A Closer Look at the 2006 Securities Fraud Lawsuits
As The D & O Diary has previously noted (here and here), earlier this month the National Economic Research Associates (NERA) and Cornerstone Research (in conjunction with the Stanford Law School Securities Class Action Clearinghouse) released their respective studies of the 2006 securities class action lawsuit filings. The NERA study can be found here and the Cornerstone study can be found here. Although the two studies differ in some of their numerical details, the two studies agree in most of their important conclusions, including the fact that the number of 2006 filings represents the lowest annual total since the passage of the Private Securities Litigation Reform Act of 1995. Each of the studies has some interesting additional observations about the 2006 filings.
In the latest issue of InSights (here), I review the two studies’ observations and also take a closer look at the 2006 lawsuits to try to better understand the data. In particular I analyze the data (by SIC Code, Industry and Sector) to determine who got sued, where and when. In addition, I review NERA’s study’s conclusions about the 2006 securities class action settlements, assesses the possible reasons for the 2006 filings decline, and close with some thoughts about the possible impact of the decline on the pricing of D&O insurance.
Famous Last Words: "I’m confident it will work, the only thing is, we’re just not sure how much dynamite to use."
One of the essential tenets of modern corporate governance is that shareholders control corporate managers through shareholder voting. This notion is founded on the premise that shareholders will vote their economic interests, and the weight of their vote will be proportionate to their economic interest. However, research by University of Texas law professors Henry Hu and Bernard Black reveals that as a result of recent capital markets developments, hedge funds and other investors can “decouple” voting rights from economic ownership of shares. For example, a hedge fund borrowing shares from institutional investors can acquire the voting rights of the borrowed shares, even though the shareholder who owns the shares retains the economic interest in the shares.
The professors’ legal research can be found here and here, and is discussed in a January 26, 2007 Wall Street Journal article entitled “How Borrowed Shares Swing Company Votes” (here, text courtesy of the Texas Law School web site).
The hedge funds or other investors who wish to obtain voting power do so by borrowing shares from large institutional investors, often as part of a short selling strategy. Borrowing the shares allows the hedge funds to gamble that the shares will decline, and they can use their vote to try to ensure that they will. The professors call the exercise of voting rights divorced from economic interests “empty voting.” The Journal article cites several examples where shortselling hedge funds used this technique as part of a successful short selling strategy.
The professors emphasize that no one knows how widespread this practice is. Their research examined 22 instances worldwide from 2001 through 2006. The Journal article notes that these kinds of votes have not yet affected outcomes in many general corporate elections. But the practice could become more important given current corporate governance momentum built around increasing “shareholder democracy,” such as the push for majority voting of directos and the right of shareholders to be able to propose board candidates.
The “empty voting” issue has attracted the attention of regulators. SEC Commissioner Paul Atkins, in a speech on January 22, 2007 (here), raised his concerns with the practice, and the Journal article quotes SEC Chairman Christopher Cox as saying that the practice is “almost certainly going to force further regulatory response to ensure that investors’ interests are protected.”
Finding a simple regulatory solution may be complicated by the fact that shareholder voting is largely controlled by state law. In addition, the vested interests in the status quo include not only hedge funds and others who might use the strategy to advance their interests, but also the institutional investors who profit by lending their shares. According to the Journal, brokerages and big banks now make $8 billion a year in fees they earn by lending their shares. CalPERS alone made $129.4 million by lending shares its holds in the year ending March 31, 2006.
The professors proposed solution puts less emphasis on regulation and more on disclosure. They propose an “integrated ownership disclosure reform,” that would require disclosure both of voting and economic ownership. The professors proposed solution would not eliminate some disclosure delays, and even allows the possibility that the disclosure might not take place until after the vote has taken place – but it would still ensure that the disclosure takes place eventually, which would both inform regulators and lawmakers for future remedial purposes, and act as some constraint on behavior.
An interesting perspective on this issue, and a presentation of the brief against further regulation on this issue, can be found on Professor Larry Ribstein’s Ideoblog, here. CFO.com also has an interesting January 26, 2007 article entitle “How to Beat the Hedge Fund Bullies” (here), that examines strategies that companies can use to identify who their shareholders are and analyze how the shareholders’ are voting.
SEC Chairman Cox on Global Competitiveness: As The D & O Diary has noted on numerous recent posts (most recently here), the issue of the competitiveness of the U.S securities markets in the global economy has been the subject of a great deal of comment lately. Regular readers will recall my concern that while the U.S. should look to its competitive interests, it should take care to avoid compromising its regulatory integrity. In a January 24, 2007 speech (here), SEC Chair Christopher Cox added the following perspective on the threats to the competitiveness of the U. S. markets:
The threat comes not from fear of foreign competition, or foreign issuers, or foreign investors. Both competition, and the influx of foreign capital and issuers, promise only good for our markets. Rather, the threat comes from the increasing opportunities for fraud, unethical trading practices, and market manipulation that globalization brings with it. Just as investors and issuers can more easily seek each other out around the world, those with less honorable intentions can also reach across borders, to prey upon distant investors. And when they succeed, they damage confidence in all of our markets.
As the proposals for regulatory reform continue to emerge in the coming months, it will be important for us to remember what kind of investors and what kind of investment activity we do and do not want to attract to U.S. securities markets.
Best in Class: Those readers who, like The D & O Diary, were fans of the late, lamented Securities Litigation Watch blog will be delighted to learn that its author Bruce Carton has launched a new blog, Best in Class, which can be found here. The early posts suggest that the new blog will be as timely and informative as the SLW.
Readers will also be interested to know that Bruce will be hosting a webcast on Tuesday January 30, 2007 at 1:00 p.m. EST on “Emerging Trends in Securities Class Actions.”
Hat tip to the 10b-5 Daily Blog for the information about Best in Class.
Next week: I will be in New York next week for the PLUS D & O Symposium (here). I hope that readers of The D & O Diary will please say hello to me during the Symposium and let me know what they think of the blog. See you all in New York.
The Content and Timing of the PCAOB’s Big Four Inspection Reports
The Public Company Accounting Oversight Board (PCAOB) has been the target of extensive criticism for the timing and content (or lack thereof) of the public reports for its inspections of the Big Four accounting Firms. (Prior D & O Diary posts on this issue can be found here and here.) This issue is reviewed at length in a January 26, 2007 CFO.com article entitled “Why The Big Four Are Still a Mystery” (here), and the article is supplemented by an email interview (here) with PCAOB board member Charles Niemeier.
The article reviews the frequent criticisms that the public inspection reports reflect a “lack of context,” because the PCAOB does not publicly reveal how many inspections it conducts on each firm. Without this kind of quantitative data, there is no way to assess how widespread the concerns are. The absence of this information means that the inspection process “is not producing the kind of results that it should for people who are using the results and trying to understand what this means,” according to the former head of Deloitte, who is now the chair of four public company audit committees, and who is quoted in the article.
The delay in reporting the results is also a concern. For example, the reports for the 2005 inspections of Ernst & Young (here) and KPMG (here) were not released until January 2007. The audits inspected were obviously completed substantially before the inspections. The delay gives analysts and others “little leeway in being able to gauge the current performance of an audit firm.”
Niemeier’s response to the concern about the lack of disclosure concerning the number of audits inspected is that it is “not a relevant figure” and “could encourage misleading, superficial comparisons between firms.” Niemeier also is opposed to supplying further details about the audit concerns noted in the inspection reports, even information designed to convey how serious the problems noted were; Niemeier feels this would be inconsistent with PCAOB’s statutory confidentiality obligations.
Niemeier is also opposed to any overall qualitative evaluation of the firms audited, on the theory that this would “divert attention” from the PCAOB’s efforts to identify risks in the audit firm’s processes. With respect to the timeliness of the inspection reports, Niemeier says that the “timing of the reports has been due to internal operational processes” and that “the time between completion of an inspection and issuance of a report should be shorter in the future.”
What to make of all of this depends on the purpose of the PCAOB’s public inspection reports. If, as with Niemeier, you believe the public reports are designed to provide the audit firms with appropriate incentive to remedy noted concerns, then the current process is adequate. But if that is the sole purpose, why bother with public reports at all? Why not simply reserve public disclosure for those concerns the audit firms fail to address during the 12-month cure period? But the reports clearly are made public (at least to the extent they are made public) for a separate purpose, which is to inform. On that score, as the CFO.com article notes, the inspection reports “don’t paint a clear enough picture about what the auditor overseer was probably trying to say in its reports.”
Niemeier’s comments that added information, such as the number of audits inspected, might be misued amounts to an assertion that investors and others can’t be trusted with the information. Clearly, the policy decision to withhold the information is calculated for the audit firms' protection, to the detriment of the investing public. These competing interests ought to militate that the PCAOB should go as far as it could to disclose information consistent with its statutory constraints – and subject only to the statutory constraints. The numerical and evaluative information critics argue that the inspection reports lack are not barred by the statutory constraints. The audit firm’s best protection against vulnerability to adverse information is in their power to control, through their own audit execution.
A good summary of the shortcomings of the PCAOB’s public inspection reports, with links to other sites, can be found on the White Collar Fraud blog, here and here.
Audit Liability Caps: In a prior post (here), The D & O Diary took a look at various proposals to cap auditors’ liability. In a January 25, 2007 speech (reported here), Conrad Hewitt, the SEC’s Chief Accountant, came out in favor of protecting the “major accounting firms” from legal liability if their audit clients become embroiled in accounting-related scandals. Hewitt is concerned about auditor liability because there are only four major accounting firms left. “It’s a concern to us if something should happen to any of the four firms.”
So The D & O Diary wonders – is the PCAOB’s policy on its public reports of the Big Four firm’s audit inspections the product of a similar concern for the survival of the “remaining four?”
Regular D & O Diary readers know that I have been maintaining a running tally of options backdating related litigation (here). According to the most recent count, so far there have been 23 securities class action lawsuits raising allegations of options grant manipulations. (The Stanford Law School Securities Class Action Clearinghouse maintains its own tally on its home page, here, that agrees with my count.)
My running tally includes cases that did not originally involve (or feature prominently) allegations related to stock grant manipulations, but that were later amended to include or emphasize options backdating allegations. Because I have already made the decision to incorporate in my tally cases that included options backdating allegations by amendment, I feel compelled to revise my tally to include the Amkor Technology case.
The initial complaints in the Amkor Technology case, filed in January 2006, may be found here. The initial complaints did not contain options backdating allegations. In an Amended and Consolidated Complaint filed in the Amkor Technology case on August 14, 2006, the allegations in that lawsuit were significantly augmented to include detailed allegations of supposed options backdating, complete with the now standard stock price graphs showing arrows superimposed on stock price troughs when options allegedly were granted. (Links to the Amended and Consolidated Complaint are unavailable, but the Amended Consolidated Complaint in Amkor is available on PACER; anyone who wants a copy of the pleading but lacks a PACER subscription should drop me a note and I will email a copy).
I only became aware of the Amkor Amended and Consolidated Complaint by accident while I was looking for something else. I am concerned that there may be other pending securities fraud cases that did not contain options backdating allegations when initially filed that have been amended to include them. It would be extraordinarily helpful if D & O Diary readers who are aware of securities fraud lawsuits that have been amended to add options backdating allegations could let me know, so that I could adjust the options litigation tally accordingly.
With the addition of the Amkor Technology case, the tally of securities fraud lawsuits raising options grant manipulation allegations stands at 24.
As also noted in my running tally, the number of companies that have been named as nominal defendants in shareholders derivative lawsuits stands at 141. This count has been substantially revised this week thanks to information supplied by alert D & O Diary readers Bill Ballowe and Ben Eng. Hat tip to these gentlemen for their helpful information.
UPDATE: My request for help from readers has already yielded results. The list of securities fraud lawsuits involving options grant manipulations has been amended to include the lawsuit pending against Quest Software. The lead plaintiff's counsel's press release regarding the Quest Software case may be found here. With the addition of this case, the tally of securities fraud lawsuits now stands at 25. Hat tip to Adam Savett of the Lies, Damned Lies blog for the link to the press release.
PCAOB Says Auditors Should Sharpen Fraud Detection
Based on the accumulated observations of its inspections of public company audits, the Public Company Accounting Oversight Board is concerned that auditors may not be doing all they could (or even all that is required) to detect the possibility of fraud at the companies they are auditing. In a January 22, 2007 release entitled “Observations on Auditors’ Implementation of PCAOB Standards Relating to Auditors’ Responsibilities with Respect to Fraud” (here), the PCAOB issued a report detailing its recurring observations in order to “focus auditors on being diligent about their responsibilities as they relate to fraud.” The report is not intended to create new standards, but rather to “remind all auditors of what the Board’s standards require of them in these areas.”
The report emphasizes that one of the key purposes of the audit, and an important point of concern of the PCAOB, is to “detect material misrepresentations caused by fraud.” The report reviews at considerable lengths the steps that auditors should be taking in planning and performing the audit to test for the possibility of fraud.
Among the more interesting discussion points is the PCAOB’s concern based on its recurring inspection observations that some audit teams are not designing their audit procedures based on an audit team “brainstorming session" to identify possible company-specific fraudulent practices. Essentially, the auditors are required to put themselves in the shoes of the would-be fraudsters, and imagine how they might go about defrauding the company, so that the auditors can then design tests to see if any of these things are actually happening. The report identifies a number of other procedural and substantive shortcomings that the PCOAB has observed (for example, failing to test for the possibility that management is overriding financial controls), but the failure to design audit tests based on company-specific fraud-imagination brainstorming is one of several apparently serious concerns.
Consistent with the PCAOB’s prior practices and statutory constraints, the PCAOB does not identify the auditors or audits on which its observations are based. As The D & O Diary has previously observed (here), the PCAOB could (and arguably should) consistent with its statutory constraints provide numerical information that would afford greater insight into how serious these problems are. For example, in connection with how many audit inspections were these concerns noted? On what percentage of the PCAOB’s inspections did these kinds of concerns arise? And, even more specifically, were there any inspections on which these concerns were noted where fraud was later found to have occurred but was not detected by the auditors? Without this kind of information, it is basically impossible to assess how serious these concerns are, and whether or not there might be fraud (and if so, how much) that is going undetected by the auditors. That said, the PCAOB is to be commended for compiling the observations and issuing the release, as it undoubtedly will have the salutary effect of focusing auditors' attention on the need for targeted fraud detection procedures.
Hat tip to the AAO Weblog (here) for the link the to the PCAOB release.
To Catch a Thief?: Anyone who doubts the need for creative application of audit procedures actively designed to detect fraud may want to read the story (here) from the front page of today’s Cleveland Plain Dealer. This story might not have made the national press but here in snowy Cleveland it is pretty big news. According to the story, the former head of the international lending unit of KeyCorp will plead guilty to embezzling $40 million from the bank over the course of 9 years.
The official fabricated loans in the name of real European banks and then took the money himself. He used subsequent loans to cover earlier loans. He got caught when he used one of the European lines of credit to pay his personal credit card bill, and it came to the attention of another bank employee. (Coincidentally, the WSJ.com Law Blog has an account, here, of a separate embezzlement scam involving the former NBC Treasurer that was also detected because the bad guy used the embezzled funds to pay a personal credit card bill.)
According to the news report, the KeyCorp embezzlement scheme escalated in 2004 when the official developed a relationship with a younger woman he met while traveling, for whom he purchased multi-million dollar homes and a 12-carat engagement ring. (The official was married to another woman at the time; unsurprisingly, they divorced after the embezzlment and the use of the embezzled funds came to light.)
Auditors who want to jumpstart their brainstorming session about possible fraud may want to contemplate the apparent ease with which this individual evaded detection for 9 years and scammed his (publicly traded) employer.
Global Forces Undercut Case for Regulatory Reforms
In prior posts (here, here and here), I argue that the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) made a “weak case” in its Interim Report for regulatory reform. Virtually all of my points apply equally to the recently released Bloomberg/Schumer report as well. The themes I sounded in my earlier posts are underscored in a January 25, 2007 Wall Street Journal article entitled “In Call to Deregulate Business, a Global Twist” (here, subscription required), which suggests that “the changing nature of global finance,” rather than the U.S regulatory environment, explains U.S. markets’ declining share of global finance business.
The Journal article explores at length the improved competitiveness of foreign markets, which in recent years have closed their “quality gap” with the U.S. markets. Developing world markets are “deep enough and liquid enough” that listing companies no longer have any financial imperative to list or trade their shares on U.S. exchanges, as they may have had in the past.
The article also zeroes in on one of the prime points cited to justify regulatory reform – that is, the declining U.S share of global IPOs. With the exception of the London’s Alternative Investment Market (AIM), IPOs are down on all developed countries’ exchanges – “the London Stock Exchange’s blue-chip Main market has seen foreign listing decline 23% since 2000. The Deutsche Borse is down 58%; Tokyo down 39%.” In other words, the declining IPO volume “is hardly an American disease.” And even with respect to AIM, the article points out that many of the AIM companies don’t “meet U.S. requirements” or are “too small to attract interest from U.S. underwriters and investors.” (My prior post, here, reviews the Bloomberg/Schumer report’s discussion of the AIM and the report’s conclusion that the U.S. markets should not lower its standards to compete for more of AIM’s business.).
The article also shows that overseas companies are now able to trade their shares freely, and even attract U.S. investors, without the need for a U.S. listing – or the need to pay the $1 million NYSE listing fee. In addition the article examines the fact that increased private equity takeover activity is a global phenomenon, not just a U.S. trait, and that rather than reflecting U.S. companies’ interests to “go private” and avoid public company regulation, the high level of private equity activity is simply a reflection of the fact that private equity firms have so much cash.
At the same time as global markets have become better, they have also closed the regulatory gap with the U.S. The article quotes the director of the SEC’s office of international affairs as saying that Sarbanes-Oxley has “not competitively disadvantaged U.S. markets, simply by virtue of the fact that they have been widely adopted elsewhere.” Even though the U.S. regulatory burden has risen, the same is true for most countries’ markets.
The article gives the advocates for regulatory reform an opportunity for rebuttal. The best that Glenn Hubbard, the chair of the Paulson Committee, can offer, is the declining “investment premium” enjoyed by foreign companies based in developed countries that cross list their shares on U.S. exchanges. Hubbard argues that the declining investment premium for these developed world companies shows that for companies already meeting their more stringent governance standards at home, the costs of meeting the U.S. benefits exceeds the costs.
I have extensively examined the investment premium issue before (here), but it is worth noting here what a total non sequitur Hubbard’s argument is. First, it concedes that there is still an investment premium for companies based in developing countries – that is, the countries with the growing economies that are most likely to be the source of increased economic activity in the years ahead. Second, while the investment premium for companies based in developed countries has declined, it has not gone away, there is still an investment premium for listing on U.S. exchanges, and that is because of the integrity of the U.S. markets, which would be eliminated if regulation were relaxed. And third, to the extent the investment premium has declined, isn’t it obvious that it is because the integrity of many foreign markets has improved? If that is the case, then why does that argue in favor of weakening U.S markets’ regulation? It just seems to me that the only conclusion that can be drawn from the investment premium issue is that we would be best served by striving to maintain the integrity of our markets, not weakening our regulatory rigor in a race for the bottom.
All of this underscores the point I have made in prior posts that business interests in the U.S. may be seizing on the effects of the changing global finance environment as a pretext to undermine regulatory requirements that may occasionally prove uncomfortable because the requirements actually have teeth. The advocates for regulatory reform may want to advance U.S. competitiveness, but steps that threaten to weaken the integrity of the U.S regulatory structure could remove the greatest advantage the U.S. markets enjoy – that is, the U.S. markets are the most highly regarded precisely because they are the most tightly regulated.
That is not to say that none of the reformers’ ideas have validity. To the contrary, the Bloomberg/Schumer report’s suggestions for immigration reform and immediate adoption of the Basel II Capital Accords are sound and should be pursed, as should many of the report’s suggestions for harmonization of competing U.S. regulatory structures, and the harmonization of U.S and international accounting standards. But aggressive revision of the U.S regulatory and legal structure, at least in the name of the competitiveness of the U.S. markets, could represent a misplaced effort that could do more harm than good.
It is worth noting that the Journal article contains an interesting quote from former Treasury Secretary Lawrence Summers, who says that “well-functioning capital markets are central to the success of the economy. What faction of capital market transactions runs through New York is of much less broad-based significance.” Summers’ observation is one that is not being heard much, but it is a point worth keeping in mind. Perhaps we should be more focused on adapting to the new reality of the global marketplace, rather than attempting to preserve the benefits of market advantages that no longer exist.
Finally, it is worth noting that several of the overseas companies discussed in the Journal article mentioned the high listing fees for U.S. exchanges. While the two task force reports released so far have tried to downplay the importance of listing fees and U.S underwriters’ fees (which also tend to be higher than European fees, as much as twice as high), evidence and logic suggest that these fees and costs are a factor affecting overseas companies’ willingness to list on U.S. exchanges. As I have argued before, the U.S. financial industry, rather than sniping at a regulatory structure that other countries are imitating, perhaps they should overhaul their cost structure, which the rest of the world has substantially improved upon.
UPDATE: The January 26, 2007 New York Times has an article (here) that raises many of the same themes as the Journal article linked about, including specifically the point that the U.S. should not be stressing about the loss of very small companies to the AIM.
The Bloomberg/Schumer Report on U.S. Capital Market Competitiveness
On Monday January 22, 2007, Republican New York City Mayor Michael Bloomberg and Democratic New York Senator Charles Schumer released the joint report they commissioned from McKinsey & Company, entitled “Sustaining New York’s and the U.S.’s Global Financial Services Leadership.” The report can be found here, and the joint press release describing the report can be found here. The report is written in the same vein as the Interim Report of the Committee on Capital Markets Regulation, or the Paulson Committee as it is popularly known, and the two reports are both of similarly impressive length. (My prior discussion of the Paulson Committee Report can be found here). There are, however, several important differences between the two reports, both in tone and in substance.
Among the more important visual differences is the explicit bipartisan support for the Bloomberg/Schumer report. Indeed, newly elected Democratic New York Governor Eliot Spitzer showed up for the ceremony to release the report, about which there is some significant irony, given the report’s concern about the problems caused by conflicting regulatory schemes. The Wall Street Journal’s discussion of the unsubtle irony of Spitzer’s involvement can be found here and here (subscription required).
The Bloomberg/Schumer report, like the Paulson Committee’s Interim Report, is focused on the competitiveness of the U.S. capital markets, but its recognition of the reasons for the heightened competitiveness of foreign securities markets is more comprehensive and detailed than the Paulson Committee’s Interim Report. The Bloomberg/Schumer report examines at length the “strong dynamics outside the U.S. driving international growth.” Its review of the reasons why many foreign companies are seeking to list their shares on exchanges outside the U.S. examines at length the geographic and economic reasons for this shift, including in particular the increased availability of adequate capital in foreign markets and improved technology and communications that has opened these markets to all international investors (including even U.S.-based investors).
The Bloomberg/Schumer report is also much less concerned about the purported threat of London’s Alternative Investment Market (AIM) that then Paulson Committee’s Interim Report. While recognizing that the AIM has successfully tailored its listing requirements to attract smaller companies, the Bloomberg/Schumer report also notes that “small-cap markets are clearly riskier that their more established counterparts.” The report also notes in a sidebar that while the AIM has attracted a growing number of listings in recent years, the growing number “masks the large and increasing number of de-listings (480 since the beginning of 2003) and low liquidity of most AIM stocks.” The Bloomberg/Schumer report concludes that because of concerns over the “disproportionate impact a bear market might have on small-cap markets and investors,” and the limited economic benefit of such markets, the report “does not recommend that U.S. exchanges lower their listing requirements to attract more small issuers.’
The Bloomberg/Schumer report also emphasizes several issues that are not addressed at all in the Paulson Committee’s Interim Report. For example, the Bloomberg/Schumer report takes a look at legal barriers that may prevent domestic markets from attracting top global financial talent and concludes that U.S immigration policies are making it harder to attract non-citizens to move to this country, and these barriers are undermining the competitiveness of U.S. securities markets. The report proposes a number of specific immigration reforms. The Bloomberg/Schumer report also recommends the rapid implementation of the Basel II Capital Accords, so that U.S.-based commercial banking institutions do not face higher capital level requirements than their foreign counterparts, which would put them at a competitive disadvantage.
Based on its conclusion that the regulatory and legal environment in this country is a substantial factor diminishing the attractiveness of U.S capital markets, the Bloomberg/Schumer report proposes a number of reforms. While the Bloomberg/Schumer report, like the Paulson Committee report, singles out Section 404 of the Sarbanes-Oxley Act, the Bloomberg/Schumer report comments that the fault does not lie with the Act itself but with the implementing regulations. (This observation coincides with the remarks of SEC Commissioner Paul Atkins on January 22, 2007 at the Corporate Directors Forum, here). The Blooberg/Schumer report urges the SEC and the PCAOB to proceed quickly with their current efforts to reform the implementing regulations (see the PCAOB's press release on its current reform efforts, here), provide further guidance with regard to what constitutes a “material weakness” in internal controls, and help implement an internal control review that is “top-down, risk-based, and focused on what truly matters to the integrity of a company’s financial statement.’
The report also suggests that the SEC should consider giving “smaller companies” (the report does not define “smaller”) the opportunity to opt-out of the more onerous requirements of the Sarbanes-Oxley Act, provided the choice is “conspicuously disclosed to investors.” In addition, the report suggests that the SEC should consider exempting foreign companies from certain parts of the Act, provided they already comply with sophisticated, SEC-approved foreign regulators’ requirements.
The Bloomberg/Schumer report also proposes limited “securities litigation reform,” which it proposes that the SEC implement through its authority under Section 36 of the Securities Exchange Act of 1934 to exempt certain companies from regulations when it deems such exemptions to be in the public interest. Specifically, the report suggest that the SEC choose to limit the liability of foreign companies with U.S. listings to securities related damages proportional to their degree of exposure to U.S. markets; and impose a cap on auditors’ damages that would maintain a deterrent effect but reduce the likelihood that the auditing industry would lose another major player. The report also repeats the suggestion that the SEC could allow companies to opt out of part of SOX (again, with “conspicuous disclosure.”) The report also proposes that the SEC promote arbitration as a means of resisting disputes between public companies and investors.
The report also proposes two legislative changes to address “long-term structural problems.” The report suggests that Congress should consider limiting punitive damages and allow litigants in federal securities actions to appeal interlocutory judgments immediately to the Circuit Courts. The report contains a number of suggestions to harmonize the various U.S. regulatory structures. It also suggests the creation of a permanent body (the “National Commission on Financial Market Competitiveness”) to focus on the competitiveness of the U.S securities markets.
Compared to the Paulson Committee Interim Report, the Bloomberg/Schumer report is both more comprehensive (for example, with its reference to immigration reform and the Basel II Capital Accords) and, in some ways, more realistic (for example, in its recognition of the myriad reasons not to lower regulatory standards simply to attract smaller listing companies). The report also presents a few modest proposals that could help incrementally improve the competitiveness of the U.S. securities markets. The report struggles to maintain the air of modesty for reforms that may not be quite so modest or feasible (for example, using federal legislation to eliminate state law provisions for punitive damages, or using regulatory provisions to create damages caps). The proposal to create an arbitration remedy for investors disputes with public companies may seem superficially attractive, but even a brief referral to one of the more serious securities class action lawsuits will reveal that these kinds of lawsuits are peculiarly unsuited for that forum and process.
But with the arrival of the Bloomberg/Schumer report and its addition to the Paulson Committee’s Interim Report, and with the added prospect of the conference that the Treasury Department plans to hold this spring on the issue of the competitiveness of the U.S Securities markets (here), it is pretty clear that momentum is building for action to be taken to assist the U.S. markets. In this environment, particularly where there seems to be a bipartisan consensus emerging, it seems likelier that regulatory and even legislative reforms may well occur. In this environment, ideas such as the increased regulatory flexibility for smaller companies and foreign companies, may receive a more sympathetic reception, even though it would have to be asked whether these changes might represent a lowering of standards that arguably could weaken the overall strength and integrity of the markets.
It also appears the regulators are reading reading the newspapers. The PCAOB's intiative to reform Auditing Standard 2 and argubly even the Department of Justice's revision of the Thompson Memo with the release of the McNulty Memo are undoubtedly the result of a multitude of factors, but the timing of these reforms may be due to the growing calls for reform. The regulators may well be attempting to get ahead of the curve; there may be further regulatory intiatives ahead.
One final observation: it is interesting to note that the Bloomberg/Schumer report concludes, in examining the reason for the decline in the number of securities class action lawsuits in 2005 and 2006, that the decline in the number of lawsuits is largely attributable to favorable economic conditions and that "if economic conditions were to decline in the future, then a strong resurgence of lawsuits would likely follow."
Additional interesting commentary about the Bloomberg/Schumer report can be found at the AAO Weblog (here) and the SOX First blog (here).
When the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) in its Interim Report (here) recommended “setting a cap on auditor liability,” the Committee relied for support on the steps in that direction that have been taken by the European Commission. In its latest effort along those lines, the European Commission on January 18, 2007 launched a “public consultation on whether there is a need to reform the rules on auditor liability in the EU.” A copy of the Commission’s press release can be found here. A copy of the Staff Working Paper can be found here.
In the Working Paper, the Commission’s staff offered four alternative proposals to cap the liability accounting firms potentially face when auditing public companies. (The Commission is asking for comment on the four proposals by March 15, 2007.) The four proposals are: a fixed monetary cap on damages that could be sought from auditors; a cap based on the audited company’s market capitalization; a cap based on a multiple of the audit fees charged; or the introduction of proportionate liability , which would hold the auditor responsible only for the damages that could be specifically attributed to them.
The initiative to afford accountants some form of liability protection is being led by Charlie McCreevy, the European Commissioner for Internal Market and Services. The initiative would potentially extend protections across the EU’s 27 member countries, although the member countries would not be required to enact them. However, the Working Paper notes that “auditor’s liability is currently capped in five Member States (Austria, Belgium, Germany, Greece and Slovenia).”
The Commission’s motivation for exploring auditor liability caps is essentially the same as that noted by the Paulson Committee in its Interim Report. That is, the Commission is concerned that as the number of audit firms capable of auditing the largest companies has dwindled down to four, the potential consequences from the failure of one of the remaining firms would be harmful to investors. In an October 27, 2006 interview in the Financial Times (here), McCreevy expressed his concern that “further reduction in the number of global firms would make it very hard for companies to get accounts signed off and published – dealing a blow to investors.” McCreevy himself advocates a cap on auditor liability.
A January 19, 2007 Wall Street Journal article entitled “EU Offers Plans for Accounting Firms’ Audit-Liability Caps” (here, subscription required) suggests that the EU proposals “could help a push by the largest firms for similar protection in the U.S.” The article goes on to note that the “adoption of a European auditor-liability shield, even if the member countries weren’t required to enact it, would potentially add to a sense that U.S. markets are increasingly at a competitive disadvantage to those in Europe, and, in particular, London.”
The competitiveness of the U.S. capital markets will be the theme of a conference that will convened in the spring by Treasury Secretary Henry Paulson. (For a description of the planned conference, announced on January 17, 2007, refer here.) The accounting industry will be one of the three major topics to be discussed at the conference, along with regulation and corporate governance. Robert Steel, the Treasury’s undersecretary for domestic finance, in describing the conference’s anticipated topics, said that (unnamed) officials are “concerned about the accounting industry,” and that the conference will look at whether there are “structural issues” that hurt the industry, such as an “unattractive liability construction.” Steel, along with Paulson, recently joined the Treasury Department from Goldman Sachs.
Is the PCAOB Shielding the Big Four?: With the anxiety surrounding the possible investor consequences to investors were another of the Big Four accounting firms to fail, could it be that regulators are treading softly around the “remaining Four?” As The D & O Diary noted in a prior post (here), the Public Company Accounting Oversight Board (PCAOB) does not reveal much about its inspections of the Big Four accounting firms. For example, the PCAOB does not reveal the number of Big Four audits it inspects as part of its annual inspection process, or the percentage of audits inspected that proved to have concerns – even though it releases this information for smaller firms.
A January 18, 2007 post on CFO Blog (here) reports on a recent speech by PCAOB founder and board member Bill Gradison, in which Gradison suggests that the PCAOB considers itself a supervisory body rather than an enforcement agency, and so the agency wants to work with firms to restore “integrity” and even “luster” to the profession. For that reason, the PCAOB prefers to give the audit firms a 12-month grace period to fix problems, rather than to make them public when they happen, since “reputation is so important in a field like auditing.”
While I am sure the accounting firm’s appreciate this deference to their reputation, investors’ interests are definitely forced into the back seat by this ordering of priorities. As my prior post linked above notes, the PCAOB’s annual inspection report disclosure leaves a great deal to be desired from the investors’ point of view. First and foremost, the PCAOB ought to inform investors what percentage of audits inspected produced inspection concerns. In addition, the PCAOB ought to tell the investing public how many of the audit concerns were material, which audit concerns were material, and what order of magnitude the material concerns represent.
According to a January 20, 2007 Wall Street Journal article entitled “Executives Get Bonuses As Firms Reprice Options” (here, subscription required), some of the companies ensnared in the options backdating scandal are paying cash bonuses to executives whose options are being repriced, as the option exercise price is shifted to the actual grant date from the backdated date. According to the article, these bonuses are going to executives who weren’t involved in options wrongdoing, and who would otherwise see the overall value of their paid compensation shrink as a result of the repricing.
Although the repricing is designed to make the executives’ compensation whole, some executives could wind up better off as a result of the cash bonuses, because they are “swapping unrealized, potential profit” (since the share price could decline) for cash. In the examples cited in the article, the cash bonuses involve payments of hundreds of thousands of dollars.
Some companies are going even further and paying the 20% excise tax payable under IRS Section 409A on “discount” options whose exercise price is below the level of the stock on the day the option is granted.
The article does point out that there are a number of companies that have concluded that the problem “should be fixed without taking more out of shareholders’ pockets” and have accordingly declined to pay additional amounts to affected executives.
What are we to make of all this? On the one hand, as Professor Larry Ribstein points out on his Ideoblog (here), the executives receiving the cash bonuses weren’t involved in the backdating: “If they didn’t do anything wrong, why punish them by taking away some of their agreed compensation?”
While I see Professor Ribstein’s point, it is a struggle for me to see that the right thing for companies to do here is make a cash payment to the executives. The point of options compensation is to align corporate managers' interests with those of shareholders by providing that managers only do well if shareholders do well. By converting that investment risk into fixed cash, the element of shared interest is eliminated. To the contrary, it converts the shared interest into exclusive service of executives’ interests at shareholders’ expense.
The reality of shareholders expense leads to another concern. The executives receiving the cash bonus may have been cleared of wrongdoing, but for the backdating to have taken place there had to have been some missing internal controls. Even if the executives were uninvolved in the wrongdoing, they were present when the errors occurred. As between the executives and investors, who ought to absorb the compensaion consequences involved with cleaning up the mess? Shareholders already are absorbing all of the costs of accountants’ and attorneys’ services required to clear up accounts. Why should shareholders also have to absorb additional costs for cash compensation to senior executives who were “on the bridge” when the malfunctions occurred?
There are also a couple of very serious atmospheric problems with the cash payments at this particular point in time. First, by communicating that the incremental additional value of the backdating options represents compensation to which the executives were entitled, the companies are inferentially suggesting that the backdating was an intended part of their compensation scheme. (This is a conclusion that Professor Ribstein overtly draws.) Whatever the theoretical debate might be about the propriety of backdating, now is a particularly poor time for companies to suggest that backdating was a calculated part of their intended compensation scheme.
Finally, with all of the scrutiny on executive compensation in general right now, providing executives with immediate cash payment for flawed variable compensation sends a very provocative message – particularly as at least some of the companies involved, according to the Journal article, have not yet determined how they will treat backdated options by nonexecutive employees.
These and other concerns are obviously the reason why many other companies are declining to reimburse executives for repriced options. The fact that many companies have declined to make these cash payments certainly puts the companies that are making the payments in a conspicuous spot – the front page of the Wall Street Journal, for starters.
H-P CEO Claims He Was Not “Bullet Dodging”: On January 19, 2007, the House Committee on Energy and Commerce forwarded to the SEC a letter that H-P CEO Mark Hurd sent to the Committee in response to the Committee’s questions about his exercising of H-P options shortly before the H-P pretexting scandal broke last fall. A copy of the Committee’s letter, to which Hurd’s letter is attached, can be found here. In his letter, Hurd defended the stock transactions, which took place two weeks before the pretexting scandal broke, and the same day as he was questioned by H-P’s outside counsel in connection with the internal investigation surrounding the abrupt resignation of former H-P board member Tom Perkins.
Hurd specifically wrote that “My August trade was not a case of bullet dodging.” Hurd stated that the trade was part of his regularly scheduled trading plan, established on the advice of his financial planner and broker, and consistent with the legal opinion he received from H-P’s counsel in advance of the trades. He also states that he began the process to execute the trades before anyone had asked to interview him. He also pointed out that the options exercised were granted, and the exercise price was set, long before the exercise date.
While the letter is interesting and its release has generated press attention (for example, this January 20, 2007 San Jose Mercury News article, here) this may all be much ado about nothing. As the While Collar Crime Prof blog points out (here), “while the timing is suspicious … the company’s stock price increased after Hurd’s sale,” so that rather than dodging a bullet, “he may actually have taken one instead.”
Oh, Behave: Some great quotes about behaving comme il faut (or not), here.
Executive Compensation, Legal Fees, and the Grasso Case
Eliot Spitzer sued former NYSE Chairman and CEO Richard Grasso to compel him to return the bulk of his nearly $190 deferred compensation and pension package, alleging that the pay package was “objectively unreasonable” under New York law governing nonprofit institutions and that Grasso had improperly influenced or misled the NYSE’s board directors to obtain their approval of the package. (The NYSE was a nonprofit institution while Grasso served as its Chair.) A copy of the complaint against Grasso can be found here.
Spitzer may have moved on the New York governor’s mansion (refer here), but the case lives on, as highly contested cases will do. The case is currently on appeal, as Grasso challenges the entry of partial summary judgment against him by New York Supreme Court Justice Charles Ramos. Justice Ramos ruled in October 2006 that Grasso had breached his fiduciary duty and that Grasso must return almost $100 million. A copy of Justice Ramos’s opinion can be found here.
Litigation at this level is expensive, but the magnitude of the expense involved may exceed even the inflated standards of our age. In a January 17, 2007 interview reported on Bloomberg.com (here), Grasso said that the “costs of all sides involved…may have exceeded $100 million,” which the article notes is an amount almost equal to the amount the New York Attorney General is seeking. Grasso is quoted as saying, “I would not be surprised if the legal bill were in excess of $100 million.” Grasso added that “This lawsuit is about honor. It is not about money any more.”
Indeed. It is always about honor. But the money does play a role, however slight it may concern Grasso, and unless the goal of the lawsuit is a massive wealth transfer to the legal community, the expense apparently involved does raise certain questions.
Of course, Grasso’s legal fee estimate may or not bear any relation to reality. Perhaps to a man accustomed to astronomical dollar figures, a number like $100 million is simply a proxy for a number of a very large size, sort of like the biblical author used the phrase 40 days and 40 nights. Grasso is also obviously motivated to characterize the lawsuit in a particular way, and so has every incentive to portray the lawsuit as excessive or even counterproductive.
But there unquestionably is something arresting about Grasso’s estimate. The prospect that the lawsuit might consume in fees as much as the case ultimately is worth brings to mind the litigation travails of another Richard, Richard Carstone, who exhausted himself pursuing his interests in the matter of Jarndyce and Jarndyce in Dickens’ novel, Bleak House. Perhaps the comparison between the two cases is not entirely apt, but there is a familiar resonance surrounding the magnitude of the fees and their relation to the matters in dispute.
The following excerpt from the novel (drawn from this source) captures the moment when the parties found the case to be “over” – not due to resolution on the merits, but because of the cumulative effect of the lawyers’ fees (the excerpt begins with the words of Mr. Kenge, an attorney):
“For many years, the--a--I would say the flower of the bar, and the--a--I would presume to add, the matured autumnal fruits of the woolsack--have been lavished upon Jarndyce and Jarndyce. If the public have the benefit, and if the country have the adornment, of this great grasp, it must be paid for in money or money's worth, sir."
"Mr. Kenge," said Allan, appearing enlightened all in a moment. "Excuse me, our time presses. Do I understand that the whole estate is found to have been absorbed in costs?"
"Hem! I believe so," returned Mr. Kenge. "Mr. Vholes, what do YOU say?"
"I believe so," said Mr. Vholes.
"And that thus the suit lapses and melts away?"
"Probably," returned Mr. Kenge.
"Mr. Vholes?"
"Probably," said Mr. Vholes.
"My dearest life," whispered Allan, "this will break Richard's heart!"
On January 16, 2007, the Lerach Coughlin firm filed a purported securities class action lawsuit in federal court in the District of Columbia against Sunrise Senior Living and several of its directors and officers. A copy of the law firm’s press release can be found here and a copy of the complaint can be found here. The complaint raises a variety of different allegations but also contains allegations that the defendants manipulated the company’s stock option program by backdating or springloading option grants.
The Complaint alleges that the “top insiders of Sunrise took advantage of the artificial inflation in Sunrise’s shares to bail out of the stock, unloading almost a million shares of the stock.” What is interesting about the plaintiffs’ insider trading allegation is their assertion that the defendants stock sales were triggered “in early 2006, as widespread revelations of a stock option backdating scandal began to sweep corporate America.” The allegedly backdated or springloaded options were awarded during the period 1997 to 2001.
The plaintiffs do not specify why the unfolding scandal supposedly motivated the defendants to sell their shares; the suggested inference, I suppose, is that defendants sold their shares because they knew when the marketplace found out about the backdating in the company’s options, the company’s share price would drop. But in fact, the company’s share price declined in value as a result of its announcement (here) that it would be restating its financial statements for the years 2003 through 2005, not because of disclosures relating to options backdating.
Apparently in anticipation of the defendants’ likely arguments that their share sales were made pursuant to Rule 10b5-1 trading plans, the plaintiffs raise a number of interesting allegations. The plaintiffs not only contend that the plan terms “did not comply with regulatory requirements” but also that when the defendants put the plans in place, they knew “that they were already pursuing a scheme to defraud and falsify Sunrise’s reported financial results” hoping that the plans “would give them protection from the legal liability they knew they would otherwise face.” In other words, the plaintiffs are trying to argue that the Rule 10b5-1 plans themselves were part of the scheme to defraud.
Updated Options Backdating Litigation Tally: The initiation of the lawsuit against Sunrise brings the total number of options backdating related securities class action lawsuits to 23. The number of companies named as nominal defendants in shareholders’ derivative lawsuits based on options backdating allegations now stands at 131. The D & O Diary’s running tally of the options backdating related lawsuits can be found here.
Courts Reject SOX Whistleblower’s Claim: Employees of public companies who believe they have been retaliated against because they engaged in “protected” whistleblowing activity may assert a claim against their employer under Section 806 of the Sarbanes-Oxley Act. The burden is on the employee to show that the protected activity was a contributing factor in the adverse employment action. The D & O Diary’s prior post about the difficulty employees are having obtaining relief under the SOX Whistleblower provisions can be found here.
There is still relatively little case authority establishing what constitutes “protected activity.” A recent federal court decision from Michigan examined how direct the causal connection has to be between the allegedly protected activity and the job action.
In the case (Sussman v. K-Mart Holding Corp.) the plaintiff (Sussman) alleged that he had sent the company’s President a letter alleging that his supervisor was accepting kickbacks from vendors. K-Mart investigated the supervisor, but before the investigation was complete, the supervisor was terminated for unrelated reasons. Five months later, Sussman’s performance came under criticism, and he received a warning. Sussman asked his (new) supervisor whether the warning was related to his complaints about his prior supervisor. After additional performance shortcomings, Sussman was terminated.
In SOX whistleblower case that Sussman filed against K-Mart, the court held that Sussman had failed to establish a causal link between the job action and the activity he claimed was protected. The court did observe that Sussman was not engaging in protected activity when he raised with his new supervisor that he had blown the whistle on his prior supervisor’s kickbacks. The court found that his comments about his previous supervisor’s actions could not be related to protecting shareholders from fraud because his prior supervisor was fired for unrelated reasons five months before he made the remarks to his new supervisor.
A detailed summary of the decision, as well as a brief overview of the “protected activity” case law, can be found a memorandum by the Sutherland, Asbill & Brennan law firm, here.
The Ultimate Team Building Video: This YouTube video is for anyone who has ever felt like a team of one. The video takes about a minute to watch, but rewards a complete viewing.
In a January 10, 2007 Wall Street Journal op-ed piece provocatively entitled "Should Steve Jobs Go to Jail?" (here, subscription required) the attorneys for Gregory Reyes, the former CEO Brocade Communications who faces criminal charges in connection with stock option activity at Brocade, present their view that "most options backdating cases" are "not fraud, but books and records errors." They recite that Steve Jobs, the CEO of Apple who faces his own set of questions about options grants at his company, like their client, is a "non- accountant who didn’t personally benefit one cent from the options grants at issue." They go on to state that the "problem with the government’s theory is that it "conflates books and records violations with criminal securities fraud." The government thus "untethers securities fraud from the legal elements that safeguard executives from conviction from inadvertent accounting violations resulting in little or no harm to companies or investors." The authors go on to assert that "there is no proof of deceit or concealment in alleged backdating cases," and that the backdating was "actually undertaken in good faith" arising from the high volume of options grants that led to "paperwork errors."
While the authors' essay is most directly intended to exonerate their client, their arguments join a chorus of other voices that have contending that options backdating in general is not illegal and the current proecutorial zeal to prosecute backdating is a combination of government (and media) overreaction and failure to understand the practical and legal ramifications of backdating. This view is most persuasively presented on Professor Larry Ribstein’s Ideoblog (here) and in Holman Jenkins columns in the Wall Street Journal (most recently, here).
There is absolutely no doubt that what has happened with the options backdating story is what usually happens when there is a contagion event across many companies. The media has jumped on the story, looking for scapegoats and all too eager to see this story as one more example of "greedy" corporate executives enriching themselves (supposedly) at shareholder expense. There is no doubt that some of the media coverage has swept with too broad a brush, and lumped together many companies and many kinds of activities as if the activity and the companies were all equivalent and equally culpable. But while not every company executive whose name has been associated with the backdating story is criminally culpable, neither is every one of them completely innocent, as the authors of the Journal op-ed piece seem to come close to suggesting.
It is undoubtedly the case, as the op-ed authors contend, that a number of different things have gotten "conflated" in the whole options backdating scandal. First and foremost, there is an unfortunate tendency for too many commentators to sweep together a whole range of conduct under the heading "options backdating." As The D & O Diary has taken great pains to emphasize in discussing the options backdating scandal, what is commonly referred to as options backdating actually includes a wide variety of options related activities, including not just backdating itself, but options springloading (here and here), employee related options backdating (here), bullet-dodging (here), and even options exercise backdating (here). Each of these kinds of activities is different, each involves different actions, and each arguably involves varying levels of culpability, both potential, and in some cases, actual. More to the point, there varying aspects of each of these different sorts of activities that make the activities more or less arguably criminal.
The variables that potentially might make options related activities more arguably criminal can be seen best in an extreme example. As chance would have it, the same day as the op-ed piece appeared in the Journal, an extreme example arose in the case of William Savin, the ex-General Counsel of Comverse Technology. On January 10, 2007, Sorin settled the enforcement proceeding that had been brought against him by the SEC in connection with options backdating allegations. The SEC’s press release about the settlement can be found here. The SEC had charged Sorin, along with former Comverse CEO Kobi Alexander and David Kreinberg, Comverse’s former CFO, of engaging in a scheme to backdate Comverse options grants from 1991 to 2001. The SEC’s complaint against the three former officials can be found here. Their scheme is alleged to have resulted in the restatement of income because of the understatement of Comverse’s compensation expense. Sorin himself was alleged to have realized more than $14 million from the sale of stock underlying the exercises of backdated option that were granted during the 1991 to 2001 period. Sorin was specifically alleged to have played a critical role in the scheme by drafting grand documents with false grant dates. Sorin is also alleged to have facilitated a similar backdating scheme at Ulticom, a Comverse subsidiary, by creating false company records.
In settling the fraud charges, Sorin neither admitted or denied the allegations. (However, on November 2, 2006, Sorin pled guilty to a single count of conspiracy to commit securities fraud, mail fraud, and wire fraud.) As part of the SEC settlement, Sorin consented to be enjoined from further securities laws violations; to pay $1.6 million in dosgorgement, of which $1 million "represented the ‘in-the-money" benefit from the exercises of backdated options grants; $800,000 in prejudgment interest; and a civil fine of $600,000. The total value of the amounts Sorin agreed to pay is more than $3 million.
Even though Sorin neither admitted or denied the allegations against him, the allegations provide an interesting context to assess the op-ed authors’ assertion that backdating is no more than a mere scrivener’s error. By contrast to the benign picture the op-ed authors conjure, Sorin was alleged to have personally benefited; he was alledged to have falsified documents, both at Comverse and at Ulticom; and Comverse investors were alleged to have been deceived because income was overstated by the understatement of expense.
Using these elements as a framework to assess potential culpability, it seems to me that the op-ed authors' theme that backdating is essentially innocent gets weaker the more a particular set of circumstances involves personal benefit, document falsification, and the greater the impact the activity had on the company’s reported financial condition. As they correctly contend, cases without these elements lack indicia of securities fraud. But as the allegations against Sorin suggest, there may be cases where these allegations of personal benefit and deception are present and where the shareholder harm was great.
Whether any particular case involved culpable behavior depends on what actually happened, and this is where the distinction between the different kinds of options grant activity matters most. As The D & O Diary pointed out when the criminal complaint was first filed against Gregory Reyes (here), the employee related options grant activity of which Reyes is accused seems to be different in kind and character from other alleged options backdating activity, precisely because it lacked the element of self-interest and self-benefit that may be involved in other kinds of options grant activities. So the differences between the kinds of activity matter. (A copy of the criminal complaint against Reyes may be found here.)
What these kinds of distinctions may mean for Steven Jobs is still an open question. As I have pointed out (here), the grant related practices under scrutiny at Apple involve both options springloading as well as options backdating. Moreover, one critical element – whether or not Jobs personally benefited from the options practices—is the subject of heated debate. For example, a January 11, 2007 Washington Post article entitled "Apple Chief Benefited From Options Dating, Records Indicate" (here, registration required) presents a perspective that the options he was granted in December 2001 and that were backdated to October 2001 personally benefited him when he later traded the options for registered shares he subsequently sold at a profit. By contrast, Professor Ribstein contends (here) that the same options grant involved no culpable activity and that the grant date was reasonably fixed at a date certain so that the exercise price could be fixed while Jobs continued his negotiations with the company over the size of the grant.
Without having the benefit of complete information, it is hard to tell what the government ultimately may do in connection with the options backdating at Apple, or for that matter at any of the other companies that are under investigation. But just as the op-ed authors argue that prosecutors ought not to conflate books and records violations with securities fraud, so too should distinctions be carefully drawn about the specific kind of activity involved, because different activities will involve different degrees of the elements that potentially could support allegations of culpability: self-benefiting activity, deceit, and shareholder harm. As the Comverse allegations illustrate, there are going to be at least some cases where these elements arguably support allegations of criminality. It seems to me that by "conflating" conduct that might be sufficiently self-interested and deceptive to constitute fraud with mere good faith paperwork errors, the op-ed authors seek to extend the justifiable excuse of the innocent to cover even the conduct of the culpable. Ironically, I happen to think that the lack of self-interest involved in the employee-related options backdating allegations against their client puts his client at the less culpable end of the spectrum.
According to an article in the January/February 2007 issue of Corporate Board Member entitled "Is Your Company Prepared for Bird Flu?" (here), boards should be anticipating and preparing for the potential impact of a bird flu pandemic. The article quotes former Secretary of Health and Human Services Tommy Thompson as saying that smart boards are preparing now, by reviewing contingency plans and establishing lines of authority in the event company leadership is stricken by the bird flu. The article does acknowledge that "[s]ome directors privately conceded that little attention is being paid to the specific challenges posed by a pandemic."
As someone who has spend the better part of my professional career thinking and worrying about board focus and function, I have to admit that under the current circumstances I have a hard time seeing bird flu as belonging anywhere the top of the list of things boards at most companies are or ought to be worrying about. Along those lines, the article does contain the following:
Damian Brew, a managing director with Marsh’s professional-liability practice, says the risk of a pandemic pales against other exposures, including oil-price fluctuations, and adds that underwriters of directors’ and officers’ liability coverage are more concerned with options backdating and CEO pay disclosure. "Boards have a limited amount of time, and there are financial issues that should take priority over something that’s not likely to happen," he says.
I agree with these statements. But the article goes on assert that boards that fail to plan for a bird flu pandemic "could find themselves targeted for dereliction of duty." The article quotes one attorney as saying that Sarbanes-Oxley requires boards to take into account almost every conceivable problem that could put the company in jeopardy. The article quote another attorney as saying that "If the business has trouble functioning, you could have shareholders saying ‘Why wasn’t there a plan in place?’ You aren’t going to be able to say you hadn’t heard about it."
Undoubtedly boards could allocate a portion of their scarce time together to worry about bird flu. They could also spend time worrying about global warming, land use policy, plate tectonics and its implication for seismic and volcanic activity, and the hole in the ozone layer. There are a limitless number of things that boards conceivably could spend their time on. At some point though, boards have to be focused on whether the company is on the right track, has the right management in place, or needs to make strategic changes. There undoubtedly are risks in every company’s environment, and boards should of course take reasonable steps to ensure that the company has a flexible catastrophe plan in place and that the plan adequately addresses the specific risks to which the particular company may most likely be prone. There are many threats facing companies today. Boards are doing their job best if they focus on the threats and opportunities that matter most immediately for their company.
On January 11, 2007, the Public Company Accounting Oversight Board (PCAOB) released its annual inspection reports of Ernst & Young LLP and KPMG LLP. The reports can be found here and here. The PCAOB is required by law to annually inspect each accounting firm that audits more than 100 public companies. The agency’s reports on E & Y and KPMG are based on inspections done in 2005 of the firm’s audits of companies’ 2004 financial results. (The PCAOB previously released its reports of PWC and Deliotte & Touche.) If this seems like a long time ago to you, you are not alone.
As noted in a January 12, 2007 Wall Street Journal article (here, registration required), there have been "criticisms from investors and members of corporate audit committees that the agency is taking too long in getting the reports out and [the board] has pledged to try and speed up the process this year."
The E & Y and KMPG reports cite multiple audit failures by both firms. The PCAOB identified 10 E & Y public company audits and 11 KPMG public company audits for criticisms. The E & Y report says that in "some cases" the errors appeared "likely to be material to the issuer's financial statements" and the KPMG report says that in "one case" the result was likely to be material. However, according to its policies, the PCAOB does not identify the companies that had their audits cited. The PCAOB also does not make their entire inspection reports available publicly. The PCAOB’s statement of policy about issuing its reports, here, explains the statutory constraints on its ability to publicly release portions of the inspection reports that deal with criticisms that the audit firm has addressed within 12 months of the inspection. The statutory constraints also prohibit disclosure of information obtained from accounting firms and their clients.
While the PCAOB’s restrictions on its reports are statutorily compelled, the constraints produce a report that reveals relatively little, particularly with respect to the deficiencies noted. In the reports, each deficiency is separately identified and described, but only in the most general terms. The brevity of the descriptions prevent the reader from making any meaningful assessment about the deficiency, including any assessment of the deficiency’s seriousness or its impact on the reported financial condition of the audit client. The disclosure constraints are statutory, but the resulting reports are of relatively little use to investors and others (e.g., D & O insurance underwriters) who would certainly like to know more about the problems that were cited. For example, which problems were the ones that were likely to have been material? How material? What does it mean to say that in "some cases" the deficiencies in the E & Y reports were material -- how many of the 10 E & Y audits cited, and which ones?
In addition, the PCAOB’s constraints on individual accounting firm’s inspections may be statutory, but arguably there are no statutory constraints on aggregate statistical information about the PCAOB’s inspections. The White Collar Fraud blog (here) has an interesting post about his unsuccessful efforts to obtain aggregate statistical information from the PCAOB, including the percentage of inspections that result in audit deficiencies by each firm. For example, the KPMG report says only that PCAOB inspectors visited 14 of 89 KPMG offices. That doesn't tell us how many KPMG audits they reviewed; the inspectors found 11 KPMG audits with concerns, but did they review 11, 110 or 1100 audits to find the 11 violations? It clearly makes a difference. The D & O Diary agrees that the PCAOB should provide more statistical information about its inspections. There may be statutory constraints on its disclosures about individual inspections, but where the PCAOB is not constrained, it should make more information available, including specifically aggregate statistical information. I also wonder whether it would be possible for the PCAOB, consistent with its statutory constraints, to provide sufficient information for inspection report readers to be able to assess the seriousness and impact of deficiencies noted.
A January 12, 2007 CFO.com article entitled "Failing Grades for E & Y, KPMG" can be found here.
Specter Reintroduces Thompson Memo Bill: As The D & O Diary previously noted (here), even though the McNulty Memo has replaced the Thompson Memo, there are still calls for a legislative remedy to the attorney-client privileges of employees who find themselves subject to criminal allegations. According to a January 10, 2007 CFO.com article entitled "Specter Re-Ups Thomspon Memo Battle" (here), Senator Arlen Specter has reintroducted the proposed bill he had previously advanced to try to circumvent the Thompson Memo. The CFO.com article quote Specter as saying that even though the McNulty Memo reflects "some improvement," it still allows prosecutors to seek privilege waivers, which he says will "erode the attorney-client relationship."
Senator Spector’s bill, originally entitled The Attorney-Client Privilege Protection Act of 2006, can be found here.
The Blogosphere Gets Respect: Amid the media coverage (for example, here) surrounding the lawsuit that Cisco Systems has filed against Apple over the use of the iPhone name, one particular detail caught my eye. That is, Cisco Systems declared its public position with respect to the lawsuit in a blog post (here), by its General Counsel, Mark Chandler. (Full disclosure: Chandler coincidentally happens to be a family friend.) As others have previously noted, blog posts increasingly are an important component of corporate media communication.
The public dignity accorded the blogosphere got a boost earlier this week when SEC Chairman Christopher Cox acknowledged during a speech that he "uses blogs to gauge public reaction to securities issues." (Refer here.) Not only that, but Cox previously posted a comment (here) on the blog of Sun Microsystems CEO Jonathan Schwarz. The SEC is also looking at whether blogs can be used to satisfy the disclosure requirements of Reg. FD.
As Professor Stephen Bainbridge noted with respect to Cox’s comments on his (Bainbridge’s) Business Associations blog (here), blogs represent increasingly important means "to communicate with lawyers, judges, and, it would seem, regulators" and that academics (or, I would assert, anyone) who wants to reach those audiences should have or have access to a blog. Cisco Systems clearly feels the same way.
Commissioner Cox, if you are reading this, you should know that you are cordially invited to guest post on my blog, anytime. Seriously. You don’t even need to call ahead.
PLUS D & O Symposium: The 2007 Professional Liability Underwriting Society (PLUS) D & O Symposium is only days 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.
This site was created and is written by Kevin M. LaCroix. I am an attorney and a director of OakBridge Insurance Services, a specialized insurance intermediary focused exclusively on Executive Liability coverages.
