The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a July 25, 2007 opinion (here), the Tenth Circuit examined whether misrepresentations in financial statements incorporated by reference in a D & O policy application could serve as a basis for policy rescission under Utah law.

The case involved a D & O policy issued to ClearOne Communications in 2002. In early 2003, ClearOne issued a press release stating that its financial statements from the preceding two years should not be relied upon, in part because the company had discovered that the company had entered distributor agreements that had the effect of accelerating revenue recognition. This disclosure triggered shareholder lawsuits (refer here), for which the company sought coverage under the D & O policy. The D & O carrier sought to rescind the 2002 policy based on the financial misstatements, which the carrier contended had been incorporated by reference in the policy application. ClearOne and one of its directors sued the carrier, seeking to enforce their rights under the D & O policy. The District Court held that the carrier had properly rescinded the policy.

On appeal, the Tenth Circuit made a number of findings. The Tenth Circuit found first that Utah law did not prohibit incorporating the financial statements into the application by reference; second, that the District Court did not err in finding that there was a sufficient misstatement to establish rescission, if the other elements were met; third, under Utah law, a misrepresentation occurs if the applicant knows or should have known about a misstatement in the application and still presents it to the insurer; and fourth, that the record was unclear whether the official that completed the application "should have known" about the financial misstatements, and so the Tenth Circuit remanded the case back to the District Court on this question.

The Court went on to construe the "severability" clause in the policy, which limits the imputation to other insureds of knowledge of misstatements, and so potentially preserves coverage for insureds who were unaware of the misstatements. The severability language in the ClearOne policy was limited by the language in the relevant section's preamble that restricted nonimputation to the "questions 8, 9 and 10" in the application. Since the insurer's rescission claim was based on answers and information provided in response to question 14, rather than on questions 8,9 or 10, "the severability clause does not cover ClearOne's misstatement and it would be ineffective against [the carrier's] rescission of the insurance policy in its entirety should the financials be deemed to be a non-innocent misrepresentation."

This Tenth Circuit's discussion of the severability issue is an important reminder of the potential significance of seemingly subtle differences in policy language. If the ClearOne severability language had been broader and not restricted to the specific application questions, then there would be a possibility that coverage might be preserved for innocent insureds even if the carrier were otherwise able to establish grounds for rescission. The marketplace has evolved significantly since the ClearOne policy was placed in 2002, so it is hardly fair to judge the language in that policy by today's standards. But there is no doubt that in the current marketplace it is possible to obtain severability language that provides more comprehensive and less restricted nonimputation protection for innocent insureds. In addition, a complete management liability insurance program today would also include a Side A/DIC policy intended to protect the directors and officers in the event that the traditional D & O policy were to be rescinded. These considerations collectively represent another example of the importance of involving knowledgeable insurance professionals in the D & O insurance acquisition process.

For a good summary of the issues surrounding the severability clause in D & O policies, refer to this article (here) by noted D & O commentator Dan Bailey.

Special thanks to Dan Standish of the Wiley Rein law firm for forwarding a link to the 10th Circuit opinion in the ClearOne case.

Climate Change and Board Duties: In earlier posts (most recently here), I have examined the increasing D & O risk arising from global climate change liability exposures. A July 24, 2006 Law.com article entitled "Boardroom Climate Change" (here) written by Jeffrey Smith and Matthew Morreale of the Cravath law firm takes a closer look at board room risks arising from global climate change and examines the ways in which climate change decision-making will "test the limits and scope of fiduciary duties of officers and directors as their responses to matters relating to climate change are questioned by stakeholders."

The authors identify "five new phenomena" that "pose new challenges for directors overseeing climate change decision-making": 1) uncertain and fragmented environmental legislation and regulation; 2) the reactions of capital and insurance markets to emerging climate change business opportunities; 3) increasing stakeholder activism; 4) pending litigation; and 5) the rapidly evolving scientific debate.

The authors contend that these factors have "added a new dimension to management's obligation to monitor corporate performance and make informed decisions in light of all reasonably available material information." The article concludes by noting that:

To the extent that a company's response to climate change becomes a proxy for both smart management and corporate stewardship, directors have an incentive to be increasingly vigilant in assuring that management has maximized economic opportunity, reduced economic risk and preserved corporate reputation.

As I have previously noted, these changing circumstances not only provide opportunities for "smart management and corporate stewardship"; they also provide a context within which it is prudent to assume that claims will arise, alleging that boards failed to exhibit appropriate management and stewardship. For that reason, boards must anticipate that "stakeholders" increasingly will demand action and information surrounding climate change issues. Companies should also anticipate that D & O underwriters increasingly will inspect companies' climate change related disclosures and actions. By the same token, D & O insurance policy wordings, particularly the pollution and the bodily injury/property damage exclusions, and program structure, including the incorporation of appropriate Side A/DIC protection, will be increasingly important parts of corporate risk management, in light of increasing potential exposures arising from global climate change.

A good summary of the climate change-related D & O policy wording issues can be found in this recent article (here) by my good friend Joe Monteleone. Joe and I will be among the panelists speaking in a Mealey's teleconference on D & O Litigation Topics on August 15, 2007 (refer here), including, among other things, issues pertaining to global climate change.

Hat tip to the SOX First blog (here) for the link to the Law.com article.

"Exploding" FCPA Enforcement Activity: In earlier posts (most recently here), I have addressed the growing corporate exposure arising from antibribery enforcement. The significance of these issues was underscored in a July 25, 2007 memorandum from the Gibson, Dunn & Crutcher law firm entitled "The FCPA Enforcement Explosion Continues" (here).
According to the memorandum, the law firm has identified "approximately 100 companies" that currently have open Foreign Corrupt Practices Act (FCPA) investigations. The memorandum's authors also state that they "expect U.S. authorities to initiate an increasing number of enforcement actions in the next few years and to seek more severe penalties for FCPA violators."

This growing FCPA enforcement threat was demonstrated just this week, with the news, according to the July 25, 2007 Wall Street Journal (here), that the Department of Justice is conducting a criminal investigation involving nearly a dozen oil and oil services companies focusing on illegal payments to customs agents in Nigeria, Kazakhstan, and Saudi Arabia.

In earlier posts (refer here), I have noted that the D & O risk associated with FCPA enforcement actions arises not so much from the FCPA enforcement action itself, but from the threat of follow-on civil claims brought by shareholders and based on the improper activity or associated disclosures. The Gibson Dunn memorandum, referring to the same cases I have previously cited, expressly notes the growing threat of FCPA-related follow-on civil litigation and states that "in the current environment of heightened scrutiny" these kinds of claims "may start to gain traction.' The memorandum further emphasizes that "one thing is clear: the legal road towards resolving an FCPA violation in the U.S. now stretches far beyond achieving peace with the DOJ and the SEC."

Away Message: The D & O Diary's publication schedule will slow down for the next few days. I will resume my "normal" schedule after August 6.

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In a recent post (here), I discussed the recent work of two blue-ribbon groups focused on eliminating "short-termism" and recommending, among other things, the elimination of quarterly earnings guidance. The results of the National Investor Relations Institute's 2007 Earnings Guidance Practices Survey (press release here, survey results here) suggest that more companies are shifting away from quarterly earnings per share guidance. The survey results also appear to refute the suggestion that companies that eliminate guidance suffer adverse effects, as discussed further below.

The NIRI survey's results appear somewhat contrary to some recent academic research on related topics. An April 2007 paper by Joel Houston and Jenny Tucker of the University of Florida and Baruch Lev of New York University entitled "To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance" (here) takes a look at a sample of 222 companies that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005. The authors found that the "stoppers" ceased guidance for a variety of reasons, all suggesting operating weakness or other concerns, such as poor earning performance, poor record beating estimates, change in management, or difficulty in predicting earnings. The authors also found that "stoppers" experienced a relative decrease in analyst coverage and a relative increase in analyst forecast dispersion.

In summarizing their findings, the authors state:

In a nutshell, guidance cessation follows a poor operating performance and causes a deterioration in the information environment about the company. The major benefits claimed from stopping quarterly guidance - enhanced investment in the long-term and increased strategic disclosures - do not appear to materialize. Moreover, 31% of the stoppers in our sample subsequently resumed quarterly guidance, suggesting that it is rather difficult for firms to buck the trend and abstain from quarterly earnings guidance. Thus, we conclude that, consistent with economic theory, decreasing disclosure - stopping guidance in our case -does not seem to benefit investors or firms.

The 2007 NIRI survey report paints a different picture, perhaps because its survey reflects a later time period than the period the academics studied. The NIRI survey group also includes companies that never provided earnings guidance, as well as "stoppers," which may account for some of the differences in findings.

The NIRI survey found that only 51% of 2007 survey respondents provide earnings guidance of some kind, compared to 60% of 2006 survey respondents, and that only 47% of 2007 survey respondents provide revenue guidance, compared to 56% of 2006 survey respondents. Of the survey respondents that provide guidance of some kind, only 27% provide quarterly guidance. The 133 responding companies that provide quarterly guidance represents only 17.68% of the 752 survey respondents.

The NIRI survey's findings about the impact on "stoppers" who ceased providing earnings guidance in the last 24 months contrasts significantly from the findings in the academics' research. The NIRI survey results reflect an indifferent reaction from both the buy-side and the sell-side to the elimination of quarterly earnings guidance. The NIRI survey respondents reported that discontinued guidance had a neutral effect on their company's stock's valuation and volatility, and that their companies had not experienced unusual shareholder turnover. Moreover, only 11% of the companies that do not provide guidance were even considering providing guidance in the future.

Perhaps the later time period reflected in the NIRI survey compared to the time period reflected in the academics' research explains some of the differences between the two reports. A more cynical view might be that the NIRI study is a survey that depends on respondents' views, whereas the academics' analysis was based on the companies' actual performance.

In any event, the presence or absence of guidance may make less of a difference for companies' goals than is generally assumed. A July 23, 2007 Wall Street Journal article entitled "Numbers Game: Why 'Guidance' May Not Matter" (here, subscription required) reported on a recent study by Thomson Financial that took a look at company performance relative to guidance. Conventional wisdom holds that company executives use guidance to "manage expectations" by keeping analysts' estimates low ahead of earnings announcements, so that the reported numbers look better. But the Thomson Financial study found that between 2001 and 2006, the S & P 500 companies that issued guidance beat analysts' estimates 65% of the time, while companies that didn't issue guidance beat analysts' estimates 63% of the time.

But whatever companies' motivations may be for providing guidance, the NIRI survey suggests that fewer and fewer companies are doing it. I don't think the academics' research can be disregarded, but I think it may need to be updated. For example, if the class of "stoppers" were brought up to date and the early part of the academics' data set eliminated (say, data from years 2002 and 2003), the academics' research might well more closely resemble the NIRI survey's results.

In any event, the academics' analysis also represents a particular point of view. The academics expressly advocate the view that it is better if companies provide guidance, on their generalized economic theory that more information is better for the marketplace. But whatever the merits of this analysis in its own context, it is divorced from the practical effect that a public earnings prediction has on the behavior of company officials. Specifically, companies that have established a target will strain to meet it. As I have previously noted (most recently here), a short term orientation driven by earning estimates is frequently at the heart of problems that lead to shareholder claims. I am all in favor of complete disclosure about past performance. But whatever the arguable economic benefits from trying to make public predictions about the future, from a risk standpoint, companies will always be better off keeping their projections to themselves, particularly on quarterly projections.

A July 24, 2007 CFO.com article discussing the NIRI survey results and the academics' reserach can be found here.

Deeper Dive: In an earlier post (here), I took a look at the 2007 year-to-date securities lawsuits, and I also took a look (here) at the question whether the downturn in securities lawsuits may be temporary or is permanent. In the latest issue of InSights (here), I take a deeper look at both of these topics.

D & O Litigation Update Teleconference: On August 15, 2007, from 2:00 pm to 3:45 pm Eastern, I will be participating in a Mealey's sponsored D & O Litigation Update teleconference (here). My co-panelists are Marialuisa Gallozzi of the Covington & Burling law firm and Joe Monteleone of the Tressler, Soderstrom law firm. Topics to be discussed include the impact of global warming legal and regulatory issues on the board room and on D & O exposure; the impact of recent Supreme Court decisions, including Tellabs; D & O coverage issues arising from the subprime lending lawsuits; and problems with insurability of Section 11 settlements.

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In an earlier post (here), I examined recent academic research questioning whether the rating agencies have played a blameworthy role in the subprime lending industry, and speculating on the rating agencies' possible litigation exposure. On July 19, 2007, the rating agencies potential litigation risk moved from supposition to reality when a shareholder of Moody's filed a purported class action lawsuit (here) alleging that Moody's failed to disclose that it "assigned excessively high ratings to bonds backed by risky subprime mortgages," and that Moody's maintained the ratings "even as the downturn in the housing market caused rising delinquencies of the subprime mortgages."

The Complaint also alleges that on July 11, 2007,

Moody's shocked investors when it announced that the Company was downgrading 399 mortgage-backed securities issued in 2006 and reviewing an additional thirty-two for downgrade, affecting approximately $5.2 million of bonds. The Company also disclosed that it had downgraded 52 bonds issued in 2005.

A July 11, 2007 Wall Street Journal article discussing Moody's downgrade of the mortgage-backed securities can be found here.

There are a number of odd things about this Complaint. First, there is the fact that it is Moody's shareholders who are bringing the lawsuit, not, as you might suppose, investors who purchased the mortgage-backed securities that supposedly were assigned excessively high ratings. The lawsuit is brought on behalf of "all purchasers of the common stock of Moody's between October 25, 2006 and July 10, 2007. " I guess the wrongdoing Moody's is alleged to have committed affected a wide variety of arguably aggrieved persons, even including Moody's shareholders. As I noted in my recent post (here), subprime lending related litigation is arising in an ever-increasing variety of forms. It's just that the investors whose investments supposedly were misleadingly rated would seem to be the ones more likely to assert a grievance about supposedly excessive ratings Moody's allegedly assigned.

The second odd thing about the Complaint is that the lawsuit names as the sole defendant Linda Huber, Moody's CFO. The Complaint does not name Moody's itself or any of its other officers or directors as defendants. The Complaint alleges that Huber was in possession of "adverse undisclosed information about the company's business." There is of course no requirement that any plaintiff name any particular defendant in a lawsuit, but there is something, well, unusual about just naming the CFO and no one else. (UPDATE: Alert reader Avi Wagner of the Stoock $ Stroock & Lavan law firm suggests that the explanation for the complaint only naming the CFO might be that the attorney hopes to bury the notice; by not naming a corporate defendant, a notice might catch fewer eyes and might not be registered with people searching courthouse news or other litigation filing reports.)

Another odd thing about the Complaint is that it involves Moody's, rather than another of the rating agencies. Of course, that is who Moody's shareholders would sue, if in their status as Moody's shareholders they would sue anybody. But the Complaint was filed just a day after Moody's own rather public whinge that, as the Wall Street Journal put it in its July 18, 2007 article "Moody's Says It is Taking a Hit" (here, subscription required), it is "paying a high price for its tough stance on lax lending standards for commercial mortgage backed securities." According to the Journal article, Moody's claims that it was "passed over and not hired to 75% of the commercial mortage-backed securities rating assignments" because the securities issuers "were hiring competitors that would hand out higher ratings on securities." In other words, by Moody's account, if there were excessively high ratings for mortgage-backed securities, it wasn't Moody's doing, thank you very much.

To be sure, even by Moody's own account, it was not until this past April 10 that it announced that it was (according to the Journal) "raising subordination levels of commercial mortgage-backed securities in an effort to enhance credit quality and further reduce the possibility of widespread defaults." The negative inference is that prior to April 10, Moody's did not have these heightened requirements.

Whatever the merits and ultimate fate of this recently filed lawsuit, the purported class of Moody's shareholders who acquired their stock between October 2006 and July 2007 would not include Moody's most prominent shareholder, Warren Buffett. According to Berkshire Hathaway's 2006 Annual Report (here), Berkshire owned 48 million Moody's shares - or 17.2% of the company - as of December 31, 2006. These shares have been reported in every Berkshire annual report since 2001, suggesting that Berkshire acquired the shares some time during 2001 -- in any event, well before the beginning of the class period.

It is probable in any event that Buffett has much more positive feelings about Moody's than does the plaintiff who initiated the lawsuit. According to Berkshire's 2006 Report, its Moody's shareholdings cost only $499 million, but as of December 31, 2006, were worth $3.315 billion. (Assuming Berkshire still holds the same number of Moody's shares, the stock would be worth about $2.832 billion today.) As I have noted more than once in this blog, you do have to admire Buffett's touch.

Hat tip to the WSJ.com Law Blog (here) for the link to the Moody's Complaint.

UPDATE: On August 29, 2007, shareholders of McGraw-Hill filed a lawsuit (refer here) alleging that the company failed to disclose that its Standard & Poor's subsidary "assigned excessively high ratings to bonds backed by risky subprime mortgages -- including bonds packaged as collateralized debt obligations -- which was materially misleading to investors concerning the quality and relative risk of these investments."


In keeping with the Harry Potter theme of my prior post, it may be worth noting here that one of the ill-fated Defense Against Dark Arts teachers at Hogwarts was none other than Alastor "Mad Eye" Moody. "Mad Eye" Moody has no known relationship with the rating agency, however. Nor as far as I know did he have any role in the subprime lending mess.

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In a July 18, 2007 publication entiled "IPO Executive Insights 2007" (here) the Nixon Peabody law firm published the results of its survey of 100 chief executive officers and chief financial officers whose companies conducted initial public offerings in the past three years. The report contains a number of interesting observations, but perhaps the most remarkable are in the summary of advice the executives have for companies now considering going public. For example, one survey respondent cautioned:

Going public is like standing in front of the X-Ray machine for every. Once one goes public one cannot go back. In other words, you are completely exposed; everything about the business is in the public domain and is in front of the competition. It is a very different environment than being a private company....Living under regulations like Sarbanes-Oxley can be crushing to a company that is not prepared to understand and manage such regulations.

A July 23, 2007 Wall Street Journal article further summarizing the survey results can be found here (subscription required).

The noted regulatory constraints might be a reason that some companies might consider listing their shares on the London Stock Exchange's Alternative Investment Market (AIM) (here). Perhaps the most valuable part of the survey report is its brief discussion of the advantages and disadvantages for a U.S.-based company in listing shares on the AIM.

The report notes that "utilizing AIM does provide a company certain advantages due to its flexible regulatory approach, lower costs and streamlined admissions process." However, the report also points out a number of risks for U.S.-based companies considering an AIM offering." The risks include:

Number of Shareholders May Trigger Reporting Obligations: Once shares are issued, "a company may have difficulty controlling the number of shareholders of record who eventually own its stock." The problem is that U.S. companies that have more than $10 million in assets "will become subject to the provisions of the Exchange Act" (including its periodic reporting requirements) if they have 500 or more shareholders of record.

Time Requirements: A company selling its shares on AIM must develop a relationship with institutions selling the company's shares. Because of travel requirements and time zone differences, these requirements can be substantial.

Reduced Liquidity: AIM has a reputation for being illiquid, and as a result investors may have difficulty disposing of their shares.

Poor Post-IPO Performance: "Post-IPO Performance for AIM shares compare unfavorabley with companies listed on NASDAQ."

AIM's Limited Diversity: Mining and energy companies account for close to half of AIM's total market value. A company that is not in one of these industries "may not garner the interest of institutional investors who buy AIM stock or the attention the company would otherwise get in another marketplace."

In light of these limitations, it is hardly surprising that, as the report notes, "AIM's growth has slowed in 2007." According to the report, the number of AIM offerings during the first four months of 2007 was more than 50% below the number of offerings during the comparable period in 2006.

Book Note: We here at The D & O Diary are impatiently waiting for our household resident teenagers to hurry up and finish reading the recently released Harry Potter book so that we can get a crack at it. While waiting our turn, we have been fortunate to have found a terrific book that we are happy to recommend to our readers.

Some readers will be sure to recall the rich combination of modern physics, philosophy and drama in Michael Frayn's Tony award-winning play "Copenhagen." (Others may recall Frayn's superbly funny farce, Noises Off.) In his 2006 book The Human Touch: Our Part in the Creation of the Universe (here) Frayn returns to the overlapping area between theoretical physics and philosophy to examine, in brilliant and entertaining fashion, questions about the universe and man's role in it. This book is as rich and rewarding as it is well-written. It would be difficult to capture the depth and breadth of this book in a single snippet, but I offer the following brief excerpt of an example of the book's reach and elegance:

Our own particular speck of the universe, the planet we live on, is as irregular as everything else. A sphere, which seems a neat enough idea - but a sphere that isn't exactly spherical, wobbling a little on its axis and spinning not quite regularly. With a surface as rumpled as an unmade bed, splashed with seas and lakes as haphazard as the spills on a bar, under a shifting blanket of air and water vapour as confused as a drawerful of tangled string.

The oddest feature of this wobbly spheroid, though, is one particular class of things scattered about amidst the rest: a range of entirely anomalous objects that construct themselves out of the material around them, and then replicate themselves - perhaps the only objects of this sort in the entire universe. Among these weird anomalies is a sub-group with a few thousand million members that are even odder, because they also have some inkling of just how odd they are.

Perhaps not everyone will find this kind of thing an adequate substitute for the urgent strivings of the adolescent wizards at Hogwarts, but I find it sufficient (at least for now).

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the personal exclusions do not override a present contractual duty to advance defense costs unless the Defendants can unequivocally now show that all of the allegations in the Illinois Class Action complaint fall within the personal conduct exclusions. Defendants have failed to show at this juncture that any of the exclusions are definitely imputed to [Hollinger] Even though the Defendants argue that Radler's guilty plea imputes the transactions to [Hollinger], the Illinois Class Action includes transactions that were not part of Radler's guilty plea....Because the Defendants have failed to show at this time the applicability of the exclusions to [Hollinger], the Court need not decide the potential applicability of the exclusions at this time.

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In prior posts (most recently here), I have noted the threat of Foreign Corrupt Practices Act (FCPA) investigations as a growing area of corporate risk. Several recent reports substantiate this concern and help explain why this area of risk continues to grow, and also highlight some of the barriers to antibribery enforcement.

A June 26, 2007 memorandum prepared by the Shearman & Sterling law firm entitled "Recent Trends and Patterns in FCPA Enforcement"(here) reports that "there has been a dramatic increase in new investigations" and that "both the DOJ and the SEC have become increasingly aggressive." According to the memorandum, there are now 55 open FCPA investigations (at least that have been publicly reported by the companies under investigation).

Part of the reason for the increased investigative activity is the increase in governmental resources devoted to foreign bribery investigations. According to a July 16, 2007 Law.com article entitled "Why Are More Companies Self-Reporting Overseas Bribes?" (here), the SEC has "added about 700 staffers to help enforce all compliance laws," and the DOJ and the FBI have both added substantial staff focused exclusively on FCPA investigations.

The more important factor for the growth of FCPA cases may potential corporate defendants desire for leniency under federal sentencing guidelines. A corporation's cooperation can produce substantial benefits; the Law.com article linked above describes in detail the substantial efforts to cooperate that Baker Hughes recently undertook in connection with its ongoing FCPA investigation (about which see my prior post, here), as a result of which Baker Hughes apparently avoided paying "an additional $27 million in fines."

These kinds of incentives have motivated companies to come forward and self-report (as I have previously noted, here). According to the Shearman & Sterling memo, during the period 2005 to 2007, some 23 of 26 new FCPA cases were self-reported. The memo notes that these numbers "underscore the trend toward companies taking on the onus of reporting or accountability and may indicate that companies now perceive the act of self-reporting to be favorable to the ultimate outcome of the investigation." An interesting additional statistic the memo notes is that many of the voluntary disclosures came after violations were unearthed in the due diligence process for a merger or acquisition. (The memo cites the recent ABB, InVision and Titan Corporation investigations as examples.) As the M & A pace continues, there may be more of these M & A related self-disclosures.

The international scope of the crackdown on corrupt practices is documented on the 2007 Progress Report (here) of Transparency International (here) on enforcement of the Convention on Combating Bribery of Foreign Public Officials (here) of the Organization for Economic Co-Operation and Development (OECD) (here). The OECD Convention, first established in 1997, is a compact of now 37 countries (including the United States) to adopt and enforce antibribery laws. The Report shows that while there has been some progress in the battle against bribery and corruption, "there has been little or no enforcement in twenty countries, demonstrating significant lack of political commitment by over half the signatories."

The Report specifically cites the UK's termination of its investigation of bribery allegations against BAE Systems on the Al Yamamah arms project in Saudi Arabia (see my prior post here) as a "serious threat to the convention," and states that the UK's "national security concern" explanation for terminating the investigation "opens a dangerous loophole that other parties could assert when investigations may offend powerful officials in important countries." Because of these concerns, the Report notes that the Convention may be "at a crossroads."

Despite these concerns, the Report does also note that during the prior year foreign bribery investigations were brought in twenty countries out of then thirty-four active signatory countries, as opposed to only seventeen out of thirty-one countries the preceding year. In addition, during the prior year there were bribery prosecutions bourght in sixteen of the thirty-four then-active signatories.

These numbers, as well as the growing number of Convention signatories, suggest that notwithstanding troublesome setbacks and lapses in political will, enforcement of antibribery laws remains an important factor in the global business marketplace. As I have noted previously (here), this exposure represents a substantial area of D & O risk, particularly with respect to the threat of follow on civil litigation based on antibribery investigations. These recent reports suggest that this could become even more significant in the months ahead.

Special thanks to a loyal reader for the link the Law.com article. Hat tip to the SOX First blog (here) for the link to the Transparency International report.

A Backdating Case Dismissal: In an order dated July 16, 2007 (here), in the consolidated options backdating related Ditech Networks derivative litigation, Judge Jeremy Fogel of the Northern District of California granted (with leave to amend) the individual defendants' motion to dismiss based on the insufficiency of the plaintiffs' pleading. The Opinion states:

As currently pled, the Complaint alleges fraudulent conduct by labeling various grants as backdated and describing them as having been made at low points within certain defined periods....While counsel for Plaintiffs represented at oral argument that the statistical likelihood of the options having been granted properly is very low, that theory is not alleged in the Complaint or in a document that the Court may consider on this motion. Even assuming that the factual allegations of the Complaint are true, many explanations other than options backdating exist for the coincidence of the grants and a low share price. The following factual detail likely would strengthen the Complaint: the degree to which the options were granted at the discretion of the compensation committee or the board, versus at fixed, preestablished times; the actual grant dates of the options and the appropriate price of the options; the date that the options were exercised; whether required performance goals were met before the options were granted; the presence or absence of other major corporate events, such as an acquisition, at the time of the grants; and the results of any request by Plaintiff for information.

Because of the inadequacy of the plaintiff's allegations, Judge Fogel noted that it would be "premature" to address federal statute of limitations and Delaware state law demand futility issues. (It should be noted that the Ditech opinion is designated as "not for publication" and "may not be cited.")

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for the link to the Ditech Networks opinion.

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The July 17, 2007 Wall Street Journal reports (here, subscription required) that private equity firm Apollo Management L.P. will (after selling a portion of the firm to the Abu Dhabi Investment Authority) be listing its shares on the new Goldman Sachs private securities exchange. The Apollo listing follows a couple of months after Oaktree Capital Management listed on the Goldman Sachs exchange.

The new Goldman Sachs exchange is one of several new private (or lightly regulated public) exchanges that have emerged in recent months. These developments raise some interesting (and potentially urgent) questions, such as: What are these new exchanges? Why are issuers and investors drawn to them? What are the implications for existing traditional markets? And what are the risks and exposures for the listing companies that access these markets?

What Are The New Exchanges?: The full name of the new Goldman Sachs exchange is the "GS Tradable Unregistered Equity OTC Market," or GSTrUE for short. A good introduction to the GSTrUE can be found here. The idea behind the market is to allow private firms to raise money and create a way for their executives to cash out, without the burden, expense, delay - or scrutiny -- of registering shares or taking on reporting responsibilities. The Goldman Sachs exchange is private and unavailable to individual investors. The exchange is available only to institutional and other sophisticated investors.

According to news report (here), NASDAQ is preparing to introduce a new electronic platform called "The Portal," to allow buying and selling of Rule 144A shares. The purpose of the exchange is to allow institutional buyers of the securities to have a market within which to later trade the shares, in the hope that the availability of a trading platform will improve investment liquidity and support improved valuations. The Portal is slated to launch in August (refer here). NASDAQ touts the Portal's advantage over the GSTrUE exchanges as a neutral platform that is not restricted to customers of a single bank. NASDAQ's application for SEC approval for the trading platform can be found here.

In addition to these private exchanges, the London Stock Exchange announced on July 12, 2007 (here) that it will launch a dedicated market for issuers of specialized funds (the "Specialized Fund Market") to create a separate market for alternative assets such as hedge funds and private equity vehicles. The market is designed to provide a trading platform and investment liquidity, in a structure restricted to trading professionals. The market is for issuers that wish to target institutional investors, such as single strategy funds, feeder funds, specialized sector funds, and specialized geographical funds. Commentators suggest (here) that the new LSE market , which unlike the GSTrUE and the Portal will at least be "lighly regulated," is designed to compete with Euronext Amsterdam for listing alternative funds.

Each of these initiatives is different and each of them is designed to achieve different goals. What they have in common is that they each provide a way for issuer companies and funds to reach institutional investors through a trading platform on which their shares can trade without the need for full registration or the adoption of full reporting status.

What Does the Record So Far Suggest?: Prior to Apollo's announcement, the only prior issuer to list on the GSTrUE was Oaktree. According to news reports (here), in May 2007, Oaktree raised $800 million by selling about 14% of the firm to 50 investors. According to today's Journal article, "Oaktree listed at only a slight discount to the valuation it could have received on the public markets."

At least based on Oaktree's experience, the GSTrUE exchange (and potentially, The Portal) offer plausible alternative ways for firms to issue tradable shares without undertaking an IPO in the public securities markets. Specifically, the Oaktree and Apollo transactions seem to represent an alternative to the public offerings that Blackstone Group and Fortress Investment Group recently completed, with the advantage that Oaktree and Apollo could complete their offerings without the burdens and scrutiny of a public offering. The Portal provides a way for private companies to offer their qualifying investors a public market and enhanced liquidity for the private company investment.

While these private markets may offer issuers an alternative to the public markets, to the public markets these innovations represent yet another threat. As I have previously noted (most recently here) several blue ribbon panels have recently been concerned with the competitiveness of the U.S. securities exchanges. But the new markets represent an innovation that addresses needs that may not be possible to meet in the public markets. Like the forces of globalization that are encouraging new markets that compete with the U.S. based public securities markets, the need for innovation is yet another force stronger than the gravitational pull of the public securities markets themselves.

What is the Regulatory Context?: For the private exchanges to avoid SEC regulation, investors will have to be limited those with over $100 million in investable assets, and in order to avoid triggering reporting requirements, any listed U.S. entity will have to make sure it does not exceed more than 500 shareholders. These restrictions obviously put certain limitations on liquidity (as, it should be noted, does the likely absence of analyst coverage).

The absence of regulatory scrutiny and reporting requirements may act as a deterrent to some investors. The potential lack of transparency may even violate the investment policies of certain public funds or other fiduciary entities. In addition, the continued ability of these markets to attract investors will largely depend on the markets perceived trustworthiness. A scandal or report of a deceptive practice by one or more issuers trading on these private exchanges could undermine market trustworthiness and potentially the confidence of the investors. The incentives of the exchanges to maintain their integrity could potentially conflict with the issuers' interests, or at least the interests of those issuers whose primary attraction to the exchange is a desire to avoid transparency and scrutiny.

What is the Risk Environment?: While the listing companies, if compliant with the requirements, will remain outside the reporting system, they will not be trading in a parallel universe to which the laws do not apply. Aggrieved or disappointed investors who believe they have been misled or deceived will identify any number of legal theories they might use to pursue legal claims against the private exchange listed firms, including, for example, common law fraud and misrepresentation theories. Of course, the institutional investors who are able to invest on these private exchanges would perhaps be less likely than retail investors to initiate litigation. But as, for example, institutional hedge fund investors have recently shown (here), given sufficient provocation, institutional investors are very willing to use litigation to redress concerns.

Issuer companies of the caliber of Oaktree and Apollo would enhance any market. But a market whose main attraction is lack of scrutiny and of reporting obligations could potentially attract participants whose presence may ultimately have a different effect on the market than enhancement. If that should happen, and unanticipated losses emerge, the lawsuit genie inevitably will escape from the bottle.

The point is that the issuers trading on these new private exchanges will not exist in a risk free environment. The perception of risk for hedge funds, private equity funds and venture capital funds has evolved in recent years; so too will the risk perception for issuer companies whose shares trade only on these private exchanges. The trading nonpublic company will represent a new category of risk. The arrival of private securities markets and of the companies whose shares trade only on their exchanges will require adaptation. To the extent the demand emerges, the insurance industry will likely need to develop new products designed to address the special needs and evolving risks of these companies.

But make no mistake, the continuing development of GSTrUE market and the anticipated arrival of the NASDAQ Portal, as well as the continued innovation in the public markets such as the LSE, represent categorically new developments that will require innovation and adaptation, particularly if their impact on the public markets is anything more than marginal.

Government Cash, Global Markets: The Abu Dhabi Investment Authority (here), with estimated assets of over $600 billion, receives the governemental revenue of Abu Dhabi's oil industries. ADIA is the largest of the new breed of governmental investment authority that is playing an increasingly large role on the global financial scene. In a prior post (here), I discussed the Norwegian Government Pension Fund (here), which at nearly $300 billion in assets is not only large, but is also playing an increasingly activist role in governance matters. Other significant governmental investment authorities include the Government of Singapore Investment Corporation (here). The very size of these entities make them important players in the financial markets. Their influence will only continue to grow as commodities scarcities dictate global cash flows. The unavoidable importance of these institutions is a looming omnipresence, that for good or ill will increasingly affect international investments in the years ahead. The political risk behind all this is a large and scary topic, but one that at least for now can be left for another day.

Location, Location, Location: Abu Dhabi, the largest of the seven emirates of the United Arab Emirates, and also UAE's capital, has a population of about 1.8 million people, about the same size as metropolitan Cleveland. But it doesn't have Lake Erie. Sure, sure, Abu Dhabi has lots of oil. But think about it. In the 21st century, fresh water could prove to be a lot more imporant than oil. I wonder if the ADIA will amasss enough wealth to be able to buy Lake Erie?

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In a 64-page opinion dated July 16, 2007 (here), U.S. District Court Judge Lewis Kaplan granted the dismissal motions of thirteen of sixteen of the individual defendants in the KPMG tax shelter litigation, ruling that he had no choice but to dismiss the charges because prosecutors had violated the constitutional rights of defendants when they coerced KPMG to cut off the defendants' legal fees.

Judge Kaplan had previously ruled (see prior post, here) that the government's action in implementing the now-superseded Thompson Memorandum (which provides guidelines for corporate prosecution) violated individuals' constitutional rights. Since that time, Judge Kaplan and the Second Circuit had wrestled with the appropriate remedy for these constitutional violations. (The Second Circuit's opinion can be found here.) In his July 16 order, Judge Kaplan ruled that dismissal was the only appropriate remedy under the circumstances.

It is important to note that the government itself had urged, in light of the Court's prior finding of constitutional misconduct, that dismissal was the appropriate remedy for thirteen of the sixteen defendants. (The government's filing in connection with the dismissal motion can be found here.) The government's position was widely viewed as tactical, calculated to hasten the government's opportunity to appeal to the Second Circuit Judge Kaplan's prior finding of constitutional violation. News reports discussing the goverment's position can be found here.

But Judge Kaplan not only granted the dismissal, as the government itself had sought, and not only reconfirmed his prior findings of constitutional violation, he added additional findings that the government's conduct "shocks the conscience in the constitutional sense." Speaking of the prosecutors, Judge Kaplan said

Just as prosecutors used KPMG to coerce interviews with KPMG personnel that the government could not coerce directly, they used KPMG to strip any of its employees who were indicted of means of defending themselves that KPMG otherwise would have provided to them. Their actions were not justified by any legitimate governmental interest. Their deliberate interference with the defendants' rights was outrageous and shocking in the constitutional sense because it was fundamentally at odds with two of our most basic constitutional values - the right to counsel and the right to fair criminal proceedings. But the Court does not rest on this finding alone. It would reach the same conclusion even if the conduct reflected only deliberate indifference to the defendants' constitutional rights as opposed to an unjustified intention to injure them.

Judge Kaplan reviewed the impact of the government's conduct on each of the individual defendants, concluding that four of the defendants were deprived of counsel of their choice, and nine defendants were would be forced to mount less of a defense than they would have presented had KPMG paid their fees. Three of the defendants, a former KPMG partner and two former KPMG employees, would not have had their fees paid by KPMG and therefore their rights were not violated and their dismissals were denied.

In granting the individual defendants' motion, Judge Kaplan squarely put the blame on the government:

The Department of Justice, in promulgating the aspects of the Thompson Memorandum here at issue, and the [United States Attorney's Office] in the respects discussed above and in [Judge Kaplan's prior opinion], deliberately or callously prevented many of these defendants from obtaining funds for their defense that they lawfully would have had absent the government's interference. They thereby foreclosed these defendants from presenting defenses they wished to present and, in some cases, even deprived them of counsel of their choice. This is intolerable in a society that holds itself out to the world as a paragon of justice. The responsibility for the dismissal of this indictment as to thirteen defendants lies with the government.

While Judge Kaplan's strongly worded ruling unquestionably represents a defense victory, the government will undoubtedly appeal Judge Kaplan's findings of unconstitutionality, so the battle for the dismissed defendants is far from over. (The White Collar Crime Prof Blog has an interesting commentary, here, on the possible impact of the government's tactical maneuvering on its appeal prospects.)

There are several noteworthy aspects of Judge Kaplan's dismissal ruling. The first relates to his observations about the defense expense associated with a case as massive as the KPMG tax shelter case. Although a few of the defendants are in straitened circumstances, most of them are millionaires. Yet even the wealthier individuals could not, Judge Kaplan found, afford to mount the defense their case required, given its magnitude. Or at a minimum they could not afford to mount the defense they would have mounted had KPMG paid for their defense. Judge Kaplan noted that while individual's defense expense estimates ranged from $7 million to $24 million, the estimates averaged $13 million, an amount clearly far beyond the reach of even many wealthy individuals.

The enormous potential costs of this type of criminal litigation - and the enormous power of the government to impose costs of this magnitude on individuals - absolutely requires that the government only exercise this power pursuant to strict constitutional guidelines. For the government to use its coercive power to compel employers to withhold funding for legal fees, particularly fees of this magnitude, imposes a form of severe punishment on individuals prior to a finding of guilt or even trial. The need for restraints around government behavior that could produce results of this type will clearly gain momentum from Judge Kaplan's opinions in the KPMG tax case.

The government, perhaps with its hand forced, had evinced its recognition of the circumstances; in December 2006, the Department of Justice , as noted in a prior post (here), issued modified guidelines in the form of the McNulty Memorandum. But in the meantime, Congress has stepped forward to address these issues.

As a means to address these issues through legislative action, Senator Arlen Specter introduced a Senate bill (as discussed in a prior post, here) designed to address a variety of concerns with the government's corporate criminality guidelines, specifically to bar the government to use the threat of indictment to compel corporations to waive their attorney client privilege or cut off the payment of employees' attorneys' fees.

On July 12, 2007, Rep Bobby Scott (D. Va.) introduced a House Bill (H.R. 3013, "The Attorney-Client Privilege Protection Act of 2007," here) which is identical to the Senate bill. In his press release announcing the bill (here), Rep. Scott said that "when government agencies use tactics that violate Constitutional rights, it is time for Congress to act." The legislation enjoys the support of diverse groups, including the ACLU (here), the American Bar Association (here), and the National Association of Criminal Defense Lawyers (here).

The need for reinforced constraint and clarity in this area is compelling. Corporations faced with their own possible criminal prosecution must be certain that their payment of attorneys' fees to employees will not subject them to the possible corporate death sentence in the form of a criminal indictment. Individuals facing the possibility of defense fees so enormous they could exceed the ability of all but a very few individuals to pay would like the reassurance that their rights to indemnification from their employer will be honored. These individuals' ability to defend themselves - indeed, their ability to benefit from their constitutional rights - hangs in the balance.

The New York Times article discussing Judge Kaplan's dismissal opinion can be found here. A Bloomberg.com article discussing the opinion can be found here.

Hat tip to the WSJ.com Law Blog (here) for the links to Judge Kaplan's July 16 opinion, the government's dismissal memorandum and the Second Circuit opinion. The WSJ.com Law Blog has a helpful chronology of events leading up to Judge Kaplan's most recent opinion, here.

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In early 2006, I nominated (here) the then-beginning wave of options backdating lawsuits as "this year's model" - that is, the hot litigation trend that was being driven by the business scandal most prominent at the time. We are now well into 2007, but I have only just now determined the 2007 nominee for this year's model. I can now say it with confidence: This year's model undoubtedly has to be subprime lending related lawsuits.

The litigation fallout from the subprime lending morass has already taken a wide variety of forms. In an earlier post (here) that I have been updating periodically, I listed the securities class action lawsuits that have ensnared subprime lenders, as well as the class action lawsuits that have been filed against home builders in the wake of decreased availability of easy credit. (I also noted in my prior post the ERISA lawsuit that employees have filed against Fremont General, the subprime lender, in connection with Fremont stock in their 401(k)).

In addition to these lawsuits listed in my prior post, subprime lending related litigation is arising in an ever-increasing variety of additional forms:

Borrowers Suing Lenders: These lawsuits allege that lenders have misrepresented aspects of their mortgage loans. For example, a class action brought by 1,600 borrowers against NovaStar Mortgage recently settled for $5.1 million (refer here). The NovaStar lawsuit alleged that the broker or lending officer who placed the mortgage was financially rewarded for steering borrowers to higher interest rate loans.

A more recently filed class action lawsuit filed by the NAACP (refer here) alleges that mortgage companies discriminated against African Americans by steering them toward higher-interest rate subprime loans while giving more favorable rates to white borrowers.

Borrowers Suing Financial Institutions: As detailed in a June 27, 2007 Wall Street Journal article entitled "How Wall Street Stoked the Mortgage Meltdown" (here), borrowers have sued a unit of Lehman Brothers for its investment involvement with a subprime mortgage lender, essentially on the theory that the Lehman unit was an enabler that encouraged unsavory tactics and practices from which Lehman profited.

Regulators Suing Lenders: A story this big inevitably will attract grandstanding politicians, and so in June, Ohio Attorney General Marc Dann sued 10 mortgage lenders (refer here), accusing them of pressuring real estate appraisers to inflate home values, a practice Dann claims left borrowers with homes that can't be sold and loans that can't be refinanced. (It is worth noting that Ohio's foreclosure rate is nearly twice the national average.) In addition, 49 states announced on July 12, 2007 (refer here) that Ameriquest Mortgage had agreed to pay a class of 481,000 borrowers $325 million for not properly disclosing terms of home loans.

Financial Institutions Suing Lenders: According to recent press reports (here), a subsidiary of Deutsche Bank has filed at least 15 lawsuits seeking as much as $14 million from mortgage companies, alleging they failed to buy back loans with early defaults. Subsidiaries of Credit Suisse and UBS reportedly also have filed similar lawsuits.

Investors Suing Financial Institutions: In April, Bankers Life sued Credit Suisse Group alleging that it lost money on investment grade bonds backed by subprime mortgages sold by the bank (refer here). Bankers Life is seeking to recover about $1.3 million for losses of principal, interest and market value.

Investor concerns about mortgage-backed securities are likely to continue. Moody's has recently indicated (refer here) that it intends to cut its credit ratings on a group of collateralized debt obligations (CDOs), the day after Moody's and S & P both said they would downgrade hundreds of subprime-mortgage backed bonds widely held by CDOs. Undoubtedly these downgrades (and others likely to come in the months ahead) will affect asset values for investors holding these assets. Credit Suisse recently attempted (here) to quantify the likely magnitude of the losses to come from bonds backed by subprime mortgages, and put the number at $52 billion. Other estimates range as high as $90 billion.

As investors experience declines in asset values, they will increasingly turn against the financial institutions that created the financial instruments. As I detailed in my prior post (here), investors may also turn against the rating agencies that assigned investment grade ratings to the financial instruments whose high-grade (or higher-grade) valuations stoked the entire machine.

While all of these identifiable threats and existing lawsuits would alone be sufficient to earn subprime lending lawsuits their designation as "this year's model," there is a deeper reality that makes the designation even more compelling.

According to Banc of America Securities (refer here), about $515 billion in adjustable rate home loans, more than 70 percent of which were made to subprime borrowers, will have interest rate resets before year end. Another $680 billion reset next year. Borrowers unable to support higher interest payments will also likely to be unable to refinance, and so the current wave of defaults and foreclosures will only grow in the near term --which in turn further erodes the values of the financial instruments that the loans backed.

The recent (and seemingly belated) investment downgrades for mortgage-backed securities, not to mention the recent near-collapse of the two Bear Stearns hedge funds (refer here), represent the canary in the coal mine on the issue of asset valuations. Institutions that own financial instruments with valuations now pegged at certain levels will increasingly find themselves compelled by events or expectations to reassess the valuations at which these assets are carried, and make disclosures about those valuations. Any balance sheet resets (or for that matter, failure to reset balance sheets) will mean increased turbulence for financial institutions involved in the mortgage backed securities business as well as for investors that hold the securities. As the concentric rings from asset valuation issues spread outward, an increasing array of companies will become engulfed in the litigation wave.

These threats, immediate and future, pose an enormous challenge for D & O underwriters and others who must identify and quantify risk exposures across companies and industries. The most obvious center of concern is the companies in the subprime lending and mortgage backed securities industries. But investors owning the subprime mortgage-related financial instruments also carry a significant risk profile. This investor group includes not only hedge funds (and hedge fund investors), insurance companies, pension funds (and pension fund beneficiaries), and commercial banks, but others whose balance sheets reflect significant asset values from mortgage backed securities. This latter group could include some surprising players, as many companies (for example, high tech companies) that have carried significant cash or cash investments on their balance sheets may have invested in mortgage-backed securities to boost returns.

And in the outermost of the concentric circles, there will be the universe of companies whose financial fortunes were driven by the availability of easy credit for home buyers: home builders, home improvement companies, home furnishing retailers, appliance manufacturers, construction materials companies, not to mention real estate brokers, surveying companies, title insurance companies, and everybody else whose fortunes may shrink in an era of tighter lending guidelines and a housing stock oversupply driven by a crescendo of defaults and foreclosures.

All in all, this year's model is pretty darn unattractive. It could get even uglier in the weeks and months ahead.

"Rahodeb" Means "Incredibly Stupid": One of the strangest stories to come along in a very long time has to be today's news (refer here) that for eight years Whole Foods Markets co-founder and chief executive John Mackey was posting online remarks in a Yahoo stock-market forum related to Whole Foods' archrival Wild Oats Markets under the pseudonym "Rahodeb." Whole Foods is now trying to buy the very company that Mackey had been for so long badmouthing online. Mackey not only used the forum to criticize the competition and, it seems, defend his own haircut, but, ironically, to assert that Wild Oats' managment "clearly doesn't know what it is doing." (He would appear to be somewhat of an expert on the topic of management that clearly doesn't know what it is doing.)

Mackey's online activites not only show incredibly poor judgment. They also beg the question: how in the world does the CEO of a $5 billion market cap company have time to hang around in online chat rooms?

As might be expected, this story has attracted some pretty interesting commentary, including this discussion of the possible legal issues Mackey's activities raise, in the Legal Pad blog (here). Yahoo has helpfully compiled all of Mackey's message board posts here.

Did You Hear the One About the Naked Sleepwalking Director?: Perhaps today was just the day for strange D & O related stories, but the July 12, 2007 Financial Times has this item (here, entitled with classic Brit restraint, "Kenmare Row Over Nude Director") about the now-former director and audit committee head of Kenmare Resources who apparently engaged in a May drink-fueled naked sleepwalk that somehow managed to bring him to the door of the company's (female) secretary and financial comptroller three times. Somewhat reassuringly, all three occasions apparently occured on the same evening. The individual former director in question, who does not deny that the incident(s) occured, insists that his ouster relates to his disagreement with other board members over strategy. I know this sounds like a bad Monty Python skit, but I promise, I am not making this up.

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In a prior post (here), I took a preliminary look at the securities class action filings for the first half of 2007. In a July 10, 2007 press release (here), Stanford Law School and Cornerstone Research released their own mid-year report discussing the year-to-date filings through June 22, 2007. The full Cornerstone Report can be found here. (The Cornerstone Report's analysis differs slightly from mine because my analysis included all filings through June 30.)

Cornerstone's Report confirms that securities filings remain "well below historical averages for the fourth consecutive six-month period." The press release contains a quotation from Stanford Law Professor Joseph Grundfest that after two years, the lower filing level "is starting to look like a permanent shift, not a transitory phenomenon" - although the Report itself contains conflicting projections about the possible levels of future filings, as discussed below.

The Report projects a year-end 2007 filing level of 124 class actions (consistent with my prior projection), which is well below the 12-month filing average of 203 class actions for the period from the second half of 1996 through the first half of 2005. The Report analyzes these levels in relation to the number of publicly traded companies by comparing the number of filings to the number of issuer companies. The Report states that the projected 2007 "number of filings per issuer" of 1.6% is well below the 2.3% average of filings per issuer during the period from the second half of 1996 through the first half of 2005.

The Report proposes two alternative (but not mutually exclusive) explanations for the continued lower filing levels. The first is the "less fraud" hypothesis, and the second is the "strong stock market" hypothesis. The "less fraud" hypothesis is based on the view (in Professor Grundfest's words) that "increased enforcement activity and a heightened awareness among corporate insiders may have led to a shift in the incidence of securities fraud litigation." The "strong stock market" hypothesis is premised on the observation that we have now enjoyed several years of strong stock market performance characterized by historically low stock price volatility. (Volatility has been correlated in the past with securities class action activity.)

These two possible explanations lead to "differing expectations for future levels of class action filings." The "less fraud" theory suggests a permanent shift, but the "strong market" suggests that the current lower level of securities class action filings is only temporary. Indeed, one of the Report's co-authors, John Gould, is specifically quoted as saying "if the market goes south, I would not be surprised to see the number of filings move back to the 200 per year level."

The Report's quotations from Professor Grundfest also include his refutation of that the prosecution of the Milberg Weiss firm and two of its partners (so far) is "chilling" the securities class action plaintiffs bar. He rejects the suggestion that "the prevalence of alleged questionable, unethical or illegal kickback or fee splitting activity is so pervasive in the class action bar that the Milberg indictment chilled other plaintiffs and law firms from instituting class actions."

The Report also details that the total market capitalization losses on cases filed in the first half of 2007 are slightly above losses associated with 2006 filings, although the losses continue at levels well below those observed in the 2000-2002 period.

The Report's analysis of the possible reasons for the lower lawsuit filing levels is interesting. I remain skeptical that we have moved to a permanently lower level of fraudulent activity. I am inclined to think that given the low stock market volatility that the Report itself details, the marketplace is now just reacting less to adverse public disclosure. (Herb Greenberg details this phenomenon in his July 7, 2007 discussion in the Wall Street Journal, here, about the lack of marketplace reaction to accounting scandals).

I also think the historically low interest rate environment has enabled many companies to use low-cost debt to avoid crises that could have otherwise required disruptive disclosures. As credit becomes less freely available and more expensive, and as volatility levels revert to the historical mean, more disruptive disclosures may be required and the stock market may prove less forgiving than it may have been in the recent past. For that reason, I personally am inclined against Professor Grundfest's view that we have passed some epochal threshold on the occurrence of fraudulent activity. I am much more inclined to the alternative view that changed marketplace conditions could lead right back to historical filing levels.

I also have to respectfully disagree with Professor Grundfest's rejection of the possibility that the Milberg Weiss criminal investigation is a contributing cause to the reduced filing levels. I start with the fact that the reduced filing levels first emerged in mid-2005, at the same time that the grand jury returned its first indictment in the Milberg Weiss investigation (about which refer here). I add the observation that the most prominent lawyers at the two most prominent plaintiffs' law firms, as well as the firms themselves, have been highly preoccupied by the criminal prosecution. I also add the common sense observation that it is extremely improbable that the behavior that is the target of the Milberg investigation was limited exclusively to that law firm. All of these factors added together mean to me that the Milberg Weiss criminal proceeding, and the scrutiny of the kickback practices, has had to have had some impact on the filing activity levels.

The quotation in the Cornerstone Report to the effect that changed stock market conditions could lead us right back to the 200 filings a year level represents a strong precautionary warning to the D & O industry. It would be a very short step from Professor Grundfest's statement that there may have been a "permanent shift" in the filing levels to the conclusion that there has been a permanent shift in D & O exposure, and that D & O pricing appropriately should be reduced commensurately. Carriers that were to act on this seeming logic could quickly find themselves instead in a very serious trouble if instead of permanently lower frequency levels, the filing levels were to revert to historical norms.

The Report's observations about the level of investor losses associated with 2006 and 2007 filings are also interesting. Most of the discussion within the D & O industry in recent months about the lower frequency levels has usually been accompanied by observations that severity levels are at all time highs. But as the level of investor loss associated with class action filings falls well below levels from the era of the corporate scandals earlier this decade, and as the cases associate with the corporate scandals work their way out of the system, the severity levels should be expected to decline. It may be that in the months and years ahead we will see severity levels fall below their current record high levels.

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The agreement by now-former Milberg Weiss partner David Bershad to enter a guilty plea in connection with the government's investigation of the firm's alleged kickbacks to individual class plaintiffs represents a watershed event, not only in connection with the criminal investigation but also potentially for the Milberg firm and even for the plaintiffs' class action securities bar. Bershad's plea agreement can be found here and the Statement of Facts accompanying the plea agreement can be found here. (Hat tip to the WSJ Law Blog, here, for the links to the plea documents.)

The Statement of Facts accompanying the plea agreement has a number of interesting features, not the least of which is the statement of potential criminal matters the government agrees that it will not continue to pursue against Bershad. The non-prosecution agreement includes not only the allegedly improper payments to class plaintiffs, but also references alleged violations of law arising out of "requests to courts for reimbursement of fees and costs of a damages expert witness and/or his associated entities based in Princeton, New Jersey" or "the Princeton Expert's financial relationship with PNC bank." These allusions to the expert witness apparently refer to regular Milberg Weiss expert witness John Torkelson, who separately entered his own guilty plea in an unrelated matter in November 2005 (refer here). Bershad's plea agreement also references non-prosecution for "election, campaign or other political contributions." Unfortunately, the plea agreement provides no further elaboration on what this last point might be all about.

Another interesting feature of the Statement of Facts is its description of the personal cash pool that Bershad and other Milberg partners supposedly formed to be "used by the Conspiring Partners to supply cash for secret payments to paid plaintiffs and others." The contributions to the pool, which was maintained in Bershad's office, were proportionate to the contributing partners' respective partnership interests. The contributing partners then "caused Milberg Weiss to award 'bonuses' to them" to reimburse them for the cash contributions to the pool. Among the partners alleged to have contributed to and made cash payments out of the fund are the pseudononymous "Partner A" and "Partner B" whom some commentators (refer here and here) believe to refer to Melvyn Weiss and Bill Lerach, respectively. Neither Weiss nor Lerach has been charged with any crime, nor even mentioned by name in any of the government documents in the criminal matter.

Among other features of the government's undertakings in the plea agreement is the government's agreement that if Bershad provides "substantial assistance to the prosecution" (according to the plea agreement's specifications) then the government agrees "to move the Court...to fix an offense level and corresponding guideline range below that otherwise advised by the Sentencing Guidelines, and to recommend a sentence no greater than the low-end of this reduced range." In other words, Bershad has a real incentive to cooperate - he will undoubtedly provide the government with a lot more particulars about the "cash pool" and the activities in connection therewith of Partner A and Partner B. (According to the Washington Post, here, Bershad could avoid jail time altogether if the government elects to fully reward him for his help.) These incentives are the reason that there had been speculation (refer here) that Bershad's entry into a plea agreement might well put enormous pressure on, say, Partners A and B.

There had been press coverage (refer here) suggesting that Mel Weiss and Bill Lerach had recently rejected possible plea agreements. (The Wall Street Journal also confirmed here that Lerach will retire from his firm by year's end.) Whether or not they will face further pressure or have further opportunities to reach an accommodation with prosecutors remains to be seen. But the obvious incentive for the government to reach an agreement with Bershad was to enlist his assistance to go after 'bigger fish" (as the Los Angeles Times put it, here) - which would suggest further pressure on Messrs. Weiss and Lerach. Indeed, most of the press coverage of Bershad's plea is focused on the boost Bershad's cooperation will give the prosecutors, as illustrated for example in the articles in USA Today (here) and the Wall Street Journal (here)

Where all of this leaves the Milberg Weiss firm itself is even more complicated. The firm was named as a defendant in the prior criminal indictment (refer here). The Statement of Facts accompanying Bershad's plea suggests that firm checks were used for some of the improper payments and that the partnership itself reimbursed the payoff pool participants out of partnership proceeds. Bershad's actions were clearly undertaken on the firm's behalf, as well. Whether the firm itself will now be forced to face the music also remains to be seen, but Bershad's forthcoming cooperation with the government does not bode particularly well for the firm. According to the Washington Post (here), the firm's criminal defense lawyer is negotiating with the government toward a possible plea agreement, supposedly involving a "multimillion dollar" payment, in advance of a scheduled August 6 hearing. The Legal Pad Blog's very pointed comments about the Milberg Weiss firm's fate can be found here.

It may take a while longer for all of these possibilities to sort themselves out, but make no mistake that the consequential effects from Bershad's plea agreement will, in the end, result in a reordered plaintiffs' class action bar. The role of the most prominent players and prominent firms on the plaintiffs' side will substantially change. Other plaintiffs firms may jockey for position, but only within the constraints of the game as it will now be played in the backwash from these events. Among other things, these events may also portend that the current lower level of securities class action filings may continue for some time, if for no other reason than that the leading players are just a little preoccupied right now.

Options Backdating Litigation Update: Regular readers know that I have been maintaining a list (here) of companies that have been sued in options backdating related litigation. I have recently updated the post to include in the list of companies named in options backdating related securities class action litigation a reference to PainCare Holdings. When the securities class action lawsuit was originally filed against PainCare (refer here), the lawsuit did not contain options backdating allegations. But when plaintiffs filed their Amended Consolidated Complaint on May 23, 2007 (here), the amended pleading included for the first time allegations of stock option manipulations. In light of the amended allegations, I have added the PainCare case to the list.

Special thanks to Cara Perlas of the Stanford Law School Securities Class Action Clearinghouse for the link to the amended complaint in the PainCare case.

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At the beginning of 2007, I took a closer look at the 2006 securities class action lawsuits (here). Now that we have reached the halfway point of 2007, it seems like a good time to take a look at the securities suits that have been filed so far this year.

I have based my review on the 2007 filings listed on the Stanford Law School Securities Class Action Clearinghouse website (here). I have taken the data as presented. Were I using these data for actuarial purposes, I would probably make a few adjustments. For example, the site's list includes at least 2 lawsuits against private companies, and at least one lawsuit where the publicly traded company is the plaintiff, not the defendant. For simplicity's sake, I have taken the data as presented, without any refinement, to avoid the need for a detailed explanation of what I omitted or included.

According to the Stanford website, there were 62 companies sued in securities class action lawsuits during the first half of 2007, which means that we are on pace for roughly 124 lawsuits by year's end. That would be slightly more than the 118 lawsuits filed in 2006. The projected 2007 number of 124 lawsuits is well below the 1996-2006 average for traditional securities class action lawsuits of 187 per year.

The companies sued so far in 2007 are spread across 47 different Standard Industrial Classification (SIC) Codes. The SIC Code with the highest number of companies sued is 2834 (Pharmaceutical Preparations), which is the SIC Code of 5 of the companies sued. There were four companies sued in SIC Codes 2836 (Biological Products), 4899 (Communications Services), and 6331 (Fire, Marine and Casualty Insurance).

The most frequently sued industrial sector so far this year has been Technology (with 15 of the lawsuits), followed by Services (14), Financial (13) and Healthcare (11). The most frequently sued industries are Biotechnology and Drugs (5), Insurance (Property and Casualty) (4), and Electronic Instruments and Controls (4).

Eight of the lawsuits involve companies domiciled outside the United States (I omitted the one case where the public company is the plaintiff from this count). The list of foreign defendants includes companies based in Israel (2), Canada, Bermuda, South Korea, Great Britain, Switzerland and China.

The lawsuits have been filed in 23 different district courts. The district courts in which companies most frequently have been sued are the Southern District of New York (13), the Central District of California (7) and the Northern District of California (4).

Nine of the class action lawsuits involve allegations involving the defendant company's initial public offering. Five involve allegations of options backdating. Six involve allegations involving subprime lending (four involving lenders, two involving home builders).

In a prior post (here), I took a closer look at subprime lending lawsuits. And in another prior post (here), I took a look at the lawsuits that have been filed against pharmaceutical companies.

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The Supreme Court's decision in the Tellabs case (about which refer here) is still new and as yet untested in the lower courts. But post-decision publications and discussions are continuing, as key players wrestle with its possible implications. In particular, D & O industry participants have been struggling to discern whether or not the decision represents a significant shift in D & O exposure. (A copy of the Tellabs opinion can be found here.)

Upon consideration of these post-decision publications and discussions, I have some further reflections about the Tellabs decision (beyond those in my initial post on the case, here) which are as follows.

Private Securities Suits Are "Essential": In its opening lines, the majority's Tellabs opinion states that "this Court has long recognized that meritorious private actions to enforce federal antifraud securities lawsuits are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively by the Department of Justice and the Securities and Exchange Commission." (Emphasis Added). As if this statement were not sufficiently emphatic, the majority opinion returns to this same theme again, in footnote 4, where it states that "private securities litigation is an indispensable tool with which defrauded investors can recover their losses."

These statements not only underscore the importance that the Supreme Court attaches to private securities litigation, but they also represent an important (and perhaps influential) perspective in the current debate surrounding possible securities litigation reform (about which refer here and here). The Court's statements provide a significant counterpoint to the contentions of would-be reformers who propose to eliminate private securities litigation, in favor of arbitration or of a government-action only model.

Scienter Requirements Deferral: One ever-present wildcard when the Supreme Court agrees to hear a securities case is the possibility that the Court might finally get around to addressing the long-deferred Hochfelder question -- that is, whether reckless behavior is sufficient for civil liability in a Section 10(b) action. The Tellabs court, in footnote 3, specifically acknowledged that it had "previously reserved" this question, but noted further that the question whether and when recklessness satisfies the scienter requirement was "not presented in the Tellabs case."

The Tellabs court noted that all of the Circuit Courts agree that recklessness is sufficient to satisfy the scienter requirement, although the court noted further that the Circuits "differ in the degree of recklessness required." The court's forebearance on this issue leaves in place the Ninth Circuit's anomalous holding that the scienter requirement requires a showing of "deliberate or conscious recklessness." For whatever this current state of affairs may represent, the pre-Tellabs disposition of the circuits on this issue remains unchanged. The Ninth Circuit's more demanding standard (about which refer here), which has resulted in a greater dismissal rate and arguably a reduced filing rate in that Circuit, remains in place.

Uniform Standard, Disparate Impact: The Supreme Court agreed to hear the Tellabs case in part because of the disagreement in the Circuits over what satisfies the PSLRA's requirement that a securities complaint plead facts that give rise to a "strong inference" that the plaintiff acted with scienter. As a result of the Tellabs majority's opinion, the district courts in the various Circuits will now apply a uniform standard going forward. But because the Circuit Courts previously had differing standards, the practical impact of this uniform standard will vary by Circuit according to the standard that previously applied. This means, as the Morgan Lewis law firm noted in its memorandum commenting on Tellabs (here), that "whether the Tellabs decision improves the litigation climate for a defendant depends on where the defendant has been sued."

The most obvious impact will be in the Seventh Circuit, where the Tellabs case originated. The Supreme Court overturned the Seventh Circuit's standard (which the K&L/Gates law firm in its memorandum commenting on the Tellabs decision, here, characterized as an "outlier") that a complaint was sufficient if it alleges facts "from which, if true, a reasonable person could infer that the defendants acted with the requisite intent."

This outcome represents a victory for defendants in the Seventh Circuit, but at most a "mild" victory, in the words of the Morgan Lewis law firm's memorandum. The Seventh Circuit's standard, requiring only that an inference be plausible, clearly falls short of the statute's requirement that that the inference be "strong." (The inadequacy of the Seventh Circuit's standard was so manifest that the Securities Law Prof Blog, here, characterized its rejection by the Supreme Court as "quite predictable.")

On the other hand, the Supreme Court rejected the standard urged by Justices Scalia and Alito in their concurring opinions, that the statute requires a plaintiff to allege facts sufficient to support the "most plausible competing inferences." In rejecting this standard, the K&L/Gates law firm's memorandum notes, the Supreme Court appears to have rejected the standard adopted by at least four of the Circuit Courts (the Sixth, First, Ninth and Fourth). For defendants in these circuits, it may now prove more difficult than in the past for defendants to prevail on a motion to dismiss, as a result of the rejection of the more rigorous standard. By the same token, the Tellabs standard, according to the K&L/Gates memo, appears substantially similar to the standards that applied in the Eighth, and arguably, the Tenth Circuits.

The Tellabs opinion's impact in the Second and Third Circuit may be less clear. The Supreme Court did not adopt the "motive and opportunity" standard that had applied in those Circuits, but in articulating its own standard, the Court noted that while "motive can be a relevant consideration," the absence of a motive is "not fatal." District courts in the Second and Third Circuits will adapt to this subtle shift in the pleading standard, but whether this change will prove outcome determinative remains to be seen.

In short, the practical impact of the Tellabs decision necessarily will be a mixed bag. That is undoubtedly why the Securities Law Prof blog opined (here) that the balance that the Tellabs courts struck "probably inflicted the least amount of damage on the plaintiffs" among realistic outcomes given the language of the statute.

Does Tellabs Change D & O Exposure?: Despite these considerations, the popular press generally has characterized the Tellabs case as a victory for the defendants and as a defeat for plaintiffs -- for example, here and here. (This view has also been expressed in some law firms' memoranda as well; for example, refer to the Proskauer Rose law firm's memorandum, here.) This perception that Tellabs represented a major victory for defendants seems, at least based on my recent conversations, to be the view most predominant in the D & O industry as well. This view in turn has led some to whom I have spoken in the D & O insurance industry to question whether the Tellabs decision represents a significant reduction in D & O exposure, and that D & O insurance pricing therefore should be expected respond accordingly.

This discussion is highly reminiscent of the debate that followed the original enactment of the PSLRA in the mid-90s. Then, several key players took the view that the statute had dramatically reduced securities litigation risk, and they cut their D & O insurance prices accordingly. But securities litigation levels soon returned to (or beyond) pre-PSLRA levels, and the D & O industry has taken years to recover from the ensuing bloodbath. This all-too-recent episode, caused by erroneous presumptions about reductions in the risk exposure, should give everyone pause as they speculate about the possible effects of the Tellabs decision.

Another reason for caution is that it is far too early to predict how district courts will apply the Tellabs case. The discussion above about the opinion's likely disparate impact further argues against jumping to conclusions about how it will affect overall D & O risk exposure.

It is entirely possible that the Tellabs decision will not, in the end, have that much of an impact one way or the other. Indeed, Justice Scalia expressly acknowledged this possibility in voting with the majority notwithstanding his view that the statute requires a more rigorous standard that the majority opinion adopted; as he stated, "I doubt in this instance, what I deem the correct test will produce results much different from the Court's."

The one category of cases that Tellabs undoubtedly will affect is that in which the existence of the allegedly fraudulent scheme is implausible. Not only is this the correct and desirable outcome, but as a practical matter, it is almost certainly the outcome to which the district courts would tend, regardless of the theoretical legal standard to be applied.

My crystal ball is no better than anyone else's, but I believe that the Tellabs court's balanced approach will in the end not have a material impact on the number of cases that get dismissed or on the number of cases that get filed. To be sure, the Tellabs opinion has clarified where battle lines must be drawn, and the placement of the battle lines may well affect some skirmishes. But neither side has been handed a strategically decisive weapon, and so the battle will rage on, in many ways much as before. In that regard, I think everyone should consider the press release that the Milberg Weiss firm issued the day the Tellabs decision was released (here); the press release says, "Investors everywhere should be very comfortable with the Supreme Court's decision. We believe that the decision will not have an adverse impact on the prosecution of securities fraud cases." I think they mean it; I also think they are right.

For these reasons, I am skeptical that the Tellabs decision represents a material change in D & O exposure, and I think it would be a mistake for D & O industry participants to change their behavior solely because of Tellabs, as least without substantial further evidence about how the trial courts are going to implement it.

But by the same token, there may be other factors out there that are altering D & O exposure. To cite but one example, I think the Dura Pharmaceuticals case has had and will continue to have a material impact on whether some complaints survive a motion to dismiss. Indeed, the impact from Dura may be one factor in the decline in the number of securities suits (about which more here). Because of Dura and other factors, I believe it is important for D & O industry participants to inquire whether the D & O risk exposure is changing. I just think it is premature (at best) for the industry to assume that the Tellabs decision alone represents a material change in D & O risk exposure.

In addition to the law firm memos cited above, some others I have read and are worth linking to here include the memos about the Tellabs decision from the following: Debevoise & Plimpton (memo here); Chadborne & Parke (memo here); Sidley Austin (memo here). The 10b-5 Daily has a round up of articles and comments on the Tellabs case, here.

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As I have noted in prior posts (most recently here), there is a growing chorus of voices calling for the elimination of "short-termism," and specifically, for the elimination of quarterly earnings guidance. The recently issued reports of two blue-ribbon groups underscore the need for companies to develop and maintain a long-term orientation. More specifically, both reports also recommend the elimination of quarterly earnings guidance.

The first of the reports, called "The Aspen Principles" (here) was released on June 18, 2007 (refer here) and developed by the Aspen Institute, a group of corporate executives, business groups and labor unions, and endorsed by the Center for Audit Quality, a nonpartisan group affiliated with the AICPA. The Aspen Principles were "prompted by concerns about the short-term pressures on publicly traded companies and rising public sentiment against executive compensation." The Aspen Principles contain a number of specific recommendations, including that corporate boards communicate with "long-term oriented inventors" about executive compensation; that senior executives be required to hold at least some portion of company stock beyond their tenure with the company; and that senior executives be barred from hedging the risk of long-term stock compensation.

The Aspen Principles also specifically recommend that "companies stop providing quarterly earnings guidance to analysts" and that they "not respond to analyst estimates." A June 20, 2007 Law.com article discussing the Aspen Principles entitled "Biz Group Takes Aim at Short-Term Investors" can be found here.

A more detailed discussion of the ways to fight companies' short-term focus appeared in the June 27, 2007 report of the Committee for Economic Development (CED), entitled "Built to Last: Focusing Corporations on Long-Term Performance." The Report can be found here, and a press release summary of the Report can be found here. The CED is an independent research group of over 200 business leaders and academics. The Report was prepared by the CED's Corporate Governance Committee, which is chaired by former SEC Chairman, William H. Donaldson.

The CED prepared its report because of its view that "an increasingly short-term focus by many business leaders is damaging the ability of public companies to sustain long-term performance." The subcommittee specifically focused on the "role directors can play in changing culture and practices of corporations" because of their view that "directors are uniquely positioned to make a difference." The subcommittee has "no illusion" that directors "by themselves can solve all the problems," and the Report acknowledges that some investors, and in particular hedge funds, may be driving short-term expectations. However, the Report expresses the belief that long-term perspectives are in the best interests of the companies themselves and of the overall economy.

The Report contains a number of specific recommendations, including the suggestion that directors should support management's development of strategic plans with long-term objectives, and structure incentive compensation so that a significant portion of executives' income is tied to long-term objectives.

The Report also specifically recommends that "companies voluntarily refrain from issuing short-term guidance," which, the Report notes, represents "both symbol and substance of concerns over companies' lack of strategic focus on long-term performance." The Report observes that about half of listed companies continue to give quarterly guidance, but that "research studies indicate that quarterly guidance is at best a waste of resources and, more likely, a self-fulfilling exercise that attracts short-term traders." The report cites a study of over 4000 companies between 1997 and 2004, which found no evidence that guidance affected valuation multiples, improved shareholder returns, or reduced share price volatility. The study did find that the cost of management time and other resources of providing earnings guidance were significant.

The Report also notes that "the availability of information on short-term performance acts as magnet to those who trade based on such considerations," but that "market pressure to provide earnings guidance may be receding," since many companies are discontinuing the practice. A June 28, 2007 news article discussing the CED Report can be found here.

As I have noted in prior posts, the elimination of quarterly earning guidance would not only contribute to the reduction of a short-term orientation, but it would also discourage activity that frequently is at the center of shareholders' claims against companies and their directors and officers. The drive to make (or avoid missing) earnings projections is the root cause of many behaviors that drive shareholder claims. As the CED Report puts it, "companies that drop quarterly guidance have one fewer reason to manage earnings."

The elimination of quarterly earnings guidance is the first step for any company that is serious about managing its securities litigation risk. By the same token, as an increasing number of companies eliminate quarterly guidance, and as more and more thought leaders call for the elimination of guidance, companies that continue to provide quarterly guidance could increasingly be viewed with concern by D & O underwriters - and perhaps even by investors with a long-term orientation.

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