Global Financial Market Watch : Global Financial Lawyer & Attorney : K&L Gates Law Firm : Government Enforcement, Investment Management

In 2011, businesses around the globe have had to react and adapt to an uncommon series of financial, environmental, and political disruptions, while governments seek expanded jurisdiction and pursue vigorous enforcement efforts to resolve their crises. K&L Gates continues to keep abreast of these events and the consequential effect on the relationship between the private and public sectors.

K&L Gates’ Global Government Solutions® 2011 Mid-Year Outlook offers analysis and perspectives on significant regulatory developments and trends for the coming year. Articles address a variety of government-related topics, including an array of financial regulatory reforms (including Dodd-Frank’s whistleblower program and state enforcement of consumer financial laws), the U.S. budget debate, worldwide energy and environmental policies, antitrust enforcement in the health care industry, and competition law issues.

To view the report, click here.
 

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K&L Gates continues to monitor and analyze the shifting relationships between business and government worldwide, as governments around the globe are increasingly involved in the economy and the private sector. Effectively navigating these dynamic relationships has become a significant challenge for organizations large and small.

K&L Gates' Global Government Solutions 2011 Annual Outlook contains informative articles on some of the most consequential government developments that we anticipate in 2011. Among the topics covered are the implementation of the Dodd-Frank financial reform law and the Basel III accords on international financial regulation, the global convergence of competition law, changes in the health care industry and related regulations, environmental and energy policies, aggressive regulatory and law enforcement efforts, and changes in the political landscape.

To view the report, click here.

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Contacts: Diane E. Ambler, Michael J. Missal, Matt T. Morley, Mark D. Perlow

2009 brought a further transformation in the relationship between business and government. Regardless of political systems or philosophies, governments around the world became more dynamic and intrusive in response to the financial crisis.

This 2010 Annual Report, prepared by members of the K&L Gates Global Government Solutions initiative, contains concise articles that seek to forecast likely government actions and priorities regarding a broad spectrum of topics.

To view the report, click here.

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By: Ian Meredith, Sean Kelsey

For investors, advisors, liquidators and institutions contemplating their exposure, or potential exposure, to the European dimensions of Bernard Madoff's Ponzi scheme, there have been notable recent developments in one of the key European centres of the funds industry, where the unwinding of the Madoff scandal has recently intersected with a significant current trend in international commercial dispute resolution.

Many of the Madoff-related claims in Europe are being brought in Luxembourg, estimated to be Europe’s largest funds centre. Prominent among these are suits seeking compensation and access to documents from Luxembourg units of UBS AG (“UBS”), custodian bank for two Madoff feeder funds, Access International Advisors LLC’s LuxAlpha Sicav-American Selection and Luxembourg Investment Fund. More than twenty suits have been dealt with to date, according to reports. Luxembourg’s Treasury and Budget Minister, Luc Frieden, anticipates “dozens” more, and some commentators suggest they could run into the hundreds. 

On April 28, Mr. Frieden urged custodian banks, fund liquidators, investors and all other parties to Madoff-related lawsuits in Luxembourg to agree to settle their differences by resort to international arbitration. Mr. Frieden believes that international arbitration - possibly seated in London or Paris - would provide a more appropriate, and a quicker solution than pursuit of such claims through the Luxembourg courts. Mr. Frieden also stated that he believed such an approach would be “in the best interest of the fund industry.”

Any solution along these lines would require the agreement of UBS, and might involve provisions permitting claimants to opt in (rather than requiring them to opt out).  In some respects, Mr. Frieden’s proposal chimes with the increasing availability of representative or “class” action as a tool for dispute resolution in a number of jurisdictions around the world, and indeed the uses to which that tool is already being put in connection with Madoff-related claims. In the United States, where class action litigation has been long established, investors are pursuing a variety of such claims against a host of feeder funds and advisors. In the arbitration context, class arbitrations have existed in the United States for over 25 years, and the American Arbitration Association has had rules for their conduct since 2003. At least one New York law firm is reportedly filing a number of Madoff-related group arbitrations. International class arbitration has been gaining in prominence more recently, and several international class arbitrations seated in the United States are currently known to exist. Enforcement, under the New York Convention, of awards resulting from international class arbitrations has, however, the potential to create issues, particularly if parties seek to enforce against assets located in jurisdictions less familiar with the class concept.

In a separate development, on April 24, a Luxembourg court selected a handful of “test cases” from more than fifty Madoff-related lawsuits that have been filed against UBS by individual investors to assess the validity of their claims for compensation. This would appear to hold out at least the possibility that claimants may be willing to pursue class-based lawsuits by way of international class arbitration if they, and UBS, perceive any advantages in doing so.

We will look to provide a more detailed analysis of the disputes landscape flowing from recent upheavals in the capital markets in a future edition of this newsletter.

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By: David T. Case, Brendon P. Fowler 

With the nearly unparalleled upheaval in world financial markets and the resulting impact on the nation’s financial institutions, many entities have either gone bankrupt or become subject to increasing levels of Government intervention, regulation, and oversight.   The Government also continues to consider actions to address “toxic” assets and to stimulate financial activity.  While Government action may ultimately lead the way to financial recovery for the broad economy, in some instances the Government may take actions, such as changing federal regulatory schemes and related contracts, that nonetheless inflict harm on individual companies.  In those situations, developments in a series of cases relating to an earlier financial crisis may provide guidance in navigating the risks of increased Government regulation and oversight, and the measure of any damages that might be recovered. 

During the Great Depression, forty percent of the nation’s home mortgages went into default, and 1,700 of the nation’s approximately 12,000 savings institutions failed.   This led to significant Government oversight of the savings and loan, or "thrift" industry, in the form of the Federal Home Loan Bank Board and the Federal Savings and Loan Insurance Corporation, as well as the passage of numerous laws such as the Home Owners’ Loan Act of 1933.  This regulatory regime remained in place until the financial crisis of the late 1970s and early 1980s, when, in order to retain deposits, thrifts were compelled to offer interest rates to depositors that exceeded the stream of income from the thrifts’ long-term, low-rate mortgages.  Over 400 thrift institutions failed by 1983, and by the mid-1980s, it became clear that Government regulatory efforts to resolve the crisis were not succeeding.  As a result, Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), which resulted in regulations that imposed more stringent capital standards on thrifts.  Many thrifts, particularly ones that had acquired failed thrifts under agreements with the Government, were immediately thrown out of compliance with regulatory capital requirements and became subject to seizure by thrift regulators. 

A number of thrifts adversely affected by the new regulations sued the Government, alleging that the passage of FIRREA breached the contracts under which the thrifts had previously agreed to acquire other failed institutions.  In United States v. Winstar Corporation, 518 U.S. 839, 843 (1996), the Supreme Court held that where the Government entered into contracts with regulated financial institutions, promising to provide particular regulatory treatment in exchange for the assumption of liabilities, the risk of regulatory change fell to the Government, even though Congress subsequently changed the law and barred the Government from honoring its agreements.  Following this ruling, the United States Court of Federal Claims and the United States Court of Appeals for the Federal Circuit addressed a series of cases where the allegations were that the Government had indeed breached its contractual obligations to various thrifts through the passage of FIRREA.  This group of cases, which is often denoted as the “Winstar-related cases,” may provide significant guidance for any cases that derive from the present crisis.

As a general matter, damages in the Winstar-related cases are based on one of three damages theories:   expectancy damages, reliance damages, or restitution damages. 

Expectancy, or “lost profit” damages, protect a bank’s expectation interest by seeking to put that institution in as good a position as it would have been had the institution’s contract with the Government been fully performed, without also providing plaintiff with a windfall.   If successful, this theory for recovery typically produces the largest quantum of damages for an injured bank, but lost profits have historically been difficult to prove and recover in the Winstar-related context.  Nevertheless, a recent Winstar-related decision by the United States Court of Appeals for the Federal Circuit (“Federal Circuit”) upheld the trial court’s acceptance of a lost profits theory that established, by way of expert testimony and models, that the Government’s implementation of FIRREA caused lost profit damages to the affected thrift.  See First Federal Sav. and Loan Ass’n of Rochester v. United States, 290 Fed. Appx. 349, 2008 WL 3822567 (Fed. Cir. 2008).  The injured thrift established with reasonable certainty its lost profits of $85 million to the satisfaction of the courts, and the Federal Circuit upheld the trial court’s reliance on plaintiff’s damages expert, and the projections of the growth (and profits) the thrift would have experienced absent the Government breach.  Id. at 357.

Reliance damages, often sought or pled in the alternative to expectation damages, are intended to address harm resulting from the thrift’s change of position in reliance on its contract with the Government.   The underlying principle in reliance damages is that a party who relies on another party’s contractual promise is entitled to damages for any losses actually sustained as a result of the breach of that promise.  Glendale Federal Bank v. United States, 239 F.3d 1374, 1382 (Fed. Cir. 2001).  In Glendale, the Federal Circuit affirmed the use of a reliance damage calculation because “for purposes of measuring the losses sustained … as a result of the Government’s breach, reliance damages provide a firmer and more rational basis” than the alternative theories argued by the parties in that case.  Id. at 1383.  Reliance damages can include both pre- and post-breach activities and costs by the thrift, and have been described as the “ideal” theory for “wounded bank” damages.  Glendale Federal Bank v. United States, 378 F.3d 1308, 1313 (Fed. Cir. 2004) (upholding trial court’s award of $381 million).

Restitution damages may be sought when proof of lost profits or reliance damages fails.  The idea behind restitution is to restore the non-breaching party to the position he would have been in had there never been a contract to breach.  Specifically, a restitution theory seeks to recover any benefit that the non-breaching party may have given to the breaching party, but such damages should not be awarded if the award would result in a windfall to the non-breaching party.  See Southwest Investment Co., Inv. v. United States, 63 Fed. Cl. 182, 197 (Fed. Cl. 2004).  Accordingly, an institution must carefully consider whether benefits conferred on the Government might nonetheless be offset fully by benefits received from the Government, as “the non-breaching party is not entitled, through the award of damages, to achieve a position superior to the one it would reasonably have occupied had the breach not occurred.”  Glendale Federal Bank v. United States, 239 F.3d 1374, 1382 (Fed. Cir. 2001).  In addition, restitution can be a challenging theory to pursue, for while a party may often be able to show benefits given to the Government, establishing an actual dollar value conferred can be difficult.  Id. at 1382 (under theory that thrift assumed risk and relieved Government of liabilities for a period of time in which the Government was able to deal with other failing thrifts, the value of Government’s time was more than zero but there is no proof of what in fact it was worth).  Where a specific dollar amount is clearly established, however, restitution may be awarded.  See 1^st Home Liquidating Trust v. United States, 76 Fed. Cl. 731, 744 (Fed. Cl. 2007).

In sum, the numerous Winstar-related decisions provide a body of law for institutions faced with a rapidly changing bank regulatory environment and possible breaches by the Government with respect to current contracts.  Familiarity with the types of damages theories and models employed by past thrift litigants against the Government may help today’s institutions develop a viable remedy if they are harmed by Government action.

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By: Clare Tanner, Paul F. Donahue

The current turmoil in financial markets has led to an increase in disputes involving financial institutions.   Parties may have entered into transactions in better times with little consideration given to the forum in which future disputes would play out.  In today’s far more challenging circumstances, the choice of forum may be central to the satisfactory resolution of disputes. 

In some areas, it is common for disputes involving financial institutions to be resolved through arbitration.  The Financial Industry Regulatory Authority (FINRA) is the largest self-regulatory organization, i.e., non-governmental regulator, for all securities firms doing business in the United States.  (FINRA’s rulemaking, however, is subject to approval by the Securities and Exchange Commission (SEC).)  Both individual and institutional customers can require a FINRA member to arbitrate disputes.  Indeed, most, if not all, securities broker/dealers will refuse to do business with customers who do not agree to arbitrate disputes.  Disputes between FINRA members may also be submitted to arbitration.

The financial crisis has resulted in a dramatic increase in the number of cases referred to FINRA arbitration.   In 2007, slightly more than 3,000 arbitration cases were filed.  In 2008, the number was almost 5,000 and the upward trend has only increased in 2009.  The number of cases filed in January 2009 was double that of a year earlier. 

An award handed down by a FINRA tribunal last month, arising from transactions in auction rate securities, illustrates the enormous magnitude of disputes arising from the financial crisis and the speed with which they can be resolved through arbitration.  The FINRA tribunal ordered Credit Suisse Securities USA LLC, a brokerage unit of the Swiss bank, to pay $400 million to its customer STMicroelectronics NV, a European semiconductor maker.  STMicroelectronics claimed it had authorized Credit Suisse to make investments in top-rated securities backed by U.S. Government guaranteed student loans, but instead the funds were invested in collateralized debt obligations some of which were backed by sub-prime mortgages.  The entire process including 28 hearing sessions over two months took just under a year.  Any court proceeding would undoubtedly have taken far longer.  Nonetheless, STMicroelectronics, according to the award, incurred more than $4 million in legal fees during that time.

While FINRA members can be compelled to arbitrate customer disputes and most require their customers to agree to arbitrate disputes, other financial institutions have traditionally been reluctant to commit to arbitration and have preferred to submit disputes to national courts.   Some of the risks and benefits associated with arbitration as a means of resolving disputes involving financial institutions can be illustrated by reference to FINRA’s procedures. 

Confidentiality
As is common with arbitration, FINRA arbitrations are confidential.   The evidence submitted and procedural and substantive hearings are not open to the public.  Although FINRA arbitral awards are made public, that is the exception, not the rule for most arbitrations unless the parties agree otherwise.  FINRA awards are not necessarily fully reasoned and may simply amount to a requirement that one party pay as was the case in the STMicroelectronics case.  Under a recent rule approved by the SEC, however, beginning next month, if both parties request it, FINRA arbitrators will have to give an “explained decision,” i.e., “a fact based award stating the general reasons for the decision” but which need not include legal authorities or damage calculations.

Confidentiality can be a significant attraction of arbitration as it avoids both financial institutions and their institutional clients airing their dirty laundry in public.   In current markets, disputes may give rise to a damaging loss of confidence in the financial institution.  Equally, even if sophisticated institutional customers feel they have been misled by a financial institution, they may wish to avoid public allegations that they share some responsibility or may not want detailed aspects of their financial dealings laid open to public scrutiny.  In disputes between sophisticated commercial enterprises, the risk of adverse publicity is seldom limited to one party. 

Arbitration will not be appropriate where a financial institution seeks to establish a legal precedent that will be publicly available.  Only a court ruling can provide that and, of course, it can be a double-edged sword.

The Tribunal
FINRA’s arbitration rules for customer disputes generally provide for a three-person tribunal with one “industry member” and two independent members.  Under a rule change effective at the end of this month the size of cases to be decided by a single arbitrator will increase to $100,000.  Three-arbitrator panels are intended to provide both industry knowledge and experience while also protecting the customer’s interests, but some have criticised such panels as too industry friendly.  Under a pilot program now underway for 400 cases, several securities firms have agreed to have panels made up of three independent arbitrators.  FINRA’s approach may not be appropriate in all cases and, for example, the arbitration rules of the London-based City Disputes Panel provide that the tribunal will usually consist of a legally qualified chairman and two experienced financial services practitioners.

Given the complex and technical nature of modern financial products, there may be a significant advantage in decisions being reached by tribunals with necessary expert knowledge.   Both financial institutions and their institutional customers may prefer such a tribunal to the vagaries of a jury trial in the U.S.  The speed at which law and market practice change are such that, even in jurisdictions where disputes may come before an experienced judge, a tribunal made up of industry experts may still be preferable.  

Procedure
Recent rule changes have sharply curtailed the ability to obtain a summary determination of a dispute in FINRA arbitrations.   The loss of the opportunity of having a frivolous claim dismissed at an early stage may be unattractive for respondents and correspondingly attractive for claimants in those jurisdictions where summary determination is only available to a claimant.  However, expedited procedures are available by agreement between the parties in both FINRA arbitrations and in other arbitral rules.  Equally, the absence of, or restrictions on, wide-ranging discovery exercises and pre-trial depositions found in FINRA and other arbitral rules may mean that, even without a summary determination, arbitration is still more attractive than litigation through national courts.

Finality
The ability to challenge an arbitration award is usually strictly limited and FINRA arbitration is no exception.   The attraction of a final award is that the cost and risk associated with any given dispute can be more easily judged.  The prospect of a defaulting party endlessly prolonging the proceedings while attempting to protect assets against enforcement is greatly diminished as is the prospect of a successful party deciding to settle simply to end the bloodletting.  

Enforcement
Many financial transactions will have an international element, as illustrated by the STMicroelectronics case.   A party may be reluctant to commence proceedings in the home court of the other party fearing “home advantage.”  Even if the parties agree to resolve disputes in the courts of a neutral state, many national courts will not permit parties to “manufacture” jurisdiction and simply will not hear such cases.  Even when they do, the successful party still faces the cost and difficulty of enforcing that judgment in another country. 

Arbitration awards made in a country which is a party to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards can be enforced in any other Convention State, by the local court giving effect to the award as if it were a court judgment.  This is subject to limited, mostly due process, exceptions.

Conclusion
Arbitration is not a panacea — as with litigation through the courts, expense and delay can be features of arbitration — but there are advantages for disputes between financial institutions or between financial institutions and their institutional clients, particularly where there is an international element.   Even parties who did not commit to arbitration at the outset may still agree, after a dispute has arisen, that arbitration is a more suitable dispute resolution mechanism.  A failure to consider arbitration may leave parties at a disadvantage and, of course, it is always best to make the decision at the outset, before disputes arise.

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By: R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

A recent decision of the Third Circuit Court of Appeals significantly bolsters the standard of proof that plaintiffs must satisfy in motions for class certification under Rule 23 of the Federal Rules of Civil Procedure (“Rule 23”).  In In re Hydrogen Peroxide Antitrust Litigation, 552 F.3d 305 (3d Cir. 2008, as amended Jan. 16, 2009), the Third Circuit emphasized that the broad discretion district courts have to control the class certification process does not “soften the rule” that each requirement of Rule 23 must be satisfied.  Class certification is a critical stage of any class action because it is the point at which the court decides whether the action may proceed on a classwide basis rather than simply as an individual case.  Rule 23(a) requires plaintiffs to demonstrate, in part, that there are questions of fact or law common to the class, and Rule 23(b)(3) requires plaintiffs to establish, in part, that those common questions predominate over questions affecting only individual members.  Because the class certification decision is often the defining moment of a class action – one that can signal the “death knell” for plaintiffs or place “unwarranted pressure” on defendants to settle meritless claims – the Third Circuit instructed that district courts must engage in a “thorough examination of the factual and legal allegations” raised by the action.  Further, because In re Hydrogen Peroxide was authored by Third Circuit Chief Judge Anthony J. Scirica, who as chair of the Standing Committee on Rules of Practice and Procedure oversaw extensive revisions to Rule 23, the decision is likely to impact federal courts’ class action jurisprudence nationwide.

With its decision, the Third Circuit clarified three aspects central to the class certification process, discussed in turn below. 

A Mere “Threshold Showing” of Predominance Does Not Satisfy Rule 23
In certifying a Rule 23(b)(3) class, which is a class that seeks primarily money damages, the district court stated that “[s]o long as plaintiffs demonstrate their intention to prove a significant portion of their case through factual evidence and legal arguments common to all class members, that will now suffice.”  Id. at 321.  The district court further stated that “plaintiffs need only make a threshold showing” that common questions predominate over individual ones.  Id.  The Third Circuit ruled, however, that neither plaintiffs’ expressed intentions nor a mere threshold showing could satisfy Rule 23.  Reversing the district court, the Third Circuit held that plaintiffs must actually set forth evidentiary proof, rather than a promise to do so at some future point, that class certification is warranted under Rule 23.  In addition, the court ruled that plaintiffs must establish the Rule 23 requirements by a preponderance of the evidence.  In other words, plaintiffs must demonstrate that the “evidence more likely than not establishes each fact necessary to meet the requirements of Rule 23.”  Id. at 320.  The Third Circuit criticized the district court for adopting a “lenient” burden, or presumption of deference, for the party seeking certification.

Courts Must Resolve Relevant Factual and Legal Disputes When Ruling on Class Certification Motions
In re Hydrogen Peroxide requires district courts to resolve all factual or legal disputes that would affect the court’s certification decision.  This may even require an analysis of the merits of the case at the class certification stage to determine whether certification is appropriate.  An analysis of the substantive elements of plaintiffs’ claims may also be necessary to evaluate whether plaintiffs have set forth a feasible trial plan where one is required by a court, namely one showing that the claims are susceptible to proof on a classwide basis.  Plaintiffs’ assurances that they intend or plan to devise a feasible trial plan at some future point do not meet their burden. 

Courts Must Weigh Expert Testimony
In conjunction with ruling that district courts must consider all relevant evidence necessary to decide class certification, the Third Circuit emphasized that this ruling encompasses consideration of expert testimony.  The court rejected the district court’s assumption that it could not weigh the parties’ competing expert testimony in deciding whether to certify a class.  Accordingly, under In re Hydrogen Peroxide, where expert testimony is necessary to the class certification decision, a district court must resolve disputes between competing expert testimony.  Furthermore, neither credibility issues nor concern for addressing the merits of a case can impede the rigorous analysis required to resolve such disputes.

Impact on Class Action Defense
The Third Circuit decision is likely to impact federal courts’ class action jurisprudence nationwide.   As noted, Chief Judge Scirica served from 1998 to 2003 as chair of the Standing Committee on Rules of Practice and Procedure.  In this role, the Chief Judge oversaw extensive revisions to Rule 23, which revisions support conducting a rigorous analysis of each class certification motion. 

For class action defendants, In re Hydrogen Peroxide heralds a welcomed bolstering of the standard of proof that plaintiffs must satisfy.  Other aspects of the decision will also likely benefit class action defendants, including the emphasis on courts understanding how the merits of class claims intersect with class certification and the role expert testimony can play in defeating class certification.

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By: R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

In its recent decision, Amoche v. Guarantee Trust Life Insurance Co., --- F.3d ----, 2009 WL 350898 (1st Cir. Feb. 13, 2009), the First Circuit Court of Appeals joined a growing number of federal courts that have articulated defendants’ jurisdictional burden under the Class Action Fairness Act (“CAFA”).  CAFA allows defendants to remove a class action matter from state court to federal court if the matter meets certain jurisdictional prerequisites.  Eight federal circuits have now ruled that defendants must establish the existence of those prerequisites, at the very least, by a “reasonable probability” or by a preponderance of the evidence.  The Amoche opinion highlights potential pitfalls that defendants may face when trying to establish that a case meets the CAFA jurisdictional prerequisites.  For instance, CAFA requires a defendant to show that the amount-in-controversy placed at issue by a plaintiff’s claims exceeds $5,000,000 on a classwide basis.  The federal circuit courts warn that speculative assertions, unsupported by evidence, will not suffice to meet this jurisdictional burden.  Rather, courts exhort defendants to carefully develop the evidentiary support necessary to demonstrate that a plaintiff’s claims have placed more than $5,000,000 at issue.

In Amoche, the plaintiffs brought suit in state court on behalf of New Hampshire consumers who allegedly had not received refunds purportedly owed to them on credit insurance policies purchased in connection with auto loans.   After certifying a class of New Hampshire consumers, the state court allowed the plaintiffs to amend their complaint to propose an expanded class of consumers from other states.  On the basis of the proposed expanded class, the defendant removed the case from state court to federal district court under CAFA, and the plaintiffs moved to send the case back to state court.  Finding that the defendant’s assertions concerning the amount-in-controversy were speculative, the district court granted the plaintiffs’ request. 

On appeal, the First Circuit held that a removing defendant must establish CAFA jurisdiction by a “reasonable probability.”    Id. at *7.  The First Circuit found that the Amoche defendant had not demonstrated to a “reasonable probability” that the alleged damages exceeded the $5,000,000 amount-in-controversy threshold and affirmed the district court’s order sending the case back to state court. 

The defendant had submitted a declaration that the New Hampshire class involved approximately $450,000 in damages, and argued, by extrapolating the New Hampshire amount to the thirteen states named in the amended complaint, that the $5,000,000 jurisdictional minimum was satisfied.  The defendant, however, did not provide a basis for that extrapolation.  The court suggested that the defendant might have met its burden through introducing information regarding its market share and revenues in states other than New Hampshire.  Because the defendant failed to account for differences in its business practices among the relevant states, the First Circuit found it could not rely on the defendant’s assertions that the class members’ claims exceeded $5,000,000 in the aggregate.

While CAFA is a powerful procedural device that makes it easier for defendants to litigate class actions in federal court rather than state court, the Amoche opinion highlights the demands federal courts are placing on defendants to carefully develop the evidentiary support necessary to sustain removal, including addressing such areas as the number of potential class members and the alleged value of those members’ claims.  Fortunately, as the First Circuit held, the remand of a class action does not necessarily foreclose subsequent attempts to remove the action under CAFA.  Indeed, “[s]uccessive attempts at removal are permissible where the grounds for removal become apparent only later in the litigation.”  Id. at *11. 
 

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By: Irene C. Freidel,  Robert W. Sparkes, III

In addressing the enforceability of class action waiver provisions included in mandatory arbitration agreements, the majority of state and federal courts have followed a two-pronged, fact-intensive test that will operate to invalidate a class action waiver where: 1) the party to be bound did not have a meaningful opportunity to negotiate or reject the arbitration agreement portion of a contract (i.e., the agreement is one of adhesion); and 2) if enforced, the waiver would effectively eliminate a party’s right to seek redress because the expected recovery is not large enough to justify the risks and costs of individual litigation.   In practice, most courts employing this analysis have found class action waivers in consumer finance related agreements to be unconscionable, and thus unenforceable, under applicable state and federal law. 

The Third Circuit Court of Appeals, however, appeared to reject the majority trend in its 2007 opinion in Gay v. CreditInform, 511 F.3d 369, 378 (3d Cir. 2007).   In Gay, the Third Circuit panel upheld a mandatory arbitration clause in an agreement between a consumer and a credit repair organization, which clause required individual arbitration of all disputes arising out of the agreement.  The Third Circuit panel held that the right to proceed on a class-wide basis was merely a procedural right and was therefore waivable.  The court refused to consider whether the consumer would have a meaningful opportunity to recover if she were barred from pursuing the claim as a class action.  Instead, the court ruled that the arbitration provision was not, on its face, so unreasonable that it could be considered unconscionable under state law.  Any further inquiry into the effect of the provision, according to the Third Circuit panel (albeit in dicta), would violate the Federal Arbitration Act’s (“FAA”) prohibition on state laws which restrict or burden the enforcement of agreements to arbitrate.  In so holding, the Third Circuit panel did not discuss the apparently contrary holdings in other federal circuits. 

On February 24, 2009, a different three-judge panel of the Third Circuit, in Homa v. American Express Company, ---F.3d---, 2009 WL 440912 (3d Cir. Feb. 24, 2009), found that a class action waiver included in a mandatory arbitration provision in a consumer credit card agreement was unconscionable under New Jersey state law.  The Third Circuit held that New Jersey had a fundamental public policy against enforcing class action waivers in the context of “a low-value consumer credit suit.”  As such, the court held that “if the claims at issue are of such a low value as effectively to preclude relief if decided individually, then, under [New Jersey law] the class-arbitration waiver is unconscionable.” Id. at *7.    

The Third Circuit’s opinion in Homa suggests that the Third Circuit may be prepared to fall in line with the majority of state and federal courts in addressing class action waivers in arbitration agreements.  This development will likely not bode well for consumer finance and consumer credit entities that seek to include such class action waivers in their various consumer agreements.  On the other hand, the Homa court’s reliance on New Jersey state law – law not at issue in the Gay case – may not signify any change in the Third Circuit’s approach to class action waivers, but may merely stand as evidence of one court interpreting and applying two different states’ laws in similar situations.  The fluidity and importance of this area of the law, however, suggest that we will not have to wait long for the next court ruling to more fully direct the analysis and the Third Circuit’s approach to class action waivers in arbitration agreements.

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By: Sarah Turpin, Jane Harte-Lovelace

The credit crunch has already given rise to numerous third party claims against financial institutions in the US, primarily by disgruntled investors and shareholders.   While the "tsunami" of litigation predicted by many lawyers has not yet arrived in the UK, the collapse of Lehman Brothers and the scandal involving Bernard Madoff's $50 billion Ponzi scheme raises the prospect of similar claims (and related investigations) emerging.   In these circumstances, companies are well advised to consider the state of their insurance coverage, particularly under Professional Indemnity/Errors & Omissions and Directors & Officers' Liability policies.  In particular, companies should pay close attention to the importance of well-drafted claims notification provisions in their insurance policies.  Companies should also be alert to the need for prompt notification to their insurers in the event of a claim or circumstances that may give rise to a claim. 

Below is a checklist of some practical points to consider in connection with insurance placed in the London market and governed by English law, although many of the points have equal application in other jurisdictions, particularly the US. 

• Check the policy provisions relating to claims notification and consider whether there is any scope for improvement.   The English Court of Appeal recently criticised the claims notification provisions in a Professional Indemnity policy as "a patchwork of provisions, which have no doubt been largely drawn from other policies but do not all fit well together".
  
   
• Make sure that any notice of claims and of circumstances is given in a timely manner.  The notice provision will normally stipulate the period within which notice has to be given and this can vary from a specified time period to "immediately" or "as soon as practicable".  Failure to comply could prove fatal if the clause is a condition precedent to the insurer's liability under the policy.
  
   
• Don't assume that the absence of the words "condition precedent" means that the notice provision will not be construed as such.  Harsh as it may seem, the English (and US) courts may hold that the requirement to give valid notice is a condition precedent even though not described as such in the policy.  English courts may allow insurers to deny liability for breach of a condition precedent, even if they have not suffered any prejudice as a result.  The position is similar in the US where, in contrast to comprehensive general liability policies, some US courts have not required an insurer to demonstrate any prejudice resulting from untimely notice under a claims-made policy.
  
   
• Set up and maintain proper internal lines of communication to ensure early identification of any errors or problems which may require notification.  This is especially relevant to businesses with global operations, particularly those based in jurisdictions where less importance is placed on the need for early notification.  In these circumstances, it may prove particularly beneficial to limit the requirement to notify to those claims or circumstances which are known to the group risk manager or general counsel.
  
   
• Make sure the notice of any circumstance is sufficiently detailed.  Some policies require detailed particulars to be given, including the identity of any potential claimants and the types of claim anticipated.  The insurer may seek to deny cover if it considers that inadequate details have been given.
  
   
• Make sure the notice of any circumstance is sufficiently broad to cover all potential claims regarded as real risks.   The policy will usually contain a “deeming” provision to the effect that any claim arising from a circumstance notified to insurers will be deemed to have been made within the policy period.  However, if the notice is not sufficiently broad and additional claims materialise which have no causal connection with the circumstance originally notified, then the deeming provision may not apply and the policy will not respond.
  
   
• Don't be economical with the truth!  A preliminary notice couched in vague terms — perhaps to avoid the prospect of higher premiums at renewal — may be held inadequate for claims notification purposes.  There is, however, a balance to be drawn between being too vague and too specific:  a notification which is too specific may enable insurers to limit their liability if the claim expands into something much wider than suggested in the original notification.
  
   
• If the matter is subject to further investigation and/or dependent upon future developments, make this clear and update the notification as further information comes to light. 
  
   
• Review and update the notification prior to renewal.
  
   
• Make sure notification is given to all insurers (including Lloyd's Underwriters and Co-Insurers).  The policy will normally provide an address where notices must be sent.  Some policies provide for notice to be sent to a broker or solicitor but, unless they are authorised by the insurers to act as their agents for claims notification purposes, they merely act as a conduit, and it is vital to ensure that the notice is actually received by the relevant insurers.  Notice to the broker or solicitor may not in itself be sufficient.
  
   
• Make sure notification is also given to any excess layer insurers, where there is any possibility that the claim will impact on those layers.  The excess layer policies may not necessarily have the same notice provisions as the primary layer, and notice to the primary layer insurers alone is unlikely to be sufficient.  This could prove catastrophic for high-value claims where the excess layer insurance may prove essential.

Whatever the jurisdiction, but certainly in England and the US, it is vital that policyholders take a proactive approach to claims notification.   Early advice both prior to and at the time of notification could prove invaluable. 

Please contact Jane Harte-Lovelace (020 7360 8280 or jane.harte-lovelace@klgates.com) or Sarah Turpin (020 7360 8285 or sarah.turpin@klgates.com ) if you would like further information.

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By: Richard S. Miller, Robert T. Honeywell, Jeffrey N. Rich

The Lehman Brothers bankruptcy sometimes seems to have exhausted the list of “biggest ever” superlatives: Biggest ever bankruptcy filing in the United States ($639 billion in assets).  “By far the largest securities broker-dealer liquidation ever attempted,” according to the trustee overseeing the liquidation of Lehman’s U.S. broker-dealer.  His British counterpart, overseeing the insolvency of Lehman’s London operations, told the press, “Enron and BCCI were large and complex but not on this scale.”  The Lehman collapse has been tied to the fall of the investment banking model, to continuing uncertainty in financial markets, and to the current turmoil in the global  economy itself. 

A less-discussed theme of the Lehman bankruptcy is the strain it is revealing between the efficiencies of global corporate cash management and the legal regimes governing creditor claims.   When the cash literally stops flowing, creditors and investors naturally ask, “Where’s my money?”  The Lehman insolvency has revealed, like many of the largest corporate bankruptcies in recent years, that this can be an extremely difficult question to answer. 

Part of the problem is that most corporate cash management systems involve one corporate entity moving cash on behalf of its affiliates, but reflecting their interests primarily through intercompany claims.   This has obvious operational efficiencies, but when “the music stops” upon a bankruptcy filing, the cash is held by the entity with legal title to it (i.e., in its accounts).  Creditors of the entity holding the cash have an immediate enforcement advantage – the money is there – while creditors of its affiliates have to chase it down, possibly across jurisdictional boundaries.  The Lehman bankruptcy is the latest example. 

Like most large companies, Lehman operated a centralized cash management system that had one entity – in this case the holding company – operate as the “central banker” for the numerous Lehman entities.   According to court filings, the holding company generally swept excess cash into its own U.S. and foreign operating accounts and used it to fund expenses of subsidiaries.  The degree to which subsidiaries were integrated into the system varied.  For example, unregulated subsidiaries had their excess cash swept on a daily basis to the holding company’s operating accounts, while regulated subsidiaries (generally broker-dealers) transferred cash to the holding company less frequently, to pay down intercompany loans for prior advances.  Some subsidiaries managed their own cash and disbursements independently (e.g., Lehman Brothers Commercial Bank).  Others had some of their collections deposited into the accounts of other subsidiaries.  For example, the regulated U.S. broker-dealer (Lehman Brothers Inc. (“LBI”)) received collections from some derivatives, futures and foreign exchange transactions of Lehman Brothers Commercial Corporation, Lehman Brothers Special Financing Inc., and Lehman Brothers International (Europe) (“LBIE”).  As to disbursements for expenses, the holding company acted as “paymaster” for most of Lehman’s European operations, while the regulated U.S. broker-dealer (LBI) acted as “paymaster” for most U.S. operations. 

A centralized cash management system such as Lehman’s may make utter sense pre-bankruptcy, but can produce legal nightmares afterward.  For one, the sheer number of transactions can make untangling intercompany claims based on those transactions a herculean task.  Lehman reported that the portion of its business related to the sale of derivatives alone involved approximately 1,500,000 transactions with approximately 8,000 counterparties.  It is now faced, in the post-bankruptcy setting, with sorting these out with a radically reduced staff, going from more than 13,000 employees to about 140.  Lehman’s London office recently lost over half of its legal staff.   Its current U.S. management, led by an outside restructuring firm, is reportedly focused on preserving its information systems and retaining employees, and estimates being able to respond to creditor inquiries in 45-60 days.  Impatient creditors in the U.S. case have filed motions for their own investigations and for the appointment of an examiner and for an independent trustee to replace Lehman’s remaining officers and directors.  Its UK insolvency administrators reported difficulty determining the UK companies’ assets, partly due to difficulties getting information from other asset custodians around the world, and that “it will take many years to finally resolve the inter-company and third-party claims.”

A review of Lehman’s cash management system also shows that numerous legal and regulatory regimes are now at play that may affect intercompany claims and, as a result, creditors’ ultimate recoveries.   The holding company that acted as the “central bank” is now subject to the U.S. Chapter 11 case, along with 16 subsidiaries; LBI is subject to a separate liquidation proceeding supervised by the Securities Investor Protection Corporation; LBIE and three other British entities are in a UK administration proceeding; other foreign subsidiaries are subject to insolvency proceedings in their own jurisdictions (for example, in Hong Kong, Australia, Singapore, Japan, The Netherlands, France and Germany); and various Lehman entities and funds are still “non-debtors,” not having yet filed a formal insolvency proceeding and thus continuing to be subject to whatever laws govern the entities and their various contracts. 

From an insolvency perspective, this means that a creditor or investor evaluating its recovery prospects must:

1. first determine which entity or entities it did business with, both directly and through guaranties, cross-collateralization, setoff and netting rights; then
2. determine which assets (including collateral) are available for recovery and which courts and regulators may have jurisdiction over those assets (including a possible stay or injunction prohibiting enforcement or foreclosure); then
3. file claims in the relevant insolvency proceedings prior to the applicable deadlines (subject to considering the risks of submitting to jurisdiction), exercise any voting and participation rights available to creditors (for example, attending creditors’ meetings and voting on a plan of reorganization), and possibly take other enforcement action (for example, a motion to modify any stay against foreclosure or other litigation); then
4. monitor the relevant insolvency proceedings, to determine the timing and amount of creditor recoveries.

The multiplicity of bankruptcy regimes now governing Lehman means that each Lehman entity is now considered a separate “bankruptcy estate” – i.e.,   a separate group of assets and creditors – and each is now vying with the other bankruptcy estates for a piece of the Lehman group’s remaining assets.    Intercompany claims are often the main vehicle through which these separate bankruptcy estates try to recover assets for themselves.  Anyone who has lived through other large corporate bankruptcies (e.g., Adelphia, Global Crossing, Refco) knows that intercompany litigation can be the most complex, intractable and even unresolvable feature of the insolvency proceeding.  Some cases feature creditors attempting to “substantively consolidate” all of the companies by collapsing all of the different bankruptcy estates into one, eliminating intercompany claims in the process, but other creditors naturally, and fiercely, resist.  Some creditors will of course benefit from corporate separateness by preserving their respective debtor-companies’ assets for themselves. 

Creditors and investors of the “asset-weak” companies try to reach through corporate boundaries by any and all means.   If they are unsuccessful, their recoveries can be much lower than their counterpart creditors at other entities in the corporate tree, in what is ostensibly the “same company.”  A typical pattern is that lenders and investors at one level (for example, stockholders and bondholders of the holding company) assert that they financed the operations of the subsidiaries and should recover accordingly; conversely, creditors of the subsidiaries assert that holding company creditors were aware of their “structural subordination” and have to live with the consequences. 

Hence, the (often furious) litigation that attends many complex corporate bankruptcies and is now gathering steam in the Lehman cases.   In addition to the multiple insolvency proceedings around the world, there are now securities class actions and criminal investigations, all of which will presumably take years to resolve.  One of the well-publicized complaints is from creditors of Lehman’s UK entities, who claim that several billion dollars was swept into Lehman’s U.S. accounts on the eve of its Chapter 11 filing.  These creditors are now faced with trying to claw back cash that once flowed easily within “Lehman Brothers” and is suddenly beyond their reach due to legal boundaries that became very real, and difficult to pierce, upon Lehman’s bankruptcy filing. 

This is one of the difficult lessons that is learned repeatedly in corporate bankruptcies but is especially potent for companies with global operations.   At a court hearing, one of Lehman’s lawyers explained its cash management system as “cash moves around with great velocity.”  This can be profitable for creditors in good times yet very dangerous in others.  Creditors should be aware of the benefits and risks of centralized cash management – specifically, of exactly which entities they have claims against, and where those entities’ cash and other assets are – so that they can understand and be prepared for the consequences in the event, “the music stops.” 

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By: Gordon F. Peery

Prior to September 15, 2008, portfolio managers placed thousands of trades with brokers at Lehman Brothers Inc. (“LBI”) in New York City.  These trades, many of which were subsequently transferred for settlement to LBI affiliates throughout the world, eventually failed to settle last month (and are referenced in settlement parlance as “trade fails”) as a result of the worldwide collapse of Lehman Brothers and the landmark civil proceedings that followed on at least three continents.  The circuitous routes taken by these trades prior to settlement failure and the legal and business implications along the way demonstrate the complexity of the global system of modern finance and the need for qualified legal counsel.

As of this time, two sets of authoritative statements have been issued with regard to certain trade fails involving LBI.

• SIPC Protocol and LBI Trustee Statement.   The Securities Investor Protection Corporation (“SIPC”), on September 26, 2008, published a protocol for closing certain open trades (“SIPC Protocol”).  The LBI bankruptcy trustee (the “LBI Trustee”) issued a related clarifying statement (“LBI Trustee Statement”).

• SIFMA RMBS Protocol.   The Securities Industry and Financial Markets Association (“SIFMA”), on October 9, 2008, published Protocol 08-02 for resolving certain outstanding agency mortgage-backed security trades with LBI (the “SIFMA RMBS Protocol”).

In light of the foregoing developments, the short and long term tasks for handling related Lehman trade fails are as follows:

1. Understand the relevant players, law and timing.  With the assistance of qualified legal counsel in the appropriate jurisdiction, the first step is to identify

   1. the relevant trades and the Lehman entity that is properly deemed to be the counterparty,
   2. the particular court/trustee/administrator that will have authority to resolve issues relating to the trades, and
   3. the time periods under the relevant protocols for securing rights and performing obligations.

Missing deadlines for filing claims in proceedings may result in the loss of important rights, including the right to recover losses.

2. Determine whether any contractual obligations are subject to a stay.  Counsel’s early efforts should focus on establishing a legal, contractual obligation that is enforceable in light of applicable insolvency proceedings.  Prime brokerage agreements often set forth remedies for trade fails and, so long as the transactions are not stayed by a Chapter 11 proceeding, stayed in a SIPC proceeding, or UK or other administration, contractual rights may be pursued with the advice of counsel and in accordance with applicable settlement protocols.

3. Interface with the relevant trustee or administrator.   Perhaps the most important step throughout the process is properly interfacing with the appropriate trustee or administrator in a timely manner.   In many cases the trustee, legal counsel representing the trustee—or both—will communicate important milestones, deadlines and, in some cases, settlement protocols.

More generally, with respect to trades involving non-LBI counterparties, affected parties would be well advised to reexamine their current forms of trade documentation.  Agreements should include terms that are consistent with current market practice, the law and the global arrangements relating to trade execution and settlement.   While the extraordinary efforts to resolve LBI trade fails seem likely to yield favorable solutions, many of these issues may arise in other situations today and in the future.

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By: Irene C. Freidel, Gregory N. Blase

A federal court in Delaware recently held that shareholders of Mortgage Electronic Registration Systems, Inc. (“MERS”) – some of the country’s largest mortgage lenders – could not be held liable for the alleged activities of MERS.  Trevino et al. v. Merscorp., Inc., et al., No. 1:07-cv-00568-JJF (D. Del.).   MERS was created in 1996 by the real estate finance industry to eliminate the need to prepare and record assignments when trading residential and commercial mortgage loans.  MERS’s chief business purpose is to simplify and streamline the manner in which mortgage ownership and servicing rights are originated, sold and tracked. Recently, in light of its visibility in connection with mortgage defaults and foreclosures, MERS and its shareholders have come under attack by plaintiffs’ class action lawyers.  The court’s decision resulted in the dismissal from the putative class action of MERS shareholders Citigroup, Inc., Countrywide Financial Corp., Fannie Mae, Freddie Mac, GMAC-RFC Holding Company, LLC, HSBC Finance Corporation, JPMorgan Chase & Co., Washington Mutual Bank, and Wells Fargo & Company (the “shareholder defendants”).

In their complaint, plaintiffs alleged that MERS overcharged them and a class of similarly situated individuals for costs arising out of proceedings to enforce mortgage instruments, including foreclosures.  Plaintiffs asserted that MERS’s alleged actions constituted breach of contract, unjust enrichment, and breach of the duty of good faith and fair dealing.

Plaintiffs sought to hold the shareholder defendants liable for the alleged actions of MERS through the theory of “piercing the corporate veil.”  Specifically, plaintiffs contended that because of its alleged “diminutive size and meager asset base,” MERS is undercapitalized and would be unable to pay on any judgment that plaintiffs and the putative class may eventually obtain.  Plaintiffs contended that these facts stated the basis for their request to pierce MERS’s corporate veil and to hold the shareholder defendants liable for MERS’s alleged wrongdoing.

The shareholder defendants moved to dismiss the complaint arguing, among other things, that there was no allegation that MERS was set up for the purpose of committing fraud or some other injustice to borrowers, that MERS was established for a legitimate business purpose, and that its shareholders – all competitors in the marketplace – could not be considered a “single functioning entity” for veil-piercing purposes.   The court agreed, finding in part, that plaintiffs had failed to allege an overall element of injustice.  The court noted that the plaintiffs’ only substantive factual allegation in support of their claim against the shareholders was that MERS was undercapitalized.  But the court held that a shortage of capital is not a per se reason to pierce the veil.  This is particularly the case where there is no allegation that the alleged undercapitalization was undertaken to defraud a corporation’s creditors.  The court noted plaintiffs’ acknowledgment that MERS was established for a legitimate business reason, i.e., to “create a secondary mortgage market, internally administer the buying and selling of mortgages, and to simplify the administration of home mortgages.” 

Finally, the court found that plaintiffs had failed to allege any unfairness sufficient to ignore MERS’s corporate form.  Specifically, while plaintiffs alleged that MERS was created to facilitate its shareholders’ business interests and to limit their liability, neither of these factors shows unfairness, unless the attempt to limit liability was undertaken in order to avoid responsibility for a specific tort or class of torts.The Trevino decision is significant because it spared MERS’s shareholders from potential exposure to consumer class actions on the now rejected theory of indirect liability.  MERS is integral to the successful functioning of the secondary mortgage market.  Plaintiffs’ discredited legal theory, if not rejected by the court, could have exposed MERS shareholders to liability for the actions of third party investors and servicers, causing further stress to the already embattled mortgage market.

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By: Gregory S. Wright

I. Introduction
In 2007, the subprime mortgage crisis triggered a wave of litigation and regulatory action involving not only the lenders that sold subprime mortgages, but also the issuers, underwriters, and other financial institutions that participated in the securitization of the mortgages and the sale of securities backed by the subprime loans.  The credit crisis of the last few months has exacerbated (and likely will continue to exacerbate) this wave of litigation and regulatory action, not only by increasing the number of claims, but also by expanding the universe of targets to include companies and individuals that were not directly involved in the sale or securitization of subprime loans.

Given this expanding crisis, many corporations (as well as their officers and directors) will be forced to incur substantial sums to defend such claims, to settle such claims, and/or to pay judgments.  In many cases, insured companies and their officers and directors should be entitled to coverage for such costs under their Directors’ and Officers’ (“D&O”) liability policies.  While this article focuses on D&O coverage, policyholders also should consider the potential for coverage under other policies, such as Errors and Omissions liability policies and Fiduciary liability policies.

It should be noted that the terms of D&O policies vary widely.  In addition, one should assume that insurers will assert all available defenses to such claims based on the specific policy language and facts at issue.  Given the potential for coverage, policyholders facing claims and investigations should carefully review their D&O policies and should take appropriate steps in order to maximize their potential insurance recoveries.

II. Credit Crisis Litigation and Investigations
The subprime mortgage crisis, and the ensuing credit crisis, has produced a wide array of claims, lawsuits, and government investigations.  Companies and individuals in a rapidly expanding list of industries have been impacted.  Many of the claims at issue target individuals who are commonly insured under D&O policies (e.g., individual directors and officers), as well as the target entity itself, and allege conduct that often potentially triggers coverage under D&O policies, such as alleged misstatements in public filings, negligent misrepresentations, and/or breaches of fiduciary duties.  Merely to illustrate, this wave of litigation and investigations includes the following types of current claims, all of which potentially may trigger coverage under D&O policies:

• Lawsuits by shareholders against lenders and certain directors and officers alleging (in part) that defendants made false and misleading statements to the public about subprime lending activities.
  
   
• Lawsuits by shareholders against investment banks and certain directors and officers alleging misstatements about the value of and risks associated with subprime-backed assets.
  
   
• Lawsuits by investors against financial institutions and certain directors and officers alleging that the defendants that sold them mortgage-backed securities misrepresented the risks associated with such securities.
  
   
• Class action lawsuits against failed banks, related holding companies, and related officers and directors, alleging that the defendants misled investors about the financial status of the bank, violated securities laws, committed fraud, made negligent misrepresentations, etc.
  
   
• Class action lawsuit on behalf of preferred shareholders of Fannie Mae and Lehman Brothers alleging false statements by named officers and directors in connection with the offerings.
  
   
• Class action lawsuits against companies not directly involved in the subprime area (such as Constellation Energy), as well as their directors and officers, alleging failure to make appropriate disclosures about exposures arising from credit problems of trading partners (e.g., Lehman Brothers).
  
   
• Class action lawsuits and regulatory investigations against companies concerning auction rate securities.   The lawsuits allege in general that the companies failed to make appropriate disclosures about the risks associated with auction rate securities.  Some (but not all) of the lawsuits name individual directors and officers.  While most of the lawsuits have been filed on behalf of the purchasers of the auction rate securities, at least one lawsuit was filed on behalf of shareholders of the entity (Merrill Lynch) that sold the auction rate securities to other investors.  See also M. King, SEC and FINRA Focusing on Individuals in Auction Rate Securities Investigation, available here.
  
   
• SEC investigations into possible market manipulation in connection with short selling in the securities of financial institutions.  See B. Ochs, Manipulation Tied to Short Selling a Top Enforcement Priority, available here.
  
   
• FBI and DOJ criminal investigations regarding accounting, disclosure, and corporate governance matters.  See M. Ricciuti, DOJ Opens Criminal Investigations under New Guidelines for Prosecuting Corporate Entities, available here.

III. Potential Coverage under D&O Policies
In general, D&O policies afford coverage for “Claims” against an “Insured” alleging “Wrongful Acts” that result in a covered “Loss.”  The availability of coverage turns on the definitions of such terms (which vary widely), other policy terms and conditions, and the nature of the specific allegations in the claim at issue.

Claim.   D&O policies generally afford coverage for “claims.”  All (or virtually all) D&O policies include “lawsuits” within the definition of “claim,” but coverage for regulatory or criminal investigations varies widely.  For example, certain D&O policies define “claim” to include SEC investigations commenced by the service of a subpoena on an insured person or criminal proceedings commenced by the return of an indictment, information, or similar document.  Other D&O policies cover a broader array of informal investigations, while other policies limit coverage to investigations commenced by a “formal order” of investigation.  In any event, given the broad array of policy language available in the market, insureds should not wait for lawsuits to be filed before analyzing the potential for coverage.

Entity Coverage.    In addition to covering claims against insured directors and officers, many D&O policies afford coverage for claims against the insured entity itself (for example, many D&O policies cover so-called “Securities Claims” filed against the insured entity, including class action securities lawsuits).   The inclusion of “entity coverage” in D&O policies often helps insurers and policyholders avoid disputes on how to allocate defense costs and/or settlement payments among covered individuals and the entity itself.

Loss.   The definition of “loss” in D&O policies varies widely.  For example, some policies expressly cover fines, penalties, multiplied damages, and punitive damages, when permitted by law.  Some D&O policies do not.  In addition, insurers and policyholders frequently litigate (and courts recently have reached conflicting opinions on) the availability of coverage for so-called “disgorgement,” “restitution,” and/or for losses paid pursuant to Section 11 of the Securities Act of 1933.  See, e.g., Bank of America Corp. v. SR International Business Ins. Co., 2007 WL 4480057 (N.C. Super. 2007) (holding that settlement of Section 11 claim may be covered under D&O policy).

Conduct Exclusions.   Insurers also may seek to rely on various exclusions in the relevant policy to deny coverage for subprime-related claims.  For example, insurers may seek to rely on so-called conduct exclusions, which bar coverage for certain claims relating to criminal or fraudulent activity or for claims alleging that the insured received a profit to which he or she was not legally entitled.  Again, it should be noted that the terms of these exclusions vary widely.  Some exclusions arguably bar coverage when the excluded conduct is merely alleged.  However, in most policies, the exclusions do not apply unless the insurer meets its burden of proving that the excluded conduct “in fact” occurred or unless the excluded conduct is established via a “final adjudication.”  When the policy at issue includes the “in fact” test or “final adjudication” test, insureds are often entitled to coverage for defense costs and/or settlements that are made without any finding or admission with respect to the excluded conduct.  In addition, many D&O policies contain severability provisions that prevent the insurer from imputing the knowledge or conduct of one insured to other insureds, which in effect preserves coverage for the “innocent insureds” and/or the company itself.

Defense Issues.   In many D&O policies, the insurer is not obligated to defend a claim, but rather is required to reimburse the policyholder’s defense costs.  Nevertheless, certain D&O policies state that the policyholder should not incur defense costs or settle a claim without the consent of the insurer.   In addition, certain D&O policies require the policyholder to obtain the insurer’s consent with respect to the selection of defense counsel (such consent not to be unreasonably withheld).  To avoid potential insurer defenses, policyholders may wish to consider taking steps to address any conditions in the policy related to defense and/or cooperation with the insurer.

Rescission Issues.   In response to claims alleging misleading statements in a public filing, insurers often attempt to rescind the policy at issue entirely to the extent the public filing at issue was attached to or incorporated by reference into the insured’s “application” for coverage.  State law on this defense varies widely, but most courts impose a high burden of proof on insurers to demonstrate (among other things) that the alleged misrepresentation was material and that the insurer in fact relied on the alleged misrepresentation when it decided to issue the policy.  In addition, many current D&O policies make coverage non-rescindable for certain types of claims or certain insureds.  Further, many D&O policies contain strict severability clauses that limit the insurer’s right to rescind to only those individuals that had specific knowledge of the misstated facts.

Renewal Issues.   As noted above, the terms of D&O policies vary widely.  Further, insureds and insurers frequently negotiate certain terms of coverage during the renewal process.  With proper planning, insureds potentially may obtain coverage-enhancing changes to standard policy forms that may be outcome-determinative when a claim is filed.  Insureds frequently retain outside coverage counsel to review their D&O policies and participate in this renewal process.

IV. Conclusion
D&O policies offer a potentially valuable resource for policyholders facing claims arising from the subprime crisis and related credit crisis.  Policyholders should take steps now to preserve their rights to coverage.

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By: Phillip L. Schulman, R. Bruce Allensworth, Andrew C. Glass, David D. Christensen

Through a spate of lawsuits, the plaintiffs’ class action bar has sought to articulate a novel theory of liability under the Real Estate Settlement Procedures Act (“RESPA”), 12 U.S.C. § 2601, et seq. Specifically, the plaintiffs’ bar has brought RESPA Section 8 claims against home builders and their affiliates who offer optional discounts on settlement costs if home buyers choose to use the affiliates’ services. In conflict with RESPA’s goal of lowering settlement costs, plaintiffs’ lawsuits challenge the ability of home builders, as well as of affiliated mortgage lenders, title insurance companies, and other settlement service providers, to offer meaningful discounts to consumers. Becoming the first federal appellate court to consider the issue, the U.S. Court of Appeals for the Eleventh Circuit recently rejected plaintiffs’ theory. See Spicer v. The Ryland Group, Inc., Appeal No. 07-15426, 2008 WL 4276909 (11th Cir. Sept. 16, 2008) (per curiam), aff’g 523 F. Supp. 2d 1356 (N.D. Ga. 2007).

Plaintiff Tanya Spicer sued The Ryland Group, Inc. (“Ryland”) and its affiliate Ryland Mortgage Company (“Ryland Mortgage”), alleging that defendants violated RESPA Section 8 through offering an optional settlement costs discount if Spicer chose to use Ryland Mortgage to finance the purchase of her home from Ryland. 523 F. Supp. 2d at 1358-59. Spicer attempted to articulate a theory of “economic coercion” in support of her claim. In particular, Spicer argued that because the amount of the discount allegedly was too great to pass up, she had “no viable economic option but to use the affiliated lender.” Id. at 1361.

RESPA Section 8 prohibits kickbacks in exchange for the referral of, and unearned fees received in connection with, real estate settlement services. The statute, however, provides a qualified exemption from Section 8 liability to affiliated business arrangements. Specifically, 12 U.S.C. § 2607(c)(4) provides that the referral of settlement services to an affiliated service provider is permitted if: (a) the existence of the affiliated business arrangement is disclosed to the person referred; (b) the person referred is not required to use any particular settlement service provider; and (c) the only thing of value that is received from the arrangement is the return on the ownership interest. Regulation X, promulgated by the Department of Housing and Urban Development to implement RESPA, permits affiliated service providers to offer “discounts or rebates to consumers for the purchase of multiple settlement services.” 24 C.F.R. § 3500.2. Such discounts do not constitute an impermissible “required use” if the discounts are “optional to the purchaser” and are “true discount[s] below the prices that are otherwise generally available, and must not be made up by higher costs elsewhere in the settlement process.”

Following the plain language of RESPA and Regulation X, the Spicer district court held that offering optional discounts on settlement costs if home buyers choose to use affiliates’ services does not violate RESPA or Regulation X. 523 F. Supp. 2d at 1362. The court specifically rejected Spicer’s claim that offering an optional settlement costs discount amounted to “economic coercion.” After briefing and oral argument, the Eleventh Circuit affirmed, adopting the district court opinion as “well-reasoned.” Spicer, 2008 WL 4276909, at *1.

The federal district court decisions to date have rejected the “economic coercion” theory of required use, and the Eleventh Circuit’s affirmation of the dismissal of the Spicer matter reinforces the consensus among federal courts that offering optional discounts on settlement costs if home buyers choose to use affiliates’ services does not violate RESPA. Changes to Regulation X’s definition of “required use” effective in January 2009, however, may alter the landscape for home builders and their affiliates.

Phillip L. Schulman, R. Bruce Allensworth, Andrew C. Glass, and David D. Christensen of K&L Gates LLP represented The Ryland Group, Inc. and Ryland Mortgage Company.

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By David T. Case

The evolving efforts of the U.S. Government to address the turmoil in the financial markets echo in many respects Government actions to address the “crisis” in the savings and loan industry in the 1980s. As a consequence, the litigation against the Government resulting from the regulatory reform of the savings and loan industry provides a useful template in the event that the current reforms cause the Government to breach promises of specific regulatory treatment. In particular, under the previous litigation, the Government has been held liable for breach of contract, and substantial damages have been awarded, including damages for lost profits.

Looking back to the 1980s, regulators were faced with the possibility of widespread failure by savings and loans, along with a corresponding threat to the deposit insurance funds and potentially enormous liquidation costs. Many early efforts to solve the savings and loan crisis resulted in contracts between savings and loans and the Government in which the Government promised specific treatment under pertinent regulations. The Federal Savings and Loan Insurance Corporation (“FSLIC”) entered into varying forms of such agreements, either as a means of directly avoiding seizure of failing institutions, or indirectly avoiding such seizures by encouraging healthy thrifts to acquire failing institutions.

Subsequent efforts to resolve the savings and loan crisis culminated in the passage and implementation of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), and in implementing the provisions of that law, the Government breached many of its earlier promises. These breaches caused a wave of claims against the Government, and one critical lesson from the tumult is that contracts with the Government for specific regulatory treatment are enforceable, and the Government will be liable for damages caused by its breach of contract. The U.S. Supreme Court has held that, where the Government entered into contracts with regulated financial institutions, promising to provide financial institutions with “particular regulatory treatment in exchange for their assumption of liabilities that threatened to produce claims against the Government as insurer,” the risk of regulatory change fell to the Government, even though “Congress subsequently changed the relevant law, and thereby barred the Government from specifically honoring its agreements.” United States v. Winstar, 518 U.S. 839, 843 (1996).

The application of these principles was recently affirmed in a case presenting a scenario remarkably reminiscent of current Government attempts to address the turmoil in the financial markets: First Federal Savings and Loan Association of Rochester v. United States, 76 Fed. Cl. 106 (2007), aff’d 2008 U.S. App. Lexis 17331 (Aug. 13, 2008). Four failing savings and loans were merged into First Federal, and the Government provided financial assistance to the institution, replaced senior management, selected members of the Board of Directors, and exercised substantial control over First Federal’s operations.

First Federal later claimed that the Government had breached its contract with First Federal by failing to honor its agreement to allow First Federal to operate at reduced capital levels. The contract had been agreed to between First Federal and FSLIC as part of a reorganization of First Federal, and the agreement was intended to permit the Association to return to financial health as an alternative to seizure, following a lengthy period of insolvency, and to save FSLIC the costs of liquidating the Association. Following this 1986 agreement, First Federal’s business prospered until 1989, when Congress passed FIRREA, nullifying all contracts between the FSLIC and thrift institutions to the extent that those contracts relaxed regulatory capital requirements for specific thrift institutions.

Finding liability against the Government, the court awarded First Federal $85 million in damages, primarily for lost profits, plus attorney’s fees and costs. The award was recently affirmed by the United States Court of Appeals for the Federal Circuit. First Federal, 2008 U.S. App. Lexis 17331 (Aug. 13, 2008).

First Federal provides a roadmap for claims that arise as a result of the Government’s breach of contract, and if a financial institution believes it has such a claim against the Government, counsel should be consulted to evaluate appropriate steps to preserve and perfect the claim.

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The United States Court of Appeals for the Second Circuit held that the National Bank Act (“NBA”) limits the ability of states to regulate tax preparers that facilitate tax refund anticipation loans (“RALs”) for national banks.  The decision in Pacific Capital Bank, N.A. v. Blumenthal is of particular interest to any federally regulated lender (national bank, federal savings association, or operating subsidiary of either) that relies on third party agents (including brokers) to source loans or other bank products.

At issue was a Connecticut statute that capped interest rates on RALs.  National banks were exempt from the law by its terms (and federal law would have preempted it for national banks anyway), but the Connecticut Attorney General concluded in a legal opinion that a tax preparer or other party that facilitated an RAL with an interest rate in excess of the statutory cap violated the statute, even if the lender was a national bank.

The court held that federal law preempted the interest rate limitation for facilitators of RALs made by national banks, at least in connection with RALs made through the arrangement at issue in the case, finding that “the natural effect” of enforcing the interest rate limits against facilitators that assist national banks offering RALs “would . . . be either to prevent a facilitator from assisting such national banks with respect to RALs or to cause it to refuse such assistance unless the national banks agreed to forgo their NBA-permitted rates and limit themselves to the lower rates specified by” the Connecticut law.   The court concluded that “[i]f a state statute subjects non-bank entities to punishment for acting as agents for national banks with respect to a particular NBA-authorized activity and thereby significantly interferes with national banks’ ability to carry on that activity, the state statute does not escape preemption on the theory that, on its face, it regulates only non-bank entities.”

The court’s reasoning could extend past the RAL context to other situations where states try to regulate parties that arrange loans for federally regulated lenders.   For example, this decision calls into question whether recently enacted state laws that prohibit mortgage brokers from arranging loans that do not meet certain underwriting standards could be applied to brokers when they are arranging loans for federally regulated lenders.

HUD/VA/GSE Developments

Moratorium on Risk-Based Premiums for FHA-Insured Loans
In July 2008, HUD shifted its mortgage insurance premium structure to a risk-based structure based on a combination of borrower credit scores and loan-to-value ratios.   In response to the FHA Modernization provisions of the Housing and Economic Recovery Act of 2008, however, HUD is now required to implement a one-year moratorium on its new risk-based premium structure.  HUD recently released Mortgagee Letter 2008-22, which, effective October 1, 2008, rescinds the Department’s risk-based premium guidance and sets forth new requirements for up-front and annual mortgage insurance premiums for FHA-insured loans.  The Mortgagee Letter also provides guidance with regard to the use of borrower credit scores to assess a borrower’s credit risk.  For instance, FHA has determined that borrowers with decision credit scores below 500 and with loan-to-value ratios at or above 90 percent are not eligible for FHA-insured mortgage financing.  Such a provision appears to be HUD’s attempt to salvage some parts of its now-rescinded risk-based premium insurance program. (LINK)  

Borrower Downpayment Requirement Increases for FHA-Insured Loans
Until the recent enactment of the Housing and Economic Recovery Act of 2008, FHA guidelines required borrowers to make a 3% cash investment in the transaction, which could include a downpayment and borrower-paid closing costs.   This requirement will change effective January 1, 2009, and HUD recently released Mortgagee Letter 2008-23 to provide guidance to mortgage lenders regarding these changes.  Notably, for all new FHA case number assignments on or after January 1, 2009, the Mortgagee Letter advises that a borrower must make a 3.5% cash downpayment, and closing costs may not be used to meet the minimum amount.  Moreover, given the 3.5% downpayment requirement, the appropriate loan-to-value ratio for all purchase-money mortgages will be 96.5%.  Thus, to determine the maximum mortgage amount for which FHA borrowers are eligible, lenders will be required to apply the 96.5% figure to the lesser of either (i) the appraiser’s estimate of value; or (ii) the contract sales price for the property (minus any required adjustments, such as seller concessions above 6% of the sales price). (LINK) 

Broker Advisors No Longer Permitted in HECM Transactions
The Housing and Economic Recovery Act of 2008 also enacted provisions affecting Home Equity Conversion Mortgages (“HECM”), which are FHA-insured reverse mortgage loans.   One such provision requires that all parties that participate in the origination of HECM loans must be approved by HUD. 

While this language itself does not appear to be groundbreaking, its effect is sure to change the way many HECM loans are currently originated - namely, with the assistance of non-approved advisors.   In response to the Housing and Economic Recovery Act of 2008’s HECM requirements, HUD recently issued Mortgagee Letter 2008-24, which effectively outlaws the use of non-FHA-approved advisors in connection with HECM transactions.  It does so by rescinding Mortgagee Letter 2008-14, which HUD issued in May 2008.  Beginning with case number assignments made on or after October 1, 2008, only FHA-approved mortgagees may participate and be compensated for the origination of HECM loans.  As a result, the use and compensation of “advisors” in connection with the origination of HECM loans may no longer be permissible. (LINK)

Freddie Mac Underscores Requirements Related to Quality Control Reviews
On September 4, 2008, Freddie Mac released an Industry Letter to its approved sellers and servicers as a reminder of Freddie Mac’s requirements related to post-funding quality control underwriting reviews.   Notably, the Industry Letter highlighted many of the timing requirements imposed on seller/servicers.  For instance, if a loan is selected for a post-funding quality control review, the seller/servicer must submit the requested loan file to Freddie Mac within 15 days of Freddie Mac’s request.  If Freddie Mac discovers any underwriting deficiencies with the loan, the seller/servicer has 30 days from the date of Freddie Mac’s request to take remedial action.  Similarly, if Freddie Mac requires repurchase of a loan following a post-funding quality control review, the seller/servicer must appeal the action or else remit the repurchase funds within 30 days from the date of Freddie Mac’s letter requiring repurchase.  Freddie Mac emphasizes in the Industry Letter that these requirements are not new ones.  Rather, given the unprecedented times in the mortgage market, Freddie Mac expects to increase its quality control efforts. (LINK)  

State Developments

Illinois Imposes Default and Foreclosure Reporting Requirements on Servicers
Many state regulators, such as those in New York and North Carolina, have begun imposing reporting requirements on mortgage servicers so that they can get a handle on the severity of loan delinquencies, defaults, and foreclosures, and perhaps an early warning before those borrowers get into trouble.   With little prior notice, Illinois regulators joined those states, announcing new biannual reporting obligations on loan servicers.  In addition to asking for statistical information about modifications, the reporting form asks servicers to provide narrative descriptions of such things as the servicers’ proactive loss mitigation steps, “including calls and mailings to borrowers" and "participation at community outreach events.”  The first of these reports is due this week.

• Default & Foreclosure Report - Filing Deadline: Oct. 1, 2008 
  
   
• Loan Servicer Questionnaire - Due: Sept. 30, 2008

Massachusetts Applies Community Investment Regulations to Mortgage Lenders and Brokers
Community-type reinvestment provisions are common fare for depository institutions, but that has not been true for non-depository lenders, such as mortgage lenders and brokers.   That has now changed in Massachusetts, where community investment regulations applicable to mortgage lenders and mortgage brokers became effective on September 5, 2008.  The regulations implement a new provision of that state’s licensing law, which was passed as part of the state’s response to the foreclosure crisis. 

The statute and implementing regulations subject Massachusetts mortgage lenders and brokers to standards that are very similar to those set forth in the federal Community Reinvestment Act of 1977 (“CRA”).   Mortgage lenders and mortgage brokers will be assessed on their record of meeting the mortgage credit needs of borrowers in Massachusetts, including low- and moderate-income neighborhoods and individuals.  The assessment will be based upon a lending test and a service test — but not an investment test — that are similar to those applicable to banks.  A licensee’s community investment rating will affect the procedures for it to obtain approvals of any applications, including license renewals, establishment or renewal of any branch, and mergers and acquisitions. 

The consequences of a poor record under the new regulations for a mortgage lender may be far greater than a poor CRA record for a bank.   A poor record could possibly result in non-renewal of a license, which would force a mortgage lender to cease lending operations in Massachusetts. (LINK)

While the federal government continues to struggle with the foreclosure crisis, states are adopting a variety of approaches to slow down foreclosures in their communities.  New Jersey is the latest to join the ranks of more than ten other jurisdictions that have enacted such laws during 2008, but the New Jersey law takes a novel approach by extending the introductory rate of an adjustable rate mortgage for 3 years. 

Effective September 15, 2008, AB 2780, the Save New Jersey Homes Act of 2008  applies to certain borrowers with adjustable rate mortgages who have received a foreclosure notice with respect to their principal residence and whose introductory rate or rate reset terms meet defined criteria. To be eligible for this three-year rate relief and the statutory suspension of foreclosure proceedings, the borrower must, among other things, certify that he or she does not have sufficient income to pay the monthly payments after the rate resets, and agree to repay all deferred interest at the time the mortgage is paid off. The Save New Jersey Homes Act of 2008 requires creditors to send written notices containing prescribed language and carries significant penalties for willful violations of its terms. (LINK)

State Foreclosure Prevention Working Group Issues Data Report #3
The State Foreclosure Prevention Working Group, a multi-state group made up of state attorneys general and state banking regulators, recently issued its third report on the performance of subprime mortgage servicing, calling the evidence “profoundly disappointing.” 

Over the past year, the Working Group has been collecting data from servicers on a monthly basis.   Their latest report finds:

• that the majority of seriously delinquent borrowers are not on track for any loss mitigation,
• the use of short sales is increasing while loan modifications are on the decline,
• 20% of loan modifications made in the past year are currently delinquent, and
• foreclosure rates remain high. 

According to the Working Group, “[s]ervicers appear to have reached the ‘low hanging fruit’ of subprime loans facing interest rate resets, while not developing effective approaches to address the bulk of subprime loans which are in default before interest rate resets.” This has led to property value declines and additional losses on mortgage loan foreclosures, according to the report.   Given the number of ARM loans facing reset over the next two years, the Working Group predicts another wave of preventable foreclosures.

With the exact terms of a federal bailout plan uncertain at the time of this writing, this report may fuel a more aggressive implementation of a foreclosure mitigation program at the federal level should a bailout plan be enacted.   A copy of the report is available here.

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By: Irene C. Freidel

On September 24, the Seventh Circuit Court of Appeals in Andrews v. Chevy Chase Ban, 2008 WL 4330761 (7th Cir. Sept. 24, 2008), joined two other federal appeals courts and the California Court of Appeals in holding that a class action may not be maintained for rescission of mortgage loans under Section 1635 of the Truth in Lending Act (“TILA”), 15 U.S.C. §§ 1601, et seq.  (See also McKenna v. First Horizon Home Loan Corp., 475 F.3d 418 (1st Cir. 2007); James v. Home Constr. Co. of Mobile, Inc., 627 F.2d 727 (5th Cir. 1980); LaLiberte v. Pacific Mercantile Bank, 53 Cal. Rptr. 3d 745 (Cal. Ct. App. 2007), cert. denied, 128 S. Ct. 393 (2007)).  The Andrews decision is likely to have an immediate impact on pending cases seeking class-wide TILA rescission against creditors and loan assignees both within the Seventh Circuit and elsewhere, as plaintiffs’ class action attorneys have placed this issue front and center in the debate over what remedies are properly available to borrowers who obtained high-risk mortgage loans.  Unquestionably, class-wide rescission of tens of thousands of mortgage loans would result in substantial liability to any entity against which a judgment is entered.

Over the last year, more than 40 class actions have been filed on behalf of thousands of borrowers in California federal courts seeking damages and class-wide rescission of pay-option adjustable rate mortgage loans.   These loans are at the core of the current mortgage crisis.  None of the courts handling these cases has yet to decide whether the classes should be certified or whether class rescission under TILA is appropriate. 

In support of its decision against a class-wide rescission remedy, the Andrews court noted, among other reasons, that rescission requires a complete “unwinding [of] the transaction in its entirety and thus requires returning the borrowers to the position they occupied prior to the loan agreement.”  When a consumer exercises the right to rescind, the lender’s security interest in the real property becomes void and the lender is obligated to take steps within 20 days after receipt of notice to reflect termination of the security interest.  The consumer will not be liable for, among other charges, finance charges; thus, the creditor must return any money or property given to anyone in connection with the transaction.  When the creditor has complied with these obligations, the consumer must then repay the loan proceeds to the creditor.  Thus, the court concluded that this “purely personal” and “highly individualized remedy” involves a “transactional unwinding” process that makes it “an extremely poor fit for the class-action mechanism.”

With the Andrews decision, the Seventh Circuit is now the third federal appeals court to reject class-wide rescission as a remedy available under TILA, making it more likely that courts in other jurisdictions, including California, will adopt this ruling.  For a more detailed discussion of the Andrews case, see here.

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By: Edward G. Eisert

On September 15, 2008, the Second Circuit Court of Appeals issued a Summary Order in the case brought by CSX Corporation (“CSX”) against The Children’s Investment Fund Management (UK) LLP and 3G Fund L.P. that affirmed the decision of the Southern District of New York not to enjoin the voting of the CSX shares acquired by the defendants in their proxy fight with CSX management.  Stating that an opinion would follow, the Second Circuit did not rule on the other issues of the case that are of great significance to the financial community — particularly the treatment of total return swaps (“TRSs”) under the Securities Exchange Act of 1934 (the “Exchange Act”).

The June 11 decision of the District Court found that through the undisclosed use of TRSs, the defendants had violated Section 13(d) of the Exchange Act and the rules thereunder and enjoined further violations thereof, dismissed all counterclaims, but held that it was “foreclosed” under controlling Second Circuit precedent from enjoining defendants from voting the shares they had acquired from the date of the violation to the trial date.

Thus, the decision of the District Court has called into question a basic expectation of the equity derivatives market:  that the long party to a TRS does not acquire beneficial ownership of the referenced securities under the TRS for purposes of Section 13(d), absent a supplemental arrangement outside of the TRS that provides a contractual right to vote or dispose of such securities.

The opinion of the Second Circuit is being anxiously awaited by the financial community, particularly in light of the current market turmoil.  For a detailed discussion of the decision of the District Court see the K&L Gates June 2008 Alert.

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