On January 2, 2007, the Stanford Law School Securities Class Action Clearinghouse , in conjunction with Cornerstone Research, released its year-end study entitled “Securities Class Action Case Filings 2006: A Year in Review” (here), as well as a press release (here) detailing the report’s filings. As The D & O Diary noted yesterday (here), the study finds that the number of securities fraud class action lawsuits in 2006 is “the lowest ever recorded in a calendar year since the adoption of the Private Securities Litigation Reform Act (PSLRA) of 1995.” The study reports that the 110 suits filed in 2006 represents a decline of 38 percent from 2005, and is 43 percent lower than the historical average of 193.

The report noted that the decline is even more striking when the options backdating cases are excluded. As The D & O Diary has noted in its running tally of options backdating lawsuits (here), there have been 22 securities fraud lawsuits containing options backdating allegations. Of these, 20 were filed in 2006. The Stanford study suggests that these lawsuits represent a “one-time event that will not recur in the future” and if the options lawsuits are excluded from the 2006 total, the total “core” 2006 securities lawsuits (omitting the backdating lawsuits) of only 90 cases represents a decline of 53% from historic norms.

The study also examines the number of lawsuits relative to the number of public companies. This is an important consideration because the number of public companies listed on the major U.S. exchanges has declined by 25% since 1996, and so it is not enough simply to compare the number of lawsuits across years. The study examined the ratio of the number of lawsuits to the number of public companies, and found that the 1.5% frequency rate is the lowest level since 1997, and significantly below the 2.2% annual average during the period 1996-2005.

The study also found that the losses in total market capitalization associated with the 2006 filings also declined substantially from already reduced levels observed in 2005, and there was a “sharp decline in the incidence of large dollar value claims.” According to one measure used in the study, the purported investor losses declined by 44 percent from 2005 to 2006.

The study attributes the decline to three causes: first, the “strengthened federal enforcement activity…may be reducing the amount of fraud in the market”; second, a strong stock market accompanied by reduced stock price volatility is reducing sharp stock price drops that attract shareholder lawsuits; and third, the huge flood of shareholder lawsuits that swept through the system following the boom and bust cycle of the late 1990s and early 2000s have largely passed through the system.

The study discounts the impact of the Milberg Weiss indictment on the number of securities filings, noting that “[b]ecause there are no material barriers to entry in the plaintiff class action sector, and because there is a large supply of firms and lawyers with the ability and incentive to pursue class action securities fraud litigation, this indictment does not appear to explain the decline in class action securities fraud litigation.”

In yesterday’s post (here), The D & O Diary noted commentary from others who expressed a view that the Milberg Weiss indictment and the elimination of the plaintiffs’ bar’s ability to rely on professional plaintiffs may be a factor in the reducted number of lawsuits. The D & O Diary’s comments on the potential impact of the Milberg Weiss indictment can be found here and here. The D & O Diary’s prior comments on the possible causes of the declining number of lawsuits can be found here and here.

A January 2, 2007 Wall Street Journal article discussing the study can be found here.

According to a December 29, 2006 Bloomberg.com article entitled “Stock Fraud Suits at 10-Year Low” (here), the 120 companies sued in securities fraud lawsuits in 2006 represented the lowest annual total since 1996. The article cites data from the Stanford Law School Class Action Clearinghouse. The total of 120 companies sued represents a drop of more that a third from the 2005 total of 181, and represents only slightly more than half of the 2004 total of 233. The article attributes the decline to “a rising stock market, increased corporate controls and the indictment of one of the top investor law firms on charges it paid illegal kickbacks to clients.”

The article quotes Columbia Law School Professor John Coffee as saying that after Enron and the other corporate scandals, there aren’t “going to be as many high profile scandals.” The article also quotes Professor Coffee as saying that the indictment of the Milberg Weiss firm has “probably paralyzed, or at least constrained, the ability of the firm to bring new class actions.” He also said that the firm’s prosecution may have discouraged other firms from using “professional plaintiffs” to bring cases. The article also quotes former federal prosecutor Robert Mintz as saying that Sarbanes-Oxley is having an impact: “The one-two punch of Sarbanes Oxley and the flurry of high profile prosecutions has certainly changed the way corporations do business” which is “reflected in the decreased number of these class action suits.”

The article mentions the options backdating scandal, noting that “at least 193 companies have announced internal investigations or government probes” of their options practices. The article does not mention that among the 120 companies sued in securities fraud lawsuits in 2006 were 21 companies that were named in securities lawsuits raising options backdating allegations. In addition, as of December 30, 2006, 127 companies had been named as nominal defendants in shareholders’ derivative lawsuits raising options timing allegations. The D & O Diary’s running tally of the options backdating related litigation may be found here.

The D & O Diary’s prior discussion of the declining number of securities lawsuits may be found here and here. The D & O Diary’s prior discussion of the possible impact of the Milberg Weiss indictment may be found here and here. Among the best discussions of the declining number of securities suits is a brief article by D & O maven Dan Bailey; his article may be found here.

What’s Coming in 2007?: The White Collar Crime Prof Blog has some interesting predictions, here.

How Did Some Companies Avoid Options Backdating Problems? One possible place to look is the attitude at the top. In a January 1, 2007 San Jose Mercury News article entitled “McNealy is One Reason Sun Never Backdated” (here), Sun Microsystems Chairman and former CEO Scott McNealy is quoted as saying “They never taught me in school that you are supposed to put the date that you signed it . . . It was kind of intuitively obvious to me that you didn’t backdate.”

Now This: Charlie Munger, the Vice Chairman of Berkshire Hathaway and Chairman of Wesco Financial Corporation, has his own explanation on why there are recurring problems with executive compensation and other abuses: “In my opinion, not enough executives have gone to jail.” The entire January 1, 2007 Los Angeles Times interview of Munger can be found here.

Photobucket - Video and Image Hosting New Wave of Options Lawsuits?: Regular readers know that The D & O Diary has been tracking options backdating lawsuits (here). A December 20, 2006 article on Law.com entitled “McAfee Employees’ Suit Reveals New Options Dynamic” (here) raised the question whether a breach of contract action brought by the employees of McAfee represents the opening salvo in a “new wave” of options backdating related litigation.

Seven McAfee employees have alleged they were “cheated” out of $2 million because the company did not permit them to exercise stock options that then expired during the company’s self-imposed blackout. The company imposed the blackout during a delay in the filing of its financial statements while it investigated possible options backdating. The blackout was imposed to prevent stock transactions that might later give rise to insider trading allegations. Employees whose shares expire during a blackout period are out of luck unless the company extends the expiration dates. McAfee apparently declined to extend the expiration date for plaintiffs’ options, all of whom had or have left the company. The plaintiffs allege that the company is “unfairly penalizing them for the accounting misdeeds of management.” The article quotes a plaintiffs’ lawyer who said that she “expects many suits similar to the McAfee action to be filed over the next few months.”

The breach of contract action is merely the latest options backdating related problem at McAfee. Press reports (here) recently suggested that Kent Roberts, McAfee’s former general counsel, may be indicted by federal prosecutors in coming weeks on charges relating to stock option grants.

Two different alert D & O Diary readers forwarded a link to the Law.com article, including Adam Savett at the Lies, Damned Lies blog and a loyal reader who prefers anonymity. Thanks to both.

Heard Melodies are Sweet, But Those Unheard are Sweeter; Therefore, Ye Soft Pipes, Play On: In a prior post (here), The D & O Diary took a look at the liability exposures for companies engaging in PIPE (Private Investment in Public Equity) transactions. (The prior post provides background about the nature and structure of these transactions.) Two recent SEC enforcement actions shed additional light on the issues and pitfalls that these transactions can sometimes present.

On December 12, 2006, the SEC announced (here) that it had filed a Complaint against Edwin “Bucky” Lyon, Gryphon Partners, and several Gryphon investment funds, in connection with thirty-five different PIPE transactions during the period from 2001 to 2004. The complaint alleges that after agreeing to invest in a PIPE transaction, the defendants sold the issuer’s stock short through “naked” short sales (that is, without owning shares to cover their short position) in Canada. Once the resale registration statement was effective, the defendants used the PIPE shares to cover their short position. The complaint also alleges that the defendants falsely represented to the PIPE issuers that they would not sell or transfer their shares other than in compliance with the securities laws. In addition, the complaint alleges that the defendants relied in inside information when they engaged in the short sales. The defendants are alleged to have realized more than $3.5 million in ill-gotten gains.

On December 20, 2006, the SEC announced (here), the filing of a separate settled complaint against broker-dealer Friedman, Billings, Ramsey & Co., its former Co-Chair and Co-CEO, and its former Director of Compliance. The complaint’s allegations relate to a 2001 PIPE transaction in which the Company acted as placement agent. The Company is alleged to have sold the issuer’s shares short while aware of material, nonpublic information prior to the public announcement of the PIPE transaction. The Company covered its short position with shares it bought from its own customers who had bought their shares in the PIPE offering. The Company’s total trading profits were under $450,000 (although its underwriting fee on the PIPE transaction was $1.764 mm), but it agreed to civil penalties of $3.756 mm, without admitting or denying the charges. The individual defendants, who also did not admit the charges, agree to lesser penalties and constraints on their ability to serve in similar roles. The company’s press release about the settlement may be found here. An interesting discussion of the case on the SEC Actions blog can be found here.

While these cases illustrate some of the pitfalls of PIPE transactions, it is significant that they do not involve charges against the issuer companies – as I pointed out in my prior post, most of the enforcement proceedings relating to PIPEs transactions involve the broker dealers or the investors, but not the issuing company. There is nothing about these two new actions that changes my prior statement that issuer companies involved in these transactions should not be treated as suspect merely because the engaged in a PIPE financing. Both of these cases also relate back to the 2001 time frame, which, as my prior post pointed out, was a period when these transactions were less structured and involved greater perils. Nevertheless, it is clear that the SEC is taking a look at these transactions.

Photobucket - Video and Image Hosting The quotation in the caption of this item (about “soft pipes,” and which admittedly has nothing to do with the item itself) is of course from “Ode to a Grecian Urn” written in 1820 by John Keats after viewing an exhibit of Greek artifacts accompanying the Elgin Marbles at the British Museum. The Elgin marbles are the remnants of marble sculpures removed from the Parthenon. Their removal to England has been a controversy since Lord Byron wrote his “Childe Harold’s Pilgimage” (“Curst be the hour when from their isle they roved”).

Holiday Interlude: The D & O Diary will be slowing down over the next few days. Readers can look forward to the resumption of the normal publication schedule after the New Year. Happy Holidays to all.

When the blue-ribbon Committee on Capital Markets Regulation (popularly known as the Paulson Committee) released its Interim Report (here) calling for regulatory reform, it based its case for reform in large part on the U.S securities exchanges’ loss of market share in the global IPO marketplace. As The D & O Diary has previously noted (here), there are serious grounds on which to question this premise. Recent developments provide additional grounds on which to question many of the Paulson Committee’s presumptions. Several of these presumptions are reviewed below, in light of these developments.
 

 

1. Lower Regulatory Requirements Give Foreign Exchanges an
"Advantage"

The Paulson Committee’s Interim Report focused in particular on London’s Alternative Investment Market’s (AIM) "hands off" approach to regulation. The Report noted that the U.K. has been "relentless in stressing its regulatory advantage and indicating its commitment to maintaining a ‘light touch’ in regulation." This lighter touch may be attractive to certain companies, but whether this is an advantage for investors is doubtful.

A December 20, 2006 Wall Street Journal article entitled "Uncertain AIM: A Hot Market In London Has Its Risks, Too" (here, subscription required), examines whether AIM market’s "laissez faire" approach may be "treacherous for investors" because some of the companies that have gone public on AIM are "intrinsically dangerous businesses." The article also examines the limitations of, and inherent conflicts of interest involved with, the AIM market’s system of "nominated advisers" or "nomads," who both vet potential deals and pitch the new company’s shares to the marketplace. Indeed, because of perceived abuses, AIM is "finalizing a new rulebook that toughens some standards" and "may be preparing further steps to restore confidence in the market." In the meantime, investors have suffered, The article cites examples of "unpleasant surprises" for AIM investors in the last 18 months, including one AIM company whose shares plunged 60% when the company disclosed one month after its offering that the oil field it was exploring was not "commercially viable."

The AIM experience suggest that while lax standards have made it attractive for weaker companies, that is not a sustainable "advantage." AIM’s belated attempts to shore up its oversight weaknesses underscores that the most important advantage a marketplace can have is investors’ perception of trustworthiness. U.S. market’s regulatory standards allow companies whose shares trade here to enjoy a valuation premium (see my prior post about the valuation premium here). A valuation premium, now that is a competitive advantage. A regulatory race to the bottom to attract marginal companies would be a huge step backwards.

One undeniably real advantage that foreign exchanges do offer is lower cost access, both in terms of lower underwriting fees and lower listing fees. Concerns about the competitiveness of U.S. securities markets’ competitiveness would be more appropriately focused on these cost disadvantages, rather than the regulatory integrity of the U.S. securities markets.

The U.S. securities markets have lost global marketshare for IPO business, but the causes are even more numerous and diffuse than the Paulson Committee assumes. The Committee’s Interim Report acknowledges that part of the reason for the decline is that foreign markets have improved. But as I have discussed previously (here), the biggest reason for the decline in the U.S. marketshare is the decline in the number of U.S.-based companies’ IPOs. This decline in U.S. companies’ IPOs may be due to cyclical reasons -certainly recent IPO activity gives reason to hope that this activity may be cycling back up. According to CFO.com (here), the number of U.S. based companies completing IPOs through November 2006 (186) represents the highest annual number since 2000. And according to the Wall Street Journal (here, subscription required), last week’s 16 offerings made it the busiest week of the year for IPOs. The recent high level of U.S. based company IPO activity raises the question whether the concerns the Paulson Committee seeks to address may be temporary and have less to do with the attractiveness of the U.S. exchanges to foreign companies than with the conditions for companies inside the U.S.

 

And even with respect to foreign companies, the decline in U.S. market share may be a reflection of the mix of foreign sources for IPO companies. As a December 18, 2006 Wall Street Journal article entitled "Israel Fades, China Takes the Lead on Foreign IPOs Listed in the U.S." (here, subscription required) discusses, Israel was "the most active foreign source of listing…by a wide margin" in the late 1990s. Since that time, the number of Israeli companies conducting offerings, both inside and outside the U.S., has been "sparse," primarily as a result of M & A activity in Israel. Also, in the 90s many of the Israeli companies "went public too early," but the "level of sales and profits that you need to go public are much higher now."

China has replaced Israel as the leading source of foreign offerings, but Chinese companies often have unique political or economic reasons for staying with local exchanges. And experience has shown that some Chinese companies may not be completely ready for the scrutiny of public ownership.

All of this should show that there are many reasons – the cyclical nature of the U.S. based IPO activity, declining IPO activity in key foreign countries – that are contributing causes for the decline in U.S. marketshare of global IPOs, and these causes certainly do not justify radical changes to the U.S. regulatory approach. Given these various factors, regulatory reform seems poorly calculated to alter the level of U.S. exchanges’ market share.
 

 

3. The U.S. Exchanges’ Loss of Global Market Share Will Hurt New York City, Its Businesses, Its Employees, and Its Taxpayers

Let’s be honest here. Nobody on Wall Street is starving. According to a December 20, 2006 New York Times article (here, registration required), securities industry employees in New York will receive almost $24 billion in compensation in 2006, up 17% from a year ago. Wall Street investment bankers are receiving record bonuses. (Goldman Sachs paid its 26,467 employees an average of $622,000 per person.) This translates into $1.6 billion in tax revenue for New York State and $580 million for New York City.

Remind me again: exactly what is the problem that New York City is facing and why does that justify gutting the U.S.’s strong regulatory regime? Isn’t it just possible that what makes all those New York investment bankers so filthy rich is that they have the privilege of working in a city with the most highly respected markets in the world?

Certainly if Wall Street is really worried about being competitive, it needs to take a hard look at its current level of profitability and then take another look at its underwriting and listing fees. Perhaps if Wall Street were a little less astonishingly profitable, the U.S. exchanges might be more attractive to foreign investors. But instead, according to news reports (here), NASDAQ plans to raise its listing fees, in order to support certain auxiliary services that it owns. That certainly is not going to make U.S. exchanges more attractive to foreign companies, or even to U.S. based companies.

 

The U.S. litigation culture does represent a burden. But as I have previously discussed (here), foreign investors increasingly are demanding accountability from company management, and increasingly are seeking (and getting) the ability to seek redress for alleged management misconduct in local courts. The most recent example of this is the class action (here) that investors in Australia initiated against senior officals at the Multiplex Group. (Hat tip to Adam Savett at the Lies, Damned Lies blog for the link). These kinds of suits will become even more common as foreign investors increasingly demand accountability from senior corporate officials. These trends mean that while the U.S. is more litigious, differences between the U.S and other countries in this respect are diminishing and will become less and less of a factor.

 

 

5. The Time is Right for Regulatory Reform

As I have previously stated (here), it is more than a little strange to be talking about regulatory reform so soon after the Enron criminal sentencings and in the midst of the options backdating scandal. But the call for reform is premature in other ways as well. An noted above, the causes of the ills the Paulson Committee seeks to remedy may in part be cyclical, and indeed there is some evidence that the evolution of the cycle will itself alleviate come of the issues with which the Committee is concerned.

Other evolutionary change may provide further relief without the need for an elaborate regulatory reform effort. Just within the last few days, the SEC (here) and the PCAOB (here) have announced efforts to address concerns about the requirements of Section 404 of the Sarbanes-Oxley Act, which is one of the Paulson Committees’ big issues. In addition, according to news reports (here), Pink Sheets LLC is looking at creating marketplace mechanisms that could prove more competitive with the AIM (refer also here). Incremental changes of these kinds may be more effective and cause less damage that a wholesale program of regulatory reform.

One thing is certain — the globalization of capital is neither a small nor a temporary phenomenon. According to an Ernst & Young study (here) released on December 18, 2006, global IPO activity was at record levels in 2006, and offerings from emerging market companies are leading the way. The largest offerings involve Chinese companies, and their listings on the Hong Kong Stock Exchange have given that marketplace the largest share of the new companies. The global economy is huge and dynamic, and financial capital has become increasingly global as well. But while the U.S. has lost manufacturing jobs to companies with lower environmental standards and fewer labor protections, few think the solution is for the U.S. to lower its own environmental standards or eliminate its labor protections. The threats and complications of the global economy represent very significant challenges, but we will not improve our lot by weakening ourselves just to compete. Just as in manufacturing, the most likely approch for success in the global economy for the financial services sector may lie in innovation, specialization and, most importantly, increased efficiencies.

 

 

4. The U.S. Litigation Environment Creates a Competitive
Disadvantage

2. The U.S. Securities Markets’ Loss of Market Share is Due to the
Regulatory Burden and Threat of Litigation Here

Photobucket - Video and Image Hosting When Deputy Attorney General Paul McNulty released the revised Department of Justice guidelines for federal prosecutors to use in determining whether or not to charge corporations criminally, it was the general perception that McNulty was responding to growing criticism of the Thompson Memo. (See my prior post on the topic, here.) It was also believed that McNulty was acting to avert legislation that had been introduced by Senator Arlen Specter. A December 16, 2006 New York Times article entitled "Judge’s Rebuke Prompts New Rules for Prosecutors" examining the events, processes and discussions that led to McNulty’s decision to release the revised guidelines may be found here (registration required).

However, while the changes embodied in the McNulty Memo (which may be found here) have generally been welcomed, there seems to be a consensus emerging in certain circles that the McNulty Memo did not go far enough and the Specter bill will still be needed.

Photobucket - Video and Image Hosting For example, the American Bar Association President Karen J. Mathis issued a December 12, 2006 statement (here) saying that the McNulty Memo changes "do not go far enough…(and) fall far short of what is needed to prevent further erosion of fundamental attorney-client privilege, work product and employee protections during governmental investigations." In particular, Mathis criticized the memo because "instead of eliminating the improper department practice of requiring companies to waive their privilege in return for cooperation credit," the new policy "merely required high level department approval before waiver requests can be made." Mathis also said that "the new policy does not fully protect employees’ legal rights in that it continues to allow prosecutors to force companies to take punitive actions against their employees in some cases in exchange for cooperation credit, long before any guilt is established." Mathis ended her statement with a plea on behalf of the ABA for Congress to take up the Specter bill when it reconvenes in January.

William Ide, the Chair of the ABA Task Force on Attorney-Client Privilege, said (here) that there is a "fundamental difference" between the Task Force’s view that requiring a privilege waiver to avoid prosecution is never appropriate and the Justice Department’s view that it sometime is. "We are going to need legislation," Ide said, unless the Justice Department goes one step further and recognizes that prosecutors are "not entitled to waiver, period, under any circumstances."

Photobucket - Video and Image Hosting The bill that Senator Specter introduced on December 7, 2006, the "Attorney-Client Privilege Protection Act of 2006," may be found here. The bill is supported by a broad coalition, including the Association of Corporate Counsel, the National Association of Criminal Defense Lawyers, the American Civil Liberties Union and the U.S. Chamber of Commerce. The bill prohibits the forced disclosure of information protected by the attorney-client privilege. The bill also prohibits the government from conditioning a civil or criminal charging decision on whether or not an organization is providing legal fees for its employees, or on whether or not the organization has terminated an employee because of the "decision by that employee to exercise the constitutional right or other legal protections of that employee."

Senator Spector is the outgoing Republican Chair of the Senate Judiciary Committee. The incoming Chair, Democratic Senator Patrick Leahy, has not yet indicated whether he will push to get the Specter bill passed. Senator Leahy did issue a statement (here) in which he said that "I remain concerned that, depending on how the new policies are implemented, prosectors may still be able to inappropriately consider a corporation’s waiver of this important privilege." He also said that "I will continue to monitor the implementation of this new policy and to hold the Administration accountable so that the right to counsel is preserved for all Americans."

The White Collar Crime Prof blog has helpfully compiled (here) a list of links to a broad range of commentary on the McNulty Memo.

Special thanks for alert reader Jeremy Gilman for the links to the ABA sources.

 

Photobucket - Video and Image Hosting On Thursday December 21, 2006, the parties to a case pending in the United States District Court for the District of Columbia will argue whether the Sarbanes-Oxley Act’s provisions establishing the Public Company Accounting Oversight Board (PCAOB) are unconstitutional. Although the case focuses on only a narrow part of the Act, it has the potential to bring down the entire statute.

The lawsuit was filed on February 7, 2006 by the Free Enterprise Fund against the PCAOB in the United States District Court for the District of Columbia, and is pending before Judge James Robertson. The FEF essentially contends that the Sarbanes-Oxley Act’s provisions establishing the PCAOB violate the separation of powers established in the U.S. Constitution. According to a December 16, 2006 Wall Street Journal op-ed piece by the FEF’s counsel, Kenneth Starr, entitled "A Verdict on Sarbanes-Oxley: Unconstitutional" (here, subscription required), the FEF contends that the PCAOB’s statutory enabling language is constitutionally defective because "unelected commissions should not have the power to regulate, tax and even punish companies and individuals." (Kenneth Starr is now a professor at Pepperdine Law School, but the former federal appellate judge and U. S. Solicitor General is perhaps best known for his service as the Independent Counsel whose investigation of the Whitewater scandal ultimately led to the impeachment of President Bill Clinton.)

Even though the FEF’s suit is addressed only to Sarbanes-Oxley’s PCAOB enabling provisions, the case has the potential to preclude enforcement of the entire Act, at least according to University of Illinois Law School professor Larry Ribstein. In a December 16, 2006 post (here) on his Ideoblog, Ribstein states, "it is a tribute to the haste and sloppiness of the Act’s creation that it contains no clause saving the rest of the Act if a particular provision is declared unconstitutional." So, according to Ribstein, if the FEF’s arguments against the PCAOB’s enabling provisions are found unconstitutional, the ruling would "bring down SOX."

At Thursday’s hearing, the parties will present their oral arguments on FEF’s motion for summary judgement. Oddly, the Court is hearing argument on the summary judgment motion without having first ruled on the PCAOB’s motion to dismiss the case for lack of jurisdiction. A ruling on the summary judgment motion is not likely until early next year.

According to Wikipedia, the Free Enterprise Fund is a free market advocacy group that promotes economic growth, lower taxes, and limited government. The group was founded by economist and policy analyst Stephen Moore. (The Wall Street Journal, in printing Starr’s op-ed advocacy piece on behalf of the FEF, neglected to mention that Moore, the FEF’s founder, is a member of the Wall Street Journal Editorial Board.) The current chairman of the FEF is Mallory Factor, founder of the merchant bank, Mallory Factor, Inc. The website whitehouseforsale.org has a lengthy decription of Factor’s business and political activities, here. (Readers should judge the reliability of the site’s information for themselves.)

Update: A December 22, 2006 Washington Post article describing oral argument on the summary judgment motion may be found here.

The Peekaboo Cloak of Secrecy: The PCAOB comes in for criticism from a completely different direction in a December 15, 2006 Washington Post article entitled "Auditing Reform: Mission Accomplished!" (here, registration required). The article is critical of the PCAOB (which, according to the article, is known as "’Peekaboo’ to its friends in the industry") because of the Board’s reliance on a scheme of "prudential regulation" to supervise the Big Four accounting firms. According to the article, prudential regulation "rests on behind-the-scenes collaboration between regulator and regulated." The biggest problem with this "industry friendly" approach, according to the article, is that

by its nature, it overlooks the worst kind of abuses – those that become so commonplace that everyone thinks they’re acceptable. Recent examples range from "managing" quarterly earnings to doling out hot stock offerings to favored customer. At some level, the lawyers, auditors and regulators understood that they violated basic principles of fair dealing. And yet few thought to question these practices.

In the end, it took whistleblowers and outsiders like journalists and states attorneys general to expose these abuses and force new rules. But in the closed loop of a prudential regulator system, none of that would have happened. The whole idea is to keep the heathens out and work things out behind the scenes, without lawsuits, public sanctions or disclosure of embarrassing details….

I have trouble believing that, as the PCAOB asks us to believe, the Big Four have miraculously transformed their corporate cultures, pushed out the bad apples and fixed all their quality-control problems…as long as the PCAOB shrouds its every action involving the Big Four under a cloak of prudential secrecy, we’ll never know, will we?

The source of these kinds of criticisms may perhaps be seen in the PCAOB’s December 14, 2006 release of its "2005 Inspection Report of Pricewaterhouse Coopers LLP" (here). According to a December 16, 2006 Wall Street Journal article entitled "PCAOB Finds Problems at Pricewaterhouse Coopers" (here, subscription required), the PCAOB found deficiencies in the accounting firm’s audit of nine companies, noting that the firm "failed in some cases to catch or address errors in the way the companies applied accounting rules or lacked sufficient evidence to back up some of its decisions."

However, according to the Journal article, "in keeping with the Board’s policies, the report doesn’t identify the companies that had their audits cited." In addition, only a portion of the Board’s report is made public; the report section detailing criticisms of the accounting firm’s quality-control systems is "kept secret and never made public if the firm is able to show that it has corrected the problems cited within 12 months of the report’s issuance."

The PCAOB must issue annual inspection reports for any accounting firm that audits 100 or more public companies. According to the Journal article, the PCAOB "has been criticized for the length of time it is taking to issue annual reports" and the Board has "yet to issue 2005 inspection reports for Ernst & Young LLP and KPMG LLP."

The Ultimate Solution to Accounting Misconduct: While the U.S. accounting profession may chafe under the current regulatory scheme and bemoan its liability exposure, they should at least be relieved to know that the Chinese method of regulatory enforcement has not caught on here. According to a December 15, 2006 CFO.com article (here), a Chinese court has affirmed the death penalty for an accountant who was involved in defrauding bank customers out of millions of dollars. Liu Yibang is accused of conspiring with Zhou Limin, the head of the China Construction Bank branch in Xi’an, by collecting up to $61 million from organizations and individuals by offering fake accounts with high interest rates. The two defendants have now exhausted their death sentence appeals, and the criminal sentence will be enforced.

 

Regular D & O Diary readers will recall my discomfort (as reflected here) with the Enron civil action plaintiffs’ leniency pleas on Andrew Fastow’s behalf at his September 26, 2006 sentencing. This week’s Fortune Magazine has an article entitled "Why Enron’s Fastow May Only Serve Five Years" (here), that explains how it came about that representatives of the lead plaintiffs in the civil action appeared at Fastow’s criminal sentencing.

It turns out that John Kekar, Fastow’s criminal defense attorney, has another prominent client – Bill Lerach, of the Lerach, Coughlin firm. Kekar represents Lerach in connection with the criminal investigation that has so far resulted in the indictment of the Milberg Weiss firm and two of its partners. Lerach also happens to be counsel for the Univeristy of California, the lead plaintiff in the Enron civil action.

Photobucket - Video and Image Hosting According to the article, in an "11th hour deal," Fastow agreed to aid Lerach in the civil case, by providing detailed debriefings (the 175-page declaration Fastow supplied the plaintiffs’ counsel can be found here) and also agreeing to sit for a deposition. In return, Fastow received "the formal support of the Enron investors in a plea for leniency (a factor the Judge explicitly noted)." Fastow was also dismissed as a defendant from the civil suit and "even got the plaintiffs’ lawyers to pay his legal fees for his deposition." As a result of the plea for leniency, the 10-year sentence to which Fastow agreed when he first entered his guilty plea was reduced to 6 years. According to the article, if Fastow is accepted into a prison drug-treatment program for his claimed addiction to anti-anxiety pills, he could be out of prison in five years.

As the article points out, Fastow’s cooperation provides a "massive windfall" for Lerach. Not only does Lerach get fresh evidence aiding the civil claims against the remaining Investment Bank defendants, but Fastow’s assistance could help "enrich Lerach, adding $100 million or more to the contingency fee for the plaintiffs’ lawyers and raising the prospect that they could walk away with close to $1 billion from the case." (Readers will recall that it was this enormous potential fee benefit that made me so uncomfortable with the civil plaintiffs pleading for leniency at Fastow’s sentencing.)

Photobucket - Video and Image Hosting Lerach’s involvement in the ongoing Milberg Weiss investigation may also be causing him problems in the Halliburton securities fraud lawsuit. According to a December 13, 2006 post on the Legal Pad blog entitled "Lerach Firm Will Fight Client to Stay in Halliburton Case" (here). The lead plaintiff in that case, the Archdiocese of Milwaukee Supporting Fund (AMS Fund), has filed a motion to remove the Lerach Coughlin firm, and its co-lead counsel Scott + Scott, as lead plaintiffs’ counsel and to substitute David Boies of the Boies, Schiller & Flexner firm. Apparently, Lerach’s involvement in the criminal investigation was a factor in the AMS Fund’s decision to file the motion.

The Halliburton case has an "unusal procedural history." An early agreement to settle the case for $6 million was scuttled when the AMS Fund, represented at the time by Scott + Scott alone, opposed the settlement as inadequate. The court agreed, and the case went forward. The Lerach Coughlin firm then intervened in the case on behalf of three public pension funds. The Lerach Coughlin firm was appointed co-lead counsel with Scott + Scott. However, the departure from Scott + Scott of Neil Rothstein seems to have been a turning point in the case. Rothstein remained "special counsel" to the AMS Fund, and in fact filed the motion to substitute Boies for Lerach on the AMS Fund’s behalf. Lerach has opposed his client’s motion, on the ground’s that the substitution would be disruptive and that Boies has a conflict of interest. The court has not yet ruled on the motion.

There is a certain symmetry here; at least according to Wikipedia (here), David Boies also represented Andrew Fastow.

Rothstein now runs Truth in Coporate Justice LLC, which appears to maintain a website (here) about the Halliburton case. Rothstein’s account (here) of his unsuccessful attempt to attend the May 17, 2006 annual meeting of Halliburton makes for some interesting reading. Not every annual meeting has a SWAT team on the roof of the meeting building.

Photobucket - Video and Image Hosting Another Backdating List: One of the byproducts of the options backdating scandal has been the proliferation of lists. For example, my ongoing tally of options backdating related lawsuits may be found here. Jack Ciesielski of the AAO Weblog (here) recently published a very thorough list of the all of the companies that have mentioned investigations of option granting practices in their filings, or have been mentioned in the news. The list, which can be found here, identifies over 200 companies (including 45 members of the S & P 500).

Little Blog Horn: As I can attest, maintaining a blog is a lot harder than it looks. So there should be little surprise that even in the few short months I have been contributing to the blogosphere that several other blogs have emerged, briefly breathed, and then blinked out of existence. The Vangal blog (here) is one of the many to meet that fate. Two more recent departures from the blogging scene, the Governance News Watch blog (here) and the Securities Litigation Watch blog (here) will both definitely be missed. But for those of you who, like me, had become fans of the Governance News Watch during its brief but interesting existence will be pleased to learn that the blog’s author, Janice Brand, has moved on to a new blog, Brand on Business, which may be found here. The new blog looks promising and we here at The D & O Diary wish Janice well.

Photobucket - Video and Image Hosting PLUS D & O Symposium: It may be hard to believe, but the 2007 Professional Liability Underwriting Society (PLUS) D & O Symposium is only a few weeks away. The 2007 Symposium will take place on January 31 and February 1, 2007, at the Marriott Marquis in New York City. I will be co-Chairing this year’s Symposium with my good friends Ivan Dolowich and Jeffrey Lattman. Among the many panelists and speakers will be such luminaries as Linda Thomsen, the head of the SEC Enforcement Division; Nell Minow, the founder and editor of the Corporate Library; and Charles Elson, Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, as well as many other distinguished speakers and guests. The keynote speaker will be former Senator and Secretary of Defense George Mitchell. The entire program schedule can be found here. The Registration materials are here. I look forward to seeing everyone there.

 

Photobucket - Video and Image Hosting As The D & O Diary has previously noted (most recently here), the Thompson Memo, the Department of Justice’s corporate criminality guidelines for prosecutors, has been the target of significant criticism. In the KMPG tax shelters prosecution, the judge found prosecutor’s implementation of the Memo to be unconstitutional (here). Most recently, Sen. Arlen Specter proposed legislation that would have overridden the Thompson Memo’s provision that compelled corporations seeking to avoid prosecution to waive their attorney client privilege and withhold payment of their employees’ attorneys’ fees.

On December 12, 2006, in apparent response to this criticism and possibly in an attempt to forestall the legislative efforts, the Department of Justice announced (here) that U. S. Deputy Attorney General Paul J. McNulty had released new guidelines revising the Thompson Memo. The new guidelines, entitled "Principles of Federal Prosecution of Business Organizations" may be found here. An Executive Summary of the new guidelines may be found here. The revised guidelines identify nine factors for prosecutors to use when deciding whether or not to charge a corporation with a criminal offense.

The most significant revisions in the McNulty Memo relate to the attorney-client privilege and the advancement of attorneys’ fees. With respect to the attorney-client privilege, the guidelines adopt a "tiered approach," by which the prosecutor must now obtain advanced written approval from the Deputy Attorney General in order to request a corporation to waive its attorney client privilege. In order to obtain approval, the prosecutor must "establish a legitimate need" by showing the likely prosecutorial benefit, as well as the absence of alternative means to obtain the information and the extent of voluntary disclosure already provided. According to the Executive Summary, prosecutors should seek attorney-client communications only in "rare circumstances."

The revised guidelines also provide new standards for when prosecutors may request a waiver of privilege in order to obtain facts uncovered in a company’s internal investigation. Before requesting these materials, prosecutors must seek the approval of their local United States Attorney, who must consult with the Assistant Attorney General for the Criminal Division.

Prosecutors are also directed in connection with their charging decision not to consider a corporation’s decision not to provide attorney-client communication after the government makes the request. (However, the prosecutors may still favorably consider a corporation’s voluntary provision of attorney-client privilege material or information.) The new memorandum also instructs prosecutors in connection with their charging decision that the cannot consider a corporation’s advancement of attorneys’ fees to employees, except in "rare exception" where the advancement of fees combined with other facts shows that the payment of fees was intended to impede the government’s investigation. (Even in the exceptional circumstances, the advancement of fees may only be considered if authorized by the Deputy Attorney General.)

The new guidelines are effective immediately and apply to ongoing investigations.

The revisions have already been criticized for not going far enough. According to news reports (here), critics are concerned that the guidelines don’t bar prosecutors from rewarding companies that waive their privilege; according to these critics, the ability to reward includes the reward to withhold the reward, which operates exactly like a punishment.

Hat tip to the White Collar Crime Prof blog (here) for the link to the McNulty Memo and the Executive Summary.

A Close Look at A Credit Rating Agency: Shareholders, creditors and even D & O underwriters who depend on the reports of credit rating agencies will want to read the December 12, 2006 New York Times article entitled "Objectivity of a Rating Questioned" (here, registration required). The article examines questions raised by 34 industrial customers of Portland General Electric in connection with a Standard & Poor’s report the utility relied upon to support the utility’s regulator petition for a rating increase.

The customers subpoenaed documents that had gone between the utility and S & P during the 21 months preceding the report’s completion. The documents showed that S & P "solicited comment from the utility on a draft report and then made at least 48 changes that the utility sought before releasing the report." The utility then used the report as "independent corroboration" of its request to raise rates, increase its profit margin, and shift fuel-cost risks to its customers.

As reflected in a comment reported in the article, the "documents illustrate a fundamental problem with allowing companies that issue stocks and bonds to pay for evaluations by credit reporting agencies."

Portland General Electric is now an independent company, but it was owned by Enron from 1997 to April 2005.

 

Lead Enron Plaintiff Moves to Dismiss Vinson & Elkins: In the serial retelling of the Enron collapse, the company’s outside professionals have been popular scapegoats, and among the most prominent targets has been the company’s former law firm, Vinson & Elkins. According to reports (here), between 1997 and 2001, Enron paid the law firm $162 million in fees. The law firm’s relation to the company and possible role in the company’s financial shenanigans has been the subject of extensive media coveage (here). But, according to a December 8, 2006 Houston Chronicle article entitled “Law Firm Could be Cut Free from Suit” (here), the lead plaintiff in the Enron civil action has moved to dismiss the Vinson & Elkins law firm from the lawsuit.

The action is scheduled to go to trial in April against the remaining defendants, including Merrill Lynch, Toronto Dominion Bank, Royal Bank of Canada, and the Royal Bank of Scotland. A spokesman for the lead plaintiff, the University of California, is quoted as saying that the inclusion of V & E at trial “threatened to raise complicated legal issues unnecessarily distracting the jury’s attention away from more culpable defendants – more solvent investment banks – from whom larger recoveries are more likely.” The lead plaintiff is represented by the Lerach, Coughlin firm.

The court has not yet ruled on the plaintiff’s motion.

Without commenting one way or other on the merits of the claims against the law firm, The D & O Diary notes that it is a very unusual kind of a case that a 700-lawyer law firm with offices in 12 cities could be viewed as a mere complication or in which there could be other parties against whom “larger recoveries” are sought. The timing seems odd, too. The plaintiff has up to this point struggled vigorously to keep the V & E in the case, strenuously opposing the law firm’s own prior motion to dismiss. Maybe the timing is purely coincidental, but The D & O Diary can’t help but wonder if the plaintiff’s move to dismiss the V & E firm now is somehow related to the same court’s recent award of sanctions (here) against the Lerach Couglin firm in connection with its attempts to pursue a claim against Alliance Capital Management in the Enron civil action.

AOL Time Warner Class Action Opt-Outs Settling Favorably?: According to a December 7, 2006 New York Post article entitled “Time Warner Case Finds a Surprise” (here), the individual plaintiffs who opted out of the AOL Time Warner class action settlement are “faring much better than” those who stayed in the class settlement. The article reports on the settlement last week involving the state of Alaska in the individual state court action it filed against AOL Time Warner in Alaska state court. The state settled its $60 million claimed investment loss for $50 million, amounting to about 83 cents on the dollar, which the state’s attorney said is “far superior to the payout in the national settlement.” The same attorney said that their individual settlement is “50 times more than what we would have received if we had remained in the class.”

According to the article, about 100 institutional plaintiffs opted out of the class settlement and signed up with Bill Lerach of the Lerach Coughlin firm. When asked if his clients were better off than those who remained in the class, Lerach is reported to have said “there’s no question that we’re getting tons more dollars.”

Between the news about the AOL Time Warner opt-outs and the Second Circuit’s decision denying class certification against the underwriter defendants in the IPO Laddering case (here), it has been a tough week for fans of the class action process.

Adam Savett of the Lies, Damned Lies blog has a more detailed comment on Alaska’s AOL Time Warner settlement, here.

For a prior D & O Diary comment on the settlement in the AOL Time Warner shareholders’ derivative action, refer here.

Prosecution Averted, But the Firm Still Failed to Survive: A December 10, 2006 New York Times article entitled “Poisoned by Scandal, Craving an Antidote” (here, registration required), describes the six-year ordeal of Rent-Way and its CEO to avoid the damaging effects of an accounting scandal. Even though the company’s extraordinary level of cooperation managed to avoid corporate prosecution, the company ultimately was forced to sell itself to a rival because of the scandal’s indelible stain.

The company itself discovered the accounting fraud and reported it to the SEC. The Company turned over documents containing attorney-client information and even invited the SEC to set up an office in the Company’s headquarters to conduct an on-site investigation. When the three employees who had perpetrated the fraud were later convicted, the local U.S. attorney’s office put out a press release commending the CEO’s openness as “a good example of how a company can alleviate” the consequences of misconduct “by fully and openly cooperating with the government.”

But this extraordinary level of cooperation was still not enough to save the company. The company’s accounting scandal reduced its creditworthiness, which in turn increased its borrowing costs. The increased borrowing costs continued to weigh on the company and its stock price. Ultimately, the company was forced to sell itself to its largest competitor. The company was not able to survive the loss of investor confidence from the accounting scandal.

Much has been made recently of the costs of complying with regulatory burdens, but the costs of compliance pale by comparison with the consequences from undisciplined practices. As Professor Ellen Podgor notes in the White Collar Crime Prof blog (here), “the best lesson that can be learned from this story is the importance of having good solid controls in place to detect fraud in one’s midst. Having a proper corporate compliance program may assist to avoid the sad consequences of the innocent CEO who detects the fraud and has to deal with how best to handle the matter.”

Bury Bonds: A December 7, 2006 article in the Boston Globe entitled “Left Holding the Bond,” (here) details “a new minefield in the surging market for leveraged buyouts” – that is, the huge negative impact that the leveraged buyout has on the target company’s existing publicly traded debt. According to the article, when take over companies acquire publicly traded target companies, they pay off shareholders but they don’t redeem existing bonds. Instead, the successor company assumes the old bonds and continues making the interest payments. The problem is that the private-equity borrowers borrow most of the funds for the acquisition, loading the business with new debt, which erodes the company’s creditworthiness and makes the old bonds less highly valued in the debt marketplace.

Thus, for example, in connection with the recent HCA acquisition, public shareholders got a 20% premium for their shares, but HCA’s public debt holders saw the value of their securities decline by 15%. Bond holders in Clear Channel Communications saw the company’s bonds lose about 11% of their value following the company’s recent leveraged buyout. The article points out that even rumors of buyouts can be enough to cause the price of public debt to decline.

Everybody else involved in the takeover transaction is making money, but the bondholders are left with diminished investment value. They would be better protected if the debt instruments required accelerated repayment of the principal amount upon a change of control, but that is a relatively rare provision, precisely because it might discourage potential suitors. The large amounts of money involved in leveraged buyouts and the extent of the detriment to bondholders may well encourage bondholders to try to look to the company or its management to make up their investment loss. Bondholders may well consider whether legal action of some kind is in their interests.

Options Backdating Litigation Update: With the addition of the action filed against Agile Software (here) , the number of companies that have been named as nominal defendants in shareholders’ derivative lawsuits raising options timing allegations is now 121. The number of companies sued in securities fraud lawsuits stands at 21. See The D & O Diary’s running tally of options backdating lawsuits here.

According to reports in a December 6, 2006 article in the New York Times entitled "Court Rejects Class Action Against Banks" (here, registration required) and a December 6, 2006 Wall Street Journal article entitled "Wall Street Wins Ruling Blocking IPO Class Action" (here, subscription required) on December 5, 2006, the United States Court of Appeals for the Second Circuit ruled in the IPO laddering cases that the district court had improvidently ruled that IPO investors’ class action could proceed as a class action in against the 55 offering underwriter defendants. Specifically, the Second Circuit ruled that said the federal judge overseeing the lawsuit had erred in granting class-action status to six "focus cases" out of 310 consolidated class actions. This of course does not eliminate the possibility that investors could pursue individual actions against the underwriters. But even though individual actions can still go forward, the ruling has a certain disaggregating impact.

The Second Circuit’s opinion may be found here. (Hat tip to the WSJ.com Law Blog, here, for the link to the opinion.)

The ruling also has an uncertain but curious potential impact on the pending settlement that the issuer defendants had entered into with investors. The issuers had agreed to pay the investors $1 billion dollars, with the issuers’ obligation to be reduced to the extent of investors’ recoveries from the underwriter defendants. (A brief summary of this settlement may be found here.) From the issuers’ perspective, this settlement was looking very good when J.P. Morgan in April 2006 agreed to contribute $425 million to the settlement. But now that the Second Circuit has ruled that the investors’ case cannot proceed against the underwriter defendants as a class action, it would appear that the issuers’ settlement could unravel –the issuers’ settlement with investors was merely proposed; it had not yet been approved by the court.

The question now on the table is whether the this unexpected but dramatic procedural undoes the issuers’ $1 billion settlement and J.P. Morgan’s $425 settlement. According to a December 6, 2006 Law.com article entitled "Huge IPO Case Hits Snag at 2nd Circuit" (here), "the issuers may try to get out of the settlement, say lawyers involved in the case" and the district court judge could "nix it based on Tuesday’s ruling."

As the New York Times put it, in a statement that while strong is not an overstatement, "the ruling was a devastating blow to the embattled securities class-action powerhouse Milberg Weiss Bershad & Schulman, which is a co-leader for the plaintiffs."

A Bloomberg.com article discussing the Second Circuit’s decision may be found here.