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

In an interesting and provocative June 7, 2011 post on the DealBook blog (here), University of Connecticut Law Professor Steven Davidoff voiced his frustration that public company directors are not held liable more often for problems at their companies. Directors, he says, “have about the same chance of being held liable for the poor management of a public firm as they have of being struck by lightning.”

 

Davidoff goes on to note that the Delaware courts set “an extraordinarily high standard for finding directors liable for a company’s mismanagement” adding that “a Delaware court is not going to find them liable no matter how stupid their decisions are,” but will only find them liable “if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.” The bottom line for Davidoff is that while the “upside” for board member is “huge,” their downside is “very limited.” 

 

I have some thoughts and comments about Davidoff’s column. My purpose is not to dispute his thesis or even necessarily to disagree with him, but rather to try to sharpen the focus of the discussion. My fundamental concern is that I think that there are already many more lawsuits against boards than there are companies engaged in corporate misconduct.

 

My fear, given the civil litigation resources our society already has deployed, is that more dramatic sanctions against corporate board members could result only in unintended collateral damage rather than greater traction in the fight against corporate misconduct. To me, a demand that all directors must face greater financial consequences in civil litigation is akin to a proposal that we must use more powerful rat poison in the kitchen – it is just as likely that we will wind up killing off the family pets and Grandma as it is that we will eliminate any greater number of rats. To be specific, if we are going to employ more potent means of controlling corporate misconduct, let us take great care to understand what our goals are and make certain the means are well calculated to achieve the intended goal.

 

Let me just say at the outset that I have nothing but respect for Professor Davidoff. His posts on the Dealbook blog are among the best out there. By raising the questions as I do below, I am merely hoping to consider his assumptions, not to disrespect his work in any way. I also should probably declare my biases at the outset, as well. I have spent most of my career worrying about the interests of corporate directors and officers. There is no doubt that I come at these issues from the perspective of the corporate officials, and with their interests in mind. However, I believe that even if it may the product of a bias, this perspective still affords an important take on these issues.

 

Davidoff seems very sure that directors are not being held liable often enough. However, it is not clear why he thinks directors should be held liable more often. Upon reflection, I can think of three possible reasons why it might be argued that directors ought to face civil liability more frequently: recompense; retribution; and deterrence. I examine each of these three reasons below and consider whether or not they substantiate the need for directors to face civil liability more frequently.

 

Recompense: Davidoff addresses the issue of recompense, at least inferentially. After identifying the two Delaware court cases in which directors have been held liable, and reviewing the amounts paid in those two cases, he aggregates the amounts paid and comments, with obvious derision, these payments amount to “no more than $8.35 million in personal payments by directors over the 26 years.”

 

While the cited figure may indeed represent the total amount that directors have themselves paid during that period in Delaware cases, it is hardly an accurate picture of the total amount of recompense paid to investors or to companies during that period. There have of course been many other cases settled during that period in which the settlement amounts were funded by D&O insurance or other sources.

 

Davidoff briefly acknowledges the role that D&O insurance plays, by stating that “even if there is a liability or a settlement, it is almost always covered by insurance of directors and officers.” But if the goal is recompense, what difference should it make whether that the funds were provided by insurance? The directors may not have paid these other settlements out of their own assets, but the settlements have provided extensive additional recompense to companies or to investors. Moreover, as I have noted on this blog (most recently here), the frequency of very large cash payments in Delaware cases and other derivative suits has become increasingly common in recent years.

 

In addition, though Davidoff briefly refers in his column to cases involving potential liability under the federal securities laws, he omits to mention that there have been billions of dollars of recoveries in these cases in recent years. Yes, as Davidoff notes, settlements in those cases rarely include amounts paid personally by directors, but if the goal is recompense (rather than retribution), the source of funds should be irrelevant.  

 

The omission of any reference to these many other settlements suggests that the real objection may not be that the cases do not produce enough recompense, but that these case resolutions do not produce enough pain for directors, because the funds did not come out of the directors’ pockets. But if the absence of pain is the problem, then the issue seems to be retribution, not recompense.

 

Retribution: Perhaps I am reading too much into Davidoff’s words, but I do not think I am being unfair in suggesting that behind Davidoff’s words is a belief that directors should face a greater threat of punishment, and specifically that their personal assets ought to be on the line.

 

In considering whether or not directors should face a greater threat of punishment, I think it is critical to note that in his column Davidoff only refers to civil litigation (specifically, Delaware state court litigation and federal securities litigation). His column does not address, discuss or mention criminal or enforcement actions.

 

There unquestionably are occasions when retribution against corporate officials may be appropriate. But the proper vehicles for retributive justice are criminal actions and enforcement proceedings, which are the appropriate means for enforcing societal values and imposing punishments.

 

There is and should be an entirely different discussion whether or not the criminal and enforcement authorities have sufficiently exercised their prosecutorial responsibilities in connection with corporate misconduct. But Davidoff’s column was restricted just to civil litigation. Civil litigation may well serve the goals of recompense (as discussed above) and deterrence (as discussed below), but I would contend that it is not the purpose of civil litigation to serve the goal of retribution, which is the goal of criminal and enforcement procedures.

 

Deterrence: Which brings us to the question of deterrence. I understand the argument that if directors faced a greater likelihood of being personally liable financially, there would be greater deterrence of corporate misconduct. But before examining this question, I want to make a few points about deterrence as it currently operates.

 

The problem with most analyses of the deterrent effect of corporate and securities litigation is that it usually assumes that the only effective deterrence is through financial consequences, and it overlooks other possibilities. My own experience is that the threat of civil litigation (as well as the possibility of criminal and enforcement proceedings) provides a powerful deterrent effect, separate and apart from the threat of financial liability.

 

My experience is that most corporate directors have a deep and abiding aversion to becoming associated with any type of corporate scandal. The prospect of seeing their name in the media paired with the word “fraud” or even “mismanagement” is a truly detestable possibility and one they are deeply committed to trying to avoid. These individuals value their reputations. They are keenly interested in avoiding the types of situations that would draw them into scandal and tarnish their personal or professional standing.

 

The individual directors are also highly motivated to avoid the burden, disruption and expense of civil litigation. And with regard to expense, I think it is critically important to note that Davidoff’s analysis of how often directors have been required to pay settlements or judgments themselves omits to consider how often directors are compelled to fund their defenses out of their own pockets.

 

Defending these kinds of suits can be hideously expensive, and if indemnification is unavailable and insurance is inadequate, directors can (and sometimes do) find themselves forced to draw on their own assets to mount their defense. Directors are well aware of these possibilities and they are highly motivated to avoid them.

 

In short, I believe that even conceding all of the points in Davidoff’s column about the infrequency of personal civil liability for directors, the threat of civil litigation still provides a powerful deterrent to corporate boards.

 

There are of course boards or individual directors to whom these deterrents are not sufficient. However, there is nothing that says that imposing greater financial liability in civil litigation would deter these undeterrable boards and individuals. Very significant personal liability was imposed on the boards of Enron, WorldCom and Tyco, but I would argue that perhaps other than with respect to the specific individuals involved these individuals’ settlement contributions otherwise had absolutely no measurable deterrent effect.

 

I can anticipate the argument that three cases alone is not enough, that personal liability must be imposed more generally in more civil cases in order to generate enough deterrent effect. But if personal liability in three cases was not enough, how many will be enough? How do we know? Doesn’t this all seem rather speculative?

 

My fear is that in the highly charged current environment, the generalized notion that individuals ought to be compelled to pay more out of their personal assets could wind up imposing costs and burdens in ways that far exceed the intended purposes – indeed, without any substantiation that it would even potentially produce the intended benefit. And likely imposing enormous costs on many of the wrong people.

 

Let me put it another way. The suggestion that individuals ought to be held personally liable is a far more comfortable notion if you are sure that the liability will never be imposed on you personally. It is an easy assertion to make against a group from which you have not only dissociated yourself, but that you have comprehensively demonized. However, you would take a far different perspective if the question involved your own personal assets. Particularly in our litigious society where sensational and even outrageous allegations can be made with impunity and where the high costs of litigation often can compel settlements simply as a way to avoid financial ruin. In these circumstances, the insistence on personal director liability looks to many directors like nothing more than a legally sanctioned predicate for future hostage crises.

 

I know that in taking this position, I may well be flying in the face of conventional wisdom. My purpose here is to provoke discussion and to make sure that before we move on to what actions we should take, we make sure that we identify our goals and ensure that the actions are well matched to the intended goals. Stronger rat poison undoubtedly will produce many effects, but there is nothing that it ensures that it will result in fewer rats.

 

My own view is that there are already far too many civil lawsuits against corporate boards, most of them involving circumstances where nothing improper has occurred. The law has evolved in response to the excess of litigation, and that is the reason for the barriers to liability that Davidoff bemoans. A welcome and interesting discussion would be one that addresses the question of how we can develop a more concentrated system of civil litigation, in which meritorious cases are resolved and fewer of the other kind are filed.

 

More About Delaware: This must have been the week to raise doubts about Delaware’s courts. In her June 9, 2011 “Summary Judgment” column on the Am Law Litigation Daily (here), which included her remarks on the nomination of Delaware Vice Chancellor Leo Strine to take the position of Chancellor of the Court, she commented, among other things, that Delaware is “soft on Corporate America” adding that corporate directors “have little to fear in terms of being held accountable when they do a lousy job and harm a lot of people in the process.” She concluded by calling on Strine to reconsider the words of the courts critics, adding that the Court “can and should send a much stronger message.”

 

In Case You Missed It: I hope readers had a chance to read the interesting guest post I published late last Friday afternoon (here), in which Bernstein Liebhardt attorney Brian Lehman presents his prediction of the outcome the Janus Capital case now pending before the U.S. Supreme Court. Lehman’s interesting prognosis is worth a look, particularly given that the Court is likely to release its decision in the Janus Capital case any day now.

 

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The unexpected resignation of an outside director may indicate that a company is about to experience tough times, according to a recent academic study. The research shows that a company experiencing a surprise director departure is likelier to face a number of different future adverse events.

 

Among other things, a company with a surprise outside director departure has a "significantly higher likelihood of being named in a federal class action securities fraud lawsuit." The study’s authors call this risk of future adverse events following a director’s departure the "dark side of outside directors."

 

These findings are set forth in a March 2010 paper entitled "The Dark Side of Outside Directors: Do They Quit When They Are Needed Most?" (here) by Rüdiger Fahlenbrach of the Ecole Polytechnique Fédérale de Lausanne, Angie Low of the Nanyang Technological University and René M. Stultz of Ohio State University. Hat tip to the Harvard Law School Forum on Corporate Governance and Financial Reform for the link to the paper. I note here that the author’s paper is copyrighted – a notation that the authors require from anyone quoting their paper.

 

The Authors’ Analysis

The authors note that among the remedial measures imposed following the era of corporate scandals last decade were requirements for increased numbers of independent directors on corporate boards. Though these measures had salutary purposes, the addition of increased numbers of independent directors also has "costs" as well as benefits.

 

Among these "costs" is what the authors refer to as "a dark side" of increased outside director involvement arising because of outside directors’ "incentives." That is, outside directors have "incentives to leave when they anticipate that the firm on whose board they sit will perform poorly and/or disclose adverse information."
 

 

The directors have incentives to quit "to protect their reputation or to avoid increases in the workload when the firm on which board they sit is likely to experience a tough time." As the authors put it, outside directors are "more likely to quit when they expect the firm to perform poorly or to disclose bad news, so they can at least partly and possibly totally escape the reputation loss."

 

Because outside directors have these incentives, an unexpected director resignation from a company’s board may indicate that the company may be poised for future adverse events.

 

The authors tested this hypothesis by examining "surprise director departures." The authors tracked resignations by directors whose ages were below the average director retirement age and then plotted the resignations against future events at the companies from whose boards the directors had resigned.

 

The authors found that following "surprise director departures" the firms involved experienced "significantly worse stock and accounting performance," and "are significantly more likely to suffer from an extreme negative return event, are significantly more likely to restate earnings, and have a significantly higher likelihood of being named in a federal class action securities lawsuit."
 

 

These results, the authors concluded, are "consistent with the directors leaving in anticipation of adverse events to protect their reputation or to avoid an increased workload."

 

Discussion

The authors’ analysis of the "dark side" of increased outside director involvement is interesting, because it suggests that the outside directors readiness to head for the exits when the going gets tough undermines the very reasons for which increased outside director involvement was required in the first place. As the authors put it, their analysis suggests that "outside directors are more likely to resign precisely when experienced outside directors are needed the most."

 

The authors’ findings about the increased risk of securities litigation following a director’s resignation are particularly interesting. Back when I was part of a D&O underwriting facility, my colleagues and I were constantly involved in trying to identify factors that were positively correlated with the risk of securities litigation. The authors’ analysis suggests that a surprise outside director departure is such a factor.

 

Specifically, the authors found that a surprise outside director departure (that is, one that is not explained by the director having reached the average age for director retirement) is "highly statistically and economically significant" in terms of litigation risk. The authors specifically found that the surprise departure of an outside director increases the probability of a securities class action lawsuit filing by 31% to 35%, with the likelihood increasing as firm size increases; if a company’s stock and accounting performance were poor in the prior year’ and if the firm raised relatively more external financing in the prior year.

 

The authors’ work raises important questions about the role of outside directors. However, for D&O underwriters, the authors’ analysis about the correlation between surprise director resignations and securities litigation risk may be the most interesting finding. At a minimum, the authors’ analysis suggests a potentially important new underwriting criterion.

 

Questioning Rating Agencies’ First Amendment Defenses: In a recent post, I discussed the latest decision questioning the applicability of rating agencies’ first amendment defenses. Left unanalyzed in these cases is the larger question of why rating agencies’ ratings opinions are thought to be entitled to first amendment protection in the first place.

 

In a June 9, 2010 Am Law Litigation Daily article (here), Susan Beck questions both the rating agencies’ entitlement to rely on the First Amendment and the limitations of the judicial decisions to date where courts have found the First Amendment defense inapplicable because the ratings were given only to a small group of sophisticated investors. Beck asks, with respect to the latter point, "Why should big, sophisticated investors like CalPERS have more redress under the law than small (and large) investors who buy securities in public offerings?"

 

Beck also suggests that "the premise of First Amendment protection for credit ratings is shaky." After reviewing and questioning the case authority on which the rating agencies rely in asserting their First Amendment defenses, Beck concludes "I'm hoping that the next judge to address the First Amendment question reads the case law differently and concludes that a credit rating, by itself, is not a matter of public concern that deserves Constitutional protection. That's not only fair, it's right."

 

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From time to time, the SEC reiterates its view of the critical role companies’ outside directors play in safeguarding investors’ interests. Nevertheless, it has been relatively rare for SEC to pursue enforcement actions against outside directors based on an alleged failure to fulfill that role, at least in connection with disclosure violations. A recent enforcement action in which the SEC charged an outside director as a primary violator for the company’s financial disclosures may suggest that the SEC is taking a more active enforcement approach against outside directors.

 

As reflected in the SEC’s March 15, 2010 press release (here), the SEC filed enforcement actions against three former senior executives and a former director of InfoGROUP. A copy of the enforcement complaint against the former director can be found here.

 

The actions arose out of allegations that the company’s CEO had used nearly $9.5 in corporate funds for a variety of personal expenses and that the company had entered into an undisclosed $9.3 million transaction with companies in which the CEO had a personal stake. The alleged personal expenses included personal travel on private jets; expenses related to the CEO’s yacht; personal credit card expenses, and other items.

 

The former director against whom the SEC pursued an enforcement action, Vasant Raval, had been chair of the board’s audit committee. Beginning in January 2005, Raval became aware of "red flags" concerning the CEO’s expenses and the related party transactions. The board asked Raval, in his capacity as audit committee chair, to investigate.

 

Ravel conducted his own investigation, without the assistance of independent counsel. His investigation revealed information suggesting inadequate documentation and explanations for many of the expenses and the related party transactions. He also received an unsolicited document from the company’s director of internal audit that questioned the business purpose of certain of the expenses. The SEC alleged that despite this information, "Ravel failed to take meaningful action to further investigate [the CEO’s] expenses."

 

Less than 2 weeks after beginning his investigation, Ravel presented he company’s board and its outside counsel the results of what he described as his "in-depth investigation," which, according to the SEC, failed to advise the board that he (Ravel) was aware of insufficient documentation for certain expenses.

 

During summer 2005, Ravel received additional information from the company’s new director of internal audit questioning some of the CEO’s expenses. The SEC alleged that Ravel failed to inform the board of these questions or to further investigate the issues himself.

 

The SEC alleged that Ravel had a duty to ensure the accuracy and completeness of the statements in the company’s SEC filings, but that he "failed to take appropriate action with respect to significant red flags" concerning the CEO’s expenses and the related party transactions. The SEC alleged that these improper expenses and transactions could have been uncovered sooner had Ravel further investigated the red flags or hired outside counsel or others to do so.

 

Ravel agreed to a bar to serving as an officer or director of a public company for five years and to pay a $50,000 civil penalty.

 

As discussed in a March 31, 2010 memo from the Bingham McCutchen law firm discussing this enforcement action (here), even though this case involves "particularly egregious allegations," it nevertheless represents "an important precedent." Though the case does not mean that "an outside director has a duty to investigate and verify all facts contained in SEC filings," it "certainly indicates that were a director is aware of ‘red flags’ concerning potential improper conduct, the director must conduct a thorough investigation."

 

It is not unprecedented for the SEC to pursue enforcement actions against outside directors. Among other things, the SEC has pursued claims for insider trading and other violations on numerous occasions. The SEC even pursued options backdating related allegations against three former directors of Mercury Interactive (about which refer here).

 

It is, however, unusual for the SEC to pursue enforcement actions against outside directors for primary violations based on disclosure obligations. The SEC did, as discussed here, pursue an enforcement action against outside directors of Spiegel for actively and knowing participating in a decision to withhold filing the company’s 10-K, out of concern over revealing the company’s "going concern" audit opinion. That case also involved rather egregious facts (for example, there were facts suggesting the directors supported efforts to withhold the filing even after having been informed that withholding the filing might violate federal securities laws).

 

Though enforcement actions against outside directors for disclosure related issues may be relatively rare and may also involve unusual and arguable egregious circumstances, they nevertheless represent significant instances where outside directors faced significant exposures. The Bingham memo expresses the concern that the action against Ravel, and particularly the harshness of the sanctions imposed against him "may indicate a new aggressiveness by the SEC in its enforcement program against outside directors."

 

Though these examples of SEC enforcement actions against outside directors involve unusual circumstances, they do underscore the fact that outside board service does involve potential liability exposures for the outside board members. Among other implications from these exposures is the critical importance of the D&O liability insurance available to protect outside board members in the event these kinds of issues should arise.

 

The typical D&O policy would not provide coverage for the penalties that Ravel paid in resolution of the enforcement action against him. However, he undoubtedly incurred significant defense expense in connection with the SEC action. A director’s defense expenses incurred under these circumstances typically would be covered, at least with respect to expenses incurred in the enforcement action itself as well as in connection with any formal investigation preceding the action.

 

However, when a company encounters significant problems of the kind leading to SEC enforcement actions or even private securities litigation, there often are many demands on the D&O insurance policy. The concern that there will be sufficient funds available to protect outside directors when problems do arise raises very important implications about policy structure, as I discuss at greater length here.

 

The bottom line is that insurance questions surrounding these issues are critically important and they underscore the importance of having a knowledgeable and skilled insurance professional involved in the D&O insurance transaction.

　

　

　

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In what may be the largest ever outside director securities lawsuit case settlement, on July 13, 2009, Southern District of California Judge Roger R. Benitez preliminarily approved the six settling outside directors’ $55.95 million settlement of the claims pending against them in the Peregrine Systems securities class action lawsuit. The July 13 order can be found here. As discussed further below, the directors’ settlement is the latest of a multiple settlements in the case, as a result of all of which former Peregrine outside directors have now agreed to pay a total of $61.55 million in settlements.

 

Background

As reflected in greater length here, in May 2002 plaintiffs filed securities class action lawsuits against Peregrine and other defendants, including certain directors and officers of Peregrine. Peregrine itself filed for bankruptcy in September 2002 and was dropped from the lawsuit. On April 5, 2004, following an initial round of motions, the plaintiffs filed their first amended consolidated complaint.

 

The complaint alleges that Peregrine materially overstated its revenues and earnings during the class period due to the company’s failure to recognize revenue properly. Peregrine ultimately issued restatements of its financial statements for fiscal years 2000 and 2001. The restatement reduced previously reported revenue of $1.34 billion by $509 million, of which, according to the SEC’s separate civil enforcement complaint against Peregrine (here), "at least $259 million was reversed because the underlying transactions lacked substance." Several Peregrine officers, including the company’s CEO and CFO, entered guilty pleas in connection with the criminal investigations of Peregrine.

 

In July 29 2006, the parties to the class action lawsuit announced a partial settlement in the amount of $56.3 million on behalf of certain settling defendants. As part of the July 2006 settlement, and as reflected further here, Arthur Anderson agreed to pay $30 million; former officer Douglas Powanda agreed to pay $4.675 million; former director William D. Savoy agreed to pay $5.1 million; and former director Thomas Watrous agreed to pay $500,000. The July 2006 settlement also included certain amounts received in bankruptcy from the company. In November 2006, Judge Benitez approved the July 2006 settlement. The case proceeded against the non-settling defendants.

 

On February 9, 2009, the plaintiffs filed a motion (here) for approval additional settlements with the remaining individual defendants, six former outside directors (John J, Moores, Charles E. Noell III, Norris vandenBerg, Richard A. Horshey II, Christopher Cole, and Rodney Dammeyer), and four former officers (Stephen P Garner, Mattew C. Gless, Frederic B. Luddy, and Richard T. Nelson).

 

One of the settling directors, John Moores, was Peregrine’s chairman from 1990 to July 2000 and from May 2002 through March 2003. For a time, Moores owned the San Diego Padres major league baseball team. According to Wikipedia, here, during his years on Peregrine’s Board, Moores sold over $600 million worth of Peregrine stock.

 

Accompanying the February 9 motion were two settlement stipulations, one each with respect to the two groups of defendants. The settlement stipulation with respect to the outside director defendants, a copy of which can be found here, is dated December 2008 and reflects the six outside director defendants’ agreement to pay a total of $55.95 million toward settlement.

 

The settlement stipulation with respect to the four officer defendants can be found here and provides that defendant Luddy will pay $100,000 and defendant Nelson will pay $25,000. The stipulation provides further that defendants Gardner and Gless "shall note be required to pay any cash in light of their current financial condition and, as to Gardner, the fact that the forfeitures obtained from him in the criminal case … may be distributed" to claimants.

 

In Judge Benitez’s July 13 order, he preliminarily approved these two proposed settlement, subject to a final determination at a hearing scheduled for October 16, 2009.

 

I should emphasize that the foregoing description as well as the analysis below is based solely on the information available in the public record. If I have mischaracterized anything or misunderstood any of the events discussed above, I encourage readers to let me know so that I can correct any errors.

 

UPDATE: Andrew Longstreth's July 16, 2009 American Lawyer article about this settlement (here)  includes a statement from counsel for one of the outside directrros that insurers did contribute toward the outside directors' settlement and the outside directors are pursuing payments from excess insurers. Counsel for the outside directrors also disputes that this is the largest ever settlement on behalf of outside directors, which could be true -- but this is still a very large settlement.

 

The Outside Directors’ Settlement

The outside directors’ settlement stipulation does not disclose the source of funds for the outside directors’ payments in the settlement. Given Peregrine’s bankruptcy, the payments obviously will not be funded by indemnification from the company. And in light of the extensive, years-long litigation, as well as the 2006 settlement, it seems probable that any potentially available D&O insurance was long ago exhausted; the stipulation itself does not indicate whether any portion of the outside directors’ settlement is to be funded by insurance.

 

There are however, certain indications in the stipulation suggesting that at least part of the outside directors’ settlement will be funded out of one or more of the directors’ personal assets. For example, of the directors’ total $55.75 million settlement contribution, $27.5 million is to be paid in the form of a note signed and payable by John J. Moores and Rebecca Ann Mores as individuals and as trustees of the John and Rebecca Ann Moores Family Trust. The stipulation also provides that the security for the note will be provided either by a letter of credit or by a security interest in JMI Holdings LLC’s economic interest in a San Diego hotel. These and other terms strongly suggest that at least a portion of the settlement will be funded out of one or more directors’ personal assets.

 

The six outside directors’ settlement, taken together with the $5.6 million in settlement amounts to which the two directors agreed as part of the July 2006 settlement, brings the total amount paid in settlement of claims against former Peregrine directors to $61.55 million, which exceeds any prior securities lawsuit solely on behalf of outside directors of which I am aware.

 

Discussion

When I spoke as a panelist at the 2009 Stanford Law School Directors’ College last month, the number one concern of the directors attending the D&O insurance session was the possibility that their personal assets might be exposed in the event of a lawsuit against them arising out of their service as directors. Although relatively rare, there is in fact some danger that directors might have to pay settlement of claims against them out of their own assets, as the Peregrine settlement strongly suggests.

 

As I noted in a prior post (here) concerning the now infamous Just for Feet case, the possibility that directors might have to contribute personally toward settlement is materially increased in the bankruptcy context, when the defunct company is unable to fulfill its indemnification obligations. In the event of complex and serious claims following bankruptcy, there is danger that the available D&O insurance could be exhausted before all claims are resolved, potentially leaving directors exposed to additional claims without insurance, which is what happened in the Just for Feet case.

 

The threat of possible exposure of personal assets of outside directors raises the question whether there are insurance solutions that can be used to try to insure against these possibilities.

 

Many companies in recent years have secured so-called Side A/DIC coverage, which in effect provides catastrophic claim protection for company officials, particularly in the event of corporate bankruptcy. However, the typical Side A/DIC policy insures all company officials, including officers, raising the risk that even the Side A/DIC policy could be exhausted by defense expense or settlement payments on behalf of the officers, potentially leaving directors exposed without adequate insurance.

 

As discussed at greater length here, the best way for an individual director or a group of directors to ensure that a pool of insurance will be available to protect them regardless of what happens is to secure a policy solely for the protection of those individual(s). One possible solution is a separate Side A policy just for nonofficer directors. An alternative solution is an individual director liability policy (IDL) designed to provide insurance protection exclusively to a named individual or group of individuals.

 

The nightmare scenario suggested in the Peregrine Systems settlement, where outside directors may have been required to contribute massive amounts out of personal assets to extricate themselves from litigation arising from their service as directors, together with the availability of alternative insurance products that could address their exposure, are the reasons why I contend that outside board members should retain and consult an independent insurance advisor in connection with the company’s D&O insurance acquisition.

 

As I noted recently (here), in my experience outside directors are keenly interested in learning more about the protection afforded by these alternative products. A separate consideration of competing and sometime conflicting interests can sometimes result in the selection of different D&O insurance structures.

 

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From the earliest days of the options backdating scandal, one of the recurring questions has been the potential extent of outside director liability exposure (refer, for example, here). On September 17, 2008, In a development that may also have significant implications for more recent events, the SEC filed settled options backdating-related charges against three former outside directors of Mercury Interactive.

 

A copy of the SEC’s September 17 press release regarding the settled charges can be found here. A copy of the Complaint can be found here.

 

 

The SEC’s complaint alleges that the three outside directors “recklessly approved backdated stock option grants, and reviewed and signed public filings that contained materially false and misleading disclosures about the company’s stock option grants and company expenses.”

The complaint alleges that the three individuals approved 21 backdated stock option grants between 1997 and April 2002. The complaint alleges that the three were aware that options with an exercise price lower than the date on which the options were actually approved created a compensation expense. Nevertheless, the complaint alleges, they repeatedly executed stock option documents while “failing to observe, among other things, that the exercise price of stock options they were approving was less than the market price of the company’s stock at the time of approval.”

 

 

The three individuals are alleged to have routinely signed unanimous consents “despite being presented with numerous facts and circumstances indicating that management was backdating option grants.” In addition to signing options grants made with earlier “as of” dates, on a few occasions the three “signed multiple written consents presented to them by management for the same grant with different grant dates that had more favorable prices.”

 

 

Without admitting or denying the allegations, the three agreed to permanent injunctions and each will pay a $100,000 financial penalty to settle the charges.

 

 

In light of the current circumstances, in which scapegoat hunting is in high gear, the SEC enforcement division’s statements about outside director liability may be instructive. SEC enforcement division director Linda Thomsen is quoted as saying, among other things, that “today’s action serves as further notice that misconduct by outside directors, as well as company management, will not be tolerated.”

 

 

Another enforcement division official is quoted as saying that, even though they understood how options expensing worked, “time and again, directors approved in-the-money option grants that had been backdated” and that the directors “recklessly approved option grants despite numerous facts and circumstances indicating to them that the grant dates they were approving were improperly backdated.”

 

 

While options backdating enforcement actions may seem like yesterday’s news (or even the day before yesterday’s news), these developments have significance today. If nothing else, they demonstrate the SEC’s willingness to pursue enforcement actions against outside directors, at least in certain circumstances, particularly if apparently knowing and active violations are involved.

These developments also underscore the continuing liability exposures to which outside directors potentially may be subject, and the need to address these exposures as part of any well-designed directors’ and officers’ liability insurance program. The SEC’s willingness to pursue outside directors for options backdating-related violations also suggests that today’s even more dramatic circumstances potentially could involve significant outside director liability exposure. The SEC’s interest in the possibility must be presumed.

 

 

Some readers may want to know what happened to the Mercury Interactive managers that proposed the backdating options for the directors’ approval. The SEC previously filed civil fraud charges against the company and four former officers (refer here). The company agreed to pay a $28 million penalty. The case against the former officers remains pending. A securities class action lawsuit arising from the Mercury Interactive options backdating allegations settled for $117.5 million (about which refer here).

 

UPDATE: The Race to the Bottom blog has an interesting post (here) discussing the SEC enforcement proceeding against Mercury Interactive's outside directors. Professor Brown suggests that this case represents another instance where federal regulatory authorities may be creating federal standards of director conduct, in a gradual preemption of state law.

 

 

Despite Settlements, Auction Rate Lawsuit Proceeds: Following the recent high-profile auction rate securities settlements, one of the unanswered questions was what impact the settlements would have on the previously pending auction rate securities lawsuits. There are still no definitive answers. But, notwithstanding the settlements, at least one auction rate securities lawsuit is going forward.

 

 

As reported in the September 17, 2008 Wall Street Journal (here), Judge Gary Sharpe of the Northern District of New York has ruled that they auction rate securities lawsuits that Plug Power filed against UBS can go forward notwithstanding UBS’s recent $19 billion action rate securities buy-back settlement. A copy of the transcript of the September 17 hearing in the case can be found here. (Hat tip to the Wall Street Journal Law Blog, here, for the transcript link.)

 

 

According to Plug Power’s Amended Complaint (here), the company had alleged that, based on supposed assurances that the auction rate securities investments were safe and liquid, the company had bought $62.9 million in auction-rate securities backed by student loans. After the market for the securities seized up in February 2008, the company was (and remains) unable to liquidate its investments. The securities make up nearly half of the company’s investment portfolio.

Under the UBS auction rate settlements, institutional investors’ securities are expected to be bought back in 2010. The Journal quotes Plug Power’s attorney as saying that “we need the funds before 2010 and they’re not providing us a guarantee that they will be able to pay out.”

 

 

The disfavored position of institutional investors is one of the features of the auction rate securities settlements I noted at the time (refer here). Other institutional investors may be motivated similarly to Plug Power to proceed with litigation notwithstanding the buy back settlements. And the September 17 ruling in the Plug Power case suggests that at least some of the cases may go forward notwithstanding the settlements.

 

 

As noted in a September 18, 2008 post on the Securities Docket (here), plaintiffs’ attorney Daniel Girard of the Girard Gibbs law firm argues that private litigation still has a role to play in the auction rate securities debacle. He points out that many billions worth of these investments are not yet part of any settlement and that even with regard to the securities covered by the settlements, it will be a considerable time before the buybacks kick in (this in connection with investments that supposedly were liquid and just like cash.).

 

 

BAE Systems Lawsuit Dismissed: In prior posts discussing civil litigation arising out of corrupt practices investigations (for example, here) one of the cases to which I have frequently referred is the derivative lawsuit filed in the District of Columbia by shareholders of BAE Systems. (For background regarding the BAE Systems case, refer here and here).

 

 

In a September 11, 2008 opinion (here), Judge Rosemary Collyer dismissed the BAE Systems derivative lawsuit on the grounds that the plaintiff lacked standing to bring the lawsuit.

The court’s ruling, while narrow, is interesting. The court held that as a result of the “internal affairs doctrine,” the law of the United Kingdom (the country in which BAE Systems is incorporated) governs the case. Under U.K. law, beneficial owners of a company’s securities lack standing to sue derivatively.

 

 

The plaintiff in the derivative suit did not directly own BAE systems shares but rather owned American Depositary Receipts (ADRs) as a result of which its ownership is merely beneficial under U.K. law. Accordingly, the plaintiff lacks standing to sue derivatively under U.K. law, and the court granted the defendants’ motion to dismiss.

 

 

Even though the court’s holding is narrow, it is significant in at least one respect. That is, it underscores the numerous potential obstacles that any plaintiff will face in attempting to use U.S. courts to assert civil liability in connection wtih a foreign domiciled company’s allegedly corrupt activities. Notwithstanding these obstacles, however, I continue to believe that the threat of civil litigation arising from corrupt practices investigations remains significant.

 

 

As the Wall Street Journal noted in its September 12, 2008 article entitled “U.S., Other Nations Step Up Bribery Battle” (here), anticorruption enforcement activity is an increasingly important prosecutorial priority worldwide, in which cross-jurisdiction cooperation is an increasingly important factor. As prosecutorial activity affects an increasing number of companies, investor interest n recovering civil damages for alleged harm to companies from the allegedly corrupt practices will continue to grow.

 

 

Special thanks to a loyal reader for the link to the BAE Systems decision.

 

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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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