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

As I noted in a prior post (here), NERA Economic Consulting, in a May 15, 2008 paper (here), had asked the question whether options backdating-related securities class action lawsuits were settling for less than data from prior class action settlements would predict. In the May 15 paper, looking at the settlements to date, NERA found that the options backdating-related securities lawsuit settlements were well below predicted amounts.

 

NERA has now published an October 22, 2008 paper (here) that revisits its earlier analysis in light of intervening options backdating-related securities settlements.

 

With respect to the previously observed expectations gap, NERA had hypothesized in its earlier paper that either suits alleging backdating are generally viewed as weaker or the weakest cases had simply settled most quickly.

 

In its most recent paper, NERA revisits these hypotheses in light of three recent settlements – Brocade Communications, UnitedHealth Group and Monster Worldwide – finding that there may be support for the conclusion that the initial settlements may have been low because the weakest cases settled first. In these three more recent dispositions, the settlements were either at or well above predicted ranges. Indeed, NERA found that the UnitedHealth Group case was as much as five times greater than the predicted amount.

 

At the same time, NERA noted that four of the more recent settlements were more consistent with prior observations, in that the settlements were below predicted ranges.

 

In its earlier report, NERA had concluded that on average the options backdating cases were settling for about 38% of the predicted amount. With the addition of the intervening settlements the average settlement is up to about 74% of predicted amounts. However, this increase is largely driven by the inclusion of the UnitedHealth Group settlement. Without the UnitedHealth Group settlement, the average of the options backdating settlements drops to 43% of the predicted amounts.

 

Nevertheless, based on its analysis (and I am simplifying here), NERA still cannot reject the hypothesis that options backdating-related securities settlements are on average no different than settlements in non-backdating cases with similar level of investor losses and other similar traits.

 

NERA notes that of the overall options backdating-related securities lawsuits, 17 remain to be settled, which represents a larger group of cases than the 15 cases that have settled to date. It remains to be seen whether or not these remaining cases will or will not settle within expected ranges.

 

My table showing all options backdating related case dispositions, including settlements and dismissals both for all options backdating-related securities lawsuits and options backdating related derivative lawsuits, can be found here.

 

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According to news reports (here), on September 8, 2008, Judge Jeremy Fogel of the Northern District of California preliminarily approved the settlement of the Apple options backdating derivative litigation.

 

As reflected in the parties’ Stipulation of Agreement of Settlement (here), the plaintiffs in the consolidated Apple derivative action agreed to dismiss the action subject to the defendants agreement to pay $14 million to the company; the defendants’ agreement to pay the plaintiffs’ counsel’s various attorneys’ fees and costs totaling $8.85 million; and the company’s agreement to adopt certain corporate governance reforms. According to the Stipulation, the various derivative lawsuits "were a material factor in obtaining the $14 million payment from Apple’s liability insurers." The total cash value of the various payments is $22.85 million.

 

UPDATE: An alert reader has raised an important question about my statement that the total cash value of this settlement is $22.85 million. The reader said the following in an e-mail to me: "You describe the settlement as involving a cash payment of $22.85 million based on the $14 million D&O settlement paid to Apple and the $8.85 million fee award expense payment made by Apple to the plaintiffs. However, as a practical matter aren't you 'double counting' since, presumably, the plaintiff fee awared was paid by Apple from the D&O proceedsit received from its carriers?"

 

Assuming this reader's analysis is correct, this is a very important distinction. The Stipulation of settlement is consistent with the reader's hypothesis, but not definitive. The Stipulation is clear that the $14 million payment is coming from Apple's D&O carriers. It also says that the $8.85 million is to be paid by Apple. It is not clear whether or not the D&O insurers will be reimbursing Apple for the $8.85 million or if the $14 million is the only payment that the D&O insurers will be making in connection with the settlement. It would be helpful if any reader with more specific knowledge of the insurance arrangements pertaining to this settlement would let me know.

This reader's question also suggests another component that is relevant to these insurance issues but that is not addressed in the Stipulation, and that is the question of defense expense. In a case like this where there are regulatory proceedings and special litigation committee activities as well as civil litigation, there frequently are disputes about which defense fees are covered and which are not. In a case like this one, the aggregate amount of all fees could well exceed $10 million. To the extent the insurer's $14 mllion payment is the total amount of insurance remitted to Apple, leaving the company to absorb both the $8.85 million of plaintiffs' attorneys' fees and expenses as well as all of the related defense expense, the $14 million payment could even be less than the amounts for which the company itself is reponsible.

 

The settling defendants include the Company; its Chairman, Steven Jobs; and certain other present and former directors and officers of the company. Judge Fogel set a final settlement hearing for October 31, 2008.

 

I have already received inquiries from persons questioning the size of the Apple options backdating derivative lawsuit settlement. The questioners are concerned that the settlement amount is seemingly small, especially in light of who the company is and the nature of the allegations.

 

There is no doubt that the Apple options backdating allegations have been very high profile. In addition, parallel SEC enforcement proceedings did result in the payment of some significant fines. On August 14, 2008 former Apple general counsel Nancy Heinen agreed to pay $2.2 million to settle options backdating charges (about which refer here), and last year former Apple CFO Fred D. Anderson agreed to pay $3.5 million to settle SEC claims against him (about which refer here).

 

The consolidated amended complaint also contains some apparently serious allegations. As discussed here, the amended complaint raised certain options springloading allegations, including the allegation that three Apple executives received a windfall when they were granted options to buy over 2 million shares the day before the announcement of a significant technology investment and other developments sent Apple’s shares up 48 percent. The amended complaint also alleges that Jobs himself received backdated options that were later cancelled in exchange for restricted stock.

 

Despite these allegations and notwithstanding the SEC settlements, the plaintiffs’ case faced certain potentially significant challenges. First, in a December 19, 2007 opinion (here), Judge Fogel had dismissed the plaintiffs’ initial pleadings, with leave to amend. In issuing this ruling, Judge Fogel did not even reach the demand futility issue, deferring that to a later date.

 

The plaintiffs filed their consolidated amended complaint on December 18, 2006 (refer here), seeking to overcome the deficiencies in the original pleadings. However, just days later, on December 29, 2006, Apple announced the completion of the special investigative committee’s investigation of the company’s stock option practices.

 

A joint statement by the committee’s co-chairs, former Vice President Al Gore and audit committee chair Jerome York, stated that Apple’s board "has complete confidence in the senior management team." The company’s 10-Q issued the same day (here) stated that the committee "found no misconduct by current management." (The 10-Q did go on to say that the investigation had "raised serious concerns about the actions of two former officials"—presumably Heinen and Anderson).

 

It is no surprise to me that faced with an apparently skeptical court and an unhelpful (if also somewhat controversial at the time) investigative committee report, the plaintiffs’ found it expedient to settle. The questions I have received have not reflected concerns about the fact that the plaintiffs settled; the concerns have had more to do with the amount of the settlement.

 

If you disregard for a moment that a high-profile company like Apple is involved, there is nothing particularly unusual about the size of this options backdating derivative settlement, at least in the context of other options backdating derivative settlements. Setting to one side the UnitedHealth Group derivative settlement (about which refer here), the options backdating derivative lawsuit settlements to date have been relatively modest, and the total value of the Apple derivative settlement is well within range of the other settlements.

 

As reflected in my running table of the options backdating lawsuit case resolutions (which can be accessed here), the total value of very few of the options backdating derivative settlements has exceeded seven figures. Indeed, the Apple settlement is actually one of the larger options backdating derivative settlements. The total cash value of only three derivative settlements exceeds the Apple settlement: UnitedHealth Group; Cablevision ($34.4 million, about which refer here); and Electronics for Imaging ($24 million, refer here).

 

By and large the options backdating derivative settlements (in the cases that have not been dismissed outright) have been relatively modest, consisting in many cases only of a payment of plaintiffs’ attorneys’ fees and the agreement to adopt certain governance reforms. Although there were a truly impressive number of options backdating derivative lawsuits filed (168 by my count, as reflected here), very few of them seem to be resulting in significant payouts.

 

As the options backdating scandal recedes in the rear view mirror, it definitely has started to seem like less and less of a big deal, particularly in the context of the current daily diet of government bailouts, floundering investment banks, and multibillion dollar securities buybacks – with one big exception, as noted below.

 

And Speaking of UnitedHealth: The UnitedHealth Group cases have definitely been the most notable big-dollar exception in the options backdating scandal. The company was back in the news again today with the announcement (here) from the options backdating securities lawsuit lead plaintiff, Calpers, that the company’s former CEO William McGuire had agreed to pay $30 million and its former general counsel David Lubben had agreed to pay an additional $500,000 in settlement of the options backdating securities claims pending against them. McGuire’s own press release about the settlement can be found here.

 

Taken together with the $895 million previously announced settlement (refer here) in the UnitedHealth Group options backdating securities lawsuit, the aggregate value of the options backdating securities settlements in the case now totals $925.5 million, certainly a large number by any measure. This settlement total is also in addition to the UnitedHealth options backdating derivative settlement, which had a total value of over $600 million.

 

Although the various press releases are not specific in this respect, the implication is that McGuire’s $30 million settlement payment will come out of his own personal assets, rather than insurance or corporate indemnity. If that is the case, this settlement would represent one of the larger individual payments of its kind.

 

Fifth Circuit Affirms Options Backdating Securities Lawsuit Dismissal: In a September 8, 2008 per curiam opinion (here), the Fifth Circuit affirmed the dismissal of an options backdating related securities lawsuits. (The district court’s October 4, 2007 dismissal can be found here. Background regarding the case can be found here.)

 

The Fifth Circuit affirmed the district court’s dismissal on loss causation grounds. The holding is interesting because the company’s stock actually did drop on the date of the alleged corrective disclosure.

 

The Fifth Circuit held that the press release in question was not sufficient to satisfy the requirements to establish loss causation because "although the stock price dropped dramatically on the day of the 1 August 2006 press release, no new facts concerning Cyberonics’ stock-option accounting were disclosed in that release which demonstrated that the ‘truth became known’ about Cyberonics’ challenged financial statements." Therefore the Fifth Circuit concluded, "a causal connection between the material misrepresentations and the loss was not adequately pled."

 

Special thanks to Neil McCarthy of Lawyer Links for alerting me to the Fifth Circuit’s opinion.

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In a very interesting May 15, 2008 paper entitled “Do Options Backdating Cases Settle for Less?” (here), NERA Economic Consulting takes a look at the options backdating-related securities class action lawsuits settlements to date, and concludes that “in the cases that have settled to date, the amounts paid to plaintiffs have been substantially lower than in comparable non-backdating class actions.” NERA’s analysis is that the options backdating class action lawsuits are settling for half the amounts forecast by NERA’s own prediction model.

Having made this rather provocative observation, NERA then concedes that only a fraction of the options backdating-related securities class action lawsuits filed have yet settled. Clearly one factor that may be involved is that the weakest cases may have settled first, a consideration that the NERA study expressly acknowledges.

Nevertheless, in attempting to understand the variation between the settlements to date compared to the expected range of settlements based on NERA’s model, the NERA report does consider the possibility that “shareholder suits with backdating allegations are perceived as weaker on the merits than other class actions.” The report also considers the possibility that future options backdating settlements, which might include more serious cases, could be more in line with other securities class action settlements.

I have several observations about the NERA analysis, the first of which is that is important for all of us to keep a running tally of outcomes, to make sure we all know and keep track of what is happening. The fact that this study comes from NERA suggests that it will (appropriately) carry weight and credibility.

That said, it should also be noted that the NERA study is based on a small sample, only six settlements out of 37 options backdating related securities class action lawsuits. (The total number of lawsuits according to my tally, here, is only 36, but I am willing to go with their number for these purposes, which is close enough anyway.)

Not only is the sample small, but it seems to have been amputated at a couple of critical points. That is, for reasons that are not explained in the report, the NERA dataset does not include either the Mercury Interactive settlement ($117.5 mm) or the Vitesse Seminconduct settlement ($10.2 mm). If I know NERA, there are probably some very good reasons why they excluded these settlements, but the report does not explain or even refer to the omission of these settlements. Given the size of the Mercury Interactive settlement in particular, the omission of these settlements could have had a significant impact on the analysis, so their omission could be significant.

UPDATE: Dr. Branko Jovanovic, one of the author's of the NERA report, was kind enough to call me and politely point out that the report actually refers, in footnote 3, to the fact that the report's authors chose to exclude the Mercury Interactive and Vitesse Semiconductor settlements from the analysis because some but not all defendants had settled. (That's what I get for trying to write blog posts in a hotel room in Toronto without the ability to print out and read documents in hard copy form. Reading the report on a laptop screen, I just missed the footnote). Dr. Jovanovic points out that if the two settlements had been included, it would have increased the difference between expected and actual settlements.

The other thing about NERA’s analysis is that as a result of the small dataset, extreme individual results could be skewing the average. In particular, according to the report, the Rambus options backdating related securities class action lawsuit of $18 million, was only 8.3% of predicted. For me, an outlier result like that suggests that it is not representative, and in fact some case specific factor may explain the outcome. In any event, an extreme result like that clearly pulls down the average. While the exclusion of the Rambus result would still not eliminate the variation from the predicted range, it would reduce the difference.

I also think it is significant in considering whether the options backdating cases are or are not deviating from expectations that dismissals should be taken into account as well as settlements. According to my running tally of option backdating related settlements, dismissals and denials (which may be accessed here), six of the 37 (or is it 36?) options backdating related securities class action lawsuits have been dismissed. (Some of these dismissals are without prejudice). I am not 100% sure which way this cuts, but I think the number of dismissals is a relevant consideration to any analysis of whether or not outcomes are within predicted ranges. The dismissals may also provide some explanation, or at least context, for the variation between settlements to date and predicted ranges.

All of that said, I reiterate my appreciation to NERA for their effort to keep track of what has happened so far. The value of NERA’s analysis is in its provision of a status update, which is a sevice that we can all hope that NERA will continue as the cases develop.

For the sake of completeness, I urge all readers interested in these topics to review the analysis of options backdating securities class action settlements on the Securities Litigation Watch blog (here), which among other things notes that these cases are settling more quickly on average than other cases, which clearly might be a factor in explaining settlement outcomes. The SLW's analysis not only takes into account the settlements that NERA's report omits, but it also considers the dismissals as well.

One final observation is that NERA's analysis relates solely to options backdating securities class action settlements, and does not refer to or include options backdating derivative lawsuit settlements.  For further information regarding options backdating derivative lawsuit settlements, please refer to the table I am maintainting, here.

CFO.com has an article discussing the NERA report here.

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Amidst all the subprime hoopla, it would be easy to forget that only a year ago, options backdating was the hot topic. Options backdating might now seem passé, but several considerations suggest that options backdating remains important and that we still have a long way to go before we can be sure we have seen all of the options backdating scandal fallout.

Accumulating Lawsuits: The first important consideration about options backdating in early 2008 is that the options backdating related lawsuits are still coming in. As I previously noted (here), last month shareholders filed an options-backdating related securities class action lawsuit against Teletech Holdings.

In addition, on February 6, 2008, plaintiffs' lawyers announced (here) that they had initiated a securities class action lawsuit in the United States District Court for the Northern District of California against Maxim Integrated Products and certain of its directors and officers. The lawsuit relates to Maxim's January 17, 2008 announcement (here) that, as a result of its Board's special committee's investigation of the company's stock option practices, the company would be restating its financial statements to record non-cash, pre-tax charges of between $550 and $650 million for additional stock-based compensation expense. The company also announced that investors should not rely on the company's financial statements for the fiscal years 1997 through 2005 and corresponding interim reporting periods through March 25, 2006.

The timing of Maxim's recent announcement is relevant here. The company had first announced its anticipated restatement nearly a year prior, in January 2007 (here), and the company's January 2008 announcement indicated that the company's review was not only not yet complete, but would have to be expanded backwards to include its 1995 and 1996 fiscal years. Maxim is surely not the only company that continues to struggle with the accounting clean-up from options backdating-related issues. There may well be additional options backdating related lawsuits filed in the months ahead.

But in any event, with the addition of the Maxim Integrated Products lawsuit to my running tally of options backdating related lawsuits (which can be found here), the current total number of options backdating related class action lawsuits now stands at 36. These 36 class action lawsuits are in addition to the 166 options backdating related derivative lawsuits that have also been filed.

Accumulating Settlements: The second important consideration about options backdating in early 2008 is that the settlements of the options backdating related cases are accumulating in a material way. Indeed, on February 8, 2008, HCC Insurance Holdings announced (here) that it had settled the options backdating-related securities class action lawsuit that had been filed against the company and certain of its directors and officers, for a payment of $10 million dollars (to be funded entirely by insurance). The company had previously announced on January 9, 2008 (here) that it had settled the options backdating related derivative lawsuit in which the company was involved, in exchange for an agreement to adopt certain governance reforms and the payment of $3 million of the plaintiffs' attorneys' fees.

As reflected in my table of options backdating-related lawsuits dismissals, denials and settlements (which can be accessed here), the HCC settlement represents the seventh of the options backdating-related securities class action lawsuits to settle. The aggregate amount of these seven settlements is $244.55 million. Three other options backdating-related securities class action lawsuits have also been dismissed, meaning that at this point, ten of the 36 options backdating related securities lawsuits have either settled or dismissed, with another 26 yet to be resolved.

As also reflected on my list of options backdating related case dispositions, there have also been a number of options backdating related derivative settlements. The value of some of these settlements has not publicly disclosed, but the value of the disclosed settlements - not counting the $900 million UnitedHealth Group derivative settlement - is over $61 million.
The sum of the value of these two categories of options backdating-related lawsuit settlements is over $300 million - and if the UnitedHealth Group settlement is included, the total value so far is over $1.3 billion. (It should be kept in mind that these figures do not reflect the derivative settlements that were not publicly disclosed). Of course, these figures do not include the costs the companies incurred to defend these cases, as well as to defend themselves and their senior officials against SEC investigations and other regulatory and criminal matters. And, perhaps most significantly here, there are many more of these cases yet to be resolved than have so far been settled or dismissed.

The Securities Litigation Watch blog has a more detailed analysis of the options backdating securities class action settlements here.

I have gone through this exercise to point out that when all is said and done, the options backdating scandal is going to have proven to have had a very significant event. While not all of the settlement and amounts and defense expenses represent covered loss (for example, the UnitedHealth Group would appear to be excluded from coverage under the typical D & O insurance policy), much of these amounts will be paid by D & O insurers.

As is clear from the fact that options backdating related lawsuits continue to emerge, and the fact that the vast majority of the options backdating-related cases are yet to be resolved, D & O insurers are going to continue to incur these losses for some time to come. And while it can certainly be hoped that the insurers' reserving practices fully anticipate future developments in these cases (and the cases yet to emerge), the possibility that options backdating might be a bigger deal than everyone has been assuming right now cannot be overlooked.

This analysis of the options backdating-related cases provides some significant context for the current rapidly unfolding subprime-related litigation wave. By any measure, the subprime wave represents a bigger threat than the options backdating related cases. There are going to be many more subprime-related securities class action lawsuits (right now, there are 43 subprime-related securities lawsuits vs. the 36 options backdating related securities lawsuits, and the subprime related lawsuits are going to be rolling in for the rest of this year and probably into the next); the subprime cases involve much more significant shareholder losses; the subprime cases will be very expensive to defend; and, due to their complexity, the subprime cases will take a long time to resolve.

Bottom line: the options backdating scandal and the subprime meltdown together represent adverse circumstances for D & O insurers - something you would never be able to discern from the current marketplace conditions.

Special thanks to Adam Savett of the Securities Litigation Watch for the link to the HCC settlement and for suggesting to me the aggregation of the options backdating related class action settlements.

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