According to August 10, 2006 press reports, Brocade Communications settled the derivative lawsuit that shareholders had filed in federal court in San Francisco in connection with Brocade’s options-award timing miscues, in exchange for an agreement to adopt certain therapeutic governance measures and the payment of $525,000 in legal fees. The settlement also involves contributions to the legal fees of the defendant directors and officers (amount undisclosed).

Fifteen current and former Brocade Directors and Officers reportedly participated in today’s settlement (including former Brocade director and Wilson Sonsini partner Larry Sonsini.) KPMG, Brodcade’s auditor, also reportedly settled. Gregory Reyes, Brocade’s former CEO, who faces criminal charge in connection with options timing problems at Brocade, did not take part in the settlement. Other shareholder lawsuits, including shareholder fraud lawsuits, remain pending. A hearing on the stipulation of settlement is scheduled for August 18.

In this prior post, the D & O Diary noted the recent resurgence of the 70’s vintage statute, the Foreign Corrupt Practices Act. Recent developments in the Comverse Technology options timing investigation underscore the increasing importance of the FCPA, particularly as the options backdating scandal continues to unfold.

On August 9, 2006, the SEC filed a civil enforcement complaint against three former officers of Comverse Technology. (The Affidavit filed in conjunction with the criminal complaint filed against the three individuals can be found here, even though the document says on its face that it is to be filed under seal.) The SEC Complaint alleges "a fraudulent scheme" by the three defendants "to grant undisclosed, in-the-money options to themselves and others by backdating stock option grants from 1991 through 2001 to coincide with historically low closing prices for the Company’s stock." The SEC Complaint alleges a variety of securities laws violations, including specifically violations of the books and records provisions of the FCPA, which are codified as amendments to the Securities Exchange Act of 1934. The FCPA allegations are that the defendants "knowingly violated …internal controls" and "falsified books, records or accounts."

These same kinds of allegations are likely to be a recurring part of future enforcement actions arising out of the options backdating investigations. Indeed, according to press reports, the criminal indictment entered on August 10, 2006 against former officials of Brocade Communications also contained "books and records" allegations.

The D & O Diary’s prior post about the FCPA noted that one of the dangers from an FCPA enforcement proceeding is the possibility of follow-on litigation. A recent securities fraud lawsuit settlement provides a glimpse of the way FCPA violations can spawn follow-on litigation, including specifically follow-on securities fraud lawsuits.

On August 9, 2006, Willbros Group, Inc. announced that it had settled the 2005 class action lawsuit that had been filed against the Company and several of its directors and officers. The Complaint alleged that the company had been the subject of numerous of numerous investigations "because the Company engaged in a campaign of illegal and illicit bribery of foreign government officials in Bolivia, Nigeria and Ecuador to successfully obtain construction projects." The Complaint alleged that the company was forced to restate several years of financial statements and to establish a reserve to accrue for possible fines and penalties for FCPA violations. The Complaint alleged that as a result of these violations, the Company had misrepresented its true financial condition. The Complaint alleged that the company’s share price declined 31% when these matters were disclosed.

In its August 9 press release, the Company did not disclose the amount of the securities class action settlement, but the press release did state that the amount of the settlement would be funded by the company’s insurance carrier.

The Willbros settlement illustrates the growing D & O risk that increased FCPA enforcement activity could represent. The threat is not so much from the underlying FCPA enforcement action itself; any FCPA fines and penalties likely would not be covered under most D & O policies. Rather, the threat is from the potential liability that could arise in any follow-on civil action, including any follow-on securities fraud lawsuit like the one filed against Willbros Group. Any settlement or judgments incurred in a follow-on action, as well as defense expenses, would usually be covered under the typical D & O policy.

As FCPA enforcement actions grow in number and magnitude, this exposure could pose an increasingly greater D & O risk.

An August 10, 2006 CFO.com article discussing the Willbros settlement, as well as the simultaneous resignation of the company’s CFO (who had been a defendant in the securities fraud action), may be found here.

Two particularly interesting articles discussing the Comverse Technology criminal complaint may be found at the White Collar Crime Prof blog, and at the Securities Litigation Watch blog.

A particularly provocative contrarian view of the Comverse Technology criminal complaint and of the whole options backdating morass may be found on this post on Professor Ribstein’s Ideoblog.

Big Numbers: An August 10, 2006 post on Bloomberg.com reports that

The number of companies with stock options grants under scrutiny passed 100…At least 105 companies have disclosed internal or federal probes, according to data compiled by Bloomberg News. Nineteen people have lost their jobs, five face criminal charges and one of them — Comverse Inc. founder Jacob Alexander — didn’t show up for his arraignment yesterday.

A separate article on Bloomberg.com, also dated August 10, reports that:

UnitedHealth Group Inc. Chairman William McGuire sparked outrage among some stockholders over his $1.8 billion in potential stock-option gains. Turns out, the board of directors that granted those options got a share of the wealth, too. UnitedHealth’s 10 non-executive directors held $230 million in stock as of March 21, according to the health insurer’s most recent proxy…“You have to ask yourself, are these people paying attention to the mission of the corporation, or are they being distracted by the amount they’re getting themselves?” says Minnesota Attorney General Mike Hatch, who is investigating Minnetonka-based UnitedHealth along with federal authorities…A board committee is reviewing 45,000 separate option grants made to 15,000 people over 13 years, the company said in a statement.

And a Japanese man was arrested this week after making 37,760 silent calls to directory inquiries because he wanted to listen to the "kind" voices of female telephone operators, according to news reports.

Sudden Complications: United Airlines’ aviation war risk insurance is up for renewal on August 31, 2006. Read the story here.

Yet Another Globalization Downside: The U.S. economy is trading factory workers for real estate agents. Take a look at this uncanny chart here.

 

Molex Execs Repay Pay: In one of the more interesting (and speediest) resolutions by a company of options timing concerns, 12 executives of Molex, Inc. agreed to repay the company a total of $685,000 to cover gains they realized on misdated options. The executives also agreed to have the prices raised on their unexercised options, reducing the options’ value and ensuring that the executives would not benefit in the future from the misdating. The Company’s press release states that the misdating was due to clerical error that in some instances had the effect of diminishing the value of certain options awards to the executives. The August 3, 2006 Wall Street Journal article describing the company’s action points out that no other company involved in the options backdating investigations has ordered a repayment from the executives who profited.

The D & O Diary notes that D & O insurers would likely contend that the Molex executives’ payments, which represent a return to the company of compensation overpayment, would not be covered under the typical D & O policy, because it would not constitute covered “loss.” Interestingly, the “personal profit” exclusion typically found in most D & O policies would not appear to preclude coverage for the payments even if the payments were otherwise covered “loss,” because the payments were not made pursuant to an “adjudication” that the executives were not legally entitled to the excess payments. (To be sure, many policies allow insurers to trigger the exclusion by obtaining a judicial declaration that amounts paid represented “remuneration” to which insured persons were not legally entitled.)

Hat Tip to Adam Savett of the Lies, Damned Lies blog for the Molex link.

Yet Another Variant of Options Timing Manipulations? As The D & O Diary has noted in prior posts, the current options timing scandal encompasses several different types of options timing practices: options backdating, which involves the retroactive setting of the grant date to an earlier date when the company’s share price was lower; options springloading, where the grant date is set ahead of the release of positive news expected to raise the company’s share price: and hiring-related options grants, which can involve setting options award dates at a time prior to an employee’s hiring, or simply at a false hiring date, to increase the value of the new hires’ options.

A July 20, 2006 article in The Economist (subscription required) identifies yet another variant of options timing: “bullet-dodging,” which involves delaying an option grant until after the bad news is announced. The value of an award made prior to the bad news announcement would diminish if shares declined in reaction to the news; waiting until after the bad news to make the award averts the decline and increases the award recipients profits if the company’s share price later rebounds.

The D & O Diary believes that it is important to distinguish these distinct options practices, as each involves different sets of issues and its own sets of concerns. For example, the profits for backdated options are locked in; profits from springloading or bullet dodging are far less certain. By the same token, hiring-related options practices lack the element of self-dealing that may characterize the other options timing practices. These differences are significant and potentially could substantially affect investigative outcomes, as well as the resolution of any civil litigation based on allegations of options timing manipulations.

One further note about hiring-related stock options: the August 9, 2006 criminal complaint is entered against three former Comverse Technology officials alleges an interesting variant of the hiring-related options timing manipulations. The complaint alleges that the defendants created a slush fund of backdated options granted to fictitious employees and later used these options to recruit and retain key personnel. One of the ficticious names allegedly used was “I.M. Fanton.”

Options Investigations and Company Share Prices: Notwithstanding the media barrage surrounding the options backdating scandal, relatively few of the companies involved in the various investigations have been sued in securities fraud lawsuits – to date, only 11 companies. (The D & O Diary is tracking Options Backdating related litigation here.) One possible reason why the plaintiffs’ bar may be shying away from suing more companies is the lack of share price decline for companies involved in the investigations.

An August 7, 2006 Forbes article reports its analysis of stock prices of 65 firms that announced financial restatement or government investigations related to their options-granting practices. Though some companies saw dramatic share price declines, the group as a whole saw no abnormal drop compared to the wider market. The companies’ share prices fell an average of 7.4% since the announcements (most of which have taken place in the last three months) compared to a 9.4% decline in the NASDAQ Composite Index since May 1. The article does note important difference; for example, companies that have lost senior executives have suffered more than others. The companies with the most significant price declines are listed here.
The absence of significant share price declines for most of the companies involved in the scandal supports The D & O Diary’s view that the scandal will not be a “severity event” for the D & O insurance industry.

Hat tip to the Vangal blog for the Forbes link.

Cooperman Paintings: For those D & O Diary readers who were interested in my prior post about the Cooperman Paintings heist and its impact on the Milberg Weiss indictment, you may want to visit the post again. I have added images of the paintings.

The Wall Street Journal’s recent series on "Private Money" describes the "new financial order" arising from "the new rules of private equity game." According to the July 25, 2006 Journal article (subscription required) entitled "Cash Machine: In Today’s Buyouts, Payday is Never Far Away," the new power players are private financiers – hedge funds, buyout firms and venture capital firms highly skilled at quickly extracting cash from the firms they acquire. The private financiers collect dividends, fees for advising, and fees for stock underwriting and management. The magnitude of the cash hauled out can be stunning; the article describes the $22 million in professional fees and $448 million in dividends that the private investors pulled out of Burger King prior to its May 2006 IPO.

The article describes the sequence of events involving Dade Behring, Inc, a medical diagnosis company that found itself saddled with enormous debt that was incurred to buy out private investors’ equity stake. Eventually the debt burden drove the company to the brink of bankruptcy. Creditors formed a committee to examine the conduct of Dade Behring’s "owners, directors and advisors." The creditors considered bringing claims relating to "illegal dividends, illegal stock redemptions and impairment of capital." (The company later recovered and subsequently went public.)

Although the Dade Behring creditors ultimately did not bring a claim, the example provides a cautionary tale for those who must assess the potential risk of D & O claims arising under the new rules of the private equity game. The presence on company boards of representatives of the new power players whose interests may conflict with the interests of the company, other investors, or creditors, creates an environment where accusations of wrongdoing may more easily arise. These same risks are present even if the private equity investors do not have company representation; the board’s actions for the benefit of private equity investors could draw criticism of the board even if the investors do not have board representation. This risk could be particularly applicable where a debt-saddled company is driven into bankruptcy. Creditors may claim they are owed special duties while the company was in the "zone of insolvency." These claimants may assert that the private investors extraction of dividends, management fees, or equity buy-outs, represent a form of "looting" or "waste" or a violation of other legal duties, and that the other directors violated their duty of care for permitting these actions.

While the significance of private funding in the world of corporate finance has long been recognized, the Wall Street Journal series reflects a growing realization that the increasing influence of private funding has its consequences. Among those consequences is a potentially growing possibility of conflicting interests that could trigger D & O claims.

Crafting the appropriate insurance response when these risks are present requires a skilled hand. The presence of differing potential interests, and differing insurable interests, creates problems of program structure and of content. In terms of policy wordings, the formulation of the Insured versus Insured exclusion present particular potential concern. Policy definitions, particularly the definition of "Loss," as well as the conduct exclusions, also could be particularly important, as would common endorsements such as a Major Shareholder exclusion.

Zone of Insolvency: Stephen Bainbridge, UCLA Law Professor and author of the ProfessorBainbridge.com blog, has written an interesting paper examining (and questioning) the duties of directors of companies that are in the "zone of insolvency." The paper may be found here.

The One Sin Greater Than Plague or Death: In our time, we are comfortable thinking about issues such as debt or bankruptcy as strictly practical or legal concerns. But in an earlier times, debt was a moral issue. This is starkly illustrated in Henry Knighton’s contemporaneous account of the Black Death in England; Knighton reports that "the Bishop of London sent word throughout his whole diocese giving general power to each and every priest…to hear confessions and to give absolution to all persons with full episcopal authority, except only in case of debt. In this case, the debtor was to pay the debt, if he was able while he lived, or others were to fulfill his obligations from his property after his death." Knighton’s report appears in Eyewitness to History, a fascinating 1988 compilation of first-hand accounts of historical events, edited by John Carey.

 

As detailed in this prior D & O Diary post, the Sarbanes-Oxley Act has imposed enormous compliance burdens and expense on companies whose shares are traded on the U.S. securities exchanges. It is hardly surprising that, according to an August 8, 2006 Wall Street Journal article (subscription required), U.S. exchanges have lost ground in luring foreign listings. The article states that “[n]ine of the world’s ten largest non-U.S. IPOs listed in New York in 2000; last year, 24 of the largest 25 chose other markets, with London the leading alternative.” Sources cited in the article suggest that the U.S. regulatory burden is the principal reason for the shift, but that high U.S. underwriting fees (which may be as much as double as those assessed in London) may be a contributing factor.

The aversion to the U.S. exchanges is not limited to non-U.S companies, nor is it limited to companies contemplating their public debut. According to an August 3, 2006 New Jersey Law Journal article entitled “Companies ‘Go Dark’ to Avoid SOX Compliance,” the high cost and burden of Sarbanes-Oxley compliance “appear to be driving of companies to simply withdraw from the major exchanges.” Some companies are going private, and others are “going dark” by deregistering their stock with the SEC. Shares of companies that go dark are listed on the “Pink Sheets,” an electronic quotation medium for companies not listed on stock exchanges. Public companies can generally file for deregistration if they have fewer than 300 shareholders of record or fewer than 500 holders and less than $10 million in assets in each of the prior three years. Even companies with thousands of shareholders can meet these requirements if investors have their shares in “street name” (where a customer’s securities are held in the name of a brokerage firm instead of the individual’s name, in effect representing a single shareholder of record). Other companies “go private,” that is, restructure to concentrate ownership in the hands of management or private equity investors, after which their shares are not traded publicly, even on the OTC markets.

According to an academic study cited in the article, and about which more below, in 2002, when SOX was enacted, 65 publicly traded companies “went dark” and 61 went private. In 2003, 183 companies “went dark” and 79 went private. In 2004, the most recent year studied, 122 companies “went dark” and 66 went private.

The academic study referenced in the article is the recent paper written by Professors Christian Leuz, Alexander Triantis, and Tracy Wang, entitled, “Why Firms Go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations.” The study may be found here. The study examines companies that “went dark” or and companies that went private both before and after the enactment of Sarbanes Oxley, to determine the causes and consequences of the companies’ actions. The authors found that in companies’ press releases announcing the companies’ decision to go dark, the usual reason stated is the high cost of SEC reporting and SOX compliance. The authors found the most likely companies to go dark are smaller firms with relatively poor performance and low growth, for whom reporting burdens are particularly burdensome. For many firms, the decision to go dark is a response to financial difficulties and deteriorating growth opportunities. By contrast, companies that go private are typically larger, better performing and less-distressed then going-dark firms. Interestingly, while the number of going-dark firms has “surged” following the enactment of Sarbanes-Oxley, the incidence of going-private transactions has not increased.

While Sarbanes-Oxley may have been an unavoidable reaction to the enormous corporate frauds that led to its enactment, it is clearly diminishing the number of companies that seek to be listed on U. S. exchanges. This unintended consequence is not only affecting the way business is conducted in this country but is also affecting the global economy as well, in ways that do not improve this country’s economic competitiveness.

Police Power and Its Limitations: I expect that many police personnel, sitting around the station house bragging about the day they “apprehended the perpetrator,” occasionally allow themselves to fantisize that some day they too might get a call, like the one that came in to Kennewick, Washington police on August 4, 2006, to run down a stolen truck full of doughnuts. Miraculously, when the perpetrator was finally apprehended, the “entire load of glazed, sugar and cream doughnuts, as well as apple fritters and bear claws” was intact. A more complicated call came in to police in Aachen, Germany on August 2, 2006, when a woman called to complain that her husband was not, shall we say, fulfilling his marital duties. Because the police confessed themselves unable to resolve the dispute, let alone issue any kind of official order, the 44-year old woman was frustrated both by her husband and by the entire police force in a single evening. On the other hand, the British police should be relieved that this sort of thing falls outside police jursidiction, as, at least according to at least one report, seven million British Women are unhappy with their sex lives. That’s a heck of a lot of non-perpetrators. The D & O Diary wonders if the problem has something to do with cream doughnuts.

An August 4, 2006 Reuters article provides numeric support for the proposition, advanced in this prior D & O Diary post, that the declining number of securities fraud lawsuits is a consequence of the Milberg Weiss indictment. The article states that the indictment is "having a big impact on [the firm’s] ability to bring fraud cases and on class-action litigation in general." The article reports that the Milberg Weiss firm has filed just 17 securities lawsuits during 2006, compared to 55 in the first half of 2005 and 36 in the second half of 2005. The article also reports that Milberg Weiss has announced no new lawsuits since the indictment. The article also states that the firm has declined to 75 lawyers, down from 125 at the time of the indictment.

The downturn is even more dramatic when the comparison of filing rates is taken further back in time. According to data graciously supplied to The D & O Diary by Bill Ballowe of Woodruff-Sawyer, the Milberg firm filed 124 lawsuits during the 16-month period from May 1, 2004 to August 31, 2005 (or an average of about 7.8 lawsuits a month), compared with only 37 new lawsuits during the period September 1, 2005 to June 30, 2006 (an average of about 3.7 lawsuits per month). The case filing data in the Reuters article suggests that this filing rate has declined as 2006 has progressed.

Nor is this dramatic downturn after September 2005 limited just to the Milberg Weiss law firm. Milberg Weiss’s alienated sibling firm, Lerach Coughlin, has also shown a similar decline in its rate of new case filings. According to Ballowe’s data, during the 16-month period from May 1, 2004 to August 31, 2005, the Lerach firm filed 179 new lawsuits (or about 11.2 per month) but during the ten-month period between September 1, 2005 and June 30, 2006, the Lerach firm filed only 52 new lawsuits (or only about 5.2 per month). There is some overlap in the filings as in many instances both firms initiated lawsuits against the same company.

This large drop off from these two major plaintiffs’ law firms is significant because, according to Ballowe’s data, only about a fifth of the time before September 1, 2005 and only about a quarter of the time after September 1, 2005, is a company sued in a securities class action lawsuit without one or the other of these two firms filing a complaint.

As The D & O Diary noted in its prior post, the drop off after mid-2005 is significant, because the indictment alleges that the practice of paying plaintiffs to permit plaintiffs’ attorneys to use their names to file lawsuits continued through 2005. Moreover, in June 2005, the U.S. Attorney’s office in Los Angeles indicted Seymour Lazar for alleged accepting millions of dollars in kickbacks from the Milberg Weiss firm. Lazar is one of the Paid Plaintiffs identified in the Milberg Weiss indictment. The Lazar indictment, discussed in this July 19, 2005 International Herald Tribune article, undoubtedly had its impact on plaintiffs’ firms and their practices. The indictment is clearly having an impact on the Milberg Weiss firm, and it hardly required a leap of imagination to suggest that the indictment is having its impact on the Lerach Coughlin firm as well. A prior D & O Diary post discussing the indictment’s possible impact on the Lerach Coughlin firm can be found here.

But regardless of its cause, the diminution in filing activities from the two leading firms has had a dramatic impact on overall securities litigation frequency.

Special thanks to Bill Ballowe for the securities class action filing data.

Anatomy of a Paid Plaintiff: One of the Paid Plaintiffs identified by name in the Milberg Weiss indictment is Stephen G. Cooperman. According to the indictment, during the relevant time, Cooperman resided in Brentwood, California and Connecticut and prior to May 1989 was a licensed ophthalmologist. According to the indictment, Cooperman and two relatives (identified as Cooperman Plaintiff 1 and Cooperman Plaintiff 2) received "approximately $6.5 million in secret and illegal kickbacks." A copy of the First Superseding Indictment against the Milberg Weiss firm may be found here.

Readers with a longer memory may recall Cooperman’s involvement in an even more colorful set of circumstances that wound up having a critical impact on the Milberg Weiss criminal investigation. According to AP news reports, in June 1997, the Cleveland Police found two paintings that had been reported stolen from the Brentwood, California home of a Stephen G. Cooperman. According to the report and a related article in the Los Angeles Times, in 1991 Cooperman acquired $12.5 million in insurance for the two paintings. In 1992, Cooperman reportedly told police that someone burglarized his Brentwood home and stole the paintings while he was on vacation in New Jersey. Police found that Cooperman’s burglar alarm had not been tripped and there were no signs of a break in. The only things taken were the two paintings. According to the press reports, the two insurance companies sued Cooperman for fraud and settled out of court. The paintings later surfaced as a result of a domestic dispute, when a Cleveland woman told police that her ex-boyfriend had paintings in a climate-controlled rented locker. The lawyer, named in the reports as James Little, had done legal work for Cooperman while in Santa Monica in the early 1990s, before Little moved to Cleveland.

The news reports about the paintings may be found here. (Scroll through the listings to the entry for June 6, 1997).

Cooperman was later prosecuted and convicted of fraud charges in 1999 and faced a 10-year prison term. According to this New York Times article, to reduce his sentence, Cooperman offered to testify against Milberg Weiss. Cooperman was not sentenced until 2001, when his sentence was reduced and he ended up serving less than two years in prison. According to the Times article, the opinion in Cooperman’s divorce case reports that Cooperman cooperated with prosecutors to help "implicate members of the Milberg Weiss firm."

As part of its settlement with Cooperman, the insurance companies acquired title to the paintings. One of the paintings, entitled "The Custom Officer’s Cabin at Pourville" was painted by Claude Monet in 1882, and was one of 14 paintings that Monet did of an abandoned Napoleonic-era coast guard post overlooking the English Channel. Photobucket - Video and Image Hosting

Monet had moved to Pourville after his first wife’s death from tuberculosis in 1879. The cycle of coast guard hut paintings prefigured later "series" paintings for which Monet is perhaps best known, reflecting a single subject in varying light and viewpoints. During the 1880s and 1890s, Monet painted over twenty views of the Rouen Cathedral, and later he painted a variety of perspectives on the water lilies in his garden at Giverny. Cooperman acquired the Monet from the Montgomery Gallery in San Francisco in 1987.

The second painting was entitled "Nude Before a Mirror" and had been painted in 1932 by Pablo Picasso. The painting’s more realistic style and more somber mood reflects the period between the wars when Picasso reverted to more of a classical technique, a phase he broke from in dramatic fashion in 1937 with his painting depicting the Guernica bombings. Cooperman also acquired the Picasso from the Montgomery Gallery.

Special thanks to a loyal D & O Diary reader for the Cooperman links.

 

When the Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse released their "2006 Mid-Year Assessment" earlier this week, the Report showed a 45% decline in the number of securities lawsuits filed in the first half of 2006 compared to the prior year period. According to the Report, the 61 securities class action lawsuits filed in the first half of 2006 represents the lowest level of securities lawsuit activity since 1996. The Report suggested a number of possible reasons for the decline, including the dissipation of the ill effects from the boom and bust period of the late 90s; the cleansing effects of Sarbanes Oxley; and the absence of stock market volatility. A prior D & O Diary post discussing the Report may be found here.

The D & O Diary finds the Report’s explanations for the litigation decline plausible, but insufficient. There is another possible explanation that, while cynical, may come closer to the truth.

Another hot topic in the securities law arena shows that sometimes only a cynical view can get at the truth. For years, academics had had been aware of a statistical pattern showing that share prices often rose quickly after options were granted. The early researchers speculated that corporate executives who knew that good news was on the horizon and made sure that options were granted beforehand. According to the May 30, 2006 Wall Street Journal(subscription required) article describing his research, when Erik Lie (now a Professor at the University of Iowa Business School) examined options grants as part of his doctoral research, he "found a striking pattern in which prices fell before the grant date, and rose soon afterward. He also discovered that the stock market as a whole also often rose following option grants at certain companies." Dr. Lie found it "uncanny" how good the executives apparently were at predicting future stock prices. He became suspicious, and when he released his research, he suggested that at least some of the awards had been timed retroactively. Other academics thought his explanation to "sinister" and rejected it. It was not until his research appeared in a front page Wall Street Journal article that his cynical explanation for a widely observed phenomenon was accepted. Professor Lie was just cynical enough to be able to explain a widely observed but inexplicable set of facts.

Perhaps a similarly cynical view may also explain the decline in securities lawsuit filings.

An alert D & O Diary reader commented that the decline actually began in September 2005. It was this observation that raised the possibility to me that the answer to the frequency decline may lie in the Milberg Weiss indictment. Paragraphs 26 and 27 of the First Superseding Indictment (which may be found here) provide as follows:

26. During the time relevant to this Indictment, MILBERG WEISS brought numerous class actions and shareholder derivative actions against publicly traded companies and other major businesses. These lawsuits generated hundreds of millions of dollars in attorneys’ fees for MILBERG WEISS. To bring these lawsuits, MILBERG WEISS needed persons who would agree to serve as named plaintiffs, and whom the courts would likely approve to represent absent class members or shareholders.

27. Beginning at least as early as in or about 1981 and continuing through at least 2005, in order to facilitate the recruitment of named plaintiffs, MILBERG WEISS, BERSHAD,SCHULMAN, and others known and unknown to the Grand Jury agreed to and did secretly pay kickbacks to named plaintiffs in class actions and shareholder derivative actions in which MILBERG WEISS served as counsel. Specifically, MILBERG WEISS, BERSHAD, SCHULMAN, and others known and unknown to the Grand Jury agreed to and did pay to certain individuals a substantial portion of the attorneys’ fees MILBERG WEISS obtained in actions in which such an individual served, or caused a relative or associate to serve, as a named plaintiff for MILBERG WEISS.

These of course are mere allegations and the defendants are entitled to a presumption of innocence. But if we assume for the sake of argument that these allegations are true, several things are clear: Milberg Weiss "needed" the paid plaintiffs because without them they could not have made hundreds of millions of dollars in fees. Milberg Weiss certainly would not have paid people to serve as plaintiffs if there were people willing to do it for free. Lacking volunteers, the firm employed mercenaries. The paid plaintiffs were an indispensable component in the firm’s ability to produce inventory — leading one to wonder whether production would have ceased or at least declined if the component supply were cut off?

Milberg Weiss now stands accused of paying kickbacks. Milberg Weiss may have drawn the prosecutors’ attention because of its prominence, and perhaps even because of the scale of its reliance on paid plaintiffs, but if it happened, is it possible that they were the only firm relying on paid plaintiffs? Or is it more likely that in the highly lucrative but highly competitive world of the plaintiffs’ securities bar that these practices were widespread?

The indictment alleges that the practice of paying plaintiffs continued "through at least 2005," right about the time it started to look as if the prosecutors were serious about pursuing Milberg Weiss criminally. The grand jury investigation was well publicized, so it became pretty clear that paying plaintiffs could lead to trouble, and, it may be presumed, the practice stopped. Right about the time that the securities lawsuit frequency started to decline.

Is it possible that securities lawsuit frequency is declining because the threat of criminal prosecution has disrupted supply of a key component in the plaintiffs’ lawyers’ most important product – that is, without the ability to pay people to serve as named plaintiffs, the plaintiffs’ lawyers can’t find anyone else to do it so they are producing fewer lawsuits? Is it possible that the lawsuits that depended on paid plaintiffs just aren’t getting filed?

The D & O Diary is interested in your comments.

D & O Insurers’ Exposure to Backdating Lawsuits: According to John Degnan, the Chief Administrative Officer of Chubb, "[t]he early hype about the impact of backdated stock options on D & O insurers may be overblown." According to news reports, Degnan cites several reasons why Chubb’s exposure may be limited:

In most cases, Chubb is only an excess carrier, so it’s not immediately exposed to costs related to directors’ and other executives’ legal costs as they defend backdating allegations, he explained. (Excess of loss insurance only kicks in when losses breach certain thresholds).

Chubb has also limited the maximum payouts on the D&O policies it writes. Limits are now "far lower" than they were when the corporate scandals of earlier this decade struck, Degnan added.

Chubb usually only insures one chunk of potential losses on each D&O policy it underwrites. That should help it avoid lots of different losses piling up, Degnan said.

Share price drops in the backdating scandal have been limited so far, which should keep securities class action lawsuits to a minimum, he also noted.

Most of the claims Chubb has received so far come from derivative lawsuits, which are harder for plaintiffs to win and usually result in smaller settlements, Degnan said

Nineteen companies have notified St. Paul Travelers of stock option-related claims or potential claims under their policies covering directors or officers, according to Chief Operating Officer Brian MacLean. Of those, St. Paul Travelers is the primary insurer at only one company, and there is a $10 million limit on that policy, he said."We believe that based on the facts today this is not going to be a big issue for us," he said. McLean’s comments may be found here.

 

Eliminate Quarterly Guidance? On July 24, 2006, the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics issued a Report entitled "Breaking the Short-Term Cycle: Discussion and Recommendations on How Corporate Leaders, Asset Managers, Investers and Analysts Can Refocus on Long-Term Value," calling on corporate leaders, asset managers and others to break the "short-term" obsession and reform practices involving earning guidance, compensation and communication to investors.

The report is the product of a series of symposia the groups co-sponsored to address issues of "short-termism." The symposia participants included a number of widely respected individuals, including John Bogle of the Vanguard Group, Louis Thompson of the National Investor Relations Institute, and other representatives from companies, investor groups and securities analyst firms.

The report states that "the obsession with short term results by investors, asset management firms, and corporate managers collectively leads to the un-intended consequences of destroying long-term value."

The report’s recommendations include the following actions:

  • End the practice of providing quarterly earnings guidance;
  • Align corporate executive compensation with long-term goals and strategies and with long-term shareholder interests;
  • Improve disclosure of asset managers’ incentive metrics, fee structures, and personal ownership of funds they manage; and
  • Endorse the use of corporate long-term investment statements to shareowners that will clearly explain – beyond the requirements that are now an accepted practice – the company’s operating model.

With respect to quarterly earning guidance, the report notes the following:

Although there may be certain benefits to providing earnings guidance, the costs and negative consequences of the current focused, quarterly earnings guidance practices are significant, including (1) unproductive and wasted efforts by corporations in preparing such guidance, (2) neglect of long-term business growth in order to meet short-term expectations, (3) a "quarterly results" financial culture characterized by disproportionate reactions among internal and external groups to the downside and upside of earnings surprises, and (4) macro-incentives for companies to avoid earnings guidance pressure altogether by moving to the private markets.

A prior D & O Diary post noted that these and other concerns increasingly are motivating companies to move toward annual earning guidance only or the elimination of earnings guidance altogether. The elimination of quarterly earning guidance would not only address the concerns noted in the recent Report, but also would discourage activity that frequently is at the center of shareholders’ claims against companies and their boards. The drive to make (or avoid missing) guidance is the root cause of many of the behaviors that drive shareholders’ claims. The D & O Diary believes that implementation of the Report’s recommendations for companies — especially the Report’s recommendation about eliminating quarterly earnings guidance — would be an important step for any company that is serious about managing its securities litigation risk.

The groups’ press release describing the Report can be found here. A summary of the Report’s recommendations can be found here. A July 25, 2006 cfo.com post discussing the report can be found here. An AAO Weblog post on the report can be found here.

Stanford Clearinghouse Mid-Year Report: On July 26, 2006, the Stanford Class Action Clearinghouse, in conjunction with Cornerstone Research, released their 2006 Mid-Year Class Action Securities Fraud Class-Action Filings Report, which can be found here. The report notes that the 61 class actions filed in the first half of 2006 represents a 45 percent decrease compared to the 111 filings observed in the first half of 2005. The 2006 mid-year numbers represent the lowest level of filing activity during a six-month period since 1996, just after the adoption of the PSLRA. The Report speculates that the decline is due to the passage of time from the Internet bubble of the late 1990s; to possible improvements to corporate governance owing to Sarbanes Oxley; and the overall absence of volatility in stock prices during recent periods. The press release that accompanies the report includes a quotation from a Cornerstone official that "[a]lthough there is no doubt that there has been a considerably lower level of filing activity over the last year, it is still too early to tell whether this is a permanent shift."

The D & O Diary agrees that it is way too early to conclude that the YTD numbers represent a fundamental change. Among other things that the D & O Diary thinks could still produce an uptick in class action securites activity this year is the options backdating scandal and the slow dissolution of the Milberg Weiss firm. Although the options backdating scandal has only produced limited class action securities litigation so far (as the Cornerstone mid-year Report duly notes), the string on the scandal still has a long way to run. The gradual out-migration of Milberg lawyers, including the spawn of new law firms, as well as the attraction of existing plaintiffs’ firms (including firms traditionally associated with tobacco or asbetos litigation) to Milberg’s space, create a population of plaintiffs’ firms and attorneys that need to justify their existence. In addition, market causes, such as the low share price volatility, can change. Rising interest rates and energy prices, war in the Middle East, and the threat of terrorism and natural catastrophes all present the potential to generate volatility and undermine the generally stable business environment we have enjoyed for several good years.

The D & O Diary also notes that the class action securities lawsuits may not even be the shareholders litigation story for the first half of 2006. The real story may be the raft of shareholders’ derivative suits that the options backdating scandal has generated (up to 49 cases at last count.)

State of the D & O Marketplace: On July 17, 2006, Advisen released its "Commercial Lines Expert Witness Report for D & O" which surveys the current state of play in the D & O insurance marketplace. The report contains the comments from 14 "thought leaders" in the D & O arena (including underwriters, reinsurers, brokers and attorneys). The commentators share their views on trends in D & O pricing and terms and conditions; the impact of the options backdating scandal and of Sarbanes Oxley on the D & O marketplace; and legal developments that the experts are following. The Advisen Report is a little repetitive, but there are a few nuggets that reward close reading, particularly with respect to policy terms and to legal trends. The comments of several underwriters that D & O pricing will (or at least should) rise in the second half of 2006 appear problematic in light of the statistics in the Cornerstone Report. The Advisen Report can be found here.

Some Healthy Options Backdating Skepticism: As observers and commentators have tried to get a handle on how widespread the options backdating scandal is, some pretty large numbers have gotten thrown around. For example, Professor Erik Lie and Randall Heron’s latest study concludes that over 2,200 companies backdated options. Comes now Broc Romanek of the CorporateCounsel.net blog who solemnly declares in this July 24, 2006 post that "[m]y gut tells me there is something fishy" about these numbers. The basis for Romanek’s skepticism is a fundamental disbelief that that many people are lying, coupled with a informed belief that many companies have already verified that their companies do not have a problem. Whether or not Romanek’s gut is more reliable than Professors Lie’s and Heron’s analysis is for others to decide, but Romanek does have a point. The sheer magnitude of the Professors’ numbers do create credibility tension. If the whole Y2K fiasco taught us nothing else, it surely taught us to be suspicious when the experts are announcing the arrival of Armageddon.

Head Case Redux: As a service to those for whom the Zidane head-butt controversy was the biggest story so far this year, The D & O Diary includes this link to a July 25, 2006 USA Today article (with video footage) entitled "Jockey apologizes for head-butting horse." (I am not making this up.) The jockey is sorry and assures everyone that this "will never happen again." I am sure the horse feels a lot better better about it now with that reassurance. The D & O Diary notes that, unlike Zidane, the jockey was wearing a helmet at the time of the head-butt. Is The D & O Diary the only one puzzled why anyone would ever use their head (which has numerous other important uses) as a weapon?

 

According to Gerald Silk of the Bernstein, Litowitz, Berger & Grossman firm, options backdating is a "make-or-break issue." Silk is not talking about the interests of aggrieved shareholders –he means that options backdating is a really big deal for the plaintiffs’ bar. His comments appear in a July 24, 2006 article entitled "Plaintiffs’ Lawyers Jockey for Position," in which law.com explores the struggle amongst plaintiffs’ lawyers for control of the growing wave of options backdating litigation. Among other things, the article examines the struggle between lawyers representing institutional and individual investors. The article also show why plaintiffs’ lawyers are preferring shareholders’ derivative lawsuit to securities fraud class actions in attempting to capitalize on the options backdating scandal; the article attributes the following to Silk:

derivative actions are more common in these backdating cases because, in order to have a securities class action under Rule 10-b(5), the stock has to fall and an investor has to demonstrate harm. This has not always been the case when it comes to the backdating scandal.

The article also shows that while derivative actions may represent a more limited opportunity for plaintiffs’ lawyers (from a fee standpoint), derivative actions have certain procedural advantages, such as the absence of a statutory preference for institutional shareholders and the absence of a statutory waiting period or discovery stay, all of which apply or may pertain in a federal securities action. As a result, plaintiffs’ lawyers representing individuals in derivative lawsuits are "rushing to court."

The article’s comments about the absence of significant share price declines for many of the companies involved in the options backdating investigation is consistent with The D & O Diary’s view that the options backdating scandal may not prove to be a "severity event" for the D & O insurance industry. On the other hand, it clearly is already a significant frequency event, and the frequency will continue to rise as the investigations continue to expand. For up-to-date frequency data for the options backdating litigation, visit this post of The D & O Diary, "Counting the Options Backdating Lawsuits."

Hat tip to Adam Savett of the Lies, Damned Lies blog for a link to the law.com article.

Following our Right Honorable Friend, Bill Lerach: "These days Bill Lerach is either at the top of his profession — or on his way to jail." That is the lead in the July 23, 2006 Los Angeles Times article reporting on what life is like these days for Lerach, in the wake of the Milberg Weiss law firm indictment. The Los Angeles Times article reflects various pundits’ speculation that Lerach’s firm or Lerach himself may yet be dragged into the criminal proceedings. In what I suppose is intended to pass as news, the article concludes that "legal observers are divided about whether prosecutors are still gunning for Lerach." While much of the article replays Lerach’s background with Milberg Weiss and his recent success in the Enron case, one comment reported in the article is particularly colorful; the article reports the following commentary from Walter Olson, a senior fellow at the Manhattan Institute for Policy Research:

Lerach is "far from the only lawyer who has concluded that being noisy and unpleasant is good tactics for getting what you want," Olson said. He stands out because "he’s personalized it in a way that others haven’t done, turning litigation into a contest of peacocks in the barnyard."

Nugget Author Moves On: Chris Jones, heretofore a partner in the Boca Raton office of the Milberg Weiss firm and also the author of the PSLRA Nugget, announced today in a post on his blog that he is leaving the Milberg Weiss firm to join two other prior Milberg Weiss departees at the new law firm of Saxena and White. According to a post on the WSJ.com law blog, the Milberg firm will now be closing the Boca Raton office and is now down to two offices from four.

Today’s PSLRA Nugget post says that future posts will "decrease a little in frequency" as Jones adjusts to his new firm. The D & O Diary hopes the PSLRA Nugget is soon back up to speed. The D & O Diary is a subscriber to and regular reader of the Nugget and looks forward to continuing to read the Nugget’s interesting and entertaining posts.

A WSJ.com law blog post with futher discussion of the implications for the Milberg Weiss firm can be found here.

Outside Director Liability: The liability of outside directors was a hot topic earlier last year when the Enron and WorldCom settlements were first announced. As a result of the options backdating scandal, outside director liability is a hot topic again. Any public company director has to be concerned with the news that three outside directors at Mercury Interactive have been served with "Wells Notices" in connection with the options backdating investigation at Mercury. (Mercury’s press release disclosing the Wells Notices can be found here.) In an earlier development, outside directors of Hollinger were served with Wells Notices in connection with the SEC’s investigation of Conrad Black. Outside director liability is clearly going to remain a hot topic. The author of The D & O Diary’s views about the risks and practical D & O insurance implications surrounding the issue of outside director liability can be found in this July 24, 2006 article entitled "Outside Director Liability: Increased Risks and Practical Considerations."

Proportionate Liability: The 10b-5Daily blog has an interesting July 24, 2006 post discussing a July 5, 2006 holding in the Enron Derivative and ERISA litigation in which the PSLRA’s proportionate liability language is examined. The court, concerned about the "havoc" that the bare statutory language could create at trial, establishes threshold requirements for proportionate liability. Becase so few securities cases go to trial, this issue has not previously been examined by a court.

 

With all of the media attention focused on the first options backdating criminal complaint, filed July 20, 2006 against two former officials of Brocade Communications Systems, and with published reports suggesting (for example in the July 21, 2006 front page article of the Wall Street Journal , subscription required) that prosecutors are investigating “over 80 companies” for options timing manipulations, it would be easy to conclude that the tide of federal white collar criminal prosecutions is mounting. And indeed with the options backdating story just beginning, it may well be that we are at the leading edge of a growing prosecutorial crackdown on corporate fraud.

But a July 18, 2006 Legal Times article entitled “Has the Wave of White-Collar Prosecutions Crested?” raises the question whether the crackdown on corporate criminals is in fact on the decline as a result of changing prosecutorial priorities. Citing the United States’ Attorneys’ Annual Statstical Report for Fiscal 2005, which can be found here, the article notes that “there was a 30 percent drop in the number of defendants charged with corporate fraud in 2005 over the previous year and a more than 50 percent decline in the number of corporate fraud investigations opened by federal prosecutors last year.” The 2005 figures were the lowest for any year since the 2002 post-Enron crackdown on corporate crime. The Legal Times article quotes a number of sources for the proposition that the decline in new prosecutions is due to a continued shift in resources toward terrorism investigation and public corruption. However, factors such as the options backdating scandal may yet relieve what could prove to be an otherwise temporary stall.

A Closer Look at the First Options Backdating Criminal Case: Wayne State University Law School Professor Peter Henning in a thoughtful July 21, 2006 post on his White Collar Crime Prof blog raises some interesting questions about the criminal complaint filed against the former Brocade Communications officials. First, he questions why the prosecutors chose to “proceed by criminal complaint rather than seeking a grand jury indictment,” and speculates that there may be plea agreements or statute of limitations concerns that motivated prosecutors to use a criminal complaint, but that there could be “an indictment in the next few weeks that may well contain more charges, perhaps including books-and-records accounting.” Professor Henning also raises questions about the merits of the criminal complaint:

While the charges allege numerous instances of options grants involving backdated documents, it remains unclear what constitutes the securities fraud….[I]t is not clear what constituted the fraudulent scheme when the employees received the proper amount of options while their additional paper gains were not “taken” from the company. To the extent that fraud is a type of larceny, it is not easy to see the company as a victim of the deception, and [defendant] Reyes did not gain from the transactions, at least not directly. Not all lies are frauds, and the government’s case may be a difficult one, at least on a securities fraud charge.

The D & O Diary notes that while the SEC filed a parallel civil complaint against three former Brocade Communications executives, thus far other Brocade officials, including Brocade’s outside directors, have not been named. The non-involvement of Brocade’s outside directors stands by interesting contrast to the Mercury Interactive investigation, where three former outside directors of Mercury have been served with “Wells” notices. As has been noted on prior this D &O Diary post, Brocade’s former outside directors include Larry Sonsini, of the Wilson Sonsini Goodrich & Rosati law firm and one of the most prominent lawyers in Silicon Valley. The WSJ.com law blog has an interesting post discussing the fact that Wilson Sonsini has represented over half of the more than 30 Silicon Valley companies that have been named in connection with the options backdating investigation. A July 22, 2006 New York Times article discussing the significance of options backdating in Silicon Valley during the dot-com boom and afterwards, and the role of the Wilson Sonsini firm, can be found here. A cool feature of the Times article is an interactive map showing the geographic location of Silicon Valley firms involved in the options backdating investigation.

Finally, The D & O Diary notes that the Brocade Communications options timing scandal presents an example of hiring-related options timing, which as discussed on this prior D & O Diary post, involves important differences from options backdating and options springloading. The most important difference that is that hiring-related options timing may not involve self-dealing or personal enrichment. According to this WSJ.com law blog post, the absence of self-dealing or personal benefit is precisely the basis on which the defense attorney for Gregory Reyes, Brocade’s former CEO, is raising in Mr. Reyes’ criminal defense.

More Statistical Analysis of Options Backdating: Graef Crystal has an interesting July 20, 2006 article on Bloomberg.com analyzing opportunistic option timing. Crystal looked 16,211 options grants made to chief executive officers between 1992 and 2005. He analyzed the actual and expected option exercise prices compared to the share prices in the 180-days before and after the date of the awards. The expectation would be that the exercise price would fall at the mid point of the price range. But instead the exercise price was consistently lower than the share price following the award. Interestingly, Crystal’s analysis shows that the statistically unexpected rise in share price after the award has continued even after the enactment of the Sarbanes Oxley Act. (Crystal estimates the probability of this outcome as a result of chance as “way less than 1-in-100 trillion.”) His analysis suggests even after Sarbanes Oxley made it more difficult for CEOs to backdate options, they have continued to springload options grants.

Not Your Average Blogger: Attentive readers may have noticed that I have added my photograph to this blog. I am feeling defensive about my blogger identity as a result of Pew Internet & American Life Project survey of bloggers, which may be found here and is discussed in this July 20, 2006 Washington Post (registration required) article. According one source quoted in the Post article, “the average blogger is a 14-year old girl writing about her cat.” My newly added picture is your assurance that I am, let us say, well over 14 years old and that posts about my cats (I have two of them, actually) will never appear on this blog. Disappointed cat lovers are directed here.