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

If the facts don’t fit, you must remit. That seems to be the view of an increasing number of companies, as they have adopted provisions requiring repayment of executive compensation found to have been based on incorrect financial statements.

The concept of compensation clawbacks was actually built into the Sarbanes Oxley Act. Section 304 requires CFOs and CEOs to reimburse their companies for incentive compensation and stock sales profits if the financial statements for that year are restated and the restatement is due to “misconduct.”

According to a June 2008 report (here) from the Corporate Library, an increasing number of companies have adopted their own clawback provisions, “either as part of the rules of an incentive plan, as governance policy, or simply as a board statement of intent.”

In its prior 2003 review, the Corporate Library had found that just 14 companies had adopted clawback provisions. But in its June 2008 survey, the report found that 295 of the 2,121 companies examined had “disclosed the adoption and implementation of a clawback provision of one kind or another.”

The survey found that the provisions vary from company to company, but could generally be classified as either “performance based” (if the provision applies to all executives who received an incentive payment of some kind based on incorrect financial) and “fraud based” (if it applies only to those executives who have engaged in fraudulent activity or misconduct that has caused a restatement). The survey found that 44.4% of the clawback provisions were “fraud-based” and 39% were “performance based.” An additional 16.6% of the provisions could not be classified.

The report cites several examples of the clawback provisions and even notes one example, involving Warnaco, in which a clawback has already occurred. The company reported in this year’s proxy statement (here, see page 21) that its compensation committee had cut the incentive pay for three executives in 2006 by a total of $120,000. The reduction occurred after the company restated its 2005 financial results due to certain accounting errors and irregularities.

These kinds of provisions have the support of various governance groups. As the June 8, 2008 New York Times stated in an article discussing the Corporate Library report (here), “why should executives keep compensation if it is discovered later that benchmarks were unmet?”

Not only do these kinds of provisions address basic principles of pay equity; they may also have a deterrent effect as well. Indeed, a June 4, 2008 CFO.com article entitled “Clawbacks Claw Their Way Into Corporate Strategy” (here), comments that “the emergence of clawbacks could be one factor in the recent decline in the number of financial restatements.” (For further background regarding the declining number of restatements, refer here.)

The possibility of a compensation clawback is not the only consequences that could affect executives at restating companies. A March 2008 study by Juan Manual Sanchez and Adi Masli of the University of Arkansas Sam M. Walton School of Business, Denton Collins of Texas Tech University, and Austin Reitenga of the University of Alabama entitled “Earnings Restatements, the Sarbanes-Oxley Act and the Disciplining of Chief Financial Officers” (here) found not only that companies restating earnings “have higher rates of involuntary CFO turnover,” but that CFOs of restating companies “face stiff labor market penalties.”

The authors looked at 167 restating companies and then matched them with a control company of comparable industry, size and age. The authors looked for instances where CFOs left the restating company within two years of the restatement. They then tracked the CFOs for four years to determine their subsequent employment.

The authors found “higher CFO turnover rates following restatements in both the pre- and post-SOX periods, which implies that governance mechanisms served to identify and discipline CFOs implicated in the restatements in both periods.”

The authors also found that “former CFOs of restatement firms are less likely to find a position with a job title that is comparable to their prior CFO position, less likely to find employment in a publicly traded company, or less likely to find a comparable position in a public firm.”

Finally, the authors found that “executives terminated in the post-SOX period appear to suffer greater reputational/labor-market penalties compared to the pre-SOX period, suggesting that firms are less willing in the post-SOX period to hire a former CFO with a tarnished reputation. This appears to be consistent with the intent of the legislation to increase executive accountability.”

With all the disincentives for bad behavior, one might optimistically hope that the sins of the past will not recur. Unfortunately, certain aspects of the current credit crisis arguably belie that hope. Nevertheless, one useful takeaway from this analysis is that the presence of corporate clawbacks could provide a deterrent for bad behavior, and could be a positive risk assessment factor.

Hat tip to the CFO.com for the reference to the academics research paper about career consequences for CFOs of restating companies.

Update on a Backdating Settlement That Went Awry: In a prior post (here), I discussed the recent opinion in which Judge Alsup used harsh language in rejecting the Zoran options backdating-related derivative lawsuit settlement. Among other things, Judge Zoran questioned the parties’ representations of the settlement’s value, and questioned the absence of any cash payment to the corporation.

According to a June 9, 2008 Forbes article entitled “Fee Fixers” (here), “it turns out that Alsup was on to something.” According to the article, on May 29, the lawyers resubmitted the settlement, but this time, the settlement included $3.4 million in cash, $3 million from Zoran’s insurance company and $395,000 from Zoran’s CEO and another executive. The article noted that “for having done such a good job,” the plaintiffs’ lawyers “have requested $1.5 million in fees and expenses, $300,000 more that the first time around.”

According to the company’s June 12, 2008 press release (here), Judge Alsup has granted preliminary approval to the settlement. The rejiggered settlement may have passed judicial muster. But let’s be explicit about what the sequence of events really consists of.  Basically, and other than with respect to the $395,000 payment, the insurance company is being asked to pony up the additional $3 million, and undoubtedly will also be called upon to pay the additional increment in the plaintiffs’ fees, as well as all of the additional defense expense incurred after the first settlement cratered. Perhaps there is nothing remarkable in all of this. But at some point, you really do start to wonder about the social utility of all of this activity. It is enough to make anybody cynical.

Hat tip to the 10b5-Daily (here) for the link to the Forbes article. Special thanks to Zusha Ellinson of The Recorder for the link to the Zoran press release.

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In October 2000, the SEC promulgated Rule 10b5-1 to provide company insiders with a way to trade their shares in company stock without incurring securities law liability, through the pre-trading adoption of a written trading plan. Despite the Rule’s protective purpose, concerns have arisen more recently about Rule 10b5-1 plan abuses, as I noted in prior posts (here and here).

 

Indeed, concerns about Angelo Mozilo’s possible Rule 10b5-1 plan misuse were an important part of the court’s recent refusal to dismiss the Countrywide subprime-related derivative lawsuit. (My prior post about the Countrywide dismissal denial can be found here. A more detailed analysis of the Countrywide court’s discussion of Rule 10b5-1 plan issues can be found on The Corporate Counsel.net blog, here.)

 

A May 27, 2008 paper by University of Chicago Law Professor Todd Henderson, Stanford Business School Professor Alan Jagolinzer, and Penn State Business Professor Karl Muller entitled “Scienter Disclosure” (here) looks at Rule 10b5-1 plans from a different perspective, asking what can be inferred from a company’s disclosure of its officials’ plans. The authors’ surprising conclusion is that the more detailed a company’s plan disclosure, the more likely are the subsequent trades to capture abnormal trading returns.

 

The starting point of the authors’ analysis is that, although Rule 10b5-1 itself does not require the plans to be disclosed, “disclosure can enhance the legal protection by increasing the likelihood of early dismissal of class action lawsuits.” This “litigation benefit” arises due to the fact a Rule 10b5-1 plan trading defense will only be available at to dismissal stage if the plan is identified and described in the company’s SEC filings (which a court may consider at the initial pleading stage). If the company fully discloses the plan details, “a court may better ascertain that the allegedly fraudulent trades fall within the Rule’s affirmative defense, thereby increasing the possibility of a low-cost dismissal.”

 

From this, the authors infer that companies perceiving a greater litigation risk are “more apt to disclose the existence and details of Rule 10b5-1 plans.” But there are costs associated with disclosing the plans, particularly “if investors infer a price relevant signal from disclosure or if disclosure enhances investors’ monitoring of insiders’ trade plan commitment.” The “signal” might encourage investor “front running” which could deprive the insider of anticipated trading profits. The monitoring “reduces the value of early termination options” the insider might have if a planned trade no longer appears desirable.

 

The authors hypothesized that insiders will nonetheless prefer Rule 10b5-1 plan disclosure if the “scienter disclosure” provides incremental litigation benefit – which is likely to be greatest precisely where the ability to trade provides the greatest opportunity to profit. That is, “pre-disclosure of trade may be strategic in the face of high legal risk if it mitigates legal risk and does not fully reveal privately held information.”

 

The authors examined company disclosures for hundreds of companies during the period between October 2000 and December 2006, and grouped the companies according to whether the companies had low, moderate or detailed Rule 10b5-1 plan disclosure. The authors then correlated the companies’ disclosure and “subsequent firm returns and earning performance.” The authors found that “more specific 10b5-1 plan disclosures are associated with more negative post-trade abnormal returns” and that “the association between sales transactions and subsequent negative performance is increasing in disclosure specificity, after controlling for other factors that are associated with firm returns.”

 

As a group, executives at those companies with the most detailed disclosure avoided an average of 12% loss in the companies’ trades relative to the broader market in the six months following their sales. The authors conclude that “voluntary Rule 10b5-1 plan disclosure is associated with the higher level firm legal risk and a proxy for insider’s potential strategic trade.”

 

In other words, the more detailed disclosure manifests insiders’ perception that subsequent trades are more likely to be advantageous – and therefore legal protection is more likely to be important, justifying the detailed disclosure.

 

These data suggest, and the authors hypothesize, that “investors should respond negatively to specific disclosures regarding 10b5-1 participation, if they infer that insiders have high strategic trade potential for which they seek high litigation protection.” However, the authors found that there is no observable negative investor response to Rule 10b5-1 disclosure.

 

The authors’ conclusions have a number of important implications. Obviously, investors may be missing an important signal related to 10b5-1 disclosure. Another important implication relates to the protection that the Rule affords; the authors’ conclusion that the companies with the most detailed disclosure are also the ones with the most fortunate timing suggests that, at least in some companies, transparency may be facilitating aggressive stock sales. The Rule was designed to provide company officials with a way to trade safely, but the authors’ study suggests that at least some company officials may be using the Rule as a shield to unload stock at an opportune time.

 

While I confess that initially I found the authors’ conclusions troubling, after further reflection I am less concerned. The problem here is not that insiders are using Rule 10b5-1 plans and plan disclosure strategically – after all, the whole idea of the Rule was to facilitate trading, and there is certainly no suggestion that trades made pursuant to the Rule cannot be advantageous. The problem is that at least so far, investors have missed the negative signal that Rule 10b5-1 plan disclosure implies.

 

The authors themselves speculate that the absence of negative investor reaction “may indicate that there are frictions to implementing strategies based on 10b5-1 disclosure signals or that investors do not understand 10b5-1 disclosure implications, which is possible if our same period reflects the transition period regarding 10b5-1 use.” To the extent, however, that the signal is better understood, the more the marketplace itself will discipline the process.

 

The greater likelihood that the mere announcement of a 10b5-1 plan could undermine a company’s share price could provide a missing disciplinary constraint on strategic trading and reduce company officials’ ability to capture abnormal returns. In other words, the whole mechanism will function better if investors appreciate the significance of 10b5-1 disclosure – an appreciation that the authors’ research clearly should facilitate.

 

A May 27, 2008 USA Today article discussing the authors’ study can be found here. An entry on the University of Chicago Law School Faculty Blog discussing the article can be found here.

 

Very special thanks to Professor Henderson for alerting me to the article and for providing me with a link.

 

Another Options Backdating-Related Class Action Settlement: In its May 8, 2008 filing (here), Kratos Defense & Security Solutions (formerly known as Wireless Facilities) announced that in March 2008, it had reached a tentative agreement to settle the options backdating-related securities class action lawsuit pending against the company and certain of its directors and officers. The amount of the settlement is $4.5 million, of which $1.7 million will come from the company and the balance of which will come from the company’s D&O insurer.

 

I have added this settlement to my table of options backdating-related lawsuit settlements and dismissals, which can be accessed here.

 

Hat tip to Adam Savett of the Securities Litigation Watch blog (here) for providing the heads’ up about the Wireless Facilities settlement

 

Not Just Immune, But Infallible: If you were immensely rich and powerful, you too might well, as did the Sultan of Brunei in 2004, amend the constitution to “declare himself infallible and immune from any obligation to appear in court …and to subject anyone who criticizes him to criminal punishment.”

 

Those curious to know how a court might actually apply a provision like this and related legal issues will want to refer to Francis Pileggi’s Delaware Corporate and Commercial Litigation Blog (here), in which Pileggi reviews a May 23, 2008 Delaware Chancery Court decisions involving the Sultan and his brother. Among other things, Pileggi notes that in the course of reaching its decision, the Court “recites the background facts of royal family battles that could be part of a movie script.”

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One of the legacies from the era of the corporate scandals is the lasting image of certain corporate leaders as “imperial CEOs” (refer here) – that is, as greedy, power hungry overlords who exploited their companies to their own enrichment and to the shareholders’ detriment. Excessive CEO pay remains a widely perceived marker for poor corporate governance and even for securities litigation risk. But recent scholarly analysis of senior corporate executive compensation suggests that outsized CEO pay may not only indicated weak governance, but may also be associated with company underperformance.

In a paper most recently revised in May 2008 entitled “CEO Centrality” (here), Lucian Bebchuk of Harvard, Martijn Creamers of Yale and Urs Peyer of INSEAD “examine the relationship between CEO centrality – the relative performance of the CEO within the top executive team in terms of ability, contribution and power – and the value, performance and behavior of public firms.”

In order to measure so-called CEO centrality, the authors used as a measure “the CEOs pay slice” (CPS) – that is, the “percentage of the aggregate compensation awareded to the firm’s top five executives captured by the CEO.” The authors hypothesized that higher CPS “will tend to reflect a greater relative performance of the CEO within the top executive team.”

In order to compute each CEO’s pay slice, the authors used data from Compustat’s ExecuComp databse from 1993-2004. The authors attempted to control for some factors that could influence the CPS, including the CEO’s tenure, the CEO's status as a large owner or founder, and the size of the company’s aggregate top-five compensation relative to peers.

The authors concluded that CEO centrality has a “rich set of relations with firms’ behavior and performance.” Specifically, the authors concluded that CEO centrality is correlated with

(i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO’s receiving a “lucky” option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck due to positive industry-wide shocks, (v) lower performance sensitivity of CEO turnover, and (vi) lower firm-specific variability of stock returns over time.

The apparent correlation of outsized CEO compensation and “firms’ behavior and performance” tends to corroborate the view expressed, for example, by the Corporate Library (here), that “CEO compensation practices that are poorly aligned with shareholder interests remain a powerful indicator of potential securities litigation.”

While the authors’ conclusions seem intuitively correct to me, I do wonder whether certain aspects of the analysis are a refection of the time spread of the data used. The database is heavily weighted to the 90s and to the era before the corporate scandals and before the recent increased focus on corporate governance and on executive compensation. It might be interesting for the authors to perform the same analysis but to use only data from the five years after the enactment of the Sarbanes-Oxley Act. Perhaps the conclusions would be the same, but I do wonder whether or not the correlations would be as strong for the more recent years.

CEO compensation practices obviously are critical, but CFO compensation practices may also be significant, as I discussed on a recent post (here).

Countrwide Derivative Lawsuit to Proceed: According to a May 15, 2008 New York Times article (here), Judge Mariana Pfaelzer of the Federal District Court in Los Angeles has denied the defendants' motion to dismiss the shareholders' derivative lawsuit that has been filed against Countrywide Financial, as nominal defendant, and certain of its directors and officers. (A description of the lawsuit can be found here.)

The opinion is not yet posted on PACER so I have not had a chance to review it yet, but from the description in the times it sounds like it could be worth reading. Among other things, Judge Pfaelzer said, with respect to Angelo Mozillo's frequently revised 10b5-1 plan, "Mozillo's actions appear to defeat the very purpose of the 10b5-1 plans."  I will try to add a link to the opinion here when I can get my hands on a copy. (I would be grateful if any reader with access to the opinion could forward me a copy.)

UPDATE: A copy of the court's May 14, 2008 order in the Countrywide Derivative case can be found here.

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It is generally understood that under Delaware law, directors enjoy broad rights of indemnification and advancement. The Delaware statutory regime does allow corporations a great deal of flexibility in how they adapt these provisions to their own circumstances. But while these principles are generally understood, it may nevertheless come as a surprise to many that a corporation’s flexibility to adjust the provisions includes the ability to eliminate former directors' advancement  rights, at least according to a recent Delaware Chancery Court opinion.

A March 28, 2008 opinion in Schoon v. Troy Corporation (here) by Vice Chancellor Stephen P. Lamb held that as a result of a board approved by-law amendment eliminating advancement rights for former directors, a former company director did not have the right to advancement of attorneys’ fees.

The company’s by-law had originally provided that “the Corporation shall pay the expenses incurred by any present or former director.” After one of the company’s directors left the board but before the director became involved in litigation relating to his prior board service, the company’s board deleted the by-law’s reference to former directors.

The former director argued to the court that his right to advancement had vested when he commenced his board service. The former director also sought to rely on a prior Delaware court decision which had held that a board cannot terminate a former director’s advancement rights while litigation is pending. Vice Chancellor Lamb rejected the former director’s arguments, holding that the director’s advancement rights do not become “vested” until litigation is actually commenced.

As Steven M. Haas of the Hunton & Williams law firm noted on the Harvard Law School Corporate Governance Blog (here), “[t]his holding may surprise some practitioners, given that the purpose of indemnification and advancement is to encourage board service and assure directors that their expenses relating to their official actions will be repaid – even if litigation arises after they resign from the board.”

The possibility that directors could lose their rights to indemnification or advancement after they leave the board may not only “surprise some practitioners,” but it would shock many directors, whom I believe rightly would be appalled to learn that they could be stripped of these rights after they leave the board. At a minimum, this holding strongly reinforces the need for each director to have their own separate indemnification agreement with the company, to reduce the possibility for a later board to eliminate these rights after the director has left board service. Without a separate contractual undertaking, directors may have no assurance that after they leave the board their rights to advancement and indemnification will be preserved.

At the same time, however, it should be emphasized that most directors and officers liability insurance policies include former directors within their definition of insured persons, and that under most circumstances a former director for whom corporate advancement and indemnification has been withheld would still have right to seek defense expense protection and indemnification under the company’s D&O liability policy. There might be some question about which retention would apply under the policy, but that issue aside, the insurance coverage should be available to protect the former director (subject to all of its terms and conditions).

Accordingly, In most circumstances, the company’s D&O insurance program should provide adequate protection even for former directors – assuming that the company has procured and continued to maintain insurance protection, and assuming further that the limits available under the insurance program are not otherwise consumed by other insured persons’ defense expense and indemnity requirements.

For directors who have left board service and who are concerned that events could conspire (whether through by-law revision, or as a result of discontinuance or exhaustion of the D&O insurance) to leave them unprotected, there is another insurance solution available. That is, a director concerned about these circumstances may want to consider a so-called former director and officer liability insurance policy. This kind of coverage, which was described at greater length in a recent CFO.com article (here) is buyer-specific; that is, it belong exclusively to the individual director or officer, and would not be subject to termination or discontinuance by the action or inaction of others. It is also noncancelable, nonrescindable, and provides coverage for up to 6 years after the director resigns, retires or is fired.

The point that should not be lost here is that the director in the case cited above lost his anticipated rights after he left the board. Directors concerned about their rights following board service will want to fully consider the available insurance alternatives.

The Ropes & Gray law firm has a May 5, 2008 memorandum (here) discussing the ways in which by-laws and indemnification agreements might be modified to protect against retroactive elimination of directors' rights.

The Delaware Corporate and Commercial Litigation Blog has a post (here) discussing other aspects of the Schoon v. Troy decision.

Speakers’ Corner: On May 6, 2008, I will be in Montreal, Quebec, participating in a panel sponsored by the Canadian Chapter of the Professional Liability Underwriting Society (PLUS). The panel (more information about which can be found here) is entitled “The Subprime Meltdown and its Impact on the Canadian Insurance Landscape” and includes a number of distinguished speakers, included Dr. Faten Sabry of NERA Economic Consulting, David Williams of Chubb, and Denis Durand of Jarislowsky Fraser Limited.

In addition, on May 8, 2008, I will be moderating a panel at a American Bar Association Tort Trial and Insurance Practice Section conference in New York. The title of the conference is "Beyond Legal: A Business Approach to Corporate Governance" and the panel is entitled "Identifying, Predicting and Minimizing Securities Litigation Risk." Joining me on the panel will be Nell Minow of the Corporate Library, Professor Eric Talley of the Boalt Hall School of Law at UC Berkeley, and Patrick McGurn of RiskMetrics. A copy of the conference brochure can be found here.

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Commentators have long focused on CEO compensation as a leading corporate governance concern. Indeed, the Corporate Library has even suggested (here) that CEO compensation practices that “are poorly-aligned with shareholder interests” are “a powerful indicator of potential securities litigation.” While CEO compensation unquestionably is an important issue, academic research recently published by three Michigan State professors suggests that the CFO’s compensation may be even more important than that of the CEO.

In an April 15, 2008 paper entitled “CFOs and CEOs: Who Has the Most Influence on Earnings Management”(here),  John Jiang, Kathy Petroni and Isabel Yanan Wang report on their investigation “whether CFOs’ equity incentives are associated with earnings management, and whether earnings management is more sensitive to CFOs’ equity incentives than to those of the CEOs.” Prior research has focused primarily on CEOs’ compensation, based on conventional wisdom that because CEOs’ equity compensation was greater than that of CFOs, it should be more influential. In addition, it was generally presumed that because the CFO is the CEO’s agent and the CEO has the power to replace the CFO, “CFOs do not respond directly to their own equity incentives but only to the wishes of their CEO.”

Contrary to these prior assumptions, the authors posited that CFOs equity incentives “may have a stronger impact on earnings management than those of the CEOs, because CFOs have the ultimate responsibility for the management of the financial system, including the preparation of the financial report.”

The authors used a database for the S&P 1500 for the period 1993 through 2006, representing 17,542 firm years of compensation data. The authors examined the CFOs’ equity incentives in three settings where prior research had demonstrated an association between CEOs’ equity incentives and earnings management, namely (1) accruals; (2) the likelihood of beating earnings benchmarks; and (3) the likelihood of restatements.

Based on their analysis, the authors conclude that “because CFOs are primarily responsible for preparing the financial statements, the impact of their equity incentives on financial reporting dominates the impact of the CEOs’ equity incentives.” Indeed, the authors conclude that “earnings management is a key tool that the CFO can expertly use to respond to equity incentives.”

Although the paper has a number of interesting insights, perhaps the most interesting is the authors’ analysis of the way that CFOs respond to the prospect of option grants. The authors found that the occurrence of the grant of options to the CFO was positively correlated to the occurrence of an earnings miss (which would lower the option strike price and thus make the grant potentially more valuable). The authors further concluded that “the likelihood of missing earnings benchmarks is higher for stock options granted to the CFO relative to those granted to the CEO and in some cases significantly so.”

One of the fundamental tenets for the compensation of corporate executives is that the executives’ interests should be aligned with those of the shareholders, and that the best way to achieve alignment is through equity-based compensation. The authors’ research suggests, however, that equity-based compensation may not create alignment, but rather motivates earnings management. Indeed, the authors’ research could be read to suggest that the equity-based compensation could create incentives that are contrary to shareholders’ interests, because shareholders obviously have no interest, for example, in engineered misses of earnings estimates.

The authors do conclude that their research underscores the importance of the SEC’s recently adopted provisions requiring disclosure of CFO compensation. This disclosure, the authors state, “should be relevant to users of financial statements in evaluating the quality of firms’ financial reporting.”

Among those to whom the CFO compensation information could be of interest are D&O underwriters. While the authors’ research does not directly make the connection between CFO equity compensation and the incidence of securities lawsuits, the link the authors do establish between CFO equity incentive compensation and earnings management should be sufficient to suggest the relevance of CFO equity compensation for D&O underwriting purposes. If, as the Corporate Library proposes, CEO compensation is an important indicator of securities litigation susceptibility, then the research of these three Michigan State professors could be interpreted to suggest that CFO compensation is also an important indicator, perhaps even more so.

Hat tip to the CFO Blog (here) for the link to the academic research paper.

For Better or Worse – Unless You Wind Up in Jail: This blog does not ordinarily comment on domestic relations issues, but we did fund it noteworthy that, according to news reports (here), former Tyco CEO Dennis Kozlowski was about to reach terms for his divorce from his wife, the former Karen Mayo. Mayo is the former waitress whom Kozlowski married in 2001, and whose $2 million Roman-themed 40^th birthday party on Sardinia that same year ultimately proved to be a key component of Kozlowski’s later criminal trial.

According to news reports, Mayo had request that the couple’s assets be split equally and she also sought alimony. The news reports do not disclose whether Mayo will receive a portion of the $1/day Kozlowski now reportedly receives “mopping floors or slinging hash” to fellow inmates at the New York correctional facility where he is serving a term of between eight years, four months and twenty-five years.

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It is nothing new for corporate America to have to contend with activist investors. But an activist international institutional investor, backed by a sovereign nation and burgeoning oil wealth and committed to a broadly-based social and environmental agenda, represents a different level of activist pressure. The prototype for this international institutional investor is the Norwegian Government Pension Fund, which collects and invests surplus revenue from the country's petroleum production, and which at $300 billion in asset value represents the largest public pension fund in Europe. The Fund is prohibited from investing in Norway, so instead it owns what amounts to a considerable slice of the world.

The Norwegian Fund's impact is not merely financial. The Fund operates according to "ethical" investment principles, pursuant to which the Fund has divested ownership in companies that the Fund's Advisory Council on Ethics believes are involved in certain kinds of weapons production, environmental damage and human rights violations. The most prominent example of its divestitures for ethical reasons was its high profile divestiture of its $400 million investment in Wal-Mart because of alleged child labor law violations by WalMart suppliers (refer here).

A May 4, 2007 New York Times article entitled in the print edition "Norway Backs Its Ethics With Its Cash" (here) discusses the Fund's ethical investing practices and their impact. The article quotes the Norwegian Finance Minister, Kristin Halvorsen, as saying "In a global economy, ownership of companies is the most important way to have influence." As many as 21 companies (so far) have felt this Norwegian "influence," twelve of them American.

Nor is the Fund's activist impact restricted to its investment activities. Norges Bank, the division of the Norwegian Central Bank responsible for managing the Fund's investments, has made its presence felt as a securities fraud lawsuit litigant. For example, Norges Bank was one of the prominent litigants that chose to opt-out of the Time Warner class action settlement (here). Norges Bank was also a major participant in the recent historic Royal Dutch Shell investor settlement (here).

The most prominent institutional investor activist in the U.S. has arguably been the California Public Employee Retirement System (Calpers), which with current investement assets of about $244 billion is actually smaller than the Norwegian Fund. Moreover, because Norway is the world's No. 3 oil exporter (behind Saudi Arabia and Russia), Norway's Fund will grow substantially in the years ahead. The Times article estimates that at the rate at which it is growing, the Fund could be worth $800 billion to $900 billion in a decade. With the Fund's growing size and activist agenda, its impact could be enormous, particularly given the Fund's apparent willingness to resort to litigation.

The Fund's growth will provide it with the powerful tools to drive its agenda. As a result, companies could face growing pressure to provide compliance and disclosure on a broad range of social and environmental issues. Readers of The D & O Diary will recall my recent post (here) on the growing importance of climate change disclosure; the Times article reports that the Norwegian Fund's next area of scrutiny will be companies that contribute to global warming. (There is of course some irony in a country which has grown wealthy from oil production presuming to lecture the rest of the world about global warming.)

The upshot is that public companies could face growing pressure on environmental and social issues, from the Norwegian Fund as well as other investors that follow their lead. Traditional notions of "good corporate governance" will necessarily evolve to adapt to these circumstances. These evolving issues represent risks that may not be apparent on companies' financial statements. Companies will face changing levels of reputational risk and even political risk as part of this evolving global investment dynamic. It will be increasingly important for companies to have tools to measure and control their exposure to these developing concerns, as well as to provide adequate disclosure of these issues to their shareholders.

Cross-Border Prosecutorial Collaboration: Along with the globalization of political and social issues, the increasing global collaboration of national regulatory and investigative personnel also represents a new and growing risk to companies in the global economy. The high-profile collaboration of a multinational investigative force in the Siemens bribery investigation (here) is a recent prominent example. Another example is illustrated in a May 4, 2007 Wall Street Journal article entitled "Cartel Arrests in U.S. Bolster Europe Probe" (here, subscription required).

According to the Journal, executives from companies in Italy, France, the United Kingdom and Japan were arrested in the U.S. this past week for their role in an alleged international cartel to fix prices for industrial hoses used in oil transportation. The arrests reportedly were "the result of a joint U.S. investigation with the European Union and U.K. agencies under a program of trans-Atlantic cooperation against bid rigging." The stumbling block for EU enforcement of its anti-cartel laws has been the lack of any personal liability for cartel participants under EU law. These limitations have restricted EU authorities' ability to pursue cartel activities. The enlistment of American authorities in the anti-cartel efforts circumvents these EU limitations by exposing individuals to personal liability under tougher American anti-cartel laws.

While these developments are perhaps socially desirable for their ability to punish and deter anticompetitive activity, the developments also carry some disturbing implications for officials at companies engaged in the global economy. Executives could face the threat of prosecution not only under the laws of their own country but under the laws of many other countries. The willingness of the U.S. to enforce its antibribery laws against foreign companies whose shares or ADRs trade on U.S. exchanges is another example of this extraterritorial impact of domestic laws. The result of this globalization of criminal enforcement could be a dramatic expansion of corporate executives' risk exposure.

Not only does this evolving globalization of criminal enforcement create a new category of risk management challenges, but it could create new challenges for the structure of the companies' D & O insurance program. Certainly, companies engaged in the global economy will want to understand their policy's potential protection for foreign investigations and proceedings, as well as the policy's protection for criminal processes such as extradition.

Be Here Now: As scientists and commentators have struggled to prefigure a future world beset with the consequences of global climate change, they have projected a litany of grave impacts: coastal erosion and subsidence from rising sea levels; extreme weather events; unprecedented economic impacts; and a deteriorating health environment.

Readers skeptical of these scenarios will want to consider these stories appearing in newspapers just this week alone: the seacoast of East Anglia in the U.K. is sliding into the sea because of rising sea levels (here); Australia's six year drought is now so serious that the country must restrict crop irrigation, while politicians struggle to respond (here); Germany will no longer apply seasonal adjustment to its unemployment statistics because the increasingly mild winters have a diminished employment impact (here); and the global incidence of asthma and hay fever has escalated as a result of the proliferation of allergens due to warming conditions (here).

After I wrote my post a few weeks ago about global climate change and D & O risk (here), I received some very skeptical and even derisive reactions. But the reality is that global climate change is not some distant theoretical construct. Its impacts are already being felt throughout the world. The answer to the question whether or not this will affect the risk profile of publicly traded companies is simply a reflection of the way you frame the issue. You can, as I think is the proper approach, regard global climate change as a separate category of risk to be analyzed as such. Or you can simply look at it as imbedded within numerous other risk categories, such as commodities pricing risk, political risk, and currency risk, as well as what insurers call parameter risk (the risk of events different than those that have occured in the past). Whether viewed separately or as a part of the overall panoply of corporate risk, global climate change will be an increasingly important part of the risk landscape that companies face. The influence of activist investors like the Norwegian Fund suggests that companies disregard these risks at their peril.

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One of the essential tenets of modern corporate governance is that shareholders control corporate managers through shareholder voting. This notion is founded on the premise that shareholders will vote their economic interests, and the weight of their vote will be proportionate to their economic interest. However, research by University of Texas law professors Henry Hu and Bernard Black reveals that as a result of recent capital markets developments, hedge funds and other investors can "decouple" voting rights from economic ownership of shares. For example, a hedge fund borrowing shares from institutional investors can acquire the voting rights of the borrowed shares, even though the shareholder who owns the shares retains the economic interest in the shares.

The professors' legal research can be found here and here, and is discussed in a January 26, 2007 Wall Street Journal article entitled "How Borrowed Shares Swing Company Votes" (here, text courtesy of the Texas Law School web site).

The hedge funds or other investors who wish to obtain voting power do so by borrowing shares from large institutional investors, often as part of a short selling strategy. Borrowing the shares allows the hedge funds to gamble that the shares will decline, and they can use their vote to try to ensure that they will. The professors call the exercise of voting rights divorced from economic interests "empty voting." The Journal article cites several examples where shortselling hedge funds used this technique as part of a successful short selling strategy.

The professors emphasize that no one knows how widespread this practice is. Their research examined 22 instances worldwide from 2001 through 2006. The Journal article notes that these kinds of votes have not yet affected outcomes in many general corporate elections. But the practice could become more important given current corporate governance momentum built around increasing "shareholder democracy," such as the push for majority voting of directos and the right of shareholders to be able to propose board candidates.

The "empty voting" issue has attracted the attention of regulators. SEC Commissioner Paul Atkins, in a speech on January 22, 2007 (here), raised his concerns with the practice, and the Journal article quotes SEC Chairman Christopher Cox as saying that the practice is "almost certainly going to force further regulatory response to ensure that investors' interests are protected."

Finding a simple regulatory solution may be complicated by the fact that shareholder voting is largely controlled by state law. In addition, the vested interests in the status quo include not only hedge funds and others who might use the strategy to advance their interests, but also the institutional investors who profit by lending their shares. According to the Journal, brokerages and big banks now make $8 billion a year in fees they earn by lending their shares. CalPERS alone made $129.4 million by lending shares its holds in the year ending March 31, 2006.

The professors proposed solution puts less emphasis on regulation and more on disclosure. They propose an "integrated ownership disclosure reform," that would require disclosure both of voting and economic ownership. The professors proposed solution would not eliminate some disclosure delays, and even allows the possibility that the disclosure might not take place until after the vote has taken place - but it would still ensure that the disclosure takes place eventually, which would both inform regulators and lawmakers for future remedial purposes, and act as some constraint on behavior.

An interesting perspective on this issue, and a presentation of the brief against further regulation on this issue, can be found on Professor Larry Ribstein's Ideoblog, here. CFO.com also has an interesting January 26, 2007 article entitle "How to Beat the Hedge Fund Bullies" (here), that examines strategies that companies can use to identify who their shareholders are and analyze how the shareholders' are voting.

SEC Chairman Cox on Global Competitiveness: As The D & O Diary has noted on numerous recent posts (most recently here), the issue of the competitiveness of the U.S securities markets in the global economy has been the subject of a great deal of comment lately. Regular readers will recall my concern that while the U.S. should look to its competitive interests, it should take care to avoid compromising its regulatory integrity. In a January 24, 2007 speech (here), SEC Chair Christopher Cox added the following perspective on the threats to the competitiveness of the U. S. markets:

The threat comes not from fear of foreign competition, or foreign issuers, or foreign investors. Both competition, and the influx of foreign capital and issuers, promise only good for our markets. Rather, the threat comes from the increasing opportunities for fraud, unethical trading practices, and market manipulation that globalization brings with it. Just as investors and issuers can more easily seek each other out around the world, those with less honorable intentions can also reach across borders, to prey upon distant investors. And when they succeed, they damage confidence in all of our markets.

As the proposals for regulatory reform continue to emerge in the coming months, it will be important for us to remember what kind of investors and what kind of investment activity we do and do not want to attract to U.S. securities markets.

Tellabs Goes to SCOTUS: On January 5, 2007, the U. S. Supreme Court granted certiorari (here) in the Tellabs case on the issue of the standard for pleading scienter under the Private Securities Litigation Reform Act of 1995 in securities fraud suits. An excellent brief summary of the issues involved in the case written by Jonathan Jacobs of the Wiley Rein firm can be found here.

Best in Class: Those readers who, like The D & O Diary, were fans of the late, lamented Securities Litigation Watch blog will be delighted to learn that its author Bruce Carton has launched a new blog, Best in Class, which can be found here. The early posts suggest that the new blog will be as timely and informative as the SLW.

Readers will also be interested to know that Bruce will be hosting a webcast on Tuesday January 30, 2007 at 1:00 p.m. EST on "Emerging Trends in Securities Class Actions."

Hat tip to the 10b-5 Daily Blog for the information about Best in Class.

Next week: I will be in New York next week for the PLUS D & O Symposium (here). I hope that readers of The D & O Diary will please say hello to me during the Symposium and let me know what they think of the blog. See you all in New York.

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According to an article in the January/February 2007 issue of Corporate Board Member entitled "Is Your Company Prepared for Bird Flu?" (here), boards should be anticipating and preparing for the potential impact of a bird flu pandemic. The article quotes former Secretary of Health and Human Services Tommy Thompson as saying that smart boards are preparing now, by reviewing contingency plans and establishing lines of authority in the event company leadership is stricken by the bird flu. The article does acknowledge that "[s]ome directors privately conceded that little attention is being paid to the specific challenges posed by a pandemic."

As someone who has spend the better part of my professional career thinking and worrying about board focus and function, I have to admit that under the current circumstances I have a hard time seeing bird flu as belonging anywhere the top of the list of things boards at most companies are or ought to be worrying about. Along those lines, the article does contain the following:

Damian Brew, a managing director with Marsh's professional-liability practice, says the risk of a pandemic pales against other exposures, including oil-price fluctuations, and adds that underwriters of directors' and officers' liability coverage are more concerned with options backdating and CEO pay disclosure. "Boards have a limited amount of time, and there are financial issues that should take priority over something that's not likely to happen," he says.

I agree with these statements. But the article goes on assert that boards that fail to plan for a bird flu pandemic "could find themselves targeted for dereliction of duty." The article quotes one attorney as saying that Sarbanes-Oxley requires boards to take into account almost every conceivable problem that could put the company in jeopardy. The article quote another attorney as saying that "If the business has trouble functioning, you could have shareholders saying 'Why wasn't there a plan in place?' You aren't going to be able to say you hadn't heard about it."

Undoubtedly boards could allocate a portion of their scarce time together to worry about bird flu. They could also spend time worrying about global warming, land use policy, plate tectonics and its implication for seismic and volcanic activity, and the hole in the ozone layer. There are a limitless number of things that boards conceivably could spend their time on. At some point though, boards have to be focused on whether the company is on the right track, has the right management in place, or needs to make strategic changes. There undoubtedly are risks in every company's environment, and boards should of course take reasonable steps to ensure that the company has a flexible catastrophe plan in place and that the plan adequately addresses the specific risks to which the particular company may most likely be prone. There are many threats facing companies today. Boards are doing their job best if they focus on the threats and opportunities that matter most immediately for their company.

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One of the great things about having a blog is that it has brought me into contact with a host of people I might otherwise never have gotten to know. Among the most interesting and colorful people I have met through my blog is Sammy Antar, Crazy Eddie's cousin, and the author of the White Collar Crime blog (here). Regular readers will recall my recent post referring to Sammy and his views, here. As a result of my post, Sammy called me up and we had a great conversation about a number of things, including D & O insurance. Among other things, Sammy wondered why D & O insurers don't condition their coverage on certain remedial or preventive measures, the way bank lenders require covenants on their loans or property insurers require for their policies.

Sammy's question is one I have encountered again and again from thoughtful people outside the D & O insurance industry. A more scholarly example of this perennial question is presented in the November 17, 2006 law review article entitled "The Missing Monitor in Corporate Governance: The Directors' and Officers' Liability Insurer," (here) written by Professors Tom Baker of the University of Connecticut Law School and Sean Griffith of the Fordham Law School (here). Baker and Griffith's well-researched, well-written, thoughtful and thought-provoking article examines the same question that Sammy Antar posed to me: why don't D & O insurers perform more of a corporate governance monitoring function?

The authors recognize the role D & O insurers theoretically might now be playing by offering lower priced insurance to companies with better governance practices. However, as the authors also recognize, competitive pressures and insurers' zeal for premium volume limit carriers' price differentiating ability and undercut the role insurance cost might otherwise play in motivating behavior. I would add that factors unrelated to governance, such as a company's size or industry, are almost always more important pricing criteria, and so even in ideal circumstances, D & O insurance pricing would provide at best a weak incentive to corporate governance behavior. In addition, for most companies during most phases of the insurance cycle, the relatively minor variations in their D & O insurance costs are unlikely to have any impact on corporate governance behavior because the dollars involved are too slight.

The authors then look at whether D & O insurers are affirmatively offering loss prevention services, the way many property or workers' compensation insurers do. The authors conducted extensive empirical research by interviewing many underwriters, brokers and risk managers. Their empirical research showed that despite logical incentives for them to do so, D & O insurers do not affirmatively provide or offer their insureds loss prevention services. (Full disclosure: I was among the insurance industry representatives the authors interviewed as part of their empirical research.) Not only that, the authors found that D & O insurers don't even manage claims that arise under their policies, but rather allow their insureds to select defense counsel and manage the defense, in a way that leaves defense expense essentially uncontrolled. The authors conclude that the D & O insurers' failure to provide loss prevention services and to manage claims allows management conduct to continue without the checking function the insurer might provide. In addition, because most D & O claims settle within the limits of the D & O insurance, company management is permitted to shift all of the consequences of their behavior away from themselves.

The authors examine the purpose and impact of D & O insurance under these circumstances and conclude that companies continue to buy D & O insurance because it provides company officials with a corporately-financed way for management to protect themselves from their own liability exposure without the requirements of any constraints on their behavior. The authors conclude that affairs are arranged this way because it suits corporate managers, who are free to indulge in risky behavior secure in the belief that their D & O insurance will protect them and their company if there are any problems. The authors question whether shareholders' interests are served by this arrangement, and whether the existence of D & O insurance (or at least corporate reimbursement and entity coverage) creates a moral hazard by insulating companies and their managers from the consequences of their behavior.

Readers familiar with my professional history know that I am perhaps uniquely qualified to comment on the reasons why D & O insurers do not offer loss prevention services. My curriculum vitae includes an extended deployment as the head of a D & O facility that was founded on the optimistic premise that a D & O insurer ought to provide loss prevention services and that offering those services would be a competitive advantage. This noble experiment died a death of many causes, and having presided over the enterprise's life span, I can authoritatively recite here why D & O insurers do not offer loss prevention services, as follows:

1. Everybody Has to Do It or Nobody Can Do It: Corporate insurance buyers want their acquisition of D & O insurance to be as uncomplicated and consume as little time as possible. Even if a D & O insurer is offering free services that will help improve their company's risk profile, the company's managment will not desire the services if the services take additional time and attention. As long as there is one competitor anywhere who will offer the same coverage (at least at the same or similar cost, more about which below) without requiring the company to "jump through hoops," the free services will go unclaimed. Of course, this is not universally true, there are some companies that will value the service, and there are other companies who could learn to appreciate the value of the services. More about these kinds of companies below.

2. Even if the Services Are Very High Quality, They Will be Undervalued in the Marketplace: Unfortunately, insurance companies are not held in the highest regard in corporate America. Too many companies view their D & O carriers with suspicion or even hostility. To be sure, there are some companies who welcome their D & O insurers' views about corporate governance, but not enough to make the costs of providing the services economically self-sustaining. Corporate management's suspicious views of their D & O insurers may be encouraged by the their outside counsel. While some lawyers (and I was always proud that it was the best lawyers) welcomed the provision of high quality loss prevention services, there were other lawyers who viewed an insurer's provision of these services as a competitive threat for services the lawyers themselves wanted to provide or as some clever ruse to permit the insurer to deny coverage later.

3. The D & O Pricing Environment Does Not Support the Pricing Premise: Some companies might want their D & O insurer's loss prevention services but not if their companies have to pay for the services. It might be possible for a D & O insurer to insist on corporate governance reforms if the insurer could offer demonstrable insurance cost savings for qualifying companies, but the reality is that the D & O insurance sector has been and remains so competitive that it is impossible to show cost savings. There is always a competitor willing to offer the same or similar coverage at the same (or better) discount, and so companies who might otherwise accept their insurer's loss prevention requirements have little monetary incentive to do so.

4. Loss Prevention Services Are Costly To Provide and Maintain: For a D & O insurer to plausibly offer credible loss prevention services recognized as valuable by senior corporate executives , the insurer has to be willing to make and sustain a very significant investment in high quality personnel. However, top management at insurance companies, who rarely have background in D & O insurance but rather are drawn from more mainstream property or casualty insurance backgrounds, and who view the business of insurance as a high volume low skill enterprise, have little appreciation for or patience with the need for this kind of investment. These kinds of expenses do put significant pressure on operating margins, and indeed ultimately may not be economically justifiable given the pricing environment that has prevailed in the D & O insurance industry for almost all of the last 20 years (except for a very brief period during 2002-03).

5. D & O Loss Prevention Has Less Certain Benefits than A Sprinkler System Does: A sprinkler's system's benefit is direct and easily understood. Good corporate governance may or may not have as direct of a benefit. Baker and Griffith seem to assume that loss prevention can improve companies and reduce their securities litigation risk. I still believe this to be true, but at the same time I have to acknowledge that a company can do everything right and still get sued. So many of the major D & O claims problems of the last few years have come from unexpected directions. Sector slides, industry contagions, practices that are widespread and accepted that suddenly become perceived as objectionable, these are all phenomena that caused boatloads of D & O losses in recent years that no amount of loss prevention would have prevented.

I could go on and on about the reasons D & O insurers don't offer loss prevention services. (Buy me a few beers sometime and I will keep it going for hours.) In fact, Baker and Griffith mention in their article a few additional factors that I did not even get to here. But I think I have shown that there are many reasons why D & O insurers do not provide these services. This fact may be lamentable, but unless circumstances change dramatically in ways I do not anticipate, this is just the way things are and seemingly will remain in the D & O insurance industry.

That said, I cannot support the Professors' conclusion that D & O insurance as it is currently purchased by most companies is a moral hazard. This particular topic is well beyond the scope of the informal blog format, but I will briefly offer my views for disagreeing with the Professors.

It is extremely unlikely that the presence of D & O insurance operates as any kind of an enabler of bad behavior: I flatter my chosen field by thinking that D & O insurance is pretty important stuff, but I am realistic enough to understand that corporate managers conduct their operations in a way that they think is either in the company's or their own best interests without regard to their D & O insurance. They don't stop before taking an action and reflect that they wouldn't do it if they didn't have D & O insurance. I view it as an extremely remote and unlikely theoretical possibility that corporate managers do anything they wouldn't otherwise do because their company has D & O insurance.

Corporate Managers Worry More About Potential Consequences For Which There is No Insurance: Corporate managers know that the same kind of conduct can attract the unwanted attention of plaintiffs' lawyers can also attract the unwanted attention of the SEC and the Department of Justice. Even if D & O insurance were to cease to exist as an earthly phenomenon tomorrow, most senior officials' conduct would go on exactly as before (that is, equally as good or bad as before) because the admonitory threat of the regulators' actions would remain as before. That is, because of the threat of regulatory action, the theoretical possibility that D & O insurance might otherwise operate as a moral hazard simply doesn't exist.

Most Corporate Managers Truly Want to Do the Right Thing: There are crooks out there; my comments here don't apply to them. In my experience, most corporate managers are interested in playing by the rules, and more importantly, for being known for playing by the rules. The idea of seeing their name in the paper as accused of fraud is absolutely mortifying. The fact that there might be insurance to eliminate the monetary inconvenience of a securities fraud lawsuit is irrelevant to their desire to avoid the kind of reputational taint that might follow an accusation of fraud, even if the accusation were merely to be made by plaintiffs' lawyers.

Because I truly believe that almost all corporate officials want to do the right thing, I think there may yet be a role for loss prevention services in the D & O insurance equation. I am an eternal optimist, and I continue to believe that high quality loss prevention services will be valued by some companies and ought to be valued by all companies. I also believe that D & O insurance professionals can and ought to offer these services.

It may be that competitive forces between and among D & O insurers will discourage the insurers from carrying the experiment forward. Brokers, by contrast to insurers, are in the business of providing consultative services, and for that reason I believe that highly qualified brokers could offer loss prevention services to their D & O clients. Baker and Griffith looked briefly as what the past practices may have been as far as brokers offering these kinds of services and concluded that brokers are not offering these services. My recent entry into a new livelihood as a D & O broker is premised on the possibility that brokers have a role to play here. I have experience in this area, after all. Anybody that wants to talk to me about it should give me a call -- I have already had a great telephone conversation with Sammy Antar about it.

Hat tip to Adam Savett at the Lies, Damned Lies blog (here) for the link to Professors Baker and Griffith's law review article.

A prior D & O Diary post commenting on an earlier article by Professors Baker and Griffith can be found here.

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Within the last few days, we have witnessed the feuding, dysfunctional H-P Board struggling with the turmoil and adverse publicity arising from its flawed investigation of media leaks. Last week we also saw the forced ouster of Bristol Myers Squibb CEO Peter Dolan. These events follow the removal of the CEOs of some of the country's largest companies, including Walt Disney, Fannie Mae, Pfizer, American International Group, Merck, and others. These events not only involve the potential for board turmoil, distraction and adverse publicity, but increasingly also present the possibility of D & O litigation.

For example, late last week, Bill Lerach of the Lerach Coughlin firm filed a shareholders' derivative suit against the H-P Board, accusing the Board (and its general counsel, as well as it purported outside investigative service) of breaches of fiduciary duties, abuse of control and waste of corporate assets, as part of an alleged campaign to entrench themselves and to punish or diminish the power of ousted directors. A copy of the complaint can be found here. The lawsuit not only seeks corporate remediation, but also seeks recovery for the "enormous" costs and burdens the company has sustained to deal with the crisis created by the revelations of the Board's investigation. Significantly, the complaint against the H-P directors seeks to compel the recovery from the defendants of the company's costs without their recourse to indemnity or insurance, even for the costs of defending the derivative litigation. A September 15, 2006 Law.com article discussing the H-P complaint can be found here.

Nor is H-P's situation the only boardroom dispute that has resulted in D & O litigation. For example, at Atmel, five independent board members (representing private equity fund investors) worked together to bring about the August 5 firing of company founder and CEO George Perlegos, as well as three other executives, for alleged misuse of corporate travel funds. Perlegos responded by filing a lawsuit against the board, arguing that his ouster was illegal because he had already called a shareholder meeting in order to remove the five independent directors. His lawsuit argues the directors should be removed because "the hasty, secretive, and precipitous manner in which they acted...will have devastating consequences for the Company, including but not limited to the loss of the [ousted executives'] decades of experience running the company and a significant loss of shareholder value." News report discussing the Atmel litigation can be found here and here.

These boardroom disputes and the others identified above are a result of a variety of factors. The increased presence and activism of independent directors, who are less inclined to take their cues from company management, is a direct result of Sarbanes-Oxley reforms and is clearly a factor in the newly contentious board environment. Regulatory and investigative pressures are also important factors. For example, the removal of AIG's and Bristol Myers Squibb's CEOs were a direct result of investigative pressures. Increased shareholder activism, including the pressure of activist hedge funds and other private equity investors, also is a contributing factor. (For a prior D & O Diary posts discussing the litigation threat of activist hedge funds, click here and here.)

All of these factors are contributing to an increasingly hostile boardroom atmosphere. This atmosphere not only presents a challenge for corporate boards, but also represents an environment where allegations of wrongdoing can more easily arise. These allegations of wrongdoing inevitably will make their way into the courtroom, and so the newly contentious boardroom environment represents a potentially significant source of increased D & O claims exposure.

On Saturday, September 16, 2006, articles appeared in Wall Street Journal (here, subscription required) and in the Washington Post (here, registration required) discussing the new hostile environment for corporate boards.

Silicon Valley Connection: The shareholders' derivative complaint filed against the H-P Board take particular aim at the Board's continued reliance on the outside counsel, the Wilson Sonsini law firm, on whose advice the company relied in connection with the investigation, the board disputes arising out of the investigation, and the company's disclosure of the investigation and the board's disputes:

[E]ven though they were facing a matter with grave implications for the corporation, [the Board] did not seek independent legal representation or advice. Worse yet, they actually relied on the advice of the law firm that was implicated in the conduct to be evaluated. Because Sonsini of Wilson Sonsini had been intimately involved in advising the Board and its Chair regarding the investigation that had taken place, the law firm knew or should have known of the dubious legality of the investigatory tactics being used and yet had advised the Board ...that the investigatory tactics being used were not unlawful and advised HP to not disclose why [Perkins, a Board member who resigned, had actually resigned.]

The Complaint goes on to allege that a demand upon the Board to bring legal action would be futile because "Wilson Sonsini and Sonsini continue to be the primary outside counsel for the Company regarding these matters and obviously, since Wilson Sonsini and Sonsini are conflicted and would be key witnesses and possible defendants in any ultimate legal action, they will advise the Company not to pursue legal action or conduct a vigorous independent investigation into matters that will embarrass the law firm, further implicate the law firm, or expose the law firm to financial liability."

Nor is the H-P lawsuit the only source of legal scrutiny facing the Wilson Sonsini firm from the H-P board investigation. According to news reports (here and here), Larry Sonsini is among the witnesses requested to appear to testify before a Congressional panel looking into the H-P board's investigation of media leaks. The Oversight and Investigations Subcommittee of the House Committee on Energy and Commerce will be holding September 28, 2006 hearings on the matter. Several witnesses, including Sonsini, have been sent letters requesting them to notify the committee on or before September 19, 2006, whether they will appear voluntarily. The attorney-client privilege and Fifth Amendment privilege issues that this congressional investigation might present are discussed in this post on the White Collar Crime Prof blog, here. The WSJ.com law blog also has an interesting post here discussing the swirl of activity surrounding Sonsini.

The H-P derivative lawsuit is far from the only salvo that Lerach has launched against the Wilson Sonsini firm recently. As noted in a prior D & O Diary post (here), Lerach has opposed efforts to dismiss the shareholders' derivative suit pending against Mercury Interactive based on an alleged conflict of the Wilson Sonsini firm -- Wilson Sonsini represents one of the defendants in the Mercury Interactive suit, and is also outside counsel for H-P, which is acquiring Mercury Interactive.

When asked who he thinks will defend the H-P Board in the shareholders' derivative suit he filed, Lerach responded that "I bet it won't be Wilson Sonsini."

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Along with the burgeoning growth of the hedge fund industry has come the increasing importance and influence of activist hedge funds. This activism has taken a variety of forms, from public pressure on portfolio companies to change business strategy, to the running of a proxy contest to gain seats on the boards of directors of portfolio companies, to litigation against present or former managers.

This increase in hedge fund activism has attracted sharp criticism. Martin Lipton of the Wachtell Lipton law firm lists "attacks by activist hedge funds" as the number one key issue for directors. He has issued a series of client memos (here, here, and here) advising companies how to prepare to fend off hedge fund attacks. He characterizes the activist hedge funds as "self-seeking, short-term speculators looking for a quick profit at the expense of the company and its long-term value." Lipton has been a vociferous advocate for greater regulatory supervision of hedge funds.

A July 2006 research paper (here) written by New York University law professor Marcel Kahan and University of Pennsylvania law professor Edward Rock, entitled "Hedge Funds in Corporate Governance and Control," takes a comprehensive look at hedge funds' impact on corporate governance. The article is replete with specific, heavily-footnoted examples of activist hedge funds' corporate governance activities. In general, the authors regard activist hedge funds' role in corporate governance as positive, and one that hedge funds are favorable position to play because of their investment approach and freedom from regulatory oversight. One particularly colorful example the authors examine involves Third Point LLC's criticism of Star Gas's CEO Irik Sevin, to whom Third Point wrote:

It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites....We wonder under what theory of corporate governance does one's mom sit on a Company board. Should you be found derelict in the performance of your executives duties, as we believe is the case, we do not believe your mom is the right person to fire you from your job.

Bowing to Third Point's pressure, Sevin resigned one month later.

While the authors contend that hedge funds have unique incentives and advantages that better position them (compared to other institutional investors) to address corporate governance issues, they do acknowledge that activist hedge funds' actions can raise certain concerns. First, hedge funds' interests can diverge from those of fellow shareholders, as, for example when a hedge fund is a potential buyer of a company in which it has a stake. Second, with billions of dollars of assets, hedge funds put stress on existing corporate governance structures, as, for example, when loose hedge-fund coalitions target a shareholder vote. The authors acknowledge these concerns, but find them no worse than concerns surrounding other institutional investors, and argue that these concerns are not sufficient to justify greater hedge fund regulation.

The most serious criticism of hedge fund activism, the one Marty Lipton raised, is that hedge funds exacerbate short-termism. The authors argue that the market will enforce adaptive approaches to deal with the potential negative effects of hedge fund short-termism. The authors cite Lipton's own "Hedge Fund Attack Response Checklist" as an example of just such an adaptive device, about which the authors state:

[Lipton's suggestions] are terrific ideas, not just to deal with activist hedge funds but in general. If companies follow Lipton's advice, hedge funds will have already made significant positive contributions to the management of U.S. companies. Moreover, if hedge funds can succeed despite companies taking these measures, we think chances are reasonably high that they have a good point.

The authors' conclusion is that "market forces and adaptive devices take by companies individually in response to activism are better designed to help separate good ideas from bad ones than additional regulation."

The increasing influence of activist hedge funds has important implications for D & O risk. Specifically, activist hedge funds' corporate governance activities can involve litigation, including litigation directed against directors and officers. A prominent recent example is Cardinal Value Equity Funds' litigation campaign involving Hollinger International and allegations of Conrad Black's self-dealing and other transactions, which culminated in a derivative lawsuit for breach of fiduciary duty against Hollinger's board of directors. After an independent Board committee investigation, Cardinal negotiated a $50 million settlement with the directors not directly implicated in the self-dealing. The settlement was funded by Hollinger's D & O insurers. (Hollinger's press release may be found here. )

Hedge funds have even sought appointment as lead plaintiffs in securities fraud lawsuits. Indeed hedge funds often are the investors with the largest losses, but because they often engage in short-selling, they may be subject to unique "reliance" issues and therefore many not be "adequate" class representatives. For that reason, courts have often, though not uniformly, rejected the appointment of hedge funds as lead plaintiffs.

But because activist hedge funds view litigation as an essential part of their activist strategy, the role of hedge funds as "the prime corporate governance and control activists" has very important implications for D & O risk. While hedge funds' activism potentially could contribute to improved corporate governance, the willingness of hedge funds to achieve their goals through litigation against directors and officers represents a dangerous variation of D & O exposure. Marty Lipton may not have been far off the mark when he described the threat of activist hedge funds as the most important issue for corporate officials.

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Eliminate Quarterly Guidance? On July 24, 2006, the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics issued a Report entitled "Breaking the Short-Term Cycle: Discussion and Recommendations on How Corporate Leaders, Asset Managers, Investers and Analysts Can Refocus on Long-Term Value," calling on corporate leaders, asset managers and others to break the "short-term" obsession and reform practices involving earning guidance, compensation and communication to investors.

The report is the product of a series of symposia the groups co-sponsored to address issues of "short-termism." The symposia participants included a number of widely respected individuals, including John Bogle of the Vanguard Group, Louis Thompson of the National Investor Relations Institute, and other representatives from companies, investor groups and securities analyst firms.

The report states that "the obsession with short term results by investors, asset management firms, and corporate managers collectively leads to the un-intended consequences of destroying long-term value."

The report's recommendations include the following actions:

• End the practice of providing quarterly earnings guidance;
• Align corporate executive compensation with long-term goals and strategies and with long-term shareholder interests;
• Improve disclosure of asset managers' incentive metrics, fee structures, and personal ownership of funds they manage; and
• Endorse the use of corporate long-term investment statements to shareowners that will clearly explain - beyond the requirements that are now an accepted practice - the company's operating model.

With respect to quarterly earning guidance, the report notes the following:

Although there may be certain benefits to providing earnings guidance, the costs and negative consequences of the current focused, quarterly earnings guidance practices are significant, including (1) unproductive and wasted efforts by corporations in preparing such guidance, (2) neglect of long-term business growth in order to meet short-term expectations, (3) a "quarterly results" financial culture characterized by disproportionate reactions among internal and external groups to the downside and upside of earnings surprises, and (4) macro-incentives for companies to avoid earnings guidance pressure altogether by moving to the private markets.

A prior D & O Diary post noted that these and other concerns increasingly are motivating companies to move toward annual earning guidance only or the elimination of earnings guidance altogether. The elimination of quarterly earning guidance would not only address the concerns noted in the recent Report, but also would discourage activity that frequently is at the center of shareholders' claims against companies and their boards. The drive to make (or avoid missing) guidance is the root cause of many of the behaviors that drive shareholders' claims. The D & O Diary believes that implementation of the Report's recommendations for companies -- especially the Report's recommendation about eliminating quarterly earnings guidance -- would be an important step for any company that is serious about managing its securities litigation risk.

The groups' press release describing the Report can be found here. A summary of the Report's recommendations can be found here. A July 25, 2006 cfo.com post discussing the report can be found here. An AAO Weblog post on the report can be found here.

Stanford Clearinghouse Mid-Year Report: On July 26, 2006, the Stanford Class Action Clearinghouse, in conjunction with Cornerstone Research, released their 2006 Mid-Year Class Action Securities Fraud Class-Action Filings Report, which can be found here. The report notes that the 61 class actions filed in the first half of 2006 represents a 45 percent decrease compared to the 111 filings observed in the first half of 2005. The 2006 mid-year numbers represent the lowest level of filing activity during a six-month period since 1996, just after the adoption of the PSLRA. The Report speculates that the decline is due to the passage of time from the Internet bubble of the late 1990s; to possible improvements to corporate governance owing to Sarbanes Oxley; and the overall absence of volatility in stock prices during recent periods. The press release that accompanies the report includes a quotation from a Cornerstone official that "[a]lthough there is no doubt that there has been a considerably lower level of filing activity over the last year, it is still too early to tell whether this is a permanent shift."

The D & O Diary agrees that it is way too early to conclude that the YTD numbers represent a fundamental change. Among other things that the D & O Diary thinks could still produce an uptick in class action securites activity this year is the options backdating scandal and the slow dissolution of the Milberg Weiss firm. Although the options backdating scandal has only produced limited class action securities litigation so far (as the Cornerstone mid-year Report duly notes), the string on the scandal still has a long way to run. The gradual out-migration of Milberg lawyers, including the spawn of new law firms, as well as the attraction of existing plaintiffs' firms (including firms traditionally associated with tobacco or asbetos litigation) to Milberg's space, create a population of plaintiffs' firms and attorneys that need to justify their existence. In addition, market causes, such as the low share price volatility, can change. Rising interest rates and energy prices, war in the Middle East, and the threat of terrorism and natural catastrophes all present the potential to generate volatility and undermine the generally stable business environment we have enjoyed for several good years.

The D & O Diary also notes that the class action securities lawsuits may not even be the shareholders litigation story for the first half of 2006. The real story may be the raft of shareholders' derivative suits that the options backdating scandal has generated (up to 49 cases at last count.)

State of the D & O Marketplace: On July 17, 2006, Advisen released its "Commercial Lines Expert Witness Report for D & O" which surveys the current state of play in the D & O insurance marketplace. The report contains the comments from 14 "thought leaders" in the D & O arena (including underwriters, reinsurers, brokers and attorneys). The commentators share their views on trends in D & O pricing and terms and conditions; the impact of the options backdating scandal and of Sarbanes Oxley on the D & O marketplace; and legal developments that the experts are following. The Advisen Report is a little repetitive, but there are a few nuggets that reward close reading, particularly with respect to policy terms and to legal trends. The comments of several underwriters that D & O pricing will (or at least should) rise in the second half of 2006 appear problematic in light of the statistics in the Cornerstone Report. The Advisen Report can be found here.

Some Healthy Options Backdating Skepticism: As observers and commentators have tried to get a handle on how widespread the options backdating scandal is, some pretty large numbers have gotten thrown around. For example, Professor Erik Lie and Randall Heron's latest study concludes that over 2,200 companies backdated options. Comes now Broc Romanek of the CorporateCounsel.net blog who solemnly declares in this July 24, 2006 post that "[m]y gut tells me there is something fishy" about these numbers. The basis for Romanek's skepticism is a fundamental disbelief that that many people are lying, coupled with a informed belief that many companies have already verified that their companies do not have a problem. Whether or not Romanek's gut is more reliable than Professors Lie's and Heron's analysis is for others to decide, but Romanek does have a point. The sheer magnitude of the Professors' numbers do create credibility tension. If the whole Y2K fiasco taught us nothing else, it surely taught us to be suspicious when the experts are announcing the arrival of Armageddon.

Head Case Redux: As a service to those for whom the Zidane head-butt controversy was the biggest story so far this year, The D & O Diary includes this link to a July 25, 2006 USA Today article (with video footage) entitled "Jockey apologizes for head-butting horse." (I am not making this up.) The jockey is sorry and assures everyone that this "will never happen again." I am sure the horse feels a lot better better about it now with that reassurance. The D & O Diary notes that, unlike Zidane, the jockey was wearing a helmet at the time of the head-butt. Is The D & O Diary the only one puzzled why anyone would ever use their head (which has numerous other important uses) as a weapon?

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One of the least understood and least studied features of the world of corporate and securities law is the impact that directors' and officers' liability insurance has on companies' conduct. A new article by two University of Connecticut Law School professors, Tom Baker and Sean Griffith, represents an ambitious attempt to understand the impact of D & O insurance on corporate governance. The article, entitled "Predicting Corporate Governance Risk: Evide