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

In a recent post on his SEC Actions blog entitled "Trends in Securities Class and Derivative Actions Suggest Proactive Steps for Directors and Officers" (here), Thomas Gorman of the Porter Wright law firm reviews a number of trends that potentially could threaten the interests of directors and officers. Gorman's blog post references the rising level of average class action securities settlements. He also reviews in interesting detail the increasing level of recent derivative settlements. The post also discusses the recent Just for Feet settlement (about which see my prior detailed commentary here). The SEC Actions blog post concludes with the comment that "all of this suggests that directors and officers would do well to take proactive steps to protect themselves." Among other steps, "D & O policies should be reviewed" focusing on "the amount and scope of coverage."

Consistent with this recommendation to consider the scope of D & O coverage as part of an overall effort to protect corporate officials in the current changing exposure environment, in the latest issue of InSights (here), I take a closer look at the changing exposures of outside directors in particular, and I also review the critical insurance options available to provide outside directors with optimal insurance protection.

Effective Governance: Sixteen Men on a Dead Man's Chest?: I suspect that many D & O Diary readers will be interested to know about the May 2, 2007 article by Peter Leeson of the West Virginia University Department of Economics, entitled "An-arrgh-chy: The Law and Economics of Pirate Organization" (here). The author's abstract describes the paper as follows:

This paper investigates the internal governance institutions of violent criminal enterprise by examining the law, economics, and organization of pirates. To effectively organize their banditry, pirates required mechanisms to prevent internal predation, minimize crew conflict, and maximize piratical profit. I argue that pirates devised two institutions for this purpose. First, I analyze the system of piratical checks and balances that crews used to constrain captain predation. Second, I examine how pirates used democratic constitutions to minimize conflict and create piratical law and order. Remarkably, pirates adopted both of these institutions before the United States or England. Pirate governance created sufficient order and cooperation to make pirates one of the most sophisticated and successful criminal organizations in history.

Hat tip to the Ideoblog (here) for the link to the article.

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Since the well-publicized settlements in the Enron and WorldCom cases, where individual directors were required to contribute toward settlement out of their own assets without recourse to indemnity or insurance, outside director exposure has been a hot topic (refer here for my prior discussion of those settlements). In addition, the SEC's recent statements about pursuing outside directors as "gatekeepers" with a responsibility to prevent corporate misconduct, reinforced by its recent enforcement action against the outside directors of Spiegel (refer here), have further raised concerns.

The recent scholarly research of Bernard Black of the University of Texas, Brian Cheffens of Cambridge University, and Michael Klausner of Stanford Law School, in an article entitled "Outside Director Liability" (here) provides some reassurance that outside directors' individual out-of-pocket contributions toward settlements have been, at least historically, an unusual and rare occurrence. The professors found only 13 cases in 25 years in which outside directors had to make out-of-pocket settlement payments. The authors conclude that the risk of outside directors being called upon to contribute has been "very low," and have largely been a reflection of the insolvency of the corporate entity or the unavailability of D & O insurance. The authors conclude that this remote possibility could be even further reduced "with appropriate [D & O] policy limits and current state of the art protections."

While the professors' analysis is comforting, a recent settlement underscores the need for outside directors, as well as their advisors and insurance professionals, to continue to keep a sharp focus on outside director exposure. An April 23, 2007 Wall Street Journal article entitled "Settlement in Just for Feet Case May Fan Board Fears" (here, subscription required) describes a recently completed settlement in which five former outside directors of Just for Feet paid a total of $41.5 million to settle a bankruptcy trustee's state court breach of fiduciary duty claim against the individual outside directors.

The Journal briefly relates that Just for Feet "collapsed amid an accounting fraud" in 1999. Three former Just for Feet officers pled guilty to crimes, and the company filed for bankruptcy protection in 2000. Just for Feet also settled a securities class action lawsuit, as a result of which, according to the Journal, only $100,000 remained available from the company's insurance. A brief description of the $24.5 million corporate defendants' class action settlement may be found here. A copy of the consolidated class action complaint can be found here. The Notice of Settlement regarding the Just for Feet class action settlement may be found here. At least one of the individual defendants named in the trustee claim was also named as a defendant in the class action lawsuit.


The Just for Feet bankruptcy trustee filed Alabama state court allegations against the outside directors and the company's outside auditor in 2001. The lawsuit charged the individuals with, among other things, conflicts of interest, misrepresentations, breach of fiduciary duty and bad faith. According to the Journal, in September 2006, four former outside Just for Feet directors agreed to pay $40 million to settle the trustee's claims against them. Last month, the last remaining outside director paid $1.5 million to settle the trustee's claims. The former directors neither admitted nor denied liability.

It does not appear that the five individuals were, like the outside directors were in the Enron and WorldCom settlements, prohibited from seeking outside indemnity or insurance. Indeed, the Journal article notes that "[i]t is unclear whether any of the former outside directors' employers, former employers or any other person on institution helped cover their portion of the settlement."

The question whether the outside directors' settlement may have been funded by a third party source, rather than out of the individuals' own assets, is an interesting and important detail (and not just to the individuals themselves). In that regard, it is important to note that one of the individual outside directors is a principal of a venture capital fund; two of the individuals are principals of private equity firms; one is a principal of an investment bank; and one is the president of a commercial bank. (The individuals' names and their respective affiliations are detailed in the Journal article.) These individuals at least potentially could have sought indemnity from the respective firms, particularly if their service on the Just for Feet board was at the direction or request of their firms. In addition, each of these individuals might have had the opportunity to attempt to recover Outside Director Liability (ODL) protection under their respective firms' D & O insurance. The fact that several of the individuals are principals of venture capital or private equity firms is particularly noteworthy in this regard. The insurance coverage available for individuals' outside directors service on the boards of venture capital and private equity firms' portfolio companies' boards is one of the most important reasons for venture capital and private equity firms to buy insurance providing this protection. Indeed, the Just for Feet settlement provides a powerful example of the reasons why private equity and venture capital firms should acquire this type of insurance.

The fact that the company's D & O insurance program was virtually exhausted by the class action settlement apparently without obtaining a release of claims against the outside directors presents another question. It is not clear from the sequence of events and the publicly available information whether or not the trustee had initiated the claims against the outside directors at the time the securities class action was settled. But it would typically be a constraint against the exhaustion or near exhaustion of policy limits if the settlement would not secure universal claims releases. The outside Just for Feet directors would obviously have had a strong interest in avoiding exhaustion without their release. That such an outcome occurred in the Just for Feet case suggests that outside directors of other companies would be well served by having more control over the disposition of D & O policy proceeds, so that they are not faced with continuing individual exposure without further insurance protection. One possibility might be to structure the now standard order-of-payments D & O policy provision to that disposition of the policy proceeds is controlled by a vote of the outside directors.

There are now a variety of commercially available insurance structures that might also help in similar situations in the future, although the perverse combination of insolvency and insurance exhaustion is a particularly fraught situation. Certainly, the availability of a Side A Excess layer or stand-alone Side A program designed solely for the protection and benefit of individuals (as opposed to the corporate entity) potentially could have provided protection. For a summary regarding Side A insurance, refer here. Many companies have already taken steps to secure this type of protection; according to the recently recently released 2006 Towers Perrin Survey of Insurance Purchasing and Claims Trends (here), 38% of public companies in the survey reported purchasing a Side A only D & O product. But protecting even these separate limits from depletion by settlement for the benefit of insider individual defendants would seem to require some formal partition of coverage between the individual inside defendants and the outside individuals, especially given the company's insolvency. The Just for Feet settlement may provide the best example yet of the need for a separate Side A program dedicated solely to the outside directors' protection -- or better yet, for a separate Individual Director Liability (IDL) policy solely for the benefit of one individual or a group of outside directors. The existence of separate limits that cannot be depleted in resolution of others' claims is the best protection against the possibility that individuals might be left to face their own liability exposure without insurance protection.

But perhaps the most significant aspect of this individual outside director settlement is its sheer size. As the Journal states, the $41.5 million Just for Feet outside director settlement may represent "the largest out-of-pocket payment by outside directors following corporate fraud allegations." While many companies now purchase Side A protection or other variants to protect individual officers and directors, the limits available under many of these structures would typically not be sufficient to entirely fund a settlement of the magnitude of the Just for Feet outside director settlement. According to the 2006 Towers Perrin Survey, the average Side A Only limit for survey participants that also have a full A/B/C program is $15 million, and only $8 million for those with only a Side A only limit. According to the data in the survey, only the very largest companies carry Side A only limits that would have been sufficient to fund a settlement of the size of the entire Just for Feet outside director settlement.

This is just one of several recent developments that threaten traditional notions of D & O limits adequacy. The rising size of average and median class action settlements (refer here), the rising level of defense cost expense, and the emerging threat of separate class action opt-opt lawsuits (refer here), have all complicated the usual calculus of D & O limits adequacy. These factors and the continuing threat of outside director liability exposures (and the need for the D & O program to be structured to address this threat) underscore the need for the involvement of a skilled insurance professional in the D & O purchasing process.

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In a recent post (here), The D & O Diary examined the SEC's decision not to pursue an enforcement action against the outside directors of the Hollinger International and examined what this move might suggest about the potential liability and enforcement action exposure for outside directors of companies caught up in the options backdating scandal. A recently settled SEC enforcement action filed against three outside directors of Spiegel suggests that, at least under certain circumstances, the SEC will pursue enforcement actions against outside directors. And even though it did not involve option timing allegations, the recent action against the Spiegel outside directors may also shed some light on outside directors' enforcement exposures in connection with the options backdating investigations.

According to the settled enforcement action that the SEC filed on November 2, 2006 (here), in 1982, OTTO Gmbh & Co., a German mail-order company primarily owned by Michael Otto, acquired Spiegel. Spiegel went public in 1997 by listing a portion of its shares on NASDAQ. Otto served as Spiegel's board Chair. Also serving on the Spiegel board were two other Germans, Michael Crusemann and Horst Hansen.

In early 2002, as a result of Spiegel's deteriorating financial condition, Spiegel's independent auditor advised that it would have to consider a "going concern" modification in its audit report that would accompany Spiegel's financial statements in its 2001 10-K. Spiegel itself was working to line up new credit facilities that the company believed would address the auditor's concerns and permit a clean audit report. Because the company did not want to face the market consequences that would result from the going concern opinion, it sought to withhold the 10-K filing while it tried to remedy its credit issues.

According to the SEC, between April 2002 and February 2003, Otto, Crusemann and Hanson, participated in a series of decisions to withhold the company's SEC fillings. The directors actively participated in decisions to withhold the filings even though their inside and outside counsel specifically advised them that the failure to file violated American law and exposed the company and its officers to legal liability. The SEC also alleged that Cruseman and others received a document entitled "Pros/Cons to Filing Form 10-K" specifically stating that corporate officials could be personally liable for failure to file. The document also attached copies of securities laws indicating liability for the failure to file. Despite these warnings, the SEC alleged, the director actively decided that Spiegel should withhold its filings to avoid having to disclose the "going concern" opinion.

Spigel not only failed to file its 2001 10-K, but also failed to file its Form 10-Qs for the first three quarters of 2002. Spiegel ultimately filed the delinquent forms in February 2003, after the SEC threatened to file an enforcement action. Within weeks of the belated filings, Spiegel filed for Chapter 11 bankruptcy.

According to the SEC's news release announcing the enforcement action settlement (here), Otto and Crusemann consented to the Court's issuance of a permanent injunction against them enjoining them from future violations of the securities laws, and each consented to pay a civil penalty of $100,000. Hansen, the former head of Spiegel's audit committee, consented to the SEC's entry of an order ordering him to cease and desist from committing or causing future violations of the federal securities laws.

The SEC's enforcement action clearly shows that at least under certain circumstances, the SEC will pursue outside directors. However, it is important to note that, at least according to the SEC's allegations, the Spiegel directors did more than merely failing to supervise. They are alleged to have been actively and directly involved in the decision to withhold Spiegel's filings, and to have done made those decisions with actual knowledge that the failure to file violated the securities laws. In effect, the directors were alleged to have knowingly pursued an illegal course of conduct.

In an interesting November 29, 2006 Law.com article (here), Christian Bartholomew of the Morgan, Lewis & Bockius law firm provides his views on what the Spiegel case might mean for possible outside director liability in the options backdating scandal. Bartholomew contends that the Spiegel enforcement action ought to set standard for what should be required before the SEC pursues options backdating-related enforcement proceedings against outside directors. Bartholomew argues that the enforcement action "should be limited to situations where the evidence is clear and compelling that a director actively and knowingly engaged in or materially assisted in an improper options dating scheme, fully understanding the legal, accounting and disclosure ramifications." By the same token, "the SEC should not pursue backdating actions arising simply from a director's failure to act or to intervene to halt management misconduct."

Bartholomew's observations about what might be described as the "Spiegel standard" are interesting, but it still remains to be seen exactly how the SEC will approach this issue. The SEC has already served three outside directors of Mercury Interactive with Wells Notices in connection with the company's options backdating investigation (see the company's press release here). Time will tell whether the SEC limits its options backdating-related enforcement actions against outside directors to cases of knowing and active violations of the kind alleged in the Spiegel case.

Seven Contemptible Years: On November 27, 2006, the Second Circuit refused (here) to overturn a lower court's denial of Martin Armstrong's petition for a writ of habeas corpus. Armstrong has been in prison since January 14, 2000 for his refusal to turn over corporate records and $15 million in assets in connection with a securities fraud investigation involving his companies.

Armstrong was arrested in 1999 on charges that he defrauded Japanese investors out of $3 billion by falsely promising to invest in certain low risk assets, while he instead lost $1 billion in speculative trading that he attempted to cover up through a "Ponzi scheme." In early 2000, in response to a civil contempt proceeding against him, Armstrong had produced $1.1 million in rare coins, one computer with the hard drive removed, three other computers (which later proved to have been tampered with), and various other assets. Armstrong failed to produce other subpoenaed items, including other specified computers, 102 gold bars, 699 bullion coins, and other rare coins worth $12.9 million. Armstrong testified that he kept some of the assets "hidden in a shed in the back yard" of his mother's house and transferred others to business associates allegedly to pay off debts. The district court held Armstrong in contempt and "directed the marshals to confine Armstrong to the Metropolitan Correctional Center until he either complied with the turnover orders or demonstrated that it would be impossible to do so." At periodic hearings since Armstrong's incarceration on January 14, 2000, Armstrong has failed to comply or prove his inability to do so. Among other things, Armstrong has consistently contended that he has no obligation to do so, relying on his alleged constitutional rights against self-incrimination and his rights to due process.

Armstrong filed the habeas petition in August 2004 to raise constitutional objections to his confinement. The district court denied his petition in December 2004, which Armstrong appealed. On August 17, 2006, while his appeal was pending, he pled guilty to securities fraud.

In his appeal of the denial of the writ, Armstrong argued that, contrary to the district court's statement that he "holds the keys to his prison cell," the "key to his freedom comes at the cost of his Fifth Amendment right against compelled self-incrimination" and that his confinement also violates the Non-Detention Act, the Recalcitrant Witness Statue and due process. The Second Circuit affirmed the district court's denial of the writ, based on the district court's finding that Armstrong is capable of complying but is simply choosing not to do so. The Second Circuit held that the constitution did not protect him against producing the property and that Congress had "specifically authorized indefinite, coercive confinement." The Second Circuit did conclude that Armstrong is entitled to a new hearing to assess whether he retains custody or control of the property. The court also noted that "on the seventh anniversary of Armstrong's confinement, his case deserves a fresh look by a different set of eyes," and directed the district court to reassign the case to a different judge.

"Indefinite, coercive confinement" certainly has a chilling sound to it. Perhaps it is time to retrieve those coins from Mom's back yard.

A November 30, 2006 New York Law Journal article about the Armstrong case can be found here.

Hat tip to the Courthouse News Service (here) for the link to the Second Circuit opinion.

While My Ukulele Gently Weeps: It has been a while since the D & O Diary has had any pretext to link to a YouTube video. We therefore choose to use the occasion of the release of new Beatles' Love compilation CD to commend to its loyal readers the video linked below. The D & O Diary has never had a very high opinion of the ukulele (it is looks like a shrunken guitar, it has a plink-plink sound, and it is spelled weird) but this video (here) depicting an absolutely virtuoso ukulele performance of "While My Guitar Gently Weeps" requires a complete reassessment of the ukulele. The performance is, in a word, awesome. Enjoy.

The Wall Street Journal has a generally favorable November 29, 2006 review of the new Beatles' Love compilation CD here (subscription required).

According to Wikipedia (here), the word "ukulele" roughly translates from Hawaiian as "jumping flea." Now you know.

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As the various corporate scandals have unfolded, one of the concerns has been whether changing laws and attitudes may mean that outside directors face increased exposure to shareholder claims and enforcement actions. (See my prior article on the topic here.) One of the elements of this concern has been the statements of various regulatory officials that they intend to pursue outside directors for their failure to prevent corporate officials' misdeeds. Among the oft-cited recent examples of regulatory intent to pursue outside directors is the December 2005 service of a "Wells Notice" on three outside directors of the Hollinger. But whatever regulators overall intent may be regarding outside directors generally, the SEC has recently advised the three Hollinger directors that it will not pursue enforcement action against them.

The SEC has been pursuing an enforcement action (here) against Hollinger's former chairman and CEO Conrad Black and its former COO F. David Radler. In addition the Department of Justice has filed criminal charges against Black, Radler and other individuals. (Here) Radler has pled guilty to the criminal charges, but the civil and criminal charges against Black remain pending. Essentially, it is alleged that Black and Radler defrauded Hollinger's shareholders by diverting the company's assets and opportunities (in simple terms, they are alleged to have looted the company). Hollinger's Board ousted Black in November 2003.

According to news reports (here), in December 2005, the SEC served Wells Notices on three members of Hollinger's board. The three individuals included Jim Thompson, the former Governor of Illinois; Richard Burt, who served as U.S. Ambassador to Germany under Ronald Reagan; and Marie-Josee Kravis, an economist and wife of financier Henry Kravis. The three made up the board's audit committee at a time when Black allegedly was fleecing the company.

But while the service of the Wells Notice on the Hollinger directors seemed to suggest a regulatory intent to pursue outside directors, it now appears that the SEC does not intend to go after the Hollinger directors after all. In an October 20, 2006 Chicago Tribune article entitled "SEC Drops Probe of Thompson" (here), the individuals stated that the SEC had recently advised them that it would not pursue legal action against them.

In a separate development, Richard Perle, another former Hollinger director who had also received a Wells Notice, also announced that he had been advised by the SEC that it would not pursue an action against him (here). The SEC's decision not to pursue Perle may be even more significant, because Perle had served on Hollinger's board's Executive Committee with Black and Radler. According to news reports, Hollinger's own internal investigation had concluded that Perle had "repeatedly breached his fiduciary duties" by failihg to evaluate consent forms that authorized transactions.

The SEC's decision not to pursue further enforcement actions against the Hollinger outside directors is consistent with expectations based on historical practices. According to a 2006 legal study by University of Texas Professor Bernard Black, Cambridge University Professor Brian Cheffins, and Stanford Law School Professor Michael Klausner, entitled "Outside Director Liability" (here), the liability risk of outside directors is "very low." The article details the infrequency with which outside directors are the target of enforcement proceedings and liability actions. The remote possibility that Outside Directors might be called upon to contribute to settlements out of their own funds, "would be avoided with appropriate [D&O] policy limits and current state of the art protections."

Nevertheless, it remains to be seen whether the current options backdating scandal will result in enforcement actions or liability exposure against outside directors. For example, three directors of Mercury Interactive have themselves been served with Wells Notices in connection with the company's options backdating investigation. (Here). (Mercury itself has proposed the pay a $35 million civil penalty, here.) In addition, according to news reports (here), in the recent shareholders' derivative action filed against Novell, plaintiffs' lawyers have indicated their particular aim to pursue board members in connection with the allegedly backdated options the board received.

Options Backdating and D & O Insurance: One of the recurring questions as the options backdating scandal has unfolded has been what the scandal may mean for D & O insurers - and their policyholders. On October 20, 2006, the San Francisco Chronicle ran an article entitled "Who Pays Mounting Legal Bills? Insurers May Cover Directors, Execs - For Now" (here). The article discusses likely D & O coverage issues and concerns from the options backdating scandal. Full disclosure: I was interviewed in connection with the article.

Conrad Black on FDR: Apparently Black has had a lifelong interest in Franklin Delano Roosevelt, and among the things for which Black is alleged to have used the funds he misappropriated from Hollinger is an auction purchase of a collection of FDR's papers. With the assistance of his wife, conservative columnist, Barbara Amiel, Black wrote a bestselling 1,280-page biography of FDR entitled Franklin Delano Roosevelt: Champion of Freedom. The book received generally positive reviews (here). On October 29, 2003, shortly before he was ousted from Hollinger, the Wall Street Journal published an op-ed column written by Black, entitled "Capitalism's Savior" (here), in which Black extols FDR's virtues and asserts that FDR is "rightly judged the greatest American president since Lincoln." A January 12, 2004 New York Magazine article examining the curious intersection between Black's literary pretensions and his legal woes may be found here.

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According to Gerald Silk of the Bernstein, Litowitz, Berger & Grossman firm, options backdating is a "make-or-break issue." Silk is not talking about the interests of aggrieved shareholders --he means that options backdating is a really big deal for the plaintiffs' bar. His comments appear in a July 24, 2006 article entitled "Plaintiffs' Lawyers Jockey for Position," in which law.com explores the struggle amongst plaintiffs' lawyers for control of the growing wave of options backdating litigation. Among other things, the article examines the struggle between lawyers representing institutional and individual investors. The article also show why plaintiffs' lawyers are preferring shareholders' derivative lawsuit to securities fraud class actions in attempting to capitalize on the options backdating scandal; the article attributes the following to Silk:

derivative actions are more common in these backdating cases because, in order to have a securities class action under Rule 10-b(5), the stock has to fall and an investor has to demonstrate harm. This has not always been the case when it comes to the backdating scandal.

The article also shows that while derivative actions may represent a more limited opportunity for plaintiffs' lawyers (from a fee standpoint), derivative actions have certain procedural advantages, such as the absence of a statutory preference for institutional shareholders and the absence of a statutory waiting period or discovery stay, all of which apply or may pertain in a federal securities action. As a result, plaintiffs' lawyers representing individuals in derivative lawsuits are "rushing to court."

The article's comments about the absence of significant share price declines for many of the companies involved in the options backdating investigation is consistent with The D & O Diary's view that the options backdating scandal may not prove to be a "severity event" for the D & O insurance industry. On the other hand, it clearly is already a significant frequency event, and the frequency will continue to rise as the investigations continue to expand. For up-to-date frequency data for the options backdating litigation, visit this post of The D & O Diary, "Counting the Options Backdating Lawsuits."

Hat tip to Adam Savett of the Lies, Damned Lies blog for a link to the law.com article.

Following our Right Honorable Friend, Bill Lerach: "These days Bill Lerach is either at the top of his profession -- or on his way to jail." That is the lead in the July 23, 2006 Los Angeles Times article reporting on what life is like these days for Lerach, in the wake of the Milberg Weiss law firm indictment. The Los Angeles Times article reflects various pundits' speculation that Lerach's firm or Lerach himself may yet be dragged into the criminal proceedings. In what I suppose is intended to pass as news, the article concludes that "legal observers are divided about whether prosecutors are still gunning for Lerach." While much of the article replays Lerach's background with Milberg Weiss and his recent success in the Enron case, one comment reported in the article is particularly colorful; the article reports the following commentary from Walter Olson, a senior fellow at the Manhattan Institute for Policy Research:

Lerach is "far from the only lawyer who has concluded that being noisy and unpleasant is good tactics for getting what you want," Olson said. He stands out because "he's personalized it in a way that others haven't done, turning litigation into a contest of peacocks in the barnyard."

Nugget Author Moves On: Chris Jones, heretofore a partner in the Boca Raton office of the Milberg Weiss firm and also the author of the PSLRA Nugget, announced today in a post on his blog that he is leaving the Milberg Weiss firm to join two other prior Milberg Weiss departees at the new law firm of Saxena and White. According to a post on the WSJ.com law blog, the Milberg firm will now be closing the Boca Raton office and is now down to two offices from four.

Today's PSLRA Nugget post says that future posts will "decrease a little in frequency" as Jones adjusts to his new firm. The D & O Diary hopes the PSLRA Nugget is soon back up to speed. The D & O Diary is a subscriber to and regular reader of the Nugget and looks forward to continuing to read the Nugget's interesting and entertaining posts.

A WSJ.com law blog post with futher discussion of the implications for the Milberg Weiss firm can be found here.

Outside Director Liability: The liability of outside directors was a hot topic earlier last year when the Enron and WorldCom settlements were first announced. As a result of the options backdating scandal, outside director liability is a hot topic again. Any public company director has to be concerned with the news that three outside directors at Mercury Interactive have been served with "Wells Notices" in connection with the options backdating investigation at Mercury. (Mercury's press release disclosing the Wells Notices can be found here.) In an earlier development, outside directors of Hollinger were served with Wells Notices in connection with the SEC's investigation of Conrad Black. Outside director liability is clearly going to remain a hot topic. The author of The D & O Diary's views about the risks and practical D & O insurance implications surrounding the issue of outside director liability can be found in this July 24, 2006 article entitled "Outside Director Liability: Increased Risks and Practical Considerations."

Proportionate Liability: The 10b-5Daily blog has an interesting July 24, 2006 post discussing a July 5, 2006 holding in the Enron Derivative and ERISA litigation in which the PSLRA's proportionate liability language is examined. The court, concerned about the "havoc" that the bare statutory language could create at trial, establishes threshold requirements for proportionate liability. Becase so few securities cases go to trial, this issue has not previously been examined by a court.

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Options Backdating Litigation Update: On June 19, 2006, the Kaplan Fox & Kilsheimer law firm initiated a new securities fraud class action lawsuit against Brooks Automation and several of its directors and officers, based on options backdating allegations. With the addition of the Brooks Automation lawsuit, the number of companies named in securities fraud class action lawsuits since the Wall Street Journal's (subscription required) March 18, 2006 article brought widespread attention to options backdating is now up to five. (The four companies previously named are Comverse Technology, United Health Group, Vitesse Semiconductor, and American Tower. The four prior lawsuits were discussed in this previous D & O Diary post.)

In addition to these five, the Consolidated Amended Complaint filed against Brocade Communications alleges misconduct (including backdating) in connection with hiring-related stock option grants. The Brocade Communications complaint was previously discussed in this D & O Diary post.

Thus, according to the D & O Diary's tally, and counting the Brocade Communications lawsuit, the number of companies sued in securities fraud class action lawsuits based on allegations of improper stock options grant timing now stands at six. The D & O Diary is interested in hearing from readers who are aware of any other lawsuits that this post may have overlooked.

Update: An alert D & O Diary reader has referred me to the securities fraud lawsuit pending against Mercury Interactive. The initial D & O Diary post about options backdating referenced the case pending against Mercury Interactive. The initial securities complaint filed in August 2005 against Mercury Interactive did not emphasize the options backdating allegations, but subsequent events, including in particular, the November 2, 2005 resignation of the company's top three executives because of improper timing practices involving employee stock options, suggest that the centerpiece of the Consolidated Amended Complaint, when filed, will be the options backdating allegations. The Order granting leave to file the Amended Complaint was entered on June 7, 2006, and the Amended Complaint must be filed by the later of 60 days from the Order's date or 21 days after Mecury Interactive files its restated financial statements, but in no event more than 90 days from the Order. Clearly, the securities fraud class action filed against Mercury Interactive involves options backdating allegations, so that case should be "counted" -- which brings the total number of companies sued in securities fraud cases involving options timing to seven, rather than six as previously stated.

In addition to securities fraud class action lawsuits, companies involved in the options backdating investigations are also being named in shareholders' derivative lawsuits. Derivative lawsuits are harder to track because the plaintiffs' lawyers do not always issue a press release when they file derivative lawsuits. The Weiss & Lurie law firm cast modesty aside in issuing its June 12, 2006 press release about the new shareholders' derivative lawsuit it has filed against KLA-Tencor. The firm not only announced the new derivative lawsuit, but stated further that it has been retained to investigate possible additional lawsuits against 48 other companies (which companies it identifies in the press release by name and ticker symbol). Not to be outdone, the law firm of Stull, Stull & Brody, in announcing the shareholders' derivative action that it initiated against Computer Sciences Corporation, claims that it is investigating "over 50" companies.

Sarbanes-Oxley Whistleblower Update: As discussed in this prior D & O Diary post, one of the most important legacies of the Enron era may be the Sarbanes-Oxley Whistleblower protection. Two recent developments increase the likelihood that this statutory provision may become increasingly significant.

On June 9, 2006, in a closely watched case involving the first worker to win protection as a whistleblower under the Sarbanes-Oxley Act, the U.S. Department of Labor Administrative Review Board held that the whistleblower's employer must reinstate him to the position he held before he was fired for criticizing the employer's accounting practices. The decision may be found here. A Washington Post article (registration required) describing the decision can be found here.

Update: CFO.com has a June 28, 2006 post in which it reports that Cardinal Bancshares (the defendant in the whistleblower case described above) has "decided once again to refuse a Department of Labor judge's recommended order to reinstate the bank's former CFO....Instead, the bank holding company plans to wwait and see whether the DoL or [the plaintiff] brings an action against the company in U.S. District Court."

The U.S. Supreme Court's June 22, 2006 decision in a Title VII case could further strengthen the Sarbanes-Oxley Act's whistleblower protection. The Court held that any adverse actions by an employer - whether in or out of the workplace, and even if they fall short of dismissal or demotion - can be illegal if they would dissuade a "reasonable" employee from filing a discrimination complaint. According to the Wall Street Journal's (subscription required) June 23, 2006 article discussing the decision, "[w]hile the ruling was in a discrimination complaint, employment lawyers said it is likely to influence retaliation cases of all sorts, including age bias and whistleblower claims under the Sarbanes Oxley law."

Outside Director Liability: After outside directors of Enron and WorldCom were forced to contribute to the class action settlements out of their own assets without recourse to insurance or indemnity, a great debate ensued about whether the settlements represented a trend or were mere artifacts of unique cases. A scholarly overview of outside director liability by Michael Klausner of the Stanford Law School summarized in the June 2006 issue of the PLUS Journal (registration required) statistically examines the historical evidence and concludes that outside directors personal exposure is limited to "very narrow exceptions." The Enron and WorldCom settlements may, according to Professor Klausner, be understood as the outcomes of "exceptional scenarios." He further comments that to protect themselves from their remote exposure to liability, outside directors should be sure that their companies have a "state-of-the-art D & O Policy with appropriate severability, bankruptcy and other protections."

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