In an earlier post (here), I took a look at recent research questioning whether corporate officials may be abusing the Rule 10b5-1 share trading safe harbor. SEC Enforcement Director Linda Thomsen said at the time that the SEC is looking hard at the issue. But months have now passed without further SEC action and questions have begun to arise whether the any SEC actions will be forthcoming.

However, in an October 10, 2007 speech (reported here), Thomsen reported that the SEC is continuing to examine whether 10b5-1 plans are being used to shield insider trading abuse. Thomasen reportedly said (refer here), that the SEC is “making sure that a rule designed to help executives with a legitimate purpose is not being used for illegitimate purposes.” Thomsen said that regulators are examining a range of issues relating to insider trading plans, including improper disclosure, the appearance of favorable dates when plans were begun or halted, and the use of excessive selling discretion.

The SEC has been asked to take a look in particular at the trading practices and trading plan of Countrywide Financial CEO Angelo R. Mozilo. According to an October 11, 2007 New York Times article entitled “Stock Sales By Chief of Lender Questioned” (here), North Carolina Treasurer Richard Moore sent SEC Chairman Christopher Cox an October 8, 2007 letter asking the Commission to examine Mozilo’s stock trading program. (A copy of Moore’s letter can be found here.) According to data first supplied by the Los Angeles Times (here), Mozilo started a trading plan in October 2006, but then twice raised the number of shares that could be sold under the plan – once in December 2006, when Countrywide stock was at $40.50 a share, and again in February 2007, when Countrywide sock hit an all-time high of $43.05 – all before the stock plunged this summer toward its current level of approximately $19 per share.

According to the Times, Mozilo has had gains of $132 million since starting the October 2006 plan, and that Mozilo expects to sell his remaining shares at the end of this week, “a move that will generate millions more.” The North Carolina Treasurer said:

As an investor and a Countrywide shareholder, I was shocked to learn that C.E.O. Angelo Mozilo apparently manipulated his trading plans to cash in, just as the subprime crisis was heating up and Countrywide’s fortunes were cooling off. The timing of these sales and the changes to the trading plans raise serious questions whether this is a mere coincidence.

The SEC apparently has declined to say whether it will examine Mozilo’s trades. Whether or not any further action follows Mozillo’s plans, the questions and Thomsen’s statements underscore the emerging risk involving 10b5-1 plans. The greater risks will involve plans that started, stopped or were altered at suspicious times, or where multiple plans were in place. In any event, it is clear that practices involving these plans will remain under scrutiny.

The Costs of Defending Backdating: According to Brocade Communications’ most recent Form 10-Q (here), Brocade’s quarterly legal expenses, including apparently the costs of defending its former CEO Gregory Reyes, were $18 million, in a quarter in which its net income was only $10.7 million. So far this fiscal year, Brocade has spent $38.4 million in legal fees, an amount that is unlikely to include the costs of Reyes’s criminal trial, which ended on August 7, 2007 with Reyes’s conviction.

According to an October 10, 2007 Bloomberg. com article entitled “Brocade Legal Bills Outpace Profits in Options Cases” (here), the company has broad indemnification plans covering its directors and officers. The article also quotes a Brocade spokesperson as saying that “we are continuing to work with our D & O insurance providers to recoup applicable costs.”

While Brocade’s directors and officers may well enjoy broad indemnification rights as well as the protection of liability insurance, Reyes’s criminal conviction would clearly affect the availability of both indemnity and insurance in connection with his legal fees. Indeed the Bloomberg article specifically acknowledges rights that typically are available to companies to recoup attorney’s fees from officials convicted of criminal misconduct.

Brocade may or may not seek to enforce any rights of recoupment it may have, but the magnitude of its legal expenses reveal the enormous costs backdating proceedings are imposing on many companies. An October 12, 2007 American Lawyer article entitled “Companies With Backdating Troubles Are Paying Astronomical Legal Fees” (here) shows that Brocade is only one of several companies that have sustained stratospheric fees in defending against backdating allegations. The American Lawyer article specifically notes that many companies are facing resistance from their D & O carriers over payment of these attorney’s fees; the carriers reportedly are withholding payment on the grounds of the personal profit exclusion and other policy provisions.

While there are cases, such as that involving Brocade’s Reyes, where there have been affirmative findings of wrongdoing, in many more cases, there have only been allegations, and the cases are settled before there on any determinations regarding the allegations. Without conclusive legal determinations, companies should be obtaining reimbursement from their D & O carriers for defense costs incurred on behalf of directors and officers. In my experience, the disputes more often arise with respect to related expense (such as the cost of internal investigations or special litigation committees, or of informal SEC investigations), or when each corporate official wants their own lawyer, and the cumulative expenses deplete the available policy limits.

Special thanks to a loyal reader for sending along the Brocade article.

Another Options Backdating Class Action Settlement: On October 11, 2007, Vitesse Semiconductor announced (here) the settlement of all of the securities class action and shareholders’ derivative litigation that had been filed against the company in connection with stock options backdating allegations. (Refer here for further particulars regarding the lawsuits.) Vitesse agreed to make a cash payment of $10.2 million, $8.75 million of which is to be paid by the company’s D & O insurers. Vitesse will also contribute 2.65 million shares of stock to the class fund and will contribute an additional 4.9 million shares to cover the derivative plaintiffs’ counsel’s attorney’s fees. (The company’s stock is currently trading at about $1.00 per share.) The company has also agreed to adopt corporate governance measures.

In addition to the company’s settlement undertakings, two Vitesse executives agreed to contribute $1.45 million and all of their over 1.2 million Vitesse shares toward the settlement. The two individuals and one more former official also agreed to release the company from indemnification of all future defense costs.

The Vitesse settlement joins the prior options backdating class action settlements previously announced involving Newpark Resources (refer here) and Rambus (refer here). The Vitesse settlement appears distinct, at least among the prior class action settlements, in the individuals’ cash contribution, which, reading between the lines, appears as if it was not intended to be reimbursed by insurance.

Vitesse may have resolved the options backdating related litigation. But the same day as it announced the backdating settlement, news of an additional lawsuit arose. In an October 11, 2007 press release, Nu Horizons Electronics announced (here) that Nu Horizons and its wholly-owned subsidiary Titan Supply Chain Services had been named as co-defendants with Vitesse in a purported securities class action lawsuit that has been filed by Vitesse shareholders. According to the press release, the lawsuit alleges that Nu Horizon and Titan “participated in a scheme to inflate Vitesse’s sales from January 2003 to April 2006.”

The new lawsuit appears to concern allegations of a type that will be directly affected by the outcome of the Stoneridge case now pending before the U.S. Supreme Court (refer here); Stoneridge will clearly determine whether or not a scheme liability case like this will be permitted to go forward.