Paulson Committee Releases Interim Report

The Committee on Capital Markets Regulation (popularly known as the “Paulson Committee”) has released its “Interim Report” (here). Weighing in at 148 graphic intensive pages, the 11.50 mb document is a memory hog. Readers who want a quick overview and don’t want to spend the rest of the day trying to download the entire report will want to refer to op-ed commentary by Committee members R. Glenn Hubbard and John L. Thornton, entitled “Action Plan for Capital Markets” in today’s Wall Street Journal (here, subscription required), which provides an overview of the Report’s recommendations “needed to maintain and improve the global competitive position of U.S. capital markets for investors.”

The authors cite the declining valuation premium afforded to foreign securities listed on U.S. exchanges as evidence of the U.S. markets declining competitiveness. (The D & O Diary’s prior post about the valuation premium can be found here.) The Committee recommends a number of regulatory or legislative changes to address this concern including:

• better implementation of Sarbanes-Oxley’s Section 404 internal control requirements, including a revision of PCAOB Auditing Standard No. 2 to ensure that reviews are risk based and focused on significant control weaknesses;
• elimination of uncertainty in private enforcement of Rule 10b-5, through the SEC’s provision of more guidance on the elements of a Rul10b-5 action, including materiality, scienter, and reliance;
• reduction of the risk of criminality of the corporate entity so that it is a last resort, and the elimination of existing guidelines in the Thompson Memo that require companies to waive the attorney client privilege and eliminate employees’ attorneys’ fee;
• strengthening of shareholder rights and elimination of barriers to an efficient and competitive market (focusing on such elements as poison pills, staggered board, and classified boards) allowing shareholders to devise alternatives to the present litigation system, such as the waiver of the right to a jury trial or adoption of arbitration, implemented at the time of the IPO or amendment to corporate charters or bylaws;
• elimination or reduction of gatekeeper litigation against auditors, either through a cap on auditor liability or creation of a safe harbor for certain auditor practices, and reduction of outside directors’ gatekeeper exposure by making an outside director’s good faith reliance on an audited financial statement sufficient to meet the standard of care;
• adoption of a cost-benefit analysis for future regulation, to assure that regulations achieve the intended effect at an appropriate cost;

The Wall Street Journal has a more detailed bullet point summary of the Committee’s recommendations here.

While the Committee’s Interim Report is impressive, if nothing else for its sheer girth, this is merely the opening salvo in what will likely be a very prolonged exchange of views and proposals. Among other things, the U.S. Chamber of Commerce is expected to release its own report early next year. In addition, Sen. Charles Schumer and NY Mayor Michael Bloomberg have hired McKinsey & Co. to assess market competitiveness and its impact on the city’s economy. The Treasury department is hosting a conference early next year to discuss the state of the country’s regulatory, legal and accounting environment. What changes, if any, will ultimately emerge at the end of this process will only be revealed in the fullness of time.

The Interim Report obviously has a lot to say about issues potentially affecting the liability exposures of directors and officers of public companies. The D & O Diary will be taking a look at these portions of the Report and providing its views in a blog post to be added in the next day or two. In the meantime, I would be very interested in any thoughts or comments that readers have about the Interim Report.

Outside Director Liability: Recent SEC Enforcement Action

In a recent post (here), The D & O Diary examined the SEC’s decision not to pursue an enforcement action against the outside directors of the Hollinger International and examined what this move might suggest about the potential liability and enforcement action exposure for outside directors of companies caught up in the options backdating scandal. A recently settled SEC enforcement action filed against three outside directors of Spiegel suggests that, at least under certain circumstances, the SEC will pursue enforcement actions against outside directors. And even though it did not involve option timing allegations, the recent action against the Spiegel outside directors may also shed some light on outside directors’ enforcement exposures in connection with the options backdating investigations.

According to the settled enforcement action that the SEC filed on November 2, 2006 (here), in 1982, OTTO Gmbh & Co., a German mail-order company primarily owned by Michael Otto, acquired Spiegel. Spiegel went public in 1997 by listing a portion of its shares on NASDAQ. Otto served as Spiegel’s board Chair. Also serving on the Spiegel board were two other Germans, Michael Crusemann and Horst Hansen.

In early 2002, as a result of Spiegel’s deteriorating financial condition, Spiegel’s independent auditor advised that it would have to consider a “going concern” modification in its audit report that would accompany Spiegel’s financial statements in its 2001 10-K. Spiegel itself was working to line up new credit facilities that the company believed would address the auditor’s concerns and permit a clean audit report. Because the company did not want to face the market consequences that would result from the going concern opinion, it sought to withhold the 10-K filing while it tried to remedy its credit issues.

According to the SEC, between April 2002 and February 2003, Otto, Crusemann and Hanson, participated in a series of decisions to withhold the company’s SEC fillings. The directors actively participated in decisions to withhold the filings even though their inside and outside counsel specifically advised them that the failure to file violated American law and exposed the company and its officers to legal liability. The SEC also alleged that Cruseman and others received a document entitled “Pros/Cons to Filing Form 10-K” specifically stating that corporate officials could be personally liable for failure to file. The document also attached copies of securities laws indicating liability for the failure to file. Despite these warnings, the SEC alleged, the director actively decided that Spiegel should withhold its filings to avoid having to disclose the "going concern" opinion.

Spigel not only failed to file its 2001 10-K, but also failed to file its Form 10-Qs for the first three quarters of 2002. Spiegel ultimately filed the delinquent forms in February 2003, after the SEC threatened to file an enforcement action. Within weeks of the belated filings, Spiegel filed for Chapter 11 bankruptcy.

According to the SEC’s news release announcing the enforcement action settlement (here), Otto and Crusemann consented to the Court’s issuance of a permanent injunction against them enjoining them from future violations of the securities laws, and each consented to pay a civil penalty of $100,000. Hansen, the former head of Spiegel’s audit committee, consented to the SEC’s entry of an order ordering him to cease and desist from committing or causing future violations of the federal securities laws.

The SEC’s enforcement action clearly shows that at least under certain circumstances, the SEC will pursue outside directors. However, it is important to note that, at least according to the SEC’s allegations, the Spiegel directors did more than merely failing to supervise. They are alleged to have been actively and directly involved in the decision to withhold Spiegel’s filings, and to have done made those decisions with actual knowledge that the failure to file violated the securities laws. In effect, the directors were alleged to have knowingly pursued an illegal course of conduct.

In an interesting November 29, 2006 Law.com article (here), Christian Bartholomew of the Morgan, Lewis & Bockius law firm provides his views on what the Spiegel case might mean for possible outside director liability in the options backdating scandal. Bartholomew contends that the Spiegel enforcement action ought to set standard for what should be required before the SEC pursues options backdating-related enforcement proceedings against outside directors. Bartholomew argues that the enforcement action “should be limited to situations where the evidence is clear and compelling that a director actively and knowingly engaged in or materially assisted in an improper options dating scheme, fully understanding the legal, accounting and disclosure ramifications.” By the same token, “the SEC should not pursue backdating actions arising simply from a director’s failure to act or to intervene to halt management misconduct.”

Bartholomew’s observations about what might be described as the “Spiegel standard” are interesting, but it still remains to be seen exactly how the SEC will approach this issue. The SEC has already served three outside directors of Mercury Interactive with Wells Notices in connection with the company’s options backdating investigation (see the company's press release here). Time will tell whether the SEC limits its options backdating-related enforcement actions against outside directors to cases of knowing and active violations of the kind alleged in the Spiegel case.

Seven Contemptible Years: On November 27, 2006, the Second Circuit refused (here) to overturn a lower court’s denial of Martin Armstrong’s petition for a writ of habeas corpus. Armstrong has been in prison since January 14, 2000 for his refusal to turn over corporate records and $15 million in assets in connection with a securities fraud investigation involving his companies.

Armstrong was arrested in 1999 on charges that he defrauded Japanese investors out of $3 billion by falsely promising to invest in certain low risk assets, while he instead lost $1 billion in speculative trading that he attempted to cover up through a “Ponzi scheme.” In early 2000, in response to a civil contempt proceeding against him, Armstrong had produced $1.1 million in rare coins, one computer with the hard drive removed, three other computers (which later proved to have been tampered with), and various other assets. Armstrong failed to produce other subpoenaed items, including other specified computers, 102 gold bars, 699 bullion coins, and other rare coins worth $12.9 million. Armstrong testified that he kept some of the assets “hidden in a shed in the back yard” of his mother’s house and transferred others to business associates allegedly to pay off debts. The district court held Armstrong in contempt and “directed the marshals to confine Armstrong to the Metropolitan Correctional Center until he either complied with the turnover orders or demonstrated that it would be impossible to do so.” At periodic hearings since Armstrong’s incarceration on January 14, 2000, Armstrong has failed to comply or prove his inability to do so. Among other things, Armstrong has consistently contended that he has no obligation to do so, relying on his alleged constitutional rights against self-incrimination and his rights to due process.

Armstrong filed the habeas petition in August 2004 to raise constitutional objections to his confinement. The district court denied his petition in December 2004, which Armstrong appealed. On August 17, 2006, while his appeal was pending, he pled guilty to securities fraud.

In his appeal of the denial of the writ, Armstrong argued that, contrary to the district court’s statement that he “holds the keys to his prison cell,” the “key to his freedom comes at the cost of his Fifth Amendment right against compelled self-incrimination” and that his confinement also violates the Non-Detention Act, the Recalcitrant Witness Statue and due process. The Second Circuit affirmed the district court’s denial of the writ, based on the district court’s finding that Armstrong is capable of complying but is simply choosing not to do so. The Second Circuit held that the constitution did not protect him against producing the property and that Congress had “specifically authorized indefinite, coercive confinement.” The Second Circuit did conclude that Armstrong is entitled to a new hearing to assess whether he retains custody or control of the property. The court also noted that “on the seventh anniversary of Armstrong’s confinement, his case deserves a fresh look by a different set of eyes,” and directed the district court to reassign the case to a different judge.

"Indefinite, coercive confinement" certainly has a chilling sound to it. Perhaps it is time to retrieve those coins from Mom's back yard.

A November 30, 2006 New York Law Journal article about the Armstrong case can be found here.

Hat tip to the Courthouse News Service (here) for the link to the Second Circuit opinion.

While My Ukulele Gently Weeps: It has been a while since the D & O Diary has had any pretext to link to a YouTube video. We therefore choose to use the occasion of the release of new Beatles’ Love compilation CD to commend to its loyal readers the video linked below. The D & O Diary has never had a very high opinion of the ukulele (it is looks like a shrunken guitar, it has a plink-plink sound, and it is spelled weird) but this video (here) depicting an absolutely virtuoso ukulele performance of “While My Guitar Gently Weeps” requires a complete reassessment of the ukulele. The performance is, in a word, awesome. Enjoy.

The Wall Street Journal has a generally favorable November 29, 2006 review of the new Beatles’ Love compilation CD here (subscription required).

According to Wikipedia (here), the word "ukulele" roughly translates from Hawaiian as "jumping flea." Now you know.

Compensation Consultant Named as Options Backdating Lawsuit Defendant

Shareholders suing Cablevision Systems over its backdated options have amended their complaint to add the company’s former compensation consultant as a defendant. According to news reports (here), the allegations against Lyons Benenson & Co., the company’s former compensation consultant, are the first in the nation to accuse a compensation advisor of taking part in a backdating scheme.

Cablevision’s options granting practices gained a certain macbre notoriety for their involvement of the first known instance of “Sixth Sense” options grants (“I pay dead people” – hat tip to Patrick McGurn at the ISS Corporate Governance Blog, here, for that great one-liner). In its 2Q06 10-K (here), Cablevision reported that its internal options investigation uncovered that the company had awarded options to a vice chairman after his 1999 death, but backdated them, making it appear that the grant was awarded when he was still alive. As Columbia Law School professor John Coffee dryly commented (here), “Trying to incentivize a corpse suggests they were not complying with the spirit of shareholder-approved stock-option plans.”

Cablevision’s filing also disclosed that its internal investigation had discovered that options had also been awarded to its compensation consultant, but that the options award had been accounted for as if the consultant were an employee. The filing reported that the award had been canceled in 2003. The filing also noted that the company’s “relationship with the company…terminated” more than a year before the options investigation began.

The company also restated its earnings for 2003 through 2005 and the first quarter of 2006 to adjust for the impact of improper options practices, which reportedly took place during the period 1997 through 2002. The company has announced that it is under investigation by the SEC as well as the U.S. Attorney’s office. The company has also received a grant jury subpoena.

The shareholder action naming Lyons Benenson as a defendant was filed by Grant & Eisenhofer on behalf of plaintiff shareholder the Teachers Retirement System of Louisiana. The complaint alleges that Lyons Benenson attended compensation meetings during which backdated options were granted in violation of the company’s employee option plan. The complaint also alleges that the consultant provided the committee with advice and documentation to facilitate the grants. The complaint also contains allegations about the options awareded to the consultant; the complaint does not allege that the options were illegal or backdated, but that they were “unusual and inappropriate” given that they came from an option account designated for Cablevision employees.

Cablevision has also been in the news lately based upon the offer by the Dolan family, which controls the company, to buy out the company’s public shareholders in a deal that values the company at about $7.9 billion. The D & O Diary previously commented on the buy out offer here. As noted in the Wall Street Journal article (here, subscription required) reporting on the Dolan’s buy out offer, the company’s recent history has been “turbulent,” as detailed further in the article.

While the Cablevision shareholders’ claim against Lyons Benenson may be the first against a company’s compensation consultant arising out of the backdating scandal, there may be many more claims against the outside advisers to companies caught up in the backdating scandal. Attorneys, auditors and others undoubtedly will also be drawn in as the story continues to unfold. (See more details below about options backdating litigation.)

What Can EDGAR Tell Us About Lyons Benenson?: The D & O Diary had not previously heard of Cablevision’s erstwhile compensation consultant, so this seemed like a good opportunity to test out the new full-text search capabilities of EDGAR, on the SEC website. (See the SEC’s November 14, 2006 press release about the new full-text search capabilities, here.) A full-text EDGAR search on the name Lyons Benenson revealed several instances associating the firm or one of its principals with various public companies. (It should be noted that the searchable text is limited only to the last four years.)

The 2002 10-K of ACTV, Inc. (here) revealed that the company had hired Lyons Benenson as a compensation consultant in 1999.

The December 22, 2003 proxy statement of DRS Technologies (here) disclosed that the company previously had retained Lyons Benenson to "assist in the design, assessment, and implementation" of the company's compensation system, but at the end of the most recent fiscal year had replaced the consultant with another firm.

The April 7, 2006 Proxy Statement of CKX, Inc. (here) disclosed that the company had retained Lyons Benenson as a compensation consultant "to assist the Committee in fulfilling its responsibilities and to provide advice with respect to all matters relating to executive compensation and the compensation practices of similar companies. The consultant is engaged by, and reports directly to, the Compensation Committee. Harvey Benenson generally attends all meetings of the Compensation Committee on behalf of Lyons, Benenson & Company Inc."

In addition, according to 2005 10-K of Penn Octane (here), Harvey L. Benenson, who is described in the filing as a "Managing Director, Chariman and Chief Executive Officer" of Lyons Benenson, served as a director of the company since his election in August 2000. Benenson also served on the company's audit and compensation committees. However, according to news reports (here), Benenson resigned from the Penn Octane board in October 2006.

Options Backdating Litigation Update: As a result of the latest additions to The D & O Diary’s running tally of options backdating litigation (which may be found here), the total number of companies named as nominal defendants in options backdating related shareholder’s derivative lawsuits now total 117. The number of companies sued in options backdating related securities fraud lawsuits stands at 21.

OK, But They Don't Get Any Stock Options Awards: From the IMdb website (here), which touts itself as the "Earth's Biggest Movie Database":

Cole Sear: I see dead people.

Malcolm Crowe: In your dreams? [Cole shakes his head no]

Malcolm Crowe: While you're awake? [Cole nods]

Malcolm Crowe: Dead people like, in graves? In coffins?

Cole Sear: Walking around like regular people. They don't see each other. They only see what they want to see. They don't know they're dead.

Malcolm Crowe: How often do you see them?

Cole Sear: All the time. They're everywhere.

Cole's perception is familiar to those (including your faithful correspondent) who have worked in certain office environments.

Regulatory Reform: Solving a Problem or Introducing a Weakness?

The Committee on Capital Markets Regulation (or the "Paulson Committee" as the group has come to be known) is scheduled to release its recommendations later this week, on November 30. The Paulson Committee is concerned with the competitiveness of the U.S. securities exchanges in the global marketplace, and the perceived inability of the U.S exchanges to compete due to the heavier regulatory and litigation burden in the U.S. Anticipation is building as the release date approaches; The Economist magazine's cover this week (reproduced above) depicts the iconic Wall Street bull entangled in red tape and asks the question "Wall Street: What Went Wrong?" A prior D & O Diary post examining some of the potential litigation reforms may be found here.

But while we are awaiting the Committee’s actual recommendations, it is still timely to ask whether the regulatory burdens really are causing the non-U.S. companies to list their shares on other exchanges or if perhaps something else may be going on.

A speech earlier this fall by Public Company Accounting Oversight Board (PCAOB) board member Charles Niemeyer entitled "American Competitiveness in International Capital Markets" (here), provides a critical challenge to many of the presumptions behind the regulatory reform efforts.

First, with respect to the notion that the regulatory burdens of the Sarbanes-Oxley Act caused a recent decline in the number of non-U.S. companies listing their shares on U.S. exchanges, Niemeyer shows that the decline of the U.S. share of IPOs listed throughout the world began declining long before Sarbanes Oxley; the U.S. share of IPOs declined dramatically between 1996 and 2001 (from about 60 percent of all IPOs to less than 6 percent), but between 2001 and 2005 – that is, the period after Sarbanes-Oxley’s enactment – the U.S. share increased somewhat (to about 15 percent in 2005). Sarbanes-Oxley clearly is not the explanation for the reduced U.S. IPO marketshare.

Niemeyer asserts that the decline in U.S. share of the global IPO marketplace may be due to a number of causes, the most significant of which may simply be the availability of capital in local markets due to the universally low level of interest rates. Niemeyer also notes that "several countries are in the midst of multi-year programs to privatize state-owned businesses." For example, five of the largest 2005 IPOs (by market capitalization) were privatizations of state owned entities in China and France. As Niemeyer notes, "there are considerable political, cultural, and other influences on such companies to list locally when their markets offer sufficient liquidity." The low interest rate levels and high level of capital availability means that shares of this type tend to be listed locally -- and many of these companies are quite large which explains the larger aggregate capitalization of IPOs outside the U.S.

Niemeyer also notes that foreign companies are often dominated by narrow "control groups" that, in countries with poor investor protections, "tend to have valuable private benefits derived from control, because they are able to extract benefits from the company unchecked by minority shareholder rights." Niemeyer notes that these control groups are loathe to submit to the types of investor protections provided by a listing of shares in the U.S. markets. So there may be many foreign companies that would not under any circumstances choose to list on U.S. exchanges either because of their nationalistic affiliation of because of their managers' self-interested aversion to U.S. shareholder rights.

Niemeyer also points out that a substantial part of the drop in the U.S. share of worldwide IPOs is due to a dramatic decrease in the number of IPOs by U.S. companies, from about 375 in 2000 to less than 100 in 2001. Even more important for purposes of assessing the competitiveness of U.S. exchanges, "there was no commensurate shift by U.S. based companies to markets in other countries." While a great deal has been made about the competitiveness of the London Stock Exchange’s Alternative Investment Market, Niemeyer points out that as of March 2006, only 29 of the AIM’s 2,200 companies were based in the U.S., and seven of those 29 have dual listings or otherwise trade their shares on a U.S. exchange. Niemeyer questions whether the remaining 22 companies would even have qualified to list on U.S. exchanges, given AIM’s lower thresholds for offering size and other lower offering prerequisites.

The question whether we should care that even some companies are resorting to AIM was underscored in the Wall Street Journal’s November 21, 2006 article entitled "For LSE, A Troubling Trend" (here, subscription required), which reported that "a number of companies [on AIM] have issued profit warnings lately." The article goes on to quote an AIM spokesman that "the profit warnings have more to do with the smaller size of companies, where you have greater economic risk." Another LSE official is reported to have conceded that some companies allowed to list on AIM, in hindsight, shouldn’t have. In other words, AIM’s low barriers (smaller size, earlier offering) to entry may be attracting some less qualified companies – companies that simply couldn’t list on U.S. exchanges. The article also reports that the AIM benchmark index is down 1.8% this year, compared with London’s benchmark FTSE 100 index, which is up about 10%.

Can the case be made that perhaps the U.S. exchanges are better off without the companies that can satisfy the lower regulatory burdens in other countries but not the U.S.? A November 25, 2006 Wall Street Journal article by Herb Greenberg entitled "Is IPO Slowdown a Bad Thing, As Sarbanes-Oxley Foes Claim?" (here, subscription required) poses the question: "Has anybody stopped, just for a moment, to ask whether fewer IPOs might actually be a good thing? Seriously, maybe some of these companies shouldn’t go public in the first place, especially if they fear or don’t want to pay for laws that are attempting to crack down on skullduggery." Greenberg points out that "going public is a privilege and companies going through the process should welcome scrutiny and encourage proper barriers to entry."

Whether or not the U.S. exchanges are better off without some of the companies that are driven away by high regulatory barriers, it is unquestionably true that the high regulatory barriers produce benefits for the companies that meet the requirements. According to Niemeyer, companies that list their shares on U.S. exchanges receive a premium on their valuations. Niemeyer shows that non-U.S. companies that cross list in the U.S. enjoy a significantly lower cost of capital – in fact, the lowest in the world. This reduction in the cost of capital translates into a valuation premium that can reach as high as 37 percent more than their valuations would have been in their home markets. As Greenberg points out in his article, it is not as if the U.S. IPO business has withered and gone away. According to Greenberg, as of November 22, 2006, 172 companies had conducted offering on U.S. exchanges during 2006, raising a combined $38.8 billion. That compares with 213 offerings in all of 2005, raising a total of $38.5 billion. Hardly a slowdown, as Greenberg notes. {See the Update at the end of this post for additional information regarding the vaulation premium}

When the Paulson Committee releases its recommendations later this week, it will be worth asking with respect to the proposed reforms whether there really is a problem that needs to be remedied. As Niemeyer points out, one of the most important aspects of Sarbanes-Oxley is that it "reduces the risk of future catastrophic financial reporting failures." As the companies caught up in the current options backdating are finding now to their everlasting regret with respect to financial reporting, the "costs of getting it wrong still exceed the costs of getting it right."

Finally, while the reformers may be militating in favor of lowering U.S. regulatory burdens, other countries may be moving in the opposite direction. A November 23, 2006 Dow Jones Newswire article entitled "Insurers See Risk From U.S.-Style Lawsuits in Europe" (here) discusses concerns regarding the spread of U.S lawyers and the possible consequent spread of U.S. litigation to Europe and elsewhere. The article quotes European insurers for the view that "there are significant signs that the number of lawsuits is rising" outside the U.S. The article specifically cites the increase of class action litigation in Norway, Germany, Sweden and the U.K.

Hat tip to Jack Ciesielski at the AAO Weblog (here) for the link to the Niemeyer speech. Ciesielski also has an interesting commentary on the Greenberg article here. An interesting contrarian perspective on Greenberg's article may be found on Professor Larry Ribstein's Ideoblog, here.

The Economist Magazine's Perspective on Regulatory Reform: The article in The Economist magazine's issue with the red tape bound bull on the cover (reproduced above), entitled "Down on the Street," (here, subscription required) takes a characteristically balanced approach to the topic of regulatory reform. The article notes that many publicly listed companies are fleeing the glare of the public marketplace by going private; the article states "more of corporate America was taken out of public ownership by private-equity firms (spending $178 billion) in the first ten months of this year than in the previous five years combined ." The D & O Diary thinks this argument is a red herring; the boom of private equity acquisitions can only be understood as a direct outgrowth of the astonishing availability of private equity funding to invest. Corporate managers may welcome the chance to avoid the headaches of being a public company, but if there were not huge pots of money involved, the companies would remain public. The article is perhaps closer to the mark when it recalls that overly tight restrictions in the 1960s may have driven lenders and borrowers to London , leading to the creation of the Eurobond market, which now accounts for the largest share of publicly traded debt. The financial centers, New York, in particular will want to avoid ceding additional advantages.

The Economist may be closest to the mark when it recounts the quip from one unnamed Washington source that referred to the Paulson Committee as the "7% committee," referring to Wall Street's typical IPO underwriting fee, double that charged by European underwriters. The unstated suggestion is that the Committee's real goal is preserving Wall Street's oversized fees, which a neutral party assumes would be the first place that objective parties interested in advancing the competitiveness of America's securities markets would turn, rather than attempting to reduce regulatory protections.

The D & O Diary thinks investors' interests might be best served if we tried cutting underwriters' fees first, before cutting investors' protections, and see if that helps make U.S securities markets more attractive to foreign companies. That might also help preserve all the advantages that higher regulatory standards produce.

And Finally: In an earlier D & O Diary post, which may be found here, I reviewed the op-ed piece written by the head of an Indian company, in which the official explained his reasons why he proudly listed his shares on a U.S. exchange, notwithstanding the higher regulatory burdens. He felt that for his company the benefits far outweighed the burden.

Update: A November 28, 2006 Wall Street Journal article entitled "Is a U.S. Listing Worth the Effort?" (here, subscription required) reports on a recent study that will "figure prominently in a report to be released" by the Paulson Committee, and that reportedly concludes that "investors have sharply reduced the premium they pay for shares of foreign companies since a regulatory crackdown on corporate malfeasance in 2002." The newspaper article's lead would seem to suggest that this new study supports the Paulson Committee's underlying premise -- that is, that the new regulation has eliminated the valuation premium (discussed above) and therefore the Sarbanes Oxley related regulation is making the U.S. less competitive. However, the article discloses that in fact the premium has increased for companies from certain countries that have less rigorous local regulation (Italy, Austria and Turkey are specifically named), and that the decrease in the valuation premium has only taken place for companies from countries that have their own rigorous regulatory programs (Japan, Hong Kong, Canada and the United Kingdom). And for that matter, even in those countries with a decline, the decline is from 51 percentage points during the period 1997 to 2001, to 31 percentage points between 2002 and 2005.

While the study's sponsors interpret these data to mean that increased regulation is decreasing the valuation premium and therefore making the U.S less competitive, I have a hard time getting to that conclusion from this information. I think the fact that the premium has increased in countries with less rigorous local regulation means that the U.S regulatory approach is even more highly valued than before. Even if there is a decrease in the valuation premium for companies from more rigorously regulated, there is still a very significant valuation premium, and the decrease could be understood in any one of a number of ways, including the possibility that increased regulatory effectiveness in the other countries have started to reduce the value that is placed on the benefits of the U.S. scheme. The willingness of the London market to accept listings for companies that would not meet U.S standards is probably also a factor. Given the increase in the valution premium for companies from less rigorously regulated countries, and the still substantial valuation premium even for companies from more highly regulated countries, it is hard for me to see how decreasing regulation would improve U. S. competitiveness. It is entirely possible that what a lax regulatory scheme would accomplish is reducing the valuation premium (and the attractiveness of U.S. markets) for companies from the economies that will be growing most quickly in upcoming years.

SOX Clawback, Executive Compensation, and Attorneys’ Fees Recoveries

A November 20, 2006 Wall Street Journal article entitled "Companies Discover It’s Hard to Reclaim Pay from Executives" (here, subscription required) details the difficulty that companies are having in their attempts to compel executives to return compensation they didn’t really earn because, as a result of later restatements, the company didn’t actually hit the compensation triggers. It wasn’t supposed to be like this; Section 304 of the Sarbanes Oxley Act was supposed to facilitate the possibility of reclaiming bonuses from top executives when reported income is wiped out by later financial restatements. For a host of reasons, the SOX clawback provisions in Section 304 have failed to live up to their purpose:

1. The provision is poorly written: As Stanford Law School Professor Joseph Grundfest has said (here), "For a statute that contains a lot of inartfully drafted provisions, this is among the most inartful." The provision calls for the CFO or CEO to reimburse the company if an issuer has to prepare a restatement "due to material noncompliance of the issuer as a result of misconduct." However, the statute doesn’t specify what constitutes "misconduct" and it doesn’t specify whose misconduct qualifies. (Must it be the CEO’s or CFO’s own misconduct? Or is a lower level employee’s misconduct sufficient?)

2. Retroactivity?: Even though the statute was enacted in 2002, restatements often reach much further back in time. For example, in connection with several of the options backdating restatements, the period of the restatement in some instances has reached back into the early nineties. The applicability of the clawback provision to compensation awarded prior to Sarbanes Oxley’s enactment raises due process and other substantive concerns.

3. No "Private Right of Action": At least two federal district courts have held that there is no private right of action in Section 304. For example, in a derivative suit brought by shareholders of Stonepath Group to recover compensation paid to the company’s CEO and CFO, the court held, according to news reports (here), that Section 304 omitted a private right of action, by contrast to other sections of the Act where Congress made it clear whether or not investors explicitly had that right.

4. The SEC Prefers Its Other Remedies: If there is no private right of action, only the SEC can enforce Section 304. But the SEC has its own power to seek disgorgement of ill-gotten gains, which it prefers these other provisions because the other means, unlike Section 304, funnel money to shareholders rather than to the companies. The SEC has never enforced Section 304.

5. Calculating the Amount Due Can Be Tough: The Journal article linked above reports an example where a former executive of Dollar General agreed to return compensation following a restatement, but the compensation included options he had already exercised, and the shares he purchased were now valued below the price he paid. When his lawyers told him he owed $6.8 million, he said, "How on earth do you calculate that anyhow?" Attempts to recover executive compensation are fraught with these kinds of issues.

If there is no private right of action and the SEC won't enforce the provision, Section 304 is basically worthless.

According to the Journal article, Massachusetts Democratic Rep. Barney Frank, the anticipated chairman of the House Financial Services Committee, plans to propose legislation that would strengthen the ability of shareholders to recoup executives’ compensation. Shareholder advisory services apparently are actively seeking to compel by-law changes or other measures to facilitate compensation recoveries.

An interesting article by Richard Wood of the Kirkpatrick Lockhart firm discussing ways that to address these issues through executive compensation contracts can be found here.

Defense Fee Recoveries: The Journal also had another article (here, subscription required) on November 17, 2006 discussing the efforts of CA, Inc. (formerly known as Computer Associates) to recover $14.9 million in attorneys’ fees it paid on behalf of its now convicted former CEO Sanjay Kumar. The company obtained an order attaching Kumar’s property as security for the repayment of his attorneys' fees.

The company’s efforts to recover attorneys’ fees are much less complicated that the attempt to try to clawback executive compensation described above. (It should be noted that CA also eventually intends to try to recover compensation paid to Kumar as well.) CA’s efforts to recover the attorneys’ fees are substantially aided by provisions in the company’s by-laws, permitted under the law of Delaware, the state of CA’s incorporation. The by-law provisions (which are set forth at length in the White Collar Crime Prof blog, here) provide that the company’s advancement of legal fees can be conditioned on the officer’s agreement to repay amounts advanced if the officer is found guilty. Kumar’s guilty plea triggers the repayment obligations.

Many companies don’t bother to try to recover advanced fees because the convicted former official has no assets. However, at least according to the Daily Caveat (here), Kumar has substantial assets, including a couple of Ferraris, a 57-foot yacht, a $9 million home, and $20 million bond portfolio (which he just happened to transfer to his wife's name the day after the New York Times ran an article questioning his company's accounting). On the other hand, there are a lot of potential claimants for Kumar's assets (including the SEC, seeking to pursue its own recoupment action) that could have a superior claim on Kumar’s assets.

A “Modest Proposal” for Securities Litigation Reform

As The D & O Diary has previously noted (most recently here), the attempts by the Paulson Committee to propose ways to improve the competitiveness of the U. S. securities exchanges in the global marketplace may include securities litigation reform. Interest in the Committee's reform efforts increased substantially as a result of media reports (here) that among other things the Paulson Committee was considering recommending the elimination of a private cause of action under Rule 10b-5. However, in a November 16, 2006 New York Law Journal article entitled "Capital Markets Competitiveness and Securities Litigation" (here, subscription required), Columbia Law School Professor John C. Coffee, Jr. (who supposedly was the source of the recommendation to eliminate private Rule 10b-5 actions) disclaims having made any such recommendation. Instead, Coffee is recommending a "far more modest proposal."

Coffee’s reform proposal begins with his view that the current private securities litigation system is "dysfunctional," but "not because the lawsuits are frivolous or extortionate." Rather, the problem, Coffee believes, is "the circularity of the securities class action." The problem is that

Shareholders are suing shareholders. As a result, diversified shareholders wind up making pocket-shifting wealth transfers to themselves. In the common securities class action dealing with a stock drop in the secondary market, the recovery will go to those shareholders who bought the stock during the "class period"… and the recovery will be bourne by the other shareholders who bought the stock before or after that class period…Inherently, this implies that such an action produces only a shareholder-to-shareholder wealth transfer.

Nevertheless, Coffee thinks that the argument can still be made that securities class action lawsuits may be justified by their deterrence effect. But the problem is that they accomplish deterrence "by punishing the innocent – the shareholders." Coffee proposes a "system of managerial and agent liability that places costs instead on the culpable."

Coffee proposes that the SEC use its regulatory authority under Section 36 of the Securities Exchange Act of 1934 to shield non-trading public corporations from liability under Rule 10b-5. (Section 36 gives the SEC the authority to exempt "any person, security or transaction from any securities laws or regulations, if the exemption is "necessary or appropriate in the public interest, and is consistent with the protection of investors.") According to Coffee, this "would not eliminate a private cause of action under Rule 10b-5, but it would force the plaintiff’s bar to sue and settle with corporate officials and agents – i.e., auditors, underwriters and law firms – instead of treating the corporate entity as the deep pocket."

Coffee anticipates that the targeted directors and officers would seek to rely on indemnification and insurance if they are targeted by the plaintiffs' lawyers. Coffee recommends that the SEC should act to force corporate boards to take their decision whether or not to indemnify much more seriously, as a result of which, Coffee claims, "in some cases, indemnification might not be paid, and in all cases there would be greater uncertainty." With respect to D & O insurance, Coffee anticipates that active wrongdoers would face substantial coverage barriers (such as the conduct exclusions) as a result of which "the insurer and the corporate insider might well settle such an action on a basis that required some payment out the insider’s own pocket." At that point, Coffee says, "real deterrence begins to be generated."

Coffee’s recommendation to exempt companies from private securities lawsuits to force individuals to bear greater personal exposure as a way to increase deterrence is detailed in Coffee’s October 2006 law review article entitled "Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation" (here). Coffee’s law review article has an extensive review of the fact that although corporate insiders are regularly sued "they rarely appear to contribute to settlement," with specific examples. In the law review article, Coffee also examines at greater length the SEC’s authority under Section 36. Coffee’s article anticipates that his recommendation to exempt companies from Rule 10b-5 liability would "alter the market for D & O insurance" because "executives would demand more insurance;" on the other hand, the recommendation would also "eliminate entity insurance." Coffee’s law review article does not examine whether carriers might alter their basic terms and conditions, as insureds maneuver to assure that coverage for their liability would not be excluded and as carriers jockey to recapture premium revenue lost after entity coverage is eliminated.

The D & O Diary thinks Coffee's reform proposal is interesting. We do wonder how all of this would actually improve the competitiveness of the U.S. securities markets. Are the managers of foreign companies more likely to list their companies' shares on U.S. exchanges if the regulatory system is changed to increase their individual liability exposure while at the same time trying to reduce their access to indemnity or insurance? Coffee’s proposal may or may not be a good idea, but it doesn’t seem like it really has anything to do with the reasons for which the Paulson Committee was formed.

Hat tip to the Securities Litigation Watch blog (here) for the links to the New York Law Journal article and Coffee’s law review article.

Thompson Memo Reform?: Reform seems to be today’s theme. According to news reports (here), the U.S. Department of Justice is considering modifying the Thompson Memo to address concerns that prosecutorial pressure is forcing companies to cut off legal support to employees under investigation and to reveal confidential communications with the company’s lawyers. According to the news reports, all prosecutors in each of the 93 U.S. attorneys’ offices would have to get the approval of the attorney general or his top deputy before seeking attorney-client waiver. In addition, companies would not be penalized for refusing to reveal confidential communications with their lawyers – but the could still get credit for cooperation. The Justice Department reportedly is also considering deleting the language in the Thompson Memo referring to legal fees for "culpable employees."

According to the news reports, Deputy Attorney General Paul McNulty has not yet signed off on the proposed changes.

As Professor Ellen Podgor notes on the White Collar Crime Prof blog (here), these proposals represent "baby steps" in the right direction, but they "would not alleviate the problem" that has led to criticisms of the Thompson Memo. For a review of The D & O Diary’s prior posts discussing the Thompson Memo criticisms, refer here and here.

Fortune Smiles on Larry Sonsini: A November 17, 2006 Fortune.com article entitled "Scandals Rock Silicon Valley’s Top Legal Ace" (here) contains a lengthy portrait of Larry Sonsini and discusses his recent involvement in a number of high-profile imbroglios. After reviewing Sonsini’s rise to prominence, the article looks at Sonsini’s involvement, as an NYSE board member, in the dispute over former NYSE CEO Richard Grasso’s compensation; at Sonsini’s connection to the board pretexting scandal at H-P; and Sonsini’s involvement with several companies (including Brocade Communications) implicated in the options backdating scandal. The article essentially exonerates Sonsini on all issues, with the exception of Sonsini’s service on the boards of companies of which he also acted as outside counsel. However, the article reports that Sonsini has resigned or will resign from all of the nine corporate boards on which he previously served.

The "Buyout Boom" and D & O Claims

The D & O Diary has previously noted (most recently here) the problems that can arise in connection with “going private” transactions in which management teams up with outside investors to buy out public shareholders’ interests. The latest example may be Clear Channel Communications’ November 16, 2006 announcement (here) that a group led by Thomas H. Lee Partners and Bain Capital Partners will acquire the company for $26.7 billion (including $8 billion of debt assumption).

Early press reports of the proposed transaction were critical of the deal; for example, the Wall Street Journal’s November 14, 2006 article “Clear Channel Buyout Talks Fuel Concern of Management Conflicts” (here, subscription required) commented that the deal was the latest transaction raising concerns that “corporate executives may be pushing transactions that are ideal for themselves but might not be optimum for shareholders.” Among other things, the Journal commented on the “lightning-fast auction” process that produced the two competing bids for the company, and on the close ties between the company’s founders and managers, the Mays family, and the company’s board. The article also raised the question whether the company adequately considered bids from groups less friendly to the Mays family or considered whether a break-up would raise more money than selling the company as one piece. According to other news reports (here), other shareholders have publicly questioned the transaction, including the benefits to the Mays family and the fact that the acquirors plan to sell off assets to finance the transaction.

The Company’s November 16, 2006 8-K (here) describing the transaction reports some details of the deal that may also raise concerns. For example, the company has only until December 7, 2006 to consider any competing bids, and the company would, if it accepting a competing bid, it would have to pay the currently proposed acquirers a break up fee of $500 million. Past going private transactions have been criticized for similarly short “go shop” periods and for break up fees so large that potential competing bidders would be discouraged.

The 8-K also discloses that if following the completion of the transaction, either the company’s CEO, Mark Mays, or its CFO, Randall Mays, have their employment terminated under change of control provisions, they would each receive cash payments equal to the sum of one year’s base salary, bonus and accrued vacation pay, plus 2.99 times the sum of each executive’s annual salary and bonus, as well as three years continued benefits. (The 8-K does note that the executives did at least give up the right to a state and federal tax “gross up” as well as the right to received 1 million options upon termination.) According to news reports (here), these provisions for payment to the Mays family member represent a "significant reduction" from the amounts originally under discussion -- but are still substantial, and are still the subject of sharholder objections, according to othere news reports (here). According to a shareholder quoted in these reports, "This is an extremely one sided deal."

Transactions involving these kinds of potential conflicts of interest create circumstances where accusations of wrongdoing can more easily arise. It is almost to be expected that the Clear Channel transaction is the subject of a purported shareholder class action. On November 16, 2006, the law firm of Wechsler Harwood filed a lawsuit (here) in Texas state court, accusing Clear Channel and its directors of breach of fiduciary duty. The lawsuit alleges that the “going private” transaction is for the benefit of insiders, particularly the Mays family, but to the detriment of the company’s public shareholders. The lawsuit seeks an injunction against the transaction, or, should the transaction be completed, damages on behalf of Clear Channel’s shareholders.

A cynical view of these kinds of lawsuits is that they represent no more than an attempt by plaintiffs’ lawyers to extract a toll from the parties to the transaction. But at least in cases where the allegations of conflicts of interest are substantial, these kinds of claims may present a threat of more than just a cost of doing business.

The Clear Channel transaction is just the latest in a series of huge “going private” transactions. These mega-deals and the accompanying risk of D & O claims are likely to continue into the foreseeable future. As the Wall Street Journal noted in its October 26, 2006 article entitled “Growing Funds Fuel Buyout Boom” (here, registration required), private equity firms have raised buyout funds of as large as $20 billion. According to the article, fifteen of the top 20 buyouts ever have taken place in the last 18 months, and larger buyouts may lie ahead as private equity funds “eye takeover targets with stock market values of $50 billion or more.” (The largest buyout ever is KKR’s $25.1 billion takeover of RJR Nabisco.) The article quotes a leading M & A attorney as saying “We are seeing a significant privatization of corporate America.”

The massive amounts of money involved in these "going private" transactions create enormous opportunities for conflicts of interest to arise, particularly where incumbent management has the potential to benefit if a particular party’s proposed transaction succeeds. These circumstances present a serious potential risk of claims against directors and officers of the target companies.

As The D & O Diary has previously noted, private equity funds themselves are drawing scrutiny; according to media reports (here), the Department of Justice has begun an investigation whether private equity funds’ “club deals” violate antitrust laws by artificially limiting the amount shareholders realize when companies are acquired.

The WSJ.com has an interesting “Who’s Who in Private Equity,” with a listing and description of the leading private equity firms here. Bain Capital, one of the successful bidders for Clear Channel, was founded by the current Republican Governor of Massachusetts, Mitt Romney.

A Rolling Stone magazine profile of Clear Channel and its influence on American radio and popular culture can be found here. Salon.com has an index of its articles about Clear Channel here.

Update: The private equity "buyout boom" continues. On November 20, 2006, the private equity firm the Blackstone Group announced (here) a $19 billion buyout of Equity Office Properties Trust.

Options Backdating Web Notes

Lucky CEOs: A new study by three leading academics claims to establish a link between governance practices and questionably timed stock options to chief executives. A November 16, 2006 study entitled “Lucky CEOs” (here) by Lucian Bebchuk of Harvard Law School, Yaniv Grinstein of Cornell, and Urs Peyer of INSEAD, examined 19,036 option grants between 1996 and 2005, involving about 6,000 companies and about 8,000 CEOs. The authors looked at the distribution of grant prices within the grant month and found a disproportionately higher numbers of grants on the date during the month with the lowest share price (and a disproportionately lower number of grants on the date with the highest share price). The authors found that these “lucky” grants were likeliest to occur at companies that did not have a majority of independent directors. The authors also found that this luck was persistent; CEOs that had lucky grants tended to have multiple lucky grants.

The authors also found that about 43% of lucky grants were “super lucky,” because they fell on the date with the lowest share price for the quarter.

Among the authors more interesting findings is their conclusion that the lucky grants were not concentrated amongst high tech companies. The authors found that a majority of the lucky grants as well as the super lucky grants were awarded at “old economy” firms.

The authors estimated (using probabilistic techniques) that about half of the lucky grants were due to manipulation rather than chance. They also estimated that about 850 CEOs at about 750 companies received or provided lucky grants produced by opportunistic timing.

The authors also found that lucky grants were likeliest to occur at companies that had CEOs with longer tenure. The authors estimated that the average gain to CEOs from the lucky grants that were backdated exceeded 20% of the reported grants and increased the CEOs total reported compensation for the year by 10%.

News reports describing the study may be found here and here. A brief commentary critical of the study can be found on Professor Larry Ribstein’s Ideoblog, here.

Stock Option Grant Givebacks: On November 15, 2006, EMCORE announced (here) that two top executives will return gains from exercising stock options that a voluntary internal investigation had concluded were the result of improper practices. EMCORE’s CEO voluntarily agreed to return $147,775 and its chief legal officer agreed to repay $97,000. The company said these amounts represented “the entire benefit received from the misdated grants they exercised.” The company’s CFO, who had not exercised any of the misdated stock option grants, voluntarily surrendered his rights to the grants. The company’s internal investigation was “unable to concluded that the company or anyone involved in the stock option granting process engaged in willful misconduct.”

A CFO.com article discussing the EMCORE stock option investigation can be found here.

As The D & O Diary previously noted (here), executives at Molex agreed to repay the company $685,000 to cover gains they realized on misdated options.

These somewhat isolated incidents pale by comparison to the givebacks involving UnitedHealth Group’s options investigation. UnitedHealth Group’s outgoing CEO William McGuire and his successor Stephen Helmsley collectively forfeit $390 million in gains from previously exercised options, and their unexercised stock options were repriced to eliminate paper gains from due to options timing. See the Wall Street Journal’s November 9, 2006 article, here, registration required. UnitedHealth Group's November 8 press release can be found here.

UPDATE: The November 20, 2006 Wall Street Journal has a front page article entitled "Companies Discover It's Hard to Reclaim Pay from Executives" (here, subscription required) discussing difficulties companies have had trying to recover past compensation to which executives were not entitled.

Options Backdating Lawsuit Update: With the recent addition of new lawsuits that have been filed against Flowserve, Biomet and Black Box, The D & O Diary’s running tally (here) of companies named as nominal defendants in shareholders derivative lawsuits raising options timing allegations now stands at 113. The number of companies sued in securities fraud lawsuits remains at 21.

U.K. Enacts New Directors’ Duties Law

On November 8, 2006, a sweeping bill affecting U.K. companies went into affect when the Companies Bill, which at 696 pages is Britain’s longest piece of legislation, received royal approval. (The House of Lords site reflecting all information pertaining to the Bill may be found here.) The Bill contains a statutory statement of directors’ general duties and extended authority for shareholders to sue directors for negligence, default, breach of duty or breach of trust – a broader range of conduct than under prior law.

The Bill’s statutory statement of directors’ general duties sets out seven duties:

• The duty to act within the company’s powers;
• The duty to promote the success of the company;
• The duty to exercise independent judgment;
• The duty to exercise reasonable care, skill and diligence;
• The duty to avoid conflicts of interest;
• The duty not to accept benefits from third parties; and
• The duty to declare any interest in any proposed transaction or arrangement with the company.

The new general statutory duty to "promote the success of the company" is the most controversial clause in the Bill, and includes many considerations of which directors must now take into account – not only the long term business consequences of any decision, but also "the impact of the company’s operations on the community and the environment." This new statutory duty requires directors to consider wider social responsibility factors when making decisions. The various statutory requirements may create obligations that conflict. But the decision of what constitutes the company’s best interests will not be set aside if made in good faith and the directors have exercised reasonable care, diligence and skill.

The Bill extends existing shareholder rights to bring derivative claims. The new statutory procedure enables a shareholder to bring a claim with respect to any actual or alleged negligence, default, breach of duty (including the new statutorily codified duties) or breach of trust. A shareholder seeking to bring a claim must petition the court for the right to proceed, based upon a showing of good faith and taking into account whether the company decided not to pursue the claim. If leave to continue is granted, the company must reimburse the shareholder for brining the action; if not, the shareholder bears his or her own costs.

According to a detailed review (here) of the Bill by the Norton Rose law firm, the absence of the risk of costs if leave to pursue the derivative claim is granted "may make shareholders more likely to bring an action under the new procedure." The new right to bring an action for breach of any duty, including the new statutory duties, "provides another tool for use by activist shareholders to push for change at underperforming companies." But how useful this tool will be depends on "the court’s willingness to exercise its discretion to intervene in what, in many cases, will be simply commercial decision making by the company, its directors and majority shareholders." In light of these considerations, the Norton Rose firm’s memo suggests that "boards should review the wording of their D & O policies to ensure that defending derivative claims is covered."

A summary of other aspects of the Bill may be found at the CorporateCounsel.net, here.

A Private Conspiracy?: According to a November 15, 2006 Bloomberg.com article entitled "KKR, Carlyle, 11 Other Accused of Rigging Buyouts" (here), the law of Wolf, Haldenstein, Adler, Freeman & Herz has brought a purported class action accusing 13 private equity firms of rigging the market to take companies private. The complaint purportedly alleges that investors did not receive full value for their shares because of a conspiracy that violated antitrust laws. The purported class potentially represents tens of thousands of shareholders in dozens of deals in which public companies were taken private. Among the specific transactions named are deals involving Univision, HCA and Harrah's Entertainment. The list of defendants reads like a who's who in the world of private equity, including KKR, Carlyle, Thomas H. Lee Partners, Blackstone Group, Bain Capital, Apollo Management, Texas Pacific Group, and others.

Prior press reports had disclosed that the antitrust division of the U.S. Deparment of Justice in Manhattan is examing potential antitrust violations by private equity firms engaged in "club deals" to acquire public companies. An October 11, 2006 Wall Street Journal article entitled "Probe Brings 'Club Deals' to the Fore" can be found here (subscription required.)

Best Commercial Ever?: You decide. Roll the tape, here.

Share Buybacks and D & O Risk

One of the most noteworthy corporate phenomena of recent months has been the increasing prevalence of companies buying back their own shares. According to an article in the New York Times (here, subscription required), the S & P 500 companies are on a pace to repurchase more than $435 billion worth of their own shares this year, compared with $349 billion in 2005 and only $131 billion in 2003. The conventional wisdom is that share buybacks help shareholders by reducing the supply of shares, thereby driving up the price. But buybacks only make economic sense of the share purchase is the most advantageous alternative for the cash used – that is, it makes sense if the shares are undervalued compared to other assets. Otherwise, shareholders are better served by a dividend payment. It strains common sense to think that all of the shares of all the companies repurchasing their own shares right now are undervalued relative to other assets, particularly since share prices generally have been rising -- which raises the question whether there may be more behind the recent wave of share buybacks than attempted maximization of shareholder interests.

Warren Buffett flagged the issue in his letter to shareholders in the 2005 Berkshire Hathaway Annual Report (here), when he described the share repurchase practices at a fictitious company, Stagnant, Inc. In Buffett’s story, Stagnant’s CEO, Fred Futile, gets rich simply by using buybacks to boost his company’s earnings per share (EPS), despite being unable to grow the company’s net income.

The issue Buffett raise was explored further in a November 12, 2006 New York Times article entitled “Why Buybacks Aren’t Always Good News” (here, subscription required), which examined whether share repurchases are being used to boost executive compensation. The article reports research conducted jointly by the Center for Financial Research & Analysis and the Corporate Library. The researchers looked of companies that engaged in share repurchases while compensating executives based on EPS, while the companies were experiencing negative cash flows for the last two years. The study found 78 companies in the S & P 500 that met these criteria, including three companies the experienced negative cash flow for the last three years. The researchers also found that none of these companies discussed in their proxies the impact of the buyback program on executive compensation.

An additional share repurchase practice that may be even greater concern is the practice of management selling their shares at the same time the company is conducting a share buyback program. An article in the November 2006 issue of CFO Magazine entitled “Can You Have Your Stock and Sell It, Too?” (here) questions whether management sales of company shares at the same time as the companies were conducting share repurchases represent a conflict of interest. The article reports research conducting by Audit Integrity, which looked for companies with market capitalizations over $100 million and that had high levels of both stock buybacks and insider selling. The research identified 16 companies with these characteristics.

None of this has been lost on the plaintiffs’ bar. The CFO Magazine article quotes Bill Lerach of the Lerach, Coughlin firm as saying:

In our view, there is an inherent conflict of interest when insiders are using the stockholders’ money to buy back shares on the theory that they are undervalued, and at the same time are unloading their own shares….We believe it to be an inherently bad practice. Certainly, when we evaluate whether to bring suit against insiders for securities fraud, it’s something we look for, and when we see it we view it to be very incriminatory.

Lerach also is quoted as saying that his is putting the finishing touches on a lawsuit he plans to file against “one of the most high-profile companies in the United States,” along with its CEO, over issues relating to its buyback program.

Because conventional wisdom views share repurchases as benign, or at least as a standard part of the management tool kit, they have at least historically not been questioned. But there really have never been share buybacks anywhere near the current level, and recent media scrutiny may raise concerns with the practice, particularly where executives are being compensated on a EPS basis. Companies whose executives are selling shares while their companies are buying shares back may face particular scrutiny, and indeed if Lerach’s statements are credited, may face a greater possibility of D & O claims. Certainly, a company whose executives are selling shares will be hard pressed to argue that its shares are undervalued relative to other assets, which undermines the theoretical basis for a buyback in the first place.

Given the growing prevalence of share repurchases, this area may represent an area of heightened scrutiny and potentially increased D & O risk in the months ahead.

For an interesting discussion critical of the New York Times referenced above, refer to Professor Larry Ribstein's Ideoblog, here.

Options Backdating Contagion?: There has been extensive media coverage discussing the potential impact of the options backdating scandals on the insurance industry (for example, see this recent San Francisco Chronicle article here). But there has been relatively little discussion whether the scandal could affect other kinds of companies, other than insurers, as a result of investigations companies under investigation.

At least one bank is at least raising the question whether its customers’ options woes could affect its business. In its 3Q06 10-Q (here), SVB Financial Group, the bank holding company for Silicon Valley Bank, included the following risk factor:

Many technology companies have been subject to scrutiny concerning their historical stock option grant activities which could negatively impact our client borrower market.

In recent periods, there have been several reports in the media questioning public company stock option practices, as well as a number of formal and informal regulatory investigations and other actions in connection with the historical stock option grant activities of certain companies. Many of our client borrowers utilize stock options in their employee compensation programs and, as such, could be adversely affected by these developments. Any increase in litigation, investigations or other regulatory actions which adversely affect companies that grant employee stock options, or that adversely affect the technology sector more generally, could adversely affect our client borrowers and potential client borrowers, and therefore could result in a material adverse impact on our results of operations.

SVB also stated that due to publicity surrounding the options backdating scandal, it had voluntarily launched an internal review of its own options practices. Its review is not yet complete and the company has not released any other details about its review.

A November 13, 2006 CFO.com article discussing SVB Financial Group’s options related disclosures can be found here.

Individuals’ Contributions to Securities Lawsuit Settlements

As The D & O Diary has previously noted (here), one of the questions following the Enron and WorldCom civil class actions settlements was whether those settlements' requirement of individual defendants’ contribution to settlement without recourse to insurance or indemnity represented a trend or an aberration. Several recent high-profile securities lawsuit settlements involving significant individual contributions seem to suggest that individual contributions to securities fraud lawsuit settlements may represent an increasingly important part of case resolution -- as well as a disturbing trend, as discussed below.

First, on October 31, 2006, Krispy Kreme Doughnuts announced (here) the settlement of a pending securities class action lawsuit and a pending shareholders’ derivative action. The derivative settlement provided that the Company’s former Chief Operating Officer John Tate and former Chief Financial Officer Randy Casstevens would each contribute $100,000 to the securities fraud case settlement (the settlement of which also included a cash payment of $34.967 million by the Company’s D & O insurers; a $4 million cash payment from the Company’s auditors; and the Company’s contribution of common stock and warrants valued at $35.833 million). Tate also agreed to cancel his interest in 6,000 shares of company stock, and Tate and Casstevens agreed to limit their claims for indemnity from the Company in connection with future proceedings before the SEC and the U.S. Attorney for the S.D.N.Y. to specified amounts. The Stipulation of Settlement expressly preserves claims the company may have against former CEO Scott Livengood to seek reimbursement for any of the settlement amounts, holding out the possibility that Livengood might also have to contribute toward settlement out of his personal assets.

In its third quarter 10-Q dated November 7, 2006, Martha Stewart Living Omnimedia announced (here) the settlement in principle of the securities class action lawsuit that had been filed in connection with Martha Stewart’s December 27, 2001 sale of shares of ImClone Systems. The total value of the class action settlement is $30 million, of which $15 million is to be paid by the Company, $10 million is to be paid by the Company’s D & O insurers, and $5 million is to be paid by Stewart herself. (The Company’s accounting charge for the settlement "does not include that portion of the settlement expected to be paid by Ms. Stweart.")

These two settlements join the Tenet Healthcare $215 million securities fraud settlement announced earlier this year (here) in which two individuals (the Company’s former CEO and former COO) agreed to contribute an additional $1.5 million toward the settlement without recourse to insurance or indemnity.

These settlements suggest that the requirement for individuals' contributions may have become an important part of securities fraud lawsuit resolution. While aggrieved shareholders and their counsel may view this development as a just way to compensate for harm done for alleged misrepresentations, it does create a disturbing prospect for potential future individual defendants. A movement toward non-recourse individual recoveries puts individuals in a position where their service as corporate officials requires them to expose their personal assets. Martha Stewart at least has been convicted of a crime (although one having nothing to do with her sales of ImClone shares or any alleged misrepresentations to her company’s shareholders); the Krispy Kreme officials have not yet been convicted of any crimes, yet they are facing what amounts to an asset forfeiture that is from their perspective indistinguishable from a criminal penalty. This alarming trend bears monitoring, and raises troubling questions about the appropriate exposures for individuals in civil lawsuits, particularly in the absence of any trial or definitive judicial finding of misconduct.

New Category of Options Backdating Lawsuits?: Much of the early publicity surrounding the options backdating scandal suggested that options backdating practices disappeared with the new options grant paperwork requirements enacted in the Sarbanes Oxley Act. In a prior post (here), The D & O Diary examined a study by the investor services firm Glass Lewis showing that options backdating practices may not have ended with Sarbanes Oxley, because many companies have not been complying with timing requirements for filing options related paperwork and that the paperwork delay may allow companies to backdate options grants to a time with the stock price was lower. The study poses the question whether there may be a whole new round of options backdating revelations – and related claims – ahead, based on these late filing practices.

A November 9, 2006 Minneapolis Tribune article entitled "Digital River Shareholder Suit Alleges Backdating" (here) reports that shareholders have filed a lawsuit against Digital River and its CEO, based on options backdating allegations. The allegations are based in part on Digital River’s habit of delaying the filing of its options related paperwork with the SEC. Digital River was one of the nine companies identified in the Glass Lewis report.

As noted in the prior D & O Diary post (here), the possibility of these kinds of claims poses a new challenge for D & O underwriters. The arrival of the Digital River lawsuit may establish that this threat is not merely theoretical but real. The underwriters must now consider whether additional claims will arise based on allegations of post-2002 late form filing and stock option increases between the grant date and the filing date.

French Class: Numerous recent media report have focused on various efforts to reduce the regulatory and litigation burden that U.S. companies face, in order to enhance the companies' ability to compete in the global marketplace. (See my most recent post regarding regulatory reform efforts here.) Ironically, reform efforts in other countries may be moving in the opposite direction, as efforts are made to increase accountability and oversight.

According to news reports (here), the French government this past week approved new legistlation that would introduce a version of the class action lawsuit in France. The bill creates a two-phase process in which judges would hear class-action complaints. Damages are capped at 2,000 euros. If the judge determines "professional fault," individual plaintiffs would have to individually negotiate with the company for compensation, then personally appear before the judge if the company refuses to settle. The law would not introduce contingency fees, punitive damages or civil trial with juries.

Enron’s Legacies and D & O Risk

The following is the text of a speech (modified to optimize Internet capabilities) prepared for the Professional Liability Underwriting Society (PLUS) International Conference on November 9, 2006.


Shortly after former Enron CEO Jeffrey Skilling’s October 23, 2006 sentencing (see prior post here), the Enron Task Force announced that it was closing down, declaring that its mission was mostly complete. The media treated these events as endpoints in the Enron criminal scandal; for example, the Washington Post ran an article entitled "End of Enron’s Saga Brings Era to a Close." (here, registration required). Whether or not these events really do represent the end of an era, it may now be time to take a look at the Enron scandal and to assess its lasting impact.

This post examines several questions: Have we indeed reached the end of an era of high profile criminal prosecutions? And now that the key figures in the Enron scandal have all had their day in court, what are Enron’s legacies? Finally, what does it all mean for D & O risk?

The End of an Era? While Skilling’s sentencing was highly anticipated and had all the air of a culminating event, a fresh wave of scandals suggests that white collar criminal prosecutions will remain an important part of the legal landscape for the foreseeable future. Indeed, the same week as Skilling’s sentencing, Comverse Technology’s former CFO became the first corporate official to plead guilty to criminal charges in connection with the options backdating scandal (here). In addition, that same week, Refco’s former CFO was indicted for accounting allegations raised following the company’s ill-fated IPO (here). These are just the latest signs that white collar crime prosecutions will remain a high prosecutorial priority for the foreseeable future.

And though Skilling’s sentencing may represent a high water mark of sorts, it is far from the end of the Enron saga itself. There are still a number of Enron-related prosecutions in the pipeline. For example, three British bankers (the "NatWest Three"), extradited to the U.S. earlier this year, will stand trial in early 2007 on allegations that they stole from their former employer in connection with an Enron-related transaction (here). There may be new trials for several former Enron executives whose earlier proceedings ended in mistrials. Several key Enron defendants, including former Enron Chief Accounting Officer Richard Causey, are yet to be sentenced. The civil lawsuit against Enron’s investment banks (at least the ones that have not yet settled) remains pending. For a rundown of the remaining Enron-related events, refer here.

And even when the book is finally closed on Enron, whenever that may be, the assault on corporate fraud seem likely to continue. This forward-looking thought leads to the next question: now that the Enron Task Force has disbanded, what are Enron’s legacies?

Enron’s Legacies: The word "Enron" has moved into the language, both as a reference to the company itself and the scandals that followed its demise, and as a shorthand expression for all of the corporate scandals that were uncovered earlier in this decade. While these two senses of the word are distinct, the two meanings merge when looking at Enron’s legacies, because Enron’s impact has been specific (for example, in connection with the criminal prosecution of former Enron officials), and general (in connection with the larger impact on markets, legislation, and corporate culture). Using "Enron" in both of these senses, here are a few of its legacies:

1. New Corporate Culture of Governance: Without question, the most important of Enron’s legacies is the new culture of corporate governance. In Enron’s wake, no corporation can ignore the implementation of serious internal compliance systems to detect and deter corruption. By the same token, the role and functioning of corporate boards has also been dramatically altered. Boards are now active, independent and involved, and in many important ways providing meaningful oversight of corporate management. Just one aspect of the way boards have changed is the increased emphasis on independent board composition. According to the National Association of Corporate Directors, 83% of boards now say that more than half of their directors are independent, up from only 54% in 2000.

These changes hold out the intriguing possibility that improved corporate governance will result in reduced D & O risk. Indeed, some commentators believe that improved governance explains the reduced number of securities fraud lawsuits that have been filed so far in 2006. For example, Stanford Law Professor Joseph Grundfest has stated (here) that "extensive and expensive corporate efforts to improve governance and accounting have reduced plaintiffs’ ability to allege fraud." There is no question that the governance reforms have improved corporate officials’ sensitivity to potential wrongdoing. But even allowing for this heightened vigilance, other commentators remain skeptical that governance reforms alone can explain the reduced number of lawsuits. As D & O authority and prominent coverage attorney Dan Bailey has written with respect to the impact of corporate governance reform on the number of securities lawsuits (here), "it appears unlikely that this is a major contributing factor to the reduced filings."

In fact, increased board independence and oversight has also in some cases led to boardroom turmoil that in turn has resulted in claims against, between and among directors and officers. The unfortunate and highly publicized events involving H-P’s Board are but the most prominent example of this effect. (See my October 2006 InSights article discussing board turmoil and D & O Risk here.)

And so, while improved corporate governance is an unquestionably important part of Enron’s legacy, the positive significance of that legacy in terms of D & O risk still remains uncertain. In addition, as discussed further below, there are movements afoot that could potentially alter this legacy.

2. Whistleblower Protection: The new culture of oversight is not limited just to the boardroom. Serious internal compliance programs, combined with the provisions of the Sarbanes-Oxley Act providing corporate whistleblower protection, encourage employees to speak up and report conduct they believe may have crossed the line. (The Sarbanes-Oxley whistleblower provision, here, is of course a legislative tribute to Enron’s own whistleblower, Sherron Watkins.)

The existence of the whistleblower provisions potentially could translate to increased D & O risk, in light of the possibility of claims based on the whistleblower’s disclosures. It has not turned out that way, at least so far, as the few whistleblower cases to emerge have gotten bogged down in procedural delays of a kind that could well deter future whistleblowers. (See my prior post on Sarbanes Oxley whistleblower procedural delays here.) Certainly there have been no dramatic cases where a whistleblower’s surprising revelations have resulted in significant claims against corporate officials.

The whistleblower provisions may yet have this effect, but so far, the whistleblower provisions have not had a significant impact on D & O claims activity.

3. CEO’s in the Hotseat: With all of the improved corporate governance procedures has also come increased scrutiny of senior corporate management. There is no doubt that following Enron and the other corporate scandals that CEOs’ hold on their jobs is more precarious. Since early 2005, the boards of some of the country’s largest companies have ousted their CEOs – including Bristol-Myers Squibb, Fannie Mae, Pfizer, Merck, and American International Group. In addition, executive compensation has come under intense scrutiny. More active boards and a greater willingness to challenge management, as well as a changed regulatory environment, have all contributed to this effect.

Significant turnover at the most senior levels of management creates a volatile environment in which accusations of wrongdoing may more easily arise. Recurring questions about executive compensation merely add to this atmosphere of increased tension. The recent wave of lawsuits involving options backdating allegations illustrates how quickly questions about compensation and management performance can lead both to executive departures and to D & O claims. (To see my running tally of Options Backdating litigation, refer here.) The increased scrutiny under which top management now operate is an important new source of D & O risk.

4. White Collar Crime Enforcement: One of Enron’s most durable legacies is the creation of a prosecutorial police force to identify and punish corporate crime. Even though the Enron Task Force has disbanded, the Corporate Fraud Task Force remains in existence and continues to find activities to investigate and prosecute. This picture of a permanent white collar fraud police force was vividly illustrated in the recent remarks of Timothy J. Coleman, a former U.S. Justice Department official who was responsible for the Corporate Fraud Task Force and who supervised the Enron Task Force and the Criminal Fraud Section. An October 25, 2006 Washington Post article (here, registration required) attributed to Coleman the statement that:

The legions of investigators hired by securities regulators, federal prosecutors and the FBI will pay lasting dividends because they will become a "standing army" ready to target business wrongdoing. "Whether it’s stock options, mutual funds or something else, corporate America should expect a continuing series of major, nationwide investigations for the foreseeable future," Coleman said.

A "standing army" to prosecute crime will inevitably find offenses to investigate, prosecute, and punish, and so the likelihood of a series of future major corporate crime investigations is one of the Enron’s most tangible legacies.

With the increased prospect of prosecutorial scrutiny comes the increased possibility of D & O claims. Just as all of the major corporate criminal scandals involved parallel civil claims, and just as the options backdating investigations have also meant a new wave of shareholder lawsuits, so too the criminal investigations yet to come will also lead to civil claims against directors and officers. The threat of future claims arising from corporate criminal investigations is perhaps the most important way that Enron has affected D & O risk.

5. Increased Severity of Civil Securities Fraud Lawsuits: Enron and the other corporate scandals have also changed the environment for civil securities fraud lawsuits. These changes have important implications for D & O carriers and their insureds. Specifically, average settlements in securities fraud lawsuits have escalated enormously due to the civil cases arising out of the corporate scandals. (See my prior post, with links to the leading studies, here.) It may be that the egregiousness of these cases drove an increase in average severity that will diminish once the worst cases have played through the system. But while the average settlements may diminish somewhat after the worst cases are gone, the rough idea of "what cases like this settle for" has been ratcheted upwards in a way that is unlikely to completely go away. This heightened severity standard has important implications for D & O carriers’ average expected severity (particularly for excess carriers) as well as for D & O insurance buyers’ limits selection. Both carriers and policyholders must now be prepared for much more expensive outcomes.

How Permanent Are Enron’s Legacies? Shortly before the Enron Task Force disbanded, another group, the Committee on Capital Markets Regulation, formed to take a look at the effect of regulatory burdens on the competitiveness of the U.S securities markets in the global economy. (The Committee has become known as the Paulson Committee because of the public support that Treasury Secretary Henry Paulson has given the Committee.) The Committee consists of leading figures from academia and business, and includes prominent figures from the current Bush administration. The Committee is taken a look at regulatory reforms that might improve U.S. competitiveness. (See my most recent post regarding the Paulson Committee here).

Among other things, the Paulson Committee is reviewing whether Sarbanes-Oxley represented an overreaction, and whether there are revisions that might swing the regulatory pendulum back to the middle. The Committee’s work has been accompanied by public statements from President Bush and Vice President Cheney that perhaps Sarbanes-Oxley went too far. The Committee’s report is due to be released on November 30, 2006. Of course, merely because the Committee will make proposals does not mean that changes will necessarily follow. But the Paulson Committee clearly has the administration’s support. The extent of its recommendations and the regulatory reforms that could follow potentially could affect the permanency of some of Enron’s most significant legacies.

Conclusion: There may yet be more of the Enron story to be told, and the current scandals (such as the options backdating investigations) undoubtedly will have an impact on corporate culture. The work of the Paulson Committee may also affect the post-Enron regulatory environment. But even though the picture may continue to evolve, that does not diminish the enormous, categorical changes that Enron has wrought. Principles and practices of corporate governance are changed forever. Corporate compliance programs are now an important part of every company’s internal operations. White collar fraud prosecution is empowered and an important component of the contemporary legal landscape. And D & O insurers and their policyholders face a changed claims environment characterized by increased risk and heightened severity expectations. By any measure, Enron’s demise was a milestone event in the history of American corporate culture, and its ramifications will affect companies for years and decades to come.

To see my prior post regarding the significance of Enron, refer here . To see my prior post regarding the sentencing of former Enron CFO Andrew Fastow, refer here.