The following article first appeared in the November 2004 SCAS Alert:

Second Circuit Refuses to Block Alabama's WorldCom Suit
By Ted Allen, Managing Editor

More pension funds may pursue their securities claims in state court and opt out of federal class actions after an Alabama pension fund negotiated a $111 million settlement with WorldCom Inc.'s underwriters, some observers say. The underwriters settled after a federal appeals court refused to delay the pension fund's state lawsuit.

The U.S. Court of Appeals for the Second Circuit overturned U.S. District Judge Denise Cote's injunction that blocked the Retirement Systems of Alabama (RSA) from pursuing a state court lawsuit against WorldCom's former top officers, accounting firm and underwriters, who are also defendants in a federal class action in New York. Cote had ordered that the state court trial, set for Oct. 18, be delayed after the resolution of the federal lawsuit, which is to go to trial on Jan. 10. Most of WorldCom's bondholders and shareholders, led by the New York State Common Retirement Fund, are plaintiffs in the federal case.

On Aug. 25, the appeals court issued a preliminary order, allowing RSA to pursue its case in state court. A month later, Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. agreed to a $111 million settlement with RSA, thus avoiding trial in Alabama. Arthur Andersen LLP, WorldCom's former auditor, also joined the settlement.

"This shows why pension funds should bring their own cases in state court,'' J. Michael Rediker, a lawyer in Birmingham, Alabama, who represents RSA, told the SCAS Alert.

WorldCom, the second-largest U.S. long-distance phone company, collapsed into bankruptcy in July 2002 amid an $11 billion accounting scandal. Shareholders lost more than $200 billion in market value. The company emerged from bankruptcy as MCI Inc. in April.

"Significant" Decision
Calling the Second Circuit decision "really significant," Rediker said it upholds the right of pension funds to sue on their own in state court, without interference from the federal judiciary. The appeals court, in a full opinion issued Oct. 18, noted that no federal judge has the right to be "the first court to hold a trial on the merits."

Rediker cautioned that the ruling would not allow a state pension fund to assemble a rival class of investors or try to thwart a federal class settlement. "As long as a pension fund and its lawyers are not trying to carry water for anyone else and are not trying to steal the march on a [multidistrict litigation] case or grab from a limited settlement fund, then it's OK,'' he said.

Rediker said he was not surprised that the underwriters moved to settle the Alabama case after failing to delay the trial. He said the banks' lawyers didn't want to expose their witnesses to cross-examination in Alabama out of fear that it might hurt them in the federal trial. They were also concerned about the prospect of a billion-dollar verdict in Alabama, he said.

The Alabama pension fund is still pursuing claims against Bear Stearns Cos., which is not a defendant in the federal case. State court jury selection began Oct. 18 and testimony is scheduled to start Nov. 8, Rediker said. RSA is also suing former WorldCom CEO Bernard Ebbers and ex-Chief Financial Officer Scott Sullivan, but those claims have been delayed until the resolution of their criminal trials.

The investors in the federal class action have already negotiated a $2.65 billion settlement with Citigroup. They are represented by Bernstein Litowitz Berger & Grossman LLP of New York and Barrack Rodos & Bacine of Philadelphia.

Arguments Against Opting Out
Traditionally, few institutional investors have litigated their claims in state court. The practice has become more common in the past two years. Last year, pension funds in Ohio and California opted out of a federal class action against AOL Time Warner to bring state court claims.

Federal class counsel have argued that investor recoveries typically occur sooner and are more certain in federal court. Defense lawyers also have tried to discourage state litigation, preferring to negotiate a single federal class settlement that would cover all investors.

At an ISS conference in February, Jerome F. Birn Jr., a partner with Wilson Sonsini Goodrich & Rosati, said defense counsel are reluctant to settle with state plaintiffs before resolving a federal class action because that would set a minimum settlement amount for the federal claims. Conversely, if a company settles a federal class action first, it will have limited room to negotiate on state claims, because the federal plaintiffs' attorneys will often demand that no one else receive a more favorable settlement. Pursuing state court claims only adds to the complexity of settling shareholder claims over corporate restatements, Birn said. That task is already difficult, given the interests of prosecutors, who may pursue criminal charges and the demands of insurers that provide directors and officers' coverage.

Litigation History
The Alabama pension fund filed suit on July 15, 2002, two and a half months after the first securities class action was filed in federal court in New York. Like the federal plaintiffs, RSA sued WorldCom's underwriters over their handling of the company's $10.1 billion bond offering in May 2001. The investors contend that the banks should have noticed the discrepancies between WorldCom's actual expenses and reported expenses before underwriting the bond issue. The RSA suit also included claims against Bear Stearns over its underwriting of an October 2001 bond offering.

A multidistrict litigation panel ordered the federal suits consolidated before Judge Cote in New York, who certified the class. Cote issued a scheduling order, asking the state judges hearing investor cases in Alabama, Ohio and Illinois ensure that those cases would not interfere with the Jan. 10 federal trial. The Ohio and Illinois judges scheduled later trials, but Alabama Circuit Judge Charles Price set an Oct. 18 trial in the RSA case. After Price refused to delay that date, the underwriters asked Cote for help. In April, Cote ordered the Alabama court to delay its trial until 60 days after a verdict in the federal class suit. In her opinion, she said her "ability to control the schedule of this complex, multidistrict securities litigation will be hamstrung'' if the Alabama trial proceeded.

Appeals Court Rules
The Second Circuit disagreed, concluding that Cote exceeded her authority. While federal judges have the power under the "All Writs Act" to issue orders to protect their jurisdiction, that authority is limited by the Anti-Injunction Act, which bars federal courts from enjoining state courts, except when expressly authorized by Congress, "where necessary in aid of its jurisdiction, or to protect or effectuate its judgments," the court said.

The appeals court distinguished the Alabama case from its In Re Baldwin-United Corp. (1985) decision, which upheld an injunction under the All Writs Act. In that case, a federal judge enjoined a group of state attorneys general from suing in state court to challenge a proposed class settlement with a group of broker-dealers of annuities. The Baldwin-United court said the injunction was necessary because "the existence of multiple and harassing actions by the states could only serve to frustrate the district court's effort to craft a settlement." The Second Circuit said Baldwin-United did not apply because the WorldCom underwriters had not shown how the Alabama litigation would undermine an actual or impending settlement. The prospect that a state court case might cause delays in the federal class action was not sufficient to justify the injunction, the appeals court said.

The decision was a surprise to many observers, because the Second Circuit is regarded as protective of the prerogatives of federal judges to coordinate multidistrict cases, Rediker said, recalled the court's rulings in Agent Orange litigation.

While some observers may see this decision as a "retrenchment," Rediker said the ruling simply affirms the right of investors to pursue their own claims in state court.

While Rediker said he expects more state pension funds to take this route, they should resist the temptation to try to represent other shareholders. "Institutional investors should ask their lawyers: ‘who else do you want to represent?' "