Monday, February 12, 2007

The Latest on the FCPA and D & O Risk

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.

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