracted by a complex multistage process that never seems to end and distracts them from the things they need to do to make their businesses successful. Litigation is bad enough as it is, but one settlement deal ends it. If multiple deals were required, it could go on and on and on… And all of these problems would be magnified enormously if there are other related procedural matters pending.

My most important objection to Professor Squire’s proposal is that it is commercially impractical. He simply asserts that “segmented settlements could easily be achieved contractually.” This statement lacks a connection to the insurance marketplace. The theoretical possibility that in the long run segmented settlements might lower insurance costs or reduce the number of lawsuits will have no meaning to an insurance buyer, when compared to the very real possibility that the segmented settlement arrangement would cause the buyer to have to absorb loss costs that would otherwise be covered. No company would ever agree to do it -- nor should any company ever agree to it.

All of that said, there unquestionably are serious ills with the current securities suit settlement process, many of which ills Professor Squire identifies in his paper. I am not sure I know how to remedy these ills. One possibility that Professor Squire considers and rejects is the possibility of a quota share arrangement, where the various carrier participants’ interests are arranged vertically, rather than horizontally. Under this arrangement, each carrier would share ratably in each dollar of loss costs, so the carriers’ interests in trying to save loss costs would be aligned in a way that would eliminate the conflict of interest problems Professor Squire identifies.

The shortcoming of the quota share approach is that it would be very difficult for all of the participating insurers to cede control to a single decision maker. In the absence of a single point of control, the claims process could be reduced to chaos. But on the plus side, there are multiple places in the insurance world now where quota share arrangements already are in place and functioning successfully. There is a lot to be said for an insurance arrangement that already actually exists as a possible solution for an insurance-related problem.

I would like to thank Professor Squire for allowing me the opportunity to read his interesting and thought-provoking paper and for allowing me to comment about his paper here. I enjoyed reading his paper and writing this comment – it kept from going crazy on a very long plane flight. I hope that readers of this blog will review the Professor’s paper on their own and will post their thoughts and comments about his paper here using this site’s comment feature.

And in Other News: With a long plane flight on Saturday, I not only had the leisure to type out this long blog post, but I also had the opportunity to read the Financial Times weekend edition at length and in full. With a more thorough reading than I am usually able to enjoy, I gleaned a couple of very interesting observations from articles in the paper.

First, in a April 14, 2012 article entitled “Unorthodox Behavior Rattles Russian Church” (here), the article’s author notes the following about Kirill I, the patriarch of the Russian Orthodox Church: “Last week bloggers discovered that a photograph of the patriarch on the Church’s website had been altered to remove a $30,000 Bruguet watch from the churchman’s wrist. While someone had used Photoshop to erase the offending object, they had forgotten to erase the watch’s reflection on a nearby mahogany table.”

And in an April 14, 2012 article entitled “Who Needs the Shard When You Have Shakespeare?” (here), commenting on the latest addition to the London Skyline (now under construction), the article’s author notes that

The skylines of European cities have traditionally told us something about what they believe in, and they still do. Until Harold Macmillan eased restrictions on buildings exceeding the height of St. Paul’s, London’s skyline consisted of two 100m-high buildings: St. Paul’s and the Big Ben clock tower. It was easy to see what London stood for: the Church and parliamentary sovereignty and not necessarily in that order. The skyline of modern London, with its dozen or so buildings more than 100m-tall, also sends a message. It is best summed up by the London Eye, which proclaims the city less a workplace than a tourist attraction. The rest of the buildings are about money.

On the Road Again: This upcoming week I will be a panelist at a session in Beijing co-sponsored by the American Bar Association Torts and Insurance Practice Section and by the China Council for the Promotion of International Trade. Information about the conference, which is entitled “Doing Business in the United States: What you Need to Know about Investing, Product Liability and Dispute Resolution,” can be found here. I will be on a panel entitled “Directors and Officers Liability, Securities Issues and Class Action Exposure” with my good friend Perry Granof, as well as Patrick Zeng of Zurich China, whom I am looking forward to meeting for the first time on this trip.

From Beijing, I will be going on to Professional Liability Underwriting Society (PLUS) Chapter events in Hong Kong and Singapore. Perry Granof will also be joining me educational sessions at these PLUS Chapter Events, as will my old friend Joe Monteleone. To those readers who may be attending the PLUS Chapter events, I am looking forward to seeing you. If we have not met before, I hope you will please take the opportunity to introduce yourself.

With the distances, time differences and commitments involved, I am not sure what sort of publication schedule will be possible over the next few days. The D&O Diary’s normal publication schedule should resume the week of April 30, 2012.