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

Whistleblower information may be one of the SEC’s “most effective weapons in its new enforcement arsenal,” but the agency’s whistleblower program “faces challenges on many fronts,” according to an April 23, 2013 New York Times Dealbook article entitled “Hazy Future for Thriving S.E.C. Whistle-Blower Effort” (here). As evidence of the whistleblower program’s promise that article cites several “previously undisclosed” enforcement actions that whistleblower information have triggered or aided. Yet due to several potential obstacles and impediments, the future of the program may, according to one source cited in the article “hang in the balance right now.”

For its part, the agency says that it has “ramped up” its staffing and the program has “gained momentum.” As evidence of the value the program has already delivered, the article cites the agency’s investigation of Knight Capital. The SEC was already investigating problems the trading company was having following the company’s bungled installation of new trading software. The investigation had been narrow until a whistleblower came forward and “the agency was able to shift gears and expand the investigation.”

According to the article, with the help of a whistleblower, the agency’s investigation of the Oppenheimer’s investment firm’s alleged overstatement of the performance of a private equity fund resulted in a fine of nearly $3 million.

The article also details an enforcement action that resulted in the first whistleblower bounty payment under the Dodd Frank Act’s whistleblower provisions. According to the article, Dee Stone, an outside consultant to China Voice Holding Corp, received a whistleblower bounty of $46,000 (so far) for providing documents showing that the company was operating a Ponzi scheme. (Refer here for more about this award, which was the first and is so far the only award under the Dodd-Frank whistleblower bounty program). The identity of the whistleblower and the subject of her whistleblower report had not previously been disclosed.

But though the program has had its successes, the SEC has also encountered obstacles from companies. Some companies have “drafted policies compelling their staffs to report fraud internally,” while other companies require employees to “attest annually that they never witnessed any fraud, a certification that could be used to discredit employees who later blew the whistle.”

The article also notes that companies have been accused of retaliating against whistleblowers. The article cites the September 2012 complaint that James Nordgaard filed in the Southern District of New York against his employer, Paradigm Capital Management and related entities, as well as against its founder and President, in which Nordgaard alleged that his employer retaliated against him after he notified the employer that he had reported what he believed to be illegal activities to the SEC.

In his complaint, a copy of which can be found here, Nordgaard sought to recover damages for retaliation under the Dodd-Frank Act. Nordgaard alleged that after he made his report, he was stripped of trading duties and “constructively terminated.” Initially, the company sought to have the dispute submitted to arbitration. In December 2012, Nordgaard voluntarily withdrew his complaint.

Discussion

Even though the article highlights the successes that the whistleblower program has already produced, the article nevertheless also suggests that company efforts may undermine the program or limits its usefulness. It may be true that some companies may succeed in diverting would be whistleblowers to internal programs, but even that could still be useful as long as the whistleblower’s reports are not swept under the rug but are dealt with.

And while company retaliation could well deter whistleblowing, the specific example of company retaliation that the article notes suggests that retaliation could be as big of a problem for the retaliating company than for the employee, given the retaliation protection available to whistleblowers under the Dodd-Frank Act.

The fact is that during the first full fiscal year of the whistleblower’s operation, the SEC received 3,001 whistleblower reports (as discussed in the agency’s 2012 annual whistleblower report, a copy of which can be found here). And while that number may be, as an unnamed source in the article suggests, “somewhat exaggerated,” it is clear that the SEC is receiving a very substantial number of whistleblower reports – and that is despite the deterrent efforts of some companies noted in the article.

The agency has at this point made only a single whistleblower bounty award. As the agency makes further awards and as those awards attract publicity, would-be whistleblowers will likely be even further motivated to come forward. As a plaintiffs’ law firm noted in a press release earlier this week, whistleblower awards provide “a reason for taking a risk.” (And it should not be overlooked that the plaintiffs’ bar clearly sees the development of a whistleblower practice as a growth opportunity. The efforts of the plaintiffs’ bar may not by itself be sufficient to cancel out the efforts of companies to try to deter whistleblowers but it does at a minimum represent a countervailing force.)

My take is that though companies may be taking steps to avert whistleblower problems, the whistleblower program ultimately will prove, as the article suggests, to be “one of the most effective weapons in the new enforcement arsenal.”

As I have said previously on this blog, if 2012 was the year in which the Dodd-Frank whistleblower program finally got off the ground, 2013 will likely be the year when the program picks up serious momentum. It seems likely  that – notwithstanding the impediments noted in the Times article -- we will not only see increased enforcement activity as a result of whistleblowers’ tips, but that we will see increased numbers of whistleblowers’ bounty awards, as well as the possibility of increased private civil litigation following in the wake of the enforcement actions.

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As I have previously noted on this blog (most recently here), plaintiffs’ lawyers recently have evolved a new approach to litigation relating to the advisory “say on pay” vote required under the Dodd-Frank Act. Under this most recent version of the say on pay litigation, the plaintiffs’ lawyers seek to enjoin upcoming shareholder votes on compensation or employee share plans on the grounds of inadequate or insufficient disclosure.

On April 3, 2013, Northern District of Illinois Judge Amy St. Eve entered an order granting the motion to dismiss of the defendants in one of these latest say on pay cases. A copy of Judge St. Eve’s April 3 opinion can be found here. An April 4, 2013 Reuters by Nate Raymond about Judge St. Eve’s decision can be found here.

As reflected in Claire Zilman's April 4, 2013 Am Law Litigation Daily article about Judge St. Eve's April 3 ruling (here), the defendants in the case before Judge St. Eve were represented by the Katten Muchin Rosenman LLP law firm. In the following guest post, Bruce G. Vanyo, Michael J. Lohnes and Christina L. Costley of the Katten Muchin  law firm take a detailed look at Judge St. Eve’s ruling and discuss the significance of the decision, including possible implications of the decision for other pending say on pay cases as well as other cases that may be raised in connection with the upcoming proxy season.

I will like to thank Bruce, Michael and Christina for their willingness to publish their article on my site. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Bruce, Michael and Christina’s guest post follows:

The Dodd-Frank say-on-pay strike suits, if not yet dead, are close. Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), 15 U.S.C. § 78n-1, requires that public companies permit shareholders to cast advisory votes on executive compensation at least once every three years. Though the Dodd-Frank Act specifically stated it did not “create or imply any change to the fiduciary duties” or “create or imply any additional fiduciary duties,” the plaintiffs’ bar immediately began bringing suits for breach of fiduciary duty following any negative say-on-pay vote. Plaintiffs initially brought the lawsuits after companies’ annual meetings and framed them as derivative claims for waste. In 2011 and early 2012, courts consistently dismissed these cases at the pleading stage, holding that plaintiffs could not plead demand futility based on a board’s decision to disregard an advisory vote. See Gordon v. Goodyear, No. 12 C 0369, 2012 WL 2885695, at *9-10 (N.D. Ill. July 13, 2012).

In mid-2012, the plaintiffs’ bar tried a new approach. Instead of bringing derivative suits after a negative say-on-pay vote, they began bringing direct suits seeking to enjoin the say-on-pay vote before it occurred. The real goal, of course, was settlement: if the corporate defendant would agree to make modest additional disclosures, and agree to an attorneys’ fee settlement in the range of $100-$500K, plaintiffs would immediately dismiss the case. Though the cases had little substance, the expense of fighting them and the risks posed by a forced delay of an annual meeting still drove settlements. Some companies chose to fight, however, and in every “pure” say-on-pay case brought, courts refused to issue injunctions. But, because the complaints alleged material omissions (materiality is ordinarily not a matter that can be resolved on the pleadings) most companies answered the complaint instead of moving to dismiss and found themselves in protracted litigation as a result. One notable exception was the Symantec case, which was dismissed by a California state court on the pleadings.

On April 3, 2013, the United States District Court for the Northern District of Illinois issued the first federal court decision on this issue in Noble v. AAR Corp., No. 12-C-7973 (N.D. Ill. April 3, 2013). AAR and its directors had already successfully opposed plaintiffs’ motion for a preliminary injunction. Following the decision on the preliminary injunction defendants immediately moved to dismiss and stay discovery. The court granted the motion to stay discovery and postponed all further hearings. Six months later, the court issued a written decision granting with prejudice defendants’ first motion to dismiss. First, the court held that a corporation cannot face liability under the Dodd-Frank Act for omitting information in its proxy statements not required to be disclosed by the applicable federal regulations, Items 402 and 407. Second, the court held, after a say-on-pay vote has occurred, plaintiffs cannot plead a direct cause of action because no injury personal to the shareholder exists. Instead, the court held, any claim that remains can be brought only as a derivative claim for waste. The court called plaintiff’s efforts to maintain the claim as a direct action “painting a derivative claim with a disclosure coating.”

The implications of AAR should be far-reaching. The AAR judge also issued the decision in Goodyear, a widely cited decision largely responsible for dispensing of plaintiffs’ efforts to bring post-vote say-on-pay claims. By holding that plaintiffs cannot bring a pre-vote breach of fiduciary duty claim based on the Dodd-Frank Act when a company has already complied with federal regulations, the court offers corporations comfort that strict compliance with pre-existing disclosure regulations should suffice to fend off lawsuits even at the pleading stage. And, by finding that the claim can only be maintained as a derivative action for waste, the court signaled to the plaintiffs’ bar that any attempt to bring a claim based on executive compensation must be strong enough to survive heightened demand futility analysis. In effect, the court has given corporations a way out of these cases at the pleading stage, before they are forced into prolonged and expensive discovery and summary judgment motions, and thus given effect to the Dodd-Frank Act’s stated intent to avoid creating a new basis for litigation.

The AAR decision comes just as proxy season is beginning. The proliferation of say-on-pay cases filed in mid- to late 2012 suggested that 2013 proxy season was going to be a mess, with lawsuits being filed in connection with every say-on-pay vote. The AAR decision will go a long ways towards preventing that. The number of say-on-pay investigation notices has already been declining relative to the number of proxy statements being filed, but with AAR, defense counsel will have a concrete tool and a well-reasoned opinion to give other courts comfort that these lawsuits should be dismissed early. The threat is not gone entirely, however, as a second wave of cases related to share authorization and equity compensation have received a relatively warmer reception by courts and have been picking up steam as proxy season continues.
 

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On May 30, 2012, Representative Barney Frank introduced a bill entitled the “Executive Compensation Clawback Full Enforcement Act” (here) that by its own terms is designed to “prohibit individuals from insurance against possible losses from having to repay illegally-received compensation or from having to repay civil penalties.” The proposed Act’s appears primarily addressed to the compensation clawback sections in the FDIC’s “orderly liquidation authority” in the Dodd-Frank Act. However, the proposed Act’s separate prohibition of insurance for “civil money penalties” appears to address the long-standing question of insurance for civil money penalties imposed on bank officials by the FDIC.

Title II of The Dodd-Frank Wall Street Reform and Consumer Protection Act provides for “orderly liquidation authority” for the FDIC to act as a receiver of failed “systemically important” financial institutions. Section 210(s) of the Act permits the FDIC to recover compensation from any senior executive or officer deemed to be “substantially responsible” for the failure of the financial institution. The FDIC may clawback all compensation the executive or director received during the tw0-year period preceding the FDIC’s appointment as receiver.

In response to these provisions, at least one industry participant introduced a new insurance product designed to provide protection against these new compensation clawback measures. The new insurance product was not only intended to provide protection for the costs of defending against a clawback action, but also “indemnification for damages sought by the FDIC “for “ earned salaries, wages, commissions, benefits, or other compensation obligations repudiated and recouped by the FDIC.

In public statements about this new product, a spokesman for the company that introduced it conceded that product could “possibly” provide indemnification for these clawbacks “if they're insurable under the law," adding that "the basic premise, of course, (is that) you're not going to be able to insure something that the law says is not insurable,"

As least as interpreted in news coverage of Rep. Frank’s introduction of the bill, the proposed Act appears to be expressly addressed to this compensation clawback insurance product. Frank himself is quoted as saying “"the creation of insurance policies to insulate financial executives from claw-backs is one more effort by some in the industry to perpetuate a lack of accountability.”

However, the proposed Act’s provisions reach more broadly than just the Dodd-Frank orderly liquidation authority clawback provisions. The proposed Act’s provisions also seem expressly designed to address the question of insurance for the FDIC’s imposition of “civil money penalties” against senior officials at depositary institutions.

The proposed Act provides in Section 2 that an officer, director, employee or “institution-affiliated party” of “a depository institution, depository holding company or nonbank financial company” who is required by law “to repay previously earned compensation or pay a civil money penalty” shall be “personally liable for the amounts so owed” and “may not , directly or indirectly insure or hedge against, or otherwise transfer the risks associated with, personal liability for the amounts so owed.”

The proposed Act provide further that the Section 2 is not intended to preclude a person from “being provided funds necessary to defend against a previously earned compensation recovery,” either from the company itself or “under an insurance policy.” The proposed Act also specifies that the Act is not intended to preclude a person from obtaining insurance against being held personally liable for “penalties, judgments or other amounts assessed against a depositary institution, depositary institution holding company, or nonbank financial company.” The Act is also not intended to prohibit insurance for personal liability against “unintentional outcomes associated with the ordinary exercise of trade or business judgment”

The question of insurability of civil money penalties is a long-standing one. As discussed in a prior guest post on this site, the FDIC has taken the position on an individual institution level basis that insurance protecting individual bank directors and officer from civil money penalties was prohibited. But while there was some discussion of and concern about these issues, the question of insurability of civil money penalties remained an uncertain issue (at least for the banks themselves, if not for the FDIC). However, if Rep. Frank’s bill becomes law, or at least of its provisions prohibiting insurance of civil money penalties becomes law, the question would obviously be resolved.

With respect to the Act’s provisions relating to compensation clawbacks, it is worth noting that the provisions prohibit insurance only with respect to the returned compensation. The proposed Act expressly allows insurance for defense costs. The insurance industry’s working presumptions about the FDIC’s clawback authority generally has been that the company’s traditional D&O insurance would, all else equal, provide defense cost protection, but that the traditional policy would not cover the returned compensation amounts. In other words, Rep. Frank’s proposed bill would not appear to change the insurance coverage arrangements that would likely apply in most situations. The bill seems only to change things with respect to the recently introduced new insurance products that promised provide insurance protection for the returned compensation.

Finally, it is probably worth noting that the proposed Act by its own terms applies only to corporate officials as depositary institutions, depositary institution holding companies and nonbank financial companies. Accordingly, the proposed bill would not seem to have any impact on the vast run of companies, one way or the other.

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The advisory shareholder vote required under the Dodd Frank Act went through its first cycle in 2011, and by and large most companies’ shareholders approved the companies’ executive compensation plans. Only about 45 companies (less than 2%) received negative “say on pay” votes from a majority of investors. But that does not mean that the say on pay process was an empty exercise. Indeed, as we move forward in the second year of advisory votes, the impact of the say on pay process may now start to tell.

First, as detailed in a February 22, 2010 Wall Street Journal article entitled “ ‘Say on Pay’ Changes Ways” (here), many of the companies that sustained negative say on pay votes last year “are working hard to avoid an embarrassing repeat as annual meeting season begins again.” According to the Journal article, “the boards of many of the companies that failed the votes have consulted with investors and hired outside compensation advisers and proxy solicitors” and some “have made broader management changes that could help remedy performance issues at the heart of some shareholder concerns about pay.”

According to the Journal article, two of the companies that sustained negative say on pay votes last year – Beazer Homes USA and Jacobs Engineering – have already obtained positive say on pay votes this year with over 95% shareholder approval

The impact of the first say on pay cycle was not limited just to companies that sustained a negative vote last year. Institutional investors themselves have also been affected by the first cycle of votes. In a very interesting February 22, 2012 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Lessons Learned: The Inaugural Year of Say-on-Pay” (here), Anne Sheehan, the Director of Corporate Governance at the California State Teachers’ Retirement System (CalSTRS), comments that “the first year of Say-on-Pay was a learning opportunity as it helped us to refine our voting process for future years.” Her article makes it clear that not only did CalSTRS vote against many company’s pay packages last year, it may well do so again this year. In 2011, CalSTRS cast 23% percent negative say on pay votes.

In her post, Sheehan explains, with reference to CalSTRS, that “we believe that poorly structured pay packages harm shareholder value by unfairly enriching executives at the expense of owners – the shareholders.” She explained that CalSTRS “predominately voted against companies’ Say-on-Pay proposals because of disconnects between pay and performance.” In consideration of its 2012 votes, CalSTRS intends to focus on companies whose peer group comparisons lead to pay packages targeted to produce above the median, “particularly when companies targeted the 75^th or 90^th percentile.” CalSTRS is concerned about companies that are “over paying for on-par or below-average performance.”

Sheehan’s post and her description of the approach of CalSTRS heading into the second say-on-pay cycle makes it clear that there will be continued pressure on many companies regarding their compensation practices and disclosures, not just the relatively few companies that sustained negative votes in 2011.

The threats companies face as result of the say on pay process include not just investor scrutiny, but also even the possibility of shareholder litigation. As discussed in prior posts on this blog (refer for example here and here), some of the negative say on pay votes last year were followed by shareholder litigation regarding executive compensation issues.

To be sure, the number of these cases was relatively small, perhaps fewer than ten out of the roughly 45 companies that had negative say on pay votes. And many of these suits have been dismissed based on the application of the business judgment rule. In effect, courts have generally proceeded on the assumption that compensation is a matter within the board’s business judgment, although at least one court in a case involving Cincinnati Bell did decline to dismiss a say-on=p-pay lawsuit.

As discussed in a February 5, 2012 memo from Kenneth B. Davis, Jr. and Keith L. Johnson of the Reinhart Boerner Van Deuren law firm entitled “Say-on-Pay Lawsuits – Is This Time Different?” (here), “boards would be ill advised to take too much comfort in the belief that the business judgment rule will always be held to immunize compensation decisions from shareholder attack in the face of a substantial negative say-on-pay note.” In particular, the authors contend, “companies that fail to adequately explain and support their compensation awards will increasingly find themselves targeted for follow-up, through whatever means and remedies investors have available.”

The memo authors’ views in this regard to a large extent mirror the sentiments Sheehan expressed in her blog post. The authors state that “the early reports are that with the experience of the first season of say-on-pay behind them, many institutional investors are now prepared to take a more active role in identifying and opposing the compensation arrangements they find troublesome.” Among the motivations behind this focus on compensation is a perception that the say-on-pay focus may be “the best remaining avenue for challenging ineffective boards.” For that reason, many institutional investors intend to “ramp up focus” on the votes and in particular to “vote against boards that are unresponsive to shareholder concerns.”

As a result of all of this, the authors conclude that disgruntled investors unhappy with board responsiveness on compensation issues will continue to consider litigation as an option. In fact, the authors “expect the volume of this litigation will likely increase.” Companies “should continue to consider litigation risk among the many costs of failing to win substantial shareholder support for their executive compensation arrangements.”

The authors conclude that in order to reduce litigation risk and increase investor support, boards should “improve their disclosures around executive compensation, engage with and respond to legitimate shareholder concerns and attend to removing both conflicts of interest and behavioral biases from the board’s compensation oversight practices.”

How all of this will play out remains to be seen. At a minimum, it seems clear that even though the say on pay vote is merely advisory, it remains a matter of significance even as it enters its second year. Institutional investors clearly intend to try to use the vote as a means to try to address executive compensation issues. The continued focus has a number of significant implications for companies, including in particular the possibility of litigation risk for companies sustaining a negative say on pay vote.

Special thanks to Ken Davis for sending me a copy of his interesting article on Say-on-Pay litigation.

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Even thought the SEC’s final regulations for the Dodd-Frank whistleblower program just became effective on August 12, 2011, the agency has already filed its first report on the whistleblower program. Under Section 924(d) of the Dodd Frank Act, the SEC must report annually to Congress on its activities, whistleblower complaints and the agency’s response to the complaints. Because the agency’s November 2011 report is written as of the September 30, 2011 end of the fiscal year, it covers only seven weeks of whistleblower data for fiscal year 2011. The Report can be found here.

The report shows that during the first seven weeks of the program, the agency received 334 whistleblower tips. The SEC itself cautions that “due to the relatively recent launch of the program and the small sample size, it is too early to identify any specific trends or conclusions from the data collected to date.” Nevertheless, even though it is early yet, there are some interesting tidbits in the report’s data.

First, a surprising number of the reports originated outside the United States. That is, not only did the agency receive individual whistleblower submissions from individuals in 37 different states, but it also received reports from individuals in eleven different foreign countries. These non-U.S. whistleblowers 32 submissions represented roughly ten percent of all of the whistleblower submissions during the reporting period. The country with the highest number of submissions was China (10), followed by the U.K. (9).

Second, though many commentators had expected that the Dodd Frank whistleblower provisions would trigger a flood of FCPA-related reports, and though there were so many reports from outside the U.S., whistleblower submissions reporting FCPA violations represented only four percent of the submissions during the reporting period, a level of submissions that has puzzled some commentators (refer for example here).

When the Dodd-Frank Act was first enacted, there was a great deal of concern that the bounty rewards in the whistleblower provisions would trigger a flood of whistleblower reports. (The bounty provisions require an award of between 10% and 30% of the amount of SEC recoveries based on the whistleblower submissions, when the SEC’s recovery exceeds $1 million). Some might find the 334 of whistleblower submissions during the reporting period surprisingly low.

But in addition to the reporting period only representing seven weeks, it is also worth noting that there still have been as yet no bounty awards under the Dodd-Frank whistleblower program. The SEC’s recent report shows that the agency maintains a fund of over $452 million in order to fund future whistleblower awards.

A former SEC official who helped draft the whistleblower provisions has said that he expects that in coming years “the SEC will exceed its previous records in both number of actions brought and the amount of sanctions collected as a result of whistleblower assistance.”

The $452 million fund available for bounty awards suggests that we will indeed see significant numbers of whistleblower submissions in the future. Based on the history of other government whistleblower programs that offer steep financial motivations, the expectation that there will be significant numbers of whistleblower report in the future seems well founded. For example, an entire industry has grown up in support of qui tam actions under the False Claims Act, with serial claimants and specialized law firms organized to pursue these claims systematically. David Barrio has a very interesting November 17, 2011 in the AmLaw Litigation Daily article (here) discussing the serial qui tam claimant and his “industrious” law firm that has over a 16-year period recovered over $2.5 billion from pharmaceutical companies accused of ripping off Medicare and Medicaid. 

And while the SEC’s first report since the whistleblower program covers only a short time period and reflects only a small number of whistleblower submissions, among those submissions are some significant items. As discussed in Jean Eaglesham’s November 16, 2011 Wall Street Journal article (here), among the reports the SEC received during the initial reporting period were tips that the Bank of New York Mellon and State Street Corp. were improperly charging large institutional clients for currency trades.

These examples show the potential significance of the whistleblower program. As these types of whistleblower reports translate into bounty awards, more submissions will follow. The SEC’s initial report for the short reporting period provides a cryptic but tantalizing glimpse of the likely future of this program.

EEOC Releases 2011 Report: And speaking of annual government reports, the Equal Employment Opportunity Commission has also released its fiscal 2011 Performance and Accountability Report. The EEOC’s report, which can be found here, contains a detailed overview of the agency itself. The report also contains some data relating to the agency’s enforcement activities.

Among other things, the agency’s report shows that in fiscal 2011, the agency received a record number of charges during fiscal 2011. The 99,947 charges the agency received during 2011 slightly exceeded the 99,922 charges the agency received in 2010. This relatively slight annual gain in the number of charges between 2010 and 2011 contrasts with the steep increase in the number of charges between FY 2004 and FY 2009, when the annual increases in the number of charges ranged from 12 to 38 percent. This rapid ramp up of the number of charges has produced increased what the report describes as the agency’s “inventory.” The report details the steps the agency is taking to try to reduce its accumulated inventory.

Cases Against U.S-Listed Chinese Companies Continues to Accumulate: As I have previously noted elsewhere, one of the significant factory in securities class action litigation filing activity during the past 18 months has been the flood of new cases involving U.S.-listed Chinese companies. One of the frequent comments about this surge of filings has been that sooner or later this phenomenon has to play itself out, since sooner or later the plaintiffs’ lawyers will just run out of companies to sue.

But while this filing phenomenon has to come to an end sooner or later, the lawsuits involving U.S. listed Chinese companies are still continuing to come in. In their November 16, 2011 press release (here), plaintiffs’ attorneys’ announced that they had filed an action in the Central District of California against Keyuan Petrochemicals and certain of its directors and officers. In their complaint, which can be found here, the plaintiffs allege that the company failed to disclose certain related party transactions and that the company’s financial statement did not reflect the company’s true financial condition.

With the filing of this complaint, there have now been a total of 36 securities class action lawsuits in 2011 involving U.S. listed Chinese companies, and a total of 47 since January 1, 2010.

Viral Video Explained: Earlier this week I included an embedded link to a bizarre video showing a group of elderly Chinese singing and dancing to the Lady Gaga song “Bad Romance.” A November 17, 2011 post on The New Yorker’s website (here) has an interesting explanation of the video, which apparently has gone viral, much to the puzzlement of the Chinese. The New Yorker post includes the video, for those who have not yet seen it.

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One of the hottest current topics in the field of D&O insurance is the question of coverage for costs incurred in connection with regulatory investigations. As discussed in the following guest post from Paul Ferrillo, who is Of Counsel and a senior litigator in the Securities Litigation/Corporate Governance Group of Weil Gotshal & Manges, LLP, these issues are likelier to become even more important as the Dodd-Frank whistleblower rules go into effect.

I would like to thank Paul for his willingness to publish his article on this site. (Paul's article previsously appeared in Propery & Casualty 360.) I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

Here is Paul’s guest post:

            Though most in-house risk professionals and in –house corporate lawyers do not exactly relish the opportunity to review their company’s directors and officers (“D&O”) liability insurance policy, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), coupled with an increasingly active regulatory environment, should cause all companies (especially smaller ones) to consider the scope and breath of their D&O policies. Particularly important under Dodd-Frank is whether and how their policies will cover internal corporate investigations caused by whistleblowers out to recover a bounty (10 to 30 percent) on potential penalties collected by the SEC in excess of $1 million. Should these sorts of complex internal investigations be covered under the Company’s pre-existing directors and officers liability insurance coverage? Here are the considerations, and here are some potential answers.

            Scope of D&O Coverage for Corporate Investigations – Then and Now

            Before we begin, its probably important to re-emphasize why this question is important. Simply put, corporate investigations set in motion by a whistleblower or regulatory authorities (SEC, DOJ, and/or the states attorney generals), can lead to a whole host of problems for a company and its directors and officers, including: (1) potential fines and penalties, (2) potential criminal repercussions for individuals who are accused of potential wrongdoing, and (3) follow-on civil litigation commenced by the plaintiff’s bar seeking to take advantage of potentially damaging facts that came to light as a result of the investigation.  It also goes without saying that internal corporate investigations are expensive to conduct, including not only the associated legal expenses, but also IT expenses as well, which are occasioned by the need to review email and other soft-copy documents that might be relevant to the investigation. A competently handled investigation where no wrongdoing is found may cause regulators to walk away satisfied that the company “did the right thing.” and will many times will add no fodder to the follow on civil litigation A poorly handled investigation can lead to disastrous consequences for all involved, especially the company who has to ultimately “foot the bill.”

            Prior to 2011, D&O coverage for certain categories of internal corporate investigations was relatively standard in most primary D&O policies. Individual directors and officers were generally covered (depending, of course, upon the primary carrier and policy form in question) for both informal inquiries and requests for information, and civil, criminal, administrative or regulatory investigations commenced by either the issuance of a Target Letter or Wells Notice, or after the service of a subpoena. The company was almost never covered, except when it was named (along with an individual directors and officer) in a “formal”[1] SEC investigation (and then only when the D&O policy at issue specifically allowed for such coverage). No coverage, at all, existed for the Company for responding to “informal” inquiries and requests for information from the SEC.

            The New Threat – More Investigations – More Risk – More Expense

            On May 25, 2011, the SEC adopted final rules implementing the whistleblower provisions of Dodd-Frank. Though these rules are somewhat complex, for the corporate risk professional they can be broken down as follows. Dodd-Frank provides that (1) an eligible individual (e.g. an employee of a company), (2) who “voluntarily” provides the SEC (3) with “original information” about a potential violation about a violation of the federal securities laws, (4) that ultimately leads to a “successful” enforcement action, (5) may be entitled to receive a cash award ranging from 10% to 30% of the total monetary sanctions, in excess of $1 million, recovered by the SEC in a civil or judicial action.[2]

            Importantly, despite the fact that the potential whistleblower might just have easily reported the potential wrongdoing through the company’s own internal reporting and compliance program, the whistleblower provisions of Dodd-Frank do not require him or her to first do so. Instead, the whistleblower may go directly to the SEC in order to be “first in line” to receive the potential bounty. The new rules enacted by the SEC do give the whistleblower an “incentive” to first report internally by (1) allowing him up to 120 days to report such information to the Commission after he or she first reports internally (and still retain her or her place in line to receive the bounty), and (2) allowing for the attribution to the whistleblower who first reports internally all subsequently reported information reported by the Company following its own internal investigation.

            These reporting provisions, along with the monetary incentives of Dodd-Frank present the company at issue with a number of potential challenges: (1) more internal investigations as a result of the clear financial incentives of employees and others to “blow the whistle” (in fact, there are reports already that the SEC has received an increased number of tips (often made with supporting documentation) since the passage of Dodd-Frank[3], (2) the potential need to quickly perform an internal investigation should the whistleblower report to the Company first (knowing that he or she has 120 days to report to the SEC). Indeed it may be in a company’s interest to self-report to the SEC before the SEC contacts it first, and/or (3) in any event, be ready to perform the investigation upon first contact with the SEC should the whistleblower choose to bypass internally reporting procedures.

            Corporate Investigations D&O Coverage Today

            Prior to 2011, companies generally had no insurance mechanism to cover a costly internal investigation triggered by a regulatory inquiry. Today that is not the case. One large insurer has created a stand-alone product that potentially covers a company for a wide variety of potential corporate investigations., whether triggered by internal reporting through a company’s internal compliance program (with subsequent self reporting of a potential securities law violation), or triggered by a direct formal or informal written or telephonic communication with the SEC requesting information, documents or interviews.[4] There are rumors that other companies will soon follow suit and provide similar, if not alternative products or solutions, to cover the costs of internal corporate investigations triggered by regulatory inquiries.

            A stand-alone corporate investigations D&O policy has a clear advantage for many companies seeking to insure for corporate investigations, and a compelling advantage from the stand-point of a director or officer of a public company. Since it is “stand-alone,” monies spent under an “investigations”  policy will not reduce the limits of the company’s pre-existing directors and officers insurance coverage. Simply put, separate dedicated limits for a corporate investigation is the best solution.

            If for cost reasons, a stand-alone product is not affordable, but a carrier agrees to attach or “blend” corporate investigations coverage directly into the primary directors and officers policy, the directors and officers should insist either (1) that company only purchase such coverage with a significant “sublimit,” (meaning that only a portion of the primary policy can be used for a corporate investigation), or (2) purchase much higher D&O limits from a “tower of insurance” perspective, knowing that “on any given Sunday” a complex investigation could eat up millions of dollars of the tower. For many companies, it may be a good idea to consult with an insurance broker or advisor that has a high degree of experience in insuring public companies, as they can often help inform and effectuate some of the corporate investigations D&O insurance strategies laid out above.

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For many years, one of the fundamental goals of shareholder rights activists has “proxy access,” which would require corporations to include shareholder nominated board candidates on the company’s proxy ballots. Last year, in the wake of the Dodd-Frank Act, the SEC promulgated rules facilitating shareholder director nominations under certain circumstances. However, on July 22, 2011, in an opinion that called the SEC’s rulemaking “arbitrary and capricious” and reflected sharp criticism of the agency, a three-judge panel of the District of Columbia Court of Appeals struck down the SEC’s rule. The opinion, which can be found here, makes for some interesting reading and raises some potentially significant implications.

Background

Shareholder activists have been lobbying for proxy access for years. As part of the sweeping financial reform encompassed in the Dodd-Frank Act, Congress provided the SEC in Section 971 of the Act with authority to promulgate proxy access rules. On August 25, 2011, the SEC adopted rules implementing this provision. Rule 14a-11 would have provided shareholders holding at least three percent of the voting power of a company’s securities who have held their shares at least three years with the right to have their director nominees included in the company’s proxy materials.

However, on September 29, 2010, the Business Roundtable and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules. On October 4, 2010, the SEC issued a stay of the rule’s effectiveness pending the court’s review. 

The July 22 Opinion

In an opinion written by Judge Douglas Ginsberg for a three-judge panel, the D.C. Circuit held that the SEC has acted “arbitrarily and capriciously” in adopting the proxy access rules. In language that was presented a particularly harsh rebuke to the SEC, the court said that:

We agree with petitioners and hold the Commission acted arbitrarily and capriciously for having failed once again …adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commentators.

The court seemed particularly concerned with the costs companies would incur as incumbent directors sought to defeat the shareholders’ electoral challenge, and with the SEC’s supposed failure to take those costs into account. The court said “although it might be possible that a board, consistent with its fiduciary duties, might forego expending resources to oppose a shareholder nominee – for example, if it believes the cost of opposition would exceed the cost to the company of the board’s preferred candidate losing the election, discounted by the probability of that happening – the Commission has presented no evidence that such forbearance is ever seen in practice. “

The court was also critical of the SEC for failing to take into account the likelihood that the proxy access process might be used by shareholders with special interests to pursue their own agendas, at the expense of other shareholders. The court said that “the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause the companies to incur costs even when their nominee is unlikely to be elected.”

The court granted the business groups’ petition and vacated the SEC rules.

Discussion

Both the court’s holding and the language it used have important implications for proxy access and for the SEC’s future rulemaking efforts.

With respect to the SEC’s proposed rule, the agency now has to decide whether to appeal the D.C. Circuit’s ruling or to try remedial efforts to try to address the D.C. Circuit’s  concern. The prospects for addressing all of the court’s concerns seem daunting. As a former SEC general counsel quoted in the July 23, 2011 Wall Street Journal article about the decision (here) put it, “given the number of objections the court had, the amount of work would be very substantial and it may just be impossible.”  It may be that at least this latest effort to implement proxy access has hit an insurmountable obstacle.

But beyond the proxy access question, the D.C. Circuit’s decision has important implications for SEC rulemaking generally. The court went out of its way to rebuke the SEC for its repeated failure to address legal requirements for the agency’s rulemaking. According to the Journal article, the July 22 opinion represents “the fourth time in recent years the same appeals court has invalidated an agency rule on similar grounds.”

The D.C. Circuit’s criticism of the agency’s rulemaking and its insistence on a high bar for rulemaking compliance comes at a time when the SEC is laboring under a significant rulemaking burden due to the requirements of the Dodd-Frank Act and at a time when the agency is also coming under significant budgetary constraints. The SEC will have to move forward to try to meet the Dodd-Frank rulemaking requirements with awareness of the harsh scrutiny its rules will face in the appellate courts.

Shareholder activists quoted in the various news articles commenting on the D.C. Circuit’s opinion suggest they will continue to try to press ahead on proxy access. It remains to be seen how the SEC will respond. But for now, proxy access has been tabled, and it may be some time before this or another initiative resuscitates the initiative.  

The Morrison & Foerster law firm’s July 22, 2011 memo discussing the D.C. Circuit’s opinion can be found here. The statement of the U.S. Chamber and the Business Roundtable about the opinion can be found here. Special thanks to the several loyal readers who sent me links about the Court’s opinion.

Meanwhile, Back at the FDIC: Although the standard current line on the continuing wave of bank failures is that the FDIC is winding down its bank closure efforts, the FDIC does not seem to have gotten the memo. This past Friday evening, the FDIC closed three more banks, bringing the July 2011 month to date total number of closures to 10, after the agency had closed only nine banks in the months of May and June combined. The latest closures brings the year-to-date total number of bank failures to 58, and with the latest closures signs area that the number of bank failures could continue to mount for some time to come.

Another thing that is striking about the YTD bank closures is how many of the closures still involve Georgia banks. So far this year, 16 Georgia banks have failed. This is after several years of massive numbers of bank failures in the state. You do start to wonder how there could be any banks left in Georgia at this point.

Morrison: Where is the Place of the Transaction?: As explained in the U.S. Supreme Court’s opinion in Morrison v. National Australia Bank, Section 10 of the ’34 Act and Rule 10b-5 apply  to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” The second of the two prongs in this standard requires courts to determine whether or not the disputed transaction is or is not “domestic,” which leave courts to try to determine where the transaction took place.

In the Quail Cruise ship case (refer here, second item), the Eleventh Circuit recently held that because the share transaction allegedly “closed” in Miami, the plaintiffs had adequately alleged that the transaction was a domestic transaction. In a more elaborate opinion, discussed here, Southern District of New York Judge Barbara Jones held in the SEC enforcement action against Goldman Sachs associate Fabrice Toure that the place of the transaction is to be determined based on the place where the transaction counterparties incurred “irrevocable liability” to take or sell the securities in question.

As discussed in Nate Raymond’s July 21, 2011 Am Law Litigation Daily article (here), last Thursday, Judge Jones quoted her own prior opinion in holding that the plaintiff in the civil action against Goldman Sachs in connection with the infamous Timberwolf CDO (to which an unfortunate Goldman associate referred in an email as “one shitty deal”)  had not adequately alleged that the security sale involved a domestic transaction. A copy of Judge Jones’ opinion can be found here.

In holding that the plaintiffs had not adequately alleged that the transaction in question took place in the U.S., Judge Jones said that in order to meet the requirements of Morrison’s second prong and establish that a transaction took place in the U.S., the plaintiff “must allege that the parties incurred irrevocable liability to purchase or sell the security in the United States.” Judge Jones dismissed the plaintiff’s complaint but with leave to attempt to replead the transactional allegations in order to establish that their transaction was cognizable under the federal securities laws.

Through sheer repetition, Judge Jones’s “irrevocable liability” test may become the de facto standard for determining whether or not a transaction has taken place in the United States.  On the other hand, the Eleventh Circuit’s recent (albeit somewhat unexplained) pronouncement that the place of the transaction closing is sufficient may present an alternative test on which parties may seek to rely. 

Choice of Law: In a prior post, I noted that choice of law may be one of the sleeper issues for determining insurance coverage. I specifically discussed the potential merits of the incorporation of a choice of law clause within the D&O insurance policy.

In a July 20, 2011 post on the Delaware Business Litigation Report blog, Edward M. McNally of the Morris James law firm takes a look at the question of choice of law in the context of breach of contract disputes, and he reviews the advantages of the incorporation into business contracts of choice of law provisions. His article specifically raises the questions that can arise in the D&O insurance context in the absence of a choice of law provision in the policy.

The Plot Thickens: When discussing the allegations many Chinese companies are raising that the assertions of accounting impropriety against the companies are the product of the fevered and self-interested imaginings of short sellers, I compared the situation to the Spy vs. Spy feature in  Mad Magazine. It turns out that I had no idea of how much skullduggery might be involved.

In a July 22, 2011 Thomson Reuters News & Insight article (here), Alison Frankel details the allegations and counter allegations that are flying in connection with online securities analyst and short-seller Muddy Waters, which has been at the center of a number of the assertions of financial impropriety involving Chinese companies. Apparently an anonymous online source has posted phony content purporting to show that Muddy Waters was the target of an SEC enforcement action for fraud and was forced to pay over $240 million for improper profits on stock manipulation. Another individual (who called himself “Shaun Coffey” in possible reference to famous former plaintiffs’ securities attorney Sean Coffey) is out trying to present himself as a Muddy Waters employee and attempting to use threats to try to blackmail Chinese companies.

Meanwhile, the July 24, 2011 New York Times had an article entitled "China to Wall Street: The Side-Door Shuffle" (here) that tells the story of how Rino International, a Chinese company, obtained its U.S. listing through a reverse merger. The article also describes how a research report from the Muddy Waters firm first raised questions about the company, following which the company's share price collapsed and lawsuits ensued. You can certainly see how there might be some people who don't like the Muddy Waters firm.

I will say that since she moved over to Thomson Reuters, Frankel has consistently been cranking out top quality articles and at an impressive rate. I marvel both at how she continues to come up with interesting story topics and how she cranks out an astonishing number of interesting and entertaining articles. Alison, everyone here at The D&O Diary salutes you.

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On May 25, 2011, In the latest example of shareholders suing a company’s board following a negative “say on pay” vote, two union pension funds filed a shareholders’ derivative action claiming that Umpqua Holdings Corporation’s board violated its duties to investor by approving the2010 compensation plan despite the negative shareholder vote.. The lawsuit follows the April 19 annual meeting of the bank holding company, in which about 62% of shareholders voted “no” in the advisory shareholder vote on the company’s 2010 executive compensation plan. The claims asserted in the lawsuit rely directly on the negative note.

Background

As I discussed in a recent post (here), Section 951 of the Dodd-Frank Act expressly requires all but the smallest publicly traded companies to hold an advisory shareholder vote on executive compensation. This requirement has already started to have an impact on executive compensation practices, as many companies are adjusting certain compensation practices to avoid a negative vote. However, while the vast majority of companies have received shareholder support for their compensation practices, there are still some companieswhose shareholders have voted “no” on the shareholder resolution regarding executive compensation. (At last count, according to The CorporateCounsel.net,  there were over thirty companies whose “say on pay” resolutions had received a negative vote from a majority of their shareholders).

Umpqua’s “Say on Pay” Vote

As reflected in the company’s April 22, 2011 filing on Form 8-K, Umpqua is among those companies receiving a negative say on pay vote. The 8-K reflects that about 62% of shareholders voted against the company’s executive compensation shareholder resolution.

The 8-K explains that the negative vote followed a recommendation from Institutional Shareholder Services (ISS) that Umpqua’s shareholders vote against the resolution. The 8-K states that ISS found a “disconnect” between the company’s 2010 executive compensation and the company’s pay-for-performance standards. The 8-K states that the company takes the vote “seriously” and that it is committed to pay-for-performance principles. Nevertheless, the company takes exception to the ISS’s “formulaic” approach which, the company contends, inappropriately viewed 2010 compensation only by comparison to 2009 compensation, when the company’s executive compensation declined 29%. The company contended that the 2010 compensation plan is reasonable in light of prior compensation and in light of the company’s overall performance, particularly relative to its peers.

The Lawsuit

On May 25, 2011, two union pension funds filed a shareholder derivative lawsuit in the District of Oregon against the company, as nominal defendant; against the company’s individual board members; against four company executives; and against the company’s compensation consultant, PricewaterhouseCoopers. The complaint alleges that the Board’s “decisions to increase CEO and top executive pay in 2010, despite the Company’s severely impaired financial results, were disloyal, irrational, and unreasonable, and not the product of a valid exercise of business judgment.”

The complaint further asserts that the board’s approval of the 2010 pay hikes “violated its own pay-for-performance policy and, as intended, favored the interests of Umpqua’s CEO and top executives at the expense of the corporation and its shareholders.”

The complaint attempts to use the negative say on pay vote to try  to avert  the defendants’ reliance on the business judgment rule. The complaint states that the “adverse shareholder vote on the 2010 executive compensation is evidence which rebutted” the usual business judgment presumption. The complaint further states with reference to the negative shareholder vote that the company’s shareholders “concluded, in their independent business judgment, that the Umpqua Boar’s 2010 CEO and top executive pay hikes were not in the best interest of Umpqua and its shareholders.”

The complaint asserts a claim against the directors for breach of the duty of loyalty; against the compensation consultant for aiding and abetting breach of fiduciary duties and breach of contract; and against the four executive officers for unjust enrichment. The complaint seeks an award to Umpqua for damages; a declaration that the shareholder vote “rebutted the presumption of business judgment”; disgorgement of the allegedly excess compensation and implementation and administration of internal controls and systems to prevent excess executive compensation.

Discussion

At this point, it seems clear that plaintiffs’ bar intends to try to utilize a negative “say on pay” vote, in at least some instances, to try to bootstrap claims for allegedly excess executive compensation. At one level, this is hardly surprising, because the negative vote does create the possibility of the board appearing to be acting contrary to shareholders’ views. And executive pay unquestionably is a hot button issue right now.

But on the other hand, the vote required under the Dodd Frank is expressly and explicitly an “advisory” vote. Congress could have made the say on pay vote binding. The fact that Congress did not make it controlling but rather left the vote as advisory clearly allows for the possibility that the company and its board retained discretion and might elect to act contrary to the shareholder vote without acting improperly. Indeed, Section 951 (c) of the Dodd Frank Act expressly states that the say on pay requirement should not be interpreted to alter any existing fiduciary duties or to create any new fiduciary duties. Congress seemed to be going out of its way to try to avoid having the say on pay process to add compulsion or  to the legal exposures of directors and officers.

Indeed, given the express statutory provisions to make the vote advisory and to try to prevent against having the vote add to directors’ legal exposures, it seems clear that Congress was hoping that the vote, and the threat of the vote, would cause companies voluntarily to adjust their compensation practices, -- not out of fear of liability but out of a desire to maintain the affirmative support of shareholders. Indeed, that in fact seems to be happening, as many companies have adjusted their practices in order to try to avoid a negative shareholder vote.

Despite Dodd-Frank’s express provisions designed to eliminate the possibility that the say on pay vote should alter the legal responsibilities of directors and officers, the plaintiffs in this case are seeking to rely on the negative say on pay vote to argue that the defendants are not entitled to the usual protections of the business judgment rule. The plaintiffs do not explain why a purely advisory vote, which by its own enacting provisions is not intended to alter or create additional legal duties, should nevertheless deprive the board of the usual protections to which they are entitled.

The lawsuit has only just been filed and it remains to be seen how it will progress. But it will be interesting to see if the plaintiffs are successful in having the defendants’ rights to rely on the business judgment rule suppressed.  

The company itself seems to think that the best defense is a good offense, as the company’s spokesperson is quoted in a May 27, 2011 Portland Business Journal article as saying with respect to the plaintiffs’ firm that brought the suit, “our understanding of this firm is they create fees by dragging the names of reputable companies through the mud.”

Our Solar System’s Family Album: A wide variety of probes and vessels have been cruising the planets, taking some amazing pictures in the process. The truly stunning highlights are compiled in a May 27, 2011 post (here), on the InFocus blog on the Atlantic Monthly’s website.

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On May 25, 2011, the SEC adopted the final rules implementing the whistleblower provisions of the Dodd-Frank Act. The SEC declined to propose a rule that would have required whistleblowers to report first through internal corporate compliance programs. However, the SEC adopted changes that are intended to “incentivize whistleblowers to utilize their companies’ internal compliance and reporting systems when appropriate.”

The SEC’s May 25, 2011 press release about the final whistleblower rules can be found here. The SEC’s 305-page document describing the final rules can be found here. The SEC’s rules will be effective 60 days after they are submitted to Congress or published in the Federal Register.

Section 922 of the Dodd-Frank Act created certain new whistleblower incentives and protections. The section directs the SEC to pay awards to whistleblowers that provide the Commission with original information about a securities law violation that lead to the successful SEC enforcement action resulting in monetary sanctions over $1 million. The section also prohibits retaliation against whistleblowers.

The SEC released proposed rules to implement the whistleblower provisions in November 2010. The SEC received hundreds of comments on the proposed rules. The final rules document released yesterday describes many of the comments as well as the way that the SEC took the comments in to account in promulgating the final rules.

One of the most significant issues raise in the comments related to the impact of the whistleblower program on internal corporate compliance processes (refer here for a discussion of this issue). The gist of the concern is that the SEC whistleblower provisions would encourage the whistleblowers to bypass internal reporting mechanism (many of which have only recently been implemented pursuant to the requirements of Sarbanes Oxley). Though some commentators urged the Commission to require whistleblowers to report violations first internally, the SEC decided not to include this requirement. Rather, the SEC included in the final rules elements it hopes will encourage potential whistleblowers to use internal compliance processes.

Specifically, the rules make the whistleblower eligible for an award if the whistleblower reports the violation internally and the company informs the SEC about the violation. The SEC will also treat the informant as a whistleblower as of the date of an internal report of the employees provides the same information to the SEC within 120 days (this allows whistleblowers to save their “place in line” for a possible award). Finally, the informant’s voluntary participation in the company’s internal reporting program will be a factor the SEC will use to increase the amount of an award.

The SEC’s final rules also identify a number of categories of persons who will not be eligible for an award, including those with a preexisting legal or contractual duty to report their information; those who obtain their information either by privileged or illegal means; officers and directors who are informed by another person of the violations; compliance and audit personnel. (There are defined circumstances when compliance and audit personnel can be eligible.

The rules also clarify the whistleblowing procedures, and provide clarification of what constitutes a voluntary report; what constitutes original information; what constitutes a successful enforcement action and so on.

These rules will be effective shortly, most likely later in the summer. The ultimate practical effect of these new rules depends on how forthcoming prospective informants are; the quality of the information; and what the SEC does with the information.

The sheer scale of the prospective awards (from 10 to 30 percent of awards in excess of $1 million) is clearly designed to encourage whistleblowing, as indeed is the SEC’s final rule. For its part, the SEC has a huge incentive in the post-Madoff era to heed whistleblower’s warnings and to pursue the reported information. Just looking at the way the incentives and motivations line up, the most probable outcome here seems to be that there will be significant numbers of whistleblower reports and that these reports will trigger significant numbers of investigations and enforcement actions. These enforcement actions could well be followed by follow-on civil litigation, which could increase the potential exposure that companies and their senior officials could face as a result of the implementation of these rules.

It certainly appears that a portion of the plaintiffs’ bar things there is an opportunity here supporting prospective whistleblowers and perhaps using their reported information as the basis for separate civil suits – refer for example to this advertisement for the “SEC Whistleblower Claims Center.” The quick emergence of an opportunistic plaintiffs’ bar eager to try to turn these new rules to their advantage is hardly surprising. Enterprising plaintiffs’ lawyers have been profiting from the whistleblower incentives in the False Claims Act for years (refer, for example, here)

However these incentives may appear now, they will all be augmented exponentially once a whistleblower or two has garnered a significant award. Given the magnitude of some of the recent SEC enforcement actions (as for example in connection with SEC enforcement action under the FCPA, refer here) the likelihood that we might see some large awards seems high. Refer here for further discussion of the particular concerns surrounding the prospects for whistleblowing activity in the FCPA context.

The bottom line is that for those of us who worry about the potential exposures of directors and officers of public companies, there is a whole new category of concerns.

Special thanks to a loyal reader for the link to the whistleblower advertisement.

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Largely (although not exclusively) driven by last summer’s enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes already now afoot have wrought a transformation in the relations between corporate boards and corporate shareholders. Even further changes lie ahead. In this post, I take a look at where we are now, what lies ahead, and what it all means.

Many of the observations in this post were influenced by the commentary during a panel discussion in which I participated on May 11, 2011, entitled “Dodd-Frank and the Rising Tide of Shareholder Empowerment”,” at the Menlo Park offices of the Orrick law firm. The views expressed in this post are my own.

Changes Already Underway

Though many of the rulemakings required by the Dodd Frank Act have fallen behind schedule, a number of the implementing rules already are in place and are already driving changes. In addition, other processes not directly connected to Dodd-Frank are also underway and changing board processes, practices and structure. Here are four specific governance reform processes currently underway:

1. Say on Pay: As a result of Section 951 of the Dodd Frank Act and the requirements of SEC rules that went into effect January 25, 2011, all but the smallest public companies have had to put their executive compensation practices to an advisory shareholder vote during the current proxy season. The practice of an advisory vote on executive compensation has been in place in many European counties for some time. Many U.S. companies and their advisors resisted the adoption of the requirement here, and others questioned the value of a mere advisory vote.

In ways that I think may have caught some observers by surprise, it appears that – even though the shareholder “say on pay” vote is purely advisory – the implementation of the requirement for a “say on pay” vote is having a significant impact on executive compensation practices. As reflected in a May 2, 2011 Wall Street Journal article entitled “Firms Feel ‘Say on Pay’ Effect” (here) , many companies, scrambling to win shareholder approval in the say on pay vote, have been pressured to alter pay practices. As the article says, “despite some early skepticism, the prospect of such votes has sparked boardroom debate over executive-pay practices that were long-rubber stamped:”

The last minute changes that some corporations have put through to avoid negative votes have included some extraordinary steps. Just before the shareholder vote at Disney, for example, the company dropped certain provisions in its contract with its CEO Robert Iger, as well as other executives removing a provision that would have grossed up any compensation awards to these officials in the event of an ownership change.

The net effect of this process, and board’s desire to avoid a negative vote, is that certain compensation practices may fall by the wayside and all companies will face greater pressure to better align executive compensation and company performance.

A May 3, 2011 memo from the Davis Polk law firm (here) provides a detailed status update on the current round of “say on pay” votes.

2. Proxy Access: On August 25, 2010, the SEC adopted rules, in changes that were to be effective November 15, 2010, to require all but the smallest public companies to include in the proxy materials that board candidates nominated by shareholders who meet certain qualifying criteria. In order to qualify to nominate a candidate, a shareholder or shareholder group must individually or collectively own at three percent of the voting power of company’s shares and must have held those shares for at least three years.  

However, on September 29, 2010, the Business Roundtable and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules that the SEC had adopted. The petitioners contend that the new rules are “arbitrary and capricious,” violate the Administrative Procedures Act, and infringe on the First and Fifth Amendments. In response to this legal challenge, the SEC on October 4, 2010 issued a stay of the effectiveness of the rules while the legal challenge is pending. A ruling in the legal challenge is expected later this year.

While the implementation of the proxy access rules are in abeyance and the outcome of the legal challenge is uncertain, the likelihood is that in the future shareholder will enjoy greater shareholder access by requiring a company to include in its proxy materials shareholder nominees to the board of directors. As two attorneys from the Saul Ewing firm wrote in an October 29, 2010 article in the Legal Intelligencer entitled “Be Prepared: Shareholder Activism is Here to Stay” (here), “whether under the rules now being considered by the court or some revision thereof, the Dodd-Frank Act, and its focus on shareholder protection and access, ensures shareholder activism is here to stay.” 

3. Board Declassification: One of the long-standing objectives of corporate governance reformers has been the elimination of classified or staggered boards, whereby directors were elected for three years terms ensuring that in any given year only a third of the directors are up for vote. The Dodd-Frank Act does not have anything to say directly on this issue. Nevertheless reformers, led by the Florida State Board of Administration, have succeeded in obtaining the voluntary agreement of a number of companies to the declassification of their boards, pursuant to which the companies will put their entire board to an annual vote.

As one recent commentator noted, “the overwhelming trend in corporate governance is toward the declassification of boards.” An April 26, 2011 press release from the Florida Board about its efforts can be found here. A May 10, 2011 commentary by Nell Minow on her Risky Business blog about the board declassification efforts can be found here.

4. Majority Voting: Another longstanding goal of corporate governance reformers has been the implantation of majority voting. In many U.S. public companies, director election requires only a plurality vote, so that a director candidate in an uncontested election who receives only one vote will be elected. In a majority vote model, a director in an uncontested election who fails to receive a majority of votes must offer their resignation.

As discussed in an April 19, 2011 Westlaw Business article entitled “Corporate Governance: Assertive Activist Investors” (here), the 2011 proxy season is the “culmination of a major drive to install majority voting standards,” and shareholders at a number of companies have voted in favor of shareholder proposals calling for majority voting standards.

Changes Just Ahead

1. Compensation Ratios: In one of legislation’s lesser noted provisions, Section 953(b) of the Dodd Frank Act directs the SEC to amend its executive compensation disclosure provisions to require reporting companies to disclose the ratio between total annual compensation of their CEO and the median annual compensation of their employees. Rules implanting these provisions are required to be adopted before the end of 2011.

As University of Denver Law Professor Jay Brown notes on his Race to the Bottom Blog (here), these disclosure requirements potentially could be “powerful.” As Professor Brown notes, the compensation ratio disclosure would shift the executive compensation dialog away from a comparison between executive compensation at different companies toward a comparison within the company itself. The provision rather obviously reflects an intuition that there is a disparity between the compensation paid to executives and the compensation to other company employees.

These provisions are controversial and there already is a move underway to repeal this provision.  But if the provisions become effective and reporting companies are required to disclose the compensation ratio as specified in the Dodd-Frank Act, it seems likely that what will follow is a protracted discussion around issues of compensation fairness and compensation equity, particularly as popular  notions about the appropriate ratios develop over time. Companies whose ratios suggest greater compensation disparity are likely to face added pressure on executive compensation issues.

2. Compensation Clawbacks: Another of Dodd-Frank’s executive compensation requirements is set out in Section 954, which requires to SEC to direct the national exchanges to impose new listing standards directing  public companies to implement compensation clawback provisions. Under Section 954, companies making accounting restatements of prior financials must recover from any current or former officer all incentive-based compensation paid during the preceding three-year period above what would have been paid without the misstated financials. According to a May 12, 2011 CFO.com article about the provisions (here), the SEC plans to propose and adopt rules implanting these requirements between August of this year and year-end.

The Dodd-Frank clawback provisions go far beyond the clawback requirements instituted in the Sarbanes Oxley Act. The SOX provisions were limited just to the CEO and CFO, where as the Dodd-Frank provisions are applicable current and former executive officer. SOX clawed back only the year prior to the restatement, whereas the Dodd Frank provisions reach back three years, and are applicable without regard to fault or wrongdoing.

The clawback provisions also have proven controversial. The CFO.com article cited above notes that these provisions have a “potentially far-reaching impact” that may “result in serious reconsideration of how incentive compensation plans are designed.” It is also possible, as another set of commentators has noted, that companies who in future find that they must restate prior financials may face litigation (or rather their officers and directors may face litigation) on questions whether a compensation clawback is required, against whom it should be enforced, and for what types or amounts of incentive compensation.

What it All Means

Though rule-making delays and litigation have delayed the implantation of some of the Dodd-Frank Act’s  requirements, many of the changes Dodd-Frank required are already here and others are just around the corner. These changes, and the other corporate governance reforms being pursued by shareholder advocates  have a number of significant implications, beyond just the most obvious practical effects.

1. Heightened Scrutiny: Not all companies are going to give in on executive compensation issues or on board process issues like board declassification and majority voting. (Indeed, there are certainly a number of serious commentators who question the value or even the wisdom of many of these reforms). But while different companies may respond to these developments in different ways, companies that resist these governance developments may face heightened levels of scrutiny, both from shareholders and from the media.

A very recent example of this kind of scrutiny involves the Internet media company, LinkedIn, which has recently filed to conduct an initial public offering of its securities. In two interesting but highly critical commentaries on the DealBook blog (refer here and here),University of Connecticut Law Professor Steven Davidoff takes LinkedIn to task for adopting “a governance structure that not only disenfranchises its future shareholders, but contains elements that have been heavily criticized by corporate governance advocates.” Among other things, Davidoff criticizes Linked In for its dual share class structure that ensures that the company founders will retain voting control of the company; for adopting a staggered board; and for instituting onerous by law provisions.

In referencing Davidoff’s critique of LinkedIn here, I am expressing no opinions in whether or not his criticisms are valid or whether LinkedIn fairly may be criticized. Rather I cite his analysis to show the kind of scrutiny all companies are likely to face if they pursue practices or implement policies that fly in the face of the current trends in corporate governance reform. This level of scrutiny is only likely to increase as other reforms, such as the compensation ratio disclosure requirements, go into effect.

2. Increased Litigation Risk: Companies that resist shareholder driven reform initiatives may not only face scrutiny, but they (or their directors and officers) may also face an increased likelihood of litigation. In a recent post (here), I noted the apparent trend in which companies who experience a negative “say on pay” vote may find themselves facing shareholder litigation relating to the companies’ compensation practices. As noted above, there are others of these current reforms – for example, the clawback provisions – that could also encourage shareholder litigation.

3. Changing Judicial Attitudes: A very strong principal traditionally informing judicial scrutiny of board processes and decision making has been a broad judicial deference to the boards themselves. With the shift towards greater shareholder empowerment, courts may also be less inclined than perhaps they were in the past to defer to boards.

This notion that evolving  corporate governance norms may affect judicial consideration of board process and functioning was highlighted in the Chancellor Chandler’s August 9, 2005 opinion in the Walt Disney Shareholder Litigation, where Chandler observed that “in this era of Enron and WorldCom debacles, and the resulting legislative focus on corporate governance, it is perhaps worth pointing out that the actions (and the failures to act) of the Disney board that gave rise to this lawsuit took place ten years ago, and that applying 21st century notions of best practices in analyzing whether those decisions were actionable would be misplaced.”

The Chancellor’s unmistakable implication is that heightened 21st century standards will be applied to 21st century board actions – in other words, as corporate governance standards change, boards will be held to standards of conduct reflecting the changed governance norms and expectations. And in an era of growing shareholder empowerment, that reality may translate into increased judicial expectation for boards to address shareholder initiatives.

Conclusion

There is of course within all of this extensive room for serious debate about whether or not these changes ultimately will advance or impede corporate performance and what impact all of this will have on the relatively competitiveness of U.S companies in a global marketplace. But whatever may be said along those lines, it seems clear that the changes brought about in the current round of corporate governance reforms are here to stay and will require corporate officials to adapt to the new environment.

Meanwhile, In Another Universe: Things that are commonplace now (the Internet, arthroscopic surgery, the E-Z pass toll collection system, open-on-the-bottom condiment containers, etc.) were virtually inconceivable just a short time ago. Rivka Galchen’s article entitled “Dream Machine” in the May 2, 2011 issue of the New Yorker provides a fascinating glimpse of even more fantastic changes the future may bring, in the form of "quantum computing" -- that is, computing based on the principles of quantum mechanics.

The promise of quantum computing is the vast improvement in computational power it could provide. As an example of a problem not otherwise resolvable through conventional computing but that could be solved through quantum computing is “prime factorization.” That is, it is easy to multiply two large prime numbers but very difficult to take a large number that is the product of two primes and to deduce the original prime factors. To factor a number of two hundred digits would take a conventional computer longer than the history of the universe but would only take a prime computer an afternoon.  

The explanation of how a quantum computer would accomplish this involves a scientific theory known as the Many Worlds Interpretation. It entails the “counterintuitive reasoning” that “every time there is more than one possible outcome, all of them occur.” So if a radioactive atom might decay and it might not, it both does and doesn’t.  From this, the many implied small branchings “ripple out until everything that is possible in fact is.”

According to Oxford physicist David Deutsch, the Many Worlds theory explains how quantum computers might work. According to Deutsch, a quantum computer would be “the first technology that allows useful tasks to be performed in collaboration between parallel universes.” The quantum computer’s processing power “would come from a kind of outsourcing of work, in which calculations literally take place in other universes.”

The Many Worlds theory to which Deutch refers to explain quantum computing’s theoretical operation seems (to me at least) to have more to do with the imaginative world of literature than it does to science. Perhaps my feeling in this respect is due in part to the unmistakable parallels between the Many Worlds theory and a short story written by the Argentine writer, Jorge Luis Borges.

Borges’s story, The Garden of Forking Paths, involves Dr. Yu Tsun, who is a descendant of a scholar (Ts'ui Pên ) who wrote an indecipherable novel about labyrinths. In this story, Dr. Yu meets a British sinologist who has uncovered the mystery of Ts'ui Pên’s novel. The British sinologist described his interpretation of the novel as follows:  

In all fictional works, each time a man is confronted with several alternatives, he chooses one and eliminates the others; in the fiction of Ts'ui Pên, he chooses-- simultaneously--all of them. He creates, in this way, diverse futures, diverse times which themselves also proliferate and fork. Here, then, is the explanation of the novel's contradictions. Fang, let us say, has a secret; a stranger calls at his door; Fang resolves to kill him. Naturally, there are several possible outcomes: Fang can kill the intruder, the intruder can kill Fang, they both can escape, they both can die, and so forth. In the work of Ts'ui Pên, all possible outcomes occur; each one is the point of departure for other forkings. Sometimes, the paths of this labyrinth converge: for example, you arrive at this house, but in one of the possible pasts you are my enemy, in another, my friend.

And so, I will leave you with this thought: In at least one universe, the quantum computer will become a working reality. The question that remains to be seen is which universe. Or to put it another way -- the possibility that there might be another universe in which the airline does not lose my luggage does not do me much good in the universe in which my luggage has been lost.

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You may have seen May 2, 2011 Wall Street Journal article entitled “Overhaul Grows and Slow” (here), which described the backlog developing as regulators struggle to meet the rule-making deadlines mandated by the Dodd-Frank Act. The article itself was interesting enough, but if you really want to appreciate the daunting task regulators face, you may want to take a look at the law firm memo on which the article was based.

The May 1, 2011 memo from the Davis Polk law firm, entitled “Dodd-Frank Rulemaking Report” (here) provides a much more detailed look at the regulators' massive burden.

As the memo details, Dodd-Frank (which was massive enough itself) mandated 387 different rulemakings from 20 different regulatory agencies. (Some of the mandates require multiple agencies to issue rules on a given topic or item; if the joint rules are not double-counted, the number drops from 387 to 243.)  Congress not only required the rulemakings, but it specified the rulemaking schedule for many of the mandates as well. Of the 387 required rulemakings, 275 have specified rulemaking deadlines or annual requirements.

The bad news for regulators is that with most of the regulatory deadlines yet to come, they have already fallen behind. For example, not a single one of the agencies involved met any of the 26 deadlines that fell in April 2011. Cumulatively, the agencies collectively have now missed more than 30 deadlines.

The worse news for regulators is that most of the deadlines are yet to come. As the chart on page 8 of the law firm memo shows, only 40 of the 387 deadlines will have occurred through the end of the 2^nd quarter 2011. The real problems will arise during the 3^rd quarter of 2011 (which will coincide with the first anniversary of Dodd-Frank’s passage). In the third quarter alone the agencies will face 108 different rulemaking deadlines, about 28% of the total. There is no relief after that, either, as 37 more deadlines fall in the fourth quarter.

The agency that will face the biggest challenge is the SEC. Of the 387 rulemaking mandates, 95 (or about one quarter of the total) are directed to the SEC. Of those 95 SEC mandated rulemakings, 75 have deadline requirements, and 45 have deadlines that fall in the third quarter of 2011. As of today, the SEC has completed new regulations only six required items, proposed 28 additional rules and missed deadlines on 11. In the second half of 2011, the SEC will have to complete a total of 52 more rulemaking -- and that doesn’t even take into account the deadlines on which the SEC has already fallen behind.

The authors of the law firm memo are not optimistic that the regulatory agencies will much greater success meeting these upcoming deadlines than they did with the deadlines that have occurred so far. As graphics in the memo depict very vividly, the commentary period that follows a proposed rulemaking produces a “mountain” of comments. Working their way through that mountain required regulators to read many comments in a short timeframe. Missed deadlines seem likely.

The rulemakings that have been delayed already include some of those relating to the Dodd-Frank Act’s most closely watched provisions. For example, the rules relating to the Act’s new whistleblower provisions, which had been due April 21, now reportedly will not be available until late July. The SEC also delayed the release of its proposed regulations on resource extraction and conflict minerals disclosure, which had been required earlier in April.

The problem is not just the sheer magnitude of the task; it is also the political pressure that interested groups are applying to the process. The Journal article cites Stanford Law Professor (and former SEC Commissioner) Joseph Grundfest as saying that “the problem is not just the number of the rules, It’s the complexity of them, and it’s the political power of the various constituencies that are affected by these rules.”

Whatever the reason for the delay, it seems like the day by which we will finally be able to assess the overall impact of the Dodd-Frank Act may now be even further off into the future.

Legal  History: The Davis in the Davis Polk law firm’s name refers to John W. Davis, who was the Democratic party candidate for President in 1924. Davis  lost the election to Calvin Coolidge.  The firm can boast of a former President among its alumni, as Grover Cleveland was a member of a predecessor firm during the period between his two separate Presidential terms.

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One of the many changes introduced by the Dodd-Frank Act was the requirement for a shareholder vote to approve executive compensation. Under the Act’s provisions, the vote is not binding on the company or its board, but is purely advisory. Nevertheless, companies whose shareholders vote against their “Say on Pay” resolutions are finding that lawsuits are following in the wake of the vote, according to Broc Romanek’s April 26, 2011 post on the TheCorporateCounel.net blog (here). 

Section 951 of the Dodd Frank Act provides that not less frequently than every three years public companies must provide their shareholders with an opportunity for an advisory vote on the compensation of the most-highly compensated employees. On January 25, 2011, the SEC adopted rules (here) implementing the requirements of Section 951. All public companies must hold Say-on-Pay votes at shareholder meetings starting on January 21, 2011. The rules are delayed for two years for companies with public float of less than $75 million. A March 2011 Investor Bulletin describing the Say on Pay requirements can be found here.

In view of public sentiment regarding executive compensation, it may not be a surprise that at some public companies the shareholders have voted against the Say on Pay resolution. According to Romanek’s April 25, 2011 post on the TheCorporateCounsel.net blog (here), a total of eight companies so far during this proxy season have seen their shareholders vote against the Say on Pay resolution. The most recent companies to have shareholders vote against their say on pay resolutions are Black and Decker (refer here) and Umpqua Holdings (refer here).

Umpqua Holdings filing on Form 8-K describing the shareholder vote on the say on pay resolution includes some interesting commentary, including among other things a statement that “our board of directors takes the results of this vote seriously and is considering ways to address this concern. “ The filing also states that “the vote against the ‘say on pay’ resolution was primarily the result of votes cast by institutional investors that followed the recommendation of Institutional Shareholder Services (ISS), a proxy advisory service,” adding that  “the ISS report found a ‘disconnect’ between our CEO’s compensation in 2010 and the company’s total shareholder return.” The company then went on to explain why it disagreed with the ISS position.

What has started to happen now that the “no” votes are starting to accumulate is that some of the company’s whose shareholders voted against the lawsuits are now finding that the lawsuits are following along after the vote. These lawsuits are being filed in the form of shareholders derivative suits against the individual board of directors, the members of the board compensation committee, and in some instances even the company’s compensation consultants.

One example where a lawsuit followed after shareholders voted no on a say on pay resolution involves Beazer Homes. As Ted Allen noted on the Risk Metrics Group Insights blog (here), at   the company’s February 2, 2011 annual meeting, over 53% of its shareholders voted against the company’s say-on-pay resolution. The company’s filing of Form 8-K discussing the vote can be found here.

On March 15, 2011, a Beazer shareholder filed a derivative lawsuit in Fulton County (Georgia) Superior Court, against the company, as nominal defendant, the company’s board, its accountant and its compensation consultant. A copy of the court’s docket can be found here. A copy of a March 15, 2011 Bloomberg article about the lawsuit can be found here. The lawsuit alleges that compensation increases for executives “violated the company’s pay-for-performance policy and favored Beazer’s CEO and top executives at the expense of the corporation.”

Another company that became involved in a shareholder suit after a say-on-pay vote, albeit before the Dodd Frank Act was enacted, was Occidental Petroleum. As described in its February 24, 2011  filing on Form 10-K (here) , the company was involved in a total of three different shareholder suits relating to compensation issues after shareholders voted on a compensation resolution. The first lawsuit, filed in federal court in Delaware in May 2010, alleged that the company’s board and certain of its executive officers had made a “false and misleading proxy solicitation” in connection with seeking shareholder approval of bonus compensation standards. All three lawsuits alleged corporate waste and breach of fiduciary duty for excessive compensation. The 10-K states that the first of the two suits was settled and the other two suits were dismissed with prejudice. However the filing does not disclosure the terms of the settlement. 

In an April 17, 2011 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation blog (here), attorneys from the Schulte Ross & Zabel law firm note that there are a number of negative consequences that follow in the wake of a negative say on pay vote, obviously referring to the Occidental case described above as well as other possible litigation:

The vote may translate into votes against directors. It also is likely to result in significant unfavorable publicity, which was the case at all 3 of the companies that received negative votes on [Say on Pay] iin 2010. In addition, lawsuits alleging breach of fiduciary duty and corporate waste were filed against directors at 2 of the companies that received a negative SOP vote in 2010. In one case, the lawsuit was settled, while it is still pending at the other company. At both of these companies, there also were changes to executive compensation policies and/or leadership.

At the 2 companies that have thus far had negative outcomes on SOP resolutions in 2011, in preparation for a possible lawsuit, plaintiffs’ firms already have announced investigations on behalf of shareholders concerning breaches of fiduciary duty …

 

The fact that there is litigation relating to executive compensation is not all that surprising, given what a hot button issue executive compensation as been in recent years. What is surprising is that the litigation is attempting to capitalize on the say on pay vote. For starters, the statute is quite clear that the required vote is not binding on the company or its board. Moreover, Section 951(c) expressly states, among other things that the shareholder vote “may not be construed” to “create or imply any change to the fiduciary duties of such issuer or board of directors” or to “create or imply any additional fiduciary duties for such issuer or board of directors.”

But even with the seeming limitations in the statute, the simple fact is that the vote is required and shareholders get to say that they disapprove of the company’s compensation practices. In April 26, 2011 post on his eponymous blog (here), UCLA Law Professor Stephen Bainbridge states that he knew these kinds of problems were coming when Congress incorporated the advisory say on pay provision in the legislation, having warned that the process “would be abused and turned from a supposed non-binding voting exercise into a club to beat directors with.” As Professor Bainbridge notes, that appears to be exactly what is happening.

Of course, merely because lawsuits are filed does not mean the suits are meritorious, and there is nothing that says that these cases are necessarily going anywhere. But they will still be costly to defend. And the fact that the Occidental case noted above was settled (albeit under undisclosed provisions) suggests that there could at least potentially be expense involved in trying to resolve these cases as well.

The defense expense involved as well as the possible costs of resolution make these kinds of cases a problem for D&O insurers. (Indeed, at least one observer noting the arrival of these kinds of suits expressly stated  that the D&O insurers had “better start watching what happens with Say on Pay.”).

One of the recurring discussions amongst D&O insurance professionals since the enactment of the Dodd Frank Act has been the extent to which the Act may increase or exacerbate D&O claims activity. The full impact of the Dodd Frank Act will only be revealed in the fullness of time. But while the full picture develops, one thing that is clear is that the Act’s Say on Pay provisions could be contributing to increased  D&O claims activity.

Maybe You Can’t Save the World, But You Can Help People Help Themselves: The Hesperian Foundation is a non-profit organization that publishes a book for people who do not have access to professional medical care called “Where the Is No Doctor.” The book has been translated into many languages and has been distributed around the world.

Here is a letter that was recently sent to the Foundation from someone who had received one of the books years ago:

About sixteen years ago, I was honored to receive from your august foundation the 1992/94 revised and reprinted precious book …”Where There is No Doctor.” I learn with great pleasure that you’ve published the 2010 revised edition…

I’m thus applying to you once again to kindly post me one book of this 2010 revised edition. I’m a teacher living and working in this densely populated suburb of Dakar where illiteracy and poverty rates are still very high. Infectious diseases like malaria, TB, STDs and influenza, and contagious but still deadly diseases like cancer, high blood pressure, diabetes, asthma, sickle cells, kidney failure, hepatitis, ulcers, general and particularly joint pains, etc., are widespread here. Dermatosis, worms, eye problems (cataract, glaucoma), teeth ache and depression or stress-related psychiatric disorders are also very frequent. In the neighboring countries, heavy rainfall forest nations like Sierra Leone, Liberia and the two Guineas …deadly diseases like typhoid, cholera and AIDS add up to the above mentioned somber list.

I’m persuaded that your in-depth and well illustrated book will again be of great help to us. As an underdeveloped country, the vast majority of people here don’t have access to computers and to the Internet. We thus very largely still depend on books like yours to learn from and to teach people in the community. We shall thus be very grateful to you and your Foundation to receive one from you…

The first thing I did when I read this letter was that I got out a checkbook and wrote the Foundation a check for $50, which is the all-in cost for processing and shipping the book to East Africa. If one book can help with so many different kinds of problems then it needs to be provided to as many people as possible.

The Foundation gets letters like this all the time, asking for copies of the book in specific languages or addressing specific situations. Among other things, the Foundation recently posted a Japanese language version of the book online, because so many earthquake victims, who may previously have the best medical care in the world, now do not have access to a doctor. Victims of the Haiti earthquake continue to depend on the book as a guide to the prevention of the spread of cholera.

The thing I particularly like about this book is that it is not a mere handout; it is a form of personal empowerment. The people who have access to one of these books can learn what they need to do to care for themselves, which is the first and most important step of self-improvement.

I was absolutely delighted to be able to make a donation so that a book could be sent to the Senegalese teacher whose letter I reproduced above. If you would like to help others just like him, please consider making a donation by visiting the Foundation’s website, here.

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In today’s global economy, business increasingly is conducted cross-jurisdictionally. Company officials and their advisors increasingly must grapple with liability issues arising under the laws of multiple jurisdictions. These liability issues in turn can present complex indemnification and insurance questions. Simply identifying the operative legal considerations can present a significant challenge.

A newly updated legal resource may afford valuable information for those struggling with these issues. Information about the new volume, entitled Directors’ Liability and Indemnification: A Global Guide, Second Edition, can be accessed here. This new edition was edited by UK Insurance maven, Ed Smerdon of the Sedgwick Detert law firm.

The book’s separate chapters describe the essential legal principles in 38 different countries. This latest edition includes new chapters on China, the Czech Republic, Kazakhstan, South Korea and the United Arab Emirates, among others. Each chapter has been written by a leading law firm in the relevant jurisdiction. For example, the chapter on the United States was written by Dan Bailey and Darius Kandawalla of the Bailey Cavalieri law firm.

Each chapter provides a country-specific overview of the legal principles governing directors’ duties and obligations. The text also contains a description of the claims environment in each country, including the relevant considerations regarding criminal and regulatory liability. The information also includes the principles governing the availability of indemnification and insurance in each country, as well.

The information for each country is presented succinctly and provides more of an introduction to the critical legal considerations than it does a comprehensive dissertation. This volume will be most useful to those looking for a quick impression of the legal environment. For those looking for a deeper understanding, this volume at least provides some starting points.

It seems likely that legal challenges arising from the cross-jurisdictional conduct of business will only increase in the months and years ahead. This volume will likely prove a valuable resource for insurance advisors and others called upon to counsel companies in connection with the associated liability exposures and related insurance considerations. We can only hope that this book’s editors and authors will continue to update and expand this volume in the years ahead.

Many thanks to Ed Smerdon for providing me with an opportunity to review an advance copy of the book.

D&O Insurance Implications of Dodd-Frank: The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 introduced sweeping reforms to every aspect of the country’s financial system. In addition, many of the Act’s provisions – including in particular its new whistleblower bounty sections -- seem likely to lead to increased SEC enforcement activity. The enforcement activity could in turn lead to follow on civil litigation.

The Act’s potential enforcement and litigation implications also carry important D&O insurance implications. These considerations and implications are reviewed in detail in a February 2011 article entitled "Dodd-Frank, SEC Enforcement Activity, Whistleblowers and D&O Insurance" (here) by my friend Priya Cherian Huskins and her colleague Carolyn Polikoff of the Woodruff Sawyer firm. Among other things, the authors discuss particular problems that may arise in connection with the Dodd-Frank’s executive compensation clawback provisions, as well as D&O insurance concerns arising from the new whistleblower provisions. The article concludes with a list of eight D&O insurance recommendations.

My thanks to Priya for reaching out to me to include a link to the article on this site.

Failed Bank Litigation Resources: Most readers who are following the events surrounding the current failed bank litigation wave likely are already familiar with the FDIC’s Failed Bank List, which is updated every Friday evening to reflect the latest banks of which the FDIC has taken control.

Another page on the FDIC website of which readers may want to be aware is the FDIC’s Professional Liability Lawsuits page. I have previously linked to this page in prior blog posts, but the FDIC has been updating the page and it now has a number of additional useful features.

First, for some time now, the FDIC has been updating the page to reflect the latest number of former directors and officers of failed banks against whom civil actions have been authorized. The page has recently been updated to show that the FDIC has now authorized civil actions against 130 directors and officers. More importantly, it is clear that the FDIC will be regularly updating this page with new information as additional actions are authorized.

In addition, in the new feature that readers may find most useful, the FDIC has now provided specific details regarding each of the four civil actions it has filed so far against former directors and officers of failed banks. From the way the information is presented (at the bottom of the page), it appears that the FDIC intends to update this information as additional actions are filed. Accordingly, this page could prove to be a valuable resource over time as the number of FDIC actions grows.

I intend to continue to track -- and link to --the FDIC litigation on my own as it is filed, as reflected here. At least for now, the FDIC itself also seems to be committed to tracking and providing this information as well. Many readers may find the FDIC’s page to be a highly credible and (we can hope) timely resource on these issues. I will continue to provide links to the lawsuits.

And speaking of failed banks, the FDIC did take control of four additional banks this past Friday night, as is reflected on the agency’s Failed Bank List. These four new closures bring the 2011 year to date number of failed banks to 18.

The 18 bank failures have been spread across 12 different states, though the largest number of closures this year has been in Georgia (4), which has led the way with the largest number of bank failures since the current wave began. The 18 failures so far in 2011 bring the total number of failed banks since January 1, 2008 to 340.

It is interesting to note that the pace of bank closure so far this year is running slightly ahead of the pace in 2010, when the FDIC closed more banks than it had in a single year since 1992. The FDIC did not close its 18^th bank in 2010 until February 19.

Living in America: On Friday, the determination of peaceful demonstrators in Egypt resulted in the historic overthrow of their oppressive government, but the lead story in Saturday’s Cleveland Plain Dealer was that the Cleveland Cavaliers’ ended their 26-game losing streak on Friday night. The Cavs’ first victory since December also apparently merited a headline in larger type as well.

As a letter to the editor in Sunday's edition put it, "Your newspaper failed to explain why all those Egyptians were so excited about the Cavs game."  

Web Animation Video Phenomenon Even Reaches the Insurance Industry: I know that many of you were as interested as I was in the February 11, 2011 Wall Street Journal article about the increasing numbers of customized computer-generated animated videos, which anyone can make on web sites such as Xtranormal.

One sure sign of how widespread this new phenomenon has become is the animated Xtranormal video now circulating that takes a light-hearted look at the perennial conversation about business between brokers and underwriters. For those of you who have not already seen it, here is the "I Need New Business" video. (The views, attitudes and opinions expressed in the video do not necessarily reflect those of The D&O Diary or its author.)

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Among the many innovations introduced in the massive Dodd-Frank Wall Street Reform and Consumer Protection Act enacted this past July are the new whistleblower provisions, designed to encourage employees and others to report securities law violations to the SEC. The bounty award provided for in the whistleblower provisions seem likely to encourage fraud reporting, but many observers are voicing concerns about these provisions. And as noted below, there may be other concerns above and beyond those generally noted, particularly with respect to potential D&O insurance coverage issues.

Section 922 of the Dodd Frank Act specifies that a person who provides "original information" to the SEC of fraud within the company that leads to an enforcement penalty of $1 million or more may be entitled to collect between 10 and 30 percent of the penalties of $1 million or more. The provision also provides substantial retaliation protections for whistleblowers.

An article in the November 1, 2010 Wall Street Journal article (here) notes a number of concerns about the new whistleblower provisions, the first and foremost of which is that the bounty provisions provide incentives for prospective whistleblowers to race to the SEC in order to be the first to report violations, which in turn encourages prospective whistleblowers to bypass internal fraud detection mechanisms mandated by the Sarbanes Oxley act. Bruce Carton previously discussed many of these same concerns on his Securities Docket blog, here.

There is little doubt that the bounty provisions are likely to encourage fraud reporting. As I have noted elsewhere, penalty awards, for example, have skyrocketed in recent years, with many recent awards in the hundreds of million dollars. Whistleblowers potential rewards are enormous.

To put this into perspective, and as noted in the Journal article, the whistleblower whose tip resulted in the recently announced $750 million settlement between GlaxoSmithKline and the Justice Department stands to get an award of $96 million, under similar whistleblower provisions in the False Claims Act.

In recognition of the likelihood of substantial whistleblower awards, the SEC has already established a fund of approximately $452 million to fund the payments to whistleblowers, according to the SEC’s Annual Report to Congress on the Whistleblower Program, which was released last week. (The congressional report was mandated by the Dodd Frank Act.)

Under these circumstances, it seems highly likely that whistleblower actions will proliferate, and so the concerns noted in the Journal article and elsewhere seem warranted. In addition to the items noted elsewhere, there are a couple of other issues arising from the new whistleblower provisions that are worth considering as well.

The first is that the threat of legal proceedings from the whistleblower action is not limited just to the possible SEC enforcement action. A related and accompanying threat is the possibility of a follow-on civil litigation, brought on behalf of the target company’s investors, in which the plaintiffs will claim that the company’s senior managers failed to take appropriate steps to ensure that proper controls were in place, or that investors were misled by the company’s statement about the company’s controls.

These kinds of follow-on civil actions have been a frequent accompaniment of FCPA enforcement actions, as I have often noted on this blog. It seems probable that as whistleblower actions mount in response to the Dodd-Frank Act provisions, that there will be a parallel increase in civil actions following on after the whistleblower enforcement action.

The fines and penalties associated with a whistleblower enforcement action would likely not be covered under a D&O insurance policy, although the fees incurred in defending against the action potentially could be covered, at least as to individual defendants.

The follow-on civil actions would likely be covered under the typical D&O insurance policy, subject to all of the applicable policy terms and conditions. However, one potential D&O insurance coverage issue that might arise concerning the follow-on civil actions has to do with the possibility that the individual whistleblower could be an insured person under the D&O policy. This might arise, for example, if the whistleblower is also an officer of the company. The risk is that either the enforcement action or the follow on civil proceeding might run afoul of the insured v. insured exclusion typically found in most D&O insurance policies.

Following the enactment of the Sarbanes Oxley whistleblower provisions a few years ago, many D&O insurance policies were amended to ensure that a claim related to a Sarbanes-Oxley whistleblower action would not run afoul of the insured v. insured exclusion. Many of these amendments were written sufficiently broadly that the coverage carve back for whistleblower claims would preserve coverage not only for Sarbanes-Oxley whistleblower claims, but would also preserve coverage under other types of whistleblower claims. Many of these amendments were written sufficiently broadly that they would likely preserve coverage for Dodd-Frank whistleblower claims as well.

However, not all of the whistleblower carve back amendments are equally broad, which may raise the question about the potential applicability of the insured v. insured exclusion to Dodd Frank whistleblower claims, whether with respect to the initial enforcement action or even the possible follow-on civil action. Given the high likelihood of future Dodd Frank whistleblower claims, the review of the applicable D&O insurance policy language, seems like a critical next step.

In any event, the range of possibilities seems to include the likelihood of an increase both in enforcement actions and follow-on civil lawsuits, which has important implications far beyond the narrow provisions of the policy’s exclusionary provisions.

More Securities Suits Against For-Profit Educational Companies: One of the most distinctive securities class action lawsuit filing trends in the second half of 2010 has been the sudden arrival of a multitude of securities suits against for-profit education companies. As I noted in an earlier post, these suits follow a congressional investigation in to the companies’ practices involving student loans.

In recent days, plaintiffs have added two more companies to the growing list of for-profit education companies that have been hit with securities lawsuits. First, on October 28, 2010, plaintiffs’ lawyers initiated a securities suit against The Washington Post Company and certain of its directors and offices, in connection with the companies Kaplan, Inc. education subsidiary. Second, on November 1, 2010, plaintiffs’ lawyers initiated a securities suit against DeVry, Inc. another for-profit education company.

These two latest suits brings the number of securities suits filed against for-profit education companies so far this year to nine, which represents about 6% of the approximately 145 securities lawsuit filed this year.

Though the Washington Post Company is obviously a media company, it actually carries the 8200 SIC Code (Educational Services), reflecting the relative importance of the Kaplan Inc. subsidiary’s revenues to the company’s overall financial picture.

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