Directors and officers insurance experts found little to celebrate in a report declaring an end to securities lawsuits arising from the credit crisis, and Goldman Sach's recent troubles had them throwing more cold water on positive findings.
"We've all been waiting for the shoe to drop on SEC enforcement actions. We just didn't know whose head it was going to come down on," said Michael Young, a litigation partner with Willkie Farr & Gallagher in New York, who represents defendants in securities cases. "It looks like it's landed on Goldman Sachs," he added.
Mr. Young noted longtime speculation among securities litigation experts that "the SEC, much humbled by Madoff [would] try to come roaring back," referring to the perception that the SEC did not do enough to react to warning signs of a Ponzi scheme orchestrated by Bernard Madoff.
"All the fanfare surrounding Goldman suggests this may just be the first in a series of SEC actions," he warned.
Kevin LaCroix, a broker for OakBridge Insurance Services in Beachwood, Ohio, said he is "concerned there might be another wave" of credit crisis lawsuits emerging in the wake of the SEC's April 16 suit, charging Goldman Sachs and one of its vice presidents, Fabrice Tourre, with defrauding investors in structuring and marketing a collateralized debt obligation known as ABACUS 2007-AC1.
Apart from European banks ABN AMRO, IKB and other investors in ABACUS, who the SEC said collectively lost $1 billion on the deal, Mr. LaCroix said there are many other investors in CDOs who may now ask whether their investments were tainted by the type of conflict of interest allegedly involved in the Goldman transaction.
Mr. LaCroix, an attorney and author of the D&O Diary blog (www.dandodiary.com) expressed similar concerns in an April 19 entry, which also links to wire service reports quoting plaintiffs lawyers who say they've already gotten inquiries from potential litigants, and to a description of an ongoing case against Merrill Lynch with similar allegations.
"Up to now, it seemed as if new filings from the credit crisis were dwindling," Mr. LaCroix said, referring to his own counts and to an analysis from New York-based Advisen reporting only one new case in first-quarter 2010. "This may revitalize interest," he said.
Mr. Young and Mr. LaCroix spoke to NU a few days after participating on a webinar about securities litigation trends hosted by Advisen and sponsored by ACE.
Although the topic of the Advisen webinar was a recent steep decline in securities lawsuits related to the credit crisis cited in its recent report, webinar participants speculated on other events that could send filing counts soaring back up again, such as potential suits against directors and officers of failed banks brought by the Federal Deposit Insurance Corp.
With news of the SEC suit coincidentally breaking as the webinar was broadcast Jim Blinn, the moderator and an Advisen principal, observed that the Obama administration has started to increase the significance of SEC enforcement, asking Mr. Young about the D&O implications.
"SEC enforcement activity can often be the match on top of the gasoline igniting [private] litigation," he responded.
"In a highly charged environment, proceedings tend not to happen in isolation," Mr. Young later told NU. "Increasingly, we encounter a full spectrum of adversarial theatres, such as the SEC, attorneys general, the Department of Justice, and even Congress, along with civil litigation. That often means that defendants are simultaneously fighting battles on numerous fronts and that resources have to be thrown into action quickly," he said.
"That's not the scenario often contemplated when a company is buying [D&O] insurance," he said, suggesting that "it may be time to recalibrate the thinking on how much insurance [limit] is needed."
Separately, details of the case against Goldman emerged, with the SEC alleging that Goldman marketed the ABACUS CDO tied to subprime mortgages without disclosing to investors that a hedge fund with economic interests adverse to theirs--Paulson & Co.--had played a key role in the portfolio selection process for the CDO.
The timing of the SEC case after the release of Advisen's analysis revealing a 39 percent plunge in first-quarter securities suit filings (including regulatory actions) was not lost on David Bradford, executive vice president at Advisen. "Within a week of the report, there's been this significant new development that could very much change the picture going forward," he told NU.
"The usual progression is that private actions follow regulatory actions," he said, predicting further regulatory actions and noting that private suits could expand beyond investors in the CDOs to investors in Goldman who saw the share price plunge more than 20 points(12.5 percent) on the day of the SEC announcement.
"I also heard that AIG, even before the SEC announcement, had been considering a suit against Goldman," Mr. Bradford said, referring to a report in the Financial Times suggesting that American International Group, an issuer of credit default swaps for some CDOs structured by Goldman, would seek to recoup its losses.
SMALLER WAVE PREDICTED
Mr. LaCroix and Mr. Bradford said they are uncertain whether the SEC's action against Goldman will have any impact on high dismissal rates they're currently witnessing for credit-crisis suits. In addition, while they foresee a resurgence of lawsuit activity, both said any new wave of securities suits will be smaller than the last credit crisis wave, which together with Madoff claims, pushed first-quarter 2009 to a record-breaking total of 294 suits
In contrast, the latest Advisen report revealed that only one securities suit was filed related to the credit crisis issue during first-quarter 2010, down from 49 crisis-related suits in first-quarter 2009 and 185 in all of 2008.
"Not all motions to dismiss were successful during the first quarter, but a clear trend seems to be emerging," Mr. Bradford said.
John Molka III, the author of Advisen's report, noted that out of 348 credit crisis securities suits, so far 32 have settled and 62 have been dismissed, with 13 dismissals coming in 2010.
Mr. LaCroix said one explanation for the high dismissal rate is the fact that judges are reviewing filings in the context of a global financial crisis. "Merely because a company suffered reversals does not alone mean there's been fraud"--a premise that has raised the bar for initial pleadings, he said.
Going forward, however, "one question in my mind is whether the accusations against Goldman, taken together with the recent examiner's report on the Lehman bankruptcy and revelations on Capitol Hill [during hearings over the last two weeks] will hearten prospective plaintiffs," he said. "Will they somewhat change the dynamic and counterbalance the skepticism some judges have shown for this type of litigation?"
Mr. Bradford noted that "the allegations in the Goldman suit are pretty flagrantly fraudulent." The SEC suit "is a different character than a lot of suits being dismissed at this point, so I'm not sure it would have any particular impact," he said.
Postulating that any forthcoming wave of securities suits will be smaller than the one that produced 348 credit crisis suits to date by Advisen's count (including shareholder class actions, regulatory actions and other suits), Mr. LaCroix said "the most attractive suits from the plaintiffs' prospective have probably already been filed."
"Eventually you start running into statute-of-limitation issues," he added-- noting, for example, that if any of the few investors in ABACUS 2007-AC1 were to file suit, they would likely bring the action under the Securities Act of 1933, allowing them to allege misrepresentation in connection with an offering.
Under the '33 Act, the statute of limitations is one year from discovery of a misrepresentation or three years from the offer date, he said, noting that the offering date for ABACUS was April 27, 2007. In general, he said, subprime securitizations ended in 2008.
Mr. LaCroix also pointed to the unusual scenario in the SEC's case against Goldman--specifically the allegation that Mr. Tourre actively misled investors by telling them that Paulson was investing long (with an interest in seeing the investment prosper), when the hedge fund actually was taking a short position (making money if investment lost money).
"That's very case specific. It's going to boil down to who said what to whom in various conversations," Mr. LaCroix said.
There's also the question of whether it would even make a difference to investors if they had known Paulson was shorting the investment, he added. "It's not news that there would have been investors shorting this investment."
Advisen's latest numbers confirm a downward trend in securities suit filings litigation over the past year that has been previously documented in a report by Mr. LaCroix, as well as in a joint report by the Stanford Law School Securities Class Action Clearinghouse in California and Cornerstone Research in Boston, a report by NERA Consulting, and most recently by PricewaterhouseCoopers in its Securities Litigation Study for 2009.
In the past, Advisen had stood apart from the pack, in part because its figures, unlike those of the other counters, include cases other than securities class actions--most notably securities fraud (regulatory) actions, such as lawsuits or proceedings by the SEC and state attorneys general.
While class-action counts have been falling, according to the other research firms, Advisen's class-action totals had been a bit steadier over the past year, and its overall figures had been buoyed by jumps in the separate regulatory actions.
In first-quarter 2010, regulatory actions continued to represent the largest category of suits--with 59 such actions representing 33 percent of the 178-suit total overall.
During the Advisen webinar, one regulator clearly on the minds of speakers was the FDIC.
Scott Meyer, executive vice president of ACE Professional Risk, noted that 42 banks were taken over in the first quarter of 2010, and Mr. LaCroix said that during the S&L crisis of the late 1980s and early 1990s, the FDIC sued directors and officers of one-out-of-four failed banks.
While FDIC litigation has not yet arrived in this go-around of bank failures, Mr. Young, who said his life was "dominated by M&A and failed bank litigation by the FDIC in 1980s," observed that "all it takes is one memo within the federal government" to get the ball rolling.
"FDIC is a formidable adversary," he added. "You are doing battle against the totality of resources of the federal government, and it is knockdown, drag out, very expensive, take-no-prisoners litigation."
While Mr. Blinn noted the relative absence of actions against community banks and non-public banks, Mr. LaCroix said some plaintiffs' attorneys have already shown interest in suing publicly traded commercial banks.
He also noted a recent report by a congressional panel indicating that $1.4 trillion of commercial real estate loans will be maturing by 2014, with about half currently under water, adding that 3,000 U.S. commercial banks have exposure to commercial real estate.
Ken Ross, executive vice president of Willis HRH, highlighted a host of other potential trends that could rekindle securities, including:
o M&A transactions, which will rise if the credit markets continue to open.
o An overall stock-market bounce-back, which creates long-term opportunities for lawyers to allege artificial stock price drops when and if individual issue decline.
o Stale cases involving firms outside the financial sector, untapped by attorneys as they grappled with suits against financial institutions during the credit crisis wave.
In addition, Mr. Young warned that fair-value accounting--the type that drove subprime litigation--will be a bigger force in years to come as U.S. standard-setters work with international bodies already using it. This type of accounting involves more judgment and more opportunity for second guessing. Another consequence--volatile earnings--will drive swings in stock prices that fuel litigation, he added.
He also noted that as the economy improves, "companies are now stepping back onto growth curves [and] analysts expectations are starting to matter again."
Fraudulent financials--"the Enron-type stuff--tend not to start with dishonesty," he said, noting that instead "they start with pressure" to meet earnings targets.
ACE's Mr. Meyer said that "what concerns me is not necessarily a particular claim trend" that experts can identify, recalling unanticipated waves of claims related to IPOs, accounting irregularities like Enron and WorldCom, mutual fund litigation, options backdating, executive compensation issues, Ponzi schemes and the credit crisis.
"After each of these that our industry deals with, there's an attribution to it being an anomaly," he said. "Something is happening now that we don't know about--that may start to poke its ugly head out in the third- or fourth-quarter, or next year."
Turning to the implications of something happening as the webinar progressed--news of increased SEC enforcement activity--Mr. Meyer said underwriters often run up against the question of whether policies should be extended to include coverage for regulatory investigations--formal or informal.
While such policies are attractive to companies looking for broad entity coverage, "there is a lot of concern from the underwriting community" that high levels of investigative expenses can deplete coverage for individual directors and officers. "It's a tough balance as to whether we should be providing that kind of coverage [that's] looked at on case-by case-basis," he said.
Mr. LaCroix, reacting to Mr. Young's advice that buyers rethink D&O limits purchased given the enormity of defense expenses, said that sometimes even significantly increased limits aren't enough for companies facing the nightmare scenarios of dealing simultaneously with adverse press, SEC and DOJ investigations, and shareholder litigation.
Referring to the case of Collins & Aikman, an auto parts maker that went bankrupt in 2005, he said, "not only were there multiple proceedings, but there were multiple defendants [and] everybody had their own defense counsel." As a result, defense costs eroded $50 million in D&O limits before any of the proceedings were resolved, he reported, adding that defense costs are soaring because of e-discovery and practices in the defense bar.
Beyond simply hiking limits, buyers need to think about alternative structures, he said, referring to outside director liability and personal director liability insurance. These structures "segregate pots of [insurance] money for small subsets of directors, such as audit committees or outside directors with particular concerns or exposures, he said.
"If individuals are interested, they may even consider segregating a pot of money that only has one individual's name on it," he said, noting that this relatively rare structure is also possible.