Defense Verdict in JDSU Securities Trial; Meanwhile, Ninth Circuit Reverses Thane International Securities Lawsuit Verdict
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On November 27, 2007, JDS Uniphase announced (here) that following a month-long trial in the securities lawsuit pending against the company and four of its former executives, the jury returned a verdict in favor of all defendants on all claims. News reports discussing the verdict can be found here and here. Law.com has a detailed November 28, 2007 article discussing the verdict here. Background regarding the JDSU securities lawsuit can be found here and my prior post discussing the JDSU trial can be found here.
The JDSU trial was being closely watched because trials in securities cases are so rare. The Securities Litigation Watch blog documents here just how rare trials in securities lawsuits are, but also points out here that coincidentally a trial is currently underway in the Apollo Group securities lawsuit as well. (Alert reader Cathy Power reports that the Apollo Group trial currently underway in federal court in Phoenix before Judge Teilborg is scheduled to run through February 2008.)
The JDSU plaintiffs of course are now free to appeal the trial outcome, which, given their sunk costs and the $20 billion in claimed damages, seems like a certainty. As they lick their wounds and contemplate their appeal, the plaintiffs might well be heartened to consider a development in the Ninth Circuit that took place just a day before the JDSU jury verdict.
As rare as a securities trial is, an appellate decision following a securities trial is an even more unusual event. In a November 26, 2007 opinion (here), the Ninth Circuit reversed and remanded the defense verdict of Central District of California Judge James Selna following a three-day bench trial in a securities lawsuit.
The case arises out of the 2002 merger of Reliant Interactive Media Corporation and Thane International. Prior to the merger, Reliant’s stock was traded on the OTCBB, while Thane’s stock was not publicly traded. As part of the merger, Reliant’s shareholders were to receive Thane stock. The lawsuit essentially turns on what representations Thane made about where its shares would be traded after the merger.
The plaintiffs contend that Thane represented that its shares would be listed on NASDAQ. It appears that the initial draft of the Prospectus stated that Thane’s post-merger stock would be listed on NASDAQ or another national stock exchange. The final Prospectus omitted the specific listing requirement, but said only that Thane’s shares had been approved for trading on NASDAQ – which appears to have been true. Thane did not, however, list its shares on NASDAQ. Its investment bankers apparently advised the company to forestall the NASDAQ listing until the company could complete a planned post-merger secondary offering. Thane’s shares traded on the OTCBB after the merger was consummated in May 2002 and its shares initially traded in the range of $7 to $8.50 a share.
Thane neither listed its shares with NASDAQ nor completed a secondary offering. Instead, as the court noted, "Thane International shareholders experienced a wild ride." Its share price sank to $2.00 on August 16, 2002 news of unfavorable financial results, and its share price thereafter continued to drop, Thane completed a February 2004 "going private" transaction at 35 cents a share.
The plaintiffs filed suit alleging violation of Section 12(a)(2) of the Securities Act of 1933 and also control person liability against several of Thane’s directors and officers under Section 15 of the Securities Act of 1933. The district court, following a three-day bench trial, held that the defendants had not violated Section 12 because the statements in the final Prospectus about Thane’s approval for a NASDAQ listing were "literally true." The district court further held that even if there were misrepresentations, they were not material because the share price did not drop its initial 18 days of trading, even though the stock obviously was not listed on NASDAQ – suggesting that investors were not perturbed by the OTCBB trading.
The Ninth Circuit reversed the district court, holding that there were material misrepresentations. The Ninth Circuit’s holding is interesting because the Ninth Circuit in fact agreed with the district court that the statements in the Prospectus about the NASDAQ listing were "literally true." However, the Ninth Circuit went on to note that "literal truth is not the standard for determining whether the statements in the Prospectus were misleading." The Ninth Circuit found a number of statements in the Prospectus that give "the clear implication that Thane International shares would not trade on the OTCBB, but instead would list on the NASDAQ." The "repeated references suggest nothing short of actual listing on NASDAQ." Therefore, the Ninth Circuit was of a "firm and definite conviction" that the district court erred in finding otherwise.
The Ninth Circuit also found that the district court erred in concluding that any misrepresentations were immaterial. The Ninth Circuit examined the parties’ respective expert witnesses’ trial testimony at length and clearly was persuaded by the plaintiffs’ expert’s testimony that the NASDAQ provides significant investor advantages over the OTCBB, and so misrepresentations about where the post-merger Thane shares would trade were not only misleading but material. (NASDAQ officials will undoubtedly be quite heartened to learn how persuaded the Ninth Circuit was of the advantages that NASDAQ offers.)
Finally, the Ninth Circuit found that the district court had not reached the issue of loss causation, and therefore declined to review that issue. Instead, the Ninth Circuit remanded the case to the district court "to enter judgment in favor of the plaintiffs, to address loss causation, and to conduct further proceedings consistent with this opinion."
The Ninth Circuit’s opinion is unusual for what it is in and of itself, an appeal from a securities lawsuit trial. But it also involves an unusual legal context (that is, it is a rare case involving Section 12 claims only) that turned upon very specific and narrow factual issues. The loss causation issue may ultimately prove to be significant. While I suppose former Reliant shareholders contend they would not have voted in favor of the transaction at all if they had known that the post-merger shares would have only traded on OTCBB, it is hard to see what the absence of a NASDAQ listing had to do with anything. The company’s stock cratered within a few weeks after the merger based on the company’s poor performance, which clearly would have happened even if the stock had been listed on NASDAQ.
But in any event, the Ninth Circuit’s opinion is a good reminder that even a trial verdict is not the final word, and appellate review can substantially affect or even determine the ultimate outcome of the case. Trial is after all just one more procedural stage, and even a party that loses a verdict can appeal and perhaps live to see another day – or even prevail. (Whether an appellate court is more or less willing to set aside a jury verdict than a judge's verdict following a bench trial is a different topic, of course, but leave that one for another day...)
And so these are the thoughts that I imagine that the Connecticut Retirement Plans and Trust Funds –lead plaintiff in the JDSU Uniphase case – are telling themselves now as they ready their notice of appeal.
In my earlier post discussing the JDSU trial (here), I ruminated on the possible reasons why so few securities cases go to trial. After considering a few alternatives, I speculated that the real reason so few securities cases go to trial is that in the end, plaintiffs’ attorneys really have no interest in or incentive to try these cases. After this well publicized verdict in a prominent case like the JDSU trial, plaintiffs’ counsel will undoubtedly have even less interest in trying securities lawsuits. The availability of appeal alternatives might provide some consolation, but it would have to seem preferable to avoid juries altogether.
Law.com has a November 27, 2007 article discussing the Ninth Circuit’s opinion in the Thane International case here.
In the world of directors’ and officers’ liability, securities class action lawsuits dominate the dialogue. Securities lawsuits generate headlines and produce eye-popping settlements. There are even websites (refer here and here) devoted exclusively to providing the latest information about securities lawsuits. The same cannot be said for derivative lawsuits, but it has not always been that way. At least until 30 years ago or so, shareholders derivative lawsuits were the main vehicle for defining the duties of corporate directors and officers and establishing the standards of corporate governance.
A November 2007 law review article by Wisconsin Law School Dean Kenneth B. Davis, Jr., entitled "The Forgotten Derivative Suit" (here), takes a detailed look at the diminished role of derivative lawsuits and examines the ways in which derivative lawsuits nevertheless still matter.
The author begins with the view that until the mid-70s, courts, acting through derivative lawsuits, provided the principal means of corporate oversight. Over the last three decades, this role has shifted, principally to independent Board directors but to others as well. In analyzing derivative litigation’s changing role, the author refers to historical analysis and prior research as well as to his own survey of 294 opinions involving derivative suits brought in federal and Delaware courts and involving Delaware corporations and issued between 2000 and the first quarter of 2007.
In Dean Davis's view, the two most important causes for the declining significance of derivative lawsuits is the judicial development of the demand requirement (and corresponding deference to independent directors) and the development of exculpatory statutes relieving directors of financial responsibility for many actions. These factors, the author finds, "have combined to marginalize the derivative suit for cases not involving self-dealing or other palpable breaches of the duty of loyalty."
In addition, a number of developments "began to supplement and supplant the derivative suit with respect to both of its recognized roles – compensation and deterrence." As for compensation, "securities and other class actions now perform many of the functions previously associated with the derivative suit." In addition, regulatory mechanisms (especially the SEC’s enforcement program) and the threat of criminal prosecution ‘have evolved to challenge the derivative suit’s reputation as the chief regulator of corporate management." Moreover, as a result of a more vigorous business press and the publicity surrounding recent corporate scandals, "the stigma of corporate misconduct" also provides significant deterrence even in the absence of formal action. All of these mechanisms fulfill functions the derivative lawsuit would have provided in the past.
The author takes a particular look at the recent wave of options backdating derivative lawsuits (about which refer here), which he notes are "consistent with the critique that derivative suits simply piggyback on what the government (or perhaps the media) has already uncovered and investigated." In this circumstance, the derivative lawsuit can contribute to deterrence only if the government lacks resources and if the plaintiff is willing to follow through. He notes that "too often, however, the economic pressures facing the plaintiffs’ attorney, coupled with the defendants’ access to indemnification and insurance, leads to a quick and non-pecuniary settlement that supports the award of attorneys’ fees but imposes little if any monetary cost on the individual defendant." (The latter point was underscored in the Wall Street Journal’s November 19, 2007 article, here, discussing the outcomes of many of the options backdating cases.)
Notwithstanding these limitations on the continued meaningfulness of derivative lawsuits, there are still circumstances, the author concludes, when derivative lawsuits are likeliest to be valuable. The first involves "misconduct at smaller companies, whose shares are less actively traded" or not publicly traded at all, and where the misconduct "will be more likely to escape the awareness and the interest of governmental agencies and the media." The second involves "cases seeking the return of a substantial benefit" which "pose a greater threat of personal loss to individual defendants." In cases "challenging transactions between the corporation and those who control it" (which would tend to involve both smaller companies and personal benefit, both of the previously identified factors), "the derivative suit continues to make its most important contributions, both as a source of compensation and deterrence for the corporation’s minority shareholders and as a public good."
The author, who clearly has devoted much time to studying and thinking about derivative lawsuits, bemoans their diminished role. He notes that:
There is no field manual, code of conduct, formal training or licensing body to spell out what directors ought to do in a specific situation….[Courts’] opinions are … the raw material for a dialogue across the business and legal professions as to what should be expected of directors….One effect of the stricter demand requirements has been to reduce the volume of case law available to perform this culture shaping role.
As someone who has spent most of my professional career involved with directors’ and officers’ liability issues, I have always felt that derivative lawsuits are underappreciated, understudied, and poorly understood. Part of the reason for this is that there is relatively little centralized information about derivative lawsuits, especially by comparison to securities class action lawsuits. Dean Davis’s article goes a long way toward helping to explain the role and significance of derivative lawsuits, and provides useful supporting data. The article helps to fill a significant void in the world of directors’ and officers’ liability.
Special thanks to Dean Davis for providing me with a link to this excellent article.
In prior posts (refer here), I have discussed the jurisdictional issues and other questions arising when foreign domiciled companies are sued in securities lawsuits in U.S. courts. But the November 26, 2007 opinion (here) in the Yukos shareholders’ lawsuit raises some unique and uniquely interesting issues. And as discussed further below, other companies are wrestling with other issues arising from the extraterritorial application of U.S. law.
The Yukos Case: The Yukos lawsuit was brought in the federal court for the District of Columbia by 43 holders of Yukos ADRs against some rather unusual defendants. The defendants include, among others, the Russian Federation, several Russian oil companies (including Gazprom and Rosneft), and several prominent Russian governmental officials, including Viktor Khristenko, the current Minister of Industry and Energy of the Russian Federation; Alexi Kudrin, who is the Minister of Finance of the Russian Federation; and Dmitri Medvedev, the First Deputy Minister of the Russian Federation. Russia’s President, Vladimir Putin, is not a defendant, although he is alleged to have "made several misstatements and omissions of material fact directed at U.S. and global securities markets."
The plaintiffs allege that the defendants expropriated Yukos beginning in 2003. The plaintiffs allege that Yukos was competing more successfully that its Russian competitors, and (perhaps more to the point) had an active business strategy of selling oil directly to the U.S. The plaintiffs allege that in a matter of days in October and November 2003, the defendants, among other things, "allegedly levied illegal and confiscatory taxes on Yukos, forced a sham sale of Yukos’s most important assets, seized a majority of Yukos shares, intimidated and harassed Yukos executive team, and used bankruptcy proceedings to paralyze Yukos’s non-Russian management team." The court noted that the plaintiffs’ allegations "tell a troubling story if proven true."
The defendants for their part moved to dismiss the case on the grounds that "the case involves the conduct of the Russian government, senior Russian government officials, Russian companies, and Russian citizens."
Judge Colleen Kollar-Kotelly, in ruling on the defendants’ motion to dismiss, opened her opinion by noting that "this Court is one of limited jurisdiction." Ultimately, she concluded that she "cannot reach the merits of Plaintiffs’ claims based on the doctrines of sovereign immunity and personal jurisdiction." The Foreign Sovereign Immunities Act generally embodies the principle that "foreign states are immune from the jurisdiction of both federal and state courts." Judge Kollar-Kotelly found that the doctrine applied to the Yukos case and that none of the exceptions to the doctrine were applicable. She concluded that the doctrine required the dismissal of the Russian Federation, the Russian government instrumentalities, and the individual Russian government defendants. Even thought the remaining defendants were not protected by the FSIA, they were also dismissed because they lacked the "continuous and systematic" contacts with the forum that are necessary to support the exercise of the court’s personal jurisdiction over them.
The separate shareholders' securities lawsuit brought by Yukos shareholders alleging the company's failure to disclose its tax liabilties was previously dismissed (refer here). The shareholders that filed the prior securities lawsuit had a decidedly different take on the events that led to Yukos's demise; the securities lawsuit alleged:
Defendants' scheme began to unravel in October 2003 when the market learned that Russian authorities had arrested the Company's largest shareholder and CEO, defendant Mikhail Khodorkovsky, and had charged him with fraud, embezzlement and evading taxes on hundreds of millions of dollars that was owed to the government. At this time, the Russian authorities also announced that they would pursue criminal prosecutions against other senior Yukos officials. Ultimately, Yukos, which has been audited by the Tax Ministry of Russia for its fiscal year 2000 tax returns, will be required to pay approximately $3.3 billion for 2000 alone due to its understatement of its tax liability, including interest and penalties. The Tax Ministry intends to audit Yukos' books for 2001-2003 based upon the same charges. Yukos could ultimately be expected to pay upwards of $10 billion to the Tax Ministry for defendants' involvement in the illegal tax evasion scheme. As a result of the revelation of defendants' wrongdoing, investors have suffered massive damages as the price of Yukos' securities plummeted.
A scholarly study of the "Yukos affair" (written in both Polish and English) can be found here.
Hat Tip to the Blog of the Legal Times (here) for the link to the Judge Kollar-Kotelly's opinion. Special thanks to Adam Savett at the Securities Litigation Watch blogfor the dismissal opinion in the prior shareholder lawsuit against Yukos.
BAE and the FCPA: While the defendants in the Yukos case were found not to be susceptible to the U.S. court’s jurisdiction, some other foreign companies are finding themselves facing uncomfortable pressure from U.S prosecutors over potential violations of U.S. law. Regular readers will recall that I have previously written (most recently here) about enforcement developments under the Foreign Corrupt Practices Act, and in a recent post (here) I specifically discussed the circumstances involved in the anticorruption investigation of BAE Systems. The BAE investigation is the subject of a lengthy and detailed November 25, 2007 New York Times article entitled "Payload: Taking Aim at Corporate Bribery" (here), that also discusses the implications of the current prosecutorial activity regarding FCPA enforcement.
Among other things, the article notes that the anticorruption investigations are a priority and that the BAE investigation is particularly high profile because "it offers a test of how aggressively anti-corruption initiatives will be pursued." The article quotes one source as saying that "the FCPA has now surpassed Sarbanes-Oxley for being at the nerve endings of corporate general counsel and executives." The article also reports that the U.S. Department of Justice's FCPA case load is "running at twice last year’s pace" and one DoJ official predicted that "the upward trend will continue in 2008."
The article also notes that "for companies that have not adapted to the new legal landscape, the consequences have become serious." The article specifically notes that several companies have paid very large fines.
But as I have noted elsewhere (here) one of the consequences of the FCPA crackdown is the threat of follow-on civil litigation. For example, BAE Systems faces a shareholders’ derivative lawsuit raising allegations pertaining to the FCPA investigation (refer here), as does Siemens, which also faces its own FCPA investigation (refer here). Other companies have faced civil lawsuits following on FCPA enforcement actions and investigations (refer here).
As prosecutors step up their enforcement efforts, the threat of follow-on civil litigation will continue to grow.
A Final Note: While Chiquita Brands is a domestic company, its recent involvement with certain improper payments to a Colombian right-wing group designated by the U.S. government as a terrorist organization has put the company in a very uncomfortable spotlight. (See my prior post about Chiquita here.) Law.com has an interesting November 26, 2007 article entitled "Blood Money Paid By Chiquita Shows Company’s Hard Choices" (here) discusses Chiquita’s struggles, dilemmas and its discussions with government officials.
Chiquita also faces lawsuits brought by alleged victims of the Colombian organization (refer here), the United Self-Defense Forces of Colombia. Portfolio magazine has an October 2007 article (here) about the organization (which it refers to as a "death squad") and about Chiquita's involvement with the group. Hat tip to The Daily Caveat blog (here) for the link to the Portfolio magazine article.
Brave New Securities Lawsuit World: Qwest Opt-Out Settlements Exceed Class Settlement
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In the latest in the series of significant opt-out settlements, two different state pension funds have announced settlements with Qwest in their separate securities actions against the company. In both instances, the funds announced that their separate settlements far exceeded the amounts that they would have recovered in Qwest’s $400 million class action settlement (refer here regarding the class action and its settlement) and it now appears that the aggregate amount Qwest has agreed to pay opt-out claimants exceeds the amount it agreed to pay the class.
In a November 21, 2007 press release (here), the Colorado Public Employees’ Retirement Association (PERA) announced a $15.5 million settlement of its separate action against Qwest. And in a November 21, 2007 announcement (here), the Alaska Permanent Fund Corporation (APFC) announced that the Alaska Department of Law had reached a $19 million settlement (net of fees and costs) on behalf of APFC, which will receive $13 million from the settlement, and on behalf of the Alaska State Department of Revenue and the Alaska Retirement Management Board, which together will split the remaining $6 million. Press article describing the Colorado settlement can be found here and regarding the Alaska settlement can be found here.
There are several significant features of these opt-out settlements. The first is what the settling funds themselves said about how they fared by proceeding separately rather than participating in the class settlement. Colorado PERA (which is Colorado’s largest pension fund and the 25th largest public pension fund in the country) said that its recovery in the class settlement would only have been $400,000, or less than one cent on the dollar of the fund’s investment losses, meaning the fund increased its recovery more than 38 times by pursuing a separate action.
The AFPC for its part said that the state’s combined recovery in the class settlement would only have been $422,000, on combined investment losses of approximately $89 million. While the state recovered only a quarter of its investment losses through its separate action, it recovered 45 times what it would have recovered in the class settlement. (The AFPC is the investment fund that receives and invests royalties from the Alaska pipeline. With over $38 billion in assets, the fund paid a fiscal 2007 dividend of $1,654 to each qualifying Alaskan state resident.)
The second significant thing about these opt-out settlements is what the funds said about their motivations in pursuing separate actions. Colorado PERA’s press release said that it "elected to forego the class recovery" because of its concerns about "excessive attorneys’ fees and an inadequate recovery" – it also reported that its counsel (the Entwistle & Cappucci firm) charged only a 5 percent fee, compared to the 15 percent fee awarded to class counsel. Although Alaska was less explicit in describing its motivations for opting out, the AFPC announcement does underscore the amount by which the state increased its recovery by opting out and also points out that the state has previously obtained opt-out settlement recoveries against WorldCom ($14 million) and AOL Time Warner ($45 million). Alaska's opt out settlement with AOL Time Warner is discussed in a prior post here.
The third significant thing about the funds’ opt-out settlements is what their actions may say about their willingness to pursue their own actions in the future. Colorado State Treasurer Cary Kennedy (a PERA board member) said, referring to its opt-out settlement, that "Colorado’s public employees should take comfort in the fact that PERA continues to be vigilant in protecting their retirement." PERA’s Board Chair added that "being involved in cases such as the separate proceeding against Qwest demonstrates our ongoing commitment to protecting the [members’] benefits." (It should be noted that PERA has been active generally in securities litigation, having served, for example, as lead plaintiff in the Royal Ahold class action.) Similarly, an Alaskan state attorney is quoted in the news article as saying that "we have a system in place to monitor cases that get filed and then decide whether we should get actively involved."
According to the Alaska press release, Entwistle & Capucci represented not only the Alaska and Colorado funds, but also the Florida State Board of Administration and the New York State Teachers’ Retirement System. These latter two funds do not appear to have made any recent announcements regarding their funds’ separate actions.
In its October 30, 2007 filing on SEC Form 10-Q (here), Qwest disclosed that the aggregate amount claimed by various persons opting out from the class settlement is "in excess of $1.9 billion." Qwest went on to state that "we have entered into settlement agreements with all of those persons." Qwest added that in connection with those settlements, "we have agreed to pay up to an aggregate of approximately $411 million, including applicable interest, on or before June 30, 2008." Although Qwest’s disclosure does not explicitly state that the $411 million amount includes the Colorado and Alaska settlements, the disclosure’s wording ("agreements with all of those persons") suggests that the $411 million does include those two settlements.
It should be noted, with all due emphasis, that the $411 million in opt out settlements exceeds the $400 million that Qwest agreed to pay in the class settlement.
As I have noted at greater length here, the emergence of these opt-out settlements presents a host of potentially significant complicating problems for current and future securities class action litigants. The involvement of public pension funds with significant investment losses, who now have a track record of having substantially increased their recoveries by having proceeded separately, suggests that significant opt out actions could become a regular part of larger class action settlements. At a minimum, these developments may raise potentially serious concerns about the continuing utility of class actions, especially if the perception becomes more widespread that, as viewed by Colorado PERA, class actions entail higher fees and lower recoveries.
All of these concerns are exacerbated if public officials are convinced they can garner valuable publicity and advance their own political interests by pursuing separate actions on behalf of state funds. The fact that the aggregate amount of the Qwest opt out settlements apparently exceeds the amount of the class settlement puts the issue in even sharper focus; indeed, the fact that Alaska is now on its third significant opt-out settlement, and has procedures in place to govern its future opt out decisions, makes it even more emphatic that opting-out may now be more routine and could become standard practice for public pension funds.
The possibility of continuing significant opt-out litigation after class settlement has been achieved threatens to increase both litigation costs and settlement expense in civil securities litigation. At a minimum, class litigants, eager to try to deter opt-outs, will feel pressure to increase class settlement amounts, in an effort to try to reduce attrition from the class. And, at some point, opt-outs may trigger the standard "blow up" provisions in many class settlement provisions, by which the class settlement in set aside of a specified percentage of class members opt out.
From the beginning, one of the questions about these opt-out settlements has been whether they are merely an attribute of the massive corporate scandals from earlier in the decade. The thought was that perhaps as the corporate scandal cases work their way through the system, the opt-out phenomenon might die down. However, the massive cases now arriving in connection with the subprime lending meltdown may create their own dynamic. The scale of the investment losses in at least some of the subprime cases may create the same incentives to opt-out as existed in the cases arising from the corporate scandals.
Indeed, at a panel on which I participated at the recent PLUS International Conference, one of the leading plaintiffs’ attorneys, who was also on the panel, said that many institutional investors (particularly European investors) were not interested in pursuing class cases at all in connection with the subprime mess, but were solely interested in individual or group actions. And as Adam Savett has noted on his Securities Litigation Watch blog (here), narrow class certification rulings are forcing other institutional investors to initiate their own separate lawsuits. With these kinds of concerns looming, we may get to the place where class litigation, long reviled by would-be corporate reformers, starts to look pretty good compared to a piecemeal process with separate investors pursuing claims separately. But at a minimum, these events and trends raise troubling questions about the future of securities class action litigation.
In a couple of months, the various consulting groups will be issuing their annual reports discussing developments in securities class action settlements. But their standard analysis, focusing exclusively on class settlements, may no longer be a sufficient basis upon which to understand what is happening in terms of total securities lawsuit severity. We have indeed entered a brave new world.
Options Backdating Case Going Back, Back to California: In an April 11, 2007 opinion (here), the federal court in California dismissed the CNET options backdating derivative case with leave to amend, later specifically instructing the parties to cooperate to allow the plaintiffs to conduct a books and records inspection under applicable Delaware law before the plaintiff refilled an amended complaint.
The parties have been involved in extensive books and records proceedings is Delaware and in a November 21, 2007 opinion (here) in the Delaware Chancery Court, Chancellor William B Chandler III granted the plaintiff’s books and records request, providing lively commentary along the way. Among other things, the Chancellor said that "it is about time the defendant…provides the requested documents, " -- and, he added, quoting The Notorious B.I.G., it is time that the case gets "going, going/back back/to Cali Cali."
The Delaware Corporate and Commercial Litigation Blog has a detailed and interesting discussion of the opinion here. Special thanks to blog author Francis Pileggi for forwarding a link to his post.
So What’s on Your iPod?: For those of you who may be wondering what Chancellor Chandler is listening to on his iPod, the song he quotes in the opinion, "Going Back to Cali," is from the Notorious B.I.G.’s posthumous double-album entitled "Life After Death," which Rolling Stonelisted as #483 on its list of the greatest 500 albums of all time. According to Wikipedia, the song "Going Back to Cali," reflects the East Coast/West Coast feud that may have led to Mr. B.I.G’s as-yet-unsolved March 1997 murder.
The "Cali" in the song apparently is a shorthand reference to "California," which would explain, sort of, the Chancellor’s reference to the song in his opinion, as that is the state to which the CNET case will now be returning. Many of the song’s lyrics are unsuitable for this family-oriented blog. Suffice it to say that Mr. B.I.G apparently believed that West Coast females possess certain physical characteristics that he regarded positively. He also apparently believed that the West Coast offered attractive leisure time alternatives. However, he also felt antagonism (apparently reciprocated) against certain West Coast rivals, and this rivalry included mutual threats of physical violence.
It must be said that Chancellor Chandler’s musical allusion reflects a remarkably ecumenical taste in music. Not to mention a phenomenally broad diversity of resources on which to draw for guidance in his judicial decision-making.
And Finally:The D & O Diary's stock of literary allusions is considerably narrower than Chancellor Chandler's. The "brave new world" referenced in this post's title is an allusion to the line from the Shakespeare's The Tempest, in which Miranda exclaims "What brave new world/That has such people in it!" (To which Prospero replies " 'Tis new to you.")
There is a sense in which this reference is particularly apt; the island on which Miranda and her father have been exiled is traditionally thought to be Bermuda, which is also where many of the financial consequences from heightened securities lawsuit severity could be felt.
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On November 21, 2007, plaintiffs’ lawyers initiated separate securities class action lawsuits against the Federal Home Loan Mortgage Corporation (better known as Freddie Mac) and against bond insurer ACA Capital Holding. Both of these lawsuits reflect the deepening seriousness of the credit problems arising from the subprime lending meltdown, and the problems besetting these companies suggest even larger problems ahead.
Freddie Mac is the better known of the two companies, and the November 20, 2007 announcement (here) of a larger-than-expected third quarter loss of $2.03 billion due to its deteriorating home mortgage loan portfolio caused its share price to drop by 29%. Perhaps not unexpectedly, plaintiffs’ lawyers have seized on these developments and launched a lawsuit against Freddie Mac and certain of its directors and officers. A copy of the plaintiffs’ lawyers November 21, 2007 press release can be found here and a copy of the complaint can be found here. According to the press release, the complaint alleges that
defendants concealed the following information, which caused their statements to be materially false and misleading: (a) defendants were not implementing sufficient risk management controls to protect the Company from acquiring billions of dollars worth of mortgages with poor underwriting standards, causing the Company to have an untenable amount of risky loans; (b) defendants were not implementing controls to ensure that appraisals were done appropriately and to prevent collusion between lenders and appraisers, increasing the risk of defaults; (c) the Company was not adequately reserving for uncollectible loans, causing its financial results to be misleading; and (d) the Company had billions of dollars of bad loans which it would eventually have to write off, causing losses and capital deficiencies.
The problems at the heart of this lawsuit bespeak the fundamental problems afflicting the U.S. residential real estate market. Just since the end of October, problems stemming from these issues have led to lawsuits against some the country’s largest financial institutions, including Citigroup, Merrill Lynch, Washington Mutual – and now Freddie Mac. But the problems leading up to the lawsuit against relatively small ACA Capital hint at even more complicated problems that may yet arise, and may lead to even larger problems outside the residential real estate sector.
ACA Capital is a bond insurer that conducted its initial public offering barely a year ago, on November 10, 2006. Like other bond insurers, ACA Capital provides bond issuers credit enhancement and protection by agreeing to cover interest and principal payments in the event of credit default. Like other bond insurers, ACA Capital’s main traditional business is insuring municipal bonds. But again, like many other bond insurers, ACA Capital has in recent years become increasingly involved in insuring structured financial products, including collaterlized debt obligations backed by residential mortgages. Because of rating agency downgrades of many CDOs over the course of recent months, ACA Capital’s stock price has plunged precipitously, down by over 90% this year.
As a result of these developments, on November 21, 2007, plaintiffs’ counsel initiated a securities class action lawsuit against ACA Capital. A copy of the plaintiffs’ counsel’s November 21 press release can be found here, and a copy of the complaint can be found here. According to the press release, the complaint alleges that the company’s Registration Statement (prepared in connection with the company’s November 2006 IPO) "failed to disclose that the Company’s CDO assets were materially impaired and overvalued."
While ACA Capital clearly already had lots of problems and the lawsuit merely adds to its woes, an even greater potential concern looms ahead. According to a November 21, 2007 Bloomberg.com article (here), ACA Capital’s credit ratings are under review for possible downgrade. Indeed, according to a November 8, 2007 Wall Street Journal article entitled "Bond Insurers Shaky As Credit Climate Worsens" (here), the same combination of circumstances plaguing ACA Capital afflicts a number of other bond insurers, and a number of the bond insurers may be in line for a rating downgrade. Nor is this problem limited to U.S bond insurers; the Financial Times reports in a November 22, 2007 article (here) that French bond insurer CIFG has received a $1.5 billion transfusion from two French mutual banks in order for the insurer to maintain its triple-A rating.
If a bond insurer were to be downgraded, there would be immediate repercussions, none of them pleasant. The most immediate concern if a bond insurer were downgraded is that "it could," according to the Journal article, "trigger a domino effect of bond-rating downgrades." Looming in the background is the possibility that a bond insurer, like ACA Capital, defaults. If a bond insurer were to default, banks would be, according to Bloomberg, forced to "take on $60 billion of collateralized debt obligation." Merrill Lynch alone may need to write down $3 billion of CDOs if ACA defaults on its obligations. A November 22,2007 Financial Times article entitled "CDOs and Insurers" (here) discusses in greater detail the consequences that would follow if ACA were to be downgraded.
UPDATE:Events move faster than even the most diligent blogger can keep up with; it appears that on November 21, 2007, S & P in fact already downgraded bond insurer MGIC, and is reviewing three other bond insurers for possible downgrade, as reported here. Obviously the MGIC downgrade puts the other comments in this blog post in even sharper relief.
The contagion effects from the bond insurers’ weakness is already roiling the municipal bond market, according to a November 16, 2007 Wall Street Journal article entitled "Credit Pressure Filters Down to Muni Market" (here). According to the Journal, the bond insurers’ troubles are "affecting the market for new municipal debt" because "buyers are backing away, in part because of concerns about the financial guarantors." The Journal reports that if the bond insurers were to be downgraded, it would "have a direct negative impact on the muni debt they insure, potentially even triggering forced selling by some investors."
All of these fears are fed by concerns that the bond insurers may not have come clean about their exposures. These concerns were underscored on November 19, 2007, when giant reinsurer Swiss Re announced (here) that it had accrued $876.4 million in after-tax losses on credit default swaps. The credit default swaps on which Swiss Re took the losses present one form of the kind of financial guarantee that bond insurers provide. Swiss Re’s reduction of the value of these instruments to zero certainly raises concerns about valuations that the bond insurers themselves may be retaining for similar transactions. Swiss Re’s write down raises concerns about the possibility of even greater turbulence ahead for the bond insurers, and perhaps for other reinsurers and insurers, that, like Swiss Re, had diversified into nontraditional products like credit default swaps.
All of which suggests that ACA Capital may not be the last bond insurer to face a shareholder claim. But of even greater concern is the possibility that ACA or another bond insurer will be downgraded, or worse, default, which would lead to a cascade of adverse consequences for bond issuers and bond investors alike. Moreover, Swiss Re’s announcement underscores that these concerns are not limited just to bond insurers. Indeed, the November 20, 2007 Wall Street Journal article discussing the Swiss re write-down (here) specifically emphasized that Swiss Re is only one of many traditional reinsurers and other insurers that expanded into nontraditional products such as credit default swaps in recent years.
So it appears that the subprime litigation wave will continue to spread outward, encompassing an ever broader diversity of companies. Indeed, in a November 21, 2007 article (here), the Wall Street Journal took a close look at the subprime credit problems distressing General Motors, as a result of deteriorating mortgage assets held by its finance unit, GMAC. The dispersion of the subprime credit problems throughout the economy suggests that the negative effects, and the ensuing litigation, will impact a widening array of companies.
I have added the Freddie Mac and ACA Capital lawsuits to the list of subprime-lending related securities class action lawsuits that I am maintaining here. With the addition of these two most recent lawsuits, the tally of subprime lending related lawsuits now stands at 22, not counting the two securities lawsuits that have been initiated against the credit rating agencies and the four subprime lending related securities class action lawsuits that have been filed against residential construction companies. (That makes 28 total.)
It is probably worth noting that the lawsuit against ACA Capital is not the first subprime lending related securities lawsuit against a bond insurer. That distinction belongs to the securities lawsuit (refer here) filed against bond insurer Radian Group earlier this year after its planned merger with rival MGIC fell through.
Yes, But Who Insures the Insurer?: Adding to the drama of the Swiss Re downgrade is the fact that it came just two weeks after the company announced its third quarter results. Floyd Norris, the New York Times financial reporter, commenting on the Swiss Re writedown in his blog (here), noted that
Analysts are feeling abused and embarassed. One muttered that such losses evidently were not unforseeable to the people who bought the insurance. Another suggested that perhaps this would become an issue for whatever company provides directors and officers insurance for the people who run Swiss Re, and asked what company had taken on that risk.
Swiss Re would not answer that question.
Special thanks to alert reader Matt Rossman at Citigroup for links to the Swiss re articles and the Floyd Norris blog post.
Web Notes: Backdating, Subprime, "F-cubed" Claimants, and More
Thanksgiving is nigh, but big things are still happening. The Apple options backdating derivative complaint has been dismissed, AIG has been sued in a subprime-related derivative lawsuit, the Non-U.S. claimants were excluded from the Royal Dutch Shell Class, a leading plaintiff’s lawyer had some interesting things to say about subprime lawsuits, and a disappointed busted buyout target company has been sued by its own shareholders, of all things. Interested? Read on.
Apple Backdating Derivative Lawsuit Dismissed: In a recent post (here), I noted that U. S. District Judge Judge Jeremy Fogel dismissed the Apple backdating securities lawsuit, with leave for the plaintiff to refile the complaint as a derivative lawsuit. However, before that plaintiff refiles, its lawyers will want to read Judge Fogel’s November 19, 2007 opinion (here) in the previously pending derivative lawsuit against Apple (as nominal defendant) and several of its directors and officers. Judge Fogel has granted the defendants' motion to dismiss. While the dismissal was with leave to amend, it was hardly on terms that would cheer the plaintiffs’ hearts.
Judge Fogel first considered the plaintiffs’ federal law claims, on the theory that the court’s jurisdiction depends on the existence of a viable federal claim. Judge Fogel found that the plaintiffs’ Section 14(a) claims were barred by the applicable three year statute of limitation. He did allow the plaintiffs leave to amend the Section 14(a) claims, but admonished them that they should not amend the claims unless the wrongful acts alleged took place after July 30, 2003, and he further noted that "greater specificity would likely strengthen the claim considerably."
Judge Fogel next held that the five-year statute of limitations was applicable to the plaintiffs’ Section 10(b) claims, but he also found that the plaintiffs had tried to bootstrap earlier option grants by alleging that the financial misstatements caused by earlier grants were perpetuated in later financial statements. He found that this "combination" was insufficient, and that because the Section 10(b) claims depend on "such a combination, it will be dismissed." He allowed plaintiffs leave to replead the Section 10(b) claims but only as to wrongful acts that occurred on or after June 30, 2001.
The judge then went on to consider whether the plaintiffs had adequately alleged scienter. He found that the complaint is "characterized by conclusory, general and non-individualized assertions as to all Defendants." He found that plaintiffs "must provide more detailed allegations giving rise to a stronger inference of scienter on the part of each defendant." He then went on and noted that the plaintiff’s "scheme liability" allegations are subject to the pending Stoneridge case (about which refer here) and in any event were dismissed because they reflected "insufficient allegations that the various defendants’ contributions to the overall scheme had a deceptive purpose and effect."
Because the plaintiffs had not yet established a valid federal claim and therefore established federal jurisdiction, Judge Fogel did not reach the plaintiffs’ state law claims. He did, however, note that the defendants "appear to raise a number of valid arguments with respect to these claims, and plaintiffs may wish to amend the claims accordingly."
Judge Fogel’s rulings, particularly those regarding the statute of limitations issues, might well be instructive to other courts and other litigants involved in other options backdating cases. However, Judge Fogel has once again indulged in his infuriating practice of issuing his opinions "not for citation." As I previously noted here, this regrettable practice does a disservice to all litigants and every other court.
One other backdating note is that on November 19, 2007, U.S. District Judge Joel Pisano dismissed (here) the options backdating derivtive lawsuit pending against Bed Bath & Beyond (as nominal defendant) and several of its directors and officers on the grounds of the New York state court's prior dismissal (refer here) of the same claims. More about Judge Pisano below...
The Apple and Bed, Bath & Beyond dismissals have been added to the running tally of options backdating dismissals, denials and settlements that I am maintaining and that can be accessed here.
Subprime Litigation Wave Hits AIG: The outward-expanding wave of subprime-related litigation has now hit the insurance industry. According to news reports (here and here), on November 20, 2007, a shareholder filed a derivative lawsuit against AIG (as nominal defendant)and several of its directors and officers. The complaint apparently alleges that AIG improperly concealed the extent of its exposure to subprime mortgage crisis, and contains claims for breaches of fiduciary duties, unjust enrichment, and other charges.
The news articles report that the complaint alleges that the defendants had "claimed that AIG’s portfolio was so sufficiently diversified that the mortgage market would have to reach ‘Depression proportions’ before negatively impacting the company. AIG was not as invulnerable as defendant claimed, however." The complaint reportedly goes on to allege that "while defendants were directing AIG to issue improper statements concerning its exposure to the subprime mortgage crisis, they were also directing AIG to repurchase over $3.7 billion of its own shares at artificially inflated prices. Even worse, certain defendants sold their personally held shares while in possession of material nonpublic information for over $6 million in proceeds."
The complaint alleges that AIG’s results were hurt by $1.4 billion in losses in AIG’s investment portfolios and mortgage insurance business.
The new lawsuit is significant because it represents the first subprime-related D & O claim in the broader insurance industry. Given the recent news from other companies in the insurance sector (as, for example, with Swiss Re, refer here) there may well be more claims to come in the insurance sector. But even more importantly, it seems increasingly likely that the subprime wave will continue to expand, even beyond insurance and the financial services industry generally, to encompass an even broader range of companies. An example of this risk outside the financial services sector may be seen in the recent problems reports at General Motors (about which refer here). Given the remarks of the leading plaintiffs’ lawyer reported below, this possibility appears to loom even larger.
"F-Cubed" Claimants Out of Royal Dutch Shell Securities Case: As I noted in an earlier post (here), a critical question arising with increasing frequency is the jurisdiction of U.S courts for foreign litigants' securities claims against foreign companies. This question is presented in its starkest form with the so called "F-Cubed" claimants (foreign domiciled claimants who bought their shares of a foreign company on a foreign exchange, for further discussion of which refer here). In the context of a U.S. class action, the question is whether or not these claimants should or should not be included within the plaintiff class.
In a November 13, 2007 decision (here), Judge Joel Pisano of the federal court in New Jersey held that "Non-U.S. Purchasers" should not be included in the class for the Royal Dutch Shell securities class action lawsuit, and dismissed their claims on the ground of lack of subject matter jurisdiction. It should be noted for purposes of this discussion that Royal Dutch Shell is a Dutch corporation with headquarters in the Netherlands, and co-defendant Shell Transport and Trading Company is a U.K. corporation with headquarters in the U.K.
The "Non-U.S. Purchasers" consisted of "persons or entities who purchased their shares on exchanges outside of the United States and at the time of such purchase were residents or citizens of, or were created in or under the laws of any jurisdiction other than the United States." The question whether or not these person should be included in the class was particularly important in the Royal Dutch Shell case because "a great majority of the securities traded during the Class Period were traded on foreign exchanges and by the Non-U.S. Purchasers." In order to address the question, Judge Pisano appointed a Special Master, whose findings he adopted in his November 13 opinion.
In adopting the Special Master’s findings, Judge Pisano clearly was influenced by the $352.6 settlement that Shell had entered in the Amsterdam Court of Appeals in the Netherlands, with a Dutch foundation specifically formed to represent the non-U.S. purchasers’ interests. (Refer here for background regarding the Dutch settlement.) Judge Pisano specifically noted that the Dutch settlement agreement is conditioned on whether the U.S. court exercised subject matter jurisdiction over the non-U.S. purchasers.
The parties had agreed that the U.S. court’s jurisdiction over the non-U.S. purchasers depended on whether the defendants’ conduct occurred with the U.S. Essentially (I am simplifying here) because the court (adopting the Special Master’s findings) found that "the genesis of all of the original disclosures relevant to the investing public was in Europe," and the court concluded there was insufficient conduct in the U.S. to support the exercise of extraterritorial jurisdiction.
The Royal Dutch Shell opinion stands in arguable contrast to the recent Vivendi class certifications decision in which some (but not all) of the non-U.S. Vivendi purchasers were included within the class (about which refer here).
The importance of the Dutch settlement’s existence to the outcome in the Royal Dutch Shell case also presents an interesting question – would the outcome have been the same if there were no existing alternative vehicle for relief of the Non-U.S. purchasers?
In any event, while the Royal Dutch Shell class decision represents an important development in the evolving issue of U.S. court’s jurisdiction over foreign shareholders’ claims against foreign companies, it is important to note that the decision was very fact specific. Because of the decision’s fact dependency, it is unlikely to control other courts, although it does represent a procedural model and a compelling summary of the relevant legal considerations.
Finally, it should be noted that Judge Pisano later affirmed that his November 13 opinion represents a final judgment, and it is therefore appealable to the Third Circuit. So there may yet be more to be heard on this issue in this case.
Subprime: What’s Happening Now: As noted above, the subprime wave is already expanding outward, but the plaintiffs’ lawyers may just be getting started. According to recent news reports (here), Patrick Coughlin of the Coughlin, Stoia, Geller, Rudman & Robbins firm, has declared subprime the "top priority." The article quotes Coughlin as saying that subprime is "really everything and the only thing now." The news article reports that the firm had "already filed 25 mortgage-related complaints against investment banks, mortgage lenders, and others, and it expects to bring about 15 more cases." The firm is considering bringing on more lawyers.
And speaking of the Coughlin Stoia firm, I recently noted (here) that the increased securities litigation activity in the second half of 2007 is due in large part to the sudden increased activity of the firm, a fact that is corroborated in the recent news reports. The article quotes Coughlin as saying "we have filed more cases in the last three or four months than we filed in the previous year."
So much for the supposed "permanent shift" to a lower level of securities lawsuit filings.
Adding Injury to Insult: In an earlier post (here), I commented on United Rental’s litigation efforts and threats to try to compel Cerberus Capital Management to honor its agreement to acquire United Rentals. It now appears in addition to United Rental’s lawsuit against Cerberus, on November 20, 2007, certain United Rentals shareholders initiated a purported securities class action lawsuit. According to the plaintiffs’ attorneys’ press release (here), the plaintiffs allege that the company and its directors and officers violated the federal securities laws by "failing to disclose that, several weeks after the Merger Agreement was signed, Cerberus contacted [United Rentals] and expressed concern about its ability to proceed with the merger given the changes in the credit and financial markets." The plaintiffs allege that the failure to disclose these facts misled investors and caused United Rental’s shares to trade at artificially inflated prices.
While I have previously speculated that the buy-out bubble bust would provoke litigation, I confess I never anticipated the possibility of securities lawsuits by the shareholders of the disappointed target company. But there certainly are no shortage of these kinds of situations around these days, and hyperactive plaintiffs’ lawyers could well create an entire category of lawsuits like this one.
The purport of the allegations suggests a keen dilemma for company managers who are trying to hold a floundering merger together; the plaintiffs’ allegations suggest that at the very time that managers are engaged in fraught negotiations to salvage the deal, they should be publicly disclosing the challenges confronting the merger’s completion.
The problem here is that the deal fell apart, which event management was trying to prevent – there would have been no injury if the deal went through, and whatever chance there was to salvage the deal would not have been advanced if management had been issuing press releases every day about the ebb and flow of the discussions.
I feel like throwing a flag on this lawsuit. Unsportsmanlike conduct, unnecessary roughness, piling on. But that doesn't mean there won't be more cases like this one, I suppose.
UPDATE: Adam Savett of the Securities Litigation Watch blog points out that a buyout bust up previously resulted in a securities class action lawsuit in connection with the failed Harman Interational buyout. I actually discussed the Harman lawsuit in an earlier post, here. So, does two lawsuits constitute a trend?
As a result of the Sarbanes-Oxley Act and other reforms, a variety of structures and procedures were put into place to try to prevent or detect fraud. A number of these reforms involve auditors and the audit profession, in the implicit assumption that auditors have an important role to play in preventing and detecting corporate fraud. But a recent Grant Thornton survey (here) shows that many CFOs still do not feel constrained by their auditors’ oversight, notwithstanding the reform measures.
According to the survey, 62% of the 221 CFOs surveyed believe it would be possible to intentionally misstate their financial statements to their auditors. As one commentator in the November 15, 2007 CFO.com article (here) commenting on the survey put it, these numbers are "alarming," given that "CFOs – if they’ve a mind to –are in a unique position, having the necessary information, intelligence and access to trick auditors in ways that are hard to decipher."
Indeed, it is disconcerting that nearly two-thirds of CFOs feel they could fool their auditors on intentionally falsified financial statements. Clearly, if such a large percentage of CFOs feel they could, some of them might, and a few of them will. This intimation of the possibility of undetected fraud should be disconcerting to investors, analysts, and others (including D & O underwriters) who rely on auditors’ assurance that the financial statements are free from "material misstatement."
The disappointment and even anger that investors and others feel when they find they have been misled by falsified financial statements often encompasses a sense of frustration that the auditors failed to detect the fraud. Accordingly, auditors are often named as co-defendants in securities fraud lawsuits, based on a failure to detect the fraud and the auditors’ statements that there are no material misstatements in the financial statements.
But a further Grant Thornton survey finding underscores the theoretical limitations of audit fraud detection. 83 percent of the surveyed CFOs said they did not feel that it was even possible for auditors to detect corporate fraud in all cases. This survey finding embodies the same sentiment expressed in the November 2006 statement of the heads of the six leading accounting firms entitled "Global Capital Markets and the Global Economy: A Vision From the CEOs of the International Audit Networks" (here). The accounting industry leaders noted that "there are limits to what auditors can reasonably uncover, given the limits inherent in today’s audits." They go on to note that while there are audit techniques whose principal goals are to "ascertain whether fraud has occurred," these techniques are "not foolproof, nor can they be expected to be."
The problem for everyone, both auditors and those who rely in their audits, is that there is, in the words of the industry leaders’ statement, an "expectations gap." According to the accounting leaders, the gap arises because "many investors, policy makers, and the media believe that the auditor’s main function is to detect all fraud, and thus, where it materializes and auditors have failed to find it, the auditors are presumed to be at fault." The accounting leaders go on to assert that:
Given the inherent limitations of any outside party to discover the presence of fraud, the restrictions governing the methods auditors are allowed to use, and the cost constraints of the audit itself, this presumption is not aligned with the current auditing standards.
The accounting leaders’ frustration is palpable; they apparently recognize, as do the CFOs that responded to the Grant Thornton survey, that management bent on misrepresenting their company’s financial condition can conceal the misrepresentations from the auditors. But the reason there is nonetheless an expectations gap is that investors and others do rely, as they must, on company’s audited financial statements. Merely naming the problem as an expectations gap, or citing the limitations of current auditing standards, does not address the problem, which is that investors and others rely on the audited financial statements in ways the auditors apparently wish they wouldn’t or believe they shouldn’t. It almost seems as if the auditors’ message to those who would rely on financial statements is – don’t (or, at least, not so much).
Given the CFOs’ and the accounting leaders’ recognition of the limitations of audit fraud detection, it may be well argued that audited financial statements in fact should not be relied upon. But what alternative do investors have? The investors necessarily place some value on the fact that professionals independent of management have examined the financial statements. It is nevertheless a significant concern that nearly two-thirds of CFOs believe they can fool their auditors. And apparently the auditors agree with the general proposition as well. This ought to make anyone who needs must rely on audited financial statements very uneasy.
Special thanks to John Condon at Audit Integrity for the link to the survey results and the CFO.com article.
A Service Error Apology: I am sorry that early in the evening on November 19, 2007, my syndication service spontaneously generated an erroneous email with the cryptic message "Forbidden 403." (For those, like me, who have to know, Error 403 messages are explained --sort of -- here.) I do not know why this error message was sent. I apologize to all of my readers for the unsolicited distribution email. I am attempting to ensure that this error will not recur.
A November 18, 2007 New York Times article entitled "If Buyout Firms Are So Smart, Why Are They So Wrong?" (here) takes a critical look at many buyout firms’ sudden haste to walk away from deals that were much ballyhooed only a short time ago. Clearly the bloom has gone off the buyout vine. As I discussed in an earlier post (here), litigation is an inevitable byproduct of the bursting of the buyout bubble. The battle lines in many of these lawsuits will the "material adverse effects" provision in the various buy-out agreements, which permit termination of the transaction where the target company’s business conditions have deteriorated.
The right of a would-be buyer to invoke this provision is getting a close examination in the lawsuits arising our of the failed J.C. Flowers takeover of Sallie Mae. As discussed in a November 14, 2007 Law.com article entitled "Sallie Mae Litigation Raises Issue of Deal ‘Adverse Effect’" (here), J.C. Flowers is arguing that the collapse of the securitization market and the disruption of asset-backed commercial paper have disproportionately affected Sallie Mae, and therefore have had a materially adverse effect on the company. Sallie Mae for its part contends that the credit crunch was excluded from the adverse effect clause. The court has set a July trial for the dispute.
The invocation of the materially adverse effect clause is one way for a would-be buyer to attempt to bail from a pending acquisition that no longer looks as attractive. An alternative approach, albeit one rarely followed, may be seen in the action of Cerberus Capital Management, which on November 14, 2007 advised United Rentals that it was not prepared to complete its planned acquisition of the company. (Refer here for the company’s announcement.) Rather than arguing that there has been a materially adverse development, Cerberus has simply terminated the contract and tendered the specified termination fee of $100 million. As United Rentals put it,
Cerberus has specifically confirmed that there has not been a material adverse change at United Rentals. United Rentals views this repudiation by Cerberus as unwarranted and incompatible with the covenants of the merger agreement. Having fulfilled all the closing conditions under the merger agreement, United Rentals is prepared to complete the transaction promptly. The Company also pointed out that Cerberus has received binding commitment letters from its banks to provide financing for the transaction through required bridge facilities. The Company currently believes that Cerberus’ banks stand ready to fulfill their contractual obligations.
The Company’s November 14, 2007 filing on Form 8-K (here) attaches all of the critical correspondence between Cerberus and United Rentals pertaining to the deal termination. It makes for rather interesting reading.
As discussed in an excellent post on the M & A Law Prof Blog (here), buyout firms in the past would have avoided terminating a deal and triggering payment of the reverse termination fee, both because of the cost involved and because reputational harm involved in walking away from a deal. The blog post puts it, "Cerberus has decided that the reputational impact of their actions is overcome in this instance by the economics." The New York Times article cited above states that "Cerberus just proved itself to be the ultimate, flighty, hot-tempered partner."
In its November 14 press release, United Rentals also announced that it had retained counsel to represent it in potential litigation. As discussed in the M & A Law Prof Blog post, it seems likely there will be litigation, possibly involving the investment banks as well. The blog post has a detailed analysis of the relative merits of the parties’ positions as well as the likely practical implications. UPDATE: The Wall Street Journal online reported on November 19, 2007 (here) that United Rentals has initiated an action against Cerberus in Delaware Chancery Court.
In short, the prospects are that the bust of the leveraged buy-out boom will entail a wave of follow-on litigation. But it should be noted that in many instances, litigation may prove to have merely been negotiation by other means. As the Times notes,
private equity firms seem to believe that they have plenty of wiggle room. In many of the recently broken deals, they appear to have relied on litigation threats rather than contractual language when telling sellers they plan to back out. As the law firm Weil, Gotshal & Manges recently noted in a briefing to its clients, "even a weak, but plausible" argument that a material financial change has occurred may "provide a buyer with a significant leverage in negotiating a deal."
On the other hand, it is worth noting that the most celebrated case in which a buyer sought to invoke the materially adverse change clause in order to cancel a deal, Tyson Foods attempt to cancel its acquisition of IBP, was unsuccessful -- the Delaware Chancery Court granted IBP's request that the court specificially enforce the acquisition agreement (about which refer here). A good overview of the issues surrounding the "materially adverse change" clause can be found here.
More About the End of the Securities Litigation Lull: As recently noted on the 10b-5 Daily blog (here), respected experts who really should know better are continuing to repeat the now-dated view that securities lawsuits are in a downturn with "no real upturn… in sight." Regular readers of this blog know that in recent posts (here and here), I have shown that while securities filings may have been down between mid-2005 and mid-2007, since July 1, 2007, securities filings have returned to historical levels.
In a recent post on the Securities Litigation Watch blog (here), Adam Savett not only corroborated my earlier conclusion about securities lawsuit filing levels, but (armed with superior information), also further concluded that filings during the second-half of 2007 in fact are above historical levels. He specifically notes that the filing rates during the period August 1, 2007 through October 31, 2007 translate to an annualized filing rate of as many as 272 filings, which could represent as much as a 41% increase over historical filing averages (depending on whose average you use by way of comparison).
This recent increased filing trend has continued so far in November, as well. By my count, as of November 16, there had already been 13 new securities class action lawsuits in November 2007. The 10b-5 Daily notes that much of this activity is being driven by the sudden hyperactivity of the Coughlin Stoia law firm, which has been the first to file many of the newest lawsuits – which, it might be added, involved in many instances foreign domiciled defendant companies. While a full statistical analysis of the 2007 filings must await a later date, it is clear that we are long past the point where responsible persons can continue to repeat that we are in a filings lull. The lull is over, having ended months ago in the wake of subprime meltdown and the disruption in the credit market.
A particularly good discussion of the reasons for the lull and the reasons why its eventual end was inevitable may be found here, in a column written by my good friend Randy Hein of Chubb and appearing in the December 2007 issue of Directors & Boards.
Dodgy Debts, Yes, But Very Good Names: As the subprime meltdown has unfolded, many of us have struggled to understand what happened and what the effects may be. A good example of a recent attempt to explain the possible consequences may be found in the November 13, 2007 Vinson & Elkins memorandum entitled "Subprime Fallout: A Ripple Effect?"(here).
A more entertaining attempt to explain the subprime meltdown and its effects may be found on this YouTube video (special thanks to Faten Sabry at NERA Economic Consulting for the link), here:
As the options backdating cases flooded in a year ago, the standard explanation of the plaintiffs' lawyers preference for shareholders derivative lawsuits over securities class action lawsuits was that stock price declines rarely accompanied companies' options backdating disclosures. (A list showing the predominance of derivative lawsuits among options backdating cases can be found here.) Any doubts about the challenge that the absence of a stock price drop poses for erstwhile options backdating securities class action litigants should be put to rest by the November 14, 2007 opinion (here) dismissing the options backdating-related securities class action lawsuit pending against Apple and 14 of its current and former directors and officers. Background on the lawsuit can be found here.
Judge Jeremy Fogel first addressed the defendants' contention that the plaintiff's claim for "corporate overpayment" properly represented a derivative rather than a direct claim. Judge Fogel noted that
The thrust of the allegation is that the recipients of the backdated options were overpaid, in violation of Apple's stock option plans. Such allegations necessarily involve an injury to the corporation in that overpayment entails a reduction in corporate assets…. Lead Plaintiff has not identified a unique injury independent of any harm done to the corporation….Were Plaintiff to file an amended complaint, their claims would be stated as derivative claims on behalf of Apple. However, any derivative claims on behalf of Apple arising from the facts alleged in the Complaint likely would be subject to consolidation with the pending derivative action.
Judge Fogel then went on to analyze the plaintiff's purported claim for fraudulent proxy solicitation under Section 14(a). Judge Fogel noted that in order to establish this claim the plaintiff must plead "both economic loss and loss causation." Because Apple's stock price did not decline on the news of options backdating, the plaintiff bases its economic harm argument on the purported dilution to the shareholders' interests from the issuance of backdated options. Judge Fogel noted that dilution is not necessarily accompanied by economic loss, because share prices might rise on the news of retention of a key executive upon issuance of options. Judge Fogel stated that "without a discernable drop in the stock price there is no basis upon which to establish an injury to shareholders. Dura bars any suit brought solely on the basis that a misrepresentation caused an inflated share price, and Lead Plaintiff alleges no more harm."
Judge Fogel dismissed the case with leave to amend, but also with the further admonition that any amended pleading should be filed as a derivative rather than as a direct complaint.
Special thanks to a loyal reader for forwarding a link to the Apple opinion.
UPDATE: The November 19, 2007 Wall Street Journal has an article entitled "Firms Settle Backdating Suits" (here) discussing options backdating lawsuit dispositions. Full disclosure: I am quoted in the article.
A Comment on Judge Fogel's Opinion: Judge Fogel's opinion is seemingly important, particularly his comments with respect to loss causation, given that many of the options backdating cases have been filed in his judicial district – and indeed many backdating cases are pending before Judge Fogel himself. However, in issuing his opinion, Judge Fogel has repeated his unfortunate practice of issuing his opinions as "Not for Citation."
As I discussed at greater length here with respect to Judge Fogel's prior effort to bar citation of one of his earlier options backdating opinions, the attempt to delimit the precedential authority of a judicial decision is a truly regretable practice. It is as if he is attempting to say that the court's business is strictly a private affair of no concern to anyone except the immediate parties. The sheer number of options backdating cases in Judge Fogel's courthouse belies this notion. Clearly, his conclusions about loss causation are of potentially great significance for other cases and litigants. It is absurd to suppose that litigants with cases presenting loss causation issues of the kind raised in the Apple case cannot refer to the Judge's own determinations on the issue but must reargue them all over again, but that is what his citation bar suggests.
It is as if he is saying, here's my decision, but don't quote me on it. Seriously, what is that all about?
The inferential suggestion that Judge Fogel is deciding cases on other than universally applicable principles ought to be a concern both to the immediate litigants and to litigants everywhere. The practice of issuing opinions, particularly on matters of great interest and obvious significance for similar pending matters, as "not for citation" is inconsistent with our common law traditions and notions of public justice and rightly deserves the strongest disapprobation.
Two Other Options Backdating Cases: There were two other options backdating case developments in the past week. First, according to the company's November 13, 2007 8-K (here), the federal court in Oregon has dismissed four consolidated options backdating cases pending against Flir Systems as nominal defendant due to lack of standing. Reportedly, however, a separate options backdating derivative suit remains pending.
In addition, on November 14, 2007, the federal court in Manhattan denied the motion of Monster Worldwide founder Andrew J. McKelvey to dismiss the options backdating-related securities class action lawsuit pending against him. (The decision apparently relates only to McKelvey and not to other defendants in the case, which include the company itself.) According to news reports (here), the court's opinion explaining the denial. will be forthcoming shortly.
In any event, I have added the Apple, Flir Systems and Monster dispositions to my list of options backdating-related lawsuit dismissals, denials and settlements, which can be accessed here.
Thanks to a loyal reader for links regarding the Monster decision.
SEC Drops Backdating Enforcement Actions: The above litigation developments occurring in the same week in which it was revealed that the SEC will not be pursing options backdating related enforcement actions against a host of companies it had been investigating. According to a November 13, 2007 Law.com article (here), Electronic Arts, Linear Technology, Nvidia, PMC-Sierra, and Zoran have each recently announced that the SEC has advised them that it had closed its backdating investigations. In addition, Verisign (refer here) and TriQuint Semiconductor (refer here) also made recent similar announcements.
It always seemed probable that the SEC would not ultimately pursue all of the companies it was investigating for options backdating. But the collective termination of this group of investigative actions, as well as other recent judicial developments, does reinforce the impression that the options backdating scandal may have been more than a little bit overblown. However, as the White Collar Crime Prof blog notes (here), the SEC may be "clearing out its investigative docket, likely clearing out weaker cases while it prepares stronger ones for some type of enforcement action."
SEC Options Backdating Enforcement Actions: The List: We here at The D & O Diary set a lot of store by lists, having gotten such great mileage out of our lists of options backdating lawsuits (here), options backdating lawsuit dispositions (here), and subprime lending lawsuits (here). So we here were very pleased recently to discover the SEC's own list of its options backdating-related enforcement actions (here).
The SEC site not only lists the SEC's options backdating-related enforcement actions in reverse chronological order, but includes links to complaints and press releases for each action. The site also indexes SEC statements and speeches on backdating, as well as links to options backdating press releases from the Department of Justice and various U.S. Attorneys' offices. For those tracking backdating generally, this site is a great resource.
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.
On November 27, 2007, JDS Uniphase announced (here) that following a month-long trial in the securities lawsuit pending against the company and four of its former executives, the jury returned a verdict in favor of all defendants on all claims. News reports discussing the verdict can be found here and here. Law.com has a detailed November 28, 2007 article discussing the verdict here. Background regarding the JDSU securities lawsuit can be found here and my prior post discussing the JDSU trial can be found here.
On November 27, 2007, JDS Uniphase announced (here) that following a month-long trial in the securities lawsuit pending against the company and four of its former executives, the jury returned a verdict in favor of all defendants on all claims. News reports discussing the verdict can be found here and here. Law.com has a detailed November 28, 2007 article discussing the verdict here. Background regarding the JDSU securities lawsuit can be found here and my prior post discussing the JDSU trial can be found here.
