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

In prior posts (here and here) I have questioned whether SOX whistleblower protection is "more theoretical than real." A forthcoming study by Richard Moberly of University of Nebraska Law School entitled "Unfulfilled Expectations: An Empirical Analysis of Why Sarbanes-Oxley Whistleblowers Rarely Win" (here) takes a look at just how poorly employee whistleblowers have fared under the Sarbanes-Oxley whistleblower protections and why.

The study looked at the 470 SOX Whistleblower cases filed at the initial regulatory level between August 19, 2002 (when the first case was filed) and July 13, 2005, as well as all 236 administrative appeals filed through June 1, 2006. Of the 361 cases that actually reached decision at the initial regulatory level, employees won only 13 times, or a rate of 3.6%, and of the 93 decisions at the administrative appeal level, employees won only 6 times or 6.5%.
Based on these statistics, the authors observes that

Despite Sarbanes-Oxley's pro-whistleblower provisions and a few early employee victories...administrative decisions over the first three years of the Act's life failed to fulfill Congress' expectation that a strong anti-retalitatory provision would both encourage and protect whistleblowers.

Based on his study of the whistleblower cases, the author suggests several statutory revisions that "would better reflect Congress' goal of protecting whistleblowers and remedying retaliation."

First, the author found that many claimants ran afout of the short 90-day statute of limitations, which he recommends extending at least to 180 days.

Second, he found that there is uncertainty surrounding "boundary issues" such as whether the company was a "covered employer" or the employee engaged in "protected activity." He calls for Congressional clarification of these issues, and clarification that "employees of privately-held companies are protected when they report fraud at publicly-traded corporations." He also recommends that the Act be modified to requires whistleblower exposure on general fraud only, without the added requirement that the disclosure pertain to securities fraud.

The author concludes by observing that:

Ultimately, Sarbanes-Oxley failed to fulfill the great expectations generated by the Act's purportedly-strong anti-retaliation provisions...The under enforcement of [the whistleblower provisions] undermines Congress' policy goal of deterring corporate fraud and leaves literally millions of private-sector employees vulnerable to retaliation.

It may be important to note that in the author's statistical analysis, he does not include as within his tally of employee "wins" the whistleblower cases that were settled. A significant percentage of cases (11.6%) have settled at the initial regulatory stage and a larger percentage (18.3%) have settled at the regulatory stage. While settlement suggests compromise, the fact that the affected employee was willing to compromise further suggests that the employee found the settlement acceptable under the circumstances. Employers for their part felt compelled to compromise, whether or not they agreed the case had merit, and so at least incurred the cost of settlement. So the "win" rate as expressed by the author's analysis may not be a sufficient statement of employers' exposure to SOX whistleblower claims. The risk to the employer extends beyond the concern that employees might prevail outright.

But in any event, it is hard to contradict the author's conclusion that the SOX whistleblower provision apparently has failed to encourage fraud detection and disclosure or to provide employees from fear of retaliation for blowing the whistle.

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

Original Whistleblower Loses Case: As if to prove the point, a June 5, 2007 article on CFO.com reports (here) that David Welch, the first person to win a case under the Sarbanes Oxley Whistleblower provisions, has had the lower-level ruling in his favor overturned by the Department of Labor's Administrative Review Board. In part the Board overturned the decision because the Welch's complaints were not "protected activtity" (because they were not with SOX itself and because they did not relate to the federal securities laws). The Board also found that Welch could not have reasonably believed that the alleged fraud would have presented investors with a misleading picture of the company's financial picture.

The Administrative Review Board's May 31, 2007 opinion can be found here.

Let Them Eat Self-Reliance: In his readable one-volume biography of Gandhi, Yogesh Chadha reports following incident that occured while Gandhi was still a young lawyer with a growing family:

Shortly after Gandhi took up chambers in Bombay, an American insurance agent visited him in his office. The smooth-talking agent discussed Gandhi's future "as though we were old friends." He stressed the need for insurance coverage for the family. Gandhi was impressed and took out an insurance policy for ten thousand rupees. Later, however, he became annoyed with himself for having fallen into the agent's trap, for he had earlier maintained that "life insurance implied fear and want of faith in God." He let the policy lapse. "In getting my life insured I had robbed my wife and children of their self-reliance," he reasoned. "Why should they not be expected to take care of themselves? What happened to the families of numberless poor in the world? Why should I not count myself as one of them?"

I don't think I have ever heard anyone contend that life insurance is a moral hazard for the beneficiaries. How many among us would consciously allow a life policy to lapse to avoid "robbing" the putative widow and orphans-- by providing for their future? I guess only a truly moral person could see that an uneducated widow with life-long, chronic health problems and a squadron of children who were prevented by their father from receiving formal schooling would be much better off without the moral burden of financial protection.

Even though the life insurance agent is twice-disparaged (not only smooth-talking but American) in my mind the unnamed agent has to be the all-time, indoor-outdoor, world champion closer - to seal the deal, he managed to overcome Gandhi's moral qualms, for crying out loud. Otherwise, how could Gandhi possibly have fallen into such a "trap" as providing for his dependants?

All in all, yet another example proving that a working professional's continuing education necessarily requires a broad curriculum.

If it has been a while since you have seen Ben Kingsley's amazing portrayal of Gandhi in Richard Attenborough's 1983 academy award winning film biography of Gandhi, you may want to view this brief excerpt from the movie; the first scene shows how Gandhi's moral rigor complicated his relations with everyone, even his wife, and in the the second scene, he articulates his philosophy of nonviolence:

• Print
• Comments
• Trackbacks

In a prior post (here), I raised the question whether the whistleblower protection under Section 806 of the Sarbanes-Oxley Act is "more theoretical than real." A February 2007 study by Alexander Dyck of the University of Toronto, Adair Morse of the University of Michigan Business School, and Luigi Zingales of the University of Chicago entitled "Who Blows the Whistle on Corporate Fraud?" (here, $ required) confirms statistically that SOX whistleblower protection is not encouraging employee whistleblowers and may be discouraging them.

The authors looked at a sample of 230 cases of corporate frauds that were alleged between 1996 and 2004 regarding companies with more than $700 million in assets, in order to determine who was involved in the revelation of fraud. The authors found that between 1996 and SOX's enactment, employee whistleblowers represented 21 percent of the fraud detectors, but that after that, they represented only 16 percent.

The authors found that employee whistleblowers face significant discinventives. They found that in 82% of cases where the employee whistleblower's identity was revealed, the employee "quit under duress, or had significantly altered responsibilities." In addition, may whistleblowers report having to move to another industry or to another town.

SOX attempted to create protections for employee whistleblowers. Section 301 requires public company audit committees to create procedures for "confidential anonymous submission" of questionable accounting or auditing matters. Section 806 provides protections for employees against being fired for coming forward with this kind of information. The authors found that the drop in the employee whistleblowers as a percentage of fraud detectors after the enactment of Sarbanes-Oxley suggests that "SOX's modest incentives for whistleblowers has not been very effective." They suggest that "protecting the whistleblower's current job is a small reward given the extensive ostracism whistleblowers face."

The D & O Diary would add to the authors' analysis that, as discussed in prior posts (most recently here), the protection that the SOX whistleblower provisions theoretically provide have proven cumbersome and procedurally challenging. The statutory protections, as implemented, arguably create affirmative disincentives for would-be employee whistleblowers.

The study's authors have an interesting observation about employee whistleblowers in industries (such as healthcare) that conduct significant business with the government, and where employees can receive substantial financial rewards for bringing a so-called qui tam action. The authors found that in the healthcare industry, where employees have these kinds of financial incentives to blow the whistle on fraud, employee whistleblowers account for 46.7% of fraud detectors, as opposed to only 16.3% in industries where employees cannot bring qui tam lawsuits. The authors also found that in the healthcare industry, fewer fraud lawsuits were dismissed or settled for less than $3 million than compared to all companies in all industries, leading the authors to conclude that there was no evidence that the availability of the qui tam lawsuits increased the level of frivolous litigation.

The authors conclude that the SOX whistleblower protection, offering only after-the-fact job protection, provides little incentive for employees to assist in fraud detection. The authors recommend "extending the qui tam statute to corporate frauds."

Whether or not employee whistleblowers should have added fraud detection financial incentives, the authors' point about the financial incentives for employee whistleblowers in the healthcare industry (and other industries that do substantial business with the government) is an important point for D & O insurance professionals. Clearly, with respect to companies in the healthcare industry and other industries that do substantial business with the government, it will be particularly important for the standard insured-versus-insured exclusion to be modified to carve back coverage for whistleblower suits, including in particular qui tam or False Claims Act lawsuits.

A February 13, 2007 CFO.com article entitled "Sarbox Curbs Fraud Whistleblowing" discussing the report referred to above can be found here.

Go Ask Alice: According to news reports (here), "a male lawyer who appeared in court in women's clothes as a protest against what he said was New Zealand's overly masculine judiciary was suspended Wednesday after being found in contempt of court." The lawyer, who officially has changed his name to "Miss Alice," was held in contempt for posting on the Internet certain documents pertaining to a bridge collapse, despite a court order that the documents not be distributed. The lawyer announced after the ruling that he would quit the law altogether, so that he would no longer appear "in a 19th century Alice in Wonderland environment that allows pomp, self-importance and deference to the court to eclipse the truth." However, a subsequent news report (here) suggested that he had changed his mind about leaving the practice of law -- perhaps he felt his attire entitled him to that prerogative.

"Miss Alice," this video is for you.

• Print
• Comments
• Trackbacks

On January 16, 2007, the Lerach Coughlin firm filed a purported securities class action lawsuit in federal court in the District of Columbia against Sunrise Senior Living and several of its directors and officers. A copy of the law firm's press release can be found here and a copy of the complaint can be found here. The complaint raises a variety of different allegations but also contains allegations that the defendants manipulated the company's stock option program by backdating or springloading option grants.

The Complaint alleges that the "top insiders of Sunrise took advantage of the artificial inflation in Sunrise's shares to bail out of the stock, unloading almost a million shares of the stock." What is interesting about the plaintiffs' insider trading allegation is their assertion that the defendants stock sales were triggered "in early 2006, as widespread revelations of a stock option backdating scandal began to sweep corporate America." The allegedly backdated or springloaded options were awarded during the period 1997 to 2001.

The plaintiffs do not specify why the unfolding scandal supposedly motivated the defendants to sell their shares; the suggested inference, I suppose, is that defendants sold their shares because they knew when the marketplace found out about the backdating in the company's options, the company's share price would drop. But in fact, the company's share price declined in value as a result of its announcement (here) that it would be restating its financial statements for the years 2003 through 2005, not because of disclosures relating to options backdating.

Apparently in anticipation of the defendants' likely arguments that their share sales were made pursuant to Rule 10b5-1 trading plans, the plaintiffs raise a number of interesting allegations. The plaintiffs not only contend that the plan terms "did not comply with regulatory requirements" but also that when the defendants put the plans in place, they knew "that they were already pursuing a scheme to defraud and falsify Sunrise's reported financial results" hoping that the plans "would give them protection from the legal liability they knew they would otherwise face." In other words, the plaintiffs are trying to argue that the Rule 10b5-1 plans themselves were part of the scheme to defraud.

Updated Options Backdating Litigation Tally: The initiation of the lawsuit against Sunrise brings the total number of options backdating related securities class action lawsuits to 23. The number of companies named as nominal defendants in shareholders' derivative lawsuits based on options backdating allegations now stands at 131. The D & O Diary's running tally of the options backdating related lawsuits can be found here.

Courts Reject SOX Whistleblower's Claim: Employees of public companies who believe they have been retaliated against because they engaged in "protected" whistleblowing activity may assert a claim against their employer under Section 806 of the Sarbanes-Oxley Act. The burden is on the employee to show that the protected activity was a contributing factor in the adverse employment action. The D & O Diary's prior post about the difficulty employees are having obtaining relief under the SOX Whistleblower provisions can be found here.

There is still relatively little case authority establishing what constitutes "protected activity." A recent federal court decision from Michigan examined how direct the causal connection has to be between the allegedly protected activity and the job action.

In the case (Sussman v. K-Mart Holding Corp.) the plaintiff (Sussman) alleged that he had sent the company's President a letter alleging that his supervisor was accepting kickbacks from vendors. K-Mart investigated the supervisor, but before the investigation was complete, the supervisor was terminated for unrelated reasons. Five months later, Sussman's performance came under criticism, and he received a warning. Sussman asked his (new) supervisor whether the warning was related to his complaints about his prior supervisor. After additional performance shortcomings, Sussman was terminated.

In SOX whistleblower case that Sussman filed against K-Mart, the court held that Sussman had failed to establish a causal link between the job action and the activity he claimed was protected. The court did observe that Sussman was not engaging in protected activity when he raised with his new supervisor that he had blown the whistle on his prior supervisor's kickbacks. The court found that his comments about his previous supervisor's actions could not be related to protecting shareholders from fraud because his prior supervisor was fired for unrelated reasons five months before he made the remarks to his new supervisor.

A detailed summary of the decision, as well as a brief overview of the "protected activity" case law, can be found a memorandum by the Sutherland, Asbill & Brennan law firm, here.

The Ultimate Team Building Video: This YouTube video is for anyone who has ever felt like a team of one. The video takes about a minute to watch, but rewards a complete viewing.

• Print
• Comments
• Trackbacks

As The D & O Diary has previously noted (most recently here), many of the protections and benefits Congress hoped for from the Sarbanes Oxley Act's whistleblower provisions have been slow to materialize. And there has been relatively little enforcement action or shareholder litigation arising from the revelations of SOX whistleblowers. But in one recent action involving Ashland Inc., the disclosures of a whistleblower who later invoked the SOX protections led to a settled SEC action.

According to a November 29, 2006 SEC Order (here), the SEC settled charges against Ashland and a former employee (Olasin), based on a finding that Olasin had improperly reduced Ashland's estimates for environmental remediation at numerous chemical and refinery sites. The SEC found that there was no reasonable basis for the reduction, which had the effect of materially understating Ashland's environmental remediation reserves and overstating its net income in quarterly and annual reports filed from 1999 to 2001.

According to the SEC, three engineers who had been involved in setting the reserves that were later reduced brought the reductions to the attention of the company. One of the three specifically asserted that the reductions were "improper." These concerns led to an internal audit, which consisted of little more than an interview of Olasin. After the audit report came out, Olasin contacted the engineer who had called the reductions "improper" (and whose name Olasin had been able to uncover) and told him that "his performance was suffering" and that he should "spend the weekend thinking about whether he wanted to stay with the company." The individual left Ashland because he felt he was being retaliated against. He later filed a SOX whistleblower complaint against the company with the Department of Labor. According to the SEC's order, the company later settled the whistleblower action.

Under the settlement with the SEC, Ashland was ordered to cease and desist from committing future violations; to strengthen internal controls; and to hire its independent auditor and an outside firm to oversee the company's procedures for setting environmental reserves and for handling employee complaints. There were not fines or penalties against either Ashland or Olasin.

Firm Indictment: The Paulson Committee's recent interim report (here) contained a number of comments and recommendations relating to corporate criminality. Among other things, the Report suggested that the indictment of a company ought to be a "last resort," because of the devastating (and potentially fatal) impact that indictment alone might have on the targeted firm.

In its discussion of these issues, the Report referred to the example of Arthur Anderson's indictment. The D & O Diary wonders whether the Paulson Committee ever considered a more recent example - the indictment of the Milberg Weiss firm. According to a December 1, 2006 Bloomberg.com article entitled "Big, Powerful and Indicted: Milberg Firm Shrinks" (here), Milberg has "shuttered six of its eight offices and lost more than 50 lawyers of the 125 it had when indicted in May." The article also details a number of class action cases where Milberg has been removed as lead plaintiff counsel since the indictment. With the criminal trial now more than a year away, these circumstances can only deteriorate while the firm awaits its day in court.

While the Paulson Committee would not have been likely to refer sympathetically to the Milberg firm, the events at the firm following its indictment certainly substantiate the concerns noted in the Committee's Report about the indictment of a corporate entity.

More Press About Larry Sonsini: As The D & O Diary previously noted here, Fortune magazine had a recent article (here) looking at the various complicated circumstances in which Larry Sonsini at the Wilson Sonsini firm has found himself involved. The Fortune article was generally favorable to Sonsini. A harsher take of Sonsini's role in the HP pretexting scandal can be found in a December 1, 2006 American Lawyer article entitled "The Trouble With Larry" (here).

Hat tip to the WSJ.com Law Blog (here) for the link to the American Lawyer article.

• Print
• Comments
• Trackbacks

When Congress incorporated the whistleblower provisions into the Section 806 of the Sarbanes-Oxley Act, they may have assumed that concerned individuals, secure in the statute's protection, would now be encouraged to come forward and expose financial misdeeds at their companies. But the sad, frustrating saga of the first SOX whistleblower (see prior D & O Diary post, here) unmistakably suggests that he statute's protection may be more theoretical than real, and that those concerned individuals who might otherwise come forward might have to accept that even with SOX protection whistleblowing remains a precarious (and potentially career-ending) activity.

David Welch was the CFO of the Floyd, Va.-based Cardinal Bankshares until he was terminated in October 2002. Welch filed a complaint with the U.S. Department of Labor, alleging that he was terminated for activities protected under the SOX Whistleblower provisions. Welch contends that he had raised questions about the company's accounting policies and internal controls, and then refused to certify the company's financial statements. He further contends that he was discharged after he refused to meet with the company's outside counsel without a personal attorney.

Welch's complaint initially was denied, but upon appeal an Administrative Law Judge, in a January 24, 2004 "Recommended Decision and Order" (here), held that he (Welch) was entitled to reinstatement and compensatory damages. After receiving this favorable ruling, Welch then began a Kafkaesque journey through a self-parodying process that has left him, to this very day, unable to enforce the remedy to which he has been found entitled.

The latest sad development in this procedurally interminable saga is the October 5, 2006 ruling by U.S. District Court Judge Glen Conrad dismissing Welch's petition to enforce the ALJ's ruling for lack of subject matter jurisdiction. In his 12-page opinion, Judge Conrad reviews the administrative process that Welch is required to exhaust (and "exhaust" is unmistakably the opeative verb here) before the court would be statutorily authorized to exercise jurisdiction. Judge Conrad specifically noted that because the Department of Labor's Administrative Review Board (ARB) has not yet ruled on the company's second appeal of the ALJ's ruling, the ALJ's ruling is not yet "final" and therefore the Court lacked jurisdiction to enforce it. (For the sake of brevity, I have summarized the full procedural history; suffice it to say that Welch has been run through multiple sequences of appeals and processes too tedious to recount here.)

Judge Conrad's opinion's concluding remarks are piquant and telling:

Finally, the Court acknowledges that the current situation represents a departure from the adjudication scheme envisioned by Congress. Sarbanes-Oxley was established to protect against the chilling effect of retaliation on whistleblowers by providing a remedy of reinstatement in a short amount of time. As a result, Congress set forth specific procedures to ensure that complaints would be quickly adjudicated by the Department of Labor, and that appeals within the administrative process would likewise progress quickly, taking a matter of days. Although this was the intent of Congress, the court recognizes that the Secretary has not complied with this mandate. Over eighteen months after the ALJ has issued his preliminary order of reinstatement, Welch has still not received a final administrative adjudication of his status. The court agrees that the delay in the administrative process has been inordinate.

Judge Conrad is right, the Department of Labor has not covered themselves with glory in processing Welch's petition. Welch's seemingly endless struggle to secure the statute's protection is hardly likely to encourage others to come forward.

An October 6, 2006 CFO.com article discussing Welch's case and Judge Conrad's ruling can be found here.

Options Backdating Litigation Update: The D & O Diary's running tally of options backdating lawsuits (which can be found here) has been updated to add the securities fraud action that was filed on October 6, 2006 (here) against Marvell Technology Group . With the addition of the Marvell Technology action, the number of companies named in securities fraud actions based on options timing allegations now stands at 20. The number of companies named as nominal defendants in shareholders' derivative lawsuits raising options timing allegations stands at 83.

Executive Coloring Book: Although anachronistic and politically incorrect, the Executive Coloring Book, a 50's vintage classic, is still wickedly funny. Click here.

• Print
• Comments
• Trackbacks

Sarbanes-Oxley Act Whistleblower Updates: In a May 31, 2006 ruling, an Administrative Review Board (ARB) of the U.S. Department of Labor has answered two important questions arising Section 806 of the Sarbanes-Oxley Act, the so-called Whistleblower provisions. (Prior D & O Diary posts regarding the Sarbanes-Oxley Whistleblower provisions can be found here and here.). First, the ARB held that the nonpublicly traded subsidiary of a publicly traded company can be a proper defendant in a Sarbanes-Oxley Whistleblower case if the subsidiary acted as an agent for the public company. The determination is one of fact, based upon the subsidiary's attributes of agency, rather than one of law based on the organizational relationship between the parent and the sub. This holding is significant because it was not previously clear whether the Whistleblower protection would extend to the employee of a private sub of a public company; while the issue is one of fact, the possibility of extension broadens the scope of potential defendants. Second, the ARB also held that it does not matter whether or not the employee who is claiming retaliation did not believe that anything fraudulent had occurred so long as the employee reasonably believed that an SEC rule or other subject "in the realm covered by" the Act had been violated. Both of these holdings tend to broaden the potential scope of Sarbanes Oxley Whistleblower protection and confirm the D & O Diary's view that the Whistleblower provisions have the potential to become a very serious concern for employers. A discussion of this case can be found in a July 6, 2006 post on Broc Romanek's CorporateCounsel.net blog.

In an update on the original Sarbanes-Oxley Whistleblower action, cfo.com reports in a July 7, 2006 post that the Department of Labor has intervened on behalf of David Welch, the former CFO of Cardinal Bankshares whom an administrative law judge has ordered to be reinstated. The post also reports that Welch has filed a U.S. District Court complaint to force the company to comply with the ALJ's order. The D & O Diary's prior post on the Cardinal Bankshares case can be found here.

Another interesting issue under the Sarbanes Oxley Whistleblower provision is its extraterritorial applicability. A July 7, 2006 post on law.com entitled "SOX Whistleblower Rule Triggers a Continental Divide" discusses the struggle between regulatory authorities in the US and in the EU over the applicability and requirements of the Sarbanes Oxley Whistleblower provisions, and in particular the potential conflict between the whistleblower data gathering requirements and EU data protection and privacy laws.

Foreign Corrupt Practices Act Update: On July 5, 2006, the SEC announced simultaneous filing of FCPA charges against and the agreement to settle by four former employees of ABB. The SEC alleges that the four individuals participated in a scheme to pay bribes to Bonga Oil Field. The complaint alleges that as a result of the four defendants' actions, ABB paid officials at the Nigerian state-owned oil production and exploration agency approximately $1 million in bribes. The four consented to entry of judgment against them without admitting or denying the allegations, and agreed to pay fines ranging between $40,000 and $50,000. One of the four also paid approximately $60,000 in disgorgement and interest. ABB itself previously agreed to final judgment in connection with these and other illicit payments, and consented to pay $5.9 million in disgorgement and interest and an ABB subsidiary agreed to pay a civil penalty of $10.5 million.

Who (if anyone) will succeed Milberg Weiss?: The July 7, 2006 New York Times (registration required) has an article reviewing the efforts of the various securities class action plaintiffs' firms to jockey for position while Milberg Weiss struggles to defend itself against its own criminal indictment. At least for purposes of the Times article, the other plaintiffs' firms are doing a surprisingly good job at maintaining the appearance of decorum. But even if the other firms can restrain themselves from the outward appearance of seeking to profit from Milberg Weiss' misfortune, the real pressure on the Milberg Weiss firm will come from the decisions of the various lead plaintiffs the firm represents, as to whether the indicted firm appropriately should be representing the class on whose behalf the lead plaintiff is acting. Here is a link to a May 20, 2006 Wall Street Journal (subscription required) article reviewing various cases where the lead plaintiffs have decided to remove the Milberg Weiss firm from the cases as a result of the firm's indictment.

Options Backdating and the SOX Clawback Provisions: UCLA Law School Professor Stephen Bainbridge has a July 6, 2006 post on his ProfessorBainbridge.com blog discussing whether or not the options backdating scandal will provide the first occasion for the implementation of the clawback provisions under Section 304 of the Sarbanes Oxley Act. The clawback provisions require executives at companies that restate their financials to return to their companies bonus compensation the executives received in the 12 months following the original issuance of the later-restated financials. Professor Bainbridge, who is critical of the clawback provision, is unaware of any attempts to date to use the clawback provisions in connection the options backdating investigations. The comments that accompany his post raise the interesting question whether the clawback provisions can be applied to require disgorgement of compensation awarded following restatement of financials that were originally created prior to the enactment of the Sarbanes-Oxley Act. A prior D & O Diary post commenting on the possible applicability of the clawback provisions to companies involved in the options backdating investigation may be found here.

SOX and Non-Profit Organizations: One of the more interesting consequences of the enactment of the Sarbanes-Oxley Act has been the statute's application far beyond the public company arena to which it was primarily addressed. A July 7, 2006 post on the accountingweb.com details the impact that the Act is having in the non-profit sector. A May 2006 article by The D & O Diary's author describing the Act's impact on privately held companies can be found here.

• Print
• Comments
• Trackbacks

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."

• Print
• Comments
• Trackbacks

Now that we have the criminal verdicts in the Enron criminal trial, it may be time to check in on one of the key legal reforms to arise from the Enron scandal. Among the key provisions that Congress included in the Sarbanes-Oxley Act was the so-called whistleblower provision, a tribute to the role of whistleblower Sherron Watkins in the Enron scandal. Section 806 of the Sarbanes-Oxley Act was included to encourage employees to blow the whistle on corporate wrongdoing by shielding them from retaliation. The law applies to all publicly traded companies and carries both civil and criminal remedies.

When the Department of Labor Occupational Safety Health Administration released the regulations implementing Section 806, some commentators speculated that the whistleblower laws and regulations "may well have as much effect on business practices, in the twenty-first century, as did civil rights laws in the twentieth." But three years' experience under the laws suggest that the reality -- at least so far -- is falling short of these predctions.

According to a recent Washington Post article, of the approximately 750 whistleblower complaints filed so far, the vast majority have been dismissed. Only five whistleblowers have won, though the number fell to four when one case was reversed on appeal. Three of the other four cases remain on appeal.

But while these statistics might suggest that the potential threat from whistleblower cases was overblown, there are other considerations that suggest that the potential danger from whistleblower cases should continue to be taken very seriously. First, of the roughly 750 cases filed so far, approximately 100 cases have been settled. Second, the rate of filing has increased each year since the law's enactment. Only about 150 cases were filed in the first year, but more than double that number were filed in the most recent year. Since many cases were filed only recently, the number of settlements is a significant statistic.

The most significant suggestion that whistleblower cases remain a serious corporate risk is the development in a recent case, where an employee's claim was permitted to proceed even though there was no accounting fraud involved. In a March 29, 2006 decision, the tribunal filed in favor of a fired employee of Nova Information Systems (a subsidiary of US Bancorp). The employee claimed she had been retaliated against for complaining that the financial institution's security controls were inadequate, increasing the risk of identity theft. Her employer argued, among other things, that no statutory violation occured because the alleged disclosure did not involve an allegation of fraud against shareholders. According to the Post article, the tribunal ruled that it was sufficient to survive a dismissal motion for the complaintant to allege that she provided information of a violation of an SEC rule or regulation, regardless whether the violation related to shareholder fraud. (The tribunal has not yet made a final decision on whether the employee was illegally fired.)

A similar issue is involved in a closely watched case pending before a US District Court in North Carolina. A former employee of Wyeth Pharmaceuticals (who has exhausted administrative procedures) alleges that he was fired in retaliation for raising concerns that vaccine production employees were improperly trained, in violation of FDA regulations. Wyeth argues that the allegations, even if true, are not sufficient to state a whistleblower claim because only disclosure of accounting fraud is protected against retaliation. A lengthy discussion of the Wyeth Pharmaceuticals whistleblower case may be found here.

A broad reading of the whistleblower protection could represent a significant concern to employers. If employees may claim that a job action arose in retaliation for an employee's supposed complaint about a violation of any rule or regulation (that is, not just disclosure of accounting fraud, and not even just disclosure of a violation of an SEC rule, but disclosure of a violation of an FDA rule or any other federal rule or regulation, which would pretty much encompass an entire universe of possibilities), whistleblower complaints could indeed become the threat that early commentators feared. Potential consequences include not only the whistleblower's make-whole civil remedy under the statute (including attorneys' fees), but in serious cases the threat of an investigation by a regulatory agency, adverse publicity, and even criminal sanctions.

The Enron criminal case may have gone to the jury, but the ramifcations from the scandal continue to unfold. The whistleblower statute may yet prove to be one of the more important permanent legacies of the Enron scandal. A good overview of the case law "so far" -- including a discussion of the numerous issues that remain unresolved -- can be found here.

An interesting commentary on Sherron Watkins, questioning the bona fides of her whistleblowing credentials, can be found here.

• Print
• Comments
• Trackbacks