Thanksgiving is nigh, but big things are still happening. The Apple options backdating derivative complaint has been dismissed, AIG has been sued in a subprime-related derivative lawsuit, the Non-U.S. claimants were excluded from the Royal Dutch Shell Class, a leading plaintiff’s lawyer had some interesting things to say about subprime lawsuits, and a disappointed busted buyout target company has been sued by its own shareholders, of all things. Interested? Read on.

Apple Backdating Derivative Lawsuit Dismissed: In a recent post (here), I noted that U. S. District Judge Judge Jeremy Fogel dismissed the Apple backdating securities lawsuit, with leave for the plaintiff to refile the complaint as a derivative lawsuit. However, before that plaintiff refiles, its lawyers will want to read Judge Fogel’s November 19, 2007 opinion (here) in the previously pending derivative lawsuit against Apple (as nominal defendant) and several of its directors and officers. Judge Fogel has granted the defendants’ motion to dismiss. While the dismissal was with leave to amend, it was hardly on terms that would cheer the plaintiffs’ hearts.

Judge Fogel first considered the plaintiffs’ federal law claims, on the theory that the court’s jurisdiction depends on the existence of a viable federal claim. Judge Fogel found that the plaintiffs’ Section 14(a) claims were barred by the applicable three year statute of limitation. He did allow the plaintiffs leave to amend the Section 14(a) claims, but admonished them that they should not amend the claims unless the wrongful acts alleged took place after July 30, 2003, and he further noted that “greater specificity would likely strengthen the claim considerably.”

Judge Fogel next held that the five-year statute of limitations was applicable to the plaintiffs’ Section 10(b) claims, but he also found that the plaintiffs had tried to bootstrap earlier option grants by alleging that the financial misstatements caused by earlier grants were perpetuated in later financial statements. He found that this “combination” was insufficient, and that because the Section 10(b) claims depend on “such a combination, it will be dismissed.” He allowed plaintiffs leave to replead the Section 10(b) claims but only as to wrongful acts that occurred on or after June 30, 2001.

The judge then went on to consider whether the plaintiffs had adequately alleged scienter. He found that the complaint is “characterized by conclusory, general and non-individualized assertions as to all Defendants.” He found that plaintiffs “must provide more detailed allegations giving rise to a stronger inference of scienter on the part of each defendant.” He then went on and noted that the plaintiff’s “scheme liability” allegations are subject to the pending Stoneridge case (about which refer here) and in any event were dismissed because they reflected “insufficient allegations that the various defendants’ contributions to the overall scheme had a deceptive purpose and effect.”

Because the plaintiffs had not yet established a valid federal claim and therefore established federal jurisdiction, Judge Fogel did not reach the plaintiffs’ state law claims. He did, however, note that the defendants “appear to raise a number of valid arguments with respect to these claims, and plaintiffs may wish to amend the claims accordingly.”

Judge Fogel’s rulings, particularly those regarding the statute of limitations issues, might well be instructive to other courts and other litigants involved in other options backdating cases. However, Judge Fogel has once again indulged in his infuriating practice of issuing his opinions “not for citation.” As I previously noted here, this regrettable practice does a disservice to all litigants and every other court.
One other backdating note is that on November 19, 2007, U.S. District Judge Joel Pisano dismissed (here) the options backdating derivtive lawsuit pending against Bed Bath & Beyond (as nominal defendant) and several of its directors and officers on the grounds of the New York state court’s prior dismissal (refer here) of the same claims. More about Judge Pisano below…
The Apple and Bed, Bath & Beyond dismissals have been added to the running tally of options backdating dismissals, denials and settlements that I am maintaining and that can be accessed here.
Special thanks to Robert Benjamin of the Kaufman, Borgeest & Ryan firm for the link the Apple derivative opinion.

Subprime Litigation Wave Hits AIG: The outward-expanding wave of subprime-related litigation has now hit the insurance industry. According to news reports (here and here), on November 20, 2007, a shareholder filed a derivative lawsuit against AIG (as nominal defendant)and several of its directors and officers. The complaint apparently alleges that AIG improperly concealed the extent of its exposure to subprime mortgage crisis, and contains claims for breaches of fiduciary duties, unjust enrichment, and other charges.

The news articles report that the complaint alleges that the defendants had “claimed that AIG’s portfolio was so sufficiently diversified that the mortgage market would have to reach ‘Depression proportions’ before negatively impacting the company. AIG was not as invulnerable as defendant claimed, however.” The complaint reportedly goes on to allege that “while defendants were directing AIG to issue improper statements concerning its exposure to the subprime mortgage crisis, they were also directing AIG to repurchase over $3.7 billion of its own shares at artificially inflated prices. Even worse, certain defendants sold their personally held shares while in possession of material nonpublic information for over $6 million in proceeds.”

The complaint alleges that AIG’s results were hurt by $1.4 billion in losses in AIG’s investment portfolios and mortgage insurance business.

The new lawsuit is significant because it represents the first subprime-related D & O claim in the broader insurance industry. Given the recent news from other companies in the insurance sector (as, for example, with Swiss Re, refer here) there may well be more claims to come in the insurance sector. But even more importantly, it seems increasingly likely that the subprime wave will continue to expand, even beyond insurance and the financial services industry generally, to encompass an even broader range of companies. An example of this risk outside the financial services sector may be seen in the recent problems reports at General Motors (about which refer here). Given the remarks of the leading plaintiffs’ lawyer reported below, this possibility appears to loom even larger.

“F-Cubed” Claimants Out of Royal Dutch Shell Securities Case: As I noted in an earlier post (here), a critical question arising with increasing frequency is the jurisdiction of U.S courts for foreign litigants’ securities claims against foreign companies. This question is presented in its starkest form with the so called “F-Cubed” claimants (foreign domiciled claimants who bought their shares of a foreign company on a foreign exchange, for further discussion of which refer here). In the context of a U.S. class action, the question is whether or not these claimants should or should not be included within the plaintiff class.

In a November 13, 2007 decision (here), Judge Joel Pisano of the federal court in New Jersey held that “Non-U.S. Purchasers” should not be included in the class for the Royal Dutch Shell securities class action lawsuit, and dismissed their claims on the ground of lack of subject matter jurisdiction. It should be noted for purposes of this discussion that Royal Dutch Shell is a Dutch corporation with headquarters in the Netherlands, and co-defendant Shell Transport and Trading Company is a U.K. corporation with headquarters in the U.K.

The “Non-U.S. Purchasers” consisted of “persons or entities who purchased their shares on exchanges outside of the United States and at the time of such purchase were residents or citizens of, or were created in or under the laws of any jurisdiction other than the United States.” The question whether or not these person should be included in the class was particularly important in the Royal Dutch Shell case because “a great majority of the securities traded during the Class Period were traded on foreign exchanges and by the Non-U.S. Purchasers.” In order to address the question, Judge Pisano appointed a Special Master, whose findings he adopted in his November 13 opinion.

In adopting the Special Master’s findings, Judge Pisano clearly was influenced by the $352.6 settlement that Shell had entered in the Amsterdam Court of Appeals in the Netherlands, with a Dutch foundation specifically formed to represent the non-U.S. purchasers’ interests. (Refer here for background regarding the Dutch settlement.) Judge Pisano specifically noted that the Dutch settlement agreement is conditioned on whether the U.S. court exercised subject matter jurisdiction over the non-U.S. purchasers.

The parties had agreed that the U.S. court’s jurisdiction over the non-U.S. purchasers depended on whether the defendants’ conduct occurred with the U.S. Essentially (I am simplifying here) because the court (adopting the Special Master’s findings) found that “the genesis of all of the original disclosures relevant to the investing public was in Europe,” and the court concluded there was insufficient conduct in the U.S. to support the exercise of extraterritorial jurisdiction.

The Royal Dutch Shell opinion stands in arguable contrast to the recent Vivendi class certifications decision in which some (but not all) of the non-U.S. Vivendi purchasers were included within the class (about which refer here).
The importance of the Dutch settlement’s existence to the outcome in the Royal Dutch Shell case also presents an interesting question – would the outcome have been the same if there were no existing alternative vehicle for relief of the Non-U.S. purchasers?

In any event, while the Royal Dutch Shell class decision represents an important development in the evolving issue of U.S. court’s jurisdiction over foreign shareholders’ claims against foreign companies, it is important to note that the decision was very fact specific. Because of the decision’s fact dependency, it is unlikely to control other courts, although it does represent a procedural model and a compelling summary of the relevant legal considerations.
Finally, it should be noted that Judge Pisano later affirmed that his November 13 opinion represents a final judgment, and it is therefore appealable to the Third Circuit. So there may yet be more to be heard on this issue in this case.

Subprime: What’s Happening Now: As noted above, the subprime wave is already expanding outward, but the plaintiffs’ lawyers may just be getting started. According to recent news reports (here), Patrick Coughlin of the Coughlin, Stoia, Geller, Rudman & Robbins firm, has declared subprime the “top priority.” The article quotes Coughlin as saying that subprime is “really everything and the only thing now.” The news article reports that the firm had “already filed 25 mortgage-related complaints against investment banks, mortgage lenders, and others, and it expects to bring about 15 more cases.” The firm is considering bringing on more lawyers.

And speaking of the Coughlin Stoia firm, I recently noted (here) that the increased securities litigation activity in the second half of 2007 is due in large part to the sudden increased activity of the firm, a fact that is corroborated in the recent news reports. The article quotes Coughlin as saying “we have filed more cases in the last three or four months than we filed in the previous year.”

So much for the supposed “permanent shift” to a lower level of securities lawsuit filings.

Adding Injury to Insult: In an earlier post (here), I commented on United Rental’s litigation efforts and threats to try to compel Cerberus Capital Management to honor its agreement to acquire United Rentals. It now appears in addition to United Rental’s lawsuit against Cerberus, on November 20, 2007, certain United Rentals shareholders initiated a purported securities class action lawsuit. According to the plaintiffs’ attorneys’ press release (here), the plaintiffs allege that the company and its directors and officers violated the federal securities laws by “failing to disclose that, several weeks after the Merger Agreement was signed, Cerberus contacted [United Rentals] and expressed concern about its ability to proceed with the merger given the changes in the credit and financial markets.” The plaintiffs allege that the failure to disclose these facts misled investors and caused United Rental’s shares to trade at artificially inflated prices.

While I have previously speculated that the buy-out bubble bust would provoke litigation, I confess I never anticipated the possibility of securities lawsuits by the shareholders of the disappointed target company. But there certainly are no shortage of these kinds of situations around these days, and hyperactive plaintiffs’ lawyers could well create an entire category of lawsuits like this one.

The purport of the allegations suggests a keen dilemma for company managers who are trying to hold a floundering merger together; the plaintiffs’ allegations suggest that at the very time that managers are engaged in fraught negotiations to salvage the deal, they should be publicly disclosing the challenges confronting the merger’s completion.

The problem here is that the deal fell apart, which event management was trying to prevent – there would have been no injury if the deal went through, and whatever chance there was to salvage the deal would not have been advanced if management had been issuing press releases every day about the ebb and flow of the discussions.

I feel like throwing a flag on this lawsuit. Unsportsmanlike conduct, unnecessary roughness, piling on. But that doesn’t mean there won’t be more cases like this one, I suppose.
UPDATE: Adam Savett of the Securities Litigation Watch blog points out that a buyout bust up previously resulted in a securities class action lawsuit in connection with the failed Harman Interational buyout. I actually discussed the Harman lawsuit in an earlier post, here. So, does two lawsuits constitute a trend?

As a result of the Sarbanes-Oxley Act and other reforms, a variety of structures and procedures were put into place to try to prevent or detect fraud. A number of these reforms involve auditors and the audit profession, in the implicit assumption that auditors have an important role to play in preventing and detecting corporate fraud. But a recent Grant Thornton survey (here) shows that many CFOs still do not feel constrained by their auditors’ oversight, notwithstanding the reform measures.

According to the survey, 62% of the 221 CFOs surveyed believe it would be possible to intentionally misstate their financial statements to their auditors. As one commentator in the November 15, 2007 CFO.com article (here) commenting on the survey put it, these numbers are “alarming,” given that “CFOs – if they’ve a mind to -are in a unique position, having the necessary information, intelligence and access to trick auditors in ways that are hard to decipher.”

Indeed, it is disconcerting that nearly two-thirds of CFOs feel they could fool their auditors on intentionally falsified financial statements. Clearly, if such a large percentage of CFOs feel they could, some of them might, and a few of them will. This intimation of the possibility of undetected fraud should be disconcerting to investors, analysts, and others (including D & O underwriters) who rely on auditors’ assurance that the financial statements are free from “material misstatement.”

The disappointment and even anger that investors and others feel when they find they have been misled by falsified financial statements often encompasses a sense of frustration that the auditors failed to detect the fraud. Accordingly, auditors are often named as co-defendants in securities fraud lawsuits, based on a failure to detect the fraud and the auditors’ statements that there are no material misstatements in the financial statements.

But a further Grant Thornton survey finding underscores the theoretical limitations of audit fraud detection. 83 percent of the surveyed CFOs said they did not feel that it was even possible for auditors to detect corporate fraud in all cases. This survey finding embodies the same sentiment expressed in the November 2006 statement of the heads of the six leading accounting firms entitled “Global Capital Markets and the Global Economy: A Vision From the CEOs of the International Audit Networks” (here). The accounting industry leaders noted that “there are limits to what auditors can reasonably uncover, given the limits inherent in today’s audits.” They go on to note that while there are audit techniques whose principal goals are to “ascertain whether fraud has occurred,” these techniques are “not foolproof, nor can they be expected to be.”

The problem for everyone, both auditors and those who rely in their audits, is that there is, in the words of the industry leaders’ statement, an “expectations gap.” According to the accounting leaders, the gap arises because “many investors, policy makers, and the media believe that the auditor’s main function is to detect all fraud, and thus, where it materializes and auditors have failed to find it, the auditors are presumed to be at fault.” The accounting leaders go on to assert that:

Given the inherent limitations of any outside party to discover the presence of fraud, the restrictions governing the methods auditors are allowed to use, and the cost constraints of the audit itself, this presumption is not aligned with the current auditing standards.

The accounting leaders’ frustration is palpable; they apparently recognize, as do the CFOs that responded to the Grant Thornton survey, that management bent on misrepresenting their company’s financial condition can conceal the misrepresentations from the auditors. But the reason there is nonetheless an expectations gap is that investors and others do rely, as they must, on company’s audited financial statements. Merely naming the problem as an expectations gap, or citing the limitations of current auditing standards, does not address the problem, which is that investors and others rely on the audited financial statements in ways the auditors apparently wish they wouldn’t or believe they shouldn’t. It almost seems as if the auditors’ message to those who would rely on financial statements is – don’t (or, at least, not so much).

Given the CFOs’ and the accounting leaders’ recognition of the limitations of audit fraud detection, it may be well argued that audited financial statements in fact should not be relied upon. But what alternative do investors have? The investors necessarily place some value on the fact that professionals independent of management have examined the financial statements.
It is nevertheless a significant concern that nearly two-thirds of CFOs believe they can fool their auditors. And apparently the auditors agree with the general proposition as well. This ought to make anyone who needs must rely on audited financial statements very uneasy.

Special thanks to John Condon at Audit Integrity for the link to the survey results and the CFO.com article.

A Service Error Apology: I am sorry that early in the evening on November 19, 2007, my syndication service spontaneously generated an erroneous email with the cryptic message “Forbidden 403.” (For those, like me, who have to know, Error 403 messages are explained –sort of — here.) I do not know why this error message was sent. I apologize to all of my readers for the unsolicited distribution email. I am attempting to ensure that this error will not recur.

A November 18, 2007 New York Times article entitled "If Buyout Firms Are So Smart, Why Are They So Wrong?" (here) takes a critical look at many buyout firms’ sudden haste to walk away from deals that were much ballyhooed only a short time ago. Clearly the bloom has gone off the buyout vine. As I discussed in an earlier post (here), litigation is an inevitable byproduct of the bursting of the buyout bubble. The battle lines in many of these lawsuits will the "material adverse effects" provision in the various buy-out agreements, which permit termination of the transaction where the target company’s business conditions have deteriorated.

The right of a would-be buyer to invoke this provision is getting a close examination in the lawsuits arising our of the failed J.C. Flowers takeover of Sallie Mae. As discussed in a November 14, 2007 Law.com article entitled "Sallie Mae Litigation Raises Issue of Deal ‘Adverse Effect’" (here), J.C. Flowers is arguing that the collapse of the securitization market and the disruption of asset-backed commercial paper have disproportionately affected Sallie Mae, and therefore have had a materially adverse effect on the company. Sallie Mae for its part contends that the credit crunch was excluded from the adverse effect clause. The court has set a July trial for the dispute.

The invocation of the materially adverse effect clause is one way for a would-be buyer to attempt to bail from a pending acquisition that no longer looks as attractive. An alternative approach, albeit one rarely followed, may be seen in the action of Cerberus Capital Management, which on November 14, 2007 advised United Rentals that it was not prepared to complete its planned acquisition of the company. (Refer here for the company’s announcement.) Rather than arguing that there has been a materially adverse development, Cerberus has simply terminated the contract and tendered the specified termination fee of $100 million. As United Rentals put it,

Cerberus has specifically confirmed that there has not been a material adverse change at United Rentals. United Rentals views this repudiation by Cerberus as unwarranted and incompatible with the covenants of the merger agreement. Having fulfilled all the closing conditions under the merger agreement, United Rentals is prepared to complete the transaction promptly. The Company also pointed out that Cerberus has received binding commitment letters from its banks to provide financing for the transaction through required bridge facilities. The Company currently believes that Cerberus’ banks stand ready to fulfill their contractual obligations.

The Company’s November 14, 2007 filing on Form 8-K (here) attaches all of the critical correspondence between Cerberus and United Rentals pertaining to the deal termination. It makes for rather interesting reading.

As discussed in an excellent post on the M & A Law Prof Blog (here), buyout firms in the past would have avoided terminating a deal and triggering payment of the reverse termination fee, both because of the cost involved and because reputational harm involved in walking away from a deal. The blog post puts it, "Cerberus has decided that the reputational impact of their actions is overcome in this instance by the economics." The New York Times article cited above states that "Cerberus just proved itself to be the ultimate, flighty, hot-tempered partner."

In its November 14 press release, United Rentals also announced that it had retained counsel to represent it in potential litigation. As discussed in the M & A Law Prof Blog post, it seems likely there will be litigation, possibly involving the investment banks as well. The blog post has a detailed analysis of the relative merits of the parties’ positions as well as the likely practical implications. UPDATE: The Wall Street Journal online reported on November 19, 2007 (here) that United Rentals has initiated an action against Cerberus in Delaware Chancery Court.

In short, the prospects are that the bust of the leveraged buy-out boom will entail a wave of follow-on litigation. But it should be noted that in many instances, litigation may prove to have merely been negotiation by other means. As the Times notes,

private equity firms seem to believe that they have plenty of wiggle room. In many of the recently broken deals, they appear to have relied on litigation threats rather than contractual language when telling sellers they plan to back out. As the law firm Weil, Gotshal & Manges recently noted in a briefing to its clients, "even a weak, but plausible" argument that a material financial change has occurred may "provide a buyer with a significant leverage in negotiating a deal."

On the other hand, it is worth noting that the most celebrated case in which a buyer sought to invoke the materially adverse change clause in order to cancel a deal, Tyson Foods attempt to cancel its acquisition of IBP, was unsuccessful — the Delaware Chancery Court granted IBP’s request that the court specificially enforce the acquisition agreement (about which refer here). A good overview of the issues surrounding the "materially adverse change" clause can be found here.

More About the End of the Securities Litigation Lull: As recently noted on the 10b-5 Daily blog (here), respected experts who really should know better are continuing to repeat the now-dated view that securities lawsuits are in a downturn with "no real upturn… in sight." Regular readers of this blog know that in recent posts (here and here), I have shown that while securities filings may have been down between mid-2005 and mid-2007, since July 1, 2007, securities filings have returned to historical levels.

In a recent post on the Securities Litigation Watch blog (here), Adam Savett not only corroborated my earlier conclusion about securities lawsuit filing levels, but (armed with superior information), also further concluded that filings during the second-half of 2007 in fact are above historical levels. He specifically notes that the filing rates during the period August 1, 2007 through October 31, 2007 translate to an annualized filing rate of as many as 272 filings, which could represent as much as a 41% increase over historical filing averages (depending on whose average you use by way of comparison).

This recent increased filing trend has continued so far in November, as well. By my count, as of November 16, there had already been 13 new securities class action lawsuits in November 2007. The 10b-5 Daily notes that much of this activity is being driven by the sudden hyperactivity of the Coughlin Stoia law firm, which has been the first to file many of the newest lawsuits – which, it might be added, involved in many instances foreign domiciled defendant companies. While a full statistical analysis of the 2007 filings must await a later date, it is clear that we are long past the point where responsible persons can continue to repeat that we are in a filings lull. The lull is over, having ended months ago in the wake of subprime meltdown and the disruption in the credit market.

A particularly good discussion of the reasons for the lull and the reasons why its eventual end was inevitable may be found here, in a column written by my good friend Randy Hein of Chubb and appearing in the December 2007 issue of Directors & Boards.

Dodgy Debts, Yes, But Very Good Names: As the subprime meltdown has unfolded, many of us have struggled to understand what happened and what the effects may be. A good example of a recent attempt to explain the possible consequences may be found in the November 13, 2007 Vinson & Elkins memorandum entitled "Subprime Fallout: A Ripple Effect?"(here).

 
A more entertaining attempt to explain the subprime meltdown and its effects may be found on this YouTube video (special thanks to Faten Sabry at NERA Economic Consulting for the link), here:

https://youtube.com/watch?v=SJ_qK4g6ntM%26rel%3D1

 

As the options backdating cases flooded in a year ago, the standard explanation of the plaintiffs’ lawyers preference for shareholders derivative lawsuits over securities class action lawsuits was that stock price declines rarely accompanied companies’ options backdating disclosures. (A list showing the predominance of derivative lawsuits among options backdating cases can be found here.) Any doubts about the challenge that the absence of a stock price drop poses for erstwhile options backdating securities class action litigants should be put to rest by the November 14, 2007 opinion (here) dismissing the options backdating-related securities class action lawsuit pending against Apple and 14 of its current and former directors and officers. Background on the lawsuit can be found here.

Judge Jeremy Fogel first addressed the defendants’ contention that the plaintiff’s claim for “corporate overpayment” properly represented a derivative rather than a direct claim. Judge Fogel noted that

The thrust of the allegation is that the recipients of the backdated options were overpaid, in violation of Apple’s stock option plans. Such allegations necessarily involve an injury to the corporation in that overpayment entails a reduction in corporate assets…. Lead Plaintiff has not identified a unique injury independent of any harm done to the corporation….Were Plaintiff to file an amended complaint, their claims would be stated as derivative claims on behalf of Apple. However, any derivative claims on behalf of Apple arising from the facts alleged in the Complaint likely would be subject to consolidation with the pending derivative action.

Judge Fogel then went on to analyze the plaintiff’s purported claim for fraudulent proxy solicitation under Section 14(a). Judge Fogel noted that in order to establish this claim the plaintiff must plead “both economic loss and loss causation.” Because Apple’s stock price did not decline on the news of options backdating, the plaintiff bases its economic harm argument on the purported dilution to the shareholders’ interests from the issuance of backdated options. Judge Fogel noted that dilution is not necessarily accompanied by economic loss, because share prices might rise on the news of retention of a key executive upon issuance of options. Judge Fogel stated that “without a discernable drop in the stock price there is no basis upon which to establish an injury to shareholders. Dura bars any suit brought solely on the basis that a misrepresentation caused an inflated share price, and Lead Plaintiff alleges no more harm.”

Judge Fogel dismissed the case with leave to amend, but also with the further admonition that any amended pleading should be filed as a derivative rather than as a direct complaint.

An earlier post discussing the New York City Employees’ Retirement System as the lead plaintiff in the Apple options backdating securities lawsuit can be found here.

Special thanks to a loyal reader for forwarding a link to the Apple opinion.
UPDATE: The November 19, 2007 Wall Street Journal has an article entitled “Firms Settle Backdating Suits” (here) discussing options backdating lawsuit dispositions. Full disclosure: I am quoted in the article.

A Comment on Judge Fogel’s Opinion: Judge Fogel’s opinion is seemingly important, particularly his comments with respect to loss causation, given that many of the options backdating cases have been filed in his judicial district – and indeed many backdating cases are pending before Judge Fogel himself. However, in issuing his opinion, Judge Fogel has repeated his unfortunate practice of issuing his opinions as “Not for Citation.”

As I discussed at greater length here with respect to Judge Fogel’s prior effort to bar citation of one of his earlier options backdating opinions, the attempt to delimit the precedential authority of a judicial decision is a truly regretable practice. It is as if he is attempting to say that the court’s business is strictly a private affair of no concern to anyone except the immediate parties. The sheer number of options backdating cases in Judge Fogel’s courthouse belies this notion. Clearly, his conclusions about loss causation are of potentially great significance for other cases and litigants. It is absurd to suppose that litigants with cases presenting loss causation issues of the kind raised in the Apple case cannot refer to the Judge’s own determinations on the issue but must reargue them all over again, but that is what his citation bar suggests.
It is as if he is saying, here’s my decision, but don’t quote me on it. Seriously, what is that all about?
The inferential suggestion that Judge Fogel is deciding cases on other than universally applicable principles ought to be a concern both to the immediate litigants and to litigants everywhere. The practice of issuing opinions, particularly on matters of great interest and obvious significance for similar pending matters, as “not for citation” is inconsistent with our common law traditions and notions of public justice and rightly deserves the strongest disapprobation.

Two Other Options Backdating Cases: There were two other options backdating case developments in the past week. First, according to the company’s November 13, 2007 8-K (here), the federal court in Oregon has dismissed four consolidated options backdating cases pending against Flir Systems as nominal defendant due to lack of standing. Reportedly, however, a separate options backdating derivative suit remains pending.

In addition, on November 14, 2007, the federal court in Manhattan denied the motion of Monster Worldwide founder Andrew J. McKelvey to dismiss the options backdating-related securities class action lawsuit pending against him. (The decision apparently relates only to McKelvey and not to other defendants in the case, which include the company itself.) According to news reports (here), the court’s opinion explaining the denial. will be forthcoming shortly.

In any event, I have added the Apple, Flir Systems and Monster dispositions to my list of options backdating-related lawsuit dismissals, denials and settlements, which can be accessed here.
Thanks to a loyal reader for links regarding the Monster decision.

SEC Drops Backdating Enforcement Actions: The above litigation developments occurring in the same week in which it was revealed that the SEC will not be pursing options backdating related enforcement actions against a host of companies it had been investigating. According to a November 13, 2007 Law.com article (here), Electronic Arts, Linear Technology, Nvidia, PMC-Sierra, and Zoran have each recently announced that the SEC has advised them that it had closed its backdating investigations. In addition, Verisign (refer here) and TriQuint Semiconductor (refer here) also made recent similar announcements.

It always seemed probable that the SEC would not ultimately pursue all of the companies it was investigating for options backdating. But the collective termination of this group of investigative actions, as well as other recent judicial developments, does reinforce the impression that the options backdating scandal may have been more than a little bit overblown. However, as the White Collar Crime Prof blog notes (here), the SEC may be “clearing out its investigative docket, likely clearing out weaker cases while it prepares stronger ones for some type of enforcement action.”

SEC Options Backdating Enforcement Actions: The List: We here at The D & O Diary set a lot of store by lists, having gotten such great mileage out of our lists of options backdating lawsuits (here), options backdating lawsuit dispositions (here), and subprime lending lawsuits (here). So we here were very pleased recently to discover the SEC’s own list of its options backdating-related enforcement actions (here).
The SEC site not only lists the SEC’s options backdating-related enforcement actions in reverse chronological order, but includes links to complaints and press releases for each action. The site also indexes SEC statements and speeches on backdating, as well as links to options backdating press releases from the Department of Justice and various U.S. Attorneys’ offices. For those tracking backdating generally, this site is a great resource.

For those keen to cast blame for the subprime meltdown, the rating agencies have already emerged as a favored target. For example, when Citigroup recently announced (here) a significantly increased write-down of subprime mortgage assets, it attributed the action to recent rating agency asset downgrades.

The rating agencies’ own shareholders have already jumped on the blame game bandwagon, suing Moody’s (refer here and here) and S & P’s parent company, McGraw-Hill (refer here), alleging that the agencies assigned excessively high ratings to bonds backed by risky subprime mortgages – including bonds packaged as CDOs – causing investors to be misled as to the quality and riskiness of these investments. (My earlier post on the lawsuits against the rating agencies can be found here.)

Connecticut Attorney General Richard Blumenthal has even announced (here) that he has issued subpoenas to the three largest rating agencies as part of an antitrust investigation into the debt rating industry.

In addition, academics have, as discussed at greater length here, already questioned whether investors in mortgage-backed assets may try to target rating agencies, alleging that they (the investors) were misled into investing in assets on the mistaken belief that they were investing in investment-grade assets. Investors, the academics theorize, might allege that the rating agencies’ conflicts of interest and involvement in the deal process led to the agencies’ understatement of risk.

One possible constraint on claims of this sort may be that in the past when rating agencies have been sued (for example, in connection with the Orange County bond default), the agencies have successfully argued that their rating activities were protected by the First Amendment, as mere opinions of creditworthiness.

In a November 2007 paper entitled "Not ‘The World’s Shortest Editorial’: Why the First Amendment Does Not Shield the Rating Agencies From Liability for Over-Rating CDOs" (here), David Grais and Kostas Katsiris of the Grais & Ellsworth law firm take the position that "the First Amendment will not protect the rating agencies in the massive litigation likely to ensue from their role in the subprime debacle."

The authors concede that rating agencies are indeed entitled to First Amendment protection when they are "acting as a member of the press," as for example when they are publishing indicies, databases or periodicals. The authors contend that a different standard applies when the rating agencies are rating a security; in particular, they contend that the courts have found that rating agencies are not entitled to the First Amendment protection when three factors are present: when a rating agency "rates only those securities it is hired to rate"; when the rating agency "participated in structuring the security"; and if the security was "privately placed" rather than "offered to the public."

These factors, the authors argue, weigh against the rating agencies in connection with any attempts to rely on the First Amendment to protect their activities in rating CDOs. The authors contend:

 

In their traditional role of rating and writing for their subscribers about all debt securities offered and traded publicly, the rating agencies may well have acted as members of the press. But in rating structured securities like CDOs, which the agencies normally rate only for a fee, often participate in the structuring of, and which are usually sold and traded privately, the reverse is true: the rating agencies are not journalists gathering information and reporting to the public, but rather participants in the transactions that they rate.

The authors go on to argue that, even if the agencies activities are found to fall within the First Amendment’s protection, the protection afforded would not be sufficient to shield the agencies from liability, since the rating agencies would still have to show why they should be exempt from "laws of general application" (such as tort law provisions for negligence or fraud, for example). The authors argue that the rating agencies would not be able to rely on either of the usual bases on which such exemption is claimed. That is, the rating agencies will not, the authors contend, be able to rely on the usual defenses of the absence of "actual malice" or that their ratings were protected "opinion." Therefore, the authors contend, neither of these theories "will help the rating agencies in litigation for over-rating CDOs and similar securities."

The rating agencies are well aware that they face these kinds of criticisms and attacks and have already begun marshalling their defenses. For example, in an August 23, 2007 publication entitled "The Fundamentals of Structured Finance Ratings" (here), S & P set out to answer its critics and defend its structured finance practices. The publication defends the dialog that occurs during the process of rating structured finance products, such as CDOs, saying that it is no different than the routine discussions involved in non-structured finance-related issues, and an in any event does not amount to "advisory" work; the publication asserts that "we will never tell an arranger what it should or should not do."

And as for the fact that the rating agencies are paid by the issuers they rate, the S & P publication asserts that its ratings are "extremely transparent" because all ratings are published and all transactions are described in press and industry reports. "Any untoward behavior," the publication notes, "would attract instant attention and endanger both investor confidence in us and our entire franchise." The issuer-pay fee mechanism also allows S & P to publish ratings free to investors, promoting the "broad and free dissemination of important information to the marketplace quickly."

While the legal article’s authors recognized the S & P publication as "thoughtful," the legal article’s authors also contend that the S & P’s points "are unlikely to persuade the courts that S & P or its competitors act as members of the press when they rate CDOs." The role that the rating agencies play may not be an advisory one, but their participation in the structuring of the security by their commentary on the various iterations may be enough to establish a role that is incompatible with the invocation the full First Amendment protections.

Whether or not the legal article’s authors’ analysis ultimately proves correct, their theories are likely to receive an attentive hearing in certain quarters, and their views are likely to strengthen the already established tendency to assign blame to the rating agencies for the subprime meltdown. Given the authors’ analysis, it seems probable that the subprime litigation wave will include mortgage-backed asset investors blaming their losses on rating agencies for investments they contend were inappropriately rated as investment-grade.

Special thanks to Kostas Katsiris for providing a copy of and a link to the legal article.

$400 Billion in Subprime Losses?: Whatever incentives there are now for blame shifting against the rating agencies are only likely to increase in the coming months, as mortgage related investment losses grow. While estimates of the likely losses from the subprime meltdown are necessarily imprecise, some of the estimates are nonetheless impressive. For example, according to a November 12, 2007 Bloomberg.com article (here), a Deutsche Bank analyst has estimated that "losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide."

The Deutsche Bank analyst specifically projects that Wall Street banks and brokers ultimately may be forced to write down as much as $130 billion due to the decline in subprime debt, up to $60 or $70 billion of that this year. (Current write-downs total around $40 billion).

Losses anywhere near that order of magnitude will definitely provoke the investors and others to look for targets against whom to assign blame. I suspect strongly that before all is said and done, the First Amendment theories discussed above will be fully ventilated in the courts.

Rule 144A Markets Form Single Trading Platform: As I have previously noted, various parties have recently launched competing platforms for trading Rule 144A securities. For example, Goldman Sachs launched it s GSTrUE platform (as discussed here), several other investment banks had combined to form the OPUS 5 platform (refer here), and NASDAQ had lauched the Portal platform (refer here).

However, on November 12, 2007, Nasdaq announced (here) that the leading Wall Street firms had dropped their competing systems and agreed to cooperate on a single platform, the Nasdaq Portal system. The founding members include Bank of America, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley , Nasdaq, UBS and Wachovia Securities.

Nasdaq said about this intitiative that:

 

The PORTAL Alliance will work with third-party service providers to create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs").

The PORTAL Alliance participants will contribute the expertise gained in connection with the development of their existing 144A platforms to create an industry standard facility with a uniform set of procedures for issuers and QIBs to bring greater efficiency and transparency to the 144A equity marketplace.

A September 12, 2007 Wall Street Journal article discussing the formation of the single platform alliance can be found here.

 

In the days following Citigroup’s November 4, 2007 announcement (here) that it would be writing off an additional $8 to $11 billion due to declines in values of U.S. subprime related debt exposures, as well as its announcement (here) of the departure of its Chairman and CEO Charles O. Prince, the company has been hit with a heap of lawsuits, making it the latest company to be caught up in the subprime lending-related litigation wave.

The first lawsuit, initiated on November 6, 2007, was filed by a Citigroup employee on behalf of participants and beneficiaries of the Citigroup 401(k) plan and the Citibuilder 401(k) plan of Puerto Rico, for alleged violations of ERISA in connection with the loss of value in the Citigroup stock held in the plans. A copy of the plaintiff’s counsel’s press release can be found here, and the complaint can be found here. The complaint names as defendants the company, Prince, and the plans’ administrative and investment committees. According to the press release, the complaint alleges that

Citigroup and the various defendants breached their fiduciary duties owed to the Plans’ participants by: (1) failing to prudently and loyally manage the Plans’ assets; (2) failing to provide participants with complete, accurate and material information concerning Citigroup’s business and financial condition necessary for participants to make informed decisions concerning the prudence of directing the Plans to invest in Citigroup stock; and (3) failing to appoint and monitor the performance of the other fiduciaries. Citigroup’s exposure to the subprime market and its contingent liabilities with respect to various off-balance sheet transaction has led to the resignation of Citigroup’s CEO and caused the Plans to suffer well over $1 billion in market losses.

Next, on November 7, 2007, a Citigroup shareholder filed a shareholders’ derivative lawsuit (here), against the Company as nominal defendant, and numerous present and former directors and officers. The complaint alleges “breaches of fiduciary duties, waste of corporate assets, unjust enrichment, and violations of the Securities Exchange Act of 1934.” The complaint alleges that the violations took place between January 2007 and the present and caused substantial monetary loss to the largest U.S. bank and other damages such as to its reputation and goodwill. A November 7 Wall Street Journal article describing the derivative lawsuit can be found here.

Then on November 8, 2007, a Citigroup shareholder filed a purported securities class action lawsuit against Citigroup and several present and former directors and officers. A copy of the plaintiff’s counsel’s press release can be found here and a copy of the complaint can be found here. (There have been several additional substantially similar securities lawsuit complaints filed against the company.) According to the press release, the complaint alleges that between April 17, 2006 and November 2, 2007,

Defendants issued materially false and misleading statements regarding the company’s business and financial results. The complaint specifically alleges that: (i) Defendants’ portfolio of CDOs contained billions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (ii) Defendants failed to properly account for highly leveraged loans such as mortgage securities; and (iii) Defendants had failed to record impairment of debt securities which they knew or disregarded were impaired, causing the Company’s results to be false and misleading.

It is now common to refer to the period earlier this decade when Enron, WorldCom and other corporate meltdowns occurred as the era of the “big corporate scandals, ” usually with the unstated implication that this era is well in the past. But with the recent high profile turmoil involving such corporate titans as Citigroup, Merrill Lynch, Washington Mutual and Countrywide Financial, it seems appropriate to ask whether the unfolding subprime meltdown may have evolved into a new (or perhaps renewed) era of corporate scandals.

At a minimum, the subprime mess has generated an impressive amount of high-stakes litigation. As reflected in my running tally of subprime lending-related lawsuits (here), 20 companies have now been sued in subprime-related securities class action lawsuits, in addition to the four residential construction companies and two credit rating agencies that have been sued in securities lawsuits, as well the three lawsuits brought by employees against their employers under ERISA raising allegations pertaining to plan losses arising from the subprime meltdown. At this point, it seems highly likely that there is significant additional litigation yet to come. The subprime mess may not yet have created any massive corporate failures on the scale of the era of corporate scandals from earlier in this decade, but the mess clearly already represents its own distinct (and growing) category of corporate scandal and related litigation.
$3 Billion in Subprime Related D & O Losses?: A recent attempt to quantify the extent of D & O insurance industry exposure from subprime-related litigation appears in the November 2007 publication of Guy Carpenter entitled “Credit Market Aftershock Threatens Professional Liability Profits” (here). The report notes that while the estimates of losses to the D & O insurance industry have varied from $1 billion to $3 billion, “when the dust settles, total insured losses are likely to be at the top end of analyst estimates (i.e. $3 billion), because most reports have understated the D & O limits at risk and assume there will not be many claims beyond what has been filed already.”
The report notes further that “there was never any doubt that the subprime mortgage market collapse would have an insurance impact. The question was one of extent. While estimates vary from $1bn to $3bn, it looks like the reality may settle at the upper end of the scale. The final answer will not come until 2008 or maybe even 2009, but history, litigation tendencies and capital markets point toward the worst case scenario,” The report goes on to note that “insured losses could account for 30% to 35% of D & O industry premium.”
Notwithstanding the scale of the reports projected losses and the extended duration of the loss period, the report speculates that the losses losses are “unlikely to reduce available reinsurance capacity or substantially impair (re)insurers’ results of balance sheets.”
While I am inclined to agree that with the report’s conclusion that losses are likely to range beyond many of current estimates, I think it is simply too early to tell the overall impact on capacity or insurer financial stability. For example, the report’s analysis relates only to lawsuits filed only through the end of October, and so omits consideration of the lawsuits already filed in November, such as the new lawsuits against Merrill Lynch, Citigroup, and Washington Mutual. The filing of these lawsuits, and the suddenness of their emergence, does tend to underscore the likelihood that losses will range higher than previously assumed, but the unanticipated emergence of the lawsuits against these corporate giants also suggests that the subprime problem may be even bigger than Guy Carpenter assumed when drafting its report. So while I agree with the report that the subprime problem is shaping up to be bigger than previously assumed, it is simply too early to predict whether or not it will impact capacity or insurer financial strength. It is worth emphasizing that the situation is worse than Guy Carpenter assumed when they wrote their report.

Foreign Institutional Investors Opt-In to U.S. Securities Litigation: In an earlier post (here), I discussed the involvement of foreign institutional investors in U.S.-based securities class actions, and the fact that courts are certifying classes including foreign investors who bought shares overseas, at least foreign investors from countries whose courts it is believed would recognize the U.S. court’s judgment. This class definition necessarily precludes investors from other countries.

As Adam Savett notes on the Securities Litigation Watch blog (here), this process has the “altogether predictable consequence” of encouraging large institutional investors that are excluded from the class definition to file individual or group actions in the United States. In fact, that is exactly what has happened with respect to foreign institutional investors precluded from the class in the Vivendi securities class action. (A copy of the Vivendi class certification decision certifying a class to include only investors from the United States, France, England, and the Netherlands, can be found here.) There have now been over a dozen individual or group actions filed by international institutional investors after having been excluded from the Vivendi class. A copy of one of the group complaints can be found here.

Would-be reformers cite U.S.-style securities litigation as one of the factors undermining the competitiveness of U.S securities markets, on the theory that overseas companies shun the U.S. exchanges to avoid American litigiousness. However, it seems clear that overseas investors find U.S. style litigation attractive. It is not far-fetched to suppose that as overseas investors become habituated to these processes for holding company management accountable, they may come to expect or even demand procedural alternatives in the home countries to hold company management accountable.

The presence of these individual or group actions paralleling the ongoing class case represent but one set of factors testing the continuing utility of securities class action litigation. Another factor is the recently increased prevalence of class action settlement opt-outs (about which refer here). Both of these developments may illustrate growing limitations to class action procedures. While alleged class action abuse has long been a rallying cry for corporate reformers, class actions arguably may be far more preferable than the alternative of massive piecemeal litigation that multiplies litigation costs and complicates efforts toward efficient case resolution.

JDS Uniphase Trial Updates: In an earlier post (here), I noted the significance of the pending securities trial of involving JDS Uniphase and several of its directors and officers. It has proven difficult to follow the trial, but as Lyle Roberts points out on the 10b-5 Daily blog (here), the best way to monitor the trial is on Crash.net, a motorsports website that is following the trial because former JDS Uniphase CEO Kevin Kalkhoven, one of the trial defendants, is also one of the owners of the Champ Car World Series.

Unfortunatly, the Crash.net website is confusing and difficult to navigate. I found that the best way to find the reports of the JDS Uniphase trial is to enter a search on Kalkoven’s name in the search box on the left-hand column. The website reports that the parties expect to complete the submission of evidence by November 16, 2007, with argument, instructions and jury deliberations to begin after Thanksgiving.

Wecome Back, Nugget: We here at The D & O Diary were fans of the late, lamented PSLRA Nugget, a securities law blog that went dormant some time ago. Apparently the old blog has been reincarnated and will be reinvigorated as the Acquirelaw Nugget (here). The old Nugget was great, so we are looking forward to seeing regular posts again from the new Nugget.

Speaker’s Corner: On Thursday November 15, 2007, I will be speaking on a panel entitled “Exploring Director & Officer Liability” at the IQPC Securities Litigation Conference in New York. Further information about the conference can be found here.

On November 6, 2007, the court in the Brooks Automation options backdating-related securities class action lawsuit substantially denied the defendants’ motions to dismiss. A copy of the opinion of Judge Rya Zobel of the District Court of Massachusetts can be found here. The Brooks Automation decisions joins the recent Openwave Systems decision (refer here), as one of now several decisions in which motions to dismiss have been denied in options backdating-related securities class actions. A complete list of the dismissals, denials and settlements in options backdating lawsuits can be found here.

The defendants had moved to dismiss the plaintiff’s claims under Section 10 of the ’34 Act on the grounds of loss causation, scienter and the statute of limitations.

With respect to loss causation,

Defendants argue that Brooks has not adequately alleged loss causation because Brooks’ stock price rose after the March 18, 2006 Wall Street Journal article and again after the July 31, 2006 publication of the Restatement. However, plaintiffs have alleged particular details regarding the decline in Brooks’ stock price that occurred during the period from May 11, 2006, through May 22, 2006, when Brooks made several successive disclosures regarding investigations into its stock option practices.

The court said that “although the parties dispute the exact timing of some of the disclosures and the resultant effect they may have had on the stock price, the complaint’s allegations of loss causation are … sufficient at this stage.”

With respect to the issue of scienter, the court said that defendants’ argument that the challenged grants “were part of either legitimate, demonstrable patterns or predetermined dates is credible.” However, the court went on to note that “the data compiled by plaintiffs and the Wall Street Journal regarding stock price movements on grant dates, together with Brooks’ Restatement, in which it admitted that millions of options were accounted for on incorrect grant dates, creates a reasonable inference that intentional backdating may have occurred.” The court did go on to find that with respect to the individual who served as the company’s CFO from November 1998 through October 2002, and with respect to one individual who served on the Board’s audit and compensation committees, that the individual allegations did not adequately scienter (although the former CFO’s motion to dismiss was denied as to control person liability allegations.)

The court also found that a factual issue remained on the question as to when the plaintiffs had or could have sufficient information available to trigger the running of that statute of limitations. The court also found that the plaintiffs’ allegations under the ’33 Act were also sufficient to survive a motion to dismiss. Judge Zobel did grant the dismissal motion of PricewaterhouseCoopers.

In substantially denying the defendants’ motions to dismiss, Judge Zobel clearly seems to have been influenced by the fact that the company had been required to restate its prior financials and that the company’s special committee found that the company had not properly accounted for its options grants. Judge Zobel also refers throughout the opinion to the allegations in the civil complaint filed by the SEC against the company’s former CEO. The implicit admission that options were backdated, and the presence of a separate SEC action, contrast with the circumstances surrounding the backdating allegations against Amkor Technologies, whose motions to dismiss were recently granted (refer here). The differing circumstances may perhaps explain the different outcomes.

In any event, the Brooks Automation dismissal denial has been added to my running tally of options backdating lawsuit dismissals, denials and settlements, which can be accessed here.

If you are like me and you don’t feel fully briefed on Option-ARM mortgages, then you will want to read the September 2006 Business Week article entitled “Nightmare Mortgages” (here) describing the pitfalls of Option-ARM loans. Among other things, the article states: “The option adjustable rate mortgage (ARM) might be the riskiest and most complicated home loan product ever created.” The article also quotes one economist as saying that the option ARM is “like the neutron bomb–it’s going to kill all the people but leave the houses standing.” The article, written more than a year ago, reads like a prophecy of war foretold.

An Option-ARM (as explained here) is an adjustable rate mortgage on which the interest rate adjusts monthly and the payment adjusts annually, with borrowers offered options on how large a payment they will make. The options include interest-only, and a “minimum” payment that is usually less than the interest-only payment. The minimum payment option results in a growing loan balance, termed “negative amortization.” Negative amortization of course means that the principal amount increases, a truly revolting development under any circumstances, but a particularly pernicious development when housing prices are falling.

In an October 24, 2007 Wall Street Journal article entitled “Countrywide’s New Scare” (here) explains how the higher commissions, lower documentation requirements, and flexible payment options encouraged Countrywide Financial Corp.’s development of this product. Deterioration on these mortgages is further undermining the results of lenders already reeling from subprime problems. Among other things, the Journal article reports that in the period 2009-2011, monthly payments on $229 billion of option ARMs will readjust (so borrowers may have to pay more).

The problems with Option-ARMs have now claimed their first lawsuit victim: Washington Mutual, along with three of its directors and officers, has been sued in purported securities class action lawsuits federal court in Manhattan. A copy of the complaint can be found here.

According to the plaintiffs’ counsel’s November 5, 2007 press release (here), the complaint alleges that:

During the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results. WaMu’s loan portfolio contained more than $57 billion in adjustable-rate mortgages or Option-ARM loans. The complaint further alleges that the Company failed to disclose: (i) that it had far greater exposure to anticipated losses and defaults in its home loan portfolio, particularly with Option-ARMs, than it had previously disclosed; (ii) that defendants’ Class Period statements about the Company undertaking significant preparations and implementing defensive measures to weather the increasingly difficult credit and housing markets were patently false; (iii) that defendants had engaged in a conspiracy and scheme to inflate the appraisal value of homes with the intent to artificially increase the estimated loan-to-value ratio of its Option-ARM portfolio; and (iv) that due to the Company’s improper appraisal practices, the mortgages it had issued were much riskier than represented.

The class action lawsuit follows WaMu’s October 17, 2007 announcement (here) that it was setting aside an additional $1.3 billion in the fourth quarter to cover its loan losses (primarily as a result of problems with Option-ARMs), and the New York Attorney General’s November 1, 2007 announcement (here) of a lawsuit against FirstAmerican Corporation and ePraiseIT, alleging that they had conspired with WaMu to inflate residential real estate appraisals.

Even though the lawsuit does not specifically reference subprime loans, the connection to Option-ARMs (which often went to first time home-buyers, and one of the advantages of which was the low documentation requirements) persuades me to add it to my running tally of subprime-related securities lawsuits (here). With the addition of this case, the tally now stands at 19 lawsuits, not counting the four subprime-related lawsuits pending against home construction companies.

In prior posts, I have discussed how conflicts of interest in management-led buyouts can give rise to litigation (refer here), and I have examined the ways the recent credit market turmoil is not only undermining leveraged buyouts but also engendering lawsuits (refer here). I have also extensively reviewed options backdating litigation (most recently here). But I never expected to see all three of these woes afflict a single company at the same time, yet that is exactly what has happened to Affiliated Computer Services, which finds itself and several of its officers the target of an unusual lawsuit brought by give not-quite-former outside directors as part of a veritable conflagration of accusations between management, the company and its independent directors.

The starting point for this story is ACS’s larger-than-life founder and Chairman, Darwin Deason, a four-times married former Arkansas farm boy who reportedly drinks the heinous combination of Diet Coke and Kahlua to self-treat an acknowledged drinking problem and who either did or did not threaten to kill his personal chef on his yacht in September 2001. These colorful personal details, and many more, are described at much greater length in a June 2003 D Magazine article entitled “Lifestyles of the Rich and Shameless” (here), as is this particularly interesting note about an unsuccessful MBO bid that Deason led in 1988, in connection with MTech, a company Deason previously founded:

In 1988, with banks failing all over Texas, MTech’s majority owner MCorp…began to slide toward Chapter 11. Reading the tea leaves, Deason puts together a $360 million management buyout of his firm. As the last second, thought, Plano-based EDS raises its hand and shouts “Four hundred and sixty-five million!” MTech is sold to the highest bidder. Deason is furious. He resigns some 90 minutes into his employment with EDS, apparently walking out before anyone can get him to sign a noncompete agreement….Five months later, with 18 of his top 22 executives from MTech on board, he launches ACS.

Having formed ACS from the remnants of a failed MBO in which he was outbid by a competing bidder, it may well be supposed that Deason was determined not to permit himself to be similarly outbid in his attempted buyout of ACS itself.

In late 2006, options backdating allegations put Deason and ACS on the front page of the Wall Street Journal. In a December 30, 2006 article entitled “Living Large and Bouncing Back” (here), the Journal provided further interesting details about Deason’s background, noting, among other things, that “although Mr. Deason, who retired as CEO in 1999 and is still ACS’s Chairman, received two option grants on extremely favorable terms, two internal probes didn’t find evidence that Mr. Deason knew about or took part in any backdating.”

The Journal article details ACS’s internal backdating investigations, the second of which resulted in the November 2006 resignation of Deason’s successor as CEO, Mark King, as well as the company’s CFO (the company’s press release about which can be found here). The Company itself later announced in a January 5, 2007 filing on Form 8-K (here) that it was amending the exercise date of certain option grants, including one grant to Deason. The Company said it was taking the step to eliminate negative tax implications. According to the Journal, these option related issues created tensions between Deason and the independent directors that may have carried over to the circumstances surrounding the MBO.

An options backdating-related shareholders’ derivative lawsuit against the company as nominal defendant and against certain current and former directors and officers remains pending (refer here).

In March 2007, Cerberus Capital Management, in conjunction with Deason (who owns 42% of the ACS voting rights, but less than 10% of its ownership by valuation) made a buyout offer that as adjusted was worth $6.2 billion. Cerberus withdrew its offer on October 30, 2007 (refer here), explaining that the withdrawal was “due to the continuation of poor conditions in the debt markets.” But while debt market turmoil undoubtedly was the ultimate trigger of the demise, a full-throttle dispute between Deason and the independent Board committee set up to review the offer was a critical circumstance in which events unfolded, and which set the stage for the current public fracas between Deason and the directors.

The dispute between Deason and the Special Committee is dramatically revealed in a series of letters, all of which are now very publicly available. The first letter (here, Exhibit A), dated October 30, 2007, and written by the Kosowitz, Benson, Torres, & Freidman law firm on behalf of ACS’s current CEO, Lynn Blodgett, demands the “immediate resignation” of the five Special Committee members, alleging that they had “totally failed to discharge [their] responsibilities, accusing them of delays that “squandered an immensely valuable opportunity” and having failed to elicit any alternative bids.” The letter also accuses the directors of having disclosed “confidential trade secret information” to one of ACS’s direct competitors. The letter concludes by accusing the five individuals of “gross breaches of their fiduciary duties,” and states that the Special Committee must be terminated and they must each resign “forthwith.”

Deason sent his own letter to the five individuals dated November 1, 2007 (here) in which he said he “most respectfully asks that you resign today from the Board.” Deason’s letter also accuses the five of delaying consideration of the Cerberus bid while failing to produce another bidder, as a result of which the Board has “lost shareholder trust.” Deason asserts that “changing the membership of the Board is in the shareholders’ best interest.” The letter also proposes a slate of “replacement directors.” Deason states that “the management of the Company has indicated it may also take action, including potential litigation, in the interests of the shareholders of the Company.” Deason concludes by asking the individuals to make the “right choice” and “resign immediately.”

The five directors responded in two letters dated November 1, 2007. First, their counsel, Weil Gotshal & Manges, responded to the October 30 letter, in a letter (here, Exhibit B) noting that the October 30 letter is “premised on the remarkable principle that it is management rather than the Board of Directors that is ultimately responsible for the business and affairs of the Company.” The Weil Gotshal letter asserts that the delays in considering the Cerberus bid were due to the inclusion in the Cerberus deal of Deason’s agreement to work exclusively with Cerberus, which provision the letter asserts was “designed to and did in fact chill the interest of competing bidders,” a provision that Deason refused until June 10, 2007 to waive. The Weil.Gotshal letter asserts that the Special Committee process did in fact result in a higher bidder, but that “management and Mr. Deason worked hard to assure that no buyer would have a full and fair opportunity to obtain the information necessary to make a proposal.”

The five ACS directors also sent their own November 1 letter (here) in response to Deason’s letter, in which they assert that they have “acted appropriately and in a manner designed to safeguard the best interests of the company.” The directors’ letter recounts the delays occasioned by Deason’s exclusivity agreement, and asserts that “you [Deason] and your management team worked hard to make it difficult for any other buyer to have access.” Their letter states that “your interest only in a transaction in which you would participate on the buy side and management’s interest in retaining their jobs” delayed the process.

The directors’ letter goes on to state, with reference to the October 30 board meeting:

Your carefully choreographed power play Tuesday evening to coerce the independent directors of ACS into resiging on the spot is consistent with your continuing refusal to understand that the Board’s fiduciary duties are to all shareholders – not just you. Your ultimatum: resign in one hour or I will go to the press and smear your reputations – was a remarkable piece of bullying and thuggery, and it almost worked.

The directors’ remarkable letter goes to state that Deason’s interference with the Special Committee “made it impossible for us to continue to effectively serve as directors.” The letter notes Deason’s extraordinary authority in his employment agreement (which apparently gives him the ability to recommend the approval or removal of directors) as well as Deason’s conduct, rendered the individuals unable to “properly discharge” their fiduciary duties. The letter observes that “we could fire you and the entire management team, but that would not help our shareholders, customers or employees. Rather it would rip the Company apart and cause a lengthy fight and a period of uncertainty from which the Company would be unlikely to recover…we have decided …that the best way for us to discharge our fiduciary duties is to resign in favor of a new majority of independent directors.” The letter concludes by stating that upon completion of the process of vetting independent director candidates, the five would step down “with great relief.”

Having offered their prospective resignations, the five individuals took one further extraordinary step: they filed a declaratory judgment action (here) in Delaware Chancery Court against the company, Deason, Blodgett, and ACS’s current CFO. The not-yet-former directors’ lawsuit, clearly filed as a preemptive strike against anticipated actions by Deason or company management, briefly repeats the assertions from the directors’ November 1 letter, and asks the court to “declare that the Plaintiffs have not breached their fiduciary duties.”

There is always a potential for a conflict of interest in a management-led buyout, as I have previously noted (here). The November 2, 2007 New York Times article entitled “A Bitter Rift When the Boss is the Buyer” (here) said that “the [ACS] drama highlights the potential conflicts that can occur when a founder or chief executive leads a deal to acquire a company, something that has become common in the recent wave of leveraged buyouts.” One of the most challenging issues that can arise in an MBO is what the Wall Street Journal describes in its November 2, 2007 article “A Failed Deal at ACS Sets Off a Board Brawl” (here) as the “fraught dynamics created inside boardrooms when insiders try to take public companies under private ownership.”

But even within the fraught dynamics that characterize these kinds of deals, the ACS tussle is extraordinary. It is pretty clear that the fraught dynamics gave way to open warfare as the two sides sought to establish who was to blame for the deal’s failure. Clearly, Deason’s determination to avoid losing out to a higher bidder, as he lost his 1988 attempt to buy out MTech, seems to be a critical part of many of the events. The topsy-turvy ouster of the independent Board members by company management may perhaps be explained, if not entirely understood, by the extraordinary provision in Deason’s employment agreement that actually gives him the authority to recommend the approval or removal of directors.

The directors for their part were put in a position of struggling against the company’s forceful Chairman while trying to determine whether an alterative to Deason’s bid would be in the sharholders’ best interests. The directors efforts took place under circumstances where shareholders had already initiated litigation (refer here) alleging that management-led buyout provided shareholders with inadequate value and that Deason had misappropriated inside information to secure Cerberus’s participation in the transaction.

Ultimately, what doomed this deal was a perverse combination of timing and the changing marketplace conditions. Although Deason eventually waived the exclusivity agreement with Cerberus, that didn’t happen until June, and the waiver only extended for two months. By August, changed conditions in the credit marketplace had greatly complicated ACS’s effort to determine potential interest in alternative buyers, and the Board sought a further extension of Deason’s waiver (about which refer here). But by then, Cerberus itself was having trouble securing financing, and the deal failed. With no prospects left, the finger-pointing began.

The five directors’ declaratory judgment action, in which they sued the very company on whose Board they still serve (at least until their prospective resignations become effective), represents another extraordinary aspect of this unusual set of circumstances. Their attempt to defend themselves preemptively by initiating a declaratory judgment action effectively seeks to enlist the court on their side in their struggle to establish that they are not to blame for what happened.

While the intensity and the public nature of the ACS dispute may be unusual, there likely will be other similar recriminations as changed credit conditions cause other planned deals to fall apart. The “fraught dynamics” may give way to further lawsuits – yet another byproduct of the changed conditions in the credit marketplace. It is probably worth noting in that regard that every aspect of these circumstances — the backdating allegations, the management-led buyout offer, and the managment dispute with the board — led to litigation against directors and officers of the company. Just something that every board should keep in mind the next time the topic of D & O insurance comes up. When things go bad, a well-structured D & O program is absolutely indispensible.

The directors’ declaratory judgment action poses some interesting issues from a D & O insurance perspective. The typical D & O policy has a so-called Insured vs. Insured exclusion, sometimes referred to as an infighting provision. While this provision usually has a coverage carveback for shareholders derivative suits, the typical wording contains nothing that would help understand where this lawsuit might fit. It would be hard to characterize these circumstances as anything other than “infighting.”

Hat tip to the WSJ.com Law Blog (here) for the links to the letters and to the directors’ complaint.

UCLA Professor Stephen Bainbridge has detailed analysis of the ACS “soap opera” on his Business Associations blog (here), including a discussion of relevant Delaware case law.

Bonfire of the Historical References: There was a real temptation in writing this post to refer to the title of Tom Wolfe’s wickedly funny book, The Bonfire of the Vanities. Although Wolfe’s title seemed perfectly apt for his book and, by extension, to this post, the book title is in fact a misplaced historical reference. The phrase “Bonfire of the Vanities” does not refer to a titanic conflagration of egos, but instead refers “the burning of objects that are deemed the occasion of sin” (according to Wikipedia, here), the most famous of which was the February 1497 burning of luxury objects by supporters of Savonarola (pictured above) in Florence, Italy. The phrase was undeniably a great title for Wolfe’s book, but a perhaps overactive desire to avoid historical infidelity constrained me from using the phrase in this post, much as it seems to fit the circumstances at ACS.