Photobucket - Video and Image Hosting In a prior post (here), I raised the question whether the whistleblower protection under Section 806 of the Sarbanes-Oxley Act is "more theoretical than real." A February 2007 study by Alexander Dyck of the University of Toronto, Adair Morse of the University of Michigan Business School, and Luigi Zingales of the University of Chicago entitled "Who Blows the Whistle on Corporate Fraud?" (here, $ required) confirms statistically that SOX whistleblower protection is not encouraging employee whistleblowers and may be discouraging them.

The authors looked at a sample of 230 cases of corporate frauds that were alleged between 1996 and 2004 regarding companies with more than $700 million in assets, in order to determine who was involved in the revelation of fraud. The authors found that between 1996 and SOX’s enactment, employee whistleblowers represented 21 percent of the fraud detectors, but that after that, they represented only 16 percent.

The authors found that employee whistleblowers face significant discinventives. They found that in 82% of cases where the employee whistleblower’s identity was revealed, the employee "quit under duress, or had significantly altered responsibilities." In addition, may whistleblowers report having to move to another industry or to another town.

SOX attempted to create protections for employee whistleblowers. Section 301 requires public company audit committees to create procedures for "confidential anonymous submission" of questionable accounting or auditing matters. Section 806 provides protections for employees against being fired for coming forward with this kind of information. The authors found that the drop in the employee whistleblowers as a percentage of fraud detectors after the enactment of Sarbanes-Oxley suggests that "SOX’s modest incentives for whistleblowers has not been very effective." They suggest that "protecting the whistleblower’s current job is a small reward given the extensive ostracism whistleblowers face."

The D & O Diary would add to the authors’ analysis that, as discussed in prior posts (most recently here), the protection that the SOX whistleblower provisions theoretically provide have proven cumbersome and procedurally challenging. The statutory protections, as implemented, arguably create affirmative disincentives for would-be employee whistleblowers.

The study’s authors have an interesting observation about employee whistleblowers in industries (such as healthcare) that conduct significant business with the government, and where employees can receive substantial financial rewards for bringing a so-called qui tam action. The authors found that in the healthcare industry, where employees have these kinds of financial incentives to blow the whistle on fraud, employee whistleblowers account for 46.7% of fraud detectors, as opposed to only 16.3% in industries where employees cannot bring qui tam lawsuits. The authors also found that in the healthcare industry, fewer fraud lawsuits were dismissed or settled for less than $3 million than compared to all companies in all industries, leading the authors to conclude that there was no evidence that the availability of the qui tam lawsuits increased the level of frivolous litigation.

The authors conclude that the SOX whistleblower protection, offering only after-the-fact job protection, provides little incentive for employees to assist in fraud detection. The authors recommend "extending the qui tam statute to corporate frauds."

Whether or not employee whistleblowers should have added fraud detection financial incentives, the authors’ point about the financial incentives for employee whistleblowers in the healthcare industry (and other industries that do substantial business with the government) is an important point for D & O insurance professionals. Clearly, with respect to companies in the healthcare industry and other industries that do substantial business with the government, it will be particularly important for the standard insured-versus-insured exclusion to be modified to carve back coverage for whistleblower suits, including in particular qui tam or False Claims Act lawsuits.

A February 13, 2007 CFO.com article entitled "Sarbox Curbs Fraud Whistleblowing" discussing the report referred to above can be found here.

Photobucket - Video and Image Hosting Go Ask Alice: According to news reports (here), "a male lawyer who appeared in court in women’s clothes as a protest against what he said was New Zealand’s overly masculine judiciary was suspended Wednesday after being found in contempt of court." The lawyer, who officially has changed his name to "Miss Alice," was held in contempt for posting on the Internet certain documents pertaining to a bridge collapse, despite a court order that the documents not be distributed. The lawyer announced after the ruling that he would quit the law altogether, so that he would no longer appear "in a 19th century Alice in Wonderland environment that allows pomp, self-importance and deference to the court to eclipse the truth." However, a subsequent news report (here) suggested that he had changed his mind about leaving the practice of law — perhaps he felt his attire entitled him to that prerogative.

"Miss Alice," this video is for you.

https://youtube.com/watch?v=X9DpC6x75s8

 

Photobucket - Video and Image Hosting In a recent post (here), I noted that the cross-border Siemens bribery investigation shows that regulators throughout the world increasingly recognize the importance of vigilance and scrutiny, and that the extent of alleged misconduct in that case could spur further efforts for oversight and reform. In that same vein, a February 15, 2007 New York Times article entitled "Germany Battling Rising Tide of Corporate Corruption" (here) notes with respect to the Siemens case and other investigations that "the current spate of scandals will prompt a serious, systemic effort by German companies to impose more stringent internal controls and systems of legal compliance to stop corruption from happening in the first place."

Whether the current wave of German corruption cases reflects lax legal compliance or simply more aggressive prosecution, it is clear that the number of cases is increasing. Germany did not have laws allowing prosecutors to bring bribery cases until 1997, by contrast to the United States, which has had the Foreign Corrupt Practices Act for over 30 years. One source quoted in the article says that in the last five years, "the notion that we need to prosecute economic criminality took on an entirely new dynamic."

This new dynamic clearly will influence both prosecutorial priorities, and by extension, expectations of corporate compliance. As I have previously noted (here), as these regulatory efforts elsewhere gain traction, differences in regulatory standards between the U.S. and other countries will diminish – a consideration that is clearly relevant to the current calls for regulatory reform in the U.S.

Photobucket - Video and Image Hosting Ready, Fire, AIM: In prior posts, I have raised concerns (most recently here) about regulatory standards for London’s Alternative Investment Market (AIM), and more recently (here) I have suggested that the AIM may be facing increasing pressure to tighten up. In a February 12, 2007 article in The Times (London) entitled "Most AIM Fundraisers Fail to Enrich Backers Over Three Years" (here) takes a look at the 802 companies that listed on the AIM during the three years ending on December 31, 2006, and finds that 52 percent were "either trading at or below their issue price, or have had their shares suspended."

The Times concludes that the "findings are likely to fuel criticism of AIM that, although it has been the most successful growth market in terms of new listings, it has often sacrificed quality for quantity."

Whatever conclusions may be drawn from the data about the quality of AIM listed companies, the fact that over half of the last three years’ listings have failed to make money for investors does have important implications for the likelihood of the past level of listings to continue in the future. This is just one more example of the reasons why current global marketplace circumstances may well change for their own reasons, without any of the regulatory revisions for which the would-be reformers in the U.S. are clamoring.

 

Photobucket - Video and Image Hosting As discussed in February 13, 2007 New York Times article entitled “SEC Seeks to Curtail Investor Suits” (here), the SEC and the DOJ have jointly filed an amicus brief in the Tellabs case pending on writ of certiorari before the United States Supreme Court, in which brief the agencies urge the Court to adopt a restrictive test that plaintiffs must satisfy in order to meet the heightened pleading standard under the Private Securities Litigation Reform Act. The agencies’ amicus brief can be found here.

The Tellabs case is before the Supreme Court to determine whether the Seventh Circuit applied the right test to determine whether the plaintiffs’ allegations satisfied the PSLRA’s requirement that the complaint “state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind.” A copy of the Seventh Circuit opinion can be found here. The Seventh Circuit held, in reversing the district court’s dismissal and holding the plaintiff’s allegations to be sufficient, that a complaint satisfied the PSLRA’s requirements to support a “strong inference” if it “alleges facts from which, if true, a reasonable person could infer that the defendant acted with the requisite intent.”

The agencies argue in their amicus brief that in enacting the heightened pleading standard in the PSLRA, Congress sought to require more than a “reasonable” inference. The agencies contend that courts must consider whether or not the facts alleged support competing inferences, including the possibility whether there are “non-culpable explanations for the defendants conduct,” and consider the relative strength of the inferences to determine whether the inference the plaintiff urges is “strong.” Specifically, the agencies argue that:

in evaluating whether a plaintiff has alleged particular facts that “giv[e] rise” to a “strong” inference of scienter, a court should determine whether, taking the alleged facts as true, there is a high likelihood that the conclusion that the defendant possessed scienter follows from these facts. (emphasis added)

The agencies’ brief is succinct and well-written. But its lawyerly elegance notwithstanding, the brief has already been the target of criticism, particularly its advocacy of the “high likelihood” requirement. The Times article quotes Fordham Law Professor Jill Fisch as saying that it is unusual for the SEC to side against investors in a fraud lawsuit in the Supreme Court: “One has to wonder if the SEC is now on the side of the defense bar.” Professor Fisch describes the “high likelihood” standard urged by the agencies as “exceedingly high.”

Illinois Law Professor Christine Hurt, writing on the Conglomerate blog (here), suggests that the “high likelihood” standard is higher than is required to get to a jury in a criminal securities case. Professor Hurt notes that “in criminal cases, prosecutors don’t even lose on directed verdict for not showing this kind of evidence of intent.” Rather, “prosecutors get to instruct the jury that the defendant can be guilty of securities fraud if the were willfully blind to the actions of others.”

The Supreme Court may yet choose to adopt the standard that the agencies propose. But The D & O Diary notes that while the PSLRA did enact a heightened pleading standard, the “high likelihood” test does not appear in the statute. The statute requires the facts to support “a strong inference” that the defendant acted with scienter – not that the inference of scienter is the only inference, or even that it is the strongest inference, but that it is an inference and that it is strong.

It can be questioned whether the Seventh Circuit’s “reasonable inference” test can be squared with the statute, but I also believe there is serious question whether the “high likelihood” test can be squared with the statute. I don’t believe the PSLRA requires courts considering motions to dismiss to determine which inference is strongest – that seems like a job for a jury to me. Rather, on a motion to dismiss, the court’s job ought to be to examine whether the facts alleged taken as true support a strong inference that the defendant acted with scienter, emphasis on the word “a”.

The 10b-5 Daily has a post about the agencies’ Tellabs amicus brief here and a prior post here about the Seventh Circuit’s opinion.

SEC Advocating Auditor Liability Caps?: As The D & O Diary has previously noted (here), the European Commission is actively looking at the possibility of caps for auditor liability. Conrad Hewitt, the SEC’s Chief Accountant, has previously come out in favor of auditor liability caps (here), and the Times article linked above reports on similar remarks from Hewitt on a more recent occasion. Hewitt’s concern is that without these caps, auditors could face ruinous liability and bankruptcy, which could force further consolidation in the already overconcentrated accounting industry.

The limits of competition among the Remaining Four accounting firms poses a serious issue. Nevertheless, as I have previously argued (here), the concern here is that the SEC (and for that matter, the PCAOB) not put itself in the position of protecting the Big Four accounting firms.

Insurance Coverage Implications of the Delaware Chancery Court’s Recent Options Backdating Decision: As I noted in a recent post (here), the Delaware Chancery Court’s opinions in the Maxim Intergrated options backdating case (here) and in the Tyson Foods options springloading case (here) have important implications for the many other options backdating related shareholders derivative lawsuits. In addition, as noted in an excellent memorandum by my good friend Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm, entitled “A Bad Week for the Defense in Options Backdating Litigation” (here) the Delaware Chancery Court opinions may have important insurance coverage implications as well.

The memorandum notes that even though the opinions did not address coverage issues, “the decisions suggest that coverage issues already raised by insurers in these claims are likely to be continuing sources of contention.” The memorandum is particularly concerned with the potential applicability of conduct exclusions in the D & O policy, give the forceful language of the Chancery Court’s opinions. The memorandum also discuses whether he rulings may also raise important questions about the insurability of settlement or judgment amounts.

The Latest Options Backdating Litigation Tally: Readers may be interested to know that according to the latest D & O Diary tally (here), there have been 147 companies named as nominal defendants in shareholders’ derivative lawsuits raising options backdating allegations.

An “Essential Supplement” to the SEC: In a prior post (here) commenting on Professor Grundfest’s proposal to eliminate private securites lawsuits, I commented that the private securities bar provides outsourced securities law enforcement for the SEC. As Adam Savett notes on the newly revitalized Securities Litigation Watch blog (here), the SEC even went so far as to state in its amicus brief in the Tellabs case that “meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC.” Savett presents additional “gentle rebuttal” against Grundfest’s proposal as well.

The D & O Diary has long contended (most recently here) that civil claims following on enforcement actions under the Foreign Corrupt Practices Act (FCPA) represent a growing area of D & O claim risk. The entry last week (refer here) of a $26 million criminal fine – the largest criminal penalty ever under the FCPA – underscores the growing importance of FCPA enforcement cases. A February 7, 2007 memorandum from the Gibson, Dunn & Crutcher law firm entitled “2006 Year-End FCPA Update” (here) provides a useful overview of 2006 FCPA enforcement activity, and underscores the growing importance of civil claims based on FCPA proceedings.

The memo notes that “2006 marked one of the busiest years of FCPA enforcement and further evidenced the recent proliferation of FCPA enforcement activity.” The memo identifies a number of important FCPA trends, including:

Voluntary Disclosure: “The number of voluntary disclosures continued to rise in 2006. Seventeen of the twenty newly disclosed FCPA investigations during the past two years were voluntarily disclosed to the DOJ or the SEC following internal investigations by the companies.”

Increased Penalties: “Enforcement activity in 2006 continued the trend of increasing the severity of penalties.”

Increasingly Broad Jurisdiction: “U.S. enforcement authorities have shown a willingness to reach far and wide outside traditional jurisdictional boundaries….The Statoil matter marked the first time that the DOJ has taken criminal enforcement action against a foreign issuer for violating the FCPA.”

Ongoing Civil Liability: Even though there is no private right of action under the FCPA, plaintiffs lawyers may be able to pursue securities fraud lawsuits based on FCPA-related misrepresentations. In the Immucor decision (discussed previously on The D & O Diary, here), “for the first time a federal court held that plaintiffs had met the heightened pleading standard requirement for fraud under the PSLRA in an FCPA case.”

According to the memo, “more than 24 other major corporations are under investigation for FCPA violations.” The memo suggests that in this environment, securities claims based on FCPA violations “may start to gain traction” and therefore “the legal road towards resolving an FCPA violation in the U.S. now stretches far beyond achieving peace with the SEC.”

The Gibson Dunn memo confirms a couple of themes that The D & O Diary has been sounding for some time. First, FCPA enforcement activity is increasing, both in frequency and severity, and, second, the threat of follow-on civil litigation from FCPA enforcement activity is also growing. As FCPA enforcement actions grow in number and magnitude, this exposure could pose an increasingly greater D & O risk.

Special thanks to a loyal D & O Diary reader for the link to the recent record-setting FCPA criminal fine.

Record Number of Restatements in 2006: According to a February 12, 2007 Wall Street Journal article entitled “Restatements Still Bedevil Firms” (here, subscription required) publicly traded companies filed a record 1,876 restatements of financial results in 2006, an increase of 17% over the number of restatements in 2005. However, the number of 2006 restatements by large companies (defined as those with over $700 million in shares available to the public) filed 196 restatements in 2006, a drop of about 20% from 2005. By contrast, companies with a public float of less than $75 million filed 1,108 restatements in 2006, more than two-thirds of all 2006 restatements, representing a 42% jump in restatements for companies of that size compared to the prior year.

The most frequent cause of restatement was related to the “measurement and recognition of debt and stock or equity instruments,” and the second most frequent cause related to compensation issues (including, in particular, options backdating).

The drop in restatements for larger companies, which have had to adapt to the reporting requirements of Section 404 of the Sarbanes Oxley Act, suggests that those companies’ internal controls are working better. The smallest companies, which do not yet have to follow Section 404, are clearly continuing to struggle.

Buy-Backs and EPS: When I commented (here) on the controversy surrounding Robert Nardelli’s compensation as the departing head of Home Depot, one of the concerns I specifically noted was the way stock buy-backs had been used to improve Home Depot’s reported earnings per share (EPS), at the same time that the executives’ compensation was adjusted to reward executives based on EPS. Fortune Magazine has a more detailed elaboration of this concern in a February 9, 2007 article entitled “Nardelli’s Fake Bogey: Earnings Per Share” (here).

The D & O Diary’s prior post about the pitfalls of stock buybacks and the way they interact with executive compensation can be found here.

At the heart of recent calls for regulatory reform in the Interim Report of the Committee on Capital Markets Regulation and in the Bloomberg/Schumer Report is the assertion that the U.S. securities markets are losing global IPO marketshare because of supposed regulatory overkill and the litigious environment in the U.S. Accompanying this assertion is the concern that foreign securities markets (particularly in London) are supposedly attracting IPO activity by their comparatively light regulatory touch. Reform of the U.S regulatory approach and litigation system is needed, these Reports assert, so that the U.S. can recapture a larger share of the global IPO activity.

The D & O Diary has previously presented (most recently here) its belief that the reformers’ case for regulatory reform is "weak." More recently, events both overseas and in the U.S. further belie both ends of the reformer’s premise – that is, these recent events suggest that companies (even foreign companies) may yet seek to list on U.S. exchanges, in preference to other exchanges, even without regulatory reform; and that companies might not be able to count on a lighter regulatory touch on competing exchanges.

1. London’s Attraction To (or Appetite For) Russian and Chinese Companies May be Waning:

Photobucket - Video and Image Hosting A very large part of the London markets’ success in growing their share of the global IPO market in recent years has been based on their success in attracting listings from Russia (and other former Soviet republics) and from China. Indeed, in 2006 alone, 12 offerings by companies from Russia or other former Soviet republics raised proceeds of nearly 6.6 billion pounds. But now in early 2007, the bloom very much seems to have gone off the rose for Russian offerings in London. As reported in a February 8, 2007 Financial Times article (here), the listing of the shares last week of two Russian companies (Polymetal and Sitronics) came in at the low end of the offering range and in response a third company, GV Gold, withdrew its offering amidst "lackluster demand." According to the Financial Times article, these developments "underline the increasingly tough environment companies from Russia and other former Soviet states are likely to face this year as investors become increasingly selective."

At the same time the pipeline of Russian companies to London has started to slow, two Chinese companies, 3SBio and JA Solar Holdings, completed successful offerings on NASDAQ.

Without the flood of Russian listings, and with Chinese companies successfully listing in the U.S., the apparent market share advantage enjoyed by the London exchanges could be diminishing

2. The Successful Fortress Investment Group IPO Will Attract Additional Hedge Fund and Private Equity Fund Listings on U.S. Exchanges

Photobucket - Video and Image Hosting Fortress Investment Group’s successful February 9, 2007 IPO was not the first public offering by a private equity fund or hedge fund, nor was it the largest. But it was the first public hedge fund offering on a U.S securities exchange, and it was the most successful. According to the February 10, 2007 Wall Street Journal (here, subscription required) 19 private equity and hedge fund firms sold shares in 2006 on foreign markets, raising $12.4 billion. U.S. groups have been among the firms to list their shares in these offering. KKR, for example, sold shares in a private equity fund on the Euronext Amsterdam exchange. But the KKR fund shares trade in a narrow range close to their offering price.

Fortress chose to list its shares on the NYSE, notwithstanding those supposedly prohibitive regulatory constraints that are driving companies away from the U.S. securities markets. Its reward was that its offering priced at the top end of the range and its shares jumped 68% in the first day of trading. Commentators can argue all they want about whether regulatory burdens are deterring companies from listing on U.S. exchanges, but high valuations and a successful debut like Fortress Investment Group’s will unquestionably attract companies to list on U.S. exchanges.

The title of the Wall Street Journal’s February 10, 2006 article about the offering, "Hedge Fund Crowd Sees More Green As Fortress Hits Jackpot with IPO" (here, subscription required) says it all. Along those lines, a February 9, 2007 Business Week article (here) reporting on the Fortress Investment Group IPO contained a prediction that more than 30 hedge funds and private equity funds could seek to list their shares on U.S. exchanges by the end of 2008.

It should also be noted that the Fortress group was one of 17 offerings this week on U.S. securities exchanges, raising over $3.4 billion, the most active week in terms of deal value in over three years. It certainly seems like the market for IPOs on the U.S. exchanges is healthy — perhaps healthy enough to question whether the reformers’ dire warnings about the competitiveness of the U.S. markets are seriously overblown.

3. London’s Regulators, Perhaps Spurred by Criticism, Have Begun to Show Some Teeth

Photobucket - Video and Image Hosting It probably has nothing to do with the remarks (here) of John Thain, the head of the NYSE, at the recent World Economic Forum in Davos, Switzerland, that the London markets need to "tighten up" to avoid "damage" to "their reputation." But within days of these remarks, the U.K.’s Serious Fraud Office launched an investigation (here) into Torex Retail, following the London Stock Exchange’s suspension of trading of Torex Retail’s shares on the Alternative Investment Market (AIM).

The Torex Retail matter may involve only one company, but it does serve as a reminder that markets will strive to maintain their integrity in order to preserve investor confidence. There are no advantages for being perceived as having won the race to the bottom. Companies attracted to the London markets out of a perception of a lighter regulatory touch will find that they still face regulatory scrutiny. It will not take too many cases like Torex Retail before the London regulators will have shown their vigilence is not less than regualtors elsewhere.

UPDATE: On February 12, 2007, another AIM listed company, Adamind LTD, disclosed (here) that the Financial Services Authority had initated an investigation regarding the company. The Adamind investigation is noteworthy because it involves one of those companies — Adamind is a U.S.-based company with R & D facilities — that chose to list in London and about which the would-be reformers have been fretting so much. Special thanks to alert reader Uri Ronnen of the AccountingClues blog for the link to the Adamind disclosure.

Each of these developments serve as a warning against seizing upon possibly temporary or transient phenomena as pretexts for reducing regulatory rigor in the U.S. In the global economy, transactions will go where they can realize their greatest financial advantage. The factors that in the recent past led to a greater number of listings in London may have had little to do with the regulatory regime in the U.S. The changing IPO market place so far in 2007 suggests that the competitive landscape among the various securities markets is already evolving, and will continue to evolve – and that that is happening without the adoption of any of the various proposed regulatory reforms. We should be very wary of compromising this country’s regulatory rigor based on transient shifts in the global financial marketplace that have no relation to the level of regulation in this country.

Now This: When we heard about the untimely death of Anna Nicole Smith, we found that we could not think of her marriage to J. Howard Marshall without associating this scene from the film, Best in Show:

https://youtube.com/watch?v=T9jxSOxtYHs

 

Photobucket - Video and Image Hosting In a widely-circulated and much discussed February 7, 2007 Wall Street Journal op-ed column entitled "The Class Action Market" (here, subscription required), former SEC Commissioner and Stanford Law Professor Joseph Grundfest (pictured above) takes a look at the declining number of securities fraud lawsuits in 2006 (see prior D & O Diary posts here and here) and reaches the startling conclusion that perhaps it is time to do away with private securities lawsuits altogether.

Grundfest’s views are based on his position that the declining number of suits is due to improved corporate behavior. As he says, "perhaps fewer companies are being sued for fraud because there is less fraud." He attributes this to the "government’s criminal and civil enforcement strategy." Not only has this enforcement activity been effective, Grundfest writes, but as a means to protect shareholders’ interests, it is superior to private securities class actions, since private suit recoveries are diminished by the amount of the plaintiffs’ attorneys’ fees. "Investors," Grundfest writes, "could come out ahead if they simply allowed the SEC to control the process and eliminated the private bar’s cut of the action."

In addition to the elimination of the lawyers’ costs, the exclusiveness of SEC enforcement would provide superior deterrence: "Private litigation does not have an equivalent deterrent effect because it can’t threaten executives with jail and because damages are almost always paid by corporations and insurers, not the executives who cause the fraud." In summary, Grundfest writes, "the private class action can be viewed as an expensive, wasteful and unnecessary sideshow that generates little deterrence and offers questionable levels of compensation."

Grundfest’s proposal to eliminate private securities lawsuits is not entirely original. {UPDATE: Please see the comment below about the origin of this idea; The D & O Diary stands corrected!}The idea of disimplying a private cause of action under Section 10 was circulated in the early stages of the work of the Committee on Capital Markets Regulation (popularly known as the Paulson Committee), as discussed here. Grundfest is a highly respected figure in the securities law arena, and for that reason his views are likely to attract significant attention. But that does not necessarily mean that the private securities lawsuits will disappear any time soon.

First of all, we don’t hear the SEC clamoring to increase its workload; to the contrary, the SEC clearly depends on the private securities bar as a way to outsource part of the burden of enforcing of the securities laws. The SEC’s hands are already pretty full; the SEC could not take on categorically increased responsibilities without a major hike in its budget and in the size of its enforcement staff. {UPDATE: As Adam Savett notes on the newly revitalized Securities Litigation Watch blog (here), the SEC went so far as to state in its amicus brief in the Tellabs case that "meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC." Savett presents additional "gentle rebuttal" against Grundfest’s proposal as well. }

In addition, the introduction of an exclusive public remedy for securities fraud entails significant costs. While shareholders may have to pay attorneys in order to be able to pursue lawsuits, those costs at least are borne by the most interested parties rather than by taxpayers as a whole. And how would taxpayers and corporate American react to a greatly enlarged securities regulator? There is a thin line between respect and fear, and an enlarged and empowered SEC would be even more fearful than it is now. Could deterrence become oppression?

And while Grundfest is correct that the SEC’s enforcement activity has a greater deterrent effect than private litigation, that does not mean that private litigation has no deterrent effect. Most corporate officials want to do the right thing, and they also want to be perceived as doing the right thing. For the typical CFO or CEO, nothing could be more mortifying than finding their name linked in the press to the word "fraud," even if the accusation comes only from a plaintiffs’ lawyer. This deterrent effect is real and an important part of life for most corporate officials.

Without a doubt, the securities class action lawsuit has been abused. It is an expensive and cumbersome tool for the enforcement of the securities laws. But it nevertheless continues to have an important role to play in protecting investors’ rights. Simply put, investors who are angry don’t have to depend on the government to redress their economic grievances; they can do something about it themselves. For all of the excesses of securities class action lawsuits over the years, it is still a tool of empowerment for investors. Readers who find my defense of the securities class action surprising should understand that I simply prefer the continued availability of a private remedy to the prospect of an even more enlarged and even more empowered SEC with a monopoly on the right to protect shareholders’ rights. There was a time, before the courts implied a private right of action, when the sole agent for enforcing the securities laws was the SEC, but private litigants whose interests were not redressed sought a private right of action in order to be able to pursue actions that SEC had not taken up. Without a private cause of action, investors would have no remedy if the SEC failed to act.

I also happen to disagree that the SEC’s enforcement activity alone explains the decline in the number of lawsuits; unlike Professor Grundfest, I think the Milberg indictment is part of the explanation, not for its affect on the Milberg firm alone, but for its effect on the entire plaintiffs’ bar (see my prior post here). I also think the current relatively healthy economy is also part of the explanation. Look at the auto parts industry; that sector has been under pressure lately, and not too surprisingly, just about every public auto parts company has been sued in a securities class action lawsuit in the last 18 months. Just this week, subprime lenders announced deteriorating results, and like clockwork one of the companies (New Century Financial) was sued in a securities class action lawsuit. (here). There are numerous causes for the decline in securities lawsuits, many of which appear to be temporary, so to the extent that Grundfest’s proposal depends on his theory that SEC enforcement activity alone explains the declining number of lawsuits, the proposal should be viewed with caution. Certianly, if the downturn proves to be temporary, the basis of his argument is eroded.

I am surprised that we have not heard a reaction out of the plaintiffs’ bar yet. I suspect we will before too long.

For a good discussion of Grundfest’s column, see the Truth on the Market blog (here).

CalSTRS Completes Another Opt-Out Settlement: As I previously noted (here), the increasing prevalence of institutional investor opt-out settlements has important implications for projected severity assumptions and even for appropriate D & O insurance limits. In the latest example of this phenomenon, the California State Teachers’ Retirement System (CalSTRS) announced (here) on February 7, 2007 that it had reached a $105 million settlement of the $135 million investment losses it claimed in its individual action, brought after the retirement fund opted out of the $2.65 billion class settlement. (Refer here for a description of the class settlement.) CalSTRS announcement in the AOL Time Warner case come just days after it announced a $46.5 million settlement in the case it filed against Quest.

In an article on CFO.com (here), counsel for CalSTRS is quoted as saying that if CalSTRS had not opted out of the class, it would have recovered only $15.5 million to $16 million. In other words, its recovery of its investor loss supposedly was increased 6.5 times by pursuing a separate action. The $105 million settlement represents about 78% of its claimed investment loss.

As I noted in my prior post linked above, separate settlements of this type, even if limited exclusively to the largest securities lawsuits, could have an enormous impact on the complexity and cost of private securities litigation.

 

Photobucket - Video and Image Hosting The options backdating scandal has engendered a flood of shareholders’ derivative lawsuits (146 as of the last count, here). The D & O Diary has previously questioned (here) plaintiffs’ lawyers’ apparent enthusiasm for these suits given the numerous potential defenses these cases present, including, among others, statute of limitations, demand failure, and the business judgment rule. However, two February 6, 2007 opinions by Chancellor William B. Chandler III (pictured above) of the Delaware Court of Chancery, rejected defendants’ dismissal motions on these grounds, and is permitting the options manipulation cases to go forward.

The two opinions were issued in connection with an options backdating case in which Maxim Integrated Products is named as a nominal defendant (Ryan v. Gifford), and with respect to the option springloading allegations in the Tyson Foods Consolidated Shareholder Litigation. The Maxim opinion can be found here and the Tyson Foods opinion can be found here.

The Maxim case is only one of several derivative lawsuits that shareholder plaintiffs have filed alleging options backdating at the company, and the Delaware case was not even the first filed. There are other cases pending in California federal and state court. The Chancellor nevertheless declined to stay the Delaware action because the case presents questions of “great import to the law of corporations.” Because Delaware courts have not addressed these “fundamental issues” and because Delaware law controls many of the backdating cases, the Chancellor found that Delaware courts have “an overwhelming interest in resolving questions of first impression under Delaware law.”

The Maxim defendants moved to dismiss on grounds of demand failure, the business judgment rule, and the statute of limitations. Chancellor Chandler rejected the Maxim defendants’ motion to dismiss the complaint for failure of the plaintiffs to demand that the board take up the allegations. The plaintiffs allege that the board’s compensation committee (composing half of the board) had approved backdating options in contravention of the written and shareholder approved plan. The Chancellor said that that “a board’s knowing and intentional decision to exceed the shareholders’ grant of express (but limited) authority raises doubt regarding whether such decision is a valid exercise of business judgment and is sufficient to excuse a failure to make demand.” In reaching his conclusion that the alleged approval of the option grants exceeded that plan, the Chancellor reviewed the backdating allegations and concluded that the “timing, by my judgment and by support of empirical data, seems too fortuitous to be mere coincidence.”

Chancellor Chandler also rejected defendants’ motion to dismiss based on the business judgment rule. The plaintiffs’ argued that the defendants were not entitled to rely on the business judgment rule because the board acted intentionally or in bad faith. The Chancellor denied the defendants’ motion to dismiss, saying “I am unable to fathom a situation where the deliberate violation of a shareholder approved stock option plan and false disclosures, obviously intended to mislead shareholders into thinking that the directors complied honestly with the shareholder approved options plan, is anything but an act of bad faith.”

The Chancellor also rejected defendants’ motion to dismiss based on the three-year statute of limitations, finding that the statute was tolled as a result of fraudulent concealment: “Inaccurate public representations as to whether directors are in compliance with the shareholder-approved stock option plan constituted fraudulent concealment of wrongdoing sufficient to toll the statute of limitations.”

The Chancellor did hold that the particular plaintiff in the Maxim case lacked standing to assert claims of alleged options backdating that occurred before plaintiff acquired his Maxim stock when Maxim took over a predecessor company in which the plaintiff owned shares. In other words, to have standing, a plaintiff must have owned his or her shares at the time the alleged backdating took place.

The Tyson case involves a multitude of allegations and supposed misconduct, including in particular four alleged instances of “springloading,” in which the defendants supposedly made stock options grants immediately in advance of the release of positive news (which in every instance led to a stock price hike). Chancellor Chandler rejected the statute of limitations defense based on the “doctrines of equitable tolling and fraudulent concealment.” The option grants themselves were disclosed but not that they were made while the defendants possessed material nonpublic information: “Such partial, selective disclosure – if not itself a lie, certainly exceptional parsimony of the truth – constitutes an ‘actual artifice’ that satisfies the requirements of the doctrine of fraudulent concealment.” He found that the “equitable tolling” doctrine also tolls the statute: “It is difficult to conceive of an instance, consistent with the concept of loyalty and good faith, in which the fiduciary may declare that an option is granted at ‘market rate’ and simultaneously withhold that both the fiduciary and the recipient knew at the time that these options would quickly be worth more.”

The Chancellor also rejected the Tyson defendants’ motion to dismiss based on the business judgment rule. Acknowledging that allegations of “options springloading” implicate a “much more subtle deception” than options backdating, Chancellor Chandler said that it is not a question whether the practice is a form of insider trading; rather the question is:

whether a director acts in bad faith by authorizing options with a market-value price, as he is required to do by a shareholder-approved incentive option plan, at a time when he knows those shares to be actually worth more than the exercise price. A director who intentionally uses inside knowledge not available to shareholders in order to enrich employees while avoiding shareholder imposed requirements cannot, in my opinion, be said to be acting loyally and in good faith as a fiduciary.

The Chancellor emphasized that in order to make this allegation, the plaintiff “must allege that options were issued according to a shareholder-approved employee compensation plan.”

Chancellor Chandler’s opinions in these two cases could have a significant impact on the many pending options backdating cases. As the Chancellor himself noted in deciding not to stay the Maxim case, “an answer regarding the legality of these practices pursuant to Delaware law plainly will affect not only the parties to this action, but also parties in civil and criminal proceedings where Delaware law controls or applies.” In other words, the Chancellor’s opinions reflect his awareness and his intent that his rulings will affect other proceedings – significantly, including even criminal proceedings.

In light of Chandler’s awareness that his rulings will carry influential, persuasive, and even precedential power, perhaps even beyond cases controlled by Delaware law, his censorious, even outraged tone is striking. It is clear that he takes a dark view of the alleged options manipulations, particularly where shareholders have been told that the options would be granted according to a plan that they have approved. Chandler had little trouble rejecting defenses the might otherwise protect the alleged misconduct. The potential impact on the many other pending cases could be substantial. Plaintiffs’ briefs in the other cases will now be replete with lengthy quotations from Chandler’s opinions, and defendants will be forced to try to distinguish the cases, even if Delaware law is not controlling, at least where the companies had shareholder approved options plans in place at the time the alleged options grant manipulations. Chandler’s ruling that options springloading (and, his opinion also suggest, options bullet dodging) might violate fiduciary duties could also have a very significant impact.

The Maxim opinion is discussed in a February 8, 2007 Wall Street Journal article entitled “Maxim Ruling Opens Door for Backdating Cases” (here, subscrition required). A more scholarly discussion of the Maxim opinion can be found on Professor Bainbridge’s Business Associations blog (here).

Special thanks to Broc Romanek of the CorporateCounsel.net blog (here) for providing me with copies of the opinions, thanks to Adam Savett of the Lies, Damned Lies blog (here) for forwarding me links to the opinion, and hat tip to Francis Pileggi of the Delaware Corporate and Commercial Litigation blog (here) for maintaining links to the opinions on his site.

SEC Files New Options Backdating Enforcement Proceeding: On February 6, 2007, the SEC filed a new civil enforcement proceeding against two former officers of Engineered Support Systems, based on the officials’ participation in an alleged six-year options backdating scheme. The SEC’s press release can be found here. The scheme was somewhat unusual because it involved the occurence of “double backdating” where backdated options that had fallen out-of-the-money were backdated a second time. This new action is the first options backdating action since the SEC filed its earlier actions against Comverse Technology and Brocade Communications last summer. It may have taken the SEC a while to get around to this most recent action, but it surely will not be the last that the SEC files. An interesting discussion of the new action, including important differences between this action and the earlier Comverse and Brocade actions, can be found on the SEC Actions blog, here. The case is also discussed on the AAO Weblog, here.

Photobucket - Video and Image Hosting In the latest of the securities class action opt out settlements, California’s teacher pension fund reached a $46.5 million settlement in its separate case against Qwest Communications, its accountants and investment banks, and certain former directors and officers. According to news reports (here), the parties resolved the pension fund’s case, which was pending in the San Francisco Country (Cal.) Superior Court, in December 2006, but the settlement only recently came to light as a result of a California Public Records Act request of the Associate Press. The pension fund had opted out of the $400 million settlement of the class action lawsuit against the Qwest defendants. A description of the class settlement as well as a number of the opt out lawsuits may be found here.

The settlement reportedly included a $1.5 million payment on behalf of Qwest’s former CEO Joseph Nacchio. According to Nacchio’s counsel (here), Nacchio’s settlement contribution was "made with insurance funds." Nacchio is scheduled to go to trial in federal court in Denver on March 19, 2007, on a 42-count insider trading indictment, in which it is alleged that Nacchio sold $101 million of Qwest stock based on inside knowledge that the company would not meet revenue targets. A February 4, 2007 Denver Post article discussing the criminal case against Nacchio can be found here.

The $46.5 million settlement with the California State Teachers’ Retirement Systems’ (CalSTRS) is apparently only one of several settlements that the Qwest defendants have recently reached with opt-out plaintiffs. According to a February 3, 2007 Rocky Mountain News article entitled "Qwest Quietly Settles Lingering Lawsuits" (here), the Qwest defendants have also reached settlements in undisclosed amounts with the New York City Employees’ Retirements System, Stichting Pensioenfunds of Netherlands, and the Teachers’ Retirement System of Louisiana.

According to the statement of its Chief Executive in a January 31, 2007 CalSTRS press release (here), the pension fund will receive "about 30 times more than it would have recovered if it had taken part in the class action." CalSTRS is one of the largest public pension funds in the country, second only to the California Public Employment Retirement System (CalPERS).

A copy of CalSTRS complaint against the Qwest Defendants may be found here, and the December 29, 2006 Amended Settlement Agreement can be found here.

The CalSTRS opt-out settlement in Qwest follows the December 2006 opt out settlement by the State of Alaska in connection with claims against AOL Time Warner (refer here). The State of Alaska reportedly received a settlement of $50 million on its claimed investor loss of $60 million, or about 83 cents on the dollar. The attorney for the State of Alaska claimed that the state received "50 times more than we would have gotten if we had remained in the class." The lawyer also said that the state was able to take advantage of Alaska’s favorable blue sky laws. (A description of the AOL Time Warner class settlement can be found here.)

These opt-out settlements follow the settlement by five New York City public pension funds that did not join the $6.1 billion World Com settlement. According to news reports (here), the pension funds received $78.9 million on their $130 million claimed fraud losses to their equity and bond portfolio. The city’s counsel claimed that the funds wound up with "three times more than they would have received if they joined the class action."

The emergence of large separate opt-out settlements represents a potentially very significant development in securities fraud litigation. Certainly if institutional investor defendants perceive that they can substantially increase their recoveries by pursuing their claims individually rather than collectively in the form of a class action, the utility of the class litigation, at least for institutional investors, could be significantly reduced.

While class lawsuits have been demonized for years, they do offer unarguable advantages in certain respects, most obviously when they afford the opportunity to resolve numerous disputes in a single proceeding. Following the adoption of the Private Securities Litigation Reform Act of 1995, there are certain procedural advantages to the federal securities class action litigation, most significantly the stay of discovery while motions to dismiss are pending. If a company is forced to defend itself in multiple proceedings in multiple courts, particularly if it is also forced to defend a class lawsuit also, the costs and complexity of defense escalate enormously. And if individual investor recoveries really do exceed class recoveries as a percentage of investor losses, then the aggregate cost of final resolution could escalate significantly as well.

But some caution may be required before it can be conclusively determined that opt-outs will fare better than class members. Typically, the percentage of a plaintiffs’ attorney’s fee recovery in an individual case is higher, because it is applied against a smaller fund. (A class attorney can accept a lower percentage because the fund is so much larger, and the resulting fee is larger as well.) So the individual plaintiffs’ recovery net of fees would have to take this larger plaintiffs’ fee percentage into account.

From the plaintiffs’ attorney’s point of view, the prospective class fee will almost always be larger than the prospective fee representing an opt out investor, and indeed a plaintiffs’ lawyer’s incentive to take on an opt out case is going to be limited to cases where the individual investor’s prospective recovery is very large. To put this into context, the median 2006 securities class action settlement, according to NERA (here), was $7.7 million. If half of all settlements are below $7.7 million, there are going to be relatively few instances where the potential incremental benefit from an opt out case will sufficiently outweigh the associated friction costs. There are not going to be very many occasions where there will be plaintiffs’ lawyers eager to pursue these cases, either. So, on its face, the opt out lawsuit would appear to be a phenomenon restricted to only the largest cases and settlements.

Nevertheless, in these largest cases, the emergence of opt out cases could require a reassessment of the assumed range of claims severity. In assessing potential severity, it may not be sufficient to look at class action settlement data alone. It may also be necessary to crank into the calculus the possibility of opt-outs, with the potential for heightened defense expense and settlement exposure. This dimension of added exposure could also have important implications about D & O insurance limits adequacy. The limits required to defend the company and its directors and officers in a multi-front war with opt-out institutional investors and the class, and required to settle all of the lawsuits (particularly if opt-outs expect recover percentages approaching 100% of investor losses), could be significantly higher than may have been assumed in the past.

The Lies, Damned Lies Blog takes a closer look at the plaintiffs’ firms involved in the CalSTRS opt out settlement with the Qwest defendants, here.

UPDATE: On February 7, 2007, CalSTRS announced (here) a separate $105 million settlement in its separate opt out action involving its claims investor loss at AOL Time Warner. Refer here for a more detailed discussion of CalSTRS AOL Time Warner settlement.

Star Trek Meets Monty Python: The ultimate nerd movie mashup.

 

Photobucket - Video and Image Hosting The growing bribery scandal at Siemens has made the front pages of the world’s financial papers in recent days. For example, on January 31, 2007, the Wall Street Journal (here, subscription required) ran an article entitled "At Siemens, Witnesses Cite Pattern of Bribery." In its February 1, 2007 SEC filing on Form 6-K (here), Siemens, whose ADRs have traded on the NYSE since 2001, reported that the U.S. Department of Justice is "conducting an investigation of possible criminal violations of U.S. law" and also announced that it "understands that the U.S. Securities and Exchange Commission’s enforcement division is conducting and informal inquiry into matters at this time."

Siemens apparently is already under investigation in German, Lichtenstein, Italy, Switzerland and Greece. The investigation gained momentum in November 2006, when, according to the Journal, more than 200 German police raided about 30 offices and homes of current and former Siemens employees." The German police searched office of Siemens management board members, including that of Siemens’ CEO, Klaus Kleinfeld. In December, the company announced that it had uncovered $544 milllion in "suspicious transactions." covering over seven years. The investigation involves the possibility that Siemens officials diverted funds through sham consulting contract to slush funds used to bribe potential customers. Investigators are looking into possible bribes in a number of countries, including Saudi Arabia, Russia, Slovakia, Argentina, Nigeria, Egypt, Cameroon, and Kazakhstan. A number of high-ranking Siemens officials have been arrested, including a member of the management board. The Company’s former CFO reportedly is a suspect.

It obviously remains to be seen whether the DoJ investigation or the informal SEC investigation will lead to further proceedings. But according to the February 3, 2007 Wall Street Journal article discussing the U.S.-based investigations (here, subscription required), these U.S investigations "heighten the legal risk for Siemens, which could face lawsuits and be banned from bidding on infrastructure contracts in the U.S. and other countries if there is evidence of wrongdoing."

The company also faces significant (but uncertain) financial risk as well. In its 6-K announcing the U.S. investigations, while acknowledging that the company "cannot exclude the possibility that criminal or civil sanctions may be brought against the Company itself or against certain of its employees," the company also reported that so far "no charges or provisions for any …penalties or damages have been accrued as management does not yet have enough information to reasonably estimate such amounts." As a company with 2006 sales of over $113 billion, Siemens would have to sustain a very significant fine, penalty or damages for it to have a material impact on its financial condition, although certain enforcement outcomes could definitely impact the company’s future prospects. The absence of any accrual at this time does raise at least the possibility of a negative financial effect from an adverse investigative development.

The involvement of the SEC in the Siemens investigation underscores a point that The D & O Diary has made in several prior posts relating to investigations involving the Foreign Corrupt Practices Act (most recent posts here and here). That is, these investigations can give rise to follow on securities claims. This is the reason that I have often cited the FCPA as a threatening potential new source of D & O exposure. The threat is not so much from the corrupt practices investigation itself, but from the follow on claims that could arise in which it is claimed that the corrupt practices caused a misrepresentation of the company’s financial condition – which presumably is the question the SEC is examining in connection with the Siemens probe.

The Siemens investigation is also important in connection with the current calls inside the U.S. for regulatory reform to improve the competitive position of U.S. securities markets in the global financial marketplace. The Siemens investigation originated outside the U.S. and only came to this country after the provision by foreign authorities of investigative information to U.S. authorities. It is evident that regulators throughout the world increasingly understand the importance of vigilance and scrutiny. The magnitude and scope of the Siemens investigation suggest cross-border commitment to regulatory rigor and the extent of the alleged misconduct is likely to spur further efforts for oversight and reform As international regulatory standards respond to these circumstances, differences between the standards in the U.S. and those elsewhere are likely to continue to diminish.

The Here After: It turns out that in the cycle of death and rebirth, what we are really here after is beer:

 

While 144 different companies have been named as nominal defendants in options backdating related derivative lawsuits (see The D & O Diary’s running tally of options backdating related lawsuits here), a new lawsuit filed in federal court in Houston on Thursday will be of particular interest to The D & O Diary’s readers, both because of the company involved and because of one of the individual defendants involved. According to a February 2, 2007 Houston Chronicle article (here), HCC Insurance Holdings has been sued as a nominal defendant in a shareholders derivative lawsuit, along with twenty of its former present and former directors and officers. The suit alleges that the defendants backdated stock option grants and caused the company to file false and misleading statements with the SEC between 1995 and 2006; diverted “hundreds of millions of dollars of corporate assets” to HCC senior executives; and subjected HCC to potential liability from regulators.

Among the individual defendants is Marvin Bush, President George W. Bush’s youngest brother. Bush was an HCC director from 1999 to 2002, until he became an advisory director. Bush is alleged to have sold 93,000 HCC shares for $2.2 million while supposedly in possession of material nonpublic information.

The lawsuit follows the company’s November 17, 2006 release (here) of the results of its internal investigation, in which it reported that “the company used incorrect measurement dates for certain stock option grants covering a significant number of employees,” from 1995 to 2006. HCC’s internal investigation was conducted by the Skadden Arps law firm. In connection with the release of the internal investigation report, company founder and CEO Stephen Way resigned. The company has also said that it is cooperating with an informal SEC investigation.

Penalties Debate Stalling Options Enforcement Cases?: Even though the SEC reportedly is investigating over 100 companies, it has charged only a handful of individuals at two technology companies – Brocade Communications Systems and Comverse Technology. According to a January 31, 2007 Blooomberg.com article entitled “SEC’s Cox Stalls Options Crackdown By Delaying Vote” (here), the SEC’s probe of over 100 companies in connection with the options backdating scandal has stalled while SEC Chairman Christopher Cox determines how to penalize the companies involved. According to the article, Brocade has been waiting since July 2006 for approval of a proposed $7 million settlement. The Commission apparently is split along party lines on whether companies should be penalized, with the two republicans opposing fines as harmful to shareholders and the two democrats supporting the practice as a deterrent and as a means to recover ill-gotten gains. Later news accounts (here) reported Cox’s denial that the decision is stalled.

Will Outside Directors Become Involved in Options Backdating Charges?: Since three outside directors received Wells Notices in connection with the Mercury Interactive stock options investigation (refer here), there has been a unanswered question surrounding the stock options scandal: to what extent will outside directors get dragged into enforcement actions and claims involving options backdating? In a January 23, 2007 speech (here), SEC Commissioner Roel C. Campos added fuel to the speculative fire when he stated, in connection with his comments on the SEC’s options backdating investigation, that so far “we have charged only officers” but that “if the specific facts are present, it wouldn’t surprise me to see charges brought against outside directors.”

Welcome Back: The D & O Diary is delighted to see the Lies, Damned Lies blog back on the blogging circuit again after a brief hiatus. Apparently the current active phase will be brief, as Adam Savett, the blog’s author, will soon be reinvigorating the dormant Securities Litigation Watch blog. In the meantime, Adam has put the Lies, Damned Lies blog up for “adoption.” (here). The D & O Diary will be interested to see how this anticipated double brain transplant works out.

Now This: The D & O Diary was surprised to learn from Wikipedia (here) that Marvin Bush is a 1979 graduate of the University of Virginia, founded by Thomas Jefferson and also the alma mater of The D & O Diary’s author (B.A. 1978). According to Wikipedia, Bush was a member of the St. Elmo Hall fraternity, known at the time for its preppy athletes. Although we overlapped for three years at UVa, I did not know Bush; my fraternity down the street from Bush’s drew from a different demographic and enjoyed a somewhat different reputation. Readers may be interested to know that Katie Couric was also at UVa at the same time. I don’t believe that Katie attended too many parties at my fraternity…