Thompson Memo Held Unconstitutional

On June 27, 2006, U.S. District Judge Lewis Kaplan held, in the KPMG tax shelter prosecution, that portions of the Thompson memo violate the constitutional rights of 16 former KMPG partners who are accused of participating in a fraudulent tax scheme. Judge Kaplan found that KPMG, seeking to show full compliance with the Thompson memo to avoid its own criminal prosecution, withheld advancement of attorneys’ fees from the individual defendants. The Judge said in his 83-page opinion that “KMPG refused to pay because the government held the proverbial gun at its head.” Judge Kaplan found that the government, through the Thompson memo and its own actions, violdated the defendants' right to due process guaranteed under the Fifth Amendment and their right to counsel guaranteed by the Sixth Amendment. The Judge declined to dismiss the indictments, holding rather that the individual defendants can pursue a civil action against KPMG seeking legal fees or that KPMG can decide on its own to advance the individuals' defense fees.

The Judge’s lengthy opinion is thoughtful and scholarly, and full of the language of liberty and individual rights. Among other things, the Judge’s opinion states that “[t]he imposition of economic punishment by prosecutors, before anyone has been found guilty of anything, is not a legitimate governmental interest – it is an abuse of power.”

While Judge Kaplan's ruling is unquestionably a significant event that will impact pending prosecutions across the country, the specific practical consequences outside the KPMG tax shelters case will remain to be seen. His ruling is based on a detailed record of the particular facts and circumstances of that specific case. In addition, as the opinion of a U.S. District Court Judge, the decision has persuasive but not precedential authority. Nevertheless, Judge Kaplan’s opinion is important and will have ramifications, and raises a host of potentially interesting questions in connection with the indictment of the Milberg Weiss law firm, among many other pending cases.

The wsj.com law blog's comments on Judge Kaplan's opinion can be found here. The wsj.com law blog's links to several major newspaper's stories and editorials about Judge Kaplan's opinion may be found here.

An interesting comment in the White Collar Crime Prof blog focusing on the legal duties of corporation's to advance defense costs and on the possible implications of Judge Kaplan's opinion for the D & O insurance industry can be found here.


The D & O Diary's prior posts on the Thompson Memo may be found here. The Wall Street Journal's (subscription required) article on the Milberg Weiss indictment may be found here.

Updates and Notes

Options Backdating Litigation Update: On June 19, 2006, the Kaplan Fox & Kilsheimer law firm initiated a new securities fraud class action lawsuit against Brooks Automation and several of its directors and officers, based on options backdating allegations. With the addition of the Brooks Automation lawsuit, the number of companies named in securities fraud class action lawsuits since the Wall Street Journal's (subscription required) March 18, 2006 article brought widespread attention to options backdating is now up to five. (The four companies previously named are Comverse Technology, United Health Group, Vitesse Semiconductor, and American Tower. The four prior lawsuits were discussed in this previous D & O Diary post.)

In addition to these five, the Consolidated Amended Complaint filed against Brocade Communications alleges misconduct (including backdating) in connection with hiring-related stock option grants. The Brocade Communications complaint was previously discussed in this D & O Diary post.

Thus, according to the D & O Diary’s tally, and counting the Brocade Communications lawsuit, the number of companies sued in securities fraud class action lawsuits based on allegations of improper stock options grant timing now stands at six. The D & O Diary is interested in hearing from readers who are aware of any other lawsuits that this post may have overlooked.

Update: An alert D & O Diary reader has referred me to the securities fraud lawsuit pending against Mercury Interactive. The initial D & O Diary post about options backdating referenced the case pending against Mercury Interactive. The initial securities complaint filed in August 2005 against Mercury Interactive did not emphasize the options backdating allegations, but subsequent events, including in particular, the November 2, 2005 resignation of the company's top three executives because of improper timing practices involving employee stock options, suggest that the centerpiece of the Consolidated Amended Complaint, when filed, will be the options backdating allegations. The Order granting leave to file the Amended Complaint was entered on June 7, 2006, and the Amended Complaint must be filed by the later of 60 days from the Order's date or 21 days after Mecury Interactive files its restated financial statements, but in no event more than 90 days from the Order. Clearly, the securities fraud class action filed against Mercury Interactive involves options backdating allegations, so that case should be "counted" -- which brings the total number of companies sued in securities fraud cases involving options timing to seven, rather than six as previously stated.

In addition to securities fraud class action lawsuits, companies involved in the options backdating investigations are also being named in shareholders' derivative lawsuits. Derivative lawsuits are harder to track because the plaintiffs’ lawyers do not always issue a press release when they file derivative lawsuits. The Weiss & Lurie law firm cast modesty aside in issuing its June 12, 2006 press release about the new shareholders’ derivative lawsuit it has filed against KLA-Tencor. The firm not only announced the new derivative lawsuit, but stated further that it has been retained to investigate possible additional lawsuits against 48 other companies (which companies it identifies in the press release by name and ticker symbol). Not to be outdone, the law firm of Stull, Stull & Brody, in announcing the shareholders' derivative action that it initiated against Computer Sciences Corporation, claims that it is investigating "over 50" companies.

Sarbanes-Oxley Whistleblower Update: As discussed in this prior D & O Diary post, one of the most important legacies of the Enron era may be the Sarbanes-Oxley Whistleblower protection. Two recent developments increase the likelihood that this statutory provision may become increasingly significant.

On June 9, 2006, in a closely watched case involving the first worker to win protection as a whistleblower under the Sarbanes-Oxley Act, the U.S. Department of Labor Administrative Review Board held that the whistleblower’s employer must reinstate him to the position he held before he was fired for criticizing the employer’s accounting practices. The decision may be found here. A Washington Post article (registration required) describing the decision can be found here.

Update: CFO.com has a June 28, 2006 post in which it reports that Cardinal Bancshares (the defendant in the whistleblower case described above) has "decided once again to refuse a Department of Labor judge's recommended order to reinstate the bank's former CFO....Instead, the bank holding company plans to wwait and see whether the DoL or [the plaintiff] brings an action against the company in U.S. District Court."

The U.S. Supreme Court’s June 22, 2006 decision in a Title VII case could further strengthen the Sarbanes-Oxley Act’s whistleblower protection. The Court held that any adverse actions by an employer – whether in or out of the workplace, and even if they fall short of dismissal or demotion – can be illegal if they would dissuade a “reasonable” employee from filing a discrimination complaint. According to the Wall Street Journal’s (subscription required) June 23, 2006 article discussing the decision, “[w]hile the ruling was in a discrimination complaint, employment lawyers said it is likely to influence retaliation cases of all sorts, including age bias and whistleblower claims under the Sarbanes Oxley law.”

Outside Director Liability: After outside directors of Enron and WorldCom were forced to contribute to the class action settlements out of their own assets without recourse to insurance or indemnity, a great debate ensued about whether the settlements represented a trend or were mere artifacts of unique cases. A scholarly overview of outside director liability by Michael Klausner of the Stanford Law School summarized in the June 2006 issue of the PLUS Journal (registration required) statistically examines the historical evidence and concludes that outside directors personal exposure is limited to “very narrow exceptions.” The Enron and WorldCom settlements may, according to Professor Klausner, be understood as the outcomes of “exceptional scenarios.” He further comments that to protect themselves from their remote exposure to liability, outside directors should be sure that their companies have a “state-of-the-art D & O Policy with appropriate severability, bankruptcy and other protections.”

Options Backdating and D & O Insurance (and Other Notes from Around the Web)

D & O insurers, concerned about lawsuits that have already have been filed and troubled by the possibility of an unknown number of lawsuits yet to come, have begun to respond to the options backdating investigation. On June 20, 2006, the Wall Street Journal (subscription required) carried an article entitled “Options Timing Raises Concern Among Insurers” discussing the response of the D & O insurance marketplace to the options backdating investigations. The D & O Diary’s author’s views on the topic of options backdating and D & O insurance may be found here, in an article entitled “The Options Backdating Scandal and the D & O Insurance Marketplace.” This article provides background on options backdating, and discusses the kinds of problems that companies involved in the investigations are facing. The article also examines the ways that the D & O marketplace is responding to the investigations and suggests practical steps for companies to take in connection with their purchase of D & O insurance under the circumstances.

Erik Lie’s website: As anyone who has followed the options backdating story knows, the existence of options backdating was first established by University of Iowa business school professor Erik Lie. Those interested in a deeper understanding of options backdating will want to visit Professor Lie’s website, which is remarkably readable and informative.

Options Springloading: As described in the June 11, 2006 post on The D & O Diary, “options springloading” refers to the practice of timing option grants to take place before expected good news. (Professor Lie’s website has a detailed discussion of options springloading). The June 20, 2006 issue of the Los Angeles Times (registration required) carried an interesting article quoting SEC Chairman Christopher Cox as saying that the SEC is “very interested” in options springloading and stating that the forthcoming SEC executive compensation rules will contain provisions designed to address options springloading.

Cost of Being Public: The cost of being public declined slightly in 2005, according to one law firm’s annual report of the costs associated with corporate governance reform. But while overall costs are declining, audit costs are continuing to climb, especially for the smallest companies. Foley & Lardner released its fourth annual study report on June 15, 2006. The firm prepared the study using a statistical analysis of proxy statement data and survey responses from 114 public companies.

The study found that the overall costs to a compnay of being public (including, among other things, legal fees, audit fees, D & O insurance, and board compensation) declined 16% for companies with under $1 billion in annual revenue and 6% for companies with revenues over $1 billion. But according to the firm’s analysis of 850 public companies’ proxy statements, audit fees increased 22% for S & P small cap companies, 6% for mid-cap companies, and 4% for S & P 500 companies. These data are somewhat inconsistent with some published reports suggesting that audit fees declined in 2005.

The study includes a number of other interesting findings, including the finding that the average cost of compliance for companies with under $ 1 billion in annual revenue has increased from approximately $1.1 million in 2001, the year prior to Sarbanes Oxley’s enactment, to approximately $2.9 million in 2005, an increase of 174%. Not too surprisingly, one in five survey respondents (21%) is considering going private as a result of corporate governance and public disclosure requirements.

While the law firm’s 2005 study report is interesting, and while the study is on solid ground where it relies on the statistical analysis of proxy statements of a large group of public companies, the study’s reliance on a limited set of survey data undermines some of its other conclusions. For example, of the 114 public company survey responses, only 33 came from companies with annual revenues of over $1 billion. These 33 companies reported an average D & O insurance premium that was 35% greater than the average D & O insurance premium reported in the 2004 study with respect to companies with revenues over $1 billion. This of course does not mean that premiums went up 35% between 2004 and 2005 for companies in that category. It does not even mean that the 33 companies in that category that responded to the 2005 survey saw their D & O insurance premium rise 35% between 2004 and 2005. It simply means that the companies in that category that responded to the 2005 survey reported premiums that averaged 35% higher than the different companies in that category that responded to the 2004 survey.

That is the problem with attempting to draw conclusions by comparing two small but different sets of data. Small differences can produce results that appear significant but that may be misleading, due to the different composition of the two sets of data. The study's authors may be faulted for not doing a reality check before issuing their report – any D & O insurance professional could have told them that D & O insurance premiums did not increase 35% between 2004 and 2005 for any category of companies.

But this shortcoming notwithstanding, the study report still merits attention, at least with respect to the portion of the report pertaining to statistical analysis of proxy data.

Another Variant on Options Backdating: Hiring-Related Stock Option Grants

The recent media coverage surrounding stock option practices primarily has been focused on options backdating, and to a lesser extent on options springloading. A new wave of media attention has drawn scrutiny of another options compensation practice – the allegedly improper use of stock options grants in connection with hiring and recruiting of new personnel.

The June 19, 2006 New York Times carries a detailed article examining stock option related hiring practices at Micrel. Micrel’s volatile stock prices created a situation where new hires’ stock option strike price (set on the date of hire) could differ significantly from the strike price on options granted to others whose date of hire was only a few days before or after. With the alleged blessing of its auditor, Deloitte & Touche, Micrel set the strike price on new hires’ stock option grants at the lowest point in the 30 days from when the new hires' stock option grant was approved. According to the Times article, the practice also had the blessing of Micrel’s outside counsel, Morrison & Foerster. Five years later, Deloitte “reversed its opinion and urged Micrel to restate its financial reports.” The company restated earnings downward and subsequently sued Deloitte claiming that the cost to Micrel from the flawed option plan could reach $58.6 million.

Deloitte is also the long standing auditor of Microsoft. According to a June 16, 2006 article in the Wall Street Journal, between 1992 and 1999, Microsoft “routinely issued options to new employees at the stock’s lowest closing price in the 30 days after they joined.”

Hiring-related stock options practices are at the heart of the securities class action lawsuit pending against Brocade Communications. The lawsuit was first filed against Brocade in May 2005. The Amended Complaint, filed April 14, 2006, alleges a variety of hiring related stock options practices designed to provide potential new hires the most potentially lucrative stock options grants. These practices allegedly took place because of the fierce competition for qualified job applicants during the tech bubble in the late 1990s. The hiring practices allegedly included giving new hires false start dates or backdating offer letters or even stock option grant dates to give new employees the advantage of lower stock option strike prices; and signing a new hire on as a current employee and then immediately placing him or her on a leave of absence (even thought the employee was still working at another company) so that Brocade could grant the new employee options at the earliest possible date and the lowest possible exercise price. The Amended Complaint alleges that these and other practices resulted in a misrepresentation of Brocade’s actual compensation expense and true financial condition. After an internal investigation, Brocade restated its financials, and, according to Brocade's 1Q06 10-Q subsequently offered to enter a settlement with the SEC. The plaintiffs have sued not only Brocade, and its directors and officers (including Larry Sonsini of the Wilson, Sonsini Goodrich and Rosati firm), and Brocade’s auditors, KMPG.

These hiring related stock options grants are in a different category from the options grants involved in the options backdating investigation – most of the options grants at the center of the options backdating investigation involve options that company officials granted themselves, as opposed to new hires. While the self-dealing allegedly involved in the options backdating investigation seems more inherently objectionable, the class action lawsuit and the SEC investigation involving Brocade shows that questions associated with hiring-related options grants can still cause companies a lot of problems. The lawsuits against the Micrel’s and Brocade’s auditors suggests the possibility that problems surrounding stock option grants could ensnare a wide variety of professionals, not merely the company officials involved in the stock options grants. The more interesting question is how potentially widespread the problems from hiring-related options grants may be. Given the popularity of stock option related compensation practices in the 1990s and early part of this decade, the problems arising from hiring-related options practices could prove to be even more widespread than the options backdating practices that have dominated the recent media coverage.

"Dozens" of Options Backdating Lawsuits Coming?

Earlier this week several publications carried reports that pension funds in the United States, Europe and Australia had retained the Lerach Coughlin law firm to sue “dozens of companies” over the timing of stock options grants to their top executives. A June 13, 2006 article in the San Jose Mercury quoted Lerach Coughlin partner Darren Robbins as stating that the pension funds are “completely beside themselves and outraged over the self-dealing that has gone on.” A June 14, 2006 article in Red Herring quotes Robbins as saying that the pension funds seek to terminate jobs of executives who diverted assets to their own pockets; the replacement of boards who permitted backdating; and the substitution of shareholder-nominated directors. The pension funds will also seek to “recover funds that were diverted from the corporate till.” In addition, he also said that the pension funds will seek recovery of damages, which, he estimates, “total in the billions of dollars.” The Red Herring article states that Robbins “has been directed to take action in 34 cases from 350 to 400 pension funds.” Five companies are identified by name in the article: American Tower, Mercury Interactive, McAfee, Juniper Networks, and United Health Group. The article is unclear whether the actions that Robbins has or will file are or will be in the form of shareholders' derivative actions (which would be consistent with the stated goal of seeking management and board reform) or of a securities fraud action for damages (which would be consistent with the stated goal of recovery alleged shareholder losses).

The D & O Diary will update this post as further information about these alleged pension fund lawsuit becomes available.

Statutes of Limitations Defenses?: One interesting question that any actions for damages under the federal securities laws will present is whether the statute of limitations bars some or all of plaintiffs’ claims. In many instances, the alleged options backdating goes back into the 1990s. For example, according to the April 17, 2006 Wall Street Journal article (subscription required) discussing questions surrounding options grants at United Health Group, the specifc grants that are under investigation took place between 1994 and 2002. Section 804 of the Sarbanes-Oxley Act of 2002 extended the statute of limitations for federal securities fraud actions at the earlier of two years after discovery of “facts constituting the violation” or “five years after such violation.” (Previously, the limitations periods had been one year and three years, respectively). The Sarbanes-Oxley Act's statute of limitations period raises a number of interesting questions: does it apply retroactively to options grants that took place before it was enacted in 2002, or does the shorter limitations period apply? Even if the longer period does apply, does the longer limitations period bar claims based on grants that took place more that five years ago? Or are the options backdating practices (and the alleged misreporting of the practices and accompanying accounting and tax mispresentations) part of a continuing course of conduct that brings the “violation” within the five year period? What is the “violation” that triggers the running of the statute? None of these questions are clear, but if plaintiffs’ lawyers are as committed to pursuing these actions as they claim, we will be hearing more on these issues as the cases go forward.

The D & O Diary is interested hearing readers’ comments on these statute of limitations questions.

First Options Backdating; Now Options Springloading?

In the last couple of months, there has been widespread media coverage (including several prior posts on The D & O Diary) discussing the growing investigation into options backdating. New allegations have surfaced that may evidence options “springloading.”

Options backdating involves retroactively dating the grant and exercise price of an options issue to a time preceding a rally in the price of the underlying shares, which maximizes the profits for the grant recipients. Options springloading, according to this June 7, 2006 Reuters article, involves looking forward to set the grant date and exercise price ahead of the release of positive news expected to raise share values, also boosting option profits.

Analog Devices Inc.'s November 15, 2005 tentative settlement with the SEC regarding the company's stock option practices involve allegations of practices that, although not using the term "options springloading," present the circumstances that phrase describes. The company's announcement stated that the settlement addressed

ADI's disclosure regarding grants of options to employees and directors prior to the release of favorable financial results....The SEC settlement would conclude that ADI should have made disclosures in its proxy filings to the effect that ADI priced these stock options prior to releasing favorable financial results.

Under the settlement Analog Devices agreed to pay a civil money penalty of $3 million, and certain of the grants to officers and directors were repriced.

Options springloading may be involved in the circumstances described in a June 9, 2006 New York Times article about options practices at Cyberonics. According to the article, the company’s Board approved stock option grants for top executives one evening in June 2004, a few hours after the company received positive news about the regulatory prospects for a promising product. When trading began the next day, Cyberonics share price soared, along with the value of the options. The option grant gave the Company’s chairman and CEO instant paper profits of $2.3 million, and lesser amounts of paper profits for the other two executives who received options in the grant. The company has publicly challenged the notion that there was anything wrong with the grant, saying that the options grant was immediately reported, and noting that none of the grant recipients has yet exercised any of options. The securities analyst whose recent report first questioned the Cyberonics option grant noted that while the grant did not involve options backdating, “the effect is exactly the same.” The analyst also noted that options are supposed to align executives’ financial interests with those of investors, but because these options were granted before investors were able to trade on the good news, the grant operated as a reward rather than an incentive. He also contends that because the options were priced below the market value fully loaded for the good news that was known to the company when the grant was made, the grant should have been counted as compensation in the quarter in which the grant was made.

The Reuters article cited above also contained a report that the SEC is looking at whether auditors have culpability in connection with the options backdating investigation. According to the article, the SEC is looking into whether auditors knew about the questionable practices and whether the auditors may have signed off on improper options backdating and springloading.

Article Plug: The D & O Diary recommends the recent law review article by Sean Fitzpatrick appearing in the Fordham Law Review. This article, entitled “The Small Laws: Eliot Spitzer and the Way to Insurance Market Reform,” argues that while Eliot Spitzer’s campaign against contingent commissions purportedly sought to eliminate anticompetitive behavior in the insurance brokerage industry, the ironic effect of Spitzer’s efforts is that smaller brokers may be harmed, as a result of which there may be further consolidation in the insurance broker industry, resulting in less rather than more competition. The article's author recommends simpler, less draconian solutions for reform. The article may be found here.

Weak Signal, Dropped Call: The Vonage IPO Securities Litigation

Vonage Holdings Corp.’s May 24, 2006 IPO raised hundreds of millions of dollars of capital. It has also generated extensive negative press, as exemplified by the June 3, 2006 front-page article (subscription required) in the Wall Street Journal entitled “How Vonage’s IPO Stumbled.” To add injury to insult, the company, several of its directors and officers, and its offering underwriters have been sued in a purported securities class action lawsuit filed in United States District Court in New Jersey. The lawsuit was filed on June 2, 2006, only ten days after Vonage’s debut (which undoubtedly is the shortest interval between IPO and lawsuit since the Refco fiasco). The lawsuit (and indeed much of the adverse publicity) is focused on the somewhat unique Directed Share Program by which Vonage pre-sold 13.5 million of the offering shares to its own customers. The Complaint accuses the defendants of a number of errors or violations in connection with the Directed Share Program.

There are several interesting things about the Vonage IPO lawsuit. The first is that the lead law firm is not one of the usual plaintiff’s class action securities firms, but is the Motley Rice firm, best known for its prominence in asbestos and tobacco litigation. Perhaps the Milberg Weiss firm’s woes are encouraging opportunistic competition. Indeed, another law firm on the Complaint, Kahn Gauthier Swick, is also best known for its attorneys' prior involvement with tobacco litigation, and was the subject of a prior D & O Diary post for the firm’s activities in connection with options backdating investigations.

Another interesting thing about the Vonage IPO securities lawsuit is that even though the Complaint’s grievances center on the alleged malfunctioning of the Directed Share Program, the purported class on whose behalf the lawsuit supposedly is brought is not limited just to the Vonage Customers who participated in the Directed Share Program, but purports to include all investors who purchased shares in the offering. The implication seems to be that all IPO investors feel the pain from the alleged Customers’ Directed Share Program malfunction.

The third and most interesting thing about the Vonage IPO Securities lawsuit is its reliance on the defendants’ alleged violation of NASD Rule 2310, the so-called “suitability” rule. The rule requires anyone recommending a security to “have reasonable grounds for believing that the recommendation is suitable” for the customer based on the customer’s “other security holdings…financial situation and need.” The Company defendants are alleged to have violated Rule 2310 because they supposedly allowed (encouraged) its customers to purchase shares regardless of suitability. This alleged violation is stretched to the Offering Underwriters, because they allegedly were responsible for ensuring that Vonage complied with NASD Rule 2310.

While the seasoned tort lawyers who filed the Vonage securities lawsuit score points for creativity in their foray into the securities arena, their overall theory (at least to the extent it relies on NASD Rule 2310) strikes The D & O Diary as ultimately deficient on several grounds. Even if the defendants violated NASD Rule 2310, the aggrieved persons' remedies are under the NASD Rules themselves (presumably, some form of arbitration or even some kind of NASD disciplinary action), not an action for damages under the securities laws. There is no separate private right of action for damages under the securities laws for NASD Rules violations, and there is to the knowledge of The D & O Diary no authority to support the notion that NASD Rule 2310 has been incorporated as a substantive standard under the federal securities laws, violation of which gives rise to a claim for damages.

The ultimate deficiency with the plaintiffs' attempt to bootstrap an alleged violation of NASD Rule 2310 into a damages claim under the federal securities laws is that, even if there were a violation of NASD Rule 2310, the alleged violation is still missing the indispensable element to support a securities action. That is, what the securities laws protect against is misrepresentations or omissions. A violation of NASD Rule 2310, while arguably grievous, does not establish the existence of a misrepresentation or omission.

Setting aside the merits of the lawsuit, there are the merits of the IPO itself to be taken into account. The risk factors in Vonage’s Prospectus make for some interesting reading. Not only has the company consistently incurred losses since its inception (with an accumulated deficit through March 31, 2006 of $467.4 million), but its service prices “are lower than those of many competitors for comparable services,” and the Company anticipates that “prices will continue to decrease.” Most interestingly, the Company’s founder, Chairman and “Chief Strategist,” is Jeffrey A. Citron, whose prior association with Datek Online resulted in his paying $22.5 million in civil penalties, “among the largest fines ever collected by the SEC against individuals,” according to Vonage’s Prospectus.

So cue the whimsical Vonage jingle tune, and just recall what Vonage itself says in its ads about the kinds of things people do.

Marginal Note: An alert D & O Diary reader points out that in February 2006, Motley Rice opened an Atlanta office and started a securities litigation practice by luring four securities class action attorneys from the Chitwood Harley Harnes firm. Chitwood Harley Harnes promptly sued the four lawyers and their new firm.

Notes from Around the Web

FLSA "Explosion": The June 5, 2006 issue of the Wall Street Journal has an article (subscription required) commenting on the "explosion" in cases under the Fair Labor Standards Act (FLSA). The article also contains statistics showing the number of FLSA actions increased four-fold between 2000 and 2005. EPL insurers have been struggling to find the appropriate marketplace response to this increased risk. The National Underwriter recently carried an article (subscription required) describing wage-hour claims as "the next frontier" for employment practices liability insurance (EPL) carriers. To date, the extent of available coverage for this type of claim seems to be restricted to sublimited defense cost coverage, available from only a few carriers.

Enron Trial Redux: In case you missed it over the weekend, the June 4, 2006 issue of the New York Times carried a lengthy article detailing the prosecutor's development of the legal strategy used in the criminal trial against Kenneth Lay. The Times article has generated much commentary, not all of it flattering to the prosecutors. Perhaps most notable are the comments of Professor Larry Ribstein in his Ideoblog post discussing the Times article. Among other things, Professor Ribstein comments:

Many people no doubt will get a warm feeling from the job our government servants have done in finally nailing the evil Lay. But as I said at the beginning, there’s an alternative narrative. The prosecutors were out to get Lay, who had already been convicted by public opinion just for being associated so closely with Enron, which of course journalists, filmmakers and other shapers of public opinion had already elevated into the symbol of whatever it was that went pop at the end of the big boom.

The WSJ.com lawblog also has a commentary on the Times article and Professor Ribstein's post. The WSJ.com lawblog post has attracted some interesting responses, which are reproduced following the WSJ.com lawblog post.

Class Action Internet Sites: Lies, Damned Lies and Forward Looking Statements, the blog written by plaintiffs’ lawyer Adam Savett, has a very useful post. that contains links to separate case-specific Internet resources devoted to the major securities class action cases, including the Enron, WorldCom and IPO Laddering cases, among others. Find the post here.

Fannie Mae Settlement: The CorporateCounsel.net blog has a thoughtful June 5, 2006 post with perceptive commentary on the "Lessons on the Fannie Mae Settlement." The author’s comments contain some interesting observations about corporate governance and board functioning. Find the post here.

Category: Tales from the Fringe, Subcategory: "Oogabooga": For those of you who have always wondered what the legal consequences would be from the inadvertent inclusion of the word "oogabooga" in an Australian tribunal’s ruling on a Burmese refugee’s asylum application (I am not making this up), you will want to look here. We will have to wait for another day to find out the consequences of the intentional use of the word "oogabooga."

The Sarbanes-Oxley Whistleblower Provisions: Unfolding Ramifications

Now that we have the criminal verdicts in the Enron criminal trial, it may be time to check in on one of the key legal reforms to arise from the Enron scandal. Among the key provisions that Congress included in the Sarbanes-Oxley Act was the so-called whistleblower provision, a tribute to the role of whistleblower Sherron Watkins in the Enron scandal. Section 806 of the Sarbanes-Oxley Act was included to encourage employees to blow the whistle on corporate wrongdoing by shielding them from retaliation. The law applies to all publicly traded companies and carries both civil and criminal remedies.

When the Department of Labor Occupational Safety Health Administration released the regulations implementing Section 806, some commentators speculated that the whistleblower laws and regulations "may well have as much effect on business practices, in the twenty-first century, as did civil rights laws in the twentieth." But three years' experience under the laws suggest that the reality -- at least so far -- is falling short of these predctions.

According to a recent Washington Post article, of the approximately 750 whistleblower complaints filed so far, the vast majority have been dismissed. Only five whistleblowers have won, though the number fell to four when one case was reversed on appeal. Three of the other four cases remain on appeal.

But while these statistics might suggest that the potential threat from whistleblower cases was overblown, there are other considerations that suggest that the potential danger from whistleblower cases should continue to be taken very seriously. First, of the roughly 750 cases filed so far, approximately 100 cases have been settled. Second, the rate of filing has increased each year since the law's enactment. Only about 150 cases were filed in the first year, but more than double that number were filed in the most recent year. Since many cases were filed only recently, the number of settlements is a significant statistic.

The most significant suggestion that whistleblower cases remain a serious corporate risk is the development in a recent case, where an employee's claim was permitted to proceed even though there was no accounting fraud involved. In a March 29, 2006 decision, the tribunal filed in favor of a fired employee of Nova Information Systems (a subsidiary of US Bancorp). The employee claimed she had been retaliated against for complaining that the financial institution's security controls were inadequate, increasing the risk of identity theft. Her employer argued, among other things, that no statutory violation occured because the alleged disclosure did not involve an allegation of fraud against shareholders. According to the Post article, the tribunal ruled that it was sufficient to survive a dismissal motion for the complaintant to allege that she provided information of a violation of an SEC rule or regulation, regardless whether the violation related to shareholder fraud. (The tribunal has not yet made a final decision on whether the employee was illegally fired.)

A similar issue is involved in a closely watched case pending before a US District Court in North Carolina. A former employee of Wyeth Pharmaceuticals (who has exhausted administrative procedures) alleges that he was fired in retaliation for raising concerns that vaccine production employees were improperly trained, in violation of FDA regulations. Wyeth argues that the allegations, even if true, are not sufficient to state a whistleblower claim because only disclosure of accounting fraud is protected against retaliation. A lengthy discussion of the Wyeth Pharmaceuticals whistleblower case may be found here.

A broad reading of the whistleblower protection could represent a significant concern to employers. If employees may claim that a job action arose in retaliation for an employee's supposed complaint about a violation of any rule or regulation (that is, not just disclosure of accounting fraud, and not even just disclosure of a violation of an SEC rule, but disclosure of a violation of an FDA rule or any other federal rule or regulation, which would pretty much encompass an entire universe of possibilities), whistleblower complaints could indeed become the threat that early commentators feared. Potential consequences include not only the whistleblower's make-whole civil remedy under the statute (including attorneys' fees), but in serious cases the threat of an investigation by a regulatory agency, adverse publicity, and even criminal sanctions.

The Enron criminal case may have gone to the jury, but the ramifcations from the scandal continue to unfold. The whistleblower statute may yet prove to be one of the more important permanent legacies of the Enron scandal. A good overview of the case law "so far" -- including a discussion of the numerous issues that remain unresolved -- can be found here.

An interesting commentary on Sherron Watkins, questioning the bona fides of her whistleblowing credentials, can be found here.