Mutual fund directors have been attacked before. For
example, in his 2002
letter to shareholders of Berkshire Hathaway, Berkshire chairman Warren
Buffett took a detour in an essay about corporate governance to express
concerns about mutual fund directors. He noted that mutual fund directors
effectively have only two "important duties"; to pick the fund manager and to
negotiate the manager's fee. The record of mutual fund managers pursuing either
goal has been "absolutely pathetic." The manager selection process for far too
many funds has become a "zombie-like process that makes a mockery of
Within months of Buffett's stinging criticisms, many
participants in the mutual fund industry were ensnared in the so-called "market timing"
scandal, in which it was alleged, among other things, that mutual funds
were permitting trading in their fund shares after market close. In the wake of
the market timing scandal, the mutual fund industry faced not only a great deal
of scrutiny but also a wave of enforcement actions.
At least according to a March 25, 2013 Wall Street
Journal article entitled "Fund Directors Are Feeling the Heat" (here),
mutual fund directors are attracting attention once again. The Journal article
was focused on the administrative proceedings that the SEC has filed against
eight former members of the board of directors overseeing several Morgan Keegan
mutual funds. The agency filed the administrative action, a copy of which can
be found here,
in December 2012. In its December 10, 2012 press
release accompanying the filing, the agency said that the directors had
"abdicated" their asset -pricing responsibilities.
The administrative proceeding relates to five Morgan
Keegan mutual funds whose portfolios contained below-investment grade debt
securities, some of which were backed with subprime mortgages. In its press
release about the proceeding, the agency claims that the funds "fraudulently
overstated the valuation of their securities as the housing market was on the
brink of financial crisis in 2007." The agency has previously charged the
funds' managers with fraud, and the Morgan Keegan itself agreed to pay $200
million to settle related charges.
The agency alleges that the directors delegated their
fair valuation responsibility to a valuation committee without providing
meaningful substantive guidance and made "no meaningful effort to learn how
fair values were being determined."
The Journal article reports that the parties to
the administrative proceeding are in settlement negotiations, but in the
meantime the proceeding is going forward. The Journal article notes that
the directors met 30 times in 2007, including 14 times in three months, and
received daily updates on the value of the five mutual funds they oversaw.
Regardless of how the administrative proceeding against
the former Morgan Keegan mutual fund directors ultimately plays out, the
proceeding is, according to the Journal article, "making waves"
across the mutual fund industry. According to a December
14, 2012 memorandum from the Debevoise & Plimpton law firm, the
administrative proceeding against the Morgan Keegan directors represents "a
stark warning to fund directors and all fund personnel charged with management
or oversight duties that they need to take their responsibilities for
overseeing fund management seriously, even with respect to the complex and
technical area of asset valuation." The action signals "the SEC's willingness
to charge senior officials for failing to ensure the fair valuation of
The SEC's decision to pursue an administrative action
against the fund directorsseems clearly calculated to send a message. The fact
that the agency filed the administrative proceeding against the directors after
it had concluded an enforcement action against the fund management company
itself does seem, as the Debevoise law firm said in its memo, that the
administrative proceeding was intended to serve as a "stark warning."
The SEC's action against the Morgan Keegan directors
unquestionably is noteworthy, but it is far from the first instance where allegations
have been raised against mutual fund directors in the wake of the financial
crisis. There were in fact a number of private securities class action lawsuits
filed against mutual funds after the subprime meltdown, and a number of these
suits included the funds' outside directors as named defendants.
For example, March 2008, investors in the Charles Schwab
YieldPlus Funds initiated
a securities suit alleging violations of the federal securities laws and
seeking damages; the defendants in that action included the funds' trustees.
The federal litigation ultimately settled for $200 million (with an additional
$35 million to settle separate but related state litigation). The consolidated
subprime-related securities class action litigation involving several
Oppenheimer mutual funds, and which also included the funds' trustees as named
defendants, ultimately settled for a total of $100 million, as discussed here.
Indeed, as discussed here, the Morgan
Keegan funds themselves were also involved in separate securities class action
litigation that included as named defendants the same individual outside
directors as were named in the SEC administrative proceeding. The separate
Morgan Keegan fund securities class action litigation ultimately was settled
for $62 million (refer here).
The SEC's administrative action against the Morgan Keegan
funds' outside directors not only has important implications in general about
mutual funds outside directors' accountability. It also has important
implications about the scope of their potential liability exposure. Together
with the possibility of private securities litigation, the possibility of an
aggressive SEC pursuing administrative actions or even enforcement proceedings
against the outside directors of mutual funds underscores the fact that serving
as a mutual fund director entails significant liability exposures.
The extent of the liability exposures in turn highlights
the importance for the outside directors to confirm that the mutual funds
maintain D&O liability insurance sufficient to ensure that the directors
can defend themselves against all claims that might arise against them. As the
circumstances surrounding the Morgan Keegan funds demonstrate, when adverse
developments lead to claims, numerous claims involving numerous parties can be
involved. This fact underscores the need to ensure that the mutual funds
maintain insurance limits of liability that are sufficient to respond in the
complex claims situations. Finally, the need to ensure that the sufficient
funds remain to protect the outside directors when multiple claims arise
underscores the need to makes sure that the insurance program is structured to
provide that a portion of the D&O insurance is dedicated solely to the
outside directors' protection.
Securities Suit Against U.S.-Listed Chinese
Company Settles: In 2010 and 2011, plaintiffs' lawyers rushed
to file securities suits in U.S. courts against Chinese companies with shares
listed on the U.S. securities exchanges. However, the suits have not proven to
be as remunerative as the plaintiffs' lawyers might have hoped. As I noted in an
earlier post, many of the cases that have settled have involved only very
A recent settlement in one of these suits might provide
modest grounds for encouragement for the plaintiffs' lawyers. On March 25,
2013, the parties to the securities class action lawsuit pending in the
Southern District of New York against Sinotech Energy Limited filed a
stipulation of settlement indicating that they had agreed to settle the case
for a total of $20 million. (The settlement does not include the company's
auditor, Ernst & Young Hua Ming LLP). The settlement is subject to court
approval. The parties' settlement stipulation can be found here.
Though this settlement is more substantial than the prior
settlements, it should be noted that Sinotech Energy's contribution to the
settlement is only $2 million. The remaining $18 million is coming from several
offering underwriter defendants who were also named as defendants in the
litigation. This outcome is in fact consistent with what many plaintiffs'
lawyers have told me about these cases, which is that while they hope to
recover from the company defendants, their real hope for recovery is based on
the attempt to try to recover from the outside professionals who helped the
companies to go public. (I am guessing that the reason that Ernst &
Young Hua Ming was not a party to this settlement may have something to do with
the $117 million that Ernst & Young agreed
to pay in the Ontario securities suit relating to Sino Forest; the
plaintiffs may be hoping they can use that prior settlement as a "price of
Whether or not the plaintiffs can succeed in recovering
from the outside advisors, they likely will have to set their expectations of
recoveries from the Chinese companies themselves at modest levels. It isn't
just that the Chinese companies have not contributed significantly to the
settlements so far; it is that apparently in many instances, the Chinese
companies are not even paying their own defense lawyers. As reflected in a
March 14, 2013 Reuters article entitled "Defense Attorneys in China
Securities Cases Look for an Exit" (here),
defense counsel in several of these cases involving U.S.-listed Chinese
companies are seeking to withdraw from the cases because their Chinese clients
are not paying them. It doesn't bode well for any eventual recovery for the
plaintiffs if the defendant company isn't bothering to pay its own lawyers.
Special thanks to a loyal reader for sending me a copy of
the Reuters article.
The M&A Litigation Problem: As
anyone following recent litigation trends knows, litigation relating to M&A
transaction has become a serious problem. If it is any consolation, the courts
are working on it, at least in Delaware, according to Vice Chancellor Donald
Parsons of the Delaware Chancery Court. In a forthcoming article entitled
"Docket Dividends: Growth in Shareholder Litigation Leads to Refinements in
Chancery Procedure" (here, Hat
Tip to the Delaware
Corporate and Commercial Litigation Blog), Parsons contends that the
Delaware Chancery Court is developing tools to address the concerns associate
with the M&A litigation.
According to Parsons, Delaware's courts are best
positioned to respond to this litigation, although, owing to the phenomenon of
multi-jurisdictions litigation, it is can't resolve all of the concerns.
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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