The subprime litigation wave has been rolling along for well over a  year, so it might be expected that by now we have seen many of the likely litigation variations. I suspect there are hosts of new variations yet to come, but the most recent subprime-related lawsuits are substantially similar to prior lawsuits. Yet each one, briefly noted below, also involves some interesting additional variations on previously established subprime litigation themes.

Royal Bank of Canada Auction Rate Securities Lawsuit: On May 12, 2008, plaintiffs’ counsel announced (here) an auction rate securities-related class action lawsuit against Royal Bank of Canada and its subsidiaries, RBC Dain Rauscher and RBC Capital Markets Corporation. A copy of the complaint can be found here.

While there have been numerous prior auction rate securities lawsuits (about which refer here) and while the allegations in the RBC lawsuit appear substantially similar to the prior auction rate securities lawsuits, this lawsuit does present a couple of additional interesting elements.

The first is the lawsuit’s timing. The preceding auction rate securities lawsuits came in a rush between March 17, 2008 and April 21, 2008. There had been no new auction rate lawsuits since April 21, and the lengthening interval might have been interpreted to suggest that the filing onslaught had played itself out. The RBC lawsuit suggests that we may not yet have seen the last of the auction rate securities lawsuit filings.

The other interesting thing about the RBC lawsuit is that RBC itself is, obviously, a Canadian company. At a PLUS Chapter event in Montreal last week, there was a great deal of discussion about whether Canadian companies will feel the litigation effects of the subprime meltdown. The lawsuit against RBC suggests that at least Canadian companies with U.S. operating units exposed to subprime-related issues may find themselves swept up in the U.S.-based subprime litigation wave.

Indeed, RBC is not even the first Canadian company to be named in an auction rate securities lawsuit, as Oppenheimer, another Canadian company, was hit with an auction rate securities lawsuit in April 2008 (about which refer here). Even if Canadian companies are not being sued in Canadian courts on subprime-related issues, they are finding themselves involved in U.S.-based litigation.

Huntington Bancshares/Sky Financial/Waterfield Mortgage:  Huntington Bancshares, a Columbus, Ohio-based bank holding company, has previously been sued in a subprime-related securities class action lawsuit (about which refer here). The plaintiffs alleged in the prior lawsuit that, due to Huntington’s July 2007 acquisition of Sky Financial, Huntington had a much greater exposure to subprime mortgages than it had disclosed, allegedly harming a class of person who acquired Huntington shares between the time of the merger and the end of the class period in November 2007.

On May 7, 2008, Huntington was sued in a separate lawsuit in the United States District Court for the Southern District of Ohio (complaint here). In this most recent lawsuit, Huntington is sued as successor in interest to Sky Financial. The lawsuit is filed on behalf of the former shareholders of Waterfield Mortgage Company, whose shares Sky Financial had acquired in an October 2006 stock for stock-and-cash merger transaction.

The May 7 complaint, which also names as defendants Sky Financial’s former CEO and former CFO, alleges that the Sky Financial and the individual defendants violated Sections 11 and 12 of the ’33 Act through alleged false and misleading statements in the registration and proxy documents issued in connection with the Waterfield acquisition. The complaint alleges that Sky Financial had an undisclosed lending relationship that resulted in a significant residential mortgage exposure for Sky Financial.

This most recent Huntington lawsuit involves a different set of plaintiffs asserting claims based on a different set of representations yet involving a defendant bank that has already been drawn into the subprime litigation wave. There will likely be other lawsuits like this one ahead, as litigation emerges to fill in the interstices of the circumstances surrounding the subprime meltdown. So far, the most noteworthy attribute of the subprime litigation wave has been its breadth. Perhaps in the months ahead, as the wave spreads to fill in other gaps, the most pronounced aspect of the litigation wave will be its depth.  

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the Huntington/Sky/Waterfield complaint.

Run the Numbers: With the addition of these two new subprime-related securities class action lawsuits, the current tally (refer here) of subprime and credit-related lawsuits stands at 79, of which 39 have been filed in 2008. With the addition of the RBC auction rate securities lawsuit, there have now been 16 auction rate securities lawsuits, all of which have been filed in 2008.

Subprime Litigation Down Under: According to a May 12, 2008 Wall Street Journal article (here), Centro Retail Ltd. and its management company, and Centro Properties Company Ltd. and its management company, collectively  an Australian shopping center group, have been named as defendants in two class action lawsuits filed in Australian federal court based on alleged misleading statements in Centro’s disclosure documents between August 9, 2007 and February 15, 2008.

As discussed in the May 13, 2008 issue of The Australian (here), the recently filed lawsuits, brought by the Maurice Blackburn firm, are actually the second set of lawsuits announced against Centro. As discussed here, lawsuits had previously been announced against Centro and its property trust by the Slater & Gordon law firm. Both sets of lawsuits relate to Centro’s alleged misrepresentations regarding its leverage and its vulnerability to adverse credit developments, as a result of which the company experienced a severe share price decline.

While the spread of subprime-related shareholder class action litigation to Australia is interesting in and of itself, one specific aspect of these two sets of lawsuits is particularly interesting to me. That is, both sets of lawsuits are proceeding in reliance on third-party litigation funding.

According to Slater & Gordon’s April 22, 2008 press release (here), its lawsuits are being funded by “U.S based litigation funder Commonwealth Legal Funding LLC.” According to the press release, litigation funders “take a percentage of the net amount recovered, after expenses and after legal fees, for advancing all expenses and accepting the risk of any adverse award.” (The law firm itself recovers a court-approved hourly rate.)

The Maurice Blackburn firm’s separate set of actions is being funded by Australian-based IMF (Australia) Ltd. IMF is actually a publicly traded company whose shares trade on the Australian stock exchange. IMF’s May 9, 2008 press releases announced the filing of the lawsuits against Centro can be found here and here.

It isn’t clear how the existence of these two competing ventures will be reconciled. One might argue that the free market should be allowed to decide; along those lines, the Slater & Gordon press release touts the “significant” advantage its funder affords, in that “it takes a lower amount of the net amount recovered, from 15 to 30 percent, compared to the top rate of 40 per cent for the other proposal.”

One of the time-honored traditions in international financial circles is to rail against the excesses of the U.S. litigation system. But for all of our litigation extremes, litigation funding is one innovation that has not caught on in this country. It obviously has, by contrast, caught fire in Australia, and according to a March 20, 2008 Legal Week article (here), it also apparently has spread to the U.K.

As to whether litigation funding might catch on in the U.S., the WSJ.com Law Blog has an interesting post discussing the issue here. The Re: The Auditors Blog also has an interesting post on the topic here.

Australia has been setting the pace on innovation lately, as, among other things, the Slater & Gordon firm itself recently became the world’s first publicly traded law firm (refer here).

Opt-Out Options for the Little Guy: In a recent post (here), I discussed Columbia Law School Professor John Coffee’s recent paper in which he speculated that that we might be moving to a two-tier securities litigation system in which institutional investors with large financial interests at stake might increasingly seek to opt out from class litigation. The class itself, Coffee speculated, might increasingly be populated only by smaller investors whose financial stakes were too slight to justify opting out or to attract the interest of plaintiffs’ attorneys.

But an aspiring plaintiffs’ attorney’s recent publicity bid suggests that there may be enthusiasm for encouraging the little guys to opt-out too. In a May 12, 2008 press release suggestively entitled “Study Finds Many Bear Stearns Employees Should Opt-Out of Class Actions” (here), Brett Sherman of the Sherman Law Firm seeks to point out to Bear Stearns employees that investors who opted out of prior cases have had a higher percentage recovery of their investment losses.

The press release cites a variety of sources regarding opt-out litigation (including, in a twist that feels odd to me, my own InSights article about opt outs). None of the studies specifically find, as the press release title suggests, that Bear Stearns employees should opt out. Rather, Sherman himself asserts that “the only reasonable conclusion is that Bear Stearns employees with substantial losses have a dramatically better chance to recover a higher percentage of losses in individual opt out cases rather than as participants in class actions.”

Perhaps if, as Coffee speculates, institutional investors will increasingly opt out of class actions, and if, as Sherman advocates, the little guys decide to opt out too, no one will be left in the class. The issue here is clearly potential class members’ perception that opt-outs recover a greater percentage of their investment loss. To the extent that perception is widely shared, class counsel may face significant pressure to show a greater percentage recover of investment loss. Otherwise, the class action itself could become an empty vessel.

Of course it remains to be seen whether either large or small potential class members actually do opt out in material numbers. But assume for the sake of argument that they do. All those who have reviled the class action litigation procedure for so many years might want to contemplate the procedural morass that would attend a multitude of individual opt-out actions. Class litigation does offer certain efficiencies whose loss we might one day mourn.

The growing importance of global anticorruption enforcement efforts was underscored this past week by the revelation of a cross-border investigation involving the French industrial giant Alstom and by developments in the continuing investigation involving Siemens. Moreover, the Siemens developments highlight the increasing significance of liabilities arising from anticorruption exposures for the D&O insurance industry.

First, in a May 6, 2008 article entitled “French Firm Scrutinized in Global Bribe Probe” (here), the Wall Street Journal reported that French and Swiss authorities are investigating whether officials acting on behalf of Alstom paid hundreds of millions of dollars between 1995 and 2003 to win contracts in Brazil, Venezuela, Singapore and Indonesia.

Then on May 9, 2008, German prosecutors announced that they will pursue a civil enforcement action against former Siemens chairman Heinrich von Pierer and several other (unnamed) former Siemens board members. (Refer here for background regarding the Siemens investigation). von Pierer served as Siemens’ chief executive from 1992 to 2005, and as its Chairman until April 2007. Prosecutors apparently have elected for the time at least not to pursue criminal charges against von Pierer.

According to a May 10, 2008 Wall Street Journal article (here), the company itself has also said that “it may seek financial compensation from former managers but didn’t name individuals.”

According to the Journal article about the Alstom investigation, the Alstom and Siemens investigations “suggest that Europe’s prosecutors have begun taking a tougher line on business practices that their U.S. counterparts have long treated as criminal.” It is not merely coincidental that these investigations are now emerging; they are in fact an outgrowth of relatively recent changes in the laws of both Germany and France.

For many years, under the laws of the two countries, corrupt payments were not only legal, but the amount of the payments were tax deductible. But both countries are signatories to the OECD Convention on Combating Bribery of Foreign Officials in International Business Transactions. To implement the Convention, in 1999 Germany passed the German International Bribery Act. According to the Journal, “France outlawed bribery of foreign officials in July 2000.”

Both companies seem to have had difficulties adapting to the new legal prohibitions, as the conduct under investigation both preceded and followed the enactment of the new laws.

One particularly interesting aspect of the Alstom investigation is the way that the circumstances under review came to light. The investigation apparently arose as a result of an audit commissioned by the Swiss Federal Banking Commission of Tempus Privatbank AG, a small private bank. The audit uncovered documents concerning Alstom-related transactions that detailed the flow of about 20 million euros from Alstom to shell companies in Switzerland and Lichtenstein.

These investigations underscore the growing significance of cross-border anticorruption actions and highlight the fact that anticorruption efforts are no longer just a U.S. priority. Moreover, the potential exposures and liabilities are enormous. Siemens itself has already paid a fine of 201 mm euros.

There are also important implications arising from Siemens’ suggestion that it may pursue claims against its former managers. According to a May 5, 2008 Business Insurance article entitled “German Insurers Brace for Siemens Claim” (here), the company has notified its D&O insurers that it intends to file a claim under its D&O policies relating to the company’s antibribery related exposures. The article reports that the company carries D&O limits of 250 million euros. The article does not detail the specifics of the insurance claim or the matters for which the company claims or intends to claim coverage, so there is no way to assess the likelihood of the company’s eventual recovery under the policies.

It is far from certain that the company’s policies would actually cover the claimed amounts. But to the extent the policy’s limit is exhausted by the claims for coverage, it could, at least according to the Business Insurance article, have a substantial impact on the German market for D&O insurance.

The potential insurance implications from the developments in the Siemens investigation demonstrate the growing significance for the D&O insurance industry of the liabilities arising from anticorruption enforcement activity. As investigations like those involving Alstom and Siemens emerge and develop, and as litigation like that involving Alcoa (about which refer here) continues to arise, these issues necessarily will become a significant priority for companies and for D&O insurers. As I have previously suggested (here), anticorruption violations may well represent the “next corporate scandal.”

The May 9, 2008 Financial Times has an interesting editorial about the Alstom investigation and the expansion of anticorruption efforts, here.

Speakers’ Corner: On May 14, 2008, I will be speaking at the American Conference Institute’s D&O Liability Insurance Conference (refer to the agenda, here). I will be participating on a panel with my good friend Dan Bailey in a session entitled “Emerging Exposures Roundup: Fiduciary Litigation, Global Warming and More.”

Then on May 15, 2008, I will be in Toronto to participate in the Professional Liability Underwriting Society (PLUS) Canadian Chapter’s educational event regarding the subprime crisis. Information about the Toronto event can be found here. The other panelists include Dr. Arturo Cifuentes of R.W. Pressprich & Co., Denis Durand of Jarislowski Fraser, and Robert Murray of Chubb.

The parties in the SCOR Holding (Switzerland) AG class action securities litigation seem to have devised a “global” settlement strategy to resolve the problems arising from the cross-border distribution of would-be class members.

First, some background. The lawsuit relates to alleged misrepresentations and omissions purportedly made by SCOR Holding’s predecessor in interest, Converium. Converium was domiciled outside the U.S .Its shares traded on the Swiss stock exchange, and its American Depositary Shares (ADS) traded on the NYSE.

In a March 6, 2008 order (here) in the SCOR Holding securities lawsuit, Judge Denise Cote had partially granted and partially denied the motion for class certification, as a result of which she certified a class consisting of U.S residents who had purchased Converium shares on the Swiss exchange, and any person who purchased Converium ADS’s on the NYSE. Excluded from the class were Non-U.S. residents who purchased Converium shares on the Swiss exchange.

The persons excluded from the class represent so-called “f-cubed” litigants – that is foreign shareholders of a foreign-domiciled company bought their shares on foreign exchanges. As I have discussed in prior posts (most recently here), courts have struggled with their response to the presence of  “f-cubed” litigants, which can involve complicated issues at the lead plaintiff stage (refer here) and at the motion to dismiss stage (refer here), as well as at the class certification stage, as the SCOR Holding case demonstrates.

But as Adam Savett noted here in a post on his Securities Litigation Watch blog (here) discussing the SCOR Holding class certification decision, the exclusion of the “f-cubed litigants” does raise the problem of how those erstwhile class members can seek compensation for their alleged injuries. As Savett discussed in a prior post on his blog (here), one possibility is that the excluded class members might launch a host of individual lawsuits, as Savett shows to be what happened in the Vivendi case.

The litigants in the SCOR Holdings case seem to have adopted a two-pronged approach to try to head the castoff foreign litigant problem off at the pass, in a settlement that might truly be described as “global.” At least, that certainly appears to the parties’ intent.

As discussed in a May 7, 2008 press release from the SCOR parent company (here), the SCOR Holding securities litigation has been settled through a two-part process. As stated in the press release, “SCOR reached an agreement to settle the claims of the certified class before the US court and the claims of non-US purchasers of Converium securities in a proceeding in the Netherlands for an aggregate amount of EUR 74 million (pre tax and before D&O recoveries).” A May 7, 2008 Business Insurance article describing the settlement can be found here. (74 mm euros is roughly $114.5 mm).

The description of the two-part settlement does not explain what portion of the aggregate total of 74 mm euros was allocable to which portion of the two separate proceedings. Nor does the press release elaborate on the Netherlands proceeding. Presumably the proceeding is similar to that employed in the much-discussed Royal Dutch Shell settlement. For detailed background on the $352.6 mm Royal Dutch Shell settlement, refer to the With Vigour and Zeal blog here and here.

The SCOR Holding litigants certainly deserve points for a creative way of avoiding the problems that arose in the Vivendi litigation with the proliferation of individual actions. They also seem to have come up with an alternative way of addressing the concerns of excluded class members desirous of obtaining relief of the kind available to U.S. resident investors.

The parties’ resort to the Netherlands proceeding does raise a number of interesting questions. One of these questions first arose at the time of the Royal Dutch Shell settlement, which is whether other litigants might try to avail themselves of the Netherlands procedures. The SCOR Holding settlement suggests that the answer is yes, and that the Netherlands procedures potentially could become an avenue for non-U.S. litigants to seek redress. Whether these procedures would be utilized without a prior U.S. based lawsuit still remains to be seen.

Another question is whether other litigants will seek to use the Netherlands procedures as part of a similar two-pronged strategy to try to achieve a settlement that resolves both U.S. and Non-U.S. investors’ claims. The extent to which the SCOR Holding settlement truly is successful in effecting a “global” settlement will clearly have some impact on whether other litigants might try to same approach. The limited information available at this point does not reveal on whose behalf the Netherlands procedure was going forward and how comprehensive the Netherlands settlement will be towards resolving all of the non-U.S. investors’ claims. To the extent the SCOR Holdings litigants’ two-pronged settlement achieves global peace, the settlement could well attract the interest and attention of litigants in other proceedings that also involve non-U.S. investors.

One final attraction of the approach employed in the SCOR Holdings settlement (and I suspect this attraction had something to do with how the approach came about) is that the two-pronged settlement enabled the plaintiffs’ counsel to corral together a larger group of aggrieved investors, which clearly would have some appeal to plaintiffs’ counsel who would not wish to litigants’ interests excluded or straying away into unrelated processes that would diminish the aggregate size of the investor interests on whose behalf the counsel can try to negotiate an aggregate settlement.

Auction Rate Securities Overview: Readers interested in a thorough background regarding auction rate securities and the events that triggered the current round of auction rate securities litigation will want to review the May 6, 2008 publication by NERA Economic Consulting entitled “Auction- Rate Securities: Bidder’s Remorse?”

It is generally understood that under Delaware law, directors enjoy broad rights of indemnification and advancement. The Delaware statutory regime does allow corporations a great deal of flexibility in how they adapt these provisions to their own circumstances. But while these principles are generally understood, it may nevertheless come as a surprise to many that a corporation’s flexibility to adjust the provisions includes the ability to eliminate former directors’ advancement  rights, at least according to a recent Delaware Chancery Court opinion.

A March 28, 2008 opinion in Schoon v. Troy Corporation (here) by Vice Chancellor Stephen P. Lamb held that as a result of a board approved by-law amendment eliminating advancement rights for former directors, a former company director did not have the right to advancement of attorneys’ fees.

The company’s by-law had originally provided that “the Corporation shall pay the expenses incurred by any present or former director.” After one of the company’s directors left the board but before the director became involved in litigation relating to his prior board service, the company’s board deleted the by-law’s reference to former directors.

The former director argued to the court that his right to advancement had vested when he commenced his board service. The former director also sought to rely on a prior Delaware court decision which had held that a board cannot terminate a former director’s advancement rights while litigation is pending. Vice Chancellor Lamb rejected the former director’s arguments, holding that the director’s advancement rights do not become “vested” until litigation is actually commenced.

As Steven M. Haas of the Hunton & Williams law firm noted on the Harvard Law School Corporate Governance Blog (here), “[t]his holding may surprise some practitioners, given that the purpose of indemnification and advancement is to encourage board service and assure directors that their expenses relating to their official actions will be repaid – even if litigation arises after they resign from the board.”

The possibility that directors could lose their rights to indemnification or advancement after they leave the board may not only “surprise some practitioners,” but it would shock many directors, whom I believe rightly would be appalled to learn that they could be stripped of these rights after they leave the board. At a minimum, this holding strongly reinforces the need for each director to have their own separate indemnification agreement with the company, to reduce the possibility for a later board to eliminate these rights after the director has left board service. Without a separate contractual undertaking, directors may have no assurance that after they leave the board their rights to advancement and indemnification will be preserved.

At the same time, however, it should be emphasized that most directors and officers liability insurance policies include former directors within their definition of insured persons, and that under most circumstances a former director for whom corporate advancement and indemnification has been withheld would still have right to seek defense expense protection and indemnification under the company’s D&O liability policy. There might be some question about which retention would apply under the policy, but that issue aside, the insurance coverage should be available to protect the former director (subject to all of its terms and conditions).

Accordingly, In most circumstances, the company’s D&O insurance program should provide adequate protection even for former directors – assuming that the company has procured and continued to maintain insurance protection, and assuming further that the limits available under the insurance program are not otherwise consumed by other insured persons’ defense expense and indemnity requirements.

For directors who have left board service and who are concerned that events could conspire (whether through by-law revision, or as a result of discontinuance or exhaustion of the D&O insurance) to leave them unprotected, there is another insurance solution available. That is, a director concerned about these circumstances may want to consider a so-called former director and officer liability insurance policy. This kind of coverage, which was described at greater length in a recent CFO.com article (here) is buyer-specific; that is, it belong exclusively to the individual director or officer, and would not be subject to termination or discontinuance by the action or inaction of others. It is also noncancelable, nonrescindable, and provides coverage for up to 6 years after the director resigns, retires or is fired.

The point that should not be lost here is that the director in the case cited above lost his anticipated rights after he left the board. Directors concerned about their rights following board service will want to fully consider the available insurance alternatives.

The Ropes & Gray law firm has a May 5, 2008 memorandum (here) discussing the ways in which by-laws and indemnification agreements might be modified to protect against retroactive elimination of directors’ rights.

The Delaware Corporate and Commercial Litigation Blog has a post (here) discussing other aspects of the Schoon v. Troy decision.

Speakers’ Corner: On May 6, 2008, I will be in Montreal, Quebec, participating in a panel sponsored by the Canadian Chapter of the Professional Liability Underwriting Society (PLUS). The panel (more information about which can be found here) is entitled “The Subprime Meltdown and its Impact on the Canadian Insurance Landscape” and includes a number of distinguished speakers, included Dr. Faten Sabry of NERA Economic Consulting, David Williams of Chubb, and Denis Durand of Jarislowsky Fraser Limited.

In addition, on May 8, 2008, I will be moderating a panel at a American Bar Association Tort Trial and Insurance Practice Section conference in New York. The title of the conference is "Beyond Legal: A Business Approach to Corporate Governance" and the panel is entitled "Identifying, Predicting and Minimizing Securities Litigation Risk." Joining me on the panel will be Nell Minow of the Corporate Library, Professor Eric Talley of the Boalt Hall School of Law at UC Berkeley, and Patrick McGurn of RiskMetrics. A copy of the conference brochure can be found here.

Commentators have long focused on CEO compensation as a leading corporate governance concern. Indeed, the Corporate Library has even suggested (here) that CEO compensation practices that “are poorly-aligned with shareholder interests” are “a powerful indicator of potential securities litigation.” While CEO compensation unquestionably is an important issue, academic research recently published by three Michigan State professors suggests that the CFO’s compensation may be even more important than that of the CEO.

In an April 15, 2008 paper entitled “CFOs and CEOs: Who Has the Most Influence on Earnings Management”(here),  John Jiang, Kathy Petroni and Isabel Yanan Wang report on their investigation “whether CFOs’ equity incentives are associated with earnings management, and whether earnings management is more sensitive to CFOs’ equity incentives than to those of the CEOs.” Prior research has focused primarily on CEOs’ compensation, based on conventional wisdom that because CEOs’ equity compensation was greater than that of CFOs, it should be more influential. In addition, it was generally presumed that because the CFO is the CEO’s agent and the CEO has the power to replace the CFO, “CFOs do not respond directly to their own equity incentives but only to the wishes of their CEO.”

Contrary to these prior assumptions, the authors posited that CFOs equity incentives “may have a stronger impact on earnings management than those of the CEOs, because CFOs have the ultimate responsibility for the management of the financial system, including the preparation of the financial report.”

The authors used a database for the S&P 1500 for the period 1993 through 2006, representing 17,542 firm years of compensation data. The authors examined the CFOs’ equity incentives in three settings where prior research had demonstrated an association between CEOs’ equity incentives and earnings management, namely (1) accruals; (2) the likelihood of beating earnings benchmarks; and (3) the likelihood of restatements.

Based on their analysis, the authors conclude that “because CFOs are primarily responsible for preparing the financial statements, the impact of their equity incentives on financial reporting dominates the impact of the CEOs’ equity incentives.” Indeed, the authors conclude that “earnings management is a key tool that the CFO can expertly use to respond to equity incentives.”

Although the paper has a number of interesting insights, perhaps the most interesting is the authors’ analysis of the way that CFOs respond to the prospect of option grants. The authors found that the occurrence of the grant of options to the CFO was positively correlated to the occurrence of an earnings miss (which would lower the option strike price and thus make the grant potentially more valuable). The authors further concluded that “the likelihood of missing earnings benchmarks is higher for stock options granted to the CFO relative to those granted to the CEO and in some cases significantly so.”

One of the fundamental tenets for the compensation of corporate executives is that the executives’ interests should be aligned with those of the shareholders, and that the best way to achieve alignment is through equity-based compensation. The authors’ research suggests, however, that equity-based compensation may not create alignment, but rather motivates earnings management. Indeed, the authors’ research could be read to suggest that the equity-based compensation could create incentives that are contrary to shareholders’ interests, because shareholders obviously have no interest, for example, in engineered misses of earnings estimates.

The authors do conclude that their research underscores the importance of the SEC’s recently adopted provisions requiring disclosure of CFO compensation. This disclosure, the authors state, “should be relevant to users of financial statements in evaluating the quality of firms’ financial reporting.”

Among those to whom the CFO compensation information could be of interest are D&O underwriters. While the authors’ research does not directly make the connection between CFO equity compensation and the incidence of securities lawsuits, the link the authors do establish between CFO equity incentive compensation and earnings management should be sufficient to suggest the relevance of CFO equity compensation for D&O underwriting purposes. If, as the Corporate Library proposes, CEO compensation is an important indicator of securities litigation susceptibility, then the research of these three Michigan State professors could be interpreted to suggest that CFO compensation is also an important indicator, perhaps even more so.

Hat tip to the CFO Blog (here) for the link to the academic research paper.

For Better or Worse – Unless You Wind Up in Jail: This blog does not ordinarily comment on domestic relations issues, but we did fund it noteworthy that, according to news reports (here), former Tyco CEO Dennis Kozlowski was about to reach terms for his divorce from his wife, the former Karen Mayo. Mayo is the former waitress whom Kozlowski married in 2001, and whose $2 million Roman-themed 40th birthday party on Sardinia that same year ultimately proved to be a key component of Kozlowski’s later criminal trial.

According to news reports, Mayo had request that the couple’s assets be split equally and she also sought alimony. The news reports do not disclose whether Mayo will receive a portion of the $1/day Kozlowski now reportedly receives “mopping floors or slinging hash” to fellow inmates at the New York correctional facility where he is serving a term of between eight years, four months and twenty-five years.

The heightened pace of securities lawsuit filings in 2008 (as previously noted here) continued in April, when there were 22 new securities class action filings. The subprime litigation wave was a significant factor in the filing activity level, as ten of the 22 cases were subprime or credit crisis related. Of the 10 subprime cases, seven pertained to auction rate securities.

The heightened April activity followed the increased activity levels in March. The March and April combined two-month total of 48 new securities lawsuit filings represents the largest two-month filing total since July and August 2004, when 51 new cases were filed.

According to Cornerstone Research (here), the average annual number of new securities class action lawsuit filings for the period 1996 through 2006 was 194. The total number of new 2008 year to date securities class action lawsuit filed through the end of April is 75. If the filing levels for first four months of 2008 were to continue for the remainder of the year, the year end 2008 total of new filings would be 225, which not only exceeds the 1996 to 2006 average, but is approximately the same number of filings as in 2002, the year of the corporate scandals. If the IPO Laddering cases are excluded from the analysis, the 2002 filing level represented the highest annual number of filings since the passage of the PSLRA.

First-Filed Tyco Opt-Out Case Partially Settles: As detailed on the Securities Litigation Watch blog (here), the first filed Tyco Opt-Out action has partially settled. The lawsuit was filed on behalf of the State of New Jersey and several NJ pension funds (refer to the plaintiffs’ 373-page second amended complaint, here).

According to the New Jersey Attorney General’s April 30. 2008 press release (here), Tyco itself agreed to pay $73.25 million to settle the plaintiffs’ claims against the company’s former GC Mark Belnick and four former Tyco directors. The settlement does not relate to the plainiffs’ claims against former Tyco CEO Dennis Kozlowski or former CFO Mark Swartz, as well as the plaintiffs’ claims against another former Tyco director and the company’s former auditor, PricewaterhouseCoopers. A May 1, 2008 Law.com article discussing the settlement can be found here.

I have added the Tyco opt-out settlement to my table of opt-out settlements, which can be accessed here. A detailed list of the various pending Tyco opt-out cases, compiled by Adam Savett of the Securities Litigation Watch, can be found here.

Section 404 Compliance Costs Decline: According to a recent Financial Executives International survey of 185 publicly traded companies (press release here), Section 404 compliance costs were lower in 2007 compared to prior years. Because the study depends on survey results, and the composition of the survey participants varies from year to year, the survey does not permits absolute costs comparisons on a year to year basis. However, the survey does show that the number of internal and external people hours required to comply with Section 404 declined for survey respondents in 2007 compared to the prior hear. The auditors annual attestation fees also decreased as a percentage of the annual audit fee.

A May 1, 2008 Wall Street Journal article commenting on the survey report can be found here. The FEI Financial Reporting Blog discusses the survey report  here.

Noises Off: While no one will mistake his letters for those of Warren Buffett, the annual letter of A.S. Perloff, the Chairman of Panther Securities P.L.C. register high on the entertainment value scale. The latest letter, part of the Panther 2007 year-end preliminary financial report, can be found here. To my ears at least, Perloff’s “ramblings” sound rather like the discourse from someone who might have had one glass of claret too many, but the letter is no less entertaining for that. Read and enjoy.

In May 2003, I was fortunate enough to to attend the Berkshire Hathaway annual meeting in Omaha, Nebraska. (Full disclosure: I attended the meeting because I was then and remain now a Berkshire shareholder.) While at the meeting I struck up a conversation with some other attendees, who turned out to be a group of doctors who had attended medical school together, and who now invest together, and who every year have a reunion of sorts at the Berkshire annual meeting.

There are many people like these investing docs who hang on Buffett’s every word, perhaps hoping to replicate in some small way Buffett’s phenomenal investing success. The good news is that it isn’t necessary to go to Omaha to get Buffett’s own words about his approach to investing and business, as all of his Berkshire shareholders’ letters from 1977 to 2007 can be found on the Berkshire website, here.

But while the shareholder letters are available online, they are presented chronologically and are not indexed. There is not even a search function on the website, so other than going through a lot of words written over a lot of years, it is very difficult to find what Buffett has written about, say, zero coupon bonds, and difficult to see how his views on any given topic have changed over the years.

The great news for Buffett devotees is that there is a terrific alternative to laboring through 30 years’ worth of Buffett’s letters to Berkshire shareholders. George Washington University Law Professor Lawrence Cunningham has read through all of them for us, and has distilled 30 years’ worth of Buffett’s commentary into a thematically arranged, absolutely wonderful book entitled “The Essays of Warren Buffett: Lessons from Corporate America,” which was recently released in a second edition (here). Professor Cunningham has added a brief introductory essay and afterword, but otherwise the book consists of the essence of Buffett. (It does also include an excerpt from one of Berkshire Vice Chairman Charlie Munger’s Letter to Wes.co shareholders and an amusing parody written by Buffett’s mentor, Ben Graham.)

Cunningham has done a masterful job distilling Buffett’s writings and organizing them according to topic. This arrangement not only facilitates a quick reference to Buffett’s comments on any given topic, but it also provides insight into how Buffett’s views on the topic may have evolved over time.

One thing that clearly emerges from a sustained reading of Buffett’s writing is that he is not only interested in developing the right investments and the right assets, he also wants to have the right sort of owner. Indeed, the reason Buffett has written the letters over the years is to develop and maintain “rational owners”; in the 1988 shareholders’ letter, Buffett makes this explicit when he says that “all of our policies and our communications are designed to attract the business-oriented long-term owner and to filter out possible buyers whose focus is short-term and market-oriented.” From his essays about stock splits and dividends, it is also clear that the reason Berkshire has never split its shares and does not pay dividends is because of Berkshire wants to “avoid policies that attract buyers with a short-term focus on our stock price.” He wants investors focused on business values, not the company’s short-term share prices, and while a stock split or dividend might increase trading in Berkshire shares, “a hyperactive stock market is the pickpocket of enterprise.”

Buffett’s writings about the kind of owners he wants also dovetails with his extensive writings about the kind of managers owners should want. He is particularly concerned about the widespread practice of announcing earnings targets, noting the “many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings target they had announced.’ He also says that investors should

beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they will are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

He adds that “managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.”

This thematic arrangement of Buffett’s writings facilitates insight into the many ways his past experience unquestionably continues to inform his decision making. For example, we might well wonder about Buffett’s view on the current subprime crisis, but when you read his commentary from the late 80s about junk bonds and the Wall Street wizards who created them, you don’t have to wonder very much about what he might think about, say, CDOs backed by subprime mortgages. In his 1990 letter, Buffett wrote about junk bonds that “as usual, the Street’s enthusiasm for an idea was proportional not it its merit, but rather to the revenue it would produce.” Buffett also commented:

In the final chapter of The Intelligent Investor Ben Graham [wrote]:"Confronted with a challenge to distill the secret of sound investment into three words, we venture a motto, Margin of Safety.” Forty-Two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses.

Buffett went on to write later:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failure we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.

Buffett’s prescience on the problems with derivates has already been the matter of commentary on this blog here.

Anyone who needs persuasion that Buffett truly is a financial master who has the added gift to be able to explain complicated things simply should review the segments of the book discussing zero coupon bonds and the difference between accounting goodwill and economic goodwill.

In addition to Buffett’s business wisdom and the clarity of his prose style, the other thing that comes through in these essays is how funny Buffett is, and in that respect Cunningham is to be complimented for managing to capture within a volume devoted to Buffett’s business writings the basic humorousness of the shareholder letters. I’m sure everyone has their favorite Buffett humor stories, but mine include the story told in the  1986 letter about the tailor who went to see the Pope, whose friends asked him what the Pope is like. Buffett writes that “our hero wasted no words: ‘He’s a forty-four medium.’” Another favorite that also makes it into this collection is the story about the man who asked his vet what to do for his horse that limped sometimes but seemed fine at other times. Buffett states that “the vet’s reply was pointed: ‘No problem – when he’s walking fine, sell him.’”

Cunningham’s book also captures my own personal favorite, from the 1985 letter. I have actually quoted this story previously on this blog, but I like it so much, I am reproducing it again here:

An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

In any compendium, there are necessarily going to be some omissions, and while Cunningham’s inclusions are comprehensive and the overall product deserving of praise, I think the volume would be even more complete were it to include selections from Buffett’s writing over the years about insurance. The insurance business has been the segment on which Buffett has concentrated the most, and his reasons for his focus on this industry convey a lot about his approach to investing and his understanding of how business cycles work. In particular, Buffett’s many comments about “float” and the insurance “cycle” convey a lot about what his overall approach to investing and business. Greater inclusion of his insurance writings would also provide greater context for Buffett’s comments about September 9/11, which is included in this volume.

This volume also excludes Buffett’s writing about his investment in Gen Re. This is a serious omission in my view. Gen Re was by far Buffett’s largest investment, and the company lost over $7 billion dollars in the early years that he owned it. Buffett’ trenchant comments about the losses represent a very public statement about what he learned from the experience, clearly one of the more significant of the losses he faced. His pointed comments about the reason for the losses underscore some of his most important business principles.

It is also a personal gripe that though this volume omits Buffett’s writings generally about insurance, somehow the book manages to include every single instance where Buffett has said that his company does not carry D&O insurance. I have always thought that these statements are dangerous for mere ordinary mortals. It is fine for Buffett and his billionaire board members to disdain D&O insurance, but persons of more ordinary means can ill afford to run the risk of uninsured board service. Every time I read Buffett’s comments about D&O insurance, I feel like they should include a warning that “Readers should be cautioned to recall that he is one of the wealthiest people on the planet and his personal net worth is greater than the policyholders’ surplus of most insurance companies’; readers should not attempt this trick at home.”

While I think this volume of essays is a worthy introduction to Buffett’s views and business philosophy, a lot of the writing will lack context for many readers. To know why Buffett quotes Ben Graham, and what he means by it, it is really necessary to understand more about Buffett’s days in graduate school and his early days working for Graham. His comments about many of his investments, such as Capital Cities/ABC or Solomon Brothers, require a great deal of prequel and sequel in order to appreciate fully what Buffett is saying. So I would recommend as a companion to this volume of essays Roger Lowenstein’s excellent biography of Buffett (here). Even though Lowenstein’s book is now 13 years old, it still conveys a lot about how Buffett got there, which is of course what most people – like those investing docs who attend the Berkshire annual meeting every year – are interested in.

But these last quibbles with the content, such as they are, are minor. The book itself is quite an accomplishment; it is that rare business book that is worthwhile and entertaining and enjoyable to read.

Special thanks to Professor Cunningham for calling my attention to the book.

One of the recurring suggestions in would-be reformers’ standard litany of proposed changes for litigation relief is the introduction of auditor liability caps. For example, the Committee on Capital Markets Regulation interim report (about which refer here) proposed the “elimination or reduction of gatekeeper litigation, either through a cap on auditor liability or creation of a safe harbor for certain auditor practices.” Similarly, in early 2007, the European Commission launched a study (about which refer here) on “whether there is a need to reform the rules on auditor liability in the EU.”

But while these initiatives are only at the proposal or study phase, the U.K. has moved forward to permit “auditor liability limitation agreements,” under legal provisions that recently went into effect. The newly effective provisions are part of the Companies Act of 2006 (refer here for the Act’s text). The auditor liability limitation provisions are contained in Sections 532 to 538 of the Act, which took effect on April 6, 2008, according to the Act’s implementation timetable (here). For background regarding the Act, refer here.

The Act allows auditors to limit their liability by contract, provided that their client’s shareholders approve. Section 534(1) of the Act allows auditors to limit their liability “in respect of any negligence, default, breach of duty or breach of trust, occurring in the course of an audit of accounts.” The limitation cannot cover more than one financial year and it must be approved by a resolution of shareholders. Under Section 537, the liability limitations are not effective except to the extent they are “fair and reasonable” in the particular circumstances.

The Act itself does not specify the particular kinds of limitations that are allowable nor does it prescribe the form the limitation is to take. However, a working group of the Financial Reporting Council, the supervisory body for U.K. auditors, has proposed “draft guidance” (here) suggesting ways that the limitation agreement might be framed. The FRC guidance document even includes specimen language to be used as a reference in preparing limitation agreements.

The FRC guidance suggests three alternative ways the auditor’s liability might be limited: (a) proportionality, “where the auditor’s liability is limited to his share of the company’s loss, taking into account the liability of others”; (b) fair and reasonable, “where the auditor’s liability is limited to such amount as is fair and reasonable in accordance with Section 537 of the Act”; or (c) monetary cap, “where the auditor’s liability is limited to a particular amount, which is either stated or calculated in some way, e.g.. as a multiple of audit fees.”

The Act’s auditor liability limitation provisions represent an interesting experiment, but it will be even more interesting to see how widespread the acceptance of auditor liability limitations agreements becomes. The Act’s requirements themselves may deter widespread adoption, particularly the one-year time limitation and the requirement for shareholder approval. One might also conjecture that there might be some stigma associated with a company’s agreement to limit its auditor’s liability, to the extent the existence of an agreement is interpreted to suggest that the only way the company could procure an auditor’s services was by granting the auditor a liability limitation. There is also legal uncertainty surrounding such issues as the extraterritorial effect of any limitations, which may be of particular concern for auditors of companies that have shareholders, creditors or other business partners outside the U.K.

It is probably also relevant that the auditor liability provisions were adopted as part of the Companies Act, which also contains provisions defining directors’ duties and incorporating new statutory procedures for bringing claims against directors. One wonders whether a company’s directors, newly sensitized to their duties and potential litigation risks, will be comfortable relieving their auditors of liability to the company for negligence or other misconduct. Even though the liability limitation has to be approved by shareholders, you can imagine the second-guessing and accusations that might surface if problems do arise later.

Within its draft guidance document, the FRC anticipates that companies may well wrestle with the question whether (or even why) they should agree to limit their auditor’s liability, and expressly observes that directors “will wish to establish that it is in the company’s interest to enter into a liability limitation agreement.” The guidance document does not attempt to suggest what interest a company would have in limiting its auditor’s liability.

Along with the question of what the take-up of the limitation agreement will be for U.K. companies is the question whether other jurisdictions will adopt the U.K. approach or similar auditor liability limitation provisions. A March 2006 report by Michael Gass and Ashwani Kochlar of Edwards Angell Palmer & Dodge entitled “U.K. Gives Auditor Liability Agreements a Greenlight, But U.S. is Unlikely to Do the Same” (same) takes a look at the new U.K. provisions and considers the possibilities for reform efforts in the U.S. The report concludes that current U.S. reform efforts are “ill-timed” and that given the turmoil in the financial markets, “garnering attention and support to adopt proposals … will be challenging” – unless one of the Big Four accounting firms implodes, in which case “all bets are off.”

The CorporateCounsel.net Blog also has an interesting post here discussing the newly effective U.K. provisions and expressing skepticism for the likelihood of auditor liability reform in the U.S. anytime soon.

Readers interested in the topic of auditor liability caps may want to refer back to my earlier post, here, in which I discuss the very interesting alternative proposal of George Washington University law professor Lawrence Cunningham. Professor Cunningham suggests having the audit firms issue bonds to the capital markets as a way to provide financial protection for their liability risks. 

U.K. Government to Appeal BAE Systems Ruling: In a recent post (here), I reviewed the April 10, 2008 decision by the U.K.’s High Court of Justice against the British government’s decision to terminate the investigation of alleged bribery involving BAE Systems in connection with a Saudi arms deal.

On April 22, 2008, Transparency International, on its own behalf as well as on behalf of several other organizations, wrote (here) to the U.K. Attorney General “urging the government not to appeal the judgment.” The letter stated that “halting the investigation has caused untold damage, both to the reputation of the U.K. and to global efforts to improve governance and combat corruption.” The letter also urged that the action to drop the investigation has “reduced [the U.K.’s] standing among its peers” in the OECD, and any move by the government to appeal “would compound the reputational damage to the U.K.” and would undermine the implementation of the United Nations Convention Against Corruption.

Nevertheless, on April 22, 2008, the Serious Fraud Office announced (here) that it will “seek permission to appeal to the House of Lords” against the lower court’s April 10 judgment. The SFO’s announcement quoted the current SFO director as saying that the April 10 judgment “raises principles of general public importance affecting, among other things, the independence of prosecutors and the role of the court in reviewing a prosecutor’s evaluation of the public interest in a case like this.”

It is very hard to argue that the U.K.’s efforts to suppress the BAE Systems investigation will not undermine its efforts elsewhere to fight corrupt practices. The unmistakable message is that the U.K. only cares about small scale corruption involving the less powerful, those whom the U.K. feels it can safely push around; but that these impediments can be overcome if the bribe is large enough and the corrupt official powerful enough. Nothing could do more to breed cynicism over anticorruption efforts that for the U.K. government to successfully suppress this investigation.

Hat tip to the Sox First blog (here) for the links to the Transparency International and Serious Fraud Office announcements.

Time Out for an Idol Thought: I was delighted to learn that my former partner from the Ross, Dixon & Bell law firm, Bill Hopkins, now apparently known by his nom de plume Will Hopkins, is a finalist in the American Idol songwriting competition. The WSJ.com Law Blog has an excellent interview of Bill, er, Will, here.

Hopkins, we shall call him, left active law practice to try to write music about the same time I left the law firm to become involved on the business side of insurance. Everyone must follow their own muse, I suppose.

Speakers’ Corner: On Monday April 28, 2008, I will be speaking as a panelist at the C5 Conference on Securities Litigation in London, on a panel entitled "Liability Never Goes Away:Managing Risk and Tackling D&O Liability" The conference features a number of very distinguished speakers. A copy of the seminar materials, including conference agenda, can be found here. If you are attending the conference, I hope you will make it a point to greet me.

As reflected in my running tally of options backdating lawsuit settlements (which can be accessed here), a number of the options backdating-related derivative lawsuits have settled for some combination of an agreement to pay the plaintiffs’ attorneys’ fees, some adjustment to the company officials’ options grants, and the company’s adoption of corporate governance reforms. But two April 7, 2008 opinions by Judge William Alsup of the United States District Court of the Northern District of California in separate options backdating derivative cases may raise potentially troublesome questions whether settlements in this form, without some cash payment directly to the corporation, are sufficient. As a minimum, the two opinions have important implications for the way settlements are presented to the court, and could also have important effects on the settlement dynamic in other cases going forward.

The first and most detailed of the two opinions relates to the options backdating derivative suit filed on behalf of Zoran Corporation, about which lawsuit I first wrote here. In a June 5, 2007 opinion in the Zoran case (here), Judge Alsup had previously denied the defendants’ motion to dismiss, as I previously discussed here.

Following the dismissal denial, the parties to the Zoran case entered settlement negotiations, resulting in a February 26, 2008 stipulation of settlement, which the parties presented to the court on March 3, 2008. At the preliminary approval hearing, the plaintiffs’ damages expert, at the court’s request, presented a report calculating the plaintiffs’ maximum damages as $16 million (including prejudgment interest), which incorporated both the alleged damaged cause to company by the defendants’ option grants as well as by option grants to the rank-and-file employees.

The proposed Zoran settlement involved: the payment of up to $1.2 million of the plaintiffs’ attorneys’ fees and costs; the repricing or cancellation of certain of defendants’ options, which repricing or cancelation was represented to the court to have a value of $1.65 million; the company’s adoption of certain corporate governance reforms; and the grant of a broad claims release.

In an April 7, 2008 opinion (here) that contains some remarkably harsh language, Judge Alsup denied the parties’ request for preliminary approval of the settlement.

The parties undoubtedly knew the settlement was in trouble when Judge Alsup opened his analysis by stating that the class action procedure can “lend itself to abuse” and “one form of abuse is a collusive settlement.” Judge Alsup said that a collusive settlement “usually comes with a cash award to counsel, a broad release of claims, and a cosmetic non-cash recovery for the abused shareholders.” Courts, Judge Alsup notes, must take care that absent shareholders are treated fairly; here, he concludes, the settlement “falls short of deserving preliminary endorsement.”

In considering the settlement, Judge Alsup turned first to the substance of the plaintiffs’ claims (the implication being that the claims appeared to be meritorious), and to a declamation upon the plaintiffs’ expert’s $16 million damages estimate. Judge Alsup then addressed each of the settlement components, finding each component lacking.

First, Judge Alsup noted that the parties were not proposing to restore to the corporation the gains the defendants made from the sale of options, but rather that certain other options would be canceled or repriced. The option cancelation was represented to have very substantial value to the corporation, but the two sides’ experts had reached different conclusions about the value. Judge Alsup found that by using the most conservative valuation method and valuation date, the value of the cancellation was only $216,955, a small fraction of the value both sides had represented to the court.

The court next turned to the repriced options, with respect to which Judge Alsup noted, with incredulity, that the options had actually been repriced in December 2006, which was not only over a year before the settlement was presented to the court, but was even before the plaintiff filed the consolidated amended complaint. The court said that “it should have been plainly disclosed that the defendants were proposing to settle based on an old concession rather than a new consideration.” The court went on to note that “even if the flaw could somehow be ignored,” the value of the repriced options had been “exaggerated.” If a “meaningful” valuation date were used, the value of the repriced options is “zero.”

Judge Alsup had similar concerns with respect to the corporate governance reforms, in that several of the reforms “were already adopted by Zoran’s board well before the parties sat down to discuss settlement terms.” The reforms in any event “do not compensate the company for damages suffered by the company as a result of defendants’ backdating.” The reforms are “hard to accept in lieu of some substantial portion of the $16 million in damages asserted by the plaintiffs’ expert.” Judge Alsup also found that the claim release was overbroad, and swept in circumstances that were not asserted in the amended complaint.

In concluding that the settlement was inadequate, Judge Alsup stressed that “the corporation would recover no cash, all the cash is going to counsel,” and even the supposed value of the $16 million of the foregone benefits is “illusory” and he concluded that this “low end settlement” did not deserve approval.

Judge Alsup was clearly troubled that he had been obliged on his own to ferret out the settlement’s weaknesses, many of which were contrary to counsels’ representations.

Judge Alsup concluded his opinion with a rather stern lecture on counsels’ “duty of candor,” which he said requires counsel to “lay out the weaknesses as well as the strengths” of the settlement. He also stressed that it is “unfair to try to slip a weak or collusive settlement past the judge, hoping he or she will sign off or will not stumble upon the right questions.” A $1.65 million settlement, while at the low end, might be adequate, but the “main vice is that the proposal does not come even close to the $1.65 million settlement it was advertised to be.”

Many of the problems the court identified clearly were the result of communications issues. The parties perhaps could have avoided some of the difficulties by making joint valuation presentations that were scrubbed and scrutinized ahead of time. The court was also clearly upset to discover upon inquiry (rather than being told) that some of the remedies proposed had been undertaken prior to the settlement agreement; better communication around these settlement components potentially could have averted some of the court’s concerns.

But there are other aspects of the court’s commentary that are not merely the consequence of poor communication. First and foremost, Judge Alsup appeared to be troubled by how little the corporation would be getting, and in particular that the corporation would be getting no cash. He was also troubled that the settlement’s putative $1.65 million value, even if valid, was at the “low end” of plaintiffs’ damages analysis. In a sign that may have important implications for other settlements, he was also clearly skeptical that the noncash portions of the settlement – including even the corporate governance reforms, to which he attached little value –had value commensurate with the claimed injuries to the corporation.

But while there clearly are important implications from Judge Alsup’s ruling in the Zoran case, before fully considering those implications, it is important also to review Judge’s Alsup’s opinion (here), also dated April 7, 2008, in the CNET Networks options backdating-related derivative lawsuit, which provides even further context.

In his CNET Networks opinion, Judge Alsup refused even to consider the parties’ proposed settlement. Judge Alsup had previously granted defendants’ motion to dismiss (refer here), on the grounds that demand was not excused, but stayed the case to allow the plaintiffs to seek discovery through the Delaware courts and to attempt to replead. In response to an inquiry from the court about status, the parties advised the court that settlement negotiations were underway, and the parties then presented a joint motion to lift the stay for the limited purpose of seeking a preliminary approval of a settlement. Judge Alsup said that it found these actions “disappointing” because the parties did not, as they had represented to the court they would, complete discovery, nor did plaintiff file an amended complaint. Instead the parties sought to settle the case, about which Judge Alsup said

any settlement, at this early stage, seems very premature, for the Court could not be in a position to evaluate a settlement until we know what claims are viable and what depositions, discovery, and damage assessments show about the strength and magnitude of those claims. At this stage, moreover, plaintiff has no standing at all to negotiate on behalf of the corporation and its shareholders. Plaintiff has never been excused from the demand requirement. Plaintiff is not in any way authorized to release claims on behalf of any shareholders or the corporation. It would be hard to see how plaintiff could do so intelligently without first framing the claims and then performing sufficient due diligence through formal discovery and investigation, including a full damage report. Now, any legitimate settlement reached later may be tainted by what could appear to have been collusion. To deal with this eventuality, all notes and materials generated by or during the recent settlement discussions should be preserved. For the Court’s views on collusive settlements see In Re Zoran Corporation Derivative Litigation.

Judge Alsup went on to note that “the best way to tee up this case for settlement is to find out first whether the plaintiff even has standing to sue (the demand issue) and thus to release claims on behalf of the corporation,” and then to evaluate which options were backdated and the dollar value to the corporation of these claims. “It would,” Judge Alsup said, “be very hard to evaluate a settlement without due diligence, including depositions and documents.”

Judge Alsup’s two opinions taken together represent a strong statement that, because of the court’s responsibilities to absent class members, the court must take its obligation to review proposed settlements very seriously. The court clearly should not be expected just to rubber stamp a settlement to which the parties’ representatives have agreed. In order to get settlement approval, and avoid the suggestion of collusion, the parties will have to show certain key considerations: first, and at a minimum, that the plaintiff even has standing to represent the class and enter the settlement; second, that the settlement is proportionate to the injury to the corporation that the plaintiff has claimed; third, that the claimed values to the corporation are supported; and fourth, that the corporation is fairly compensated for its damages and its release of claims.

Even though Judge Alsup’s opinions technically have no precedential effect beyond the immediate cases themselves, the strength of the language he used, the seriousness of the concerns he noted, and the possibility of similar questions undermining other settlements could well have an in terrorem effect on other litigants in other cases. Certainly no litigant would want to take a chance that a court might suggest that their proposed settlement could be “collusive.” Even though many of the aspects of these opinions are a reflection of the particular circumstance involved, the opinions also bespeak more general principles that could have broad influence. In particular, Judge Alsup’s statement in the CNET Networks case that he could not even consider a proposed settlement until the plaintiff first establishes its right to enter a settlement and presents an adequate factual record and damages analysis suggests that cases must have progressed past a certain stage before the parties can even proffer a proposed settlement to the court.

There are several interrelated issues arising from Judge Alsup’s requirement for a damages analysis, his requirement that the settlement be proportionate to the alleged harm, and his obvious concern in the Zoran case that no cash was going to the corporation. The overall suggestion is that a few gestures and payment of some legal fees may not be enough. There may actually need to be some cash going to the corporation, proportionate to the alleged harm. Judge Alsup’s unwillingness to recognize significant value to the corporation for the corporate governance reforms may be particularly troublesome.

As I noted at the outset, many of the options backdating derivative cases that have been settled so far have been resolved on terms similar in many respects to the components of the Zoran settlement. The likely reason why there is no cash payment to the corporation in many of these cases is that D&O insurers balk at funding amounts they contend represent a disgorgement or a return of an ill-gotten gain. The individual defendants, for their part, resist making out of pocket payments for which insurance is unavailable. The parties thus perforce attempt to cobble together an agreement that resolves the case without any cash transfer other than the payment of plaintiffs’ counsel’s fees.

Judge Alsup’s opinion, particularly his repeated use of the word “collusive” and statement that the value to the corporation from the Zoran settlement was “illusory” could introduce a great deal of tension into this negotiation dynamic. Both insurance carriers and individuals could face heightened pressure to make cash contributions to the corporation to resolve these cases. Insurers will likely continue to resist any payment on their part, owing to policy exclusions for disgorgement and the return of ill-gotten gains.

Another important implication is that the parties must be prepared to substantiate their settlement, and that discovery, depositions, damages assessments and other procedures may be required to satisfy these requirements. These procedures could prove costly for all concerned – particularly for the D&O insurers, who not only will foot the bill for increased defense expense, but also ultimately could be called upon to pay the plaintiffs’ fees as well, as part of any eventual settlement.

Notwithstanding the foregoing, of the parties involved, the participants that may face the biggest problems if these cases become more difficult to resolve are the plaintiffs’ lawyers. There is a suggestion in both of these cases that the plaintiffs’ lawyers are starting to find the cases tiresome and just want them to go away. Indeed, one of the things that clearly seemed to be bothering Judge Alsup in these cases is that the plaintiffs’ lawyers were settling (too) cheap or walking away without even doing what the Judge at least believes to be minimally required. The plaintiffs’ lawyers piled into these kinds of cases with enthusiasm but they may now be repenting their involvement. The implication of Judge Alsup’s opinion may be that the plaintiffs’ lawyers may be challenged to extricate themselves.

According to my tally (which can be found here), there have been a total of 166 options backdating lawsuits filed. To date, only a small portion of these cases (less than a third) have been settled or otherwise resolved. The vast majority, well over one hundred, of these cases remain pending. Of course it remains to be seen, but I suspect that Judge Alsup’s opinions in these two cases will prove to have introduced significant challenges for parties trying to move these pending cases toward resolution.

Very special thanks to Zusha Elinson of The Recorder for providing me with copies of these opinions. Elinson’s April 24, 2008 article in The Recorder about the opinions entitled “Alsup Rejects Easy Options Deals” can be found here (Full disclosure: I was interviewed in connection with the article).

Next up as targets in the ever-growing wave of subprime-related class action lawsuits are closed-end funds that issued auction preferred securities. The auction marketplace for these securities, like the market for auction rate municipal bonds, has broken down, and investors who bought the securities are now suing the closed end funds that issued the instruments.

First, some background. According to the Investment Company Institute’s web page describing and explaining closed end funds (here), closed end funds are managed investment companies that issue a fixed number of shares. The shares trade on the open market. In addition to these common shares, many closed end funds also issue preferred shares. The owners of the preferred shares are paid dividends, but they do not participate in the fund’s gains and losses. The sale of preferred shares gives the fund leverage, by permitting the fund to make additional investments, hoping to improve the common shareholders’ returns. For auction rate preferreds, the dividend rate is set through periodic auctions, typically held every seven or 28 days.

According to a March 9, 2008 New York Times article entitled “As Good as Cash, Until It’s Not” (here), the marketplace for municipalities’ auction rate notes is $330 billion, and the market for closed end fund auction rate preferred securities is $65 billion. But more to the point, investors in auction rate preferred securities, like investors in municipalities’ auction rate notes, have discovered that due to the February 2008 breakdown of the auction rate marketplace, investors find they are “stuck” with their investments and unable to sell them through the auction market.

But auction rate preferred investors are, according to the Times article, faring “far worse than investors stuck with municipal issues,” because many municipal note investors are receiving a penalty rate of up to 12 percent or more, a rate that is “much higher than the caps on closed-end notes, which are currently around 3.25 percent.” The closed end issuers “have no incentive to redeem their notes since the interest rate resulting from the failed auction is so low.”

A March 30, 2008 New York Times article entitled “If You Can’t Sell, Good Luck” (here) explains that auction rate preferred investors’ difficulties put the closed-end fund issuers “in something of a conflicted position,” because the common shareholders’ returns are enhanced by the leverage from the preferred securities investment. While the preferred holders would like their shares to be redeemed, the “common shareholders would lose out on extra income generated by the preferred share structure.”

Under these circumstances, it is hardly surprising that the class action securities attorneys have now gotten involved. According to their press release (here), on April 21, 2008, the plaintiffs’ attorneys’ filed a purported securities class action lawsuits in the United States District Court for the Southern District of New York against the Calamos Global Dynamic Income Fund, on behalf of investors who acquired “Auction Rate Cumulative Preferred Shares” (ARPS) in the fund’s September 17, 2007 offering of $350 million of the securities. The complaint, which can be found here, also names as defendants the two investment banks that led the offering.

According to the press release, the complaint alleges that the offering documents omitted that:

(i) the purported “auctions” used by Calamos Fund to get the dividend rates were not bona fide auctions at all, but rather a mechanism to maintain the illusion of an efficient and liquid market for the ARPS so that the Calamos Fund could continue to earn fees from the so-called auctions and from the ongoing stabilizing of the market because of the lack of buyer demand; (ii) the default interest rate set as a consequence of a failed auction is less than the interest rate paid when auctions of certain competing municipal auction rate securities (“MARS”) offered directly by municipal issuers fail; (iii) the ARPS suffer from an additional disadvantage compared to MARS because the ARPS are securities which exist in perpetuity until such time as the Fund calls them due while MARS have a set due date; and (iv) the default interest rate as set would cause the ARPS to trade at a discount to their par value if, and when, the auctions began to fail.

The complaint further alleges that as a result of the auction rate marketplace failure “auction rate securities that were once offered as ‘cash equivalents’ are now illiquid, resulting in economic losses and severe hardships for investors.”

As I have previously noted (most recently here and here), there already is a growing wave of auction rate securities class action lawsuits. However, this most recent lawsuit differs from the prior actions, and not merely because it involves closed end fund auction rate preferred securities rather auction rate notes issued by municipalities. The new lawsuit is also different because it targets the issuer; in the prior auction rate lawsuits, the plaintiffs targeted the broker dealers that sold the securities, not the municipalities that issued the securities.

One thought I had while reviewing the Calamos complaint is that many of these auction rate lawsuits may present some interesting issues related to damages. In most instances, the instruments are continuing to pay interest according to their terms. With respect to the closed end fund notes, the securities are backed by real assets held in the funds, which would seem to suggest that the instruments retain substantial economic value. Even if the auction rate market itself proves to be permanently broken, it would seem that there should be strong economic incentives all the way around for a secondary market for these shares to develop. Of course, whether a fully functional secondary market emerges, and whether the marketplace requires a significant discount for these shares to trade, remains to be seen. But right now, calculating the alleged damages does seem to pose some challenging issues, particularly some mechanism to trade the shares develops while these cases are pending.  

Subprime Litigation Wave Hits Credit Suisse: On April 21, 2008, plaintiffs’ counsel also initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Credit Suisse Group and certain of its directors and officers. According to the plaintiffs’ attorneys’ press release (here), the complaint alleges that the “defendants failed to write down known impaired securities containing mortgage-related debt.” Specifically, the complaint alleges that

(a) that defendants failed to record losses on the deterioration in mortgage assets and collateralized debt obligations (“CDOs”) on Credit Suisse’s books caused by the high amount of non-collectible mortgages included in the portfolio; (b) that Credit Suisse’s internal controls were inadequate to ensure that losses on residential mortgage-related assets were accounted for properly; and (c) that Credit Suisse’s traders had put incorrect values on CDOs and other debt securities, concealing the exposure the Company had to losses.

The complaint (which can be found here), also alleges that on February 19, 2008, the company announced (here) fair value reductions of $2.25 billion following its repricing of its asset-backed positions, triggering a sharp decline in the company’s share price.

The plaintiffs’ lawyers have engineered the purported class on whose behalf the action is brought, in a clear attempt to avoid jurisdictional challenges and other concerns. The purported class includes all shareholders who purchased Credit Suisse ADRs on the NYSE, and all U.S. residents or citizens who purchased Credit Suisse stock elsewhere. This purported class excludes non-U.S. investors who purchased their securities outside of the United States.

This class composition seems tailored to match the composition of the class recently certified in the Converium securities lawsuit (as discussed in greater detail on the Securities Litigation Watch blog, here). This class composition also avoids many of the so-called “f-cubed” litigant problems (involving foreign domiciled shareholders who bought their shares in a foreign company on a foreign exchange). Avoiding this issue could eliminate friction at the lead plaintiff, motion to dismiss, and class certification stages. It does raise questions about the foreign litigants and their apparent inability to seek class remedies of the type that other securityholders in the same company are able to pursue in the U.S. Whether that triggers these securityholders to file a bunch of individual actions, as happened after the foreign litigants were excluded from the Vivendi lawsuit (as also discussed on the Securities Litigation Watch blog, here), remains to be seen.

For further background about the “f-cubed” issue, refer to my prior posts, here and here.

Run the Numbers: With the addition of these two new lawsuits, the current tally of subprime and other credit crisis related lawsuits, which can be accessed here, now stands at 76, 36 of which have been filed in 2008. Of the 38 so far in 2008, 15 (including the Calamos lawsuit described above) are auction rate securities lawsuits.

Excess D&O Insurance Coverage Issues: In several posts (most recently here), I have examined the increasingly important emergence of coverage disputes involving excess D&O insurance. In the latest issue of InSights, entitled “Excess Liability Insurance: Coverage Disputes and Possible Solutions” (here), I take a more comprehensive look at the coverage issues involving excess D&O insurance.

Speaker’s Corner: On April 22, 2008 at 1:00 P.M. EDT, I will be participating in a one-hour webinar sponsored by Merrill Corporation entitled “The Subprime Ripple Effect: Preparing for the Wave of Litigation.” The other participants include Thomas Reilly, the former Massachusetts Attorney General and a shareholder in the Greenburg Traurig law firm, and Mark Kindy, EVP of Strategy and Operations for Merrill Corp. Registration (which is free) can be accessed here.