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.

With the recent dismissals of the options backdating securities class actions filed against Hansen Natural (refer here) and Amkor Technology (refer here), it was beginning to seem that momentum might be building against these suits. But in an October 31, 2007 opinion (here), the court denied in significant part the motion to dismiss the options backdating securities class action lawsuit pending against Openwave Systems and certain of its present and former directors and officers. The portion of the ruling of Judge Denise Cote of the federal court in Manhattan denying the dismissal motion may provide other plaintiffs some grounds to hope that their complaints may also survive motions to dismiss.

The amended complaint against Openwave contained allegations both under the Securities Act of 1933 and the Securites Exchange Act 0f 1934. The court granted the defendants’ motion to dismiss the ’33 Act claim, on the ground that claim, raising allegations related to Openwave’s 2005 secondary offering and only added to the lawsuit in the plaintiff’s amended complaint, was barred by the ’33 Act’s one-year statute of limitations. The dismissal included also the plaitniff’s ’33 Act claims against the company’s offering underwriters and the company ‘s auditors.
Judge Cote also granted certain individual defendants’ motions to dismiss the ’34 Act claims against them as well, on the grounds that the specific individuals had left the company before the beginning of the class period; did not arrive at the company until the alleged backdating took place; or were not alleged to have participated in the supposed misrepresentations.

Judge Cote denied the company’s and the remaining individual defendants’ motions to dismiss the ’34 Act claims. The defendants had moved to dismiss the allegations for failure to plead scienter and loss causation. In concluding that the plaintiffs had adequately pled scienter as to certain individual defendants, the court found that the individuals had “benefited in a concrete and personal way” by receiving backdated options from which they “garnered immediate returns,” which the court said were “immediate and risk free.” The court rejected as “irrelevant” defendants’ arguments that the options grant dates were nowhere near the monthly lows, noting that this “simply indicates that backdating did not achieve as much benefit to the grantee as it could have,” not that backdating did not occur.

The court also found, referring to plaintiff’s backdating allegations, that “such evidence” is “no less probative of scienter after the Supreme Court’s decision in Tellabs.” Judge Cote found that the defendants had “not pointed to any competing inferences” that “could explain their receipt of options bearing dates other than the ones on which they received them.” Judge Cote also rejected defendants’ arguments based on the fact that the defendants had received options prior to the class period, since the financials issued during the class period reflected faulty accounting based on the allegedly improper grants.

The court also specifically denied motions to dismiss as to the compensation committee member defendants, finding that their failure to monitor the exercise dates of the options grants “give rise to an inference of scienter.”

The court also found that plaintiff had adequately pleaded loss causation, rejecting defendants’ arguments that other causes explained the company’s stock price fluctuations, the factual determination of which the court found “is not an issue to be resolved on the basis of the pleadings alone,” but is rather “a matter for proof at trial.”

As shown on my running list of options backdating case dispositions (here), there has been at least one prior dismissal motion denial in an options backdating securities class action lawsuit (in the UnitedHealth Group class action case, refer here), but the Openwave Systems court’s denial, perhaps by contrast to the UnitedHealth opinion, is based on a detailed review of the allegations and applicable law. The Openwave dismissal denial also stands in contrast to the recent options backdating dismissal grants, such as in the recent Hansen Natural decision granting a motion to dismiss (refer here), where the court seemed very skeptical of plaintiffs’ allegations and very unwilling to find any support for the plaintiffs’ contention that the options had actually been backdated.

The short shrift given the defendants’ arguments represents a potentially significant development for plaintiffs in other options backdating securities cases. The quick work the court made of defendants’ arguments on scienter and loss causation could, if followed by other courts, have a significant impact on the ourcome of pending motions to dismiss.

The question is whether other courts will follow. Not all judges will be as willing as Judge Cote to conclude that the recipient of options “garnered returns” that were “immediate and risk free.” Other judges may focus on the fact there can be no gains on any options until they are exercised, and that until exercised, the share price can decline below the exercise price. Other judges might find the fact that the grants were not even at monthly lows to be inconsistent with the theory of fraud, just as when courts (and as did Judge Cote in another part of her opinion) will find an insider’s sale of a small portion of their share holdings to be inconsistent with the theory of fraud. Other courts might well conclude, in line with their duties under Tellabs, that options grants at other than the maximizing date to be similarly inconsistent with the theory of fraud, and sufficient to create a competing theory at least as compelling as theory that the defendants acted with the requisite intent.

In any event, I have added the Openwave Systems opinion to my running tally of options backdating lawsuit settlement, dismissals and denials, which can be found here. Press coverage discussing the October 31 opinion can be found here.

Openwave Systems (as nominal defendant) and certain of its current and former directors and officers were also the targets of options backdating-related shareholders’ derivative lawsuits. On May 17, 2007, the California federal court presiding over the consolidated shareholders’ derivative litigation granted (here) the defendants’ motion to dismiss with leave to amend. The plaintiffs filed an amended complaint June 29, 2007, and the defendants’ motion to dismiss the amended complaint remains pending.

In an earlier post (here), I questioned whether the two-year lull in securities class action filings had ended. I posed the question then because of the uptick in securities class action filings between August 1, 2007 and September 30, 2007. But with continued active filing levels during October 2007, the statement no longer has to put in the form of a question. It can be now be declared: the two-year lull is over.

According to my count, there were 24 new securities class action lawsuits filed in October 2007. That makes 61 companies sued for the first time between August 1, 2007 and October 31, 2007. If that three month filing rate were projected over a 12-month period, it would annualize to 244 filings (compared to the average of 202 annual filings during the period 1994 to 2004, according to Cornerstone Research). In other words, for the three solid months, the filings have been coming in at (or even arguably above) historical filing levels.

The final three days of October saw a particularly concentrated burst of new lawsuits, with eight companies sued for the first time in those three days alone:

Part of the increased activity is attributable to the subprime mortgage meltdown, but by no means all of it. For example, only two of the 24 October lawsuits (E*Trade and Merrill Lynch) clearly relate directly to the subprime mess. There are others that relate more generally to the strained real estate marketplace, but most of the October lawsuits have no apparent connection to subprime lending.

The 24 companies sued in October are in some ways a very diverse mix. Among the 24 companies, 21 different SIC Codes are represented. No SIC Code group had more than two companies represented. There are large companies (Merrill Lynch, Novartis) and small companies (Micrus Endovascular, Smart Online). It is interesting to note that five of the 24 companies are domiciled outside the United States, including three from China. Of the 19 remaining U.S. domiciled companies, four are based in Florida, four are based in California, two are from Connecticut and two are from New York.

Two of the three Chinese companies (LDK Solar and China Sunergy) are solar panel manufactures who launched their U.S IPOs to great fanfare earlier this year (about which refer here). Their fate (whether deserved or not) is not likely to help attract additional Chinese companies to offer their shares on U.S. exchanges. At least five of the new lawsuits (including the two against the Chinese solar panel manufacturers) contain allegations relating to the named companies’ recent IPOs.

While the view was expressed earlier this year (refer here), in light of the two-year stretch of reduced securities lawsuit filings, that perhaps there had been a “permanent shift” to a lower class action activity level, it now seems clear that there was nothing permanent about the lower filing levels that prevailed from mid-2005 to mid-2007. Recent turbulence in the financial markets, among other factors, clearly has led to renewed litigation activity at or even above historical levels. The likelihood of continued financial marketplace instability suggests that litigation levels may remain elevated for some time to come.

Investors undoubtedly were angry after Merrill Lynch announced on October 24, 2007 (here) that the company’s 3rd quarter results included “write-downs of $7.9 billion across CDOs and subprime mortgages, which are significantly greater than the incremental $4.5 billion write-down Merrill Lynch disclosed at the time of its earnings pre-release.” The $3.4 billion write-down increase less than three weeks after Merrill’s October 5, 2007 pre-release (here) perhaps made in inevitable that the lawsuits would fly, and so it comes as no surprise that on October 30, 2007, the Coughlin Stoia firm filed a complaint against Merrill Lynch and for of its directors and officers (including its now-former Chairman and CEO, Stanley O’Neill). The law firm’s October 30 press release about the case can be found here. The complaint can be found here.

The complaint is filed on behalf of shareholders who purchased Merrill Lynch stock between February 26, 2007 and October 23, 2007, and alleges that (as summarized in the press release):

during the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results. Merrill had gone heavily into Collateralized Debt Obligations (“CDOs”) which generated higher yields in the short term but which would be devastating to the Company as the real estate market continued to soften and the risky loans led to losses. According to the complaint, Defendants knew or recklessly disregarded that: (i) the Company was more exposed to CDOs containing subprime debt than it disclosed; and (ii) the Company’s Class Period statements were materially false due to their failure to inform the market of the ticking time bomb in the Company’s CDO portfolio due to the deteriorating subprime mortgage market, which caused Merrill’s portfolio to be impaired.

While at one level it is not surprising that Merrill Lynch has been targeted, there are reasons to wonder about the lawsuit filing. The most specific question relates to damages. Even though Merrill’s stock price dropped from 65.56 at a closing price of 63.22 on the day the larger than expected write down was announced, the stock closed today (October 30) at 65.56, just 2.34% less than the opening price on the day of the announcement. The plaintiffs apparently seek to augment these apparently shallow damages by stretching the purported class period back to February 2007, when Merrill’s stock was trading over 97. But the plaintiffs will have a difficult time establishing loss causation for the portion of the share price decline that preceded the October 24 announcement. The plaintiffs may try to claim that Merrill dribbled the corrective disclosure in two pieces, the pre-release and the actual release. Merrill’s share price opened at 76.67 the day of the pre-release, so plaintiff’s may try to rely on the decline from that point, but the emotional appeal of the case is the unexpected increase in the amount of the write-down, which of course came later and after the share price was already beaten down.

There is another sense in which the Merrill lawsuit is puzzling, at least from a detached point of view. It is arguable that all Merrill did was to try to get full disclosure of the deterioration in its subprime-backed assets out into the financial marketplace. As an October 30, 2007 Wall Street Journal editorial noted (here), while Merrill’s write-down was a “big surprise” suggesting that “oversight was late in coming,” the write-down “implies that Merrill did the right thing by taking a good hard look at its books before reporting its results,” while, the Journal notes, “some other banks haven’t been so candid.” The implication is that other investment banks have avoided the obloquy Merrill has faced simply by soft-pedaling their disclosure.

Whether or not Merrill was more forthcoming that its peers, it is clear that many more write-downs will be coming. For example, UBS, which pre-announced on October 1, 2007 (here) that it would be taking a $3 billion write down in mortgage related assets, announced on October 29, 2007 (here) that “further deterioration in the U.S housing and mortgage markets as well as rating downgrades for mortgage-related securities … could lead to further write-downs.” As the October 28, 2007 article on the online version of The Economist asked (here), “is Merrill the tip of the iceberg?” It seems probable, indeed inevitable, that there are further write-downs to come. More difficult to discern is who will be taking the write-downs and for how much (about which refer to my prior post, here).

In any event, I have added the new Merrill Lynch lawsuit to the running tally I am keeping of the subprime lending lawsuits (which can be found here). I fear there are many more cases to come.

Two Other New Real Estate-Related Lawsuits: Two other lawsuits filed this week, while not directly attributable to the subprime mortgage meltdown, definitely arise from previously frothy conditions in real estate lending, and reflect the current strained credit market conditions.

The first, filed on October 29, 2007, alleges, according to the plaintiffs’ lawyers press release (here), that BankAtlantic Bancorp and certain of its directors and officers “materially understated reserves for real estate loan losses on its financial statements.” The complaint also alleges that the bank gave a $27.8 million real estate loan to two borrowers without first getting an appraisal of the Florida property involved, which the borrowers were allegedly using as a part of a scheme to obtain real estate loans with inadequate collateral. The bank later had to increase its loan loss reserves as a result of problems with its Florida real estate portfolio.

The second, filed on October 30, 2007, alleges, according to the plaintiffs’ lawyers press release (here), that CBRE Realty Finance and certain of its directors and officers, in connection with the company’s September 2006 IPO, failed to disclose that “at the time of the IPO more than $20 million in loans on the company’s books were impaired and should have been written down but were not.” When the company announced in August 2007 that it was taking a $7.8 million impairment charge due to a foreclosed asset, the company’s share price declined.

Even though these two new lawsuits are not subprime-lending related, they show that deteriorating real estate market conditions and the turbulence in the credit sector are stressing many companies, not just those involved in subprime lending, and also generating additional lawsuits. There undoubtedly will be more to come.

Happy Birthday to the Drug and Device Law Blog: The Drug and Device Law blog has celebrated its first anniversary with an interesting note (here) reflecting on the burdens and rewards of the blogging life. Because the post captures so many of my own thoughts (particularly about how hard blogging is), I have linked to it here. And I would be remiss if I did not also wish happy birthday to an excellent blog.

As various options backdating lawsuit settlements and dismissals have accumulated in recent days, I have received a variety of inquiries from readers about comparisons with prior dispositions or about the outcomes of various other specific cases. The absence of a single, all-inclusive resource to address these questions led me to put together a compiled list of options backdating lawsuit settlements, dismissals and denials, which can be found here.

The options backdating lawsuits dispositions list linked-to above is arranged in a series of seven tables, which provide the following information: options backdating securities class action lawsuit settlements and dismissals, as well as dismissal motion denials; options backdating shareholders derivative lawsuit settlements, dismissals and dismissal denials; and options backdatings lawsuits that were voluntarily dismissed. With respect to each listed item, I have tried to provide a link to the relevant court order or other source material.

I created the list using information from a variety of sources. While I am reasonably confident that the information is accurate, the list may be incomplete. The list captures most of the options backdating case dispositions that have attracted publicity, but there undoubtedly are others that were not as highly publicized and about which I am unaware. Readers are encouraged to please let me know of any omissions from the list; links or citations for any needed additions would be greatly appreciated. I will do my best to keep the list updated with future dispositions as well as any supplemental information that readers provide.

In addition, a blank in the "links" column indicates that I have not been able to locate a link to the relevant source document. It would be great of readers can provide the missing source links so that the document is more complete.

Readers should note that I have written prior blog posts about many of these case dispositions. I did not attempt to incorporate into the options backdating disposition list any links back to my prior blog posts, but readers interested in any specific case disposition should just type the case name in the search box on the upper left hand corner of the blog home page to find my blog posts relevant to specific cases.

I welcome any comments readers may have about the attached list, particularly if readers have concerns about the accuracy or completeness of any entry.

 

For those keeping track, the options backdating-related securities class action lawsuit filed against Hansen Natural can be added to the list of options backdating-related securities class action dismissals. (Refer here regarding prior dismissals.) Hansen announced in its 8-K dated October 23, 3007 (here) that the court granted the defendants’ motion to dismiss the plaintiff’s complaint, without leave to amend.

In its October 16, 2007 opinion (here), the court granted the Hansen Natural defendants’ motion on several grounds. The court found that the complaint failed to allege fraud with particularity, and that the complaint failed to allege facts sufficient to give rise to a strong inference that the defendants acted with scienter. In particular, the court found that none of the plaintiff’s allegations of a backdating scheme, accounting fraud, lack of internal controls, corporate authority, or insider trading gave rise to a strong inference of scienter. The court also found that the plaintiff failed to sufficiently plead either materiality or loss causation.

The court clearly was not impressed with the plaintiff’s argument, based upon a comparison of the company’s stock price graph and the option grant dates, that the defendants “must have engaged in backdating.” The court declined to draw any inferences from the plaintiff’s analysis, which, as the court noted, “is no analysis at all, but simply a series of charts and graphs comparing Hansen’s stock price on the date of each of the stock option grants with the stock price on the tenth day after the stock option grant day.” The court noted that between 1997 and the end of 2005, Hansen’s stock price increased about 15,000 percent, so “it is not surprising that Hansen’s stock price would have risen following the twelve stock grants.”

As readers will recall, there was a stir (refer here) as the options backdating story unfolded last year about the fact that many companies apparently were late in filing their Form-4s (as was detailed in a well-publicized Glass Lewis report). The notion at the time was that perhaps the late Form-4 filing indicated (or at least facilitated) backdating. The Hansen Natural court specifically considered and rejected this argument, in part because the Form-4s by themselves showed nothing other than they were late, and in part because the company’s Special Committee had specifically found that the Form-4s did not support a finding of backdating.

The court’s perspective on the case was clearly influenced by external events surrounding the backdating allegations, particularly the Special Committee’s findings that there was no willful or intentional misconduct in connection with stock option grants; and that the company’s outside auditor’s conclusion that the needed options-related accounting adjustments were not material. The court took judicial notice of a wide variety of documents and materials outside the complaint. While the plaintiffs did not object to some of the items of which the court took judicial notice, the court’s ultimate conclusions do have an air of factual determination about them. The Tellabs decision’s requirement that courts weigh competing inferences puts them squarely in the business of making assessments. But reasonable minds might ask at what point the development and consideration of a voluminous record outside the complaint, supporting evaluations of factual allegations, is entirely consistent with the court’s limited role at the motion to dismiss stage.

Nevertheless, the Hansen Natural court’s categorical rejection of the plaintiff’s complaint may foreshadow developments in other pending backdating cases that depend upon the plaintiffs’ contention that there must have been backdating. For courts in the post-Tellabs business of weighing competing inferences, stock graphs overlain with option grant dates may simply not be enough to create a strong inference of scienter – as further corroborated below in the discussion of the Delta Petroleum options backdating-related shareholders’ derivative case.

Two More Backdating Derivative Lawsuit Dismissals: In separate decisions, two courts recently granted motions to dismiss in options backdating related derivative lawsuits. There are some features of these two dismissals that are particularly noteworthy.

The first dismissal involves the shareholders derivative lawsuit brought against Delta Petroleum, as nominal defendant, and several of its directors and officers. The court’s September 26, 2007 opinion dismissing the Delta Petroleum case can be found here. The second dismissal came in the derivative lawsuit filed against Glenayre Technologies, as nominal defendant, and several directors and officers. The court’s October 9, 2007 dismissal opinion can be found here.

The two cases raised both raised allegations (pled derivatively) under both the federal securities laws and under applicable state law. The Delta Petroleum court dismissed the federal securities law allegations on the grounds that the plaintiffs had not stated a claim, because they had not made sufficient allegations that the options were, in fact, backdated. The plaintiffs relied on the standard litany of sources: the March 2006 Wall Street Journal article, the May 2006 research of the Center for Financial Research and Analysis, and the supposed suspicious timing of the stock options grants. The court found these references “insufficiently specific,” noting that

The Plaintiffs have repeatedly alleged that the odds of there being so many option grants near the monthly low were “remote.” However, they allege no facts to support this conclusion, not do they explain why they believe this to be the case.

The court did allow the plaintiffs leave to attempt to replead; as of today, however, they have not yet filed an amended complaint.

The Glenayre Technologies court dismissed the federal securities laws allegations on the basis of the statute of limitations. The plaintiffs in the federal court case, faced with a competing state court case involving the same company and the same allegations, sought to secure their federal court case by alleging that the individual defendants violated the federal proxy solicitation statute and rules by filing false and misleading proxies. The court found that none of the proxy-related allegations were timely and dismissed the case on the basis of the statute of limitations applicable to claims alleging proxy solicitation violations.

Both the Delta Petroleum court and the Glenayre court, having dismissed the federal claims, declined to exercise jurisdiction over the remaining state law claims and dismissed those claims as well. In the Glenayre case, that is perhaps easier to understand, given the existence of the parallel state court action involving the same defendants and the same essential claims. But both courts had supplemental jurisdiction over the state law claims under 28 U.S.C. 1367, and while the statute says courts”may” dismiss supplemental jurisdiction claims when the original jurisdiction claims have been dismissed, the courts had discretion to retain the state law claims. (The existence of the parallel state court proceedings in the Glenayre case gets into complicated principles under the abstention doctrine and the application of the Colorado River abstention criteria, but the bottom line is that the federal courts both had the discretion to retain jurisdiction over the state law claims.) The alacrity with which the federal courts declined to retain supplemental jurisdiction over the state law claims suggest an earnest wish to banish to state court those annoying state corporate law issues.

While there have to date been some options backdating settlements, some quite substantial, and there have been some impressive decisions (particularly out of Delaware) denying motions to dismiss, there is an increasingly impressive list of options backdating cases where the motions to dismiss have been granted. For all of the options backdating sound and fury, in the end, the whole scandal may not signify all that much, even given the settlements so far, if most cases wind up getting dismissed. Certainly, the disdain of the courts cited above for the “must have been backdating” theory is a dark portent for the plaintiffs’ prospects in many of the pending backdating cases.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for copies of the Delta Petroleum and Glenayre opinions.

According to news reports (here , here and here), a jury trial in the securities class action lawsuit filed against JDS Uniphase commenced on Monday in federal court in Oakland. As documented in an October 2007 presentation from Risk Metrics Group (here), trials in securities cases are such a rarity that it is a historical record-keeping challenge to compile a list of the few securities cases that actually have been tried.

The lead plaintiff in the JDS Uniphase case is the Connecticut Retirement Plans and Trust Fund, and the defendants include the company itself and four of its former officers. The lawsuit relates back to the company’s astonishing $50.6 billion net loss the company report in fiscal 2001. The complaint alleges that the company knew that the boom was over and that the four individual defendants, also aware of that fact, sold more than $350 million in JDS Uniphase stock between July 31 and August 31, 2000, and that other insiders sold $503 million in stock.

The trial, which began on October 22, 2007, is scheduled to last 19 trial days, and the judge reportedly expects the jury to being deliberating before Thanksgiving.

As for why this case is going to trial, the AP news report quotes the Connecticut Treasurer’s general counsel as saying that the company “didn’t take the mandatory pretrial settlement talks seriously.”

I have always thought that if there more securities cases went to trial, fewer would get filed. Earlier in my career, I had the pleasure, while acting as an insurer’s claims attorney, of directing a securities case through a jury trial, and I suspect that until the moment the jury foreman read the defense verdict, the plaintiffs’ attorneys did not believe we actually wanted to take the case to verdict.

But as much pleasure as it gives me to recount that anecdote, there are some fairly practical reasons why so few of these cases go to trial. The first is that the theoretical damages are often potentially ruinous, exceeding not only the amount of available insurance but the ability of any defendant to pay. Indeed, this “magnitude of damages” consideration is one of the many intriguing things about why the JDS Uniphase case, of all cases, is actually going to trial – the potential damages in the case have to be astronomical. By contrast, in the trial in which I was involved, the maximum potential damages were manageable, a circumstance that will rarely be the case.

Another reason so few cases go to trial is the fraud exclusion in the typical D & O policy, which precludes coverage in the event of an “adjudication” of fraud. Defendants, aware of this provision, are unwilling to risk going to trial and having a jury finding wipe out their insurance. In the case in which I was involved, the insurer waived all potential coverage defenses (known and unknown), but perhaps few carriers would be willing to agree to that.

I have always thought that another important reason so few of these cases go to trial is that the plaintiffs’ lawyers really don’t want to try them. Much easier to make allegations and collect the fee award out of a settlement than to go through the hard work of making the allegations stand up in court. Indeed, given the enormous burden and expense required to try a securities case, it arguably makes no economic sense for a plaintiffs’ lawyer to take all of that on and to risk losing it all at trial. That is perhaps the most intriguing thing about the JDS Uniphase trial – the institutional investor lead plaintiff is clearly calling the shots, and is clearly willing to run the risk of a trial.

If the JDS Uniphase trial actually gets all the way to a verdict (at this point still an uncertain proposition), and if the defendants prevail, it may be a while before you see another plaintiff willing to push their case to a jury, even tough talking institutional investors who may have a political agenda. Indeed, a contrary dynamic could be established, with defendants threatening trial, as a way to try to leverage a better settlement.

On the other hand, if the JDS Uniphase plaintiff prevails and the jury awards substantial damages, an entirely new dynamic could be introduced into the securities litigation arena. We could see other institutional plaintiffs, emboldened by the JDS Uniphase plaintiff’s success, taking a more aggressive litigation approach and distaining settlement in favor of a jury trial – or making that threat to leverage settlement to their advantage.

All in all, this will be a very interesting case to watch. I wonder if Vegas has posted a line on the case.

Interesting blog posts about the case can be found on the WSJ.com Law Blog (here), the 10b-5 Daily (here) and the Securities Litigation Watch (here and here).

In a recent post (here), I wrote about the September 18, 2007 petition submitted to the SEC by several environmental groups, seeking to persuade the SEC to institute rules requiring companies to assess and fully disclose their financial risks from climate change. These groups clearly want to use the SEC’s disclosure requirements to pressure companies on climate change related issues. But while these groups want to increase companies’ disclosure, existing disclosure requirements already require companies to make environmental disclosures (refer here), and the SEC has recently shown an increased willingness to police environmental financial disclosures and to hold corporate officials responsible for disclosure violations.

In connection with the most recent environmental disclosure-related enforcement proceeding, the SEC announced on June 29, 2007 (here) its settlement with several former ConAgra Foods executives. The enforcement action pertained to a variety of different financial disclosures, but among other things the SEC specifically alleged that the former ConAgra officials “reversed $35 million in ConAgra’s excess legal and environmental reserves to income”; that ConAgra’s then-CFO should have know that the “accounting for $23.8 million of this reduction was not in accordance with GAAP”; and that the company’s 10-Q reflecting the reserve reduction “misleadingly failed to disclose that at least $23.8 million of these reserves were excess in prior periods.” These issues were among a variety of improper practices that the SEC alleged “resulted in ConAgra materially misstating its financial performance.” The former CFO agreed to pay a disgorgement of $425,531, as well as interest and other forfeitures and penalties.

The ConAgra settlement joins two other settlements that the SEC has entered in recent years involving environmental financial disclosures. Perhaps the most noteworthy of these prior actions is the accounting fraud proceeding the SEC brought against Safety-Kleen and several of its former top officials. As described in the SEC’s September 12, 2002 press release announcing the entry of judgment (here), the SEC alleged that the former officials engaged in a number of improper accounting adjustments to avoid an anticipated earnings shortfall.

As detailed in the SEC’s complaint (here), among the accounting improprieties alleged was the Safety-Kleen officials’ creation of “ficticious income” by “reducing several environmental reserve accounts.” The former CFO later pled guilty to criminal securities and bank fraud.

In another recent proceeding involving environmental financial disclosures, the SEC announced on November 29, 2006 (here) the institution and settlement of proceedings against Ashland, Inc. and its former Director of Environmental Remediation. The SEC found that the former official had improperly reduced Ashland’s estimates for environmental remediation at numerous chemical refinery sites. The reductions decreased Ashland’s total reserve estimates by approximately $160 million in both 1999 and 2000. The SEC found that there was no reasonable basis for the reduction, which had the effect of materially understating Ashland’s environmental remediation reserves and overstating net income. Ashland agreed to certain internal control changes and the former official was prohibited from further involvement in Ashland’s financial reporting. (I previously wrote about the Ashland case here because of the involvement in the case of a corporate whistleblower.)

As noted in a July 26, 2007 Jenner & Block memorandum entitled “Recent SEC Enforcement of Environmental Financial Disclosure” (here),

The SEC seems to have turned its attention on environmental financial disclosures and corporations and corporate executives should take special note of the heightened attention that the SEC is now giving to these disclosures. Although the SEC has not announced any new guidelines or initiatives, corporations and corporate executives should certainly be cognizant of the increased number of civil and criminal actions being brought by the SEC against corporations and officials who fail to observe existing environmental reporting requirements.

The SEC’s “heightened attention” to environmental disclosure issues preceded the recent petition in which the environmental groups seek increased climate change related disclosures. In other words, the SEC has already demonstrated its willingness to police existing environmental disclosure requirements. While the existing requirements do not explicitly address climate change issues or requirements, corporate officials should, as the Jenner memo put it, “certainly be cognizant” of the increased vigilance the SEC has shown on environmental disclosure issues, even in the absence of any new guidelines or initiatives. Even if, as seem likely, the SEC takes no action on the environmental groups’ climate change disclosure petition, reporting companies will still face potential scrutiny regarding their environmental disclosures relating to climate change issues.

On a related note, Hunton & Williams has published an October 2007 memorandum entitled “Climate Change Now on Court Dockets” (here) summarizing pending climate change-related litigation.

Under Section 104(b) of the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) is required to inspect audit firms that regularly provide audit reports for fewer than 100 public companies “not less frequently than once every 3 years.” On October 22, 2007, the PCAOB released a Report regarding its inspections of these so-called “triennial firms” entitled “Report on the PCAOB’s 2004, 2005 and 2006 Inspections of Domestic Triennially Inspected Firms.” (here). The Report is significant because even though many of the 497 triennial firms inspected are small and may audit as few as a single public company, as a group the triennial firms “audit thousands of public companies.” Because the triennial firms audit so many public companies, the PCAOB’s Report detailing its concerns regarding the firms’ audits has significant implications for those who rely on those audits.

It is important to emphasize that the PCAOB’s concerns do not relate to all triennial firms or to all triennial firms’ audits. As many as 43% of the PCAOB’s 497 triennial firm inspections did not identify any audit performance deficiencies. And it is also important to note that the PCAOB’s inspections encompass only a fraction of the audits that the triennial firms have performed.
Nevertheless the PCAOB took the opportunity to identify the frequently recurring audit deficiencies, so that the triennial firms are fully aware of the areas where they can enhance the quality of their audits. The PCAOB Report identifies 11 areas where auditing or quality control deficiencies were noted. The 11 areas are summarized on the PCAOB’s October 22, 2007 news release (here), as well as in the October 22, 2007 CFO.com article entitled “PCAOB: The 11 Things Auditors Need to Fix”(here).
While the 11 items cover a lot of ground, several of the items appear to be quite important, particularly given that among the “thousands” of public companies that the triennial firms audit are likely to be smaller or less financially stable companies. Without reading too much into it, the Report does seem to suggest that in some instances the triennial firms’ audits may represent less of an assessment of the audited companies’ financial statements than those who rely on the audits might otherwise assume.
For example, the first concern noted in the Report has to do with the triennial firms’ failure to perform adequate procedures to test the validity and/or appropriate accounting of revenue. While revenue issues are of concern with regard to all companies, revenue issues may be of particular importance regarding smaller or developmental stage companies. For these kinds of companies, investors and others may put particular emphasis on revenue because often there are not profits and there is not lengthy operating history on which to assess the company.
Another troublesome issue relates to the PCAOB’s concern that some triennial firms were not performing sufficient procedures to determine whether or not an entity can continue as a going concern. Because an auditor’s “going concern” opinion would be critically important to investors, creditors and others who might rely on the audit opinion, some triennial firms’ failure to perform the required audit procedures is potentially very troublesome, particularly since among the companies that the triennial firms audit are likely to be smaller and less financially stable companies.
A more technical concern noted relates to the proper accounting for “reverse acquisitions,” where the auditor is required to determine the “accounting acquirer,” without regard to the legal form. Where, for example, an actively operating private company merges with a dormant shell, the private company is the accounting acquirer, rather than the shell. So, for example, accounting comparisons across reporting periods should relate back to the private company’s previous operations than to the public shell’s. The failure of some triennial firms to get this correct again raises serious concerns.
The PCAOB’s report identifies numerous other issues, some equally as if not more important than those noted above. However, it certainly should not be assumed that all problems are avoided with a Big Four auditor; indeed, the CFO.com article notes that “each of the Big Four inspection reports so far have listed at least seven audit deficiencies,” while 124 of the triennial firm inspections noted no deficiencies at all. Moreover, it would be a misinterpretation to take the PCAOB’s Report as a condemnation of triennial firms. To the contrary, the whole purpose of the Report is to help triennial firms to take steps to improve their audit quality, not to attack them.
Nevertheless, some of the issues discussed in the PCAOB’s Report are concerning. For investors, creditors, D & O underwriters and others who review and rely on public company audit reports, the PCAOB’s Report at least raises the question of the extent to which reliance on some audits could be misplaced. At a minimum, those reviewing public companies’ financial statements that have been audited by triennial firms may want to proceed cautiously and supplement their financial statement review with other inquiries.