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

In the opening keynote address on June 20, 2010 at the Stanford Directors’ College at Stanford Law School in Palo Alto, California, SEC Chair Mary Schapiro discussed the SEC’s "singular" mandate to address the needs of investors, noting the increasing challenges involved in "making sure the markets are fair and efficient."

 

Schapiro opened her speech discussing the ways that ways the agency is adopting its regulatory approach in light of rapidly changing technology. In particular, she addressed the events involved in and the consequences of the May 6, 2010 "flash crash" and the steps the agency is taking to "minimize chances it can ever happen again." Among other things, she steps the agency is taking to propose and implement "circuit breaker" rules to protect both the markets and investors from "clearly erroneous trades."

 

Schapiro also discussed the ways that technology has transformed trading activities, including for example the growth in ultra high speed trading activity. These developments and the increasing presence of dark pools trading, among other things, have led the agency to launch a series of initiatives, including new rules that would give the agency much faster and more complete access to information about trading activity.

 

Schapiro said that she appreciates the benefits and advantages that the various technological changes offer, particular those that "make markets more efficient, reduce costs, and increase liquidity." But, she added, "when these changes have the potential to destabilize markets without significantly contributing to key market functions, we believe they deserve a second look."

 

Schapiro then talked about the steps the agency has been taking as part of its mandate to protect the interests of "all investors, large and small." In later remarks during the Q&A, Schapiro underscored the importance to her and the agency of this aspect of the agency’s mission, noting that the SEC has to help investors, noting that "there is not another agency that works for the interests of investors."

 

Among other steps the agency is taking to try to advance its goals of helping investors is to reevaluate all existing corporate filing forms and disclosure requirements in order to consider what will be most meaningful to investors and what will "elicit better disclosure." She noted that these efforts may be slowed somewhat by the current financial reforms process and the likelihood of increased agency mandates will emerge from Congress, but the process to improve investor information will continue.

 

The final topic Schapiro addressed are the current reform initiatives, both within the agency and in Congress, with respect to corporate governance. She emphasized the SEC’s role is not to define what constitutes good governance, but rather to ensure that its requirements encourage "accountability and meaningful communication" about how the company is governed.

 

For example, the SEC’s role is not to mandate a particular board structure, but to ensure that investors know why a particular board structure was selected. She also emphasized that investors should have meaningful information about director candidates’ qualifications.

 

Among other specific governance issues Schapiro discussed were proxy disclosures and shareholder voting process issues. She enumerated a number of voting related issues that require further discussion, including, for example, the question whether proxy advisory firms should be subject to increasing SEC oversight and how to encourage retail investors voting participation.

 

Schapiro concluded by noting that while there agency faces many challenges, the "higher goal is a financial marketplace where investors invest capital in dynamic companies in a growing economy."

 

UPDATE: The text of Schapiro's speech has now been posted online, here.

 

Speakers' Corner: I am here at Stanford Law School for the conference as an interested member of the audience as well as member of the Directors’ College faculty. Tomorrow morning, I will be participating on a panel entitled "Personal Liability Risks, Indemnification and D&O Insurance." Joining me on the panel will be my good friends Priya Cherian Huskins of Woodruff Sawyer and Chris Warrior of Beazley. Though I have official responsibilities, I hope to be able to add post blog updates during the conference.

 

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Both the number of restatements and the number of companies reporting restatements are declining according to a new study. The number of restatements has been declining for three years now, and the number has declined materially since the figures peaked in 2006, both because of better controls and changing standards.

 

 

The study, by Audit Analytics, is not yet available online, but it has been widely reviewed, including in a March 4, 2010 CFO.com article (here) and a March 1, 2010 article by Matt Kelly of Compliance Week (here).

 

 

As reflected in this article, the study shows that there were just 630 companies reporting 674 accounting restatements in 2009. There were 24% fewer restatements in 2009 compared to the prior year, when there were 923. The 2009 figures represent the lowest number of restatements since 2001 (when accounting scandals dominated the headlines).

 

 

The number of restatements has actually declined for three years in a row since they reached their peak in 2006, when 1,564 companies filed 1,796 restatements. In other works, the number of restatements in 2009 was 62 percent less than the number in 2006.

 

 

In addition to the declining number of restatements, accounting errors requiring a restatement are now being caught sooner. The average restatement in 2009 covers a period of 476 days, compared to 716 days in 2006.

 

 

Restatements also reduced earnings by smaller amounts. 2009 restatements on average reduced earnings by $4.6 million, compared to $7.2 million in 2008 and $23.5 million in 2006.

 

 

The CFO.com article reports that the study’s authors attribute the decline to two factors: improved internal controls as a result of Section 404 of the Sarbanes Oxley Act, and a 2008 recommendation by the SEC’s Advisory Committee on Improvements to Financial Reporting that the SEC “relax its requirements on what types of errors should trigger restatements.”

 

 

One circumstance supporting the suggestion that SOX may be contributing to the reduced number of restatements is the fact that the majority of U.S.-based companies issuing 2009 restatements (374 out of 522) were “nonaccelerated filers,” meaning that Section 404’s requirements do not yet apply to them. Of course, there are, in fact, more nonaccelerated filers than accelerated filers in the first place, so the raw numbers alone may not tell the whole story. In addition, the smaller nonaccelerated filers simply may be more likely to have problems due to their small staffs and fewer tools.

 

 

On his Compliance Week blog, Kelly points out that the number of restatements by accelerated filers grew between 2002 and 2005, the year they had to comply with Section 404, but they have declined since that time. Kelly concludes that, despite all of the criticism of the provision, Section 404 may be working.

 

 

To those who say we had a crisis in 2008 notwithstanding Section 404, Kelly points out that the most recent crisis “has largely been a crisis of flawed assumptions and reckless risk management coming home to roost – not accounting fraud.” Kelly concludes that whatever financial reform Congress might conjure up in response to the current crisis, it is not time to “start rewriting Sarbanes-Oxley wholesale,” as “the law is working just fine.”

 

 

The suggestion that the declining number of restatements is due to SOX reforms brings to mind the long-standing question whether the changes in the number of securities class action filings are also attributable to improved company behavior as a result of SOX.

 

 

However, though the number of restatements has declined steadily, the number of lawsuits has fluctuated from year to year. Indeed, the most recent year with the highest numbers of restatements, 2006, when there were almost three times as many restatements as in 2009, there were fewer class action lawsuit filings (116) than in any year since 1996, and certainly significantly fewer filings than in 2009, when there were (depending on whose count you are using) at least 178 filings.

 

 

So there may well be fewer restatements as a result of Sarbanes Oxley, but that alone does not explain what has been happening with fluctuating securities class action lawsuit filings. Changed corporate behavior as a result of Sarbanes Oxley, even if it has occurred, is not a sufficient explanation for lawsuit filing levels. There may simply be too many other areas of corporate activity, beyond those addressed in Sarbanes Oxley, that continue to attract the unwanted attention of the plaintiff’ class action securities lawsuits.

 

 

The bottom line seems to be that as good as the news is that the number of restatements is declining, that does not necessarily mean as a general matter that companies are necessarily less likely to be sued.

 

 

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Time-honored legal principles typically shield corporate officers and shareholders from direct personal liability for legal violations of the corporation itself, consistent with the notion that the corporation itself has a distinct and separate legal identity. However, as I noted in a prior post (here), courts have evolved a concept called "the responsible corporate officer doctrine," pursuant to which individuals can be held liable for corporate misconduct without involvement in or even awareness of the wrongdoing. Recent indications suggest that regulatory authorities may be planning a more aggressive use of this doctrine, a development that may have disturbing implications.

 

The responsible corporate officer doctrine was first articulated by the U.S. Supreme Court in the 1943 case of United States v. Dotterweich, in which corporate officers in positions of authority were held personally (and in that case, criminally liable) for violating strict liability statutes protecting the public welfare.

 

The Supreme Court approved the application of liability under the Food, Drug and Cosmetic Act (FDCA) in the 1975 case of United States v. Park holding that the FDCAs "requirements of foresight and vigilance" are "no more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and wellbeing of the public that supports them." The Supreme Court approved the imposition of liability in that case, though the defendant had no involvement in or personal knowledge of the violation.

 

The responsible corporate officer doctrine has been absorbed into environmental law as well, and, as discussed here, and has served as the basis of imposing liability in environmental enforcement actions.

 

According to a March 5, 2010 memo from the Skadden law firm entitled "FDA Announces New Push to Prosecute Corporate Officers and Executives for No-Intent Crimes" (here), the FDA, under fire for lack of active oversight of its office of criminal investigations, has advised Congress that it intends to "increase the appropriate use of misdemeanor prosecutions…to hold corporate officials accountable." The law firm memo suggests that this FDA statement to Congress is consistent with the "recent uptick" in prosecutions relying on the responsible corporate officer doctrine against pharmaceutical and medical device executives.

 

The responsible corporate doctrine unquestionably is a well-established tool for the imposition of liability on corporate officials in the context of public "health and wellbeing." But though well-recognized, it nevertheless has disturbing implications. The FDA’s apparent intention to use the responsible corporate officer doctrine more aggressively arguably is part of a larger and even more disturbing trend to try to hold corporate officers liable without regard to personal culpability.

 

First, the idea that liability can be imposed on an individual for corporate misconduct, in apparent disregard of the corporate form and without culpable involvement or even a requirement of a culpable state of mind, seems inconsistent with the most basic concepts surrounding the corporate form. The doctrine arguably imposes liability for nothing more than a person’s status. The word "responsible" in the doctrine’s name does not mean that the individual is responsible for the misconduct, but on that that the individual is responsible for the corporation.

 

Second, the application of the doctrine can have serious ramifications. The Skadden memo points out that in one recent FDCA prosecution, the individuals against whom liability was imposed on the basis of responsible corporate officer doctrine were required to pay criminal fines of $34.5 million (The imposition of liability is currently on appeal.) The imposition of criminal penalties of this extraordinary magnitude without any fault or even culpable state of mind seems fundamentally inconsistent with the fault-based framework of our criminal justice system.

 

But the most troubling thing about the responsible corporate office doctrine is that the apparently expanded willingness of regulators to use the doctrine to impose liability on corporate officials is entirely consistent with developments elsewhere that also suggest a willingness of government regulators to try to impose liability without regard to involvement of awareness of the alleged wrongdoing.

 

In that regard, there have been at least two instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged legal wrongdoing. Though these regulatory enforcement actions did not expressly rely on or even refer to the responsible corporate officer doctrine, the enforcement actions implicitly reflect a similar presumption, which is that in certain instances corporate officials can be held liable solely on the basis of their position without respect to the presence or absence of personal culpability.

 

First, as noted here, the SEC has initiated an enforcement action against the former CEO of CSK Auto, in which the SEC seeks to "clawback" compensation the CEO earned at a time with respect to which the company subsequently had to restate its financial statements. The SEC is pursuing this claim even though the former CEO is not only not charged with fraud, but is not even alleged to have had any involvement in or even awareness of the circumstances requiring the later restatement.

 

Similarly , the SEC more recently filed an enforcement action seeking impose control person liability on two officer of Nature’s Sunshine Products, in which the SEC sought to hold the individuals liable for the company’s Foreign Corrupt Practices Violation, though the individuals were not alleged to have had any involvement in or awareness of the wrongful conduct. The Nature’s Sunshine Products case is discussed here.

 

Though these recent SEC enforcement actions did not expressly rely on the responsible corporate officer doctrine, the SEC’s actions in these cases reflect a willingness – similar to that of the FDA and other regulatory authorities -- to impose liability on corporate officials without regard to fault or culpability. These regulatory actions raise a very disturbing specter of strict liability for executives.

 

Even if there are circumstances where, as the U.S. Supreme Court has long recognized, that public health and welfare may justify the imposition of liability without culpability under certain circumstance, the enormous burden this possibility would impose on the civil rights and liberties of the affected individuals would seem to argue that these principles be used to impose liability on individuals only in the rarest and most extreme purposes.

 

But rather than restrict its use of these principles out of an appropriate respect for basic notions of fairness and individual liberty, regulators are moving in the exact opposite direction and apparently seeking new opportunities to use these principles to expand their regulatory reach.

 

The regulators may well feel this approach may be justified in order to accomplish regulatory goals and ensure that somebody pays the price for wrongdoing. The problem is that scapegoating individuals for misconduct in which they were not involved and of which they were not even aware is fundamentally unfair. In my view, this approach is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

 

If there are circumstances where public health and welfare might sometimes require the imposition of responsibility on a strict liability basis, the use of those circumstances should be infrequent and unusual. Regulators should be looking for ways to avoid relying on these powers rather than looking to expand their use. The imposition of penalties without regard to fault or culpability is a fundamentally unfair practice that should be discouraged at every possible opportunity.

 

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In the wake of numerous corporate scandals in recent years, many factors have been suggested as possible indicators of fraud, including outsized compensation, questionable accounting and failed oversight. But a recent paper by three Canadian academics proposes a surprising alternative indicator of fraudulent misconduct they suggest is more reliable – the size of the CEO’s ego.

 

The authors suggest that egotistical managers, stoked by media attention and analyst praise, gain a "feeling of invincibility" that leads them to "take more risks in fraudulent activities," akin to the "moths attracted to the flames that ultimately kill them."

 

In their paper, "Like Moths Attracted to Flames: Managerial Hubris and Financial Reporting Frauds" (here), Michel Magnan of Concordia University in Montreal, Denis Cormier of UQAM and Pascale Lapointe-Antunes of Brock University report on their analysis of financial reporting frauds or improprieties committed at Canadian publicly traded firms between 1995 and 2005 and that led to the imposition of penalties or fines by securities regulators.

 

At the outset, the authors observed that while the "fraud triangle" of incentives, opportunity and rationalization are "red flags" indicating possible fraud, the fact is that many companies exhibit one or more of these characteristics but very few of them are actually engaged in fraud. Because these "red flags" may not actually indicate fraud, the "red flags morph into red herrings, that may lead to numerous and unfruitful wild investigation chases."

 

The authors contend, based on their review of the 15 companies in their sample, that the missing element in the analysis is the factor that explains why some companies become involved in fraud. The missing element, they contend, is "managerial hubris", which they say "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud." The authors define "managerial hubris" as "exaggerated pride or self-confidence often resulting in retribution," deriving the meaning from the concept in Greek tragedy for "man’s fatal flaw."

 

The authors propose that:

 

Hubris actually ignites and accelerates the sequence of incentives, opportunities and attitudes (rationalization) that bring CEOs to engage in financial reporting frauds or to be oblivious to such frauds being committed in their own entourage.

 

Interestingly, the authors noted that many of the firms studied were not completely unrestricted; to the contrary, many seemed to exhibit governance mechanisms that appeared to be functioning. Thus, for example, 12 of the 15 firms had a majority of independent directors, and "at least 7 out of the 15 had ‘star’ directors who brought considerable credibility." In addition, "most of the sample firms were supposedly screened or watched by some of Canada’s leading intermediaries."

 

The authors noted that the firms "were subjected to what would appear to be appropriate oversight and scrutiny." The authors’ view is that "for fraud or impropriety to be committed, governance and markets monitoring conditions need to be present, as they provide additional cover."

 

The authors’ most striking observation is that all of the sample firms or their top executives "were the objects of glowing media, society or stock market reports," which "may have either enhanced the willingness of perpetrators of fraudulent activities to pursue their actions or removed successful CEOs from carefully monitoring their executive team." The authors observed that "hubris can be fed and magnified when there is too much self-reflection of success and achievements." This managerial hubris, stoked by the fawning attention of the media and analysts "ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud."

 

The authors suggest that awareness of these factors can aid fraud detection, because this element of hubris is "more likely to be transparent" when executives are asked about "plans realizations, future strategies." The authors suggest that "inconsistencies between executives’ statements and observable facts or realities, outlandish claims, and a lack of concern for operational detail can be signals that managerial hubris has set in."

 

Thought the authors’ study is limited to Canadian companies, the authors note that "it is highly likely that managerial hubris is present in U.S. cases of fraudulent financial reporting as well" (citing the example of Scott Sullivan, the former CFO of WorldCom).

 

But while the authors refer to the possible applicability of their analysis to financial fraud in the U.S., they also acknowledge the potential limitations of their analysis as well. Among other things, they note the small size of their sample, which they acknowledge represents a "limitation" even though it also afforded them the opportunity for a more detailed study of each case.

 

The authors note that there may be factors unique to Canada at work as well. For example, they note that due to the relatively small size of Canada’s business environment and the relatively fewer number of media outlets there, "it is probably easier for someone to attain ‘star" status in Canada."

 

The authors also note that many Canadian firms have a CEO who is also a controlling shareholder or member of a control group, which may both give the CEO a stronger personal incentive to commit fraud and great opportunities to overcome internal controls. This fact may explain much about the cases the authors studied; in 13 of the 15 cases, the firm’s CEO was "an important shareholder, if not the controlling shareholder."

 

These somewhat distinctly Canadian factors may limit the extent to which the authors’ analysis may be applicable outside Canada, particularly in the U.S. where very few public companies are as controlled as were these Canadian firms. The characteristics of those Canadian firms may have given the hubristic CEOs more opportunity to indulge their egotistical goals, in ways that might not be available to many CEOs in the U.S., even to highly egotistical American CEOs.

 

Of course, there are countless examples of egotistical CEOs of U.S companies that led their companies in fraudulent misconduct –it is just that the presence of a hubristic CEO may or may not be as indicative of fraudulent misconduct in the U.S. as in Canada. Perhaps it is a topic for further study.

 

There is the problem about what to do with the authors’ conclusions, even if we accept them as valid and applicable both in Canada and outside as well. It is not as if analysts, auditors or D&O insurance underwriters can administer personality tests to measure the size of CEOs egos. And favorable press, even highly favorable press, is not always an indicator of problems looming – to the contrary, the media reports might be lavishing praise not because they are duped by fraud, but because the company’s performance actually is praiseworthy. Moreover, many CEOs have enormous egos. Arguably, only someone with a massive ego would even attempt to do their jobs.

 

In the end, the authors are suggesting only that signs of hubris should be watched for, and where found in the presence of more typical red flags, uses as a trigger for further investigation – an observation that is undeniably sound.

 

One final observation is that at some level, the authors’ research conclusions are consistent with the research I discussed in a prior blog post (here) that suggested an inverse correlation between the size of CEO’s houses and their company’s performance. Both studies suggest that if a company becomes an instrument in a CEO’s self-aggrandizement, shareholders better watch out.

 

Very special thanks to Professor Michel Magnan for providing me with a copy of the research paper. Hat tip to the Securities Docket (here), for linking to an August 26, 2009 Toronto Globe and Mail article (here) discussing the research paper.

 

And Speaking of Hubris: One of the more astonishing parts of the global financial crisis is the outsized role that banks based in Iceland played, particularly in the early stages of the crisis. The question of how several banks from a very small county in the North Atlantic created such havoc is one of the great puzzles of the crisis.

 

Picking up on the Canadian authors’ research, I would suggest that one of the ways Icelandic banks came to assume such an outsized, and ultimately dangerous role, was hubris. If you have any doubt, watch the following (pre-collapse) video from Kaupthing Bank, which, before it was seized by Iceland’s banking regulators, had transformed itself into Iceland’s largest bank. You don’t think there were some massive egos involving in this operation? (Fatal last words: "We can if we think we can... We think we can continue to grow the same way we always have.") 

 

Hat tip to Clusterstock (here) for the link to the video.

 

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A variety of news articles and blogs have expressed surprise and even outrage that Bank of America is advancing the legal expense that former Countrywide CEO Angelo Mozilo is incurring in defending against the various claims that have been raised against him, including the recent SEC enforcement action.

 

There is no particular reason for me to bestir myself to justify BofA’s action, particularly since Mozilo has done such an effective job making himself look like a cartoon villain (as I discussed here). But under Delaware law and under the legal understandings that BofA reached when it acquired Countrywide, BofA has a legal obligation to advance Mozilo’s expenses. The only outrage would be if BofA refused to do so.

 

Countrywide was a Delaware Corporation. BofA is a Delaware Corporation. Under Section 145(e) of the Delaware General Corporation Law, companies are permitted to advance expenses directors and officers incur in defending claims brought against them for actions undertaking in their capacities as directors and officers. Most companies’ by-laws make these advancement requirements mandatory, which I presume would have been the case for Countrywide. Mozilo may even have had a separate advancement and indemnification agreement; many senior executives do. In addition, as reflected in a June 9, 2009 Bloomberg article (here), the two companies’ July 1, 2008 merger agreement specified that Bank of America would maintain Countrywide’s existing indemnification rights for six years.

 

There is a very good reason for the legal formality surrounding advancement and indemnification; that is, the question of entitlement to these rights usually comes up only after serious allegations have arisen. Accordingly, it is important to lock down rights and obligations at a calmer time, so that duties and expectations are clear if questions later do arise. Having entered these agreements, companies are not at liberty to dispense with the commitments simply because they later find it distasteful or repugnant to honor the commitments.

 

Mozilo may well be one of the most unpopular figures in the United States right now, and a lot of people want to make him the poster child for everything that went wrong with our financial system. But as reviled as some might perceive him to be, that does not deprive him of his legal rights nor does it relieve BofA, as Countywide’s successor-in-interest, of its legal obligations.

 

Keep in mind that Mozilo has not been convicted of anything (yet?) – indeed, though he is one of the subjects of an SEC civil enforcement action, no criminal charges have been brought against him. Nor has he yet been found liable in any of the many civil actions against him.

 

Indeed, even if criminal charges had been brought, Mozilo would nonetheless retain the right to advancement of his defense expenses. In considering the extent of Mozilo’s rights, it is important to recall the July 30, 2008 Delaware Chancery Court opinion (here) in which Vice Chancellor Leo Strine held that the Sun-Times Media Group had to continue to advance the defense expenses of four former officers, including Lord Conrad Black, even though: 1) the four had been convicted of various criminal offenses; 2) the four had already been sentenced; 3) the convictions had been upheld on appeal; and 4) the company had already advanced $77 million in defense expenses for the four. Vice Chancellor Strine held that under Delaware statutory law and the applicable by-law provisions, requiring advancement until "final disposition," the obligation to advance expenses continued until the "final, non-appealable conclusion" of the criminal action, which had not yet been reached.

 

Whatever else may be said, advancement rights are enforceable and durable. (I will leave aside the problem created by the Schoon v. Troy case, about which refer here, which did seemingly permit the retroactive elimination of advancement rights, the Delaware legislature recently created a statutory remedy for that bobble.)

 

BofA is of course entitled to obtain from Mozilo an undertaking to repay the expenses advanced if it is later determined that he did not act in "good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation." Mozilo is a very wealthy man, wealthy enough that if the statutory standard for repayment is triggered, BofA can try to recover the amount advanced – that is if there’s anything left at that point.

 

I understand that the main objection to BofA’s advancement of Mozilo’s defense expenses is that BofA has accepted $45 billion in bailout money. The objection is that taxpayers are effectively paying Mozilo’s legal fees, or something like that.

 

One might try to argue that, because taxpayers shouldn’t have to foot the bill, companies accepting bailout funds ought to be required to terminate advancement or indemnification rights of former officers and directors, but as far as I know there were no such requirements imposed in connection with the bailout money provided to BofA. Moreover, even though Congress has a pretty impressive record of trying to impose retroactive conditions on bailout recipients -- without the slightest regard for the requirements of binding contracts -- there are still some very good policy reasons why even Congress would have to hesitate to retroactively superimpose a bailout condition like that.

 

In any event, the objection about Mozilo’s defense expenses is not to advancement of defense expenses as a general matter, but to advancement for Mozilo in particular. There is no principled basis on which to isolate one individual, no matter how unpopular he may be, and single him out as the one person retroactively disentitled to his otherwise enforceable rights. To put it another way, if Mozilo is not entitled to advancement, then no current or former director or officer from an entity receiving bailout funds should be entitled to advancement. I suspect that even the most thick-skulled, grandstanding member of Congress would see the policy concerns with taking that position.

 

There is an added component to this question – that is, the extent to which Countrywide’s D&O insurance may be reimbursing BofA for its advancement of Mozilo’s defense expense. Countrywide undoubtedly carried D&O insurance, likely with limits of liability in the tens and perhaps in the hundreds of millions of dollars. The Countrywide insurance program may have had a significant self-insured retention, but that has likely been satisfied even if it is many millions of dollars.

 

The problem with D&O insurance as a source of reimbursement for defense expenses is that there are so many lawsuits against Countrywide and its directors and officers in so many different courts that the insurance limits could quickly be depleted or even exhausted, assuming for the sake of discussion that the carriers have not asserted defenses to coverage.

 

To the extent not reimbursed by insurance, BofA will have to advance Mozilo’s defense expenses. For those who still just find this too much to swallow, here’s one final thought – even if BofA is obliged to pay Mozilo’s defense expense due to an undertaking the merger documents, BofA appears to be making money from the Countrywide acquisition. According to Bloomberg (here), BofA reported mortgage-banking income in the first quarter of $3.71 billion, compared to $1.52 billion in the first quarter of 2008, "because of surging demand for home loan refinancings." This is a significant form of consolation for the fact that BofA is on the hook for Mozillo’s defense expenses.

 

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One of Congress’ goals when it instituted the "lead plaintiff" provisions of the PSLRA was to encourage institutional investors to become more involved in controlling and monitoring securities class action lawsuits. But now that institutional investors are indeed more involved in securities lawsuits, the question has become – what difference has it made? A recent academic study suggests that institutional investor involvement in securities litigation not only enhances investors’ success in seeking financial recovery, but also improves the quality of the defendant companies’ corporate governance. The authors conclude that securities litigation is an effective corporate monitoring tool for institutional investors.

 

A January 2009 paper entitled "Institutional Monitoring through Shareholder Litigation" (here), by Agnes Cheng of LSU, Henry He Huang of Prairie View A&M University, Yinghua Li of Purdue, and Gerald Lobo of University of Houston, examined all securities lawsuits that were filed from January 1, 1996 to July 20, 2005 and that had been resolved by June 1, 2006. 1,811 lawsuits met these selection criteria, of which 1,525 lawsuits were led by individual lead plaintiffs, 178 lawsuits were led by at least one public/union pension fund or mutual fund, and 108 lawsuits were led by other categories of institutions.

 

Among other things, the authors found a "trend of increasing institutional involvement in securities litigation." The percentage of lawsuits with institutional investor lead plaintiffs has more than doubled from less than 15% in 1996 to more than 30% in 2004.

 

The authors were most concerned in determining the effect of institutional investor involvement in case outcomes. Prior research had already shown (as reflected in my prior post, here) that cases with institutional investor lead plaintiffs result in larger settlements, primarily because institutional investors tend to become more involved in the larger, more serious cases.

 

In order to be able to control for the differences due to the kind of case in which institutional investors become involved, the authors identified the "determinants" that affect institutional investor involvement and used these factors as control variables. The authors identified a range of variable associated with the increased likelihood of institutional investor involvement, including merit and potential damages, size of the defendant company, and prior performance of the defendant company.

 

Among other things, the authors found that institutional investors are more likely to be involved when the case does not involve an IPO, when accounting issues are present, and when accounting firms are involved. The cases also tend to involve longer class periods, more significant investor losses and companies with higher levels of institutional shareholdings.

 

The authors used a multivariable regression analysis to control for these case differences, in order to be able to determine the impact attributable to having an institutional investor as the lead plaintiff. The authors found that after controlling for the determinants of having an institutional investor lead plaintiff, "lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements."
 

 

Specifically, the authors found that "institutional plaintiffs play a significant role in defeating the defendant firm’s motion to dismiss," finding that "an institutional lead plaintiff can reduce the dismissal probability by 38.2%" The authors found this relationship held even when tested against control variables relating to the possibility that the institutional lead plaintiffs simply selected the most meritorious cases.

 

The authors also found that the presence of an institutional lead plaintiff "can increase the total settlement amount by approximately 59.8%," when controlling for all the various factors that might be due to the type of case in which institutional investors tend to become involved. The authors concluded that "having an institutional investor lead plaintiff is associated with both a statistically and an economically larger impact on the settlement amount than having an individual lead plaintiff."

 

Finally, the authors also found that within three years of the lawsuit filing, defendant companies that faced institutional investor lead plaintiffs experienced greater improvement in board independence than those facing individual lead plaintiffs.

 

To measure this impact, the authors looked at changes in three variables within three years of the lawsuit filing: percentage of independent boar members in the full board, percentage of independent audit committee members, and whether there is a lead director. The authors found that the presence of an institutional lead plaintiff was associate with more significant reform in these three areas, from which the authors concluded that "the impact of securities class action on governance change depends on the type of lead plaintiff."

 

From these various observations, the authors conclude that "institutional investors’ involvement in securities litigation enhances not only investors’ success in seeking financial recovery, but also the quality of the defendant firms’ corporate governance." From this, the authors further conclude that "institutional investors could use litigation as a mechanism to discipline management and to secure the long-term health of the firm"

 

The authors noted the increasing incidence of institutional investors choosing to opt out of certain class settlements, which the authors note suggests that some investors may find opting out and filing individual lawsuits to be a stronger monitoring tool that leading the class action. The authors, citing recent research by Columbia Law Professor John Coffee (about which refer here), observed that "while the reasons for institutions opting out are interesting, our empirical sample limits our ability to study that issue." The questions surrounding institutional investors’ willingness to opt out raises a host of interesting issues, not the least of which is the relative importance on a continuing basis of class action litigation of a monitoring tool along the lines the authors suggest. The authors note that this is an interesting question for another day.

 

One final observation about the authors’ interesting study is that their article, like an increasing amount of legal literature, depends on the application of sophisticated mathematical tools to problems arising in the legal context. While this approach unquestionably has its value, it does make for some daunting presentations and some impenetrable analyses.

 

I certainly am in no position to question (much less fully appreciate) the validity of the authors’ quantitative approach. I confess that I must simply take it on faith that the authors’ regression analyses are both suitable and properly applied. The more critical approach I generally prefer to take is simply not an option for me when it comes to considering this type of quantitative analysis. I am uncomfortable taking so much on appearances – the authors’ work certainly appears to be rigorous – but without undertaking a massive self-reeducation project, I am hardly in a position to do anything differently.

 

At least I understand and appreciate the authors’ conclusions. Like a docile and uncritical church congregation, I know when to say "Amen."

 

A post on the Harvard Law School Forum on Corporate Governance and Financial Regulation blog about the authors’ paper can be found here.

 

Inspiring Words: While reading Ronald C. White, Jr.’s literary biography of Abraham Lincoln entitled The Eloquent President (here), I had occasion to re-read Lincoln’s First Inaugural Address, including the speech’s stirring final paragraph:

 

I am loath to close. We are not enemies, but friends. We must not be enemies. Though passion may have strained it must not break our bonds of affection. The mystic chords of memory, stretching from every battlefield and patriot grave to every living heart and hearthstone all over this broad land, will yet swell the chorus of the Union, when again touched, as surely they will be, by the better angels of our nature.

 

It is easy for us now to admire the eloquence of these words at the remove of nearly a century and a half and with the luxury of time for quiet reflection, but the words are even more impressive when considered in the context of the circumstances in which they were first delivered. At the time of the inauguration, seven states had already seceded; the very next day, Lincoln would receive word from the commander of Fort Sumter that his supplies were nearly exhausted. Lincoln’s optimistic words reflect an earnest but nearly impossible hope for reconciliation at one of our nation’s darkest hours.

 

Reading Lincoln’s words filled me with the same feelings I had when listening to Winston Churchill’s "Battle of Britain" speeches while I was touring the War Cabinet Rooms in London earlier this year. Both examples underscore the powerful potential of words to illuminate and inspire, even in desperate and hopeless times.

 

One of the more interesting details about this paragraph of Lincoln’s speech is that it was the result of an unlikely collaboration between Lincoln and his Secretary of State, William Seward. As well-told in Doris Kearns Goodwin’s excellent book, Team of Rivals, Lincoln and Seward would go on to become political allies and close friends, but at the outset of Lincoln’s presidency, they were political rivals who hardly knew each other and who had never worked together. Lincoln set aside his ego and not only asked Seward to review his draft speech, but he adopted most of Seward’s suggestions.

 

The most fascinating part of this collaboration is how Lincoln adopted Seward’s suggestions. White’s book puts Seward’s suggestions and Lincoln’s final text in side by side columns, which highlights how Lincoln transformed Seward’s proposed language, sometimes in subtle, sometimes in powerful ways. For example, Seward did indeed suggest the phrase "mystic chords" but Lincoln rendered the phrase as "mystic chords of memory." Seward suggested "the guardian angel of the nation," which Lincoln changed into "the better angels of our nature." Lincoln turned Seward’s well-intentioned prose into meaningful, musical poetry, with words that still resonate and inspire.

 

The transformative power of Lincoln’s use of language was not lost on Seward; he came to appreciate the power of Lincoln’s words perhaps as much as anyone. Though Seward presumed to make six pages of suggestions to Lincoln’s First Inaugural Address, his presumptions changed as he came to know Lincoln better. Three years later, when asked if he had helped Lincoln write the Gettysburg Address, Seward said, "No one but Abraham Lincoln could have made that address."

 

One of the more remarkable things about Lincoln’s powerful use of language is that he had less than one year of formal education. For some reason, in our own time, we have restricted higher office eligibility to individuals who acquired at least a part of their higher education at one of two elite Eastern universities. Indeed, the current President and his three immediate predecessors all share this common educational connection. I am not sure why this peculiarly narrow form of educational elitism now predominates our politics, but the danger is that something vital and fundamentally American could be lost as a result.

 

One interesting note about Lincoln’s first inauguration is that Lincoln was the ninth President for whom Chief Justice Roger Taney administered the oath of office, a feat of longevity and endurance that so unlikely that is seems incomprehensible. Given our current Chief Justice’s relative youth, one can wonder whether he might eventually swear in as many Presidents as Taney. Perhaps in future inaugurations, Chief Justice Roberts will actually administer the Oath’s required words correctly, on the first try.

 

In our time, the Gettysburg Address, the Emancipation Proclamation and even Lincoln’s Second Inaugural Address may all be better remembered than the speech Lincoln delivered at his first inauguration. Lincoln’s words in his other speeches are indeed memorable. But it seems to me that in our time as throughout our history, the mystic chords of memory unite us to our past and our aspirations now more than ever and the prayerful hope for the influence of the better angels of our nature remain as strong as ever.

 

Lincoln’s words remind us that our nation’s history includes days that were darker than even those today, but even in those desperate times, we never lost hope and we did persevere — as Lincoln might have said, with God’s help.

 

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As governance ratings have become ubiquitous, they have also attracted an increasing about amount of attention, not all of it positive. As I noted in a prior post (here), one academic study questions the "predictive validity" of the governance ratings. A more recent academic study questions the applicability of uniform governance standards to disparate companies.

 

In any April 2009 paper entitled "Elusive Quest for Global Governance Standards" (here), Harvard Law Professor Lucien Bebchuk and Hebrew University of Jerusalem Professor Assaf Hamdani question whether the effort to establish uniform governance metrics suffers from a "basic shortcoming"; that is, the authors question whether certain corporate arrangements counted as good governance should be considered equally valuable for all companies.

 

In particular, the authors contend that the value of certain arrangements "depends considerably on companies’ ownership structure" and that "measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder."

 

In elaborating on this perspective, the authors note that in the U.S. most public companies lack a controlling shareholder, by contrast to companies outside the U.S. that often have a controlling shareholder. Given the absence of a controlling shareholder, "for anyone approaching governance arrangement from a U.S. perspective finds it is natural to assume that the arrangements governing control contests are a key element in the governance of public companies." This kind of bias results in a preference for governance arrangements that, for example, relate to takeovers and proxy fights. However, for companies that have controlling shareholders, "the presence of arrangements providing protection against a hostile takeover or a proxy fight is neither good nor bad, but simply irrelevant."

 

In view of these differences deriving from this important ownership distinction, certain governance practices, the authors suggest, should be weighed in assessing governance according to whether or not companies have a controlling shareholder.

 

The authors reviewed the governance rating methodology of three governance rating systems: RiskMetrics’ Corporate Governance Quotient (CGQ); and two measures developed by academics, the Anti-Self-Dealing Index and the Anti-Director-Rights Index. The authors conclude that presumptions built into the measures reflect a "failure" to "properly take into account the relationship between ownership structure and corporate governance," which "substantially undermines the indices’ ability to serve as effective metrics for the quality of the governance at firms or countries worldwide."

 

The authors are not against the development of governance metrics; as they put it, they "do not question the feasibility of developing a methodology for large-scale governance assessments." Rather they argue that commentators and practitioners should "develop separate systems – one for controlled and one for widely held firms," so that the rating methodology "fits the company’s ownership structure."

 

The authors’ analysis makes an important contribution for the understanding and use of the now ubiquitous governance measures. In particular, it may be critical for those relying on these measures to understand their limitations in certain contexts. By the same token, it is worth emphasizing that the limitations the authors cite will be most relevant in connection with companies outside the Unites States. The authors apparently do not question the general usefulness of the measures for U.S.-domiciled companies that lack a controlling shareholder (or for that matter, for any company lacking a controlling shareholder).

 

The more interesting question may be whether or not there are other limitations on the one-size-fits all approach to corporate governance measurement. I have often been concerned that governance metrics applicable to larger companies may not be as applicable to smaller companies, or that governance requirements best suited for mature companies may not be the same as those suited, say, for a developmental stage company. I have also often wondered whether the standards should be applied the same to all companies in all industries.

 

All of which to me suggests that there could be room for additional research along the lines undertaken in this study, to examine whether or not there may be other ways in which governance metrics should reflect separate methodologies for assessing different categories of companies.

 

He’s At It Again: Some readers may recall the recent post (here) in which I reported on the lawsuit that purported to be brought on behalf of Bernard Madoff by federal prison inmate Jonathan Lee Riches against Brittney Spears. As reported in a May 23, 2009 article in the Spokane Spokesman-Review (here), Riches has now filed another lawsuit in the Eastern District of Washington seeking an injunction to stop the Guinness Book of World Records from naming him as the person who has filed the most lawsuits in the history of mankind. A copy of Riches’ latest complaint can be found here.

 

Riches contends that the Guinness Book plans to print false information about him, among other things apparently by undercounting the number of lawsuits Riches claims he has filed. He also objects to the names the Guinness Book intends to call him, including "Johnny Sue-nami," "Sue-per-man," "the Patrick Ewing of Suing" and the "the Lawsuit Zeus." He says that these phrases "hurt my feelings and violates my civil rights."

 

Riches filed his case in the Eastern District of Washington despite the February 23, 2009 order (here) entered in that court by Judge Justin Quackenbush, in a case in which Riches had sued the Peanut Corporation of America claiming to have been poisoned with Salmonella-tainted peanut butter. In the order, Judge Quackenbush had admonished Riches that his "ability to file future cases in this court will be enjoined" if Riches continue to filed cases that fail to state a claim or that are "deemed frivolous or malicious."

 

Among other things, in his latest lawsuit, Riches claims that the Guinness Book has "no right to publish my work, my legal masterpieces." Riches prior lawsuit targets include among others Somali pirates, Plato, Nostradamus, George Bush and New England Patriots Coach Bill Belichick. (Riches undoubtedly filed the Belichick lawsuit to prove that not all of his lawsuits are frivolous.) In his latest complaint, Riches says he has also sued Black History Month, the president of Iran and butter substitute "I Can’t Believe It’s Not Butter!"

 

Riches also asserts that "when I get out of prison, I’m going to start a Lawsuit 101 shop and teach Americans how to file pro se lawsuits." He also said "I will sell Jonathan Lee Riches T-shirts" saying "Watch out what you do, or I’ll sue you."

 

Hat tip to the Overlawyered blog (here) for the link to the Spokane Spokesman-Record article.

 

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A growing chorus of voices is calling for public companies to make the separation of the Chairman and CEO functions the default governance structure. This movement, which may have the support of the new SEC Chair, appears likely to lead to some type of "adapt or explain" approach. Increasing evidence that the companies where the CEOs also act as board Chair are likelier to have "certain troubling governance characteristics" will likely encourage shareholder interest in the initiative as well.

 

The idea of separating the two roles is hardly new, but it has gained significant support from a wide variety of sources recently. First, on March 30, 2009, the Chairmen’s Forum of the Millstein Center for Corporate Governance at Yale School of Management issued a report entitled "Chairing the Board: The Case for Independent Leadership in Corporate North American" (here) calling on all North American companies to "voluntarily adopt independent chairmanship as the default model of board leadership," and if they chose to take a different course "to explain to their corporate shareholders why doing so represents a superior approach to optimizing long-term shareholder value."

 

(The Chairman’s Forum is a group of more than 50 current and former board chairs, directors and CEOs convened at the Millstein Center.)

 

The Millstein Center’s March 30, 2009 press release (here) reports that while in the U.k. only 5% of the FTSE 350 companies combine the chairman and CEO roles, over 60% of the S&P 500 companies have boards that are chaired by their CEOs. The press release quotes one commentator as saying that the independent chair model "has been adopted successfully by many companies in many regions of the globe as a means to further ensure and empower board independence."

 

The press release also quote the former chairman of Northwest Airlines as saying that combining both roles puts both functions in one person who "is obviously conflicted in the essential duty of providing oversight and monitoring the CEO and management team."

 

A March 30, 2009 Wall Street Journal article discussing the Chairmen’s Forum’s report can be found here.

 

Recent remarks from, Mary Schapiro, the SEC’s new Chair, in her April 6, 2009 speech to the Council of Institutional Investors (here), seem to suggest the possibility of an SEC move to a disclosure based approach toward separating the two roles. Among other things, she said that "we’ll also be considering whether boards should disclose to shareholders their reasons for choosing their particular leadership structure—whether that structure includes an independent chair, a non-independent, or a combined CEO/Chair."

 

As Professor Jay Brown has suggested on his Race to the Bottom blog (here), Schapiro’s remarks may suggest a SEC attempt to influence corporate governance through disclosure. Professor Brown has been a vocal advocate in favor of separating the two roles (as shown here).

 

The logic of targeting this particular issue as an important corporate governance objective was reinforced by the research recently released by The Corporate Library. As described in their March 25, 2009 press release (here), companies whose CEOs also serve as board Chair are "more likely to have certain troubling corporate governance characteristics than companies where the roles are separated."

 

The troubling characteristics, which are "associated with board entrenchment or lessened oversight of management," include relatively long CEO tenures; fewer board meetings per year; classified board structure; and "the presence of executive committees, which are typically given the power to act on behalf of the entire board, potentially allowing for a concentration of power."

 

The Corporate Library’s findings raise the possibility that having a single person as the Chair and CEO could be a risk factor for D&O insurance underwriters to assess. Along those lines, it is worth considering, as noted by the Chairmen’s Forum report, that "the overwhelming majority of financial institutions had combined roles before the current crisis erupted" – including, among others, Bear Stearns, Lehman Brothers, Citigroup, Washington Mutual and Wachovia.

 

On the other hand, there may be limits to how much can be expected or discerned from this single governance trait. As the Chairmen’s Forum’s report also notes, "splitting the role of chairman and CEO does not guarantee the application of independent oversight," adding that "it is no secret that certain companies, featured in some of the most famous corporate debacles, had separate CEOs and chairmen." Splitting the roles must be accompanied by other steps "in order for the independent chairman to fulfill the important leadership role."

 

In other words, while the continued combination of the two roles in a single person may (particularly in the current climate) represent something of a risk factor, the separation of the two functions alone is no guarantee of the absence of risk.

 

In any event, it seems likely that pressure for change will continue for all companies, and that companies that do not change will find themselves increasingly called upon to explain.

 

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Litigation over executive compensation is nothing new. The long-running clash over Richard Grasso’s $187 million NYSE pay package is only one of many titanic legal battles compensation issues produced in the past. But executive compensation litigation recently seems to have entered a new phase, fueled by moral outrage.

 

Drawing on popular anger evidenced most recently in the outrage surrounding the AIG bonuses, these most recent compensation-related cases could represent an even more pronounced litigation threat than prior lawsuits over pay. The same forces driving the litigation have also produced a variety of other corporate and social responses, some of which may or may not fully serve the purposes of overall social utility.

 

Among other recently filed lawsuits involving executive compensation is the derivative complaint filed on April 1, 2009 in California (Los Angeles County) Superior Court against the current AIG CEO Edward Liddy and several other AIG directors and officers. The complaint (copy here) among other things alleges that "there was no rational business purpose or justification for these lucrative additional payments, particularly given AIG’s deteriorating financial condition and dismal financial performance," and described Liddy’s explanation of the bonus payments as "outrageous on its face" and "absurd." The complaint seeks to recover damages for corporate waste, breach of fiduciary duty, abuse of control and unjust enrichment.

 

The bonuses paid to Merrill Lynch employees at year end just prior to the consummation of the company’s merger with Bank of America also features prominently in the shareholders’ litigation filed against Bank of America earlier this year, following the revelation of Merrill’s massive and previously unreported losses.

 

The $68 million exit package awarded Citigroup CEO Charles Prince following his November 2007 departure from the company is the subject of one of the claims in a Delaware shareholders’ derivative suit against Citigroup’s board. The claim, which alleges waste, is particularly noteworthy, because in a February 24, 2009 decision (here) in which the Delaware Chancery Court otherwise dismissed the plaintiffs’ claims against the Citigroup board for failure to monitor the company, the court found that the claim related to Prince’s compensation had been adequately pled. Unlike plaintiffs other claims, the claim for waste survived the motion to dismiss. An April 2009 memo entitled "Executive Compensation Under Fire" (here) from the Greenberg Traurig law firm described the denial of the motion to dismiss in the Citigroup case on the waste issue as "an unusual move from the traditionally pro-business courts."

 

As noted on the CorporateCounsel.net blog (here), the Delaware Court’s ruling in the Citigroup case regarding the compensation claims could be the most significant part of the decision and could suggest a possible judicial receptivity to waste claims related to executive compensation. The Greenberg Traurig memo cited above comments that as a result of this decision, "don't be surprised if more companies face similar challenges to executive compensation in the future," adding that these challenges might include not only a derivative suit like the one involving Citigroup, but also shareholder demands on the board; books and records requests; and even proxy contests.

 

An April 6, 2009 Law.com article entitled "Executive Bonuses Triggering Lawsuits Nationwide" (here) observes that litigation triggered by executive compensation controversies not only include claims of excess compensation but also lawsuits ranging "from corporate officers who allege their companies reneged on bonuses to officers who believe they were fired for protesting them." The article, which cites several examples of each of these kinds of claims, also notes that "attorneys are bracing for more litigation and legislation involving executive bonuses and compensation matters."

 

In addition, another recurring theme currently surrounding executive compensation is the possibility of a clawback remedy, to recover compensation already paid, which is a topic I previously discussed here.

 

One positive consequence of the current furor over executive compensation is that at least some companies have become more solicitous of shareholders’ views on pay. Indeed, as discussed in an April 6, 2009 Wall Street Journal article entitled "Companies Seek Shareholder Input on Pay Practices" (here) reports that biotech firm Amgen invites its shareholders to complete a 10-question online survey to determine the shareholders’ views on whether the company’s compensation plan is based on performance and whether performance goals are clearly disclosed and understandable. The article identified other companies that are taking similar steps to consult or enlist shareholders.

 

That said, the actions taken based on current popular outrage over executive compensation issues also have an ugly side. The stones thrown through the home windows of former RBS chairman Fred Goodwin and the French workers’ recent seizures of local managers, among other recent examples, suggest the possibility that the current populist backlash could slip into far more dangerous manifestations, which is one of the dangers when politicians play to the galleries on these kinds of issues.

 

Popular anger over bonuses paid to money-losing managers is understandable. Indeed Goldman Sachs Chairman and CEO Lloyd Blankfein has said (here) that he recognizes why the public is angry and called for a reform of the way financial institution executives are compensated, particularly at companies receiving government bailout funds.

 

All the same, we should take care as a society that our proclivity for blamecasting and scapegoating does not unleash darker forces. Social disorder has arisen in past economic crises, and there is nothing that says that it can’t happen again.

 

An April 7, 2009 Wall Street Journal op-ed column considers (here) how generalized populist outrage can quickly transform into nationalist or ethnic rage.

 

My apologies to The Economist  for using the cover art from this week's issue of the magazine to lead this post. I figure that on the cover of last week's issue of the magazine, they shamelessly imitated the iconic Saul Steinberg Map of New York cover art from the March 29, 1976 issue of The New Yorker Magazine. In its original form, Steinberg's map reflected a view of the world as seen from New York's Ninth Avenue. On the cover of last week's issue, The Economist adapted Steinberg's map as a contemporary map of Beijing, adding an apology for the adaptation. I extend to The Econmist the same apology here for my adaptation of the magazine's cover art here.

 

Subprime Securities Litigation: Early Trends: Even though the subprime and credit crisis-related litigation wave recently entered its third year (as I noted here), and though there have been a few settlements as well as a few rulings on motions to dismiss (refer here), by and large, the cases remain only in their earliest stages.

 

Nevertheless some trends have begun to emerge, as detailed in the March 23, 2009 memorandum from the Gibson Dunn law firm entitled "Suprime-Related Securities Litigation: Early Trends" (here). The memo does a particularly good job categorizing the various kinds of allegations that plaintiffs have alleged as well as the defenses that defendants have asserted. As for what may lie ahead, the memo states that "there is unlikely to be any slowdown in the near future of new filings of securities cases related to the credit crisis."

 

The National Map of Bank Distress: The FDIC did not close any banks this past Friday night, so the number of year-to-date bank failures remains at 21, and the total number of bank failure since January 1, 2008 remains at 46.

 

Those readers who are tracking these banking-related developments closely may want to refer to this nifty interactive graphic (here) from TheStreet.com, on which they have plotted the bank closures since January 1, 2008 on a map of the United States. Cool.

 

Some Things in the Insurance Industry Never Change: In his enjoyable book about the rebuilding of London following the Great Fire of 1666 entitled London Rising, author Leo Hollis discusses the innovation Nicholas Barbon introduced when he launched "the first fire insurance company in the world." Hollis writes that

 

His scheme was brilliantly simple: it offered a defence against the risks of living in the city while also making him a healthy profit. For a premium of 2.5 per cent of the yearly rent for brick buildings and 5 per cent for wooden-frame structures he offered insurance against fire for terms of seven, eleven, twenty-one and thirty-one years. By the 1680s, he would have over four thousand subscribers.

 

However, insurance industry behavior pattern apparently were established even in the industry’s earliest days; Hollis notes that "the problem with innovation is that it is often copied and Barbon’s ideas were swiftly replicated." The City Corporation offered its own competing scheme and offered terms for life. Barbon "had to work hard to sell his services before the opposition stole his market," while the Corporation soon found "that it was offering too much to get customers."

 

So it may be said, with respect to the insurance industry’s apparently inexhaustible capacity for self-destructive competition, ‘twas ever thus.

 

And Finally: On behalf of everyone who has watched as much college basketball on TV over the last few weeks as I have, I would like to make a motion – that is, that every single person associated in any way with the production or distribution of the Taco Bell "nacho drag" commercial should be taken out and summarily shot, without benefit of clergy. All those in favor say "Aye."

 

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As the difficulties and challenges from the global economic crisis continue to mount, one recurring question has been – how could things possibly have gone so wrong?

 

One way to try to answer this question is to look at the root causes – that is, the financial and economic conditions that produced the current circumstances. A February 19, 2009 memorandum by my friend Faten Sabry of NERA Economic Consulting and her colleague Chudozie Okongwu and entitled "How Did We Get Here?: The Story of the Credit Crisis" (here) does an excellent job explaining how "problems that first manifested in a relatively small part of the mortgage market" have "led to a contagion" that has "quickly spread to threaten the liquidity and possible solvency of may financial institutions around the world."

 

As alternative to looking for root economic causes is to try to determine who, rather than what, is responsible for the current mess. It is perhaps inevitable given the magnitude of the current crisis that attempts would arise to assign blame. Time Magazine’s recently published gallery (here) of the 25 persons most responsible for the financial crisis is just one manifestation of this inevitable fault finding process.

 

The supposed regulatory shortcomings of the SEC are among the contributing factors cited by some commentators.Indeed, former SEC Chairman Christopher Cox is among those whose names appeared on the Time Magazine list.

 

With the SEC under scrutiny and facing questions, the incoming agency leadership faces pressure to burnish the agencies’ supervisory credentials. It appears that this rehabilitative exercise may include in part the assignment of responsibility for the financial crisis, a process that apparently may target corporate boards.

 

According to a February 20, 2009 Washington Post article entitled "SEC to Examine Boards’ Role in Financial Crisis" (here), one of new SEC Chairman Mary Schapiro’s "first tasks" will be looking into "whether the boards of banks and other financial institutions conducted effective oversight leading up to the financial crisis," as part of an SEC effort to "intensify scrutiny at the top levels of management."

 

This process, described as an "inquiry into what went wrong at the board level," will examine boards that "signed off on the risks the companies took." The Post article quotes observers who note that "the boards of top financial firms had characteristics that promoted risky business practices and harmed shareholders." Among the characteristics the article cites are: board members overloaded with commitments to multiple boards; failure to separate the CEO and Chairman functions; and insufficient oversight of compensation issues.

 

To a certain extent, the Post article, and perhaps even the reported SEC initiative to scrutinize boards, reflects something of a faulty premise. The article states that "with few exceptions, boards have received little media attention as the country has sought explanations for financial firms’ taking on such perilous risks. Whether or not boards have received "media attention," they certainly have not escaped scrutiny, as the boards of numerous companies already have been subjected to extensive private securities class action litigation by shareholders. Were there to be an SEC initiative targeting boards, plaintiffs’ attorneys’ undoubtedly would be emboldened to bring even further litigation in the SEC’s wake.

 

To be sure, the Post article also cites comments by other observers who question whether boards should be "held culpable for a financial crisis that just about everyone missed." One commentator observes that the "universe of people who misread the risks…is very broad" and "could extend to rating agencies, managements and regulators." (The mention of regulators’ own potential culpability adds a certain ironic note here.) Regrettably, in the current environment, this observation about the broad dispersion of culpability may represent less of a statement of exculpation that a justification for enlarging the list of persons on whom blame might be cast for the present predicament.

 

The causes of the current situation may be myriad and the responsibilities widely dispersed. Nevertheless, for cultural reasons buried deep in the American psyche, particularized blame apparently must be assigned. The prospect of the SEC deliberately targeting financial institutions’ boards unquestionably elevates directors’ potential liability exposures. This heightened exposure extends not only to the boards of the high profile companies that have already failed, been bailed out or been merged out of existence. It also extends to the boards of the many other banks, insurance companies and other financial institutions, and even companies outside the financial sector, that are currently struggling.

 

The prospect of heightened board scrutiny inevitably leads to questions concerning the adequacy of the potentially targeted board members’ D&O insurance. Now more than ever, board members will want to ensure that they have appropriate insurance structures in place to protect themselves should they attract the unwanted attention either of regulators or plaintiffs’ attorneys.

 

Potential Liability of Other Professionals: Consistent with the suggestion cited above that a wide range of persons potentially culpable for misreading the risks, investors seeking to recover their massive losses are targeting numerous other "gatekeepers," in addition to the directors and offices of the troubled companies. These gatekeepers include companies’ outside professionals, many of whom have been named as defendants in the subprime and credit crisis-related securities lawsuits.

 

On February 24, 2009 at 2:00 p.m. EST, the Securities Docket will be hosting a webcast on the "Liability of Professionals in the Financial Crisis." In this free webcast, Stuart Grant of Grant & Eisenhofer and Michael Young of Wilkie Farr and Gallagher will be addressing questions surrounding the potential liability of professionals such as auditors, investment bankers, rating agencies, lawyers and others.

 

For further information about the webcast and to register, refer here.

 

Did the Media Fail Their Gatekeeper Function, Too?: Add the media to the list of gatekeepers that arguably failed in their gatekeeper responsibilities. In a February 21, 2009 interview in the Wall Street Journal (here), NYU Professor Nouriel Roubini observes that

 

in the bubble years, everyone becomes a cheerleader, including the media. This is the time when journalists should be asking tough questions, and I think there was a failure there. The Masters of the Universe were always on the cover, or the front page -- the hedge-fund guys, the imperial CEO, private equity. I wish there had been more financial and business journalists, in the good years, who'd said, 'Wait a moment, if this man, or this firm, is making a 100% return a year, how do they do it? Is it because they're smarter than everybody else . . . or because they're taking so much risk they'll be bankrupt two years down the line?"

And I think, in the bubble years, no one asked the hard questions. A good journalist has to be one who, in good times, challenges the conventional wisdom. If you don't do that, you fail in one of your duties.

 

There is, it seems, no shortage of blame to spread around. The question remains whether anyone in particular can or should be held directly responsible for failing to see what no one else saw – and if so, whom.

 

The Week Ahead: The PLUS D&O Symposium: This week, I will be in NYC to help co-Chair the annual Professional Liability Underwriting Society (PLUS) D&O Symposium, which will take place on Wednesday, February 25, 2009 and Thursday 26, 2009, at the Marriott Marquis hotel in Times Square. Details about the Symposium, including the agenda and registration information, can be found here.

 

I know that many readers will be attending the Symposium, and I hope readers at the conference will make a point of greeting me, particularly if we have not previously met. I look forward to seeing everyone in New York.

 

Because of the Symposium and related PLUS duties and functions, The D&O Diary will not be appearing according to its usual schedule. Regular publication activities will resume next week.

 

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The recent news about the eleventh hour award of nearly $4 billion in bonuses to Merrill Lynch employees is only the latest in a series of events exciting enthusiasm for "clawbacks" of allegedly excessive or undeserved Wall Street bonuses. Reports that New York City financial firms disbursed $18.4 billion in cash bonuses is 2008 added further fuel to the fire.

 

Senator Chris Dodd stated, with particular reference to executives receiving bonuses from financial institutions benefiting from government bailouts, "I’m going to look at every possible legal means to get that money back," adding "I’m going to be urging – in fact not urging, demanding—that the Treasury Department figures some way to get the money back."

 

President Obama, for his part, referred to the award of bonuses during a recession and while financial companies are seeking financial help to be "shameful" and the "height of irresponsibility."

 

The idea of compelling executives to disgorge compensation has been a recurring part of the public discussion surrounding the current economic crisis. The suggestion that the government should clawback financiers’ prior compensation has been a rallying cry for academics (here) and commentators (here) alike.

 

Indeed, the Dealbook blog reports (here) from Davos that a discussion of the topic of executive compensation turned a conference session into " a bit of a lynch mob, Davos-style" in response to a proposal to force those financiers who benefitted from the boom to "disgorge some of the money they ‘earned’ in bonuses based on profits that have since vanished."

 

This lynch mob mentality is familiar to those who recall the public outcry that accompanied the last era of corporate scandals. In fact, the perceived compensation excesses at Enron and Tyco, among others, resulted in a statutory provision specifically designed for the purpose of clawing back unwarranted compensation, Section 304 of the Sarbanes Oxley Act.

 

Section 304 has in fact been used to recover executive compensation, in the noteworthy options backdating settlement involving UnitedHealth Group (about which refer here). However, the fact that over six years’ after the enactment of the statutory clawback provision that there is only one noteworthy example of its utilization underscores the provision’s limited usefulness.

 

Simply put, and as discussed in detail here, Section 304 has several critical limitations: the provision lacks a private right of action; the provision’s language is poorly written; and it can only be used against the CEO and the CFO, limiting its use against other executives.

 

Moreover, as discussed in a December 24, 2008 CFO.com article (here), a federal district court recently ruled that the provision cannot be enforced against a company’s CEO or CFO if the company did not restate its financial results, even if the company had accounting discrepancies. The restriction clearly could further limit the provision’s usefulness and could constrain the government’s attempt to use the provision to recover the recent controversial bonus payments.

 

There are, however, other legal avenues that litigants might pursue to try to recover executive compensation, as discussed in the January 29, 2009 New York Law Journal article entitled "Limiting, Clawing Back Executive Pay in the Wake of the Financial Bailout" (here) by David Pitofsky and Matthew Tulchin of the Goodwin Proctor law firm.

 

The authors note that while the business judgment rule traditionally has shielded compensation decisions "shareholders seeking equitable rescission and restitution via derivative suits have been successful in recovering ill-gotten gains, even in the absence of compelling proof of personal impropriety." The authors cite as an example the recovery of $40 million in bonuses from HealthSouth CEO Richard Scrushy.

 

The authors also reference the mixed results presented in recent attempts to use state corporate governance laws to recoup executive compensation. On the one hand, they note the unsuccessful regulatory efforts to recoup a $187 million compensation package from former NYSE Chairman Richard Grasso (about which refer here).

 

On the other hand, the authors also note the more recent and successful use of New York’s fraudulent conveyance laws by current New York Attorney General Andrew Cuomo, who obtained AIG’s agreement, in response to the Attorney General’s demand letter, to freeze salaries and eliminate bonuses for certain former top AIG executives. (An October 15, 2008 New York Times article discussing Cuomo’s letter can be found here.)

 

University of California law professor Jesse Fried, among others, suggests (here) that the New York fraudulent conveyance laws, upon which Cuomo relied in his efforts involving AIG, might be used to recover unwarranted bonuses. Fried points out that the statute applies to all firms in New York, even those that have not applied for bankruptcy, and gives creditors the right to recover payments made to insiders under certain circumstances.

 

Provisions regarding executive pay were in fact a part of the federal bailout bill enacted by Congress last fall. However, amendments specify that the provision only applies to firms that receive government bailout funds by selling assets to the government in an auction. Because the bailout funds have not been deployed as originally intended to buy assets, the compensation recoupment provision may prove "toothless," as discussed in a December 18, 2008 Washington Post article (here).

 

Nevertheless, the lynch mob mentality in evidence at Davos is likely to continue to arise elsewhere, and in all likelihood, popular interest in recouping executive compensation will continue as a prominent topic while Congress continues to grapple with the current economic crisis.

 

Among other things, we can also expect continued discussion on whether or not Congress should enact a legislative limit on executive pay, as discussed in Robert Frank’s January 3, 3009 New York Times column (here).

 

In addition we can expect increasing pressure on companies to adopt their own clawback provisions, either as part of their incentive compensation plan, as governance policy, or as a statement of intent. My prior post discussing corporate clawback policies can be found here.

 

Whenever the issue of possible litigation against corporate officials comes up, the question arises concerning who will bear the costs. Obviously, the amounts of any compensation clawed back or disgorged would not be covered by the typical D&O policy. However, under the wording of the typical policy, a corporate official that is the target of a compensation clawback lawsuit would have substantial grounds on which to argue that his or her costs of defending against the suit should be covered.

 

To the extent that current popular sentiment for compensation recoupment translates into litigation, the resulting defense expense could become yet another area of growing claims expense for increasingly beleaguered insurers.

 

The Heat is On: Banco Santander started it, with its offer to make good on its clients' Madoff related losses. The word is out now, and at least some other banks have gotten the message.

 

As reported in the January 29, 2009 Financial Times (here), the National Bank of Kuwait has fully reimbursed all of its clients that lost money on the Madoff-related Ponzi scheme -- full reimbursement meaning both the clients initial investment as well as "the gains, thought to be ficticious, that they thought they had made."

 

As the Financial TImes article notes, the NBK move "puts pressure on other banks and fund managers whose clients lost money in Mr. Madoff's alleged fraud." (I wonder why the FT found it necessary to add the work "alleged.") The article goes on to note that NBK had the advantage of relatiively small losses to cover

 

Proud to Be a ‘KM Pick’: Knowledge Mosaic, the online subscription information service for attorneys, regulators, journalists and academics, offers a number of excellent services, including a weekly newsletter entitled Wired Mosaic. A feature of the newsletter is the KM Pick, in which the newsletter highlights a legal-oriented blog.

 

I am proud to report that in the January 29, 2009 issue of the newsletter (here), The D&O Diary is featured as the KM Pick. Modesty prevents me from reciting here the blush-inducing words of the newsletter's glowing encomium, but suffice it to say that I sure hope everyone will take a look at the item (right hand column, scroll down).

 

 

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One of the legacies of the era of corporate scandals earlier in this decade is a heightened awareness of corporate governance issues. This development is most obvious for publicly traded companies in the United States, with the governance requirements embodied in the form of the Sarbanes-Oxley Act. The heightened governance awareness has also had spill-over effects for private companies (refer here) and even non-profit entities (refer here).

 

But there are many other types of non-listed firms, beyond just private companies and non-profit enterprises – including joint ventures and family-owned firms, as well as venture funds, private equity firms and hedge funds. The heightened governance awareness has also affected these other kinds of non-listed firms. But many of the principles and practices developed for publicly traded companies may be ill-suited to these other kinds of non-listed firms.

 

 

In a comprehensive book entitled “Corporate Governance of Non-Listed Companies” (here), Professors Joseph McCahery of the University of Amsterdam and Erik P.M. Vermuelen of Tilberg University take a look at corporate governance principles and practices for these other kinds of non-listed firms.

 

 

The professors begin with observations about current attitudes toward governance, particularly those evolved from the context of publicly traded companies. They note that “it could very well be argued that non-listed companies do not always benefit from the spill-over effect of the application of disproportionate governance rules” and that a “corporate governance framework that is not consistent with the social and economic requirement of non-listed companies will yield imperfections over time.”

 

 

In their book, the authors propose a corporate governance framework for non-listed firms that will “foster strong decision-making, accountability, transparency and ultimately firm performance.”

The authors organize their corporate governance analysis around “three pillars.” The “core pillar” represents “company law, which provides rules and standards for registration and formation, organization and operation.” The second pillar consists of “contractual mechanisms, such as joint venture agreements and shareholder limitations.” The third pillar consists of the non-listed firms “embrace of the corporate governance rules and principles that are tailored to the organization of their publicly held counterparts.”

 

 

The authors’ exhaustive overview of the transjurisdictional development of “company law” demonstrates how various legal norms have evolved in many jurisdictions to address concerns arising from the need to protect investors and creditors from “managerial opportunism.” But these paramount principles of governance for publicly traded firms, whose ownership is widely dispersed and at an informational disadvantage to management, may not be as relevant within the ownership structures of non-listed firms.

 

 

Because of the differing needs and structures of non-listed firms, many of their governance requirements and expectations are highly contractual in nature, and tend to be more focused on protecting one set of owners and shareholders from another set of owners or shareholders. These contractual arrangements tend to address “four fundamental elements – risk of losses, return, control and duration.”

 

 

From the authors’ perspective, the value and importance of these contractual arrangements underscores the limitations of a “one-size-fits-all” approach to corporate governance and also militates against the regulatory imposition of rigid governance mandates on non-listed companies. The authors particularly address these concerns in depth in the context of private equity firms and hedge funds.

 

The third pillar of the authors’ governance framework pertains to non-listed firms’ voluntary adoption of governance measures to improve transparency and accountability. The authors suggest that companies have “strong incentives to adopt or disregard governance recommendations based on a cost-benefit assessment.” Non-listed firms have a “high-powered incentive to comply with corporate governance provisions.” The implementation of appropriate internal control measures, for example can “(1) reduce financial/reporting errors; (2) help firms follow their business practices and performance; (3) assist in tracking inventory; and (4) signal potential weaknesses within the firm.”

 

 

The authors argue for the adoption of an “optimal set of recommendations” that not only would “create a dynamic and sustainable network of business practices and advice tailored to the needs of non-listed companies” but would also “head off legislative pressures.” The “steady and healthy growth” of these kinds of firms, which are so critical to overall economic growth and development, would be advanced by their implementation of mechanisms ensuring that

 

(a) financial statements fairly present the performance of the business; (b) independent and knowledgeable directors and/or supervisors are appointed; (c) audit committees are established; and (d) strong internal control systems and processes reduce business risks and lower costs.

 

The authors’ ultimate point is that “the ‘one-size-fits-all’ and regulatory mentality arguably led to some undesirable spill-over effects to non-listed companies.” They advocate “the introduction of a separate approach” based on the development of guidelines for non-listed firms that are “sufficiently attractive and coherent from a cost-benefit perspective to persuade non-listed companies to opt into a well-tailored framework of legal mechanisms and norms.” The authors conclude that non-listed companies that operate under “well-designed and effective governance structures are likely to perform better and consequently will be more attractive to external investors.”

 

 

The authors’ analysis of the limitations of a one-size-fits-all approach to corporate governance is well-founded, and indeed these concerns may be valid even among listed companies as well as between listed companies and their non-listed counterparts. The authors’ analysis of the possibilities for and limitations of contractual mechanisms for non-listed companies is perceptive, particularly with regard to private equity firms and hedge funds.

 

 

In the end, the implementation of effective governance mechanisms and controls is critical for all firms, regardless of the particular form within which any specific firm operates. The most critical point is that mechanisms adopted must be suited to the form in which any particular firm does business. Mandatory regulatory requirements may not be sufficiently sensitive to the differing needs of different kinds of firms.

 

 

Very special thanks to Professor McCahery for providing me with a copy of this excellent book.

 

 

Olympic Questions:

 

1. Am I the only one that found the opening ceremonies scary?

 

2. Who decided beach volleyball is such a big deal?

 

3. Why does Bob Costas think Cris Collinsworth is so damned funny?

 

4. How did Mark Spitz win seven gold medals without a swim cap or goggles?

 

5. Bela Karolyi. Discuss.  

 

6. Why do so many commercials (including political ads for both Presidential candidates) have images of wind turbines?

 

7. With a 32-year old winning two swimming relay gold medals, a 38-year old winning the women’s marathon, a 33-year old female gymnast winning silver in the vault competition,  and a 41-year old winning two swimming silver medals, is it possible the Chinese are on the wrong track with their prepubescent “women’s” gymnastics team? 

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One of the received truths from the era of corporate scandals earlier this decade is that corporate governance matters. As a result, a high-profile part of the current assessment of any company is whether or not the company practices “good” governance. Even though the evaluation of any particular company’s governance has an eye-of-the-beholder aspect, several different commercial enterprises have emerged in recent years, each offering to provide their subscribers with objective governance ratings.

 

In the space of just a few short years, these governance ratings have become ubiquitous. They are now a critical part of company evaluations for investors, regulators, the financial press, and even D&O insurance underwriters. The quick acceptance of these ratings suggests that they meet a widely perceived need. However, their wide acceptance notwithstanding, it is still worth asking what exactly these ratings actually tell us about the companies and future company performance.

 

In a June 26, 2008 paper entitled “Rating the Ratings: How Good Are Commercial Governance Ratings?” (here), Stanford Law Professors Robert Daines and Ian Gow, and Stanford Business School Professor David Larcher examine four leading ratings firms’ ratings and analyze “the association between these ratings and future firm performance and undesirable outcomes such as accounting restatements and shareholder litigation.”

 

The authors reach a number of provocative conclusions, including in particular their finding that “the level of predictive validity for these ratings is well below the threshold necessary to support the bold claims made for them” by the commercial ratings firms.

 

The authors examined the corporate governance ratings produced by Audit Integrity, RiskMetrics (previously Institutional Shareholder Services), Governance Metrics International, and The Corporate Library. The authors compiled ratings for U.S. firms for each of the four ratings services, cover the period from late 2005 to early 2007. The analysis was primarily focused on ratings available as of December 31, 2005, as that was the earliest date at which the authors established “a sizeable cross-section of ratings across the four ratings firms.”

 

The authors first looked at whether the various ratings were at least consistent with each other. The authors noted that “if, as seems to be often posited, there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it, then we would expect these measure to be highly correlated.”

 

However, the authors found that there is “surprisingly little cross-sectional correlation among the ratings.” Indeed, the ratings are “close to being uncorrelated.”

 

In particular, the authors found that in certain instances, the various ratings rated specific companies dramatically differently. The authors concluded that “either the ratings are measuring very different corporate governance constructs and/or there is a high degree of measurement error (i.e., scores that are not reliable) in the rating process across the firms.”

 

With respect to future outcomes, the authors found that three of the ratings have “a very modest ability to predict accounting restatements” and two of the ratings have “a very modest ability to predict class action lawsuits.” The authors further concluded that at least one rating firm’s ratings exhibited “virtually no predictive validity.” Overall, the authors concluded that “the level of predictive validity even for the best ratings is well below the threshold necessary to support the bold claims by the corporate rating firms.”

 

The authors’ observation about the lack of agreement between the four ratings is, to me at least, unsurprising, as they various ratings clearly aim to measure different things, based on different visions of “good governance.” Even though “good governance” is a widely used term, there is no consensus definition. As the authors themselves note, “defining good governance and distinguishing good governance from bad governance has proved…elusive.”

 

The authors’ conclusions about the ratings’ relative lack of predictive power undoubtedly will be disputed by the ratings firms themselves. From my perspective, the authors’ overall conclusion about the ratings’ overall lack of strong predictive power is unsurprising, particularly as it relates to predicting securities class action litigation.

 

In my prior life running a D&O underwriting facility, my colleagues and I spent a great deal of time and effort attempting to determine what factors might predict securities litigation. We had conjectured early on that corporate governance might afford a useful tool in segmenting litigation risk. Over many years’ time,  we concluded that corporate governance alone was not sufficiently predictive of securities litigation risk, and that certain other criteria (including company size, industry, and age) were much more highly correlated with securities litigation risk.

 

Because of this experience, my colleagues and I were always somewhat skeptical of commercial governance-based securities litigation prediction tools. In my own experience, these tools are at their best when used negatively, that is, when identifying companies to avoid, but they were less helpful when used to determine which risks to accept, which is of course how D&O underwriters earn their keep.

 

The authors’ conclusions are more or less consistent with my own experience on these points. However, the real value of the authors’ thorough examination of these issues is that it will likely start a dialogue on these issues. It may well be that a different analysis or a different approach might support a different conclusion about the predictive power of the ratings.

 

Indeed, the authors themselves expressly acknowledge that they might not have used the “right model” to measure the ratings, and that “given the right model specification,” the ratings “might well prove to be significant and informative.” The authors state that, to the degree this is true, then the ratings firms should “disclose the ‘right’ model” and disclose “how well their ratings predict future performance using the ‘right’ model.” This disclosure “would enable investors to evaluate the net benefits produced by their purchase of the ratings.”

 

The authors’ interesting analysis and discussion undoubtedly will provoke debate, particularly in the corporate governance community itself. I would welcome responsible comments from the representatives of the ratings firms who might wish to respond on this blog to the authors’ conclusions about the ratings’ predictive power. (PLEASE see below for responses.)

 

 A June 30, 2008 Stanford Law School press release describing the article can be found here. A June 26, 2008 Fortune report discussing the article can be found here.

 

Very special thank to the authors for their permission to quote their article on this blog.

UPDATE: In response to my invitation to the governance rating firms to respond to the authors's study, Ric Marshall, the Chief Analyst at The Corporate Library, and Kimberly Gladman, the Director of Research and Ratings at The Corporate Library, submitted this repsonse:

Thank you for your invitation to respond to the recent Stanford study regarding the predictive value of governance ratings, including those of The Corporate Library (TCL).
 
The study found that TCL’s ratings have a statistically significant ability to predict accounting restatements and future operating performance. In addition, at the extremes (very poor or very good ratings), the study found that our ratings correlated with future alpha.  The authors state that these relationships are modest, and suggest that they may be inadequate to make our ratings useful. Our clients, however, who come from a wide range of industries, do find value in our ratings. For example, a portfolio manager who has used our ratings over the past four years in stock selection has told us that doing so has contributed substantially to his returns; our insurance clients regularly and successfully employ our ratings to identify companies that warrant greater due diligence and may present higher risk.
 
We understand that, as you point out in your recent posting about the study, it is not always effective to use governance indicators alone as a guide to financial or litigation risk.  Indeed, most of our clients combine our ratings with a number of other tools, and our own Securities Litigation Risk Analyst Ratings (which were not examined in the Stanford study) combine governance data with a number of financial and industry-related variables. We also agree with your assessment that governance indicators are often most useful in identifying areas of concern, rather than strengths; this is the essence of our approach. Client feedback has shown that taking governance ratings into account, especially in cases where doing so helps chiefly to avoid problems, brings substantial benefits to their businesses.  The Stanford study suggests that corporations themselves tend to agree: according to interviews the authors conducted with boards of directors, they often use low governance ratings as a red flag indicating that they should step up monitoring.
 
The authors’ surprise at how “little cross-sectional correlation” they found among these ratings reveals the study’s chief flaw, which is the assumption that, “there is an agreed upon definition of ‘good governance’ and each of these commercial measures seeks to measure it.” This is not the case at all, as each of the four rating services reviewed have a different focus, and are employed in different ways by a wide range of commercial clients. While Riskmetrics and GMI do both measure ‘good governance’ against specific standards, our own focus is on identifying governance weaknesses and thereby companies for clients to avoid. We have always taken issue with the notion that any one governance model can be the most effective for every company.

Special thanks to Ric and Beverly for taking the time to provide a detailed written response.

FURTHER UPDATE: Jack Zwingli, the CEO of Audit Integrity, has also provided a detailed response to the academic study. Jack's response can be found here.
 

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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: Evidence from the Directors' and Officers' Liability Insurance Market" presents the authors' theory that D & O insurance provides a deterrence function within corporate governance and securities law by forcing worse-governed firms to pay higher premiums than better-governed firms. Because the authors joined their analysis to detailed interviews of key players in the D & O insurance industry, the article does a praiseworthy job describing the industry and the broad outlines of the D & O underwriting process. The article's insights into the D & O underwriting process alone reward close reading.

However, The D & O Diary questions the article's authors' premise concerning D & O insurance underwriters' ability to accurately segment securities litigation risk based upon the underwriters' assessment of various companies' corporate governance practices. The premise derives from some underwriters' own statements of their belief in their ability to differentiate "deep governance" variables such as "culture" and "character." Some underwriters may well believe they have those differentiation capabilities, but the reality is that D & O underwriters necessarily have only limited and brief access to senior company management and rarely see management engaged in unrehearsed activity. Underwriters who believe they truly can discern culture and character on this necessarily limited basis are, in reality, doing little more than their version of Johnny Carson's old Carnac the Magnificent routine, without the humor (or, one hopes, without the costume). In addition, even if D & O insurance rates may be adjusted at the margins for governance factors, the rates themselves are largely driven by the insurance cycle, which for most companies is a much more important factor than corporate governance practices in determining the ultimate price that the companies will pay for its D & O insurance. Because of the impact of the cycle and the level of competition within the D & O insurance industry, it would be difficult to quantify any cost savings a company could realize through better corporate governance. Because the financial link between premium levels and governance practices is so indeterminate, the deterrence role of D & O insurance in corporate governance is theoretical at best. Finally, The D & O Diary questions whether D & O insurance premiums alone could be sufficient to perform the significant role that the article's authors postulate; for most companies, their D & O insurance premium is just another cost of doing business. Companies who can be persuaded to improve their corporate governance practices will do so out of fear of litigation or of government regulators, or because they simply want to do the right thing; the expectations or requirements of D & O underwriters, by comparison, are unlikely to be as important --with all due respect to my many good friends in the D & O underwriting community. (In fairness to the article's authors, the D & O Diary acknowledges that the article recognizes all of the considerations raised in this post; the article simply draws different conclusions. )

All of these concerns notwithstanding, the article does represent an unprecedented and important academic attempt to understand how D & O insurance really works, and in particular, the article's authors' methodology of developing a deeper understanding of the D & O insurance industry through interviews with industry professionals represents an important academic innovation. The D & O Diary suggests that this methodology could very productively be used to develop a better understanding of the true role of D & O insurance in the settlement of shareholders' securities fraud claims.

Full disclosure: the author of The D & O Diary was interviewed by one of article's authors in connection with the empirical research on which their article is based.

A tip of the hat to Adam Savett of the Lies, Damned Lies blog for providing a link to the article.

Aux Armes, Citoyens! Formez Vos Bataillons! Given the level of media coverage, it is hardly surprising that plaintiffs' lawyers have sought to secure their place in the options backdating litigation battlefield by announcing, for example, that they have formed an "Options Backdating Investigation Division", or that they are investigating 48 different companies or "over 50 companies." Perhaps inevitably, the first entrant from the defense bar into this escalating press release arms race has now appeared. On July 10, 2006, the Proskauer Rose law firm announced that it has formed a "Stock Options Task Force," which, their press release explains, is a special multidisciplinary group of over 20 lawyers that will work with companies on stock option timing issues. None of this is surprising to The D & O Diary, since I predicted in my very first post on options backdating that the issue would be "this year's model" of the Lawyers' Relief Act.

In a much more ominous development on the options backdating front, Kevin Ryan, U. S. Attorney's Office in San Francisco announced on July 13, 2006 that his office has formed its own stock options backdating task force. The team is responsible for investigating companies and individuals in Northern California who retroactively changed the dates of stock options with the intent to defraud. According to this post in the wsj.com law blog, the Mr. Ryan's office's press release stated that the task force "will bring criminal charge when appropriate."

Head Case: On the theory that anything that is the subject of a front page article in the Wall Street Journal (subscription required) is a suitable topic for this Internet weblog, The D & O Diary has decided to weigh in on the Zidane head butt controversy -- possibly the only story this year that has gotten more widespread media coverage than options backdating. First, we would like to introduce as Defense Exhibit No. 1 the following link to an extensive video portfolio of the misbehavior of Marco Materazzi on prior occasions, which may explain what may have preceded Zidane's now infamous head butt of Signore Materazzi. Second, in the interests of world peace and understanding, The D & O Diary would like to introduce as Defense Exhibit No.2 the following link as proof that there are a lot of people out there with a lot of time on their hands to exploit the humor in any situation, even the video footage of Monsieur Zidane's head butt. (Does anyone remember who won the game?)

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