Among the reasons behind the recent calls for regulatory reform, including the Paulson Committee’s Interim Report (here), is the belief that foreign companies are declining to list their shares on U.S. exchanges because of the burdens of U.S class action securities litigation. While the U.S. propensity for litigation may be deter some foreign companies from listing in the U.S. now, it should also be noted that international investors increasingly are demanding management accountability, and increasingly are seeking redress in courts – both in the U.S. and in their own countries.

Photobucket - Video and Image Hosting A December 5, 2006 Law.Com article entitled “A Wary Europe Moves a Step Closer to Class Actions” (here), examines the apparent trend for European countries to permit the consolidations of related claims in a single action. According to the article, England, Spain, Germany and the Netherlands have already adopted “some form of class litigation.” A draft bill is before the French legislature to permit collective consumer litigation (as previously discussed on the D & O Diary, here), and the Irish, Italian and Finnish governments are considering legislation to permit collective litigation by multiple parties. Norway and Denmark are also considering the adoption of an opt-in class action procedure.

Photobucket - Video and Image Hosting The new German collective-action procedure is examined in a December 2, 2006 New York Times article entitled “Collective Shareholder Lawsuits Reach European Courts” (here). The Times article takes a look at the action now pending under the new procedure against DaimlerChrysler. Interestingly, the plaintiff shareholder group includes investors from the U.S. According to the article, other companies that have also been sued under the new procedure include Deutsche Telecom and the aircraft maker European Aeronautics Defense & Space.

While these new procedures permit collective action in a single lawsuit, the actions lack many of the attributes of U.S. style class action litigation. In most jurisdictions, pre-trial discovery is unavailable or severely limited; the loser pays both sides’ legal fees; and punitive damages are barred. As the Times article notes, a few cases “do not mean that the Continent is poised for a flood of litigation.”

On the other hand, these new procedures represent a growing legislative recognition that investors are entitled to judicial means to compel accountability from corporate management. As The D & O Diary noted (here), the U.K. recently adopted new legislation that expanded shareholders’ rights to pursue derivative lawsuits against corporate officials. And as the Times article noted, “the trend toward a greater number of collective lawsuits will not be reserved soon.” The article quotes a Dutch lawyer as saying “the laws are changing and so are the attitudes.” It might be more accurate to say that the changed laws reflect a changed attitude.

European investors are also showing an increased interest in becoming more involved in shareholder litigation in the U.S. As detailed in a December 4, 2006 post on the ISS Corporate Governance Blog entitled “Europeans Take a More Active Role in U.S. Cases” (here), European investors (particularly public pension funds) are seeking to serve as lead counsel in U.S. securities fraud class actions. Among other cases, European pension funds are serving as lead plaintiffs in the cases against Parmalat. European and other international investors are also leading U.S. based derivative litigation and are seeking U.S governance changes.

U.S. based plaintiffs’ lawyers understand their opportunity and have begun what plaintiffs’ lawyer Adam Savett at the Lies, Damned Lies blog has called an “arms race”(here) in their efforts to attract international institutional clients. Several U.S. plaintiffs’ firms have announced that they are opening European offices or forming partnerships with U.S. firms. The European institutions for their part are interested in assuring that they are maximizing their opportunity to protect their beneficiaries’ interests.

International investors clearly are becoming more accustomed to using the courts to compel accountability both in their own countries and in the U.S. These investors are already successfully compelling changes to their legal systems as they press for means to enforce accountability. As procedures evolve and as these investors become more reliant on their own courts to compel corporate accountability, the differences between the systems may diminish. That process already seems to be underway.

Photobucket - Video and Image Hosting Rubles Without A Cause?: Among the primary concerns to which the Paulson Committee’s proposed reforms are addressed is the U.S. exchanges’ loss of global IPO market share, particularly to the London exchanges. As the Paulson Committee’s Interim Report notes, many of the foreign companies listing on the London exchanges are Russian. The Report acknowledges the possibility that many companies from Russia (and elsewhere) may represent “unacceptable risks,” but the Report makes no attempt to exclude “unacceptable risks” from their calculation of what U.S. exchanges have “lost.”

A December 5, 2006 Wall Street Journal article entitled “British Spy Probe Turns to �migr�s” (here, subscription required) sheds an interesting light on this issue. The article is accompanied by a chart showing how many Russian companies have listed their shares on the London Stock Exchange in recent years. Just the seven deals completed in 2006 alone total 15.23 billion pounds. The article’s details about the Russian �migr�s’ lifestyle are about equal parts amusing and appalling; the article’s details about some of the Russian companies whose shares trade in London are basically just appalling:

Earlier this year, in a huge offering, state-controlled Russian oil company OAO Rosneft listed its global depositary receipts on the London Stock Exchange. Underscoring the disputes from Russia that have spilled over into London, the stock offering came about only after lawyers from Russian oil company OAO Yukos failed to stop the listing after claiming that Rosneft’s assets came from the unlawful seizures and sales of Yukos.

Wall Street’s bankers may well lament the loss of underwriting fees for these kinds of deals to their counterparts in The City, but readers will decide for themselves how sorry we should be that the stringency of U.S. regulations discourages companies of this type from listing on U.S. exchanges. The D & O Diary wonders on what basis the “failure” of U.S. exchanges to “attract” offerings of this type could possibly justify diminishing regulatory rigor in the U.S. It seems to me that the quickest way to eliminate the valuation premium that foreign companies now enjoy by listing their shares on U.S. exchanges would be for the U.S. to lower its standards so that lower quality companies feel more comfortable listing on U.S. exchanges. (My prior post on the valuation premium may be found here. )

A December 6, 2006 Wall Street Journal article entitled “At Lukoil, an Executive’s Death Exposes Network of Inside Deals” (here, subscription required) provides a more detailed look inside another Russian company.

Photobucket - Video and Image Hosting Backdating Up North Too, Eh?: According to a recent press report (here), Canadian companies may also have an options backdating problem. An academic study of options grants between June 2003 and October 2006 at 66 of Canada’s largest publicly traded companies found options grant patterns that “may be consistent with backdating” and also that many options grants are not being reported as quickly as required under Canadian law. The final version of the report is due later this month.

As The D & O Diary has previously noted (most recently here), many of the protections and benefits Congress hoped for from the Sarbanes Oxley Act’s whistleblower provisions have been slow to materialize. And there has been relatively little enforcement action or shareholder litigation arising from the revelations of SOX whistleblowers. But in one recent action involving Ashland Inc., the disclosures of a whistleblower who later invoked the SOX protections led to a settled SEC action.

According to a November 29, 2006 SEC Order (here), the SEC settled charges against Ashland and a former employee (Olasin), based on a finding that Olasin had improperly reduced Ashland’s estimates for environmental remediation at numerous chemical and refinery sites. The SEC found that there was no reasonable basis for the reduction, which had the effect of materially understating Ashland’s environmental remediation reserves and overstating its net income in quarterly and annual reports filed from 1999 to 2001.

According to the SEC, three engineers who had been involved in setting the reserves that were later reduced brought the reductions to the attention of the company. One of the three specifically asserted that the reductions were “improper.” These concerns led to an internal audit, which consisted of little more than an interview of Olasin. After the audit report came out, Olasin contacted the engineer who had called the reductions “improper” (and whose name Olasin had been able to uncover) and told him that “his performance was suffering” and that he should “spend the weekend thinking about whether he wanted to stay with the company.” The individual left Ashland because he felt he was being retaliated against. He later filed a SOX whistleblower complaint against the company with the Department of Labor. According to the SEC’s order, the company later settled the whistleblower action.

Under the settlement with the SEC, Ashland was ordered to cease and desist from committing future violations; to strengthen internal controls; and to hire its independent auditor and an outside firm to oversee the company’s procedures for setting environmental reserves and for handling employee complaints. There were not fines or penalties against either Ashland or Olasin.

Firm Indictment: The Paulson Committee’s recent interim report (here) contained a number of comments and recommendations relating to corporate criminality. Among other things, the Report suggested that the indictment of a company ought to be a “last resort,” because of the devastating (and potentially fatal) impact that indictment alone might have on the targeted firm.

In its discussion of these issues, the Report referred to the example of Arthur Anderson’s indictment. The D & O Diary wonders whether the Paulson Committee ever considered a more recent example – the indictment of the Milberg Weiss firm. According to a December 1, 2006 Bloomberg.com article entitled “Big, Powerful and Indicted: Milberg Firm Shrinks” (here), Milberg has “shuttered six of its eight offices and lost more than 50 lawyers of the 125 it had when indicted in May.” The article also details a number of class action cases where Milberg has been removed as lead plaintiff counsel since the indictment. With the criminal trial now more than a year away, these circumstances can only deteriorate while the firm awaits its day in court.

While the Paulson Committee would not have been likely to refer sympathetically to the Milberg firm, the events at the firm following its indictment certainly substantiate the concerns noted in the Committee’s Report about the indictment of a corporate entity.

More Press About Larry Sonsini: As The D & O Diary previously noted here, Fortune magazine had a recent article (here) looking at the various complicated circumstances in which Larry Sonsini at the Wilson Sonsini firm has found himself involved. The Fortune article was generally favorable to Sonsini. A harsher take of Sonsini’s role in the HP pretexting scandal can be found in a December 1, 2006 American Lawyer article entitled “The Trouble With Larry” (here).

Hat tip to the WSJ.com Law Blog (here) for the link to the American Lawyer article.

One of the great things about having a blog is that it has brought me into contact with a host of people I might otherwise never have gotten to know. Among the most interesting and colorful people I have met through my blog is Sammy Antar, Crazy Eddie’s cousin, and the author of the White Collar Crime blog (here). Regular readers will recall my recent post referring to Sammy and his views, here. As a result of my post, Sammy called me up and we had a great conversation about a number of things, including D & O insurance. Among other things, Sammy wondered why D & O insurers don’t condition their coverage on certain remedial or preventive measures, the way bank lenders require covenants on their loans or property insurers require for their policies.

Sammy’s question is one I have encountered again and again from thoughtful people outside the D & O insurance industry. A more scholarly example of this perennial question is presented in the November 17, 2006 law review article entitled "The Missing Monitor in Corporate Governance: The Directors’ and Officers’ Liability Insurer," (here) written by Professors Tom Baker of the University of Connecticut Law School and Sean Griffith of the Fordham Law School (here). Baker and Griffith’s well-researched, well-written, thoughtful and thought-provoking article examines the same question that Sammy Antar posed to me: why don’t D & O insurers perform more of a corporate governance monitoring function?

The authors recognize the role D & O insurers theoretically might now be playing by offering lower priced insurance to companies with better governance practices. However, as the authors also recognize, competitive pressures and insurers’ zeal for premium volume limit carriers’ price differentiating ability and undercut the role insurance cost might otherwise play in motivating behavior. I would add that factors unrelated to governance, such as a company’s size or industry, are almost always more important pricing criteria, and so even in ideal circumstances, D & O insurance pricing would provide at best a weak incentive to corporate governance behavior. In addition, for most companies during most phases of the insurance cycle, the relatively minor variations in their D & O insurance costs are unlikely to have any impact on corporate governance behavior because the dollars involved are too slight.

The authors then look at whether D & O insurers are affirmatively offering loss prevention services, the way many property or workers’ compensation insurers do. The authors conducted extensive empirical research by interviewing many underwriters, brokers and risk managers. Their empirical research showed that despite logical incentives for them to do so, D & O insurers do not affirmatively provide or offer their insureds loss prevention services. (Full disclosure: I was among the insurance industry representatives the authors interviewed as part of their empirical research.) Not only that, the authors found that D & O insurers don’t even manage claims that arise under their policies, but rather allow their insureds to select defense counsel and manage the defense, in a way that leaves defense expense essentially uncontrolled. The authors conclude that the D & O insurers’ failure to provide loss prevention services and to manage claims allows management conduct to continue without the checking function the insurer might provide. In addition, because most D & O claims settle within the limits of the D & O insurance, company management is permitted to shift all of the consequences of their behavior away from themselves.

The authors examine the purpose and impact of D & O insurance under these circumstances and conclude that companies continue to buy D & O insurance because it provides company officials with a corporately-financed way for management to protect themselves from their own liability exposure without the requirements of any constraints on their behavior. The authors conclude that affairs are arranged this way because it suits corporate managers, who are free to indulge in risky behavior secure in the belief that their D & O insurance will protect them and their company if there are any problems. The authors question whether shareholders’ interests are served by this arrangement, and whether the existence of D & O insurance (or at least corporate reimbursement and entity coverage) creates a moral hazard by insulating companies and their managers from the consequences of their behavior.

Readers familiar with my professional history know that I am perhaps uniquely qualified to comment on the reasons why D & O insurers do not offer loss prevention services. My curriculum vitae includes an extended deployment as the head of a D & O facility that was founded on the optimistic premise that a D & O insurer ought to provide loss prevention services and that offering those services would be a competitive advantage. This noble experiment died a death of many causes, and having presided over the enterprise’s life span, I can authoritatively recite here why D & O insurers do not offer loss prevention services, as follows:

1. Everybody Has to Do It or Nobody Can Do It: Corporate insurance buyers want their acquisition of D & O insurance to be as uncomplicated and consume as little time as possible. Even if a D & O insurer is offering free services that will help improve their company’s risk profile, the company’s managment will not desire the services if the services take additional time and attention. As long as there is one competitor anywhere who will offer the same coverage (at least at the same or similar cost, more about which below) without requiring the company to "jump through hoops," the free services will go unclaimed. Of course, this is not universally true, there are some companies that will value the service, and there are other companies who could learn to appreciate the value of the services. More about these kinds of companies below.

2. Even if the Services Are Very High Quality, They Will be Undervalued in the Marketplace: Unfortunately, insurance companies are not held in the highest regard in corporate America. Too many companies view their D & O carriers with suspicion or even hostility. To be sure, there are some companies who welcome their D & O insurers’ views about corporate governance, but not enough to make the costs of providing the services economically self-sustaining. Corporate management’s suspicious views of their D & O insurers may be encouraged by the their outside counsel. While some lawyers (and I was always proud that it was the best lawyers) welcomed the provision of high quality loss prevention services, there were other lawyers who viewed an insurer’s provision of these services as a competitive threat for services the lawyers themselves wanted to provide or as some clever ruse to permit the insurer to deny coverage later.

3. The D & O Pricing Environment Does Not Support the Pricing Premise: Some companies might want their D & O insurer’s loss prevention services but not if their companies have to pay for the services. It might be possible for a D & O insurer to insist on corporate governance reforms if the insurer could offer demonstrable insurance cost savings for qualifying companies, but the reality is that the D & O insurance sector has been and remains so competitive that it is impossible to show cost savings. There is always a competitor willing to offer the same or similar coverage at the same (or better) discount, and so companies who might otherwise accept their insurer’s loss prevention requirements have little monetary incentive to do so.

4. Loss Prevention Services Are Costly To Provide and Maintain: For a D & O insurer to plausibly offer credible loss prevention services recognized as valuable by senior corporate executives , the insurer has to be willing to make and sustain a very significant investment in high quality personnel. However, top management at insurance companies, who rarely have background in D & O insurance but rather are drawn from more mainstream property or casualty insurance backgrounds, and who view the business of insurance as a high volume low skill enterprise, have little appreciation for or patience with the need for this kind of investment. These kinds of expenses do put significant pressure on operating margins, and indeed ultimately may not be economically justifiable given the pricing environment that has prevailed in the D & O insurance industry for almost all of the last 20 years (except for a very brief period during 2002-03).

5. D & O Loss Prevention Has Less Certain Benefits than A Sprinkler System Does: A sprinkler’s system’s benefit is direct and easily understood. Good corporate governance may or may not have as direct of a benefit. Baker and Griffith seem to assume that loss prevention can improve companies and reduce their securities litigation risk. I still believe this to be true, but at the same time I have to acknowledge that a company can do everything right and still get sued. So many of the major D & O claims problems of the last few years have come from unexpected directions. Sector slides, industry contagions, practices that are widespread and accepted that suddenly become perceived as objectionable, these are all phenomena that caused boatloads of D & O losses in recent years that no amount of loss prevention would have prevented.

I could go on and on about the reasons D & O insurers don’t offer loss prevention services. (Buy me a few beers sometime and I will keep it going for hours.) In fact, Baker and Griffith mention in their article a few additional factors that I did not even get to here. But I think I have shown that there are many reasons why D & O insurers do not provide these services. This fact may be lamentable, but unless circumstances change dramatically in ways I do not anticipate, this is just the way things are and seemingly will remain in the D & O insurance industry.

That said, I cannot support the Professors’ conclusion that D & O insurance as it is currently purchased by most companies is a moral hazard. This particular topic is well beyond the scope of the informal blog format, but I will briefly offer my views for disagreeing with the Professors.

It is extremely unlikely that the presence of D & O insurance operates as any kind of an enabler of bad behavior: I flatter my chosen field by thinking that D & O insurance is pretty important stuff, but I am realistic enough to understand that corporate managers conduct their operations in a way that they think is either in the company’s or their own best interests without regard to their D & O insurance. They don’t stop before taking an action and reflect that they wouldn’t do it if they didn’t have D & O insurance. I view it as an extremely remote and unlikely theoretical possibility that corporate managers do anything they wouldn’t otherwise do because their company has D & O insurance.

Corporate Managers Worry More About Potential Consequences For Which There is No Insurance: Corporate managers know that the same kind of conduct can attract the unwanted attention of plaintiffs’ lawyers can also attract the unwanted attention of the SEC and the Department of Justice. Even if D & O insurance were to cease to exist as an earthly phenomenon tomorrow, most senior officials’ conduct would go on exactly as before (that is, equally as good or bad as before) because the admonitory threat of the regulators’ actions would remain as before. That is, because of the threat of regulatory action, the theoretical possibility that D & O insurance might otherwise operate as a moral hazard simply doesn’t exist.

Most Corporate Managers Truly Want to Do the Right Thing: There are crooks out there; my comments here don’t apply to them. In my experience, most corporate managers are interested in playing by the rules, and more importantly, for being known for playing by the rules. The idea of seeing their name in the paper as accused of fraud is absolutely mortifying. The fact that there might be insurance to eliminate the monetary inconvenience of a securities fraud lawsuit is irrelevant to their desire to avoid the kind of reputational taint that might follow an accusation of fraud, even if the accusation were merely to be made by plaintiffs’ lawyers.

Because I truly believe that almost all corporate officials want to do the right thing, I think there may yet be a role for loss prevention services in the D & O insurance equation. I am an eternal optimist, and I continue to believe that high quality loss prevention services will be valued by some companies and ought to be valued by all companies. I also believe that D & O insurance professionals can and ought to offer these services.

It may be that competitive forces between and among D & O insurers will discourage the insurers from carrying the experiment forward. Brokers, by contrast to insurers, are in the business of providing consultative services, and for that reason I believe that highly qualified brokers could offer loss prevention services to their D & O clients. Baker and Griffith looked briefly as what the past practices may have been as far as brokers offering these kinds of services and concluded that brokers are not offering these services. My recent entry into a new livelihood as a D & O broker is premised on the possibility that brokers have a role to play here. I have experience in this area, after all. Anybody that wants to talk to me about it should give me a call — I have already had a great telephone conversation with Sammy Antar about it.

Hat tip to Adam Savett at the Lies, Damned Lies blog (here) for the link to Professors Baker and Griffith’s law review article.

A prior D & O Diary post commenting on an earlier article by Professors Baker and Griffith can be found here.

 

As noted yesterday (here), the Committee on Capital Markets Regulation (often referred to as the Paulson Committee) has released its Interim Report (here). The Report contains much text, many graphics, and 32 recommendations supposedly addressed to how to improve the competitiveness of the U.S. securities markets. As proof that the U.S. markets are losing their competitive edge, the Committee cites two key measures: the decline of U.S. marketshare of global IPOs; and the increase in going private transactions. The Committee correctly observes that there are a variety of factors behind these trends, including improvements to foreign public markets and increased liquidity in foreign and private markets. The Committee nevertheless believes that the U.S. regulatory and litigation systems are also important causes. The Committee’s focus surprisingly is not so much on the Sarbanes-Oxley Act, the discussion of which is relegated to the end of the report. Rather, a much more prominent place is given to reforms of civil and criminal litigation.

By contrast to early leaks suggested that the Committee might recommend far more dramatic revisions (for example, see my prior post here discussing reports that the Committee might recommend eliminating private securities litigation), the Committee’s actual securities litigation reform recommendations are surprisingly modest; the Committee recommends that :

The SEC should proved more guidance, using a risk-based approach, for the elements of a Rule 10b-5 actions, including materiality, scienter, and reliance (a good summary of the Report’s detailed recommendations with respect to these points can be found on The 10b-5 Daily blog, here);

The SEC should require that any private damage awards should be offset by any amount the SEC has collected from the defendants under the SEC’s Fair Funds authority;

The SEC should prohibit certain supposed practices of the plaintiffs’ bar (about which more below);

In order to improve the defenses available for IPO companies’ outside directors, the SEC should revise Rule 176 to clarify that outside directors may conclusively establish their "due diligence" defense (and thereby avoid liability under Section 11) by showing their good faith reliance on the company’s audited financial statements;

As another means of protecting IPO companies’ outside directors, the SEC should reverse its longstanding position (here) that indemnification of directors for damages awarded in Section 11 actions is against public policy, at least if the directors have acted in good faith.

With respect the practices of the plaintiffs’ bar, the Report notes that "some plaintiffs may have private motives for bringing suit that they do not share with other shareholders." The Report examines the possibility that some public institutional shareholders may be motivated to initiate lawsuits as a result of plaintiffs’ lawyers’ contributions to public officials electoral campaigns, a practice the Report calls "pay to play." Without citing any specific data or examples, the Report asserts that "pay to play practices are likely to result in some class actions being filed by pension funds that would not have been filed in the absence of reciprocal arrangements." The Report acknowledges that the extent of these practices is "uncertain," but then goes on to say that "there seems to be little downside to discouraging such practices." The Report recommends that the SEC create regulations specifying that lawyers who directly or indirectly may political contributions to state of municipal pension funds should be prohibited from representing the fund as lead plaintiff in a securities class action. The Report also recommends prohibiting paid plaintiffs.

The Report also recommends that the SEC should permit shareholders to "adopt alternative procedures for resolving disputes with their companies." These alternative remedies might include arbitration or waiver of jury trials. The Report notes the difficulties companies might face in adopting these reforms. The Report recommends that shareholder votes be permitted allowing the revision of companies’ charters or bylaws to permit these alternative procedures.

While most of the Report’s proposed litigation reforms focus on civil lawsuits, the Report also includes recommendations relating to criminal litigation. The Report recommends that the Justice Department "revise its prosecutorial guidelines so that firms are only prosecuted in exceptional circumstances of pervasive culpability throughout all offices and ranks." The Report also recommends that the Justice Department revise the prosecutorial guidelines in the Thompson Memo to "prohibit federal prosecutors from seeking waivers of the attorney-client privilege or the denial of attorneys’ fees to employees, officers or directors."

Perhaps predictably, the Report has triggered a wide variety of responses, as reflected in the December 1, 2006 New York Times article entitled "Sharply Divided Reactions to Reports on U.S. Markets" (here, registration required). The most colorful comments are those of former SEC Commissioner Richard Breeden, who referred to the Report as "very elegant whining" consisting of "a bunch of warmed-over, impractical ideas, many of which have been kicking around for a long time."

The motivations behind the Report have also been questioned because of the Committee’s financial backing. A December 1, 2006 Washington Post article entitled "Report on Corporate Rules is Assailed" (here, registration required) reports that the Committee "received $500,000 in financial support from the C.V. Starr Foundation," described in the article as a charity with "longstanding ties to [former AIG Chairman] Maurice R. Greenberg." The article states that investor groups have "sounded alarms" because of the Committee’s ties to "an executive battling civil charges."

An interesting commentary by Walter Olson of the PointofLaw.com blog about the need for U.S. market to "Learn from London" can be found here.

The D & O Diary is frankly disappointed in the Report’s proposals with respect to litigation reform. After painting a dire picture about the declining fortunes of America’s financial markets, the Report essentially comes up with few litigation reform items that can at best be described as academic tinkering at the margins. Some of the ideas, like the proposal to allow shareholders to adopt alternative dispute resolution mechanisms or waive their rights to a jury trial, are so obviously not going to be adopted you have to wonder why the Committee even bothered to include them. (Jury trial waiver would be of zero practical value anyway, since virtually no securities cases actually go to trial). Other ideas, like the improvement to outside directors’ Section 11 defenses and indemnification rights are unquestionably worthwhile. The suggested revision to the Thompson Memo’s cooperation guidelines concerning the attorney client privilege and the payment of employees’ attorneys fees are absolutely correct.

But event though the Report does have some worthwhile suggestions, as well as others that have been criticized elsewhere (see here and here), the most obvious objection is the question whether any of the proposed litigation reforms would really make any difference for the competitiveness of the U.S. securities markets. The D & O Diary is prepared to concede that America’s peculiar penchant for litigation might well contibute to foreign companies’ decisions to avoid our securities markets. But The D & O Diary doubts that the Report’s proposed litigation reforms, even if adopted verbatim immediately, would improve the competitiveness of the U. S securities markets. Do the managers of foreign companies really weigh the value of outside directors’ indemnification rights or the possibility of a double recovery under the SEC’s Fair Funds authority? Seems pretty unlikely to me, which make me wonder why these kind of marginal reforms are even included in a report intended to address a supposed lack of global competitiveness. All of these proposed bandaids seem poorly calculated to dress the wound. As I have noted elsewhere (here), I am also skeptical that attempts to rollback the currently regulatory rigor are the right approach to improving the competitiveness of the U.S. securities markets.

I also continue to find the timing of this reform initiative puzzling. We are only weeks away from the very public sentencing of the leading figures in the Enron scandal. And we are only in the beginning stages of the unfolding options backdating scandal. There may indeed be a day when it is appropriate for the regulatory pendulum to swing back, but this does not seem like the right time.

The D & O Diary feels compelled to make a final observation. The Report cites the high cost of D & O insurance in the U.S., relative to the much lower cost in Europe, as a factor deterring foreign companies from listing on U.S. exchanges. The D & O Diary concedes, as it must, that there are material differences between D & O pricing in the U.S. and in Europe. But we find it amusing that the Report finds the differential in insurance costs significant, but at the same time concludes that the significant differences in investment bank underwriting fees and exchange listing fees are not a factor. The Report’s observations seem to have been strained through a very peculiar kind of lens.

The Report notes at the outset that "during the next two years, our Committee will continue to explore issues affecting other aspects of the competitiveness of the U.S. capital markets." The Economist magazine reports (here, subscription required) that the Committee’s second report is "due next year," and is likely to call for "better coordination between state and federal regulators by suggesting that the SEC and other agencies merge some operations." The next report "will also tackle other factors considered disadvantageous, such as an insistence on all firms using the GAAP accounting standard."

 

The Committee on Capital Markets Regulation (popularly known as the "Paulson Committee") has released its "Interim Report" (here). Weighing in at 148 graphic intensive pages, the 11.50 mb document is a memory hog. Readers who want a quick overview and don’t want to spend the rest of the day trying to download the entire report will want to refer to op-ed commentary by Committee members R. Glenn Hubbard and John L. Thornton, entitled "Action Plan for Capital Markets" in today’s Wall Street Journal (here, subscription required), which provides an overview of the Report’s recommendations "needed to maintain and improve the global competitive position of U.S. capital markets for investors."

The authors cite the declining valuation premium afforded to foreign securities listed on U.S. exchanges as evidence of the U.S. markets declining competitiveness. (The D & O Diary’s prior post about the valuation premium can be found here.) The Committee recommends a number of regulatory or legislative changes to address this concern including:

  • better implementation of Sarbanes-Oxley’s Section 404 internal control requirements, including a revision of PCAOB Auditing Standard No. 2 to ensure that reviews are risk based and focused on significant control weaknesses;
  • elimination of uncertainty in private enforcement of Rule 10b-5, through the SEC’s provision of more guidance on the elements of a Rul10b-5 action, including materiality, scienter, and reliance;
  • reduction of the risk of criminality of the corporate entity so that it is a last resort, and the elimination of existing guidelines in the Thompson Memo that require companies to waive the attorney client privilege and eliminate employees’ attorneys’ fee;
  • strengthening of shareholder rights and elimination of barriers to an efficient and competitive market (focusing on such elements as poison pills, staggered board, and classified boards) allowing shareholders to devise alternatives to the present litigation system, such as the waiver of the right to a jury trial or adoption of arbitration, implemented at the time of the IPO or amendment to corporate charters or bylaws;
  • elimination or reduction of gatekeeper litigation against auditors, either through a cap on auditor liability or creation of a safe harbor for certain auditor practices, and reduction of outside directors’ gatekeeper exposure by making an outside director’s good faith reliance on an audited financial statement sufficient to meet the standard of care;
  • adoption of a cost-benefit analysis for future regulation, to assure that regulations achieve the intended effect at an appropriate cost;

The Wall Street Journal has a more detailed bullet point summary of the Committee’s recommendations here.

While the Committee’s Interim Report is impressive, if nothing else for its sheer girth, this is merely the opening salvo in what will likely be a very prolonged exchange of views and proposals. Among other things, the U.S. Chamber of Commerce is expected to release its own report early next year. In addition, Sen. Charles Schumer and NY Mayor Michael Bloomberg have hired McKinsey & Co. to assess market competitiveness and its impact on the city’s economy. The Treasury department is hosting a conference early next year to discuss the state of the country’s regulatory, legal and accounting environment. What changes, if any, will ultimately emerge at the end of this process will only be revealed in the fullness of time.

The Interim Report obviously has a lot to say about issues potentially affecting the liability exposures of directors and officers of public companies. The D & O Diary will be taking a look at these portions of the Report and providing its views in a blog post to be added in the next day or two. In the meantime, I would be very interested in any thoughts or comments that readers have about the Interim Report.

 

In a recent post (here), The D & O Diary examined the SEC’s decision not to pursue an enforcement action against the outside directors of the Hollinger International and examined what this move might suggest about the potential liability and enforcement action exposure for outside directors of companies caught up in the options backdating scandal. A recently settled SEC enforcement action filed against three outside directors of Spiegel suggests that, at least under certain circumstances, the SEC will pursue enforcement actions against outside directors. And even though it did not involve option timing allegations, the recent action against the Spiegel outside directors may also shed some light on outside directors’ enforcement exposures in connection with the options backdating investigations.

According to the settled enforcement action that the SEC filed on November 2, 2006 (here), in 1982, OTTO Gmbh & Co., a German mail-order company primarily owned by Michael Otto, acquired Spiegel. Spiegel went public in 1997 by listing a portion of its shares on NASDAQ. Otto served as Spiegel’s board Chair. Also serving on the Spiegel board were two other Germans, Michael Crusemann and Horst Hansen.

In early 2002, as a result of Spiegel’s deteriorating financial condition, Spiegel’s independent auditor advised that it would have to consider a “going concern” modification in its audit report that would accompany Spiegel’s financial statements in its 2001 10-K. Spiegel itself was working to line up new credit facilities that the company believed would address the auditor’s concerns and permit a clean audit report. Because the company did not want to face the market consequences that would result from the going concern opinion, it sought to withhold the 10-K filing while it tried to remedy its credit issues.

According to the SEC, between April 2002 and February 2003, Otto, Crusemann and Hanson, participated in a series of decisions to withhold the company’s SEC fillings. The directors actively participated in decisions to withhold the filings even though their inside and outside counsel specifically advised them that the failure to file violated American law and exposed the company and its officers to legal liability. The SEC also alleged that Cruseman and others received a document entitled “Pros/Cons to Filing Form 10-K” specifically stating that corporate officials could be personally liable for failure to file. The document also attached copies of securities laws indicating liability for the failure to file. Despite these warnings, the SEC alleged, the director actively decided that Spiegel should withhold its filings to avoid having to disclose the “going concern” opinion.

Spigel not only failed to file its 2001 10-K, but also failed to file its Form 10-Qs for the first three quarters of 2002. Spiegel ultimately filed the delinquent forms in February 2003, after the SEC threatened to file an enforcement action. Within weeks of the belated filings, Spiegel filed for Chapter 11 bankruptcy.

According to the SEC’s news release announcing the enforcement action settlement (here), Otto and Crusemann consented to the Court’s issuance of a permanent injunction against them enjoining them from future violations of the securities laws, and each consented to pay a civil penalty of $100,000. Hansen, the former head of Spiegel’s audit committee, consented to the SEC’s entry of an order ordering him to cease and desist from committing or causing future violations of the federal securities laws.

The SEC’s enforcement action clearly shows that at least under certain circumstances, the SEC will pursue outside directors. However, it is important to note that, at least according to the SEC’s allegations, the Spiegel directors did more than merely failing to supervise. They are alleged to have been actively and directly involved in the decision to withhold Spiegel’s filings, and to have done made those decisions with actual knowledge that the failure to file violated the securities laws. In effect, the directors were alleged to have knowingly pursued an illegal course of conduct.

In an interesting November 29, 2006 Law.com article (here), Christian Bartholomew of the Morgan, Lewis & Bockius law firm provides his views on what the Spiegel case might mean for possible outside director liability in the options backdating scandal. Bartholomew contends that the Spiegel enforcement action ought to set standard for what should be required before the SEC pursues options backdating-related enforcement proceedings against outside directors. Bartholomew argues that the enforcement action “should be limited to situations where the evidence is clear and compelling that a director actively and knowingly engaged in or materially assisted in an improper options dating scheme, fully understanding the legal, accounting and disclosure ramifications.” By the same token, “the SEC should not pursue backdating actions arising simply from a director’s failure to act or to intervene to halt management misconduct.”

Bartholomew’s observations about what might be described as the “Spiegel standard” are interesting, but it still remains to be seen exactly how the SEC will approach this issue. The SEC has already served three outside directors of Mercury Interactive with Wells Notices in connection with the company’s options backdating investigation (see the company’s press release here). Time will tell whether the SEC limits its options backdating-related enforcement actions against outside directors to cases of knowing and active violations of the kind alleged in the Spiegel case.

Seven Contemptible Years: On November 27, 2006, the Second Circuit refused (here) to overturn a lower court’s denial of Martin Armstrong’s petition for a writ of habeas corpus. Armstrong has been in prison since January 14, 2000 for his refusal to turn over corporate records and $15 million in assets in connection with a securities fraud investigation involving his companies.

Armstrong was arrested in 1999 on charges that he defrauded Japanese investors out of $3 billion by falsely promising to invest in certain low risk assets, while he instead lost $1 billion in speculative trading that he attempted to cover up through a “Ponzi scheme.” In early 2000, in response to a civil contempt proceeding against him, Armstrong had produced $1.1 million in rare coins, one computer with the hard drive removed, three other computers (which later proved to have been tampered with), and various other assets. Armstrong failed to produce other subpoenaed items, including other specified computers, 102 gold bars, 699 bullion coins, and other rare coins worth $12.9 million. Armstrong testified that he kept some of the assets “hidden in a shed in the back yard” of his mother’s house and transferred others to business associates allegedly to pay off debts. The district court held Armstrong in contempt and “directed the marshals to confine Armstrong to the Metropolitan Correctional Center until he either complied with the turnover orders or demonstrated that it would be impossible to do so.” At periodic hearings since Armstrong’s incarceration on January 14, 2000, Armstrong has failed to comply or prove his inability to do so. Among other things, Armstrong has consistently contended that he has no obligation to do so, relying on his alleged constitutional rights against self-incrimination and his rights to due process.

Armstrong filed the habeas petition in August 2004 to raise constitutional objections to his confinement. The district court denied his petition in December 2004, which Armstrong appealed. On August 17, 2006, while his appeal was pending, he pled guilty to securities fraud.

In his appeal of the denial of the writ, Armstrong argued that, contrary to the district court’s statement that he “holds the keys to his prison cell,” the “key to his freedom comes at the cost of his Fifth Amendment right against compelled self-incrimination” and that his confinement also violates the Non-Detention Act, the Recalcitrant Witness Statue and due process. The Second Circuit affirmed the district court’s denial of the writ, based on the district court’s finding that Armstrong is capable of complying but is simply choosing not to do so. The Second Circuit held that the constitution did not protect him against producing the property and that Congress had “specifically authorized indefinite, coercive confinement.” The Second Circuit did conclude that Armstrong is entitled to a new hearing to assess whether he retains custody or control of the property. The court also noted that “on the seventh anniversary of Armstrong’s confinement, his case deserves a fresh look by a different set of eyes,” and directed the district court to reassign the case to a different judge.

“Indefinite, coercive confinement” certainly has a chilling sound to it. Perhaps it is time to retrieve those coins from Mom’s back yard.

A November 30, 2006 New York Law Journal article about the Armstrong case can be found here.

Hat tip to the Courthouse News Service (here) for the link to the Second Circuit opinion.

While My Ukulele Gently Weeps: It has been a while since the D & O Diary has had any pretext to link to a YouTube video. We therefore choose to use the occasion of the release of new Beatles’ Love compilation CD to commend to its loyal readers the video linked below. The D & O Diary has never had a very high opinion of the ukulele (it is looks like a shrunken guitar, it has a plink-plink sound, and it is spelled weird) but this video (here) depicting an absolutely virtuoso ukulele performance of “While My Guitar Gently Weeps” requires a complete reassessment of the ukulele. The performance is, in a word, awesome. Enjoy.

The Wall Street Journal has a generally favorable November 29, 2006 review of the new Beatles’ Love compilation CD here (subscription required).

According to Wikipedia (here), the word “ukulele” roughly translates from Hawaiian as “jumping flea.” Now you know.

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Shareholders suing Cablevision Systems over its backdated options have amended their complaint to add the company’s former compensation consultant as a defendant. According to news reports (here), the allegations against Lyons Benenson & Co., the company’s former compensation consultant, are the first in the nation to accuse a compensation advisor of taking part in a backdating scheme.

Cablevision’s options granting practices gained a certain macbre notoriety for their involvement of the first known instance of “Sixth Sense” options grants (“I pay dead people” – hat tip to Patrick McGurn at the ISS Corporate Governance Blog, here, for that great one-liner). In its 2Q06 10-K (here), Cablevision reported that its internal options investigation uncovered that the company had awarded options to a vice chairman after his 1999 death, but backdated them, making it appear that the grant was awarded when he was still alive. As Columbia Law School professor John Coffee dryly commented (here), “Trying to incentivize a corpse suggests they were not complying with the spirit of shareholder-approved stock-option plans.”

Cablevision’s filing also disclosed that its internal investigation had discovered that options had also been awarded to its compensation consultant, but that the options award had been accounted for as if the consultant were an employee. The filing reported that the award had been canceled in 2003. The filing also noted that the company’s “relationship with the company…terminated” more than a year before the options investigation began.

The company also restated its earnings for 2003 through 2005 and the first quarter of 2006 to adjust for the impact of improper options practices, which reportedly took place during the period 1997 through 2002. The company has announced that it is under investigation by the SEC as well as the U.S. Attorney’s office. The company has also received a grant jury subpoena.

The shareholder action naming Lyons Benenson as a defendant was filed by Grant & Eisenhofer on behalf of plaintiff shareholder the Teachers Retirement System of Louisiana. The complaint alleges that Lyons Benenson attended compensation meetings during which backdated options were granted in violation of the company’s employee option plan. The complaint also alleges that the consultant provided the committee with advice and documentation to facilitate the grants. The complaint also contains allegations about the options awareded to the consultant; the complaint does not allege that the options were illegal or backdated, but that they were “unusual and inappropriate” given that they came from an option account designated for Cablevision employees.

Cablevision has also been in the news lately based upon the offer by the Dolan family, which controls the company, to buy out the company’s public shareholders in a deal that values the company at about $7.9 billion. The D & O Diary previously commented on the buy out offer here. As noted in the Wall Street Journal article (here, subscription required) reporting on the Dolan’s buy out offer, the company’s recent history has been “turbulent,” as detailed further in the article.

While the Cablevision shareholders’ claim against Lyons Benenson may be the first against a company’s compensation consultant arising out of the backdating scandal, there may be many more claims against the outside advisers to companies caught up in the backdating scandal. Attorneys, auditors and others undoubtedly will also be drawn in as the story continues to unfold. (See more details below about options backdating litigation.)

What Can EDGAR Tell Us About Lyons Benenson?: The D & O Diary had not previously heard of Cablevision’s erstwhile compensation consultant, so this seemed like a good opportunity to test out the new full-text search capabilities of EDGAR, on the SEC website. (See the SEC’s November 14, 2006 press release about the new full-text search capabilities, here.) A full-text EDGAR search on the name Lyons Benenson revealed several instances associating the firm or one of its principals with various public companies. (It should be noted that the searchable text is limited only to the last four years.)

The 2002 10-K of ACTV, Inc. (here) revealed that the company had hired Lyons Benenson as a compensation consultant in 1999.

The December 22, 2003 proxy statement of DRS Technologies (here) disclosed that the company previously had retained Lyons Benenson to “assist in the design, assessment, and implementation” of the company’s compensation system, but at the end of the most recent fiscal year had replaced the consultant with another firm.

The April 7, 2006 Proxy Statement of CKX, Inc. (here) disclosed that the company had retained Lyons Benenson as a compensation consultant “to assist the Committee in fulfilling its responsibilities and to provide advice with respect to all matters relating to executive compensation and the compensation practices of similar companies. The consultant is engaged by, and reports directly to, the Compensation Committee. Harvey Benenson generally attends all meetings of the Compensation Committee on behalf of Lyons, Benenson & Company Inc.”

In addition, according to 2005 10-K of Penn Octane (here), Harvey L. Benenson, who is described in the filing as a “Managing Director, Chariman and Chief Executive Officer” of Lyons Benenson, served as a director of the company since his election in August 2000. Benenson also served on the company’s audit and compensation committees. However, according to news reports (here), Benenson resigned from the Penn Octane board in October 2006.

Options Backdating Litigation Update: As a result of the latest additions to The D & O Diary’s running tally of options backdating litigation (which may be found here), the total number of companies named as nominal defendants in options backdating related shareholder’s derivative lawsuits now total 117. The number of companies sued in options backdating related securities fraud lawsuits stands at 21.

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OK, But They Don’t Get Any Stock Options Awards: From the IMdb website (here), which touts itself as the “Earth’s Biggest Movie Database”:

Cole Sear: I see dead people.

Malcolm Crowe: In your dreams? [Cole shakes his head no]

Malcolm Crowe: While you’re awake? [Cole nods]

Malcolm Crowe: Dead people like, in graves? In coffins?

Cole Sear: Walking around like regular people. They don’t see each other. They only see what they want to see. They don’t know they’re dead.

Malcolm Crowe: How often do you see them?

Cole Sear: All the time. They’re everywhere.

Cole’s perception is familiar to those (including your faithful correspondent) who have worked in certain office environments.

Photobucket - Video and Image Hosting The Committee on Capital Markets Regulation (or the "Paulson Committee" as the group has come to be known) is scheduled to release its recommendations later this week, on November 30. The Paulson Committee is concerned with the competitiveness of the U.S. securities exchanges in the global marketplace, and the perceived inability of the U.S exchanges to compete due to the heavier regulatory and litigation burden in the U.S. Anticipation is building as the release date approaches; The Economist magazine’s cover this week (reproduced above) depicts the iconic Wall Street bull entangled in red tape and asks the question "Wall Street: What Went Wrong?" A prior D & O Diary post examining some of the potential litigation reforms may be found here.

But while we are awaiting the Committee’s actual recommendations, it is still timely to ask whether the regulatory burdens really are causing the non-U.S. companies to list their shares on other exchanges or if perhaps something else may be going on.

A speech earlier this fall by Public Company Accounting Oversight Board (PCAOB) board member Charles Niemeyer entitled "American Competitiveness in International Capital Markets" (here), provides a critical challenge to many of the presumptions behind the regulatory reform efforts.

First, with respect to the notion that the regulatory burdens of the Sarbanes-Oxley Act caused a recent decline in the number of non-U.S. companies listing their shares on U.S. exchanges, Niemeyer shows that the decline of the U.S. share of IPOs listed throughout the world began declining long before Sarbanes Oxley; the U.S. share of IPOs declined dramatically between 1996 and 2001 (from about 60 percent of all IPOs to less than 6 percent), but between 2001 and 2005 – that is, the period after Sarbanes-Oxley’s enactment – the U.S. share increased somewhat (to about 15 percent in 2005). Sarbanes-Oxley clearly is not the explanation for the reduced U.S. IPO marketshare.

Niemeyer asserts that the decline in U.S. share of the global IPO marketplace may be due to a number of causes, the most significant of which may simply be the availability of capital in local markets due to the universally low level of interest rates. Niemeyer also notes that "several countries are in the midst of multi-year programs to privatize state-owned businesses." For example, five of the largest 2005 IPOs (by market capitalization) were privatizations of state owned entities in China and France. As Niemeyer notes, "there are considerable political, cultural, and other influences on such companies to list locally when their markets offer sufficient liquidity." The low interest rate levels and high level of capital availability means that shares of this type tend to be listed locally — and many of these companies are quite large which explains the larger aggregate capitalization of IPOs outside the U.S.

Niemeyer also notes that foreign companies are often dominated by narrow "control groups" that, in countries with poor investor protections, "tend to have valuable private benefits derived from control, because they are able to extract benefits from the company unchecked by minority shareholder rights." Niemeyer notes that these control groups are loathe to submit to the types of investor protections provided by a listing of shares in the U.S. markets. So there may be many foreign companies that would not under any circumstances choose to list on U.S. exchanges either because of their nationalistic affiliation of because of their managers’ self-interested aversion to U.S. shareholder rights.

Niemeyer also points out that a substantial part of the drop in the U.S. share of worldwide IPOs is due to a dramatic decrease in the number of IPOs by U.S. companies, from about 375 in 2000 to less than 100 in 2001. Even more important for purposes of assessing the competitiveness of U.S. exchanges, "there was no commensurate shift by U.S. based companies to markets in other countries." While a great deal has been made about the competitiveness of the London Stock Exchange’s Alternative Investment Market, Niemeyer points out that as of March 2006, only 29 of the AIM’s 2,200 companies were based in the U.S., and seven of those 29 have dual listings or otherwise trade their shares on a U.S. exchange. Niemeyer questions whether the remaining 22 companies would even have qualified to list on U.S. exchanges, given AIM’s lower thresholds for offering size and other lower offering prerequisites.

The question whether we should care that even some companies are resorting to AIM was underscored in the Wall Street Journal’s November 21, 2006 article entitled "For LSE, A Troubling Trend" (here, subscription required), which reported that "a number of companies [on AIM] have issued profit warnings lately." The article goes on to quote an AIM spokesman that "the profit warnings have more to do with the smaller size of companies, where you have greater economic risk." Another LSE official is reported to have conceded that some companies allowed to list on AIM, in hindsight, shouldn’t have. In other words, AIM’s low barriers (smaller size, earlier offering) to entry may be attracting some less qualified companies – companies that simply couldn’t list on U.S. exchanges. The article also reports that the AIM benchmark index is down 1.8% this year, compared with London’s benchmark FTSE 100 index, which is up about 10%.

Can the case be made that perhaps the U.S. exchanges are better off without the companies that can satisfy the lower regulatory burdens in other countries but not the U.S.? A November 25, 2006 Wall Street Journal article by Herb Greenberg entitled "Is IPO Slowdown a Bad Thing, As Sarbanes-Oxley Foes Claim?" (here, subscription required) poses the question: "Has anybody stopped, just for a moment, to ask whether fewer IPOs might actually be a good thing? Seriously, maybe some of these companies shouldn’t go public in the first place, especially if they fear or don’t want to pay for laws that are attempting to crack down on skullduggery." Greenberg points out that "going public is a privilege and companies going through the process should welcome scrutiny and encourage proper barriers to entry."

Whether or not the U.S. exchanges are better off without some of the companies that are driven away by high regulatory barriers, it is unquestionably true that the high regulatory barriers produce benefits for the companies that meet the requirements. According to Niemeyer, companies that list their shares on U.S. exchanges receive a premium on their valuations. Niemeyer shows that non-U.S. companies that cross list in the U.S. enjoy a significantly lower cost of capital – in fact, the lowest in the world. This reduction in the cost of capital translates into a valuation premium that can reach as high as 37 percent more than their valuations would have been in their home markets. As Greenberg points out in his article, it is not as if the U.S. IPO business has withered and gone away. According to Greenberg, as of November 22, 2006, 172 companies had conducted offering on U.S. exchanges during 2006, raising a combined $38.8 billion. That compares with 213 offerings in all of 2005, raising a total of $38.5 billion. Hardly a slowdown, as Greenberg notes. {See the Update at the end of this post for additional information regarding the vaulation premium}

When the Paulson Committee releases its recommendations later this week, it will be worth asking with respect to the proposed reforms whether there really is a problem that needs to be remedied. As Niemeyer points out, one of the most important aspects of Sarbanes-Oxley is that it "reduces the risk of future catastrophic financial reporting failures." As the companies caught up in the current options backdating are finding now to their everlasting regret with respect to financial reporting, the "costs of getting it wrong still exceed the costs of getting it right."

Finally, while the reformers may be militating in favor of lowering U.S. regulatory burdens, other countries may be moving in the opposite direction. A November 23, 2006 Dow Jones Newswire article entitled "Insurers See Risk From U.S.-Style Lawsuits in Europe" (here) discusses concerns regarding the spread of U.S lawyers and the possible consequent spread of U.S. litigation to Europe and elsewhere. The article quotes European insurers for the view that "there are significant signs that the number of lawsuits is rising" outside the U.S. The article specifically cites the increase of class action litigation in Norway, Germany, Sweden and the U.K.

Hat tip to Jack Ciesielski at the AAO Weblog (here) for the link to the Niemeyer speech. Ciesielski also has an interesting commentary on the Greenberg article here. An interesting contrarian perspective on Greenberg’s article may be found on Professor Larry Ribstein’s Ideoblog, here.

The Economist Magazine’s Perspective on Regulatory Reform: The article in The Economist magazine’s issue with the red tape bound bull on the cover (reproduced above), entitled "Down on the Street," (here, subscription required) takes a characteristically balanced approach to the topic of regulatory reform. The article notes that many publicly listed companies are fleeing the glare of the public marketplace by going private; the article states "more of corporate America was taken out of public ownership by private-equity firms (spending $178 billion) in the first ten months of this year than in the previous five years combined ." The D & O Diary thinks this argument is a red herring; the boom of private equity acquisitions can only be understood as a direct outgrowth of the astonishing availability of private equity funding to invest. Corporate managers may welcome the chance to avoid the headaches of being a public company, but if there were not huge pots of money involved, the companies would remain public. The article is perhaps closer to the mark when it recalls that overly tight restrictions in the 1960s may have driven lenders and borrowers to London , leading to the creation of the Eurobond market, which now accounts for the largest share of publicly traded debt. The financial centers, New York, in particular will want to avoid ceding additional advantages.

The Economist may be closest to the mark when it recounts the quip from one unnamed Washington source that referred to the Paulson Committee as the "7% committee," referring to Wall Street’s typical IPO underwriting fee, double that charged by European underwriters. The unstated suggestion is that the Committee’s real goal is preserving Wall Street’s oversized fees, which a neutral party assumes would be the first place that objective parties interested in advancing the competitiveness of America’s securities markets would turn, rather than attempting to reduce regulatory protections.

The D & O Diary thinks investors’ interests might be best served if we tried cutting underwriters’ fees first, before cutting investors’ protections, and see if that helps make U.S securities markets more attractive to foreign companies. That might also help preserve all the advantages that higher regulatory standards produce.

And Finally: In an earlier D & O Diary post, which may be found here, I reviewed the op-ed piece written by the head of an Indian company, in which the official explained his reasons why he proudly listed his shares on a U.S. exchange, notwithstanding the higher regulatory burdens. He felt that for his company the benefits far outweighed the burden.

Update: A November 28, 2006 Wall Street Journal article entitled "Is a U.S. Listing Worth the Effort?" (here, subscription required) reports on a recent study that will "figure prominently in a report to be released" by the Paulson Committee, and that reportedly concludes that "investors have sharply reduced the premium they pay for shares of foreign companies since a regulatory crackdown on corporate malfeasance in 2002." The newspaper article’s lead would seem to suggest that this new study supports the Paulson Committee’s underlying premise — that is, that the new regulation has eliminated the valuation premium (discussed above) and therefore the Sarbanes Oxley related regulation is making the U.S. less competitive. However, the article discloses that in fact the premium has increased for companies from certain countries that have less rigorous local regulation (Italy, Austria and Turkey are specifically named), and that the decrease in the valuation premium has only taken place for companies from countries that have their own rigorous regulatory programs (Japan, Hong Kong, Canada and the United Kingdom). And for that matter, even in those countries with a decline, the decline is from 51 percentage points during the period 1997 to 2001, to 31 percentage points between 2002 and 2005.

While the study’s sponsors interpret these data to mean that increased regulation is decreasing the valuation premium and therefore making the U.S less competitive, I have a hard time getting to that conclusion from this information. I think the fact that the premium has increased in countries with less rigorous local regulation means that the U.S regulatory approach is even more highly valued than before. Even if there is a decrease in the valuation premium for companies from more rigorously regulated, there is still a very significant valuation premium, and the decrease could be understood in any one of a number of ways, including the possibility that increased regulatory effectiveness in the other countries have started to reduce the value that is placed on the benefits of the U.S. scheme. The willingness of the London market to accept listings for companies that would not meet U.S standards is probably also a factor. Given the increase in the valution premium for companies from less rigorously regulated countries, and the still substantial valuation premium even for companies from more highly regulated countries, it is hard for me to see how decreasing regulation would improve U. S. competitiveness. It is entirely possible that what a lax regulatory scheme would accomplish is reducing the valuation premium (and the attractiveness of U.S. markets) for companies from the economies that will be growing most quickly in upcoming years.

 

A November 20, 2006 Wall Street Journal article entitled “Companies Discover It’s Hard to Reclaim Pay from Executives” (here, subscription required) details the difficulty that companies are having in their attempts to compel executives to return compensation they didn’t really earn because, as a result of later restatements, the company didn’t actually hit the compensation triggers. It wasn’t supposed to be like this; Section 304 of the Sarbanes Oxley Act was supposed to facilitate the possibility of reclaiming bonuses from top executives when reported income is wiped out by later financial restatements. For a host of reasons, the SOX clawback provisions in Section 304 have failed to live up to their purpose:

1. The provision is poorly written: As Stanford Law School Professor Joseph Grundfest has said (here), “For a statute that contains a lot of inartfully drafted provisions, this is among the most inartful.” The provision calls for the CFO or CEO to reimburse the company if an issuer has to prepare a restatement “due to material noncompliance of the issuer as a result of misconduct.” However, the statute doesn’t specify what constitutes “misconduct” and it doesn’t specify whose misconduct qualifies. (Must it be the CEO’s or CFO’s own misconduct? Or is a lower level employee’s misconduct sufficient?)

2. Retroactivity?: Even though the statute was enacted in 2002, restatements often reach much further back in time. For example, in connection with several of the options backdating restatements, the period of the restatement in some instances has reached back into the early nineties. The applicability of the clawback provision to compensation awarded prior to Sarbanes Oxley’s enactment raises due process and other substantive concerns.

3. No “Private Right of Action”: At least two federal district courts have held that there is no private right of action in Section 304. For example, in a derivative suit brought by shareholders of Stonepath Group to recover compensation paid to the company’s CEO and CFO, the court held, according to news reports (here), that Section 304 omitted a private right of action, by contrast to other sections of the Act where Congress made it clear whether or not investors explicitly had that right.

4. The SEC Prefers Its Other Remedies: If there is no private right of action, only the SEC can enforce Section 304. But the SEC has its own power to seek disgorgement of ill-gotten gains, which it prefers these other provisions because the other means, unlike Section 304, funnel money to shareholders rather than to the companies. The SEC has never enforced Section 304.

5. Calculating the Amount Due Can Be Tough: The Journal article linked above reports an example where a former executive of Dollar General agreed to return compensation following a restatement, but the compensation included options he had already exercised, and the shares he purchased were now valued below the price he paid. When his lawyers told him he owed $6.8 million, he said, “How on earth do you calculate that anyhow?” Attempts to recover executive compensation are fraught with these kinds of issues.

If there is no private right of action and the SEC won’t enforce the provision, Section 304 is basically worthless.

According to the Journal article, Massachusetts Democratic Rep. Barney Frank, the anticipated chairman of the House Financial Services Committee, plans to propose legislation that would strengthen the ability of shareholders to recoup executives’ compensation. Shareholder advisory services apparently are actively seeking to compel by-law changes or other measures to facilitate compensation recoveries.

An interesting article by Richard Wood of the Kirkpatrick Lockhart firm discussing ways that to address these issues through executive compensation contracts can be found here.

Defense Fee Recoveries: The Journal also had another article (here, subscription required) on November 17, 2006 discussing the efforts of CA, Inc. (formerly known as Computer Associates) to recover $14.9 million in attorneys’ fees it paid on behalf of its now convicted former CEO Sanjay Kumar. The company obtained an order attaching Kumar’s property as security for the repayment of his attorneys’ fees.

The company’s efforts to recover attorneys’ fees are much less complicated that the attempt to try to clawback executive compensation described above. (It should be noted that CA also eventually intends to try to recover compensation paid to Kumar as well.) CA’s efforts to recover the attorneys’ fees are substantially aided by provisions in the company’s by-laws, permitted under the law of Delaware, the state of CA’s incorporation. The by-law provisions (which are set forth at length in the White Collar Crime Prof blog, here) provide that the company’s advancement of legal fees can be conditioned on the officer’s agreement to repay amounts advanced if the officer is found guilty. Kumar’s guilty plea triggers the repayment obligations.

Many companies don’t bother to try to recover advanced fees because the convicted former official has no assets. However, at least according to the Daily Caveat (here), Kumar has substantial assets, including a couple of Ferraris, a 57-foot yacht, a $9 million home, and $20 million bond portfolio (which he just happened to transfer to his wife’s name the day after the New York Times ran an article questioning his company’s accounting). On the other hand, there are a lot of potential claimants for Kumar’s assets (including the SEC, seeking to pursue its own recoupment action) that could have a superior claim on Kumar’s assets.

As The D & O Diary has previously noted (most recently here), the attempts by the Paulson Committee to propose ways to improve the competitiveness of the U. S. securities exchanges in the global marketplace may include securities litigation reform. Interest in the Committee’s reform efforts increased substantially as a result of media reports (here) that among other things the Paulson Committee was considering recommending the elimination of a private cause of action under Rule 10b-5. However, in a November 16, 2006 New York Law Journal article entitled "Capital Markets Competitiveness and Securities Litigation" (here, subscription required), Columbia Law School Professor John C. Coffee, Jr. (who supposedly was the source of the recommendation to eliminate private Rule 10b-5 actions) disclaims having made any such recommendation. Instead, Coffee is recommending a "far more modest proposal."

Photobucket - Video and Image Hosting Coffee’s reform proposal begins with his view that the current private securities litigation system is "dysfunctional," but "not because the lawsuits are frivolous or extortionate." Rather, the problem, Coffee believes, is "the circularity of the securities class action." The problem is that

Shareholders are suing shareholders. As a result, diversified shareholders wind up making pocket-shifting wealth transfers to themselves. In the common securities class action dealing with a stock drop in the secondary market, the recovery will go to those shareholders who bought the stock during the "class period"… and the recovery will be bourne by the other shareholders who bought the stock before or after that class period…Inherently, this implies that such an action produces only a shareholder-to-shareholder wealth transfer.

Nevertheless, Coffee thinks that the argument can still be made that securities class action lawsuits may be justified by their deterrence effect. But the problem is that they accomplish deterrence "by punishing the innocent – the shareholders." Coffee proposes a "system of managerial and agent liability that places costs instead on the culpable."

Coffee proposes that the SEC use its regulatory authority under Section 36 of the Securities Exchange Act of 1934 to shield non-trading public corporations from liability under Rule 10b-5. (Section 36 gives the SEC the authority to exempt "any person, security or transaction from any securities laws or regulations, if the exemption is "necessary or appropriate in the public interest, and is consistent with the protection of investors.") According to Coffee, this "would not eliminate a private cause of action under Rule 10b-5, but it would force the plaintiff’s bar to sue and settle with corporate officials and agents – i.e., auditors, underwriters and law firms – instead of treating the corporate entity as the deep pocket."

Coffee anticipates that the targeted directors and officers would seek to rely on indemnification and insurance if they are targeted by the plaintiffs’ lawyers. Coffee recommends that the SEC should act to force corporate boards to take their decision whether or not to indemnify much more seriously, as a result of which, Coffee claims, "in some cases, indemnification might not be paid, and in all cases there would be greater uncertainty." With respect to D & O insurance, Coffee anticipates that active wrongdoers would face substantial coverage barriers (such as the conduct exclusions) as a result of which "the insurer and the corporate insider might well settle such an action on a basis that required some payment out the insider’s own pocket." At that point, Coffee says, "real deterrence begins to be generated."

Coffee’s recommendation to exempt companies from private securities lawsuits to force individuals to bear greater personal exposure as a way to increase deterrence is detailed in Coffee’s October 2006 law review article entitled "Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation" (here). Coffee’s law review article has an extensive review of the fact that although corporate insiders are regularly sued "they rarely appear to contribute to settlement," with specific examples. In the law review article, Coffee also examines at greater length the SEC’s authority under Section 36. Coffee’s article anticipates that his recommendation to exempt companies from Rule 10b-5 liability would "alter the market for D & O insurance" because "executives would demand more insurance;" on the other hand, the recommendation would also "eliminate entity insurance." Coffee’s law review article does not examine whether carriers might alter their basic terms and conditions, as insureds maneuver to assure that coverage for their liability would not be excluded and as carriers jockey to recapture premium revenue lost after entity coverage is eliminated.

The D & O Diary thinks Coffee’s reform proposal is interesting. We do wonder how all of this would actually improve the competitiveness of the U.S. securities markets. Are the managers of foreign companies more likely to list their companies’ shares on U.S. exchanges if the regulatory system is changed to increase their individual liability exposure while at the same time trying to reduce their access to indemnity or insurance? Coffee’s proposal may or may not be a good idea, but it doesn’t seem like it really has anything to do with the reasons for which the Paulson Committee was formed.

Hat tip to the Securities Litigation Watch blog (here) for the links to the New York Law Journal article and Coffee’s law review article.

Photobucket - Video and Image Hosting Thompson Memo Reform?: Reform seems to be today’s theme. According to news reports (here), the U.S. Department of Justice is considering modifying the Thompson Memo to address concerns that prosecutorial pressure is forcing companies to cut off legal support to employees under investigation and to reveal confidential communications with the company’s lawyers. According to the news reports, all prosecutors in each of the 93 U.S. attorneys’ offices would have to get the approval of the attorney general or his top deputy before seeking attorney-client waiver. In addition, companies would not be penalized for refusing to reveal confidential communications with their lawyers – but the could still get credit for cooperation. The Justice Department reportedly is also considering deleting the language in the Thompson Memo referring to legal fees for "culpable employees."

According to the news reports, Deputy Attorney General Paul McNulty has not yet signed off on the proposed changes.

As Professor Ellen Podgor notes on the White Collar Crime Prof blog (here), these proposals represent "baby steps" in the right direction, but they "would not alleviate the problem" that has led to criticisms of the Thompson Memo. For a review of The D & O Diary’s prior posts discussing the Thompson Memo criticisms, refer here and here.

Fortune Smiles on Larry Sonsini: A November 17, 2006 Fortune.com article entitled "Scandals Rock Silicon Valley’s Top Legal Ace" (here) contains a lengthy portrait of Larry Sonsini and discusses his recent involvement in a number of high-profile imbroglios. After reviewing Sonsini’s rise to prominence, the article looks at Sonsini’s involvement, as an NYSE board member, in the dispute over former NYSE CEO Richard Grasso’s compensation; at Sonsini’s connection to the board pretexting scandal at H-P; and Sonsini’s involvement with several companies (including Brocade Communications) implicated in the options backdating scandal. The article essentially exonerates Sonsini on all issues, with the exception of Sonsini’s service on the boards of companies of which he also acted as outside counsel. However, the article reports that Sonsini has resigned or will resign from all of the nine corporate boards on which he previously served.