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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Priceless: A perfect hangover cure, here.

 

SEC Options Backdating Investigations List: Directorship.com has posted on its website a hotlinked list of companies (here) that have been contacted by the SEC, revealed a probe by the SEC, or have been subpoenaed by a U.S. attorney, in connection with the options timing investigations. The Wall Street Journal’s Options Scorecard list of companies involved in the options backdating investigation (here) is more complete, in that the Journal’s list also includes companies that have announced their own internal investigations. But the Directorship.com list zeroes in on the companies that have SEC or U.S. Attorney’s office inquiries and investigations, and is hotlinked to provide information about the authorities’ investigations.

The D & O Diary is also maintaining a list (here) of companies that have been sued in civil lawsuits involving options timing issues. The D & O Diary’s list was most recently updated on August 31, 2006, to include the new shareholders’ derivative lawsuit that has been filed against Family Dollar(here). The addition of the Family Dollar lawsuit brings the number of companies sued in shareholders’ derivative lawsuits (of which The D & O Diary is aware) to 60. The number of companies sued in securities class action lawsuits currently stands at 15.

Why so Many Options Backdating Derivative Suits? The D & O Diary has previously speculated (here) that the reason so few of the companies involved with the options backdating investigation have been sued in securities fraud class action is that for many of the companies, their announcement of options timing issues was not accompanied by the kind of stock price drop that would support a securities fraud lawsuit. But that still doesn’t explain why plaintiffs’ lawyers are so interested in filing shareholders derivative lawsuits, especially because the cases usually settle with the companies agreeing to a few corporate therapeutics and the payment of modest plaintiffs’ attorneys’ fees.

An August 31, 2006 article in the International Herald Tribune entitled “In the Hunt for Heftier Awards, Lawyers Seek Backdating Suits,” (here) takes a look at the reasons why plaintiffs’ lawyers might be more interested in the derivative suits, even though the payday for the plaintiffs’ lawyers would probably be lower in a derivative suit than a securities fraud class action lawsuit. The article quotes Columbia University Professor John Coffee that “You can often bribe the plaintiffs attorney with a non-pecuniary settlement coupled with high attorney fees.” The article also reports that the amount of derivative settlements has increased in recent months. Full disclosure: I was interviewed in connection with the article.

Welcome: The D & O Diary extends a hearty welcome to a great new weblog that Directorship.com has launched, the Corporate Governance News blog (here). The CGN has numerous posts throughout the day with items from around the web relating to corporate governance issues. Even though CGN has only been live a short time, The D & O Diary has already found it an indispensable resource for keeping track of governance related news and information. The D & O Diary also notes that Janice Brand, who runs the CGN blog, has a really cool title : Online Editor-in-Chief. However, the D & O Diary is still holding out for a preferred title: The Big Kahuna.

In a prior post (here), The D & O Diary commented on “Private Money and D & O Risk,” noting the heightened potential for disputes to arise when the new “power players” (private equity funds, hedge funds, and buyout firms) have interests that conflict with those of management, other investors or creditors. An August 29, 2006 article in The Wall Street Journal (here, registration required) entitled “Hedge Funds Play Hardball with Firms Filing Late Financials” presents a particularly vivid example of the problems these conflicts of interest can create.

The article discusses the “new game of hardball” that hedge funds are playing with the companies in which they invest when the companies fail to file quarterly reports on time; the hedge funds are demanding immediate payment of debt or extracting substantial fees. This problem has been exacerbated recently as numerous companies have delayed filings as they deal with the accounting issues arising from options backdating problems. The Journal reports that of the 138 companies with market capitalizations over $75 that filed late second quarter financial reports, 48 companies blames options investigations. (The number of companies filing late apparently is a record, according to other news reports.)

In the past, bondholders would work with company management facing delayed reporting issues to let them work out their problems. This past forbearance was in part a result of a tacit agreement between bond investors that they would not force a problem that could trigger an acceleration of all of the company’s debt, potentially forcing the company into bankruptcy. Hedge fund investors, aiming to produce outsized returns for their investors if they can force a company to redeem its bonds (which the hedge funds purchased at a discount) at their face value. In the last 18 months, at least 25 companies have had their bonds accelerated this way or were forced to pay multimillion dollar fees to bondholders.

In at least one case cited in the article, this kind of dispute has led to litigation. The article reports that a trustee representing BearingPoint bondholders filed an a lawsuit against the company claiming that it was in default on two bond issues because it missed an SEC filing deadline due to accounting issues. BearingPoint’s 8-K describing the litigation can be found here.

While the BearingPoint lawsuit was filed against the company itself, the threat of litigation surrounding these issues, as well as the larger threat of bankruptcy looming in the background, underscore the potential D & O risk these circumstances present. The conflicting interests between a company and its investors creates an environment where accusations of wrongdoing can more easily arise.

An August 30, 2006 post on CFO.com entitled “Backdating Sparks Bond Battle,” (here) provides a detailed description of the actions that UnitedHealth Group’s bondholders have taken, and the company’s response, based upon the company’s delayed second quarter SEC filing.

Delaware Court Rejects “Deepening Insolvency” Tort: The threat of bankruptcy arising from debt acceleration includes the threat of claims against the bankrupt companies’ directors and officers. One bankruptcy related claim that has gained some currency in recent years is the allegation that the Ds & Os acted improperly while the company was in the “zone of insolvency” or that they were responsible for “deepening insolvency.” While there is a body of case law supporting claims based on this legal theory, an August 10, 2006 decision (here) by Delaware Court of Chancery Vice Chancellor Leo Strine rejected deepening insolvency as an independent cause of action. Chancellor Strine stated that adoption of the this legal theory would “fundamentally transform Delaware law” by imposing liability on a board of directors who, “acting with due diligence and good faith, pursue business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt.” Rather, the board’s conduct should be evaluated based on “the traditional fiduciary duty rule,” under which the fact of insolvency is a contextual consideration to be taken into account when evaluating the board’s conduct. The board would also be entitled to the protection of the business judgment rule.

Special thanks to alert reader Robert Benjamin for the link to the Court of Chancery decision.

William Smith and David Topol of the Wiley Rein law firm have written a good brief summary of the Court of Chancery opinion, here. Francis G. X. Pileggi has an interesting post (here) on his Delaware Corporate and Commercial Law blog rounding up the commentary in the blogosphere about the decision.

The August 2006 issue of CFO Magazine has an interesting article entitled “Delaware Rules,” (here) discussing the role of the Delaware Court of Chancery in the evolving world of corporate governance. The article has interesting background about the Court, the chancellors, the important decisions that have become before the Court in the past, and the issues that will likely come before the Court in the future.

Lawyers, Boards and Options: Law.com has an August 30, 2006 post (here) entitled “Sonsini on Boards of Several Companies With Dubious Stock Awards.” The article delivers less than the title implies, but it is still interesting.

Thanks to Adam Savett of the Lies, Damn Lies blog for the Law.com link (and for the link to the article on the Delaware Corporate and Commercial Litigation blog).

Chart of the Day: A scary look at what has happened to home values over the last few years, here. This looks a lot like the “before” view of the NASDAQ composite index chart (here), circa March 2000. If the “after” version of the home values chart has as steep a decline as the incline, we could be in for a very rough ride. A brief, interesting discussion of how a housing slump could affect the economy can be found here.

In a prior post (here), The D & O Diary fretted that Sarbanes-Oxley compliance costs could be driving foreign companies away from U.S. exchanges or encouraging existing public companies to delist their shares. An August 21, 2006 op-ed piece in the Wall Street Journal written by Maurice Greenberg and entitled “Regulation, Yes. Strangulation, No.” (here, subscription required) made similar points.

But two articles in the August 28, 2006 Wall Street Journal suggest that perhaps these concerns could be overstated and that there are reasons to interpret the situation more positively.

First, in an article (here, subscription required) entitled “Foreign Companies Cash in on U.S. Exchanges,” the Journal reports that 2006 YTD, non-U.S. companies have sold $5.8 billion in stock through U.S.-listed IPOs, which is already the highest annual total since 2000, and double the amount of money raised by non-U.S. companies at this point last year. Larger non-U.S. IPOs may be going to other markets, but that is not to say that deals are not getting done in the U.S.

Second, in an August 28 op-ed piece (here, subscription required) entitled “Good Governance is Good Business,” Neeraj Bhargava, the CEO of WNS (Holdings) Limited , a company that recently listed ADRs on the NYSE, lays out the reasons why his company chose a U.S. exchange listing notwithstanding the burdens of SOX compliance. Among other things, he feels that his company’s ability to clear the high regulatory burdens gives his company credibility and global visibility. He also says that as a result of greater visibility and transparency for companies traded on U.S. exchanges, his company enjoys a higher valuation and its shareholders enjoy greater liquidity for their shares. Bhargava states that he also believes that satisfying the regulatory requirements, while undeniably costly and burdensome, affords numerous benefits including “lower cost of capital, smoother follow-on financing and greater flexibility in future M & A activities.” As a result, “the benefits continue to outweigh the challenges and to drive companies toward greater efficiencies, stability and long-term growth.”

So while there may well be evidence to suggest that companies are selecting away from the U.S. exchanges (as reported in the prior post), there may also be reason to conclude that there are still companies that will see the benefit of listing on U.S. exchanges.

The Governance News Watch has a post (here) on Bhargava’s op-ed piece. (The Governance News Watch is an excellent online resource with daily posts on corporate govenance news.)

Lawyer/Directors on Boards with Options Issues: Law.com has an August 28, 2006 post (here) entitled “Prominent Corporate Lawyers Didn’t Stop Shady Options Deals,” in which it reports on its analysis of options practices at 17 Silicon Valley firms that had Valley lawyers on their boards. The article reports that it found “questionable grant dates” at five companies (out of the 17 studied), none of which previously has been associated with backdating questions. Each of the five has a prominent Valley lawyer on its board: Amylin Pharmaceuticals, James Gaither (Cooley Godward); Heartport, Robert Gunderson (Gunderson Dettmer); LSI Logic, Larry Sonsini (Wilson Sonsini); Lattice Semiconductor, Larry Sonsini; Echelon, Larry Sonsini. The article states that “the awards may also spur new questions about the multiple roles these directors played at a host of Valley startups now under the close scrutiny of regulators, prosecutors and plaintiffs lawyers.”

A WSJ.com law blog post commenting on the Law.com article can be found here.

A casual reader of the New York Times business page or the Wall Street Journal might well get the impression that PIPEs (private investments in public equity) financing transactions are the devil’s own handiwork. Both publications have recently run stories fraught with dire tones and ominous insinuantions about PIPEs transactions. The New York Times August 13, 2006 article (here, registration required) entitled "Secrets in the Pipeline" is a particularly egregious example. The D & O Diary is concerned that this perspective on a type of financing that is becoming increasingly popular could lead to the inaccurate and unwarranted perception that companies involved in PIPEs financings all belong in a particularly suspect risk class. While there are PIPEs transaction characteristics that could well suggest larger problems, there is nothing inherent about a PIPEs financing transaction that should cause a company resorting to this type of financing to be viewed with suspicion.

PIPEs transactions typically are structured as a minority investment in a publicly traded company. PIPEs offer accredited investors the opportunity to acquire company securities at a discount to the securities’ market value. The issuer undertakes to register the PIPEs securities with the SEC, usually within 90 to 120 days of the transaction closing. There are two main types of PIPEs, traditional and structured. In a traditional PIPE, the company issues common or preferred stock at a set price. In a structured PIPE, the company issues debt securities that are convertible into common or preferred shares according to a conversion ratio that may vary.

PIPEs are an established part of the financial landscape. In 2005, there were a total of 1,301 PIPEs transactions, worth $20 billion. As of August 2006, there have already been nearly 800 PIPEs transactions worth $18 billion.

A PIPE transaction offers the issuing company certain advantages compared to other capital raising alternatives:

• Flexibility: SEC registration is not required prior to offering or closing;
• Transaction Size: To complete a secondary offering, investment bankers and investors require a minimal transaction size, roughly $ 75 mm or more. A company that needs a lesser amount, or that is simply too small to engage in a transaction of that size, has greater flexibility with a PIPEs transaction;
• Efficient Use of Management’s Time: The preparation required for a PIPE is minimal compared to a secondary offering, and there is no need for management to become involved in roadshow meetings, etc.

PIPEs do have downsides for the issuing company. PIPEs are dilutive of existing shareholders’ equity interest, but so too are secondary offerings. PIPEs may also attract short term investors whose interests may not align with those of management or other shareholders, as discussed below.

Investors are attracted to PIPEs for a number of reasons:
• Discount Pricing: Issuers offer securities as a modest discount (5% to 25%) to the market value, in light of the initial illiquid nature of the securities before the registration process is complete;
• Public Market Liquidity: Once the registration process is complete, investors can sell into the public market;
• Speed to Closing: Since the company is already public, extensive information is already available and there is no SEC registration process before closing.
There are disadvantages for investors, primarily because a PIPE transaction usually involves only a small stake in the company. Investors do not acquire a sufficiently large stake to be able to control the company’s board or the timing or outcome of major corporate decisions.

History may explain part of the reason PIPEs are often viewed with suspicion. PIPEs transactions have been known as "death spiral" or "toxic" offerings, primarily as a result of PIPEs transactions completed during 2000 and 2001, when the declining stock markets made it difficult or impossible for many companies to raise money through secondary offerings. During that period, companies conducting PIPEs by issuing convertible preferred securities where the conversion ratio changed based on the company’s share price. Companies found that investors had every incentive to drive down the company’s share price after closing so that investors could get more company shares upon conversion. Many of these transactions ended badly for the companies involved, and indeed for investors as well. The wreckage from that era has been cleared, and structured PIPEs now represent a much smaller portion of the market, and usually incorporate mechanisms (caps, floors, etc.) to remove or minimize incentives for investors to push shares down.

Another reason PIPEs may be viewed with suspicion these days is that the PIPEs investors increasingly are hedge funds. Hedge funds buying securities in a PIPE are not acquiring a controlling ownership position, so their opportunity to gain from the transaction is not dependent on a restructuring or a management change; the investors must make profits from the transaction itself. So many hedge funds will "hedge" their position by selling the company’s stock short, to ensure gains even if the company’s shares decline. This understandably may make many managers and existing shareholders uneasy because of the hedge funds’ mixed motivations. Companies can set contractual limits around the timing or amount of investors’ short selling, but that typically will come at the price of a larger discount on the securities offered in the PIPE transaction.

The complicated and potentially conflicted role of the PIPE investor is clearly of concern to the SEC, and in recent months there have been several SEC enforcement proceedings focused on PIPEs investors’ activities:

• In March 2006, the SEC settled with three hedge funds and their portfolio manager for alledgely engaging in "naked" short sales, whereby the shorted shares in PIPEs transactions without actually borrowing publicly traded shares to cover their short position. (Short sellers cannot cover their short position with securities acquired in the PIPE transaction because they are not publicly available shares during the pre-registration period.) One of the hedge funds also shorted the company’s shares before it was publicly known that the company sought to raise money in a PIPE transaction. A copy of the SEC’s press release on this action can be found here.
• In May 2006, the SEC settled an enforcement action against a hedge fund advisor and its portfolio manager for trading in the shares of 19 companies based on information that the companies were about to announce PIPEs transactions. A copy of the SEC’s press release on this action can be found here.

These and other SEC enforcement actions (which can be found here and here) generally are focused on investors’ conduct or the conduct of the broker handling the PIPE transaction, rather than the conduct of the issuing company. At least recently, the problems have not involved the issuing companies.

To be sure, there are transaction attributes that can justify wariness of companies engaged in PIPEs transactions:

• Reset or variable rate PIPEs: These types of transactions are still getting done, but they are clearly riskier deals. The riskiest of all are transactions that lack or have insufficient caps or floors on the conversion ratio for convertible securities, because these transactions hold the "death spiral" potential. It is unlikely that any company that has other financial options would enter a transaction of this type.
• Officers or directors buying shares in a PIPE transaction: This is obviously a problem – shares are being offered at below market values in a transaction that is not public knowledge until after closing. At a minimum, it raises the possibility of self-dealing or conflicts of interest (for example, in setting the level of the discount), and it raises concerns about shareholder approvals as well.
• Excessive discount: Discounts for PIPEs securities typically are modest, in the range of 5 to 25%. Discounts at a level greater than this suggest desperation or the existence of some other problem with the transaction.

So the picture with respect to PIPEs can be complex. But companies engage in these transactions for important and legitimate reasons, and therefore PIPEs are likely to remain an important part of the financial landscape. Clearly, the many companies engaged in these transactions cannot be treated as suspect simply because they have resorted to PIPEs financing. A company that has completed a PIPE should not be treated as a suspect D & O risk simply because of the PIPE. As noted above, there are features that could make a PIPE transaction riskier, but in the absence of those characteristics, a PIPE transaction alone should not make the company a suspect D & O risk.

A particularly good short summary on about PIPE financing can be found here. A more academic (and slighly dated) overview can be found here.

A good brief examination of a single company’s motivations and experience with PIPE financing can be found here.

Professor Larry Ribstein also has a post (here) on his Ideoblog that is critical of the New York Times’ article about PIPE mentioned above.

Options Backdating Litigation Update: The D & O Diary’s list of options backdating lawsuits (here) has been updated to add the new securities fraud lawsuit that has been filed against Apple Computer (here) and certain of its directors and officers alleging misrepresentations and omissions in its SEC filings and proxy statements about the company’s alleged stock options practices. The addition of the Apple lawsuit brings to 15 the total number of companies sued in purported class action securities fraud lawsuits alleging options timing manipulations.

 

The D & O Diary’s list of options backdating litigation (here) has been updated to include the action (here) filed on August 23, 2006 against Zoran Corporation and ten of its past or present directors and officers. The Zoran complaint presents an interesting variation in the options backdating litigation, because it focuses on allegedly improper or misleading solicitation of shareholder proxies and consent. The complaint alleges that between July 1998 and September 2001, senior Zoran executives were granted unlawfully backdated stock options at the expense of Zoran shareholders, in violation of GAAP and the Internal Revenue Code. The complaint alleges that the defendants’ grant of the backdated options and subsequent solicitation of shareholder proxies, consent or authorization violated the Exchange Act.

The complaint is filed on behalf of a purported class of shareholders who received Zoran proxy statements between April 30, 1999 and May 1, 2006. The class period covers this longer period even though the allegedly improper grants took place between 1998 and 2001 because each of the allegedly improper grants were for a term of ten years, so the first date at which the grants expire has not yet occurred, while the Company has continued to issue proxy statements allegedly containing misleading information about the grants.

Under Section 14 of the Securities Exchange Act of 1934 and its corresponding rules, whenever shareholders must approve a compensation plan, the issuer must accurately disclose the material elements of the proposed plan. With respect to stock options, the compensation disclosure must include the grant date, the exercise price, and grant and exercise tax consequences for the issuer and the recipient. If the issue is soliciting proxies in connection with the grant of stock options having a below-market exercise price, the issuer must disclose the option exercise price and the market price on the grant date, as well as the value of the options at the market price on the grant date.

If the company does not apply the proper tax treatment for below market options grants, the proxy disclosures may inaccurately reflect the tax consequences for grant and exercise. Because the difference between the grant and market prices for backdated options represents income to the recipient, the recipient must pay tax and withholding on the difference. The issuer could be liable for income and FICA tax it failed to withhold upon exercise, as well as interest and penalties. In addition, because the difference between the exercise price and the market price represents compensation, it counts toward the $1 million maximum for each executive’s compensation deductibility under Internal Revenue Code Section 162(m). If the issuer did not allow for this compensation in connection with deduction for the executive’s compensation, the issuer could owe additional taxes, interest and penalties.

Even if we assume that the plaintiffs’ allegations are true, the value of the remedies the Zoran plaintiffs’ seek is uncertain. The complaint seeks to void the election of directors based on the allegedly improper proxies, which seems like a perhaps principled but not very financially valuable remedy at this late date (unless you assume for the sake of discussion that shareholders are better off without any of the current directors involved with Zoran in any way). The complaint also seeks unspecified damages. Whether the plaintiffs can demonstrate damages that are not simply speculative or fraught with causation questions seems debatable, at best.

Bruce Vanyo and Michael Weisman of the Katten Muchin Rosenman firm have written an interesting paper entitled "Backdating Stock Options: An Overview" (here) that examines these proxy solicitation and income tax issues, as well as other legal issues surrounding option backdating, in much greater depth.

Special thanks to Adam Savett of the Lies, Damned Lies blog for the link to the Vanyo paper.

The Securities Litigation Watch blog is also maintaining a list of securities class action lawsuits relating to options backdating, which may be found here.

The Fugitive: Kobi Alexander, Photobucket - Video and Image Hosting the former CEO of Comverse Technology and a fugitive from criminal allegations filed against him in connection with the options backdating investigation at the company, has been found in Sri Lanka, according to news reports. An intersting legal commentary on the prospects for Alexander’s extradition from Sri Lanka can be found on the White Collar Crime prof blog, here. A more entertaining discussion of Alexander’s choice of Sri Lanka as his hideout appears on the DealBreaker.com blog, here. The DealBreaker.com also had an earlier, amusing discussion (here) of the issues a fugitive faces in attempting to flee overseas.

Now This: While many astronomers (and bloggers) still hope for signs of intelligent life on planet Earth, signs of another sort abound (here). Caution: Viewer discretion advised, may not be appropriate for all audiences.

 

Earlier in the summer, it was a seemingly daily occurrence for one or more public companies to announce that they were launching internal probes of their options practices. (These announcements were accompanied, and no doubt encouraged, by numerous simultaneous announcements of SEC probes, U.S. Attorney’s subpoenas, and the like.) Now as the summer has, alas, started to wane, the wave of new investigation announcements seems to have been replaced by a growing number of companies’ announcements that they have completed their internal investigations and found no evidence of options fraud or timing manipulations.

Just in the last week, Intuit, Xilink, Equinix and Redback have each announced that they have completed internal investigations without finding intentional or fraudulent misconduct. The companies also announced that they have so advised governmental authorities. Several of these companies did announce that they were taking accounting charges, without restating, because their probes had found that some options were dated earlier than the actual grant date, due to administrative or processing delays.

In addition, on August 21, 2006, the Corporate Library announced (here) the results of a study of the stock options granted over the past decade by a dozen financial institutions. The study looked at stock option awards to executives at the nation’s five largest banks, and at several other financial companies that made use of options. The study found no evidence of backdating of options issued to the executives at the institutions whose options were analyzed.

The AAO Weblog has an interesting August 21, 2006 post about Intuit’s announcement, including a discussion of the factors that will affect how long these kinds of internal investigations are likely to take to complete.

Milberg Weiss Indictment Fall Out Continues: The WSJ Law Blog has an August 21, 2006 post reporting that four more partners have left the Milberg Weiss firm. At this rate, it may wind to be a moot point whether or not the prosecutors actually prove their allegations against the firm. In the meantime, Saxena and White, formed of attorneys from Milberg’s Boca Raton office (including Chris Jones, the author of the PSLRA Nugget blog), has surfaced with an announcement of the filing of a securities class action complaint, as discussed here in the Lies, Damned Lies blog.

As The D & O Diary has previously noted (here and here), it is hard to say what the final consequential effect of the Milberg Weiss indictment will be, but the firm’s slow dissolution and the setting up of competitor (successor) firms will each have their own impact, as will the perhaps opportunistic attraction to the securities litigation arena of plaintiffs’ firms best known for their prominence in asbestos and tobacco litigation.

Freddie Mac Settles ERISA Lawsuit: Freddie Mac announced (here) on August 21, 2006 that it had agreed to pay $4.65 million to settle a class-action lawsuit that had been brought under ERISA following the company’s restatement of financial results for the years 2000 through 2002. The company had been accused of overstating its earnings, inflating the value of its shares. Some of the allegely inflated stock was held in employee retirement plans. The company announced that the settlement was fully covered by insurance.

 

Along with the burgeoning growth of the hedge fund industry has come the increasing importance and influence of activist hedge funds. This activism has taken a variety of forms, from public pressure on portfolio companies to change business strategy, to the running of a proxy contest to gain seats on the boards of directors of portfolio companies, to litigation against present or former managers.

This increase in hedge fund activism has attracted sharp criticism. Martin Lipton of the Wachtell Lipton law firm lists "attacks by activist hedge funds" as the number one key issue for directors. He has issued a series of client memos (here, here, and here) advising companies how to prepare to fend off hedge fund attacks. He characterizes the activist hedge funds as "self-seeking, short-term speculators looking for a quick profit at the expense of the company and its long-term value." Lipton has been a vociferous advocate for greater regulatory supervision of hedge funds.

A July 2006 research paper (here) written by New York University law professor Marcel Kahan and University of Pennsylvania law professor Edward Rock, entitled "Hedge Funds in Corporate Governance and Control," takes a comprehensive look at hedge funds’ impact on corporate governance. The article is replete with specific, heavily-footnoted examples of activist hedge funds’ corporate governance activities. In general, the authors regard activist hedge funds’ role in corporate governance as positive, and one that hedge funds are favorable position to play because of their investment approach and freedom from regulatory oversight. One particularly colorful example the authors examine involves Third Point LLC’s criticism of Star Gas’s CEO Irik Sevin, to whom Third Point wrote:

It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites….We wonder under what theory of corporate governance does one’s mom sit on a Company board. Should you be found derelict in the performance of your executives duties, as we believe is the case, we do not believe your mom is the right person to fire you from your job.

Bowing to Third Point’s pressure, Sevin resigned one month later.

While the authors contend that hedge funds have unique incentives and advantages that better position them (compared to other institutional investors) to address corporate governance issues, they do acknowledge that activist hedge funds’ actions can raise certain concerns. First, hedge funds’ interests can diverge from those of fellow shareholders, as, for example when a hedge fund is a potential buyer of a company in which it has a stake. Second, with billions of dollars of assets, hedge funds put stress on existing corporate governance structures, as, for example, when loose hedge-fund coalitions target a shareholder vote. The authors acknowledge these concerns, but find them no worse than concerns surrounding other institutional investors, and argue that these concerns are not sufficient to justify greater hedge fund regulation.

The most serious criticism of hedge fund activism, the one Marty Lipton raised, is that hedge funds exacerbate short-termism. The authors argue that the market will enforce adaptive approaches to deal with the potential negative effects of hedge fund short-termism. The authors cite Lipton’s own "Hedge Fund Attack Response Checklist" as an example of just such an adaptive device, about which the authors state:

[Lipton’s suggestions] are terrific ideas, not just to deal with activist hedge funds but in general. If companies follow Lipton’s advice, hedge funds will have already made significant positive contributions to the management of U.S. companies. Moreover, if hedge funds can succeed despite companies taking these measures, we think chances are reasonably high that they have a good point.

The authors’ conclusion is that "market forces and adaptive devices take by companies individually in response to activism are better designed to help separate good ideas from bad ones than additional regulation."

The increasing influence of activist hedge funds has important implications for D & O risk. Specifically, activist hedge funds’ corporate governance activities can involve litigation, including litigation directed against directors and officers. A prominent recent example is Cardinal Value Equity Funds’ litigation campaign involving Hollinger International and allegations of Conrad Black’s self-dealing and other transactions, which culminated in a derivative lawsuit for breach of fiduciary duty against Hollinger’s board of directors. After an independent Board committee investigation, Cardinal negotiated a $50 million settlement with the directors not directly implicated in the self-dealing. The settlement was funded by Hollinger’s D & O insurers. (Hollinger’s press release may be found here. )

Hedge funds have even sought appointment as lead plaintiffs in securities fraud lawsuits. Indeed hedge funds often are the investors with the largest losses, but because they often engage in short-selling, they may be subject to unique "reliance" issues and therefore many not be "adequate" class representatives. For that reason, courts have often, though not uniformly, rejected the appointment of hedge funds as lead plaintiffs.

But because activist hedge funds view litigation as an essential part of their activist strategy, the role of hedge funds as "the prime corporate governance and control activists" has very important implications for D & O risk. While hedge funds’ activism potentially could contribute to improved corporate governance, the willingness of hedge funds to achieve their goals through litigation against directors and officers represents a dangerous variation of D & O exposure. Marty Lipton may not have been far off the mark when he described the threat of activist hedge funds as the most important issue for corporate officials.

 

In an August 15, 2006 speech entitled “How to be an Effective Board Member” (here), SEC Commissioner Roel Campos made a number of interesting comments about the potential liability of corporate board members, and for that reason the entire speech merits reading. Of particular interest to The D & O Diary are Commissioner Campos’ remarks about the options backdating cases:

Finally, let me discuss briefly stock option backdating cases. So far, the SEC has brought two cases, against Brocade and Comverse, and we’re likely to bring more in the future. As yet, we have charged only officers in option backdating cases. However, if the facts permit — and I want to emphasize that all of our Enforcement cases are very fact specific — it wouldn’t surprise me to see charges brought against outside directors.

I also think that the backdating cases can provide a few lessons in terms of “do’s and don’ts” for directors. In my opinion, the two big “don’ts” are: (1) don’t use “as of” dates unless you have carefully thought about the consequences and have explicit approval from legal counsel that it is acceptable to use an “as of” date; and (2) don’t assign critical board functions to “committees of one,” unless you’re extremely careful to adopt procedures to ensure that there are appropriate checks and balances in place. In terms of “do’s”, let me highlight one: do pay attention to procedures and processes — such as properly signing and dating Actions by Unanimous Written Consent — because simple logistics can get you into trouble.

The D & O Diary finds a couple of points of interest in these remarks. First, the Commissioner is discrete about the possibility that outside directors might face exposure to SEC enforcement actions in connection with options backdating, saying only that he wouldn’t be surprised if it happened, but The D & O Diary reads that to mean that it probably will happen. Indeed, the Commissioner seems to overlook that “Wells notices” already have been served on three outside directors of Mercury Interactive. (A prior D & O Diary post discussing the Mercury Interactive Wells notices may be found here.)

Second, the Commissioner may not have anything in particular in mind in his reference to the Committee of One, but The D & O Diary believes that this could be a reference to the situation at Brocade Communication, where Silicon Valley legal giant Larry Sonsini, who was an outside director of Brocade, for a time allegedly operated as a Brocade board compensation committee of one. A prior D & O Diary post commenting on the circumstances at Brocade may be found here. A WSJ Lawblog post commenting on Sonsini’s service as a committe of one may be found here. The Commissioner’s further remarks with respect to Committees of One are interesting in light of the situation at Brocade:

I think my advice to “don’t assign critical decisions to committees of one” is fairly self-explanatory, but apparently it’s advice that’s also been ignored. Again, I’m not suggesting that committees of one are per se wrong — Delaware law permits it, after all. However, at best, it’s far from being a “best practice” in good corporate governance. And at worst, it’s a signal to the company’s officers that directors are not taking their obligations as a director seriously and are willing to let expediency guide their decision-making.

Comment on ABA’s Thompson Memo Resolution: In a prior post, The D & O Diary commented on the American Bar Association’s recent resolution calling for revision of policies embodied the Thompson Memo. An August 14, 2006 post in the SEC Actions blog has the following interesting comment on the ABA’s action:

In view of the continued actions by the government that are eroding fundamental rights in the name of effective law enforcement, the ABA positions represent a good start, yet more is necessary. What is needed here is a recognition by the government – both DOJ and the SEC – that it cannot effectively enforce the law by eroding it. In fact, eroding fundamental rights disrespects the law. Rather, both DOJ and the SEC need to reform their standards for evaluating cooperation to focus on what they need: the basic facts involved and reasonable assurances that the questionable activity has been halted and will not reoccur. If good prosecutors are satisfied on these points they should have what they need in most cases to evaluate cooperation and make whatever prosecutorial decisions are necessary without eroding fundamental rights of the company and its employees.

The D & O Diary couldn’t agree more.