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.