Another High Profile Corruption Investigation Underscores a Growing Area of Potential D & O Risk
With its announcement (here) that it is the target of a Department of Justice antibribery investigation, BAE Systems added its name to the growing list of foreign-domiciled companies targeted by U.S. officials for alleged violations of U.S. anticorruption laws. The recent high-profile investigation of Siemens (about which refer here), as well as investigations involving Total, the French oil company, and Magyar Telecom of Hungary, not to mention a long list of domestic companies, are all part of an increasingly tough stance by U.S. regulators and prosecutors toward allegedly corrupt business activities.
The BAE disclosure says that the U.S. investigation relates “to the company's compliance with anticorruption laws including the company's business concerning the Kingdom of Saudi Arabia." News reports (here) state that the investigation involves a 20-year old transaction involving the Al-Yamamah Saudi arms deal, and encompasses two areas of activities. The first is the alleged use of a supposed slush fund that BAE used to transfer tens of millions of dollars of hospitality benefits to Saudi officials. The second is the allegation that Prince Bandar bin Sultan, the former Saudi ambassador to Washington, received a total of up to 1 billion British pounds in the form of deposits to a Saudi embassy bank account at Riggs Bank in Washington, D.C. In addition to the Department of Justice investigation, the Financial Times reports (here) that BAE is also the target of an SEC investigation focused on potential violations of the books and records provisions of the Foreign Corrupt Practices Act (FCPA).
The British government previously brought a halt to an investigation by the Serious Frauds Office because of national security concerns. (Saudi Arabia apparently threatened to end intelligence collaboration with Great Britain if the investigation continued.) Beyond these concerns, there are additional complications to the circumstances under investigation. The first is that the Saudi government’s relation the Saud royal family is highly interwoven, creating a complicated issue over the question, for example, of who rightfully was the beneficiary of the deposits to the Riggs Bank account. And while Prince Bandar undoubtedly was, as the Saudi Ambassador to Washington, and as Saudi Arabia's current national security chief, a government official, it could prove very difficult to show that even very large amounts of cash actually bought influence, since he is a an extremely wealthy person (his 56,000 sq. ft. Aspen mansion is on sale for $135 million).
But while there are these complicating factors, it is apparently not a constraint on any enforcement action against BAE that it is foreign domiciled and the alleged corrupt activity aimed at influence outside the U.S. Even if the involvement of the Riggs bank account were not a sufficient nexus, the U.S. authorities have already demonstrated their willingness and ability to pursue foreign domiciled companies for corrupt activities abroad. Indeed, last year, the Department of Justice forced Statoil, the Norwegian state oil company, to pay a $21 million fine for bribery activities involving Iranian government officials, even though the company had already paid a $3 million fine in connection with a Norwegian investigation. (The company did get a credit for the prior payment).
The current high profile investigations against Siemens and now BAE are significant in their own right, but the larger significance is that these two prominent cases may be that they are only a part of more than 55 public companies the Financial Times reports (here) that U.S. officials are currently investigating for overseas corruption. These investigations can of course result in fines and penalties that may be significant in and of themselves. But as I have pointed out in prior posts (most recently here), these investigations can also lead to follow on civil lawsuits alleging improper disclosures or accounting inadequacies as a result of the underlying activities or the investigations themselves.
With over 55 publicly traded companies under investigation, the possibility of follow on civil litigation could represent an increasingly significant D & O risk. These risks extend to foreign domiciled companies whose shares trade on U.S. exchanges, as well as domestic companies with significant overseas operations or activities. In an increasingly global economy, this risk could become an important part of the D & O liability exposure, particularly given the U.S regulators’ and prosecutors’ increased focus on anticorruption issues.
When it passed the Sarbanes Oxley Act in 2002, Congress' primary focus was on the transparency and governance of publicly traded companies. But the Act has turned out to have a more pervasive influence, affecting not just public companies but also private companies and nonprofit entities as well. A June 18, 2007 report (here) by a special committee of the Board of Regents of the Smithsonian Institution illustrates how extensive the influence of Sarbanes-Oxley has become, and underscores the heightened expectations for corporate governance in the post-SOX era, even at nonprofit entities.
The Smithsonian itself is an unusual creation. It was founded in 1846 as a hybrid public/private institution to receive a bequest from James Smithson. It is organized as a trust, but functions as a body of the federal government, and it in fact receives the majority of its funding from the federal government. The institution is governed by the Board of Regents, whose members include the Vice President and the Chief Justice of the Supreme Court.
Even though the Smithsonian is a unique institution, earlier this year it found itself facing the kind of crisis that has become all too familiar for institutions and entities across the economy. A February 2007 series of articles in the Washington Post questioned the lavish compensation and spending habits of the Institution’s then-Secretary, Lawrence Small. (As a result of the controversy following this publicity, Small resigned as the Institution’s Secretary on March 26, 2007.) The Institution’s Board commissioned a special investigative committee to look into the concerns. The committee consisted of Charles Bowsher (former Comptroller General and head of the GAO), Stephen D. Potts (fomer director of the U.S. Government Office of Government Ethics) and A.W. "Pete" Smith (former head of the Private Sector Council and also former head of Watson Wyatt Worldwide). The Committee issued its Report on June 18.
The Committee’s Report provides interesting detail surrounding Small’s compensation and corporate spending habits, as well as his insular and imperious management style. News coverage discussing the Report’s findings regarding Small’s compensation, spending and management style can be found here and here. But perhaps even more interesting aspect of the Report is the Committee’s comments and observations on nonprofit corporate governance in the post-SOX era.
The Committee’s governance commentary derives from its observation that “the root cause of the Smithsonian’s current problems can be found in failures of governance and management.” The Committee specifically observed that “as a result of the corporate scandals of the early part of this decade and the adoption of the Sarbanes-Oxley Act of 2002, boards of directors have become increasingly active,” and “many nonprofit institutions have also updated their governance practices following the adoption of Sarbanes-Oxley.” The governance structure of the Smithsonian, the committee found, needs “comprehensive reform,” a process to which the Institution’s Regents “must devote substantial time and resources over the next several months.”
Many of the Committee’s suggested reforms are narrowly targeted to the issues of setting and monitoring the Smithsonian’s Secretary’s salary and spending. The Report also contains numerous recommendations to revise the Board of Regents' composition and process to better position the Board to function more consistently with current governance best practices. The Committee recommended modifying the Institution’s board governance structure, so that the Smithsonian is “run by a governing board whose members act as true fiduciaries and who have both the time and the experience to assume the responsibilities of setting strategy and providing oversight.” The Committee also stated that the Institution’s “system of internal controls and audit needs to be strengthened through additional resources, adoption of best practices, and retention of personnel with substantial experience in the financial and audit area.” The Smithsonian is far from the typical nonprofit entity, but the problems it faces and the governance reforms it must implement represent increasingly common challenges for nonprofit entities generally. Indeed, the Committee expressly recognized that the Smithsonian’s challenges present issues with implications for all nonprofit entities. The Committee further noted that the increased scrutiny and expectations for transparency raise “the issue of effective management of nonprofits and how governance at these entities should be structured, the responsibilities of their boards of directors and trustees and how oversight of these organizations should be provided.”
The Committee commented that “boards of nonprofits – especially large nonprofits – should move to reform their governance structures to bring them in line with best practices.” While some nonprofits have made progress, others have not, about which the Committee commented that “failure to take voluntary action will likely lead, ultimately, to action by Congress, state legislatures, and the courts to impose reforms from without, just as was done in the case of the corporate world.”
Even without the Committee’s warning about possible legislative or judicial mandates, nonprofit entities have sufficient motivation to address heightened governance and transparency expectations. Well-advised entities are already taking steps to implement reforms addressed to governance, financial controls and reporting, and oversight.
There are a number of good resources on the meaning of SOX for nonprofit entities, a few of which may be found here and here. My recent article on the implications of Sarbanes-Oxley for private companies can be found here.
One final observation is that it is not at all surprising that the Smithsonian’s present challenge, like so many that have arisen in the for-profit world, derives from issues surrounding executive compensation. For whatever reason, executive compensation seems to be the bane of all organizations, regardless of their profit orientation. For that reason, the effective and well-documented regulation of executive compensation should be an indispensable part of any organization’s institutional reform.
The Smithsonian Still Has Hope: For all of its present ills, the Smithsonian remains the repository of many of the world’s irreplaceable treasures. A favored childhood memory of a visit to the Smithsonian includes a visit to the Museum of Natural History’s Gem Collection, which houses the astonishing Hope Diamond. According to popular legend, the Hope Diamond carries a curse that brings misfortune on its owner. Among the unfortunate who supposedly have suffered as a result of the curse is Louis XVI, who gave the diamond to Marie Antoinette. Their enjoyment of the diamond's ownership was, shall we say, cut short.
The Supreme Court has issued its much-anticipated opinion in the Tellabs case. The opinion can be found here. The case examined the question of what a plaintiff is required to plead under the Private Securities Litigation Reform Act (PSLRA) in order to establish a "strong inference" that the defendant acted with the requisite mental state. The Court's opinion, written for an 8-1 majority by Justice Ruth Bader Ginsburg, rejected both the Seventh Circuit's standard (by which the statute's requirements could be met if the complaint alleged facts "from which, if true, a reasonable person could infer that the defendant acted with the required intent") and the more demanding standard sought by the SEC in its amicus brief (urging the Court to require plaintiff to allege facts that establish a "high likelihood" that the plaintiff acted with intent).
The Court held that to qualify as "strong" an inference of scienter "must be more than merely plausible or reasonable -- it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." The Court specifically held that in considering whether an inference is "strong," a court must consider competing inferences, something which the Seventh Circuit had expressly declined to do. The inquiry, the Court said, is "inherently comparative." The inference "need not be irrefutable," but "it must be more than merely 'reasonable' or 'permissible' -- it must be cogent and compelling, thus strong in light of other explanations." A complaint should survive a motion to dismiss only if "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inferences one would draw from the facts alleged."
In looking at the Tellabs case itself, the Court noted that "motive can be a relevant consideration" and that "personal financial gain may weigh heavily in favor of a scienter inference" but the Court also agreed that "the absence of a motive allegation is not fatal." The significance of an allegation of motive "depends on the entirety of the complaint." The court's job "is not to scrutinize each allegation in isolation but to assess all the allegations holistically." The court's job is to ask: "When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?"
While the Supreme Court says that the district court must weigh competing inferences, the Court rejected the Seventh Circuit's suggestion that this type of comparative process usurps the jury's role and violates the Seventh Amendment: "A Court's comparative assessment of plausible inferences, while constantly assuming the plaintiff's allegations to be true, we think it plain, does not impinge upon the Seventh Amendment right to a jury trial."
With respect to the Tellabs case, the Court said that neither the District Court nor the Seventh Circuit "had the opportunity to consider the matter in light of the prescriptions we announce today." The Court vacated the Seventh Circuit's judgment and said that the case should be reexamined in accord with the Court's construction of the PSLRA.
Even though the Court rejected the Seventh Circuit's standard, the Supreme Court's opinion does not go quite as far as the SEC and others may have hoped. Although the Supreme Court requires the court to weigh inferences, it does not require the inference the plaintiff urges to be the most plausible inference, only that it be at least as plausible as other inferences. A Wall Street Journal article discussing the opinion (here) quotes Barbara Hart of the Labaton Sucharow & Rudoff law firm as saying "these are the types of cases we are bringing already; our cases already meet this standard."
The Court clearly aimed to achieve a balanced approach. It described its task in ruling on the Tellabs case as being to "prescribe a workable construction of the 'strong inference' standard" and to come up with "a reading geared to the PSLRA's twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims." And while the majority accepted the notion that trial courts must weigh inferences in determining whether the PSLRA's requirements must be met, it expressly rejected the position urged by Justices Scalia and Alito that "the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence." (Italics in Justice Scalia's original concurring opinion) The majority's rejection of this heightened standard is consistent with the Court's stated goal of prescribing a workable construction that balances the "twin goals" of the PSLRA.
Because the Court deliberately strove for a balanced approach based on a "workable construction," it seems unlikely that this decision will have an outcome-determinative impact on a significant number of future securities suits, and even less of an impact on whether or not suits get filed. The heightened standard that Justices Scalia and Alito urged might well have had a more significant impact, but the majority's approach seems less likely to affect as many cases. The early commentary seems consistent with this view. For example, the Business Law Prof blog notes (here):
The majority standard is not what the defense bar wanted; they wanted the standard of the concurring judges, which the court rejected. This is not a defense bar victory; it is a draw at best. Reporters will fail to get this correct and will rack this up as another victory for corporate American; it is not. The majority held, importantly, that the pleading standard was not higher that the standard of proof required at trial; the defense bar argued that Congress so intended it to be higher. This is a big difference.
the decision should not be viewed as a clear victory for either side. Rather, the decision reflects a balance between the competing interests Justice Ginsburg sought to reflect in her opinion, permitting meritorious classes to proceed, but weeding out those that lack merit... In the standard adopted today, the Court blended together the requirement that plaintiff plead a cause of action properly and the heightened pleading requirements of the PSLRA. At the same time, the Court rejected definitions of “strong inference” that would have made it virtually impossible to plead such a case. Overall, it was a balanced decision by the Court.
The WSJ.com Law Blog has a round up of securities lawyers' views on the Tellabs opinion (here), and they all seem to be consistent that while the Tellabs defendants successfully got the Seventh Circuit opinion thrown out, the decision is not a huge victory for defendants generally. While the Tellabs case will undoubtedly define where the battle lines will be drawn at the pleading stage in future securities litigation, the decision may not have as significant impact as it might have.
The 10b-5 Daily blog has a good summary of the case, here.
The Case of the Stolen Jade Falcon: An interesting sidelight is the interplay between majority and concurring opinions discussing Justice Scalia's concurring opinion's use of the example of the stolen jade falcon. Justice Scalia's concurring opinion asks "If a jade falcon were stolen from a room to which only A and B had access, could it possibly be said that there was a 'strong inference' that B was the thief?"
Justice Ginsburg responds (in footnote 5) that "I suspect...that law enforcement officials as well as the owner of the precious falcon would find the inference of guilt as to B quite strong --certainly strong enough to warrant further investigation."
Justice Scalia, committed to getting in the last word on the fabulous stolen jade falcon, responds (in a footnote to his opinion) the "it is quite clear (from the dispassionate perspective of one who does not own a jade falcon) that a possibility, even a strong possibility, that B is responsible is not a strong inference that B is responsible."
There is also a vigorous verbal volley between Justice Scalia and Justice Stevens, whose lone dissent urged adoption of the Seventh Circuit's more permissive standard. Justice Stevens characterized the standard Justice Scalia urges as "clearly wrong" and Justice Scalia referred to Justice Stevens as "mistaken." The WSJ.com law blog captures this exchange, here.
An apology to all of my readers: This blog comment was originally posted yesterday at 11:30 am but my syndication service was offline due to technical difficulties until early this morning, so I have reposted it to facilitate the syndication emails.
The Supreme Court has issued its much-anticipated opinion in the Tellabs case. The opinion can be found here. The case examined the question of what a plaintiff is required to plead under the Private Securities Litigation Reform Act (PSLRA) in order to establish a "strong inference" that the defendant acted with the requisite mental state. The Court's opinion, written for an 8-1 majority by Justice Ruth Bader Ginsburg, rejected both the Seventh Circuit's standard (by which the statute's requirements could be met if the complaint alleged facts "from which, if true, a reasonable person could infer that the defendant acted with the required intent") and the more demanding standard sought by the SEC in its amicus brief (urging the Court to require plaintiff to allege facts that establish a "high likelihood" that the plaintiff acted with intent).
The Court held that to qualify as "strong" an inference of scienter "must be more than merely plausible or reasonable -- it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." The Court specifically held that in considering whether an inference is "strong," a court must consider competing inferences, something which the Seventh Circuit had expressly declined to do. The inquiry, the Court said, is "inherently comparative." The inference "need not be irrefutable," but "it must be more than merely 'reasonable' or 'permissible' -- it must be cogent and compelling, thus strong in light of other explanations." A complaint should survive a motion to dismiss only if "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inferences one would draw from the facts alleged."
In looking at the Tellabs case itself, the Court noted that "motive can be a relevant consideration" and that "personal financial gain may weigh heavily in favor of a scienter inference" but the Court also agreed that "the absence of a motive allegation is not fatal." The significance of an allegation of motive "depends on the entirety of the complaint." The court's job "is not to scrutinize each allegation in isolation but to assess all the allegations holistically." The court's job is to ask: "When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?"
While the Supreme Court says that the district court must weigh competing inferences, the Court rejected the Seventh Circuit's suggestion that this type of comparative process usurps the jury's role and violates the Seventh Amendment: "A Court's comparative assessment of plausible inferences, while constantly assuming the plaintiff's allegations to be true, we think it plain, does not impinge upon the Seventh Amendment right to a jury trial."
With respect to the Tellabs case, the Court said that neither the District Court nor the Seventh Circuit "had the opportunity to consider the matter in light of the prescriptions we announce today." The Court vacated the Seventh Circuit's judgment and said that the case should be reexamined in accord with the Court's construction of the PSLRA.
Even though the Court rejected the Seventh Circuit's standard, the Supreme Court's opinion does not go quite as far as the SEC and others may have hoped. Although the Supreme Court requires the court to weigh inferences, it does not require the inference the plaintiff urges to be the most plausible inference, only that it be at least as plausible as other inferences. A Wall Street Journal article discussing the opinion (here) quotes Barbara Hart of the Labaton Sucharow & Rudoff law firm as saying "these are the types of cases we are bringing already; our cases already meet this standard."
The Court clearly aimed to achieve a balanced approach. It described its task in ruling on the Tellabs case as being to "prescribe a workable construction of the 'strong inference' standard" and to come up with "a reading geared to the PSLRA's twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims." And while the majority accepted the notion that trial courts must weigh inferences in determining whether the PSLRA's requirements must be met, it expressly rejected the position urged by Justices Scalia and Alito that "the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence." (Italics in Justice Scalia's original concurring opinion) The majority's rejection of this heightened standard is consistent with the Court's stated goal of prescribing a workable construction that balances the "twin goals" of the PSLRA.
Because the Court deliberately strove for a balanced approach based on a "workable construction," it seems unlikely that this decision will have an outcome-determinative impact on a significant number of future securities suits, and even less of an impact on whether or not suits get filed. The heightened standard that Justices Scalia and Alito urged might well have had a more significant impact, but the majority's approach seems less likely to affect as many cases. The early commentary seems consistent with this view. For example, the Business Law Prof blog notes (here):
The majority standard is not what the defense bar wanted; they wanted the standard of the concurring judges, which the court rejected. This is not a defense bar victory; it is a draw at best. Reporters will fail to get this correct and will rack this up as another victory for corporate America; it is not. The majority held, importantly, that the pleading standard was not higher that the standard of proof required at trial; the defense bar argued that Congress so intended it to be higher. This is a big difference.
the decision should not be viewed as a clear victory for either side. Rather, the decision reflects a balance between the competing interests Justice Ginsburg sought to reflect in her opinion, permitting meritorious classes to proceed, but weeding out those that lack merit... In the standard adopted today, the Court blended together the requirement that plaintiff plead a cause of action properly and the heightened pleading requirements of the PSLRA. At the same time, the Court rejected definitions of “strong inference” that would have made it virtually impossible to plead such a case. Overall, it was a balanced decision by the Court.
The WSJ.com Law Blog has a round up of securities lawyers' views on the Tellabs opinion (here), and they all seem to be consistent that while the Tellabs defendants successfully got the Seventh Circuit opinion thrown out, the decision is not a huge victory for defendants generally. While the Tellabs case will undoubtedly define where the battle lines will be drawn at the pleading stage in future securities litigation, the decision may not have as significant impact as it might have.
The 10b-5 Daily blog has a good summary of the case, here.
The Case of the Stolen Jade Falcon: An interesting sidelight is the interplay between majority and concurring opinions discussing Justice Scalia's concurring opinion's use of the example of the stolen jade falcon. Justice Scalia's concurring opinion asks "If a jade falcon were stolen from a room to which only A and B had access, could it possibly be said that there was a 'strong inference' that B was the thief?"
Justice Ginsburg responds (in footnote 5) that "I suspect...that law enforcement officials as well as the owner of the precious falcon would find the inference of guilt as to B quite strong --certainly strong enough to warrant further investigation."
Justice Scalia, committed to getting in the last word on the fabulous stolen jade falcon, responds (in a footnote to his opinion) the "it is quite clear (from the dispassionate perspective of one who does not own a jade falcon) that a possibility, even a strong possibility, that B is responsible is not a strong inference that B is responsible."
There is also a vigorous verbal volley between Justice Scalia and Justice Stevens, whose lone dissent urged adoption of the Seventh Circuit's more permissive standard. Justice Stevens characterized the standard Justice Scalia urges as "clearly wrong" and Justice Scalia referred to Justice Stevens as "mistaken." The WSJ.com law blog captures this exchange, here.
An apology to all of my readers: This blog comment was originally posted yesterday at 11:30 am but my syndication service was offline due to technical difficulties until early this morning, so I have reposted it to facilitate the syndication emails.
In the latest manifestations of what Forbes magazine recently (here) called "the biggest buyback binge in the history of the market," both Home Depot and Expedia announced that they would undertake massive amounts of debt to buyback significant portions of their outstanding shares.
The Home Depot plan (which it announced here) is particularly mind-boggling. According to the Wall Street Journal’s June 20, 2007 article entitled "Home Depot Boosts Buyback, Sets Unit Sale" (here, subscription required), Home Depot’s plan authorizes additional share buybacks of $22.5 billion, bringing the total authorized level of share repurchases to a staggering $40 billion. This is a company with a $74.9 billion market cap. Although an asset sale will fund $10.3 billion of the newly authorized share buyback, the remaining $12.2 billion will be financed with debt.
Expedia's plan (which it announced here) is that it will repurchase as many as 117 million of its Class A shares, which represents as much as 42% of its shares, and will spend up to $3.5 billion, as much as $2.5 billion of which will be financed with debt. Expedia’s current market cap is $8.8 billion.
These companies share prices responded positively to these announcements, and there are indeed arguable benefits to these types of transactions. As the Wall Street Journal note (here, subscription required) in discussing the Expedia leveraged buyback, "reducing the outstanding stock can help a company boost per-share earnings, as the profit is divided by fewer shares. Also, interest payments on [the] debt are tax-deductible."
But not all of the effects of a leveraged buyback are beneficent or benign. As the recent Forbes article (here) commented, buybacks "give a temporary, one-time artificial boost to earnings, they cause creaky cash-poor companies to load up on debt, leaving them vulnerable should the economy unexpectedly deteriorate and they pulverize credit ratings, causing borrowing costs to soar." The credit rating concern may already have affected Home Depot; according to the Journal, Standard & Poor’s rating service and Moody’s Investor Service "both placed Home Depot’s credit ratings under review for possible downgrades."
Detailed research suggests that the buybacks, at best, may provide "a short-term steroid shot." The Forbes article quotes research from Birinyi Associates, which looked at the stock performance of 375 S & P companies that bought back shares in the six years through December 2006. Over that period, the companies’ median return post-buyback was 56%, far less than the 72% at companies that did not repurchase, and the average return post-buyback was 102%, less that then 131% at companies that did not repurchase.
Nevertheless, S & P 500 companies repurchased $432 billion of their own stock in 2006, more than triple the 2003 amount. Why are companies doing this? One guess is executive pay. The Forbes article notes that "buybacks can goose executive pay, because executive compensation is often linked to earnings per share." Indeed, the Journal article discussing the Expedia share buyback plan, in trying to understand the plan, noted that "Expedia’s proxy statement gives one explanation: Executive Compensation is pegged to, among other goals, enhancing per-share earnings. And that looks to be one result of this particular buyback." It is also probably worth noting that using share repurchases to boost executive bonus comp based on an EPS trigger is one of the practices for which Home Depot’s departed CEO Robert Nardelli was criticized, as I previously noted here.
One particularly troublesome form of share buybacks involves an aggressive, debt-financed buyback program that coincides with active insider sales. A recent study by Audit Integrity (cited in the Forbes article) identified 13 companies with market caps over $100 million that had both high levels of stock buybacks and insider selling. But the insiders sales don’t necessarily have to be contemporaneous to be troublesome; as the Forbes article notes, "insiders may be way too tempted to do buybacks so they can sell their holdings more lucratively once the buyback pushes the stock price higher."
As I discussed in my prior post (here) about Share Buybacks and D & O Risk, none of this is lost on the plaintiffs’ lawyers. Indeed, the Forbes article cites the settlement of the Sprint class action lawsuit settlement "in which Sprint agreed that it would no longer allow insiders to sell Sprint shares while the company was buying them." Sprint may have agreed to this under duress, but this requirement in fact seems like a prudent policy calculated to avoid activity that otherwise presents some troubling visuals. It should not be overlooked that this activity has already attracted the plaintiffs' lawyers attention.
The share repurchase phenomenon may eventually abate as long term interests rates rise and the era of cheap credit comes to an end. We are definitely not there yet, as the Home Depot and Expedia buyback programs announced this week demonstrate. But when the music stops, there are could be some companies, saddled with buyback-motivated debt they are unable to service, refinance or restructure, that could pay a very steep price for their "buyback binge."
Supreme Court Rejects IPO Laddering Antitrust Case
The Supreme Court still has not yet issued its much-anticipated decision in the Tellabs case (about which refer here), but it did issue a 7-1 decision today (refer here) in the Credit Suisse Securities v. Billing case, holding that the securities laws preclude application of the antitrust laws in a case filed against ten investment banks and asserting IPO laddering allegations.
The plaintiffs alleged that between March 1997 and December 2000, the defendant investment banks "abused the practice of combining into underwriting syndicates" by allegedly agreeing among themselves to impose conditions on investors who wanted access to shares in sought-after IPOs. The alleged conditions included "laddering" (requiring investors to buy additional shares in the aftermarket); "tying arrangements" (requiring investors to purchase other, less-attractive securities), and excess commissions. The plaintiffs alleged that these supposed practices violated the Sherman Act, the Clayton Act, and state antitrust laws.
The case was before the Supreme Court on the question whether or not the securities laws "implicitly preclude the application of the antitrust laws to the conduct at issue in this case." The regulation of underwriting syndicates’ behavior in connection with securities offerings is within the purview of the SEC, because it is "central to the proper functioning of well-regulated capital markets," and the law grants the SEC the legal authority to supervise the activities in dispute – a legal authority the SEC has "continuously exercised."
The court concluded that "to permit antitrust actions such as the present one threatens serious securities-related harm," particularly given the fine line that exists between permitted underwriting syndicate-building collaborative activity and prohibited collusive activity. The SEC, according to the Court, is responsible for drawing a "complex, sinuous line separating securities-permitted from securities-prohibited conduct." The Court asked "who but the SEC" could make these determinations with confidence? Without this sophisticated oversight, there is an "unusually high risk that different court will evaluate different factual circumstances differently," which would in turn "suggest that antitrust courts are likely to make unusually serious mistakes."
Under these circumstances, offering underwriters would not only steer clear of conduct the securities law forbids, "but also a wide range of joint conduct that the securities law permits and encourages (but which they fear could lead to an antitrust lawsuit and the risk of treble damages)."
The Court concluded that the need for antitrust-related enforcement is very small, since the SEC actively enforces its own existing rules prohibiting the contested conduct, and in any event, investors harmed by the disputed practices "may bring lawsuits and obtain damages under the securities laws."
This last point about the availability of remedies under the securities laws may be the most telling. Many of us who can remember the inundation of IPO laddering cases that flooded the courts in 2001 will remember the antitrust cases that also appeared as stray artifacts from a period of lawsuit-filing madness. The mad rush for a piece of the IPO laddering action led to the filing of securities cases against over 310 companies (subsequently consolidated into the IPO Laddering action, about which refer here). This antitrust case looked at the time like nothing more than an attempt to purchase by other means a piece of the litigation territory that prior plaintiffs had claimed in securities lawsuits. The Supreme Court may well have sensed this "end-run" attribute of the antitrust action, noting that "to permit an antitrust lawsuit risks circumventing [the statutory requirements of the PSLRA] by permitting plaintiffs to dress what is essentially a securities complaint in antitrust clothing."
There are several aspects of this decision that are interesting, beyond the holding itself. The first is that Justice Breyer, usually perceived as a member of the court’s liberal wing, wrote the opinion for a 7-1 majority (Justice Kennedy not participating) that cut broadly across the court’s usual political fault line. Justice Breyer has shown an interest in the past for business cases (he wrote the majority opinion in the punitive damages case earlier in the term). While this does not necessarily tell us anything one way or the other helpful to prognosticating the outcome of the Tellabs case, it does suggest that we can hope for an outcome that is at least clear-cut and that provides guidance on the pleading issues presented in the Tellabs case. (I wonder, without any basis whatsoever for so speculating, whether Justice Breyer will write the majority opinion in the Tellabs case?)
The second interesting aspect of this decision is that the Court seemed to have little trouble rejecting the compromise position advocated by the solicitor general, who advocated remanding the case to the lower court for further proceedings. This absence of deference to the government’s official position suggests that the court might not be overly swayed by the SEC’s amicus brief in the Tellabs case (refer here), which urged a narrow view of the PSLRA pleading standard. On the other hand, the majority opinion in the Credit Suisse case seems to reflect an awfully high opinion of the SEC’s expertise on securities law issues.
Good brief descriptions of the Credit Suisse decision can be found on the SCOTUS blog (here) and on the Legal Pad blog (here).
Ever since “entity coverage” (sometimes called “Side C coverage”) became a part of the standard D & O policy in the mid-90’s, bankruptcy courts have wrestled with the issue whether or not the D & O policy proceeds are property of the estate under Bankruptcy Code Section 541(a) and subject to the automatic stay under Bankruptcy Code Section 362. The directors and officers of the bankrupt company want access to the insurance proceeds to fund defense expense or settlements, but the bankruptcy trustee wants the proceeds preserved so they are available to satisfy the trustee’s own claims, and so the trustee seeks to subject payment of the proceeds to the bankruptcy stay.
A recent decision in the federal bankruptcy court in Delaware arising out of the bankruptcy of World Health Alternatives addressed the issue whether the directors and officers could access the proceeds of the bankrupt company’s D & O policy to settle separate shareholders litigation pending against them.
World Health Alternatives filed for bankruptcy in February 2006. However, prior to the bankruptcy filing, the company and several of its directors and officers had been sued in federal court in Pennsylvania in a securities class action lawsuit (refer here), and in October 2005, plaintiffs filed a separate derivative action. The cases were later consolidated. After the company filed its bankruptcy petition, it was dropped as a defendant from the shareholder litigation. In August 2006, the parties settled the consolidated shareholder action and in November 2006 filed a settlement agreement with the court.
The consolidated shareholder litigation settlement provides for the payment of $1.7 million (the remaining limits under the company’s D & O policy). In addition, the company’s former CEO agreed to transfer 435,000 shares of stock in three other organizations, and the company’s former accounting firm agreed to pay $1 million. The settlement proceeds were tendered into escrow, and the final settlement hearing was scheduled for June 11, 2007.
On May 21, 2007, the trustee in bankruptcy initiated an adversary proceeding in federal bankruptcy court in Delaware against the company’s former directors and officers, alleging, among other things, breaches of fiduciary duty and unjust enrichment. The trustee petitioned the bankruptcy court to enjoin the approval of the shareholder litigation settlement agreement and to direct the transfer of the proceeds of the D & O policy to the trustee.
In an June 8, 2007 opinion (here), Bankruptcy Judge Kevin Gross considered “whether a debtor’s creditors have priority over the debtor’s shareholders in the proceeds of an insurance policy to which both claim entitlement.” The court said that the threshold issue in the petition for a preliminary injunction is whether there is a “reasonable probability that the Trustee will win on the merits of his claim of priority to the proceeds of the policy,” which turns on “whether the proceeds are property of the estate.”
The question the court faced was complicated by the fact that the company’s D & O policy (like most current D & O policies) contained Side A coverage protecting the individuals, as well as Side B coverage providing the company with reimbursement coverage of amounts for which the company indemnified the individual directors and officers, and Side C “entity coverage” protecting the company from its own securities claim liability.
Typically, when a liability policy provides coverage to a debtor, the proceeds of the policy are property of the bankrupt estate. The court said that
When a policy covers the debtor and its directors and officers, and there is risk that payment of the proceeds to the directors and officers will result in insufficient coverage of the debtor, then the proceeds are property of the estate and any attempts to obtain the proceeds are prohibited under the automatic stay.
Judge Gross found, however, that under the circumstances “it appears that the proceeds of the Debtor’s insurance policy are not the property of the estate.” He reached this conclusion because “the policy proceeds which are being used to fund the settlement…are from the Policy’s Coverage A,” and the Trustee “has no right to any Coverage A proceeds.” The court said, quoting with approval from In re Allied Digital Technologies Corp., 306 B.R. 505, 512 (Bankr. D. Del. 2004):
The Trustees’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from the D & O Policy rather than as a potential defendant seeking to be protected by the D & O Policy. In this way, Trustee is no different than any third party plaintiff suing defendants covered by a wasting Policy.
Because the court found that “there is no reasonable probability that the Trustee would succeed on the merits,” he denied the petition for a preliminary injunction.
On June 11, 2007, the court in the shareholders’ class action in Pennsylvania approved the shareholders' action settlement and entered final judgment.
Judge Gross noted that there were numerous “other impediments” to the trustee’s recovery under the Policy, including the fact that the trustee did not even file the adversary proceeding against the company’s former directors and officers until after the claims-made D & O policy had lapsed. (As an aside, this fact alone would have been sufficient to dispense with the entire matter, since there would be no coverage in any event under the policy for the trustees’s claim, but the court chose a different line of analysis.)
Judge Gross also noted that the D & O Policy had a “Priority of Payments” provision “which requires that payments first be made to Coverage A insureds.” But while noting that the policy had a priority of payments provision, Judge Gross did not affirmatively conclude that the provision would defeat the trustee’s claims that the policy proceeds are property of the estate.
Though the court in the World Health Alternatives bankruptcy held that the trustee could not prevent the company’s former directors and officers from using the D & O policy proceeds to settle claims against them, there is a split of authority whether D & O policy proceeds are part of the debtor company’s estate and subject to the automatic stay. A priority of payments clause is one approach that some companies have used to try to avoid the assertion that the policy proceeds are part of the estate.
Another way to provide against the adverse effects that could follow in the event that the standard D & O policy (containing entity coverage) is subject to the stay in bankruptcy is to structure the company’s D & O insurance program to include a separate Side A policy that provides coverage solely for the individual directors and officers. Because these policies protect only the individuals, the policies’ proceeds are unlikely to be held part of a debtor company’s estate and therefore would not be subject to the stay in bankruptcy. Excess Side A policies providing so-called “drop down” protection in the event the standard D & O policy is subject to the bankruptcy stay may be the most cost effective protection against this possibility.
A good, brief summary of the issues surrounding the proceeds of the D & O policy in the context of bankruptcy by Kimberly Melvin of the Wiley Rein law firm can be found here.
Special thanks to Adam Savett of the Securities Litigation Watch (here) for the link to the bankruptcy court's opinion.
In prior posts (most recently here), I described various attempts to shift the blame for alleged option grant manipulations to company gatekeepers. In the latest development, Vitesse Semiconductor announced on June 13, 2007 (here) that it has sued KPMG, its former auditing firm, seeking $100 million in damages and alleging that the firm failed to properly provide auditing and other services to the company.
On December 19, 2006, Vitesse announced (here) the results of a review conducted by a special committee of its board of directors that had been organized to look into allegations of possible options grant manipulations. The special committee "found evidence that members of Vitesse’s former senior management team backdated and manipulated the grant dates of stock options issued over a number of years, utilized improper accounting practices primarily related to revenue recognition and inventory, and prepared or altered financial records to conceal those practices." The special committee estimated that the total additional expense to Vitesse from the stock grant manipulation is approximately $120 million since 1995.
The special committee identified a number of accounting issues, some of which "appear to have been used on certain occasions to manipulate revenues for accounting periods in consideration of Wall Street expectations." Among the practices identified were: the failure to properly account for returned inventory; use of false sales invoices to increase revenue; and improper revenue recognition practices, including channel stuffing and improper recognition of consignment sales.
The company’s December 19, 2006 press release also stated that Vitesse’s board had "dismissed KPMG LLP based on its lack of independence." However, in a December 22, 2006 press release (here), Vitesse clarified its prior statement about KPMG’s dismissal, noting that "the dismissal was as a result of Vitesse’s consideration of potential claims it may have with respect to KPMG, which would impair its independence, rather than any finding that KPMG lacked independence with respect to Vitesse prior to the date of the Special Committee’s report." A CFO.com article regarding the clarifying press release can be found here.
The Vitesse lawsuit against KPMG follows the lawsuit that another former KPMG client recently filed against the firm. KPMG was named, along with PricewaterhouseCoopers, as a defendant in a lawsuit that Collins & Aikman Corp. filed against its former CEO, David Stockman, and other former company executives. The Collins & Aikman lawsuit (about which refer here) alleges that the accountants "turned a blind eye to accounting improprieties" at the company.
The Vitesse and Collins & Aikman lawsuits are only the most recent of KPMG’s litigation woes. KPMG also was targeted in the Department of Justice’s investigation of tax shelters KPMG developed and sold between 1996 and 2002 (refer here), in settlement of which KPMG agreed to make payments totaling $456 million.
Vitesse itself and several of its former directors and officers face securities class action litigation (here) based on allegations of stock option manipulations. At least one of the securities class action complaints filed against Vitesse (here) also named KPMG as a defendant.
Vitesse is not the first company having uncovered options backdating to sue its former auditor. As discussed in an earlier post (here), Micrel sued its former auditor, Deloitte and Touche, for allegedly faulty advice regarding the company’s options practices. Deloitte settled the case for a payment of $15.5 million.
French Accent: "Vitesse" is of course the French word for "speed. " The D & O Diary associates the word with the French TGV trains ("train à grande vitesse") which SNCF, the French rail company, operates. The TGV Eurostar train goes through the Chunnel from Paris to London. On April 4, 2007 (refer here), a modified TGV train set the conventional train speed record, clocking in at 357.2 mph. (To my knowledge, Vitesse Semiconductor has nothing to do with the TGV.)
In an earlier post (here), I examined the risk characteristics surrounding Private Investment in Public Equity (PIPEs) financing, and argued that PIPEs are an increasingly important part of small public company financing, and that companies should not be viewed as suspect merely because they have resorted to PIPEs financing. Since the time of my prior post, PIPEs have continued to increase in importance. According to CFO.com (here), in the first quarter of 2007 alone, there were 302 PIPEs transactions totaling $10.92 billion in equity raised, which represents a 48 percent increase over the amount raised in the first quarter of 2006.
In a PIPE, accredited investors (usually hedge funds) acquire company securities in a private offering as a discount to the securities’ market value. The issuer undertakes to register the shares with the SEC, usually within 90 to 120 days of the private offering closing. My earlier post reviewed the benefits of PIPEs to issuers and investors.
A June 9, 2007 article by William K. Sjostrom, Jr. of Northern Kentucky University Law School entitled simply "PIPEs" (here) takes a closer look at PIPEs financing, reviews why hedge funds invest in these offerings, examines the regulatory issues (including the SEC enforcement actions) in which hedge funds get involved, and critiques the SEC’s current regulatory stance on PIPEs.
The article emphasizes that PIPEs are an important funding source for small companies, Approximately 90% of 2006 PIPEs transactions involved companies with market caps below $250 million, generally because they have no financing alternatives. More than 84% of PIPEs issuers have negative operating cash flows and a majority would run out of cash without the PIPE.
Under the circumstances, it might well be asked who would invest in a PIPE; the answer is hedge funds.
Hedge funds constitute nearly 80% of the investors in microcap PIPEs, and the hedge funds invest in PIPEs because of the returns they can achieve. By using a strategy whereby they sell short the issuer’s common stock promptly after the PIPE deal is disclosed, they are able to lock in the deal purchase discount (which, all in, ranges from 14.3% to 34.7%), as either a rise or fall in the issuer’s share price after the PIPE would cause an increase in value of either the long or short position and a decrease in the complementary position.
To execute this strategy, the hedge fund must be able to borrow the shares to cover their short position. But since the stock of many PIPEs issuers is very thinly traded, the hedge fund may not have shares to cover the short position – a so-called "naked short," which while not illegal per se, may constitute illegal stock manipulation. (An SEC enforcement action against a hedge fund investor that engaged in a naked short in connection with a PIPE transaction can be found here.) A June 14, 2007 New York Times article about naked short selling can be found here.
Because of the popularity of PIPEs investments, as well as the fact that (as Professor Sjostrom puts it) some hedge funds "routinely push the legal envelope with their trading strategies," the SEC has stepped up its enforcement activities in this area and "has brought at least eleven enforcement actions relating to PIPEs deals."
The SEC has, for example, alleged that hedge funds have engaged in illegal insider trading by shorting the issuer companies’ stock prior to the announcement of the PIPE transaction (refer here for a case example) and that the hedge fund investor has violated Section 5 of the Securities Act of 1933 by using the shares the hedge fund bought in the PIPE private placement to cover their open short position (refer here for a case example). The SEC’s position is that the hedge fund should use shares purchased on the open market to cover the open short position. (A prior D & O Diary post discussing these enforcement actions can be found here.)
The SEC’s regulatory response to tighten its control over PIPEs has been to declare that PIPEs deals involving more than 33% of an "issuer’s float" constitutes a "primary" offering, which would render investors (such as hedge funds) in a PIPE of more than 33% of float into "underwriters" and therefore subject them to potential liability under Section 11 of the ’33 Act. A December 27, 2006 Wall Street Journal article discussing the SEC’s position can be found here (subscription required). The SEC’s position was stated more recently in a January 27, 2007 speech (summarized here) by David Lynn, at the time the SEC’s Chief Counsel of the Division of Corporate Finance. (Lynn recently left the SEC and joined the CorporateCounsel.net team, refer here.)
According to another recent article (here) discussing the SEC's new cap and commenting on the possibility that under the SEC's new guidelines PIPEs investors might take on underwriter liability exposure under Section 11,
Most PIPE investors are unwilling to ... accept such liability. PIPE investors who might be willing to accept liability as underwriters certainly would require the full panoply of the underwriter's traditional protections: representations and warranties, indemnity, conflict letters, opinions, and extensive due diligence. The speed and efficiency associated with PIPEs would be lost.
Professor Sjostrom’s article points out that this constraint effectively puts a cap on the size of PIPEs deals, and that the lower the dollar value of a company’s public float, the less money it will be able to raise through a PIPE transaction. As the author notes, the SEC’s cap "hits small companies the hardest, the very companies that have few, if any, other financing options." The author calls on the SEC to take into account the effect its regulation has on the PIPEs financing market, "considering that it represents the sole financing option for many small public companies." The author concludes that "a more measured and transparent SEC approach to PIPE regulation is in order."
A very good and detailed (albeit more technical) discussion of the regulatory issues, including the practical implications of the SEC's screening process under the new guidelines, can be found here.
As I discussed in my prior post, PIPEs are likely to remain an important part of the financial landscape, in part because, as Professor Sjostrom argues, companies that engage in PIPEs often have no other financing alternatives. There are, as I previously pointed out, some PIPEs elements that characterize riskier PIPEs deals, but a transaction should not be suspect simply because it is a PIPE. That is, a PIPE should be viewed , and, as Professor Sjostrom argues, regulated, with a more "measured" approach, and the focus should be on the riskier deals (such as the so-called "structured PIPEs") that represent the relatively greater risk to issuers and investors.
Do Activist Investors Hurt Bondholders?: While I’m on the subject of hedge funds, I should reference the June 13, 2007 CFO.com article (here) about a recent Moody’s study showing that demands of "short-term shareholder activists" (read: hedge funds) are "generally negative for credit quality." This can be caused by the actions responsive to activist investor pressures, such as the company's sale of significant assets with the proceeds passed to shareholders; increases in dividends or share buybacks; or a more leveraged financial strategy. These activities have "the potential to change the company’s credit profile over the short to medium term." The short-term activists also "distract management from running the business to deal with their demand, eating up corporate resources and wealth."
There are, however, a "minority of cases" where following activist intervention "a company embarks on a more focused strategy…and makes significant improvement to practices, including disciplined capital allocation."
A Full Disclosure Endnote: The full name of the Northern Kentucky University Law School is the Salmon P. Chase College of Law. The school's name refers to the 19th century Ohio Senator and Governor who served in Lincoln's cabinet as Secretary of the Treasury and who also served as Chief Justice of the United States Supreme Court from 1864 until his death in 1873 (refer here for more detail). While serving as Chief Justice, Chase presided at the impeachment trial of Andrew Johnson. In addition to the Law School, Chase Manhattan Bank (now part of JP Morgan Chase) is also named after the former Chief Justice.
Delaware Chancery Court Dismisses Options Backdating Derivative Case
In the options backdating related derivative case pending in Delaware Chancery Court involving Sycamore Networks as nominal defendant, Vice Chancellor Leo E. Strine, Jr. granted the defendants’ motion to dismiss, in an opinion (here) that carefully distinguished the earlier Delaware Chancery Court dismissal denials in the Ryan v Gifford (Maxim Integrated Products) case and the Tyson Foods case. (Refer here for my post regarding the prior cases.) In addition to holding that the Sycamore Networks plaintiff lacked standing to challenge option grants that occurred before the plaintiff acquired his shares, Vice Chancellor Strine also held that the plaintiff had not established demand futility.
The Sycamore Networks plaintiff’s allegations involved three categories of grants, Employee Grants, Officer Grants and Outside Director Grants. With respect to the Employee Grants, the Vice Chancellor held that "because the complaint is devoid of any facts suggesting a rational inference that any members of Sycamore’s board, much less a majority, knew about the backdated Employee Grants, [the plaintiff] has failed to create a reasonable doubt about the Sycamore board’s ability to impartially consider a demand as to this category of claim."
The Officer Grant allegation involved not only options backdating allegations but "the more subtle issues raised by "springloading and bullet-dodging as well. The Court held with respect to these allegations that the plaintiff had failed to show that there was not a disinterested majority of the board available to consider the allegations. In making this finding, Vice Chancellor Strine specifically distinguished the earlier decision in the Tyson case, which contained detailed allegations of multi-year concealments, by contrast to the Sycamore Networks complaint, which alleged only "weak allegations about a single alleged instance of spring loading involving information that did not even clearly affect the company’s stock trading price."
Vice Chancellor Strine found in connection with the third category of backdated grants, the Outside Director Grants, that because the directors in fact received the disputed grants, it would be "difficult to find them independent." However, the Vice Chancellor found that the disputed options were made pursuant to a shareholder approved plan that expressly permitted below-market grants, and no adverse inferences could be drawn from the fact that the awards followed adverse news disclosures. Chancellor Strine specifically noted that by contrast to the plaintiff in the Ryan v. Gifford (Maxim Integrated Products) case, the Sycamore Network plaintiff "has pled no facts to suggest even the hint of a culpable state of mind of any director."
The Vice Chancellor also drew a contrast between the detailed allegations in the Tyson case, which built upon the fruits of a prior books and records request, and the Sycamore Networks plaintiff, who "rushed in to court, making generalized charges unaccompanied by fact pleading about the involvement of the directors in the improprieties he contends occurred."
The 77-page Sycamore Networks opinion not only reflects a detailed analysis of the case before the Court, but also contains a painstaking comparison between the Sycamore Networks allegations and the allegations in the Maxim Integrated Products case and the Tyson Foods case. The Sycamore Networks case on the one hand and the two prior cases on the other hand now present opposite outcomes under Delaware law on options backdating derivative case dismissal motions, and represent contrasting precedents from which parties in future cases will attempt to argue. Certainly, Vice Chancellor Strine’s distinction between the Sycamore Networks complaint and the allegations in the prior two cases will present a road map from which defendants can attempt to argue their dismissal motions.
The Sycamore Networks opinion also contains a lengthy discussion of the important differences between backdating, on the one hand, and sprinloading and bullet dodging on the other hand, as well as a broad discussion of boards’ duties and potential liabilities generally.
The Sycamore Networks plaintiff relied heavily on the allegations contained in the separate complaint of a former Sycamore Networks employee who claimed that his employment contract was terminated because he complained about the company's stock option practices. A July 12, 2006 Wall Street Journal article describing the complaint and the backdating allegations can be found here, subscription required.
Professor Larry Ribstein has an interesting discussion of the Sycamore Networks case on his Ideoblog (here). Hat tip to the Delaware Corporate and Commercial Litigation Blog (here) for the link to the opinion.
Zoran Backdating Case Survives Motion to Dismiss: The Sycamore Networks case and several other options backdating related derivative cases (refer here) have been dismissed due to the plaintiffs’ failure to establish that a demand on the board to address the alleged misconduct would be futile. However, on June 5, 2007, Judge William Alsup denied the defendants’ motion to dismiss in the Zoran backdating derivative litigation, specifically holding that the plaintiffs had established demand futility. A copy of the Zoran opinion can be found here.
The basis of the Court’s finding of demand futility is the plaintiffs’ allegation that each board member (including even two who were not named as defendants) had received backdated stock options. Based on this allegation, Judge Alsup concluded that that the directors are "interested" in the dispute, stating:
a decision now to correct the grant dates would have a detrimental impact on the directors by removing the financial benefit of the backdating. The director may be required to pay back the difference in price between the true grant date and the purported grant date. The directors may even face legal exposure. Accordingly, if plaintiffs can plead with particularity that the directors received backdated grants, those directors will be considered interested.
Judge Alsup specifically cited the Ryan v Gifford (Maxim Integrated Products) case. The Zoran opinion preceded the Sycamore Networks case, and so Judge Alsop’s analysis does not consider the distinguishing factors to which Vice Chancellor Strine referred in concluding that the Sycamore Network directors were not "interested" despite having received challenged options.
A press release discussing the Zoran decision can be found here. My prior post discussing the Zoran lawsuit can be found here.
Alleged Sharp Practices: If you have not read Judge James M. Rosenbaum’s denial of the defendants’ motion to dismiss in the United Health Group options backdating related securities class action lawsuit, you will definitely want to take a moment and read the brief opinion here.
The fate of the dismissal motions was definitely tipped when the court characterized the defendants’ motions as "expending forests of trees and millions of electrons." Of the plaintiffs’ allegations, the court said, "if plaintiffs are correct, this case is incredibly simple. Plaintiffs claim defendants were playing with a stacked deck. When awarded options, with deliberately selected grant dates which were already in the money, defendants were playing a game they knew they could not lose; and unsurprisingly, defendants won."
Having started with the "stacked deck" card playing analogy, Judge Rosenbaum switches his comparison to horse racing, and compares the defendants’ alleged scheme to the plot of the 1973 Academy Award-winning movie The Sting, in which the lead characters revenge themselves by a "scheme involving ‘past-posting,’ or betting on horse races after the results are known." The Court’s conclusion? Motion denied, with a note that "the Court commends The Sting to all parties."
While the Court settled on the horse racing analogy, I have myself preferred the card-playing comparison, as I noted in my comment (here) early in the unfolding of the backdating scandal, where I quoted Talleyrand’s remarks about the baleful effects of cheating at cards.
Hat tip to Adam Savett of the Securities Litigation Watch (here) for the link to the United Health Group opinion.
Anyone who was around when The Sting first came out will undoubtedly recall the film's score, inspired by the music of Scott Joplin, including the movie theme based on Joplin's song , The Entertainer, a sound file for which can be found here.
An inspired updated video mash up based on The Sting can be found here:
As the number and magnitude of buyout deals has continued to grow, shareholders have become increasingly restive. Shareholders seem increasingly inclined to demand, and in some cases successfully compel, a larger acquisition price for the target company. For example, Biomet shareholders successfully compelled the company’s would-be private equity acquirers to increase their $10.9 billion buyout bid by $500 million (refer here).
Some shareholders are upset about more than the buyout price alone. In some instances, shareholders are employing lawsuits on the grounds that a proposed buyout is fundamentally unfair. A June 7, 2007 Washington Post article entitled "Lifting the Lid: Investors Sue Over Cozy Deals" (here) reports that shareholders have filed "a string of lawsuits claiming that the deals are unfair to investors and sometimes only serve to enrich top executives." In these cases the shareholders argue that "managers accept low ball offers because they have cut lucrative deals for themselves with the buyers that might allow them to continue running the company." The article specifically mentions lawsuits filed in connection with buyouts at Lear, Topps and Ceridian.
But while lawsuits surrounding buyout transactions have proliferated, the more interesting question may be whether a second round of litigation may lie ahead, as some of the recent buyout deals start to strain and threaten to fail. A June 8, 2007 Wall Street Journal article entitled "Boom Aside, Not All LBOs Look So Hot" (here) reports that "a number of recent high profile deals are already showing signs of strain." Significant debt fueled many of the buyout deals "potentially causing problems as bond yields climb and the U.S. economy runs into new obstacles." While none of the deals mentioned in the Journal article have failed altogether, the article notes that "it is striking how quickly a few deals have run into problems."
A default or other failure could trigger a wave of recriminations, from bondholders, lenders, creditors or fund investors, against the buyout firms or company management. The extraordinarily generous terms of the debt instruments (for example, the absence of any kinds of covenants) could lead to accusations against the banks that structured the deals, or by investors whose portfolio managers invested in the debt.
While my crystal ball is no better than anyone else’s, the number of high-profile merger failures in the recent past (think AOL Time Warner and Daimler Chryser) suggests that the inevitable end of the current buyout boom may involve at least a few significant casualties. If the buyout funds or debt investors lose money, which would be hard to avoid in the event of a significant default, the recriminations will follow as day follows night. Ironically, the current push to drive up buyout prices could set the stage for later problems, as the higher buyout prices necessitate increased debt, leading to a smaller margin for error. Some deals may end in tears – and lawsuits.
For prior D & O Diary posts discussing buyout related lawsuits and D & O claims, refer here and here.
Conflict Control: An interesting effort to control the conflicts that can arise in a management-led buyout is reflected in a June 7, 2007 "Guidance Note" from Australia’s Takeovers Panel, entitled "Insider Participation in Control Transaction" (here). (According to its website, the Takeovers Panel is "the primary forum for resolving disputes about a takeover bid until the bid period has ended. The Panel is a peer review body, with part time members appointed from the active members of Australia's takeovers and business communities.").
The Note provides that when a board or company becomes aware of a takeover bid that is likely to involve the participation of insiders, the board should appoint an "independent board committee" and "establish protocols" regarding who should communicate on the target company’s behalf and what limitations should restrict the participating insider. Essentially the Note recommends that the participating insider be quarantined from the transaction. Significantly, the guidelines are not meant to be exhaustive, nor even meant to encompass all the legal duties any particular situation may require.
Hat tip to the SOX First blog (here) for the link to the Guidance Note.
Global Warming and D & O Coverage: In prior posts (most recently here), I have commented on the D & O insurance exposure arising from global climate change. A recent paper by Joe Monteleone of the Tressler, Soderstrom, Maloney & Priess law firm entitled "Global Warming – Will There Be Exposures for Directors and Officers and Will It Be Covered?" (here) takes a deeper look at these issues, with particular emphasis on the relevant D & O policy provisions. Special thanks to Joe for allowing me to link to this timely and well-written article.
A Comprehensive Look at Climate Change Liability Risks
In an earlier post (here), I wrote about global climate change and D & O risk. The potential challenge to D & O insurers from the risks and potential liabilities of global climate change is only a part of the full range of liability exposures the insurance industry potentially faces as a result of climate change. A May 2007 article by Christine Ross, Evan Mills and Sean Hecht entitled "Limiting Liability in the Greenhouse: Insurance Risk-Management Strategies in the Context of Global Climate Change" (here) take a comprehensive look at the insurance industry’s liability exposures arising from the causes and consequences of climate change.
The authors’ premise is that the discussion of potential insurance consequences from climate change tends to focus on the property damage concerns of extreme weather events. Their article, by contrast, focuses on the "relatively subtle but equally important dimension of liability." The authors examine a broad range of potential liabilities and insurance coverages that could be implicated, including commercial general liability claims; product liability claims; environmental liability claims, professional liability claims; political liability claims; and others.
The authors' starting point is that "parties that disproportionately contribute to the impacts of climate change are not required through any statutory or regulatory scheme to internalize costs of these impacts." The externalized costs "are left of the victims to bear," based upon which, the authors observe, "applying tort law to climate change harm could be consistent with tort law’s basic goals of reducing the societal costs of human activities, compensating those who are harmed unduly by these activites, and providing corrective justice." While substantial barriers could impede efforts to impose tort liability, the costs of defense alone will be burdensome on companies and their insurers.
In addition to attempts to redress climate change through litigation, other climate change initiatives are or will impact many companies. For example, investors have evinced an increasing desire to compel full disclosure of environmental liability risks. The article notes that "over the last seven proxy seasons, climate change resolutions filed by shareholders have increased from six in 2001 to a record forty-two filed in the first two months of 2007." The authors also specifically note that "shareholder resolutions were filed with four insurance companies during the 2007 proxy season … requesting those companies to disclose strategy and actions on climate change." While in the past these kinds of resolutions would have arisen from special interest investor groups, now "some of America’s most powerful institutional investors …are becoming increasingly active in environmental and social issues."
The authors also note that several SEC regulations deal directly or indirectly with environmental risk disclosure, including Items 101 and 303 of Reg. S-K. The article does note that, at least in the past, there has been "lax enforcement" of these disclosure requirements, and that only five times in the last thirty years has the SEC taken action to enforce environmental liability disclosure. Moreover, the SEC "does not specifically require reporting on greenhouse gas emissions and climate change."
The authors assert that the growing awareness of the potential impact of climate change on companies' circumstances is increasing pressure on the companies to address these disclosure issues. The authors cite the 2006 SEC enforcement action (here) against Ashland Inc., where the SEC found that the company understated its environmental reserves by improperly reducing its remediation estimates. The authors state that this enforcement action may "be a signal of the SEC’s increasing willingness to hold companies accountable for failure to adequately disclose material environmental risks." (Refer here for my prior post about the Ashland enforcement action.)
In addition, the authors further note that "failing to establish standards or to take proactive measures to reduce greenhouse gas emissions could expose companies to reputation and brand damage, as well as regulatory and litigation risk." Among the specific litigation risks, the authors note that "shareholder lawsuits could be focused on a company’s performance suffering due to negligent planning by corporate directors for climate change risk." The authors also note that "ignoring climate change, or even worse, misrepresenting its risks can result in exposure to litigation risk."
The authors cite a study finding that 53% of the largest 500 publicly traded companies are doing "a poor job" describing climate change risks to investors, and "are thus at risk of shareholder lawsuits." The authors further note that insurers may be particularly vulnerable, since insurers in particular "have been reluctant to disclose their climate-related risks."
After comprehensively reviewing a wide variety of potential liability exposures, the authors move on to suggest a variety of risk management and mitigation strategies. The authors also call on financial services companies in general to incorporate environmental awareness into their portfolio strategies. The authors call on insurers in particular to "offer innovative products and services that maximize incentives for energy efficiency while minimizing risk." The authors cite, among other things, insurer initiated property loss mitigation efforts and pay-as-you-drive automobile insurance as examples of innovative insurance efforts "to take concrete actions that generate profits while maintaining insurability and protecting customers from extreme weather-related losses, as well as reducing greenhouse gas emissions."
The authors conclude by noting that:
The insurance industry, perhaps more than any other institution, has the power to set the stage for enduring and significant contributions to solving the problem of global climate change. In doing so, liability insurance considerations could prove to be as important as the more widely studied property insurance consequences of climate change.
As I discussed in my earlier post, global climate change is going to loom increasingly large, not least as a growing source of potential liability risk for companies and their directors and officers. Readers who are interesting in these topics will want to know about the free June 12, 2007 webinar entitled "Tackling Global Warming: Challenge for Boards and Their Advisors," co-sponsored by The CorporateCounsel.net and the National Council for Science and the Environment. Information about the webinar can be found here. Readers interested in global climate change as an environmental phenomenon will be interested to read the June 7, 2007 Washington Post article entitled "Icy Island Warms to Climate Change" (here) discussing the wide-ranging impacts of climate change that Greenland and its inhabitants are already experiencing.
Hat tip to the Sox First blog (here) for the link to the climate change article.
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.
With its announcement (here) that it is the target of a Department of Justice antibribery investigation, BAE Systems added its name to the growing list of foreign-domiciled companies targeted by U.S. officials for alleged violations of U.S. anticorruption laws. The recent high-profile investigation of Siemens (about which refer here), as well as investigations involving Total, the French oil company, and Magyar Telecom of Hungary, not to mention a long list of domestic companies, are all part of an increasingly tough stance by U.S. regulators and prosecutors toward allegedly corrupt business activities.
