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

Most securities lawsuits settle. The common assumption is that once the cases are settled, the litigation wraps up and everybody moves on. But does the litigation have a lingering effect on the defendant company? Is there a "hidden dark side" for companies that settle securities lawsuits?

That is the question asked in a March 18, 2010 paper entitled "Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms" (here) by Cincinnati Law Professor Lynn Bai, Duke Law Professor James Cox, and Vanderbilt Law Professor Randall S. Thomas. (Hat Tip to the Class Action Countermeasures blog, which has a post about this paper here.):

Through their research, the authors sought to discover whether getting hit with a securities a lawsuit and then subsequently entering into a settlement "weakens the defendant firm so that from the point of view of well-received financial metrics the firm is permanently worse off as a consequence of the settlement."

In order to examine this question, the authors examined 480 companies that were defendants in settled post-PSLRA securities class action lawsuits. The authors then examined whether there is any change in the defendants’ financial well-being and stock performance relative to their peer group over time.

The authors compared the defendants’ performance with that of comparable companies over several time periods. "Comparable" companies consisted of those with the same SIC Code and the same asset size but that had not been involved in a securities class action lawsuit during the relevant time periods.

The authors compared the defendant companies to the comparable companies using seven performance criteria, including asset turnover; return-on-assets: the ratio of Earnings Before Income and Tax payments to total assets; the current ratio; the Altman Z-Score (a bankruptcy prediction measure); the market to book ratio; and the one-year stock price return. The authors looked at changes in defendants’ performance according to these measures over time using multivariate regressions.

The authors’ research produced a number of results which even they characterized as "puzzling." On the one hand, companies that settled securities class action lawsuits experienced no decline in sales opportunities, but did "experience a reduced level of operating efficiency while the lawsuit was pending (but not after it was settled)."

More significantly however, the authors did also observe that "defendant firms experience liquidity problems post-settlement and worsening Altman-Z scores." The authors wrestle with how to interpret these latter findings. On the one hand, the deterioration of the Altman Z-scores could suggest that "settlements drive firms toward financial distress (i..e., settlements are causally related to the worsening situation)," but on the other hand these data could suggest that "the financial deterioration observed in earlier time periods continues downward." Or perhaps it could be some combination.

The authors concede that their analysis could support alternative conclusions, but they nevertheless offer their own interpretations as well. Among other things, they note that "while uncertainty persists about the precise connection between the settlements and financial distress, there is no uncertainty that firms that are involved in securities class action litigation experience statistically greater risks of financial distress than their cohort firms."

The authors also conclude that their findings "lend strong support for the view that such suits are better directed toward the officers, advisors and other individuals who bear responsibility for the fraudulent representation(s) that spawned the suit."

Discussion

The authors’ findings about the post-litigation performance of companies settling securities class action lawsuits are interesting. With full recognition that the question of the causation for that diminished performance is uncertain, the conclusion that companies experiencing securities suits perform worse than there peers is relevant information, both from an investment and a D&O insurance underwriting standpoint.

One implication of the authors’ analysis is particularly interesting to me, because one factor implicitly contributing to the negative post-litigation performance is the financial burden the litigation and the settlement imposed on the company. This implication (if indeed my interpretation is valid) seems at odds with other recent research, particularly that of Stanford Law Professor Michael Klausner, who in a recent article published with a colleague concluded that "on the whole D&O insurance pays substantial portions of settlements in a large majority of cases, and that both corporate and individual defendants are highly protected."

There seems to be a tension in the analysis between these two academic studies, since if it is the case that D&O insurance substantially protects corporate defendants in securities class action lawsuits, why should there be lingering negative financial effects on the defendants companies?

Perhaps the answer may be that the reason for the negative performance relative to the companies’ peers post-litigation may not be financially related, but may be operationally related, and the same below standard operational performance post-litigation in some cases may be related to the factors that led to the litigation in the first place.

An alternative explanation may be that while the D&O insurance funds a "substantial portion" of settlements, that still leaves a substantial portion unfunded, and the burden on the companies to fund the difference harms them financially. The authors even note that their analysis insurance in consistent with the conclusion that insurance "provided less than full coverage of the settlement amounts and that the defendants paid the discrepancy out of their current assets. The settlement payment exacerbated liquidity constraints, making the defendants more vulnerable to liquidity crunches and prone to bankruptcy."

In other words, it may be that once the case is settled, everyone may move on to other things, but the company is left financially impaired in a way that undermines its future performance – which obviously harms the interests of the company’s shareholders. All of which does leave you wondering about the ultimate value of a process carried out in the name of shareholders but that leaves shareholders’ interests indelibly impaired. .

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Several of the lawyers for the plaintiffs in the Bisys Group securities lawsuit are concerned with the whereabouts of more than $9 million from the $65.8 fund established in connection with the settlement of the case. 

As reflected in the transcript of the April 20, 2009 hearing before Southern District of New York Judge Ned Rakoff (here), in response to a question from the court about the missing $9.3 million, counsel for plaintiffs’ attorney Gene Cauley (sole signatory on the settlement fund escrow account) reported that "the funds are presently unavailable to be delivered," and when asked why, counsel responded by saying that "if I go into anymore detail, I think I might violate a privilege against self-incrimination."

In response, Judge Rakoff said that "it appears not unlikely... that Mr. Cauley may have committed a crime or several crimes" and that "he may have committed disbarrable conduct in one or many ways." Judge Rakoff also said that he was drawing the inference from Cauley’s taking the Fifth that "Mr. Cauley has either misappropriated or otherwise misallocated these funds" and that because of that possibility, Rakoff "asked the U.S. Attorney to have someone here today." There was in fact an AUSA in the courtroom at the hearing, and Rakoff observed that "I trust there will be a prompt investigation of this matter by the U.S. Attorney’s office."

When the Bisys Group litigation settled in October 2006, Cauley’s former law firm, Cauley Bowman Carney & Williams, was a co-lead counsel in the case and appointed as custodian for the settlement fund. Cauley was designated as sole signatory on the escrow account in which the funds were deposited.

Rakoff had ordered distribution of the settlement funds to the class plaintiffs through a class action settlement administrator, AB Data. The class funds were to be provided to administrator in a series of payments, the last of which, in the amount of $9.3 million, was to have taken place on April 2, 2009. Apparently Cauley advised A.B. Data that the funds for the April 2 installment were invested in a 90-day Treasury bill and that the funds would be available by April 8. However, the $9.3  million is yet to be provided to A.B. Data.

On April 15, several of the lawyers from Cauley’s former firm, now part of a firm called Carney Williams, faxed Rakoff a letter advising him of the situation. Though Rakoff was out of the country at the time, he directed his law clerk to convene a joint conference call, in which Cauley apparently declined to participate. Rakoff then issued an order requiring Cauley’s appearance at the April 20 hearing.

At the April 20 hearing, Rakoff ordered the funds that have been deposited so far with the settlement administrator to be distributed to the plaintiff class.

In a WSJ.com Law Blog post about these remarkable circumstances here, Cauley’s counsel is quoted as stating with respect to the missing $9.3 million that Cauley is "working to be able to find the money and to pay it in 90 days." The lawyer also said that Cauley "expects to make everyone 100% whole."

Judge Rakoff closed the April 20 hearing with a brief peroration reflecting on the unusual circumstances in the Bisys Group case: "When I hear people cracking lawyer jokes, I always take umbrage and point out that the profession of Lincoln, the profession of Madison and Jefferson often represents the highest ideals in our society. But recent events give me pause about how true that is."

Cauley was the subject of a past, somewhat colorful WSJ.com Law Blog post (here), which makes for even more interesting reading in light of these more recent circumstances.

Special thanks to a loyal reader who also forwarded me a copy of the hearing transcript.

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Though the subprime and credit crisis-related securities litigation wave is now well into its third year, relatively few of the cases have yet settled or otherwise finally been resolved. However, the parties to one of the securities lawsuits filed in the earliest stages of the litigation wave have announced that they have settled the case, in a development that potentially may have significance for the many other pending cases.

On May 5, 2009, Beazer Homes announced (here) the settlement of the securities lawsuit that had been filed in the Northern District of Georgia in March 2007 against the company and certain of its directors and officers. In the settlement, the plaintiffs agreed to dismiss the case with prejudice and release all claims against the defendants in exchange for the payment of $30.5 million. According to the press release, the settlement is to be “funded from insurance proceeds” on behalf of the Company and the individual defendants and “there will be no financial contribution by the Company.” The settlement agreement is subject to court approval.

As reflected in the May 5, 2009 memorandum the plaintiffs’ filed in support of their request for judicial approval of the settlement (here), the settlement apparently also applies to the company’s auditor, Deloitte and Touche, which had been named as a defendant in the case.

Beazer Homes is a residential home builder that also provided home loan and mortgage finance services to home buyers. As reflected at greater length here, in quick succession in March 2007, the company announced the resignation of its CFO and that the company had received inquiries regarding its mortgage lending practices. The company’s share price declined and plaintiffs filed several securities class action lawsuits. On May 12, 2008, Beazer restated its financial statements for the previous nine years.

As reflected in their amended complaint, the plaintiffs’ alleged that the audit committee of the company’s board concluded that the company’s mortgage practice violated certain federal and/or state origination requirements and also discovered accounting and financial reporting errors or irregularities that required restatement because of improper accumulation of reserves, improper revenue recognition and other accounting and financial misstatements. The plaintiffs allege that the company’s disclosures during the class period had misled investors about the company’s origination practices and financial condition.

Relatively few of the many subprime and credit crisis-related securities lawsuits filed to date have yet been settled or otherwise resolved to date. (A complete list of the subprime and credit crisis-related lawsuit settlements, dismissals, and dismissal motion denials can be accessed here.) The outsized Merrill Lynch settlement (about which refer here) is noteworthy for its sheer size, but otherwise may have relatively little to say about many of the other pending cases that involve relatively smaller companies, and relatively smaller investment losses. In this context then, the Beazer Homes settlement may be significant for a number of reasons.

First, the case appears to have been settled before the court had ruled on the plaintiffs’ motions to dismiss. Particular cases may settle for any number of reasons, so that fact that the Beazer Homes case settled prior to the dismissal motion ruling may or may not imply anything about other cases – but nevertheless, the settlement prior to dismissal motion ruling does at least raise the possibility for other cases. Along those lines it should be noted that the memorandum the plaintiffs filed in support of their request for settlement approval reports that the parties settled the case as a result of mediation in April 2009, while the dismissal motions were fully briefed by not yet argued.

The Beazer Homes case is also significant because it represents a substantial settlement funded entirely with proceeds of the company’s insurance. If the number of aggregate dollars required to resolve the many other pending subprime and credit cases is extrapolated out from the Beazer settlement, the implied resulting figure – even allowing for the likelihood that a substantial number of the cases will be dismissed – is potentially huge. There have in fact been some noteworthy estimates of the likely aggregate cost to the insurance industry required to resolve all of these cases; whether or not these estimates ultimately prove accurate, the Beazer settlement suggests at least for now that the final resolution of these cases could in the aggregate required some truly impressive sums from insurers.

All of that said, there are some material attributes of the Beazer case that might suggest that its settlement may not necessarily be representative of what to expect from other subprime and credit crisis cases. The first is that the company’s own audit committee concluded that it had violated certain applicable mortgage origination laws. The second is that (at least according to the amended complaint) the company remains under investigation from governmental and regulatory authorities, including the SEC. These circumstances may distinguish Beazer from many of the other cases that have been drawn into the subprime and credit crisis litigation wave, and to that extent at least the settlement may or may not provide a useful indication of likely future settlements in other cases.

I have in any event added the Beazer Homes settlement to my list of subprime and credit crisis-related lawsuit settlements and other case resolutions, which can be accessed here.

Delaware Amends Corporations Code to Address Indemnification and Advancement Concern: As I noted in an earlier post (here), in a March 2008 decision in the Schoon v. Troy case, the Delaware Chancery Court raised concerns when it held that a subsequent board may retroactively eliminate the advancement rights of a prior director.

As explained in the April 2009 issue of the Tressler, Soderstrom firm’s Special Lines Advisory (here, see page 3), the Delaware legislature has now amended Section 145 of the state’s General Corporation code to provide that “rights to indemnification may not be eliminated after the date an act giving rise to a claim takes place, unless a corporation’s indemnification provisions expressly preserve the right to retroactively eliminate the individual’s right to indemnification as permitted by the court in Schoon.“ The amendments are effective August 1, 2009.

Special thanks to my good friend Joe Monteleone for providing me with a copy of his firm’s memo.

Elliptically Speaking Awards (Euphemism Category): I might have considered this a bad parody if I had not seen for myself that this is an actual press release on the website of Nokia Siemens Networks. On November 11, 2008, the company announced (here) the following update on its “synergy-related headcount-adjustment goal.”

Nokia Siemens Networks has completed the preliminary planning process to identify the proposed remaining headcount reductions necessary to reach its previously announced synergy-related headcount adjustment goal. … To date, the company has achieved an adjustment of more than 6,000 employees and continues to expect a total synergy-related adjustment of approximately 9,000 employees. …Simon Beresford-Wylie, chief executive officer of Nokia Siemens Networks, [said] “With the successful completion of these plans, we will have the vast majority of the synergy-related headcount reductions completed and we can then start to put this chapter of our history behind us and focus on creating a world-class company.”

The proposed headcount adjustments are a result of merger-related synergies, including changes to the product portfolio; site optimization; streamlining of various functions; strategic, long-term R&D and workforce balancing; and other factors designed to build a competitive Nokia Siemens Networks. “We have now completed the preliminary planning necessary to identify the specific areas where we have additional synergy-related reduction needs,” said Bosco Novak, head of human resources at Nokia Siemens Networks. “It is our goal to engage constructively with employee representatives in Finland, Germany and other countries to quickly and fairly achieve these needed changes so we are able to remove the ongoing uncertainty that our employees have about synergy-related headcount reductions.”

Hat tip to Harper’s Magazine, which reproduced the press release in its May 2009 issue (here).

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