The information in this post was last updated on September 10, 2008

The purpose of this blog post is to track options backdating related litigation. All of the companies that have been sued — and of which the The D & O Diary is aware — have been listed below. The D & O Diary will update this information as additional companies are sued, or as loyal readers advise The D & O Diary of any omissions. The D & O Diary will note at the top and bottom of this post the date on which the information was most recently updated, and will indicate in red which information has been most recently added. Readers interested in keeping up to date on the number of lawsuits will want to check back frequently. The running tallies below are meant to include a listing of any company that has been sued based on allegations of options timing manipulations, regardless whether the allegations are based on options backdating, options springloading, or hiring-related options timing.

Securities Fraud Class Actions (Total as of latest update = 39):

1. American Tower
2. Amkor Technology (see discussion of this case here)
3. Apple Computer
4. Apollo Group
5. Aspen Technology
6. Broadcom
7. Brocade Communications
8. Brooks Automation
9. Comverse Technology
10. Cyberonics
11. Hansen Natural Corporation
12. HCC Insurance Holdings
13. Jabil Circuit
14. Juniper Networks
15. KLA-Tencor
16. Marvell Technology Group
17. Maxim Integrated Products
18. Meade Instruments
19. Mercury Interactive
20. Michaels Stores
21. Monster Worldwide

22. MRV Communications
22. Newpark Resources (see discussion of this case here)
24. Openwave Systems
25. PainCare Holdings (see discussion of this case here).
26. Quest Software
27. Rambus
28. SafeNet
29. Semtech
30. Sonic Solutions
31. Sunrise Senior Living
32. TeleTech Holdings
33. The Children’s Place Retail Stores
34. Vitesse Semiconductor
35. United Health Group
36. UTStarcom
37. Wireless Facilities
38. Witness Systems
39. Zoran (see discussion of this case here).

 Shareholders Derivative Lawsuits (current total as of latest update = 168)

1. Actel
2. Activision
3. Adobe Systems
4. Affiliated Computer Service
5. Affymetrix
6. Agile Software
7. Alkermes
8. Altera
9. American Tower
10. Amkor
11. Analog Devices
12. Apollo Group
13. Apple
14. Applied Micro Circuits
15. Arthrocare
16. Aspen Technology
17. Asyst
18. Atmel
19. Autodesk
20. Barnes and Noble
21. BEA Systems
22. Bed Bath and Beyond
23. Biomet
24. Black Box
25. Blue Coat
26. Boston Communications Group
27. Broadcom
28. Brocade Communications
29. Brooks Automation
30. CA, Inc.
31. Cable Vision Systems
32. Cardinal Health
33. Caremark Rx

34. Ceradyne
35. Cheesecake Factory
36. Children’s Place Retail Stores
37. Chordiant Software
38. Cirrus Logic
39. Cisco Systems
40. Citrix Systems
41. Clorox
42. CNET Networks
43. Coherent
44. Computer Sciences Corp.
45. Comverse Technology
46. Corinthian College
47. Countrywide Financial Corp.

48. Costco Wholesale Corp.
49. Crown Castle International
50.Cyberonics
51. Delta Petroleum
52. Dean Foods
53. Digital River
54. Ditech Networks
55. Eclipsys
56. Electronic Arts

57. Electronics for Imaging
58. Embarcadero Technologies
59. EMCORE

60. Epiq Systems
61. ePLUS
62. Equinix
63. F5 Networks
64. Family Dollar
65. Finisar
66. Flir Systems
67. Flowserve
68. Fossil
69. Foundry Networks
70. Getty Images
71. Glenayre Technologies
72. Hain Celestial Group
73. HCC Insurance Holding
74. Home Depot
75 Hansen Natural Corp.
76. Hot Topic
77. Hovnanian Enterprises
78. i2 Technologies
79. Basis
80. Infosonics
81. Insight Enterprises
82. Integrated Silicon Solutions
83. Intuit
84. J2 Global Communications
85. Jabil Circuit
86. Juniper Networks
87. Jupitermedia Corp.
88. KB Homes
89. Keithley Instruments
90. KLA-Tencor
91. Kopin Corp.
92. KV Pharmaceutical
93. L-3 Communications Holding
94. Lehman Brothers Holdings
95. Linear Technology
96. M-Systems (see note below)
97. Marvell Technology
98. Mattel
99. Maxim Integrated
100. McAfee
101. Meade Instruments
102. Medarex
103. MercuryInteractive
104. Michael’s Stores
105. Microtune
106. MIPS Technologies
107. Molex
108. Monster.com
109. MSC Industrial Direct
110. Nabors Industries
111. Network Appliance
112. Newpark Resources
113. Novell
114. Novellus
115. Nvidia
116. Nyfix
117. Openwave
118. Par Pharmaceuticals
119. Pediatrix
120. Peet’s Coffee & Tea
121. Pool Corp.
122. PMC Sierra
123. Power Integrations
124. Progress Software
125. Quest Software
126. QuickLogic
127. Redback Networks
128. Rambus
129. Research in Motion
130. RSA Security
131. Safenet
132. Sanmina-SCI
133. Sapient
134. ScanSource
135. SecureLogic Corp.
136. Semtech
137. Sepracor
138. Sharper Image
139. Sigma Designs
140. Silicon Storage Tech
141. Sonic Solutions
142. Sonus Networks
143. SPSS
144. Staples
145. Sunrise Senior Living
146. Superior Industries International
147. Sycamore Networks
148. Take-Two Interactive
149. Tetra Tech
150. The First American Corp.
151. THQ
152. Trident Microsystems
153. TriQuint Semiconductor
154. Tyson Foods
155. Ultratech
156. Ulticom
157. United Healthcare
158. UTStarcom
159. Valeant
160. Verisign
161. Vitesse Semiconductor
162. Waste Connections
163. Western Digital Corp.
164. Westwood One
165. Wind River Systems
166. Witness Systems
167. Xilinx
168. Zoran Corp

 

ERISA or 401(k) Litigation (Total as of latest update = 5):

1. United Health Group

 

2. Affiliated Computer Services
3. Analog Devices
4. KB Homes
5. The Home Depot

In addition to these lawsuits, SanDisk Corporation has been sued in connection with its proposed acquisition of M-Systems. The defendants include not only SanDisk, but M-Systems and certain directors and officers of M-Systems. The lawsuits allege that the terms of the deal are not fair to M-Systems shareholders. In addition, the plaintiffs allege that the M-Systems officers and directors breached their fiduciary duty to M-Systems shareholders by backdating stock options and sought to further their own interests by approving the merger. A description of the lawsuit may be found here. Special thanks to Adam Savett of the Lies, Damned Lies blog for bringing this lawsuit to the attention of The D & O Diary.

Also, Sycamore Networks has been named in a lawsuit brought by a former employee, in which the former employee alleges that his employment contract was terminated because he complained about the company’s stock option practices. A Wall Street Journal article (subscription required) describing the lawsuit can be found here.

The information in this post was last updated on: August 4,  2008.

 

 


Erik Lie, the University of Iowa Business School professor whose research is widely credited with unlocking the emerging options backdating scandal, has published a new research paper concluding that practice of options backdating was far more widespread than current media reports suggest. According to Lie’s July 14, 2006 paper, written with Associate Professor Randall Heron of the University of Indiana Business School, “the alleged incidents of backdating that have surfaced in the media appear to represent merely the tip of the iceberg.”

The paper’s authors examined a sample of 39,888 stock option grants made to 7,774 companies’ CEOs, Presidents and Chairmen of the Board, using information from the Thompson Financial Insider Filing database and insider transactions reported to the SEC. The study analyzed whether or not there were “abnormal [investment] returns around option grants.” The authors’ assumption is that, without manipulation, half the returns should be positive and half should be negative, but in fact the distribution was shifted upward. The authors used this analysis to infer the number of grants that were backdated or otherwise manipulated.

According to the authors, 13.6% of the grants studied were backdated or manipulated. Because grants that are scheduled to take place at the same time every year are more difficult to backdate or otherwise manipulate, the authors focused their attention on unscheduled grants that were in-the-money or at-the money. (Grants that were out-of-the-money, that is, with the exercise price below the share price on the grant date, presumptively were not the subject of manipulation.). The authors concluded that 18.9% of the unscheduled, in-the-money or at-the money option grants were backdated or otherwise manipulated. The authors also concluded that the practice was more widespread before August 29,2002, when the SEC implemented new rules requiring option grants to be filed within two days. The authors concluded that 23% of the unscheduled at-the-money grants between January 1, 1996 and August 29, 2002, and 10% of the unscheduled grants after August 29, 2002, were backdated or otherwise manipulated.

The number of backdated or otherwise manipulated grants is different from the number of firms that engaged in backdating. The authors compared expected and average actual options returns for the 7,774 companies in their data population to estimate that 29.2% of companies (or 2,270 companies) engaged in backdating or similar manipulation of grants to top executives at some point between 1996 and 2002. The authors also estimate that 16.1% of companies in the study engaged in backdating between August 29, 2002 and December 1, 2005.

The authors’ finding of continued backdating after the SEC’s August 29, 2002 implementation of the new filing rule may be partially understood by some companies’ apparent disregard for the new filing rules. The authors found that while 10% of the unscheduled at-the-money grants after August 29, 2002 were backdated or otherwise manipulated, the incidence was 19.9% for companies that filed their grants late, but only 7% for companies that filed within the required two business days.

The study also found that the incidence of unscheduled at-the-money grants that are backdated or otherwise manipulated is 20.1% among low tech firms but 32% among high tech firms; 23.1% among small firms (market capitalization within 20 days before the grant < $100 million), 27% among medium-sized firms ($100 million $1 billion); and 13.6% among the firms with the lowest one-third of share price volatility, 26.2% among the firms with the middle third level of share price volatility, and 29% among firms with the one-third highest level of volatility.

The study also concludes that smaller auditors (i.e., those other than the big five) are associated with more companies that backdated after August 29, 2002. Among the big five firms, PwC and KPMG are associated with less backdating before August 29, 2002, and PwC with less after August 29, 2002. However, the authors note that care should be taken in interpreting the backdating differences among the auditors, as the differences might reflect characteristics of the audited companies.

The New York Times July 17, 2005 article reporting on the new study quotes Professor Lie as saying that the widespread nature of options backdating is “pretty scary and quite surprising to me.” The Times article also reports that Professor Lie said the findings were so surprising that he asked several colleagues to check his numbers, and they concluded that the numbers probably erred on the low side.

The D & O Diary notes that because the study is limited to analysis of grants made to the most senior company officials, the study necessarily omits companies that engaged in options timing practices for grants to other persons. For example, another option timing practice that has been the subject of scrutiny is the award of hiring-related options grants, whereby new hires or potential new hires were offered grants backdated to a date prior to their hire date, when the company’s share price was trading at a higher price. The backdating potentially made the options grant more attractive to potential new hires. Hiring-related options grants was the subject of a prior D & O Diary post, which may be found here.

Professor Lie’s Options Backdating website may be found here.

Options Backdating Criminal Charges Coming? An article in the July 14, 2006 issue of The Recorder predicts that Gregory Reyes, the ex-CEO of Brocade Communcations may be the first executive indicted in the options backdating scandal. Brocade was one of the first companies implicated in the scandal, as it restated its financials due to options related issues in January 2005. According to this February 13, 2006 Business Week article, Reyes blames one of the most prominent lawyers in Silicon Valley, Larry Sonsini of the Wilson Sonsini Goodrich & Rosati firm and a former member of Brocade’s board, for the company’s options problems. According to Reyes, Sonsini suggested a compensation structure in which Reyes sat as a “committee of one” and those could aware stock options at will. When stock options questions arose, Reyes said, Sonsini argued for him to resign. Sonsini is named as a defendant in the Consolidated Amended Complaint filed in the civil securites fraud class actions that has been filed against Brocade Communications. A WSJ.Com Law Blog post on the anticipated indictment can be found here.

According to a July 17, 2006 article on Bloomberg.com, after the first indictment, which is anticpated this week, “at least 12 more cases will probably follow.” The Bloomberg.com article also quotes sources as saying that in the enforcement action this week, the SEC will probably file a civil case in tandem with criminal charges by the Justice Department. The Bloomberg.com article also notes that the June 2003 criminal complaint filed against Peregrine Systems encompassed a wide variety of charges including stock-option violations. The SEC’s June 2003 complaint against Peregrine Systems can be found here (the stock options allegations are in paragraph 29).

Jupiter Networks Sued in Options Backdating Securities Class Action: According to a July 17, 2006 press release, Jupiter Networks has been named in a securities class action lawsuit based on allegations of improper options backdating. This brings the number of companies sued in securities class action lawsuit based on allegations of improper options backdating to nine. Prior D & O Diary post tallying the other eight lawsuits and identifying the companies previously sued can be found here and here and here.

Options Backdating Link: Readers interested in more regular servings of options backdating news may want to check out the Vangal blog, which may be found here. Tip of the hat to Adam Savett at the Lies, Damn Lies blog for the Vangal link. The Vangal blog apparently is affiliated with Vangal Strategy and Business Consulting, whose website describes the company as “the leading strategy consulting firm for high-velocity companies who are facing a crisis with Stock Options Backdating [and] and Spring-loading grants.” A June 24, 2006 article in the San Jose Mercury News describing Vangal and other blogs discussing options backdating can be found here.

One of the least understood and least studied features of the world of corporate and securities law is the impact that directors’ and officers’ liability insurance has on companies’ conduct. A new article by two University of Connecticut Law School professors, Tom Baker and Sean Griffith, represents an ambitious attempt to understand the impact of D & O insurance on corporate governance. The article, entitled "Predicting Corporate Governance Risk: Evidence from the Directors’ and Officers’ Liability Insurance Market" presents the authors’ theory that D & O insurance provides a deterrence function within corporate governance and securities law by forcing worse-governed firms to pay higher premiums than better-governed firms. Because the authors joined their analysis to detailed interviews of key players in the D & O insurance industry, the article does a praiseworthy job describing the industry and the broad outlines of the D & O underwriting process. The article’s insights into the D & O underwriting process alone reward close reading.

However, The D & O Diary questions the article’s authors’ premise concerning D & O insurance underwriters’ ability to accurately segment securities litigation risk based upon the underwriters’ assessment of various companies’ corporate governance practices. The premise derives from some underwriters’ own statements of their belief in their ability to differentiate "deep governance" variables such as "culture" and "character." Some underwriters may well believe they have those differentiation capabilities, but the reality is that D & O underwriters necessarily have only limited and brief access to senior company management and rarely see management engaged in unrehearsed activity. Underwriters who believe they truly can discern culture and character on this necessarily limited basis are, in reality, doing little more than their version of Johnny Carson’s old Carnac the Magnificent routine, without the humor (or, one hopes, without the costume). In addition, even if D & O insurance rates may be adjusted at the margins for governance factors, the rates themselves are largely driven by the insurance cycle, which for most companies is a much more important factor than corporate governance practices in determining the ultimate price that the companies will pay for its D & O insurance. Because of the impact of the cycle and the level of competition within the D & O insurance industry, it would be difficult to quantify any cost savings a company could realize through better corporate governance. Because the financial link between premium levels and governance practices is so indeterminate, the deterrence role of D & O insurance in corporate governance is theoretical at best. Finally, The D & O Diary questions whether D & O insurance premiums alone could be sufficient to perform the significant role that the article’s authors postulate; for most companies, their D & O insurance premium is just another cost of doing business. Companies who can be persuaded to improve their corporate governance practices will do so out of fear of litigation or of government regulators, or because they simply want to do the right thing; the expectations or requirements of D & O underwriters, by comparison, are unlikely to be as important –with all due respect to my many good friends in the D & O underwriting community. (In fairness to the article’s authors, the D & O Diary acknowledges that the article recognizes all of the considerations raised in this post; the article simply draws different conclusions. )

All of these concerns notwithstanding, the article does represent an unprecedented and important academic attempt to understand how D & O insurance really works, and in particular, the article’s authors’ methodology of developing a deeper understanding of the D & O insurance industry through interviews with industry professionals represents an important academic innovation. The D & O Diary suggests that this methodology could very productively be used to develop a better understanding of the true role of D & O insurance in the settlement of shareholders’ securities fraud claims.

Full disclosure: the author of The D & O Diary was interviewed by one of article’s authors in connection with the empirical research on which their article is based.

A tip of the hat to Adam Savett of the Lies, Damned Lies blog for providing a link to the article.

Aux Armes, Citoyens! Formez Vos Bataillons! Given the level of media coverage, it is hardly surprising that plaintiffs’ lawyers have sought to secure their place in the options backdating litigation battlefield by announcing, for example, that they have formed an "Options Backdating Investigation Division", or that they are investigating 48 different companies or "over 50 companies." Perhaps inevitably, the first entrant from the defense bar into this escalating press release arms race has now appeared. On July 10, 2006, the Proskauer Rose law firm announced that it has formed a "Stock Options Task Force," which, their press release explains, is a special multidisciplinary group of over 20 lawyers that will work with companies on stock option timing issues. None of this is surprising to The D & O Diary, since I predicted in my very first post on options backdating that the issue would be "this year’s model" of the Lawyers’ Relief Act.

In a much more ominous development on the options backdating front, Kevin Ryan, U. S. Attorney’s Office in San Francisco announced on July 13, 2006 that his office has formed its own stock options backdating task force. The team is responsible for investigating companies and individuals in Northern California who retroactively changed the dates of stock options with the intent to defraud. According to this post in the wsj.com law blog, the Mr. Ryan’s office’s press release stated that the task force "will bring criminal charge when appropriate."

Head Case: On the theory that anything that is the subject of a front page article in the Wall Street Journal (subscription required) is a suitable topic for this Internet weblog, The D & O Diary has decided to weigh in on the Zidane head butt controversy — possibly the only story this year that has gotten more widespread media coverage than options backdating. First, we would like to introduce as Defense Exhibit No. 1 the following link to an extensive video portfolio of the misbehavior of Marco Materazzi on prior occasions, which may explain what may have preceded Zidane’s now infamous head butt of Signore Materazzi. Second, in the interests of world peace and understanding, The D & O Diary would like to introduce as Defense Exhibit No.2 the following link as proof that there are a lot of people out there with a lot of time on their hands to exploit the humor in any situation, even the video footage of Monsieur Zidane’s head butt. (Does anyone remember who won the game?)

 

Sarbanes-Oxley Act Whistleblower Updates: In a May 31, 2006 ruling, an Administrative Review Board (ARB) of the U.S. Department of Labor has answered two important questions arising Section 806 of the Sarbanes-Oxley Act, the so-called Whistleblower provisions. (Prior D & O Diary posts regarding the Sarbanes-Oxley Whistleblower provisions can be found here and here.). First, the ARB held that the nonpublicly traded subsidiary of a publicly traded company can be a proper defendant in a Sarbanes-Oxley Whistleblower case if the subsidiary acted as an agent for the public company. The determination is one of fact, based upon the subsidiary’s attributes of agency, rather than one of law based on the organizational relationship between the parent and the sub. This holding is significant because it was not previously clear whether the Whistleblower protection would extend to the employee of a private sub of a public company; while the issue is one of fact, the possibility of extension broadens the scope of potential defendants. Second, the ARB also held that it does not matter whether or not the employee who is claiming retaliation did not believe that anything fraudulent had occurred so long as the employee reasonably believed that an SEC rule or other subject "in the realm covered by" the Act had been violated. Both of these holdings tend to broaden the potential scope of Sarbanes Oxley Whistleblower protection and confirm the D & O Diary’s view that the Whistleblower provisions have the potential to become a very serious concern for employers. A discussion of this case can be found in a July 6, 2006 post on Broc Romanek’s CorporateCounsel.net blog.

In an update on the original Sarbanes-Oxley Whistleblower action, cfo.com reports in a July 7, 2006 post that the Department of Labor has intervened on behalf of David Welch, the former CFO of Cardinal Bankshares whom an administrative law judge has ordered to be reinstated. The post also reports that Welch has filed a U.S. District Court complaint to force the company to comply with the ALJ’s order. The D & O Diary’s prior post on the Cardinal Bankshares case can be found here.

Another interesting issue under the Sarbanes Oxley Whistleblower provision is its extraterritorial applicability. A July 7, 2006 post on law.com entitled "SOX Whistleblower Rule Triggers a Continental Divide" discusses the struggle between regulatory authorities in the US and in the EU over the applicability and requirements of the Sarbanes Oxley Whistleblower provisions, and in particular the potential conflict between the whistleblower data gathering requirements and EU data protection and privacy laws.

Foreign Corrupt Practices Act Update: On July 5, 2006, the SEC announced simultaneous filing of FCPA charges against and the agreement to settle by four former employees of ABB. The SEC alleges that the four individuals participated in a scheme to pay bribes to Bonga Oil Field. The complaint alleges that as a result of the four defendants’ actions, ABB paid officials at the Nigerian state-owned oil production and exploration agency approximately $1 million in bribes. The four consented to entry of judgment against them without admitting or denying the allegations, and agreed to pay fines ranging between $40,000 and $50,000. One of the four also paid approximately $60,000 in disgorgement and interest. ABB itself previously agreed to final judgment in connection with these and other illicit payments, and consented to pay $5.9 million in disgorgement and interest and an ABB subsidiary agreed to pay a civil penalty of $10.5 million.

Who (if anyone) will succeed Milberg Weiss?: The July 7, 2006 New York Times (registration required) has an article reviewing the efforts of the various securities class action plaintiffs’ firms to jockey for position while Milberg Weiss struggles to defend itself against its own criminal indictment. At least for purposes of the Times article, the other plaintiffs’ firms are doing a surprisingly good job at maintaining the appearance of decorum. But even if the other firms can restrain themselves from the outward appearance of seeking to profit from Milberg Weiss’ misfortune, the real pressure on the Milberg Weiss firm will come from the decisions of the various lead plaintiffs the firm represents, as to whether the indicted firm appropriately should be representing the class on whose behalf the lead plaintiff is acting. Here is a link to a May 20, 2006 Wall Street Journal (subscription required) article reviewing various cases where the lead plaintiffs have decided to remove the Milberg Weiss firm from the cases as a result of the firm’s indictment.

Options Backdating and the SOX Clawback Provisions: UCLA Law School Professor Stephen Bainbridge has a July 6, 2006 post on his ProfessorBainbridge.com blog discussing whether or not the options backdating scandal will provide the first occasion for the implementation of the clawback provisions under Section 304 of the Sarbanes Oxley Act. The clawback provisions require executives at companies that restate their financials to return to their companies bonus compensation the executives received in the 12 months following the original issuance of the later-restated financials. Professor Bainbridge, who is critical of the clawback provision, is unaware of any attempts to date to use the clawback provisions in connection the options backdating investigations. The comments that accompany his post raise the interesting question whether the clawback provisions can be applied to require disgorgement of compensation awarded following restatement of financials that were originally created prior to the enactment of the Sarbanes-Oxley Act. A prior D & O Diary post commenting on the possible applicability of the clawback provisions to companies involved in the options backdating investigation may be found here.

SOX and Non-Profit Organizations: One of the more interesting consequences of the enactment of the Sarbanes-Oxley Act has been the statute’s application far beyond the public company arena to which it was primarily addressed. A July 7, 2006 post on the accountingweb.com details the impact that the Act is having in the non-profit sector. A May 2006 article by The D & O Diary’s author describing the Act’s impact on privately held companies can be found here.

 

Options Backdating Securities Litigation: On June 29, 2006, a putative securities fraud class action was initiated against KLA-Tencor. This brings the number the number of companies sued in securities fraud class action lawsuits based on options timing allegations to eight. Background on the other seven companies previously named can be found on prior D & O Diary posts here and here. In addition, Apple Computers announced on July 5, 2006 that it had been sued in two derivative action based upon its awarding of stock option grants.

Mercury Interactive Restatement: A sense of the magnitude of the problems that options backdating can cause can be found in Mercury Interactive’s July 3, 2006 release of its restated financials. Among other things, the company reported that as a result of problems surrounding its options practices it would restate its earnings before taxes for the period 1992 through 2004 downward by $566.7 million. All told, the company’s special investigative committee found 55 instances in which "the exercise price of stock options was established based on a stated grant date that was different from the actual grant date." Jack Cielski has a detailed review of Mercury’s options practices and the resulting accounting mess in a July 6, 2006 post on the AAO Weblog.

Mercury Interactive also announced that on June 23, 2006, the SEC staff provided three of the company’s outside directors with "Wells" notices, signifying the staff’s intent to pursue charges against the individuals. A July 6, 2006 post on the ISS Securities Litigation Watch blog points out that it is "quite unusual" for the SEC to pursue outside directors in connection with financial problems at the company on whose board they serve, but that appears to be the direction the SEC is headed in connection with the Mercury Interactive mess. (The SEC also served Wells notices on outside directors of the Hollinger Corporation, as discussed here.) The July 5, 2006 Wall Street Journal (subscription required) article describing Mercury Interactive’s restatement and its directors receipt of Wells notices may be found here.

In a related development, on July 5, 2006, Opsware announced that its CFO had received a "Wells" notice pertaining to her prior service as Mecury Interactive’s CFO.

Ken Lay’s Death and the Resurrection of D & O Coverage? It may be an idle question on my part, but a July 5, 2006 note on Professor Peter Henning’s White Collar Crime Prof blog has left me wondering about the D & O insurance implications arising from the legal effects of Ken Lay’s death. Professor Henning reports that under established Fifth Circuit precedent, a criminal defendant’s death during the pendency of an appeal "abates, ab initio, the entire criminal proceeding." Under United States v. Estate of Parsons, 367 F.3d 409) (5th Cir. 2004), "the appeal does not just disappear….Instead, everything associated with the case is extinguished, leaving the defendant as if he had never been indicted or convicted." Now, it may well be that the available D & O insurance was exhausted long ago, and it may be that the applicable policy language differs in a way that avoids this whole line of analysis. But assume for the sake of discussion that the applicable policy had the standard "after adjudication" language in the criminal conduct exclusion, pursuant to which the exclusion precludes coverage only upon final adjudication of criminality. There is no question that a jury of 12 persons good and true found Ken Lay guilty of multiple criminal acts. But if his death operates to leave him "as if he had never been indicted or convicted," does the exclusion apply? Or would his death resurrect coverage, or rather remove the obstacle to coverage? The entire question may be moot due to the exhaustion of coverage, and because the lead plaintiff in the pending civil securities action against Lay (as quoted in the July 6, 2006 Times of London), has stated publicly that it does not expect to pursue the case against Mr. Lay’s estate. But it is still an interesting question, albeit based upon a fact pattern that presumably will not frequently recur…

A July 7, 2006 Wall Street Journal (subscription required) article discussing the legal effects of Ken Lay’s death, as well as the financial condition of his estate, can be found here.

 

On June 27, 2006, U.S. District Judge Lewis Kaplan held, in the KPMG tax shelter prosecution, that portions of the Thompson memo violate the constitutional rights of 16 former KMPG partners who are accused of participating in a fraudulent tax scheme. Judge Kaplan found that KPMG, seeking to show full compliance with the Thompson memo to avoid its own criminal prosecution, withheld advancement of attorneys’ fees from the individual defendants. The Judge said in his 83-page opinion that “KMPG refused to pay because the government held the proverbial gun at its head.” Judge Kaplan found that the government, through the Thompson memo and its own actions, violdated the defendants’ right to due process guaranteed under the Fifth Amendment and their right to counsel guaranteed by the Sixth Amendment. The Judge declined to dismiss the indictments, holding rather that the individual defendants can pursue a civil action against KPMG seeking legal fees or that KPMG can decide on its own to advance the individuals’ defense fees.

The Judge’s lengthy opinion is thoughtful and scholarly, and full of the language of liberty and individual rights. Among other things, the Judge’s opinion states that “[t]he imposition of economic punishment by prosecutors, before anyone has been found guilty of anything, is not a legitimate governmental interest – it is an abuse of power.”

While Judge Kaplan’s ruling is unquestionably a significant event that will impact pending prosecutions across the country, the specific practical consequences outside the KPMG tax shelters case will remain to be seen. His ruling is based on a detailed record of the particular facts and circumstances of that specific case. In addition, as the opinion of a U.S. District Court Judge, the decision has persuasive but not precedential authority. Nevertheless, Judge Kaplan’s opinion is important and will have ramifications, and raises a host of potentially interesting questions in connection with the indictment of the Milberg Weiss law firm, among many other pending cases.

The wsj.com law blog’s comments on Judge Kaplan’s opinion can be found here. The wsj.com law blog’s links to several major newspaper’s stories and editorials about Judge Kaplan’s opinion may be found here.

An interesting comment in the White Collar Crime Prof blog focusing on the legal duties of corporation’s to advance defense costs and on the possible implications of Judge Kaplan’s opinion for the D & O insurance industry can be found here.

The D & O Diary’s prior posts on the Thompson Memo may be found here. The Wall Street Journal’s (subscription required) article on the Milberg Weiss indictment may be found here.

Options Backdating Litigation Update: On June 19, 2006, the Kaplan Fox & Kilsheimer law firm initiated a new securities fraud class action lawsuit against Brooks Automation and several of its directors and officers, based on options backdating allegations. With the addition of the Brooks Automation lawsuit, the number of companies named in securities fraud class action lawsuits since the Wall Street Journal’s (subscription required) March 18, 2006 article brought widespread attention to options backdating is now up to five. (The four companies previously named are Comverse Technology, United Health Group, Vitesse Semiconductor, and American Tower. The four prior lawsuits were discussed in this previous D & O Diary post.)

In addition to these five, the Consolidated Amended Complaint filed against Brocade Communications alleges misconduct (including backdating) in connection with hiring-related stock option grants. The Brocade Communications complaint was previously discussed in this D & O Diary post.

Thus, according to the D & O Diary’s tally, and counting the Brocade Communications lawsuit, the number of companies sued in securities fraud class action lawsuits based on allegations of improper stock options grant timing now stands at six. The D & O Diary is interested in hearing from readers who are aware of any other lawsuits that this post may have overlooked.

Update: An alert D & O Diary reader has referred me to the securities fraud lawsuit pending against Mercury Interactive. The initial D & O Diary post about options backdating referenced the case pending against Mercury Interactive. The initial securities complaint filed in August 2005 against Mercury Interactive did not emphasize the options backdating allegations, but subsequent events, including in particular, the November 2, 2005 resignation of the company’s top three executives because of improper timing practices involving employee stock options, suggest that the centerpiece of the Consolidated Amended Complaint, when filed, will be the options backdating allegations. The Order granting leave to file the Amended Complaint was entered on June 7, 2006, and the Amended Complaint must be filed by the later of 60 days from the Order’s date or 21 days after Mecury Interactive files its restated financial statements, but in no event more than 90 days from the Order. Clearly, the securities fraud class action filed against Mercury Interactive involves options backdating allegations, so that case should be "counted" — which brings the total number of companies sued in securities fraud cases involving options timing to seven, rather than six as previously stated.

In addition to securities fraud class action lawsuits, companies involved in the options backdating investigations are also being named in shareholders’ derivative lawsuits. Derivative lawsuits are harder to track because the plaintiffs’ lawyers do not always issue a press release when they file derivative lawsuits. The Weiss & Lurie law firm cast modesty aside in issuing its June 12, 2006 press release about the new shareholders’ derivative lawsuit it has filed against KLA-Tencor. The firm not only announced the new derivative lawsuit, but stated further that it has been retained to investigate possible additional lawsuits against 48 other companies (which companies it identifies in the press release by name and ticker symbol). Not to be outdone, the law firm of Stull, Stull & Brody, in announcing the shareholders’ derivative action that it initiated against Computer Sciences Corporation, claims that it is investigating "over 50" companies.

Sarbanes-Oxley Whistleblower Update: As discussed in this prior D & O Diary post, one of the most important legacies of the Enron era may be the Sarbanes-Oxley Whistleblower protection. Two recent developments increase the likelihood that this statutory provision may become increasingly significant.

On June 9, 2006, in a closely watched case involving the first worker to win protection as a whistleblower under the Sarbanes-Oxley Act, the U.S. Department of Labor Administrative Review Board held that the whistleblower’s employer must reinstate him to the position he held before he was fired for criticizing the employer’s accounting practices. The decision may be found here. A Washington Post article (registration required) describing the decision can be found here.

Update: CFO.com has a June 28, 2006 post in which it reports that Cardinal Bancshares (the defendant in the whistleblower case described above) has "decided once again to refuse a Department of Labor judge’s recommended order to reinstate the bank’s former CFO….Instead, the bank holding company plans to wwait and see whether the DoL or [the plaintiff] brings an action against the company in U.S. District Court."

The U.S. Supreme Court’s June 22, 2006 decision in a Title VII case could further strengthen the Sarbanes-Oxley Act’s whistleblower protection. The Court held that any adverse actions by an employer – whether in or out of the workplace, and even if they fall short of dismissal or demotion – can be illegal if they would dissuade a "reasonable" employee from filing a discrimination complaint. According to the Wall Street Journal’s (subscription required) June 23, 2006 article discussing the decision, "[w]hile the ruling was in a discrimination complaint, employment lawyers said it is likely to influence retaliation cases of all sorts, including age bias and whistleblower claims under the Sarbanes Oxley law."

Outside Director Liability: After outside directors of Enron and WorldCom were forced to contribute to the class action settlements out of their own assets without recourse to insurance or indemnity, a great debate ensued about whether the settlements represented a trend or were mere artifacts of unique cases. A scholarly overview of outside director liability by Michael Klausner of the Stanford Law School summarized in the June 2006 issue of the PLUS Journal (registration required) statistically examines the historical evidence and concludes that outside directors personal exposure is limited to "very narrow exceptions." The Enron and WorldCom settlements may, according to Professor Klausner, be understood as the outcomes of "exceptional scenarios." He further comments that to protect themselves from their remote exposure to liability, outside directors should be sure that their companies have a "state-of-the-art D & O Policy with appropriate severability, bankruptcy and other protections."

 

D & O insurers, concerned about lawsuits that have already have been filed and troubled by the possibility of an unknown number of lawsuits yet to come, have begun to respond to the options backdating investigation. On June 20, 2006, the Wall Street Journal (subscription required) carried an article entitled "Options Timing Raises Concern Among Insurers" discussing the response of the D & O insurance marketplace to the options backdating investigations. The D & O Diary’s author’s views on the topic of options backdating and D & O insurance may be found here, in an article entitled "The Options Backdating Scandal and the D & O Insurance Marketplace." This article provides background on options backdating, and discusses the kinds of problems that companies involved in the investigations are facing. The article also examines the ways that the D & O marketplace is responding to the investigations and suggests practical steps for companies to take in connection with their purchase of D & O insurance under the circumstances.

Erik Lie’s website: As anyone who has followed the options backdating story knows, the existence of options backdating was first established by University of Iowa business school professor Erik Lie. Those interested in a deeper understanding of options backdating will want to visit Professor Lie’s website, which is remarkably readable and informative.

Options Springloading: As described in the June 11, 2006 post on The D & O Diary, "options springloading" refers to the practice of timing option grants to take place before expected good news. (Professor Lie’s website has a detailed discussion of options springloading). The June 20, 2006 issue of the Los Angeles Times (registration required) carried an interesting article quoting SEC Chairman Christopher Cox as saying that the SEC is "very interested" in options springloading and stating that the forthcoming SEC executive compensation rules will contain provisions designed to address options springloading.

Cost of Being Public: The cost of being public declined slightly in 2005, according to one law firm’s annual report of the costs associated with corporate governance reform. But while overall costs are declining, audit costs are continuing to climb, especially for the smallest companies. Foley & Lardner released its fourth annual study report on June 15, 2006. The firm prepared the study using a statistical analysis of proxy statement data and survey responses from 114 public companies.

The study found that the overall costs to a compnay of being public (including, among other things, legal fees, audit fees, D & O insurance, and board compensation) declined 16% for companies with under $1 billion in annual revenue and 6% for companies with revenues over $1 billion. But according to the firm’s analysis of 850 public companies’ proxy statements, audit fees increased 22% for S & P small cap companies, 6% for mid-cap companies, and 4% for S & P 500 companies. These data are somewhat inconsistent with some published reports suggesting that audit fees declined in 2005.

The study includes a number of other interesting findings, including the finding that the average cost of compliance for companies with under $ 1 billion in annual revenue has increased from approximately $1.1 million in 2001, the year prior to Sarbanes Oxley’s enactment, to approximately $2.9 million in 2005, an increase of 174%. Not too surprisingly, one in five survey respondents (21%) is considering going private as a result of corporate governance and public disclosure requirements.

While the law firm’s 2005 study report is interesting, and while the study is on solid ground where it relies on the statistical analysis of proxy statements of a large group of public companies, the study’s reliance on a limited set of survey data undermines some of its other conclusions. For example, of the 114 public company survey responses, only 33 came from companies with annual revenues of over $1 billion. These 33 companies reported an average D & O insurance premium that was 35% greater than the average D & O insurance premium reported in the 2004 study with respect to companies with revenues over $1 billion. This of course does not mean that premiums went up 35% between 2004 and 2005 for companies in that category. It does not even mean that the 33 companies in that category that responded to the 2005 survey saw their D & O insurance premium rise 35% between 2004 and 2005. It simply means that the companies in that category that responded to the 2005 survey reported premiums that averaged 35% higher than the different companies in that category that responded to the 2004 survey.

That is the problem with attempting to draw conclusions by comparing two small but different sets of data. Small differences can produce results that appear significant but that may be misleading, due to the different composition of the two sets of data. The study’s authors may be faulted for not doing a reality check before issuing their report – any D & O insurance professional could have told them that D & O insurance premiums did not increase 35% between 2004 and 2005 for any category of companies.

But this shortcoming notwithstanding, the study report still merits attention, at least with respect to the portion of the report pertaining to statistical analysis of proxy data.

 

The recent media coverage surrounding stock option practices primarily has been focused on options backdating, and to a lesser extent on options springloading. A new wave of media attention has drawn scrutiny of another options compensation practice – the allegedly improper use of stock options grants in connection with hiring and recruiting of new personnel.

The June 19, 2006 New York Times carries a detailed article examining stock option related hiring practices at Micrel. Micrel’s volatile stock prices created a situation where new hires’ stock option strike price (set on the date of hire) could differ significantly from the strike price on options granted to others whose date of hire was only a few days before or after. With the alleged blessing of its auditor, Deloitte & Touche, Micrel set the strike price on new hires’ stock option grants at the lowest point in the 30 days from when the new hires’ stock option grant was approved. According to the Times article, the practice also had the blessing of Micrel’s outside counsel, Morrison & Foerster. Five years later, Deloitte “reversed its opinion and urged Micrel to restate its financial reports.” The company restated earnings downward and subsequently sued Deloitte claiming that the cost to Micrel from the flawed option plan could reach $58.6 million.

Deloitte is also the long standing auditor of Microsoft. According to a June 16, 2006 article in the Wall Street Journal, between 1992 and 1999, Microsoft “routinely issued options to new employees at the stock’s lowest closing price in the 30 days after they joined.”

Hiring-related stock options practices are at the heart of the securities class action lawsuit pending against Brocade Communications. The lawsuit was first filed against Brocade in May 2005. The Amended Complaint, filed April 14, 2006, alleges a variety of hiring related stock options practices designed to provide potential new hires the most potentially lucrative stock options grants. These practices allegedly took place because of the fierce competition for qualified job applicants during the tech bubble in the late 1990s. The hiring practices allegedly included giving new hires false start dates or backdating offer letters or even stock option grant dates to give new employees the advantage of lower stock option strike prices; and signing a new hire on as a current employee and then immediately placing him or her on a leave of absence (even thought the employee was still working at another company) so that Brocade could grant the new employee options at the earliest possible date and the lowest possible exercise price. The Amended Complaint alleges that these and other practices resulted in a misrepresentation of Brocade’s actual compensation expense and true financial condition. After an internal investigation, Brocade restated its financials, and, according to Brocade’s 1Q06 10-Q subsequently offered to enter a settlement with the SEC. The plaintiffs have sued not only Brocade, and its directors and officers (including Larry Sonsini of the Wilson, Sonsini Goodrich and Rosati firm), and Brocade’s auditors, KMPG.

These hiring related stock options grants are in a different category from the options grants involved in the options backdating investigation – most of the options grants at the center of the options backdating investigation involve options that company officials granted themselves, as opposed to new hires. While the self-dealing allegedly involved in the options backdating investigation seems more inherently objectionable, the class action lawsuit and the SEC investigation involving Brocade shows that questions associated with hiring-related options grants can still cause companies a lot of problems. The lawsuits against the Micrel’s and Brocade’s auditors suggests the possibility that problems surrounding stock option grants could ensnare a wide variety of professionals, not merely the company officials involved in the stock options grants. The more interesting question is how potentially widespread the problems from hiring-related options grants may be. Given the popularity of stock option related compensation practices in the 1990s and early part of this decade, the problems arising from hiring-related options practices could prove to be even more widespread than the options backdating practices that have dominated the recent media coverage.

Earlier this week several publications carried reports that pension funds in the United States, Europe and Australia had retained the Lerach Coughlin law firm to sue “dozens of companies” over the timing of stock options grants to their top executives. A June 13, 2006 article in the San Jose Mercury quoted Lerach Coughlin partner Darren Robbins as stating that the pension funds are “completely beside themselves and outraged over the self-dealing that has gone on.” A June 14, 2006 article in Red Herring quotes Robbins as saying that the pension funds seek to terminate jobs of executives who diverted assets to their own pockets; the replacement of boards who permitted backdating; and the substitution of shareholder-nominated directors. The pension funds will also seek to “recover funds that were diverted from the corporate till.” In addition, he also said that the pension funds will seek recovery of damages, which, he estimates, “total in the billions of dollars.” The Red Herring article states that Robbins “has been directed to take action in 34 cases from 350 to 400 pension funds.” Five companies are identified by name in the article: American Tower, Mercury Interactive, McAfee, Juniper Networks, and United Health Group. The article is unclear whether the actions that Robbins has or will file are or will be in the form of shareholders’ derivative actions (which would be consistent with the stated goal of seeking management and board reform) or of a securities fraud action for damages (which would be consistent with the stated goal of recovery alleged shareholder losses).

The D & O Diary will update this post as further information about these alleged pension fund lawsuit becomes available.

Statutes of Limitations Defenses?: One interesting question that any actions for damages under the federal securities laws will present is whether the statute of limitations bars some or all of plaintiffs’ claims. In many instances, the alleged options backdating goes back into the 1990s. For example, according to the April 17, 2006 Wall Street Journal article (subscription required) discussing questions surrounding options grants at United Health Group, the specifc grants that are under investigation took place between 1994 and 2002. Section 804 of the Sarbanes-Oxley Act of 2002 extended the statute of limitations for federal securities fraud actions at the earlier of two years after discovery of “facts constituting the violation” or “five years after such violation.” (Previously, the limitations periods had been one year and three years, respectively). The Sarbanes-Oxley Act’s statute of limitations period raises a number of interesting questions: does it apply retroactively to options grants that took place before it was enacted in 2002, or does the shorter limitations period apply? Even if the longer period does apply, does the longer limitations period bar claims based on grants that took place more that five years ago? Or are the options backdating practices (and the alleged misreporting of the practices and accompanying accounting and tax mispresentations) part of a continuing course of conduct that brings the “violation” within the five year period? What is the “violation” that triggers the running of the statute? None of these questions are clear, but if plaintiffs’ lawyers are as committed to pursuing these actions as they claim, we will be hearing more on these issues as the cases go forward.

The D & O Diary is interested hearing readers’ comments on these statute of limitations questions.