Update on Private Money, Public Company Risk

Hedge Fund Hardball Update: In an earlier post (here), The D & O Diary commented on the new game of "hedge fund hardball," drawing on a Wall Street Journal article (here, registration required) with that title. As discussed in the prior post, hedge funds are demanding, when the companies in which they invest miss filing their periodic report with the SEC, that the companies either pay the face amount of the debt or pay substantial penalties. A recent ruling by a New York trial court in an action that three hedge funds initiated against BearingPoint demonstrates the risk these actions present.

BearingPoint has failed to file a series of its periodic SEC filings as a result of previously disclosed issues with its internal controls and financial accounting. An indenture trustee, acting on behalf of hedge fund investors holding over 25% of a $200 million subordinated debenture issue, sued BearingPoint alleging that the company's failure to file the periodic reports breached covenants under the indenture agreement and represented a default. In a September 18 ruling (here), the NY trial court granted summary judgment on the trustee’s behalf, ruling that the company’s failure to file its periodic reports represented a default under the indenture agreement. The court reserved the question of damages for trial.

In its September 26, 2006 8-K (here), BearingPoint outlined the problems that the ruling presents for the company. The company noted that holders of other debt instruments could also try to establish a default and that "there could be material negative consequences on the Company’s other outstanding debt obligations, indemnity agreements…and customer contracts" if the court’s ruling should cause bondholders or parties on these other instruments to seek default or acceleration. The company also announced that due to the uncertainty surrounding the court’s ruling the company was delaying filing its annual report with the SEC. Bearing Point’s shares declined sharply on the news.

The hedge fund plaintiffs’ motives in the action may be gleaned from the comment of one of the hedge fund principals quoted in the September 28, 2006 Washington Post article entitled "Bondholders Seek $21.5 million in Damages from BearingPoint Default" (here, registration required). The hedge fund principal is quoted as saying that "of course, it is just a technical default. But they breached the covenant. We wanted damages due to us as a result of the default." The principal also commented that "it was ludicrous" to suggest that the $21.5 million that the plaintiffs are demanding would hurt the company. (Keep in mind that the hedge fund plaintiffs supposedly own about 25% of the debt issue in dispute, so if that is true the face value of their investment is about $50 million -- their demand represents over 40% of the face value of their investment, all for what they concede is a technical default.)

It is pretty clear that the hedge funds are seizing upon technical default to wring money from the company. As noted in The D & O Diary’s prior post, this tactic is of particular concern right now, because the number of companies who have had to delay their filings is at an all-time high, in part due to the number of companies that have had to hold up their filings because of options backdating issues. Even though the BearingPoint lawsuit is only against the company itself and not against any individual defendants, the threat of litigation surrounding these issues, as well as the larger threat of bankruptcy looming in the background, underscores the potential D & O risk these circumstances present. The conflicting interests between the company and its investors creates an environment where accusations of wrongdoing can more easily arise.

The CoporateCounsel.net Blog has a detailed post (here) discussing the legal issues in the BearingPoint case. Hat Tip to the CorporateCounsel.net Blog for the link to the NY trial court ruling.

More About MBOs, Going Private Transactions, and D & O Risk: In prior posts (here and here), The D & O Diary discussed the increased risk of D & O claims arising from the involvement of public company management in private investors’ takeover transactions in the form of "management buy-outs" (MBOs) or "going private" deals. A purported class action lawsuit filed on September 26, 2006 in a Texas trial court (complaint here) against Freescale Semiconductor, its Chairman and CEO, and five other directors, presents an example of the kinds of claims that can arise.

The complaint alleges that the defendants sold the company for inadequate consideration in a transaction "tailored to meet the specific needs of a private equity consortium led by the Blackstone Group," and that the defendants rejected a more richly priced offer from a group led by KKR. The complaint alleges that the agreement with the Blackstone-led consortium imposes barriers to competing bidders, including a $300 million break-up fee if another bidder succeeds. The complaint further alleges that the individual defendants "will reap disproportionate benefits" from the transaction – although the complaint omits any specifics of these benefits. The complaint seeks to enjoin the consummation of the agreement with the Blackstone consortium and to compel the defendants to complete an auction to ensure that the shareholders receive the benefit of the highest acquisition price.

In addition, in a September 21, 2006 8-K (here), Metrologic Instruments announced that two derivative lawsuits have been filed against the company and its board alleging that the consideration shareholders will receive for the planned transaction to take Metrologic private is inadequate. Among the investor participants in the takeover is Metrologic’s founder and CEO. The first of the two complaints alleges that the defendants timed and structured the transaction to allow themselves to capture the benefit of the company’s future business potential without fair consideration to shareholders. The second complaint alleges that the defendants failed to maximize value and that the proposed takeover represents an attempt to engage in a self-dealing transaction.

As The D & O Diary has previously noted, the increasing involvement of private financing in public company ownership give rise to complicated D & O claims possibilities including allegations of conflicts of interest and of wrongdoing. These possibilities represent a growing area of D & O risk.

Options Backdating Litigation Update and Other Web Notes

The D & O Diary’s running tally of options backdating lawsuits (which can be found here) has been updated to include new securities lawsuits that have been filed against Meade Instruments and Michaels Stores; a new ERISA action against Home Depot; and several new shareholders' derivative actions.

With the addition of the new actions, the count of options timing-related securities fraud lawsuits now stands at 19, and new cases are still continuing to arise. Even though the cases are coming in gradually rather than all at once, the total volume is starting to accumulate toward the point where collectively they are starting to look like a more serious problem for the D & O insurance industry. The number of options timing related derivative lawsuits, which now stands at 79, also represents a frequency concern. The count of ERISA related lawsuits stands at 6.

Thanks to alert reader Paul Curley for the Home Depot and Michaels Stores links.

Merck/Vioxx Case Study: A very detailed post on the LawReader.com blog entitled "Merck Insurance Carriers Jump Ship Over Vioxx Diasaster" (here) reviews the enormous burden that Merck faces as a result of the flood of litigation involving its now withdrawn Vioxx drug. The post quotes at length from Merck’s SEC filings regarding the litigation, including, for example, the note that during 2005 Merck spent $285 million (!) defending the various lawsuits, including shareholder lawsuits relating to Merck's Vioxx disclosures. The post also reviews the various insurance coverages that Merck potentially has available to respond to the litigation, including its directors and officers liability insurance program. The post reports, however, that all of Merck’s insurance may not be available due to disputes that have already arisen with its insurance carriers. The post quotes Merck’s August 7, 2006 SEC filing that "[a]t this time, the Company believes that its insurance coverage with respect to the Vioxx lawsuits will not be adequate to cover its defense costs and any losses."

The article is quite detailed and very interesting. Thanks to Adam Savett of the Lies, Damn Lies blog for the link to the LawReader.com post.

Options Backdating Seminar: On October 13, 2006, I will be participating on a panel entitled "Directors and Officers Insurance Policies and Coverage for Options Claims," at the"Stock Options Practices" seminar, to be held at the Marriott Financial Center in New York. The seminar is sponsored by HarrisMartin. Further information about the seminar may be found here.

Fastow's Sentence, Future Civil Litigation, and D & O Insurance

On September 26, 2006, U. S District Judge Kenneth Hoyt sentenced former Enron CFO Andrew Fastow to six years’ imprisonment, a reduction from the ten-year term to which Fastow had agreed in his January 2004 plea agreement. According to news reports (here and here), apparently among the factors that Judge Hoyt relied upon in support of leniency for Fastow was Fastow's cooperation with the plaintiffs’ lawyers in the civil litigation arising out of the Enron scandal.

The plaintiffs in the civil litigation have already recovered over $7.3 billion from a host of defendants, including investment banks such as JPMorgan Chase and Citigroup. But the plaintiffs’ lawyers continue to pursue claims against other investment banks, including Merrill Lynch and Credit Suisse First Boston. According to Bloomberg.com (here), Fastow began cooperating with plaintiffs’ attorneys “over three weeks ago,” and on the day before Fastow’s sentencing provided them with a 175-page declaration (the declaration can be found here) that supplied a wealth of specific information and documents in support of the plaintiffs' claims against the investment banks. Among other things, Fastow’s declaration states that:

Certain Enron banks, particularly Merrill, CSFB, RBS, and Barclays, worked to solve certain of [Enron’s] financial problems. We told certain banks our financial objectives and they, in many instances, created solutions utilizing complex financial structures….We paid a premium – in the aggregate, hundreds of millions of dollars – in order to engage in structured finance transactions that contributed to causing Enron to report its financial statements in the desired manner…. My conversation with senior bankers led me to believe that certain banks understood that some transactions were done primarily for generating certain accounting benefits and financial-reporting objectives for Enron.

In exchange for this substantial assistance, plaintiffs’ attorneys and a representative of the University of California (the lead plaintiff in the civil litigation) requested leniency for Fastow at his sentencing. According to Bloomberg.com (here), Retired U.S. District Judge Lawrence Irving, a special counsel to the lead plaintiffs’ firm, told Judge Hoyt, “Andy Fastow is a critical witness for the victims of this fraud…His cooperation could result in the recovery of additional billions of dollars. That opportunity is unprecedented and reason unto itself for leniency.” According to the Houston Chronicle (here), Bill Lerach, the lead plaintiffs’ attorney, said “(Fastow) makes it clear for all to see that not only did the Enron banks drive the getaway car in one of the great financial scandals in our nation’s history, but the Enron banks served as the actual masterminds behind the scheme to defraud.”

The plaintiffs' lawyers' support for Fastow apparently had its effect on Judge Hoyt; in delivering the sentence, Judge Hoyt, according to the Bloomberg.com article, specifically referenced Fastow’s efforts “to not simply right the criminal ship but to right the civil ship.”

There may be some who find it unutterably bizarre for the representatives of the injured shareholders to be pleading for criminal sentencing leniency on behalf of one of the architects and main beneficiaries of the scheme that injured the shareholders in the first place. If you can get past that cognitive speedbump, there is the further question about what impact this development may have on future criminal defendants’ behavior. Will they too reach out to the plaintiffs’ bar with an offer to aid the civil case, in exchange for support for leniency at the time of criminal sentencing? If it worked for Fastow, surely it can work for others too? As the WSJ.com law blog put it (here), “are prison sentences the currency with which plaintiffs’ lawyers buy information to help them with their cases?”

It may be that Fastow had uniquely valuable currency to trade. After all, there are very few cases where a criminal defendant can offer information worth billions of dollars of potential civil recoveries. And just think about what that might mean for the plaintiffs' attorneys' potential fee recovery -- no wonder the plaintiffs' lawyers felt compelled to ask Judge Hoyt to go a little easy on Fastow. But as Professor Ellen Podgor observes in the White Collar Crime Prof blog (here), does the criminal defendant who is unlucky enough to lack anything to trade, or is merely last in line, have to be condemned to a longer jail term? The D & O Diary notes that there used to be an idea in criminal law that the length of the criminal term was supposed to have something to do with the degree of culpability -- not the strength of the criminal defendant’s bargaining position with civil plaintiffs’ attorneys.

In any event, there may be an insurance consideration that could constrain plaintiffs’ attorneys willingness to set up a leniency-support-for-information barter system, at least where the plaintiffs’ attorneys hope to use the information in civil claims against a defendant company or other defendant directors and officers. That is, most D & O insurance policies contain a so-called “Insured vs. Insured” exclusion, that precludes coverage if the action is not (to quote one leading carrier’s form) “totally independent of, and totally without the assistance of” any director or officer of the company. If an insured person within the meaning of the policy is providing substantial information upon which plaintiffs’ attorneys intend to rely in support of claims against other directors or officers or the company, that could be the type of “assistance” that could preclude D & O coverage under the policy. (There is some judicial authority requiring an added element of “collusion” for coverage to be precluded– an added consideration that is worthy of a separate blog post in and of itself.)

So a criminal defendant’s offer to exchange information for leniency support may be a poisoned chalice for the plaintiffs’ attorneys, because accepting it and using the information against other directors and officers could potentially have the effect of precluding D & O insurance coverage. However, the criminal defendant’s information offer might still be attractive to the plaintiffs' lawyers if the D & O coverage is already blown or out of the picture, or if the offer will aid plaintiffs’ claims against defendants other than the directors and officers or the company. This possibility has to be one of the more unexpected legacies of the Enron scandal.

The D & O Diary finds this idea of information-for-leniency barter with the plaintiffs' bar pretty damn unsavory, particulary where, as in Fastow's case, the plaintiffs' attorneys chances of gaining an enormous fee are substantially advanced by the criminal defendant's help.

Roll the Tape: Reasonable minds may differ about the appropriateness of Fastow’s six-year sentence, particularly in comparison to the six-year sentence imposed against Jamie Olis, a lower level Dynegy employee who did not personally benefit from his criminal conduct, whose conduct did not destroy the company, but who did have the temerity to insist on his constitutional presumption of innocence and his constitutional right to a jury trial. (See The D & O Diary ‘s post here about Olis’s sentence, and see interesting commentary on the Fastow/Olis sentence comparison here.)

It is worth asking whether it was even appropriate for Fastow to request leniency, or for prosecutors to present evidence of Fastow’s cooperation in support of Fastow’s leniency bid, given Fastow’s testimony at the criminal trial of Ken Lay and Jeffrey Skilling. According to the trial testimony reproduced at length here, Fastow testified -- in response to prosecution questioning and in order to rebut Skilling's lawyer's suggestion that Fastow was shaping his testimony to curry favor with prosecutors in a bid for a lighter sentence – that the 10-year term to which he agreed in his plea agreement could not be reduced.

In fairness, it should be noted that the prosecutors did not themselves request to have Fastow's sentence reduced. They did, however, provide information upon which Fastow relied in support of his request for leniency.

Criminal Sentencing Perspective on Plaintiffs'-Style Damages Calculations

On September 22, 2006, Judge Sim Lake of the United States District Court in Houston re-sentenced former Dynegy tax executive and lawyer Jamie Olis to six years in prison for securities fraud, upon reconsideration after Olis's initial sentence of 24 years that had been reversed on appeal. (Press reports of the resentencing may be found here and here.) Both the history of Olis’s sentencing and Judge Lake’s September 22, 2006 sentencing memorandum (here) provide an interesting perspective on the plaintiffs’-style damages calculations that prosecutors urged the Court to use in determining Olis’s sentence.

Olis, along with two other Dynegy executives, Gene Foster and Helen Sharkey, was indicted for an alleged conspiracy to commit fraud; mail fraud; wire fraud; and securities fraud. The essential allegation was that the defendants had engaged in a scheme (“Project Alpha”) to distort Dynegy’s financial statements by disguising a $300 million loan as operating cash flow. Foster and Sharkey pled guilty to conspiracy and cooperated with the government. Olis’s case was tried to a jury in November 2003, and he was convicted on all counts.

Judge Lake originally sentenced Olis to 24 ¼ years in prison. Judge Lake based this sentence on the federal sentencing guidelines, which he viewed as mandatory, and his determination of the pecuniary loss that Dynegy shareholders suffered as a result of the fraud. Olis appealed his conviction and his sentence to the Fifth Circuit. While his appeal was pending, the U.S. Supreme Court issued a ruling that the federal sentencing guidelines are merely advisory and not mandatory. In October 2005, the Fifth Circuit affirmed Olis’s conviction, but vacated his sentence and remanded the case to Judge Lake. In remanding the case, the Fifth Circuit stated that it was unclear whether Judge Lake would have imposed the same sentence if the Judge had regarded the sentencing guidelines as advisory rather than mandatory. The Fifth Circuit also specifically held that Olis’s sentence “overstated” the shareholder loss caused by the fraud.

On resentencing, Judge Lake began his analysis by re-examining the question of the Dynegy shareholders’ “actual loss” from the fraud. (The pecuniary loss from the criminal conduct is a factor for courts to consider under the federal sentencing guidelines.) In making this determination, Judge Lake, following Fifth Circuit precedent, relied upon “applicable principles of recovery of civil damages for securities fraud.” In other words, even though the context was a criminal sentencing, Judge Lake relied upon principles of civil damages calculations, so his comments about those principles are relevant in both contexts.

In support of their argument that Dynegy’s shareholders loss from the fraud was in the range of from $161 million to $714 million, the prosecutors relied on the testimony of an economic expert, Frank Graves of the Brattle Group. Graves used an “events study” to determine the per-share inflationary effect to Dynegy’s share price as a result of Project Alpha. Graves then used two alternative models to estimate the number of shares that were damaged, the proportional trader model and the two-trader model. Using these assumptions, Graves estimated the range of shareholder damages from $161 million to $714 million. Olis’s attorneys, supported by a former SEC Commissioner and Stanford Law Professor Joseph Grundfest (who was acting pro bono on Olis’s behalf and who testified at Olis's two-day resentencing hearing), argued that Graves’s analysis failed to account for Dynegy’s numerous other negative announcements unrelated to Project Alpha and relied on numerous unproveable assumptions. (A copy the sentencing memorandum submitted on Olis's behalf, including Grundfest's written declaration, is bookmarked here.) After a lengthy review of the economic analyses, Judge Lake concluded that “it is not possible to estimate with any degree of reasonable certainty the actual loss to shareholders attributable to the corrective disclosures.”

Because Judge Lake could not determine the “actual loss” to shareholders, he instead looked to the “intended loss” of the defendants’ conduct. There had been trial testimony from one of the cooperating defendants that the defendants had intended that Project Alpha would avoid $79 million in federal taxes. Using this "intended loss" figure and taking into account a number of mitigating circumstances (including specifically the fact that Olis had not intended to profit personally from Project Alpha), Judge Lake resentenced Olis to 6 years’ imprisonment. Olis has already served two years and four months in prison, so he could be out of prison by May 2010, or earlier for good behavior.

Judge Lake’s rulings in Olis’s resentencing are significant in several respects. First, his reasoning and analysis carry important implications for Jeffrey Skilling, whom Judge Lake is scheduled to sentence on October 23, 2006. As discussed in detail on the White Collar Crime Prof blog (here), many of the mitigating factors that Judge Lake considered in Olis’s case are absent in Skilling’s, and Judge Lake’s remarks could be interpreted to suggest by implication that Skilling may face the prospect of a much more severe sentence. (The White Collar Crime Prof blog suggests that Skilling may face more than 20 years’ imprisonment and a fine of $400 million.)

Judge Lake’s rulings are also important for his analysis of the plaintiffs’-style damages calculation. The Judge explicitly relied on principles of civil case damages analysis in his attempt to calculate the Dynegy shareholders’ “actual loss.” The prosecution’s expert used analytic tools that plaintiffs’-style damages experts often use to estimate the purported loss of the shareholder class in civil securities fraud actions. So the fact that Judge Lake concluded that the prosecution had not established the actual loss with reasonable certainty, using these standard analytic tools, has potentially important implications for the credibility of these tools in civil cases.

To be sure, Judge Lake was very careful to note that his conclusion was based “on the facts of this case; it is not a conclusion that such estimates are never possible.” These are the words of a careful judge who is taking pains to try to limit the effects of his analysis to the case before him. But the reality is that the defense objections to the prosecutor’s experts analysis are equally applicable to the plaintiffs’ experts’ analysis used to calculate purported shareholder damages in many civil securities fraud cases. (Professor Grundfest's devastating critique, which is linked above, while keyed to the facts of the case, would apply at the theoretical level to the damages analyses in most civil securities cases.) And the bases for Judge Lake’s conclusion that the methodologies used did not produce a calculation of the shareholders' actual loss with reasonable certainty are equally applicable as well.

A variety of causes conspire to ensure that securities fraud lawsuits almost never go to trial. One consequence is that many of the standard tools in the plaintiff’s lawyers’ toolkit have rarely been subjected to judicial scrutiny. This is particularly true with respect to plaintiffs’-style damages calculations, which plaintiffs’ lawyers use to produce highly inflated estimates of purported shareholder damages. Plaintiffs’ lawyers use the calculations as a basis upon which to try to extract enormous settlements, with some effectiveness. (Indeed, the Dynegy/Project Alpha civil action settled for more than $474 million.) Yet both the damages calculations themselves and the calculations methodologies are largely untested by judicial scrutiny. Judge Lake’s ruling in the Olis resentencing suggests that were the plaintiffs’ style damages calculation more regularly subject to judicial scrutiny, many inflated damages estimates might not survive. Even though it is within the criminal context, Judge Lake’s opinion may provide some ammunition to use against the plaintiffs’-style damages calculation. Judge Lake’s reasoned opinion and the outcome of his analysis also suggest that scrutiny of the plaintiffs’-style damages calculation may be long overdue.

The D & O Diary is interested in its readers comments on the Olis resentencing and its possible implications, particulary those who may disagree with my views about the shareholder damages calculation.

A Note of Concern About Olis's Sentence: Even though Judge Lake significantly reduced Olis's sentence, Olis's sentence still stands in contrast to the lighter sentences that his co-defendants received. Gene Foster, who was Olis's boss, received a sentence of only 18 months, and the third defendant, Helen Sharkey received a sentence of only one month. It is hard to avoid the impression that the other two defendants received a lighter because they entered guilty pleas, but that prosecutors sought a heavier sentence for Olis because he insisted on going to trial. As Professor Ellen Podgor writes in the White Collar Crime Prof blog (here):

a question that definitely needs to be considered and addressed by Congress and the courts is whether the government should have this enormous prosecutorial power to leverage individuals against each other in order to obtain evidence for a prosecution on the individual who decides not to enter a plea. Is it within the bounds of the Constitution to punish individuals with higher sentences because they decide they want to use their constitutional right to a jury trial?

The September 25, 2006 issue of the Washington Post has an interesting and thoughtful article entitled "Cook the Books, Get Life in Prison: Is Justice Served?" (here, registration required) discussing the problem of calibrating sentences for white collar criminals


Hats Off to Joseph Grundfest: I have never had the honor of making Professor Grundfest’s acquaintance. I do know the high esteem in which he is held in the securities industry and the legal community generally. I can only imagine the demands on his time, and the opportunities he has to advance his own professional and monetary interests. The defense of a convicted white collar criminal is not a popular cause in the post-Enron, Sarbanes-Oxley world. The fact that he would take the time, burden and responsibility to become involved on a pro bono basis in Olis’s resentencing is truly impressive. Professor Grundfest, The D & O Diary salutes you.

An FCPA Enforcement Case Study and Other Web Notes

The D & O Diary has previously written (here and here) about the recent revival of the Foreign Corrupt Practices Act (FCPA) and the potential implications for D & O risk. PricewaterhousCoopers’ Summer 2006 Solutions newsletter (here) has an interesting article entitled “ABB Ltd and the Foreign Corrupt Practices Act” taking a closer look at the FCPA problems at one particular company – ABB Ltd., the Switzerland-based energy engineering and construction company whose ADRs trade on the NYSE.

The article first reviews the 2004 enforcement proceeding against ABB, involving allegedly improper payments ABB subsidiaries made between 1998 and 2003 in Nigeria, Angola, and Kazakhstan. ABB ultimately consented to a judgment (without admitting or denying the allegations) enjoining the firm from future violations and requiring it to pay $5.9 million in disgorgement and a $10.5 million penalty. The article then reviews three subsequent incidents where ABB itself identified and self-reported possible additional FCPA violations involving suspected improper payments in Africa, Europe and the Middle East. The article comments that “[t]he continuing series of discoveries of suspected payments, disclosures to the SEC and DOJ (and the market) and ensuing internal control investigative results… raise questions about the control environment; imply that ABB’s compliance controls are inadequate; tarnish the Company’s reputation; and expose ABB to possible substantial fines and penalties.”

The article concludes with the observation that FCPA compliance is “on the SEC’s radar screen, and more cases like ABB are very likely to come. The hard lessons learned by ABB ought not to go unnoticed or unheeded by other global companies.” The article merits reading in its entirety.

A Further Commentary on the “Milberg Effect”: In a prior post (here), The D & O Diary added its observations on the Wall Street Journal’s editorial (here, subscription required) about the “Milberg Effect,” that is, the impact that the indictment of the Milberg Weiss firm is having on the declining number of securities fraud lawsuit filings. A recent post (here) by plaintiffs’ attorney Adam Savett on his Lies, Damn Lies blog provides an interesting additional perspective on the apparently declining number of securities fraud lawsuits. Savett suggests that “the number of federal securities class actions has potentially slowed because a substantial portion of the plaintiffs’ bar is busy filing other types of securities cases, including state and federal derivative actions.” This is an observation that The D & O Diary has also made (here), but the fact that this observation is coming from a member of the plaintiffs’ bar makes it more interesting.

Options Backdating Litigation Update: Perhaps the most obvious proof that the plaintiffs’ bar is concentrating on filing shareholders’ derivative lawsuits rather than securities fraud lawsuits is the pattern of lawsuit filings arising out of the options backdating scandal. As shown in The D & O Diary’s running tally of the options backdating litigations (which may be found here, and which was recently updated to add several new derivative lawsuits) only 17 companies have been sued in securities fraud lawsuits, but 78 companies have been named as nominal defendants in shareholders’ derivative lawsuits. Clearly, the plaintiffs’ bar is showing a preference for the derivative lawsuit, at least with respect to options backdating litigation.

Securities Lawsuit Filings Are Down, So What About D & O Rates?

As has been noted previously on The D & O Diary (here), a recent study by Cornerstone Research (here) shows that the number of YTD 2006 securities fraud lawsuit filing is down significantly from a year ago. The decline in lawsuit filings is so significant that it almost begs the question: when is D &O pricing going to go down in response to the declining number of suits?

I know my many friends in the D & O underwriting community are thinking, how much further can rates go down? But the reality is that while current pricing is below 2003 levels, it remains well above 2000-01 levels. So The D &O Diary asks the question: should rates be going down further in response to the declining securities fraud lawsuit filings?

It must be conceded that in the very asking of the question there is an unstated premise that should be examined and not merely assumed – that is, that the current reduced level of securities litigation activity represents a secular and not merely a cyclical trend. For those of us who have lived long enough, there is a certain familiarity to the current circumstances. It was just ten years ago, in 1996, just after the enactment of the Private Securities Litigation Reform Act, that securities lawsuit filings were as low as current levels. (See the chart on the Stanford Clearinghouse website, here.) At that time, several carriers acted in response to the apparently lower level filing rate levels and reduced their D & O rates. That set off a price war that reduced pricing to much lower levels– just as an unprecedented wave of new securities filing began to hit the courts. The ensuing blood bath amongst D & O carriers continues to stain the industry’s balance sheets. So if the D & O industry has any memory at all (and also has enough fortitude to conform its actions to its experience, a highly dubious proposition), carriers will hesitate before reducing pricing based upon the current securities filing levels.

There is yet another unstated premise in the question, which is that D & O claims frequency drives D & O pricing. This one seems like a rather logical presumption, but analysis by David Bradford at Advisen discussed at the recent PLUS D & O West Symposium shows that D & O pricing only loosely correlates with D & O claims experience -- the most significant factor in determining D & O pricing is insurers’ general level of policyholder surplus (key slides here and here). As it happens, surplus levels are quite high, and likely to go higher if the current mild hurricane season continues. So D & O pricing may indeed decline further in the short term, but if it does, it will have more to do with the fact that the wind didn’t blow this year than with the fact that securities filings are down.

The carriers’ typical response when confronted with the fact that filings are down is a statement that even if frequency is down, average severity is up. Indeed, the annual surveys by all the major consultants that follow the issue show that average securities fraud lawsuit severity has been rising steadily over the last few years (here). The claims settlements that are contributing to the current high severity levels are the sad remnants from the stock market collapse earlier in this decade. The plaintiffs’ style damages calculations in those cases run into the billions of dollars (or in the case of the Cicso Systems securites case that recently settled for more than $ 90 million, into the hundreds of billions of dollars). The magnitude of the purported shareholder loss in those cases makes most of those cases categorically different from the cases that are filed under post-bubble market conditions. More importantly for pricing purposes, these prior accident year claims loss levels arguably have slight predictive power for the likely losses that will accrue in current and future accident years. Continued reference to the post-collpase cases isn’t just driving the car by looking in the rearview mirror (a predilection to which insurers are particularly susceptible), it is trying to drive the car by reading the newspapers from several years ago.

That said, there are other claims-related factors to which carriers more justifiably might refer when contending against the arguments for further price declines. First, securities lawsuit filing rates may be down, but that does not mean that overall D & O claims activity levels are down. In particular, the number of derivative lawsuits is up. A significant shift has occurred in D & O lawsuit filings, away from securities fraud lawsuits and toward shareholders’ derivative lawsuits. This shift may be seen in the lawsuits relating to options backdating. That is, though relatively few companies with options timing problems have been sued in securities fraud lawsuits (16 at last count), over 75 companies have been sued in derivative lawsuits. (For a running count of options backdating lawsuits, see The D & O Diary’s tally, here) Second, there are a variety of forces beyond just options backdating that are contributing to increased numbers of derivative lawsuits ; as The D & O Diary has noted in prior posts (here and here), activist hedge funds are pursuing litigation as part of their overall strategy, management buy-outs are creating conflicts of interest between management and their companies (see here), private equity funds are seeking disproportionate advantages which gives rise to conflict of interest (refer here), and boardroom turmoil is creating a hostile environment in which accusations of wrongdoing more easily can arise (refer here). All these factors are all contributing to increased numbers of shareholders’ derivative lawsuits. The increased number of derivative lawsuits means increased claims frequency exposure at least for primary insurers, and arguably for excess carriers as well given rising defense fee expense and increased derivative settlement levels in recent months.

In addition, there are a variety of developing threats that also could make it precarious to conclude that the current reduced level of securities lawsuits means that overall D & O risk can be presumed to be below historical levels for all purposes. As The D & O Diary has noted (here and here) increased activity levels under the Foreign Corrupt Practices Act present a worrisome new source of D & O risk. A similar observation might be made about the Sarbanes Oxley whistleblower provisions, the Pension Protections Act of 2006 (which together with new FASB requirements that begin phasing in at the end of this year and that c0uld involve new levels of accounting risk). The unfolding of the options backdating scandal is far from complete. These factors and the ever present threat of a change in legislation or case law, makes it very dicey to predict with confidence that overall D & O risk is and will remain down.

So when it comes to D & O risk, the current case for and against further D & O pricing declines is decidedly mixed, notwithstanding the YTD 2006 decline in securities lawsuit filings. A more definitive claims-based view of the evolving D & O risk will only be possible in the fullness of time. The bottom line for now seems to be that if D & O pricing declines further in the short term, it will more likely reflect overall industry policyholder surplus levels rather than any categorical changes in the D & O risk. That said, if securities fraud lawsuit filing rates continue at current lower levels, carriers will undoubtedly face increased pressure to lower their rates.

SEC Settles First SOX Case Filed Against a Foreign Issuer

A continuing debate surrounding the Sarbanes-Oxley Act has been the extent to which the Act may be discouraging foreign companies from listing their shares on U. S. securities exchanges. (Prior D & O Diary post on the topic may be found here and here.) Enforcement activity against foreign issuers undoubtedly will influence the relative attractiveness of U. S. exchanges to foreign companies. In that connection, it is important to note that the SEC has reached a settlement of what press reports (here) have called the SEC's first enforcement lawsuit against a foreign company under the Sarbanes-Oxley Act.

On September 14, 2006, the SEC announced (here) a settlement of an enforcement action that it had filed against TV Azteca, S.A., a Mexican domiciled company, several related companies, and two TV Azteca officials, Chairman Ricardo Salinas Pilego and former CEO Pedro Padilla Longorio. According to press reports (here), Salinas Pilego is a Mexican media tycoon and a billionaire. Under the settlement, Salinas Pilego agree to pay $7,500,000 and Padilla Longorio agreed to pay $1 million to establish a Fair Fund (under Section 308 of the Sarbanes Oxley Act) to compensate affected investors. According to the company’s announcement (here), the settlement “does not involve economic consequences for TV Azteca."

The SEC filed its enforcement action (here) in January 2005, in connection with TV Azteca’s cellphone unit. A company owned by Salinas Pliego and a partner bought debt issued by the cellphone unit at a discount. The debt subsequently was redeemed at face value, permitting Salinas Pilego and his partner to make $109 million profit. Salinas Pilego did not reveal his involvement with the debt until it came to light following the resignation of TV Azteca’s U.S. law firm, which told the company's board of directors and management that it was resigning consistent with its obligations under Section 307 of the Sarbanes Oxley Act. Salinas Pilego and Padilla Longorio were alleged to have schemed to conceal Salinas Pilego’s involvement with the debt.

Board Turmoil and D & O Risk

Within the last few days, we have witnessed the feuding, dysfunctional H-P Board struggling with the turmoil and adverse publicity arising from its flawed investigation of media leaks. Last week we also saw the forced ouster of Bristol Myers Squibb CEO Peter Dolan. These events follow the removal of the CEOs of some of the country’s largest companies, including Walt Disney, Fannie Mae, Pfizer, American International Group, Merck, and others. These events not only involve the potential for board turmoil, distraction and adverse publicity, but increasingly also present the possibility of D & O litigation.

For example, late last week, Bill Lerach of the Lerach Coughlin firm filed a shareholders’ derivative suit against the H-P Board, accusing the Board (and its general counsel, as well as it purported outside investigative service) of breaches of fiduciary duties, abuse of control and waste of corporate assets, as part of an alleged campaign to entrench themselves and to punish or diminish the power of ousted directors. A copy of the complaint can be found here. The lawsuit not only seeks corporate remediation, but also seeks recovery for the “enormous” costs and burdens the company has sustained to deal with the crisis created by the revelations of the Board’s investigation. Significantly, the complaint against the H-P directors seeks to compel the recovery from the defendants of the company’s costs without their recourse to indemnity or insurance, even for the costs of defending the derivative litigation. A September 15, 2006 Law.com article discussing the H-P complaint can be found here.

Nor is H-P’s situation the only boardroom dispute that has resulted in D & O litigation. For example, at Atmel, five independent board members (representing private equity fund investors) worked together to bring about the August 5 firing of company founder and CEO George Perlegos, as well as three other executives, for alleged misuse of corporate travel funds. Perlegos responded by filing a lawsuit against the board, arguing that his ouster was illegal because he had already called a shareholder meeting in order to remove the five independent directors. His lawsuit argues the directors should be removed because “the hasty, secretive, and precipitous manner in which they acted…will have devastating consequences for the Company, including but not limited to the loss of the [ousted executives’] decades of experience running the company and a significant loss of shareholder value.” News report discussing the Atmel litigation can be found here and here.

These boardroom disputes and the others identified above are a result of a variety of factors. The increased presence and activism of independent directors, who are less inclined to take their cues from company management, is a direct result of Sarbanes-Oxley reforms and is clearly a factor in the newly contentious board environment. Regulatory and investigative pressures are also important factors. For example, the removal of AIG’s and Bristol Myers Squibb’s CEOs were a direct result of investigative pressures. Increased shareholder activism, including the pressure of activist hedge funds and other private equity investors, also is a contributing factor. (For a prior D & O Diary posts discussing the litigation threat of activist hedge funds, click here and here.)

All of these factors are contributing to an increasingly hostile boardroom atmosphere. This atmosphere not only presents a challenge for corporate boards, but also represents an environment where allegations of wrongdoing can more easily arise. These allegations of wrongdoing inevitably will make their way into the courtroom, and so the newly contentious boardroom environment represents a potentially significant source of increased D & O claims exposure.

On Saturday, September 16, 2006, articles appeared in Wall Street Journal (here, subscription required) and in the Washington Post (here, registration required) discussing the new hostile environment for corporate boards.

Silicon Valley Connection: The shareholders’ derivative complaint filed against the H-P Board take particular aim at the Board’s continued reliance on the outside counsel, the Wilson Sonsini law firm, on whose advice the company relied in connection with the investigation, the board disputes arising out of the investigation, and the company’s disclosure of the investigation and the board’s disputes:

[E]ven though they were facing a matter with grave implications for the corporation, [the Board] did not seek independent legal representation or advice. Worse yet, they actually relied on the advice of the law firm that was implicated in the conduct to be evaluated. Because Sonsini of Wilson Sonsini had been intimately involved in advising the Board and its Chair regarding the investigation that had taken place, the law firm knew or should have known of the dubious legality of the investigatory tactics being used and yet had advised the Board …that the investigatory tactics being used were not unlawful and advised HP to not disclose why [Perkins, a Board member who resigned, had actually resigned.]

The Complaint goes on to allege that a demand upon the Board to bring legal action would be futile because “Wilson Sonsini and Sonsini continue to be the primary outside counsel for the Company regarding these matters and obviously, since Wilson Sonsini and Sonsini are conflicted and would be key witnesses and possible defendants in any ultimate legal action, they will advise the Company not to pursue legal action or conduct a vigorous independent investigation into matters that will embarrass the law firm, further implicate the law firm, or expose the law firm to financial liability.”

Nor is the H-P lawsuit the only source of legal scrutiny facing the Wilson Sonsini firm from the H-P board investigation. According to news reports (here and here), Larry Sonsini is among the witnesses requested to appear to testify before a Congressional panel looking into the H-P board’s investigation of media leaks. The Oversight and Investigations Subcommittee of the House Committee on Energy and Commerce will be holding September 28, 2006 hearings on the matter. Several witnesses, including Sonsini, have been sent letters requesting them to notify the committee on or before September 19, 2006, whether they will appear voluntarily. The attorney-client privilege and Fifth Amendment privilege issues that this congressional investigation might present are discussed in this post on the White Collar Crime Prof blog, here. The WSJ.com law blog also has an interesting post here discussing the swirl of activity surrounding Sonsini.

The H-P derivative lawsuit is far from the only salvo that Lerach has launched against the Wilson Sonsini firm recently. As noted in a prior D & O Diary post (here), Lerach has opposed efforts to dismiss the shareholders’ derivative suit pending against Mercury Interactive based on an alleged conflict of the Wilson Sonsini firm -- Wilson Sonsini represents one of the defendants in the Mercury Interactive suit, and is also outside counsel for H-P, which is acquiring Mercury Interactive.

When asked who he thinks will defend the H-P Board in the shareholders’ derivative suit he filed, Lerach responded that “I bet it won’t be Wilson Sonsini.”

Comment on the ”Milberg Effect”

On September 12, 2006, the Wall Street Journal carried an editorial entitled “The Milberg Effect,” (here, subscription required) commenting on the possible impact of the Milberg Weiss indictment on the decline in the number of securities lawsuits in 2006. (To see the Cornerstone Consulting data about the decline, refer here.) The Journal editorial incorporated a bit of dodgy math projecting the likely year-end 2006 number of securities lawsuits and attributing the entire projected annual decline to the Milberg firm’s reduced filing activities. The editorial itself has been the subject of some criticism in the blogosphere. Both the Securities Litigation Watch (here) and the 10b-5 Daily (here) criticized the editorial for failing to account for the fact that multiple law firms usually target each company that is sued, so that the Milberg firm’s reduced activity alone could not be the sole cause of the reduced number of securities lawsuits in 2006.

The D & O Diary does not dispute these honorable fellow bloggers’ commentaries on the Journal editorial. Indeed, when the Milberg firm this week announced (here) what is its first new lawsuit since the firm was indicted in May 2006, the company it sued (IMAX) had in fact already been sued by multiple other law firms. (Refer here for a law firms that previously sued the company).

There are undoubtedly multiple reasons behind the decline in the number of lawsuits. (It is possible that improved corporate behavior is one of the important causes, although The D & Diary has its doubts, as discussed in a prior post, here.) But even conceding the criticisms of the Journal editorial, the D & O Diary believes that the Milberg indictment nevertheless has had an important impact on the decline in number of securities lawsuits.

As The D & O Diary noted previously noted (here), the most important fact to take into account in assessing the possible reasons for the decline is the fact that the decline began in September 2005. The significance of the date is that that is the same month that the grand jury that ultimately indicted the Milberg firm and two of its partners returned its first indictment. That first indictment was filed against Seymour Lazar, who was later named in the Milberg indictment as one of the paid plaintiffs that the Milberg firm allegedly maintained in order to be able to quickly file lawsuits when companies announced bad news. The D & O Diary poses the question (previously discussed at greater length in its prior post, here) whether or not it is a coincidence that the number of lawsuits began to decline immediately after the Lazar indictment. Could the Lazar indictment have communicated to the entire plaintiffs’ bar that the grand jury investigation was serious and that the practice of paying people to act as paid plaintiffs had to be abandoned immediately? Is the significance of the Milberg indictment not limited to its effect on the law firm itself, but does it perhaps reach to the activities of the entire plaintiffs’ bar? The D & O Diary wonders whether the reason that the number of lawsuits has declined since September 2005 is because the lawsuits that depended on the availability of paid plaintiffs are no longer being filed.

For an interesting study (with pictures) of one of the alleged paid plaintiffs named in the Milberg indictment, see this prior D & O Diary post (here) –scroll down the page to view the entry regarding the paid plaintiffs.

Options Backdating Litigation Update: The D & O Diary’s running tally of options backdating lawsuits (which may be found here) has been updated to incorporate the shareholders' derivative lawsuits that have been filed naming Affymetrix (here), Bed Bath & Beyond (here), Cable Vision Systems (here) and Par Pharmaceuticals (here) as nominal defendants. The addition of these lawsuits brings the number of companies named in options timing related derivative suits to 75. The number of companies named in securities fraud lawsuits stands at 16.

Special thanks to Bill Ballowe for the link to the Bed Bath and Beyond lawsuit.

Four Things to Watch in the World of D & O

The world of directors’ and officers’ liability often seems as if it is in a state of constant change -- and it is no wonder, because so many factors affect it: legislation, litigation, volatile securities markets, and the ever-changing global economy. With so many shifting factors and varying dynamics, it can sometimes be difficult to isolate trends and identify their significance. This difficulty is exacerbated when there is a single issue that, like the current options backdating scandal, is dominating the headlines. In a September 2006 Insights article (here), I identify four current trends in the world of D&O and comment on their significance. While some of these trends may not yet be in the headlines, they represent important developments in the D&O arena.

To see prior issues of Insights, click here.

Yes, But WHY Are They Filing Derivative Suits?

In recent days, there has been extensive media attention (here and here) focused on the fact that plaintiffs’ lawyers seeking to exploit the options backdating scandal are filing shareholders’ derivative suits in preference to securities fraud class action lawsuits. Indeed, The D & O Diary’s running tally of options backdating lawsuits (here) shows that only 16 companies have been named in securities fraud lawsuits, but over 70 companies have been named as nominal defendants in shareholders’ derivative lawsuits. But while the observation that plaintiffs’ lawyers are preferring shareholders' derivative lawsuits appears to be valid, this observation does not explain why plaintiffs’ lawyers are so eager to file derivative lawsuits. Traditionally, derivative lawsuits have not been nearly as lucrative for plaintiffs' lawyers as securities fraud suits. So why are plaintiffs' lawyers preferring derivative lawsuits in connection with the options backdating scandal?

It may be supposed that recent trends in other recent derivative lawsuits’ recoveries makes these suits more attractive to plaintiffs’ lawyers now than perhaps they were in the past. The derivative lawsuit filed against the Hollinger board resulted in a $50 million settlement (here) – funded entirely by D & O insurance – and the Oracle derivative settlement resulted in Larry Ellison’s payment of $100 million to charity, as well as his payment of the company’s $22 million attorneys’ fees. In addition, the existence of a derivative lawsuit was a “substantial factor” in the payment of $200 million in settlement of various litigation against AOL Time Warner. But there need to be numerous caveats around the purported value of the AOL Time Warner derivative settlement (see the prior D & O Diary post concerning the AOL Time Warner settlement here) and the Oracle settlement with its payment to charity rather than to the company requires a very big asterisk (and is probably a worthy topic of a separate post). The Hollinger settlement may be more apposite, but it may also represent an extreme case.

Whether or not these other settlements represent a trend that might be increaing plaintiffs' lawyers interest in filing shareholder derivative suits, the derivative lawsuits brought in connection with options timing allegations appear subject to numerous defenses or other practical limitations. To name but a few of the defenses and limitations:

Standing: For many of the companies involved in the backdating scandal, the period during which the alleged misdating took place covers a large swath of time, in some cases going back to the early or mid 90’s. In order to have sufficient standing to pursue the derivative suit, a shareholder plaintiff will have to show continuous share ownership, at the time of the alleged wrongdoing as well as the at the time of the lawsuit. Some putative plaintiffs may satisfy this requirement, but not many, and most of the plaintiffs in whose name the options lawsuits have been brought lack the requisite standing (and for an additional comment about standing, see the note below about the Mercury Interactive shareholders' derivative lawsuit);

Statute of Limitations: The statute of limitations under Delaware law for shareholder derivative suits is three years. Shareholders’ claims for alleged options timing misconduct more than three years’ prior to the spring or summer 2006 (when most of the lawsuits were filed) may well be time barred. Plaintiffs’ lawyers undoubtedly will seek to circumvent this bar by alleging concealment or some other excuse to stay of the limitations bar, but the whole point of a limitations statute is to avoid trying events from the distant past. The limitations period may well prove a substantial bar to many of the plaintiffs’ claims.

Demand Requirement: In the race to the courthouse that followed the media frenzy surrounding the options backdating scandal, many of the plaintiffs’ lawyers disregarded the derivative lawsuit filing prerequisite that the plaintiffs first demand that the board pursue the lawsuit on the corporations’ behalf or present allegations to show why demand would be futile. The demand requirement is substantial and cannot be circumvented by mere conclusory allegations of futility; the plaintiff must plead with particularity why a majority of the board lack sufficient disinterest to consider the demand. This should be a particular burden in the many cases where the directors did not themselves benefit from the options timing. Moreover, where (as in most cases) the plaintiffs filed their suits without first pursuing a books and records request to obtain requisite factual information as a basis for their claim, a
dismissal based a failure to meet the demand requirement will be with prejudice;

Exculpatory Clause: Most corporations have adopted an exculpatory clause in their corporate charter, as permitted under Delaware law, precluding liability against the directors for breach of fiduciary duty except upon a showing of bad faith or disloyalty. Liability for mere breaches of the duty of care is waived under these exculpatory provisions. In most cases, the boards of directors of companies caught up in the backdating scandal were simply unaware of the backdating, and therefore allegations of wrongdoing amount to no more than alleged breached of the duty of care, the liability for which is precluded under the exculpatory clause.

To be sure, there are some companies with respect to which more substantial or active wrongdoing is alleged, and with to respect to which the derivative claim may be more substantial and perhaps potentially more lucrative for the plaintiffs’ lawyers. But these claims amount to no more than a very small handful; almost all of the derivative complaints that have been filed are subject to the above defenses and other substantial defenses and limitations. It remains to be seen whether the flood of derivative lawsuits raising options timing allegations produces substantial value for the corporations on whose behalf the lawsuits have been filed, or for the plaintiffs' lawyers who filed the lawsuits. But the number and strength of the potential defenses makes the D & O Diary wonder: why are the plaintiffs lawyers filing all these derivative suits?

The D & O Diary is interested in readers' comments about the potential merits of the shareholders' derivative options backdating lawsuits.

Unique Standing Defenses in the Mercury Interactive Derivative Lawsuit: Among the companies involved in the options backdating scandal is Mercury Interactive, which also was named as the nominal defendant in a shareholders’ derivative lawsuit brought by the Lerach Couglin firm. On July 25, 2006, while the derivative lawsuit was pending, Mercury Interative announced its acquisition by Hewlett-Packard. According to a September 11, 2006 story on Law.com entitled “H-P Deal May Kill Mercury Suit” (here), one of the individual defendants (who is represented by the Wilson Sonsini firm) has filed a motion to dismiss based on the argument under Delaware law that as a result of the H-P acquisition, the plaintiffs lack standing to assert the claim against the individual defendants. The only way the case can continue is if H-P decides to take it up on its own. The story has a definite "clash of the titans" feel to it, because the Lerach firm's response to the motion to dismiss is to contend that because of the Wilson Sonsini's firm's alleged involvement in the H-P board's brouhaha about its own Board investigation, Wilson Sonsini is or ought to be precluded from being involved in the Mercury Interactive lawsuit. Lerach's arguments based on the Wilson Sonsini firm's role with H-P probably indicates nothing so much as that the motion to dismiss is almost certainly meritorious, as mergers of this type generally divest plaintiffs of standing under Delaware law.

Thanks to Adam Savett of the Lies, Damn Lies blog (here) for the link to the Law.com article. (The comments about the case are strictly my own.)

Options Backdating Litigation Tally Update: The D & O Diary has updated its options backdating litigation tally (here) to add the new securities fraud class action lawsuit that has been brought against Aspen Technology (here). The addition of the Aspen Technology lawsuit brings the number of securities fraud lawsuits based on options timing allegations to 16. In addition, the number of companies sued in shareholders’ derivative lawsuits is now stands at 71, with the addition to the lawsuit against Home Depot (here), THQ (here), and Witness Systems (here).

Request for Information: As previously noted on The D & O Diary (here), Lynn Turner, the former Chief Accountant at the SEC and now a managing director at Glass Lewis, testified on Capitol Hill on September 6, 2006. As part of his written testimony (here), Turner attached an appendix that listed the companies involved in the options backdating investigations. A column on the appendix purported to identify the companies that have been named in options backdating shareholder suits (but not differentiating between securities fraud suits and shareholders' derivative suits). There were some companies that were not identified in Turner's exhibit as having shareholder suits that have in fact been sued (e.g., Mattel), and there were others identified as having been sued that The D & O Diary simply cannot independently corroborate as having been sued. The companies that Turner lists as having been sued for which The D & O Diary can find no corroboration are: Amkor, Blue Coat, Boston Communications, Dot Hill, Molex, and Newpark Resoureces. Most if not all of these six companies have shown up on various plaintiffs' law firms' press releases as being "under investigation" but as far as I have been able to determine they have not actually been sued. The D & O Diary would greatly appreciate it if its readers could provide any further corroboration about the existence of lawsuits against these companies -- or any others that do not appear on The D & O Diary's list of options backdating lawsuits.

Special thanks to Michael Miraglia for a link to the Turner testimonial exhibit and to Bill Ballowe for his help in locating options backdating lawsuits.

More About MBOs and D & O Risk

The D & O Diary has written on several prior occasions (here, here and here) about the increasing D & O risk arising from the public company involvement of private fund investors, such as private equity funds, hedge funds and buy-out firms. In a prior post (here), The D & O Diary discussed the increased complexity arising from the involvement of public company management in private investors' take overs, in the form of "management buy outs"(MBOs). In a September 8, 2006 article entitled “In Some Deals, Executives Get a Double Payday,” (here, subscription required) the Wall Street Journal focused on the conflicts of interests that can arise when management becomes involved in “going private” buy-outs of public companies; the article noted that private-equity firms will team up with management to improve their take-over bid, and that the private investors sweeten the deal by providing management with significant financial inducements:

In such cases, management with all its detailed knowledge of the company, goes from being a seller striving for a higher price to being a buyer looking for an attractive price. Usually the sale of a public company involves an auction or a competitive-bidding process. But when management joins private-equity buyers, there often isn’t such an open procedure, and the process is especially fraught with potential conflicts of interest.

The Journal article emphasizes that the conflict is all the more abrupt when private investors offer management lucrative compensation packages that could permit management to benefit significantly if the buy-out is successful. The compensation can involve ownership participation and substantial performance bonuses.

While many boards actively review the takeover proposals, the take-over bidder will also attempt to skew the process in their favor, for example by telescoping the period where the bid remains open, forcing potential rival bidders to act on short notice. Potential bidders (who do not enjoy the support of management, but who may present a proposal that is more to shareholders’ benefit) also may face a prohibitively high “break up” fee to try to get rid of the original bidder.

As may be expected, shareholders “sometimes revolt against such largess” as company management stands to gain in the buy-out transaction. The article cites the lawsuit Petco Animal Supplies shareholders filed in August 2006 against the company’s directors based on the directors' “attempts to provide certain insiders and directors with preferential treatment in connection with their efforts to complete the sale of Petco” to private equity investors. A more detailed description of the Petco transaction, including the company's decision to go with the management led bid even though the rival bidder offered shareholders a 13.3% higher proposal, and including a more detailed description of the lawsuits (and the substantial benefits that management stands to gain if the original bidder successfully completes its buyout), can be found here.

As The D & O Diary previously has noted, the increasing involvement of private financing in public company ownership creates an environment where conflicts of interest -- and accusations of wrongdoing -- can more easily arise. These claims possibilities also present an enormously complicated D & O exposure environment. These considerations also make it more important than ever for companies to involve knowledgeable and experienced insurance professionals in their D & O insurance acquisition.

Is SOX Putting the Plaintiffs’ Lawyers Out of Business?

The Institutional Shareholder Service (ISS) Corporate Governance Blog has a September 7, 2006 post entitled “Has SOX Led to Fewer Lawsuits?” (here) that raises the question whether the declining number of securities lawsuits in 2006 (here) is due to improved corporate governance because of the Sarbanes-Oxley Act. While the CG blog is careful to note that multiple factors may be causing the declining number of lawsuits, it does also note that “[m]ost U.S. companies have significantly improved their governance practices,” and quotes Stanford Law School Professor Joseph Grundfest’s statement that “the most intriguing hypothesis” for the decline in the number of lawsuits “is that extensive and expensive efforts to improve governance and accounting have reduced plaintiffs’ ability to allege fraud.” The article quotes seveal other academics to the same effect.

The D & O Diary certainly hopes that the burdens and expense Congress mandated in Sarbanes-Oxley has improved corporate governance and reporting. But The D & O Diary continues to suspect, as it previously noted here, that the decline of securities lawsuits may have more to do with the Milberg Weiss indictment and the impact it has had on the ability of the entire plaintiffs’ bar to be able to rely on paid plaintiffs in order to file lawsuits. (In fairness, the CG blog cites the Milberg Weiss indictment as a possible cause of the reduced number of securities suits.)

The D & O Diary remains skeptical that SOX itself is reducing plaintiffs' ability to raise fraud allegations, for a number of reasons. If SOX really were having such a salutary impact, there would be a few expected effects, none of which have yet happened. For instance, if there really were such a significant reduction in corporate misbehavior that plaintiffs’ lawyers simply couldn’t find fraud to allege, you would think that the Enron task force would be starting to think about winding down because it should be starting to run out of companies to investigate and prosecute. But in an interview in the September 2006 issue of CFO Magazine (here) , U.S. Deputy Attorney General Paul McNulty, who heads the Enron task force, was asked, “Do you envision a time when the Task Force won’t be necessary?” McNulty answered

No. The need to remain vigilant in this area is not going to go away. We see things emerging regularly that remind us that there are tremendous temptations in the area of business finance and that there will always be a certain percentage of people who will not resist the temptation to enrich themselves.

If prosecutors don't see any threat to their livelihood, why should we suppose that plaintiffs' lawyers will not have anything to do?

And if there really were a shortage of material upon which plaintiffs' might base securities fraud complaints, it might be expected that the plaintiffs' lawyers would be leaving the field and trying to find something else to do. Instead, exactly the opposite is happening. As has been noted previously on this blog (here) and more recently on Adam Savett's blog, Lied, Damn Lies (here), the ranks of plaintiffs' securities firms has been swelling recently with the addition of several firms who previously were best known for their involvement in asbestos or tobacco litigation. Clearly, these firms would not be coming into the arena if they didn't think there were sufficient opportunities.

Another reason to be skeptical that company behavior is so improved that plaintiffs’ lawyers livelihood is imperiled is the statements of CFOs themselves about their own conduct. The September 2006 issue of CFO Magazine also reports (here) that in August 2002, when SOX was enacted, 9% of CFOs surveyed reported that on one or more occasions (7% on three or more occasions) their company had engaged in aggressive accounting practices in the last three years. If SOX really did categorically improve corporate conduct, these numbers would be expected to decline. Instead, the magazine found that today, 18% of CFOs surveyed reported that on one or more occasions (6% on three or more occasions) their company had engaged in aggressive accounting practices in the last three years.

As McNulty said, a “certain percentage” of people are always going to find motivations to justify their conduct. SOX changed the rules, but it did not change human nature. The D & O Diary is skeptical that SOX alone will deprive plaintiffs’ lawyers of their livelihood.

D & O underwriters will be interested to know that the CFOs who reported having engaged in aggressive accounting practices during the last three years identified the most common areas involved (some CFOs identifies more than one area) as revenue recognition (65%) and reserves (55%).

CEO Compensation and Real Estate Bubble Wrap: Michelle Leder, the author of the Footnoted.org blog, has written an article on Slate.com (here) entitled “The CEO Real Estate Scam,” in which she comments on the “first post-real-estate-bubble compensation trick.” CEOs, she claims, have “figured out how to shelter their own houses from the declining real estate market.—by getting their corporations to guarantee their sale price. You may be sweating that you have to sell at a loss, but your CEO isn’t.” Leder writes that

since the beginning of this summer, at least a half-dozen companies, including eBay and Nike, have disclosed in their routine Securities and Exchange Commission filings that they’re now protecting their executives from real estate market forces. The terms may vary – protection against loss, loss protection, and price protection – but the meaning is the same: They are essentially guaranteeing that executives’ homes will sell for a good price. In other words, companies that depend on free markets are making sure that their own executives are safeguarded from them. In the past, companies often offered to buy a relocating executive’s house if it didn’t sell after a specific amount of time. But that’s different than the price guarantees now being offered.

In a September 7, 2006 post on Footnoted.org (here), Leder reports that Clorox also offered its new CEO a “loss protection” provision in connection with his sale of his current home. Leder notes that “the idea of protecting top executives of publicly traded companies – the very people you’d expect to epitomize the power of free markets—from market forces just because these markets happen to be declining is more than a little ironic.” Perhaps the “most ironic example” that Leder cites in the Slate article involves Orleans Homebuilders, which as disclosed that it has offered one of its executives “price protection” on the sale of his home. As Leder notes, “I can only guess that the company does not offer a similar program to any of its customers, who will bear the brunt of falling prices as the real estate market tanks.”

The D & O Diary notes that the irony notwithstanding, there is absolutely nothing wrong with CEOs negotiating at arm’s-length for compensation terms they find desirable, particularly where (as seems to be the case in each example that Leder cites) those terms are fully disclosed. The real problem with CEO compensation comes from terms that are not the result of arm’s-length negotiations or are not disclosed. That said, however, CEOs willingness and ability to insulate themselves from the scary real estate situation that everyone else has to deal with is not going to help them win any popularity contests.

The Options Lawsuits List has Been Updated: Speaking of Clorox, The D & O Diary has updated its list of options backdating lawsuits (here) to include the shareholders' derivative suit that has been filed against Clorox (here) in connection with its options timing investigation. The list has also been updated to include derivative suits that have been filed against Corinthian College (here), Cheesecake Factory(here), and Progress Software (here). This brings the number of options related derivative lawsuits to 66. The number of securities fraud class action lawsuits stands at 15. The D & O Diary reiterates here its entreaty to its loyal readers to please let the Diary know of any lawsuits of which readers are aware that have been omitted from the list.

Analogies Like Chalupas Full of Guacamole: Read the story, here.

Capitol Hill Looks at Options Backdating

The unfolding options backdating story may have hit its high water mark (or its low point, depending on your perspective) on September 6, 2006, when the Senate Committee on Banking, Housing and Urban Affairs and the Senate Finance Committee both held hearings concerning options backdating. The hearings involved the testimony of numerous regulators, academics and other pundits, and included the testimony of SEC Chariman Christopher Cox (testimony here), which was noteworthy for its identification of Internal Revenue Code Section 162(m) as the culprit in the scandal. Among other things, Cox said:

…one of the most significant reasons that non-salary forms of compensation have ballooned since the early 1990s is the $1 million legislative caps on salaries for certain top public company executives that was added to the Internal Revenue Code in 1993. As a Member of Congress at the time, I well remember that the stated purpose was to control the rate of growth of CEO pay. With complete hindsight, we can all agree that this purpose was not achieved. Indeed this tax law change deserves pride of place in the Museum of Unintended Consequences…The million-dollar cap on tax deductibility of executive compensation…doesn’t apply to options granted at fair market value. So for companies that wanted or needed to pay compensation in excess of $1 million per year, the tax code outlawed deducting it if it was paid in a straightforward way through salary, but permitted a deduction if the compensation was paid through at-the-money options.

So the tax law encouraged at-the-money options, which in turn encouraged creative actions to maximize the return under the options.

Linda Thomsen, Director of the SEC Enforcement Division, also testified (here) about the tax incentives that provide context for options backdating.

Cox’s and Thomsen’s testimony also make interesting reading for the history they provide about the SEC’s enforcement activity in connection with the options timing investigations, and in particular the enforcement activity that preceded the media attention that was drawn to the issue earlier this year. Cox’s testimony reviews the 2003 enforcement proceedings the SEC brought against Peregrine Systems, and the 2004 action against Symbol Technologies. (Thomsen’s testimony also discusses the Symbol Technologies action in detail.) Peregrine Systems was charged with financial fraud for failing to record any expense for compensation when it issued incentive stock options. The Symbol Technologies case involved manipulation not of options grant dates but of exercise dates, to ensure that the exercise date was the most advantageous to the grant recipient during a 30-day lookback period. The Symbol Technolgies complaint, which alleged numerous allegely misleading activites, was settled with a payment of $37 million.

Cox’s stated that the SEC’s Enforcement Division is “currently investigating over 100 companies concerning possible fraudulent reporting of stock option grants.” Cox added that while not all of these investigations will result in enforcement proceedings, “we have to expect that other enforcement proceedings will be forthcoming in the future.”

The written testimony of all of the witnesses who appeared before the Senate Banking Committee can be found here. The written testimony of all the witnesses who appeared before the Senate Finance Committee can be found here. The Wall Street Journal’s September 7, 2006 article describing the hearings can be found here (subscription required).

Options Timing Hot Seats Multiply: Senate Finance Committee Chair Charles Grassley (R. Iowa), in his closing remarks at the hearing (which can be found here) declared his intentions to target “all the actors” involved in the options backdating scandals. That includes accountants, lawyers, and compensation consultants who advised executives to backdate options, and board members who “blessed it or looked the other way.” Sen. Grassley apparently is going to lead a campaign to request materials from companies involved in the backdating investigation, including board minutes regarding the decision to backdate “as well as any and all materials from advisors…who assisted in these efforts.” Grassley also said that he is considering legislation to address the tax issues that Cox and other identified.

More about Options Springloading: The testimony on Capitol Hill reflected the continuing debate surrounding options springloading (granting options now in anticipation of good news later that it is anticipated will increase the company’s share price). As The D & O Diary has previously noted (here), options springloading seems categorically different from options backdating, among other reasons the value of the options at the time of the grant cannot be locked in as with options backdating, since there is no way to be sure how the market will react to the impending news. In addition, some commentators, including SEC Commissioner Paul Atkins (remarks here), have publicly stated that they see nothing wrong with springloading. But in his testimony before the Senate Banking Committee (testimony here) Lynn Turner, the former chief accountant at the SEC, came down in strong disagreement “with those who say it’s not illegal or a problem.” Turner clearly equates springloading with trading on inside information, and therefore unlawful. He also cites numerous ways in which the failure to disclose springloading would make proxies and other disclosures misleading. He concludes his thoughts about springloading by saying "I believe that disclosures made in the past regarding springloaded options grants will be found in all too many instances to have been false and misleading, violating the securities laws and regulations." Turner also asks rhetorically with respect the options practices that have come to light"Where were the gatekeepers, including legal counsel and independent auditors?"

The Cost of Backdating: Three University of Michigan professors have written an article entitled “The Economic Impact of Backdating of Executive Options,” (here) which attempts to determine the financial impact of options timing. The authors analyzed thousands of stock option grants between 2000 and 2004 at 48 companies who had announced prior to July 1, 2006 that they were under investigation in connection with stock options practices. The authors measured the maximum possible gains for executives if they backdated every option grant during that period. The authors also measured the drop in market capitalization of the 48 companies by comparing the companies’ share prices in the ten days before and the ten days after the news of the backdating inquiry was released. The authors found that while the average executive’s pay would have been increased about 1.25 percent, the average decline in market value per company when the news of the options investigation was announced was an average of eight percent.

The D & O Diary notes that while the cost of options backdating to the companies and their shareholders clearly is greater than the benefit to the executives, the eight percent market cap decline that the authors’ determined is consistent with The D & O Diary’s ongoing theory on why this scandal has not produced more securities fraud litigation. (According to the D & O Diary’s tally, here, there have only been 15 companies sued in securities class action lawsuits so far.) A stock price drop of that magnitude is just not sufficient to attract the attention of the plaintiffs’ lawyers. Indeed, in a September 5, 2006 New York Times article (here, registration required), Melvin Weiss of the Milberg Weiss firm is quoted as saying in explanation for why there is not more securities fraud litigation in connection with the options timing scandal, "A lot of these companies aren't reacting with big drops in price, or, if they dropped initially, they come back over a short period of time."

The D & O Diary also has an observation about the authors’ presentation of their research. While their paper is now available on line, it states on its face that it will appear in the June 2007 issue of the Michigan Law Review. The article is timely and topical now, but by next summer it is going to be completely out of date. Almost all of the footnotes will have been superseded by intervening events, and many of the legal issues that the authors conjecture about will have been addressed in actual proceedings. The lag time almost guarantees that the article, while relevant today, will be completely irrelevant by the time it appears in a traditional publication form. All of this is by way of observation that the Internet may be making traditional forms of legal scholarship obsolete. Perhaps Internet weblogs are the rightful successors to more traditional law journals in an Internet age.