Photo Sharing and Video Hosting at Photobucket Even as the number of new securities lawsuits in general fell to 10-year lows in 2006 (refer here), the number of lawsuits filed against pharmaceutical companies has remained at elevated levels. As noted in my prior analysis of the 2006 securities lawsuits filings (here), eight of the 110 securities fraud class action lawsuits filed in 2006 were brought against companies within SIC Code 2834 (Pharmaceutical Preparations) and another four were brought against companies within SIC Code 2836 (Biological Products).

These 2006 filings followed elevated levels of securities class action filings against pharmaceutical companies in 2004 and 2005. And the pace of filings has continued in 2007. Already this year, securities fraud lawsuits have been filed against Eli Lilly; Amgen, USANA Health Sciences and OrthoClear Holdings.

Plaintiffs’ claims against pharmaceutical companies proceed on diverse kinds of allegations. The most common securities fraud claims against a pharmaceutical company are based on allegations that the company misrepresented the efficacy of its product. In addition, in recent years, plaintiffs’ lawyers have targeted several drug companies in securities class action lawsuits based on alleged misrepresentations or omissions regarding product safety. Other allegations that have served as the basis of securities fraud allegations relate to clinical trial results; the quality or safety of the company’s manufacturing processes; the commercialization or marketing of the company’s product; the company’s description of its product; or the company’s revenue recognition or financial reporting practices. A good (although now slightly dated) analysis of the securities fraud lawsuits brought against life sciences companies, by Michael Kichline and David Kotler of the Dechert law firm, can be found here.

But while pharmaceutical companies have remained a favored target for plaintiffs’ lawyers , pharmaceutical have not always proven to be easy targets. In the last several weeks, a number of the securities class action lawsuits pending against pharmaceutical companies have been dismissed. For example, on April 13, 2007, Merck announced (here) that a federal judge had dismissed a class action lawsuit that had been filed against the company related to its discontinued arthritis pain reliever Vioxx. The court ruled (refer here) that investor claims should be dismissed because they were time-barred under the statute of limitations. The lawsuit was dismissed with prejudice.

The Merck suit dismissal is only the latest of several dismissals of securities fraud class action cases pending against pharmaceutical companies. On March 28, 2007, a federal judge in Boston dismissed the securities fraud lawsuit pending against Praecis Pharmaceuticals (refer here). The court held that the allegedly misleading statements lacked the requisite allegations of scienter, came within the safe harbor for forward looking statements, or were mere “puffery” that could not serve as the basis for a securities fraud lawsuits. The court held that the pleadings did not present a “strong inference” that the defendants had acted with the requisite mental state.

In addition to the Merck and Praecis cases, the cases pending against Boston Scientific and EPIX Pharmaceuticals were also recently dismissed. The court has not yet released its Memorandum Opinion in the Boston Scientific case. The EPIX Pharmaceuticals case was dismissed (without prejudice) “for failure of Plaintiff to prosecute” the action.

Though the reasons for these various dismissals are varied, collectively the dismissals provide reason to hope that plaintiffs’ firms might yet come to recognize potential disincentives to pursuing securities claims against pharmaceutical companies, and perhaps hesitate before suing them quite so quickly.

Several of the dismissals are described in further detail in an April 20, 2007 National Law Journal article entitled “Defense Wins Key Pharmaceutical Cases” (here).

More About 10b5-1 Plans: In a prior post (here), I examined the increasing regulatory scrutiny regarding 10b5-1 plans. In a recent article (here), Priya Cherian Huskins takes a closer look at this issue, and also provides useful and interesting practical suggestions about how to address the growing concerns regarding these plans. Special thanks to Priya for the link to her article.

Photo Sharing and Video Hosting at Photobucket Two of the recent reports of blue ribbon groups looking at the competitiveness of U.S. capital markets recommended among other things that the SEC should consider permitting public companies to amend their charters to provide for arbitration of securities claims. According to an April 16, 2007 Wall Street Journal article entitled, “SEC Explores Opening Door to Arbitration” (here, subscription required), the SEC, as part of a “broader package” of shareholder rights proposals, is now exploring whether or not to allow corporate charter provisions requiring the arbitration of complaints by aggrieved shareholders.

The Interim Report of the Committee on Capital Markets (here, at pages 109 to 112) recommended “that the SEC should permit public companies to contract with their investors to provide for alternative procedures in securities litigations, including providing for arbitration (with or without class action procedures) or non-jury trials.” The Interim Report went on to state that “the Commission should not force shareholders to accept the costs that go with class action securities litigation, particularly the substantial and unpredictable risk of large jury verdicts that effectively force settlement of what may well be non-meritorious claims.”

The Bloomberg/Schumer Report (here, at pages 100-104) recommended that the SEC reverse “its historical opposition to the arbitration of disputes between investors and publicly traded companies.” The Report asserts that “shareholders should have the opportunity before the fact to determine whether submitting the future securities grievances to arbitration is in their own and the company’s best interest.” The Report also states that arbitration “would benefit all parties involved,” by reducing cost and speeding resolution, while permitting SEC enforcement action in appropriate cases.

While the SEC is exploring the possibility of allowing companies to amend their charters to require arbitration of shareholder claims, the Journal reports that SEC Chairman Christopher Cox does not believe that arbitration is a “panacea.”

There are several obvious shortcomings for the use of arbitration for shareholder fraud claims. First, there is limited opportunity in an arbitration proceeding for discovery, in a type of dispute that increasingly depends on extensive review of electronic communications and other electronic documents and data. Second, there is limited opportunity for appeal, which could substantially affect the rights of plaintiffs and defendants whose legal rights are determined by the arbitration panel. Third, arbitration hearings typically are conducted in private, rather than in a public forum, which would undercut the deterrent effect of private securities claims. Fourth, even if the company were able to require shareholders to pursue claims against the company and company officials through arbitration, shareholders would still be free to pursue related claims against other defendants (underwriters, accountants, lawyers, for example) in court. An overview of arbitration can be found here.

The Journal article anticipates that the arbitration proposal “is likely to spark fierce opposition from both investor-rights groups and trial lawyers.” Another group that might be motivated to object is the states’ attorneys general, who have recently discovered the profit and political appeal of class action opt-out cases (refer here) and who recently filed an amicus brief in the Tellabs case in the U.S. Supreme Court arguing against pleading restrictions that would limit their rights to bring shareholder claims (refer here). The Journal article notes that as a result of likely opposition, there is “a good chance” that the idea of permitting companies to require arbitration of shareholder claims “could fall flat.”

But even if the SEC were to go ahead, the possibility of a charter amendment requiring arbitration would be optional – that is, companies, would have to affirmatively choose to include the arbitration requirement in their charters. For existing public companies, that would presumably require a shareholder vote approving the charter amendment. To consider what shareholders might be asked to approve, it is worth thinking about what a proposed charter amendment might look like.

A prescient April 10, 2007 article entitled “Compelling Arbitration of Stockholder Class Actions Based on Federal Securities Law” (here), by Joseph Bartlett and Cathy Reese of the Fish & Richardson firm, takes a look at what enabling charter language might look like (including a sample charter amendment). The proposed language has some interesting features, including, for example, a requirement that the SEC be notified of the arbitration and have the opportunity to participate. The sample language brings home some of the limitations as well – for example, should a shareholder be compelled to Wilmington, Delaware to arbitrate? Looking at the proposed charter amendment makes me wonder how many companies’ shareholders would approve these kinds of charter amendments?

Interesting blog posts on the arbitration proposal can be found on the FEI Financial Reporting Blog (here), the 10b-5 Daily blog (here), and Ideoblog (here).

D & O Conference: This week, I will be participating in the American Conference Institute event entitled “D & O Liability Insurance” in New York City (refer here). On Wednesday April 18, 2007, I will be speaking on a panel entitled “State of the Market: New Coverages and Developing Exposures,” and on Thursday, April 19, 2007, I will be on a panel entitled “Boards of Directors: What are They Worried About and What are They Looking For?” If you attend the Conference, I hope you will greet me and introduce yourself.

In the latest issue of InSights, entitled “Opt-Outs: A Worrisome Trend in Securities Class Action Litigation ” (here), I review recent opt-out settlement developments, take a look at whether or not the current trend will continue, and examine what the trend may mean for D&O carriers and policyholders.

Prior D & O Diary posts on class action opt-out can be found here and here.

Photo Sharing and Video Hosting at Photobucket On April 11, 2007, Judge William Alsup of the San Francisco federal court granted the defendants’ motion to dismiss the consolidated shareholders’ derivative complaint filed in the connection with alleged options backdating at CNET Networks, based on plaintiffs’ failure “to plead with particularity that demand on the board was excused as futile.”

The plaintiffs’ complaint, as amended, asserted four derivative claims based on federal securities laws, against thirteen individuals and against CNET itself as nominal defendants. Six of the thirteen individuals were board members at the time that the plaintiffs’ filed the initial complaint. In order for plaintiffs to pursue their claim, the plaintiffs are required under Rule 23.1 of the Federal Rules of Civil Procedure to plead the steps they have taken to “obtain the action the plaintiff desires from the directors or comparable authority” or alternatively to show the reasons for not making this effort. The CNET plaintiffs alleged they did not make any demand on CNET’s board because they contend demand would have been futile. In assessing the plaintiffs’ demand futility allegations, Judge Alsop relied on Delaware law because CNET is a Delaware corporation.

In order to support their allegation that demand was futile, the plaintiffs allege that the six individual defendants who were directors when the complaint was filed received backdated options and that they had “ratified” the backdated options grants.

Judge Alsup had “failed to plead with particularity that a majority of the board was not disinterested or independent or did not exercise business judgment in making decisions.” Judge Alsup examined the plaintiffs’ options grant allegations, and found with respect to board recipients of the few options grants the plaintiffs successfully allged to have been backdated, only one board member recipient was still on the board when the complaint was initially filed. So the plaintiffs’ allegtions that the board members had received the backdated options failed to establish demand futility. Judge Alsup also found that the plaintiffs’ allegations that the board members “ratified” the allegedly backdated options grants was conclusory and insufficiently particularized to support demand futility allegations.

In reaching the conclusion that the plaintiffs had not adequately plead demand futility, Judge Alsup expressly distinguished Chancellor Chandler’s recent finding of demand futility in the Maxim Integrated Products case (here), where, Judge Alsop noted, the plaintiffs “had pleaded particularized facts” supporting demand futility, including allegations of knowing approval of backdated option grants, along with alleged intentional failure to disclose the backdated options. (My prior post regarding the Maxim Integrated Products case can be found here.)

The amended complaint on which Judge Alsup granted the dismissal motion was the CNET plaintiffs’ fourth iteration, due to which Judge Alsup said that he was “inclined to deny further leave to amend.” However, he withheld his final determination on whether or not to grant leave to amend. He asked the parties to provide additional submissions on the question whether he had authority to allow the plaintiffs limited discovery about the possible “taint” to two of the directors defendants’ service on the CNET board’s compensation committee.

As noted in the April 16, 2007 Law.com article entitled “Federal Judge Axes CNET Stock Option Claims” (here), the CNET decision shows “how difficult it may be for plaintiffs to succeed in numerous similar claims related to stock-options backdating.” It does show that plaintiffs will have to allege more than merely that options grant dates differed from the measurement date, or even that the members of the board received allegedly backdated options.

Judge Alsup’s opinion also show that the Delaware Chancery Court decision in the Maxim Integrated Products case is not necessarily determinative of the demand futility question in other backdating cases, even other cases to which Delaware law applies. Judge Alsup’s particularized inquiry based on the plaintiffs’ specific allegations suggests that these issues will be determined on a case by case basis. Judge Alsup’s insistence on particularized allegations and his unwillingness to accept unsupported inferences as a basis for demand futility suggests that it could prove challenging for demand futility allegations in other options backdating lawsuits to survive dismissal motions.

UPDATE: According to the CorporateCounselNet.com blog (here), Judge Alsup has ruled to allow the plaintiffs to amend, and is considering whether to stay the case while permitting limited discovery.

An interesting and helpful memo on the CNET case by the Fenwick & West law firm can be found here.
Options Backdating Litigation Update: With the addition of the new derivative complaint filed against Lehman Brothers Holdings (here), The D & O Diary’s current tally (here) of the number of companies sued as nominal defendants in shareholders’ derivative complaints based on options backdating allegations stands at 157. The number of securities class action lawsuits stands at 29. In addition, as a result of the ERISA suit filed against KB Homes (here), the number of ERISA or 401(k) options backdating lawsuits now totals 5.

Photo Sharing and Video Hosting at Photobucket On April 11, 2007, Royal Dutch Shell announced (here) that it had agreed to pay $352.6 million to non-U.S. investors who bought Shell shares outside the U.S., in connection with the company’s 2004 oil resources accounting scandal. According to the Times (London), here, the agreement is "thought to represent the largest ever class action settlement in Europe." The agreement is subject to the approval of the Amsterdam Court of Appeals as we as to "agreed opt-out provisions."

Shell also announced that it will be seeking a proportional settlement in the U.S. class action proceeding. According to Bloomberg (here), the European settlement is "contingent on a U.S. judge’s ruling not to include claims by non-U.S. investors within the existing class action claim."

Legal counsel for the European shareholder is New York-based Grant & Eisenhofer and the Dutch law firm Pels Rijcken & Drooglever Foruijn .

CFO.com has further information about the settlement, here.

Would-be reformers of U.S. securities regulation, who routinely cite U.S. litigiousness as the justification for proposed reform, should note that this is a European settlement on behalf of European investors (from multiple countries) proceeding in a European court. I have long contended (most recently here) that differences in regulatory and even litigation regimes in advanced economies may well diminish over time, and, in particular, that investors overseas will increasingly seek legal means in local courts to obtain compensation for corporate misconduct. The Shell settlement is the most recent, and perhaps the most vivid, example of these phenomena.

The With Vigour and Zeal blog has interesting and important background on this settlement here as well as links to key resource documents and materials regarding the settlement here. The Best in Class blog also has an interesting post on the settlement here.

A Different Look at Backdating Luck: A central tenet of the backdating scandal has been the supposedly lucky timing of many of the questioned stock option grants (see my earlier post on Lucky Options grants here). A recent paper by NERA Economic Consulting entitled "Options Backdating: The Statistics of Luck" (here) takes a closer look at what role luck or chance might actually have played in many of the questioned option grants, and reaches the somewhat contrarian conclusion that "some of the grant patterns that at first appear extremely unlikely are actually likely and should be expected."

The study finds that just as there are companies that granted options on very favorable days, there are companies that granted on very unfavorable days. The article specifically states that the calculations presented in the Wall Street Journal articles that launched the backdating scandal "can be misleading," and in particular "overstate the number of D & O that have been very lucky."

Hat tip to Kelly Reyher for the link to the NERA article.

 

Photo Sharing and Video Hosting at Photobucket The U.S. Supreme Court’s landmark April 2, 2007 decision in Massachusetts v. EPA (here) may represent a turning point in the evolving governmental response to global warming. As discussed below, the decision itself and the regulatory, legislative and litigation consequences that will likely follow could have important implications for many publicly traded companies and their directors and officers, particularly companies in certain industries. These effects in turn could have important D & O insurance implications as well.

Let me acknowledge at the outset that a short time ago I would probably have had little patience with an article like this one. I cannot abide alarmists who try to turn peripheral concerns into major crises (see, for example, my prior post, here, decrying specious efforts to convert avian flu into a generalized corporate priority). But the Supreme Court’s recent opinion, together with a confluence of other causes and concerns, persuades me that many companies no longer have the luxury of treating global warming as a peripheral concern.

The most important (but by no means the sole) factor in my revised view of this topic is the recent U.S. Supreme Court ruling in Massachusetts v EPA. The Court held that the EPA had violated the Clean Air Act by improperly declining to regulate new-vehicle emissions standards to control carbon dioxide emissions that contribute to global warming. In and of itself, the Court’s ruling is somewhat narrow. Indeed, the Court declined to reach the question whether or not the EPA must reach “an endangerment finding” requiring regulation of carbon dioxide emissions in new vehicles. The Court held only that the EPA had “offered no reasoned explanation for its refusal to decide whether greenhouse gases cause or contribute to climate change.” The court remanded the matter to the lower court (and from there, to the EPA) with the direction that the EPA “must ground its reasons for action or inaction in the statute.”

While the Court’s holding is narrow, there are two components of the Supreme Court’s decision that are, however, very important. The first is the Court’s holding that the injury of which Massachusetts complained in bringing the suit was sufficiently particularized for Massachusetts to have “standing” to bring its claim. The second is that greenhouse gas emissions are “pollutants” under the Clean Air Act. These elements, taken in the case’s full political, economic and legal context, could mean that the decision will, in the words of the April 3, 2007 Washington Post article discussing the case (here), “serve as a turning point.”

Among the most important reasons the decision may serve as a turning point is the plethora of lower court cases that had been held in abeyance pending the outcome of Massachusetts v. EPA. The most important of these other cases is the Mass v. EPA companion case in the D.C. Circuit, Coke Oven Environmental Task Force v. EPA, No. 06-1322 (D.C. Cir., filed April 27, 2006) (refer here). Just as the Mass v. EPA case challenged the EPA’s inaction on new mobile source (i.e., automobiles) greenhouse gas emissions, the Coke Oven case challenges the EPA’s inaction on new stationary sources (i.e., utilities) greenhouse gas emissions. The Supreme Court’s holding in the Mass v EPA case that greenhouse gases are indeed pollutants under the Clean Air Act is broadly applicable to both mobile and stationary sources. In other words, the EPA’s regulatory response necessarily must carry implications for a broad range of industries. In addition to the Coke Oven case, other lower court cases on these and related issues were also held in abeyance, and will now go forward in light of the Supreme Court’s ruling in Mass v EPA.

In addition, a variety of state and federal cases either filed in the past or now pending have directly attacked the sources of greenhouse gas emissions (particularly automobile manufacturers and electric utilities) in several tort-based lawsuits, usually on public nuisance theories. The courts have largely dodged these cases in the past, invoking the principle that the claimants’ allegations of generalized harm are insufficiently particularized to support a justiciable controversy. The Supreme Court’s holding that Massachusetts had adequate standing to present a justiciable controversy could have a very significant impact on future courts’ rulings on jurisdictional standing and justiciability criteria that must be satisfied for litigants to bring climate change-based cases. (An interesting commentary on the Supreme Court’s standing holding can be found here.)

The Supreme Court’s decision is only one of several important recent developments affecting these issues. The November 2006 election also dramatically changed the political landscape, and the Democratic majority in both houses of Congress has brought climate change to the top of the legislative agenda. Bills have already been introduced in both chambers to address climate change directly. While a congressional consensus on these issues may prove elusive, the states are in the meantime moving forward. California’s landmark Global Warming Solutions Act of 2006 is only one of several states’ legislative initiatives in this area. A decision by the EPA to decline the Supreme Court’s invitation to reconsider its decision not to regulate greenhouse gases could be the worst possible outcome for business, because it will spur Congress to action, and even barring that, invite action from the states, who are racing ahead of Washington on these issues. The Economist magazine has a good summary (here, subscription required) of the confluence of the legistaltive and regulatory forces on the issue of greenhouse gas emissions.

None of this has been lost on the business community. For example, on January 22, 2007, a coalition of ten companies joined several environmental groups to propose (refer here) a cap-and-trade program regarding greenhouse gas emissions.

All of these forces are likely to gain momentum in light of continuing developments, such as the Intergovernmental Panel on Climate Change’s April 6, 2007 release of its latest report (here) on climate change impacts, raising even more alarming concerns regarding global climate change (about which, refer here).

The point here is not merely some generalized concern about the changing cultural, political, regulatory, legislative and litigation context. The point is that all of these changes represent particularized concerns for many public companies, affecting their disclosure obligations under Regulation S-K. Two provisions of Reg. S-K are particularly applicable here, Item 101 and Item 303.

Item 101(c)(1)(xii) requires companies to disclose current and anticipated “material effects” of compliance with environmental regulations:

Appropriate disclosure also shall be made as to the material effects that compliance with Federal, State and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, may have upon the capital expenditures, earnings and competitive position of the registrant and its subsidiaries. The registrant shall disclose any material estimated capital expenditures for environmental control facilities for the remainder of its current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.

As new EPA regulations and state mandates regarding greenhouse gas emissions accumulate, many companies may find themselves for the first time obliged to provide Item 101 environmental regulation impact disclosure, and other companies will be compelled to provide more extensive Item 101 disclosure than may have been the case in the past.

Item 303 requires companies to “describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenue or income from continuing operations.” There are an increasingly large number of increasingly important trends and uncertainties surrounding global climate change that will affect an increasingly greater number of companies, requiring these companies to adapt their Item 303 disclosure accordingly.

The type and range of financial consequences that might arise from global warming is a topic far beyond the scope of the blog format. A good summary of these topics can be found in the Association of British Insurers June 2005 report entitled “Financial Risks of Climate Change” (here). There is, in brief, no limit to the number of potential “risks, trends and uncertainties.”

Because of these disclosure obligations, many public companies will face the increasing challenge of articulating the impact of global climate change regulation, legislation and litigation on their business and operations. Because of the extent of the impact (both probable and possible) and the prospect for developments that could have dramatically negative consequences for at least some companies, future shareholder litigation surrounding these disclosures necessarily must be anticipated. The various political, regulatory and litigation trends identified above will obviously affect companies in the automotive and energy generation businesses (and supporting industries), but emphatically not these companies alone. Other industries that seem likely to be affected include insurance, transportation, manufacturing, shipping, and other businesses whose operations have (or which could sustain) a substantial environmental impact, even if it is entirely localized. There are certainly other industries that are beyond my imaginative capacity to anticipate here.

In short, the public company disclosure obligations create a context within which it is prudent to assume that D & O claims may arise. To the extent claims do arise, the wording of applicable D & O policies could have an enormous impact on the availability of D & O insurance to defend and indemnify companies and their directors and officers.

D & O policies typically contain a pollution exclusion. I was surprised to observe, upon careful reading of several typical pollution exclusions for purposes of writing this post, that it is not obvious that the standard pollution exclusions were intended to pertain to greenhouse gas emissions or consequences arising therefrom. The term “pollutant” as used in many policies’ exclusions simply may not encompass greenhouse gas emissions. Indeed, there may be several arguments on which to contend that the standard pollution exclusion wording has no relation to greenhouse gas emissions or their environmental consequences. (Of course, whether or not such contentions would be persuasive to a court is a matter of pure conjecture, on which I do not opine.)

Nevertheless, assuming the exclusion would otherwise preclude coverage for claims pertaining to greenhouse gas emissions, the pollution exclusion in most D & O policies these days carves back coverage for derivative suits and shareholder claims. In light of the possible course of future litigation in this area, the wording of the pollution exclusion, and in particular the wording of the carve back for shareholder claims and derivative lawsuits, will be absolutely critical. The fact that this policy language must anticipate cases and claims of kind that may not have previously arisen underscores the importance of enlisting the assistance of skilled D & O insurance professionals in the D & O insurance transaction.

A good resource in this area is the article by J. Wylie Donald and Loly Garcia Tor of the McCarter & English law firm entitled “Climate Change and The D & O Pollution Exclusion” (here).

A good round up of blog commentary on the Massachusetts v. EPA case can be found here. A round up of press coverage about the case can be found here.

Connecticut Law School Conference: On Thursday April 12, 2007, I will be participating on a panel at a conference at the University of Connecticut Law School. The conference is entitled “D & O Insurance: Shareholder’s Friend or Foe?” and the panel on which I am participating is entitled “Can Insurers Reduce Securities Litigation Risk?” Further information about the conference can be found here. Prior D & O Diary posts on the topic of D & O insurance and corporate governance can be found here and here.

Weather Central: If the rest of the world must learn to adapt to extreme weather as a result of climate change, they may want to spend a little time here in Cleveland. For the first time in recent memory we missed a White Christmas last year, but by God we are going to “enjoy” a White Easter this April. The rest of the country has no absolutely no idea how chilling is the phrase “The lake effect snow machine is engaged and stalled over the lakeshore.” The old story about the Eskimos having dozens of words for “snow” undoubtedly is true, but kindred spirits here understand that almost all of the “snow words” would be unsuitable for a family-oriented blog.

As the list of options backdating lawsuits has grown ever longer (refer here), one question has been: where will it all lead? Sooner or later, these cases will all have to be resolved, but so far it has remained unclear what the resolution might look like. A recent settlement in the derivative cases filed against two former executives of SafeNet provides at least a suggestion of where at least some of the cases could be headed.

In an April 3, 2007 filing on SEC Form 8-K, SafeNet announced (here) that it had reached settlements with former Chairman and CEO Anthony Caputo and former President, COO and acting CFO Carole Argo, both of whom had previously resigned following a review of the company’s stock option practices. Caputo agreed to put $1.5 million in escrow, and Argo agreed to put $100,000 in escrow, pending the approval of the courts presiding over the derivative actions against the two individuals. (The 8-K also describes the procedures to be followed in the event of shareholder objections to the settlements, or in the event the court does not approve the settlements.) The settlement agreements also provide that certain of Caputo’s and Argo’s stock option grants will be canceled and the other option grants will be repriced.

The company’s 8-K disclosure does not specify which courts’ approval is required. The disclosure also leaves a number of other questions unanswered. For example, the disclosure is silent about the impact of these settlements on the derivative claims filed against SafeNet’s board. It simply isn’t clear from the disclosure the extent to which the settlements represent something less than complete resolution of the derivative actions.

However, at least some of SafeNet’s backdating related litigation does now seem to have been resolved, beyond the settlements with Caputo and Argo. Regular readers will recall my prior post (here) describing the lawsuit that one of SafeNet’s investors had brought alleging that some SafeNet directors had agreed to a low ball sale of the company in an effort to avoid potential liability for backdating stock options. According to an April 4, 2007 Baltimore Sun article (here), the investor that brought the suit had notified the court in which the case was pending that it had reached an “agreement in principle.”

Brocade Criminal Case Tests Prosecutors: An April 4, 2007 San Jose Mercury article entitled “Brocade to Test Prosecution of Backdated Options” (here) describes the “complexities and challenges of bringing criminal charges against executives implicated in the murky legal landscape of backdated stock options.”

While prosecutors targeted two Brocade executives to demonstrate the government’s resolve to prosecute stock options manipulations, prosecutors could have, according to the article, “picked a more egregious case for the first criminal charges.” Instead, prosecutors must make a case where neither of the defendants benefited personally from the alleged wrongdoing, making the case less intuitively appealing. On the other hand, the government’s case does involve “basic document falsification and false statements.”

The criminal case is scheduled to go to trial in June 2007. The outcome of the case could have an enormous impact on the course and extent of future prosecutions in other options backdating related cases.

My prior post on the question whether backdating is criminal, including specifically a discussion of the criminal case against former Brocade CEO Gregory Reyes, can be found here.

Photo Sharing and Video Hosting at Photobucket It is now a well-established part of the mythology of American capitalism that Warren Buffett still lives in the same modest brick colonial in Omaha, pictured above, that he bought in 1958 for $31,000. (According to Forbes magazine’s annual survey of billionaires’ houses, here, Buffett’s home had a 2003 tax valuation of $700,000.) Intuitively, we believe that the relative modesty of Buffett’s home tells us something about his values and priorities, just as we all probably make certain assumptions about the values and priorities of the occupants of the truly execrable miniature Versailles mansions that have sprouted in recent years on the far-flung fringes of most American cities –even Cleveland, for God’s sake!

In one of the more interesting and entertaining articles I have read in a long time, Crocker Liu of the Arizona State University Business School and David Yermack of N.Y.U. Business School take a look at what else the size and valuation of CEOs’ homes might tell us. In their March 2007 article entitled "Where Are The Shareholders’ Mansions? CEOs’ Home Purchases, Stock Sales, and Company Performance" (here), the authors’ "central research question concerns the association between CEO real estate purchases and subsequent performance of their company."

The authors developed their hypotheses by questioning whether a CEO’s home purchase more nearly indicates the CEO’s commitment to their company and its community, or rather represents the CEO’s "entrenchment," particularly if the CEO is unconcerned about liquidating their assets (especially their holdings in company shares) and investing in an expensive home so as to provide "a public signal about the executive’s status and security."

In order to determine which hypothesis is accurate, the authors undertook some rather creative detective work to identify the homes of the CEOs of the S & P 500 companies (including, among other things, each home’s location, size, valuation, date of acquisition, and method of financing). The authors ultimately were able to identify the homes of 488 of the CEOs, 164 of which the CEOs had acquired after taking office.

What the authors found out about the CEOs’ homes is fascinating. The median CEOs’ home is more than 5,600 square feet, and sits on over one and a quarter acres. The median 2006 market valuation of the CEOs’ homes is $2.7 million (although this may be understated because some of the homes are sufficiently unique that there are no ready market valuations). 12% of CEOs’ homes are on the waterfront, and 8.5% are on golf courses. The median distance from the office for CEOs’ homes is 12.5 miles, but 16 of the CEOs live more than 1,000 miles from their company headquarters and another 16 live between 250 and 1,000 miles from their office.

With respect to the question about the correlation between the CEO’s home purchase and company performance, the authors found that when a CEO buys a home, "future company performance is inversely related to the CEO’s liquidation of company shares and options" to finance the transaction, even if the stock sales are small relative to the CEO’s holdings. The authors also found that "future performance deteriorates when CEOs acquire extremely large or costly mansions or estates," regardless of the method of financing. The authors found a "significantly negative stock performance following the acquisition of very large homes by company CEOs," a negative trend that persists for several years after the home purchase.

The authors’ assessment of this finding is that the CEO who purchases his or her home without selling shares is perhaps signaling their commitment to the company and expectation of future stock returns. The CEO who liquidates his or her shares to finance their home purchase , or buys a very expensive home, is signaling his or her perception of his or her status and security, and therefore the purchase represents a proxy for CEO "entrenchment."

The authors contend that these facts suggest an investment strategy, essentially shorting the shares of companies whose CEOs who acquire very large and expensive homes, but maintaining long positions on the companies whose CEOs acquired their homes without selling company shares. According to the authors, both ends of this strategy would substantially outperform the companies taken as a whole.

I find the authors’ work intriguing, but I wonder whether the apparent link between the CEO’s home valuation and corporate performance might not be a manifestation of what a former colleague of mine poetically calls "multicollinearity." That is, is the inverse correlation between CEO home valuation and corporate performance simply the quantification of another phenomenon – for example, the level of CEO compensation?

For the record, Buffett’s home was not among the houses the authors studied, since Berkshire Hathaway inexplicably is not a part of the S & P 500. The authors’ data set also does not include Bill Gates’ $140 million, 66,000 square foot home, since he is no longer the CEO of Microsoft. Steve Ballmer’s $8 million, 4,100 square foot home was included, however.

I am hoping that the authors’ next article will compare the valuations of CEOs homes to those of the leading securities class action plaintiffs’ lawyers. I suspect it would provide even more interesting analysis.

One of the Internet tools the authors used is the website, Zillow.com (here). If you have never visited the site, drop what you are doing immediately and go there. Just be prepared to spend the next few hours figuring out how much you neighbors’, friends’, and acquaintances’ houses are valued for. Unless you really don’t find things like that interesting at all. (Right…) Coincidentally, the April 4, 2007 Wall Street Journal reports (here, subscription required) that Zillow.com CEO Richard Barton is currently attempting to sell his Seattle home for $2.6 million (marked down from the intial asking price of of $3.475 million).

Special thanks to an alert reader (who prefers anonymity) for the link to the article.

Adults Only: When my oldest daughter was eight years old, she expressed an interest in reading The Hunchback of Notre Dame. (For reasons that no one who has actually read the book could possibly explain or understand, Disney had just released a childrens’ cartoon movie based on the book.) I told her that I did not believe the book was appropriate for children. She of course asked why, and I told her that the book deals with "adult themes." She cocked her head at me and squinted her eyes and said, "You mean like real estate?"

Yes, like real estate. Exactly.

 

Photo Sharing and Video Hosting at Photobucket When the giant hedge fund Amaranth imploded in late September 2006 in the largest hedge fund failure ever, it made the front page of the Wall Street Journal (here, subscription required). Amaranth lost more than $6 billion after the natural gas bet of one of its traders, Brian Hunter, took a severely wrong turn. Investors understandably were upset, but Amaranth nevertheless reportedly appealed to investors to agree not to sue the firm in exchange for a speedier liquidation (here).

The possibility that the fund might evade litigation costs disappeared on March 29, 2007, when one of the fund investors, the San Diego County Employees Retirement Association (SDCERA) filed a lawsuit in federal court in Manhattan against Amaranth Advisors (the fund’s management company), three of its officers, and Hunter, the fund’s former natural gas trader. A copy of the Complaint can be found here. SDCERA’s press release about the lawsuit can be found here.

The Complaint alleges that on September 1, 2005, SDCERA invested $175 million in Amaranth, but that as a result of the fund’s September 2006 collapse, the fund lost over $6 billion and SDCERA lost more than $150 million. The Complaint alleges that the advisory company and its principals induced SDCERA to invest in the fund based on a series of allegedly false statements to SDCERA and its representatives, as well as a series of allegedly false statements in the fund’s private placement memorandum and amended private placement memorandum. Specifically, SDCERA alleges that the advisory company and its principals misled SDCERA by representing in face to face meetings and in documents that the fund was “a multi-strategy hedge fund” that invested in six different market sectors and used sophisticated risk management controls. The Complaint further alleges that, in contrast to those representations, the fund “was being run, either intentionally or negligently, as a defacto single-strategy natural gas fund, placing billions of dollars at risk in highly volatile markets and with no exit strategy.”

SDCERA further alleges that having induced SDCERA to invest, the advisory company and its principals made a number of statements, to fund investors in general and to SDCERA and its representatives in particular, that misrepresented the extent of the fund’s natural gas investment, the extent of its capital commitment to its natural gas investments, and the extent of the advisory company’s risk management controls. SDCERA also alleges that the advisory company and its principals timed their disclosures to avoid periodic withdrawal windows, in effect trapping SDCERA in the fund as it was melting down, and at the same time providing misleading reassurance that minimized the fund’s natural gas exposure.

SDCERA seeks recovery from the advisory company and its principals for alleged violations of Section 10(b) of the Securities and Exchange Act of 1934; common law fraud; gross negligence; breach of fiduciary duty; and vicarious liability. SDCERA also seeks recovery from the advisory company for breach of contract and from Hunter for gross negligence.

SDCERA’s attempt to increase its recovery through litigation represents an interesting gamble. The lawsuit potentially could have exactly the opposite of the intended effect. As the March 31, 2007 Wall Street Journal article discussing the lawsuit (here, subscription required) noted, “the funds… to defend the case would have to come out of the limited assets still remaining” because the hedge fund’s structure “provides that investors effectively indemnify the management company … in the event of lawsuits.”

By the same token, SDCERA’s lawsuit is not a class action; if SDCERA manages to overcome the circularity of the indemnification provision in the management agreement, and manages further to increase the amount of its recovery, it will either be: decreasing other investors’ recoveries; exacting some kind of payment from the individuals’ own assets; or perhaps even extracting some form of insurance recovery. These possibilities will compel the other fund investors to consider whether they too should pursue their own lawsuits, and risk possibly even further reducing the overall recoveries, or forbear, and lose the chance to augment their own recoveries – or even watch their recoveries diminish to the benefit of the more litigious fellow investors.

Of course, it remains to be seen whether SDCERA’s litigation strategy will succeed or backfire. The larger significance from SDCERA’s lawsuit may be in its potential implications for other hedge fund advisory companies and their principals. There have of course been other investor lawsuits brought against hedge funds in the past, but none as high profile as this lawsuit following Amaranth’s collapse. The prospect of large institutional investors suing hedge fund advisory firms and their principals when the hedge fund’s investment strategy goes awry potentially presents a significant layer of risk to the hedge fund management equation. It also make the various insurance solutions available in this sector a much more urgent consideration for hedge fund advisory firms and their principals.

In the meantime, Brian Hunter, the erstwhile trader whose strategy triggered the largest hedge fund failure in history, has formed a new commodities trading firm, and is seeking to raise hundreds of millions of dollars from investors in Europe and the Middle East. According to a March 23, 2007 Wall Street Journal article (here, subscription required), the new fund proposes to charge investors 2% of its assets and 20% of profit; in addition, each manager gets to keep his own 20% profit fee and as much as half of the 2% annual fee. Those who may wonder which investors would possibly consider investing in Hunter’s new fund will recall the old adage about who is born every minute.

On March 21, 2007, Cornerstone Research released its analysis of 2006 securities class action settlements (here). Cornerstone had previously released its study of 2006 securities class action filings (here). NERA Economic Consulting also previously released its analysis of 2006 securities class action filings and settlements (here). Cornerstone’s study differs in some details from the NERA report but the two studies are directionally consistent. The Cornerstone study also includes some interesting additional observations and conclusions.

The most significant conclusion of the Cornerstone study is its observation that the aggregate value of all 2006 settlements was $17.1 billion, an all-time high, and that even excluding the massive Enron settlement, the remaining $10.6 billion was still an all-time high, exceeding 2005’s previous high of $9.4 billion. The 2006 record high was primarily driven by an increase in average settlements, which in turn was driven by the presence of multiple settlements in excess of $1 billion. These mega settlements are part of a group of 14 cases that settled for $100 million or more.

These large settlements led to a 2006 average settlement of $100.6 million (excluding the Enron settlement), compared with a 1996-2005 average of $22.6 million (adjusted for inflation and excluding the WorldCom and Cendant settlements). If the excluded cases are included, the 2006 average is $180.6 and the 1996-2005 average (adjusted for inflation) is $36.2 million. If the five 2006 settlements over a billion are excluded, the 2006 average settlement is $45 million.

But while the mega cases were driving up the average settlement, settlements in smaller cases did not change that much from prior years. 60% of all 2006 settlements were below $10 million, and the 2006 median settlement of $7.0 million is close to the $6.7 million median during the period 1996-2005.

The 2006 settlement data may reflect a peak of sorts. According to Stanford Law Professor Joseph Grundfest’s comments in Cornerstone’s press release about the study, (here), “2007 is virtually certain to generate a far smaller aggregate settlement amount.” This is largely because the bulk of the mega cases have worked their way through the system, as a result of which, according to Grundfest, “aggregate settlement amounts have only one way to move, and that’s down.” Grundfest noted that “because a smaller number of cases are now being filed and because these cases involve smaller market losses, I wouldn’t be surprised if the aggregate annual settlement statistics fall dramatically over a period of several years.”

The Cornerstone study also notes a number of specific factors that appear to affect settlement amounts:

Section 11/Section 12(a)(2) Claims: These allegations appear in about 20% of lawsuits, and appear to result in increased settlements. During the period 1996 to 2006, lawsuits with Section 11/Section 12 (a)(2) claims settled for 4.2% of estimated damages, compared to 3.3% for lawsuits with no Section 11/Section 12 (a)(2) claims.

Institutional Investors: Institutional investors are serving as lead plaintiffs in an increasing number of class actions, and served as lead plaintiffs in 50% of all cases settled in 2006. Cases with institutional investors have significantly higher settlement amounts, but that raises a question whether institutions choose to participate in cases with stronger merits or higher potential damages. But even when the data is controlled for these factors, “the presence of an institutional investor results in a statistically significant increase in settlement size.” For example, the median settlement for a case with an institutional investor lead plaintiff in 2006 was $9.0 million, compared with $4.3 million in cases without an institutional investor lead plaintiff. (For a more extensive discussion of the impact of institutional investors as lead plaintiffs, see my prior post, here.)

Derivative Actions: The number of cases with companion derivative actions is increasing, and an accompanying derivative action appears to correlate with a higher class action settlement (perhaps because accompanying derivative actions are most likely when investor loss is greater or the allegations are most serious). During the period 1996 to 2006, the median class action settlement in class actions with accompanying derivative cases was $13.8 million, compared to $5.1 million for cases without accompanying derivative settlements.

SEC Actions: Over 20% of post-Reform Act securities class actions are accompanied by SEC enforcement actions. Class actions with accompanying SEC enforcement actions tend to result in larger settlements (again, perhaps because the SEC Actions are most likely to arise in cases with the most egregious facts). During the period 1996 to 2006, the median settlement in class actions with accompanying SEC actions was $11.0 million, compared to $6.5 million for cases without SEC actions.

Bankruptcy: Over 35% of settlements involved companies that had filed for bankruptcy or had their stock delisted. But settlements of cases involving distressed companies resulted in smaller settlement. The median settlement during the period 1996 to 2006 for a distressed company was $5.3 million, compare to a median settlement for non-distressed companies of $6.8 million.

Opt-Outs: The Cornerstone study notes what “might be the beginning of the trend of an increase in ‘opt-out’ plaintiffs.” But other than noting the (potential) trend, the study does not report or comment on the opt-out cases, undoubtedly because the momentum in opt-out settlements didn’t really get going until 2007.

For whatever it may be worth, I note that the prevalence of opt-out settlements may prove to be a factor that cuts against a decline in securities fraud lawsuit severity, notwithstanding Professor Grundfest’s comments about the probably decline in the size of class action settlements. The D & O Diary’s prior comments about the effect of opt-out settlements in severity can be found here and here.

One final interesting detail: according to the Cornerstone study, the aggregate amount paid in securities class action settlements between 1996 and 2006 is $43.69 billion. That of course does not include defense expense and amounts paid in settlement of SEC actions, or fines or penalties.

My prior analysis of the 2006 securities class action filings and settlements can be found here.

My prior post about Cornerstone’s study of 2006 securities class action filings can be found here. My prior post about the 2006 NERA study can be found here.

Options Backdating Litigation Update: With the addition of the Wireless Facilities securities fraud lawsuit (here), the count of companies that have been sued in securities class action lawsuits based on options backdating allegations now stands at 29. The number of companies named as nominal defendants in shareholders derivative suits stands at 154. The D & O Diary’s running tally of the options backdating lawsuits can be found here.

The Securities Litigation Watch is also maintaining a count of the options backdating related securities lawsuits, which can be found here.

A Break in the Action: There will be a break in The D & O Diary’s publication schedule over the next few days. Normal publication will resume after April 1.