Another Securities Class Settlement Complication: Government Intervention
The securities lawsuit and the shareholder derivative litigation first arose in September 2005, when shareholders sued the company and certain of its directors and officers. Refer here for background regarding the litigation. The shareholders’ amended complaint alleged that the individual defendants inflated the company’s share value then sold substantially all their shares, shortly prior to the company’s announcement of law enforcement officials’ concerns regarding the protective value of the company’s bullet proof vests and of certain issues regarding the company’s financials. The company ultimately withdrew reliance on its financial statements for 2003, 2004 and the first nine months of 2005.
On July 13, 2006, the company announced (here) a joint settlement of the securities lawsuit and the derivative litigation. According to the company’s announcement, the settlement consisted of the company’s agreement to pay $34.9 million in cash, plus 3,184,713 shares of company stock. The derivative case was settled in consideration of the company’s agreement to adopt corporate governance reforms and pay $300,000 of the derivative plaintiffs’ counsel’s fees. $12.9 million of the cash payment is to be paid by the company’s insurers. In addition, the company’s founder, Chairman and CEO, David Brooks, agreed to resign from all positions he held.
The company itself lacked cash to fund the portion of the cash settlement in excess of the insurance. To fund the settlement, the company entered into a transaction with Brooks whereby he would received nonregistered company shares in exchange for cash the company could use to fund the settlement. In return for his agreement to provide financing sufficient to fund the settlement, Brooks required that the company release him from any claims the company might have arising from his conduct as an officer of the company.
The court has held a series of hearings to consider final approval of the settlement, but the settlement has not yet been finally approved.
In a separate but related development, on October 25, 2007, the U.S. Attorney’s Office for the Eastern District of New York filed a superseding criminal indictment (here) charging Brooks and the company’s former Chief Operating Officer with insider trading, fraud, obstruction of justice, and tax evasion. As described here, the indictment alleges that the two officials inflated the company’s stock price by manipulating its financial records to increase earnings, including fraudulent accounts of armor inventory. The two were also charged with cutting themselves company checks for personal gain. Among the personal expenses Brooks is alleged to have charged to the company are $16,000 for a photographer for his son’s Bar Mitzvah and $101,190 for a "belt buckle studded with diamonds, rubies and sapphires." A scathing commentary on the indictment and the company’s allegedly unsatisfactory role in the provision of body armor to U.S. troops in Iraq can be found here. His daughter's Bat Mizvah, which allegedly cost $10 million, has also drawn, well, interesting commentary on the Internet.
At the same time as prosecutors commenced the criminal action, the SEC also initiated a civil enforcement action against Brooks (refer here). Among other things, the SEC complaint alleges that Brooks sold $186 million of his personal holdings of DHB stock while in the possession of material nonpublic information. Among other things, the SEC complaint seeks reimbursement by Brooks to DHB of bonuses and profits from stock sales pursuant to Section 304 (the so-called "clawback" provision) of the Sarbanes-Oxley Act.
These developments in the criminal proceeding and the SEC enforcement action became relevant to the securities lawsuit and the derivative lawsuit on November 19, 2007, when the Department of Justice filed its objections to the pending shareholder litigation settlement (here).
The government’s objections to the pending settlement are two-fold: first that the criminal defendants might try to use their release in the proposed settlement "to avoid their obligation, if convicted, to make full restitution." Second, the government also objects on the ground that the proposed settlement release document purports to release the defendants from Section 304 liability, and to indemnify them for any third party Section 304 claim or settlement.
With respect to the release potentially absolving the defendants of their potential restitution obligation, the government asks for the "addition of a specific provision to the proposed settlement agreement providing that ‘nothing contained in this settlement is intended to limit the United States’ ability to pursue forfeiture, restitution or fines in any criminal, civil or administrative proceeding.’"
With respect to the government’s objections relating to Section 304, the government notes that to allow the defendants to be released and indemnified by the company "would undermine the very purpose behind Congress’ enactment of section 304." The government "asks the Court not to approve the settlement unless this provision is removed."
But the government did not stop there. Having had its say about the parts of the settlement that affect the interests of the United States, the government then went on to express its views about other aspects the settlement. As the government put it, "there are several other aspects of the proposed settlement that may warrant specific attention." In explaining its provision of these additional comments, the government added that it "takes no position" on "whether these aspects of the proposed settlement should preclude a finding that the proposed settlement is fair, adequate and reasonable."
The government’s extra two cents worth consists of the observation first that "the majority of the Defendants in these actions are [sic] not paying any consideration towards the settlement, but are nonetheless receiving broad releases." The second is that, because the company’s share price has risen since the settlement was first proposed, the value of the shares Brooks purchased to fund the settlement have appreciated, as a result of which Brooks could "earn a profit of approximately $10 million on those shares, thus reducing his out-of-pocket contribution to the settlement." Accordingly, the government notes "the Court may therefore want to assess whether Brooks’ contribution to the settlement is appropriate."
The government is of course not a party to the private securities lawsuit. The bases on which the government made its appearance are under the Class Action Fairness Act of 2005 (pursuant to which the Attorney General must be given notice of class settlement) and 28 U.S.C. Section 517 (which gives the Attorney General the right to send an officer "to attend to the interests of the United States in a suit pending in a court of the United States.")
While the U.S. government uses its Section 517 authority to appear in a wide variety of cases (refer, for example, here and here), I am not familiar with the government using this authority to intervene in a private securities class action to object to its settlement --I welcome others' comments if this is more common than I am aware. In any event, it may be that the government resorted to this approach due to the fact that the case settlement preceded the indictment, as a result of which the government was unable to arrange the kind of collaborative settlement, for example, recently announced in connection with the UnitedHealth Group options backdating derivative settlement and SEC settlement.
But the troublesome thing about the government’s objection in the DHB Industries case is that having made its appearance, the government took the liberty of providing its own commentary on the merits of other aspects of the settlement. Section 517 may give the government authority to "attend to the interests of the United States" in pending lawsuits, but even under Section 517, the government's role is limited to "attending" to the interests of the United States.
Whatever else anybody might want to say about these circumstances, the parties to the lawsuit have the right to negotiate their interests, without concerns of the government providing potentially obtrusive supervision. The class members are fully and appropriately represented under class action procedures, subject to the court's review. Individual class members retain all of their rights to object to the proposed settlement and in fact some members of the class in fact have done so. What right does the government have to criticize elements of the settlement beyond the government’s interests?
The government’s actions undoubtedly are a reflection of the unique circumstances surrounding the case. But the prospect of the government acting as a kibitzer on class settlements is a concern. The terrain surrounding private securities class action litigation is already challenging enough without the government getting into the act.
Special thanks to Bill Baker of Latham & Watkins for sending along a copy of the government’s objections.
Securities Litigation Filing Trends: In recent posts (most recently here), I have noted that during the second-half of 2007, securities lawsuit filing levels have returned to historical norms after a tw0-year lull. In the most recent issue of InSights, entitled "The Two-Year Lull is Over: Securities Lawsuit Filings Rise" (here), I detail the recent increase in securities lawsuits filing activity and comment on the potential significance of these changes for the D&O insurance marketplace.
Blog Watch: The D & O Diary has recently been reading with interest the postings on the new blog PomTalk (here), a blog on corporate and securities law issues of interest to institutional investors produced by the Pomerantz Haudek Block Grossman & Gross law firm. The blog looks like a worthy addition to the blogosphere, and we look forward to reading future PomTalk posts.
Oil in Hell: Those struggling to understand how so many of the big investment banks have gotten burned so badly on their own holdings in subprime mortgage-backed securities may gain some insight from this excerpt, taken from the Chairman's Letter in the 1985 Berkshire-Hathaway Annual Report:
You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not .... Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence," said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”