Options Backdating: It’s "Blame the Gatekeeper" Time

In an earlier post (here) entitled "Options Backdating: Sue the Gatekeeper," I discussed a recent case where a company had sued its former accountant for the accountant’s options timing advice. It now appears, in addition to "sue the gatekeeper," that "blame the gatekeeper" has emerged as a part of options backdating litigation. A May 30, 2007 Law.com article entitled "On Judge’s Advice, Brocade Drops Wilson Sonsini" (here) discusses a number of cases in which companies and individuals who are defending themselves against allegations of options-related misconduct have attempted to blame alleged improprieties on outside lawyers and accountants.

The case discussed most prominently is the article involves Brocade Communications, whose ex-CEO George Reyes is facing criminal charges related to backdating at the company. According to the article, Reyes blames Wilson Sonsini partner (and former Brocade director) Larry Sonsini "for recommending that Reyes be allowed to aware options with little oversight." In light of Reyes’s defense, and apparently at the suggestion of the trial judge, Brocade has dropped Wilson Sonsini as its counsel on its own options-related lawsuit. According to a prior San Jose Business Journal article (here) discussing the hearing at which the judge questioned Wilson Sonsini's involvment in connection with the proposed settlement of the Brocade derivative case; the Business Journal article reports that the judge asked the Wilson Sonsini attorney at the hearing: "There is evidence out there that Mr. Sonsini was involved in the mechanism ... which officers utilized in granting backdated options. Is it appropriate for you as the law firm to negotiate the settlement?"

Another company mentioned in the Law.com article is KLA Tencor, for whom Sonsini also apparently acted as outside counsel. The article quotes a November 1998 email from KLA Tencor’s general counsel to Sonsini, in which the general counsel tells Sonsini that PricewaterhouseCoopers accountants had approved a process by which the company’s stock options committee could meet "during the 30 days following August 31 and set the price for repricing at that time in order to maximize the value for employees." KLA Tencor apparently has acknowledged that the August grant was backdated and has repriced those options.

The article suggests that the difficulty and complexity of relevant options accounting rules put management in a position where they had to rely on outside lawyers and accountants for guidance. The defendants will argue that that their interactions with lawyer and accountants show that they did not intend to commit a crime. The difficulty for defendants trying to use this as a defense is that they will have to show that the attorneys or accountants were explicitly informed of the defendants’ behavior. Moreover, as Mark Fagel, the head of enforcement in the SEC’s San Francisco office, puts it in the article, "I’m skeptical of the claim that someone didn’t understand that there was an accounting issue when they created a false document."

In an earlier post (here) entitled "Is Backdating Criminal?" I discuss an op-ed piece written by Reyes’s criminal defense lawyers in which they contend that "most backdating cases" are "not fraud, but books and records errors." In the post, I contend that the "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."

To Woo Rather Than Scourge: When he was New York’s Attorney General, Eliot Spitzer made his name, and paved his way to the New York governor’s mansion, by taking on Wall Street and major insurance companies. Now that he is governor, he has decided to try New York financial services companies now need his help in order to remain competitive in the global market place.

In a May 29, 2007 Executive Order (here), Spitzer formed the New York Commission to Modernize the Regulation of Financial Services. A press release accompanying the order (here) states that the purpose of the Commission will be to "identify ways in which regulatory powers could be integrated, rationalize and changed in order to promote economic innovation and protect the consumer."

Spitzer’s Executive Order follows the recent tradition established by other leading New York politicians in their release of the Bloomberg-Schumer report (here), also designed to suggest ways to address the competitiveness of the New York financial markets. According to a May 30, 2007 New York Times article entitiled "Now, Spitzer Is Warming to Wall St." (here), the Bloomberg/Schumer report "focused on the patchwork of federal and state regulation," whereas Spitzer’s Commission will be "focused, at least initially, on trying to rationalize outdated state regulations."

New York currently has four departments responsible for regulating financial service in New York. The Commission will seek to rationalize the structure. The Commission will produce a report by the end of June 2008, but will try to put changes into place before then, including in particular a new principles-based system of insurance regulation.

The Commission will be chaired by Eric Dinallo, the New York State Insurance Commissioner, and will include leaders from Insurance, Securities, Banking, Business, Law and Government. The full list of Commission members can be found here.

This story brims with irony, particularly in the fact that among the insurance leaders that Spitzer has appointed to the Commission is AIG CEO Martin Sullivan. I am sure that most readers will recall that on March 15, 2005 (refer here), Sullivan’s predecessor, Maurice "Hank" Greenberg, resigned under pressure from Spitzer while Spitzer was New York Attorney General. As summarized in Wikipedia (here), Spitzer later filed a complaint against Greenberg and others alleging fraudulent business practices, securities fraud, common law fraud, and other violations. All criminal charges were later dropped and Greenberg was not held responsible for any crimes. Some civil charges remain (refer here). An interesting commentary on Spitzer's criminal nonprosecution of Greenberg can be found here.

Spitzer appears to have decided that his current political interests are better served by ingratiating himself with business leaders, rather than suing them (which served him so well in the past). I think most of us would understand if it took Sullivan a while to get comfortable in his new Commission seat.

I wonder, is it an inate human instinct to suspect zealous converts, particularly where the conversion is still recent and has an unmistakable air of calculation about it?

Hat tip to the FEI Financial Reporting Blog (here) for the link to the Executive Order and the Press Release.

Is Lerach Going to Retire?: According to a post yesterday on the Legal Pad blog (here), Bill Lerach of the Lerach Couglin law firm may be getting ready to retire:

The nation's preeminent class action lawyer, Bill Lerach, 61, informed at least one major client this week that he would be retiring imminently from his firm, Fortune has learned.

There have been multiple hearsay accounts all day to the effect that Lerach also informed his partners at San Diego-based Lerach Coughlin Stoia Geller Rudman & Robbins at a meeting last night, but Fortune has been unable to confirm those accounts with any one actually present.

Special thanks to a loyal reader for the link to the Legal Pad blog.

At the same time, there are also rumors circulating (refer here) that former Milberg Weiss partner David Bershad is in plea talks in connection with the ongoing Milberg Weiss criminal investigation and prosecution.

Outside Directors: Optimal Insurance for Changing Liability Exposures

In a recent post on his SEC Actions blog entitled "Trends in Securities Class and Derivative Actions Suggest Proactive Steps for Directors and Officers" (here), Thomas Gorman of the Porter Wright law firm reviews a number of trends that potentially could threaten the interests of directors and officers. Gorman's blog post references the rising level of average class action securities settlements. He also reviews in interesting detail the increasing level of recent derivative settlements. The post also discusses the recent Just for Feet settlement (about which see my prior detailed commentary here). The SEC Actions blog post concludes with the comment that "all of this suggests that directors and officers would do well to take proactive steps to protect themselves." Among other steps, "D & O policies should be reviewed" focusing on "the amount and scope of coverage."

Consistent with this recommendation to consider the scope of D & O coverage as part of an overall effort to protect corporate officials in the current changing exposure environment, in the latest issue of InSights (here), I take a closer look at the changing exposures of outside directors in particular, and I also review the critical insurance options available to provide outside directors with optimal insurance protection.

Effective Governance: Sixteen Men on a Dead Man's Chest?: I suspect that many D & O Diary readers will be interested to know about the May 2, 2007 article by Peter Leeson of the West Virginia University Department of Economics, entitled "An-arrgh-chy: The Law and Economics of Pirate Organization" (here). The author's abstract describes the paper as follows:

This paper investigates the internal governance institutions of violent criminal enterprise by examining the law, economics, and organization of pirates. To effectively organize their banditry, pirates required mechanisms to prevent internal predation, minimize crew conflict, and maximize piratical profit. I argue that pirates devised two institutions for this purpose. First, I analyze the system of piratical checks and balances that crews used to constrain captain predation. Second, I examine how pirates used democratic constitutions to minimize conflict and create piratical law and order. Remarkably, pirates adopted both of these institutions before the United States or England. Pirate governance created sufficient order and cooperation to make pirates one of the most sophisticated and successful criminal organizations in history.

Hat tip to the Ideoblog (here) for the link to the article.

Backdating Case Last Rites Prove Premature

In an earlier post (here), I reported on the voluntary dismissal of the options backdating related derivative lawsuit that had been filed against Novellus Systems (as nominal defendant) and certain of its directors and offices. The May 7, 2007 press release (here) issued by Novellus’ defense firm, Morrison Foerster, referring to the voluntary dismissal, announced "there goes one case you can strike from the options backdating scorecard." Referring to the case as "one of the few outright wins by a company accused of backdating stock options," the press release quotes MoFo partner Daryl Rains as saying that "it’s not often you get a plaintiff to give up and walk away. I’m pleased that Lerach Coughlin was willing to take a hard look at the facts and see the case had no merit."

It appears that plaintiffs’ lawyers willingness to "give up and walk away" is even less common that Mr. Rains thought. According to a May 25, 2007 San Jose Mercury News article (here), "less than three weeks after its attorney declared victory in a stock-option case, Novellus Systems was hit with harsher allegations…in a lawsuit filed by the same plaintiff." The new lawsuit, filed on May 24, 2007 in San Jose federal court, accuses 14 past and present Novellus officers and directors of enriching themselves through stock option manipulations, including backdating, springloading, and bullet dodging. The new lawsuit alleges that the defendants received more than $125 million as a result of options manipulations and seeks the return of the gains and additional damages. A copy of the new complaint can be found here.

The plaintiffs’ counsel, Darren Robbins of the Lerach Coughlin firm, is quoted in the Mercury News article as saying that he was "baffled" by earlier press release, which he said was "false and misleading." Robbins cited the fact that the March 23, 2007 lawsuit dismissal had been without prejudice and allowed the plaintiffs the opportunity to amend their complaint, which the plaintiffs apparently intended to do even though their counsel voluntarily withdrew the lawsuit on May 2nd.

I can’t help but wonder whether the Lerach Coughlin firm would have refiled the lawsuit if the defense firm had not issued the press release, or issued one that was a little more, well, restrained.

Hat tip to the WSJ.com Law Blog (here) for the link to the press release and the new complaint.
Another Insufficient Demand Futility Allegations Dismissal: On May 17, 2007, U.S. District Judge Susan Illston granted the defendants’ motion to dismiss the options backdating derivative lawsuit that had been filed against Openwave Systems as nominal defendant and 18 of its current and former directors and officers. The court found that he plaintiffs’ allegations did not satisfy the requirements under Delaware law (applicable to Openwave, a Delaware corporation, under Federal Rule of Civil Procedure 23.1) to show that a demand on the company’s board to pursue the lawsuit directly would have been futile. A copy of the opinion can be found here. (Special thanks to Adam Savett at the Securities Litigation Watch (here) for the link to the Openwave opinion.)

Significantly, the court distinguished the Ryan v. Gifford case (involving Maxim Integrated Products, discussed here), which it said was "analogous." The court found that the Openwave plaintiffs’ allegations did not "allege facts sufficient to support an inference of backdating" and in fact the pattern alleged was "consistent with a random selection of stock option grant dates, as with a pattern of backdating." The court found that "plaintiffs complaint fails to plead sufficient facts to avoid Rule 23.1 demand requirements," but allowed granted leave to amend "to allow plaintiffs the opportunity to conduct and present a more comprehensive statistical analysis, or other allegations supporting an inference of backdating."

It will of course remain to be seen whether plaintiffs can amend their complaints sufficiently to overcome the pleading deficiency. In the meantime, it is worth noting that the Openwave dismissal joins a growing line of cases that have been dismissed on the ground of insufficient demand futility allegations, including CNET (here), CSC (here) and Bed Bath and Beyond (here). In addition, the Openwave decision also cited a prior dismissal in the Linear Technology Corp. case, a decision of which I was not previously aware.

Early on in the whole options backdating scandal, I asked (here) the rhetorical question, with respect to growing number of options backdating related derivative lawsuits, "Yes, but WHY are they filing derivative lawsuits," based on the observation that derivative lawsuits face many defenses including in particular the demand futility requirement. When the Maxim Integrated Products decision came down in February 2007, it appeared that my concerns might have been misplaced, since the Delaware Chancery Court’s rejected the defenses so enthusiastically in that case. But as time has gone by, the evidence is starting to mount that, at least in jurisdictions other than Delaware (even in cases to which Delaware law otherwise applies), the substantial hurdles that derivative action plaintiffs face may make many of these cases far less rewarding than the plaintiffs’ lawyers may have hoped.

Meade Instruments Settles Options Backdating Cases: According to a May 24, 2007 remark by Meade Instruments President and CEO Steve Muellner in the company’s quarterly earnings conference call (here), the company has reached a settlement in principle in the class action and shareholder derivative suits" that had been filed against he company with respect to options backdating. Muellner noted that both settlements are contingent upon court approval. Neither Muellner or the company released the details of the settlement.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for links to the Openwave decision and the Meade Instruments conference call statement.

Final Act in Loss Mitigation Insurance Episode

In the final act in the unfolding of a scheme to use "insurance" to misrepresent the financial statements of Brightpoint, on May 25, 2007, a civil jury found against Brightpoint’s former risk manager, Timothy Harcharik, on claims of aiding and abetting civil securities laws violations. (Refer here and here for news coverage.)

The case against Harcharik arose out of events at Brightpoint involving losses at its UK division. According to the complaint (here) the SEC filed against Harcharik and others, in October 1998, Brightpoint announced that it would be recording a loss of $13 to $18 million because of the losses in the UK division. However, as the quarter unfolded, it became apparent that the loss would be as much as $29 million.

According to the complaint, in order to find a way to avoid reporting a loss larger than the $13 to $18 million announced in the October release, Harcharik and the company’s Chief Accounting Officer, John Delaney, contacted the Loss Mitigation Unit of one of American International Group’s insurance subsidiaries. The parties agreed to develop a policy that essentially required Brightpoint to pay $15 million in premium in installments over a three year period, for which the company would recover $15 million in loss payments. The policy, finalized in January 1999, enabled Brightpoint to report an insurance recoverable to be netted against the UK losses, bringing the net loss to within the $13 to $18 million range. According to the complaint, Harcharik and others specifically negotiated the contract and the documentation to accomplish the desired accounting objectives.

Following an SEC inquiry, the company’s auditors examined the transaction and Brightpoint ultimately announced two successive restatements, following the second of which the transaction was accounted for as a deposit rather than as insurance.

The SEC filed a civil complaint against Brightpoint, AIG, Harcharik, Delaney, and Brightpoint’s former CFO. According to the SEC’s Litigation Release (here), the transaction was simply a "round trip" of cash from Brightpoint to AIG and back to Brightpoint, but because the premium was spread over three years it enabled Brightpoint to spread a loss over the three years that should have been recognized immediately. According to the litigation release, the other defendants all agreed to settle the civil allegations, but Harcharik elected to contest them. News coverage of the civil case filing can be found here. Harcharik was also separately charged criminally for giving false testimony in connection with the investigation of the transaction (refer here), although the indictment was later dismissed on the grounds of improper venue (here)

In the May 25, 2007 verdict, after a week long trial at which Harcharik chose to represent himself, the jury found against Harcharik on three counts of aiding and abetting securities fraud, but the jury found in his favor on another aiding and abetting count and on a count of securities fraud. The court will decide Harcharik’s penalties at a later date.

AIG for its part, according to the SEC's litigation release, agreed to pay a $10 million civil fine for the Brightpoint transaction, part of a total of $126 million AIG agreed to pay in November 2004 connection with investigations surrounding the Brightpoint transaction and a separate deal involving PNC Financial Services. AIG's press release can be found here, and related news coverage can be found here.

The Brightpoint episode is only one of several so-called "finite" insurance transactions that authorities have been investigating. For example, the SEC has also filed civil charges (here) against three officials at Renaissance Re Holdings, alleging that they had "structured and executed a sham transaction that had no economic substance and no purpose other than to smooth and defer over $26 million of Ren Re's earnings from 2001 to 2002 and 2003." Ren Re itself agreed in February 2007 to pay a $15 million fine to settle the civil charges against the company (here).

The invocation in the Brightpoint episode of the phrase "loss mitigation insurance" resonates with the echoes of an earlier time in the insurance industry, many of the associations of which are quite far afield from the kind of transaction in which Brightpoint was involved. In the late 90’s and in the early part of this decade, just about every industry conclave included some discussion of loss mitigation insurance as a way to provide additional retroactive excess insurance protection for securities claims that had already been filed. You just don’t hear anything about this sort of thing these days, no doubt for many reasons, including in particular the current general high level of scrutiny surrounding all forms of "finite" insurance and reinsurance transactions.

It certainly appeared at the time that many of these loss mitigation policies were being written in connection with then-pending securities claims. I have always wondered what the results for this product line ultimately wound up looking like. Given the dramatic escalation of securities class action settlements that has occurred in recent years, I have to surmise that the results were not favorable, which may provide another explanation why you don’t hear much about these kinds of policies any more.

More About the Tyco Settlement: In an earlier post (here), I wondered about the D & O insurance contribution to the recent massive Tyco class action settlement. A May 25, 2007 issue of Business Insurance (link unavailable) provided the following additional information:

Sources, however, said that Tyco can apply the bulk of its $200 million of D&O coverage to the settlement. The remainder has been used to cover the legal costs of former Tyco officials who have not been convicted of crimes for their roles in the scandal, sources said.

Warren, N.J.-based Chubb Corp. leads the coverage. American International Group Inc. of New York and Bermuda-based ACE Ltd. participate on excess layers, sources say.

Chubb unit Federal Insurance Co. filed suit in New York state court in January 2003 in an effort to rescind its coverage, arguing that Tyco had obtained coverage on the basis of fraudulent financial disclosures. But Federal halted that effort five months later, after Tyco paid a total of $92 million of additional premium to its D&O insurers to maintain and extend coverage (BI, May 19, 2003).

Tyco's D&O coverage would amount to less than 10% of the cost of
the company's settlement, which must be approved by a court. But, the settlement
still results in a full-limits loss for the D&O market.

Dismissals: Granted and Denied

Add Bed Bath & Beyond to the growing list of companies whose options backdating related shareholders’ derivative lawsuits have been dismissed because of the plaintiffs’ failure to adequately plead demand futility. According to a May 22, 2007 article in the New York Law Journal (here), a New York Supreme Court Justice dismissed the Bed Bath & Beyond lawsuit because the plaintiffs failed to show that demanding action from the company’s board would be futile.

The New York court focused on the fact that, because the majority of the company’s board had not received backdated option grants, the plaintiffs needed to allege with particularity why these directors also had an interest in the backdating transactions. "The mere presence of directors on committees is not particular as to their individual participation or alleged collusion with interested directors in the backdating of stock options," the Judge said.

The Bed Bath & Beyond case joins the CNET (here) and Computer Sciences Corp. (here) lawsuits as instances where the courts have found that plaintiffs’ demand futility allegations were insufficient. However, in two notable Delaware cases (here), the court denied dismissal motions and held that the demand futility requirements had been met. (A good overview of the demand futility requirement in derivative actions generally can be found here.)

Another interesting aspect of the Bed Bath & Beyond decision relates to the Court’s remarks about the company’s remedial measures. The company has adopted reforms to its options grant policy and revised the dates of certain grants. It also adjusted its balance sheet to reduce its shareholders’ equity by $66 million and took a $7.2 million charge to quarterly income. According to the article, the Court said that "the voluntary actions could have rendered the derivative suit moot." The possibility that remedial measures might moot backdating related derivative lawsuits could potentially have a significant impact on the many pending cases, since many of the companies involved in the lawsuits have also taken similar remedial measures. It will be interesting to see whether other courts conclude that remedial measures would moot pending derivative lawsuits.

Dismissal Denied in FCPA Follow-On Lawsuit: I have frequently noted (most recently here) the growing risk of civil actions following on Foreign Corrupt Practices Act investigations or enforcement proceedings. Another example of an FCPA follow-on action is the securities class action litigation involving Nature’s Sunshine Products. A May 21, 2007 order in the case (here) denied the defendants' motion to dismiss, in a case that arises out of allegedly improper foreign payments.

In opposing the motion, the plaintiffs relied heavily on a letter the company’s former auditor, KPMG, had sent to the SEC. In the letter, KPMG asserted that the company’s CEO was aware of "fraud in international operations of the company," yet represented otherwise to the auditors in audit representation letters; that the CEO had approved a payment that violated the FCPA; that the CEO had sought to cover up the fraud; and that the fraud had a material impact on the company’s prior financial statements. The plaintiffs also relied on the Company’s March 20, 2006 8-K (here)in which the Company stated that it had contacted the U.S. Department of Justice about potential violations of law. The plaintiffs also alleged that the CEO gave false reassurances to investors that the company’s financial statements were accurate when he was aware of the fraud, and was aware that KPMG had raised issues concerning the fraud. According to the plaintiffs, following the reassuring statements, the CEO and others sold large portions of their holding in the Company’s stock.

In ruling on the motion to dismiss, the court concluded that the plaintiffs had sufficiently identified false and misleading statements and had adequately pled materiality and scienter. The court did, however, shorten the class period.

The Nation’s Sunshine Products case not only represents another instance of the FCPA follow-on action, but it also presents another example of the reason why these kinds of cases could become more prevalent. That is, the investigation was the result of the company’s own self-reporting. This phenomenon of self-reporting is resulting in more FCPA investigations and enforcement actions. And increasingly, civil actions follow.

A May 21, 2007 Salt Lake Tribune article describing the Nature’s Sunshine Products decision can be found here.

Speaking of Follow-On Lawsuits: It sure didn't take long after the resignations of Jonathan Weil and Lynn Turner from proxy advisory firm Glass Lewis for the lawsuits to come in. It has barely been 24 hours since the news broke (refer here) that the two prominent executives had quit the firm after questions were raised over whether its parent, Xinhua Finance Media, had withheld unfavorable information about its chief financial officer from investors. In his resignation letter, Weil said he was "uncomfortable and deeply disturbed by the conduct, background and activities of our new parent company Xinhua Finance Ltd., its senior management, and its directors." Weil said further that"to protect my reputation, I no longer can be associated with Glass Lewis or Xinhua Finance." (Xinhua acquired the 80% of Glass Lewis it did not already own earlier this year.) A May 22, 2007 Wall Street Journal article discussing the resignations, as well as Glass Lewis' relationship to Xinhua, can be found here (subscription required).

The resignations seem to relate to the recent resignation of Xinhua's Chief Financial Officer, over the company's failure to report in its March2007 IPO documentation that the CFO was under a cease and desist order from NASD for violating securities laws at another organization for which the individual was also CFO.

A press release distributed late in the day on May 22, 2007 (here) states that the plainiffs firm of Bernstein Liebhard and Lifshitz had commenced a securities class action lawsuit against Xinhua in Manhattan federal court. The claim reportedly alleges that Xinhua failed to disclose in its March 2007 prosectus and subsequently the true circumstances involving the CFO, including the existence of the cease and desist order.

This all strikes me as very unseemly for a proxy advisory firm, a point the Journal also makes in the article linked above. Special thanks to a loyal reader for the class action press release link.

The venerable Lies, Damn Lies blog had an interesting post late last year (here) about the alacrity with which securities class action complaints sometimes follow on bad news.

Did Culture Enable Backdating?: Bloomberg.com has a long, interesting May 22, 2007 article entitled "Billionaires from Jakarta, Shanghai Undermined by Options" (here) examining the options backdating scandal at Marvell Technology Group. The article explores the company’s history from its earliest days, and examines how Sehat Sutardja built up the company after coming to the U.S., working with his brother, Pantas, and his wife Weili Dai. The article also goes in depth into the company’s backdating woes.

While the article focuses primarily on Marvell itself, it also explores the Silicon Valley culture out of which the options backdating scandal grew. The article contains the following comment, which I found quite arresting:

``Silicon Valley has a bad case of exceptionalism that we're so special and important to American society that some of the rules do not apply or ought to be loosely interpreted,'' says Kirk Hanson, executive director of the Markkula Center for Applied Ethics at Santa Clara University. ``That's a slippery slope that leads to various forms of misbehavior, and backdating is the best current example.''

Hanson is later quoted in the same article as saying ``Backdating is a product of the bubble,'' Hanson says. ``There was so much money awash in the streets of Silicon Valley that less thoughtful executives were trying to sweep as much into their pockets as possible.''

While these statements are noteworthy and attention grabbing, it is also fair to note that options backdating may perhaps have been more common in Silicon Valley, it was by no means confined to Silicon Valley.

The article is long but it merits a complete reading. Special thanks to a loyal reader for the link the Bloomberg article.

Speakers' Corner: I will be speaking at the Reinsurance Association of America (RAA) Current Issues Forum at the Four Seasons Hotel in Philadelphia, Pa. on Thursday May 24, 2007, on the topic "D & O: Where it Stands Today?" The program brochure can be found here. If you are attending the conference, I hope you will greet me and introduce yourself.

FCPA Follow-On Securities Settlement (and lots of other stuff, too)

In prior posts (most recently here), I have written about how the increased level of Foreign Corrupt Practices Act (FCPA) enforcement activity (about which refer here) can lead to heightened D & O risk. The risks arise not so much from the enforcement activity itself, but from the threat of follow-on civil actions. A recently announced securities class action lawsuit settlement demonstrates this FCPA follow-on civil suit claim risk.

On May 21, 2007, Immucor announced (here) its entry into an agreement to settle the class action lawsuits that had been filed against the company and certain of its directors and officers. According to the company’s press release, the company’s insurance carrier agreed to pay $2.5 million to settle the claims.

The plaintiffs’ claims against the Immucor defendants grew out of an FCPA investigation involving "payments made by the Company’s Italian subsidiary to individuals associated with government medical facilities." (The Company’s news release regarding the SEC’s FCPA enforcement action can be found here.) The plaintiffs in the civil action alleged not that the defendants failed to disclose the existence of the problems; rather, the plaintiffs alleged that in its periodic reports to the SEC, press releases and in conference calls with stock analysts, the defendants misled potential investors into an overly optimistic assessment of the extent of Immucor’s corrupt business practices and the strength of Immucor’s internal controls. (A copy of the plaintiffs’ Consolidated Amended Complaint can be found here.)

An unusual aspect of this case is the allegation that one of the individual defendants (Gioachinno De Chirico) was the head of the company’s Italian subsidiary at the time the alleged bribes took place, prior to his becoming Immucor’s CEO (a position he still holds). In denying the defendants’ motion to dismiss, the Court said (refer here) that "while parts of the disclosure may have been accurate, Defendants’ duty was to describe fully the nature and scope of the conduct under investigation – conduct of which De Chirico was fully aware because he participated in it." The Court denied the motion to dismiss because the omitted information was material and its omission was misleading.

The Immucor settlement joins the previously announced settlement involving the Willbros Group. As discussed in a prior post (here), Willbros agreed to pay $10.5 million to settle the class action lawsuit that alleged that the company was forced to restate several years of financials and to establish a reserve to accrue for possible fines and penalties for FCPA violations. The Willbros action (and its settlement) are described further here.

These settlements illustrate the growing risk that FCPA enforcement activity represents. The threat is not so much from the enforcement activity itself, since the resulting fines and penalties would not be covered under the typical D & O policy. The threat comes from the follow-on civil action, which seem to follow enforcement proceedings with increasing frequency. Indeed as I noted in recent in a recent post (here), both the current Siemens bribery investigation and the recent Baker Hughes enforcement action have triggered follow on shareholders’ derivative lawsuits.

These types of lawsuits are likely to increase in the future, as FCPA actions themselves increase. More companies are self-identifying FCPA violations because of operational reviews required by Sarbanes Oxley, and the companies are self-reporting in an effort to avert prosecution under the Justice Department’s guidelines for corporate criminality.

The First Public Law Firm: According to the May 21, 2007 Sydney Morning Herald (here), the Melbourne law firm of Slater & Gordon has become "the first law firm in the world to list on a stock exchange." The firm, which projects 2007 revenue of A$58.7 million, raised a total of A$35 million in its IPO. (According to XE.com, one Australian dollar is currently worth 0.821383 US dollars.) The firm’s shares are now traded on the Australian Securities Exchange, under the symbol SGH. The shares closed their first day at A$1.40, up from their initial offering price of A$1.00. For more about the firm's ASX listing, refer here.

On its website (here), the firm describes itself as "specializing in personal injury, commercial, family and asbestos-related law." The firm’s offering prospectus can be found here.

While I certainly wish the firm and its shareholders every success, there is a part of me that would be curious to witness the plaintiffs' lawyers-suing-plaintiffs' lawyers spectacle that could unfold if the firm disappoints investors and winds up in a securities class action lawsuit.

Hat tip to The Blog of the Legal Times (here) for the link to the news article. The Best in Class blog (here) also has a post on the law firm IPO.

Now, Here's Something: According to a May 21, 2007 press release from the Bank of International Settlements (here), the over-the-counter derivatives market grew last year from $298 trillion in 2005 to a notional outstanding value totaling $415 trillion worldwide as of December 2006. Yes, that's trillion.

A CFO.com article (here) commenting on this truly astounding statistic quotes European Central Bank President Jean-Claude Trichet as saying that credit derivatives may create risks to the financial markets if events prompt investors to bail out at the same time. Investors "may react in a way that can suddenly lead to dangerous herding behavior," he reportedly said at the annual meeting of the International Swaps and Derivatives Association. "Such situations are also a matter of concern from a systemic liquidity viewpoint."

With all due respect to Monsieur Trichet, I prefer to refer to the words of the Sage of Omaha himself, Warren Buffett, who wrote in his 2005 Letter to Berkshire Shareholders with respect to financial derivatives (here):

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

Or as he said, perhaps more vividly, in his 2004 Berkshire shareholders' letter (here):

Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying problems (and occasionally fraud). The real test of the earning power of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.

To translate Monsieur Trichet's comments quoted above into more vivid terms, it is not going to be pretty when the tide goes out.

For those readers interested in such things, $415 trillion is approaching half a quadrillion dollars. That would be ten to the fifteenth power. (I freely admit that I had to ask my 13 year-old son what comes after a trillion.) That's getting up there. A few more zeros and you will be all the way to a googol.

For some reason, I can't think about these statistics without the song "Wipe Out" by the Safaris running through my head.

The “Going Private” Wave and the Delaware Courts

If corporations domiciled in Delaware are going to be affected by the wave of “going private” transactions, then Delaware courts want to make sure that they set the ground rules. In a May 9, 2007 decision in the In re Topps Company Shareholders Litigation in the Delaware Chancery Court (opinion here), Chancellor Leo Strine held, in a case involving the $385 million takeover of the Topps Company, that Delaware’s interests in maintaining its own laws were sufficiently important for the court to retain jurisdiction over the case even though a related case had been first-filed elsewhere.

As a recent post in Francis Pileggi’s Delaware Corporate and Commercial Litigation blog (here) explains, the basis of the Court’s ruling is the “internal affairs doctrine,” which holds that courts will refuse to allow actions to proceed against corporations from other jurisdictions if the shareholders have sufficient avenues to address malfeasance under the laws of the corporation’s domicile. By the same token, courts will retain jurisdiction under the doctrine if the corporation is domiciled in the court’s own jurisdiction.

This principle was tested in the Topps case because of a separate principle by which Delaware courts generally will decline jurisdiction if the same or similar case was previously filed elsewhere. In the Topps case, a shareholder suit challenging the takeover of the Topps company had been filed in New York one day before a substantially similar challenge to the transaction was filed in Delaware. (A New York Sun article discussing the Topps takeover and the nature of the shareholder controversy can be found here.)

Chancellor Strine found that policy interests weighed in favor of keeping the case in Delaware. As he observed in declining to defer in favor of the first-filed case, “the paramount interest is ensuring that the interests of the stockholders in the fair and consistent enforcement of their rights under the law governing the corporation are protected.” He went on to note that “when a corporation forms under the laws of a particular state, the rights of its stockholders are determined by that state's law and that the chartering state has a powerful interest in ensuring the uniform interpretation and enforcement of its corporation law, so as to facilitate economic growth and efficiency.”

The Topps opinion observes that the policy considerations behind the internal affairs doctrine are particularly compelling in light of the wave of private equity takeovers of publicly traded companies, since over half of the Fortune 500 companies are domiciled in Delaware. Chancellor Strine wrote that “the reality is that the Topps Merger is part of a newly emerging wave of going private transactions involving private equity buyers who intend to retain current management.” These transactions present interesting questions about how to address potential conflicts of interest "and how to balance deal certainty against obtaining price competition in a very different market dynamic." He further noted that "as with the phenomenon of stock options backdating, Delaware has an important policy interest in having its courts speak to these emerging issues in the first instance, creating a body of decisional authority that directors and stockholders may confidently rely upon."

The Topps opinion is the latest example where the Delaware Court of Chancery has evinced its willingness to use its authority to police “going private” transactions. In March 2007, Strine postponed a shareholder vote regarding the $115 million buyout of Netsmart Technologies Inc. until the company provided shareholders more information about future cash flow projections, and about why its board did not pursue strategic buyers. (The Netsmart opinion can be found here.) Netsmart's shareholders later approved the buyout (refer here).

In addition, Vice Chancellor Stephen Lamb refused last year to approve the settlement of a lawsuit involving a buyout of SS&C Technologies Inc. that was instigated by SS&C's CEO without prior authorization from its board. Lamb chastised the parties for failing to consult the court about a planned settlement based on supplemental proxy disclosures, and for failing to demonstrate that potential claims of shareholder plaintiffs had been adequately investigated. The opinion in the SS&C case can be found here.

The current buyout wave shows no signs of letting up, and litigation is an inevitable side effect of the wave. The Delaware court seem increasingly committed to making sure it is clear they are in charge.

A detailed discussion of the Topps decision can be found in this May 15, 2007 memorandum by the Potter Anderson & Corroon law firm, here.

A May 20, 2007 news article in the Wilmington News Journal discussing the Topps case can be found here. A May 17, 2007 post on the Harvard Law School Corporate Governance blog about the competition between states with respect to corporate law can be found here. Professor Larry Ribstein has an interesting commentary on the Topps decision in his Ideoblog (here).

In a recent post (here), I noted that the “internal affairs doctrine” may pose substantial hurdles for investors filing derivative actions in U.S. courts against foreign domiciled corporations.

You're the Topps, You're the Coliseum: According to Wikipedia (here), the recent takeover attempt is not the Topps company's first going private experience. The company first went public in 1972, but was acquired in a leveraged buyout in 1984 by Forstmann Little & Company. The company again went public in 1987. The latest takeover attempt is led by Michael Eisner. It will probably only be a matter of time before the company is once again taken public.

Topps of course makes the famous baseball trading cards (for details about which refer here). Bazooka bubble gum , which Topps also makes, originated the bubble gum comics, starring the iconic Bazooka Joe. It is no mystery, at least not to me, why grown-up little boys keep trying to buy the whole company. I would do it if I could.

In Two Hours, Blackstone Will Be Hungry Again: When Blackstone recently announced its plan to sell shares in an inital public offering (here), it seemed like the whole private equity thing had to have reached some kind of a peak. But now comes the announcement that China will invest $3 billion of its $1.2 trillion in reserves in an 9.9% equity position in Blackstone (here). Even though as part of the deal China agreed that it would not invest in a rival private equity firm for twelve months, it is hard to disagree with the Financial Times' assessment (here) that "the decision suggests China is testing the water for a much bigger investment in private equity. It could open the floodgates to a tide of money flowing into the sector at the precise moment regulators are becoming concerned it may be overheating." The private equity thing seems to have a lot further to run.

Updated Options Backdating Settlements: In a recent post (here), I took a look at a number of dismissal and settlements in options backdating-related lawsuits. In response to my post, readers brought additional settlements to my attention, which I have incorporated by updates into the original post. If any readers are aware of additional settlements, dismissals, or dismissal denials, please let me know and I will update the post as appropriate.

Paulson's Initiatives and U.S. Capital Market Competitiveness

On May 17, 2007, Treasury Secretary Henry M. Paulson, Jr. announced (here) his latest “initiatives…to enhance U.S. capital market competitiveness.” In a Financial Times op-ed piece published the same day (here), Paulson said the purposes of the initiatives were to “ensure we preserve an efficient financial reporting system that provides reliable information, is supported by a sustainable auditing industry, and has enhanced compatibility with foreign reporting requirements.”

The most substantial part of the initiatives is the commencement of two studies. One study, to be led by former SEC Chairman Arthur Levitt and former SEC Chief Accountant Donald Nicolaisen will “address auditing industry concentration” and “consider options available to strengthen the industry’s financial soundness and its ability to attract and retain qualified personnel.” The second study will “analyze the factors driving financial restatements and their impact on investors and financial markets.”

The rise in the number of restatements, up from 116 in 1997 to 1,876 in 2006 (or one for every ten public companies), is a point of particular emphasis in Paulson's op-ed piece. Paulson notes that “restatements pose significant costs on our capital markets. They have the potential to confuse investors and erode public confidence in public reporting.” The volume of restatements reflects, in part, “the complexity of our financial reporting system.” The Treasury’ study is intended to complement the SEC’s efforts to reduce the complexity.

The Treasury Department also announced its support of the SEC’s and the PCAOB’s efforts to “improve the application of Section 404” of the Sarbanes Oxley Act. In his op-ed piece, Paulson states that “a more risk-based implementation will be a positive step.” Finally, the Treasury Department also expressed its support of SEC effort to effect the convergence of the U.S. GAAP and International Financial Reporting Standards, and eliminating the U.S. GAAP reconciliation requirements by IFRS-reporting foreign companies by 2009.

With their proposal for a couple of studies and their expression of support for SEC proposals, the Treasury initiatives are strikingly modest. (To be sure, the recent announcement took great pains to emphasize that this is only the first salvo; the Treasury announcement specifically notes that "Secretary Paulson will continue to provide follow up steps to other ideas.") But even if the initiatives themselves are modest, it seems fair to ask whether their underlying premise is overstated, or even valid. That is, while Paulson and others (refer here) are fretting loudly about U.S. capital markets’ competitiveness, the markets are busy surging ahead.

According to news reports (here), total U.S. capital markets equity underwriting of common and preferred stock during the first quarter of 2007 rose 42.6 percent compared with the prior year period, and raised $61.4 billion in connection with 202 deals. Corporate bond issuance rose during the first quarter to a record $308 billion, up 23.6 percent from the first quarter of 2006. According to a PricewaterhouseCoopers report (here), U.S. IPO activity during the first quarter of 2007 was at its highest first quarter level in 7 years. During the first quarter of 2007, there were 64 IPOs that raised $12.1 billion, compared to 54 deals that raised $11.6 billion during the first quarter of 2006. And as I have noted in prior posts (most recently here), foreign companies continue to be attracted to U.S. capital markets, contrary to the contention of the would-be reformers.

There may or may not be good reasons for the various studies Paulson has launched, and there is no harm at taking a closer look at things. But to the extent reform proposals emerge that are premised on the supposed declining competitiveness of the U.S. capital markets, there is reason to be skeptical, if not concerned. As the CFO Blog noted (here), the “whole argument” for Paulson’s Capital Market Plan is “looking kind of shaky.” While studies themselves can do no harm, the danger is the possibility of reform proposals that undermine the very things that give the U.S. markets their strength, -- that is, their justified reputation for transparency and integrity.

Whistleblower’s Lament: In prior posts (most recently here), I have examined the question whether the whistleblower protection under Sarbanes-Oxley may actually be discouraging fraud detection. Anyone who doubts this concern may want to review the May 18, 2007 CFO.com article entitled “Five Years Out of Work” (here). The article contains an interview with David Welch, the first person to file for whistleblower protection under Sarbanes-Oxley. After five years of unemployment and attorneys’fees of over a half million dollars, his case if far from over and seems likely to have years left to run. His conclusion?: “ If you are a whistleblower and you have no money, you have to stop. The deep pockets of corporations can starve out an unemployed whistle-blower.”

As I noted in a prior post (here) discussing Welch’s case, the Sarbanes-Oxley whistleblower protection may be “more theoretical than real.”

More Options Backdating Lawsuit Dismissals and Settlements

In prior posts, I have tracked options backdating lawsuit dismissals (refer here) and settlements (refer here). Over the last few days, a number of additional backdating-related lawsuit dismissals and a settlement have surfaced.

Here are the dismissals:

Computer Sciences Corp.: On March 26, 2007, the United States District Court for the Central District of California dismissed the backdating-related derivative complaint that had been filed against certain of Computer Sciences Corp.'s directors, as well as against CSC as nominal defendant. The Court found that because four of the six director defendants had neither approved nor received the allegedly backdated options, the plaintiffs had failed to allege facts to show that a majority of CSC’s board faced a substantial likelihood of liability. The Court dismissed the plaintiffs’ complaint for failure to establish demand futility. The CSC dismissal is described in a May 8, 2007 memorandum by the Bingham McCutchen law firm, here. (The CNET dismissal that is also described in the linked document was previously discussed in The D & O Diary, here.)

Novellus: As disclosed in Novellus’ May 10, 2007 filing on Form 10-Q (here), on March 23, 2007, the Court dismissed the options backdating shareholders’ derivative lawsuit that had been filed against certain members of the Novellus board, as well as against the company itself as nominal defendant. The dismissal gave the plaintiffs until May 3, 2007 to seek to amend the complaint. On May 2, 2007, according to the 10-Q, “the plaintiffs voluntarily dismissed the case without prejudice.” According to Novellus’ defense counsel (quoted here), the Lerach Coughlin firm dropped the lawsuit because they “had nothing” to build a case on.

Xilinx: According to Xilinx’s February 2, 2007 10-Q (here), on January 8, 2007, the U.S. District Court for the Northern District of California dismissed with prejudice the consolidated shareholder derivative lawsuit that had been filed against members of the company’s board and certain of the company’s officers. The Xilinx dismissal was also a voluntary dismissal.

The Xilinx and Novellus dimissals are discussed in a May 15, 2007 Marketwatch article entitled “Why The Lawsuits Over Options Backdating Are Failing" (here).

The options backdating lawsuit settlement that recently surfaced related to federal and state court shareholders’ derivative lawsuits that had been filed against certain directrors and officers of J2 Global Communications, as well as against the company itself as nominal defendant. According to J2’s May 9, 2007 filing on Form 10-Q (here), on March 19, 2007, the parties to both the federal and state derivative actions “entered into a settlement agreement that provides for dismissal of the four derivative cases and a release of all current and potential claims relating to our stock option granting practices.” The 10-Q does not describe the terms of the settlement, but according to reliable sources, the settlement involved corporate governance changes and the payment of plaintiffs’ attorneys’ fees of $625,000.

UPDATE: In response to this post, readers brought a couple of additional options backdating-related derivative settlements to my attention:

Dean Foods: In its May 10, 2007 filing on Form 10-Q (here), Dean Foods disclosed that it had settled the two options backdating related shareholders derivative lawsuits against certain current and former directors and officers. The company said in its 10-Q that "the derivative actions were settled in the first quarter of 2007. The settlement resolves all claims and includes no finding of wrongdoing on the part of any of the defendants and no cash payment other than attorneys’ fees. The Company has agreed to adoption and implementation of stock option grant procedures that reflect developing best practices. The district court approved the settlement and the actions were dismissed." A newspaper article discussing the Dean Foods settlement can be found here.

Molex: In its April 30, 2007 filing on Form 10-Q (here), Molex disclosed that the settlement of the shareholders derivative lawsuit that had been amended to include allegations of options backdating. In its 10-Q, Molex said that following about the amended lawsuit and the settlement: "In November 2006, plaintiffs filed a further amended complaint that added allegations that stock options were priced and issued improperly. The parties reached a settlement in principle of this action in February 2007. The settlement received final approval by the court on April 20, 2007. The settlement included an award of attorneys’ fees funded by insurance proceeds and the Board’s commitment to maintain certain corporate governance measures."

Special thanks to a loyal reader for the information about the J2 settlement. Thanks to yet another alert reader for the links to the Molex and Dean Foods settlements.

Tyco Settlement Observations: Tyco’s May 15, 2007 announcement (here) of its massive $2.975 billion securities class action settlement has garnered extensive media attention. The Wall Street Journal’s article about the settlement can be found here (subscription required) and the New York Times’ article about the settlement can be found here.

I was struck by a couple of things that were not mentioned either in Tyco’s announcement or in the press coverage. First, there is no reference in any of the discussion of the settlement to Tyco’s D & O insurance. To the contrary, Tyco’s press release states that “the company will incur a charge of $2.975 billion in the current quarter.” This certainly suggests that the company expects to eat the whole thing. It is entirely possible that the D & O coverage has been exhausted by litigation expense and the resolution of other matters, but it is striking that apparently none of the securities class action settlement will be covered by insurance.

Second, by contrast to the WorldCom and Enron settlements, the Tyco settlement does not, at least according to the publicly available information, seem to involve any payment by Tyco’s outside directors. To be sure, claims against criminally convicted former CEO Dennis Kozlowski and former CFO Mark Swartz will go forward, as will claims against former director Frank Walsh, who received a secret $20 million payment for helping arrange a merger and pleaded guilty to securities fraud. But the other former Tyco directors do not appear to have been required to contribute toward the class action settlement, unlike the Enron and WorldCom outside directors who had to contribute to settlement without recourse to insurance or indemnity.

It will be interesting to see if investors choose to participate in the class settlement or instead choose to opt out of the class and pursue individual claims. After all the publicity attending the improved percentage of investment loss that the opt outs from the Time Warner settlement recovered over what they would have recovered by remaining in the class (refer here), investors may well consider whether to pursue opt out claims rather than participate in the Tyco settlement.

The 10b-5 Daily's post about the Tyco settlement can be found here.

The Cardinal Health Settlement: The Tyco settlement comes close on the heels of another massive settlement, the $600 million Cardinal Health settlement (refer here). According to Cardinal Health's May 8, 2007 filing on Form 10-Q (here), on May 2, 2007, the company's board approved a memorandum of understanding regarding the settlement, subject to approval by the plaintiffs' class representatives and the Court. Cardinal previously established a $600 million reserve to cover the cost of the settlement. But Cardinal's 10-Q also discloses that it is involved in litigation with its insurance carrier, in which the carrier disputes coverage for the securities class action lawsuit as well as for related shareholders' derivative and ERISA lawsuits. Cardinal says in its 10-Q with respect to the insurance coverage litigation that "the Company currently believes that there will be some insurance coverage available under the Company’s insurance policies."

The Cardinal Health settlement stands out, because unlike Tyco, Enron and WorldCom settlements, the underlying case was not really a part of the massive wave of corporate fraud that followed the stock market collapse in the early part of this decade. The Cardinal Health securities lawsuit was not filed until 2004, well after the enactment of the Sarbanes Oxley Act, and relates to accounting allegations specific to that company (refer here for a description of the Cardinal Health securities lawsuit). The Cardinal Health settlement may suggest that the higher level of securities class action severity is not exclusively an attribute of the cases arising out of a narrow set of pre-SOX corporate scandals, but rather may reflect higher overall severity levels. Certainly, the average severity for 2007 settlements will remain at elevated levels as a result of these settlements.

Hat tip to The 10b-Daily (here) for the Cardinal Health settlment links.

2006 PwC Securities Litigation Study: In a prior post (here), I reported on the 2006 PricewaterhouseCoopers 2006 Securities Litigation Study. At the time I created that post there was no link available for the Study, but the Study is now available online (here). I discussed the 2006 PwC Study in my prior post.

If Foreign IPOs Are Booming, Do We Still Need Reform?

In recent months, several blue ribbon panels, concerned about the competitiveness of the U.S. securities markets, have proposed reforming U.S. securities regulation, on the theory that the regulatory burden that has driven overseas companies to list their shares outside the U.S. As I have discussed at length previously (most recently here), there are a host of reasons why overseas companies have been list their shares on other exchanges. But despite all of these reasons driving the growth of other countries’ markets, there nevertheless seems to be a continuing and arguably growing interest among overseas companies, particularly Chinese companies, to list their shares on U.S. exchanges.

According to the May 11, 2007 Financial Times article entitled “Chinese Listing Influx Begins” (here, subsciption required), 35 Chinese companies expect to list on U.S. exchanges this year, as many as listed in the last three years combined. Three Chinese companies – Qiao Xing Mobile, Acorn International and LDK Solar – together expect to raise $1 billion in U.S. listings.

A second May 11, 2007 Financial Times article entitled “New York Proves an Attractive Destination” (here) explains that the reason for the influx of Chinese companies is that “a pipeline of private equity and venture capital investments, mostly made by U.S. based funds…have reached maturity.” These companies are drawn to the U.S. markets and are not deterred by U.S. regulations because “despite Sarbox, they can still get better valuations and wider analyst coverage … than in the resurgent Chinese domestic markets or in other parts of the world.” Chinese companies have been drawn to the U.S., according to one commentator, because “they were looking to establish their brand internationally and nothing matches that like a U.S. listing.”

As one source quoted in an April 4, 2007 Law.com article entitled “Law Firms Compete for Chinese Companies’ IPO Action” (here) put it, “in China, everyone wants to get registered to raise funds in the public markets in the U.S.” A U.S. listing, another commentator in the article notes, “provides legitimacy and transparency.”

A prior post on the "healthy" U.S. market for foreign IPO market can be found here.

The Chinese companies’ perception that they will enjoy a better valuation on the U.S exchanges is supported by recent academic research. According to an April 2007 paper by Craig Doidge of the University of Toronto and George Andrew Karolyi and Rene Stulz of the Ohio State University entitle “Has New York Become Less Competitive Over Time? Evaluating Foreign Listing Choices Over Time” (here), there is a significant valuation premium for U.S. exchange listings, and the premium did not decline after the passage of SOX. The article go on to state that “all of our evidence is consistent with the theory that there is a distinct governance benefit for firms that list on the U.S. exchanges.” An April 27, 2007 Wall Street Journal article entitled “Maybe U.S. Markets Are Still Supreme” (here, subscription required) discusses the academics' research.

As I have previously argued (most recently here), the would-be reformers' case for regulatory reform is “weak.” But if, as further evidence increasingly seems to substantiate, overseas companies on balance find U.S. markets preferable to other markets, the case for reform goes from weak to nonexistent.

All of this underscores a point I have frequently made, that Wall Street may be attempting to use the effects of the evolving global financial marketplace as a pretext to undermine regulatory requirements that occasionally prove to be uncomfortable because they actually have teeth. The would-be reformers may claim that they seek to advance U.S. competitiveness, but anything that weakens 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 highly regulated.

Over There, Over Here: As I have also frequently noted, overseas investors are becoming much more accustomed to using litigation as a means to hold management accountable. Further evidence of this can be found in a May 2007 Institutional Investor Services paper entitled “Accountability Goes Global: International Investors and U.S. Securities Class Actions” (here) takes a look at the growing role of overseas institutional investors as lead plaintiffs in U.S. securities class actions.

Among other things, the paper notes that “in every year since 2002, international institutional investors have filed lead plaintiff motions in more than 5% of all securities class actions,” including not only suits against companies that are domiciled in their home countries, but also suits against U.S.-based companies. The international institutional investors, drawn from 17 countries, sought to serve as lead counsel in 182 cases between 1996 and March 31, 2007.

The paper was written by Adam Savett, who also maintains the Securities Litigation Watch blog (here).

Hat tip to the 10b-5 Daily (here) for the link to the ISS paper.

Rating Agencies and the Subprime Lending Meltdown

AIG’s announcement on May 10, 2009 (here) that it was taking a $128 million charge to allow for write-downs on subprime loans issued by its savings banking division illustrates how widespread the fallout from the subprime lending collapse is, and suggests the possibility that there may be further reverberations across the business economy ahead.

A May 2007 draft paper by Joseph Mason of Drexel University and Joshua Rosner of Graham Fisher & Co., entitled “Where Did the Risk Go? How Miapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruprtions” (here), attempts to explain how subprime lending became so widespread, how rating agencies helped fuel that growth, and how rating agencies conflicts and involvement in the deal process may have led to the understatement of risk involved for investors buying instruments backed by subprime loans. The authors also suggest a possible direction future litigation involving the rating agencies might take.

The lenders who originated subprime loans sought ways to shift these assets off their balance sheets. The likeliest buyers for these kinds of assets, pension funds and insurance companies, are required to invest in only investment grade securities. In order to sell subprime loans to these institutional investors, a number of mortgage backed instruments, including in particular collateralized debt obligations (CDO) were created from pools of subprime loans. The indispensable element for the success of these instruments was the willingness of the rating agencies to grant investment grade ratings to the instruments.

According to the authors, the rating agencies became very involved in the deal making process. And no wonder, because the issuers paid the rating agencies for the ratings. The business of rating CDOs and other mortgage backed securities became a very important part of the rating agencies’ business. For example, according to Fortune (here) Moody’s net income “went from $159 million in 2000 to $705 million in 2006, in part because of increases in fees from ‘structured finance.’”

The authors point out that the rating agencies’ role was not passive and not limited simply to expressing an opinion on creditworthiness. By the rating agencies own analysis, their role was “iterative and interactive,” and consisted of informing issuers of the “requirements to attain the desired ratings in different tranches and largely defining the requirements of the structure to achieve target ratings.” In other words, the rating agency helped the issuers to structure the deal so that the agencies could give the deal an investment grade rating which, once obtained, entitled the issuer to sell the instruments to institutional investors.

The ability to sell subprime loans as investment grade assets fueled enormous growth in the subprime loan industry. This in turn created greater access to credit for potential homebuyers, which in turn cause home prices to rise, which allowed the mortgage pools to show a very low default rate, which reinforced the apparent validity of the alchemy that transformed subprime loans into investment grade securities.

But the recent downturn in the residential real estate market and the deterioration of the subprime mortgages threatens this arrangement. Nevertheless, so far, the rating agencies have downgraded only a very small portion of the mortgage-backed securities. There may well be very good reasons for this, but one possibility that suggests itself if that the rating agencies are concerned about the cascading effects that would follow widespread downgrades. The investors who hold instruments would have to divest assets that fell below investment grade. This in turn would cause prices for these securities to plummet. The authors suggest that if home prices deteriorate further, CDOs and other instruments could cause “significant losses.” If the market for these instruments were to withdraw, a “major source of liquidity will evaporate,” leading to a tightening of credit, which creates the “potential for prolonged economic difficulties that could interfere with home ownership in the U.S.”

If investors lose significant money on assets they purchased in the belief that they were acquiring investment-grade investments, the authors believe that “among the possible responses” will be litigation against many of the parties involved, including the rating agencies. In the past, when rating agencies have been sued (for example, in connection with the Orange County bond default), they have successfully argued that their rating activities were protected by the First Amendment, as mere opinions of creditworthiness. But he authors argue that the rating agencies indispensable role in the creation of these mortgage backed securities, including in particular their “interactive” involvement in the structuring of the deals, made them participants in the transaction. This, according to the authors, suggests that there “does seem to be some basis to consider" that the rating agencies may have liability as “underwriters” under Section 11 of the Securities Act.

A May 11, 2007 Financial Times article entitled “Rating Agencies Could Be Liable for Losses” (here), discusses the author’s analysis further. A March 19, 2007 Fortune article entitled "The Dangers of Investing in Subprime Debt" can be found here.

Whether or not litigation against the rating agencies ultimately emerges or is successful, the larger threat of the collapse of the market for mortgage backed securities is a concern. Between 2003 and 2006, nearly a trillion dollars of CDOs were issued ($500 billion in 2006 alone). The deterioration of these assets could cause substantial investment losses for investors. And, as the authors point out, the availability of credit could be seriously affected.

To bring all of this back to the beginning, this analysis shows that there are many potentially significant ways the subprime lending collapse could unfold. While only time will tell, there certainly are a sufficient number of reasons to be concerned – and for The D & O Diary to continue to keep track of subprime lender lawsuits (here).

Blog Bites Man: It was one year ago this week that, in a fit of optimism and naïveté, I launched The D & O Diary. When I started this venture, I had no idea where it would lead. Armed only with a desire for self-expression and a healthy sense of adventure and curiosity, I took the plunge. It has been an amazing, eye-opening ride.

One of the great discoveries along the way has been finding out about the social and support network among bloggers. It has really been interesting getting to know or communicating with fellow bloggers such as Adam Savett of the Securities Litigation Watch, Broc Romanek of the CorporateCounsel.net, Susan Mangiero of the Pension Risk Matters blog, Lyle Roberts at the 10b-5 Daily, Bruce Carton at the Best in Class blog, Sam A. Antar at the White Collar Fraud blog, Francis Pileggi at the Delaware Corporate and Commercial Litigation blog, and Werner Kranenburg at the With Vigour and Zeal blog. There have been many other bloggers far too numerous to recount here with whom I have communicated or corresponded during the year. It has truly been a pleasure interacting with my fellow bloggers.

In addition to other bloggers, the blog has also brought me into contact with interesting and interested readers from around the world. Some of my favorite blog posts originated as comments or links provided to me by one of my readers. I am very grateful to everyone who has communicated with me and I hope readers out there will continue to send me their thoughts, comments, suggestions and links.

One aspect of my readership which I truly had not anticipated is its cosmopolitan composition. While it is not surprising that I might have readers in, say, France or Italy, I do find myself wondering exactly what it is about my blog that interests readers in, say, Mongolia, Suriname, Vietnam, Ghana, Moldova or Kyrgyzstan? The Internet is an amazing thing….

Portrait of an Artist as a Young Blogger: There are those benighted souls who might dare to question the ultimate value of an ephemeral occupation like blogging. Admittedly, it might later be said of our age of blogging, as Edward Gibbon said of the state of Roman literature after the age of the Caesers, "[a] cloud of critics, of compilers, of commentators darkened the face of learning, and the decline of genius was soon followed by a corruption of taste." What is blogging after all but criticism, compilation, and commentary, and of a particularly self-indulgent variety to boot?

But even if blogging is mere self-indulgent compilation and commentary, it serves a deep need for self-expression, and fulfills the spirit of inquiry that lives within all of us. Might we not say, to paraphrase David Hume’s comment on philosophizing, that if a man reaped no advantage from blogging, "beyond the gratification of an innocent curiosity, yet ought not even this to be despised, as being as accession to those few safe and harmless pleasures which are bestowed on the human race." If blogging is self-indulgent, if it is mere compilation and commentary, it at least affords a safe and harmless means to gratify innocent curiosity – for author and reader alike.

And for those readers who may have already observed that the preceding two paragraphs represent prime examples of self-indulgent compilation and commentary, to you are vouchsafed the deeper truths of the inner blogosphere.