As has been noted previously on The D & O Diary (here), a recent study by Cornerstone Research (here) shows that the number of YTD 2006 securities fraud lawsuit filing is down significantly from a year ago. The decline in lawsuit filings is so significant that it almost begs the question: when is D &O pricing going to go down in response to the declining number of suits?

I know my many friends in the D & O underwriting community are thinking, how much further can rates go down? But the reality is that while current pricing is below 2003 levels, it remains well above 2000-01 levels. So The D &O Diary asks the question: should rates be going down further in response to the declining securities fraud lawsuit filings?

It must be conceded that in the very asking of the question there is an unstated premise that should be examined and not merely assumed – that is, that the current reduced level of securities litigation activity represents a secular and not merely a cyclical trend. For those of us who have lived long enough, there is a certain familiarity to the current circumstances. It was just ten years ago, in 1996, just after the enactment of the Private Securities Litigation Reform Act, that securities lawsuit filings were as low as current levels. (See the chart on the Stanford Clearinghouse website, here.) At that time, several carriers acted in response to the apparently lower level filing rate levels and reduced their D & O rates. That set off a price war that reduced pricing to much lower levels- just as an unprecedented wave of new securities filing began to hit the courts. The ensuing blood bath amongst D & O carriers continues to stain the industry’s balance sheets. So if the D & O industry has any memory at all (and also has enough fortitude to conform its actions to its experience, a highly dubious proposition), carriers will hesitate before reducing pricing based upon the current securities filing levels.

There is yet another unstated premise in the question, which is that D & O claims frequency drives D & O pricing. This one seems like a rather logical presumption, but analysis by David Bradford at Advisen discussed at the recent PLUS D & O West Symposium shows that D & O pricing only loosely correlates with D & O claims experience — the most significant factor in determining D & O pricing is insurers’ general level of policyholder surplus (key slides here and here). As it happens, surplus levels are quite high, and likely to go higher if the current mild hurricane season continues. So D & O pricing may indeed decline further in the short term, but if it does, it will have more to do with the fact that the wind didn’t blow this year than with the fact that securities filings are down.

The carriers’ typical response when confronted with the fact that filings are down is a statement that even if frequency is down, average severity is up. Indeed, the annual surveys by all the major consultants that follow the issue show that average securities fraud lawsuit severity has been rising steadily over the last few years (here). The claims settlements that are contributing to the current high severity levels are the sad remnants from the stock market collapse earlier in this decade. The plaintiffs’ style damages calculations in those cases run into the billions of dollars (or in the case of the Cicso Systems securites case that recently settled for more than $ 90 million, into the hundreds of billions of dollars). The magnitude of the purported shareholder loss in those cases makes most of those cases categorically different from the cases that are filed under post-bubble market conditions. More importantly for pricing purposes, these prior accident year claims loss levels arguably have slight predictive power for the likely losses that will accrue in current and future accident years. Continued reference to the post-collpase cases isn’t just driving the car by looking in the rearview mirror (a predilection to which insurers are particularly susceptible), it is trying to drive the car by reading the newspapers from several years ago.

That said, there are other claims-related factors to which carriers more justifiably might refer when contending against the arguments for further price declines. First, securities lawsuit filing rates may be down, but that does not mean that overall D & O claims activity levels are down. In particular, the number of derivative lawsuits is up. A significant shift has occurred in D & O lawsuit filings, away from securities fraud lawsuits and toward shareholders’ derivative lawsuits. This shift may be seen in the lawsuits relating to options backdating. That is, though relatively few companies with options timing problems have been sued in securities fraud lawsuits (16 at last count), over 75 companies have been sued in derivative lawsuits. (For a running count of options backdating lawsuits, see The D & O Diary’s tally, here) Second, there are a variety of forces beyond just options backdating that are contributing to increased numbers of derivative lawsuits ; as The D & O Diary has noted in prior posts (here and here), activist hedge funds are pursuing litigation as part of their overall strategy, management buy-outs are creating conflicts of interest between management and their companies (see here), private equity funds are seeking disproportionate advantages which gives rise to conflict of interest (refer here), and boardroom turmoil is creating a hostile environment in which accusations of wrongdoing more easily can arise (refer here). All these factors are all contributing to increased numbers of shareholders’ derivative lawsuits. The increased number of derivative lawsuits means increased claims frequency exposure at least for primary insurers, and arguably for excess carriers as well given rising defense fee expense and increased derivative settlement levels in recent months.

In addition, there are a variety of developing threats that also could make it precarious to conclude that the current reduced level of securities lawsuits means that overall D & O risk can be presumed to be below historical levels for all purposes. As The D & O Diary has noted (here and here) increased activity levels under the Foreign Corrupt Practices Act present a worrisome new source of D & O risk. A similar observation might be made about the Sarbanes Oxley whistleblower provisions, the Pension Protections Act of 2006 (which together with new FASB requirements that begin phasing in at the end of this year and that c0uld involve new levels of accounting risk). The unfolding of the options backdating scandal is far from complete. These factors and the ever present threat of a change in legislation or case law, makes it very dicey to predict with confidence that overall D & O risk is and will remain down.

So when it comes to D & O risk, the current case for and against further D & O pricing declines is decidedly mixed, notwithstanding the YTD 2006 decline in securities lawsuit filings. A more definitive claims-based view of the evolving D & O risk will only be possible in the fullness of time. The bottom line for now seems to be that if D & O pricing declines further in the short term, it will more likely reflect overall industry policyholder surplus levels rather than any categorical changes in the D & O risk. That said, if securities fraud lawsuit filing rates continue at current lower levels, carriers will undoubtedly face increased pressure to lower their rates.

A continuing debate surrounding the Sarbanes-Oxley Act has been the extent to which the Act may be discouraging foreign companies from listing their shares on U. S. securities exchanges. (Prior D & O Diary post on the topic may be found here and here.) Enforcement activity against foreign issuers undoubtedly will influence the relative attractiveness of U. S. exchanges to foreign companies. In that connection, it is important to note that the SEC has reached a settlement of what press reports (here) have called the SEC’s first enforcement lawsuit against a foreign company under the Sarbanes-Oxley Act.

On September 14, 2006, the SEC announced (here) a settlement of an enforcement action that it had filed against TV Azteca, S.A., a Mexican domiciled company, several related companies, and two TV Azteca officials, Chairman Ricardo Salinas Pilego and former CEO Pedro Padilla Longorio. According to press reports (here), Salinas Pilego is a Mexican media tycoon and a billionaire. Under the settlement, Salinas Pilego agree to pay $7,500,000 and Padilla Longorio agreed to pay $1 million to establish a Fair Fund (under Section 308 of the Sarbanes Oxley Act) to compensate affected investors. According to the company’s announcement (here), the settlement “does not involve economic consequences for TV Azteca.”

The SEC filed its enforcement action (here) in January 2005, in connection with TV Azteca’s cellphone unit. A company owned by Salinas Pliego and a partner bought debt issued by the cellphone unit at a discount. The debt subsequently was redeemed at face value, permitting Salinas Pilego and his partner to make $109 million profit. Salinas Pilego did not reveal his involvement with the debt until it came to light following the resignation of TV Azteca’s U.S. law firm, which told the company’s board of directors and management that it was resigning consistent with its obligations under Section 307 of the Sarbanes Oxley Act. Salinas Pilego and Padilla Longorio were alleged to have schemed to conceal Salinas Pilego’s involvement with the debt.

Within the last few days, we have witnessed the feuding, dysfunctional H-P Board struggling with the turmoil and adverse publicity arising from its flawed investigation of media leaks. Last week we also saw the forced ouster of Bristol Myers Squibb CEO Peter Dolan. These events follow the removal of the CEOs of some of the country’s largest companies, including Walt Disney, Fannie Mae, Pfizer, American International Group, Merck, and others. These events not only involve the potential for board turmoil, distraction and adverse publicity, but increasingly also present the possibility of D & O litigation.

For example, late last week, Bill Lerach of the Lerach Coughlin firm filed a shareholders’ derivative suit against the H-P Board, accusing the Board (and its general counsel, as well as it purported outside investigative service) of breaches of fiduciary duties, abuse of control and waste of corporate assets, as part of an alleged campaign to entrench themselves and to punish or diminish the power of ousted directors. A copy of the complaint can be found here. The lawsuit not only seeks corporate remediation, but also seeks recovery for the "enormous" costs and burdens the company has sustained to deal with the crisis created by the revelations of the Board’s investigation. Significantly, the complaint against the H-P directors seeks to compel the recovery from the defendants of the company’s costs without their recourse to indemnity or insurance, even for the costs of defending the derivative litigation. A September 15, 2006 Law.com article discussing the H-P complaint can be found here.

Nor is H-P’s situation the only boardroom dispute that has resulted in D & O litigation. For example, at Atmel, five independent board members (representing private equity fund investors) worked together to bring about the August 5 firing of company founder and CEO George Perlegos, as well as three other executives, for alleged misuse of corporate travel funds. Perlegos responded by filing a lawsuit against the board, arguing that his ouster was illegal because he had already called a shareholder meeting in order to remove the five independent directors. His lawsuit argues the directors should be removed because "the hasty, secretive, and precipitous manner in which they acted…will have devastating consequences for the Company, including but not limited to the loss of the [ousted executives’] decades of experience running the company and a significant loss of shareholder value." News report discussing the Atmel litigation can be found here and here.

These boardroom disputes and the others identified above are a result of a variety of factors. The increased presence and activism of independent directors, who are less inclined to take their cues from company management, is a direct result of Sarbanes-Oxley reforms and is clearly a factor in the newly contentious board environment. Regulatory and investigative pressures are also important factors. For example, the removal of AIG’s and Bristol Myers Squibb’s CEOs were a direct result of investigative pressures. Increased shareholder activism, including the pressure of activist hedge funds and other private equity investors, also is a contributing factor. (For a prior D & O Diary posts discussing the litigation threat of activist hedge funds, click here and here.)

All of these factors are contributing to an increasingly hostile boardroom atmosphere. This atmosphere not only presents a challenge for corporate boards, but also represents an environment where allegations of wrongdoing can more easily arise. These allegations of wrongdoing inevitably will make their way into the courtroom, and so the newly contentious boardroom environment represents a potentially significant source of increased D & O claims exposure.

On Saturday, September 16, 2006, articles appeared in Wall Street Journal (here, subscription required) and in the Washington Post (here, registration required) discussing the new hostile environment for corporate boards.

Silicon Valley Connection: The shareholders’ derivative complaint filed against the H-P Board take particular aim at the Board’s continued reliance on the outside counsel, the Wilson Sonsini law firm, on whose advice the company relied in connection with the investigation, the board disputes arising out of the investigation, and the company’s disclosure of the investigation and the board’s disputes:

[E]ven though they were facing a matter with grave implications for the corporation, [the Board] did not seek independent legal representation or advice. Worse yet, they actually relied on the advice of the law firm that was implicated in the conduct to be evaluated. Because Sonsini of Wilson Sonsini had been intimately involved in advising the Board and its Chair regarding the investigation that had taken place, the law firm knew or should have known of the dubious legality of the investigatory tactics being used and yet had advised the Board …that the investigatory tactics being used were not unlawful and advised HP to not disclose why [Perkins, a Board member who resigned, had actually resigned.]

The Complaint goes on to allege that a demand upon the Board to bring legal action would be futile because "Wilson Sonsini and Sonsini continue to be the primary outside counsel for the Company regarding these matters and obviously, since Wilson Sonsini and Sonsini are conflicted and would be key witnesses and possible defendants in any ultimate legal action, they will advise the Company not to pursue legal action or conduct a vigorous independent investigation into matters that will embarrass the law firm, further implicate the law firm, or expose the law firm to financial liability."

Nor is the H-P lawsuit the only source of legal scrutiny facing the Wilson Sonsini firm from the H-P board investigation. According to news reports (here and here), Larry Sonsini is among the witnesses requested to appear to testify before a Congressional panel looking into the H-P board’s investigation of media leaks. The Oversight and Investigations Subcommittee of the House Committee on Energy and Commerce will be holding September 28, 2006 hearings on the matter. Several witnesses, including Sonsini, have been sent letters requesting them to notify the committee on or before September 19, 2006, whether they will appear voluntarily. The attorney-client privilege and Fifth Amendment privilege issues that this congressional investigation might present are discussed in this post on the White Collar Crime Prof blog, here. The WSJ.com law blog also has an interesting post here discussing the swirl of activity surrounding Sonsini.

The H-P derivative lawsuit is far from the only salvo that Lerach has launched against the Wilson Sonsini firm recently. As noted in a prior D & O Diary post (here), Lerach has opposed efforts to dismiss the shareholders’ derivative suit pending against Mercury Interactive based on an alleged conflict of the Wilson Sonsini firm — Wilson Sonsini represents one of the defendants in the Mercury Interactive suit, and is also outside counsel for H-P, which is acquiring Mercury Interactive.

When asked who he thinks will defend the H-P Board in the shareholders’ derivative suit he filed, Lerach responded that "I bet it won’t be Wilson Sonsini."

 

On September 12, 2006, the Wall Street Journal carried an editorial entitled “The Milberg Effect,” (here, subscription required) commenting on the possible impact of the Milberg Weiss indictment on the decline in the number of securities lawsuits in 2006. (To see the Cornerstone Consulting data about the decline, refer here.) The Journal editorial incorporated a bit of dodgy math projecting the likely year-end 2006 number of securities lawsuits and attributing the entire projected annual decline to the Milberg firm’s reduced filing activities. The editorial itself has been the subject of some criticism in the blogosphere. Both the Securities Litigation Watch (here) and the 10b-5 Daily (here) criticized the editorial for failing to account for the fact that multiple law firms usually target each company that is sued, so that the Milberg firm’s reduced activity alone could not be the sole cause of the reduced number of securities lawsuits in 2006.

The D & O Diary does not dispute these honorable fellow bloggers’ commentaries on the Journal editorial. Indeed, when the Milberg firm this week announced (here) what is its first new lawsuit since the firm was indicted in May 2006, the company it sued (IMAX) had in fact already been sued by multiple other law firms. (Refer here for a law firms that previously sued the company).

There are undoubtedly multiple reasons behind the decline in the number of lawsuits. (It is possible that improved corporate behavior is one of the important causes, although The D & Diary has its doubts, as discussed in a prior post, here.) But even conceding the criticisms of the Journal editorial, the D & O Diary believes that the Milberg indictment nevertheless has had an important impact on the decline in number of securities lawsuits.

As The D & O Diary noted previously noted (here), the most important fact to take into account in assessing the possible reasons for the decline is the fact that the decline began in September 2005. The significance of the date is that that is the same month that the grand jury that ultimately indicted the Milberg firm and two of its partners returned its first indictment. That first indictment was filed against Seymour Lazar, who was later named in the Milberg indictment as one of the paid plaintiffs that the Milberg firm allegedly maintained in order to be able to quickly file lawsuits when companies announced bad news. The D & O Diary poses the question (previously discussed at greater length in its prior post, here) whether or not it is a coincidence that the number of lawsuits began to decline immediately after the Lazar indictment. Could the Lazar indictment have communicated to the entire plaintiffs’ bar that the grand jury investigation was serious and that the practice of paying people to act as paid plaintiffs had to be abandoned immediately? Is the significance of the Milberg indictment not limited to its effect on the law firm itself, but does it perhaps reach to the activities of the entire plaintiffs’ bar? The D & O Diary wonders whether the reason that the number of lawsuits has declined since September 2005 is because the lawsuits that depended on the availability of paid plaintiffs are no longer being filed.

For an interesting study (with pictures) of one of the alleged paid plaintiffs named in the Milberg indictment, see this prior D & O Diary post (here) -scroll down the page to view the entry regarding the paid plaintiffs.

Options Backdating Litigation Update: The D & O Diary’s running tally of options backdating lawsuits (which may be found here) has been updated to incorporate the shareholders’ derivative lawsuits that have been filed naming Affymetrix (here), Bed Bath & Beyond (here), Cable Vision Systems (here) and Par Pharmaceuticals (here) as nominal defendants. The addition of these lawsuits brings the number of companies named in options timing related derivative suits to 75. The number of companies named in securities fraud lawsuits stands at 16.

Special thanks to Bill Ballowe for the link to the Bed Bath and Beyond lawsuit.

The world of directors’ and officers’ liability often seems as if it is in a state of constant change — and it is no wonder, because so many factors affect it: legislation, litigation, volatile securities markets, and the ever-changing global economy. With so many shifting factors and varying dynamics, it can sometimes be difficult to isolate trends and identify their significance. This difficulty is exacerbated when there is a single issue that, like the current options backdating scandal, is dominating the headlines. In a September 2006 Insights article (here), I identify four current trends in the world of D&O and comment on their significance. While some of these trends may not yet be in the headlines, they represent important developments in the D&O arena.

To see prior issues of Insights, click here.

 

In recent days, there has been extensive media attention (here and here) focused on the fact that plaintiffs’ lawyers seeking to exploit the options backdating scandal are filing shareholders’ derivative suits in preference to securities fraud class action lawsuits. Indeed, The D & O Diary’s running tally of options backdating lawsuits (here) shows that only 16 companies have been named in securities fraud lawsuits, but over 70 companies have been named as nominal defendants in shareholders’ derivative lawsuits. But while the observation that plaintiffs’ lawyers are preferring shareholders’ derivative lawsuits appears to be valid, this observation does not explain why plaintiffs’ lawyers are so eager to file derivative lawsuits. Traditionally, derivative lawsuits have not been nearly as lucrative for plaintiffs’ lawyers as securities fraud suits. So why are plaintiffs’ lawyers preferring derivative lawsuits in connection with the options backdating scandal?

It may be supposed that recent trends in other recent derivative lawsuits’ recoveries makes these suits more attractive to plaintiffs’ lawyers now than perhaps they were in the past. The derivative lawsuit filed against the Hollinger board resulted in a $50 million settlement (here) – funded entirely by D & O insurance – and the Oracle derivative settlement resulted in Larry Ellison’s payment of $100 million to charity, as well as his payment of the company’s $22 million attorneys’ fees. In addition, the existence of a derivative lawsuit was a "substantial factor" in the payment of $200 million in settlement of various litigation against AOL Time Warner. But there need to be numerous caveats around the purported value of the AOL Time Warner derivative settlement (see the prior D & O Diary post concerning the AOL Time Warner settlement here) and the Oracle settlement with its payment to charity rather than to the company requires a very big asterisk (and is probably a worthy topic of a separate post). The Hollinger settlement may be more apposite, but it may also represent an extreme case.

Whether or not these other settlements represent a trend that might be increaing plaintiffs’ lawyers interest in filing shareholder derivative suits, the derivative lawsuits brought in connection with options timing allegations appear subject to numerous defenses or other practical limitations. To name but a few of the defenses and limitations:

Standing: For many of the companies involved in the backdating scandal, the period during which the alleged misdating took place covers a large swath of time, in some cases going back to the early or mid 90’s. In order to have sufficient standing to pursue the derivative suit, a shareholder plaintiff will have to show continuous share ownership, at the time of the alleged wrongdoing as well as the at the time of the lawsuit. Some putative plaintiffs may satisfy this requirement, but not many, and most of the plaintiffs in whose name the options lawsuits have been brought lack the requisite standing (and for an additional comment about standing, see the note below about the Mercury Interactive shareholders’ derivative lawsuit);

Statute of Limitations: The statute of limitations under Delaware law for shareholder derivative suits is three years. Shareholders’ claims for alleged options timing misconduct more than three years’ prior to the spring or summer 2006 (when most of the lawsuits were filed) may well be time barred. Plaintiffs’ lawyers undoubtedly will seek to circumvent this bar by alleging concealment or some other excuse to stay of the limitations bar, but the whole point of a limitations statute is to avoid trying events from the distant past. The limitations period may well prove a substantial bar to many of the plaintiffs’ claims.

Demand Requirement: In the race to the courthouse that followed the media frenzy surrounding the options backdating scandal, many of the plaintiffs’ lawyers disregarded the derivative lawsuit filing prerequisite that the plaintiffs first demand that the board pursue the lawsuit on the corporations’ behalf or present allegations to show why demand would be futile. The demand requirement is substantial and cannot be circumvented by mere conclusory allegations of futility; the plaintiff must plead with particularity why a majority of the board lack sufficient disinterest to consider the demand. This should be a particular burden in the many cases where the directors did not themselves benefit from the options timing. Moreover, where (as in most cases) the plaintiffs filed their suits without first pursuing a books and records request to obtain requisite factual information as a basis for their claim, a
dismissal based a failure to meet the demand requirement will be with prejudice;

Exculpatory Clause: Most corporations have adopted an exculpatory clause in their corporate charter, as permitted under Delaware law, precluding liability against the directors for breach of fiduciary duty except upon a showing of bad faith or disloyalty. Liability for mere breaches of the duty of care is waived under these exculpatory provisions. In most cases, the boards of directors of companies caught up in the backdating scandal were simply unaware of the backdating, and therefore allegations of wrongdoing amount to no more than alleged breached of the duty of care, the liability for which is precluded under the exculpatory clause.

To be sure, there are some companies with respect to which more substantial or active wrongdoing is alleged, and with to respect to which the derivative claim may be more substantial and perhaps potentially more lucrative for the plaintiffs’ lawyers. But these claims amount to no more than a very small handful; almost all of the derivative complaints that have been filed are subject to the above defenses and other substantial defenses and limitations. It remains to be seen whether the flood of derivative lawsuits raising options timing allegations produces substantial value for the corporations on whose behalf the lawsuits have been filed, or for the plaintiffs’ lawyers who filed the lawsuits. But the number and strength of the potential defenses makes the D & O Diary wonder: why are the plaintiffs lawyers filing all these derivative suits?

The D & O Diary is interested in readers’ comments about the potential merits of the shareholders’ derivative options backdating lawsuits.

Unique Standing Defenses in the Mercury Interactive Derivative Lawsuit: Among the companies involved in the options backdating scandal is Mercury Interactive, which also was named as the nominal defendant in a shareholders’ derivative lawsuit brought by the Lerach Couglin firm. On July 25, 2006, while the derivative lawsuit was pending, Mercury Interative announced its acquisition by Hewlett-Packard. According to a September 11, 2006 story on Law.com entitled "H-P Deal May Kill Mercury Suit" (here), one of the individual defendants (who is represented by the Wilson Sonsini firm) has filed a motion to dismiss based on the argument under Delaware law that as a result of the H-P acquisition, the plaintiffs lack standing to assert the claim against the individual defendants. The only way the case can continue is if H-P decides to take it up on its own. The story has a definite "clash of the titans" feel to it, because the Lerach firm’s response to the motion to dismiss is to contend that because of the Wilson Sonsini’s firm’s alleged involvement in the H-P board’s brouhaha about its own Board investigation, Wilson Sonsini is or ought to be precluded from being involved in the Mercury Interactive lawsuit. Lerach’s arguments based on the Wilson Sonsini firm’s role with H-P probably indicates nothing so much as that the motion to dismiss is almost certainly meritorious, as mergers of this type generally divest plaintiffs of standing under Delaware law.

Thanks to Adam Savett of the Lies, Damn Lies blog (here) for the link to the Law.com article. (The comments about the case are strictly my own.)

Options Backdating Litigation Tally Update: The D & O Diary has updated its options backdating litigation tally (here) to add the new securities fraud class action lawsuit that has been brought against Aspen Technology (here). The addition of the Aspen Technology lawsuit brings the number of securities fraud lawsuits based on options timing allegations to 16. In addition, the number of companies sued in shareholders’ derivative lawsuits is now stands at 71, with the addition to the lawsuit against Home Depot (here), THQ (here), and Witness Systems (here).

Request for Information: As previously noted on The D & O Diary (here), Lynn Turner, the former Chief Accountant at the SEC and now a managing director at Glass Lewis, testified on Capitol Hill on September 6, 2006. As part of his written testimony (here), Turner attached an appendix that listed the companies involved in the options backdating investigations. A column on the appendix purported to identify the companies that have been named in options backdating shareholder suits (but not differentiating between securities fraud suits and shareholders’ derivative suits). There were some companies that were not identified in Turner’s exhibit as having shareholder suits that have in fact been sued (e.g., Mattel), and there were others identified as having been sued that The D & O Diary simply cannot independently corroborate as having been sued. The companies that Turner lists as having been sued for which The D & O Diary can find no corroboration are: Amkor, Blue Coat, Boston Communications, Dot Hill, Molex, and Newpark Resoureces. Most if not all of these six companies have shown up on various plaintiffs’ law firms’ press releases as being "under investigation" but as far as I have been able to determine they have not actually been sued. The D & O Diary would greatly appreciate it if its readers could provide any further corroboration about the existence of lawsuits against these companies — or any others that do not appear on The D & O Diary’s list of options backdating lawsuits.

Special thanks to Michael Miraglia for a link to the Turner testimonial exhibit and to Bill Ballowe for his help in locating options backdating lawsuits.

 

The D & O Diary has written on several prior occasions (here, here and here) about the increasing D & O risk arising from the public company involvement of private fund investors, such as private equity funds, hedge funds and buy-out firms. In a prior post (here), The D & O Diary discussed the increased complexity arising from the involvement of public company management in private investors’ take overs, in the form of "management buy outs"(MBOs). In a September 8, 2006 article entitled "In Some Deals, Executives Get a Double Payday," (here, subscription required) the Wall Street Journal focused on the conflicts of interests that can arise when management becomes involved in "going private" buy-outs of public companies; the article noted that private-equity firms will team up with management to improve their take-over bid, and that the private investors sweeten the deal by providing management with significant financial inducements:

In such cases, management with all its detailed knowledge of the company, goes from being a seller striving for a higher price to being a buyer looking for an attractive price. Usually the sale of a public company involves an auction or a competitive-bidding process. But when management joins private-equity buyers, there often isn’t such an open procedure, and the process is especially fraught with potential conflicts of interest.

The Journal article emphasizes that the conflict is all the more abrupt when private investors offer management lucrative compensation packages that could permit management to benefit significantly if the buy-out is successful. The compensation can involve ownership participation and substantial performance bonuses.

While many boards actively review the takeover proposals, the take-over bidder will also attempt to skew the process in their favor, for example by telescoping the period where the bid remains open, forcing potential rival bidders to act on short notice. Potential bidders (who do not enjoy the support of management, but who may present a proposal that is more to shareholders’ benefit) also may face a prohibitively high "break up" fee to try to get rid of the original bidder.

As may be expected, shareholders "sometimes revolt against such largess" as company management stands to gain in the buy-out transaction. The article cites the lawsuit Petco Animal Supplies shareholders filed in August 2006 against the company’s directors based on the directors’ "attempts to provide certain insiders and directors with preferential treatment in connection with their efforts to complete the sale of Petco" to private equity investors. A more detailed description of the Petco transaction, including the company’s decision to go with the management led bid even though the rival bidder offered shareholders a 13.3% higher proposal, and including a more detailed description of the lawsuits (and the substantial benefits that management stands to gain if the original bidder successfully completes its buyout), can be found here.

As The D & O Diary previously has noted, the increasing involvement of private financing in public company ownership creates an environment where conflicts of interest — and accusations of wrongdoing — can more easily arise. These claims possibilities also present an enormously complicated D & O exposure environment. These considerations also make it more important than ever for companies to involve knowledgeable and experienced insurance professionals in their D & O insurance acquisition.

 

The Institutional Shareholder Service (ISS) Corporate Governance Blog has a September 7, 2006 post entitled “Has SOX Led to Fewer Lawsuits?” (here) that raises the question whether the declining number of securities lawsuits in 2006 (here) is due to improved corporate governance because of the Sarbanes-Oxley Act. While the CG blog is careful to note that multiple factors may be causing the declining number of lawsuits, it does also note that “[m]ost U.S. companies have significantly improved their governance practices,” and quotes Stanford Law School Professor Joseph Grundfest’s statement that “the most intriguing hypothesis” for the decline in the number of lawsuits “is that extensive and expensive efforts to improve governance and accounting have reduced plaintiffs’ ability to allege fraud.” The article quotes seveal other academics to the same effect.

The D & O Diary certainly hopes that the burdens and expense Congress mandated in Sarbanes-Oxley has improved corporate governance and reporting. But The D & O Diary continues to suspect, as it previously noted here, that the decline of securities lawsuits may have more to do with the Milberg Weiss indictment and the impact it has had on the ability of the entire plaintiffs’ bar to be able to rely on paid plaintiffs in order to file lawsuits. (In fairness, the CG blog cites the Milberg Weiss indictment as a possible cause of the reduced number of securities suits.)

The D & O Diary remains skeptical that SOX itself is reducing plaintiffs’ ability to raise fraud allegations, for a number of reasons. If SOX really were having such a salutary impact, there would be a few expected effects, none of which have yet happened. For instance, if there really were such a significant reduction in corporate misbehavior that plaintiffs’ lawyers simply couldn’t find fraud to allege, you would think that the Enron task force would be starting to think about winding down because it should be starting to run out of companies to investigate and prosecute. But in an interview in the September 2006 issue of CFO Magazine (here) , U.S. Deputy Attorney General Paul McNulty, who heads the Enron task force, was asked, “Do you envision a time when the Task Force won’t be necessary?” McNulty answered

No. The need to remain vigilant in this area is not going to go away. We see things emerging regularly that remind us that there are tremendous temptations in the area of business finance and that there will always be a certain percentage of people who will not resist the temptation to enrich themselves.

If prosecutors don’t see any threat to their livelihood, why should we suppose that plaintiffs’ lawyers will not have anything to do?

And if there really were a shortage of material upon which plaintiffs’ might base securities fraud complaints, it might be expected that the plaintiffs’ lawyers would be leaving the field and trying to find something else to do. Instead, exactly the opposite is happening. As has been noted previously on this blog (here) and more recently on Adam Savett’s blog, Lied, Damn Lies (here), the ranks of plaintiffs’ securities firms has been swelling recently with the addition of several firms who previously were best known for their involvement in asbestos or tobacco litigation. Clearly, these firms would not be coming into the arena if they didn’t think there were sufficient opportunities.

Another reason to be skeptical that company behavior is so improved that plaintiffs’ lawyers livelihood is imperiled is the statements of CFOs themselves about their own conduct. The September 2006 issue of CFO Magazine also reports (here) that in August 2002, when SOX was enacted, 9% of CFOs surveyed reported that on one or more occasions (7% on three or more occasions) their company had engaged in aggressive accounting practices in the last three years. If SOX really did categorically improve corporate conduct, these numbers would be expected to decline. Instead, the magazine found that today, 18% of CFOs surveyed reported that on one or more occasions (6% on three or more occasions) their company had engaged in aggressive accounting practices in the last three years.

As McNulty said, a “certain percentage” of people are always going to find motivations to justify their conduct. SOX changed the rules, but it did not change human nature. The D & O Diary is skeptical that SOX alone will deprive plaintiffs’ lawyers of their livelihood.

D & O underwriters will be interested to know that the CFOs who reported having engaged in aggressive accounting practices during the last three years identified the most common areas involved (some CFOs identifies more than one area) as revenue recognition (65%) and reserves (55%).

CEO Compensation and Real Estate Bubble Wrap: Michelle Leder, the author of the Footnoted.org blog, has written an article on Slate.com (here) entitled “The CEO Real Estate Scam,” in which she comments on the “first post-real-estate-bubble compensation trick.” CEOs, she claims, have “figured out how to shelter their own houses from the declining real estate market.–by getting their corporations to guarantee their sale price. You may be sweating that you have to sell at a loss, but your CEO isn’t.” Leder writes that

since the beginning of this summer, at least a half-dozen companies, including eBay and Nike, have disclosed in their routine Securities and Exchange Commission filings that they’re now protecting their executives from real estate market forces. The terms may vary – protection against loss, loss protection, and price protection – but the meaning is the same: They are essentially guaranteeing that executives’ homes will sell for a good price. In other words, companies that depend on free markets are making sure that their own executives are safeguarded from them. In the past, companies often offered to buy a relocating executive’s house if it didn’t sell after a specific amount of time. But that’s different than the price guarantees now being offered.

In a September 7, 2006 post on Footnoted.org (here), Leder reports that Clorox also offered its new CEO a “loss protection” provision in connection with his sale of his current home. Leder notes that “the idea of protecting top executives of publicly traded companies – the very people you’d expect to epitomize the power of free markets–from market forces just because these markets happen to be declining is more than a little ironic.” Perhaps the “most ironic example” that Leder cites in the Slate article involves Orleans Homebuilders, which as disclosed that it has offered one of its executives “price protection” on the sale of his home. As Leder notes, “I can only guess that the company does not offer a similar program to any of its customers, who will bear the brunt of falling prices as the real estate market tanks.”

The D & O Diary notes that the irony notwithstanding, there is absolutely nothing wrong with CEOs negotiating at arm’s-length for compensation terms they find desirable, particularly where (as seems to be the case in each example that Leder cites) those terms are fully disclosed. The real problem with CEO compensation comes from terms that are not the result of arm’s-length negotiations or are not disclosed. That said, however, CEOs willingness and ability to insulate themselves from the scary real estate situation that everyone else has to deal with is not going to help them win any popularity contests.

The Options Lawsuits List has Been Updated: Speaking of Clorox, The D & O Diary has updated its list of options backdating lawsuits (here) to include the shareholders’ derivative suit that has been filed against Clorox (here) in connection with its options timing investigation. The list has also been updated to include derivative suits that have been filed against Corinthian College (here), Cheesecake Factory(here), and Progress Software (here). This brings the number of options related derivative lawsuits to 66. The number of securities fraud class action lawsuits stands at 15. The D & O Diary reiterates here its entreaty to its loyal readers to please let the Diary know of any lawsuits of which readers are aware that have been omitted from the list.

Analogies Like Chalupas Full of Guacamole: Read the story, here.

The unfolding options backdating story may have hit its high water mark (or its low point, depending on your perspective) on September 6, 2006, when the Senate Committee on Banking, Housing and Urban Affairs and the Senate Finance Committee both held hearings concerning options backdating. The hearings involved the testimony of numerous regulators, academics and other pundits, and included the testimony of SEC Chariman Christopher Cox (testimony here), which was noteworthy for its identification of Internal Revenue Code Section 162(m) as the culprit in the scandal. Among other things, Cox said:

…one of the most significant reasons that non-salary forms of compensation have ballooned since the early 1990s is the $1 million legislative caps on salaries for certain top public company executives that was added to the Internal Revenue Code in 1993. As a Member of Congress at the time, I well remember that the stated purpose was to control the rate of growth of CEO pay. With complete hindsight, we can all agree that this purpose was not achieved. Indeed this tax law change deserves pride of place in the Museum of Unintended Consequences…The million-dollar cap on tax deductibility of executive compensation…doesn’t apply to options granted at fair market value. So for companies that wanted or needed to pay compensation in excess of $1 million per year, the tax code outlawed deducting it if it was paid in a straightforward way through salary, but permitted a deduction if the compensation was paid through at-the-money options.

So the tax law encouraged at-the-money options, which in turn encouraged creative actions to maximize the return under the options.

Linda Thomsen, Director of the SEC Enforcement Division, also testified (here) about the tax incentives that provide context for options backdating.

Cox’s and Thomsen’s testimony also make interesting reading for the history they provide about the SEC’s enforcement activity in connection with the options timing investigations, and in particular the enforcement activity that preceded the media attention that was drawn to the issue earlier this year. Cox’s testimony reviews the 2003 enforcement proceedings the SEC brought against Peregrine Systems, and the 2004 action against Symbol Technologies. (Thomsen’s testimony also discusses the Symbol Technologies action in detail.) Peregrine Systems was charged with financial fraud for failing to record any expense for compensation when it issued incentive stock options. The Symbol Technologies case involved manipulation not of options grant dates but of exercise dates, to ensure that the exercise date was the most advantageous to the grant recipient during a 30-day lookback period. The Symbol Technolgies complaint, which alleged numerous allegely misleading activites, was settled with a payment of $37 million.

Cox’s stated that the SEC’s Enforcement Division is “currently investigating over 100 companies concerning possible fraudulent reporting of stock option grants.” Cox added that while not all of these investigations will result in enforcement proceedings, “we have to expect that other enforcement proceedings will be forthcoming in the future.”

The written testimony of all of the witnesses who appeared before the Senate Banking Committee can be found here. The written testimony of all the witnesses who appeared before the Senate Finance Committee can be found here. The Wall Street Journal’s September 7, 2006 article describing the hearings can be found here (subscription required).

Options Timing Hot Seats Multiply: Senate Finance Committee Chair Charles Grassley (R. Iowa), in his closing remarks at the hearing (which can be found here) declared his intentions to target “all the actors” involved in the options backdating scandals. That includes accountants, lawyers, and compensation consultants who advised executives to backdate options, and board members who “blessed it or looked the other way.” Sen. Grassley apparently is going to lead a campaign to request materials from companies involved in the backdating investigation, including board minutes regarding the decision to backdate “as well as any and all materials from advisors…who assisted in these efforts.” Grassley also said that he is considering legislation to address the tax issues that Cox and other identified.

More about Options Springloading: The testimony on Capitol Hill reflected the continuing debate surrounding options springloading (granting options now in anticipation of good news later that it is anticipated will increase the company’s share price). As The D & O Diary has previously noted (here), options springloading seems categorically different from options backdating, among other reasons the value of the options at the time of the grant cannot be locked in as with options backdating, since there is no way to be sure how the market will react to the impending news. In addition, some commentators, including SEC Commissioner Paul Atkins (remarks here), have publicly stated that they see nothing wrong with springloading. But in his testimony before the Senate Banking Committee (testimony here) Lynn Turner, the former chief accountant at the SEC, came down in strong disagreement “with those who say it’s not illegal or a problem.” Turner clearly equates springloading with trading on inside information, and therefore unlawful. He also cites numerous ways in which the failure to disclose springloading would make proxies and other disclosures misleading. He concludes his thoughts about springloading by saying “I believe that disclosures made in the past regarding springloaded options grants will be found in all too many instances to have been false and misleading, violating the securities laws and regulations.” Turner also asks rhetorically with respect the options practices that have come to light”Where were the gatekeepers, including legal counsel and independent auditors?”

The Cost of Backdating: Three University of Michigan professors have written an article entitled “The Economic Impact of Backdating of Executive Options,” (here) which attempts to determine the financial impact of options timing. The authors analyzed thousands of stock option grants between 2000 and 2004 at 48 companies who had announced prior to July 1, 2006 that they were under investigation in connection with stock options practices. The authors measured the maximum possible gains for executives if they backdated every option grant during that period. The authors also measured the drop in market capitalization of the 48 companies by comparing the companies’ share prices in the ten days before and the ten days after the news of the backdating inquiry was released. The authors found that while the average executive’s pay would have been increased about 1.25 percent, the average decline in market value per company when the news of the options investigation was announced was an average of eight percent.

The D & O Diary notes that while the cost of options backdating to the companies and their shareholders clearly is greater than the benefit to the executives, the eight percent market cap decline that the authors’ determined is consistent with The D & O Diary’s ongoing theory on why this scandal has not produced more securities fraud litigation. (According to the D & O Diary’s tally, here, there have only been 15 companies sued in securities class action lawsuits so far.) A stock price drop of that magnitude is just not sufficient to attract the attention of the plaintiffs’ lawyers. Indeed, in a September 5, 2006 New York Times article (here, registration required), Melvin Weiss of the Milberg Weiss firm is quoted as saying in explanation for why there is not more securities fraud litigation in connection with the options timing scandal, “A lot of these companies aren’t reacting with big drops in price, or, if they dropped initially, they come back over a short period of time.”

The D & O Diary also has an observation about the authors’ presentation of their research. While their paper is now available on line, it states on its face that it will appear in the June 2007 issue of the Michigan Law Review. The article is timely and topical now, but by next summer it is going to be completely out of date. Almost all of the footnotes will have been superseded by intervening events, and many of the legal issues that the authors conjecture about will have been addressed in actual proceedings. The lag time almost guarantees that the article, while relevant today, will be completely irrelevant by the time it appears in a traditional publication form. All of this is by way of observation that the Internet may be making traditional forms of legal scholarship obsolete. Perhaps Internet weblogs are the rightful successors to more traditional law journals in an Internet age.

The D & O Diary has previously written (here and here) about the problems and conflicts of interests that can arise from the involvement of private fund investors (private equity firms, hedge funds and buyout firms) in publicly traded companies. In a September 3, 2006 column in the New York Times (here, registration required) entitled "On Buyouts, There Ought to Be a Law," investment pundit and humorist Ben Stein explores yet another example of the risks arising from private financing. Stein decries the evils of management buyouts (MBOs), or "going private" deals. Stein’s view is sharp and specific; he says that "these deals ought to be illegal on their face. That is, they should simply not be allowed as a matter of law."

Stein is concerned about leveraged buyouts of publicly traded companies involving senior members of the management team. His primary objection is that insiders will use their inside knowledge to buy the company from public shareholders on the cheap. He also is concerned that insiders may propose to buyout lenders or other investors business plans (and investment returns) that are undisclosed to public shareholders.

Stein’s concerns are legitimate, and they vividly illustrate the conflicts of interest that can arise in an MBO. However, his draconian solution to prohibit management buyouts is not the best solution from the perspective of the shareholders. There may well be times when a company may operate more efficiently as a private company (indeed, in this post Sarbanes-Oxley era, an increasing number of companies may be reaching that conclusion); and there may be times when the management’s buyout proposal is the best available alternative for shareholders. The problems arise not from the MBO itself, but when the information from which shareholders might make an informed decision about their best interest is withheld. The solution to Stein’s concerns is not to outlaw transactions that may make economic sense in some situations; the solution is to make sure that these kinds of transactions only go forward with adequate disclosure and shareholder protections.

The D & O Diary (which is influenced by the comments of Professor Dale Oesterle of the Business Law Prof blog, here) believes the perferred approach would be to require the would-be MBO participants to disclose their reasons for taking the company private, and the reasons why a private company rather than a publicly traded company should carry out their plans. In addition, management should be required to disclose their calculations for profit from the transaction (an indispensable element in determine whether the buyout valuation is fair). Finally, no management led buyout should go forward without the opportunity for an auction process (following the previously identified disclosures), to ensure that shareholders are getting the best possible price.

In any event, MBO transactions represent yet another example where the increasing influence of private investors in public company finance has the potential to create conflicts of interest that could generate disputes and trigger D & O claims. The possibility of shareholder claims against senior management who are pursuing an MBO presents particularly complex D & O issues, since the acquirers would not be acting in their "insured capacity" as directors and officers of the company. But to the extent that the claims allege wrongdoing in their capacity as directors and officers, their D & O policies would be triggered. As the D & O Diary has previously noted, it takes a particularly skilled hand to craft D & O coverages in light of the complex challenges arising from the increasing involvement of private money in public company financing.

Professor Larry Ribstein has a post (here) on his Ideoblog that is highly critical of Stein’s column.

Thanks to alert reader Marty Perry for the link to the Stein column.

Priceless: A perfect hangover cure, here.