Notes from Around the Web

New Wave of Options Lawsuits?: Regular readers know that The D & O Diary has been tracking options backdating lawsuits (here). A December 20, 2006 article on Law.com entitled “McAfee Employees’ Suit Reveals New Options Dynamic” (here) raised the question whether a breach of contract action brought by the employees of McAfee represents the opening salvo in a “new wave” of options backdating related litigation.

Seven McAfee employees have alleged they were “cheated” out of $2 million because the company did not permit them to exercise stock options that then expired during the company’s self-imposed blackout. The company imposed the blackout during a delay in the filing of its financial statements while it investigated possible options backdating. The blackout was imposed to prevent stock transactions that might later give rise to insider trading allegations. Employees whose shares expire during a blackout period are out of luck unless the company extends the expiration dates. McAfee apparently declined to extend the expiration date for plaintiffs’ options, all of whom had or have left the company. The plaintiffs allege that the company is “unfairly penalizing them for the accounting misdeeds of management.” The article quotes a plaintiffs’ lawyer who said that she “expects many suits similar to the McAfee action to be filed over the next few months.”

The breach of contract action is merely the latest options backdating related problem at McAfee. Press reports (here) recently suggested that Kent Roberts, McAfee’s former general counsel, may be indicted by federal prosecutors in coming weeks on charges relating to stock option grants.

Two different alert D & O Diary readers forwarded a link to the Law.com article, including Adam Savett at the Lies, Damned Lies blog and a loyal reader who prefers anonymity. Thanks to both.

Heard Melodies are Sweet, But Those Unheard are Sweeter; Therefore, Ye Soft Pipes, Play On: In a prior post (here), The D & O Diary took a look at the liability exposures for companies engaging in PIPE (Private Investment in Public Equity) transactions. (The prior post provides background about the nature and structure of these transactions.) Two recent SEC enforcement actions shed additional light on the issues and pitfalls that these transactions can sometimes present.

On December 12, 2006, the SEC announced (here) that it had filed a Complaint against Edwin “Bucky” Lyon, Gryphon Partners, and several Gryphon investment funds, in connection with thirty-five different PIPE transactions during the period from 2001 to 2004. The complaint alleges that after agreeing to invest in a PIPE transaction, the defendants sold the issuer’s stock short through “naked” short sales (that is, without owning shares to cover their short position) in Canada. Once the resale registration statement was effective, the defendants used the PIPE shares to cover their short position. The complaint also alleges that the defendants falsely represented to the PIPE issuers that they would not sell or transfer their shares other than in compliance with the securities laws. In addition, the complaint alleges that the defendants relied in inside information when they engaged in the short sales. The defendants are alleged to have realized more than $3.5 million in ill-gotten gains.

On December 20, 2006, the SEC announced (here), the filing of a separate settled complaint against broker-dealer Friedman, Billings, Ramsey & Co., its former Co-Chair and Co-CEO, and its former Director of Compliance. The complaint’s allegations relate to a 2001 PIPE transaction in which the Company acted as placement agent. The Company is alleged to have sold the issuer’s shares short while aware of material, nonpublic information prior to the public announcement of the PIPE transaction. The Company covered its short position with shares it bought from its own customers who had bought their shares in the PIPE offering. The Company’s total trading profits were under $450,000 (although its underwriting fee on the PIPE transaction was $1.764 mm), but it agreed to civil penalties of $3.756 mm, without admitting or denying the charges. The individual defendants, who also did not admit the charges, agree to lesser penalties and constraints on their ability to serve in similar roles. The company's press release about the settlement may be found here. An interesting discussion of the case on the SEC Actions blog can be found here.

While these cases illustrate some of the pitfalls of PIPE transactions, it is significant that they do not involve charges against the issuer companies – as I pointed out in my prior post, most of the enforcement proceedings relating to PIPEs transactions involve the broker dealers or the investors, but not the issuing company. There is nothing about these two new actions that changes my prior statement that issuer companies involved in these transactions should not be treated as suspect merely because the engaged in a PIPE financing. Both of these cases also relate back to the 2001 time frame, which, as my prior post pointed out, was a period when these transactions were less structured and involved greater perils. Nevertheless, it is clear that the SEC is taking a look at these transactions.

The quotation in the caption of this item (about "soft pipes," and which admittedly has nothing to do with the item itself) is of course from "Ode to a Grecian Urn" written in 1820 by John Keats after viewing an exhibit of Greek artifacts accompanying the Elgin Marbles at the British Museum. The Elgin marbles are the remnants of marble sculpures removed from the Parthenon. Their removal to England has been a controversy since Lord Byron wrote his "Childe Harold's Pilgimage" ("Curst be the hour when from their isle they roved").

Holiday Interlude: The D & O Diary will be slowing down over the next few days. Readers can look forward to the resumption of the normal publication schedule after the New Year. Happy Holidays to all.

Paulson Committee’s Weak Case for Regulatory Reform

When the blue-ribbon Committee on Capital Markets Regulation (popularly known as the Paulson Committee) released its Interim Report (here) calling for regulatory reform, it based its case for reform in large part on the U.S securities exchanges’ loss of market share in the global IPO marketplace. As The D & O Diary has previously noted (here), there are serious grounds on which to question this premise. Recent developments provide additional grounds on which to question many of the Paulson Committee’s presumptions. Several of these presumptions are reviewed below, in light of these developments.

1. Lower Regulatory Requirements Give Foreign Exchanges an
"Advantage"

The Paulson Committee’s Interim Report focused in particular on London’s Alternative Investment Market’s (AIM) "hands off" approach to regulation. The Report noted that the U.K. has been "relentless in stressing its regulatory advantage and indicating its commitment to maintaining a ‘light touch’ in regulation." This lighter touch may be attractive to certain companies, but whether this is an advantage for investors is doubtful.

A December 20, 2006 Wall Street Journal article entitled "Uncertain AIM: A Hot Market In London Has Its Risks, Too" (here, subscription required), examines whether AIM market’s "laissez faire" approach may be "treacherous for investors" because some of the companies that have gone public on AIM are "intrinsically dangerous businesses." The article also examines the limitations of, and inherent conflicts of interest involved with, the AIM market’s system of "nominated advisers" or "nomads," who both vet potential deals and pitch the new company’s shares to the marketplace. Indeed, because of perceived abuses, AIM is "finalizing a new rulebook that toughens some standards" and "may be preparing further steps to restore confidence in the market." In the meantime, investors have suffered, The article cites examples of "unpleasant surprises" for AIM investors in the last 18 months, including one AIM company whose shares plunged 60% when the company disclosed one month after its offering that the oil field it was exploring was not "commercially viable."

The AIM experience suggest that while lax standards have made it attractive for weaker companies, that is not a sustainable "advantage." AIM’s belated attempts to shore up its oversight weaknesses underscores that the most important advantage a marketplace can have is investors’ perception of trustworthiness. U.S. market’s regulatory standards allow companies whose shares trade here to enjoy a valuation premium (see my prior post about the valuation premium here). A valuation premium, now that is a competitive advantage. A regulatory race to the bottom to attract marginal companies would be a huge step backwards.

One undeniably real advantage that foreign exchanges do offer is lower cost access, both in terms of lower underwriting fees and lower listing fees. Concerns about the competitiveness of U.S. securities markets’ competitiveness would be more appropriately focused on these cost disadvantages, rather than the regulatory integrity of the U.S. securities markets.

2. The U.S. Securities Markets’ Loss of Market Share is Due to the
Regulatory Burden and Threat of Litigation Here

The U.S. securities markets have lost global marketshare for IPO business, but the causes are even more numerous and diffuse than the Paulson Committee assumes. The Committee’s Interim Report acknowledges that part of the reason for the decline is that foreign markets have improved. But as I have discussed previously (here), the biggest reason for the decline in the U.S. marketshare is the decline in the number of U.S.-based companies’ IPOs. This decline in U.S. companies’ IPOs may be due to cyclical reasons –certainly recent IPO activity gives reason to hope that this activity may be cycling back up. According to CFO.com (here), the number of U.S. based companies completing IPOs through November 2006 (186) represents the highest annual number since 2000. And according to the Wall Street Journal (here, subscription required), last week’s 16 offerings made it the busiest week of the year for IPOs. The recent high level of U.S. based company IPO activity raises the question whether the concerns the Paulson Committee seeks to address may be temporary and have less to do with the attractiveness of the U.S. exchanges to foreign companies than with the conditions for companies inside the U.S.

And even with respect to foreign companies, the decline in U.S. market share may be a reflection of the mix of foreign sources for IPO companies. As a December 18, 2006 Wall Street Journal article entitled "Israel Fades, China Takes the Lead on Foreign IPOs Listed in the U.S." (here, subscription required) discusses, Israel was "the most active foreign source of listing…by a wide margin" in the late 1990s. Since that time, the number of Israeli companies conducting offerings, both inside and outside the U.S., has been "sparse," primarily as a result of M & A activity in Israel. Also, in the 90s many of the Israeli companies "went public too early," but the "level of sales and profits that you need to go public are much higher now."

China has replaced Israel as the leading source of foreign offerings, but Chinese companies often have unique political or economic reasons for staying with local exchanges. And experience has shown that some Chinese companies may not be completely ready for the scrutiny of public ownership.

All of this should show that there are many reasons – the cyclical nature of the U.S. based IPO activity, declining IPO activity in key foreign countries – that are contributing causes for the decline in U.S. marketshare of global IPOs, and these causes certainly do not justify radical changes to the U.S. regulatory approach. Given these various factors, regulatory reform seems poorly calculated to alter the level of U.S. exchanges’ market share.

3. The U.S. Exchanges’ Loss of Global Market Share Will Hurt New York City, Its Businesses, Its Employees, and Its Taxpayers

Let’s be honest here. Nobody on Wall Street is starving. According to a December 20, 2006 New York Times article (here, registration required), securities industry employees in New York will receive almost $24 billion in compensation in 2006, up 17% from a year ago. Wall Street investment bankers are receiving record bonuses. (Goldman Sachs paid its 26,467 employees an average of $622,000 per person.) This translates into $1.6 billion in tax revenue for New York State and $580 million for New York City.

Remind me again: exactly what is the problem that New York City is facing and why does that justify gutting the U.S.’s strong regulatory regime? Isn’t it just possible that what makes all those New York investment bankers so filthy rich is that they have the privilege of working in a city with the most highly respected markets in the world?

Certainly if Wall Street is really worried about being competitive, it needs to take a hard look at its current level of profitability and then take another look at its underwriting and listing fees. Perhaps if Wall Street were a little less astonishingly profitable, the U.S. exchanges might be more attractive to foreign investors. But instead, according to news reports (here), NASDAQ plans to raise its listing fees, in order to support certain auxiliary services that it owns. That certainly is not going to make U.S. exchanges more attractive to foreign companies, or even to U.S. based companies.

4. The U.S. Litigation Environment Creates a Competitive
Disadvantage

The U.S. litigation culture does represent a burden. But as I have previously discussed (here), foreign investors increasingly are demanding accountability from company management, and increasingly are seeking (and getting) the ability to seek redress for alleged management misconduct in local courts. The most recent example of this is the class action (here) that investors in Australia initiated against senior officals at the Multiplex Group. (Hat tip to Adam Savett at the Lies, Damned Lies blog for the link). These kinds of suits will become even more common as foreign investors increasingly demand accountability from senior corporate officials. These trends mean that while the U.S. is more litigious, differences between the U.S and other countries in this respect are diminishing and will become less and less of a factor.

5. The Time is Right for Regulatory Reform

As I have previously stated (here), it is more than a little strange to be talking about regulatory reform so soon after the Enron criminal sentencings and in the midst of the options backdating scandal. But the call for reform is premature in other ways as well. An noted above, the causes of the ills the Paulson Committee seeks to remedy may in part be cyclical, and indeed there is some evidence that the evolution of the cycle will itself alleviate come of the issues with which the Committee is concerned.

Other evolutionary change may provide further relief without the need for an elaborate regulatory reform effort. Just within the last few days, the SEC (here) and the PCAOB (here) have announced efforts to address concerns about the requirements of Section 404 of the Sarbanes-Oxley Act, which is one of the Paulson Committees’ big issues. In addition, according to news reports (here), Pink Sheets LLC is looking at creating marketplace mechanisms that could prove more competitive with the AIM (refer also here). Incremental changes of these kinds may be more effective and cause less damage that a wholesale program of regulatory reform.

One thing is certain -- the globalization of capital is neither a small nor a temporary phenomenon. According to an Ernst & Young study (here) released on December 18, 2006, global IPO activity was at record levels in 2006, and offerings from emerging market companies are leading the way. The largest offerings involve Chinese companies, and their listings on the Hong Kong Stock Exchange have given that marketplace the largest share of the new companies. The global economy is huge and dynamic, and financial capital has become increasingly global as well. But while the U.S. has lost manufacturing jobs to companies with lower environmental standards and fewer labor protections, few think the solution is for the U.S. to lower its own environmental standards or eliminate its labor protections. The threats and complications of the global economy represent very significant challenges, but we will not improve our lot by weakening ourselves just to compete. Just as in manufacturing, the most likely approch for success in the global economy for the financial services sector may lie in innovation, specialization and, most importantly, increased efficiencies.

McNulty Memo Fails to Silence Calls for Specter Bill

When Deputy Attorney General Paul McNulty released the revised Department of Justice guidelines for federal prosecutors to use in determining whether or not to charge corporations criminally, it was the general perception that McNulty was responding to growing criticism of the Thompson Memo. (See my prior post on the topic, here.) It was also believed that McNulty was acting to avert legislation that had been introduced by Senator Arlen Specter. A December 16, 2006 New York Times article entitled “Judge’s Rebuke Prompts New Rules for Prosecutors” examining the events, processes and discussions that led to McNulty’s decision to release the revised guidelines may be found here (registration required).

However, while the changes embodied in the McNulty Memo (which may be found here) have generally been welcomed, there seems to be a consensus emerging in certain circles that the McNulty Memo did not go far enough and the Specter bill will still be needed.

For example, the American Bar Association President Karen J. Mathis issued a December 12, 2006 statement (here) saying that the McNulty Memo changes “do not go far enough…(and) fall far short of what is needed to prevent further erosion of fundamental attorney-client privilege, work product and employee protections during governmental investigations.” In particular, Mathis criticized the memo because “instead of eliminating the improper department practice of requiring companies to waive their privilege in return for cooperation credit,” the new policy “merely required high level department approval before waiver requests can be made.” Mathis also said that “the new policy does not fully protect employees’ legal rights in that it continues to allow prosecutors to force companies to take punitive actions against their employees in some cases in exchange for cooperation credit, long before any guilt is established.” Mathis ended her statement with a plea on behalf of the ABA for Congress to take up the Specter bill when it reconvenes in January.

William Ide, the Chair of the ABA Task Force on Attorney-Client Privilege, said (here) that there is a “fundamental difference” between the Task Force’s view that requiring a privilege waiver to avoid prosecution is never appropriate and the Justice Department’s view that it sometime is. “We are going to need legislation,” Ide said, unless the Justice Department goes one step further and recognizes that prosecutors are “not entitled to waiver, period, under any circumstances.”

The bill that Senator Specter introduced on December 7, 2006, the "Attorney-Client Privilege Protection Act of 2006," may be found here. The bill is supported by a broad coalition, including the Association of Corporate Counsel, the National Association of Criminal Defense Lawyers, the American Civil Liberties Union and the U.S. Chamber of Commerce. The bill prohibits the forced disclosure of information protected by the attorney-client privilege. The bill also prohibits the government from conditioning a civil or criminal charging decision on whether or not an organization is providing legal fees for its employees, or on whether or not the organization has terminated an employee because of the “decision by that employee to exercise the constitutional right or other legal protections of that employee.”

Senator Spector is the outgoing Republican Chair of the Senate Judiciary Committee. The incoming Chair, Democratic Senator Patrick Leahy, has not yet indicated whether he will push to get the Specter bill passed. Senator Leahy did issue a statement (here) in which he said that “I remain concerned that, depending on how the new policies are implemented, prosectors may still be able to inappropriately consider a corporation’s waiver of this important privilege.” He also said that “I will continue to monitor the implementation of this new policy and to hold the Administration accountable so that the right to counsel is preserved for all Americans.”

The White Collar Crime Prof blog has helpfully compiled (here) a list of links to a broad range of commentary on the McNulty Memo.

Special thanks for alert reader Jeremy Gilman for the links to the ABA sources.

Is SOX Unconstitutional?

On Thursday December 21, 2006, the parties to a case pending in the United States District Court for the District of Columbia will argue whether the Sarbanes-Oxley Act’s provisions establishing the Public Company Accounting Oversight Board (PCAOB) are unconstitutional. Although the case focuses on only a narrow part of the Act, it has the potential to bring down the entire statute.

The lawsuit was filed on February 7, 2006 by the Free Enterprise Fund against the PCAOB in the United States District Court for the District of Columbia, and is pending before Judge James Robertson. The FEF essentially contends that the Sarbanes-Oxley Act’s provisions establishing the PCAOB violate the separation of powers established in the U.S. Constitution. According to a December 16, 2006 Wall Street Journal op-ed piece by the FEF’s counsel, Kenneth Starr, entitled “A Verdict on Sarbanes-Oxley: Unconstitutional” (here, subscription required), the FEF contends that the PCAOB’s statutory enabling language is constitutionally defective because “unelected commissions should not have the power to regulate, tax and even punish companies and individuals.” (Kenneth Starr is now a professor at Pepperdine Law School, but the former federal appellate judge and U. S. Solicitor General is perhaps best known for his service as the Independent Counsel whose investigation of the Whitewater scandal ultimately led to the impeachment of President Bill Clinton.)

Even though the FEF’s suit is addressed only to Sarbanes-Oxley’s PCAOB enabling provisions, the case has the potential to preclude enforcement of the entire Act, at least according to University of Illinois Law School professor Larry Ribstein. In a December 16, 2006 post (here) on his Ideoblog, Ribstein states, “it is a tribute to the haste and sloppiness of the Act’s creation that it contains no clause saving the rest of the Act if a particular provision is declared unconstitutional.” So, according to Ribstein, if the FEF’s arguments against the PCAOB’s enabling provisions are found unconstitutional, the ruling would “bring down SOX.”

At Thursday’s hearing, the parties will present their oral arguments on FEF’s motion for summary judgement. Oddly, the Court is hearing argument on the summary judgment motion without having first ruled on the PCAOB’s motion to dismiss the case for lack of jurisdiction. A ruling on the summary judgment motion is not likely until early next year.

According to Wikipedia, the Free Enterprise Fund is a free market advocacy group that promotes economic growth, lower taxes, and limited government. The group was founded by economist and policy analyst Stephen Moore. (The Wall Street Journal, in printing Starr’s op-ed advocacy piece on behalf of the FEF, neglected to mention that Moore, the FEF’s founder, is a member of the Wall Street Journal Editorial Board.) The current chairman of the FEF is Mallory Factor, founder of the merchant bank, Mallory Factor, Inc. The website whitehouseforsale.org has a lengthy decription of Factor's business and political activities, here. (Readers should judge the reliability of the site's information for themselves.)

Update: A December 22, 2006 Washington Post article describing oral argument on the summary judgment motion may be found here.

The Peekaboo Cloak of Secrecy: The PCAOB comes in for criticism from a completely different direction in a December 15, 2006 Washington Post article entitled “Auditing Reform: Mission Accomplished!” (here, registration required). The article is critical of the PCAOB (which, according to the article, is known as “’Peekaboo’ to its friends in the industry”) because of the Board’s reliance on a scheme of “prudential regulation” to supervise the Big Four accounting firms. According to the article, prudential regulation “rests on behind-the-scenes collaboration between regulator and regulated.” The biggest problem with this “industry friendly” approach, according to the article, is that

by its nature, it overlooks the worst kind of abuses – those that become so commonplace that everyone thinks they’re acceptable. Recent examples range from "managing” quarterly earnings to doling out hot stock offerings to favored customer. At some level, the lawyers, auditors and regulators understood that they violated basic principles of fair dealing. And yet few thought to question these practices.

In the end, it took whistleblowers and outsiders like journalists and states attorneys general to expose these abuses and force new rules. But in the closed loop of a prudential regulator system, none of that would have happened. The whole idea is to keep the heathens out and work things out behind the scenes, without lawsuits, public sanctions or disclosure of embarrassing details….

I have trouble believing that, as the PCAOB asks us to believe, the Big Four have miraculously transformed their corporate cultures, pushed out the bad apples and fixed all their quality-control problems…as long as the PCAOB shrouds its every action involving the Big Four under a cloak of prudential secrecy, we’ll never know, will we?

The source of these kinds of criticisms may perhaps be seen in the PCAOB’s December 14, 2006 release of its “2005 Inspection Report of Pricewaterhouse Coopers LLP” (here). According to a December 16, 2006 Wall Street Journal article entitled “PCAOB Finds Problems at Pricewaterhouse Coopers” (here, subscription required), the PCAOB found deficiencies in the accounting firm’s audit of nine companies, noting that the firm “failed in some cases to catch or address errors in the way the companies applied accounting rules or lacked sufficient evidence to back up some of its decisions.”

However, according to the Journal article, “in keeping with the Board’s policies, the report doesn’t identify the companies that had their audits cited.” In addition, only a portion of the Board’s report is made public; the report section detailing criticisms of the accounting firm’s quality-control systems is “kept secret and never made public if the firm is able to show that it has corrected the problems cited within 12 months of the report’s issuance.”

The PCAOB must issue annual inspection reports for any accounting firm that audits 100 or more public companies. According to the Journal article, the PCAOB “has been criticized for the length of time it is taking to issue annual reports” and the Board has “yet to issue 2005 inspection reports for Ernst & Young LLP and KPMG LLP.”

The Ultimate Solution to Accounting Misconduct: While the U.S. accounting profession may chafe under the current regulatory scheme and bemoan its liability exposure, they should at least be relieved to know that the Chinese method of regulatory enforcement has not caught on here. According to a December 15, 2006 CFO.com article (here), a Chinese court has affirmed the death penalty for an accountant who was involved in defrauding bank customers out of millions of dollars. Liu Yibang is accused of conspiring with Zhou Limin, the head of the China Construction Bank branch in Xi’an, by collecting up to $61 million from organizations and individuals by offering fake accounts with high interest rates. The two defendants have now exhausted their death sentence appeals, and the criminal sentence will be enforced.

Enron, Halliburton and the Milberg Weiss Criminal Investigation

Regular D & O Diary readers will recall my discomfort (as reflected here) with the Enron civil action plaintiffs’ leniency pleas on Andrew Fastow’s behalf at his September 26, 2006 sentencing. This week’s Fortune Magazine has an article entitled “Why Enron’s Fastow May Only Serve Five Years” (here), that explains how it came about that representatives of the lead plaintiffs in the civil action appeared at Fastow’s criminal sentencing.

It turns out that John Kekar, Fastow’s criminal defense attorney, has another prominent client – Bill Lerach, of the Lerach, Coughlin firm. Kekar represents Lerach in connection with the criminal investigation that has so far resulted in the indictment of the Milberg Weiss firm and two of its partners. Lerach also happens to be counsel for the Univeristy of California, the lead plaintiff in the Enron civil action.

According to the article, in an “11th hour deal,” Fastow agreed to aid Lerach in the civil case, by providing detailed debriefings (the 175-page declaration Fastow supplied the plaintiffs' counsel can be found here) and also agreeing to sit for a deposition. In return, Fastow received “the formal support of the Enron investors in a plea for leniency (a factor the Judge explicitly noted).” Fastow was also dismissed as a defendant from the civil suit and “even got the plaintiffs’ lawyers to pay his legal fees for his deposition.” As a result of the plea for leniency, the 10-year sentence to which Fastow agreed when he first entered his guilty plea was reduced to 6 years. According to the article, if Fastow is accepted into a prison drug-treatment program for his claimed addiction to anti-anxiety pills, he could be out of prison in five years.

As the article points out, Fastow’s cooperation provides a “massive windfall” for Lerach. Not only does Lerach get fresh evidence aiding the civil claims against the remaining Investment Bank defendants, but Fastow’s assistance could help “enrich Lerach, adding $100 million or more to the contingency fee for the plaintiffs’ lawyers and raising the prospect that they could walk away with close to $1 billion from the case.” (Readers will recall that it was this enormous potential fee benefit that made me so uncomfortable with the civil plaintiffs pleading for leniency at Fastow’s sentencing.)

Lerach’s involvement in the ongoing Milberg Weiss investigation may also be causing him problems in the Halliburton securities fraud lawsuit. According to a December 13, 2006 post on the Legal Pad blog entitled “Lerach Firm Will Fight Client to Stay in Halliburton Case” (here). The lead plaintiff in that case, the Archdiocese of Milwaukee Supporting Fund (AMS Fund), has filed a motion to remove the Lerach Coughlin firm, and its co-lead counsel Scott + Scott, as lead plaintiffs’ counsel and to substitute David Boies of the Boies, Schiller & Flexner firm. Apparently, Lerach’s involvement in the criminal investigation was a factor in the AMS Fund’s decision to file the motion.

The Halliburton case has an “unusal procedural history.” An early agreement to settle the case for $6 million was scuttled when the AMS Fund, represented at the time by Scott + Scott alone, opposed the settlement as inadequate. The court agreed, and the case went forward. The Lerach Coughlin firm then intervened in the case on behalf of three public pension funds. The Lerach Coughlin firm was appointed co-lead counsel with Scott + Scott. However, the departure from Scott + Scott of Neil Rothstein seems to have been a turning point in the case. Rothstein remained “special counsel” to the AMS Fund, and in fact filed the motion to substitute Boies for Lerach on the AMS Fund’s behalf. Lerach has opposed his client’s motion, on the ground’s that the substitution would be disruptive and that Boies has a conflict of interest. The court has not yet ruled on the motion.

There is a certain symmetry here; at least according to Wikipedia (here), David Boies also represented Andrew Fastow.

Rothstein now runs Truth in Coporate Justice LLC, which appears to maintain a website (here) about the Halliburton case. Rothstein's account (here) of his unsuccessful attempt to attend the May 17, 2006 annual meeting of Halliburton makes for some interesting reading. Not every annual meeting has a SWAT team on the roof of the meeting building.

Another Backdating List: One of the byproducts of the options backdating scandal has been the proliferation of lists. For example, my ongoing tally of options backdating related lawsuits may be found here. Jack Ciesielski of the AAO Weblog (here) recently published a very thorough list of the all of the companies that have mentioned investigations of option granting practices in their filings, or have been mentioned in the news. The list, which can be found here, identifies over 200 companies (including 45 members of the S & P 500).

Little Blog Horn: As I can attest, maintaining a blog is a lot harder than it looks. So there should be little surprise that even in the few short months I have been contributing to the blogosphere that several other blogs have emerged, briefly breathed, and then blinked out of existence. The Vangal blog (here) is one of the many to meet that fate. Two more recent departures from the blogging scene, the Governance News Watch blog (here) and the Securities Litigation Watch blog (here) will both definitely be missed. But for those of you who, like me, had become fans of the Governance News Watch during its brief but interesting existence will be pleased to learn that the blog’s author, Janice Brand, has moved on to a new blog, Brand on Business, which may be found here. The new blog looks promising and we here at The D & O Diary wish Janice well.

PLUS D & O Symposium: It may be hard to believe, but the 2007 Professional Liability Underwriting Society (PLUS) D & O Symposium is only a few weeks away. The 2007 Symposium will take place on January 31 and February 1, 2007, at the Marriott Marquis in New York City. I will be co-Chairing this year’s Symposium with my good friends Ivan Dolowich and Jeffrey Lattman. Among the many panelists and speakers will be such luminaries as Linda Thomsen, the head of the SEC Enforcement Division; Nell Minow, the founder and editor of the Corporate Library; and Charles Elson, Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, as well as many other distinguished speakers and guests. The keynote speaker will be former Senator and Secretary of Defense George Mitchell. The entire program schedule can be found here. The Registration materials are here. I look forward to seeing everyone there.

McNulty Memo Replaces Thompson Memo

As The D & O Diary has previously noted (most recently here), the Thompson Memo, the Department of Justice’s corporate criminality guidelines for prosecutors, has been the target of significant criticism. In the KMPG tax shelters prosecution, the judge found prosecutor’s implementation of the Memo to be unconstitutional (here). Most recently, Sen. Arlen Specter proposed legislation that would have overridden the Thompson Memo’s provision that compelled corporations seeking to avoid prosecution to waive their attorney client privilege and withhold payment of their employees’ attorneys’ fees.

On December 12, 2006, in apparent response to this criticism and possibly in an attempt to forestall the legislative efforts, the Department of Justice announced (here) that U. S. Deputy Attorney General Paul J. McNulty had released new guidelines revising the Thompson Memo. The new guidelines, entitled “Principles of Federal Prosecution of Business Organizations” may be found here. An Executive Summary of the new guidelines may be found here. The revised guidelines identify nine factors for prosecutors to use when deciding whether or not to charge a corporation with a criminal offense.

The most significant revisions in the McNulty Memo relate to the attorney-client privilege and the advancement of attorneys’ fees. With respect to the attorney-client privilege, the guidelines adopt a “tiered approach,” by which the prosecutor must now obtain advanced written approval from the Deputy Attorney General in order to request a corporation to waive its attorney client privilege. In order to obtain approval, the prosecutor must “establish a legitimate need” by showing the likely prosecutorial benefit, as well as the absence of alternative means to obtain the information and the extent of voluntary disclosure already provided. According to the Executive Summary, prosecutors should seek attorney-client communications only in “rare circumstances.”

The revised guidelines also provide new standards for when prosecutors may request a waiver of privilege in order to obtain facts uncovered in a company’s internal investigation. Before requesting these materials, prosecutors must seek the approval of their local United States Attorney, who must consult with the Assistant Attorney General for the Criminal Division.

Prosecutors are also directed in connection with their charging decision not to consider a corporation’s decision not to provide attorney-client communication after the government makes the request. (However, the prosecutors may still favorably consider a corporation’s voluntary provision of attorney-client privilege material or information.) The new memorandum also instructs prosecutors in connection with their charging decision that the cannot consider a corporation’s advancement of attorneys’ fees to employees, except in “rare exception” where the advancement of fees combined with other facts shows that the payment of fees was intended to impede the government’s investigation. (Even in the exceptional circumstances, the advancement of fees may only be considered if authorized by the Deputy Attorney General.)

The new guidelines are effective immediately and apply to ongoing investigations.

The revisions have already been criticized for not going far enough. According to news reports (here), critics are concerned that the guidelines don’t bar prosecutors from rewarding companies that waive their privilege; according to these critics, the ability to reward includes the reward to withhold the reward, which operates exactly like a punishment.

Hat tip to the White Collar Crime Prof blog (here) for the link to the McNulty Memo and the Executive Summary.

A Close Look at A Credit Rating Agency: Shareholders, creditors and even D & O underwriters who depend on the reports of credit rating agencies will want to read the December 12, 2006 New York Times article entitled “Objectivity of a Rating Questioned” (here, registration required). The article examines questions raised by 34 industrial customers of Portland General Electric in connection with a Standard & Poor’s report the utility relied upon to support the utility’s regulator petition for a rating increase.

The customers subpoenaed documents that had gone between the utility and S & P during the 21 months preceding the report’s completion. The documents showed that S & P “solicited comment from the utility on a draft report and then made at least 48 changes that the utility sought before releasing the report.” The utility then used the report as “independent corroboration” of its request to raise rates, increase its profit margin, and shift fuel-cost risks to its customers.

As reflected in a comment reported in the article, the “documents illustrate a fundamental problem with allowing companies that issue stocks and bonds to pay for evaluations by credit reporting agencies.”

Portland General Electric is now an independent company, but it was owned by Enron from 1997 to April 2005.

Notes from Around the Web

Lead Enron Plaintiff Moves to Dismiss Vinson & Elkins: In the serial retelling of the Enron collapse, the company’s outside professionals have been popular scapegoats, and among the most prominent targets has been the company’s former law firm, Vinson & Elkins. According to reports (here), between 1997 and 2001, Enron paid the law firm $162 million in fees. The law firm’s relation to the company and possible role in the company’s financial shenanigans has been the subject of extensive media coveage (here). But, according to a December 8, 2006 Houston Chronicle article entitled "Law Firm Could be Cut Free from Suit" (here), the lead plaintiff in the Enron civil action has moved to dismiss the Vinson & Elkins law firm from the lawsuit.

The action is scheduled to go to trial in April against the remaining defendants, including Merrill Lynch, Toronto Dominion Bank, Royal Bank of Canada, and the Royal Bank of Scotland. A spokesman for the lead plaintiff, the University of California, is quoted as saying that the inclusion of V & E at trial "threatened to raise complicated legal issues unnecessarily distracting the jury’s attention away from more culpable defendants – more solvent investment banks – from whom larger recoveries are more likely." The lead plaintiff is represented by the Lerach, Coughlin firm.

The court has not yet ruled on the plaintiff’s motion.

Without commenting one way or other on the merits of the claims against the law firm, The D & O Diary notes that it is a very unusual kind of a case that a 700-lawyer law firm with offices in 12 cities could be viewed as a mere complication or in which there could be other parties against whom "larger recoveries" are sought. The timing seems odd, too. The plaintiff has up to this point struggled vigorously to keep the V & E in the case, strenuously opposing the law firm’s own prior motion to dismiss. Maybe the timing is purely coincidental, but The D & O Diary can’t help but wonder if the plaintiff’s move to dismiss the V & E firm now is somehow related to the same court’s recent award of sanctions (here) against the Lerach Couglin firm in connection with its attempts to pursue a claim against Alliance Capital Management in the Enron civil action.

AOL Time Warner Class Action Opt-Outs Settling Favorably?: According to a December 7, 2006 New York Post article entitled "Time Warner Case Finds a Surprise" (here), the individual plaintiffs who opted out of the AOL Time Warner class action settlement are "faring much better than" those who stayed in the class settlement. The article reports on the settlement last week involving the state of Alaska in the individual state court action it filed against AOL Time Warner in Alaska state court. The state settled its $60 million claimed investment loss for $50 million, amounting to about 83 cents on the dollar, which the state’s attorney said is "far superior to the payout in the national settlement." The same attorney said that their individual settlement is "50 times more than what we would have received if we had remained in the class."

According to the article, about 100 institutional plaintiffs opted out of the class settlement and signed up with Bill Lerach of the Lerach Coughlin firm. When asked if his clients were better off than those who remained in the class, Lerach is reported to have said "there’s no question that we’re getting tons more dollars."

Between the news about the AOL Time Warner opt-outs and the Second Circuit’s decision denying class certification against the underwriter defendants in the IPO Laddering case (here), it has been a tough week for fans of the class action process.

Adam Savett of the Lies, Damned Lies blog has a more detailed comment on Alaska’s AOL Time Warner settlement, here.

For a prior D & O Diary comment on the settlement in the AOL Time Warner shareholders’ derivative action, refer here.

Prosecution Averted, But the Firm Still Failed to Survive: A December 10, 2006 New York Times article entitled "Poisoned by Scandal, Craving an Antidote" (here, registration required), describes the six-year ordeal of Rent-Way and its CEO to avoid the damaging effects of an accounting scandal. Even though the company’s extraordinary level of cooperation managed to avoid corporate prosecution, the company ultimately was forced to sell itself to a rival because of the scandal’s indelible stain.

The company itself discovered the accounting fraud and reported it to the SEC. The Company turned over documents containing attorney-client information and even invited the SEC to set up an office in the Company’s headquarters to conduct an on-site investigation. When the three employees who had perpetrated the fraud were later convicted, the local U.S. attorney’s office put out a press release commending the CEO’s openness as "a good example of how a company can alleviate" the consequences of misconduct "by fully and openly cooperating with the government."

But this extraordinary level of cooperation was still not enough to save the company. The company’s accounting scandal reduced its creditworthiness, which in turn increased its borrowing costs. The increased borrowing costs continued to weigh on the company and its stock price. Ultimately, the company was forced to sell itself to its largest competitor. The company was not able to survive the loss of investor confidence from the accounting scandal.

Much has been made recently of the costs of complying with regulatory burdens, but the costs of compliance pale by comparison with the consequences from undisciplined practices. As Professor Ellen Podgor notes in the White Collar Crime Prof blog (here), "the best lesson that can be learned from this story is the importance of having good solid controls in place to detect fraud in one’s midst. Having a proper corporate compliance program may assist to avoid the sad consequences of the innocent CEO who detects the fraud and has to deal with how best to handle the matter."

Bury Bonds: A December 7, 2006 article in the Boston Globe entitled "Left Holding the Bond," (here) details "a new minefield in the surging market for leveraged buyouts" – that is, the huge negative impact that the leveraged buyout has on the target company’s existing publicly traded debt. According to the article, when take over companies acquire publicly traded target companies, they pay off shareholders but they don’t redeem existing bonds. Instead, the successor company assumes the old bonds and continues making the interest payments. The problem is that the private-equity borrowers borrow most of the funds for the acquisition, loading the business with new debt, which erodes the company’s creditworthiness and makes the old bonds less highly valued in the debt marketplace.

Thus, for example, in connection with the recent HCA acquisition, public shareholders got a 20% premium for their shares, but HCA’s public debt holders saw the value of their securities decline by 15%. Bond holders in Clear Channel Communications saw the company’s bonds lose about 11% of their value following the company’s recent leveraged buyout. The article points out that even rumors of buyouts can be enough to cause the price of public debt to decline.

Everybody else involved in the takeover transaction is making money, but the bondholders are left with diminished investment value. They would be better protected if the debt instruments required accelerated repayment of the principal amount upon a change of control, but that is a relatively rare provision, precisely because it might discourage potential suitors. The large amounts of money involved in leveraged buyouts and the extent of the detriment to bondholders may well encourage bondholders to try to look to the company or its management to make up their investment loss. Bondholders may well consider whether legal action of some kind is in their interests.

Options Backdating Litigation Update: With the addition of the action filed against Agile Software (here) , the number of companies that have been named as nominal defendants in shareholders' derivative lawsuits raising options timing allegations is now 121. The number of companies sued in securities fraud lawsuits stands at 21. See The D & O Diary's running tally of options backdating lawsuits here.

Second Circuit Rejects Class Action Against Underwriter Defendants in IPO Laddering Cases

According to reports in a December 6, 2006 article in the New York Times entitled "Court Rejects Class Action Against Banks" (here, registration required) and a December 6, 2006 Wall Street Journal article entitled "Wall Street Wins Ruling Blocking IPO Class Action" (here, subscription required) on December 5, 2006, the United States Court of Appeals for the Second Circuit ruled in the IPO laddering cases that the district court had improvidently ruled that IPO investors' class action could proceed as a class action in against the 55 offering underwriter defendants. Specifically, the Second Circuit ruled that said the federal judge overseeing the lawsuit had erred in granting class-action status to six “focus cases” out of 310 consolidated class actions. This of course does not eliminate the possibility that investors could pursue individual actions against the underwriters. But even though individual actions can still go forward, the ruling has a certain disaggregating impact.

The Second Circuit's opinion may be found here. (Hat tip to the WSJ.com Law Blog, here, for the link to the opinion.)

The ruling also has an uncertain but curious potential impact on the pending settlement that the issuer defendants had entered into with investors. The issuers had agreed to pay the investors $1 billion dollars, with the issuers' obligation to be reduced to the extent of investors' recoveries from the underwriter defendants. (A brief summary of this settlement may be found here.) From the issuers' perspective, this settlement was looking very good when J.P. Morgan in April 2006 agreed to contribute $425 million to the settlement. But now that the Second Circuit has ruled that the investors' case cannot proceed against the underwriter defendants as a class action, it would appear that the issuers' settlement could unravel --the issuers' settlement with investors was merely proposed; it had not yet been approved by the court.

The question now on the table is whether the this unexpected but dramatic procedural undoes the issuers' $1 billion settlement and J.P. Morgan's $425 settlement. According to a December 6, 2006 Law.com article entitled "Huge IPO Case Hits Snag at 2nd Circuit" (here), "the issuers may try to get out of the settlement, say lawyers involved in the case" and the district court judge could "nix it based on Tuesday's ruling."

As the New York Times put it, in a statement that while strong is not an overstatement, "the ruling was a devastating blow to the embattled securities class-action powerhouse Milberg Weiss Bershad & Schulman, which is a co-leader for the plaintiffs."

A Bloomberg.com article discussing the Second Circuit's decision may be found here.

As International Investors Demand Greater Accountability, Will Legal Systems’ Differences Diminish?

Among the reasons behind the recent calls for regulatory reform, including the Paulson Committee’s Interim Report (here), is the belief that foreign companies are declining to list their shares on U.S. exchanges because of the burdens of U.S class action securities litigation. While the U.S. propensity for litigation may be deter some foreign companies from listing in the U.S. now, it should also be noted that international investors increasingly are demanding management accountability, and increasingly are seeking redress in courts – both in the U.S. and in their own countries.

A December 5, 2006 Law.Com article entitled "A Wary Europe Moves a Step Closer to Class Actions" (here), examines the apparent trend for European countries to permit the consolidations of related claims in a single action. According to the article, England, Spain, Germany and the Netherlands have already adopted "some form of class litigation." A draft bill is before the French legislature to permit collective consumer litigation (as previously discussed on the D & O Diary, here), and the Irish, Italian and Finnish governments are considering legislation to permit collective litigation by multiple parties. Norway and Denmark are also considering the adoption of an opt-in class action procedure.

The new German collective-action procedure is examined in a December 2, 2006 New York Times article entitled "Collective Shareholder Lawsuits Reach European Courts" (here). The Times article takes a look at the action now pending under the new procedure against DaimlerChrysler. Interestingly, the plaintiff shareholder group includes investors from the U.S. According to the article, other companies that have also been sued under the new procedure include Deutsche Telecom and the aircraft maker European Aeronautics Defense & Space.

While these new procedures permit collective action in a single lawsuit, the actions lack many of the attributes of U.S. style class action litigation. In most jurisdictions, pre-trial discovery is unavailable or severely limited; the loser pays both sides’ legal fees; and punitive damages are barred. As the Times article notes, a few cases "do not mean that the Continent is poised for a flood of litigation."

On the other hand, these new procedures represent a growing legislative recognition that investors are entitled to judicial means to compel accountability from corporate management. As The D & O Diary noted (here), the U.K. recently adopted new legislation that expanded shareholders’ rights to pursue derivative lawsuits against corporate officials. And as the Times article noted, "the trend toward a greater number of collective lawsuits will not be reserved soon." The article quotes a Dutch lawyer as saying "the laws are changing and so are the attitudes." It might be more accurate to say that the changed laws reflect a changed attitude.

European investors are also showing an increased interest in becoming more involved in shareholder litigation in the U.S. As detailed in a December 4, 2006 post on the ISS Corporate Governance Blog entitled "Europeans Take a More Active Role in U.S. Cases" (here), European investors (particularly public pension funds) are seeking to serve as lead counsel in U.S. securities fraud class actions. Among other cases, European pension funds are serving as lead plaintiffs in the cases against Parmalat. European and other international investors are also leading U.S. based derivative litigation and are seeking U.S governance changes.

U.S. based plaintiffs’ lawyers understand their opportunity and have begun what plaintiffs’ lawyer Adam Savett at the Lies, Damned Lies blog has called an "arms race"(here) in their efforts to attract international institutional clients. Several U.S. plaintiffs’ firms have announced that they are opening European offices or forming partnerships with U.S. firms. The European institutions for their part are interested in assuring that they are maximizing their opportunity to protect their beneficiaries’ interests.

International investors clearly are becoming more accustomed to using the courts to compel accountability both in their own countries and in the U.S. These investors are already successfully compelling changes to their legal systems as they press for means to enforce accountability. As procedures evolve and as these investors become more reliant on their own courts to compel corporate accountability, the differences between the systems may diminish. That process already seems to be underway.

Rubles Without A Cause?: Among the primary concerns to which the Paulson Committee’s proposed reforms are addressed is the U.S. exchanges’ loss of global IPO market share, particularly to the London exchanges. As the Paulson Committee’s Interim Report notes, many of the foreign companies listing on the London exchanges are Russian. The Report acknowledges the possibility that many companies from Russia (and elsewhere) may represent "unacceptable risks," but the Report makes no attempt to exclude "unacceptable risks" from their calculation of what U.S. exchanges have "lost."

A December 5, 2006 Wall Street Journal article entitled "British Spy Probe Turns to Émigrés" (here, subscription required) sheds an interesting light on this issue. The article is accompanied by a chart showing how many Russian companies have listed their shares on the London Stock Exchange in recent years. Just the seven deals completed in 2006 alone total 15.23 billion pounds. The article’s details about the Russian émigrés’ lifestyle are about equal parts amusing and appalling; the article’s details about some of the Russian companies whose shares trade in London are basically just appalling:

Earlier this year, in a huge offering, state-controlled Russian oil company OAO Rosneft listed its global depositary receipts on the London Stock Exchange. Underscoring the disputes from Russia that have spilled over into London, the stock offering came about only after lawyers from Russian oil company OAO Yukos failed to stop the listing after claiming that Rosneft’s assets came from the unlawful seizures and sales of Yukos.

Wall Street’s bankers may well lament the loss of underwriting fees for these kinds of deals to their counterparts in The City, but readers will decide for themselves how sorry we should be that the stringency of U.S. regulations discourages companies of this type from listing on U.S. exchanges. The D & O Diary wonders on what basis the "failure" of U.S. exchanges to "attract" offerings of this type could possibly justify diminishing regulatory rigor in the U.S. It seems to me that the quickest way to eliminate the valuation premium that foreign companies now enjoy by listing their shares on U.S. exchanges would be for the U.S. to lower its standards so that lower quality companies feel more comfortable listing on U.S. exchanges. (My prior post on the valuation premium may be found here. )

A December 6, 2006 Wall Street Journal article entitled "At Lukoil, an Executive's Death Exposes Network of Inside Deals" (here, subscription required) provides a more detailed look inside another Russian company.



Backdating Up North Too, Eh?: According to a recent press report (here), Canadian companies may also have an options backdating problem. An academic study of options grants between June 2003 and October 2006 at 66 of Canada’s largest publicly traded companies found options grant patterns that "may be consistent with backdating" and also that many options grants are not being reported as quickly as required under Canadian law. The final version of the report is due later this month.

SOX Whistleblower’s Disclosures Lead to SEC Action

As The D & O Diary has previously noted (most recently here), many of the protections and benefits Congress hoped for from the Sarbanes Oxley Act’s whistleblower provisions have been slow to materialize. And there has been relatively little enforcement action or shareholder litigation arising from the revelations of SOX whistleblowers. But in one recent action involving Ashland Inc., the disclosures of a whistleblower who later invoked the SOX protections led to a settled SEC action.

According to a November 29, 2006 SEC Order (here), the SEC settled charges against Ashland and a former employee (Olasin), based on a finding that Olasin had improperly reduced Ashland’s estimates for environmental remediation at numerous chemical and refinery sites. The SEC found that there was no reasonable basis for the reduction, which had the effect of materially understating Ashland’s environmental remediation reserves and overstating its net income in quarterly and annual reports filed from 1999 to 2001.

According to the SEC, three engineers who had been involved in setting the reserves that were later reduced brought the reductions to the attention of the company. One of the three specifically asserted that the reductions were "improper." These concerns led to an internal audit, which consisted of little more than an interview of Olasin. After the audit report came out, Olasin contacted the engineer who had called the reductions "improper" (and whose name Olasin had been able to uncover) and told him that "his performance was suffering" and that he should "spend the weekend thinking about whether he wanted to stay with the company." The individual left Ashland because he felt he was being retaliated against. He later filed a SOX whistleblower complaint against the company with the Department of Labor. According to the SEC’s order, the company later settled the whistleblower action.

Under the settlement with the SEC, Ashland was ordered to cease and desist from committing future violations; to strengthen internal controls; and to hire its independent auditor and an outside firm to oversee the company’s procedures for setting environmental reserves and for handling employee complaints. There were not fines or penalties against either Ashland or Olasin.

Firm Indictment: The Paulson Committee’s recent interim report (here) contained a number of comments and recommendations relating to corporate criminality. Among other things, the Report suggested that the indictment of a company ought to be a "last resort," because of the devastating (and potentially fatal) impact that indictment alone might have on the targeted firm.

In its discussion of these issues, the Report referred to the example of Arthur Anderson’s indictment. The D & O Diary wonders whether the Paulson Committee ever considered a more recent example – the indictment of the Milberg Weiss firm. According to a December 1, 2006 Bloomberg.com article entitled "Big, Powerful and Indicted: Milberg Firm Shrinks" (here), Milberg has "shuttered six of its eight offices and lost more than 50 lawyers of the 125 it had when indicted in May." The article also details a number of class action cases where Milberg has been removed as lead plaintiff counsel since the indictment. With the criminal trial now more than a year away, these circumstances can only deteriorate while the firm awaits its day in court.

While the Paulson Committee would not have been likely to refer sympathetically to the Milberg firm, the events at the firm following its indictment certainly substantiate the concerns noted in the Committee’s Report about the indictment of a corporate entity.

More Press About Larry Sonsini: As The D & O Diary previously noted here, Fortune magazine had a recent article (here) looking at the various complicated circumstances in which Larry Sonsini at the Wilson Sonsini firm has found himself involved. The Fortune article was generally favorable to Sonsini. A harsher take of Sonsini’s role in the HP pretexting scandal can be found in a December 1, 2006 American Lawyer article entitled "The Trouble With Larry" (here).

Hat tip to the WSJ.com Law Blog (here) for the link to the American Lawyer article.

Why Aren’t D & O Insurers Better Corporate Governance Monitors?

One of the great things about having a blog is that it has brought me into contact with a host of people I might otherwise never have gotten to know. Among the most interesting and colorful people I have met through my blog is Sammy Antar, Crazy Eddie’s cousin, and the author of the White Collar Crime blog (here). Regular readers will recall my recent post referring to Sammy and his views, here. As a result of my post, Sammy called me up and we had a great conversation about a number of things, including D & O insurance. Among other things, Sammy wondered why D & O insurers don’t condition their coverage on certain remedial or preventive measures, the way bank lenders require covenants on their loans or property insurers require for their policies.

Sammy’s question is one I have encountered again and again from thoughtful people outside the D & O insurance industry. A more scholarly example of this perennial question is presented in the November 17, 2006 law review article entitled “The Missing Monitor in Corporate Governance: The Directors’ and Officers’ Liability Insurer,” (here) written by Professors Tom Baker of the University of Connecticut Law School and Sean Griffith of the Fordham Law School (here). Baker and Griffith’s well-researched, well-written, thoughtful and thought-provoking article examines the same question that Sammy Antar posed to me: why don’t D & O insurers perform more of a corporate governance monitoring function?

The authors recognize the role D & O insurers theoretically might now be playing by offering lower priced insurance to companies with better governance practices. However, as the authors also recognize, competitive pressures and insurers’ zeal for premium volume limit carriers’ price differentiating ability and undercut the role insurance cost might otherwise play in motivating behavior. I would add that factors unrelated to governance, such as a company’s size or industry, are almost always more important pricing criteria, and so even in ideal circumstances, D & O insurance pricing would provide at best a weak incentive to corporate governance behavior. In addition, for most companies during most phases of the insurance cycle, the relatively minor variations in their D & O insurance costs are unlikely to have any impact on corporate governance behavior because the dollars involved are too slight.

The authors then look at whether D & O insurers are affirmatively offering loss prevention services, the way many property or workers' compensation insurers do. The authors conducted extensive empirical research by interviewing many underwriters, brokers and risk managers. Their empirical research showed that despite logical incentives for them to do so, D & O insurers do not affirmatively provide or offer their insureds loss prevention services. (Full disclosure: I was among the insurance industry representatives the authors interviewed as part of their empirical research.) Not only that, the authors found that D & O insurers don’t even manage claims that arise under their policies, but rather allow their insureds to select defense counsel and manage the defense, in a way that leaves defense expense essentially uncontrolled. The authors conclude that the D & O insurers' failure to provide loss prevention services and to manage claims allows management conduct to continue without the checking function the insurer might provide. In addition, because most D & O claims settle within the limits of the D & O insurance, company management is permitted to shift all of the consequences of their behavior away from themselves.

The authors examine the purpose and impact of D & O insurance under these circumstances and conclude that companies continue to buy D & O insurance because it provides company officials with a corporately-financed way for management to protect themselves from their own liability exposure without the requirements of any constraints on their behavior. The authors conclude that affairs are arranged this way because it suits corporate managers, who are free to indulge in risky behavior secure in the belief that their D & O insurance will protect them and their company if there are any problems. The authors question whether shareholders’ interests are served by this arrangement, and whether the existence of D & O insurance (or at least corporate reimbursement and entity coverage) creates a moral hazard by insulating companies and their managers from the consequences of their behavior.

Readers familiar with my professional history know that I am perhaps uniquely qualified to comment on the reasons why D & O insurers do not offer loss prevention services. My curriculum vitae includes an extended deployment as the head of a D & O facility that was founded on the optimistic premise that a D & O insurer ought to provide loss prevention services and that offering those services would be a competitive advantage. This noble experiment died a death of many causes, and having presided over the enterprise’s life span, I can authoritatively recite here why D & O insurers do not offer loss prevention services, as follows:

1. Everybody Has to Do It or Nobody Can Do It: Corporate insurance buyers want their acquisition of D & O insurance to be as uncomplicated and consume as little time as possible. Even if a D & O insurer is offering free services that will help improve their company’s risk profile, the company's managment will not desire the services if the services take additional time and attention. As long as there is one competitor anywhere who will offer the same coverage (at least at the same or similar cost, more about which below) without requiring the company to "jump through hoops," the free services will go unclaimed. Of course, this is not universally true, there are some companies that will value the service, and there are other companies who could learn to appreciate the value of the services. More about these kinds of companies below.

2. Even if the Services Are Very High Quality, They Will be Undervalued in the Marketplace: Unfortunately, insurance companies are not held in the highest regard in corporate America. Too many companies view their D & O carriers with suspicion or even hostility. To be sure, there are some companies who welcome their D & O insurers’ views about corporate governance, but not enough to make the costs of providing the services economically self-sustaining. Corporate management’s suspicious views of their D & O insurers may be encouraged by the their outside counsel. While some lawyers (and I was always proud that it was the best lawyers) welcomed the provision of high quality loss prevention services, there were other lawyers who viewed an insurer’s provision of these services as a competitive threat for services the lawyers themselves wanted to provide or as some clever ruse to permit the insurer to deny coverage later.

3. The D & O Pricing Environment Does Not Support the Pricing Premise: Some companies might want their D & O insurer's loss prevention services but not if their companies have to pay for the services. It might be possible for a D & O insurer to insist on corporate governance reforms if the insurer could offer demonstrable insurance cost savings for qualifying companies, but the reality is that the D & O insurance sector has been and remains so competitive that it is impossible to show cost savings. There is always a competitor willing to offer the same or similar coverage at the same (or better) discount, and so companies who might otherwise accept their insurer’s loss prevention requirements have little monetary incentive to do so.

4. Loss Prevention Services Are Costly To Provide and Maintain: For a D & O insurer to plausibly offer credible loss prevention services recognized as valuable by senior corporate executives , the insurer has to be willing to make and sustain a very significant investment in high quality personnel. However, top management at insurance companies, who rarely have background in D & O insurance but rather are drawn from more mainstream property or casualty insurance backgrounds, and who view the business of insurance as a high volume low skill enterprise, have little appreciation for or patience with the need for this kind of investment. These kinds of expenses do put significant pressure on operating margins, and indeed ultimately may not be economically justifiable given the pricing environment that has prevailed in the D & O insurance industry for almost all of the last 20 years (except for a very brief period during 2002-03).

5. D & O Loss Prevention Has Less Certain Benefits than A Sprinkler System Does: A sprinkler’s system’s benefit is direct and easily understood. Good corporate governance may or may not have as direct of a benefit. Baker and Griffith seem to assume that loss prevention can improve companies and reduce their securities litigation risk. I still believe this to be true, but at the same time I have to acknowledge that a company can do everything right and still get sued. So many of the major D & O claims problems of the last few years have come from unexpected directions. Sector slides, industry contagions, practices that are widespread and accepted that suddenly become perceived as objectionable, these are all phenomena that caused boatloads of D & O losses in recent years that no amount of loss prevention would have prevented.

I could go on and on about the reasons D & O insurers don't offer loss prevention services. (Buy me a few beers sometime and I will keep it going for hours.) In fact, Baker and Griffith mention in their article a few additional factors that I did not even get to here. But I think I have shown that there are many reasons why D & O insurers do not provide these services. This fact may be lamentable, but unless circumstances change dramatically in ways I do not anticipate, this is just the way things are and seemingly will remain in the D & O insurance industry.

That said, I cannot support the Professors’ conclusion that D & O insurance as it is currently purchased by most companies is a moral hazard. This particular topic is well beyond the scope of the informal blog format, but I will briefly offer my views for disagreeing with the Professors.

It is extremely unlikely that the presence of D & O insurance operates as any kind of an enabler of bad behavior: I flatter my chosen field by thinking that D & O insurance is pretty important stuff, but I am realistic enough to understand that corporate managers conduct their operations in a way that they think is either in the company’s or their own best interests without regard to their D & O insurance. They don’t stop before taking an action and reflect that they wouldn’t do it if they didn’t have D & O insurance. I view it as an extremely remote and unlikely theoretical possibility that corporate managers do anything they wouldn’t otherwise do because their company has D & O insurance.

Corporate Managers Worry More About Potential Consequences For Which There is No Insurance: Corporate managers know that the same kind of conduct can attract the unwanted attention of plaintiffs’ lawyers can also attract the unwanted attention of the SEC and the Department of Justice. Even if D & O insurance were to cease to exist as an earthly phenomenon tomorrow, most senior officials’ conduct would go on exactly as before (that is, equally as good or bad as before) because the admonitory threat of the regulators’ actions would remain as before. That is, because of the threat of regulatory action, the theoretical possibility that D & O insurance might otherwise operate as a moral hazard simply doesn’t exist.

Most Corporate Managers Truly Want to Do the Right Thing: There are crooks out there; my comments here don’t apply to them. In my experience, most corporate managers are interested in playing by the rules, and more importantly, for being known for playing by the rules. The idea of seeing their name in the paper as accused of fraud is absolutely mortifying. The fact that there might be insurance to eliminate the monetary inconvenience of a securities fraud lawsuit is irrelevant to their desire to avoid the kind of reputational taint that might follow an accusation of fraud, even if the accusation were merely to be made by plaintiffs’ lawyers.

Because I truly believe that almost all corporate officials want to do the right thing, I think there may yet be a role for loss prevention services in the D & O insurance equation. I am an eternal optimist, and I continue to believe that high quality loss prevention services will be valued by some companies and ought to be valued by all companies. I also believe that D & O insurance professionals can and ought to offer these services.

It may be that competitive forces between and among D & O insurers will discourage the insurers from carrying the experiment forward. Brokers, by contrast to insurers, are in the business of providing consultative services, and for that reason I believe that highly qualified brokers could offer loss prevention services to their D & O clients. Baker and Griffith looked briefly as what the past practices may have been as far as brokers offering these kinds of services and concluded that brokers are not offering these services. My recent entry into a new livelihood as a D & O broker is premised on the possibility that brokers have a role to play here. I have experience in this area, after all. Anybody that wants to talk to me about it should give me a call -- I have already had a great telephone conversation with Sammy Antar about it.

Hat tip to Adam Savett at the Lies, Damned Lies blog (here) for the link to Professors Baker and Griffith’s law review article.

A prior D & O Diary post commenting on an earlier article by Professors Baker and Griffith can be found here.

Looking at The Paulson Committee’s Proposed Litigation Reforms

As noted yesterday (here), the Committee on Capital Markets Regulation (often referred to as the Paulson Committee) has released its Interim Report (here). The Report contains much text, many graphics, and 32 recommendations supposedly addressed to how to improve the competitiveness of the U.S. securities markets. As proof that the U.S. markets are losing their competitive edge, the Committee cites two key measures: the decline of U.S. marketshare of global IPOs; and the increase in going private transactions. The Committee correctly observes that there are a variety of factors behind these trends, including improvements to foreign public markets and increased liquidity in foreign and private markets. The Committee nevertheless believes that the U.S. regulatory and litigation systems are also important causes. The Committee’s focus surprisingly is not so much on the Sarbanes-Oxley Act, the discussion of which is relegated to the end of the report. Rather, a much more prominent place is given to reforms of civil and criminal litigation.

By contrast to early leaks suggested that the Committee might recommend far more dramatic revisions (for example, see my prior post here discussing reports that the Committee might recommend eliminating private securities litigation), the Committee’s actual securities litigation reform recommendations are surprisingly modest; the Committee recommends that :

The SEC should proved more guidance, using a risk-based approach, for the elements of a Rule 10b-5 actions, including materiality, scienter, and reliance (a good summary of the Report’s detailed recommendations with respect to these points can be found on The 10b-5 Daily blog, here);

The SEC should require that any private damage awards should be offset by any amount the SEC has collected from the defendants under the SEC’s Fair Funds authority;

The SEC should prohibit certain supposed practices of the plaintiffs’ bar (about which more below);

In order to improve the defenses available for IPO companies’ outside directors, the SEC should revise Rule 176 to clarify that outside directors may conclusively establish their “due diligence” defense (and thereby avoid liability under Section 11) by showing their good faith reliance on the company’s audited financial statements;

As another means of protecting IPO companies’ outside directors, the SEC should reverse its longstanding position (here) that indemnification of directors for damages awarded in Section 11 actions is against public policy, at least if the directors have acted in good faith.

With respect the practices of the plaintiffs’ bar, the Report notes that “some plaintiffs may have private motives for bringing suit that they do not share with other shareholders.” The Report examines the possibility that some public institutional shareholders may be motivated to initiate lawsuits as a result of plaintiffs’ lawyers’ contributions to public officials electoral campaigns, a practice the Report calls “pay to play.” Without citing any specific data or examples, the Report asserts that “pay to play practices are likely to result in some class actions being filed by pension funds that would not have been filed in the absence of reciprocal arrangements.” The Report acknowledges that the extent of these practices is “uncertain,” but then goes on to say that “there seems to be little downside to discouraging such practices.” The Report recommends that the SEC create regulations specifying that lawyers who directly or indirectly may political contributions to state of municipal pension funds should be prohibited from representing the fund as lead plaintiff in a securities class action. The Report also recommends prohibiting paid plaintiffs.

The Report also recommends that the SEC should permit shareholders to “adopt alternative procedures for resolving disputes with their companies.” These alternative remedies might include arbitration or waiver of jury trials. The Report notes the difficulties companies might face in adopting these reforms. The Report recommends that shareholder votes be permitted allowing the revision of companies’ charters or bylaws to permit these alternative procedures.

While most of the Report’s proposed litigation reforms focus on civil lawsuits, the Report also includes recommendations relating to criminal litigation. The Report recommends that the Justice Department “revise its prosecutorial guidelines so that firms are only prosecuted in exceptional circumstances of pervasive culpability throughout all offices and ranks.” The Report also recommends that the Justice Department revise the prosecutorial guidelines in the Thompson Memo to “prohibit federal prosecutors from seeking waivers of the attorney-client privilege or the denial of attorneys’ fees to employees, officers or directors.”

Perhaps predictably, the Report has triggered a wide variety of responses, as reflected in the December 1, 2006 New York Times article entitled “Sharply Divided Reactions to Reports on U.S. Markets” (here, registration required). The most colorful comments are those of former SEC Commissioner Richard Breeden, who referred to the Report as “very elegant whining” consisting of “a bunch of warmed-over, impractical ideas, many of which have been kicking around for a long time.”

The motivations behind the Report have also been questioned because of the Committee’s financial backing. A December 1, 2006 Washington Post article entitled “Report on Corporate Rules is Assailed” (here, registration required) reports that the Committee “received $500,000 in financial support from the C.V. Starr Foundation,” described in the article as a charity with “longstanding ties to [former AIG Chairman] Maurice R. Greenberg.” The article states that investor groups have “sounded alarms” because of the Committee’s ties to “an executive battling civil charges.”

An interesting commentary by Walter Olson of the PointofLaw.com blog about the need for U.S. market to "Learn from London" can be found here.

The D & O Diary is frankly disappointed in the Report’s proposals with respect to litigation reform. After painting a dire picture about the declining fortunes of America’s financial markets, the Report essentially comes up with few litigation reform items that can at best be described as academic tinkering at the margins. Some of the ideas, like the proposal to allow shareholders to adopt alternative dispute resolution mechanisms or waive their rights to a jury trial, are so obviously not going to be adopted you have to wonder why the Committee even bothered to include them. (Jury trial waiver would be of zero practical value anyway, since virtually no securities cases actually go to trial). Other ideas, like the improvement to outside directors’ Section 11 defenses and indemnification rights are unquestionably worthwhile. The suggested revision to the Thompson Memo’s cooperation guidelines concerning the attorney client privilege and the payment of employees’ attorneys fees are absolutely correct.

But event though the Report does have some worthwhile suggestions, as well as others that have been criticized elsewhere (see here and here), the most obvious objection is the question whether any of the proposed litigation reforms would really make any difference for the competitiveness of the U.S. securities markets. The D & O Diary is prepared to concede that America’s peculiar penchant for litigation might well contibute to foreign companies' decisions to avoid our securities markets. But The D & O Diary doubts that the Report’s proposed litigation reforms, even if adopted verbatim immediately, would improve the competitiveness of the U. S securities markets. Do the managers of foreign companies really weigh the value of outside directors' indemnification rights or the possibility of a double recovery under the SEC's Fair Funds authority? Seems pretty unlikely to me, which make me wonder why these kind of marginal reforms are even included in a report intended to address a supposed lack of global competitiveness. All of these proposed bandaids seem poorly calculated to dress the wound. As I have noted elsewhere (here), I am also skeptical that attempts to rollback the currently regulatory rigor are the right approach to improving the competitiveness of the U.S. securities markets.

I also continue to find the timing of this reform initiative puzzling. We are only weeks away from the very public sentencing of the leading figures in the Enron scandal. And we are only in the beginning stages of the unfolding options backdating scandal. There may indeed be a day when it is appropriate for the regulatory pendulum to swing back, but this does not seem like the right time.

The D & O Diary feels compelled to make a final observation. The Report cites the high cost of D & O insurance in the U.S., relative to the much lower cost in Europe, as a factor deterring foreign companies from listing on U.S. exchanges. The D & O Diary concedes, as it must, that there are material differences between D & O pricing in the U.S. and in Europe. But we find it amusing that the Report finds the differential in insurance costs significant, but at the same time concludes that the significant differences in investment bank underwriting fees and exchange listing fees are not a factor. The Report’s observations seem to have been strained through a very peculiar kind of lens.

The Report notes at the outset that “during the next two years, our Committee will continue to explore issues affecting other aspects of the competitiveness of the U.S. capital markets.” The Economist magazine reports (here, subscription required) that the Committee’s second report is “due next year,” and is likely to call for “better coordination between state and federal regulators by suggesting that the SEC and other agencies merge some operations.” The next report “will also tackle other factors considered disadvantageous, such as an insistence on all firms using the GAAP accounting standard.”