From the earliest days of the options backdating scandal, one of the recurring questions has been the potential extent of outside director liability exposure (refer, for example, here). On September 17, 2008, In a development that may also have significant implications for more recent events, the SEC filed settled options backdating-related charges against three former outside directors of Mercury Interactive.


A copy of the SEC’s September 17 press release regarding the settled charges can be found here. A copy of the Complaint can be found here.



The SEC’s complaint alleges that the three outside directors “recklessly approved backdated stock option grants, and reviewed and signed public filings that contained materially false and misleading disclosures about the company’s stock option grants and company expenses.”

The complaint alleges that the three individuals approved 21 backdated stock option grants between 1997 and April 2002. The complaint alleges that the three were aware that options with an exercise price lower than the date on which the options were actually approved created a compensation expense. Nevertheless, the complaint alleges, they repeatedly executed stock option documents while “failing to observe, among other things, that the exercise price of stock options they were approving was less than the market price of the company’s stock at the time of approval.”



The three individuals are alleged to have routinely signed unanimous consents “despite being presented with numerous facts and circumstances indicating that management was backdating option grants.” In addition to signing options grants made with earlier “as of” dates, on a few occasions the three “signed multiple written consents presented to them by management for the same grant with different grant dates that had more favorable prices.”



Without admitting or denying the allegations, the three agreed to permanent injunctions and each will pay a $100,000 financial penalty to settle the charges.



In light of the current circumstances, in which scapegoat hunting is in high gear, the SEC enforcement division’s statements about outside director liability may be instructive. SEC enforcement division director Linda Thomsen is quoted as saying, among other things, that “today’s action serves as further notice that misconduct by outside directors, as well as company management, will not be tolerated.”



Another enforcement division official is quoted as saying that, even though they understood how options expensing worked, “time and again, directors approved in-the-money option grants that had been backdated” and that the directors “recklessly approved option grants despite numerous facts and circumstances indicating to them that the grant dates they were approving were improperly backdated.”



While options backdating enforcement actions may seem like yesterday’s news (or even the day before yesterday’s news), these developments have significance today. If nothing else, they demonstrate the SEC’s willingness to pursue enforcement actions against outside directors, at least in certain circumstances, particularly if apparently knowing and active violations are involved.

These developments also underscore the continuing liability exposures to which outside directors potentially may be subject, and the need to address these exposures as part of any well-designed directors’ and officers’ liability insurance program. The SEC’s willingness to pursue outside directors for options backdating-related violations also suggests that today’s even more dramatic circumstances potentially could involve significant outside director liability exposure. The SEC’s interest in the possibility must be presumed.



Some readers may want to know what happened to the Mercury Interactive managers that proposed the backdating options for the directors’ approval. The SEC previously filed civil fraud charges against the company and four former officers (refer here). The company agreed to pay a $28 million penalty. The case against the former officers remains pending. A securities class action lawsuit arising from the Mercury Interactive options backdating allegations settled for $117.5 million (about which refer here).


UPDATE: The Race to the Bottom blog has an interesting post (here) discussing the SEC enforcement proceeding against Mercury Interactive’s outside directors. Professor Brown suggests that this case represents another instance where federal regulatory authorities may be creating federal standards of director conduct, in a gradual preemption of state law.



Despite Settlements, Auction Rate Lawsuit Proceeds: Following the recent high-profile auction rate securities settlements, one of the unanswered questions was what impact the settlements would have on the previously pending auction rate securities lawsuits. There are still no definitive answers. But, notwithstanding the settlements, at least one auction rate securities lawsuit is going forward.



As reported in the September 17, 2008 Wall Street Journal (here), Judge Gary Sharpe of the Northern District of New York has ruled that they auction rate securities lawsuits that Plug Power filed against UBS can go forward notwithstanding UBS’s recent $19 billion action rate securities buy-back settlement. A copy of the transcript of the September 17 hearing in the case can be found here. (Hat tip to the Wall Street Journal Law Blog, here, for the transcript link.)



According to Plug Power’s Amended Complaint (here), the company had alleged that, based on supposed assurances that the auction rate securities investments were safe and liquid, the company had bought $62.9 million in auction-rate securities backed by student loans. After the market for the securities seized up in February 2008, the company was (and remains) unable to liquidate its investments. The securities make up nearly half of the company’s investment portfolio.

Under the UBS auction rate settlements, institutional investors’ securities are expected to be bought back in 2010. The Journal quotes Plug Power’s attorney as saying that “we need the funds before 2010 and they’re not providing us a guarantee that they will be able to pay out.”



The disfavored position of institutional investors is one of the features of the auction rate securities settlements I noted at the time (refer here). Other institutional investors may be motivated similarly to Plug Power to proceed with litigation notwithstanding the buy back settlements. And the September 17 ruling in the Plug Power case suggests that at least some of the cases may go forward notwithstanding the settlements.



As noted in a September 18, 2008 post on the Securities Docket (here), plaintiffs’ attorney Daniel Girard of the Girard Gibbs law firm argues that private litigation still has a role to play in the auction rate securities debacle. He points out that many billions worth of these investments are not yet part of any settlement and that even with regard to the securities covered by the settlements, it will be a considerable time before the buybacks kick in (this in connection with investments that supposedly were liquid and just like cash.).



BAE Systems Lawsuit Dismissed: In prior posts discussing civil litigation arising out of corrupt practices investigations (for example, here) one of the cases to which I have frequently referred is the derivative lawsuit filed in the District of Columbia by shareholders of BAE Systems. (For background regarding the BAE Systems case, refer here and here).



In a September 11, 2008 opinion (here), Judge Rosemary Collyer dismissed the BAE Systems derivative lawsuit on the grounds that the plaintiff lacked standing to bring the lawsuit.

The court’s ruling, while narrow, is interesting. The court held that as a result of the “internal affairs doctrine,” the law of the United Kingdom (the country in which BAE Systems is incorporated) governs the case. Under U.K. law, beneficial owners of a company’s securities lack standing to sue derivatively.



The plaintiff in the derivative suit did not directly own BAE systems shares but rather owned American Depositary Receipts (ADRs) as a result of which its ownership is merely beneficial under U.K. law. Accordingly, the plaintiff lacks standing to sue derivatively under U.K. law, and the court granted the defendants’ motion to dismiss.



Even though the court’s holding is narrow, it is significant in at least one respect. That is, it underscores the numerous potential obstacles that any plaintiff will face in attempting to use U.S. courts to assert civil liability in connection wtih a foreign domiciled company’s allegedly corrupt activities. Notwithstanding these obstacles, however, I continue to believe that the threat of civil litigation arising from corrupt practices investigations remains significant.



As the Wall Street Journal noted in its September 12, 2008 article entitled “U.S., Other Nations Step Up Bribery Battle” (here), anticorruption enforcement activity is an increasingly important prosecutorial priority worldwide, in which cross-jurisdiction cooperation is an increasingly important factor. As prosecutorial activity affects an increasing number of companies, investor interest n recovering civil damages for alleged harm to companies from the allegedly corrupt practices will continue to grow.



Special thanks to a loyal reader for the link to the BAE Systems decision.