The D & O Diary has had numerous posts commenting on the possible reasons for the YTD 2006 decline in the number of securities class action lawsuits (most recent post here). D & O maven and prominent coverage attorney Dan Bailey of the Columbus, OH law firm of Bailey Cavalieri has recently formulated his own explanation for the declining number of suits, in his article “Why Are There Fewer Securities Suits?” (here). Dan’s article is, as usual for Dan’s work, well-written and thorough.

Dan attributes the drop to a number of contributing factors, most of which he views as merely temporary. Among the factors he considers are the recent reduction in stock price volatility, enhanced corporate governance and the Dura decision. He is skeptical that the Milberg Weiss indictment has had much impact on the number of securities suits, and thinks that any diversion of plaintiffs’ lawyers’ attention based upon their filing of options backdating related derivative suits will be purely temporary. Because Dan regards many of the causes of the current lawsuit decline as temporary, he believes that it is “extremely unlikely” that this decrease in shareholder litigation will be permanent and therefore “neither D & O Insurers nor Insureds should overreact to this seemingly temporary reprieve from higher-frequency securities litigation.” He also specifically notes that “an over-reactive softening of the market today in response to this development will likely cause another significant market correction in a few years.”

Readers should be aware that Dan’s firm’s website has an archive of Dan’s other D & O-related writings (here, scroll down to “Director and Officer Liability”) His articles are uniformly interesting and well-written, and collectively represent a useful resource on D & O liability issues.

Special thanks to Dan for providing a copy of (and a link to) his article.

Pay Scale: According to an October 12, 2006 article in the Rocky Mountain News (here), the Lerach Couglin firm sought $96 million in legal fees for its role as lead plaintiffs’ counsel in connection with the $400 million settlement of the Qwest Communications securities class action lawsuit. Denver attorney Curtis Kennedy, representing the Association of U. S. West Retirees, succeeded in getting the legal fees cut to $60 million, providing $36 million more for the shareholders. Kennedy’s fee? $40,500. Seems like there might be an ironic parable about “value for value” here…

FCPA Perspective: Regular readers know that the D & O Diary has frequently written about the Foreign Corrupt Practices Act, and the growing importance that the FCPA has for D & O risk (most recent posts here and here). Alert reader Winnie Van called our attention to an article that appeared in the San Francisco Business Times entitled “Feds Take Aim at Bribery” (here). The article documents the recent sharp spike in FCPA enforcement activity, which the article attributes in part to the growing importance of doing business in India and China, as well as the increased scrutiny on operations and controls under Sarbanes Oxley. The article also discusses that several major law firms and accounting firms have been gearing up to address their clients’ issues under the FCPA, because they see it as a growing threat. As The D & O Diary has noted, the FCPA is also a growing area of potential D & O risk (here).

Blog Alert: The many D & O Diary readers who are involved in insurance coverage counseling and litigation may be interested to take a look at the Insurance Coverage Law Blog (here). While the blog does not specifically address professional liability coverage issues, it does generally have interesting posts and links related to insurance coverage issues.

Hat tip to Adam Savett at the Lies, Damn Lies blog for the link.

Why Google Bought YouTube: If, like The D & O Diary, you find yourself wondering what Google could possibly have been thinking when it agreed to pay $1.65 billion for YouTube, perhaps a glance at this Google-generated “trends” chart (here) might illuminate what was on Google’s mind.

If you still aren’t sure about the $1.6 billion price tag, it may be because you are unacquainted with the whole viral Internet video phenomenon. I suggest a quick look at two of the all-time most popular Internet videos: The Llama Song video (here) and the Badger Badger video (here). If you are now completely mystified, then we are in agreement.

Worst Headline Ever? You decide. Click here.

The D & O Diary has previously commented (most recently here) on the increasing risk of D & O claims arising from “going private” transactions in which incumbent management teams up with outside investors to buy out the interests of public shareholders. The most recent high-profile “going private” transaction to be announced – the Dolan family’s $7.9 billion proposal to take Cablevision private – has already resulted in a claim against the company’s board, according to this October 10, 2006 press release, here. Shareholders’ objection to the proposed transaction is that it allegedly puts the Dolan family in an advantaged position, to the detriment of public shareholders. A colorful expression of this concern is reflected in the remarks of a T. Rowe Price portfolio manager, who was quoted in an October 10, 2006 Wall Street Journal article about the Cablevision transaction (here, subscription required), as saying that “I’m tired of management and private-equity firms trying to steal companies from underneath our noses, and I think this is another example of that.”

An interesting commentary about the Cablevision transaction and the shareholder lawsuit appears on the Lies, Damn Lies blog, here.

Shareholders concerns about “going private” transactions also extend to the ability of management to pursue potential buy-out opportunities in which management might participate, without even the board of directors’ knowledge, in a way that potentially discourages or disadvantages potential competing bidders. A recent SEC filing of Kinder Morgan, whose shareholders are now considering a $14.8 billion buyout deal, provides an interesting perspective into this process. (The filing may be found here.) Kinder Morgan’s President entered discussions with investment banks in February 2006 about the possibility of pursuing alternative strategies. The discussion changed direction when the investment bank requested the opportunity to act as principal investor in a leveraged buyout. These discussions continued for months, yet the company’s board was not made aware of the potential transaction until May 13, 2006.

According to the Wall Street Journal article (here, subscription required) describing the Kinder Morgan transaction,

The timing of events is notable because boards of directors often prefer to control the process of a management buyout as much as possible. The earlier they are aware of a potential buyout, the more they can shape the terms in ways that are favorable to the overall company….The tensions between management and board can become acute because the board is often interested in maximizing the number of bidders while management is eager for its own bid to succeed. For example, Mr. Kinder [Kinder Morgan’s founder], at the request of Goldman’s private-equity team, committed to not engage in talks with any third party in connection with any bid for 90 days. In an effort to keep the playing field more level, the board’s special committee…requested that Mr. Kinder terminate that agreement.

The Kinder Morgan board’ special committee later obtained more advantageous terms from the prospective acquirors and now the board supports the takeover proposal.

The Kinder Morgan transaction has also resulted in a claim against the company’s management and its board of directors. (A copy of the complaint may be found here.)

The attributes of a management-led buyout are fraught with potential conflicts of interest. Management is highly motivated to ensure that their proposed transaction will succeed, which may cause them to agree to structures (such as not to talk to potential competing bidders) that may favor their proposal, but to which shareholders might otherwise object.

Nor are the potential conflicts of interest limited to management. The Kinder Morgan transaction reflects the unusual circumstance where the investment bank to who the company’s management turned for strategic advice emerged as the principal investor, putting the investment bank in the unusual position of advising the company’ management in connection with the bank’s own proposal (in which management was participating) to buy the company.

In circumstances packed with so many potential conflicts of interest, it is all too easy for allegations of wrongdoing to arise. The high stakes involved exacerbate this risk. For that reason, these transactions almost inevitably generate shareholder claims alleging that management breached their duty of loyalty and that the board breached their duty of care. A cynical view is that these lawsuits are nothing more than plaintiffs’ lawyers’ attempts to extract a toll from the transaction participants. But where management’s interests in a transaction potentially diverge from those of shareholders, the claims may present a more serious exposure.

As the Journal article (linked above) discussing the Kinder Morgan transaction put it, “As private-equity transactions continue to sweep through the financial markets, investors will begin putting extra scrutiny on how these transactions come together, and how fair they are to all shareholders.”

Private Equity Conflicts: A different kind of conflict of interest may exist among the potential buyers in these “going private” transactions. According to an October 10, 2006 Wall Street Journal article entitled “Private-Equity Firms Face Anticompetitive Probe” (here, subscription required), the U.S. Department of Justice is looking into whether some of the top tier private equity firms have developed a tacit understanding that they would not undercut each other’s takeover attempts with competing bids. Among other approaches under investigation is whether these firms form “clubs” drawing in potential competing bidders, which potentially could have the effect of depressing acquisition prices. The investigation apparently is in its early stages. A second article about the investigation appeared in the October 11, 2006 Journal (here, registration required)

Worse Than a Bad Hair Day: “Lightning Exits Woman’s Bottom.” (I am not making this up.) Read the story here.

When Congress incorporated the whistleblower provisions into the Section 806 of the Sarbanes-Oxley Act, they may have assumed that concerned individuals, secure in the statute’s protection, would now be encouraged to come forward and expose financial misdeeds at their companies. But the sad, frustrating saga of the first SOX whistleblower (see prior D & O Diary post, here) unmistakably suggests that he statute’s protection may be more theoretical than real, and that those concerned individuals who might otherwise come forward might have to accept that even with SOX protection whistleblowing remains a precarious (and potentially career-ending) activity.

David Welch was the CFO of the Floyd, Va.-based Cardinal Bankshares until he was terminated in October 2002. Welch filed a complaint with the U.S. Department of Labor, alleging that he was terminated for activities protected under the SOX Whistleblower provisions. Welch contends that he had raised questions about the company’s accounting policies and internal controls, and then refused to certify the company’s financial statements. He further contends that he was discharged after he refused to meet with the company’s outside counsel without a personal attorney.

Welch’s complaint initially was denied, but upon appeal an Administrative Law Judge, in a January 24, 2004 “Recommended Decision and Order” (here), held that he (Welch) was entitled to reinstatement and compensatory damages. After receiving this favorable ruling, Welch then began a Kafkaesque journey through a self-parodying process that has left him, to this very day, unable to enforce the remedy to which he has been found entitled.

The latest sad development in this procedurally interminable saga is the October 5, 2006 ruling by U.S. District Court Judge Glen Conrad dismissing Welch’s petition to enforce the ALJ’s ruling for lack of subject matter jurisdiction. In his 12-page opinion, Judge Conrad reviews the administrative process that Welch is required to exhaust (and “exhaust” is unmistakably the opeative verb here) before the court would be statutorily authorized to exercise jurisdiction. Judge Conrad specifically noted that because the Department of Labor’s Administrative Review Board (ARB) has not yet ruled on the company’s second appeal of the ALJ’s ruling, the ALJ’s ruling is not yet “final” and therefore the Court lacked jurisdiction to enforce it. (For the sake of brevity, I have summarized the full procedural history; suffice it to say that Welch has been run through multiple sequences of appeals and processes too tedious to recount here.)

Judge Conrad’s opinion’s concluding remarks are piquant and telling:

Finally, the Court acknowledges that the current situation represents a departure from the adjudication scheme envisioned by Congress. Sarbanes-Oxley was established to protect against the chilling effect of retaliation on whistleblowers by providing a remedy of reinstatement in a short amount of time. As a result, Congress set forth specific procedures to ensure that complaints would be quickly adjudicated by the Department of Labor, and that appeals within the administrative process would likewise progress quickly, taking a matter of days. Although this was the intent of Congress, the court recognizes that the Secretary has not complied with this mandate. Over eighteen months after the ALJ has issued his preliminary order of reinstatement, Welch has still not received a final administrative adjudication of his status. The court agrees that the delay in the administrative process has been inordinate.

Judge Conrad is right, the Department of Labor has not covered themselves with glory in processing Welch’s petition. Welch’s seemingly endless struggle to secure the statute’s protection is hardly likely to encourage others to come forward.

An October 6, 2006 CFO.com article discussing Welch’s case and Judge Conrad’s ruling can be found here.

Options Backdating Litigation Update: The D & O Diary’s running tally of options backdating lawsuits (which can be found here) has been updated to add the securities fraud action that was filed on October 6, 2006 (here) against Marvell Technology Group . With the addition of the Marvell Technology action, the number of companies named in securities fraud actions based on options timing allegations now stands at 20. The number of companies named as nominal defendants in shareholders’ derivative lawsuits raising options timing allegations stands at 83.

Executive Coloring Book: Although anachronistic and politically incorrect, the Executive Coloring Book, a 50’s vintage classic, is still wickedly funny. Click here.

In an October 4, 2006 Law.com article entitled “Enron’s True Legacy Is a Lesson on Compliance” (here), Andrew Weissmann, the former director of the Enron Task Force and now a partner at the Jenner & Block law firm, lays out his assessment of the lasting effects of the Enron scandal and criminal prosecution. Weissmann makes essentially four claims for Enron’s legacy:

  • A New Culture of Corporate Governance: “Enron’s unintended commentary on the state of corporate governance produced an important cultural paradigm shift and led to fundamental changes in the way business is done in this country. In the shadow of Enron, not a single major American corporation can afford to ignore the implementation of serious internal compliance systems to detect and deter corruption.”
  • Safety to Blow the Whistle: “Serious internal compliance programs serve to encourage employees to speak the truth to power – to report conduct that they believe may have cross the line.”
  • Document Preservation: “Companies have devoted millions of dollars in creating and enforcing document policies that properly ‘hold’ documents in anticipation of litigation.”
  • More Active Boards: “Boards of directors that often served no more of a check on corporate malfeasance than a grand jury does on a federal prosecutor are newly emboldened to display true oversight and backbone.”

In describing Enron’s legacy, Weissmann is clearly using the word “Enron” both to refer to the Enron criminal prosecution and as a shorthand for all of the corporate scandals and their repercussions. Weissmann is absolutely correct about the changed governance culture. This cultural shift has affected not only the board rooms of America’s largest companies, but the effect has also extended to private companies and even nonprofit entities. And Wiessman certainly is correct about the heightened independence of corporate boards. According to the National Association of Corporate Directors (as quoted in the Wall Street Journal, here, subscription required), 83% of boards said that more than half of their directors are independent, up from 54% in 2000. The increased predominance of independent directors clearly has shifted board participation away from the passive nonconfrontational approach that may have prevailed in the past, toward a more active and even distrustful dynamic.

But in addition to claims Weissmann has made for Enron’s legacy, I would add a few additional considerations, assuming for the sake of discussion that the term “Enron legacy” encompasses the effects of the entire wave of corporate scandals:

  • CEOs in the Hot Seat: There is no doubt that as a reaction to the wave of corporate scandals CEOs’ hold on their jobs is far more precarious. By way of illustration, since early 2005, the boards of some of the country’s larges companies have ousted their CEOs — including Bristol-Myers Squibb, Fannie Mae, Pfizer, Merck and American International Group. In addition, there has been intense scrutiny of executive compensation, including most recently the phenomenon of backdated options. More active boards and a great willingness to challenge management, as well as a changed regulatory environment, have all contributed to this effect.
  • White Collar Crime Enforcement Apparatus: Enron begat the Enron Task Force. Even though the Enron criminal trial itself is nearly played out, the Enron Task Force itself has no plans to disband. U.S. Deputy Attorney General Paul McNulty, the current head of the Corporate Fraud Task Force, was quoted in the September 2006 issue of CFO Magazine (here), as saying that the Task Force continues to find activities to investigate and prosecute. In the same vein, the SEC Enforcement Division’s budget was dramatically increased in the Sarbanes-Oxley Act. There is no movement to shrink that budget back down. So one of the most concrete legacies of the Enron era is the permanent structure of prosecutors and regulators focused on corporate malfeasance.
  • Hardball Prosecutorial Tactics: The wave of corporate scandals and the subsequent criminal proceedings has institutionalized a host of aggressive tactics for white collar crime prosecutions, including, for example, the obligatory “perp walk;” the use of threatened charges against family members; and the compulsion of corporate investigatory targets to cut-off support for employees who assert their constitutional right against self-incrimination.
  • Increased Severity of Civil Securities Fraud Lawsuits: There is no doubt that the average settlements of securities fraud lawsuits has escalated enormously from the civil cases arising out of the corporate scandals. It may be that the egregiousness of those cases drove an increase in average severity that will diminish once the worse cases have played through the system. But while average settlements may decline, the rough idea of “what cases like this settle for” has been ratcheted upwards in a way that is unlikely to completely go away.

There are other potential legacies of the Enron era. For example, evolving notions of appropriate sentences for white collar crime are being sorely tested as the various defendants receive their prison terms. It is also possible that Andrew Fastow’s success in using his cooperation with the civil plaintiffs’ attorneys in order to support his plea for lenience in his criminal sentence (discussed in a prior D & O Diary post, here), will engender increased collaboration between criminal defendants and the plaintiffs’ bar.

In some respect, Enron and the wave of corporate scandals is still too recent to be certain of all of its legacies and consequences. But there is no doubt that the environment of corporate conduct has been dramatically changed, and there will be no going back.

According to news reports (here), Alan Greenspan recently made public statements critical of the Sarbanes-Oxley Act, apparently telling the Massachusetts Technology Leadership Council on September 24, 2006 that the Act has become a “nightmare” that should be scrapped. Greenspan apparently told the audience that the SOX regulations are hampering business, discouraging risk taking, and driving listing companies to London.

As you might expect, these kinds of remarks from someone as highly regarded as Alan Greenspan have excited considerable commentary (here and here). But by far the most interesting comments about Greenspan’s remarks appear on the While Collar Fraud blog (here), which is maintained by none other than Sam “Sammy” Antar, infamous for his role in the Crazy Eddie criminal securities fraud. Antar was the CFO at electronics retailer Crazy Eddie, which turned out to be one of the largest financial frauds of the 80’s. Sammy’s cousin, Eddie Antar, ultimately pled guilty to securities fraud after his initial criminal conviction was reversed on appeal. Sammy never did time because he testified as a prosecution witness at Eddie’s criminal trial.

In his blog comments and in an October 2, 2006 interview in the Boston Herald (here), Sammy asserts that if Sarbanes-Oxley been in place at the time, his company would never have been able to sustain the wholesale fraud they engineered.

Sammy specifically addresses two aspects of Sarbanes-Oxley as particularly important in preventing fraud. First, he contends that the Sarbanes-Oxley ban on having accountants perform consulting work is important to preventing fraud from going undetected. Antar asserts that because Crazy Eddie’s outside accountants were so grateful for the lucrative consulting work the company gave them, the company was able to manipulate the accountants’ audit work: “Whenever ‘red flags’ came up, they always accepted management’s version of the truth where any reasonable person would not.”

Second, Sammy also asserts that the Sarbanes-Oxley internal control requirements are important in preventing fraud: “Strong internal controls are the most effective means of preventing white collar crime.”

The only part of Sarbanes- Oxley that Greenspan was willing to defend was the Act’s requirement that senior company officials certify the company’s financial statements. Ironically, that also is the one part of Sarbanes-Oxley in which Sammy does not set much store: “Criminals have no problem signing false certification documents in furtherance of crime. It is simply a natural extension of the deceit and lies we use to successfully execute our crime.”

Greenspan may have all the credibility in the world when it comes to markets and the economy. But Sammy’s commentary might be just cynical enough (or realistic enough, depending on your point of view) to be persuasive. I know, I know – the very idea of Antar defending Sarbanes-Oxley against Alan Greenspan is not just crazy, it’s “INSANE!”

Photobucket - Video and Image HostingThe whole Crazy Eddie financial scam has moved into the arena of myth and legend, and even further – into modern cyberspace. Crazy Eddie even has its own page on Wikipedia, here. Among other interesting details in the Wikipedia article is the historical footnote that one of the prosecuting attorneys at Eddie Antar’s first criminal trial was none other than the current Secretary of Homeland Security, Michael Chertoff, who reportedly referred to Eddie Antar as the “Darth Vader of Capitalism.” (The Wikipedia quotation helpfully provides hot links to both Darth Vadar and capitalism, and so we feel compelled to do the same. ) But the reason that Crazy Eddie’s legend endures in the popular imagination is not the criminal fraud, but the store’s manic, iconic commercials, which also live on in cyberspace. The official Crazy Eddie website (here) archives some of the best ones (click on “Crazy Eddie TV Commercials” link in the right hand column — you might want to turn the volume down on your computer first).

Brevity Is the Soul of Wit: Sometimes a short handwritten note says it best, as may be seen here. (Hat tip to the CorporateCounsel.net blog for the link).

Hedge Fund Hardball Update: In an earlier post (here), The D & O Diary commented on the new game of "hedge fund hardball," drawing on a Wall Street Journal article (here, registration required) with that title. As discussed in the prior post, hedge funds are demanding, when the companies in which they invest miss filing their periodic report with the SEC, that the companies either pay the face amount of the debt or pay substantial penalties. A recent ruling by a New York trial court in an action that three hedge funds initiated against BearingPoint demonstrates the risk these actions present.

BearingPoint has failed to file a series of its periodic SEC filings as a result of previously disclosed issues with its internal controls and financial accounting. An indenture trustee, acting on behalf of hedge fund investors holding over 25% of a $200 million subordinated debenture issue, sued BearingPoint alleging that the company’s failure to file the periodic reports breached covenants under the indenture agreement and represented a default. In a September 18 ruling (here), the NY trial court granted summary judgment on the trustee’s behalf, ruling that the company’s failure to file its periodic reports represented a default under the indenture agreement. The court reserved the question of damages for trial.

In its September 26, 2006 8-K (here), BearingPoint outlined the problems that the ruling presents for the company. The company noted that holders of other debt instruments could also try to establish a default and that "there could be material negative consequences on the Company’s other outstanding debt obligations, indemnity agreements…and customer contracts" if the court’s ruling should cause bondholders or parties on these other instruments to seek default or acceleration. The company also announced that due to the uncertainty surrounding the court’s ruling the company was delaying filing its annual report with the SEC. Bearing Point’s shares declined sharply on the news.

The hedge fund plaintiffs’ motives in the action may be gleaned from the comment of one of the hedge fund principals quoted in the September 28, 2006 Washington Post article entitled "Bondholders Seek $21.5 million in Damages from BearingPoint Default" (here, registration required). The hedge fund principal is quoted as saying that "of course, it is just a technical default. But they breached the covenant. We wanted damages due to us as a result of the default." The principal also commented that "it was ludicrous" to suggest that the $21.5 million that the plaintiffs are demanding would hurt the company. (Keep in mind that the hedge fund plaintiffs supposedly own about 25% of the debt issue in dispute, so if that is true the face value of their investment is about $50 million — their demand represents over 40% of the face value of their investment, all for what they concede is a technical default.)

It is pretty clear that the hedge funds are seizing upon technical default to wring money from the company. As noted in The D & O Diary’s prior post, this tactic is of particular concern right now, because the number of companies who have had to delay their filings is at an all-time high, in part due to the number of companies that have had to hold up their filings because of options backdating issues. Even though the BearingPoint lawsuit is only against the company itself and not against any individual defendants, the threat of litigation surrounding these issues, as well as the larger threat of bankruptcy looming in the background, underscores the potential D & O risk these circumstances present. The conflicting interests between the company and its investors creates an environment where accusations of wrongdoing can more easily arise.

The CoporateCounsel.net Blog has a detailed post (here) discussing the legal issues in the BearingPoint case. Hat Tip to the CorporateCounsel.net Blog for the link to the NY trial court ruling.

More About MBOs, Going Private Transactions, and D & O Risk: In prior posts (here and here), The D & O Diary discussed the increased risk of D & O claims arising from the involvement of public company management in private investors’ takeover transactions in the form of "management buy-outs" (MBOs) or "going private" deals. A purported class action lawsuit filed on September 26, 2006 in a Texas trial court (complaint here) against Freescale Semiconductor, its Chairman and CEO, and five other directors, presents an example of the kinds of claims that can arise.

The complaint alleges that the defendants sold the company for inadequate consideration in a transaction "tailored to meet the specific needs of a private equity consortium led by the Blackstone Group," and that the defendants rejected a more richly priced offer from a group led by KKR. The complaint alleges that the agreement with the Blackstone-led consortium imposes barriers to competing bidders, including a $300 million break-up fee if another bidder succeeds. The complaint further alleges that the individual defendants "will reap disproportionate benefits" from the transaction – although the complaint omits any specifics of these benefits. The complaint seeks to enjoin the consummation of the agreement with the Blackstone consortium and to compel the defendants to complete an auction to ensure that the shareholders receive the benefit of the highest acquisition price.

In addition, in a September 21, 2006 8-K (here), Metrologic Instruments announced that two derivative lawsuits have been filed against the company and its board alleging that the consideration shareholders will receive for the planned transaction to take Metrologic private is inadequate. Among the investor participants in the takeover is Metrologic’s founder and CEO. The first of the two complaints alleges that the defendants timed and structured the transaction to allow themselves to capture the benefit of the company’s future business potential without fair consideration to shareholders. The second complaint alleges that the defendants failed to maximize value and that the proposed takeover represents an attempt to engage in a self-dealing transaction.

As The D & O Diary has previously noted, the increasing involvement of private financing in public company ownership give rise to complicated D & O claims possibilities including allegations of conflicts of interest and of wrongdoing. These possibilities represent a growing area of D & O risk.

 

The D & O Diary’s running tally of options backdating lawsuits (which can be found here) has been updated to include new securities lawsuits that have been filed against Meade Instruments and Michaels Stores; a new ERISA action against Home Depot; and several new shareholders’ derivative actions.

With the addition of the new actions, the count of options timing-related securities fraud lawsuits now stands at 19, and new cases are still continuing to arise. Even though the cases are coming in gradually rather than all at once, the total volume is starting to accumulate toward the point where collectively they are starting to look like a more serious problem for the D & O insurance industry. The number of options timing related derivative lawsuits, which now stands at 79, also represents a frequency concern. The count of ERISA related lawsuits stands at 6.

Thanks to alert reader Paul Curley for the Home Depot and Michaels Stores links.

Merck/Vioxx Case Study: A very detailed post on the LawReader.com blog entitled “Merck Insurance Carriers Jump Ship Over Vioxx Diasaster” (here) reviews the enormous burden that Merck faces as a result of the flood of litigation involving its now withdrawn Vioxx drug. The post quotes at length from Merck’s SEC filings regarding the litigation, including, for example, the note that during 2005 Merck spent $285 million (!) defending the various lawsuits, including shareholder lawsuits relating to Merck’s Vioxx disclosures. The post also reviews the various insurance coverages that Merck potentially has available to respond to the litigation, including its directors and officers liability insurance program. The post reports, however, that all of Merck’s insurance may not be available due to disputes that have already arisen with its insurance carriers. The post quotes Merck’s August 7, 2006 SEC filing that “[a]t this time, the Company believes that its insurance coverage with respect to the Vioxx lawsuits will not be adequate to cover its defense costs and any losses.”

The article is quite detailed and very interesting. Thanks to Adam Savett of the Lies, Damn Lies blog for the link to the LawReader.com post.

Options Backdating Seminar: On October 13, 2006, I will be participating on a panel entitled “Directors and Officers Insurance Policies and Coverage for Options Claims,” at the”Stock Options Practices” seminar, to be held at the Marriott Financial Center in New York. The seminar is sponsored by HarrisMartin. Further information about the seminar may be found here.

On September 26, 2006, U. S District Judge Kenneth Hoyt sentenced former Enron CFO Andrew Fastow to six years’ imprisonment, a reduction from the ten-year term to which Fastow had agreed in his January 2004 plea agreement. According to news reports (here and here), apparently among the factors that Judge Hoyt relied upon in support of leniency for Fastow was Fastow’s cooperation with the plaintiffs’ lawyers in the civil litigation arising out of the Enron scandal.

The plaintiffs in the civil litigation have already recovered over $7.3 billion from a host of defendants, including investment banks such as JPMorgan Chase and Citigroup. But the plaintiffs’ lawyers continue to pursue claims against other investment banks, including Merrill Lynch and Credit Suisse First Boston. According to Bloomberg.com (here), Fastow began cooperating with plaintiffs’ attorneys "over three weeks ago," and on the day before Fastow’s sentencing provided them with a 175-page declaration (the declaration can be found here) that supplied a wealth of specific information and documents in support of the plaintiffs’ claims against the investment banks. Among other things, Fastow’s declaration states that:

Certain Enron banks, particularly Merrill, CSFB, RBS, and Barclays, worked to solve certain of [Enron’s] financial problems. We told certain banks our financial objectives and they, in many instances, created solutions utilizing complex financial structures….We paid a premium – in the aggregate, hundreds of millions of dollars – in order to engage in structured finance transactions that contributed to causing Enron to report its financial statements in the desired manner…. My conversation with senior bankers led me to believe that certain banks understood that some transactions were done primarily for generating certain accounting benefits and financial-reporting objectives for Enron.

In exchange for this substantial assistance, plaintiffs’ attorneys and a representative of the University of California (the lead plaintiff in the civil litigation) requested leniency for Fastow at his sentencing. According to Bloomberg.com (here), Retired U.S. District Judge Lawrence Irving, a special counsel to the lead plaintiffs’ firm, told Judge Hoyt, "Andy Fastow is a critical witness for the victims of this fraud…His cooperation could result in the recovery of additional billions of dollars. That opportunity is unprecedented and reason unto itself for leniency." According to the Houston Chronicle (here), Bill Lerach, the lead plaintiffs’ attorney, said "(Fastow) makes it clear for all to see that not only did the Enron banks drive the getaway car in one of the great financial scandals in our nation’s history, but the Enron banks served as the actual masterminds behind the scheme to defraud."

The plaintiffs’ lawyers’ support for Fastow apparently had its effect on Judge Hoyt; in delivering the sentence, Judge Hoyt, according to the Bloomberg.com article, specifically referenced Fastow’s efforts "to not simply right the criminal ship but to right the civil ship."

There may be some who find it unutterably bizarre for the representatives of the injured shareholders to be pleading for criminal sentencing leniency on behalf of one of the architects and main beneficiaries of the scheme that injured the shareholders in the first place. If you can get past that cognitive speedbump, there is the further question about what impact this development may have on future criminal defendants’ behavior. Will they too reach out to the plaintiffs’ bar with an offer to aid the civil case, in exchange for support for leniency at the time of criminal sentencing? If it worked for Fastow, surely it can work for others too? As the WSJ.com law blog put it (here), "are prison sentences the currency with which plaintiffs’ lawyers buy information to help them with their cases?"

It may be that Fastow had uniquely valuable currency to trade. After all, there are very few cases where a criminal defendant can offer information worth billions of dollars of potential civil recoveries. And just think about what that might mean for the plaintiffs’ attorneys’ potential fee recovery — no wonder the plaintiffs’ lawyers felt compelled to ask Judge Hoyt to go a little easy on Fastow. But as Professor Ellen Podgor observes in the White Collar Crime Prof blog (here), does the criminal defendant who is unlucky enough to lack anything to trade, or is merely last in line, have to be condemned to a longer jail term? The D & O Diary notes that there used to be an idea in criminal law that the length of the criminal term was supposed to have something to do with the degree of culpability — not the strength of the criminal defendant’s bargaining position with civil plaintiffs’ attorneys.

In any event, there may be an insurance consideration that could constrain plaintiffs’ attorneys willingness to set up a leniency-support-for-information barter system, at least where the plaintiffs’ attorneys hope to use the information in civil claims against a defendant company or other defendant directors and officers. That is, most D & O insurance policies contain a so-called "Insured vs. Insured" exclusion, that precludes coverage if the action is not (to quote one leading carrier’s form) "totally independent of, and totally without the assistance of" any director or officer of the company. If an insured person within the meaning of the policy is providing substantial information upon which plaintiffs’ attorneys intend to rely in support of claims against other directors or officers or the company, that could be the type of "assistance" that could preclude D & O coverage under the policy. (There is some judicial authority requiring an added element of "collusion" for coverage to be precluded- an added consideration that is worthy of a separate blog post in and of itself.)

So a criminal defendant’s offer to exchange information for leniency support may be a poisoned chalice for the plaintiffs’ attorneys, because accepting it and using the information against other directors and officers could potentially have the effect of precluding D & O insurance coverage. However, the criminal defendant’s information offer might still be attractive to the plaintiffs’ lawyers if the D & O coverage is already blown or out of the picture, or if the offer will aid plaintiffs’ claims against defendants other than the directors and officers or the company. This possibility has to be one of the more unexpected legacies of the Enron scandal.

The D & O Diary finds this idea of information-for-leniency barter with the plaintiffs’ bar pretty damn unsavory, particulary where, as in Fastow’s case, the plaintiffs’ attorneys chances of gaining an enormous fee are substantially advanced by the criminal defendant’s help.

Roll the Tape: Reasonable minds may differ about the appropriateness of Fastow’s six-year sentence, particularly in comparison to the six-year sentence imposed against Jamie Olis, a lower level Dynegy employee who did not personally benefit from his criminal conduct, whose conduct did not destroy the company, but who did have the temerity to insist on his constitutional presumption of innocence and his constitutional right to a jury trial. (See The D & O Diary ‘s post here about Olis’s sentence, and see interesting commentary on the Fastow/Olis sentence comparison here.)

It is worth asking whether it was even appropriate for Fastow to request leniency, or for prosecutors to present evidence of Fastow’s cooperation in support of Fastow’s leniency bid, given Fastow’s testimony at the criminal trial of Ken Lay and Jeffrey Skilling. According to the trial testimony reproduced at length here, Fastow testified — in response to prosecution questioning and in order to rebut Skilling’s lawyer’s suggestion that Fastow was shaping his testimony to curry favor with prosecutors in a bid for a lighter sentence – that the 10-year term to which he agreed in his plea agreement could not be reduced.

In fairness, it should be noted that the prosecutors did not themselves request to have Fastow’s sentence reduced. They did, however, provide information upon which Fastow relied in support of his request for leniency.

 

On September 22, 2006, Judge Sim Lake of the United States District Court in Houston re-sentenced former Dynegy tax executive and lawyer Jamie Olis to six years in prison for securities fraud, upon reconsideration after Olis’s initial sentence of 24 years that had been reversed on appeal. (Press reports of the resentencing may be found here and here.) Both the history of Olis’s sentencing and Judge Lake’s September 22, 2006 sentencing memorandum (here) provide an interesting perspective on the plaintiffs’-style damages calculations that prosecutors urged the Court to use in determining Olis’s sentence.

Olis, along with two other Dynegy executives, Gene Foster and Helen Sharkey, was indicted for an alleged conspiracy to commit fraud; mail fraud; wire fraud; and securities fraud. The essential allegation was that the defendants had engaged in a scheme (“Project Alpha”) to distort Dynegy’s financial statements by disguising a $300 million loan as operating cash flow. Foster and Sharkey pled guilty to conspiracy and cooperated with the government. Olis’s case was tried to a jury in November 2003, and he was convicted on all counts.

Judge Lake originally sentenced Olis to 24 � years in prison. Judge Lake based this sentence on the federal sentencing guidelines, which he viewed as mandatory, and his determination of the pecuniary loss that Dynegy shareholders suffered as a result of the fraud. Olis appealed his conviction and his sentence to the Fifth Circuit. While his appeal was pending, the U.S. Supreme Court issued a ruling that the federal sentencing guidelines are merely advisory and not mandatory. In October 2005, the Fifth Circuit affirmed Olis’s conviction, but vacated his sentence and remanded the case to Judge Lake. In remanding the case, the Fifth Circuit stated that it was unclear whether Judge Lake would have imposed the same sentence if the Judge had regarded the sentencing guidelines as advisory rather than mandatory. The Fifth Circuit also specifically held that Olis’s sentence “overstated” the shareholder loss caused by the fraud.

On resentencing, Judge Lake began his analysis by re-examining the question of the Dynegy shareholders’ “actual loss” from the fraud. (The pecuniary loss from the criminal conduct is a factor for courts to consider under the federal sentencing guidelines.) In making this determination, Judge Lake, following Fifth Circuit precedent, relied upon “applicable principles of recovery of civil damages for securities fraud.” In other words, even though the context was a criminal sentencing, Judge Lake relied upon principles of civil damages calculations, so his comments about those principles are relevant in both contexts.

In support of their argument that Dynegy’s shareholders loss from the fraud was in the range of from $161 million to $714 million, the prosecutors relied on the testimony of an economic expert, Frank Graves of the Brattle Group. Graves used an “events study” to determine the per-share inflationary effect to Dynegy’s share price as a result of Project Alpha. Graves then used two alternative models to estimate the number of shares that were damaged, the proportional trader model and the two-trader model. Using these assumptions, Graves estimated the range of shareholder damages from $161 million to $714 million. Olis’s attorneys, supported by a former SEC Commissioner and Stanford Law Professor Joseph Grundfest (who was acting pro bono on Olis’s behalf and who testified at Olis’s two-day resentencing hearing), argued that Graves’s analysis failed to account for Dynegy’s numerous other negative announcements unrelated to Project Alpha and relied on numerous unproveable assumptions. (A copy the sentencing memorandum submitted on Olis’s behalf, including Grundfest’s written declaration, is bookmarked here.) After a lengthy review of the economic analyses, Judge Lake concluded that “it is not possible to estimate with any degree of reasonable certainty the actual loss to shareholders attributable to the corrective disclosures.”

Because Judge Lake could not determine the “actual loss” to shareholders, he instead looked to the “intended loss” of the defendants’ conduct. There had been trial testimony from one of the cooperating defendants that the defendants had intended that Project Alpha would avoid $79 million in federal taxes. Using this “intended loss” figure and taking into account a number of mitigating circumstances (including specifically the fact that Olis had not intended to profit personally from Project Alpha), Judge Lake resentenced Olis to 6 years’ imprisonment. Olis has already served two years and four months in prison, so he could be out of prison by May 2010, or earlier for good behavior.

Judge Lake’s rulings in Olis’s resentencing are significant in several respects. First, his reasoning and analysis carry important implications for Jeffrey Skilling, whom Judge Lake is scheduled to sentence on October 23, 2006. As discussed in detail on the White Collar Crime Prof blog (here), many of the mitigating factors that Judge Lake considered in Olis’s case are absent in Skilling’s, and Judge Lake’s remarks could be interpreted to suggest by implication that Skilling may face the prospect of a much more severe sentence. (The White Collar Crime Prof blog suggests that Skilling may face more than 20 years’ imprisonment and a fine of $400 million.)

Judge Lake’s rulings are also important for his analysis of the plaintiffs’-style damages calculation. The Judge explicitly relied on principles of civil case damages analysis in his attempt to calculate the Dynegy shareholders’ “actual loss.” The prosecution’s expert used analytic tools that plaintiffs’-style damages experts often use to estimate the purported loss of the shareholder class in civil securities fraud actions. So the fact that Judge Lake concluded that the prosecution had not established the actual loss with reasonable certainty, using these standard analytic tools, has potentially important implications for the credibility of these tools in civil cases.

To be sure, Judge Lake was very careful to note that his conclusion was based “on the facts of this case; it is not a conclusion that such estimates are never possible.” These are the words of a careful judge who is taking pains to try to limit the effects of his analysis to the case before him. But the reality is that the defense objections to the prosecutor’s experts analysis are equally applicable to the plaintiffs’ experts’ analysis used to calculate purported shareholder damages in many civil securities fraud cases. (Professor Grundfest’s devastating critique, which is linked above, while keyed to the facts of the case, would apply at the theoretical level to the damages analyses in most civil securities cases.) And the bases for Judge Lake’s conclusion that the methodologies used did not produce a calculation of the shareholders’ actual loss with reasonable certainty are equally applicable as well.

A variety of causes conspire to ensure that securities fraud lawsuits almost never go to trial. One consequence is that many of the standard tools in the plaintiff’s lawyers’ toolkit have rarely been subjected to judicial scrutiny. This is particularly true with respect to plaintiffs’-style damages calculations, which plaintiffs’ lawyers use to produce highly inflated estimates of purported shareholder damages. Plaintiffs’ lawyers use the calculations as a basis upon which to try to extract enormous settlements, with some effectiveness. (Indeed, the Dynegy/Project Alpha civil action settled for more than $474 million.) Yet both the damages calculations themselves and the calculations methodologies are largely untested by judicial scrutiny. Judge Lake’s ruling in the Olis resentencing suggests that were the plaintiffs’ style damages calculation more regularly subject to judicial scrutiny, many inflated damages estimates might not survive. Even though it is within the criminal context, Judge Lake’s opinion may provide some ammunition to use against the plaintiffs’-style damages calculation. Judge Lake’s reasoned opinion and the outcome of his analysis also suggest that scrutiny of the plaintiffs’-style damages calculation may be long overdue.

The D & O Diary is interested in its readers comments on the Olis resentencing and its possible implications, particulary those who may disagree with my views about the shareholder damages calculation.

A Note of Concern About Olis’s Sentence: Even though Judge Lake significantly reduced Olis’s sentence, Olis’s sentence still stands in contrast to the lighter sentences that his co-defendants received. Gene Foster, who was Olis’s boss, received a sentence of only 18 months, and the third defendant, Helen Sharkey received a sentence of only one month. It is hard to avoid the impression that the other two defendants received a lighter because they entered guilty pleas, but that prosecutors sought a heavier sentence for Olis because he insisted on going to trial. As Professor Ellen Podgor writes in the White Collar Crime Prof blog (here):

a question that definitely needs to be considered and addressed by Congress and the courts is whether the government should have this enormous prosecutorial power to leverage individuals against each other in order to obtain evidence for a prosecution on the individual who decides not to enter a plea. Is it within the bounds of the Constitution to punish individuals with higher sentences because they decide they want to use their constitutional right to a jury trial?

The September 25, 2006 issue of the Washington Post has an interesting and thoughtful article entitled “Cook the Books, Get Life in Prison: Is Justice Served?” (here, registration required) discussing the problem of calibrating sentences for white collar criminals


Hats Off to Joseph Grundfest: I have never had the honor of making Professor Grundfest’s acquaintance. I do know the high esteem in which he is held in the securities industry and the legal community generally. I can only imagine the demands on his time, and the opportunities he has to advance his own professional and monetary interests. The defense of a convicted white collar criminal is not a popular cause in the post-Enron, Sarbanes-Oxley world. The fact that he would take the time, burden and responsibility to become involved on a pro bono basis in Olis’s resentencing is truly impressive. Professor Grundfest, The D & O Diary salutes you.

The D & O Diary has previously written (here and here) about the recent revival of the Foreign Corrupt Practices Act (FCPA) and the potential implications for D & O risk. PricewaterhousCoopers’ Summer 2006 Solutions newsletter (here) has an interesting article entitled “ABB Ltd and the Foreign Corrupt Practices Act” taking a closer look at the FCPA problems at one particular company – ABB Ltd., the Switzerland-based energy engineering and construction company whose ADRs trade on the NYSE.

The article first reviews the 2004 enforcement proceeding against ABB, involving allegedly improper payments ABB subsidiaries made between 1998 and 2003 in Nigeria, Angola, and Kazakhstan. ABB ultimately consented to a judgment (without admitting or denying the allegations) enjoining the firm from future violations and requiring it to pay $5.9 million in disgorgement and a $10.5 million penalty. The article then reviews three subsequent incidents where ABB itself identified and self-reported possible additional FCPA violations involving suspected improper payments in Africa, Europe and the Middle East. The article comments that “[t]he continuing series of discoveries of suspected payments, disclosures to the SEC and DOJ (and the market) and ensuing internal control investigative results… raise questions about the control environment; imply that ABB’s compliance controls are inadequate; tarnish the Company’s reputation; and expose ABB to possible substantial fines and penalties.”

The article concludes with the observation that FCPA compliance is “on the SEC’s radar screen, and more cases like ABB are very likely to come. The hard lessons learned by ABB ought not to go unnoticed or unheeded by other global companies.” The article merits reading in its entirety.

A Further Commentary on the “Milberg Effect”: In a prior post (here), The D & O Diary added its observations on the Wall Street Journal’s editorial (here, subscription required) about the “Milberg Effect,” that is, the impact that the indictment of the Milberg Weiss firm is having on the declining number of securities fraud lawsuit filings. A recent post (here) by plaintiffs’ attorney Adam Savett on his Lies, Damn Lies blog provides an interesting additional perspective on the apparently declining number of securities fraud lawsuits. Savett suggests that “the number of federal securities class actions has potentially slowed because a substantial portion of the plaintiffs’ bar is busy filing other types of securities cases, including state and federal derivative actions.” This is an observation that The D & O Diary has also made (here), but the fact that this observation is coming from a member of the plaintiffs’ bar makes it more interesting.

Options Backdating Litigation Update: Perhaps the most obvious proof that the plaintiffs’ bar is concentrating on filing shareholders’ derivative lawsuits rather than securities fraud lawsuits is the pattern of lawsuit filings arising out of the options backdating scandal. As shown in The D & O Diary’s running tally of the options backdating litigations (which may be found here, and which was recently updated to add several new derivative lawsuits) only 17 companies have been sued in securities fraud lawsuits, but 78 companies have been named as nominal defendants in shareholders’ derivative lawsuits. Clearly, the plaintiffs’ bar is showing a preference for the derivative lawsuit, at least with respect to options backdating litigation.