Securities Litigation Update on the Options Backdating Probe

On May 30, 2006, American Tower Corporation became the fourth company to be named in a securities class action lawsuit connected with the options backdating probe. (As noted in this prior post on The D & O Diary, the three companies previously named in securities class action lawsuits related to options backdating are Vitesse Semiconductor, Comverse Technology, and United Health Group.) American Tower also reported that it had been named in a shareholders' derivative lawsuit in Massachusetts state court.

In an even more ominous development on the options backdating litigation front, on May 30, 2006, the plaintiffs' firm of Kahn Gauthier Swick LLC issued a press release announcing "the creation of the nation's first privately funded Independent Options Pricing Investigations Division," which reportedly was formed to invesitgate options backdating at U.S. companies. The press release names five companies the firm is currently investigating (Altera Corp., Brocade Communications, Broadcom Corp., Brooks Automation and CNet Networks), and urges shareholders of these companies to contact the firm "to discuss your legal rights." According to Kahn Gauthier's website, the firm was founded by tobacco litigation plaintiffs' attorney Wendall Gauthier.

Thompson Memo Update: In a prior post, the D & O Diary commented on the enormous burden the so-called Thompson Memo places on business organizations facing criminal investigations. Among other things, the firms can find themselves forced to withhold payment of their individual employees' attorneys' fees, or even to waive the attorney client privilege, in a bid for leniency in a criminal prosecution. The May 31, 2006 issue of USA Today carries a lengthy story discussing these issues in greater detail. Accompanying the article is a spiffy chart listing the 21 companies that have been forced to waive their attorney client privilege in connection with criminal investigations. The chart lists the wide variety of types of criminal matters in which the issue has arisen. According the WSJ.com law blog, the government's decision to indict the Milberg Weiss law firm has drawn together a variety of different organizations who object to the prosecutorial action of forcing firms to waive the privilege or cut off employees' attorneys' fees or face the death penalty of corporate criminal indictment. Among the groups joining together to voice their concern are the US Chamber of Commerce, corporate counsel groups and corporate defense lawyers.

Coming Soon to a Courtroom Near You?: You may have missed it over the long holiday weekend, but on Saturday, May 27, 2006, the Wall Street Journal carried an article (subscription required) entitled "Scandals Seem Bad Now? Just Wait," speculating on the corporate scandals to come now that the grandaddy of them all from the last wave of corporate scandals -- the Enron criminal prosecution -- has been to the jury. The article conjectures that the credit boom of the last few years will generate several waves of scandals, including issues arising from: "proprietary trading at investment banks"; "scandalously incompetent lending" -- the prediction is that future blow ups will "expose those in the hedge fund world and elsewhere who've taken on excessive risk in pursuit of quick returns"; securitized loans, such as collateralized debt obligations, which the article comments is "an area rich in conflicts of interests, hazy pricing, excessive leverage and opportunities for self-dealing." Other fruitful areas for "tomorrow's accounting outrages" include excessive executive compensation, hedge funds' excessive management fees, and dual-share stock structures that enable founders or insiders to maintain corporate control to the detriment of other shareholders.

Individuals' Settlement Contributions and Other Notes From Around the Web

Individual Settlement Contributions: When the Enron and WorldCom consolidated class action settlements were announced, much was made of the fact that individual directors and officers were compelled to contribute to those settlements out of their own assets without recourse to insurance or indemnity. This occasioned debate about whether the requirement for individuals' settlement contribution represented a trend or was simply an attibute of the massive fraud involved in those particular corporate scandals. The debate continues, but it has been little noted that there was at least one significant subsequent settlement that also included this feature of individuals' contributions out of their own funds without indemnity or insurance.

On January 12, 2006, Tenet Healthcare announced the settlement of the consolidated securities class action lawsuits and shareholders' derivative lititgation that had been filed against the company and six present or former directors and officers, among other defendants. The company said that the monetary settlement would consist of a payment of $215 million by the company and/or its D & O insurers. In addition, two individual defendants agreed to contribute an additional $1.5 million to the settlement out of their own funds -- Jeffrey Barbakow, Tenet's former chairman and chief executive agreed to contribute $1 million, and Thomas Mackey, Tenet's former chief operating officer, agreed to contribute $500,000. According to the Notice of Proposed Settlement sent to the class members regarding the settlement, "the sums contributed by [Barbakow and Mackey] shall not be reimbursed to them, by their insurance carriers or by Tenet or its agents." A Wall Street Journal article discussing this settlement, including the individuals' contributions, may be found here (via wsj.com, subscription required).

First-Ever Patriot Act Enforcement Action: On May 22, 2006, the SEC announced its first-ever enforcement action under the Patriot Act. The enforcement action was brought against broker-dealer Crowell, Weedon & Co. under the anti-money laundering provisions of the Patriot Act that requires broker-dealers to implement and document identity verification procedures for all new accounts. The SEC alleged that Crowell, Weedon's representatives were simply filing attestations that they had personal knowledge of each of then new account holders, rather than following the brokerage's specified procedure to search public databases and review government issued identification documents. Crowell, Weedon did not admit to violations but agreed to enter a cease and desist order.

While the enforcement action against Crowell, Weedon relied exclusively on the specific Patriot Act provisions relating to broker-dealers, the Act's anti-money laundering provisions generally apply to a very broad range of financial institutions and authorizes a broad range of sanctions for failure to comply with those provisions. Among other things, regulatory agencies are authorized to consider a financial insitution's record of combating money laundering when reviewing applications in connection with a merger or acquisition, and financial institutions are subject to civil and criminal penalties of up $1 million for money laundering violations. The SEC may have pursued Crowell, Weedon to make an example, but it is far likelier that the SEC, energized by Congress's March 2006 renewal of the Patriot Act, is newly motivated to add some enforcement teeth to the Act's money laundering provisions. The D & O Diary expects to see more Patriot Act enforecement actions against a broader range of financial institutions.

Options Backdating and D & O Insurance: As The D & O Diary noted in its May 11, 2006 post, the plaintiffs' class action lawyers have quick to try to capitalize on the growing options backdating scandal and have launched a number of securities class action lawsuits against companies caught up in the probe. This development is obviously of concern to directors and officers liability insurance carriers, and the May 24, 2006 issue of Business Insurance has an article entitled "Stock Option Probe Sparks D & O Concerns" (subscription required) discussing the possible impact of the options backdating story on the D & O insurance marketplace.

Talleyrand on Options Backdating: As the options backdating story has continued to unfold, some have questioned whether or not there is anything wrong with options backdating. For example, the wsj.com law blog has a May 23, 2006 video post containing a debate between a business school prof and a CNBC reporter on the topic. Options backdating is obviously not harmless -- the revelation of options backdating has already proven damaging to at least some of the companies caught up in the probe as they have had to restate their past financials to reflect their true compensation costs. But even beyond the restatement threat, there is a particular reason why the options backdating story has gained momentum in a way that stories about excecutives' use of corporate aircraft or gold-plated pensions have not. The peculiar feature of the options backdating scandal is captured in the following epigramatic statement of Talleyrand:

If a gentleman commits follies, if he keeps mistresses, if he treats his wife badly, even if he is guilty of serious injustices toward his friends, he will be blamed, no doubt, but if he is rich, powerful and intelligent, society will still treat him with indulgence. But if that man cheats at cards he will be immediately banished from decent society and never forgiven.

The whole point of options-based compensation is to align executives' financial interests with those of investors. Options-based compensation should subject executives to the same investment risk as investors. But back-dating options to ensure that executives gain in a way that investors cannot not only breaks the alignment between executives' interests and those of investors, it unfairly stacks the deck in the executives' favor. It is, in Talleyrand's memorable phrase, cheating at cards, which no one will ever forgive. The D & O Diary believes the options backdating story has legs and has a long way to run.

For more about Talleyrand and Options backdating, see this post.

Thompson Memo Redux: Due to a technological snafu, subscribers to The D & O Diary did not receive an email feed for my May 23, 2006 post commenting on the Thompson memo. (Since the syndication service is free, I am hardly in a position to complain.)

The Thompson Memo and its Discontents

The so-called "Thompson Memo," is an internal Department of Justice memorandum specifying the circumstances under which business organizations will be criminally prosecuted. The document places a great deal of emphasis on an organization's level of cooperation in the prosecutor's decision whether or not to prosecute the firm. The memo's onerous cooperation standards have been the highly criticized, most recently in the editorial (via wsj.com, subscription required) in the May 22, 2006 issue of the Wall Street Journal. The Journal condemns the government's decision to prosecute the Milberg Weiss law firm, saying the government "essentially held a gun to Milberg Weiss's head and threatened to indict unless the firm waived the attorney-client privilege and agreed to label its own partners criminals." The editorial asserts (with an ironic acknowledgement of the fact that it is downright odd for the Journal to be defending Milberg Weiss) that this is "a dangerous precedent that can -- and surely will-- be used against more honest business enterprises."

Just as insidious as government attempts to compel business organizations to waive the attorney-client privilege is the attempt to force companies to cut off their employees' attorneys fees. There is an extensive debate whether or not the government improperly pressured KPMG -- in connection with the allegations that KPMG sold fraudulent tax shelters -- to withhold individual employees' and partners' defense fees. (KPMG itself, seeking to avoid the death sentence of a criminal indictment, agreed to a $456 million deferred prosecution agreement). A May 19, 2006 post of the Corporate Crime Reporter attibutes the following to the Judge who heard argument in a pretrial hearing in the KPMG matter:

Isn’t it just perfectly obvious from a reading of the Thompson memorandum that it is the position of the United States Department of Justice that a company facing possible prosecution hurts its case for a favorable outcome by advancing defense costs to present and former employees, except where they are legally obligated to do so, and that the natural consequence of that is that some corporations in that position, in furtherance of their enlightened self-interest, will cut off defense costs for individuals, who in the fullness of time will be indicted, and thus be deprived to one degree or another of the means of mounting a defense against the indictment?

Other cases have presented this same question. In March 2006, a federal judge granted a three-month postponement of the criminal trial of five former executives of Enterasys Networks. According to defense lawyers' filings, government lawyers pressured the company to cut off legal fees to the defendants to weaken the employees' ability to fight the charges. A March 28, 2006 Wall Street Journal article (via wsj.com, subscription required) discussing the Enterasys Networks case also states that in their investigation of accounting fraud at HealthSouth, federal prosecutors informed the company that payment of fees to indicted executives would be viewed as a sign of noncooperation, according to defense lawyers. The article also reports that prosecutors encouraged Symbol Technologies to withhold fees from exectives charged in an alleged accounting fraud. (Symbol apparently was able to pay the fees after it convinced prosecutors that the company bylaws required it to do so.) An article in the Spring 2006 issue of The John Liner Review (subscription required) details the government's largely successful efforts in connection with the prosecution of two executives from Westar Energy to prevent the utility from advancing defense costs to the officers despite the company's bylaws clearly mandating advancement

An extensive April 17, 2006 New York Times article discussing the issue of individuals' attorneys' fees and corporate cooperation under the Thompson Memo can be found here. (Registration required.)

The cover page of the Thompson memo states that "[f]urther experience with these guidelines may lead to additional adjustments." The time for the additional adjustments is overdue.

Update: The options backdating story has grown beyond The D & O Diary's ability to keep up with it. Fortunately, wsj.com has set up a separate page devoted to options backdating, which it updating on a daily basis. The WSJ Law Blog has an interesting post examining the apparent turf battle between the EDNY and the SDNY in issuing subpoenas in the options backdating probe (current score: EDNY 7 subpoenas, SDNY 6).

AOL Time Warner Derivative Litigation Settlement: More to It Than Meets the Eye?

On May 12, 2006, the United States District Court for the Southern District of New York preliminarily approved the settlement of the consolidated derivative litigation filed on behalf of AOL Time Warner against 25 of the company's present and former directors and officers as well as other third party defendants. The various derivative lawsuits alledged that the defendants had breached their fiduciary duties in connection with the AOL/Time Warner merger. The settlement requires the company to undertake a wide variety of corporate governance reforms. A cursory reading of the settlement documents might also lead one to conclude that the settlement also involved a payment of $200 mm by the company's directors and officers insurance carriers in settlement of the derivative litigation, which would make this settlement by far the largest derivative settlement of which The D & O Diary is aware. However, a closer reading of the settlement documents reveals a more nuanced picture about the monetary portion of the settlement.

The Stipulation of Settlement filed with the Court states that on September 5, 2005, the derivative litigation plaintiffs made a policy limits demand under the Company's D & O Policy, and on September 7, 2005, "the Company was able to reach a settlement with its directors and officers insurance carriers pursuant to which the carriers will pay approximately $200 million in addional fund in connection with the securities and derivative claims listed in Exhibit D." Although the propinquity of the plaintiffs' demand and the insurers' settlment could be interpreted to suggest that the former caused the latter, that interpretation may be an illustration of the logical fallacy post hoc ergo propter hoc ("after this, therefore because of this"). By its own terms, the Stipulation states that the $200 mm payment under the insurance company settlement was in connection with both the derivative and the securities cases, not the derivative cases alone. Moreover, the referenced Exhibit D identifies 38 separate items of litigation in connection with which the insurance settlement had been made, including the SEC investigation, the DOJ investigation, the consolidated securities litigation, the ERISA litigation, and a very long list of many other items, including but definitely not limited to the derivative litigation.

Accordingly, it does not appear accurate to conclude that the $200 mm was paid just to settle the derivative litigation, or at least to settle the derivative litigation alone. Indeed, the parties never make that statement in any of the supporting documents. The documents state only that the "Derivative Actions were a substantial factor in the Company's ability to obtain an approximately $200 million insurance recovery." The settlement documents apparently are quite careful not to say how substantial of a factor the derivative actions were, or how substantial other factors (such as the $2.65 billion consolidated class action settlement) might have been.

The final settlement hearing in the consolidated derivative litigation is scheduled for June 28, 2006.

Options Backdating Probe Deepens

In the latest development in the evolving options backdating story, the May 19,2006 issue of the Wall Street Journal contains a report (via wsj.com, subscription required) that federal prosecutors have launched criminal probes of at least five companies involved in potential stock-option backdating abuses. The article reports that Caremark RX, SafeNet, Affiliated Computer Services, Vitesse Semiconductor and United Health Group have received subpoenas from the U.S. Attorney from the Southern District of New York. Caremark and SafeNet also reported that they received informal SEC inquiries. United Health group also announced that it had received a request from the Internal Revenue Service for documents from 2003 to the present relating to stock options and other compensation for company executives.

Affliliated Computer Services has publicly taken the position that its processes legally involved backdating. In a May 10, 2006 Form 12b-25 filing with the SEC, the company presented a detailed explanation of its stock option practices, explaining that options were granted as a specified date after all compensation committee members' consent were obtained, often after the specified grant date.

An increasing number of companies are announcing the formation of special litigation committees to look into options grant practices. For example, American Tower today announced that a special committee of independent directors will be conducting a review of the company's stock option practices. The company's announcement also reported that it had received a document request from the SEC.

The media are definitely taking this story and running with it, and it is not just the Wall Street Journal pursuing the story. On May 14, 2006, the St. Louis Post-Dispatch carried a story examining in great detail the stock options practices of Engineered Support Systems. (Most of Engineered Support's top management retired after the company was sold in January to DRS Technologies for nearly $2 billion.) Engineered Support is separately under SEC investigation in connection with alleged insider trading.

The May 19 Journal article also reported that five pension funds had filed a lawsuit against United Health Group on May 18, 2006 in federal Court in Minneapolis, seeking to prevent the company's two top executives from exercising about $1.5 billion in options.

wsj.com is now maintinaing a detailed, company-specific ledger of the key companies involved in the options probe and the status with respect to each company. The posting identifies 13 companies by name. (The list does not include American Tower or Engineered Support Systems.)

Update: On Monday May 22, 2006, the Wall Street Journal ran another front page article (via wsj.com, subscription required) naming five additional companies whose option grant dates and stock price graphs seem to suggest the existence of options backdating. The five additional companies were identified using the same analytical technique used to identify the companies named in the Journal's original March 16, 2006 article about options backdating. The May 22 article notes that the phenomenon of options backdating seems to have disappeared after mid-2002, following the enactment of the Sarbanes-Oxley Act.

FCPA: A 70's Revival?

A venerable statute from the 1970's is going through a 21st Century revival, and that is not good news for companies who are active in the global econonmy or for their directors, officers and employees.

The Foreign Corrupt Practices Act of 1977 (FCPA) is a federal law containing antibribery and accounting requirements. The antibribery provisions make it unlawful for any US person (and certain foreign issuers) to make a payment to a foreign official for the purpose of obtaining or retaining business for or with, or directing business to, any person. The FCPA (as amended) also added accounting requirements to the Securities and Exchange Act of 1934. These accounting provisions require publicly traded companies to maintain records that accurately and fairly represent the company's transactions and to have an adequate system of internal accounting controls. Under the antibribery provision, corporations are subject to fines of up to $2 mm, and officers, directors, employees and agents are subject to fines of up to $100,000 and up to five years' imprionment. However, as a result of the Sarbanes Oxley Act's enlargement of criminal penalties for willful violations of the '34 Act, violation of the FCPA's accounting requirements subject corporations to fines of up to $25 mm and individuals to fines of up to $5mm and up to 20 years' imprisonment.

The FCPA emerged from SEC investigations in the mid-1970's that led to over 400 US companies admitting having made questionable or illegal payments to foreign governments and officials. The Act was enacted to bring a halt to the bribery of foreign officials and to restore public confidence. The Act was amended in 1998 by the International Anti-Bribery Act of 1998 which as designed to implement the anti-bribery conventions of the Organization for Economic Co-operation and Development (OECD).

In recent years, there have been a rash of FCPA investigations involving US companies. Among the companies involved are Titan Corporation, Universal Corporation, and Immucor. In its most recent 10-Q, United Parcel Service disclosed a FCPA problem with one of its larges subsidiaries. On April 27, 2006, the SEC entered a cease-and-desist order against Oil States International in connection with improper payments by a consultant to the Venezuelan government oil company. Among other things, the SEC found that Oil States' "internal controls failed to ensure that [its subsidiary's] books and records accurately reflected the purpose and nature" of the improper payments.

An increasingly important factor in the escalating number of FCPA actions is the challenge of doing business in China. It is a business cliche these days that every company needs to have its China strategy. But a recent front page article in the Washington Post provides a lengthy examination of the problems US businesses face in China and concludes that "the lure of China profits combined with local corruption is tempting foreign companies and managers and bringing them into conflict with US anti-bribery laws." U.S. Companies find themselves "adopting Chinese-style tactics to secure sales, as they compete in a market in which Communist Party officials routinely control businesses, and purchasing agents consider kickbacks as part of their salary." These conditions have brought an increasing number of US companies into conflict with the requirements of the FCPA. Among US companies recently facing FCPA problems from their Chinese operations are Lucent Technologies, InVision Technologies, Schnitzer Steel Industries, and Diagnostic Products Corp.

The primary reason for the dramatic increase in the number of FCPA investigations and enforcement actions is the enactment of The Sarbanes-Oxley Act of 2002. Sarbanes-Oxley 's requirements that senior management assess their internal controls and verify their financial statements, including the requirement that companies identify any material weaknesses, are increasing management scrutiny and leading to the identification of more FCPA concerns. Companies are obligated to report potential FCPA violations to the company's chief legal officer, or the company's audit committee or full board. The increase in FCPA activity is a result of Sarbanes-Oxley's emphasis on top level management responsibility.

Another important factor for the surge in FCPA actions is The Thompson Memo , which identifies considerations that the Department of Justice will take into acccount in deciding whether or not to prosecute a corporation. A corporation may avoid prosecution altogether if, among other things, the corporation has self-reported and cooperated fully with the authorities. Companies are now choosing to voluntarily disclose FCPA violations in an attempt to receive favorable treatment and to mitigate what might otherwise be harsher penalties. The increased internal scrutiny triggered by Sarbanes Oxley combined with the rise in self reporting has resulted in a substantial increase in FCPA investigations and enforecement proceedings.

In addition to the possibility of criminal punishment, fines and penalties for violation of the FCPA itself, FCPA violations can give rise to follow-on civil litigation. For example, conduct that violates the FCPA may also give rise to to a private cause of action for treble damages under the Racketeering Influenced and Corrupt Organizations Act. For example an action might be brought under RICO by a competitor who alleges that the bribery caused the defendant to win a foreign contract.

Another possibility for follow-on civil lititation arises from Sarbanes-Oxley. While the FCPA imposes certain books-and-record and internal control requirements, Section 404 of Sarbanes Oxley creates disclsoure requirements about internal controls (including a requirement for management's annual "assessment" of internal controls), and Section 302 imposes requirements for CEOs and CFOs to certify their company's financial statements. Shareholders of companies facing FCPA difficulties may allege that prior internal control assessments or certifications were deceptive or misleading due to failure to dislose internal control or other weaknesses that failed to prevent or detect improper payments.

In the wake of Sarbanes Oxley, companies are devoting an increasing amount of effort to maintaining compliance programs, and as the business economy become progressively more global, FCPA compliance will be more important than ever.

A good resource from which to follow FCPA developments is the While Collar Crime Prof Blog.

Notes from Around the Web

Numbers Pressure: In an article in its May 2006 issue, CFO Magazine reports the results of a survey of finance executives. Among other things, the survey participants were asked:

Do you ever feel pressure from your superiors to use aggressive accounting techniques to make results appear more favorable?

11 percent of public company participants and 23 percent of private company participants answered this question "Yes, " meaning that they did feel pressure from superiors to use aggressive accounting. The article optimistically suggests that these results show that Sarbanes Oxley's certification requirements are having a positive impact, because of the superior public company survey results. The glass-is-half-empty interpretation, by contrast, is that even in this day of heightened corporate scrutiny, some companies CEOs are still straining to leverage accounting to make their numbers. The private company survey results are particularly dispiriting. Corporate boards may also want to note the survey finding that 44% of the respondents believe that their CEO does not know as much about finance as he or she should.

Perhaps the CEOs Should Buy This Book: In light of the CFO Magazine survey's results suggesting that some CEOs may lack of sufficient financial knowledge, it may be timely that the latest title in the "For Dummies" series is Sarbanes-Oxley for Dummies. Although the book favors simplicity of expression over depth of analysis, it is actually a pretty good resource. The book contains a number of useful appendices, including sample audit committee reports, etc., The book's list of the "Ten Ways to Avoid Getting Sued or Criminally Prosecuted" probably would justify the book's price for most corporate officials.

And Speaking of Sox...: An alert D & O Diary reader raises the interesting question whether the current wave of restatements arising from options backdating will lead to the first application of the forfeiture provisions of Section 304 of the Sarbanes-Oxley Act. Section 304 provides for officers' forfeiture of incentive/bonus compensation in the event of restatements. Give that any restatements for options backdating would be due to a requirement to accurately present the officers' compensation, there would be a certain symmetry in requiring the officers to return the compensation and stock profits to the company.

"Thompson Memo" Update: Readers as concerned as the D & O Diary is about the possibility that corporations seeking to avoid criminal prosecution by following the Thompson Memorandum might choose to terminate payment of employees' attorney's fees will want to read today's post on The CorporateCounselnet blog.

Earnings Guidance: Meet, Beat or Delete?

The classic statement on the pitfalls of providing optimistic earnings guidance appeared in Warren Buffett's Letter to Shareholders in the 2000 Berkshire Hathaway Annual Report (only an excerpt is reproduced here, but the entire Letter warrants reading, especially in light of subsequent events):

The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie [Munger, Berkshire's Vice Chairman] and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to "make the numbers." These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more "heroic." These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)

Buffett didn't exactly predict the wave of corporate scandals that came in the years immediately after he wrote these words, but he sure wasn't surprised by it. He was prescient even if he wasn't prophetic.

The recent corporate scandals have produced a changed atmosphere and led to changed corporate practices, including changed practices regarding earnings guidance . A 2006 survey conducted by the National Investor Relations Institute found that fewer and fewer companies are providing quarterly earnings and revenue guidance. Among the survey's findings is that the number of companies providing earnings guidance declined to 66% from the 71% in the prior year's survey (and down from 79% in the 2001 survey), and that only 56% of companies provide revenue guidance, down from 60% in the prior year. The survey also found that only 52% of companies were providing quarterly earnings guidance, down from 61% in the prior year. Among the prominent public companies that are declining to provide guidance are: Coca-Cola, AT&T, McDonald's, Google, General Motors , Ford, Motorola, and Campbell Soup. A Wall Street Journal article discussing the 2006 NIRI survey appears here (via wsj.com, subscription required).

A thoughtful discussion of the issues surrounding earnings guidance appeared (via economist.com, subsciption required) in a recent issue of The Economist magazine. Among other things, the article presents data from an academic study showing that companies that actively guided met or beat analysts' estimate more often that occasional or nonguiders, but that the active guiders grew more slowly than occasional or nonguiders. On the other hand, the article quoted a different academic study analyzing 76 companies that have ended quarterly guidance since 2000 and concluded that poor performers were more likely to reduce guidance, suggesting that "ending guidance can be a fig leaf for companies in trouble." (While that certainly can't be said of Berkshire or Google, it might be an accurate statement about GM or Ford).

One thing is for sure; more and more companies are deciding that the best way to avoid missing guidance is to avoid giving guidance. A detailed discussion of the pitfalls of earning guidance and analyst communications -- and how to avoid them -- can be found here.

Accounting Discipline

A May 4, 2006 article on CFO.com reports that a former accountant for a heart-disease research foundation was sentenced to two to six years in prison for embezzling more than $237,000 from the foundation. The accountant apparently used the embezzled funds to pay for the services of Lady Sage, a dominatrix. He also allegedly charged purchases at stores such as Leather Creations, Victoria's Secret and Wicked Naughty Accessories. His attorney told the press that "It's just one of those things. I guess it was a midlife crisis." Apparently that explanation did not satisfy the accountant's wife, who, according to the article, "was so angry that she refused to pay for [his] $10,000 bail."

Options Backdating Update

Well, it didn't take long for my prediction in yesterday's post -- that we would be hearing more about options backdating -- to be proven correct. Today's Wall Street Journal has a front page article (via wsj.com, subscription required) reporting that United Health Group has warned that it may need to restate three years of financials because of "significant deficiencies" in how the company administered options grants. The article also reports that Brooks Automation will restate seven years of financial statements because it believes it recognized too little compensation expense for options granted to executives. The article is accompanied by a graphic entitled "Key Companies in Options Probes" describing options inquiries at seven companies. The article also states that the SEC has "ramped up its investigation" of options grants and that the SEC is "now conducting reviews of about 20 companies."

Options Backdating: This Year's Model?

Every day seems to bring fresh media outrage on the topic of executive compensation. Yesteday, the New York Times ran this article questioning executives’ personal use of corporate aircraft. (See a useful discussion of this article on the CorporateCounsel.net blog).

Among the more interesting media analyses on the topic of executive compensation is the series of articles that the Wall Street Journal has published on the topic of options backdating. The first article (via wsj.com, subscription required) in the series, entitled "The Perfect Payday," appeared on March 18, 2006. The article reported an apparent (but statistically unlikely) pattern at several companies of options grants to senior executives dated just before a sharp rise in the share price, and at or near the bottom of a steep dip.

In a subsequent article (via wsj.com, subscription required) on May 6, 2006, the Journal reported that a number of the companies named in the original article have had (or will have) to restate prior year's financials as a result of options backdating. The restatements were required because the restating companies have to record "additional noncash charges," because accounting rules require companies to report an expense for grants of "in the money" options. The article also explained that companies that backdated options may face bills for unpaid income taxes because backdated options wouldn't qualify for compensation-related tax deductions that may have already been taken.

This recent media attention follows an SEC inquiry looking into alleged options backdating that has been proceeding since November 2004 and that according to some media reports has involved more than a dozen companies. The SEC investigation has resulted in Analog Devices agreeing to pay a civil money penalty of $3 million in November 2005 . In addition, three senior officers at Mercury Interactive resigned in November 2005 and the company was delisted from NASDAQ after the SEC investigation uncovered backdated options grants.

Perhaps inevitably following the front page publicity of the issue in the Journal , the securities class action lawsuits raising option backdating allegations have begun to arrive. Since the March 18 Journal article, three of the seven companies identified by name in the Journal series of articles have been named in separate securities class action lawsuits raising allegations pertaining to alleged options backdating. The three companies named so far are Comverse Technology, Vitesse Semiconductor and United Health Group. In addition to these purported shareholder class actions, United Heath Group has also been sued in a separate purported class action raising substantially similar allegations on behalf of United Health Group employees in connection with their 401(k) plan. A detailed discussion of Comverse Technology's recent woes, including separate shareholder derivative litigation that recently has been filed against the company in connection with these issues, appears at this post. (In addition to these three lawsuits, Mercury Interactive was named in an August 2005 securities class action complaint, but the complaint does not contain options backdating allegations.)

The alacrity with which the plaintiffs' lawyers have jumped on this issue makes me wonder if the plainitffs' bar will try to turn the options backdating story into"this year's model", along the lines of the successive litigation onslaughts we saw in the recent past following, for example, the bursting of the Internet bubble, the IPO laddering conflagration, the telecom industry collapse, the energy industry implosion, etc.

As the quotation below may suggest, the alleged practice of backdating options may not have been widespread. We can, however, be certain that we are going to be hearing a lot more from the media about executive compensation issues -- and I expect that we will also be hearing more about options backdating. Whether or not additional companies will be named in shareholder lawsuits raising options backdating allegations of course remains to be seen.

Quotation of Note:

In the May 6 Journal article, commenting on how widespread options backdating may be, David Aboody, an associate professior at the Anderson School of Management at UCLA, said "It's like stealing money. How many CEO's steal money from their company?"

Varying Averages for 2005 Securities Class Action Settlements

Each of the various published studies of the 2005 securities class actions has its own average settlement amount for 2005 securities class action settlements. The Cornerstone study reported an average 2005 securities class action settlement of $28.5 million, not including the WorldCom settlement. The NERA study reported an average settlement of $24 million, not including the WorldCom settlement. By contrast to these two reports, which are more or less in the same ballpark, the PricewaterhouseCoopers study reported an average settlement of $71.1mm, not including the WorldCom and Enron settlements.

The explanation for this difference can be found in the footnote 1 on page 18 of the PwC study, in which the authors state:

Settlement year is determined by the year the settlement is disclosed. Settlements listed for 2005 include some that were announced and/or preliminarily approved in 2005.

The PwC study's use of the date of the settlement's announcement contrasts with the NERA study's and the Cornerstone's study's use of the date of the settlement approval. Because the PwC study uses the announcement date, it has included within the 2005 settlements a number of very large settlements that were announced but not yet approved in 2005. These other settlements include the $1.1 billion Royal Ahold settlement (announced in November 2005), the $2.5 billion AOL Time Warner settlement (announced in April 2005, preliminarily approved in September 2005, but not finally approved until February 2006), and the McKesson $960 million settlement.

One of the PwC's study's authors has confirmed this analysis to me.