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

As discussed in an earlier guest post on this site (here), entrepreneurial plaintiffs’ lawyers seem to have hit upon a new way to extract a fee from the fights over executive compensation. This new wave of executive comp suits, in which the plaintiff’s seek to enjoin upcoming shareholder votes on compensation or employee share plans on the grounds of inadequate or insufficient disclosure, have resulted in some success – at least for the plaintiffs’ lawyers involved. These new kinds of executive compensation–related lawsuits possibly may be “gaining steam,” according to a recent law firm study.

A November 19, 2010 memo from the Pillsbury law firm entitled “Plaintiffs’ Firms Gaining Steam in New Wave Say-on-Pay Lawsuits” (here) reviews the history of say-on-pay litigation that has followed in the wake of the Dodd Frank Act’s requirements for an advisory shareholder vote on executive compensation. The memo shows that of the at least 43 companies that experienced negative say-on-pay votes in 2011, at least 15 were hit with shareholder suits alleging, among other things, that the companies’ directors and officers had violated their fiduciary duties in connection with executive compensation. However, as is well documented in the law firm memo, these suits have not fared well in the courts; ten of the eleven of the 2011 suits that have reached the motion to dismiss stage have resulted in dismissals.

Faced with this poor track record on last year’s say-on-pay suits, plaintiffs’ lawyers have filed fewer of these kinds of suits this year against companies that experience negative votes. However, as the law firm memo explains, one plaintiffs’ firm has now “orchestrated a new strategy to hold companies liable: suits to enjoin the shareholder vote because the proxy statement failed to provide adequate disclosure concerning executive compensation proposals.” According to the memo, there have been at least 18 of these types of suits, with nine of them having been filed just in the month preceding the memo’s publication.

As detailed in Nate Raymond’s November 30, 2012 Reuters story entitled “Lawyers gain from ‘say-on-pay’ suits targeting U.S. firms” (here), these new style lawsuits (of which the article says some 20 have been filed) have met with some success. According to the article, at least six of these suits “have resulted in settlements in which the companies have agreed to give the shareholders more information on the pay of the executives.” These settlements have also “resulted in fees of up to $625,000 to the lawyers who brought the cases.” The article also notes, however, that while the settlements have provided additional disclosures and legal fees for the firm that has filed almost all of these suits, “they have netted no cash for shareholders.”

These new suits share certain characteristics with the M&A-related lawsuits that are another current litigation trend. (Refer here for background regarding the M&A-related litigation trends.)  That is, they are filed at a time when the defendant company is under time pressure that motivates the company to settle quickly rather than deal with the lawsuit. Just as in the merger context, where the company wants to move the transaction forward and doesn’t want the lawsuit holding things up, companies facing these new style say-on-pay lawsuits, facing an imminent shareholder vote, are pressured to reach a quick settlement rather than risking a delay in the shareholder vote.

It is hard to disagree with the sentiment of one defense counsel, quoted in the Reuters article, that these lawsuits are nothing more than a “shakedown for a quick buck.” At least some companies are trying to resist these suits. For example, in a November 13, 2012 ruling, Alameda County (California)Superior Court Judge Wynne Carvill rejected the plaintiff’s injunction request, holding that there is “no risk of any interim, much less irreparable harm” if the say-on-pay vote went forward. A copy of the November 13 order can be found here.

A battleground issue that may be increasingly important, at least for the companies trying to fight these suits, will be venue. The plaintiffs’ firm that is leading the charge on these cases has chosen to file them in state courts outside of Delaware. The defendants usually seek to remove the cases to federal court, but, as discussed in Alison Frankel’s November 30, 2012 post on her On the Case blog (here), the plaintiffs have had some success in having the cases remanded to state court. As the statements of the defense attorneys quoted in Frankel’s blog post show, however, the defense attorneys have not conceded this issue, which they clearly view as a vital battleground in trying to fight these cases.

But while some companies and their attorneys may be fighting these cases, the plaintiffs’ firms pushing these suits seem likely to continue to file them as long as they can make money doing so. As the author of the Pillsbury memo notes, in a quote in the Reuters article, “Where the plaintiffs securities bar sees that they will get a return on their investment, they’re going to keep filing them.”

In my view, both the kinds of say-on-pay lawsuits filed last year and the new style version of the suits that are hot right now are symptoms of a larger phenomenon, which is the attempt by the plaintiffs’ securities bar to diversify their product line. The root cause is that there are fewer traditional securities class action lawsuits these days and the ones that are filed are tougher to prosecute as a result of a string of U.S. Supreme Court decisions over the last several years, as well as the cumulative effect of Congressional reforms. Faced with fewer profit making opportunities in their traditional product line, the plaintiffs’ securities firms have been trying to diversity.

A number of current litigation trends are the result of the plaintiffs’ securities bar’s diversification efforts – not just the various kinds of say-on-pay lawsuits, but also the M&A-related litigation that has ramped up so much recently, as well as the class action opt-out litigation trends I noted in a recent post (here). (Indeed, you could argue that these diversification efforts first started with the options backdating cases, most of which were filed as derivative suits, rather than as securities class action lawsuits). The pressure on the plaintiffs’ firms to diversify will likely continue to lead to more lawyer-driven litigation of these kinds, including not only the varieties of lawsuits I have noted here but also perhaps other kinds of suits that will emerge in the months ahead.

To be sure, it could be argued that these evolving litigation trends are simply a reflection of the fact that we have an entrepreneurial and opportunistic plaintiffs’ bar in this country. An alternative point of view is that in a global economy our domestic companies are put at an enormous competitive disadvantage as a result of the unproductive costs our over-active litigation system imposes on them. Anybody making a list of unproductive costs accruing due to lawyer-driven litigation would have to put the expenses associated with these new wave say-on-pay suits right at the top of the list.

Second H-P Securities Suit Sweeps in a Broader Roster of Defendants: In a post last week, I noted that plaintiffs’ lawyers had quickly jumped on the Autonomy acquisition accounting scandal at H-P and had filed a securities class action lawsuit. As I noted in my post, the first suit filed, at least, named only H-P and certain of its current and former officers as defendants. In particular, I noted that the first complaint did not name as defendant Autonomy or any of its former officers or directors, nor did it name any of H-P’s outside advisors.  However, I also noted that further lawsuit seemed likely, and noted the possibility that additional suits might include additional defendants.

Now further lawsuits have in fact been filed and the latest suits have expanded the roster of defendants. As reflected in plaintiffs’ lawyers November 30, 2012 press release (here), the latest suit to be filed names as defendants not only H-P and certain of its officers, but also H-P directors, Autonomy and Deloitte LLC, H-P’s auditors. The complaint can be found here. The individual defendants named in the complaint include not only H-P's former and current CEOs and its current CFO, as well as two other H-P's chief accounting officers, but also Michael Lynch, the former CEO of Autonomy, and Sushovan Hussain, Autonomy's former CFO. (Speical thanks to a loyal reader for providing a copy of the complaint.)

The H-P/Autonomy debacle continues to attract critical press scrutiny, including a November 30, 2012 New York Times article entitled “H-P’s Autonomy Blunder May be One for the Record Books” (here) in which James B. Stewart writes that H-P’s acquisition of Autonomy arguable ranks as one of the worst deals ever, ranking right up there with the disastrous Time Warner acquisition of AOL. Among other things, Stewart writes:

It’s true that H.P. directors and management can’t be blamed for a fraud that eluded teams of bankers and accountants, if that’s what it turns out to be. But the huge write-down and the disappointing results at Autonomy, combined with other missteps, have contributed to the widespread perception that H.P., once one of the country’s most admired companies, has lost its way.

Second Circuit Affirms Dismissal of Securities Suit Filed Against U.S.-Listed Chinese Company: Over the last several years, plaintiffs have filed dozens of securities suits against U.S.-Listed Chinese companies, alleging accounting misrepresentations as well as undisclosed transactions benefiting insiders. (This litigation phenomenon is detailed and discussed at greater length here.)  Though some of these cases have survived dismissal motions, others have not survived the initial pleading hurdles. On November 29, 2012, the Second Circuit, in a summary order (here), affirmed the dismissal of one of these suits.

On October 26, 2010, Mecox Lane Limited issued over 11 million American Depositary Receipts in an IPO. As discussed here, on December 3, 2010, following company disclosures, investors filed an action against Mecox, certain of its directors and officers, and its offering underwriter, alleging that the Company's gross margins had been adversely impacted by increased costs and expenses which made it impossible for Mecox Lane to achieve the results defendants projected at the time of the IPO. On March 5, 2012, Southern District of New York Judge Robert Sweet granted the defendants’ motion to dismiss. The plaintiff appealed.

In the November 29 summary order affirming the dismissal, a three judge panel of the Second Circuit noted that:

Even taking all of the Complaint’s allegations as true and drawing all reasonable inferences in favor of the Plaintiffs, the statements that they point to as untrue or misleading are neither. The Complaint does not mention undisclosed information, but points to nothing to show that disclosures were required.

More About the U.S.-Listed Chinese Companies: The Mecox Lane case is the second of the recent securities suits involving U.S.-listed Chinese companies to reach the Second Circuit. As discussed here, in August 2012, the Second Circuit revived a securities suit that had been filed against China North Petroleum Holding that had been dismissed by the District Court.

In addition to the revived securities suit, China North Petroleum has other problems as well. As described in its November 30, 2012 litigation release (here), the SEC has filed a civil enforcement action in the Southern District of New York against the company, its CEO and former Chairman, and its founder and former director, as well as other officers and the family members of one of the officers.

The SEC alleges, in connection with the company’s two 2009 stock offerings, that the CEO and the founder, as well as the other officers, “diverted offering proceeds to the personal accounts of corporate insiders and their immediate family members, and also engaged in fraudulent conduct in connection with at least 176 undisclosed transactions between the company and its insiders or their immediate family members, otherwise known as related-party transactions.” The SEC alleges that the transactions totaled approximately $59 million during 2009.

More About Law Firm Management Liability Insurance: As I noted in a prior post (here, second item), unsecured creditors of the bankrupt Dewey LeBoeuf law firm have sought the bankruptcy court’s leave to file an action against three of the law firm’s former managing partners, accusing them of law firm management misconduct and seeking to recover under the law firm’s management liability insurance policy.

As discussed in a November 29, 2012 Am Law Daily article (here), the bankruptcy court has granted the creditors leave to pursue the claims. However, as the article also discusses, the claimants could face barriers attempting to recover under the insurance policy. As the article notes, “the lead insurer connected to the policy … has said such suits may not be covered because Dewey, as the policyholder, is essentially suing itself.” The article does not explain the basis on which the carrier is contending that the claims of the creditors represent the claims of Dewey itself. However, given the stakes involved, it seems likely that these issues will be sorted out as the creditors press their claims.

Special thanks to a loyal reader for sending me a link to the Am Law Daily article.

Deconstructing “Skyfall”: (Spoiler Alert, these comments will give away key plot element of the movie, so don’t read this if you haven’t seen the movie).

1. Can I just say that Bond’s idea of luring Raoul Silva northward to Bond’s childhood home was a really crappy plan? Not only did it directly result in M’s death, but M16 never did recover the stolen list of undercover agents. The entire sequence conclusively proved that Bond is no longer qualified for service, as the M16 tests earlier in the movie showed. M chose to disregard what the tests clearly established, which ultimately cost her her life.

2. Shortly after we were informed that Bond’s childhood home had been sold, the structure was first strafed with automatic gunfire from a helicopter gunship and then blown up. At the real estate closing, it is going to be a disappointing walk-through for the property’s buyers, that’s for sure.

3. In case you were wondering, the poem M said she had learned from her late husband and that she recited (in part) to the Parliamentary committee (just before armed gunmen burst into the Committee room) is “Ulysses” by Alfred, Lord Tennyson. Here is the portion she quoted:

Though much is taken, much abides; and though

We are not now that strength which in the old days

Moved earth and heaven; that which we are, we are,

One equal-temper of heroic hearts,

Made weak by time and fate, but strong in will

To strive, to seek, to find, and not to yield.

4. So we know for sure that Judi Dench will not be in the next Bond movie. But how about Daniel Craig? Most of Skyfall seemed to be a variation on the theme that Bond is getting old and might just be over the hill. And in the scenes where Bond was unshaven, Craig sure was looking pretty scraggly. I am not making any predictions, but don’t be surprised if Craig isn’t there next time Bond is back.   

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This mix of items from around the web may be just the thing after a long weekend of leftover turkey --even though we are well aware that nothing can come close to a heaping helping of Turkey Tetrazzini three days after Thanksgiving. 

Adding up the Likely Legal Costs from H-P’s Autonomy Accounting Scandal: Last week’s news that H-P is taking an accounting charge of $8.8 billion dollars following the company’s discovery of “serious accounting improprieties” at Autonomy, which H-P acquired last year, is likely to generate more than just headlines in the business pages. As the various parties try to sort out responsibility for this debacle, litigation that could take years to resolve seems likely, according to Ohio State Law School Professor Steven Davidoff and Wayne State Law Professor Wayne Henning in their November 21, 2012 post on the New York Times Deal Professor Blog (here).

H-P’s announcement of the accounting issues and related charges included the company’s statement that it had notified the Serious Fraud Office and the SEC of the supposed accounting improprieties H-P had uncovered at Autonomy. But the likely litigation fall out from the company’s disclosures are likely to include not only regulatory investigations and enforcement actions, but also civil litigation, perhaps involving Autonomy’s former executives and even perhaps officials at H-P itself, as well as H-P’s advisors in connection with the Autonomy transaction.

However, all of these likely investigative and litigation initiatives could be complicated by the fact that Autonomy was a U.K company whose shares did not trade in the U.S and by the fact that H-P’s acquisition of Autonomy took place outside of the U.S. It may difficult for prospective claimants to pursue their claims in the U.S. particularly under the U.S. securities laws, as a result of the U.S. Supreme Court’s decision in Morrison v. National Australia Bank.

Despite these potential complications, litigation nonetheless seems likely. The professors conclude that “while the matter will probably involve tens of thousands of hours and millions of dollars spent on investigation and litigation, none of this is likely to restore the $8.8 billion the company lost.” 

Insurance Coverage for Data Breach Claims: One of the growing liability risks that many companies face is the exposure arising from the possibility of a serious breach of the company’s computer systems. The costs associated with a data breach can be enormous, as the companies involved respond to state law notification requirements and possible third-party claims. As the potential costs associated with data breaches mount, a recurring question has been the availability of insurance to protect against these costs.

A November 2012 memorandum from the Kelley, Drye & Warren law firm entitled “Insurance Coverage for Data Breach Claims” (here) takes a look at these recurring insurance coverage questions. The memorandum reviews the considerations affecting the availability for data breach claims under CGL and Property Insurance policies, as well as under specialty insurance policies. The authors conclude that “any time a potential data breach occurs, it is essential for an insured to consider all forms of insurance that it carries and to provide prompt notice to its insurer(s) of any policy that even potentially could apply.”

More About the Plaintiffs’ Lawyers’ Latest Say-on-Pay Litigation Gambit: A recent guest post on this site (here) discussed the plaintiffs’ lawyers latest say-on-paylitigation tactic, which involves a pre-emptive lawsuit filed in advance of the annual say on pay vote that challenges the adequacy of the compensation-related disclosures in the company’s proxy statement.

A November 19, 2012 memorandum from the Pillsbury Winthrop Shaw Pittman law firm entitled “Plaintiff’s Firms Gaining Steam from New Wave of Say-on-Pay Suits?” (here) describes the plaintiffs’ lawyers “new strategy” of trying to “hold companies liable: suits to enjoin the shareholder vote because the proxy statement fails to provide adequate disclosure concerning executive compensation proposals.” According to the memo, plaintiffs’ lawyers have filed at least 18 of these lawsuits in recent months. The memo notes that these new cases “have met with some success – with two court orders enjoining shareholder meetings and five settlements prior to companies’ annual meetings.”

Accompanying the memorandum are two helpful and interesting tables, detailing the outcomes of the various say on pay related lawsuits during the period 2010 through 2012, as well as the disposition of the latest injunctive relief actions that have been filed more recently.

Leftovers Again: Did you know that Turkey Tetrazzini is named in honor of the famous early 20^th century Italian opera star, Luisa Tetrazzini? Neither did we. In honor of the patron saint of leftover Thanksgiving turkey, here is an audio tribute to Signora Tetrazzini, La regina del staccato:

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I am pleased to publish below a guest post from Bruce Vanyo, Richard Zelichov and Christina Costley of the Katten Muchin Rosenman law firm These three attorneys’ post addresses a new approach that plaintiffs’ lawyers are taking to “say on pay” challenges – that is, a preemptive attack in the form of a lawsuit seeking to enjoin the vote based on alleged misrepresentations in the proxy statement

I would like to thank Bruce, Richard and Christina for their willingness to publish their article on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is their guest post:

Nobody can accuse the plaintiff’s shareholder bar for suffering from a lack of creativity or being easily dissuaded from purporting to represent shareholders. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) in July 2010. Section 951 of Dodd-Frank requires a stockholder advisory vote on executive compensation (a “say-on-pay” vote). The Dodd-Frank Act, however, “specifically provides” that the say-on-pay vote (1) “shall not be binding on the issuer or the board of directors;” and (2) does not “create or imply any change to the fiduciary duties of the board members.” 15 U.S.C. § 78n-1(c)). Nonetheless, the plaintiff’s bar began filing stockholder derivative lawsuits alleging breach of fiduciary duty after any negative say-on-pay vote. The vast majority of these cases have been dismissed because the plaintiff failed to make demand on the company’s board of directors before bringing suit and such See Gordon v. Goodyear, 2012 WL 2885695, *10 (N.D. Ill. July 13, 2012) (collecting cases); see also Swanson v. Weil, 2012 WL 4442795 (D. Colo. Sept. 26, 2012); Haberland v. Bulkeley, No. 5:11-CV-463-D (E.D.N.C. Sept. 26, 2012).

As a result, the plaintiff’s bar has resorted to a new attack based on a tactic developed from the merger cases: suing companies before the say-on-pay vote to enjoin the vote based on alleged misleading disclosures. In the last month or so, Plaintiffs’ shareholder lawyers have issued over 30 notices of investigation concerning such suits, and over the course of the last year, they have sued over 20 companies. The complaints assert two theories (either alone or in combination). They assert that the proxy statement fails to disclose material facts necessary for the shareholders to cast an informed vote on executive compensation and/or they assert that the proxy fails to disclose material facts necessary for the shareholders to determine whether to increase the number of shares available to be granted to executives and employees as incentive compensation under company plans providing for such grants. The two theories are slightly different because the shareholder vote on executive compensation is purely advisory and exists solely because of the Dodd-Frank Act while the vote on increasing the number of shares available under a stock plan is required either by state law or the company’s articles of incorporation, bylaws or listing standards of the exchange on which the company trades.

While the trend has picked up recently, the first such case was filed on January 13, 2012 against AmDocs Ltd. in New York County Supreme Court. Plaintiff sought injunctive relief based on a proposal to increase the number of shares available under an equity incentive plan. Plaintiff did not challenge the proposal, but rather, the adequacy of the disclosures in the proxy statement regarding the proposal. The alleged omissions – the equity value of the shares; the timing of the issuance; the “dilutive impact” that the shares might have; the reason for issuing more shares when the existing incentive plan still had shares available; and the reason “why” the company was granting to shares to executives at an increasing rate, though management had not improved the Company’s performance – were not material, and basically amounted to asking “why” in connection with a shareholder vote plaintiff opposed. Defendants (represented by Katten Muchin Rosenman LLP) removed to the Southern District of New York, moved to dismiss, and opposed plaintiff’s request for a preliminary injunction. Plaintiff then voluntarily dismissed the claim.

Despite their initial loss in the case against AmDocs, plaintiffs have surprisingly had success in some of these cases. Specifically, in a case concerning Brocade Communications Systems, Inc., a plaintiff sought injunctive relief based on alleged omissions regarding a proposal to increase the number of shares in an equity options plan. Plaintiff argued the proxy: (1) omitted internal projections regarding future stock grants/share repurchases and their dilutive impact; (2) misled shareholders by claiming a repurchase plan would reduce potential dilution; and (3) failed to include a “fair summary” of the board’s analysis, including its equity utilization compared to peer companies. On April 10, 2012, the court enjoined the annual vote and required Brocade to disclose its internal projections regarding future stock grants. Similarly, WebMd, H&R Block and NeoStem settled cases filed against them by agreeing to additional disclosures requested by the plaintiff.

Plaintiff’s streak of success, however, recently came to halt in another case defended by Katten Muchin Rosenman LLP. On October 2, 2012, a plaintiff filed a complaint in DuPage County, Illinois seeking to enjoin a say on pay vote alleging, among other things, that the proxy statement omitted material information regarding peer companies and fees paid to compensation consultant. The case was removed to the Northern District of Illinois and the plaintiff set the hearing on the TRO nearly immediately. With just four business days in which to oppose, we filed a comprehensive brief opposing Plaintiff’s motion, and distinguishing the other cases in which the plaintiff had had success. At a hearing on October 9, 2012, the District Court denied Plaintiff’s Motion for a temporary restraining order.

In short, the plaintiffs’ shareholders bar continues to explore options to take advantage of the Dodd-Frank Act’s say on pay provisions. They have had some success and companies must be vigilant to defend their practices as compliant with all applicable law and not subject to injunction.

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In what is by far the largest settlement of a credit crisis-related securities class action lawsuit, Bank of America has agreed to pay $2.43 billion to settle the suit filed against the company and certain of its directors and officers in connection with the bank’s financial crisis-driven acquisition of Merrill Lynch. The settlement is subject to court approval. Bank of America’s September 28, 2012 press release announcing the settlement can be found here.

The settlement is not only the eighth largest securities class action lawsuit settlement ever (refer here for the Stanford Law School Class Action Clearinghouse’s list of the top ten largest securities suit settlements), but according a September 28, 2012 press release from the Ohio Attorney General (whose office represented several Ohio pension funds that were among the lead plaintiffs in the case) it is the fourth largest settlement funded by a single defendant for violations of the federal securities laws, and it is largest securities class settlement ever resolving a Section 14(a) case (alleging misrepresentations in connection with the a proxy solicitation). According to the Ohio AG, the settlement is also the largest securities class action settlement where there were no criminal charges against company executives.

The three largest single-defendant securities class action settlements are Tyco’s $2.975 billion settlement in 2007; Cendant’s 1998 settlement ($2.83 billion); and Citigroup’s $2.65 billion contribution to the WorldCom case settlement. The total amount paid in settlement in each of these cases was larger than these amounts due to the contribution s of other defendants.

As discussed here, the BofA Merrill Lynch merger case had survived two rounds of dismissal motions, and according to press reports was scheduled to go to trial on October 22, 2012. In her On the Case blog (here), Alison Frankel has an interesting account of how the settlement came about and the various factors (including the looming trail date) that “forced” BofA to settle the case. Susan Beck has an interesting September 28, 20912 article on the Am Law Litigation Daily(here) in which she questions BofA’s decision to rely on the Wachtel Lipton firm (which had advised the bank in connection with the Merrill Lynch acquisition) for its defense in the securities suit. 

The case arises out of BofA’s agreement, reached in mid-September 2008, at the height of the global financial crisis, to acquire Merrill Lynch. In October and November 2008, while shareholder approval of the transaction was pending, Merrill suffered losses of over $15 billion and also took a $2 billion goodwill impairment charge. The Complaint alleges that BofA’s senior officials were aware of these losses as they occurred. The Complaint alleges that the losses were so significant that BofA management discussed terminating the transaction, prior to the December 5, 2008 shareholder vote on the merger, in which BofA shareholders approved the merger.

On December 17, 2008, BofA Chairman and CEO Kenneth Lewis called Treasury Secretary Henry Paulson to advise him that BofA was "strongly considering" invoking the “material adverse change” clause in the merger agreement, in order to terminate the deal prior to its scheduled January 1, 2009 close date.  At Paulson’s invitation, Lewis flew to Washington for a face-to-face meeting, at which Paulson and Federal Reserve Board Chair Ben Bernanke urged Lewis not to invoke the MAC clause.

In subsequent conversations, Lewis again advised the government officials that BofA intended to invoke the MAC clause. According to the plaintiffs’ allegations, BofA’s board voted on December 21, 2008 to invoke the MAC clause, but on the following day, the Board voted to approve the merger, apparently in part based on Lewis’s statement that he had received verbal assurances from Paulson that BofA would received a capital infusion and a guarantee against losses from risky assets if the merger concluded.

On January 16, 2010, BofA disclosed the fourth quarter losses of both BofA and Merrill and also revealed the federal funding package, which included $20 billion in capital and protection against further losses on $118 billion in assets. In following days, news reports revealed that in the days prior to the deal’s close, Merrill employees had been paid massive bonuses. 

In the two trading days following the January 16 disclosure, BofA’s market capitalization dropped over $20 billion, and shareholder litigation ensued. The plaintiffs alleged that the defendants misstated and concealed matters related to the Merrill bonuses, the losses that accrued in the Fourth Quarter of 2008 after the merger was announced, and the pressure to consummate the deal from government officials. After the securities and derivative lawsuits were consolidated, the defendants moved to dismiss.

In a lengthy August 27, 2010 opinion (about which refer here), Southern District of New York  Judge Kevin Castel denied in part and granted in part the defendants’ motions to dismiss. First, he denied the defendants’ dismissal motions with regard to the plaintiffs’ allegations concerning the disclosures of the Merrill bonuses. Next, he concluded that while the plaintiffs had also alleged that there were materially misleading misrepresentations or omissions about Merrill Lynch’s deteriorating 4Q08 financial condition and about the promised government financial inducements, the plaintiffs had not adequately alleged scienter as to these topics, and so he denied the defendants’ motion to dismiss as to these allegations.

Thereafter, the plaintiffs filed an amended complaint.The defendants renewed their motions to dismiss. . 

In a July 29, 2011ruling (about which refer here), Judge Castel denied the defendant’s  renewed dismissal motion as to the allegations surrounding Merrill’s declining 4Q08 financial condition, but granted the dismissal motion as to the allegations about the government bailout. He held that the plaintiffs’ amended complaint adequately alleged scienter as to the Merrill’s financial condition in the fourth quarter of 2008, but did not adequately allege a duty to update prior disclosures as to the financial support the government officials offered in order to facilitate the deal.

According to BofA’s September 28 press release about the settlement, the settlement is to be funded “by a combination of Bank of America’s existing litigation funding reserves and incremental litigation expense to be recorded in the third quarter of 2012.” The company estimates that its total third quarter litigation expense (including the incremental cost of the settlement) will be $1.6 billion. The company’s press release does not indicate that any portion of the settlement will be funded by insurance.

The settlement resolves not only the claims against the company but also those against the individual defendants as well. The individuals apparently will be making no personal contribution toward the settlement. According to Alison Frankel’s blog post, the plaintiffs attorneys intend to seek attorneys’ fees of $150 million

In addition to the monetary amount, BofA also agreed as part of the settlement to certain corporate governance reforms. Among other things, the bank agreed to institute or to continue certain corporate governance enhancements through January 1, 2015, “including those relating to majority voting in director elections, annual disclosure of noncompliance with stock ownership guidelines, policies for a board committee regarding future acquisitions, the independence of the board’s compensation committee and its compensation consultants, and conducting an annual ‘say-on-pay’ vote by shareholders.”

As I noted at the outset, this settlement eclipses by far any other settlement of a subprime meltdown or credit crisis-related securities class action lawsuit, far exceeding what had until now had been the largest of the financial crisis lawsuits, the $627 Wells Fargo/Wachoia Bondholders securities suit settlement (about which refer here).

Indeed, the $2.43 billion BofA settlement amounts to nearly half of the aggregate amount of all of the other credit crisis securities suit settlements. The 54 prior credit crisis related settlements together totaled about $5.5 billion. With the addition of the latest settlement, the total of all of the credit crisis securities suit settlements is now about $7.93 billion.

It is striking what a significant portion of the $7.93 billion total that BofA has had to fund due to its credit crisis era acquisitions of Merrill Lynch and Countrywide. As noted on the top ten list below, there have been a number of credit crisis securities class action lawsuit settlements involving these two companies. The total amount that BofA has had to pay in settling these cases (including the latest settlement) is just under $4 billion, representing slightly over half of all amounts that have been paid in settlement of credit crisis cases.

The ten largest credit crisis securities suits settlements are as follows:

Though the BofA/Merrill Lynch merger securities suit was one of the highest  profile of the securities lawsuits from the financial crisis, there are other high profile cases yet to be resolved, including the one involving AIG and the Citigroup bondholders suit. The resolution of the cases filed as part of the credit crisis-related litigation wave still has much further to go.

I have updated my running tally of the subprime and credit crisis case resolutions to reflect this latest settlement. The tally can be accessed here.

Two Subprime-Related Securities Suits Dismissed: In addition to the BofA settlement, there were other developments last week in connection with high profile subprime and credit crisis-related securities suits. In separate decisions, the subprime related securities suits involving Freddie Mac and UBS were dismissed.

First, on September 24, 2012, Southern District of New York Judge John F. Keenan dismissed with prejudice the subprime-related securities class action lawsuit that had been filed against the Federal Home Loan Mortgage Corporation (Freddie Mac) and certain of its directors and officers. A copy of Judge Keenan’s order can be found here. As discussed here, Judge Keenan had previously granted the defendants’ motion to dismiss the case, but without prejudice. The plaintiffs filed an amended complaint and the defendants renewed their dismissal motions.

In a sharply worded opinion, Judge Keenan granted the defendants’ renewed motion to dismiss, saying, among other things, that “the bevy of truthful disclosures that Freddie Mac made throughout the Class Period, covering everything from detailed credit characteristics to extensive risk management also negates the inference of scienter. It defies logic to conclude that executives who are seeking to perpetrate fraudulent information upon the market would make such fulsome disclosure.” A September 27, 2012 Bloomberg article about the Freddie Mac dismissal can be found here.

Second, in a September 28, 2012 order (here), Southern District of New York Judge Richard Sullivan granted the defendants’ motion to dismiss in the subprime-related securities suit that had been filed against UBS and certain of its directors and officers. Among other things, Judge Sullivan said that “Although UBS made a series of bad bets with disastrous consequences for the company and its shareholders, those consequences alone are insufficient to establish scienter and support a claim for securities fraud.”

In granting the motion as to the individual defendants, Judge Sullivan concluded that the plaintiffs had failed to allege sufficiently specific misrepresentations as to each individual defendant, saying (in reliance on the Supreme Court’s opinion in the Janus Capital Group case) “"While it is true that Janus might not alter the well-established rule that a corporation can act only through its employees and agents, it is nonetheless also true that a theory of liability premised on treating corporate insiders as a group cannot survive a plain reading of the Janus decision.”

I have added these two dismissals to my running tally of subprime and credit crisis-related securities suits dismissal motion rulings, which can be accessed here.

Say-on-Pay Lawsuit Dismissed on the Merits: Though in many instances litigation has followed in the wake of a negative say-on-pay vote, the say-on-pay lawsuits generally have not fared particularly well, as I noted in a recent post (here). In general, however, these cases have generally faltered due to procedural shortcomings, such as a failure to make a pre-suit demand on the board of directors, rather than on the actual merits of the case. However a recent decision in a say on pay lawsuit out of Eastern District of North Carolina granted the defendants motion dismiss based on the merits.

On May 3, 2011, fifty two percent of Dex One shareholders rejected the company’s executive compensation plan. Afterwards, the board investigated shareholder concerns and ultimately decided not to amend its 2010 executive compensation plan. In September 2011, a Dex One shareholder initiated a derivative suit against Dex One, as nominal defendant, and against certain directors and executive officers of Dex One. The plaintiff alleged, among other things, that the defendants had misled the company’s shareholders about the executive compensation plan in the 2011 proxy statements and had breached their fiduciary duties in failing to amend or alter the 2010 executive compensation plan. The defendants moved to dismiss.

In a September 26, 2012 order (here), Eastern District of North Carolina Judge James C. Dever III granted the defendants’ motion to dismiss, concluding among other things that the 2011 proxy statement “did not contain false or misleading information.” Judge Dever also rejected the plaintiff’s claim that the defendants had breached their fiduciary duties by failing to alter or amend the executive compensation plan.

Judge Dever’s ruling in the Dex One case is very fact specific, and so it may be of limited applicability in other say-on-pay cases. It is, however, consistent with the outcome of many other say-on-pay cases, most of which have resulted in dismissals. But though the plaintiffs have fared poorly in these cases, that does not necessarily mean that they will stop being filed. In pursuing these cases, the plaintiffs are not motivated so much by a desire to try to secure any type of monetary recovery so much as they are trying to use the litigation as another means to try to pressure the board on executive compensation issues. Given the near certainty that disputes regarding executive compensation will continue to arise, it seems likely that we will continue to see these kinds of say-on-pay lawsuits, even though plaintiffs generally have not been very successful in these cases.

Special thanks to Alan Parry of the Smith Anderson law firm for sending me a copy of Judge Dever’s Order. The Smith Anderson represented the defendants in the Dex One say-on-pay lawsuit.

The Week Ahead: During the upcoming week, The D&O Diary will be traveling overseas on business so there may be some disruption in the publication schedule for the next few days. The publication schedule will return to "normal" after October 8.

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Among the many litigation threats companies face, a couple of specific kinds of cases have recently emerged: the civil action following on in the wake of an FCPA investigation or enforcement action, and the shareholder suit following after a negative “say on pay” vote. Many companies involved in an FCPA investigation or experiencing a negative say on pay vote have been hit with these kinds of suits However, as discussed below, more recently these cases appear to be failing to get past the preliminary motions stage.

FCPA Follow-On Civil Suit Dismissals

There is no private right of action under the Foreign Corrupt Practices Act. However, as I have noted previously on this blog, companies announcing an FCPA investigation or enforcement action often are hit with follow-on civil actions, in which the claimants typically allege that the company’s directors breached their fiduciary duties by failing to ensure that the company had adequate internal controls or compliance programs to have prevented the improper payments.

In at least a couple of recent instances, lawsuits involving these types of allegations have failed to get past the preliminary dismissal motions. The most example of this involved the shareholders’ derivative suit filed in the District of Massachusetts against Smith & Wesson, as nominal defendant, and members of its board of directors. The complaint followed after the indictment on FCPA allegations of the company’s former director of international sales.  (The indictment was later dismissed.) The claimants essentially alleged that the company’s directors breached their duty of care by failing to have effective FCPA controls and oversight. The claimants did not make a pre-suit demand on the company’s board, alleging instead that the demand would have been futile. The defendants moved to dismiss the complaint on the grounds that the claimants had failed to establish demand futility.

In a July 25, 2012 order (here), District of Massachusetts Judge Michael A. Ponsor granted the defendants’ motion to dismiss. Judge Ponsor found two reasons for concluding that the plaintiffs had failed to establish demand futility. The first is that a previous decision in a prior, unrelated state court derivative suit (involving allegations that the company had misrepresented its financial condition), the court had concluded that demand was not excused in that prior suit because there was a disinterested and independent board majority that could have considered the pre-suit demand. Applying principles of issue preclusion, Judge Ponsor concluded that the prior court’s conclusion about the independence of the board majority was determinative of the issue in this case.

Judge Ponsor did go on to note that even if there had been no prior determination of the issue, the plaintiffs in this case had failed to present the requisite particularized allegations to establish demand futility. He noted that “nothing offered in the complaint comes close to pushing the case” over the “difficult threshold” to establish that demand would be futile, adding that “the complaint is flatly devoid of any adequate justification for failing to make the required pre-suit demand.”

The decision in the Smith & Wesson case follows shortly after a similar decision in a case in the Eastern District of Louisiana involving Tidewater, Inc. In November 2011, and in settlement of FCPA allegations involving alleged improper payments in Azerbaijan and Nigeria, the company agreed to pay the SEC $8.1 million in disgorgement and pre-judgment interesting, and also agreed to pay the U.S. Department of Justice a $7.35 million penalty as part of a Deferred Prosecution Agreement.

A Tidewater shareholder filed a shareholder derivative action against Tidewater, as nominal defendant, and against its board, alleging that the directors had breached their fiduciary duty by disregarding the payment of bribes and by failing to ensure that the company had adequate internal controls to ascertain FCPA compliance. The defendants moved to dismiss on the grounds that the plaintiff had failed to make pre-suit demand on the board and that the plaintiff had not pled sufficient facts to establish demand futility.

In a July 2, 2012 order (here), Eastern District of Louisiana Judge Jane Triche-Milazzo granted the defendants’ motion to dismiss, finding that the “even taking all of plaintiff’s allegations as truth, he has failed to plead with particularity that demand on the board would have been futile.” However, Judge Triche-Milazzo did grant the plaintiffs’ leave to file a motion to amend their complaint.

In addition to these cases involving the pre-suit demand requirements, at a recent hearing in the Delaware Chancery Court involving civil litigation arising out of the recent Wal-Mart bribery scandal, Chancellor Leo Strine chastised the prospective lead plaintiffs for rushing to file their suits without first making a books are records request as allowed under the Delaware statutes.

As discussed in Lance Duroni’s July 16, 2012 article on Law 360 (here, registration required) about the Wal-Mart hearing, the purpose of the hearing was to determine which of the competing claimants would be named as lead plaintiff in the Delaware derivative litigation seeking to hold certain Wal-Mart directors and officers liable in connection with the company’s alleged improper payments in Mexico. Chancellor Strine rejected motions from both erstwhile lead plaintiffs, stating, according to the article, that “more energy has been spent by the dueling plaintiffs on who gets to be lead plaintiff and counsel than was spent investigating and writing these complaints.” At least one other claimant had in fact made a books and records request, and Strine said he would defer choosing a lead plaintiff until the company had responded to the request and the parties had beefed up their complaints. Alison Frankel also has a July 17, 2012 article on her On the Case blog (here) discussing Chancellor Strine’s ruling in the Wal-Mart case.

If nothing else, these cases show that claimants eager to pursue shareholder derivative suits following on FCPA investigations cannot dispense with the procedural prerequisites. The requirement to conduct pre-suit due diligence and then to make the requisite pre-suit demand are substantial requirements with which a failure to comply can be prohibitive. At a minimum, the requirement for pre-suit due diligence raises the cost for prospective litigants, and the enforcement of the requirement for a pre-suit demand could represent an insurmountable barrier in many cases.

These procedural requirements are of course not new. If however prospective litigants recognize that they are not going to be able to bypass these requirements, at least some prospective litigants may be deterred from filing their suits. If that were to happen, there might be fewer of these FCPA enforcement follow-on civil suits filed I n the first place.

Say on Pay Suits Fare Poorly

 During 2011, the first year in which companies held advisory shareholder votes on executive compensation as required by the Dodd-Frank Act, many of the companies experiencing negative shareholder votes subsequently were hit with shareholder suits, often filed in reliance of the negative “say on pay” vote (as I discussed in posts at the time, here and here).

Early on, these cases looked like they may have legs, particularly after a judge in the Southern District of Ohio denied the motion to dismiss in the shareholder suit filed against Cincinnati Bell and certain of its directors and officers after the company experienced a negative say on pay vote. As discussed here, Southern District of Ohio  Judge Timothy Black held in a September 2011 opinion that, where plaintiffs alleged that the company’s directors breached their fiduciary duty when they approved an executive pay package after a negative say on pay vote, “the plaintiff’s allegations create a reasonable doubt that the challenged transaction is the result of valid business judgment, and accordingly, the directors possess a disqualifying interest sufficient to render pre-suit demand futile and hence unnecessary.”

However, as discussed in a July 10, 2012 memo from the Vinson & Elkins law firm entitled “Say-on-Pay Lawsuits Losing Steam” (here), many courts considering these same issues after the Cincinnati Bell decision have reached a contrary conclusion, and have rejected the argument that a negative say on pay vote rebuts the business judgment rule or constitutes a disqualifying interest. The subsequent cases “indicate that Cincinnati Bell’s approach is quickly falling in to disfavor,” noting that “courts have repeatedly disavowed this approach.”

The article notes that these more recent decisions do not necessarily mean that “companies will cease to be sued for negative say-on-pay results.” However, the decisions “do suggest that derivative suits in the wake of an adverse say-on-pay vote may soon be less common than before.”

Both of these types of lawsuits – the follow-on FCPA-related civil action and the shareholder suit following a negative say-on-pay vote – seemed to attract a great deal of interest from certain parts of the plaintiffs’ bar. However, recent dismissal motion outcomes in these cases are beginning to suggest that these cases are not faring all that well in the courts. Even if these recent dismissal motion rulings do not discourage the filing of these cases altogether, it may deter some suits from being filed. In many instances these kinds of suits may not represent the opportunity that plaintiffs’ lawyers may have thought earlier on.

To be sure, many of the say-on-pay lawsuits may not have been about money. In some instances, the lawsuits may simply represent one more way that activist shareholders are trying to pressure corporate boards about executive compensation issues. To the extent that the lawsuits are simply one more tactical approach in a larger strategic battle about executive compensation, the adverse dismissal motion rulings may represent less of a deterrent. 

Community Banks and D&O Insurance: If you have not yet seen it, you may want to take a look at the June 2012 paper that Advisen has posted on its website entitled “Community Bank Lending: Practices and Failures, and the Role of Directors and Officers (D&O) Insurance” (here). The paper provides an interesting top level overview of the risks and exposures facing community banks and their directors and officers – particularly the former directors and officers of failed banks. A more current update of the statistical information in the paper can be found in my recent post on FDIC failed bank lawsuits here.

This is Going to Really Bug You: In his article “The Mosquito Solution” in the July 16, 2012 issue of The New Yorker (here), Michael Spector writes, with respect to mosquitos, that “there has never been a more effective killing machine” adding that “researchers estimate that mosquitos have been responsible for half of the deaths in human history.”

Malaria accounts for much of the mortality, but mosquitos “also transmit scores of other potentially fatal infections, including yellow fever, dengue fever, chikungunya, lymphatic filariasis, Rift Valley fever, West Nile fever and several types of encephalitis.” Mosquitos “pose a greater risk to a larger number of people than ever before.”

Spector’s article describes an experimental approach to try to combat mosquitos, by releasing genetically altered male mosquitos into the wild. The modified males mate but their progeny are genetically programed to die quickly after hatching. This approach has shown early promise by reducing the mosquito populations in controlled release areas. However, the proposal to release genetically altered bugs into the wild has proved to be controversial, as described in the article.

This is an interesting and important article.

Three Thoughts About the London Olympics:

1. Her Royal Majesty Queen Elizabeth II as a Bond  girl. Sheer brilliance. The rest of the opening ceremony looked a lot like chaos dressed up in period costumes.

2. After waiting four years to see Olympic sports competition, and after an entire day of Olympic competition in which numerous medals were awarded, we turn on our TV in prime time, and what does NBC choose to show us? A preliminary round of Beach Volleyball. And Ryan Seacrest. Oh. My. God.   

3. Ryan Lochte wins Olympic gold in the 400 meter individual medley. Switch to a commercial break with three ads featuring Ryan Lochte. And to think that Jim Thorpe once had to forfeit his Olympic medals for violating the principles of amateurism because he had played semi-pro baseball to earn a living.

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FDIC Files First Failed Bank Lawsuit in Florida: Even though Florida has had the second highest number of bank failures of any of the states during the current bank failure wave (trailing only Georgia), the FDIC had not filed any failed bank lawsuit in Florida—until now. On March 13, 2012, the FDIC filed an action in the Middle District of Florida in the agency’s capacity as receiver of the failed Florida Community Bank of Immokalee, Florida, against the failed bank’s former CEO and six of the failed bank’s former directors. A copy of the FDIC’s complaint can be found here.

The bank failed on January 29, 2010. In its complaint, the FDIC alleges that the bank’s collapse was caused by “grossly negligent loan underwriting and loan administration, resulting in excessive and dangerous concentrations” of commercial real estate loans and of acquisition and development loans. The FDIC seeks to recover on losses of in excess of $62 million dollars in connection with six specific loans. The FDIC asserts state law claims of negligence against the former directors and against the former CEO, as well as claims of gross negligence under FIRREA against all of the individual defendants.

The FDIC’s lawsuit in the Florida Community Bank case is the 26^th that the FDIC has filed in connection with the current bank failure wave. It is also the eighth that the FDIC has filed so far in 2012. Though the FDIC has now filed 26 lawsuits, according to the FDIC’s website and as of February 14, 2012, the FDIC has authorized suits in connection with 49 failed institutions against 427 individuals for D&O liability with damage claims of at least $7.8 billion. Thus, there are at least 23 additional lawsuits approved and in the pipeline. And it seems like that when the FDIC next updates the authorized lawsuit figures on its website, there will be yet other lawsuits authorized. As I have previously discussed, it seems likely that we will see many of these forthcoming lawsuits during 2012.

CIT Group Subprime-Related Suit Settles for $75 Million: In the latest of the subprime and credit crisis-related securities class action lawsuits to settle, on March 13, 2012, the parties to the CIT Group subprime suit filed with the court a stipulation of settlement reflecting that the case had been settled for $75 million. A copy of the parties’ settlement stipulation can be found here.

As reflected here, the plaintiffs first filed suit against CIT Group and certain of its directors and officers in July 2008. The plaintiffs alleged that CIT's public financial statements failed to account for tens of millions of dollars in loans to Silver State Helicopter, which loans were highly unlikely to be repaid and should have been written off. The plaintiffs also alleged that the company had misrepresented the performance of its subprime home lending and student loan portfolios.

In November 2009, CIT Group itself filed for bankruptcy and the company was dismissed out of the lawsuit. As discussed here (scroll down), on June 10, 2010, Southern District of New York Judge Barbara Jones denied the remaining defendants’ motion to dismiss. Following the dismissal motion ruling, the parties entered mediation that ultimately resulted in the settlement. The settlement is subject to court approval. (CIT Group rather conspicuously emerged from bankruptcy after only six weeks.)

The CIT Group settlement is noteworthy if for no other reason than that it came about in 2012. Even though there are many subprime and credit crisis-related securities cases pending, including many that have already passed the motion to dismiss stage, the pace of settlement of these cases seems to have slowed to a crawl (indeed, in its recently released annual study of securities class action lawsuit settlements, refer here, Cornerstone Research specifically noted the slow settlement pace of the credit crisis suits as one reason why both the number and aggregate monetary value of securities suit settlements was down significantly in 2011).

Readers of this blog may be interested to know whether or to what extent D&O insurance contributed toward the CIT Group settlement. The settlement stipulation is nonspecific, but it does suggest that insurance is playing a role in the settlement of this case. For example, in describing the settlement amount, the stipulation provides that within a specified time of the court’s preliminary approval of the settlement, the defendants or CIT shall pay or “cause their insurers” to pay into escrow the $75 million settlement amount. In his March 14, 2012 Am Law Litigation Daily article about the settlement (here), Victor Li reports that “all 13 current and former CIT executives named as defendants were indemnified by CIT and covered by D&O insurance.”

I have in any event added the CIT Group settlement to my running tally of subprime and credit crisis-related lawsuit settlements, which can be accessed here.

SEC Files Enforcement Action against Three Former Thornburg Mortgage Executives: In the latest civil subprime and credit crisis-related enforcement action, the SEC on March 13, 2012 filed a civil enforcement action in the District of New Mexico against three former executives of Thornburg Mortgage, including the company’s former CEO, Larry Goldstone. Prior to its 2008 collapse, Thornburg was the second largest mortgage originator in the United States. The SEC’s complaint can be found here. The SEC’s March 13, 2012 press release about the case can be found here.

The SEC alleges that the three defendants schemed to fraudulently overstate the company’s income by more than $400 million and falsely record a profit rather than an actual loss for the fourth quarter in its 2007 annual report. The complaint alleges that in the days before the company filed its 2007 10-K, the company was facing a severe liquidity crisis due to the company’s receipt of numerous margin calls totaling more than $300 million. The complaint alleges that the defendants withheld information about the margin calls from investors and even from the company’s own auditors. However, two hours after the 10-K filing, the company received additional margin calls that it was unable to meet. The company was forced to disclose these developments and soon thereafter the company disclosed that it would be filing an amended annual report. By the time the company filed its amended 10-K, its share price had collapsed. The company never recovered and ultimately filed for bankruptcy.

The March 13, 2012 statement of two of the individual defendants regarding the SEC’s enforcement action can be found here.

Neither the SEC’s press release nor complaint explains why the complaint is only being filed now, more than four years after many of the events described in the complaint. The SEC has faced some criticism for allegedly failing to act aggressively enough in the wake of the global financial crisis. Perhaps in recognition of these criticisms, the SEC itself emphasizes in its press release that with the Thornburg Mortgage enforcement action SEC has now filed financial crisis related enforcement actions against 98 individuals and entities.

The press release also links to a page on the SEC’s website, entitled “SEC Enforcement Actions: Addressing Misconduct That Led to or Arose from the Financial Crisis.” The website page makes for interesting reading, but it is hard to shake the impression that it is a relatively short list of items, in light of the magnitude of the financial crisis and in light of the over 230 subprime and credit crisis related securities class action lawsuits that investors have filed. Given the long lag between the events involved and the filing of the Thornburg Mortgage enforcement action, it may be that there are more cases that are still in the pipeline, perhaps many, relating to the financial crisis.

Thornburg Mortgage and certain of its directors and officers were also the subject of a separate investor lawsuit, although as discussed in detail here, the first of the investor lawsuits was filed in August 2007, well before the events described in the SEC’s enforcement action. As discussed here, in January 2010, District of New Mexico James Browning granted the defendants’ motions to dismiss large parts of the investors’ lawsuit, although parts of the case survived, and perhaps critically, the investors’ claims against Goldstone, the former CEO, largely survived. In February 2012, the parties to the investor suit advised the court that the plaintifs had reached a settlement with 13 individual defendants, including Goldstone. The parties hope to file their settlement documents with the court in April.

As Alison Frankel lnotes in her March 14, 2012 Am Law Litigation Daily article about the settlement (here), once again the SEC "once again lags the private bar." .(Hat top to Frankel for the link to the letter in which the parties to the securities suit advised the court of the settlement.)

A March 13, 2012 Huffington Post article discussing the SEC’s Thornburg Mortgage enforcement action can be found here.

Securities Suit Against U.S.-Listed Chinese Company Survives Dismissal Motion: In a recent post (here), I raised the question of how far the plaintiffs are really going to be able to go in the wave of securities class action lawsuits that have been filed against U.S.-listed Chinese companies. While it still remains to be seen how far these cases ultimately will go, at least one of these cases filed in 2011 has survived the initial dismissal motion.

As discussed here, in April 2011, the plaintiffs first filed their action in the Central District of California against ZST Digital Networks and certain of its directors and officers. The plaintiffs alleged the in 2008, the company reported to the SEC revenues of over $50 million and over $100 million in 2009, but reported to the Chinese governmental agency the State Administration of Industry and Commerce (SAIC) revenues of only a very small fraction of those amounts. The company’s 2010 10-K acknowledged the discrepancy between the figures and stated that the company’s reports to the SAIC were not in compliance with applicable regulations.

The defendants moved to dismiss the action on the grounds that the complaint failed to meet threshold pleading requirements. Among other things, the defendants argued that there was no particularized allegation that it was the SEC filings and not the SAIC filings that were untrue.

In a February 14, 2012 order (here) Judge Gary Allen Feess granted in part and denied in part the defendants’ motion to dismiss. In responding to the defendants’ argument that the plaintiffs have insufficiently pled which of the company’s filings were untrue, Judge Feess noted that the two filed reports “differ by a factor of over two thousand,” and the $6 million profit reported in the SEC filing contrasts particularly sharply with the loss reported in China. The Court said the defendants’ preferred explanation “merely dances around the issue” without explaining how the company came to report such widely different figures.

The court’s rejection of the defendants’ argument that the plaintiffs’ had insufficiently alleged which of the two filings was untrue stands in contrast to the November 2011 conclusion that a different Central District of California Judge reached in the China Century Dragon Media case (about which refer here). In that prior ruling, the court found that the plaintiffs had not sufficiently alleged, in connection with an alleged discrepancy in regulatory filings, that the SEC filings were untrue. The court in that prior case had allowed the plaintiffs leave to replead, however.

Judge Feess did dismiss certain other aspects of the plaintiffs’ case without prejudice. But his ruling that the discrepancy between the SEC filings and the SAIC filings was sufficient to overcome the initial pleading hurdles could be relevant in a number of the other pending cases involving U.S.-listed Chinese companies. Whether or not the plaintiffs ultimately succeed with many of these cases remains to be seen. But getting over the initial pleading threshold is an important first step.

A March 13, 2012 case study of the opinion in the ZST Digital Networks case written by Stephen Brodsky of the Bernstein LItowitz firm can be found here (registration required).

Four Say-on-Pay Lawsuits Are Dismissed in Quick Succession: In a recent post (here), I reported on comments from some observers that investors unhappy with companies’ responses to negative say-on-pay votes will likely continue to pursue say-on-pay related litigation in 2012. But any investor (or their counsel) considering filing a say-on-pay related lawsuit will want to take a look at David Bario’s March 12, 2012 Am Law Litigation Daily article (here) reporting that in quick succession, motions to dismiss recently have been granted in four of the pending say-on–pay lawsuits. (The original article listed only three, but an update at the bottom of the article adds the fourth case to the list.)

According to the article, dismissal motions have been granted just in the last two weeks in the say-on-pay lawsuits that were filed against the boards of Intersil Corporation; Umpqua Holding Corporation; Jacobs Engineering; and BioMed Realty Trust. As far as I know, only one of the say-on-pay lawsuits has survived the initial dismissal motion; as noted here, the say-on-pay suit involving Cincinnati Bell did survive the dismissal motion. However, there have been other cases that have been dismissed. Given that there were only ten total suits filed out of the approximately 41 companies that sustained negative say-on-pay votes, the track record for these case does not look great, and could not be encouraging for any prospective plaintiff that might consider filing a similar action in connection with any company that sustains a negative say-on-pay vote during the 2012 proxy season.

Speakers’ Corner: On Tuesday March 27, 2012, I will be participating as a panelist at the C5 Forum on D&O Liability Insurance in London. I will be speaking about the latest U.S. legal developments affecting the D&O exposure of non-U.S. companies. Information about the conference, including registration information, can be found here. If you are attending the conference in London, I hope you will take the time to introduce yourself, particularly if we have not previously met.

A Video for St. Patrick’s Day: You will definitely want to round up your mates to watch this St. Patrick’s Day video featuring Gareth Longrass and his faithful dog Roy. Roy is a legend is Gloucestershire. Cheers, everyone.

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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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Only small a small number of companies experienced a negative “say on pay” vote this past proxy season, but many of the companies that did found themselves hit with a shareholder lawsuit in the wake of the negative vote. Cincinnati Bell is one of the companies that with both a negative vote and subsequent shareholder lawsuit.  Now, in a September 20, 2011 opinion (here) that expressly references and even relies on the negative vote, Southern District of Ohio Judge Timothy S. Black denied the defendants’ ‘motion to dismiss the shareholder suit, finding that whether the defendants would be entitled to rely on the business judgment rule is a question for trial, and also finding hat the shareholders’ pre-lawsuit demand was excused.

Under Section 951 of the Dodd-Frank Act, reporting companies must seek a non-binding shareholder vote in the form of a resolution to approve the company’s executive compensation plan at least every three years. Cincinnati Bell’s 2011 proxy included a resolution seeking shareholder approval of its 2010 executive compensation plan. On May 3, 2011, 66% of the company’s voting shareholders voted against the resolution.

Thereafter, a shareholder plaintiff filed a derivative lawsuit alleging that the company’s board breached its fiduciary duty of loyalty when it approved large pay raises and bonuses to its top three executives in a year that, according to the plaintiff, the company performed poorly. The plaintiff’s complaint specifically referenced the negative say of pay vote.

The defendant board members moved to dismiss, arguing that their actions with respect to executive compensation were protected by the business judgment rule, and arguing further that the plaintiff had failed to make the requisite pre-lawsuit demand that the board consider the claims that he asserted in his lawsuit.

In his September 20 opinion, Judge Black found that that the plaintiff had adequately alleged that the Cincinnati Bell board was not entitled to rely on the business judgment rule, and that while the defendants may attempt to rely on the business judgment rule at trial, they were entitled to rely on the rule as a basis for dismissal.

In making this ruling, Judge Black noted that the plaintiff’s factual allegations “raise a plausible claim that the multi-million dollar bonuses approved by the directors at a time of the company’s declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and were not in the best interests of Cincinnati Bell’s shareholders and therefore constituted an abuse of discretion and/or bad faith.”

Judge Black also rejected the defendants’ argument that the plaintiff’s lawsuit must be dismissed due to the plaintiff’s failure to make a pre-lawsuit demand on the company’s board. In reaching the conclusion that the demand was excused as futile, Judge Black said that:

Given that the director defendants devised the challenged compensation, and suffered a negative shareholder vote on the compensation, plaintiff has demonstrated sufficient fact to show that there is reason to doubt these same directors could exercise their independent judgment over whether to bring suit against themselves.

In reaching both of these conclusions, Judge Black specifically referenced and even relied on the fact of the negative say on pay vote. In reaching the conclusion that the defendants were not entitled to rely on the business judgment rule at the dismissal motion stage, and in concluding in particular that the plaintiff had adequately alleged that the board’s actions were “not in the best interests of Cincinnati Bell’s shareholders,” Judge Black specifically cited the plaintiff’s allegation that the negative say on pay vote “provides direct and probative evidence that the 2010 executive compensation was not in the best interests of the Cincinnati Bell shareholders.” As noted in the preceding paragraph, Judge Black also specifically referenced the negative say on pay vote in concluding that demand was excused as futile.

Discussion

As I have noted before, it is hardly surprising that there is shareholder litigation over executive compensation. Executive pay is a hot button issue that generates a great deal of interest and emotion. Indeed, in a footnote, Judge Black expressly cited a media commentary that “excessive executive compensation is the No. 1 problem in corporate governance.” This perspective clearly influenced Judge Black’s consideration of the dismissal motion.

But though the litigation itself may not be surprising, it is somewhat surprising that Judge Black in effect conceded the shareholder’s entitlement to rely on the negative say on pay vote. The Dodd-Frank Act is quite clear that the required vote is not binding on the company or its board. Moreover, Section 951(c) of the Act 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.”

Judge Black acknowledged these statutory limitations on the vote’s significance. He even acknowledged the concerns of Dodd-Frank critics that the say on pay requirement will lead to “extensive, frivolous litigation.” He nevertheless quoted with approval from other sources that “a negative say on pay vote give the court evidence that there’s been a breach of duty. It doesn’t mean there’s been a breach of duty, but it can support a finding of breach.”

On the one hand, all that has happened here is that the complaint has survived a dismissal motion. That is far from a finding that the defendants have actually violated any duties. On the other hand, it is highly unlikely that the defendants will context these claims all the way through trial. Most corporate and securities cases settle and their will be pressure on the defendants here to settle as well.

There is something very ironic about the fact that on the one hand the say on pay vote is nonbinding but was also expressly built to leave existing legal standard unchanged, and on the other hand the outcome of the say on pay vote can be used as a basis for denying a motion to dismiss an excessive compensation lawsuit – which in turn will create pressures for the corporate defendants to settle.

It is true that for companies whose executive compensation practices receive a positive shareholder vote, the say on pay requirement will not encourage litigation. But nevertheless, those who question whether the say on pay requirement will encourage litigation need to take a look at this case. The company’s negative say on pay vote was followed by litigation, and the outcome of the say on pay vote was used as a basis for denying the motion to dismiss. The vote created the context for the claim and also provided the plaintiffs a tool with which to maintain the claim.

As UCLA Law Professor Stephen Bainbridge said in an April 26, 2011 post on his blog (here), he knew these kinds of problems were coming when Congress incorporated the advisory say on pay provision in the Dodd-Frank 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.”

The saving grace, perhaps, is that the vast majority of companies did not have a negative say on pay. However, for the companies that did, and who thereafter got caught up in shareholder litigation, these cases will be costly to defend and could be costly to resolve. These costs are a concern not only to the companies themselves but to their D&O insurers, who may wind up having to foot the bill at least for the defense expenses. All of this because of a non-binding vote that wasn’t supposed to change the legal standards in any way….

Alison Frankel notes in her post on Thomson Reuters News & Insight (here) that Judge Black’s ruling in the Cincinnati Bell case is contrary to the ruling of the Georgia state court in the Beazer Homes say on pay case.

Many thanks to Dan Gilman of SCN Strategies for providing me with a copy of Judge Black’s decision.

Ain’t Too Proud to Beg: The LexisNexis Insurance Law Community has now begun the process to select the Top 50 Insurance Law Blogs of 2011. I am pleased to note that The D&O Diary is among the blogs nominated for this list. The editors at LexisNexis are now soliciting comments from legal practitioners and others as part of the process to select the Top 50 blogs. The comments will serve as a part of the information the editors use to select the Top 50 blogs.

The initial list of nominees includes a number of fine blogs. I encourage readers to visit the site and post a comment about their favorite insurance law blog. I would be humbled if any reader would consider posting a comment about my site on the LexisNexis Insurance Law Community. To submit a comment, visitors need to log on to their free LexisNexis Communities account.  More detailed instructions about how to post a comment can be found here. If you haven’t previously registered, you can do so at the Insurance Law Community for free. The comment box is at the very bottom of the blog nomination page. The comment period for nominations ends on October 7, 2011. 

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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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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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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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