Apple, The Big Apple, and “Pay to Play” Plaintiffs’ Lawyers
In a series of recent editorials, the New York Sun has raised some interesting and troubling questions about a New York City’s pension fund's involvement as lead plaintff in the Apple Computer options backdating securities litigation.
The first Sun editorial on the topic, entitled “New York Versus Apple "appeared on January 25, 2007 (here). The editorial noted the irony that the same day as the city’s Mayor, Michael Bloomberg, and its senior U.S. Senator, Charles Schumer, released a report (here) asserting among other things that meritless securities litigation was undercutting the competitiveness of the city’s financial markets, the New York City Employees’ Retirement System (NYCERS) was named as lead plaintiff in a class action lawsuit against Apple Computer and its executives and directors. The editorial observed that the city’s law firm in the lawsuit, Grant & Eisenhofer, includes on staff as Senior Counsel, Leslie Conason, whose firm website bio reports that prior to joining the law firm, she “was responsible for managing all securities lititgation for the City of New York, where she was in charge of securities litigation for the $100 billion in pension assets held by the workers and retirees of the City of New York."
The editorial also points out that a partner at the Grant & Eisenhofer law firm, Keith Fleischman, had made a $1,000 campaign contribution to the city’s Comptroller, William Thompson, Jr., in 2003, when Fleishman was at the Milberg Weiss firm. (As reported on the Comptroller's website, here, among Thompson's duties is the managment of the city's pension funds.) The editorial concludes by saying that:
The notion of a shareholder suit against Apple strikes us, in any event, as a stretch. Whatever shenanigans went on with Steve Jobs' stock options, the company's stock price is up 600% over the past two years, far outpacing the overall gains by the stock market or NYCERS. Any reasonable shareholder should be happy as a clam. New York's economy and streetscape have certainly benefited from the city's Apple Stores in SoHo and at the plaza of the GM building. If there's a bright spot, it's that one of the Apple directors named as a defendant is Albert Gore, Jr. By the time the vice president is done being deposed by the class action lawyers hired by the NYCERS board, he may be ready to line up with Messrs. Schumer and Bloomberg the next time they call for legal reform.
In a letter to the editor printed in the February 27, 2007 issue of the Sun (here), Thompson defended himself and the city’s process for selecting counsel. His letter explains that after a selection process that included interviews and reference checks, the city executed agreements with nine plaintiffs’ firms in mid-2006. His letter also points out that each of the city’s pension systems’ Board of Trustees makes the final determination as to whether or not to proceed with this type of litigation. Thompson’s letter also defended the decision to pursue the Apple litigation, and the city’s role in shareholder litigation generally.
In the same February 27, 2007 issue in which Thompson’s letter to the editor appeared, the Sun ran a second editorial, this one entitled “Thompson’s Trial Lawyers” (here). The paper found that six of the nine firms in New York City’s “securities litigation pool,” had made a total of $102,491 in donations to Mr. Thompson’s 2005 election campaign – an election in which Thompson “faced only token opposition” and in which he was “reelected with more than 90% of the vote.” Among other firms, the Kirby, McInerney & Squire firm is reported to have given $39, 975, and the Wolf Popper firm is reported to have given $36,256. Wikipedianotes that Thompson is a leading candidate to become the Mayor of New York in 2009 and has amassed a compaign fund of over $2 million.
In addition, the editorial reports that the head of the pensions division in the city’s Law Department said that the Grant & Eisenhofer “brought the idea of NYCERS filing a lead plaintiff application to the Law Division.” In other words, the editorial notes, the city didn’t discover it was injured and look for a lawyer, “a lawyer chased down a perfectly healthy client and brought the client the idea of a lawsuit, even though the Apple stock the city owned was up 600% in the past two years.” The editorial concluded that:
It's one thing… to take campaign money from trial lawyers. It's another thing entirely to turn around and allow those lawyers to use the good name of the city pension fund to pursue litigation with no redeeming value other than racking up huge fees for those same trial lawyers. The price Mr. Thompson pays for the more than $100,000 in campaign contributions he has taken from the class-action aecurity lawyers who represent the city is inevitability that the newspapers — and, someday, perhaps, voters — are going to question his judgment in pursuing this sort of litigation.
The Sun added a third editorial on February 28, 2007, entitled “Absentee Trustees” (here) in which the paper took a closer look at Thompson’s assertion that a pension fund Board of Trustees had supervised the decision to pursue securities litigation on behalf of the fund. The paper found that at the October 24, 2006 Board “regular meeting” at which the city’s Law Department claims that the vote to pursue litigation took place, “the so-called meeting of the ‘board' included not 11 trustees [the total number of trustees on the board], not 10 trustees, not nine trustees, not eight trustees, but exactly one. That’s right, just one actual trustee.” The editorial points out that the board may want to reconsider its processes; “after all, the directors of Apple Computer are being sued by NYCERS for allegedly failing to provide proper oversight.” The editorial concludes with the observation that “if things take an unfortunate turn for the New York City Employees’ Retirement System, it’s conceiveable that some enterprising class-action lawyer might look at them as a target. Apple stock appreciated 600% and it still got sued.”
Way back in the optimistic era of securities litigation reform, back when Chris Cox was still just a Congressman from Orange County, when Congress enacted the Private Securities Litigation Reform Act of 1995, there was a notion that institutional investors needed to become more involved in order to eliminate abusive lawyer-driven securities litigation. So Congress promulgated a lead plaintiff process, in which the “most adequate platiniff” would be selected based on which plaintiff showed the “largest financial interest.” Whatever Congress thought might result from this reform, it seems fairly likely that it did not envision institutional plaintiffs pursing lawsuits as a result of an unsupervised and campaign finance driven process, supplemented by a revolving door between the institutional investors and the plaintiffs’ firms. (As an aside, I also suspect that Congress did not envision institutional investor driven opt-out litigation either, about which I recently commented here.)
The Sun identifed the ironic propinquity of the Bloomberg/Schumer report’s release and NYCERS' selection as lead plaintiff in the Apple litigation. An irony the Sun missed is that the Paulson Committee Interim Report (here), which preceded the Bloomberg/Schumer report by only a few weeks and raised similar concerns about the adverse competitive effects of meritless securities litigation, specifically decried “pay to play” practices between institutional investors and the plaintiffs’ bar. The Paulson Committee Report asserted that:
When political contributions are made by lawyers to individuals in charge of a state or municipal pension fund, the attorneys should not be permitted to represent the fund as a lead plaintiff in a securities class action. Following the lead of the municipal bonds industry, the securities litigation regulations should be comprehensive and should cover any direct contributions as well as indirect contributions (made through “consultant” or other similar arrangements) … At a minimum, the SEC, as an amicus, should ask courts to require disclosure of all political contributions or fee-sharing arrangements between class counsel and a lead plaintiff (or controlling individuals within the lead plaintiff organization). This disclosure should occur prior to the court’s appointment of either counsel or plaintiff and should be followed by a similar disclosure at the fee award hearing. (Emphasis added)
The D & O Diary has a suggestion for Mayor Bloomberg. If he really thinks abusive securities lawsuits are undermining the competitiveness of his city’s financial markets, he should toss the report that he and Senator Schumer paid McKinsey to write and read the Paulson Committee’s Interim Report’s comments about “pay to play” practices. And then he should take a very hard look at practices in his city’s Law Department. The good news for Mayor Bloomberg is that he doesn't even need to await the SEC action the Paulson Committee’s Interim Report advocated; he can institute his own securites litigation reform without any fuss or bother or press conferences or grandstanding speeches or anthing like that. For reasons the D & O Diary has elaborated upon at length elsewhere (most recently here), this reform is unlikely to affect the relative competitiveness of the city's financial markets in the global marketplace, but it certainly would clean up some pretty unattractive looking circumstances and practices.
How to Find out Who is "Paying to Play": Readers who are interested to know more about plaintiffs’ lawyers campaign contributions (or those of anybody else, for that matter) will definitely want to spend some time on the website (here) of the Center for Responsive Politics, where campaign contributions are searchable by donor name. (Click on the “Who Gives” tab and select “Donor Lookup” from the dropdown menu.) For example, a search on the name William Lerach identifes 150 separate donations totaling $1,283,430 (including several donations to Hillary Clinton ) A search on the name Mel Weiss shows that Weiss made 120 donations totaling $699,102. Among other candidates, Weiss made a number of donations to Senator Schumer. Hmmm, that's kind of interesting... maybe after the law firm's indictment, Schumer felt he could...yep, that's probably it.
Isn't It Ironic, Don't You Think?: The Sun obviously has an eye for irony and an interest in securities fraud litigation. The Sun's outlook must be in its DNA, because its founding investors, according to Wikipedia (here), included none other than Conrad Black, who has been working for years on his own wing in the securities fraud litigation house of blues. You don't suppose that has anything to do with the paper's obvious and manifest hostility to securites lawsuits?Nahhh...
The D & O Diary wishes to acknowledge with grateful thanks the two alert readers who prefer anonimity and who provided links to the Sun editorials and to the Center for Responsive Politics website.
In an earlier post (here), The D & O Diary commented on the research published by Lucian Bebchuk of Harvard Law School and two colleagues, in which they examined over 19,000 options grant awards between 1996 and 2005, finding a disproportionately higher number of grants on the date during the month with the lowest share price. In an article in the March/April 2007 issue of Harvard Magazine entitled “’Insider Luck’: How Stock-Option Grants Were Gamed – And What to Do About It” (here), Bebchuk elaborates and comments upon his research.
A portion of the magazine article summarizes Bebchuk's previously released study, in which the researchers found that 12% of all CEO options grants were “lucky grants,” defined as grants awarded on days on which the stock price was at its monthly low. (The research findings are summarized in my prior post, linked above.) The magazine article adds the further research finding that “opportunistic timing has not been limited to executive’ grants; rather it has been present to a significant degree in outside directors’ grants as well.” The research showed that about 9% of the grants to outside directors were “’lucky’ events taking place on dates with stock prices at monthly lows.” Bebchuk reports that the opportunistic timing was spread over about 460 companies, and that “in companies in which opportunistic timing of options awards took place, luck tended to lift the boats of both executives and outside directors.”
Bebchuk emphasizes that the research showed that “most companies have not engaged in such timing in awarding options,” but that certain factors were associated with a higher likelihood of lucky grants. The option grants were more likely to be “lucky” when the potential payoffs were relatively high, and opportunistic timing was “correlated with increased influence of the CEO on the company’s internal pay-setting and decision-making process.”
Bebchuk goes on to note that the “fact that many outside directors were themselves recipients of lucky grants reinforces the view that opportunistic stock-options awards were produced by governance failures, not business decisions made rationally and in good faith to serve shareholder interests.” Bebchuk concludes by commenting that “even though significant backdating may belong to the past, its underlying causes are problems with which the corporate governance system must continue to wrestle.”
Bebchuk’s research and commentary are interesting. But I have begun to be a little suspicious of research studies showing that backdating took place at a very large number of companies, far greater than the number that have announced backdating problems so far. We are now nearly a year beyond the first wave of media attention surrounding the backdating issue. How many more companies can there be out there yet to divulge options grant manipulations? If Bebchuk’s numeric research conclusions are not ultimately borne out, are his other conclusions and comments adequately supported? To be sure, there may yet be many companies about to reveal options timing problems, and Bebchuk’s research could be validated by forthcoming disclosure events. At this point, I have become a little skeptical that there are as many companies yet to reveal options timing problems as Bebchuk’s research would suggest.
Losing AIM?: In prior posts (most recently here), I have suggested that global financial markets are evolving, and that factors that may have made London’s Alternative Investment Market (AIM) more attractive than U.S securities markets in the last few years may be changing on their own. A February 22, 2007 article in the U.K.-based LegalWeek.com entitled “Losing AIM – Three Years of Market Boom Has Come to an End” (here) confirms that "the twin shadows of market indigestion and long-simmering concerns regarding the quality of companies floating has finally called a halt to the AIM express.”
The article notes that the recent headlines regarding Torex Retail (see my prior post, here) “have taken their toll, though regulatory concerns have been brewing for months.” Although the article optimistic about the prospects for renewed future prosperity on the AIM, it does acknowledge that right now, the market is going through a “necessary correction.” As one commentator quoted in the article says, “we are paying the price for the number of deals done in 2005 for companies of questionable quality.”
Contrary to the arguments of would-be reformers, the AIM experience is not bearing out the need for U.S securities markets to loosen their regulatory standards in order to compete in the global marketplace. To the contrary, the AIM experience increasingly is substantiating the need for markets to maintain their regulatory discipline in order to preserve investor confidence. Moreover, it appears that some of the differences in the global financial marketplace that have been driving competition in recent years are turning out to be transient, and are evolving. As The D & O Diary has frequently noted (most recently here), we should be very cautious about relying on transient phenomena as a basis for compromising the U.S. securities markets’ regulatory integrity.
Hat tip to Werner Kranenburg of the With Vigor and Zeal blog for the link to the LegalWeek.com article.
Practice, Practice, Practice? How you really get to Carnegie Hall -- refer here.
The would-be reformers who propose restructuring the U.S securities regulation regime cite the loss of U.S. IPO market share to overseas markets, particularly London’s Alternative Investment Market (AIM), as justification for regulatory reform. But as The D & O Diary has previously noted (most recently here and here), these overseas markets, especially the AIM, face precisely the opposite pressure – that it, to validate their regulatory integrity in order to maintain investor confidence.
Along those lines, on February 20, 2007, the London Stock Exchange (LSE) announced a variety of new rules for AIM companies, providing further disclosure obligations and clarifying guidance regarding the rules for “Nominated Advisors” (or Nomads, as they are more popularly known). In its press release (here) announcing the rules changes, the LSE said that the “changes are intended to ensure the AIM maintains the right regulatory balance as the market continues to grow and thrive internationally.” The AIM Director of Markets is quoted as saying that "as the market grows and becomes increasingly international, the Exchange will take incremental steps to build on the quality and integrity of the market."
The LSE’s summary of the rules changes, as well as a summary of the process leading up to the changes, can be found here. The amended Rules for AIM Companies can be found here.
The key changes in the new Rules for Companies include new requirements for disclosure of critical information on each AIM Company’s website; enhanced disclosure requirements for pre-admission announcements; and guidance regarding reverse takeovers. The changes also include revisions to the AIM disciplinary guidelines, including the provision for the LSE to be able to issue warnings for AIM rules violatins, and an increase in the maximum disciplinary fine (from 25,000 pounds to 50,000 pounds). A good summary of the new rules by the Pillsbury Winthrop Shaw Pittman law firm can be found here.
The AIM summary of the changes (here) notes that a number of commentators on the proposed rules during the notice-and-comment period had suggested that that the LSE “should mandate particular corporate governance requirements for AIM companies.” The LSE declined to implement uniform corporate governance standards, observing that “given the wide range of companies that admit to AIM, the Exchange believes that the corporate governance measures to be adopted remain a matter for the nomad to provide advice about, on a company-by-company basis, both on admission and also on an ongoing basis as the company develops.”
Even though the LSE declined to require uniform governance measures, the LSE’s increased emphasis on disclosure, and tightened requirements for Nomads, as well as the increased disciplinary provisions, bespeak an appreciation for the need to encourage regulatory integrity to maintain investor confidence. As The D & O Diary has noted in the past, companies attracted to the AIM out of a perception of a lighter regulatory touch there will find that they still face regulatory scrutiny. Moreover, the changes suggest that the comparative landscape among the various global exchanges is evolving. For that reason, the U.S. should hesitate to alter its regulatory structure to address what may be transient differences in the global financial marketplace.
Special thanks to Werner Kranenburg of the With Vigor and Zeal blog and to alert reader Doug Edinburgh for links regarding the AIM rules changes.
A Baker’s Dozen of Canadian Securities Regulators: In the meantime, Canada is wrestling with a different issue – whether to unite its current system of 13 provincial securities regulators into a single, national regulator. According to news reports (here), a panel convened last year concluded that a single regulator could “consistently enforce investor rights across Canada.” Canada is the “only major developed country without unified securities regulation, “ as a result of which bad actors who have been fined or barred from activity can simply move from province to province.
The push for a single unified regulator has recently gained momentum because of several high profile insider trading cases, and the movement got a further boost when Alberta’s finance minister came out in favor of a unified regulatory approach (here). But the boost proved shortlived, as the head of the Alberta securities commission publicly opposed both the single regulator proposal and the finance minister (here). The Ontario government has been pushing for a single regulator, but other provinces, notably Quebec, have been pushing back.
Epic Poet: Homer -- first the Illiad and the Odyssey, then the Simpson. Read Homer's most eternal statements, here. (Better not to have any food in your mouth when you read these.)
My recent posts on securities fraud opt-out litigation settlements (here and here) provoked a number of interesting responses, including one comment that was so detailed that I thought it would make an interesting guest blog post. The commentator accepted my invitation to be a D & O Diary guest blogger. I am pleased to present the latest D & O Diary guest post, below.
Our guest blogger today is Richard Bortnick of the Philadelphia law firm, Cozen O’Conner. Here is Rick’s guest post, in the indented text below -- the comments following the indented text are mine:
The potential implications of the recent high dollar opt-out settlements, as discussed in your postings here and here, should not be taken lightly. To the contrary, while certainly not a trend, they could portend the dawning of a new era in shareholder litigation and lead to a dangerous future of far greater exposure for corporate defendants and, in some cases, their D&O insurers (if not by the individual defendants themselves). In short, these latest developments suggest that a class action settlement may not be the end of the day for the defense side, both with respect to defense costs and indemnity expense. As Yogi Berra once said, "it ain't over till it's over," and it may not be over until the last large opt-out plaintiff has settled or presented its case to a jury.
In the past, a good percentage of shareholders who opted-out of a class action settlement did so for either moral or personal reasons partially or wholly unrelated to money. As such, opt-outs generally were not a concern to the defense side, and all interested persons were able to cap and account for the costs of shareholder litigation. Of course, this is not to suggest that the issue of opt-outs was ignored in the settlement documentation. Rather, virtually every class action settlement agreement contains (and has forever contained) a provision pursuant to which the settling defendants could "blow up" the settlement if shareholders owning a certain percentage of shares elected not to participate in the settlement. A typical "blow provision" contains opt-out percentages ranging from 2%-5% or more. While the enumerated percentage may have been triggered in a few stray cases, neither the company nor its D&O insurer felt the threat of future exposure justified their invoking their rights under the "blow provision." The settlement, for all intents and purposes, put a cap on the amount of money a company and its D&O insurer knew they would spend for a claim and allowed them to reserve and ultimately pay a liquidated amount.
In light of recent developments, however, this may no longer be the case. Indeed, the number and, more importantly, the potential severity of opt-out claims and settlements may have a profound impact on whether and how companies, their D&O insurers and other categories of defendants (i.e., accountants, attorneys, underwriters, etc.) respond to a situation where the "blow provision" is implicated.
Let's assume that shareholders who own 3% of a public company defendant's stock elects to opt-out and go it alone in private litigation (or in combination with a sufficient number of other shareholders so as to constitute a "mass action," but not a "class action"). What are a company and its D&O insurer to do? How about a non-settling accounting or law firm? At present, there is no simple solution, no "magic bullet" to avoid additional, and potentially severe, exposure both for defense and indemnity.
Moreover, such a situation could have implications on the proposed class action settlement, as the company and its D&O insurer (as well as, where applicable, settling accountants, attorneys, etc.) may invoke the settlement agreement's "blow provision," and elect simply to "roll the dice" and try the class action, although that may be the least attractive option to someone who likes certainty and hates surprises. Of course, a decision to blow up a settlement could have wide-ranging business (and marketing) implications, particularly for a D&O insurer which develops a reputation of being a company which blows up settlements and leaves its insureds exposed to personal liability by way of a jury trial or otherwise. And, in any event, from where will the money to defend and ultimately settle the opt-out case come? The company? The D&O insurer which had not exhausted its policy’s limit as part of the class action settlement? The company’s outside accountants, attorneys, and whoever else had a hand in the transaction that gave rise to the lawsuit? Or, perhaps, the D&O’s themselves. In the few mega-opt-out cases to date, the plaintiffs pursued recovery from virtually everyone person and entity with any potential for exposure. And, we assume that most of these categories of defendants paid something toward the settlement.
One alternative might be to negotiate in the class action settlement a provision which allows the defendants to reduce the settlement amount they are to pay ( i.e., a "clawback"), should the number of opt-outs exceed an agreed number. As a second alternative or as an adjunct, the class action settlement could be on an "opt in" basis, whereby class members must take affirmative steps to become part of a class and a class action settlement. Or thirdly, the D&O insurer could decide to exhaust (if it hasn’t done so already) and leave the opt-outs behind, to fight with the Company and the D&O's (although, this is not a realistic approach from a cash-flow standpoint). Quite simply, none of these choices is attractive, and none address the underlying problem: what do we do with the opt-outs?
The implications for plaintiffs' counsel could be equally as profound. In a class action settlement situation, class counsel must apply to the court for an award of attorneys' fees, and the quantum awarded is within the full discretion of the presiding judge. Depending on the size of the settlement and, oftentimes, the amount of work performed by plaintiffs' counsel, courts have been known to award attorneys' fees of anywhere between 7% and 30% (or more) of the gross settlement figure. Regardless of the quantum, however, the ultimate decision on attorneys’ fees was not one the lawyers or their clients were empowered to make. The final decision belonged to the court. In stark contrast, in the case of a "mass action" or individual opt-out action, the opt-out plaintiffs and their counsel are free to negotiate any fee arrangement they choose, without court involvement or intervention, capped only by governing ethical rules and the parties’ respective views. To the point, unlike in a class action setting, court approval of their private fee arrangement is unnecessary.
Assuming the recent spate of opt-outs is not an anomaly, the evolution of this process ultimately could lead to a regime whereby (1) smaller or less well-known plaintiffs' counsel prosecute the class action aspect of a securities fraud litigation and then apply to the court for a fee award if/when a settlement is reached, while (2) the bigger, more well known plaintiffs' firms transform a good portion of their practice to representing large, typically institutional, opt-out clients, thereafter negotiate a huge settlement with the defendants (and their D&O insurer?), and then collect whatever amount they have pre-negotiated with the client(s). Equally inviting to prospective opt-out counsel, they oftentimes would be relieved from having to devote the time, resources and money typically necessary to prosecute a securities fraud claim, as all of the work, including paper discovery and depositions, already will have been completed by the class action counsel in the context of the class action litigation. In other words, work much less and recover much more. Now that's capitalism!
In short, a new opt-out regime may be upon us, and companies and their D&O insurers alike, as well as class counsel and their class members, should be sensitive to the possibility that the number of litigated opt-out cases could escalate and cause heretofor non-existence problems for all of them, absent a reasonable and realistic solution. It may be that nothing can be done, short of legislated changes to Rule 23 of the Federal Rules of Civil Procedure governing class actions, and complimentary judicial activism. But people need to begin talking about the problem now, before the whole team of horses has left the barn.
Reading Rick’s comments made me wonder how likely it is that defendants or their insurers would ever elect to exercise the "blow provision" or if they did, what would cause them to do it? Would it be opt outs of a certain number? Or of a certain size? Clearly, there would have to be some development that convinced them that they were not getting the benefit from the class settlement for which they thought they had bargained, and that they would be better off without the class settlement. That still seems only a theoretical possibility, even with the magnitude of the recent opt out settlements.
I also wonder how much the opt-out phenomenon is a D & O insurance problem. Most of the recent prominent opt out settlements have come in association with mega class action settlements, where the class settlement (plus defense expense) far exceeded the amount of the D & O insurance. Perhaps one exception is the recent Qwest opt-out settlement, where insurers for Joseph Naccio reportedly (here) contributed $1.5 milllion on his behalf in settlement of the individual investor opt-out claim against him. But even with that exception, I wonder whether D & O insurers have been called upon to make significant contributions to the recent wave of opt out settlements, since the policies for the companies involved were long ago depleted in connection with the class settlement and defense expense.
And along those lines, I think it is important to note that the settling defendants in the recent CalSTRS opt-out settlements in the Qwest and AOL Time Warner cases involved numerous non-D & O defendants, including investment banks and auditors. We don't know how much each of these defendants contributed. But in view of these defendants’ contributions toward settlement, the companies’ contribution might well have been relatively slight, particularly if CalSTRS remains a shareholder of the companies.
These considerations make me wonder how big of a problem opt outs may be (or become) for D & O insurers. Based on the publicly available details of the recent prominent opt outs settlements, I don’t think there is enough data to know for sure. But the threat of opt out cases dragging on after the class case has been settled unquestionably has important implications for D & O insurers' severity assumptions. It also has important implications for D & O policyholders’ limits selection. (My prior post, here, has further thoughts about opt outs and severity assumptions and limits selection.)
I also wonder whether the apparent proliferation of opt out settlements may be an artifact of the massive corporate frauds from earlier in this decade, and whether opt out settlements will largely fade out as those cases finally work their way through the system. On the other hand, a more depressing possibility is that the plaintiffs' bar has developed a lasting addiction to opt out cases and that institutional investor opt outs will go on even after the last of the mega cases is finally resolved. Although I appreciate the sentiment of Rick's suggestion that revisions to Rule 23 may be needed, I wonder what specific revisions could eliminate the opt out curse. You can't make anyone join a class of which they do not want to be a part.
A final thought: all those would-be reformers who want to do away with class litigation need to take a good hard look at the alternative to resolving everything in one lawsuit. The alternative is not pretty.
In any event, special thanks to Rick for his excellent guest blog post. The D & O Diary is always interested in responsible readers' guest post submissions on appropriate topics. Authors interested in submitting a guest post should feel free to contact me any time.
"I never said half the things I really said": Rick's reference to baseball great Yogi Berra made me reflect that although Berra was a fifteen time All-Star and league MVP three times, and appeared in fourteen World Series (including ten championships), he is now mostly remembered for his Yogiisms, a list of which may be found here.
We here at The D & O Diary find these words good rules to live by: "You can observe a lot by watching" and "If you can't imitate him, don't copy him." Alas, it is true, as Berra observed, that "a nickel ain't worth a dime anymore."
A philosophical defense of Berra and his penchant for unintentionally funny comments can be found here. Baseball purists may prefer Berra's career player stats, here.
As the Wall Street Journal noted in its February 16, 2007 article entitled “Probes of Backdating Move to Faster Track” (here, subscription required), the various options backdating investigations may be moving more rapidly now. Within the last weeks, there have been guilty pleas entered in connection with the Take-Two (here) and Monster Worldwide (here) investigations, and the Journal article also suggested that criminal charges may be forthcoming in the Broadcom investigation.
The reason that the pace of activity seems to be picking up may be due to a looming deadline. According to a February 20, 2007 San Jose Mercury article entitled “Clock Ticking on Prosecuting Backdating Options” (here), investigators are “bumping up against a legal deadline” – the five year statute of limitations for securities fraud. According to the article, the window may be closing because stock options misdating largely ended in 2002 because of Sarbanes-Oxley options reporting requirements. The article suggests that the looming deadline may force prosecutors to allege lesser related charges, such as conspiracy or lying to prosecutors, because they are not yet ready to press criminal securities charges. Prosecutors may also seek waivers from potential defendants, but defendants may have little incentive to agree to a waiver. Prosecutors may also seek to allege that until recent disclosures and restatements, the options timing practices were concealed, and therefore the running of the statute should be tolled – but obviously prosecutors would rather avoid taking the chance that a court might not agree that the statute was tolled.
In determining whether or not to bring charges, prosecutors are, according to the Journal article linked above, looking for “plus factors” that can increase prosecutors’ “promise of success” – these factors include “written indications of deliberate backdating; falsified documents; efforts to hide manipulation from auditors or investigators; or indications that top executives gave themselves backdated options.” (These factors are similar to those I cited in my earlier post, Is Backdating Criminal?, here.)
Prosecutors undoubtedly will be, among other things, reviewing company email traffic pertaining to options grants, as the Wall Street Journal’s February 20, 2007 article entitled “Emails Reveal Backdating Scheme” (here, subscription required) suggests. Certainly, email references (such as those the Journal reports to have appeared in emails at Mercury Interactive) to “magic backdating ink” are not helpful for individuals hoping to avoid investigators’ attention.
The Ultimate Solution to Investment Fraud: According to news reports (here), a Chinese businessman has been sentenced to death for a fraudulent $385 million investment scheme. Wang Zhendong promised investors returns of 60 percent on investments in an ant-breeding scheme. (Ants apparently are used in traditional Chinese medicinal remedies; refer here for background) The scheme drew over 10,000 investors between 2002 and 2005. The investment arrangement was really a pyramid scheme, and most investors lost their entire investment. The Intermediate People’s Court in Yingkou sentenced Wang to death.
Regular readers know that I have previously questioned (most recently here) the case for regulatory reform. Among the grounds the reformers routinely cite as the basis for regulatory reform is the U.S.’s loss of global IPO marketshare. A February 20, 2007 Wall Street Journal article entitled “Do Tough Rules Deter Foreign IPO Listing in the U.S.?” (here, subscription required) reports the findings of a recent study by Thomson Financial which found “little evidence of foreign companies shying away from U.S. exchanges since the adoption of Sarbanes-Oxley.” Thomson Financial apparently studies new stock issues in the past 20 years and concluded that “in terms of dollars raised, foreign IPO activity in the U.S. looks very healthy indeed.”
The study found that foreign IPOs (excluding investment funds and closed end funds) accounted for 16% of 2006 IPOs in U.S. exchanges, the highest proportion in the 20-year period studied. In addition, the $10.6 billion raised in foreign company offerings represents 26% of 2006 IPO volume, the highest level since 1994. According to the study’s author, “the statistics show that things look rather healthy” and that even after Sarbanes-Oxley, “there doesn’t seem to be any really significant deterioration of the IPO market.”
The competitive challenge for the U.S. markets is not that they can’t attract foreign companies' listings, it is that financial activity in general is increasingly global, and that global growth has more to do with what is happening overseas than with the state of regulation in the U.S. markets. As the February 20, 2007 Bloomberg.com article entitled “IPOs Shun U.S. Exchanges While Wall Street Collects Record Fees” (here) points out, activity on overseas markets may be booming, but “it is not that America’s economy and markets are shrinking – it is that the other ones are growing.” The article also notes that “for companies based in Europe, the Middle East and Asia, the choice of where to raise capital often comes down to geography and time zones.”
The increasing competitiveness of the global financial marketplace is due to a host of causes, most having nothing to do with the level of regulatory scrutiny in the U.S. As I have noted in prior posts, we should be wary of allowing the effects of larger global financial forces to serve as a pretext for reducing the level of regulation in our markets. The evidence above does not support the hypothesis that foreign companies are unwilling to list their shares here, and the increased financial activity overseas has no relation to the level of regulatory rigor in this country.
There is, however, one area, where the U.S. securities markets clearly are at a competitive disadvantage – cost. As the Bloomberg article notes, “for all the talk about keeping U.S. markets competitive and safeguarding jobs, the reality is that investment banks have helped price the U.S. out of the global IPO market.” U.S firms charge more to underwrite shares than do firms elsewhere; according to Bloomberg, U.S. investment banks charged fees averaging 4.4 percent of the value of stock sales in 2006, by comparison than 2.3 percent in Europe.
Whether or not the higher underwriting costs for listing in the U.S. really are deterring foreign business, cutting costs would be a particularly easy way to remove at least one impediment to doing business here, and it is a step that doesn’t require any governmental authority’s cooperation to accomplish. At a time when U.S. financial firms are booking record profits, this seem like a reasonable first step toward removing impediments to the competitiveness of the U.S markets.
In my commentary on reform proposals, I have also frequently noted (refer here) that other countries' reforms are narrowing differences between the U.S. and other countries. An article in the February 17, 2007 issue of the Economist magazine entitled "If You Can't Beat Them, Join Them" (here, subscription required) comments that while European business interests may not welcome American style class action lawsuits, "welcome or not, class action lawsuits are on the way." Britain, Netherlands, Germany and Spain all already permit some form of collective action, and Italy and France are considering their own versions. (France recently tabled its version until after the May elections.) To be sure, these European versions lack many of the attributes of American class action litigation, including contingent fees, jury verdicts on damages, and the possibility of punitive damages awards. The Economist declares that these new forms of collective action deserve a "caution welcome" because they permit efficient resolution of widespread claims, and because they provide injured European investors a way to seek remedies without having to resort to U.S. courts.
Reasonable minds can disagree over whether the differences or similarities between the U.S and the European models of collective civil actions are most important now. But as global investors become more accustomed to seeking judicial remedies for management misconduct, the similarities will matter more than the differences.
In a prior post (here), I raised the question whether the whistleblower protection under Section 806 of the Sarbanes-Oxley Act is “more theoretical than real.” A February 2007 study by Alexander Dyck of the University of Toronto, Adair Morse of the University of Michigan Business School, and Luigi Zingales of the University of Chicago entitled “Who Blows the Whistle on Corporate Fraud?” (here, $ required) confirms statistically that SOX whistleblower protection is not encouraging employee whistleblowers and may be discouraging them.
The authors looked at a sample of 230 cases of corporate frauds that were alleged between 1996 and 2004 regarding companies with more than $700 million in assets, in order to determine who was involved in the revelation of fraud. The authors found that between 1996 and SOX’s enactment, employee whistleblowers represented 21 percent of the fraud detectors, but that after that, they represented only 16 percent.
The authors found that employee whistleblowers face significant discinventives. They found that in 82% of cases where the employee whistleblower's identity was revealed, the employee “quit under duress, or had significantly altered responsibilities.” In addition, may whistleblowers report having to move to another industry or to another town.
SOX attempted to create protections for employee whistleblowers. Section 301 requires public company audit committees to create procedures for “confidential anonymous submission" of questionable accounting or auditing matters. Section 806 provides protections for employees against being fired for coming forward with this kind of information. The authors found that the drop in the employee whistleblowers as a percentage of fraud detectors after the enactment of Sarbanes-Oxley suggests that “SOX’s modest incentives for whistleblowers has not been very effective.” They suggest that “protecting the whistleblower’s current job is a small reward given the extensive ostracism whistleblowers face.”
The D & O Diary would add to the authors' analysis that, as discussed in prior posts (most recently here), the protection that the SOX whistleblower provisions theoretically provide have proven cumbersome and procedurally challenging. The statutory protections, as implemented, arguably create affirmative disincentives for would-be employee whistleblowers.
The study's authors have an interesting observation about employee whistleblowers in industries (such as healthcare) that conduct significant business with the government, and where employees can receive substantial financial rewards for bringing a so-called qui tam action. The authors found that in the healthcare industry, where employees have these kinds of financial incentives to blow the whistle on fraud, employee whistleblowers account for 46.7% of fraud detectors, as opposed to only 16.3% in industries where employees cannot bring qui tam lawsuits. The authors also found that in the healthcare industry, fewer fraud lawsuits were dismissed or settled for less than $3 million than compared to all companies in all industries, leading the authors to conclude that there was no evidence that the availability of the qui tam lawsuits increased the level of frivolous litigation.
The authors conclude that the SOX whistleblower protection, offering only after-the-fact job protection, provides little incentive for employees to assist in fraud detection. The authors recommend “extending the qui tam statute to corporate frauds.”
Whether or not employee whistleblowers should have added fraud detection financial incentives, the authors’ point about the financial incentives for employee whistleblowers in the healthcare industry (and other industries that do substantial business with the government) is an important point for D & O insurance professionals. Clearly, with respect to companies in the healthcare industry and other industries that do substantial business with the government, it will be particularly important for the standard insured-versus-insured exclusion to be modified to carve back coverage for whistleblower suits, including in particular qui tam or False Claims Act lawsuits.
A February 13, 2007 CFO.com article entitled "Sarbox Curbs Fraud Whistleblowing" discussing the report referred to above can be found here.
Go Ask Alice: According to news reports (here), “a male lawyer who appeared in court in women’s clothes as a protest against what he said was New Zealand’s overly masculine judiciary was suspended Wednesday after being found in contempt of court.” The lawyer, who officially has changed his name to “Miss Alice,” was held in contempt for posting on the Internet certain documents pertaining to a bridge collapse, despite a court order that the documents not be distributed. The lawyer announced after the ruling that he would quit the law altogether, so that he would no longer appear “in a 19th century Alice in Wonderland environment that allows pomp, self-importance and deference to the court to eclipse the truth.” However, a subsequent news report (here) suggested that he had changed his mind about leaving the practice of law -- perhaps he felt his attire entitled him to that prerogative.
Changing Circumstances in the Global Financial Marketplace
In a recent post (here), I noted that the cross-border Siemens bribery investigation shows that regulators throughout the world increasingly recognize the importance of vigilance and scrutiny, and that the extent of alleged misconduct in that case could spur further efforts for oversight and reform. In that same vein, a February 15, 2007 New York Times article entitled “Germany Battling Rising Tide of Corporate Corruption” (here) notes with respect to the Siemens case and other investigations that “the current spate of scandals will prompt a serious, systemic effort by German companies to impose more stringent internal controls and systems of legal compliance to stop corruption from happening in the first place.”
Whether the current wave of German corruption cases reflects lax legal compliance or simply more aggressive prosecution, it is clear that the number of cases is increasing. Germany did not have laws allowing prosecutors to bring bribery cases until 1997, by contrast to the United States, which has had the Foreign Corrupt Practices Act for over 30 years. One source quoted in the article says that in the last five years, “the notion that we need to prosecute economic criminality took on an entirely new dynamic.”
This new dynamic clearly will influence both prosecutorial priorities, and by extension, expectations of corporate compliance. As I have previously noted (here), as these regulatory efforts elsewhere gain traction, differences in regulatory standards between the U.S. and other countries will diminish – a consideration that is clearly relevant to the current calls for regulatory reform in the U.S.
Ready, Fire, AIM: In prior posts, I have raised concerns (most recently here) about regulatory standards for London’s Alternative Investment Market (AIM), and more recently (here) I have suggested that the AIM may be facing increasing pressure to tighten up. In a February 12, 2007 article in The Times (London) entitled “Most AIM Fundraisers Fail to Enrich Backers Over Three Years” (here) takes a look at the 802 companies that listed on the AIM during the three years ending on December 31, 2006, and finds that 52 percent were “either trading at or below their issue price, or have had their shares suspended.”
The Times concludes that the “findings are likely to fuel criticism of AIM that, although it has been the most successful growth market in terms of new listings, it has often sacrificed quality for quantity.”
Whatever conclusions may be drawn from the data about the quality of AIM listed companies, the fact that over half of the last three years’ listings have failed to make money for investors does have important implications for the likelihood of the past level of listings to continue in the future. This is just one more example of the reasons why current global marketplace circumstances may well change for their own reasons, without any of the regulatory revisions for which the would-be reformers in the U.S. are clamoring.
As discussed in February 13, 2007 New York Times article entitled “SEC Seeks to Curtail Investor Suits” (here), the SEC and the DOJ have jointly filed an amicus brief in the Tellabs case pending on writ of certiorari before the United States Supreme Court, in which brief the agencies urge the Court to adopt a restrictive test that plaintiffs must satisfy in order to meet the heightened pleading standard under the Private Securities Litigation Reform Act. The agencies’ amicus brief can be found here.
The Tellabs case is before the Supreme Court to determine whether the Seventh Circuit applied the right test to determine whether the plaintiffs’ allegations satisfied the PSLRA’s requirement that the complaint “state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind.” A copy of the Seventh Circuit opinion can be found here. The Seventh Circuit held, in reversing the district court’s dismissal and holding the plaintiff’s allegations to be sufficient, that a complaint satisfied the PSLRA’s requirements to support a “strong inference” if it “alleges facts from which, if true, a reasonable person could infer that the defendant acted with the requisite intent.”
The agencies argue in their amicus brief that in enacting the heightened pleading standard in the PSLRA, Congress sought to require more than a “reasonable” inference. The agencies contend that courts must consider whether or not the facts alleged support competing inferences, including the possibility whether there are “non-culpable explanations for the defendants conduct,” and consider the relative strength of the inferences to determine whether the inference the plaintiff urges is “strong.” Specifically, the agencies argue that:
in evaluating whether a plaintiff has alleged particular facts that “giv[e] rise” to a “strong” inference of scienter, a court should determine whether, taking the alleged facts as true, there is a high likelihood that the conclusion that the defendant possessed scienter follows from these facts. (emphasis added)
The agencies’ brief is succinct and well-written. But its lawyerly elegance notwithstanding, the brief has already been the target of criticism, particularly its advocacy of the “high likelihood” requirement. The Times article quotes Fordham Law Professor Jill Fisch as saying that it is unusual for the SEC to side against investors in a fraud lawsuit in the Supreme Court: “One has to wonder if the SEC is now on the side of the defense bar.” Professor Fisch describes the “high likelihood” standard urged by the agencies as “exceedingly high.”
Illinois Law Professor Christine Hurt, writing on the Conglomerate blog (here), suggests that the “high likelihood” standard is higher than is required to get to a jury in a criminal securities case. Professor Hurt notes that “in criminal cases, prosecutors don’t even lose on directed verdict for not showing this kind of evidence of intent.” Rather, “prosecutors get to instruct the jury that the defendant can be guilty of securities fraud if the were willfully blind to the actions of others.”
The Supreme Court may yet choose to adopt the standard that the agencies propose. But The D & O Diary notes that while the PSLRA did enact a heightened pleading standard, the “high likelihood” test does not appear in the statute. The statute requires the facts to support “a strong inference” that the defendant acted with scienter – not that the inference of scienter is the only inference, or even that it is the strongest inference, but that it is an inference and that it is strong.
It can be questioned whether the Seventh Circuit’s “reasonable inference” test can be squared with the statute, but I also believe there is serious question whether the “high likelihood” test can be squared with the statute. I don’t believe the PSLRA requires courts considering motions to dismiss to determine which inference is strongest – that seems like a job for a jury to me. Rather, on a motion to dismiss, the court’s job ought to be to examine whether the facts alleged taken as true support a strong inference that the defendant acted with scienter, emphasis on the word “a”.
The 10b-5 Daily has a post about the agencies' Tellabs amicus brief here and a prior post here about the Seventh Circuit's opinion.
SEC Advocating Auditor Liability Caps?: As The D & O Diary has previously noted (here), the European Commission is actively looking at the possibility of caps for auditor liability. Conrad Hewitt, the SEC’s Chief Accountant, has previously come out in favor of auditor liability caps (here), and the Times article linked above reports on similar remarks from Hewitt on a more recent occasion. Hewitt’s concern is that without these caps, auditors could face ruinous liability and bankruptcy, which could force further consolidation in the already overconcentrated accounting industry.
The limits of competition among the Remaining Four accounting firms poses a serious issue. Nevertheless, as I have previously argued (here), the concern here is that the SEC (and for that matter, the PCAOB) not put itself in the position of protecting the Big Four accounting firms.
Insurance Coverage Implications of the Delaware Chancery Court’s Recent Options Backdating Decision: As I noted in a recent post (here), the Delaware Chancery Court’s opinions in the Maxim Intergrated options backdating case (here) and in the Tyson Foods options springloading case (here) have important implications for the many other options backdating related shareholders derivative lawsuits. In addition, as noted in an excellent memorandum by my good friend Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm, entitled “A Bad Week for the Defense in Options Backdating Litigation” (here) the Delaware Chancery Court opinions may have important insurance coverage implications as well.
The memorandum notes that even though the opinions did not address coverage issues, “the decisions suggest that coverage issues already raised by insurers in these claims are likely to be continuing sources of contention.” The memorandum is particularly concerned with the potential applicability of conduct exclusions in the D & O policy, give the forceful language of the Chancery Court’s opinions. The memorandum also discuses whether he rulings may also raise important questions about the insurability of settlement or judgment amounts.
The Latest Options Backdating Litigation Tally: Readers may be interested to know that according to the latest D & O Diary tally (here), there have been 147 companies named as nominal defendants in shareholders' derivative lawsuits raising options backdating allegations.
An "Essential Supplement" to the SEC: In a prior post (here) commenting on Professor Grundfest's proposal to eliminate private securites lawsuits, I commented that the private securities bar provides outsourced securities law enforcement for the SEC. As Adam Savett notes on the newly revitalized Securities Litigation Watch blog (here), the SEC even went so far as to state in its amicus brief in the Tellabs case that "meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC." Savett presents additional "gentle rebuttal" against Grundfest's proposal as well.
The D & O Diary has long contended (most recently here) that civil claims following on enforcement actions under the Foreign Corrupt Practices Act (FCPA) represent a growing area of D & O claim risk. The entry last week (refer here) of a $26 million criminal fine – the largest criminal penalty ever under the FCPA – underscores the growing importance of FCPA enforcement cases. A February 7, 2007 memorandum from the Gibson, Dunn & Crutcher law firm entitled “2006 Year-End FCPA Update” (here) provides a useful overview of 2006 FCPA enforcement activity, and underscores the growing importance of civil claims based on FCPA proceedings.
The memo notes that “2006 marked one of the busiest years of FCPA enforcement and further evidenced the recent proliferation of FCPA enforcement activity.” The memo identifies a number of important FCPA trends, including:
Voluntary Disclosure: “The number of voluntary disclosures continued to rise in 2006. Seventeen of the twenty newly disclosed FCPA investigations during the past two years were voluntarily disclosed to the DOJ or the SEC following internal investigations by the companies.”
Increased Penalties: “Enforcement activity in 2006 continued the trend of increasing the severity of penalties.”
Increasingly Broad Jurisdiction: “U.S. enforcement authorities have shown a willingness to reach far and wide outside traditional jurisdictional boundaries….The Statoil matter marked the first time that the DOJ has taken criminal enforcement action against a foreign issuer for violating the FCPA."
Ongoing Civil Liability: Even though there is no private right of action under the FCPA, plaintiffs lawyers may be able to pursue securities fraud lawsuits based on FCPA-related misrepresentations. In the Immucor decision (discussed previously on The D & O Diary, here), “for the first time a federal court held that plaintiffs had met the heightened pleading standard requirement for fraud under the PSLRA in an FCPA case.”
According to the memo, “more than 24 other major corporations are under investigation for FCPA violations.” The memo suggests that in this environment, securities claims based on FCPA violations “may start to gain traction” and therefore “the legal road towards resolving an FCPA violation in the U.S. now stretches far beyond achieving peace with the SEC.”
The Gibson Dunn memo confirms a couple of themes that The D & O Diary has been sounding for some time. First, FCPA enforcement activity is increasing, both in frequency and severity, and, second, the threat of follow-on civil litigation from FCPA enforcement activity is also growing. As FCPA enforcement actions grow in number and magnitude, this exposure could pose an increasingly greater D & O risk.
Special thanks to a loyal D & O Diary reader for the link to the recent record-setting FCPA criminal fine.
Record Number of Restatements in 2006: According to a February 12, 2007 Wall Street Journal article entitled “Restatements Still Bedevil Firms” (here, subscription required) publicly traded companies filed a record 1,876 restatements of financial results in 2006, an increase of 17% over the number of restatements in 2005. However, the number of 2006 restatements by large companies (defined as those with over $700 million in shares available to the public) filed 196 restatements in 2006, a drop of about 20% from 2005. By contrast, companies with a public float of less than $75 million filed 1,108 restatements in 2006, more than two-thirds of all 2006 restatements, representing a 42% jump in restatements for companies of that size compared to the prior year.
The most frequent cause of restatement was related to the “measurement and recognition of debt and stock or equity instruments,” and the second most frequent cause related to compensation issues (including, in particular, options backdating).
The drop in restatements for larger companies, which have had to adapt to the reporting requirements of Section 404 of the Sarbanes Oxley Act, suggests that those companies’ internal controls are working better. The smallest companies, which do not yet have to follow Section 404, are clearly continuing to struggle.
Buy-Backs and EPS: When I commented (here) on the controversy surrounding Robert Nardelli’s compensation as the departing head of Home Depot, one of the concerns I specifically noted was the way stock buy-backs had been used to improve Home Depot’s reported earnings per share (EPS), at the same time that the executives’ compensation was adjusted to reward executives based on EPS. Fortune Magazine has a more detailed elaboration of this concern in a February 9, 2007 article entitled “Nardelli’s Fake Bogey: Earnings Per Share” (here).
The D & O Diary’s prior post about the pitfalls of stock buybacks and the way they interact with executive compensation can be found here.
The Weak Case for Regulatory Reform Gets Even Weaker
At the heart of recent calls for regulatory reform in the Interim Report of the Committee on Capital Markets Regulation and in the Bloomberg/Schumer Report is the assertion that the U.S. securities markets are losing global IPO marketshare because of supposed regulatory overkill and the litigious environment in the U.S. Accompanying this assertion is the concern that foreign securities markets (particularly in London) are supposedly attracting IPO activity by their comparatively light regulatory touch. Reform of the U.S regulatory approach and litigation system is needed, these Reports assert, so that the U.S. can recapture a larger share of the global IPO activity.
The D & O Diary has previously presented (most recently here) its belief that the reformers' case for regulatory reform is “weak.” More recently, events both overseas and in the U.S. further belie both ends of the reformer’s premise – that is, these recent events suggest that companies (even foreign companies) may yet seek to list on U.S. exchanges, in preference to other exchanges, even without regulatory reform; and that companies might not be able to count on a lighter regulatory touch on competing exchanges.
1. London’s Attraction To (or Appetite For) Russian and Chinese Companies May be Waning:
A very large part of the London markets’ success in growing their share of the global IPO market in recent years has been based on their success in attracting listings from Russia (and other former Soviet republics) and from China. Indeed, in 2006 alone, 12 offerings by companies from Russia or other former Soviet republics raised proceeds of nearly 6.6 billion pounds. But now in early 2007, the bloom very much seems to have gone off the rose for Russian offerings in London. As reported in a February 8, 2007 Financial Times article (here), the listing of the shares last week of two Russian companies (Polymetal and Sitronics) came in at the low end of the offering range and in response a third company, GV Gold, withdrew its offering amidst “lackluster demand.” According to the Financial Times article, these developments “underline the increasingly tough environment companies from Russia and other former Soviet states are likely to face this year as investors become increasingly selective.”
At the same time the pipeline of Russian companies to London has started to slow, two Chinese companies, 3SBio and JA Solar Holdings, completed successful offerings on NASDAQ.
Without the flood of Russian listings, and with Chinese companies successfully listing in the U.S., the apparent market share advantage enjoyed by the London exchanges could be diminishing
2. The Successful Fortress Investment Group IPO Will Attract Additional Hedge Fund and Private Equity Fund Listings on U.S. Exchanges
Fortress Investment Group’s successful February 9, 2007 IPO was not the first public offering by a private equity fund or hedge fund, nor was it the largest. But it was the first public hedge fund offering on a U.S securities exchange, and it was the most successful. According to the February 10, 2007 Wall Street Journal (here, subscription required) 19 private equity and hedge fund firms sold shares in 2006 on foreign markets, raising $12.4 billion. U.S. groups have been among the firms to list their shares in these offering. KKR, for example, sold shares in a private equity fund on the Euronext Amsterdam exchange. But the KKR fund shares trade in a narrow range close to their offering price.
Fortress chose to list its shares on the NYSE, notwithstanding those supposedly prohibitive regulatory constraints that are driving companies away from the U.S. securities markets. Its reward was that its offering priced at the top end of the range and its shares jumped 68% in the first day of trading. Commentators can argue all they want about whether regulatory burdens are deterring companies from listing on U.S. exchanges, but high valuations and a successful debut like Fortress Investment Group’s will unquestionably attract companies to list on U.S. exchanges.
The title of the Wall Street Journal's February 10, 2006 article about the offering, "Hedge Fund Crowd Sees More Green As Fortress Hits Jackpot with IPO" (here, subscription required) says it all. Along those lines, a February 9, 2007 Business Week article (here) reporting on the Fortress Investment Group IPO contained a prediction that more than 30 hedge funds and private equity funds could seek to list their shares on U.S. exchanges by the end of 2008.
It should also be noted that the Fortress group was one of 17 offerings this week on U.S. securities exchanges, raising over $3.4 billion, the most active week in terms of deal value in over three years. It certainly seems like the market for IPOs on the U.S. exchanges is healthy -- perhaps healthy enough to question whether the reformers' dire warnings about the competitiveness of the U.S. markets are seriously overblown.
3. London’s Regulators, Perhaps Spurred by Criticism, Have Begun to Show Some Teeth
It probably has nothing to do with the remarks (here) of John Thain, the head of the NYSE, at the recent World Economic Forum in Davos, Switzerland, that the London markets need to “tighten up” to avoid “damage” to “their reputation.” But within days of these remarks, the U.K.’s Serious Fraud Office launched an investigation (here) into Torex Retail, following the London Stock Exchange’s suspension of trading of Torex Retail’s shares on the Alternative Investment Market (AIM).
The Torex Retail matter may involve only one company, but it does serve as a reminder that markets will strive to maintain their integrity in order to preserve investor confidence. There are no advantages for being perceived as having won the race to the bottom. Companies attracted to the London markets out of a perception of a lighter regulatory touch will find that they still face regulatory scrutiny. It will not take too many cases like Torex Retail before the London regulators will have shown their vigilence is not less than regualtors elsewhere.
UPDATE: On February 12, 2007, another AIM listed company, Adamind LTD, disclosed (here) that the Financial Services Authority had initated an investigation regarding the company. The Adamind investigation is noteworthy because it involves one of those companies -- Adamind is a U.S.-based company with R & D facilities -- that chose to list in London and about which the would-be reformers have been fretting so much. Special thanks to alert reader Uri Ronnen of the AccountingClues blog for the link to the Adamind disclosure.
Each of these developments serve as a warning against seizing upon possibly temporary or transient phenomena as pretexts for reducing regulatory rigor in the U.S. In the global economy, transactions will go where they can realize their greatest financial advantage. The factors that in the recent past led to a greater number of listings in London may have had little to do with the regulatory regime in the U.S. The changing IPO market place so far in 2007 suggests that the competitive landscape among the various securities markets is already evolving, and will continue to evolve – and that that is happening without the adoption of any of the various proposed regulatory reforms. We should be very wary of compromising this country’s regulatory rigor based on transient shifts in the global financial marketplace that have no relation to the level of regulation in this country.
Now This: When we heard about the untimely death of Anna Nicole Smith, we found that we could not think of her marriage to J. Howard Marshall without associating this scene from the film, Best in Show:
In a widely-circulated and much discussed February 7, 2007 Wall Street Journal op-ed column entitled “The Class Action Market” (here, subscription required), former SEC Commissioner and Stanford Law Professor Joseph Grundfest (pictured above) takes a look at the declining number of securities fraud lawsuits in 2006 (see prior D & O Diary posts here and here) and reaches the startling conclusion that perhaps it is time to do away with private securities lawsuits altogether.
Grundfest’s views are based on his position that the declining number of suits is due to improved corporate behavior. As he says, “perhaps fewer companies are being sued for fraud because there is less fraud.” He attributes this to the “government’s criminal and civil enforcement strategy.” Not only has this enforcement activity been effective, Grundfest writes, but as a means to protect shareholders’ interests, it is superior to private securities class actions, since private suit recoveries are diminished by the amount of the plaintiffs’ attorneys’ fees. “Investors,” Grundfest writes, “could come out ahead if they simply allowed the SEC to control the process and eliminated the private bar’s cut of the action.”
In addition to the elimination of the lawyers’ costs, the exclusiveness of SEC enforcement would provide superior deterrence: “Private litigation does not have an equivalent deterrent effect because it can’t threaten executives with jail and because damages are almost always paid by corporations and insurers, not the executives who cause the fraud.” In summary, Grundfest writes, “the private class action can be viewed as an expensive, wasteful and unnecessary sideshow that generates little deterrence and offers questionable levels of compensation.”
Grundfest’s proposal to eliminate private securities lawsuits is not entirely original. {UPDATE: Please see the comment below about the origin of this idea; The D & O Diary stands corrected!}The idea of disimplying a private cause of action under Section 10 was circulated in the early stages of the work of the Committee on Capital Markets Regulation (popularly known as the Paulson Committee), as discussed here. Grundfest is a highly respected figure in the securities law arena, and for that reason his views are likely to attract significant attention. But that does not necessarily mean that the private securities lawsuits will disappear any time soon.
First of all, we don’t hear the SEC clamoring to increase its workload; to the contrary, the SEC clearly depends on the private securities bar as a way to outsource part of the burden of enforcing of the securities laws. The SEC’s hands are already pretty full; the SEC could not take on categorically increased responsibilities without a major hike in its budget and in the size of its enforcement staff. {UPDATE: As Adam Savett notes on the newly revitalized Securities Litigation Watch blog (here), the SEC went so far as to state in its amicus brief in the Tellabs case that "meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC." Savett presents additional "gentle rebuttal" against Grundfest's proposal as well. }
In addition, the introduction of an exclusive public remedy for securities fraud entails significant costs. While shareholders may have to pay attorneys in order to be able to pursue lawsuits, those costs at least are borne by the most interested parties rather than by taxpayers as a whole. And how would taxpayers and corporate American react to a greatly enlarged securities regulator? There is a thin line between respect and fear, and an enlarged and empowered SEC would be even more fearful than it is now. Could deterrence become oppression?
And while Grundfest is correct that the SEC’s enforcement activity has a greater deterrent effect than private litigation, that does not mean that private litigation has no deterrent effect. Most corporate officials want to do the right thing, and they also want to be perceived as doing the right thing. For the typical CFO or CEO, nothing could be more mortifying than finding their name linked in the press to the word “fraud,” even if the accusation comes only from a plaintiffs’ lawyer. This deterrent effect is real and an important part of life for most corporate officials.
Without a doubt, the securities class action lawsuit has been abused. It is an expensive and cumbersome tool for the enforcement of the securities laws. But it nevertheless continues to have an important role to play in protecting investors’ rights. Simply put, investors who are angry don’t have to depend on the government to redress their economic grievances; they can do something about it themselves. For all of the excesses of securities class action lawsuits over the years, it is still a tool of empowerment for investors. Readers who find my defense of the securities class action surprising should understand that I simply prefer the continued availability of a private remedy to the prospect of an even more enlarged and even more empowered SEC with a monopoly on the right to protect shareholders' rights. There was a time, before the courts implied a private right of action, when the sole agent for enforcing the securities laws was the SEC, but private litigants whose interests were not redressed sought a private right of action in order to be able to pursue actions that SEC had not taken up. Without a private cause of action, investors would have no remedy if the SEC failed to act.
I also happen to disagree that the SEC’s enforcement activity alone explains the decline in the number of lawsuits; unlike Professor Grundfest, I think the Milberg indictment is part of the explanation, not for its affect on the Milberg firm alone, but for its effect on the entire plaintiffs’ bar (see my prior post here). I also think the current relatively healthy economy is also part of the explanation. Look at the auto parts industry; that sector has been under pressure lately, and not too surprisingly, just about every public auto parts company has been sued in a securities class action lawsuit in the last 18 months. Just this week, subprime lenders announced deteriorating results, and like clockwork one of the companies (New Century Financial) was sued in a securities class action lawsuit. (here). There are numerous causes for the decline in securities lawsuits, many of which appear to be temporary, so to the extent that Grundfest’s proposal depends on his theory that SEC enforcement activity alone explains the declining number of lawsuits, the proposal should be viewed with caution. Certianly, if the downturn proves to be temporary, the basis of his argument is eroded.
I am surprised that we have not heard a reaction out of the plaintiffs’ bar yet. I suspect we will before too long.
For a good discussion of Grundfest's column, see the Truth on the Market blog (here).
CalSTRS Completes Another Opt-Out Settlement: As I previously noted (here), the increasing prevalence of institutional investor opt-out settlements has important implications for projected severity assumptions and even for appropriate D & O insurance limits. In the latest example of this phenomenon, the California State Teachers’ Retirement System (CalSTRS) announced (here) on February 7, 2007 that it had reached a $105 million settlement of the $135 million investment losses it claimed in its individual action, brought after the retirement fund opted out of the $2.65 billion class settlement. (Refer here for a description of the class settlement.) CalSTRS announcement in the AOL Time Warner case come just days after it announced a $46.5 million settlement in the case it filed against Quest.
In an article on CFO.com (here), counsel for CalSTRS is quoted as saying that if CalSTRS had not opted out of the class, it would have recovered only $15.5 million to $16 million. In other words, its recovery of its investor loss supposedly was increased 6.5 times by pursuing a separate action. The $105 million settlement represents about 78% of its claimed investment loss.
As I noted in my prior post linked above, separate settlements of this type, even if limited exclusively to the largest securities lawsuits, could have an enormous impact on the complexity and cost of private securities litigation.
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.
In a series of recent editorials, the New York Sun has raised some interesting and troubling questions about a New York City’s pension fund's involvement as lead plaintff in the Apple Computer options backdating securities litigation.
