Photobucket - Video and Image Hosting While the number of securities fraud lawsuits declined in 2006 (see here and here), the average size of securities fraud lawsuit settlements increased by 37% relative to 2005, even excluding the impact of the Enron settlement, according to a January 2, 2006 study by National Economic Research Associates (NERA). The study, entitled “Recent Trends in Shareholder Class Action Litigation: Filings Plummet, Settlements Soar” (here), also found that there were more settlements over $100 million in 2006 than in 2005, which was itself a record-breaking year. There were four settlements in 2006 over $1 billion, even though prior to 2006 there had only been 3 settlements over $1 billion. Seven of the ten largest settlements have occurred in 2005 and 2006.

The average securities class action settlement in 2006 was $86.7 million, which is 17.7% greater than the 2005 average settlement of $73.6 million. (As The D & O Diary previously noted, here, the annual averages reported in NERA’s studies may differ from averages reported elsewhere, because NERA assigns settlements to the year in which they are first finally approved, while some other analysts assign settlements to the year in which they are first announced.) These averages reflect in part the inclusion of the mega-settlements over a billion dollars. If the annual averages are normalized by excluding the billion dollar settlements from both 2005 and 2006, the 2006 average of $34 million is still about 37% above the normalized 2005 annual average of $25 million.

But while these average figures are impressive, averages can be skewed by a relatively few data points at the extremes. As the NERA study notes, a median is “more descriptive of typical cases.” The median settlement also rose to $7.3 million in 2006, about 4.2% above the 2005 median settlement of $7.0 million. The $7.5 million 2006 median is also 21% greater than the five-year $6.2 million median for the period 2002-2006.

The NERA study also examines the declining frequency of securities fraud lawsuit; while this trend has been reported elsewhere (for example, in the Cornerstone study also released on January 2, here), the NERA study adds the interesting observation that the percentage decline is not uniform amongst the federal circuits. The NERA study notes:

The largest drop in absolute terms has come from the Ninth Circuit, where, compared to a peak of 68 in 2004, there have been only 27 shareholder class action suits filed through December 15, 2006. However, every circuit has fewer standard filings in 2006 than the average level from 1998-2004. The drop is smallest in the Second Circuit, which in 2006 has seen fully 87% of the filings it typically received over 1998-2004.5 The rest of the circuits as a group have received only about half of their typical 1998-2004 filings. All but two of the circuits had a decline of at least one-third from 2005 to the projected 2006 figures.

In examining the possible reasons for the decline in securities fraud lawsuit frequency in 2006, the NERA study cites this differential impact as possible evidence that improved corporate behavior as a result of Sarbanes Oxley is probably not the explanation. The decline would be more uniform if Sarbanes Oxley were the cause. (The study examines and rejects the hypothesis that the lack of geographic uniformity is a result of the regional distribution of companies in different industries.) The NERA study speculates that the Milberg Weiss indictment and the Lerach firm’s distraction with the Enron litigation may possibly explain the decline.

The study also notes that since the 1995 passage of the Private Securities Litigation Reform Act, the chances are much greater that securities fraud cases will be dismissed. More than 38% of the cases filed between 1999 and 2004 were dismissed (although this figure may be overstated because it includes dismissals without prejudice and cases that are still on appeal).

The NERA study noted that the biggest single factor determining settlement size is the magnitude of investor loss; average investor losses ballooned from $140 million to $2.5 billion in 2003. Other factors that can increase the size of the settlement include the involvement as plaintiffs of multiple classes of securities holders (such as bondholders or options investors, as well as equity shareholders); the presence of accounting improprieties (which increase expected settlements by more than 20%); and the presence of an IPO (which increases expected settlements by approximately a third). Companies in the health services sector also pay significantly higher settlements than defendants in other industries.

D & O insurers will likely cite the increasing annual average and median settlement levels to counter arguments that D & O insurance premiums should decline as a result of the declining claim frequency. It undoubtedly is hard for the carriers to imagine dropping prices while dollars are flying out the door to fund mega-settlement. But if the carriers were reserving appropriately (admittedly, a big “if”), they should have reserved for these losses years ago, and so the current payouts should not be affecting current calendar year results. In addition, the current settlements involve cases filed years ago. The premiums to be collected now will go to fund losses to be incurred in the future. The NERA study documents that the single most significant predictor of settlement size is the magnitude of investor losses; the Cornerstone study (here) documents that the investor losses in cases filed in 2006 are down significantly from the investor losses involved in the cases filed in the late 90s and early part of this decade. In other words, future settlements should be expected to start trending downward as the cases filed this year move toward resolution. And in any event there are significantly fewer cases to start with, so aggregate losses should also be expected to trend downward.

Nevertheless, as I have previously discussed at length (here), there may still be compelling reasons why carriers may be justified in continuing to resist price decreases. These other considerations include the fact that while the number of securities fraud lawsuits is down, overall claims activity is up (including, for instance, the nearly 130 shareholder derivative claims filed in connection with the options backdating scandal, and the wave of derivative lawsuits growing out of private equity takeovers and arising from activist hedge fund activity). There are other developing threats as well, including among other things, increased activity under the Foreign Corrupt Practices Act. (My prior post, here, details these additional evolving exposure areas).

But while carriers may reasonably try to contend that there are reasons to hold the line on pricing, carriers undoubtedly will continue to face pressure to lower their rates, particularly if securities fraud lawsuit activity remains at its current lower levels.

A CFO.com article discussing the NERA study can be found here.

Photobucket - Video and Image Hosting A dispute arising out of the Clifford Chance law firm’s brief attempt to establish a California presence by recruiting a number of partners from the late, lamented Brobeck, Phleger & Harrison firm has resulted in a ruling under New York law on the proper standard to use in allocating loss between covered and uncovered parties under a management liability policy, according to a January 3, 2007 Law.com article entitled “Judge Rebuffs Clifford Chance’s Bid to Recover Costs of Brobeck Settlement” (here).

According to the article, in 2002, Clifford Chance recruited 17 partners from Brobeck’s San Francisco office (including the firm Chairman, Tower Snow) to open a California office. Brobeck declared bankruptcy the following year. A San Francisco Chronicle article detailing the firm’s dissolution can be found here. The Brobeck bankruptcy trustee and retired Brobeck partners apparently pursued claims against Clifford Chance and the departed Brobeck partners, alleging that partners’ departure, induced by Clifford Chance, had precipitated Brobeck’s demise. In 2004, Clifford Chance agreed to pay $5.5 million to Brobeck’s bankruptcy trustee and an undisclosed amount to a group of retired Brobeck partners. The trustee’s claim and the circumstances surrounding the claim settlement are described here.

Clifford Chance sought to have its management liability insurer, Indian Harbor Insurance Company, pay the full amount of the settlement plus $2.3 million in legal fees. The insurer said it should have to pay only 40 percent of the settlement, arguing that the balance should be allocated to the former Brobeck partners, who were not covered under the Clifford Chance management liability policy.

In its motion for summary judgment, Clifford Chance argued that the court should apply the “larger settlement rule,” pursuant to which management liability insurers are barred from allocating loss to uninsured corporate entities unless those entities’ activities resulted in a larger settlement.

Manhattan Supreme Court Justice Bernard J. Fried found that there was no New York precedent for applying the “larger settlement rule.” The rule, he noted, had been developed in the Ninth Circuit (in the Nordstrom case) and in the Seventh Circuit (in the Caterpillar case) in cases involving the allocation of costs under policies that lacked explicit allocation provisions. The Clifford Chance policy contained language stating that the loss should be allocated between covered and uncovered parties taking into account “the relative legal and financial exposures of, and relative benefits obtained in connection with the defense and/or settlement of the Claim by the Insured and others.” Based on this language, the Court found that the appropriate test to apply is the “relative exposures” rule, pursuant to which loss is allocated between covered and uncovered parties according to their relative exposure to liability. The Court reserved for trial the question whether the insurer appropriately allocated 60 percent of the loss to the uncovered parties.

Disputes over allocation of loss between covered and uncovered parties have been relatively infrequent since the inclusion of entity coverage as a standard part of D & O liability policies in response to the Nordstrom and Caterpillar decisions. The inclusion of the corporate entity as an insured eliminated disputes that a portion of defense costs or settlement amounts were allocable to the corporate defendant, which would not have been covered under prior D & O policy forms. But in addition to the inclusion of entity coverage, insurers reacting to the Nordstrom and Caterpillar decisions also included as a standard feature of their policies allocation language of the type the Court applied in the Clifford Chance case. The interesting thing about the Court’s ruling is that shows how a court will interpret and apply the language when allocation disputes do arise. The Court’s ruling suggests that in future disputes, parties may be well advised to take into account the need for an allocation and attempt to negotiate rather than forcing a judicial resolution.

According to January 2, 2007 news reports (here and here), DaimlerChrysler AG has reached a settlement with its D & O insurers in connection with the $300 million settlement of the securities class action lawsuit that had been filed against the company.

The securities class action lawsuit was filed in May 2002, relating to the 1998 merger of Daimler Benz and Chrysler that formed the company. The securities lawsuit had alleged that the defendants issued statements assuring the markets that the transaction would be a "merger of equals," when defendants intended to turn Chrysler into a division of the merged company. The lawsuit cited an interview with former DaimlerChrysler Chairman Jurgen Schrempp in which he said that the transaction had been referred to as a merger of equals rather than as a takeover "for psychological reasons" only. In August 2003, the Company agreed to settle the securities lawsuit for $300 million (or about 240 million euros at the then applicable exchange rate). Further information regarding the securities litigation settlement can be found here.

The company sought to have its 200 milllion euros directors’ and officers’ liability insurance program cover the bulk of the settlement. According to news reports, only AIG agreed to contribute its limit (25 million euros). The eight remaining insurers on the D & O program declined to pay, apparently arguing that Schrempp’s comments showed that the misrepresentations were intentional, which led to litigation between the Company and the remaining insurers. (The remaining insurers were led by ACE and are each named in the news reports linked above.)

The lawsuit between the Company and the remaining D & O carriers was scheduled to go to trial on January 9, 2007 (here, in German), but according to the January 2 news reports linked above, the parties reached a settlement pursuant to which the eight carriers reportedly agreed to pay 168 million euros out of the remaining 175 million euros in limits.

According to Reuters (here), the head of ACE’s European Operations said that he "hoped the settlement would spark a discussion in Germany about whether Directors’ and Officers’ liability insurance coverage was too broad."

The settlement of the securities class action lawsuits was unrelated to the separate but similar individual lawsuit brought by Tracinda Corporation (owned by Kirk Kirkorian) in Delaware federal court. Tracinda claimed that defendants’ statements that the transaction was a "merger of equals" had deprived it of a merger premium for its Chrysler shares. The Tracinda lawsuit went to a bench trial between December 2003 and February 2004, and in April 2005, the court entered judgment in the defendants’ favor, rejecting Tracinda’s arguments. Tracinda’s appeal to the Third Circuit remains pending. (Details regarding the Tracinda action can be found here and here.)

In 2004, a separate action was also filed in Delaware federal court on behalf of current of former DaimlerChrysler shareholders who are neither citizens or residents of the United States and who acquired their DaimlerChrysler shares through a foreign stock exchange. The district court dismissed the complaint in January 2006. The plaintiffs’ appeal to the Third Circuit remains pending.

In addition, in 1999, former shareholders of Daimler Benz instituted a valuation proceeding against the merged company in Stuttgart district courts. The shareholders claimed that the exchange ratio used in the merger did not properly value their shares. An expert commissioned by the court issued a December 2005 report calculating a range of alternative values for the shares, and in August 2006, the court, in reliance on the expert’s report, ruled that the company must pay the shareholders additional compensation which amounted in the aggregate to about 232 million euros. The company continues to contend that the original ratio used was appropriate. Details regarding the Stuttgart valuation action can be found in DaimlerChrysler’s annual report, here (refer to pages 182 through 186).

Special thanks to the new With Vigor and Zeal blog (here) for the links to the news reports and other sources regarding the D & O insurance settlement.

An interesting Tuck School of Business at Dartmouth case study about the DaimlerChrysler merger, including an examination of the reasons why the merger failed, may be found here.

An excerpt from Taken for a Ride: How Daimler-Benz Drove Off With Chrysler, the book length examination of the merger, can be found here. The excerpt contains the following memorable description of Schrempp’s departure from the first meeting between the managers of the two companies:

Schrempp and the group bellowed song after song until the wee hours. The German co-chairman led one final chorus of ”Bye, Bye, Miss American Pie.” Then, with a wild gleam in his eye, Schrempp grabbed his ever-present assistant, Lydia Deininger, picked her up, and threw her over his shoulder. The room exploded in laughter as Schrempp snatched a bottle of champagne in his free hand, raised it in the air, and yelled out with a grin: ”See you later, boys!” Then he carried her off, not to be seen for the rest of the night.

 

More Last Words on Skilling’s Sentencing: We here at The D & O Diary would have thought that the last word on Jeffrey Skilling’s sentencing had already been written, but a January 1, 2007 post on The New Yorker’s website (here) by Malcolm Gladwell (author of Blink and The Tipping Point) sets out a dramatic retelling of the sentencing hearing, including Skilling’s lawyer’s unsuccessful attempt to have the sentence reduced 10 months so that Skilling could serve his sentence at a lower security facility. An interesting short commentary on the New Yorker column appears on Dealbreaker.com, here. The D & O Diary’s prior comments on the Skilling sentencing can be found here.

The Art of Conversation: The current issue of The Economist magazine includes an examination on the dying art of conversation. The article (here, subscription required) warrants reading in full, but here is a selected sample:

The more modern the manual of conversation, the more concrete its advice is likely to be. Ms Shepherd offers seven quick ways to tell if you are boring your listeners, which include: "Never speak uninterrupted for more than four minutes at a time" and "If you are the only person who still has a plate full of food, stop talking." Her checklist of things best not said to the parent of a newborn baby should be memorised for future use. It comprises: "What’s wrong with his nose?" "Should he be that colour?" "Isn’t he awfully small?" "Shouldn’t you be breast-feeding?" "Did you want a boy?" "Is he a good baby?" "He looks like Churchill!/She looks like ET!" "It’s really cute!"

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

 

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

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

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

 

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

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

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

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

 

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

 

 

5. The Time is Right for Regulatory Reform

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

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

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

 

 

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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